KOSOVOInstitutions and Policies forReconstruction and Growth

Dimitri G. Demekas

Johannes Herderschee

Davina F. Jacobs

I N T E R N A T I O N A L M O N E T A R Y F U N D

2002

©2002 International Monetary Fund

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Demekas, Dimitri G.Kosovo: institutions and policies for reconstruction and growth/Dimitri G.

Demekas, Johannes Herderschee, Davina F. Jacobs.—Washington, DC: Inter-national Monetary Fund, 2002.

p.; cm.

Includes bibliographical references.

ISBN 1-58906-098-9

1. Kosovo (Serbia)—Economic conditions. 2. Kosovo (Serbia)—Eco-nomic policy. 3. Finance, Public—Kosovo (Serbia). 4. Fiscal policy—Kosovo(Serbia). 5. Kosovo (Serbia)—Politics and government. I. Herderschee, Johannes. II. Jacobs, Davina F. III. International Monetary Fund.

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Preface v

Acronyms vi

1. Overview 1

2. Political and Institutional Developments Since the End of the Conflict 2

3. Recent Economic Trends and Policies 5

Production, Income, and Poverty 5Public Finances 8The Financial Sector 11

4. Policy Priorities for the Near Term 14

Fiscal Sustainability 15Financial Sector Deepening 17Private Sector Development 19Good Governance 20

5. Concluding Observations 21

Boxes

1. The New Constitutional Framework 42. Budgetary Structure 83. Chronology of Developments in the Insurance Sector 124. The Proposed Privatization Plan 19

Figures

1. Kosovo and Bosnia and Herzegovina, Unrequited Transfers 142. Medium-Term Projections of Expenditure 163. International Comparison of Current Expenditure 17

Tables

1. Sectoral Investment Flows 52. GDP and National Income 63. Balance of Payments 74. Consolidated Budget 9

Contents

iii

5. Overall Fiscal Position 106. Commercial Bank Balance Sheet 127. International Comparison of Government Expenditures 18

Appendices

I. The Joint Interim Administrative Structure (JIAS) 22II. Estimates of GDP and Balance of Payments 23

III. The Tax System and Future Plans 25

iv

CONTENTS

The following symbols have been used throughout this paper:

. . . to indicate that data are not available;

— to indicate that the figure is zero or less than half the final digit shown, or that the itemdoes not exist;

– between years or months (for example, 2000–01 or January–June) to indicate the yearsor months covered, including the beginning and ending years or months;

/ between years (for example, 2000/01) to indicate a crop or fiscal (financial) year.

“Billion” means a thousand million.

Minor discrepancies between constituent figures and totals are due to rounding.

The term “country,” as used in this paper, does not in all cases refer to a territorial entitythat is a state as understood by international law and practice; the term also covers someterritorial entities that are not states, but for which statistical data are maintained and pro-vided internationally on a separate and independent basis.

The authors are grateful for helpful comments and suggestions from a large numberof IMF and World Bank colleagues, in particular Adrienne Cheasty, Robert Corker,Carlo Cottarelli, Shigeo Kashiwagi, Marina Wes, and Emmanuel Zervoudakis. Theauthors are also grateful to Gail Berre of the External Relations Department whoedited the paper for publication and coordinated production. This report is primarilybased on the work of an IMF team that visited Kosovo in September 2001, consistingof Dimitri G. Demekas, Johannes Herderschee, and Davina Jacobs, and assisted bythe World Bank representative in Pristina, Giuseppe Zampaglione. The IMF teamheld a wide range of meetings, including with Mr. Hans Haekkerup, the Special Rep-resentantive of the UN Secretary-General at that time; senior officials of UNMIK;representatives of commercial banks, insurance companies, private enterprises, andthe major donors; and the leaders of the major political parties and ethnic communi-ties in Kosovo. The authors would like to thank without implicating these individu-als for their time and cooperation.

The views expressed in this study are those of the authors and do not necessarilyreflect those of the IMF or its Executive Directors.

Preface

v

BPK Banking and Payments Authority of KosovoCFA Central Fiscal AuthorityKEK Kosovo Electricity CompanyKFOR Kosovo ForceKTA Kosovo Trust AgencyOSCE Organization for Security and Cooperation in

EuropePISG Provisional institutions of self-governmentPTK Posts and Telecommunications of KosovoUNSCR UN Security Council ResolutionUNMIK United Nations Interim Administration Mission

in Kosovo

Acronyms

vi

Overview

K osovo is a province of Serbia in the Federal Re-public of Yugoslavia. Following the end of the

Kosovo war of March–June 1999, United Nations Se-curity Council Resolution 1244 (UNSCR 1244) ofJune 10, 1999 placed Kosovo under temporary UNadministration. While reaffirming the sovereignty ofthe Federal Republic of Yugoslavia over the territoryof Kosovo, UNSCR 1244 authorized the UN Secre-tary-General to establish an interim administrationthat would provide “substantial autonomy and self-government” to the people of Kosovo.

Since Kosovo was placed under temporary UNadministration, it has developed the instrumentsand institutions necessary to formulate and imple-ment an independent economic policy. Kosovo’seconomy remains linked to the rest of the FederalRepublic of Yugoslavia through trade, but theUnited Nations Interim Administration Mission inKosovo (UNMIK) has severed virtually all linkswith the Federal Republic of Yugoslavia in the areaof economic policy. Although a final political settle-ment for the province is still pending, its economicpolicy today is effectively independent. In the two-and-a-half years since the end of the conflict,Kosovo has been a laboratory of economic institu-tion building from the ground up.

At the request of UNMIK, and together with therest of the international community, the IMF hasbeen assisting institution building and economicpolicy implementation in Kosovo.1 The IMF Fiscal

Affairs Department has focused on setting up thetax system, budgetary institutions, and the treasury.The IMF Monetary and Exchange Affairs Depart-ment has helped establish the Banking and Pay-ments Authority of Kosovo, which has centralbanking and financial supervision functions; has ap-pointed its first managing directors; and is workingtoward introducing a modern payments system. TheIMF Statistics Department has provided assistanceon a new statistical framework. Last but not least,IMF staff have provided macroeconomic policy ad-vice to UNMIK on an ongoing basis. The IMF’swork has been closely coordinated with the WorldBank and other bilateral and multilateral donors,notably through participation in the High-LevelSteering Group of the Group of Eight.

This paper gives an overview of institutional andeconomic developments in Kosovo to date and dis-cusses the main economic policy challenges cur-rently facing the province. Tackling these challengeswill be a task not only for UNMIK but, increasingly,for the Kosovars themselves. Kosovo’s recently pro-mulgated constitutional framework created new in-stitutions, including a Kosovar Assembly and a gov-ernment, which are currently being formed followingthe first province-wide general elections in Novem-ber 2001. These new institutions of self-governmentwould take over from UNMIK a large share of itscivil administration responsibilities, including in thearea of economic and financial policy.

1

1

1UNSCR 1244 explicitly authorizes the UN Secretary-General to seek the assistance of “relevant international organi-zations” in establishing an international civil presence inKosovo, and encourages “all Member States and international

organizations to contribute to economic and social reconstruc-tion” in the province. On this basis, in July 1999 the IMF Execu-tive Board approved the provision of technical services toKosovo.

Political and Institutional Developments Since the End of the Conflict

T he immediate priorities of the internationalcommunity after the end of the Kosovo con-

flict were to establish order and security and averta humanitarian catastrophe. Despite the short du-ration of armed conflict between NATO and Yu-goslav forces, which lasted 78 days, the Kosovoconflict caused significant human dislocation. Atthe peak of the conflict, nearly one million Koso-vars—mainly ethnic Albanians—representingabout 45 percent of the prewar population of theprovince fled their homes. Following the end ofthe conflict, some 210,000 Serbs and other non-Albanian minorities were displaced and remain soto this day. The conflict also caused extensivedamage to property, especially to the housing stockand public infrastructure. After the end of the war,the NATO-led Kosovo Force (KFOR) andUNMIK inherited a precarious domestic securitysituation: widespread possession of arms, humanrights abuses, violence, and the risk of generalizedconflict between armed Albanian groups. KFORand UNMIK’s first major tasks were thus to estab-lish a secure environment and provide emergencyassistance to the population. During the first fourmonths after the conflict, relief agencies distrib-uted food rations to about 1.5 million people inKosovo, and some 900,000 people—about half ofthe population—continued to receive food aidthroughout the winter of 1999–2000. Constructionmaterials were provided for home reconstruction,and emergency repairs were carried out on healthfacilities and on the road, energy, and water supplynetworks. The handling of the immediate postcon-flict crisis by the international community was a

success: by the early summer of 2000, the humani-tarian emergency was over.2

In parallel, UNMIK used its authority underUNSCR 1244 to establish a civilian administrationin Kosovo. This resolution gave the Special Repre-sentative of the Secretary-General and UNMIK avery broad mandate, including the authority to per-form civilian administrative functions, maintain lawand order, develop provisional institutions for self-government, and support the reconstruction andeconomic development of the province. UNMIKwas initially set up with four sections or “pillars,”each run by an international agency: humanitarianaffairs (the UN High Commissioner for Refugees);civil administration (UN); democracy building (Or-ganization for Security and Cooperation in Europe);and reconstruction (European Union). These fourpillars, as well as the 30 municipalities in Kosovo,were managed by international UNMIK staff. In ad-dition, KFOR continued to guarantee security andorder. In July 2000, after the humanitarian emer-gency was over, the humanitarian affairs pillarceased to exist as a formal component of UNMIK,and the number of pillars was reduced to three.

