Kosovo has displayed remarkable resilience in the face of euro area turbulence, benefiting from robust Diaspora inflows. Commendable steps have been taken to enhance competitiveness—including efforts to strengthen the business climate and infrastructure investments—but much remains to be done. In the past two years, the government has restored a sustainable fiscal stance. Policy discipline and broad political support for macro-financial stability will be needed to preserve this achievement. The banking sector has grown rapidly while remaining stable. However, a saturation point appears to have been reached, and further progress will require strengthening institutions. The authorities have taken important steps to strengthen the financial safety net.

1. Kosovo’s economy has performed remarkably in the face of headwinds from the global financial crisis and euro area turbulence. Since the onset of the financial crisis in 2007, annual real growth GDP has never been less than two percent, and average growth has been among the highest in the Western Balkans, at around 4½ percent. However, adverse price developments—notably a secular increase of prices for imported food that compressed real incomes—have prevented the full benefits of Kosovo’s growth to be passed on to the population.

2. After sub-par growth in 2012 of around 2 percent, the short-term is for a gradual strengthening of activity, in line with expected developments for the euro area. Real GDP growth is expected to be between 2½ and 3 percent in 2013—still significantly below potential—but to recover gradually to around 4½ percent in subsequent years, in line with Kosovo’s growth performance in the past decade. The relatively high expected growth rates reflect in part population growth, while per-capita growth is expected to be roughly in line with Kosovo’s peers. Inflation is being driven by prices for imported food, but core inflation is expected to remain contained at around 2 percent, consistent with Kosovo’s unilateral adoption of the euro.

3. The economy’s recent resilience owes to factors that could turn into a risk should the external environment change. Kosovo’s economy depends heavily on remittances and other inflows from the Diaspora that live mostly in Germany and Switzerland. As these economies have held up well, inflows from the Diaspora have been stable, and have therefore continued to support household incomes and domestic demand. At the same time, there are almost no financial or export linkages to crisis countries. Kosovo’s concentrated external exposure would turn into a risk, however, should the prospects for the Diaspora host countries change, or in case the Diaspora would at some point become less attached to Kosovo in the longer term. Containing and insuring against such risk requires the build-up of a robust tradable sector that could support self-sustained growth.

4. Since the 2011 Article IV consultation, Kosovo has taken commendable steps toward building a more competitive economy. These include (i) efforts to strengthen of the business climate—as reflected by Kosovo’s improvement in the World Bank’s ‘Doing Business’ survey—, (ii) investments in public infrastructure, (iii) cautious public sector wage policies since 2011, (iv) the preparation of a rules-based framework for setting minimum wage levels, and (v) efforts to support the development of small- and medium-sized enterprises. Equally important for growth prospects are recent initiatives to normalize cross-country relations within the Western Balkans and integrate the region—including Kosovo—closer with the European Union.

5. Enhancing competitiveness and building a tradable sector is a long-term process, however, that requires stamina and patience from policymakers. This said, there are indications that the authorities’ efforts are already bearing fruit, notably anecdotal evidence on import substitution for agricultural goods. Kosovo’s competitiveness strategy would usefully be reinforced by efforts to strengthen education and training—i.e., investments not only in physical but also in human capital—and to enhance governance.

6. Kosovo has made large strides toward fiscal sustainability. In the past two years, the government restored a sustainable budgetary stance through a mix of revenue measures and expenditure-saving structural reforms, notably in the energy sector. Preserving the progress made in these areas is critical. Future budgets from 2014 would be guided by the rules-based fiscal framework expected to be enacted in June. If implemented as foreseen, the rules-based framework would safeguard fiscal sustainability also going forward. The government debt market—set up only in 2012—has been off to a good start, although it may take a few years until it will be sufficiently deep and liquid to cover the government’s financing needs in a sustainable manner.

