Macroeconomic performance

Economic growth was moderate over the last two years. Kosovo’s economy has been somewhat shielded from adverse external developments during the global economic crisis. As a result, when most countries in the region performed poorly, the economy of Kosovo grew at about 4 per cent on average for the period between 2009 and 2011. However, GDP growth moderated in the last two years to an average of 3.1 per cent, which is attributable to both domestic and external demand dropping slightly. At the same time, inflation has slowed significantly, remaining below 0.5 per cent year-on-year since December 2013.

Fiscal policy has been less prudent in the past year. In light of the country’s unilateral adoption of the euro, a sound fiscal policy has been important for maintaining macroeconomic stability. The International Monetary Fund (IMF) has supported the establishment of Kosovo’s fiscal programme and framework. Following the successful completion of a staff-monitored programme in January 2012, the IMF approved a 20-month €106.6 million Stand-By Arrangement (SBA) for Kosovo in April 2012. The agreement was brought to a successful conclusion in December 2013. To lock in the adjustments achieved under the IMF programmes, from 2014 fiscal policy is anchored by a fiscal rule that sets a ceiling of 2 per cent of GDP on the general government deficit (with very limited exceptions allowed) and a cap of 40 per cent of GDP on the public debt. However, although the rule is likely to be observed this year, large pre-election increases in public sector wages, pensions and other benefits have come at the cost of a major compression in capital spending.

Growth is expected to remain moderate in 2014. Output is forecast to be about 3.5 per cent in 2014 supported by strong remittance inflows and a rise in external demand. Kosovo is the poorest country in south-eastern Europe (SEE), and it therefore has more catch-up potential than other countries in the SEE region. However, downside risks are substantial due to a range of internal problems and ongoing difficulties in the eurozone. Negative contagion effects have been limited so far, but Kosovo’s dependence on remittances from its diaspora makes it vulnerable to foreign deterioration. Furthermore, major infrastructure projects are highly dependent on official foreign funding sources as domestic capital markets are underdeveloped.

Major structural reform developments

Progress has been made towards a Stabilisation and Association Agreement with the EU. In July 2014 the agreement between Kosovo and the EU was initialled by both sides. The initialling of the SAA marks the formal end of the negotiation process and represents an important step in Kosovo’s EU approximation. The next steps will likely be the signing of the agreement and ratification by the European parliament, which may take place in 2015.

Privatisation of the country’s main telecommunications company failed. In December 2013 parliament failed to approve the sale of a majority stake in PTK, a state-owned telecommunications company. The winning bid of €227 million for a 75 per cent stake had been submitted by a US-German consortium in April 2013, after an open tender. However, amid significant political opposition to the deal, the government’s attempt to privatise the company failed for the second time in the last four years. This is a serious setback to Kosovo’s efforts to privatise state-owned assets and attract much-needed foreign direct investment.

Progress on privatisation has been weak. Many key state-owned companies have still not been privatised. At the end of 2013 the Privatisation Agency of Kosovo (PAK) had 585 “socially-owned” companies in its portfolio. During 2013 PAK held three privatisation waves but progress on this front has been limited, not least because of political instability and the economic slow-down, which has further dampened investor interest, but also due to the failure to fill positions on PAK’s board. In addition, the challenging business environment is a major deterrent to investment in Kosovo. The country has made notable progress over the past year in improving business conditions, but it still lags behind most other countries in the region.

Further steps have been taken to improve the business environment, albeit from a low base. Kosovo’s ranking on the World Bank Doing Business 2015 report has improved markedly in recent years, to 75th (out of 189 countries). The change was particularly significant with regard to starting a business, where the country’s ranking climbed from 100th to 42nd in the latest report. Nonetheless, Kosovo still lags behind regional peers on most competitiveness indicators. Over the past few years, contract certification and enforcement have improved. In addition, bureaucracy has been reduced with the introduction of bailiffs (enforcement agents) and the establishment of a notary system in 2012, followed by the certification of Kosovo’s first notaries in 2013. Financial management and corporate governance are also improving for some of the larger companies, with a higher number of high-quality corporate financial reports produced throughout 2013. Demonstrating social responsibility and good governance (management boards) has also been recognised by some companies as a marketing tool and as a way to gain access to finance. However, rule of law implementation remains weak in many areas and the level of corruption is perceived to be high. These factors, alongside widespread informality in the economy, constrain private investment and sustainable economic development.

Important problems remain in the electricity sector. Kosovo has considerable potential to improve energy efficiency and increase the proportion of renewables in power generation. Currently, nearly all electricity produced comes from two old, inefficient and highly polluting lignite-fired thermal power plants (TPP). The “Kosovo A” TPP is considered one of the worst polluters in the region and is scheduled to be shut down in 2017. The 40-year-old thermal power plant experienced a major explosion in June 2014 that killed two people, threatening the stability of the power system and costing an estimated €60 million in damages. The construction of a new thermal power station close to the capital, Pristina, has been announced. Improvements are also needed in transmission infrastructure, particularly in increasing interconnection capacity, which is currently one of the key factors constraining imports. In addition, although the present electricity tariffs are partly subsidised by the state (and are hence not reflective of costs), network losses, which are mainly non-technical in character, account for almost 40 per cent of the electricity produced.

There remain major transition gaps in providing critical infrastructure services to businesses and households. Kosovo made some progress in addressing part of the investment needs in the wastewater sector, with support from the KfW Development Bank and the German and Swiss governments. However, a discussion with the EU within the Stabilisation and Association Process framework in May 2014 highlighted the overall slow progress in the transport, environment, energy, climate and regional development sectors. To date, little investment and local capacity building has occurred in these areas, and private participation has been limited.

The banking sector remains stable. The capital adequacy ratio stood at 17.4 per cent at the end of March 2014. Although still the lowest in the SEE region, non-performing loans (which, according to Kosovo’s central bank, do not include substandard loans) have continued to edge up and now stand at 8.6 per cent of total loans as of the end of March 2014, but they are well provisioned. The banking sector is largely foreign owned, with parent banks coming primarily from eurozone countries and Turkey. However, lending is mainly financed from deposits, so the risks of crisis spillover through cross-border financing are limited.