UNMIK moved quickly to set up the structuresand institutions necessary for an autonomous eco-nomic policy. A key early decision in this regard was

2

2

2United Nations, Security Council, Report of the Secretary-General on the United Nations Interim Administration Mission inKosovo (New York, 2000); International Crisis Group, KosovoReport Card, Balkan Report No. 100 (Brussels, 2000); and UnitedNations, Interim Administration Mission in Kosovo, A Year anda Half in Kosovo (Pristina, 2000).

to legalize the use of all foreign currencies for do-mestic transactions, including payment of taxes.Since the deutsche mark was already widely used inKosovo before the conflict, it soon became the dom-inant currency. In addition, UNMIK took a numberof important institution-building steps with exten-sive technical assistance from the internationalcommunity, particularly the IMF.

• A Central Fiscal Authority (CFA) was createdand put in charge of budget formulation andimplementation, tax policy, and tax administra-tion. In December 1999, the Authority pre-pared for 2000 the first Kosovo consolidatedbudget, covering the recurrent expenditures ofthe central government, municipalities, andpublic enterprises. There are no transfers be-tween the Kosovo consolidated budget and thebudget of the Federal Republic of Yugoslavia.

• The Department of Reconstruction was taskedwith the coordination of donor assistance forreconstruction and the preparation of the pub-lic investment program.

• As the Yugoslav tax collection system had bro-ken down in the province even before the con-flict, a new tax system and tax administrationwere set up to provide the resources for theKosovo consolidated budget and replace theparallel tax structures that had developed dur-ing the 1990s.

• The complex and distortionary trade regimethat was inherited from the Federal Republic ofYugoslavia was replaced by a simple system,with no quantitative restrictions and a single 10percent tariff rate, administered by a new Cus-toms Department.

• The Banking and Payments Authority ofKosovo (BPK) was established in November1999 to provide a system for domestic pay-ments; to license and supervise domestic banks;and to ensure their liquidity, solvency, and ef-fective functioning.

• The payments system was reformed with the ini-tial introduction of a depository and cash facilityat the BPK. More recently, as indigenous banksstarted to appear, the BPK started developing aninterbank clearing and settlement system.

As a result of these measures, a new, autonomousinstitutional structure for economic policy hasemerged in Kosovo. UNMIK took these institution-

building steps on the basis of realities on the groundand the urgent need for a functioning administra-tion in Kosovo. The result was an institutionalstructure that has gone further toward autonomythan originally envisaged. Under the RambouilletAccords, the Federal Republic of Yugoslavia was ex-pected to maintain responsibility for monetary pol-icy, customs policy, and federal taxes in the territoryof Kosovo. Although UNSCR 1244 referred tothese Accords, it provided flexibility to UNMIK torespond to the needs of Kosovo. The outcome waseconomic policy structures and institutions that are,in effect, entirely independent.

Political institutions also evolved during the lasttwo-and-a-half years. In order to share the adminis-trative responsibility with the people of Kosovo,UNMIK set up in February 2000 the Joint InterimAdministrative Structure. The functions of the ad-ministration were passed to the Structure’s 20 de-partments and divided across the four pillars (whichbecame three after July 2000 when the humanitarianaffairs pillar was discontinued). Each department wasco-headed by an expatriate and a Kosovar (Appen-dix I). Following the municipal elections of October2000, the administration of municipalities was alsohanded over to locally elected representatives.

The new Constitutional Framework and the firstelections for a Kosovo-wide assembly in November2001 were further major steps toward self-govern-ment. In May 2001, the Special Representative ofthe Secretary-General promulgated a new Constitu-tional Framework for provisional self-government inKosovo. This Constitutional Framework, togetherwith UNSCR 1244, is now the fundamental docu-ment regulating the governance of Kosovo, pendinga resolution of its final status. The Framework cre-ated a president, an assembly, and a governmentthat would replace the joint interim administrativestructure departments, collectively referred to as the provisional institutions of self-government(PISG). The framework also provided for the sepa-ration of executive, legislative, and judicial powersand institutions. The first Kosovo-wide electionsunder this Framework took place in November 2001and, at the time of the writing of this report, theseinstitutions were being formed. At the same time,the Framework circumscribed the authority of thePISG by reserving some key powers and responsibil-ities exclusively for the Special Representative ofthe Secretary-General. These include, inter alia, theauthority to set the overall parameters of economicpolicy (see Box 1).

3

Political and Institutional Developments

The new Constitutional Framework has to beimplemented under continuing uncertainty regard-ing Kosovo’s final status and the ongoing segrega-tion of the Serb and Albanian communities. TheFramework has the support of the government ofthe Federal Republic of Yugoslavia, as indicated bythe UNMIK-Federal Republic of Yugoslavia Com-mon Document of November 5, 2001. However, itdoes not resolve the uncertainty regardingKosovo’s final political status. This uncertaintycomplicates the establishment of property rightsand the process of economic policymaking. In ad-dition, although inter-ethnic violence has abated,ethnic relations are far from harmonious. Serbs inKosovo continue to live in enclaves protected byKFOR, and movement outside these enclaves in

the rest of the province is a security risk. Finally, itis not clear how power sharing between UNMIKand the Kosovar government will work in practice.In the area of economic policy, in particular, ten-sions may arise between the power of the SpecialRepresentative of the Secretary-General to set theoverall parameters of the budget on one hand, andthe government’s responsibility to implement itand discretion to allocate funds among various useson the other. Furthermore, from an institutionalpoint of view, frictions may arise between the newministries and the administrative structures thatthe Special Representative of the Secretary-General will need to keep under his direct controlin order to exercise his reserved powers, such as theCFA.

4

2 POLITICAL AND INSTITUTIONAL DEVELOPMENTS

Box 1. The New Constitutional Framework

The new Constitutional Framework, promulgated bythe Special Representative of the Secretary-Generalon May 15, 2001—supplemented by a regulation onthe executive branch and passed in September—setsup a comprehensive legal framework for self-govern-ment in Kosovo. The main elements of the Frameworkare listed below.

Provisional institutions of self-government. Afterthe elections of November 2001, the following institu-tions are being established:

• The assembly consists of 120 members elected for athree-year term. One hundred seats are filled by pro-portional vote, ten are allocated to Kosovo Serbs,and ten to other ethnic communities.

• The president is elected by the assembly with a two-thirds majority for a three-year term.

• The government, consisting of the prime ministerand nine ministers, is approved by the assembly atthe proposal of the president. Ministers do not haveto be members of the assembly. At least one ministermust be a Kosovo Serb, and one a member of an-other minority ethnic community.

Power sharing. The Special Representative of theSecretary-General continues to promulgate laws

voted by the assembly, coordinate with KFOR on se-curity issues, and have the authority to appoint anddismiss judges and prosecutors. In addition, a numberof executive powers are reserved exclusively for the Special Representative. These reserved powersinclude:

• concluding agreements with states and interna-tional organizations

• controlling the police, correctional services, andthe Kosovo Protection Corps

• setting the overall policy parameters for the bud-get, on the advice of the Economic and FiscalCouncil

• controlling the UNMIK Customs Service• administering state-owned and socially owned

property, in cooperation with the provisional insti-tutions of self-government

• exercising authority over railways, frequency man-agement, and civil aviation

• appointing the members of the Economic and Fis-cal Council; the members of the board of theBanking and Payment Authority; the chief execu-tives of the Customs Service and Tax Inspectorate;and the auditor general.

Recent Economic Trends and Policies

Production, Income, and Poverty

The productive capacity of Kosovo had been se-verely degraded during the 1980s and 1990s. Like therest of Serbia, the province had suffered from thebreakup of the former Socialist Federal Republic ofYugoslavia and the associated conflicts, as well as theeconomic mismanagement of the Federal Republic ofYugoslavia during the 1980s and 1990s (Table 1). Es-pecially after 1989, when the autonomy of Kosovowithin the Republic of Serbia was suspended, theprovince experienced massive disinvestment. Opera-tions and maintenance in industry and infrastructurewere neglected. As a result, estimates based on offi-cial data suggest that industry collapsed and real out-put contracted in the early 1990s.

The 1999 conflict caused additional destruction ofeconomic infrastructure and severe loss of humancapital. Two-thirds of the homes were severely dam-aged or destroyed; 40 percent of water sources werecontaminated; bridges, roads, and other infrastructuresuffered wartime damage; and large areas of the coun-tryside were mined. Perhaps more importantly, theconflict and its aftermath caused a significant outflowof Kosovo’s human capital. Before the war, most man-agerial and professional positions had been held bySerbs. The subsequent expulsion of a large number ofSerbs left the province with a severe shortage of edu-cated and skilled workers and professionals.

The dearth of economic statistics precludes an ac-curate assessment of the current economic situation.There are no official statistics on any macroeco-nomic aggregates, including national accounts, in-flation, trade, and other financial flows with the restof the world. The Statistical Office of Kosovo is

building up its operations with technical assistanceby donors, but its output is thus far limited to vitalstatistics for the population, a business registry forlarge firms, and monitoring of farmgate food prices.A living standards survey in cooperation with theWorld Bank and the first business survey are alsobeing finalized. In the meantime, other sources ofdata are scarce and coverage is fragmentary. The ex-ception is public finances, where accurate statisticsare available for the central government.

Preliminary staff estimates suggest that GDPamounted to DM 2.75–3.25 billion (US$700–800 percapita) in 2000. National accounts estimates by IMFstaff (Table 2) are little more than guesses based onfragmentary information and supplemented by anec-dotal evidence. The GDP estimate is almost identicalto that made earlier by staff for the same year,3 but in-corporates lower figures for private consumption,

5

3

TABLE 1Sectoral Investment Flows(In percent: 1971=100)

1980 1988 1990

Industry and mining 294 89 28Agriculture 409 248 116Public utilities and housing 291 196 188

Total investment 274 115 68

Source: Riinvest estimates, based on official data.

