Republic of Kosovo: 2021 Article IV Consultation-Press Release and Staff Report
Author: International Monetary Fund. European Dept.
Publication Date:
12 Jan 2022
eISBN:
9781616359577
ISBN:
9781616359577
Language:
English
Keywords:
IMF staff estimate; growth projection; reserve adequacy; IMF definition; vaccination ratio
Download PDF (12.4 MB)

1. A decline in the number of new COVID-19 cases and increased vaccination rates have allowed a relaxation of stringency measures and supported mobility, which has returned to more normal levels:

Abstract

1. A decline in the number of new COVID-19 cases and increased vaccination rates have allowed a relaxation of stringency measures and supported mobility, which has returned to more normal levels:

Context: Mobility Normalization, Extraordinary Diaspora Support and Improved Expectations, the Keys of the Recovery

1. A decline in the number of new COVID-19 cases and increased vaccination rates have allowed a relaxation of stringency measures and supported mobility, which has returned to more normal levels:

  • Except for a sudden surge and equally rapid decrease in August-September 2021, the number of new cases has remained low since May.

  • The government has already secured vaccines to cover 70 percent of the population through COVAX, bilateral donations and budgetary purchases; and has allocated funds in the 2022 budget to procure additional vaccines for booster shots and to further expand coverage. After a sluggish start, the pace of vaccinations accelerated in mid-2021, and as a result, Kosovo’s vaccination ratio is now among the highest of the Western Balkans.

  • While mobility has largely normalized, some restrictions remain in place, including on the number of people allowed in gatherings, and the hours of operation of restaurants and other establishments. For indoor activities, vaccination certificates are required.

uA001fig01

Kosovo: COVID-19 New Cases and Deaths

(7-day moving average)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: Johns Hopkins Center for Systems Science and Engineering, COVID-19 Database.
uA001fig02

Fully Vaccinated Population

(Percent of total population )

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: Our World in Data.
uA001fig03

Number of Tourists from Abroad

(2019 = 100, cumulated flows through August)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: Haver Analytics; and IMF staff calculation.

2. A more stable political environment provides an opportunity to effectively contain the health crisis and revitalize the reform process. Following a number of short-lived and caretaker administrations over 2019–20, the government that took office in March 2021 has a clear majority in Parliament. This provides a window to focus on combating the pandemic and passing critical legislation.

3. After contracting 5.3 percent in 2020, GDP is projected to have rebounded by 7.5 percent in 2021 on renewed mobility and extraordinary support from the diaspora. Diaspora inflows (remittances, tourism, compensation of seasonal migrants, and real estate investment) averaged 37.5 percent of GDP in 2018–19, plummeted to 31 percent in 2020, but overshot their pre-pandemic level in 2021, reaching about 43 percent of GDP. In particular, the number of visitors from abroad surpassed by a large margin its pre-pandemic level of 2019, making Kosovo a unique case in Europe. Moreover, renewed mobility and political stabilization have improved expectations about the future and strengthened confidence, further supporting demand (Box 1).

uA001fig04

Diaspora Flows

(Percent of GDP)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: CBK; and IMF staff calculations.

Increase of 2021 Fiscal Revenues

(Percent of GDP)

article image
Sources: Kosovo Ministry of Finance; and IMF staff calculations.
uA001fig05

Private Sector Credit Growth

(Percent change, year-on-year)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: CBK; and IMF staff calculations.

Mitigation and Recovery Measures 2020–2021

(Euro million)

article image
Sources: Kosovo Ministry of Finance; and IMF staff calculations.

4. The contribution of policies to economic activity in 2021 has been mixed:

  • The fiscal policy stance tightened. A strong recovery in fiscal revenues together with broadly unchanged levels of nominal spending are projected to have brought the fiscal position to a small deficit of 0.4 percent of GDP in 2021, compared to 7.9 percent of GDP in 2020. The increase of fiscal revenues (of about 4 pp of GDP, excluding grants) was explained by the cyclical recovery, formalization gains, excise tax increases, one-off dividends from Public-owned Enterprises (POEs), and the effect of the diaspora travel overshoot on taxes tracking consumption. In turn, the expenditure-to-GDP ratio declined on the back of double-digit nominal GDP growth (of 10.7 percent) and low absorption of the investment budget, in part due to the absence of a functioning Board at the Procurement Review Body (PRB) since March 2021, and a reassessment of priorities by the new government.

  • Financial policies allowed credit to keep flowing. Regulatory forbearance measures in early 2021, improved expectations, and strong diaspora inflows supported credit growth, which after some deceleration in 2020, picked up in 2021, in particular to households.1

5. Mitigation and recovery budgetary programs adequately targeted those most affected by the pandemic. The 2021 Economic Revival Program (ERP-21) extended most of 2020’s measures (including lifelines for households and firms, the expansion of healthcare capacity, and wage bonuses for essential workers), but it also added new measures, such as employment support, child and maternity allowances, support for POEs to improve their management and operation, and a blanket reserve for additional capital expenditures. While the execution of the current expenditure components of the ERP-21 has been in line with expectations, investment absorption has been low.

uA001fig06

Contributions to Inflation

(Percent increase, y/y)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: KAS; and IMF Staff calculations.
uA001fig07

International Price Movements

(2019=100)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: EIA: FAO: KAS: and IMF staff calculations.

