II. POLITICAL, ECONOMIC AND SOCIAL CONTEXT. A. Political Environment

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1 II. POLITICAL, ECONOMIC AND SOCIAL CONTEXT A. Political Environment 4. Kosovo declared its independence on February 17, By mid-december 2009, Kosovo had been recognized by 63 countries and had become a member of the IMF and the World Bank Group. Kosovo has also been granted the status of potential candidate by the statusneutral European Union (EU). The United Nations Interim Administration Mission in Kosovo (UNMIK) still acts under the United Nations Security Council Resolution (UNSCR) However, Kosovo authorities are of the opinion that this resolution is no longer relevant, and the national authorities govern under the Constitution of the Republic of Kosovo. The Constitution, which pledges to build an equal, inclusive, and multiethnic society, was ratified on April 9, 2008, and became effective on June 15, In October 2008, the UN General Assembly requested an advisory opinion from the International Court of Justice (ICJ) on whether Kosovo s declaration of independence was in accordance with international law. Since then, the Court adopted its first procedural order and has heard arguments from countries with views (both for and against) on the legality of Kosovo s declaration of independence. The ICJ is expected to issue its non-binding advisory opinion in this matter in the first half of Kosovo has moved towards greater security and stability in recent years, but international actors continue to play significant roles to address lingering post-conflict security challenges and risks. Ethnic Albanians, who represent more than 90 percent of Kosovo s population, overwhelmingly support independent statehood. However, ethnic Serbs, who comprise 4 to 6 percent of the population, tend to question the legitimacy of Kosovo s government and institutions. In this context, the central government has limited control over northern Serbdominated municipalities and enclaves, and the risk of tensions remains significant. However, the substantial albeit evolving international presence minimizes these risks. A NATO-led peacekeeping force (KFOR) has maintained a strong contingent in Kosovo, with 14,500 soldiers from 32 NATO and non-nato countries. KFOR focuses on maintaining security in North Mitrovica and overseeing the newly established Kosovo Security Force. In 2008, an International Civilian Office (ICO) was established to oversee Kosovo s compliance with Constitutional guarantees on the rights of ethnic communities. Though the drawdown of UNMIK is expected to be completed by end-2009, this mission continues to facilitate dialogue with Belgrade, monitor developments on the ground, support a field presence in Mitrovica, and supervise border crossings to and from northern Kosovo. Since December 2008, EULEX, the EU-led status-neutral mission, has gradually assumed UNMIK s police, judicial, and customs duties. EULEX currently has about 2,500 international and national employees in Kosovo, including in Serbian-dominated areas. The multi-ethnic Kosovo Police Service also plays a vital role in maintaining security and stability in the country. 6. The largest political parties in Kosovo are the centre-right Democratic League of Kosovo (LDK), and two parties having their roots in the Kosovo Liberation Army (KLA): the centre-left Democratic Party of Kosovo (PDK) and the centre-right Alliance for the Future of Kosovo (AAK). In addition, the centre-left Reformist Party, ORA, was formed in 2004 and the new Kosovo Alliance was formed in Kosovo Serbs formed the Serbian List for Kosovo and Metohija (SLKM) in 2004 and won several seats, but have boycotted Kosovo's institutions and never taken their seats in the Kosovo Assembly. 7. Following the November 2007 elections, Kosovo s government has been dominated by the PDK and the LDK, with the former naming the Prime Minister and Speaker of the