3R. Corker, D. Rehm, and K. Kostiel, Kosovo: MacroeconomicIssues and Fiscal Sustainability (Washington: International Mone-tary Fund, 2001).

based on a recent World Bank household consump-tion survey, and higher figures for private investment.Appendix II explains in detail these estimates andthe source data.

All indicators show economic activity rebound-ing strongly in 2001, with real GDP growth wellinto the double digits. Reconstruction of buildingsand infrastructure is evident everywhere; anecdotalevidence suggests that the 2001 harvest was per-haps 20–30 percent higher than in the previousyear, as land was cultivated once again and agricul-ture recovered from a drought; the provision ofpublic services is slowly improving; and there is avibrant private service sector. Industrial produc-tion has yet to recover, but there are indications oflight manufacturing activity—agricultural process-ing, machine parts, soft beverages—some of it asso-ciated with exports to the rest of the Federal Re-public of Yugoslavia. Although domestic foodprices remained fairly stable during the first part of2001, reflecting increased supply, other prices havereportedly increased faster, and the GDP deflator is estimated by IMF staff to have risen by some

8 percent.4 As a result, GDP in 2001 is estimatedat DM 3.5–4 billion (US$850–950 per capita).

This level of activity, and the even higher levelof disposable income and consumption, reflects themagnitude of foreign assistance. As Table 2 shows,the structure of GDP is very distorted. In 2001,gross national disposable income is estimated atabout 172 percent of GDP, merchandise imports atabout 75 percent of GDP, and consumption about120 percent of GDP (or US$1,000–1,100 percapita). This was made possible by the extraordi-nary amount of foreign transfers from officialsources, as well as from Kosovars abroad. Staff esti-mates show that official transfers amounted to DM 1.5 billion in 2000 and DM 1.6 billion in2001, most of it for reconstruction (Table 3).

6

3 RECENT ECONOMIC TRENDS AND POLICIES

TABLE 2GDP and National Income(In millions of deutsche mark, unless otherwise indicated)

20002001_______________________

Original Revised Estimate

Gross domestic product 3,000 3,052 3,807Per capita (US$) 746 759 899

Gross national income 3,000 3,202 4,107

Gross national disposable income 5,540 5,446 6,545

Consumption 4,380 3,864 4,607Private 4,077 3,450 3,912Public 303 414 695

Investment 1,160 1,577 2,107Private 405 531 688Public/foreign financed 755 1,046 1,419

Exports 0 404 467Merchandise 0 21 43Services 0 383 424

Imports –2,540 –2,793 –3,375Merchandise –2,540 –2,414 –2,871Services 0 –380 –504

Net factor income from abroad 0 150 300

Net transfers from abroad 2,540 2,244 2,439

Sources: Central Fiscal Authority (CFA), Banking and Payments Authority of Kosovo (BPK), UNMIK depart-ments; and IMF staff estimates.

4This may indeed be an underestimate. A preliminary exerciseby the CFA shows that consumer prices rose by 6.2 percent dur-ing the first half of 2001, and the 12-month inflation rate in June2001 was 14.4 percent. These estimates would suggest that theincrease in the GDP deflator could be in the range of 10–15 per-cent in 2001.

Transfers associated with the activities of KFORare not included in these figures. Private transfers,on which there are no firm data, are estimated atan additional DM 750–850 million each year, andare used to finance private consumption or repairsof private homes. These transfers covered the largetrade deficit. Finally, the sizable presence of expa-triates in Kosovo also helped shore up demand forlocal goods and services and support private con-sumption. Although firm data are not available,there are currently about 10,000 UNMIK staff in Kosovo; an estimated 5,000–10,000 expatriatesworking for various other agencies and nongovern-mental organizations; and perhaps 40,000 KFORtroops.

Poverty in Kosovo is widespread but relativelyshallow. A World Bank assessment for 20005 sug-gests that about half the population of Kosovo hadconsumption levels below the poverty line. How-ever, the size of the poverty gap indicates that thedepth of poverty was small: the consumption levelsof the poor needed to rise on average by less than 16percent (or about DM 17 per month per person) forpoverty to be eliminated. Moreover, the relativelyflat distribution of income (an estimated Gini coef-ficient of 29 percent) makes the distinction betweenpoor and nonpoor households in Kosovo very

7

Production, Income, and Poverty

TABLE 3Balance of Payments(In millions of deutsche mark, unless otherwise indicated)

20002001_______________________

Original Revised Estimate

Trade balance –2,540 –2,393 –2,828Exports 0 21 43Imports –2,540 –2,414 –2,871

Nonfactor services 0 3 –80Exports 0 383 424Imports1 0 –380 –504

Net factor income from abroad 0 150 300Factor income 0 150 300Factor payments 0 0 0

Transfers 2,540 2,244 2,439Private transfers 1,200 750 850Official transfers 1,340 1,494 1,589

Humanitarian assistance 312 200 100Donor grants for current spending 272 285 169Reconstruction aid 756 1,009 1,320

Current account balance 0 5 –169Current account balance as a share of

GDP (percent) 0.0 0.2 –4.4

Capital account 0 100 150Private foreign direct investment 0 100 150Loans 0 0 0

Errors and omissions2 0 100 243

Overall balance 0 205 224

Net change in international reserves 0 –205 –224Official reserves (–, increase) 0 –77 0Net international reserves of the banking

system (–, increase) 0 –128 –224

Sources: Central Fiscal Authority (CFA), Banking and Payments Authority of Kosovo (BPK), UNMIK depart-ments; and IMF staff estimates.

1Excluding services provided by nonresidents living in Kosovo, which are paid by foreign donors.2Including transfers effected earlier but deposited in the banking system during 2000 and 2001.

5The World Bank, Poverty Assessment, Kosovo, Federal Republicof Yugoslavia (Washington: World Bank, 2001).

blurred. Extreme poverty was relatively limited: theshare of people in this category was less than 12 per-cent. The assessment also found that donor assis-tance and, in particular, food aid in the postconflictperiod had been quite successful in mitigatingpoverty in Kosovo.

Public Finances

Although the CFA has established proper bud-getary procedures, the management of the financesof the general government sector is fragmented, andreporting and accounting standards are uneven. Thebudgetary structure is presented in Box 2. The CFAhas introduced a basic tax system, effective expendi-ture control mechanisms, and transparent account-ing in the central government. However, reportingand accounting standards in the municipalities andpublic enterprises are much weaker. Also, theKosovo consolidated budget so far covers mainly re-current spending; the bulk of investment spending isfinanced by donors and managed separately by theDepartment of Reconstruction.

Given the low revenue base and UNMIK’s inabil-ity to borrow, fiscal policy has very limited room formaneuver and depends heavily on foreign grants.Total revenue amounted to some 24 percent of esti-mated GDP in 2001, of which some 60 percent wascollected at the border because, despite recent im-provements, domestic compliance is very weak. Themain revenue sources of the Kosovo consolidated

budget have thus far been an excise tax on oil prod-ucts, a 10 percent import duty, and a VAT that re-placed a tax on business turnover in July 2001(Table 4). There are no direct taxes, although thereare plans to introduce taxes on wages and profits in2002 (for details on the current tax system andplans, see Appendix III). Expenditures, on the otherhand, including for reconstruction, amounted tojust under 60 percent of estimated GDP in 2001.6The gap was covered by donor grants (Table 5).

Donor support for recurrent spending declined in2001, but this was offset by improved domestic rev-enue performance. The 2001 budget envisagedabout one-third of recurrent expenditure to be fi-nanced by donor grants (DM 162 million, primarilyfrom the European Union), down from about one-half in 2000. In the event, revenue performance wasmuch better than expected due to the rapid growthin activity and improvements in tax and customsadministration. For the year as a whole, general bud-get revenue is estimated at DM 573 million, com-pared with an original budget target of DM 338 mil-lion. This enabled the CFA to revise its budgettargets in November, allowing for an increase in cur-rent spending limits of DM 63 million and allocat-ing the rest of the unanticipated revenue to buildingcash reserves.

The 2002 budget projects a further significantincrease in revenue to DM 682 million on the basisof rapid growth in activity, further improvementsin efficiency, and the introduction of taxes onwages and profits. On the financing side, the bud-get projects a fall in donor support for both recur-rent and reconstruction spending: the former is ex-pected to be limited to DM 50 million in 2002.This sets the envelope for expenditures. Withinthis envelope, the 2002 draft budget shifts priori-ties toward a number of one-off outlays associatedwith the new assembly and the expected decline inthe number of UNMIK international staff, and in-cludes an increased allocation for capital spending.Current spending is also projected to grow signifi-cantly, in part through higher transfers to munici-palities, reflecting the devolution of responsibilityto local governments for the provision of certainservices. These services include primary healthcare, education, and the maintenance of restored

8

3 RECENT ECONOMIC TRENDS AND POLICIES

Box 2. Budgetary Structure

General Budget: Recurrent costs of government;administered by the CFA; financed by local rev-enue and foreign grants

Kosovo Consolidated Budget: General budget +municipalities + public enterprises; monitored bythe CFA; financed by local revenue and foreigngrants

Major Off-Budget Items:• Reconstruction: capital spending; administered

by the Department of Reconstruction; financedby foreign grants

• UNMIK: salaries of UNMIK staff; administeredby the UN; financed by the UN and donors

• KFOR: administered and financed by donorcountries

6This excluded the cost of maintaining UNMIK; the directcontributions to the administration of Kosovo made by the Euro-pean Union, the UN, and other donors; and KFOR’s contribu-tion to security.

