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How Emerging Europe Came Through the 2008/09 Crisis
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Chapter 15. Kosovo: Watching the Global Crisis from the Sidelines

Author(s):
Bas Bakker, and Christoph Klingen
Published Date:
August 2012
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Kosovo’s financial and economic integration with the global economy is limited. Since the end of the Kosovo war in 1999, the emphasis has been on rebuilding the country with international assistance and establishing government institutions—since 2001 under interim United Nations administration and Provisional Institutions of Self-Government and since its declaration of independence in 2008 under its own government. Due to the insularity of Kosovo’s economy, the global financial crisis merely dented growth in 2009. Nonetheless, Kosovo faces formidable development challenges. The IMF supported Kosovo through a stand-by arrangement (SBA) and a staff-monitored program.

Background

Kosovo’s separation from Serbia turned into an armed conflict between the Kosovo Liberation Army and Federal Yugoslav forces during 1998–99. Following NATO’s successful military campaign to halt the violence, the United Nations Interim Administration Mission in Kosovo was established. In 2001, the UN mission promulgated a constitutional framework for the establishment of Provisional Institutions of Self-Government. In February 2008, Kosovo declared independence. It joined the IMF and the World Bank in June 2009.

This painful path to still-fresh independence also shaped Kosovo’s economic developments. Years of conflict and disruption led to a neglect of education and investment. Low human capital and infrastructure bottlenecks, such as frequent power outages, traffic logjams, and inadequate regional connectivity in the transport and energy systems, depress its competitiveness and living standards. Economic activity is dominated by services, including retail trade and construction, and although there are some green shoots in the manufacturing sector, job opportunities are insufficient, with official unemployment hovering around 40 percent. Exports are very low and per capita income remains one of the lowest in the region. Import dependence is high. Kosovo’s large current trade deficit is financed by remittances and foreign direct investment from Kosovo citizens working abroad as well as official international assistance.

Nonetheless, much progress has been made in building institutions and adopting a market-based economy. Most of the state-owned enterprises have been privatized, including the largest exporter, and the private sector now accounts for the bulk of economic activity. The banking sector is dominated by foreign banks, which account for 90 percent of assets, without, however, relying much on foreign financing. Inflation is low thanks to the unilateral adoption of the euro. Public finances have tended to be in surplus, reflecting efficient value-added tax collection at the border, frequent underexecution of the budget, and an absence of borrowing opportunities. But the fiscal balance turned negative after independence, especially owing to the scaling-up of the investment program.

The Run-Up to the Global Financial Crisis

Economic growth was relatively robust before the global crisis, averaging close to 5 percent during 2003–08. The following main factors explain this performance. First, remittances were a significant and reliable income source of 12 to 15 percent of GDP per year. Second, Kosovo boasts one of Europe’s youngest populations, with around half of the population below the age of 25; population growth hovers around an estimated 1.5 percent per year. Third, large-scale international support helped spur growth shortly after the end of the armed conflict. Fourth, fiscal policy provided for rapid expenditure growth, underpinning brisk domestic demand growth.

Following the initial reconstruction boom, the growth momentum began to shift from the international public sector to the private sector, partially financed by credit. Private sector credit grew by 60 percent in real terms during 2003–08, albeit from a very low base. Moreover, Kosovo’s banking sector had the distinct advantage of a stable funding base. The financial sector was set up from scratch, and despite the closure of one small domestic bank in 2006, the sector was quick to gain the population’s confidence. As a result, substantial holdings of mattress money and remittances bolstered deposit growth, which exceeded 20 percent per year during 2003–08. Foreign liabilities, therefore, were minor on the eve of the global financial crisis—just 2 percent of GDP in September 2008—and the loan-to-deposit ratio stood at a comparatively low 82 percent in 2008. In addition, the Central Bank of the Republic of Kosovo (CBK) successfully dampened credit growth by tightening supervision and exercising moral suasion to convince banks to keep loan-to-deposit ratios below the 80 percent mark.

Impact of the Global Financial Crisis

Given the limited dependence on foreign lending, the global financial crisis only had a moderate impact on Kosovo’s economy. The primary transmission channels included exports, remittances, and foreign direct investment. Although exports of goods dipped during 2009, their low base shielded the real economy from major disturbances. Workers’ remittances experienced a moderate peak-to-trough decline of 12 percent, reflecting the resilience of labor markets in Germany and Switzerland, the primary hosts of Kosovo’s migrants. Given that a substantial share of foreign direct investment reflects migrants’ real estate purchases, its decline was also moderate.

Bank lending decelerated significantly but remained in positive territory. Because banks were not dependent on foreign financing and domestic deposits held up well, banks had no reason to deleverage sharply. Liquidity strains did not arise, since the decline of deposit growth was less pronounced than the decline of lending growth (Figure 15.1).

Figure 15.1Kosovo: Bank Deposits and Loans, 2007–11

(Year-over-year percent change)

Source: Central Bank of Kosovo.