2 Assembly, and the latter the Presidency. In addition, three ministries are administered by minority political parties, in accordance with the provisions of the Constitution. The next general elections were announced for 2011 by the President and the ICO, which provoked a public dispute with opposition parties that had requested an earlier date. Nationwide municipal elections were implemented in November 2009 and were free of violence and generally considered to be well-managed and fair. The Central Elections Commission was fully responsible for organizing the elections, albeit with support from the Organization of Security and Cooperation in Europe (OSCE) mission in Kosovo. The outcome of the elections confirmed the dominant position of the PDK and LDK in Kosovo politics, although the main opposition party, AAK, gained strength in Western Kosovo. Notably, representatives of the Serb community participated in elections and assumed local government positions in some 3-4 municipalities although Serb participation continued to be very limited in Northern Kosovo. 8. In the longer-term, Kosovo is looking to deepen its integration with the EU and an agreed mechanism for monitoring progress towards this goal has already been established. While the mechanism to advance on integration for most Western Balkan countries is the EU s Stability and Association Process (SAP), an alternative mechanism -- the SAP Tracking Mechanism (STM), established in 2002 has been established for Kosovo, taking into account its disputed status. Between 2002 and 2006, progress towards integration was monitored regularly via an annual report. In 2006, Kosovo adopted a European Partnership Action Plan (EPAP) designed to meet the requirements of the STM and which has also been updated annually. B. Economic Environment 9. Kosovo s economic growth has been solid since the end of the conflict, attributable in part to large public investments in post-conflict rebuilding as well as an increase in private investment (albeit from a low base). GDP growth, reflecting the massive donor-funded reconstruction effort and high public and private investment, averaged 4 percent since the end of the conflict and reached 5.4 percent in It reverted to about 4 percent in 2009 in the wake of the global economic crisis, a better outcome than in most neighboring countries, which suffered declines in output. Kosovo has established the euro as the local currency, which has led to relatively low inflation. Inflation picked up in 2008, but prices began to fall again in 2009, and it was -2.8 percent for the first three quarters of Kosovo achieved a series of budget surpluses through 2007 when the primary surplus reached 7.1 percent of GDP, due to a conservative policy on recurrent spending, rising government revenues (about 25 percent of GDP), and under-spending on the capital budget. 10. The relatively small impact of the global financial and economic crisis on real growth up to this point reflects Kosovo s limited international integration with the world economy. Although Kosovo s exports suffered a sharp decline (about 40 percent) in 2009 after a 4-5 year period of rapid growth, their still-small contribution (5 percent) to GDP, meant the impact on overall growth was proportionately small. The drop in external demand has been offset by rising public expenditures and output growth has been sustained by high inflows of remittances and donor activity. The banking sector has remained stable, with deposits as well as credit to the private sector continuing to grow in double digits. There is some evidence, however, that banks are now more cautious in providing loans. 11. Although Kosovo s economy has remained resilient to the crisis, the macroeconomic outlook embodies some downside risks. Uncertain economic prospects in the EU could prolong Kosovo's economic slowdown through three main channels: (i) a weak or no rebound in remittances; (ii) continuing softness in demand for Kosovo's exports; and (iii) continued low

3 levels of FDI entering the country. In turn, a prolonged economic slowdown could affect the banking sector, which -- though relatively stable to date -- could see an increase in nonperforming loans (NPLs) and a concomitant reduction in willingness to extend credit. Finally, Kosovo faces several domestic and external political issues that have negative economic repercussions. For example, both imports and exports are hindered by the absence of customs controls in the Serb-dominated northern Kosovo, as well as by the non-recognition of Kosovo s customs stamps and license plates by Bosnia and Serbia. Resolution of these issues is highly unlikely in the near future. 12. Given the lack of monetary policy instruments, fiscal policy is the main anchor for macroeconomic stability, but after some early gains, Kosovo s fiscal stance has given cause for concern. Kosovo achieved early successes in fiscal policy, including reforms in tax policy and administration and the introduction of new taxes and collection methods that contributed to a five-fold increase in domestic revenues between 2000 and Import-related taxes and duties collected at the borders currently account for close to three-quarters of total revenues. While revenue collection has remained relatively strong, significant deficiencies in fiscal policy and planning have become apparent in recent years including lack of clarity on policy priorities and loose management of expenditures. Poor planning and under-spending, mostly of capital expenditure, led in 2007 to a primary surplus of about 7 percent of GDP. The subsequent easing of the government s cash position led the government to shift towards an expansionary stance in part to address Kosovo s severe infrastructure gap and in part to cover costs of implementing commitments under the Ahtisaari package with respect to creation of new municipalities and new government departments. As a result, the budget moved to a balance in 2008 and to a projected deficit of 1.9 percent of GDP in 2009 (or close to 7% if the one-off dividend of 5 % of GDP from the telecom company is excluded). This increase was driven mostly by a larger allocation for capital projects, but also by increases in recurrent expenditures, including wages. Another significant contributor to the deterioration in the public balance in 2009 was the need to finance the publicly-owned energy company, Korporota Energjetike e Kosoves (KEK). 13. Kosovo s budget process has also grown more undisciplined in recent years. Overall budget ceilings were not respected in 2009 and the Kosovo authorities failed to adopt a budget rectification that would rein in spending and bring the budget back in line with the original ceilings.. In fact, in the 2009 mid-year budget review, the government added 108 million on top of its initial budget, which was already excessively expansionary. In addition, a number of pieces of legislation were submitted to parliament without proper costing of their fiscal impact. There is also a need for better coordination among agencies and strengthened capacity to design, approve and execute a multi-year budget. Finally, there is a growing incidence of problems with respect to Kosovo's procurement systems, including high levels of re-tendering, price distortions, and limited participation of the private sector. 14. However, there are important indications that Government has begun to take corrective actions which would enable a return to a sound macroeconomic (including fiscal) environment. In October 2009, the authorities invited the IMF to assist them in preparing the 2010 budget, and following two IMF missions to Kosovo, the Government adopted a budget proposal in line with IMF s key recommendations. In addition, two important pieces of legislation, a new public debt law and a revised Central Bank law, were drafted with guidance from the IMF team. The Government and the IMF are exploring a new Stand-by Arrangement, which could be in place sometime in the first half of A program with the IMF will help to minimize some key fiscal risks, such as the likelihood of reverting to a more expansionary fiscal policy in a mid-year budget review, and will likely provide further stimulus for reforms in the tax

