October 2, 2017

• Albania’s economy continues to strengthen, benefitting from rising domestic demand, large energy-related Foreign Direct Investment, growing tourism, and a recovery in key EU trading partners.
• Under the recently concluded Fund-supported program, the authorities lowered fiscal and financial vulnerabilities, but further efforts are needed to cement these gains. The reform momentum has slowed given the elections and extended government transition.
• The growing economy and clear electoral mandate provides a unique opportunity for the new government to redouble reform efforts. Advancing the reform agenda is crucial to maintain macroeconomic stability, reduce fiscal risks, and raise growth potential.

Recent Economic Developments and Outlook

The economic recovery continues, supported by large energy-related Foreign Direct Investment projects and rising consumer confidence. GDP growth is projected to increase to 3.9 percent in 2017, driven by rapid expansion of tourism and construction sectors, offsetting the negative impact of drought on electricity production. Job recovery continues with unemployment falling to 13.9 percent at 2017:Q2. Credit to households and exports are rising. The current account deficit is expected to widen slightly in 2017, reaching 8.0 percent of GDP, as energy investment and drought-related electricity imports pick up. Pass-through of higher external inflation and increasing domestic demand is expected to push inflation to around 2 percent (yoy, average) in 2017.

Despite the strengthening recovery, fiscal consolidation is expected to slow down in 2017 . Based on the revised budget, the mission projects the general government primary balance to slightly deteriorate from a surplus of 0.2 percent of GDP in 2016 to 0.1 percent of GDP in 2017, owing to large pending value-added tax (VAT) refunds, electricity import guarantees, and local government expenditures. However, overall general government deficit is expected to decline modestly to 2.0 percent of GDP due to interest savings. Public debt (including substantial local and central government arrears) is also projected to decline from 73.3 percent of GDP at end-2016 to 71½ percent of GDP at end-2017.

The medium-term outlook appears favorable, provided the reform momentum is sustained. In 2018, growth is projected to ease to 3.7 percent as investments by the large energy-related projects taper off. Growth is expected to subsequently increase to 4 percent over the medium-term, catalyzed by reforms towards European Union (EU) accession and recovery in the main EU trading partners. Risks to the outlook are balanced. On the upside, improved confidence following the resolution of political uncertainty and spillovers from the large energy and infrastructure projects could lead to higher investment and a stronger credit recovery. On the downside, continued drought conditions could affect electricity generation and pose quasi-fiscal risks. A slowdown in the reform momentum and fiscal slippages could dampen confidence, increase risk premia and increase rollover risks. Banking distress in Europe or rapid deleveraging by EU banks could lead to financial sector stress.

In this context, the main policy priorities are to (i) maintain macroeconomic stability and (ii) deepen structural reforms to improve the investment climate and catch up to EU incomes levels. Policies should seek to address challenges arising from high public debt, low credit, and weak institutions that deter investment.

Fiscal Policy: Ensuring Fiscal Sustainability and Supporting Growth-Friendly Spending

Fiscal consolidation should continue to ensure debt sustainability. Albania’s public debt level and gross financing needs remain high. The authorities are committed to reducing public debt below 60 percent of GDP by 2021, in line with the long-term debt objective of 45 percent of GDP in the Organic Budget Law. To achieve these objectives, the draft 2018 budget and medium-term budgetary frameworks target a primary surplus of 0.6 percent of GDP, and a gradual consolidation to reach a primary surplus of 2.3 percent of GDP by 2021. The authorities’ fiscal strategy envisages a large scale-up of public investment, while containing public wages (except for health and education sectors) and reducing energy support, as well as increased revenues from value-based property tax and compliance gains from the anti-informality campaign.

To reach the debt objective, the mission recommends a more front-loaded consolidation . In the absence of tax policy measures, the mission projects public debt to reach around 63.5 percent of GDP by 2021. This includes a buildup of a prudent deposit buffer (1 percent of GDP) but excludes any debt or contingent liability arising from Public-Private Partnerships-financed investments (€1 billion, around 7 percent of GDP by 2021). The mission estimates that additional permanent measures to the tune of 1¼ percent of GDP over 2018-19 would be needed to achieve the debt target. Ensuring that the 2017 revised budget stays within the original target by locking in existing savings and avoiding inefficient year-end spending would also help.

Additional measures are needed to mobilize revenues for increased priority spending in health, education and infrastructure. Tax efficiency is low compared to neighboring countries reflecting high tax thresholds and weak compliance. Heavy reliance on specific taxes has also led to low tax elasticity with respect to GDP. The mission welcomes the planned introduction of a value-based property tax and strengthening of tax compliance, and recommends additional measures such as indexation of excises to inflation to preserve its real value, transfer duty on property sales as a transition to the value-based property tax, environmental excises, and broadening of the tax base. The authorities should refrain from granting any new tax exemptions or preferential tax treatments, or lowering tax rates. The design of VAT and CIT taxation on small businesses should consider a simplified regime to minimize the burden on tax administration.

Structural Fiscal Reform: Reducing Fiscal Risks and Improving Efficiency

Strengthening fiscal institutions is crucial to mitigate fiscal risks and enhance efficiency.