6. Inflation in 2021 is projected to have increased to more than 5 percent on higher energy and food prices. Base effects explained most of the increase as energy and food prices rebounded to pre-pandemic levels. A one-off increase in communication tariffs also played a role. Although households have so far remained insulated from the increase of electricity prices in Europe, a few firms in the export-oriented mining sector have been severely affected.2 Core inflation has remained low, but it has begun to creep up in 2021:H2. In turn, nominal wages recovered by 6 percent (y/y) through October 2021 after contracting 4 percent in 2020.

7. The size of the current account deficit (CAD) in 2021 remained similar to that in 2020. The CAD is projected to have reached 7 percent of GDP, as the expansion in the value of imports and other debits was offset by the recovery in exports of goods and services and remittances. Non-traditional exports (mainly furniture) expanded briskly, though from a low base, while traditional nickel exports suffered in 2021:H2 due to the higher European electricity prices. The CAD was financed by increased unofficial diaspora inflows, reflected in larger errors and omissions of about 2.5 percentage points (pp) of GDP, and by stronger FDI. Rebuilt fiscal buffers and the new SDR allocation led to stronger Central Bank of Kosovo (CBK) international reserves, whose size is assessed to be adequate using the IMF’s reserve adequacy (RA) metrics. In turn, the results of the EBA-lite methodology suggest that the external position in 2021 is projected to be moderately weaker than implied by medium-term fundamentals and desirable policy settings (Annex III).

The Outlook: Growth to Normalize in 2022 AMID Still-High Uncertainty

8. Absent negative pandemic-related surprises, real GDP growth is expected to slow to a more normal pace in 2022. While activity will be buoyed by 2021’s economic momentum, staff’s GDP growth projection of 3.8 percent is based on the following assumptions: (i) no strict lockdowns and an increase in vaccination rates to at least 70 percent of the population; (ii) a return of diaspora inflows to their pre-pandemic norm after their overshoot in 2021; (iii) a fiscal impulse of at least 2 pp of GDP; and (iv) continued expansion in net bank credit to the private sector. Inflation (y/y) is projected to remain high in 2022:H1, but to decelerate thereafter to 2.5 percent by end-2022 as base effects disappear. The CAD is projected to narrow slightly to 6.5 percent of GDP as pent-up consumption demand peters out.

9. Pandemic-induced long-term scarring is now projected to be lower than originally envisaged. Diaspora inflows have proved to be more resilient than expected, helping sustain contact-intensive activities. Accordingly, the output loss compared to the pre-crisis trend is now expected at about 3.3 percent in 2025, i.e., ½ of that projected in the 2020 Article IV Consultation. A smaller medium-term output loss remains as on-and-off implementation of stringency measures is expected to still limit somewhat contact intensive activities, while factor reallocation will be gradual given institutional, human capital and infrastructure gaps.

uA001fig08

Headline and Potential GDP

(Millions of chained 2016 Euros)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: KAS; and IMF staff calculations.

10. While lower than in early 2021, uncertainty remains high, and downside risks are prevalent (Annex I). New virus variants may lead to a surge in cases, disrupting economic activity and setting growth back, especially if they affect the strongly seasonal diaspora travel. High regional electricity prices can negatively affect traditional nickel exports by 1 – 2 pp of GDP in 2022. Budget implementation could suffer if PRB normalization takes longer than expected, and the quality of public expenditure composition may deteriorate if the new law on public wages leads to generalized wage hikes. In turn, inflation can be higher than expected if imported inflation proves to be persistent and domestic electricity tariffs are increased. On the upside, the increase in diaspora inflows observed in 2021 may prove to be more permanent than envisaged by staff, and lead to stronger activity.

Authorities Views

11. While the authorities were more optimistic about the strength of the economic upswing, they agreed with staff that the pandemic continues to represent the main downside risk. They agreed that increased mobility played a key role in the recovery and emphasized that good progress in vaccinations allowed the return of diaspora travel. They noted that they projected real GDP growth to reach about 10 and 8 percent in 2021 and 2022 respectively, due to the positive effect of policies, a continuation of strong diaspora inflows, higher public and private investment, and continued growth in non-traditional exports. They argued that an ambitious program of government actions will play a catalytic role in expanding economic activity and lead to real GDP growth of more than 7 percent per year in 2022–24. They concurred with staff that the pandemic remains the main downside risk but emphasized that the continuation of the vaccination program should mitigate it. The authorities also agreed with staff that inflation will remain persistently high in 2022:H1, but that it will gradually ease thereafter.

Policy Discussions: Pivoting from Emergency Response to Structural Transformation

A. Fiscal Policy: Backstopping the Recovery While Shifting Expenditure Composition to Support Growth and Resilience

12. Fiscal policy needs to return to a more supportive stance in 2022. Staff pointed out that the projected softening of diaspora inflows will result in lower fiscal revenues of around 0.8 pp of GDP; this, together with an increase in expenditures of about 1 – 1.5 pp of GDP, mainly for investment projects, will provide a fiscal impulse of around 2 pp of GDP that would help sustain the recovery by cushioning the projected softening of external inflows, while keeping the deficit within the fiscal rule limits. 3

uA001fig09

Public Wage Bill, and Subsidies and Transfers

(Percent of GDP)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: KAS; and IMF staff calculations.Note: The jump in 2020 includes extra-payment to frontline workers.

13. The transparency, focus, and composition of public spending should be strengthened, including to support economic resilience. In this regard, staff emphasized that,

  • The intended policy actions under the Economic Revival Program for 2022 (ERP-22) could be better defined. A blanket allocation for this program in the budget for 2022 together with other contingency reserves amount to about 2 percent of GDP.4 Staff agreed that a contingency reserve to address pandemic-related downside risks is appropriate but urged the authorities to broadly define the ERP-22’s intended policy actions and beneficiaries.