4 administration as well as in the energy sector. The Bank is also working with the Government on strengthening its capacity for setting expenditure priorities and improving budget planning and discipline. 15. The increase in public spending does not confront Kosovo with immediate financing or liquidity risks, but significant policy adjustments are needed nonetheless, to ensure mediumterm sustainability. The Kosovo government currently has several sources of financing available, including its sizeable bank balance at the CBK (estimated at around 450 million). In addition, with the new Law on Public Debt, the Ministry of Economy and Finance (MEF), as well as municipalities (after at least two years), could start to borrow on the domestic market. Nonetheless, the use of either of these sources of financing has downside risks, including possible liquidity shortages in the medium term and consequent crowding out of the private sector from

5 the banking system. To offset this risk, the Government plans to maintain a minimum reserve balance of 200 million in its bank account to guard against any possible liquidity shortages. More importantly, the recently-approved 2010 budget helps take important steps towards achievement of a sustainable fiscal path. It will, however, be critical that the Government remains steadfast in budget implementation especially in avoiding the risk of raising expenditure allocations at the time of the mid-year budget review as has been done in previous years. 16. Going forward, the Government needs to consider the new liabilities that Kosovo has recently taken over towards IBRD as well as other potential liabilities. When Kosovo became a member of the World Bank, it agreed to take on responsibility for past Federal Republic of Yugoslavia debt to the IBRD amounting to about 381 million (Kosovo C loan) and planned in advance for the servicing costs of these new liabilities in its forward budget tables and in the the Medium-Term Expenditure Framework (MTEF). In parallelt, a Bank-administered multi-donor trust fund was established to assist Kosovo to repay the debt. Thus far, the trust fund has received US$125 million from the US and 5 million from the EC. In October 2009, the MEF prepaid one-third of the IBRD loan using the funds in the debt Trust Fund and additional funds from the budget. Further donor contributions to the Trust Fund are expected which will be used either to service the debt or retire additional debt. However, Kosovo is facing other contingent liabilities (mostly towards the Paris and London Clubs) which could be similar in amount to the IBRD debt. In the event that Kosovo assumes these liabilities, the consequences for debt sustainability would be significant. 17. A debt sustainability analysis (DSA) undertaken by the IMF and the Bank indicates Kosovo s risk of debt distress is moderate. The DSA concludes that all debt indicators remain on a sustainable path, over the next two decades, in the baseline fiscal and external scenarios. The robustness of the conclusions with respect to debt sustainability is further strengthened by the assumption in the baseline scenarios that Kosovo will take over the above-mentioned debt from former Yugoslavia and begins servicing this debt in However, fiscal and external sustainability is subject to prominent risks. The public debt trajectory becomes unsustainable in case of a moderate but permanent increase in the primary deficit. For example, a primary deficit of 2.5 percent of GDP over the DSA projection period would put debt on an unsustainable path. This finding underscores the need for devising an effective fiscal anchor that is consistent with a medium-term macro framework. Moreover, Kosovo s narrow export base, and high dependence on remittances, magnifies the impact of external shocks. This highlights the importance of making far-reaching structural reforms to improve competitiveness and enhance export sector performance. 18. The uncertainties related to the debt stock and the external vulnerabilities call for prudent macroeconomic policies. Servicing such debt would also put additional pressure on the budget, when resources are already limited and inadequate to meet all the institutional and infrastructure investment needs of the country. The Government can neither borrow nor print money in order to cover any short term liquidity shortfalls. A possible slowdown in foreign aid or remittances could quickly weaken imports which would affect government revenues through their impact on customs revenue, leading to a rapid drawdown of the government s bank balance. Should there be liquidity shortages in the banking sector, the economy also has no lender of last resort, again suggesting caution. Privatization of large public enterprises, such as the telecom company, could bring substantial resources, but given the uncertain external environment, immediate materialization of these plans should not be taken for granted. In this context, the GoK s macro-fiscal framework does not include proceeds from privatization of telecoms.

