On behalf of the Albanian authorities, we thank staff for the well-written and informative reports, which are further proof of the remarkably close and constructive cooperation with the authorities.
Thanks to prudent monetary and fiscal policies, the Albanian economy has been able to weather very well the external shocks that occurred in 2007, particularly a severe regional drought and rising food and energy prices. Growth accelerated to 6.0 percent, from 5.0 percent in 2006, fueled by robust industrial and mining production and export growth (+19.0 percent in nominal terms on an annual basis), and is expected to remain at 6.0 percent also in the current year.
Average inflation should increase from 2.9 to 4.0 percent in 2008, as a consequence of the recent exogenous price increase and power disruption, but is expected to decline to about 3.0 percent in 2009, in line with the Bank of Albania’s (BoA) 3±1 percent target band. Underlying inflation is somewhat lower (2.5 percent) and inflation expectations remain well anchored, thanks to the vigilance of BoA and its prompt actions to raise the policy rate three times in 2007 so as to avoid second-round effects.
Strong increases in VAT and personal income tax revenues contributed to meet the 2007 budget target (3.9 percent of GDP), despite additional expenses of about 1.0 percent of GDP reflecting an emergency transfer to the state-owned electricity company KESH and higher social security outlays. In 2008 the overall budget deficit will register a one-time spike, from 3.8 to 5.2 percent of GDP, as a result of an acceleration in capital spending related to a major road project, but will decline to 3.7 percent in 2009 already.
Against the background of a broadly favorable macroeconomic scenario, the authorities are fully aware of some challenges, including: new delays in the planned reforms of the energy sector and rapid credit growth, despite some recent moderation.
In the face of the ongoing uncertainties with KESH and cost overruns with the Rreshen-Kalimas road project, the 2008 budget outcome has been protected against heightened risks with contingency reserves of about 1.5 percent of GDP, which would allow for a flexible reallocation of expenditure if needs be. The authorities have also committed to the assessment, through a midterm budget review and in consultation with the Fund, of the need for expenditure cuts in the event of risks to the deficit ceiling.
After this year’s temporary acceleration of capital spending, the authorities plan to adopt in the near future an explicit fiscal deficit cap of 4 percent of GDP. This will give the automatic stabilizers on the revenue side some room for maneuver and help bring the debt burden to below 50 percent of GDP.
Over the last two years the authorities have carried out a major overhaul of the tax system, by introducing flat personal income and corporate tax rates. As a result, the direct tax structure has become less distortionary and easier to administer.
One of the key objectives of the authorities for this year is to make substantial improvements in the transport infrastructure. However, they are committed to reallocating potential savings from under-execution of the road project to reduce the budget deficit.
Monetary and financial sector policies
As a result of tighter monetary policy, complemented by more stringent prudential and regulatory measures, credit growth, a major concern this time last year, has been contained and is expected to further decrease to a more sustainable pace. The authorities recognize that potential risks stem from the ongoing large scale formalization and titling of real estate, as this reform will presumably lead to an expansion of available collateral. Thus, they stand ready to use monetary policy to counteract any unwarranted increase in credit growth.
The banking system is largely foreign owned (about 90 percent of total assets in 2007, up from 47 percent in 2003) and is well-capitalized and profitable. The authorities are aware that enhanced vigilance is nonetheless required, given that the loan portfolio of commercial banks has been built up during favorable circumstances and therefore remains untested by adverse economic conditions. To further safeguard the system’s financial stability, they will take the necessary legal and administrative steps to improve the ability of commercial banks to execute collateral.
The Bank of Albania has made considerable progress in its capacity to supervise individual banks and now conducts a full inspection of every bank at least once a year. In parallel with the rapidly maturing financial system, BoA plans to establish Memoranda of Understanding with the home country supervisors of major banks.
To improve the effectiveness of monetary policy, the authorities aim at developing efficient interbank and secondary markets. To this end, they are in the initial phase of developing a delivery versus payment system for government securities. Furthermore, foreign and domestic non bank institutions have recently been given full access to government securities auctions. In December 2007, for the first time, the Albanian authorities were able to issue a Lek 6 billion bond with a 7-year maturity, as a way to reduce rollover risk and attract foreign investors in government securities. They also intend to gain access to international capital markets and may plan to issue Albania’s first Eurobond in 2008.
Macroeconomic implication of the difficulties in the electricity sector
Deep-seated problems in the electricity sector still condition the macroeconomic performance of the Albanian economy. Although part of the recent decline in electricity generation is attributable to a regional drought, chronic power disruptions have taken a toll on inflation, the budget deficit and current account (because of the ensuing need to import more costly energy).
In order to achieve a more lasting solution and ensure a stable supply of electricity over the medium term, the authorities are in the process of privatizing the distribution arm of KESH by end-2008, under the advice of the IFC. Furthermore, they are establishing the required regulation and market structure with assistance from USAID. Meanwhile, in order to stabilize the company’s finances and address the potential fiscal risk, they have committed to take additional measures to meet the newly-introduced structural benchmark of reducing the quasi-fiscal losses of the company to 1.2 percent of GDP by mid-June 2008. To this end, they rely on tariff increases and improvements in collections. A 15 percent tariff increase has become effective in the current month and another one is foreseen in summer. Furthermore, the authorities aim to raise the effective collection rate by 10 percentage points in 2008, up from 52.5 percent the year before, including through a stricter approach to cutting off service to nonpaying customers. Overall, the above measures are expected to increase KESH’s revenues by about 0.75 percent of GDP.
The authorities are also developing additional sources of electricity supply. Construction of a thermal power plant, financed jointly by the World Bank, EIB and EBRD, has already started and should be completed by 2009.
The objective of the authorities’ medium-term economic strategy is to foster continued strong private sector-led growth. They are aware that macroeconomic and financial sector stability is a necessary condition that has to be complemented by structural reforms.
All quantitative program targets and all but one of the structural benchmarks (SBs) for the fourth review have been met. SBs are related to improving public expenditure management, reducing fiscal vulnerabilities and strengthening the financial system. In particular, the Large Taxpayer Office has been transformed into a full-service office and all large taxpayers now have the possibility to file and pay electronically. A cross-agency campaign to improve social security compliance has also been conducted and inactive taxpayers have been removed from the tax registry. Furthermore, a credit bureau has been set up within the Bank of Albania to improve banking supervision. The only structural benchmark that was missed relates to the submission of legislation to Parliament for transferring supervisory authority over the remaining leasing companies to the Bank of Albania. A draft of the law is currently being reviewed by the Ministry of Finance.
To improve public expenditure management, a new budget law has been submitted to Parliament and will strengthen the role of the Medium-Term Budget Program, and a register of public investment projects has been introduced to increase the capacity of execution.
The Albanian authorities set forth their poverty reduction strategy for 2007-13 in the recently approved National Strategy for Development and Integration (NSDI). The strategic priorities are: a commitment towards integration in the E.U. and NATO; the democratization of the society; the consolidation of the rule of law; and the achievement of rapid and sustainable economic and social development. The NSDI is being integrated into the three-year Medium-Term Budget Program (MTBP), which identifies policy objectives as intermediate steps to the achievement of the NSDI goals.