9

Public Finances

TABLE 4Consolidated Budget(In millions of deutsche mark)

20002001

2002________________________Preliminary Budget1 Preliminary Budget

General budgetRevenue 248.9 486.1 572.8 681.6

Tax revenue 237.7 464.1 544.1 654.6Customs 60.5 80.0 93.1 62.8Excises 38.2 125.0 150.7 207.2Sales and VAT 124.0 203.0 245.7 311.6Presumptive business tax 9.2 50.0 52.4 43.0Profit tax 0.0 0.0 0.0 20.0Wage tax 0.0 0.0 0.0 10.0Other 5.8 6.1 2.2 0.0

Nontax revenue 11.2 22.0 28.7 27.0Expenditures 430.5 562.5 536.7 731.6

Recurrent expenditure 430.5 515.1 510.5 608.2Salaries, goods and services 274.8 350.8 347.2 325.7

Of which: wages and salaries 167.0 201.9 196.1 154.92

Of which: goods and services 107.8 148.9 151.1 170.8Subsidies and transfers 155.7 164.3 163.3 282.6

To households 60.1 . . . 93.2 122.0Of which: pensions 0.0 0.0 0.0 43.0

To municipalities and others 32.5 . . . 20.4 145.82

To public enterprises 63.0 . . . 49.7 14.8Interest payments 0.0 0.0 0.0 0.0Capital expenditure and transfers 0.0 22.3 26.2 38.1Reserves and contingency 0.0 25.1 0.0 85.2

Overall budget balance –181.6 –76.4 36.1 –50.0Overall budget balance (including grants) 48.9 85.5 165.2 0.0Financing 181.6 76.4 –36.1 50.0

Undesignated donor grants 211.1 150.0 124.9 50.0Designated donor grants 19.4 11.9 4.2 0.0Domestic (change in bank balances) (residual) –48.9 –85.5 –165.2 0.0

Local authoritiesRevenue 22.0 33.6 26.4 163.7

Of which: own revenue3 3.0 6.0 6.0 17.9Expenditures (recurrent) 22.0 33.6 26.4 163.7Balance 0.0 0.0 0.0 0.0Public enterprisesRevenue 276.7 196.8 377.2 644.8

Of which: own revenue 213.7 196.8 327.5 508.9Expenditures4 117.4 188.6 321.5 485.3

Operating costs 62.9 148.6 281.5 485.3Electricity imports 54.5 40.0 40.0 0.0

Balance 159.3 8.2 55.7 159.6Donor grants for electricity imports 54.5 40.0 40.0 0.0Change in bank balances –213.8 –48.2 –95.7 –159.6Kosovo consolidated budgetRevenue 465.6 688.9 906.3 1,208.4Expenditure 474.3 784.7 814.6 1,219.9Balance –8.8 –95.8 91.8 –11.6Balance (including grants) 276.3 106.1 260.9 38.4Financing 8.8 95.8 –91.8 11.6

Budgetary donor grants 230.5 161.9 129.1 50.0Donor grants for electricity imports 54.5 40.0 40.0 0.0Domestic (change in bank balances) (residual) –276.3 –106.1 –260.9 –38.4

Sources: UNMIK; and IMF staff estimates.1Budget as revised in November 2001.2Due to a devolution of responsibility for education and health spending to municipalities, with a consequent increase in transfers from the con-

solidated budget.3Own revenues include only revenue raised directly and paid over to the Kosovo Central Bank.4Includes only current expenditure of public enterprises.

roads. As a result, spending by the central govern-ment in these areas is projected to decline.UNMIK is planning a review of staffing and wagesin its administration during 2002 to rationalize andincrease the transparency of the system. Recon-struction spending projections show a marked de-cline in 2002, reflecting the expected decrease indonor transfers for investment projects. To facili-

tate better planning and coordination of the recur-rent and reconstruction budgets, the CFA is cur-rently working toward consolidating the two bud-gets, in line with earlier IMF and World Bankrecommendations.

The performance and management of public en-terprises is very uneven and raises questions abouttheir governance. The main public enterprises are

10

3 RECENT ECONOMIC TRENDS AND POLICIES

TABLE 5Overall Fiscal Position

20002001

2002________________________Preliminary Budget1 Preliminary Budget

(In millions of deutsche mark)Kosovo consolidated budgetRevenue 465.6 688.9 906.3 1,208.4Expenditure 474.3 784.7 814.6 1,219.9Balance –8.8 –95.8 91.8 –11.6Balance (including grants) 276.3 106.1 260.9 38.4

Financing 8.8 95.8 –91.8 11.6Budgetary donor grants 230.5 161.9 129.1 50.0Donor grants for electricity imports 54.5 40.0 40.0 0.0Domestic (change in bank balances) (residual) –276.3 –106.1 –260.9 –38.4

Capital expenditure2 1,046.0 1,393.1 1,393.1 881.0

Overall fiscal positionRevenue 465.6 688.9 906.3 1,208.4Expenditure 1,520.3 2,177.8 2,207.7 2,100.9Balance –1,054.8 –1,488.9 –1,301.3 –892.6Balance (including grants) 239.6 32.7 187.5 –42.6

Financing 1,054.8 1,488.9 1,301.3 892.6Grants to recurrent budget 285.0 201.9 169.1 50.0Grants to reconstruction budget 1,009.3 1,319.7 1,319.7 800.0Domestic (change in bank balances) (residual) –239.6 –32.7 –187.5 42.6

(In percent of GDP)Kosovo consolidated budgetRevenue 15.3 15.0 23.8 26.1Expenditure 15.5 17.1 21.4 26.3Balance –0.3 –2.1 2.4 –0.2Balance (including grants) 9.1 2.3 6.9 0.8

Financing 0.3 2.1 –2.4 0.2Budgetary donor grants 7.6 3.5 3.4 1.1Donor grants for electricity imports 1.8 0.9 1.1 0.0Domestic (change in bank balances) (residual) –9.1 –2.3 –6.9 –0.8

Capital expenditure2 34.3 30.3 36.6 19.0

Overall fiscal positionRevenue 15.3 15.0 23.8 26.1Expenditure 49.8 47.4 58.0 45.4Balance –34.6 –32.4 –34.2 –19.3Balance (including grants) 7.8 0.7 4.9 –0.9

Financing 34.6 32.4 34.2 19.3Grants to recurrent budget 9.3 4.4 4.4 1.1Grants to reconstruction budget 33.1 28.7 34.7 17.3Domestic (change in bank balances) (residual) –7.8 –0.7 –4.9 0.9

Sources: UNMIK; and IMF staff estimates.1Budget as revised in November 2001.2Kosovo reconstruction budget and capital expenditure by public enterprises.

the electricity generation and distribution company;the posts and telecommunications company;Pristina airport; Kosovo railways; and a number oflocal water, waste, and heating companies.

• The Kosovo Electricity Company (KEK) hasmajor engineering and management problems.Its two thermal generators are old and prone tofailure. About one-third of total electricity gen-erated by the company is lost due to technicalproblems or theft, and less than half of the re-maining output is paid by the consumers. Withabout 10,000 employees, the company is over-staffed. As a result, KEK has been a drain on thebudget. Emergency repairs and stricter oversightby UNMIK have improved performance some-what. However, KEK is still not able to generateenough electricity to meet domestic needs, andblackouts are frequent.

• Posts and Telecommunications of Kosovo(PTK) is quite profitable as a result of its mo-nopolistic position and a concession to a for-eign company to operate a mobile telephonenetwork. Indeed PTK appears to have been thesingle source of the sizable accumulation of de-posits in the public enterprise sector during2000–01 (Table 4). However, the company suf-fers from serious internal accounting problems:its financial operations are not transparent,oversight by UNMIK is weak, and reporting tothe fiscal authorities is deficient.

• Although not a public utility, the Trepc̆a min-ing complex is a drain on the budget. A verti-cally integrated conglomerate, including min-ing, smelting, processing, etc., Trepc̆a has about4,000 workers on its payroll, down from about10,000 original employees, and currently oper-ates at minimum capacity. UNMIK has esti-mated the immediate costs of revitalization atabout DM 100 million, but it is unclear whichparts of the company, if any, are viable in thelong term. Also there is clearly a limit to the ex-tent to which the budget can continue subsidiz-ing the mining sector, and the fact that the com-pany’s activities are largely in the Serb enclavesmakes this a politically sensitive issue.

A new social security system is slated for intro-duction in 2002. Kosovo so far has not had an in-digenous social security system, and rights accumu-lated under the old Yugoslav system cover only asmall part of the population. UNMIK designed a

three-tier system, and the regulation was signed intolaw in late December 2001. The new system is de-signed to provide a minimum social safety net forthe elderly population through a universal basic citi-zens’ pension (first tier) and to create a mandatory,fully funded system for new contributors (secondtier). The system also allows private pension fundsto be created on a voluntary basis (third tier). Thefirst tier will be funded through general budget rev-enues. Because of the phased introduction of thenew system during 2002, the impact on the 2002budget is expected to be DM 43 million.

The Financial Sector

The banking system is in a state of infancy. At theend of the conflict, financial intermediation inKosovo was nonexistent and virtually all transactionswere settled in cash. Although this is still largely thecase, banking activity started in earnest in late 2001and was spurred by the replacement of the deutschemark by euros in 2002. There are currently 7 licensedbanks and 15 microfinance institutions operating inKosovo. Two of the banks and most of the microfi-nance institutions were created and financed bydonors and, with one exception, are very small: theaggregate balance sheet of the commercial banks atend-December 2001 was DM 982 million. The ex-ception is the Micro-Enterprise Bank, a foreign-owned bank partly capitalized by the European Bankfor Reconstruction and Development and the Inter-national Finance Company, which accounts for morethan half of the aggregate balance sheet of the bank-ing system. Bank deposits amounted to DM 935 mil-lion (about one-quarter of estimated GDP), and bankloans to the private sector were just DM 48 million(Table 6), with the microfinance institutions provid-ing an additional DM 29 million of loans, most ofwhich were to finance trade and services. Most of theincrease in deposits occurred in the last three monthsof the year as a result of preparations for conversionto the euro.

