On behalf of the Albanian authorities, we wish to express our appreciation to the staff for a well-written report, which reflects the remarkable cooperation and very constructive dialogue with the authorities.
The Albanian economy continues its strong performance, supported by sound policies and structural reforms. Economic growth is expected to return to its trend rate of 6 percent in 2007, thanks to positive results in the export sector, acceleration in the growth of services, and by a rise in public investment, including the road sector. Average inflation was held to 2.5 percent in 2006, in part due to two 25-basis point hikes in the policy interest rate. On the fiscal side, relevant administrative efforts aimed at increasing the tax base yielded tangible results: in 2007 tax revenues should be at about 23.7 percent of GDP from 22.9 in 2006. A responsible fiscal stance has contributed to maintaining the primary deficit, including grants, at only 0.4 percent of GDP in 2006 and should only slightly increase it at about 1 percent of GDP in 2007, mainly due to a slight slowdown of domestic revenue collection in early 2007. However, the total public debt should decline from 55.7 percent of GDP (2006) to 54.2 percent of GDP this year, also thanks to privatization receipts estimated at about 1.1 percent of GDP, half of which will be used for debt reduction. The ongoing fiscal policy will allow a steady improvement in government solvency. In the mid-year fiscal package, the authorities have decided to reduce the marginal personal income tax rate, to further broaden the tax base and improve compliance. The supplementary budget also includes a transfer of about 0.5 percent of GDP to the electricity company KESH, to be mostly absorbed by increases in indirect taxes.
Notwithstanding this favorable macroeconomic framework, the authorities are aware that downside risks have increased.
- Additional risks may arise from the strong credit growth. The Bank of Albania stands ready to take further restrictive measures to address this concern, as confirmed by the recent latest 25 basis points increase in the policy rate on June 27.
- Another potential risk is related to the still weak position of the public electricity utility, KESH, where poor collection performance, despite the last improvement, and a sharp increase in the import price of electricity have reduced cash flow and net worth.
We elaborate further on these two issues below.
2. Monetary and financial sector policies
The BoA has successfully maintained inflation within the midpoint of the target range without causing undue real appreciation or preventing growth from recovering to its potential rate. This achievement resulted partly from two policy rate increases—in July and November 2006.
However the authorities are aware that the underlying transmission mechanism operates primarily by controlling the pass-through effect on the lek price of traded goods. Changes in the policy rate appear less effective in mitigating the demand effects of rapid credit creation, and as a result the economy is potentially vulnerable to demand shocks. Recognizing this, the authorities are committed to remaining vigilant and reacting quickly to any deterioration in inflationary expectations or any excessive increase in the rate of credit growth. Consequently, they have adopted a precautionary approach. They believe that full transparency is critical in order to curb inflationary expectations, and have therefore clearly communicated to the public their firm intention to raise the policy rate again if this is necessary to maintain price stability.
Moreover, given limitations in the transmission mechanism, they have implemented innovative, but market friendly, improvements in the regulatory framework aimed at maintaining the quality of the loan portfolio and possibly reducing the supply of credit.
In particular, stricter requirements will be applied to those banks where the growth of credit and/or non-performing loans exceed specific thresholds. Should credit growth remain excessive, based on prudential considerations, the authorities are ready to supplement policy rate increases with additional prudential and regulatory measures. These could include the imposition of higher provisioning requirements on foreign currency loans to customers lacking foreign currency income, as well as higher reserve requirements on foreign currency deposits. The authorities are also refining and enhancing banking supervision, and developing a credit bureau within BoA, which will be operational by the end of this year.
The reform of the market infrastructure (in particular the implementation of the delivery versus payment system) will reduce risks and increase volumes in the secondary market for government debt and will foster the development of the interbank market, with positive effects both for monetary policy implementation and for the overall intermediation process. The authorities intend to protect the existing high level of institutional quality in the financial sector and are committed to avoiding legislative or regulatory action that weakens the independence of the BoA. This includes the Supervisory Board of the BoA’s control over the Bank’s budget and its authority to decide on compensation levels.
With respect to the nonbank financial sector, the unification of the non-bank supervisory agencies under the Financial Supervisory Authority provides a sound framework for moving forward. However, the authorities are cognizant that significant effort will need to be devoted to this sector to effect needed institutional changes and to raise the quality of supervision to acceptable standards.
Finally, for the first time this spring Albania was rated B1 by Moody’s and the rating was accepted by Government. This is a huge step toward entering financial markets and Eurobond perspective for Albania, at the same time it shows that the macroeconomic picture and debt sustainability are in favorable conditions.
3. Macroeconomic implications of the difficulties in the electricity sector
The electricity sector is posing some non-trivial problems to the economy for its implications on the budget, (both in terms of uncollected bills and financial losses) as well as for its potential effects on inflation and growth. Recent data on the distribution losses, which declined from 41 to 34 percent average, are encouraging but such a level is still above the 10-15 percent that is considered “normal” for a country with a similar stage of development. For this reason, the authorities are taking several initiatives. In particular they have appointed a new CEO of the electricity company, they have implemented an incentives package for key employees in sales and collection to achieve performance targets, and they have adopted a stricter position with respect to cutting off service to nonpaying customers. Moreover, in consultation with the World Bank, they have finalized strong measures to improve efficiency, reduce waste and theft, and raise collection rates through better financial management and technical improvements. The authorities believe that, with strong political support, KESH’s financial performance could be improved relatively quickly. Finally they are committed to the privatization of the distribution arm of KESH as soon as possible, and have already selected IFC as an advisor.
4. Other issues
On structural reforms, significant and tangible results have been achieved also thanks to the valuable support of the Fund and donors. In particular:
- Significant progress has been done in the area of debt management: the average domestic debt maturity has increased from 284 days at end-2006 to 327 days at end May 2007. To better coordinate cash and debt management functions, the authorities have developed weekly cash forecasts on the basis of cash needs of line ministries; and the Ministry of Finance and the Bank of Albania are now holding regular meetings twice a month to coordinate debt management and liquidity operations.
- Public financial management is improving: a new organic budget law will establish a comprehensive budget process, covering both regular budget organizations and special (extra-budgetary) funds, at both the central and local government level; it will also strengthen the link between the Medium Term Budget Program and the annual budget preparation process.
- The new public investment unit of the Ministry of Finance will select public investment projects and approve procedures for public investment management, including the obligation for submitting a cost-benefit analysis for investment projects.
- Finally, in order to enhance the business environment, the authorities have reformed the business registration process and set up the National Registration Center that will establish a one-stop shop for business registration by the end of September 2007. They are working to reduce barriers in the licensing system and have reduced the legal timeline for business registration from 30 to 8 days. Other initiatives, such as the new procurement law and a new concessions law will both serve to improve the transparency and competitiveness of the bidding process; the law on the business advisory council and the law on chambers of commerce and industry will further promote a better business environment.