  • The wage bill needs to remain within its legal ceiling. While the budget for 2022 does not envisage across the board wage hikes, the new draft law regulating public wages is expected to be discussed by Parliament in 2022:H1. Staff argued that the new law should strengthen transparency and compensation fairness but be based on wage coefficients that do not unsustainably increase the total wage bill.

  • New social transfer programs need to be more targeted, and the growth of existing transfers contained. The budget for 2022 envisages new child and maternity allowances of 0.6 percent of GDP. Staff argued that while there is fiscal space to expand the coverage of households benefitting from social transfers, these transfers need to be targeted to low-income, vulnerable, households. In addition, staff emphasized that the certification of war veterans should be finalized, and that the budgetary envelope for their benefits needs to be insulated from the expected increase in minimum wages.

  • Public investment should be geared at increasing economic resilience. The combined share of investment envisaged for education and health in the budget for 2022 represents only about 11 percent of the total (0.6 percent of GDP). Staff argued that a modest investment reallocation (e.g., from defense to social infrastructure) can help expand the health system’s capacity and the access to computers for households and schools. This would help Kosovo cope with a renewed spike of cases without resorting to costly stringency measures and would limit the damage to education if virtual learning needs to be reinstated.

uA001fig10

Nominal Wage and Value Added

(2012 = 100)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: KAS; and IMF staff calculations.

14. Continued fiscal contingency planning is essential in the face of still-high uncertainty. If the pandemic surprises on the downside, staff underscored that the fiscal deficit can be allowed to increase beyond the fiscal rule ceiling. While replenished fiscal buffers and the new SDR allocation would constitute the first line of defense to a decline in fiscal revenues, staff noted that to further mitigate this risk the authorities could anticipate public debt placements and explore contingent bilateral and multilateral financing. These actions would add to the implementation of further mitigation programs on the expenditure side, which should be financed by the contingency reserves already in the 2022 budget. Staff noted that other fiscal risks include the ongoing revision of the law on salaries (which can add 1 pp of GDP to the wage bill) and an increase in war veteran benefits, which continue to breach their 0.7 percent of GDP legal ceiling. Given the upbeat GDP growth and revenue projections in the budget for 2022, staff argued that preparing an alternative scenario based on, for example, the more conservative consensus growth forecast, can help the authorities identify potential financing needs as well as expenditure programs that need containing. On the upside, staff acknowledged that the fiscal revenue base may be higher if the overshoot in diaspora inflows of 2021 proves to be permanent; and that an allocation for expropriations in the budget for 2022 (of 0.7 percent of GDP) can facilitate the absorption of donor-financed investment projects.5

15. The authorities’ commitment to stick to the fiscal rule as the guide for policy in the medium-term is appropriate. While the authorities’ plan is to reinstate the fiscal rule in 2023, staff expect its de-facto reinstatement already in 2022 based on investment implementation projections that consider the historical track record. The use of the fiscal rule as a guide for policy will anchor public debt below the 40 percent of GDP legal ceiling through the medium-term (Annex II). Staff also discussed other medium-term fiscal priorities. In this regard,

  • Staff urged to continue efforts to expand the tax base. Numerous exemptions and special regimes weaken the tax base, and the implementation of the FTA with Turkey and the EU Stabilization and Association Agreement (SAA) will reduce customs revenues by 1 pp of GDP through 2026. Staff argued that rationalizing exemptions and increasing excise taxes, including on coal, could raise 0.5 – 1 pp of GDP to offset customs revenue losses. Staff welcomed efforts to improve tax administration and encouraged the authorities to intensify tax debt collections. Moreover, staff emphasized the importance of measuring and publishing tax expenditures as an annex to each year’s budget.

  • Staff welcomed progress on e-procurement and urged to further strengthen fiscal transparency. The e-procurement system covers 100 percent of expenditures since early 2020, and all procurement stages, including bids, since August 2021. Moreover, the auditor general’s report of the 2020 budget concluded that most budget organizations provided the necessary data to analyze pandemic-related spending.6 To further strengthen transparency and avoid conflicts of interest, staff encouraged the authorities to finalize the new law on beneficial ownership transparency that will lead to the creation and publication of the Beneficial Ownership Transparency Registry.

  • Staff emphasized the need to improve spending efficiency and to use the windfall provided by the diaspora to close infrastructure gaps and diversify growth engines. Staff noted that many of the initiatives in the “Program of the Government of Kosovo 2021–25” are likely to result in recurrent social benefits and other transfers (Box 2). While acknowledging that supporting social cohesion is essential, staff called for a more balanced approach. In this regard, staff argued that reallocating expenditures to improve and expand social infrastructure in education and health will support human capital formation and ease labor reallocation, which together with expanded and greener physical infrastructure, including on energy generation, can increase the attractiveness of Kosovo as an FDI destination.

  • While the government’s balance sheet strengthened significantly in 2021, staff encouraged the authorities to expand the investor base of government debt. The replenished fiscal buffers (estimated to have reached 5.5 percent of GDP at end-2021) and the projected absence of a financing gap provide an opportunity to initiate the process to obtain a rating for Kosovo’s government securities. This action would help expand the size and liquidity of the domestic public debt market, which remains thin and may reach its satiation point in 3–5 years (Appendix II).

uA001fig11

Public Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: Kosovo Ministry of Finance; and IMF staff calculations.
uA001fig12

Domestic Government Debt Demand and Supply

(Percent of GDP)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: IMF staff calculations.Note: Domestic debt excludes the scheduled reimbursement from the government to the KP5T on replenishing the pension saving.