Bank supervision is strong. UNMIK regulationspromulgated in November 1999 with IMF technicalassistance established a framework for licensing, reg-ulating, and supervising banks. The BPK has sincebuilt a small but strong supervisory team, staffedlargely by international staff.

Although the BPK is operationally independent,it depends on the budget for financial support andsuffers from internal accounting problems. Its

11

The Financial Sector

12

3 RECENT ECONOMIC TRENDS AND POLICIES

TABLE 6Commercial Bank Balance Sheet(In thousands of deutsche mark)

20002001______________________________________________

December March June September December

AssetsCash 22,826 28,927 22,988 23,300 168,413Balance with BPK 26,794 32,308 52,321 71,866 328,588Non-interest-bearing current account with other banks 12,155 7,196 16,250 12,509 57,660Loans to financial institutions (placement) 127,547 166,854 217,303 286,834 351,099Securities — — — — 14,665Net loans 6,157 9,230 20,239 27,907 47,660Property and equipment (net of depreciation) 863 1,374 2,362 4,304 6,976Interest receivable and other assets 5,038 3,810 3,124 3,642 7,108

Total assets 201,380 249,699 334,587 430,362 982,169

LiabilitiesDeposits 181,898 223,986 297,744 387,300 934,943Borrowings 5,719 5,985 9,867 9,867 9,867Interest payable and other liabilities 1,731 1,274 1,508 3,048 2,356Subordinated debts — — 22 — —Shareholders’ equity 12,032 18,454 25,463 30,148 35,003

Total liabilities and shareholders’ equity 201,380 249,699 334,604 430,363 982,169

Off-balance-sheet commitments and contingencies 11,660 9,988 10,914 3,462 3,836

Source: Banking and Payments Authority of Kosovo, Financial Statistics, January 2002.

Box 3. Chronology of Developments in the Insurance Sector

November 1999. UNMIK decides to make third-party motor vehicle liability insurance mandatory andissues an administrative order setting the requirementsfor licensing insurance companies: DM 5 million ofcapital (could also be a commercial letter of credit),reinsurance arrangements, and adequate staff. No pru-dential standards are specified, and no supervisoryagency is set up (UNMIK’s Pillar II is responsible forlicensing insurance companies, but without specializedstaff). Five insurance companies are quickly set up.

April 2000. In the face of complaints about businesspractices, UNMIK issues a second administrative orderspecifying minimum premiums, commissions, andmaximum discounts allowed for car insurance con-tracts. In response to this administrative price setting,illegal practices multiply, allegedly including extortionand criminal activity.

July 2000. The co-owner of an insurance companyapplies for a banking license, and the BPK discoversthat he is not fit and proper for a financial institution.UNMIK begins to realize the extent of the problems inthe insurance sector.

October/November 2000. UNMIK requests financialinformation from the insurance company, which the

company refuses to provide. UNMIK’s legal adviserconfirms that, under the existing legal framework, thecompany is under no obligation to report financial in-formation. UNMIK and the BPK decide to draft a newinsurance regulation and ask for donor assistance. Inthe meantime, insurance companies continue to issuepolicies under the existing framework.

May 2001. With the new regulation still in the draft-ing stage, UNMIK renews the licenses of the existinginsurance companies for three months, under the con-dition that they undergo an audit of their financial ac-tivity. By the end of July 2001, about 189,000 policieshave been issued, yielding premium income of DM 67million (about 1!/2 percent of estimated GDP).

September 2001. With the draft of the new regulationstill under review, UNMIK again extends the licensesof the insurance companies, under the condition thatthey deposit 40 percent of unearned premiums withthe BPK. At the same time, the BPK starts the processof evaluating the audits in order to assess the state ofthe existing insurance companies and to determineany necessary remedial measures.

October 2001. The new regulation is promulgated,and insurance supervision passes to the BPK.

dependence on budgetary transfers to finance its op-erations reflects the absence of seigniorage from theissuing of currency; a low level of capitalization; andhigh operating costs: the BPK maintains 29branches partly due to the lack of commercial bankbranches in many locations. Moreover, the BPK hasbeen plagued by internal accounting weaknesses.

In the insurance sector, an inadequate legalframework, the absence of supervision, andUNMIK’s slow response to a festering problem ledto a crisis. In November 1999, UNMIK promulgated

a legal framework for third-party motor vehicle lia-bility insurance that did not set adequate prudentialrequirements and did not provide for supervision.Following this, five insurance companies quicklyemerged. Their operations gradually raised concernsabout their solvency and allegations of extortionand criminal activity. Only in October 2001, how-ever, did UNMIK pass a new regulation and handover the responsibilities for licensing and supervis-ing the insurance industry to the BPK (Box 3),which is in line with international best practice.

13

The Financial Sector

Policy Priorities for the Near Term

D espite the signs of vigorous private economicactivity, Kosovo’s long-term economic

prospects are clouded by considerable uncertainty.Revitalizing the province’s infrastructure and capitalbase after years of degradation and wartime damagewould require significant up-front investments. Oneof Kosovo’s greatest assets, its young population,7would also require sizable investments in educationto realize its full potential. Donor assistance has beencritical in averting a humanitarian tragedy and get-ting Kosovo’s economy back on its feet, but it cannotbe relied upon fully to finance these necessary long-term investments. At the same time, domestic andespecially foreign private investors are unlikely toundertake major projects in Kosovo as long as uncer-tainty about the province’s final status persists.

In addition, regardless of the timing of the finalpolitical settlement, in the more immediate futureKosovo is facing the prospect of a rapid decline inforeign transfers (Figure 1). Humanitarian assis-tance has already started declining and is expectedto drop to very low levels by 2003. In the same year,donor grants for recurrent budgetary spending areexpected to end. Grants for reconstruction arelikely to decline to DM 300–400 million by 2004from DM 1.3 billion in 2001. While the currentmagnitude and medium-term outlook for privatetransfers are uncertain, these are unlikely to persistat their present level. In all, foreign transfers are ex-pected to fall to 15–20 percent of estimated GDPby 2004 from 67 percent in 2001. This pattern issimilar to that of Bosnia and Herzegovina after the

war. Indeed, the experience of the latter suggeststhat the decline of foreign transfers to Kosovomight, if anything, be even steeper over themedium term. The presence of international staff inKosovo is also likely to be reduced.

The near-term economic policy goal should thusbe to develop the domestic productive capacity andfurther the integration of Kosovo’s economy intothat of the region and the rest of Europe. This wouldmitigate the impact of the decline in foreign assis-tance. Moreover, given the longer-term uncertain-ties, it would maximize the chances of building asustainable economy. To achieve this goal, UNMIK

14

4

7With over half the population under 25 years of age, Kosovohas one of the youngest populations in Europe.

0

20

40

60

80

Kosovo 2000–04

Bosnia and Herzegovina1996–2000

Year 5Year 4Year 3Year 2Year 1

Figure 1.Kosovo and Bosnia and Herzegovina:Unrequited Transfers(In percent of GDP)1

Source: IMF staff estimates and projections.1Data are subject to considerable uncertainty.

and the provisional institutions of self-governmentshould focus on four broad policy priorities: fiscalsustainability, financial sector deepening, privatesector development, and good governance. Each ofthese is discussed in turn below.

Fiscal Sustainability

The main fiscal challenge for 2002 and themedium term will be to keep spending growth inline with that of available resources. Despite better-than-expected revenue collection in 2001, localrevenue growth will be unable to compensate forthe drop in donor grants in the short to mediumterm. Spending needs, however, will remain high,even after reconstruction is over. Resolving the ten-sion between resources and needs in a rational man-ner will require transparency, a medium-term vision,and the political courage on the part of UNMIK andthe provisional institutions of self-government tomake tough decisions.

Tax policy should aim at simplicity, low and uni-form tax rates, and as broad a tax base as possible. Taxcollection is likely to continue to grow rapidly as theeconomy expands, major new taxes are introduced(on wages and profits in 2002 and on all incomes in2003), and tax compliance is improved. However, thecapacity and human resources of the tax administra-tion are likely to remain strained. The following mea-sures would help maximize the contribution of thetax system to economic growth while, at the sametime, keeping it manageable and equitable.

• The planned wage tax should apply to all wage earners, including Kosovars employed byUNMIK.

• The future income tax should be levied on allsources of personal income, including thatfrom labor, interest, rents, pensions, and socialtransfers.

• The import tariff rate should be reduced or,preferably, abolished altogether in order toeliminate the associated trade distortions. How-ever, this step should only be taken if the asso-ciated revenue loss can be fully offset by othermeans, such as lowering the VAT threshold andimproving domestic revenue collection.

• Strengthening the tax and customs adminis-tration should continue to be a priority, and

care should be exercised in creating customswarehouses.

• UNMIK should resist the temptation to granttax exemptions to certain categories of goods,regions, or groups of taxpayers. Internationalexperience has shown that such exemptions donot generate permanent benefits for the econ-omy as a whole, but reduce the transparency ofthe tax system, hamper the efficiency of tax ad-ministration, and open the door to corruption.

On the basis of this tax policy, and without thepossibility of borrowing, staff projections of revenueand the outlook for donor grants provide a tentativeestimate of the envelope for public expendituresover the medium term. These projections suggestthat the resources available to finance public spend-ing will decline (Figure 2). Since reconstructionneeds will naturally fall, however, the room for cur-rent spending within this overall envelope will actu-ally increase over the medium term. The share ofcurrent spending to GDP in Kosovo—excluding in-terest and pensions, which have so far been zero—isbroadly in line with that of other countries in theregion, as well as that of a representative sample oflow- and middle-income countries (Figure 3 andTable 7). This suggests that the medium-term ex-penditure envelope in Figure 2 is adequate for theneeds of Kosovo without additional support bydonors for current spending. It also underscores theneed for UNMIK and the provisional institutions ofself-government to put the emphasis on allocatingthe existing resources efficiently.