Policy Responses

Since the global financial crisis largely bypassed Kosovo, a specific policy response was not necessary. However, fiscal policy turned more expansionary in 2008 upon independence due to escalating demands for social spending, transfers to the loss-making energy sector, and infrastructure investments. By 2009, the general government budget deficit had reached nearly 6 percent of GDP (not counting the large one-time dividend payment from the publicly owned telecom company of 5 percent of GDP). In 2010, the government decided to begin constructing the first highway that will provide direct access to the port of Durres in Albania. The World Bank estimates that this project will cost about 24 percent of 2010 GDP over a period of four years. While the fiscal surpluses of previous years had accumulated substantial government balances at the CBK, which could now be drawn down, such large-scale investment projects required a broader fiscal strategy with substantial consolidation in other areas (Figure 15.2). It is in this context, rather than in response to imminent pressures from the global financial crisis, that the authorities turned to the IMF for the July 2010 SBA (Box 15.1).

Figure 15.2Kosovo: General Government Bank Balances and Budget Balance

(Percent of GDP)

Sources: Kosovo authorities; and IMF staff calculations.

Box 15.1The IMF-Supported Program of July 2010

An 18-month stand-by arrangement was approved by the IMF Executive Board on July 21, 2010, in the amount of SDR 92.5 million (about €108.9 million). The program was built around (i) restraint on current spending, higher revenues, and privatization proceeds to contain the impact of the investment program on the overall deficit, and (ii) bolstering of the government’s deposits with the central bank to build buffers for fiscal and financial contingencies. In particular:

  • The authorities committed to a combination of revenue and spending measures to limit budget deficits to 3.4 percent of GDP in 2010 and 5.5 percent of GDP in 2011, amid accelerating highway-related spending in 2011. To this end, excise taxes were raised and capital spending (other than for the highway) was reduced as part of an amendment to the 2010 budget. The Law on Public and Financial Management and Accountability was amended in order to improve fiscal discipline and to ensure that any spending initiatives would be budget-neutral at future midyear budget reviews. Moreover, the authorities undertook to limit current spending, to refrain from commercial borrowing in 2011, and to upgrade the quality of expenditure and public financial management.
  • To buttress financial sector stability, the Assembly adopted a new central bank law that meets international standards and establishes a limited lender-of-last-resort function for the Central Bank of the Republic of Kosovo (CBK). However, given euroization, the scope for the CBK to engage in lender-of-last-resort activities is narrow. The CBK’s international reserves mainly comprise the counterpart of the government’s deposits held at the CBK and liquid assets linked to the CBK’s equity capital. Hence, the authorities pledged to maintain their central bank deposits at prudent levels.

The 2011 budget adopted by the newly constituted Assembly deviated from program commitments, notably by increasing public sector wages by between 30 and 50 percent in the context of an early parliamentary election. Unfunded social spending initiatives with unclear budgetary implications posed additional fiscal risks. As a result, no review under the program could be completed.

Economic Outcomes in 2009–11

Real GDP growth decelerated from its 6.9 percent peak in 2008 to 2.9 percent in 2009. It rebounded to about 4 percent in 2010 and 5 percent in 2011 on account of reviving exports and a pickup in foreign direct investment. The current account deficit remained large, although it may have been overstated due to underreported cash transfers, but it continues to be financed through foreign direct investment and other non-debt-creating flows for now.

Throughout the period of the global financial crisis, Kosovo’s banking sector remained adequately capitalized and very profitable. True, the loan portfolios started showing signs of strain, but the rise of nonperforming loans to a peak of 6 percent of total loans in mid-2011 from a precrisis low of 3.3 percent was modest compared to developments elsewhere in emerging Europe.

The Kosovo Pension Savings Fund initially took a hard hit. This fund is charged with investing the contributions collected by the second and third pillars of the private pension system. Absent domestic securities, the vast majority of this pension fund’s assets are invested abroad. The fund thus suffered an investment loss of 32 percent in 2008. However, by end-2010, it had recovered about four-fifths of this loss.

Challenges Ahead

Developing Kosovo’s economic potential requires, foremost, a reorientation of its growth model and a strategic rethinking of its fiscal priorities. So far, growth has relied mostly on exceptionally high remittances and foreign direct investment, but longer-term prospects for these flows will be subdued as diaspora Kosovars integrate more closely into their host countries. A key challenge is therefore to develop a vibrant tradable sector, which in turn requires upgrading public infrastructure and education while keeping wages competitive. In the fiscal area, large infrastructure projects require careful evaluation, and other spending initiatives will need to take a back seat to ensure sustainability of public debt and adequate buffers for liquidity management.

Since July 2011, Kosovo’s reform efforts, especially in the fiscal area, have been supported by a staff-monitored program with the IMF. While this program involves neither endorsement by the IMF Executive Board nor financial assistance, such informal agreements with IMF staff help monitor the implementation of the authorities’ economic program, with a view to establishing a track record of strong economic performance. The staff-monitored program was successfully completed at the end of 2011, with substantial progress in fiscal structural adjustment, improvements in budgetary planning and execution, better revenue collection, and steps to strengthen the financial system’s resilience.