Authorities Views

16. While the authorities concurred with most of staff’s recommendations, they emphasized that they expect government policies to jumpstart a virtuous circle of higher growth and stronger fiscal revenues. They agreed on the positive role played by ERP-21 implementation and indicated that the under-execution of the investment program in 2021 reflected investment reprioritization following national and local elections. The authorities highlighted that budget execution will be more supportive of activity in 2022 and clarified that measures linked with ERP-22 will be finalized as the areas that need additional support become clearer. On social transfers, they acknowledged staff’s concern about targeting, but emphasized that the cost of new schemes will not be high. They agreed on the importance of public investment in education and health and highlighted that the budget for 2022 includes an allocation to build new kindergartens that will help close pre-school education gaps. On fiscal risks, the authorities reassured staff that war veteran benefits will be decoupled from minimum wage increases and that the drafting of the new law on salaries will consider the impact on the wage bill. While acknowledging that growth projections in the budget for 2022 are stronger than consensus, they were confident that planned government policies will preserve economic momentum and help sustain a trend of high growth rates initiated in 2021, contributing to maintain the strong fiscal revenue performance. On medium-term priorities, they agreed that the tax base should be expanded and pointed out that technical work on tax policy changes and on measuring tax expenditures is ongoing. The authorities acknowledged that the market for government securities remains thin and that they are considering the various options highlighted by staff to expand its depth.

B. Financial Policies: Unwinding Emergency Support While Strengthening Credit Monitoring

17. Kosovo’s financial sector continues to be resilient overall, but pockets of vulnerabilities remain. Credit to the private sector is dominated by banks, with microfinance institutions (MFIs) mainly focused on short-term financing to micro and small-sized businesses (MSBs).

  • Banks’ aggregate performance has been robust throughout the pandemic. This positive outcome was predicated on strong pre-pandemic capital and liquidity buffers, appropriate CBK policies, and the stronger-than-expected economic rebound. However, a few smaller banks remain vulnerable. These banks have experienced fast lending, in particular to the construction sector, but have lower-than-average capital buffers and provisions.

  • After a contraction in both lending and profitability in 2020, MFIs performance improved in 2021. The main risks facing the sector stem from their client base (mainly small businesses, which have generally been more affected by the pandemic) and their reliance on external loans for funding.

18. Given the more normal economic conditions, the CBK’s decision to gradually unwind its pandemic-related support measures in 2021 was warranted. Staff noted that NPLs in 2020–21 increased marginally vis-à-vis their pre-pandemic level of 2019, even as regulatory forbearance measures expired.7 Despite this limited aggregate increase, staff recommended to strengthen credit risk monitoring to ensure that bank-by-bank provisioning reflects the underlying change in asset quality, and that capital buffers are sufficient to absorb write-downs and keep the flow of credit. Staff pointed out that, if needed, the CBK should agree on action plans with affected banks to restore their financial health with some flexibility on the timeframe. For more resilient banks, the CBK can consider a gradual resumption of dividend payments, after assessing their capital trajectory in a forward-looking setting. In this regard, staff emphasized that the CBK should continue to develop its capacity to evaluate the expected credit loss (ECL) frameworks of regulated entities in the context of IFRS-9 implementation.

19. Implementing the recommendations of the 2019 Financial Sector Stability Review (FSSR) and those of the 2020 Safeguards’ Assessment (SA) is essential. Staff welcomed Parliament’s decision to fill vacancies at the CBK Board in November 2021 but noted that the long delay to take this action (of around 18 months) prevented the CBK to adopt its budget and implement needed reforms. As Board operation resumes, staff urged the authorities to accelerate the implementation of FSSR and SA recommendations, including to ensure that the financial stability function reports directly to the Executive Board; that the CBK’s governance is reviewed to assess the effectiveness of decision-making bodies and the appropriateness of membership in key committees; and that the audit and risk committees are strengthened, including through expanding their scope to the oversight of financial reporting and risk management activities (Annex IV).

20. Given the comfortable level of fiscal buffers, the new SDR allocation can be used to strengthen the CBK’s ability to provide liquidity support to banks. While Kosovo’s banks generally maintain high liquidity ratios, the size of the CBK’s Emergency Liquidity Assistance (ELA) window (€92 million), and that of repo and overnight liquidity facilities (€100 million) are insufficient to respond to systemic events of even a modest magnitude. Staff argued that the SDR allocation can be kept available to finance pandemic-related budget expenditures should downside risks materialize in the near term, but that they should add to the CBK’s bank lending facilities in the medium-term. This is important as foreign reserves are likely to fall below 100 percent of the IMF RA metric in the medium term (Annex III).8

Authorities Views

21. The authorities agreed with staff about the banking sector’s strength and on the positive role that policies played to mitigate the pandemic’s impact on financial stability. They concurred with staff that losses after lifting supervisory relief measures will be limited and that banks have sufficient capital buffers to absorb them. The authorities added that they did not foresee the adoption or further extension of relief measures, unless downside risks materialize, and that they will return to the standard practice of engaging with banks on a case-by-case basis to decide on dividend payment approvals. The CBK acknowledged staff’s concern about risks stemming from certain smaller banks, and emphasized that they will continue to monitor developments closely. On MFIs, the CBK agreed that MSBs in contact-intensive sectors were the most affected by the pandemic, but reassured staff that external donor support to MFIs remains stable. The authorities agreed that delays to fill Board vacancies slowed down the adoption of FSSR and SA recomendations, but committed to accelerate their implementation going forward. On the use of the SDR allocation, they concurred with staff to keep it available for contingent budget financing in the short-term, but to use it to strengthen the CBK’s ability to lend to banks in the medium-term.