Deciding on public resource allocation in an effi-cient manner will be a challenge. First, although re-construction spending will naturally fall in the nearfuture, the need for capital spending will continueto be high, especially in the energy sector. Second,social spending, such as education and health, to-gether with the recent introduction of a pension sys-tem will require an increasing portion of budgetaryresources. Third, new spending needs will arise, suchas the possible burden from Kosovo’s share of formerYugoslav debt and several off-budget expenditurescurrently financed directly by donors. The specialcircumstances of ethnic minorities are also likely togenerate expenditure pressures.

Against this background, it will be critical to setexpenditure priorities over a medium-term horizon,rather than from one annual budget to the next, andto control current spending, especially the public

15

Fiscal Sustainability

wage bill. The wage bill already absorbs the bulk ofthe consolidated budget. UNMIK has not been ablethus far to tackle widely acknowledged overstaffingin the public sector, notably among administrativestaff in the health sector and in the Kosovo Protec-tion Corps, relying instead on wage compression tokeep the wage bill manageable. This policy deprivesthe public sector of qualified personnel. The reviewof medium-term staffing needs and pay, currentlyplanned in the context of the 2002 budget, is atimely initiative. It should be accompanied by aplan to reduce and rationalize public sector employ-ment starting in 2002, with the savings partly usedto increase wage differentiation.

The public enterprise sector urgently needs bettermanagement, and greater transparency and ac-countability. It makes little sense to rely on donorsfor financing recurrent expenditures while, at thesame time, public enterprises are accumulating largecash balances. Posts and Telecommunications ofKosovo must be brought under the Public UtilitiesDepartment, and its transactions—in particular itscash balances, which derive from its status as a statemonopoly—must be accounted for with complete

transparency. The telecommunications sector needsto be opened up to private sector competition assoon as possible. Kosovo Electricity Company re-quires new and professional management to reduceoverstaffing, streamline operations, and improveservice to the public.

The new pension system addresses an importantneed, but care should be exercised to ensure its fi-nancial viability. The main risk for the proposed sys-tem is setting the basic citizen’s pension at a levelthat is not fiscally responsible. This risk is consider-able because, under the pension regulation, the as-sembly is responsible for setting the benefit levelwhile taxation remains in the reserved powers of theSpecial Representative of the Secretary-General. Amechanism is thus required to ensure that the bene-fit level set by the assembly is low enough to be con-sistent with available resources and adjusted in atransparent, nonpolitical way. A relatively low basicpension would also strengthen the fully funded sec-ond and third pillars, which would then become themain components of the system. Furthermore, be-cause the basic citizen’s pension is essentially a so-cial safety net for the elderly, it should be subject to

16

4 POLICY PRIORITIES FOR THE NEAR TERM

0

10

20

30

40

50

60

70

Capital Expenditure

Current Expenditure

Total Expenditure

200620052004200320022001

Figure 2.Medium-Term Projections of Expenditure(In percent of GDP)

Sources: UNMIK; and IMF staff estimates.

the future income tax, which would provide amethod of means testing. Finally, pension fundsshould be managed for the benefit of their contribu-tors, strictly supervised, and required to invest inlow-risk instruments, which are unlikely to be avail-able in Kosovo in the near future.

Financial Sector Deepening

Financial sector development in Kosovo is fac-ing formidable obstacles. Financial intermediarieshave a critical role to play in evaluating and pric-ing risk, allocating savings, financing investment,and enforcing good accounting and managementpractices, thereby bringing the “shadow economy”into the light. However, Kosovo’s financial sector

is stunted by lack of confidence in banks; lack oftrained, experienced managers and supervisors; anda weak legal framework for private business. In ad-dition, political uncertainty deters potential for-eign investors.

Despite these obstacles, significant, albeit un-even, progress is being made. Kosovo’s nascentbanking system is growing rapidly, as deposits and asmall but healthy loan portfolio are rising. Theearly introduction of a sound regulatory frameworkand the work of the BPK in establishing and en-forcing high supervisory standards have con-tributed to this development, as has the process ofthe introduction of the euro. Structural reforms inother areas, such as passage of bankruptcy legisla-tion, introduction of a property registry, and pay-ment of public employees and suppliers through di-

17

Financial Sector Deepening

0

10

20

30

40Interest and Pensions

Other Current Expenditure

Low-incomecountries 19984

Middle-incomecountries 19983

Romania1999

FYR Macedonia19992

Croatia1998

Bulgaria1998

Albania2000

Kosovo2002

Figure 3.International Comparison of Current Expenditure1

(In percent of GDP)1

Sources: IMF, Government Finance Statistics Yearbook (Washington, various years); and IMF staff estimates. 1Estimated outcome for Kosovo consolidated budget, excluding budgets of the public enterprises. Subsidies and transfersinclude unallocated contingency reserves. 2Former Yugoslav Republic of Macedonia. 3Barbados, Botswana, Chile, Colombia, Costa Rica, Cyprus, Dominican Republic, Egypt, El Salvador, Fiji, Hungary,Islamic Republic of Iran, Jordan, Malta, Mauritius, Morocco, Panama, Paraguay, Peru, Romania, Swaziland, Thailand, Tunisia, Turkey, Uruguay, and Zimbabwe. 4Burkina Faso, Cameroon, Democratic Republic of Congo, Ghana, Kenya, Lesotho, Malawi, Mali, Sierra Leone, Sri Lanka, and Zambia.

rect bank deposit, would help accelerate bankingsystem growth. Above all, however, the BPKshould continue to exercise close oversight, as newbanks with inexperienced management trying toacquire market share often take excessive risks ifnot properly supervised. Moreover, as the bankingsystem develops it will be important to ensure ade-quate rules on loan-loss classification, provision-ing, and connected lending.

Developments in the insurance sector, however,were a serious setback for the industry, as well as forUNMIK. The original regulation was hastily pre-pared by inexperienced staff; supervision was nonex-istent; and once problems were identified, correc-tive action was delayed and there was noaccountability. The resulting crisis was predictable,

and could have been prevented with more timelyaction by UNMIK. The new insurance regulation,which assigned the BPK a supervisory role over in-surance companies, is a welcome—albeit much de-layed—step in the right direction. The magnitude ofthe problem and the possible costs arising from un-dercapitalized insurance companies, however, areyet to be fully assessed.

There are good arguments for extending the BPK’ssupervisory role over new financial intermediaries. Inthe future, new financial intermediaries will be cre-ated, starting with the pension funds. It would nor-mally be unusual for a quasi-central bank to supervisepension funds. But in the circumstances of Kosovo,given that the BPK has already amassed significantexpertise in financial oversight, it would make sense

18

4 POLICY PRIORITIES FOR THE NEAR TERM

TABLE 7International Comparison of Government Expenditures(Average as percent of GDP)

FYR Middle- Low-Kosovo1 Albania Bulgaria Croatia Macedonia Romania Income2 Income3

2001 2000 1998 1998 1999 1999 1998 1998

Expenditures by economic type(including net lending) 17.3 31.4 36.8 31.0 37.7 35.6 27.7 25.6

Current expenditures 16.4 24.9 34.2 25.4 35.1 32.6 21.9 18.6Goods and services 11.3 12.4 16.5 16.6 12.4 11.7 11.5 12.6

Wages4 5.8 6.5 8.7 9.6 9.3 5.0 7.9 6.7Other goods and services 5.4 5.9 7.8 7.0 3.1 6.7 3.6 5.9

Interest 0.0 5.7 4.4 1.4 1.6 5.5 2.5 3.2Subsidies and transfers 5.1 6.8 13.3 7.4 21.1 15.4 7.9 2.8

Of which: pensions 1.0 5.4 11.6 5.8 13.6 10.6 4.6 1.3Capital expenditures 0.9 6.5 4.0 4.8 2.6 2.9 4.7 6.0Net lending5 0.0 0.0 –1.4 0.8 . . . 0.1 1.1 1.0

Expenditures by function6 17.3 31.4 41.5 29.9 37.6 35.6 26.7 26.3Military and civil defense 2.5 1.2 2.7 5.3 2.4 3.6 3.4 3.0Education 3.8 3.2 3.8 3.4 4.0 3.3 3.8 3.9Health 3.0 2.3 3.6 0.6 6.1 3.0 2.0 1.7Social security and welfare 2.7 8.4 11.6 5.8 13.6 10.6 4.6 1.3Housing 0.4 1.3 1.7 1.9 0.0 1.7 1.1 0.7Economic services 2.5 1.2 1.0 . . . 2.0 0.5 5.7 6.4Other government services7 2.4 8.1 12.7 . . . 7.9 7.4 3.6 6.1Interest 0.0 5.7 4.4 1.4 1.6 5.5 2.5 3.2

Number of countries 26 11

Sources: IMF, Government Finance Statistics Yearbook (Washington, various years); and IMF staff estimates.1Estimated outcome for Kosovo consolidated and reconstruction budgets, excluding the budgets of the public enterprises. Subsidies and trans-

fers include unallocated contingency reserves.2Barbados, Botswana, Chile, Colombia, Costa Rica, Cyprus, Dominican Republic, Egypt, El Salvador, Fiji, Hungary, Islamic Republic of Iran,

Jordan, Malta, Mauritius, Morocco, Panama, Paraguay, Peru, Romania, Swaziland, Thailand, Tunisia, Turkey, Uruguay, and Zimbabwe.3Burkina Faso, Cameroon, Democratic Republic of Congo, Ghana, Kenya, Lesotho, Malawi, Mali, Sierra Leone, Sri Lanka, and Zambia.4Military wages included in other goods and services for Bosnia and Herzegovina in 1999.5Data unavailable for the former Yugoslav Republic of Macedonia.6Does not include lending minus repayments.7Services provided by Ministries of Agriculture, City Planning and Construction, Development, Economy, and Information; the Bureau of Statis-

tics; and other agencies.

to charge it with the supervision of these intermedi-aries, provided it has adequate resources to do so.