6 C. Socio-economic Environment 19. Although Kosovo has come a long way in reestablishing peace and social stability, although a few municipalities with sizeable minority populations mainly those in the north of Kosovo experience serious societal tensions and remain prone to localized outbreaks of violence. As might be expected, tensions are especially high between ethnic Serbs and the majority ethnic Albanian population, particularly in ethnically mixed municipalities. Moreover, many Serbian majority municipalities, concentrated in Northern Kosovo, continue to resist cooperation with the Government of Kosovo while continuing to look to Belgrade for financial and other support. Other minorities tend to keep a low profile in terms of ethnic conflict, but often suffer economic and social discrimination and are disproportionately represented among Kosovo s poorest households. 20. With a GDP per capita of 1760, Kosovo is one of the poorest countries in Europe, with poverty higher among ethnic minorities and specific demographic groups such as children and the elderly. Poverty remains persistent and widespread. 45 percent of the population consumes less than the national poverty line, and an estimated 17 percent are extremely poor i.e., unable to meet basic nutritional needs. Extreme poverty is disproportionately high among children, the elderly, households with disabled members and female-headed households. Kosovo s four main ethnic minorities Serbs, Turkish Muslims, Slav Muslims and Roma are particularly vulnerable, with extreme poverty the highest among Roma and Slav Muslim households. However, the narrowness of the poverty gap and analyses of the severity of poverty suggest that poverty is not deep: the average incremental consumption needed to escape from poverty is about 10 percent of the poverty line. The observation of widespread, but shallow, poverty is reinforced by Kosovo s moderate Gini index (0.5 in 2005) and a relatively flat consumption distribution. 21. A 2007 World Bank Poverty Assessment found that poverty has been increasing in rural areas while it has dropped in urban areas, and that almost two-thirds of Kosovo s poor people are rural dwellers. As about 90 percent of the rural population is engaged in agriculture and a large proportion of these households are primarily dependent on agriculture for their livelihoods, improving agricultural productivity could help in Kosovo s efforts to reduce poverty. Unfavorable farm structures and underinvestment prevent the sector from meeting its production potential. Of the approximately 160,000 farms in Kosovo, 97 percent are smaller than five hectares and occupy over three-quarters of Kosovo s total agricultural land. In 2005, the average family holding was about 1.5 hectares, fragmented among 8 plots. 22. Widespread unemployment and a lack of quality jobs have contributed significantly to poverty and income insecurity as well as to ethnic tensions. With a 45 percent unemployment rate and a low employment rate (29 percent), Kosovo has the weakest employment track record in Europe, and Kosovo s 53 percent labor participation rate among the working age population is substantially below the ECA average (65 percent). Obviously, the lack of jobs has direct consequences on income, and empirical evidence suggests that the risk of poverty is 20 percent higher for the unemployed than the employed. Households with unemployed heads have the highest extreme poverty indices. In addition, many households with adult members in precarious or unsteady jobs are also below the poverty line. Many of these households are dependent on small, informal enterprises for the majority of their income, reflecting the high degree of informality apparent in Kosovo s economy. 23. Kosovo s difficult labor market conditions have been especially severe for youth, with obvious implications for social stability. Unemployment among the population years old

7 reaches 76 percent -- a figure that is more alarming considering that half of Kosovo s total population is under 25, and 21 percent is between the ages of 15 and 25. The poor quality of the education system and limited employment opportunities make it difficult for young people to access and retain jobs. A current estimate suggests that there are 530 registered unemployed persons per job vacancy in the country. Moreover, young people who do find employment are typically hired into low-skilled, low-productivity positions, often in the informal sector. In 2005, about 20 percent of employed youth did not have an employment contract, 37 percent were not entitled to paid leave, and 73 percent were not registered in the social security system. 24. Kosovo s households remain heavily dependent on remittances, which are now the third largest source of income behind work earnings and government transfers. A 2003 household survey found that remittances comprised 15.2 percent of total household income among the extreme poor, and 15.4 percent among the non-poor. In total, 25 percent of the households included in the survey reported receiving cash or non-cash assistance from abroad, making these families particularly vulnerable to the global economic downturn. To the extent that the number of Kosovars working abroad is likely to have grown since 2003, a decline in remittances could have serious consequences for poverty in Kosovo. 25. Besides facing challenges of widespread income poverty, Kosovo s citizens have insufficient opportunity for investment in health and education as evidenced by relatively low social indicators. Health outcomes in Kosovo are extremely low. According to 2007 UNDP data, Kosovo had the highest child and infant mortality rates and the lowest life expectancy (69 years) in Southeast Europe (SEE). Major investments in the quality of basic healthcare services are needed to improve outcomes in tuberculosis, immunization, and reproductive care, where outcomes significantly underperform Millennium Development Goals (MDGs). Healthcare access also presents significant barriers. Within Europe, Kosovo has the lowest hospital admission rate and the second lowest visitation rate for outpatient care. Shortages of essential drugs are widespread, and out-of-pocket payments drive 80 percent of the pharmaceutical market. Education indicators are also problematic. Though Kosovo s net primary enrollment rate reaches 96 percent, the country s secondary and higher education enrollment lags behind rates in SEE. For example, Kosovo s 75 percent net secondary enrollment rate trails the 82 percent rate in FYR Macedonia, and drop-out rates remain high in rural areas, especially among girls. Moreover, Kosovo s education system does not provide its nearly half a million students adequate curricula and instruction to produce the skills that its evolving labor market requires.