C. Structural Policies: Diversifying Growth Engines to Accelerate Income Convergence

22. Gradual improvements in institutions, infrastructure, and the policy framework as well as sustained increases in diaspora inflows have helped Kosovo narrow the pre-pandemic income gap with advanced economies. While staff reiterated many of the recommendations of the 2018 and 2020 Article IV consultations, this year’s discussions focused on structural policies to: (i) gradually diversify Kosovo’s growth engines; (ii) tackle informality; and (iii) create the conditions for greener economic growth.9

uA001fig13

Diaspora Flows and GDP Growth

(PP of GDP)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: CBK; and IMF staff calculations.
uA001fig14

Average Real GDP Growth Rate. 2010–2019

(Percent)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: WEO; and IMF staff calculations.

Diversifying Kosovo’s Growth Engines

23. Kosovo’s growth model relies heavily on the diaspora. While lower COVID-19 cases and higher vaccination rates have enabled the resumption of diaspora travel, its increasing economic role has been facilitated by the improvement of air transport infrastructure, and by the expansion of the hospitality industry (hotels, restaurants, retail, and entertainment). While diaspora inflows have contributed to higher pre-pandemic growth rates than for peers, their upside for long-term economic growth is likely to eventually subside for several reasons: (i) the growth of diaspora inflows is bound to gradually converge down to the growth rate of the advanced host economies where the diaspora resides; (ii) long-term productivity growth in hospitality is slower than in modern manufacturing and high value-added services, and the skills set required from workers is generally lower; (iii) certain hospitality activities are more prone to small firms in the informal sector; and, (iv) the ties between the diaspora and the motherland tend to become more diffuse with the passage of time.

24. Gaps in physical infrastructure, labor force skills, and institutional quality continue to limit the size and composition of FDI flows, leaving diaspora inflows as the main growth engine. Kosovo’s many strengths, including proximity to the EU, a young labor force, relatively low wages, few limits on capital flows, and trade agreements with the EU and other international partners, have not yet led to a diversification of FDI flows, which remain concentrated in real estate, banking, and mining. This severely limits the country’s growth upside and the speed of economic convergence.

25. Diversifying the sources of economic growth and accelerating convergence calls for a better investment environment:

  • Closing the economic infrastructure gap requires improving public investment management, investment composition, and POEs’ performance. While Kosovo has improved road and broadband internet infrastructure, there are areas where progress has been less significant, including on water provision and electricity generation. As privatization revenues decline as a source of public investment financing, improving the composition of public investment and the absorption capacity of donor-financed projects will be essential. In this regard, staff reiterated the importance to advance in the implementation of the IMF’s Public Investment Management Assessment (PIMA) recommendations to increase the efficiency, quality, and growth focus of infrastructure spending (Annex V). Staff pointed out that the “4-year Government Program” can place more emphasis on closing the infrastructure gap. In addition, improving the management and operation of POEs remains essential to increase the quality of public services in communications, water, and electricity provision.

  • Strengthening human capital calls for improving social infrastructure and for the education system to meet the needs of the economy. While public education spending has increased in GDP terms and is now comparable with the EU average, the quality of education still compares unfavorably with peers as reflected in PISA scores that remain the lowest in the Western Balkans. The pandemic has further eroded education quality, as virtual education was constrained by insufficient access to computers by schools and households. Moreover, university enrollment is biased towards social sciences, with natural, applied, and formal sciences attracting considerably less interest. In line with this, firms refer to a skills gap as an obstacle to doing business. Staff emphasized that supporting vocational education, improving teacher preparation, updating curricula, and strengthening the collaboration between higher education and businesses remain priorities. In the near term, improving students’ access to computers is essential to preserve education quality in case virtual learning needs to be reinstated.

uA001fig15

Budgetary Expenditure in Education

(Percent of GDP)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: Eurostat; KAS; OECD; and IMF staff calculations.*/ Most recent data available for Costa Rica is 2017.
uA001fig16

University Students by Fields of Study

(Percent)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: Eurostat; Kosovo authorities; and IMF staff calculations.

Authorities Views

26. The authorities acknowledged the importance of closing infrastructure and skills gaps to attract FDI and diversify Kosovo’s growth engines. They pointed out that they intend to prepare a list of key infrastructure projects and accelerate their implementation in close coordination with donors. They highlighted that the allocation for kindergartens in the budget for 2022 will help close existing gaps in preschool education. On skills mismatches the authorities explained that they are rolling out measures to better align enrollment by major in public universities with expected market demand by firms.

Tackling Kosovo’s Informality

27. Kosovo’s high levels of informality negatively affect competition, working conditions and firm size, limiting economic growth. According to both the World Bank and the EU, Kosovo’s informal sector amounts to over a third of total employment. High informality erodes the tax base limiting funding for education, health, and infrastructure; hampers fair market competition as it places tax complying businesses at a disadvantage; limits firm productivity, size, and economies of scale due to restricted access to finance; and negatively affects labor conditions and social and customer protection.

uA001fig17

Paper-based Payment Transactions

(January to August, percent)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: Central Bank of Kosovo and IMF Staff Calculations.
uA001fig18

Change in Different Economic Categories, 2021

(January to September, compared to the same period in 2019, percent)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: CBK; TAK; and IMF staff calculations.*/ Data refers to change from January to August in 2021 compared to the same period in 2019.