In order to perform its functions properly, theBPK should have not only operational autonomybut financial independence as well. UNMIKshould consider a plan for the gradual capitaliza-tion of the BPK. Independence, however, ought togo hand-in-hand with good governance and ac-countability. The BPK’s resolution of its internalaccounting problems and rationalization of its op-erations—notably the reduction of the number ofits branches to two—are thus key priorities, as wellas prerequisites for recapitalization.

Private Sector Development

Private activity in Kosovo today is vibrant but re-mains mostly limited to informal services. There-fore, it remains small scale, outside the official taxnet, and vulnerable to crime. While this activitybears testimony to the entrepreneurial spirit of theKosovars, it is unlikely to be sufficient as the basisfor sustainable development.

The key to transforming the existing activitiesinto a modern business sector is an appropriate legalframework and the institutional apparatus to en-force it. UNMIK has made significant progress inpromulgating a basic package of laws, including acontract law, a company law, a foreign investmentlaw, a customs and excise law, a foreign exchangelaw, a banking law, and a law for the pledging of mo-bile assets. This package now must be supplementedby legislation on bankruptcy, protection of competi-tion, and mortgages, as well as a functioning cadas-tre and property registry. Equally important is thestrengthening of the judiciary so that the new lawscan be properly administered.

UNMIK has prepared a proposal for privatization,but legal and political obstacles have stalled imple-mentation. There are currently some 300–350 so-cially owned enterprises in Kosovo. According totentative UNMIK estimates, one-quarter to one-halfare unlikely to be viable as going concerns—althoughthey might still own potentially valuable assets. Asmall number (i.e., 20–40) are estimated to havecompetent management, working capital, and an es-tablished market that could attract outside investors.In between, there is a large number of enterprises thatmay be viable in some form, but are unlikely to at-tract investment. Box 4 outlines a proposal for athree-pronged approach to privatization that the re-

construction pillar of UNMIK developed in early2001. This plan, however, has raised a number oflegal and political issues. UN legal services have in-terpreted UNSCR 1244 as not allowing UNMIK tomake any change to the ownership status of sociallyowned enterprises in Kosovo that would prejudicethe rights of former owners or claimants. Potentially,old Serbian claims or concession agreements with for-eign companies could stop the sale of such companiesin Kosovo. Although the proposal is designed toovercome these legal snags, UN legal services haveyet to decide how and whether to proceed.

Privatization of state-owned and socially ownedenterprises is an important component of the transi-tion to a market economy and should start as soonas possible, either in the proposed form or under another scheme. Some argue that, in the case ofKosovo, privatization would have limited benefitsbecause many or most of these enterprises are notviable. The importance of privatization, however,should not be underestimated.

• It would unlock the potential of valuable assetsthat many of these enterprises hold, notablyland.

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Private Sector Development

Box 4. The Proposed Privatization Plan

The proposal developed by the reconstruction pillar of UNMIK envisages three channels for privatization.

Spin-offs: Assets of enterprises that could attractnew investment would be transferred to a new com-pany, fully owned by the old enterprise. The latterwould retain all liabilities. The old enterprise wouldthen be liquidated (voluntarily or through bank-ruptcy) or transformed (see below), while the newcompany could seek new investors.

Transformation: Shares of enterprises that are ableto meet minimum capital requirements but are un-likely to attract strategic investors would be distrib-uted to employees (60 percent) and the rest to a newly created Kosovo Trust Agency (KTA). TheKTA would be a public agency separate fromUNMIK, thus shielding UNMIK from potential lia-bilities. The Agency would be governed by a board ofgovernors appointed by the Special Representativeof the Secretary-General, and would be in charge ofpromoting the restructuring and privatization of theenterprises in which it holds shares.

Liquidation: Nonviable companies would be liqui-dated or reorganized through bankruptcy.

• It would eliminate a source of quasi-fiscal liabilities.

• It would restore a level playing field betweenthese enterprises and potential private sectorcompetitors and reduce corruption.

• It would send a powerful signal to domestic eco-nomic agents, as well as to the rest of the world,about the kind of economy Kosovo wants tobuild.

Good Governance

Governance is a major weakness. UNMIK andKFOR have been very successful in improving thesecurity situation and reducing violent crime.However, the process of building new state institu-tions in an area devastated by war has inevitablycreated gaps in laws and law enforcement, some ofwhich still persist. As a result, Kosovo is vulnerableto corruption, tax evasion, and other economiccrime. An even bigger threat is international orga-nized crime, which concentrates on the weakestlinks in international law enforcement. Establish-ing and enforcing the rule of law should thus re-main one of the highest priorities in order to pro-mote sustainable economic development andprevent Kosovo from becoming a pariah in the in-ternational community.

UNMIK has recently started focusing on eco-nomic crime. In November 2001, it initiated workon an anti-economic-crime strategy, which includesthe creation of an Economic Crime Unit. The strat-egy will be aimed at establishing priorities, buildinginstitutions, and mobilizing resources in fightingeconomic crime. It will be important to ensure thatthis strategy cover anti-money-laundering legisla-tion and infrastructure, and that it utilize the al-ready considerable capacities and expertise of thecustoms administration in this area.

Good governance goes beyond law and order; itencompasses transparency and accountability in gov-ernment decision making and in managing public re-sources. Key measures to improve governance and fa-cilitate the implementation of power sharing underthe new constitutional framework are the following:

• Coordination and accountability in decisionmaking. In a number of cases, notably insur-ance and privatization, important regulationstook months of legal review, and budget deci-sions were not always implemented by spend-ing agencies due to differences in policy priori-ties or interpretation within UNMIK. Thesedelays have real economic costs for donors andKosovars alike. Steps need to be taken to shorten review procedures, strengthen in-terdepartmental coordination, and enhanceaccountability.

• Institutional structure of public finances.Under the new constitutional framework, theauthority for fiscal policy in Kosovo is to besplit between the Special Representative ofthe Secretary-General and the governmentthat will emerge from the elections. This splitresponsibility risks weakening budgetary disci-pline and therefore needs to be carefullyplanned and implemented. In addition, ac-counting and reporting standards, and treasuryoperations should remain unified for bothparts of government spending, as well as forlocal authorities.

• Coverage of the Kosovo consolidated budget.The budget today covers only part of publicexpenditure: investment spending remainsoutside, as do many other donor-financed–off-budget activities. It is imperative to incorpo-rate into the budget all public spending and allsources of financing in order to increase trans-parency and rationalize resource allocation.

Improving the statistical infrastructure is also animportant step toward transparency and better poli-cies. The lack of statistics—with the notable excep-tion of public finances and the recently publishedmonetary statistics—precludes the accurate assess-ment of the economic situation and hampers policydesign. The importance of statistics has recentlybeen fully recognized by UNMIK. It will be criticalto continue efforts in this area, placing priority on national accounts and external trade statistics,and providing adequate resources to the StatisticalOffice of Kosovo.

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4 POLICY PRIORITIES FOR THE NEAR TERM

Concluding Observations

K osovo is a successful case study in economicinstitution building. The province’s economy

emerged from a decade of neglect and a short butdestructive conflict with its human capital andphysical capital severely diminished. Economic in-stitutions were virtually nonexistent, and the vac-uum was in some cases filled by parallel structures ofdubious legality. The financial system was obliter-ated, and the economy had reverted to cash-basedtransactions. Against this background, the work ofreconstruction and institution building undertakenby the international community since the end of theconflict is impressive. Today, Kosovo’s economy hasa recognizable face: private business is thriving, fi-nancial intermediation is restarting in a supervisedmanner, and there is a government providing publicservices partly financed through taxation. Thereare, of course, severe shortcomings and distortionsin almost every part of this economy, but the nuts-and-bolts are there.

Nevertheless, the economic challenges ahead re-main daunting. The economy needs prodigiousamounts of investment in physical capital andhuman resources. Poverty is widespread. With thepossible exception of mining, the natural resourcesof Kosovo’s small, landlocked territory are relativelylimited, and communications with neighboring re-gions are hampered by geography and inadequateinfrastructure. The existing institutions are yet todevelop deep roots and, as a result, Kosovo is vul-nerable to criminality, both domestic and interna-tional. More importantly, ethnic and political ten-sions still run high, and the risk of a lapse intoviolence and anarchy, though greatly diminished,has not entirely disappeared.

In this context, the international communitycontinues to have a key responsibility in Kosovo.Continued engagement is necessary at all levels.First and foremost, under the current arrangementsthe initiative to resolve Kosovo’s constitutionalstatus cannot be taken by anyone but the interna-tional community which, through the United Na-tions, is collectively responsible for the administra-tion of the province. Moreover, regardless of theshape of the final political settlement, Kosovo’s po-litical and economic institutions cannot continueto develop without significant assistance from therest of the world. Last, but not least, considerableresources and technical expertise are required forthe significant capital investment needed to liftKosovo’s economy from poverty and place it onto asustainable growth path. These resources cannotmaterialize without donor support. The interna-tional community’s “exit strategy” from Kosovoshould be a very gradual process.

However, the presence of the international community in Kosovo, while crucial, will not by itself be enough to achieve any of these goals. The ubiquitous presence of expatriates in Kosovotoday, occupying virtually every position of au-thority, conveys a misleading impression. The fate of Kosovo is ultimately in the hands of the Kosovars themselves. The new democratic institu-tions of self-government, however provisional,have already given Kosovars considerable influ-ence in shaping events in Kosovo, and this influ-ence is bound to increase with time. They nowhave to make the choice to build a peace-ful, well-governed society and a strong market economy.