• Tax administration : The tax administration has made good progress in implementing its strategic plan. The mission supports its focus on improving debt collection processes and compliance risk management. The announced merger of the tax and customs administrations should be revisited, given the high risks of undermining revenue collection and the ongoing tax administration reforms. More generally, the reorganization of central government administration should be implemented with due consideration of its functional impact.
• Public financial management: With the planned scaling up of public investments, it has become crucial to strengthen public investment management, in particular the project appraisal and selection processes, in order to reduce waste and abuse. Adhering to the medium term budgetary framework is important for reducing the risks of unfunded commitments and arrears. Even under an increased expenditure envelope in the 2018 budget, new planned projects are crowding out existing commitments.
• Public Private Partnerships (PPPs) : The authorities’ ambitious agenda for public investment through PPPs poses substantial fiscal risks. It is of paramount importance to strengthen the implementation of the PPP framework and start making use of the Ministry of Finance’s recently expanded legal powers to assess and monitor PPP projects. Contrary to current practice, the impact of PPPs on the fiscal accounts and public debt should be reflected transparently and in line with international norms.
• Debt management : The Ministry of Finance should further lengthen the maturity of public debt and diversify the investor base, while avoiding risks posed by excessive reliance on foreign currency and non-concessional borrowing.
• Arrears clearance and prevention : As of end-June, central and local governments have accumulated arrears of 1.1 percent of GDP. This includes 0.3 percent of GDP in arrears on VAT refunds. To prevent arrears, the authorities should improve the tax refund process, strengthen commitment controls, particularly at the Ministry of Energy and Infrastructure, expand the Treasury’s IT system to local governments, register all unbudgeted commitments, and record unpaid bills.

Reforms in the state-owned electricity sector need to be reinvigorated. After impressive early gains, the reform process has stalled. Continued reforms are important for unlocking donor support, which will speed up financial restructuring in the sector. The authorities should improve operational efficiency, including through strengthened corporate governance and better targeting of investment. In addition, institutional and market design reforms should be accelerated, including establishing a power exchange, unbundling the electricity distribution company, and moving medium-voltage customers to the free market. The drought-induced fall in hydropower generation so far this year underscores the importance of diversifying Albania’s sources of electricity.

Monetary and Financial Policy: Strengthening Inflation Targeting and Mitigating Risks

The Bank of Albania (BoA) accommodative monetary policy stance remains appropriate, in view of the still negative output gap and appreciating exchange rate . Any unwinding of monetary easing should await clear evidence of a sustained rise in inflation. To strengthen inflation targeting and reduce financial stability risks, the de-euroization strategy should be implemented gradually, balancing the risks of financial disintermediation. The central bank law needs to be amended to align it with modern central banking legislation, strengthen BoA independence and legal protection of employees , and improve its governance and operations.

The weak non-performing loans (NPLs) resolution framework continues to hamper credit recovery, particularly for corporates. The mission welcomes progress in restructuring the NPLs of large borrowers. Together with mandatory write-offs, these actions have led to a sizable decline in the NPL ratio. However, the recent regulation on private bailiff fees is likely to hinder the collateral execution process and should be reversed. The authorities should urgently adopt the bylaws to implement the new Bankruptcy Law and facilitate out-of-court restructuring. Reviving the NPL Working Group can help advance this agenda.

The mission welcomes the authorities’ continued efforts to strengthen financial supervision. The banking system remains stable, well-capitalized and liquid. The authorities should continue to strengthen their microprudential focus on the fastest-growing and systemically important segments of the banking system to minimize build-up of credit risks. They should ensure healthy capitalization levels by strictly enforcing limits on large exposures.

Recent structural changes in banking and non-banking sectors call for enhanced supervisory vigilance . The consolidation in the banking sector is welcome. To mitigate risks to banking stability, BoA should ensure that new bank license candidates meet appropriate fit and proper criteria, possess adequate banking experience, and avoid conflicts of interest. Given the expansion of investment funds and other non-bank financial institutions, the authorities should urgently strengthen the regulator’s crisis preparedness and capacity. Close cooperation between bank and non-bank supervisory authorities is needed as financial interconnectedness increases. Developing capital market institutions requires high transparency and governance standards. A liquid secondary market for domestic government bonds will also be key for financial deepening.

Structural Reforms: Deepen Reforms to Accelerate the Pace of Convergence

Addressing structural impediments to competitiveness remains key to achieving faster growth. Despite recent improvements, Albania’s competitiveness indicators lag behind regional peers. While Albania’s wages are competitive, its investment climate suffers from low efficiency of the tax system, high informality, skill mismatches, and regulatory unpredictability. Weak property rights and a corrupt and inefficient judiciary also hinder investment prospects. Albania’s infrastructure gap, the highest in the region, remains a significant bottleneck to productivity.

Further structural reforms will be crucial to tackling these bottlenecks . The sweeping judicial reform adopted in mid-2016 should be pursued with speed and determination. A new strategy on property rights is needed to advance property registration and digitization and coordinate the restitution and legalization processes. To address demographic pressures arising from continued emigration, skills mismatches in Albania’s otherwise flexible labor market, and the high youth unemployment rate, the authorities should strengthen the capacity of public employment agencies and invest further in higher education and vocational training. To reduce informality, minimum wage policies for young, low-skilled, or part-time workers should be revisited. In this context, the authorities’ goal of reducing regulatory burden is also welcome.

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The IMF team thanks the authorities and other interlocutors in the public and private sectors for their cooperation, open and constructive discussions, and warm hospitality.