7. The rules-based fiscal framework needs to be reinforced by policy discipline and sound fiscal practices. In particular, spending initiatives require careful costing and planning, with respect to both social spending—where policymakers need to resist temptations to react ad-hoc to spending pressures—and investment projects, such as the government’s ambitious highway construction program. Otherwise, unfunded expenditure obligations could rapidly put fiscal achievements at risk. Avoiding such an outcome is a common responsibility of all stakeholders.

8. Upcoming challenges to revenue policy require careful preparation. The public sector relies heavily on indirect taxation to cover its financial needs, which is appropriate for now, given the transfer-dependent, import-heavy structure of the economy. The efficiency of indirect taxation is reinforced by Kosovo’s well-designed and administered VAT system. Looking ahead, however, customs duties will need to be replaced as Kosovo integrates more closely with its neighbors and the EU; and the government will need to strengthen its ability to tax the domestic economy as Kosovo’s growth model shifts from dependence on transfers to more domestic production. For the medium term, the recommendations of an IMF technical assistance mission from 2011 on tax policy remain topical, in particular proposals to (i) increase fiscal disincentives for harmful activities, including by raising environmental taxes and excises, (ii) broaden the tax base and increase progressivity, and (iii) gradually raise income and property taxes from current low levels. Some of these measures have already been taken in the past two years.

9. The public sector’s expenditure structure is conducive to growth, but may be difficult to sustain in view of pressing social needs. Government spending is modest compared to Kosovo’s peers, and heavily tilted toward public investment. While this structure is supportive of economic development, it is likely that the current spending envelope would, over time, become gradually more similar to that of neighboring countries. It is critical to manage this process in a gradual and orderly manner.

10. The government’s bank balance with the central bank is a critical precautionary buffer that needs to be guarded carefully. In Kosovo’s unilaterally euroized economy, the bank balance is the main tool to insure both the public sector and the financial system against liquidity shocks. The floor on the bank balance inscribed in the rules-based fiscal framework of 4½ percent of GDP is at the lower range of levels that can be considered adequate. The government should aim at exceeding this floor whenever large payment obligations are upcoming, such as large-scale investment projects or debt servicing obligations. The government and the central bank should also continue to explore options to fund a portion of reserves from non-government sources.

11. Kosovo’s banking system has grown rapidly in the past decade, but further progress will depend on strengthening institutions. Banking sector depth in Kosovo is at or even above levels of countries with similar characteristics. At the same time, credit intermediation spreads remain high, reflecting high credit risk and feeble underlying institutions, notably slow and incomplete contract enforcement by the judicial system. Segments of the financial system other than banks—notably insurance and government securities markets—are at early stages of development, and the legal framework for non-banks needs strengthening.

12. Despite its fast growth, the banking system has remained stable, with adequate capital buffers and profitability, a modest level of non-performing loans, and high liquid reserves. Banks have also avoided funding imbalances typical for many other countries in Emerging Europe, being financed mostly from domestic deposits. Stress tests conducted in 2012 in the context of the joint IMF/World Bank Financial Sector Assessment Program suggest that the banking system is resilient to a wide range of shocks, including an intensification of turbulence in the euro area.

13. Persistent supervisory vigilance is critical to preserve this achievement. A gradual move to comprehensive risk-based supervision and the development of a macro-prudential policy framework are also called for to contain financial risks.

14. The authorities have made important progress in strengthening the financial safety net. The new banking law, passed in 2012, enhances bank governance standards and strengthens the central bank’s power to resolve financial institutions. Amendments to the deposit insurance law, passed also in 2012, allow for an enhanced target size of the deposit insurance fund (DIFK), and the use of DIFK funds for purchase and assumption transactions in bank resolution. The establishment of a special reserves fund (SRF)—financed by the government but under the exclusive control of the central bank—provides the means to extend emergency liquidity assistance to banks if needed. Priorities ahead include establishing a permanent funding mechanism for the SRF.

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We wish to thank the authorities for their hospitality and for constructive discussions.