28. Staff contended that the pandemic brought about formalization gains. Government lifelines to businesses promoted employment formalization as the condition to access them included requiring workers to have formal employment contracts of at least 1-year duration. In addition, stringency measures and social distancing forced households and businesses to reduce cash-based transactions and increase digital payments, reducing tax avoidance. Finally, sustained progress in tax administration, supported by IMF technical assistance, continued to reduce tax evasion.

uA001fig19

State of Progress in Rule of Law, 2021

(Scores)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: European Commission, Progress Reports, 2021.Notes: The scores are on a five-point scale: (1) at an early stage, (2) some level of preparation, (3) moderately prepared, (4) good level of preparation, and (5) well advanced.

29. Simplified tax procedures, improved secondary education and enhanced financial inclusion will help sustain and expand recent formalization gains. Simplified tax procedures and enhanced monitoring and enforcement reduce the costs of formalization while increasing those of being informal. In addition, improved quality, and enrollment in secondary education, including technical and vocational training, has been found to be negatively associated to informality. In turn, linking taxes paid to services supplied by the state raises transparency, trust, and awareness about the benefits of formalization. Finally, enhancing financial inclusion and electronic payments make tax avoidance more difficult.

30. In the medium-term, formalization gains will be tied to improving the efficiency of the judicial system and tackling corruption. A high volume of backlog cases has become an obstacle to contract enforcement, increasing the cost of formality, and negatively impacting Kosovo’s business environment and FDI flows. In this regard, staff emphasized that passing the draft Law on Commercial Courts, which among other reforms will increase the number of commercial judges and courts, is critical to improve the efficiency of the justice system.10 In addition, staff urged the authorities to continue strengthening their anti-corruption and rule of law efforts and address remaining deficiencies in the AML/CFT framework (Annex V).

Authorities Views

31. The authorities highlighted that reducing informality is one of their overarching policy priorities. They concurred with staff about the positive effect that policy actions had on formalization gains and highlighted that Kosovo’s tax administration agency (TAK) has been increasingly conducting risk and cluster-based checks and enforcement measures to increase compliance and reduce informality. They agreed on the role of digital payments to promote formalization, and they have proposed to lower the threshold required for electronic payments. They recognized the negative impact of the heavy backlog of cases on the business climate and expect the situation to gradually improve after the Law on Commercial Courts is adopted. The authorities acknowledged the need for steady progress on improving the AML/CFT framework and pointed out that they view the real estate and construction sectors as particularly challenging, given their widespread informality and prevalence of cash payments.

Greening Kosovo’s Economic Growth

32. Lignite-based electricity generation is the main contributor to greenhouse gas (GHG) emissions in Kosovo. While per capita emissions are relatively low due to the small share of manufacturing in GDP, the lignite-based electricity generation is behind the economy’s high carbon intensity as measured by carbon emissions per unit of output. Moreover, the reliance on air-polluting energy generation has had a costly impact on health, in particular in the capital, Pristina. The World Bank assessed the health cost of air pollution at around 2.5–4.7 percent of GDP in 2016.

uA001fig20

C02 Emissions Intensity, 2016

(Kg per 2017 PPP $ GDP)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: World Development Indicators.
uA001fig21

Greenhouse Gas Emmissions in Kosovo, 2013

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: Ministry of Environment and Spatial Planning, 2018.

33. Kosovo’s intention to reduce carbon emissions is commendable, and staff urged the authorities to turn plans into action. Staff noted that Kosovo’s “Climate Change Strategy (2018–27)” and “Climate Change Action Plan (2019–21)” appropriately set emission mitigation objectives but lack a clear roadmap for reduction targets and supportive measures. Staff emphasized that a credible climate and environment mitigation strategy should be centered around carbon pricing, while allocating its proceeds to investment in green projects and to mitigate the impact of higher energy prices on vulnerable households. Moreover, staff added that revenue-neutral policies (such as feebates) can be applied at the sectoral level. In the near term, staff urged the authorities to make progress in the installation of filters in “Kosovo B” (the largest lignite-based energy generation plant) in collaboration with the EU.

Authorities Views

34. The authorities agreed on the need to reduce GHG emissions and environmental pollution. They noted that progress has been made in improving the energy efficiency of municipal buildings. They emphasized that many legislative initiatives on climate, energy and air pollution were delayed due to the pandemic but that, as the emergency is left behind, they intend to resume work on a draft law on climate change. They concurred with staff that the decarbonization strategy would need to be in line with their strategic investment program on energy generation. Finally, the authorities agreed on the need to swiftly begin the work to install filters on “Kosovo B”, but since this will require temporarily shutting down the plant, they are discussing with the EU on the right phasing of works.

Staff Appraisal

35. Kosovo’s people and its economy experienced a return to a certain degree of normality in 2021. Increased vaccination rates allowed a relaxation of stringency measures, supported mobility, and created the conditions for a resumption of diaspora travel. While the health system continued to cope reasonably well, still-binding supply constraints are a reminder of the need to expand the sector’s capacity more decisively. Though uncertainty appears to have subsided with respect to 12 months ago, it remains high.

