IMF Concludes 2021 Article IV Consultation with Republic of Kosovo

Washington, DC : The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation^[1]with Kosovo and considered and endorsed the staff appraisal without a meeting.

Kosovo’s economy is rebounding from its deepest recession in a decade, driven by improved vaccination rates, renewed mobility, policy actions and extraordinary support from the diaspora. After contracting 5.3 percent in 2020, real GDP is projected to grow by 7.5 percent in 2021.

The fiscal response to the pandemic provided lifelines for households and firms and cushioned the impact of the shock on those most affected by the pandemic. On the back of a strong rebound in revenues, the fiscal policy stance tightened to an almost balanced position in 2021 from a deficit of close to 8 percent of GDP in 2020. However, its drag on the economy was more than offset by extraordinary diaspora inflows and sustained increases in net credit to the private sector. Inflation in 2021 is forecast to have increased to more than 5 percent (year-on-year) due to higher energy and food prices, which rebounded to their pre-pandemic levels. With strong capital and liquidity buffers and low NPLs, the banking sector has been resilient overall.

Economic activity is forecast to grow at 3.8 percent in 2022, driven partially by strong economic momentum in 2021. Uncertainty around the outlook remains high, and the pandemic continues to represent the main downside risk. Long-term scarring from the pandemic is now expected to be lower than that projected in the 2020 Article IV consultation, as diaspora flows have been more resilient than expected. Structural policies, such as diversifying Kosovo’s growth engines, tackling informality, and creating the conditions for greener economic growth, could mitigate these longer-term effects of the pandemic.

Executive Board Assessment^[2]

In concluding the 2021 Article IV consultation with Kosovo, Executive Directors endorsed the staff’s appraisal, as follows:

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.

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.

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.

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.

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.

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.

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.

The recommendations of the 2019 FSSR and those of the 2020 Safeguards Assessment 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.

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.

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.

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.

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.

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