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5

Appendix I. The Joint Interim AdministrativeStructure (JIAS)

JIAS Institutions1

22

Special Representative of the Secretary-General

Kosovo Transitional Council (KTC)

36 members, advisory roleInterim Administrative Council

(IAC) 4 Kosovars, 4 UNMIK

Pillar III:Democracy Building

(Deputy Special Representative of the Secretary General: Organization for Security and

Cooperation in Europe)

Democratic Governance and Civil Society

Pillar II:Civil Administration

(Deputy Special Representative of the Secretary-General:

United Nations)

Pillar IV:Reconstruction

(Deputy Special Representative of the Secretary General:

European Union)

Central Fiscal Authority (CFA)

Reconstruction

Trade and Industy

Utilities

Agriculture

Civil Security

Culture

Education

Environment

Public Services

Health and Social Security

Justice

Employment

Local Administration

Nonresident Affairs

Post and Tele-communications

Sports

Youth

Transportation

Source: United Nations.1Pillar I (Humanitarian Affairs), run by the United Nations High Commisioner for Refugees, ceased to exist as a formal component within

UNMIK in July 2000.

Appendix II. Estimates of GDP and Balance of Payments

E stimates of GDP and the balance of paymentsuse earlier IMF staff work for 2000,8 as well as

newly available information, and are extended into2001. Given the scarcity of data, these GDP esti-mates are compiled using the expenditure approach,based on partial information and some educatedguesswork. The main data sources and assumptionsunderlying the estimates are as follows:

• The estimate of private consumption in 2000is based on a household survey conducted bythe World Bank.9 The survey yields a privateconsumption estimate of DM 3 billion. As thestudy acknowledges, consumption is underesti-mated for two reasons: certain items are notincluded (particularly consumption of housingservices); and survey data are systematicallylower than consumption estimates for nationalaccounts purposes. To take these factors intoaccount, the World Bank estimate for 2000 isadjusted upward by 15 percent. For 2001, theconsumption deflator was estimated to be 8percent and real consumption growth was esti-mated to be 5 percent. This conservative as-sumption reflects the hypothesis that the mainsource of GDP growth in 2000 and especiallyin 2001 was investment, and it may well be anunderestimate of private consumption.

• Estimates of public consumption for 2000 and2001 are based on data from the Kosovo con-

solidated budget and, as such, are relatively reliable.

• Public investment includes all donor-financedprojects managed by UNMIK’s Department ofReconstruction, as well as a small amount ofcapital spending (estimated at 5 percent of thetotal) from the Kosovo consolidated budget.

• The significant construction efforts observed inPristina and elsewhere in Kosovo suggest thatthere is substantial private investment. How-ever, there are no reliable estimates of the valueof total private investment. IMF staff estimatesare based on the assumption that private invest-ment was equivalent to about 40 percent ofpublic investment. For 2000, this amount isaugmented by DM 110 million and for 2001 byDM 120 million, which is approximately two-and-a-half times the amount of bank lending inKosovo.

• Merchandise exports consist of cross-border ex-ports and sales to the expatriate nonresidentcommunity. Cross-border exports are estimatedon the basis of discussions with the CustomsDepartment and information on the activitiesof selected companies made available by theCFA. On this basis, cross-border exports are es-timated at DM 9.5 million in 2000 and DM 25million in 2001. Sales to the nonresident expa-triate community are estimated at DM 300 percivilian and DM 100 per military staff in 2000and DM 500 per civilian and DM 200 per mili-tary staff in 2001.

• As regards services exports, it is assumed that the average expatriate civilian spent some

23

8Corker, Rehm, and Kostiel, Macroeconomic Issues and FiscalSustainability.

9World Bank, Poverty Assessment, Kosovo.

DM 12,000 on housing, plus some DM 3,000 in2000 and DM 8,000 in 2001 on other locally pro-duced services. The average expatriate militarystaff is assumed to have purchased local servicesof some DM 200 in 2000 and DM 600 in 2001.

• Merchandise import estimates are based on datafor energy imports, humanitarian assistance, andthe public investment program, as well as actualcustoms data for 2000 and January–June 2001. Itis assumed that in 2000, 50 percent of public in-vestments consisted of imports, a figure that de-clined to 45 percent in 2001. For 2001, the cus-toms data are adjusted upwards by 22 percent.This adjustment reflects imports from Serbiaacross the administrative boundary line, whichare not recorded in customs statistics, and isbased on the share of Serbian imports to totalsales tax receipts. In addition, import figures areincreased by an arbitrary factor to capture the ex-tent of smuggling, as well as the magnitude onimports by KFOR and nongovernmental organi-zations, which are not reported. This factor is as-sumed to be 60 percent in 2000 and 45 percentin 2001, the latter reflecting improvements incompliance. Finally, import projections for thesecond half of 2001 assume a nominal growth ofsome 45 percent compared to the first half of theyear to take account of the rapid GDP growthand the expanded coverage of customs statistics.On the basis of these estimates, import growth in2001 was 19 percent.

• Services imports are assumed to be equivalentto 15 percent of private investment and 25 per-

cent of public investment, as well as 1 percentof private consumption.

• The estimates of factor income, private trans-fers, and direct investment from abroad arebased on the assumption that in 2000 a totalof some 200,000 Kosovars living abroad trans-ferred an average of some DM 5,000 back toKosovo. This assumption is based on anecdo-tal information provided by UNMIK staff andis slightly lower than World Bank estimates.Of this amount, it is assumed that three-quarters was private unrequited transfers andthe rest remittances (DM 150 million) andforeign direct investment (DM 100 million).In 2001, private transfers were projected to increase by DM 100 million, factor income by DM 150 million, and foreign investment byDM 50 million.

On this basis, the current account shows a smallsurplus of some DM 5 million in 2000. BPK dataprovide some information on net foreign assets ofthe banking system, on the basis of which it is esti-mated that net bank reserves increased by DM 205million, roughly half of which were financed bysurpluses on the current and capital accounts. Thisleaves a residual DM 100 million of errors andomissions in 2000. For 2001, a similar calculationyields an increase in net bank reserves of DM 224million and errors and omissions equivalent to DM 243 million. The large amount of errors andomissions largely reflect deutsche mark that werepreviously held in cash and are progressively beingdeposited in the banking system.

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APPENDIX II

Appendix III. The Tax System and Future Plans

Current Tax System andPerformance

Kosovo has made considerable progress in build-ing a sound tax system and tax administration. Thelatter, in particular, had to be rebuilt from scratchbecause staff, records, and infrastructure had beendispersed, looted, or destroyed. Today, Kosovo has abasic functioning tax system that collects revenuemainly from imports and some domestic sources.The main sources of tax revenue are the following:

• Imports are subject to a 10 percent uniform cus-toms tariff, with the exception of agriculturaland medical products and humanitariangoods.10

• Since July 1, 2001, a value-added tax at 15 per-cent replaced the sales tax previously paid byimporters. The VAT also applies to domestictaxpayers, but the high turnover threshold (DM 200,000 annually) and widespread taxevasion limit its efficacy.

• Excise taxes were mostly levied on an ad val-orem basis. The rates varied between 10 per-cent on soft drinks, 20–50 percent on alcoholicbeverages, and 25 percent on tobacco. In Octo-ber 2000, ad valorem rates on several categoriesof excisable goods (alcohol, tobacco, and fuel)were switched to specific rates. An increase in

the excise tax rate for fuel of 5 pfennig eachquarter was introduced on January 1, 2001.

• A presumptive tax on businesses is levied at a rate of 3 percent of gross receipts in excess ofDM 15,000 per quarter.

Custom duties, excise and sales taxes, and a largeshare of VAT are collected only at the borders. Thisreliance on border taxes makes revenue collectionin Kosovo vulnerable to border disturbances, as il-lustrated by incidents involving the setting of aboundary line with Serbia and the temporary clo-sure of the border with the former Yugoslav Repub-lic of Macedonia in 2001.

In addition to these sources of tax revenue, thebudget also collects vehicle registration fees and afew other small amounts in the form of charges anduser fees.

Overall, revenue performance in Kosovo im-proved significantly in 2001, largely owing to rapidgrowth but also because of improved tax collectionat the borders. The introduction of the VAT in Julyhas proved successful, and the removal of certain ex-emptions on food has also contributed to higher per-formance. The quarterly increase of 5 pfennig perliter in petrol excise taxes boosted tax revenue evenfurther.

Compliance with existing domestic taxes is cur-rently very low. Recent estimates by the CFA haveshown that the level of compliance is around 35–50percent. There are also very strong indications thatmany products, notably fuel and cigarettes, aresmuggled into Kosovo. After the full range of newtaxes is implemented, it will be possible to shift re-sources from implementation to compliance.

25

10Customs tariffs are not levied on goods originating in theFederal Republic of Yugoslavia, because it is not a foreign coun-try. Also, imports from the former Yugoslav Republic of Macedo-nia, with which the Federal Republic of Yugoslavia has a freetrade agreement, are subject only to the 1 percent administrativefee levied on all imports.

Future Tax Policy andAdministration Reforms

The following tax reforms are in the pipeline,subject to approval of the necessary regulations:

• the wage withholding tax, to be implemented in2002 at the following proposed monthly rates:

• DM 1–100: zero

• DM 101–500: 5 percent

• DM 501 and higher: 10 percent

• a profit tax at a rate of 20 percent on businessprofits, to be implemented at the start of 2002,

that will replace the current presumptive tax forthe larger enterprises

• an income tax, to be introduced in 2003, thatwould be levied on all sources of personal in-come, which includes income from labor, inter-est, rents, pensions, and social transfers

• a lowering of the VAT threshold to DM 100,000 inJuly 2002 from DM 200,000

• a reduction in the customs tariff in July 2002.

Proposals for several other taxes are under consid-eration, such as lottery or gambling taxes and amotor vehicle property tax.

26

APPENDIX III