36. The fiscal response to the pandemic has been broadly adequate. The use of lifelines for households and firms, wage bonuses for essential workers, employment support, and child and maternity allowances for vulnerable households adequately cushioned the impact of the shock on those most affected by the pandemic. While the fiscal policy stance tightened in 2021 on the back of a strong rebound in revenues, its drag on the economy was more than offset by extraordinary diaspora inflows and sustained increases in net credit to the private sector.

37. Fiscal policy needs to return to a more supportive stance in 2022. The projected normalization of diaspora inflows calls for a relaxation of the fiscal stance of around 2 pp of GDP; this will require additional expenditures, mainly in the form of investment projects of about 1–1.5 pp of GDP. The relaxation of the fiscal stance would help sustain the recovery by cushioning the projected softening of external inflows, while keeping the deficit within the fiscal rule limits.

38. The focus, composition, and transparency of public spending needs strengthening, including to support economic resilience. While the objective to intensify vaccinations is both appropriate and commendable, intended policy actions under the “Economic Revival Program” need to be better defined, new social transfer programs should be more targeted, and the growth of existing transfers needs to be contained. While across the board wage hikes are currently not expected, the new law on public salaries should contain the wage bill within its legal ceiling. Public investment should be geared towards increasing economic resilience and preparing the economy for a renewed spike of cases.

39. Continued fiscal contingency planning is needed in the face of still-high uncertainty. Options for risk mitigation, on top of the reserves already in the 2022 budget, include anticipated public debt placements and contingent bilateral and multilateral financing. Other fiscal risks include the ongoing revision of the law on salaries and the indexation of war veteran benefits, which continue to breach their 0.7 percent of GDP legal ceiling. The upbeat GDP growth and revenue projections in the budget for 2022 call for the preparation of an alternative fiscal scenario based in the consensus growth forecast to identify potential financing needs as well as expenditure programs that need containing.

40. The commitment to stick to the fiscal rule as the guide for medium-term policy is appropriate. This will anchor public debt below the 40 percent of GDP legal debt ceiling through the medium term. Other medium-term fiscal priorities include expanding the tax base, strengthening fiscal transparency, and expanding the investor base of government debt. Importantly, the revenue windfall provided by the diaspora should be used to close social and economic infrastructure gaps and diversify growth engines.

41. The CBK’s decision to gradually unwind its pandemic-related support measures in 2021 was warranted. While the financial system has remained resilient overall and the increase in aggregate NPLs is expected to be limited, strengthening credit risk monitoring is essential to ensure that bank-by-bank provisioning reflects the underlying change in asset quality, and that capital buffers are sufficient to absorb write-downs and keep the flow of credit. The supervisor authority’s capacity to evaluate the ECL frameworks of regulated entities in the context of IFRS-9 implementation needs to continue improving.

42. The recommendations of the 2019 FSSR and those of the 2020 SA need to be implemented. The resumption of CBK Board operation will allow the implementation of FSSR and SA recommendations, including to ensure that the financial stability function reports directly to the Executive Board; that the CBK’s governance is reviewed to assess the effectiveness of decision-making bodies and the appropriateness of membership in key committees; and that the audit and risk committees are strengthened, including through expanding their scope to the oversight of financial reporting and risk management activities.

43. The new SDR allocation can be used to strengthen the CBK’s ability to provide liquidity support to banks. The SDR allocation would enhance international reserves, which are projected to fall below 100 percent of the IMF RA metric in the medium term, and thus support the CBK’s lending facilities. On competitiveness, Kosovo’s external position was assessed to be moderately weaker than the level implied by fundamentals and desirable policy settings in 2021.

44. Gaps in physical infrastructure, labor force skills, and institutional quality limit FDI flows, leaving diaspora inflows as the main growth engine. Diversifying the sources of economic growth requires improving infrastructure, public investment management, investment composition, POEs’ management and performance, and for the education system to meet the needs of the economy.

45. Kosovo’s high levels of informality negatively affect competition, working conditions and firm size, limiting economic growth. Simplified tax procedures, improved secondary education, and enhanced financial inclusion will help sustain and expand recent formalization gains. In the medium-term, formalization gains will be tied to improving the efficiency of the judicial system and tackling corruption.

46. Kosovo’s intentions to reduce carbon emissions are commendable. A credible climate and environment mitigation strategy should be centered around carbon pricing, while allocating its proceeds to investment in green projects and to mitigate the impact of higher energy prices on vulnerable households. In the near term, the priority is to make progress in the installation of filters in the largest lignite-based energy generation plant in collaboration with the EU.

47. The next Article IV consultation with Kosovo is expected to be conducted on the standard 12-month cycle.

Assessing the Strength of the Recovery: Nowcasting Kosovo’s GDP

The pandemic highlighted the importance of having timely and reliable indicators on the strength of economic activity. This proved to be particularly important to measure the impact of mobility restrictions and recoveries, and to assess the appropriate size and timing of economic policies as well as their impact. While Kosovo’s data is sufficient for surveillance, it lacks the range and depth available in more developed economies. In this context, staff implemented a nowcasting framework for Kosovo’s GDP to weigh what available high frequency data conveyed about the strength of the recovery. The challenges for its implementation in Kosovo included the mixed data reporting frequencies, missing data and series of different length, and different reporting times for different data series.