Kosovo: Principal Economic and Financial Indicators, 2003–11
200320042005200620072008200920102011
Real Sector Indicators
GDP (real growth in percent)5.42.63.83.46.36.92.93.95.0
Domestic demand (real growth in percent)10.67.84.33.18.68.44.25.34.6
Net exports (real growth contribution in percent)0.71.0−0.81.2−2.7−1.9−1.1−1.5−0.1
Exports of goods and services (real growth in percent)−19.0103.48.132.013.44.77.824.213.6
CPI (end-of-period change in percent)0.5−3.70.71.110.50.50.16.63.6
Employment (growth in percent)
Unemployment rate (percent)47.545.445.1
Public Finances
Fiscal balance (percent of GDP)1.6−4.6−3.12.77.2−0.2−0.6−2.6−1.9
Government revenue (percent of GDP)19.921.120.923.126.524.529.327.628.1
Government expenditure (percent of GDP)18.325.724.020.319.324.729.930.230.0
Government primary expenditure (percent of GDP)18.325.724.020.319.324.729.930.029.8
Government primary expenditure (real growth in percent)−9.1−1.7−8.5−6.6−6.213.911.83.64.7
Public debt (percent of GDP)17.616.715.0
Of which foreign held17.616.715.0
External Sector
Current account balance (percent of GDP)−8.1−8.4−7.4−6.7−8.3−15.3−15.4−17.4−20.3
Net capital inflows (percent of GDP)1−1.90.71.310.712.3−1.07.68.5
FDI1.53.69.312.78.87.28.18.4
Portfolio−1.1−0.6−2.1−1.10.4−1.6−0.7−1.3
Other investment−2.3−2.3−5.8−0.93.0−6.70.21.5
Exports (percent of GDP)5.410.611.114.115.114.815.518.520.0
Exports (€, growth in percent)−20.494.57.432.716.011.16.428.819.1
Global export market share (basis points)
Remittances (percent of GDP)11.612.213.915.015.213.815.013.612.6
Imports (percent of GDP)38.645.147.350.853.756.055.259.161.1
Imports (€, growth in percent)−3.214.68.211.714.918.40.115.413.7
External debt (percent of GDP)17.616.715.0
Gross international reserves (€ billions)0.40.30.30.40.60.70.60.70.6
Gross international reserves (percent of GDP)14.310.79.311.419.117.416.016.413.5
Reserve coverage (GIR in percent of short-term debt)
Monetary Sector
Broad money (end of period, growth in percent)20.329.923.17.723.811.741.615.510.7
Monetary base (end of period, growth in percent)22.719.834.9−3.218.317.781.0−32.00.0
Private sector credit (end of period, percent of GDP)7.812.817.120.426.330.732.934.434.4
Of which foreign currency denominated
Of which foreign currency indexed
Cross-border loans to nonbanks (Q4, percent of GDP)
Private sector credit (end of period, real growth in percent)167.666.936.522.526.832.08.75.410.6
Financial Sector
Assets (percent of GDP)19.026.931.435.940.344.753.856.255.2
ROA (percent)2.32.92.61.41.81.5
ROE (percent)60.454.860.355.355.657.0
CAR (percent of risk-weighted assets)16.817.416.517.918.817.6
NPLs (percent of total loans)4.14.13.34.35.25.7
Loan-to-deposit ratio0.70.80.80.70.80.8
Cross-border claims by foreign banks (all sectors, percent of GDP)
Financial Markets
Interest rates (end of period, one-year government bond, percent)
CDS spreads (sovereign, end of period, basis points)
EMBIG spread (sovereign, end of period, basis points)
Exchange rate (end of period, domestic currency/€)1.01.01.01.01.01.01.01.01.0
NEER (index, 2003 = 100)100.0102.7103.1103.6103.2104.1107.7106.8107.8
REER (CPI-based, 2003 = 100)100.097.992.789.489.392.291.290.693.0
REER (ULC-based, 2003 = 100)
Memorandum Items
GDP (nominal, in billions of domestic currency)3.02.93.03.13.43.93.94.24.6
GDP (nominal, in billions of €)3.02.93.03.13.43.93.94.24.6
Source: IMF staff.Note: CAR = capital adequacy ratio; CDS = credit default swap; CPI = consumer price index; EMBIG = Emerging Markets Bond Index Global; FDI = foreign direct investment; GIR = gross international reserves; NEER = nominal effective exchange rate; NPLs = nonperforming loans; REER = real effective exchange rate; ROA = return on assets; ROE = return on equity; ULC = unit labor cost.

Financial and capital account balances excluding EU balance-of-payments support, use of IMF resources, and SDR allocations.

Source: IMF staff.Note: CAR = capital adequacy ratio; CDS = credit default swap; CPI = consumer price index; EMBIG = Emerging Markets Bond Index Global; FDI = foreign direct investment; GIR = gross international reserves; NEER = nominal effective exchange rate; NPLs = nonperforming loans; REER = real effective exchange rate; ROA = return on assets; ROE = return on equity; ULC = unit labor cost.

Financial and capital account balances excluding EU balance-of-payments support, use of IMF resources, and SDR allocations.

The main authors of this chapter are Jürgen Odenius and Arbër Domi.

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