The output of the nowcasting framework quite accurately estimated the size and timing of Kosovo’s GDP recovery. High frequency indicators used in the framework include industrial production indices, remittances, electricity consumption, price indices, budget revenues, business turnover and SWIFT messages on trade finance. The results show that both the “real-time nowcast” (which estimates the GDP growth rate in period t using available information up to t) and the “full information nowcast” (which estimates the growth rate in all periods using the entire sample) track observed GDP quite accurately, though the “full information nowcast” naturally shows a better fit given the larger information set used in its estimation.

uA001fig22

Nowcasts of Kosovo GDP

(Percent change, y/y)

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: IMF staff calculations.

In a context of high uncertainty, Kosovo’s nowcasting proved very helpful in policy discussions. This was particularly the case in 2020:Q4 and 2021:Q1, when there were conflicting data signals on the size of the output contraction in 2020, and the timing of the start of the recovery. While preliminary data seemed to suggest that the recovery had accelerated strongly in 2020:Q4, the nowcasting output was consistent with continued weakness, a result that was confirmed later by further data releases. This helped inform staff policy advice to the authorities at a moment of heightened uncertainty.

The Program of the Government of Kosovo, 2021–25

The “Government Program” announced in May 2021 covers a wide array of areas, ranging from securing vaccines to the integrity of justice institutions. The economic policy section of the program includes job creation, tackling informality, improving the business environment, supporting investment and entrepreneurship, improving infrastructure, and social welfare, while preserving the sustainability of public finances. Some of the employment and household support measures have been included in the revised budget for 2021 as part of the Economic Revival Program.

Many of the initiatives in the “Government Program” will result in an increase of recurrent budgetary spending. Although the implementation timing and cost of many initiatives remains to be determined, the annualized cost of the measures included in the revised budget for 2021 is around 1.3 percent of GDP. The preliminary estimate of the annualized cost of initiatives affecting recurrent spending is about 2 – 2.5 percent of GDP. The government also announced that the program would target road and railway infrastructure, but the detail of projects, financing and implementation timing remains to be determined.

article image

Only if transfers to war veterans are indexed to minimum wage increases.

The budget for 2022 has an allocation to build kindergartens of €5 million (around 0.1 percent of GDP).

Figure 1.
Figure 1.

Kosovo: Recent Economic Developments

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: Haver Analytics; Kosovo Agency of Statistics; Central Bank of Kosovo; Kosovo Energy Corporation; Kosovo Company for Distribution and Supply; WEO; and IMF staff estimates.1/ Domestic tax revenues is calculated as the sum of direct tax revenues and in-country VAT revenues.2/ Data includes consumers 220 – 110kV; total consumption does not include technical losses, commercial losses and transmission losses.
Figure 2.
Figure 2.

Kosovo: Fiscal Developments

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Source: Ministry of Finance, Central Bank of Kosovo, and IMF staff calculations.
Figure 3.
Figure 3.

Kosovo: External Sector Developments

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Source: Haver Analytics; KAS; Ministry of Finance Labor and Transfers, Pristina International Airport; WEO and IMF staff estimates.
Figure 4.
Figure 4.

Kosovo: Banking Sector Overview

Citation: IMF Staff Country Reports 2022, 005; 10.5089/9781616359324.002.A001

Sources: Central Bank of Kosovo, IMF staff estimates.
Table 1.

Kosovo: Selected Economic Indicators, 2018–26

(Percent, unless otherwise indicated)

article image
Sources: Kosovo authorities; and IMF staff estimates and projections.

The “fiscal rule” caps the overall fiscal deficit at 2 percent of GDP, excluding investment financed with privatization receipts and donor financing contracted after 2015, as well as PAK-related current expenditure; the IMF calculates expenditures from carried-forward own-source revenue (OSR) as the difference in the municipal OSR stock.

Includes guarantees and beginning in 2020, Euro 120 million of debt with KPST. It does not include contigent debt of former Yugoslavia.

Total foreign assistance excluding capital transfers.

Table 2.

Kosovo: Consolidated Government Budget, 2018–261/

(Including donor designated grants and PAK operations; millions of Euros)

article image
Sources: Kosovo authorities; and IMF staff estimates and projections.

It does not yet reflect the GFSM 2014 methodology,

The “fiscal rule” caps the overall fiscal deficit at 2 percent of GDP, excluding investment financed with privatization receipts and donor financing contracted after 2015, as well as PAK-related current expenditure; the IMF calculates expenditures from carried-forward own-source revenue (OSR) as the difference in the municipal OSR stock.

Excludes DDGs, revenues held in trust, and additional net PAK expenditure.

The stock of public debt no longer includes the former Yugoslavia debt, which has been reclassified as a contingent liability. Beginning in 2020, it includes Euro 120 million of debt with KPST.

Table 3.

Kosovo: Consolidated Government Budget, 2018–261/

(Including donor designated grants and PAK operations; percent of GDP)

article image
Sources: Kosovo authorities; and IMF staff estimates and projections.

It does not yet reflect the GFSM 2014 methodology.

The “fiscal rule” caps the overall fiscal deficit at 2 percent of GDP, excluding investment financed with privatization receipts and donor financing contracted after 2015, as well as PAK-related current expenditure; the IMF calculates expenditures from camed-forward own-source revenue (OSR)as the difference in the municipal OSR stock.

Excludes DDGs, revenues held intrust, and additional net PAKexpenditure.

The stock of public debt no longer includes the former Yugoslavia debt, which has been reclassified as a contingent liability. Beginning in 2020, it includes Euro 120 million of debt with KPST.