Public Information Notice No. 05/30

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with Albania

March 10, 2005

On February 28, 2005 the Executive Board of the International Monetary Fund (IMF) concluded the 2004 Article IV consultation with Albania.¹

Background

The macroeconomic performance of the Albanian economy has been remarkable by both regional and international standards. After a slowdown in 2002, economic growth recovered to about 6 percent in 2003-04; inflation declined, generally remaining within the 2-4 percent target range of the Bank of Albania; and the external current account deficit narrowed by almost 3 percentage points of GDP reflecting trade gains. The public debt-to-GDP ratio has been reduced by 11½ percentage points to 55¼ percent in 2002-04 and confidence in the lek has been restored, as reflected in its appreciating trend. Rising incomes underpinned progress along some basic dimensions of poverty—although some education and health care indicators have deteriorated. However, a self-sustained, across-the-board expansion of tradable output has not yet taken root. At 23 percent of GDP in 2004, the external goods and services trade deficit remains high, as does the economy's dependence on migrant remittances and other transfers from abroad. Poor transport, telecommunications, and other infrastructure and a weak institutional environment are considered the main obstacles to investment.

The Bank of Albania's tight monetary policy stance since early 2002 has prevailed on inflation and buttressed confidence in the lek—against the backdrop of a strengthening banking sector. With inflation subdued and the lek appreciating, the Bank of Albania's policy interest rate has gradually eased since 2002 to 5¼ percent, although monetary conditions have remained tight. The successful privatization of the Savings Bank has revamped banking activity, supported by the Bank of Albania's provision of financial market infrastructure. Increased confidence and interest rate differentials have supported an increase in deposits—mostly contributed by lek deposits—and a reduction in the cash-to-broad money ratio. Foreign reserve cover was at a comfortable four months of imports at end-2004.

The public finances have strengthened over the past few years but fiscal institutional reforms have lagged behind. Budget and expenditure management were hindered by over-optimistic budget revenue projections that, when they failed to materialize, prompted haphazard spending cuts to meet financing targets. In 2004, after revised revenue and expenditure projections during the fourth program review, domestic revenue has broadly met forecasts and budget implementation has improved. However, shortfalls in external project-related financing and grants prompted spending reductions and an overall deficit overperformance of 1¼ percentage points of GDP relative to program. In 2004, the current budget was broadly balanced for the first time since transition. The enacted 2005 budget embodies further fiscal consolidation and savings on current spending—premised on a much improved revenue projection.

Some structural reforms gained momentum in 2004—notably privatization and sectoral restructuring. The authorities have initiated the privatization of several public enterprises—INSIG (insurance), Albtelecom (fixed-line telecom) and ARMO (refinery)—and are successfully restructuring the electricity sector.

Albania has been engaged in a series of Fund-supported programs since the beginning of the transition in 1992. The macroeconomic objectives of these programs were generally achieved and financial policies were decisively implemented, fostering macroeconomic stability and growth. The implementation of structural reforms was satisfactory overall, particularly in macro-critical areas, but the pace of the reforms was uneven. In addition, the achievements remained fragile on account of pervasive poverty, lingering administrative capacity weaknesses, and slow progress in improving governance.

Executive Board Assessment

Executive Directors commended Albania's good macroeconomic performance in recent years, observing that growth has been strong, inflation has generally remained low, and the current account deficit, although still high, has declined. Moreover, confidence in the domestic currency and the financial sector has firmed up. This favorable performance has been underpinned by fiscal consolidation, a firm monetary policy stance, and progress in privatization and other structural reforms. Directors cautioned, however, that a self-sustained broad-based expansion of net exports has not yet taken root, and that the external balance remains dependent on migrant remittances and other transfers which could be expected to decline over time. Furthermore, although the number of people living in absolute poverty has declined, poverty remains a key challenge.

Directors expected growth to continue at a brisk pace in 2005 and over the medium term. They emphasized, however, that this outlook is contingent on improvements in governance and the investment climate and on acceleration of the pace of reform, including in areas such as property rights protection and law enforcement. Directors concurred that vulnerabilities are limited by the moderate external indebtedness, but stressed that attainment of external sustainability will depend on improving competitiveness and attracting strategic export-oriented investment. Directors also pointed out that the possibility of softer demand in trading partner countries poses risks to the outlook, particularly since the strength of the lek might have eroded competitiveness in some sectors.

Directors were encouraged by the progress in building a sound monetary policy framework based on a clear inflation and financial stability mandate of the Bank of Albania, central bank independence, and a flexible exchange rate regime. With inflation within the Bank of Albania's target range, Directors considered that the gradual easing of the monetary policy stance since 2002 has been appropriate, and that the current neutral bias is warranted. Directors emphasized that the Bank of Albania should avoid having any explicit or implicit exchange rate target in its foreign exchange interventions, as monetary policy should remain focused on price stability.

Directors welcomed the increased dynamism of the financial sector in the wake of the Savings Bank privatization. They commended the authorities' ongoing initiatives to deepen financial intermediation and reduce the use of cash in the economy, and encouraged the authorities to take measures to develop the treasury bill, foreign exchange, and interbank money markets. Directors also noted the need to step up prudential vigilance in light of increasing credit to the private sector and the level of dollarization. They urged the authorities to monitor closely the health of the financial sector, and in this regard looked forward to the findings and recommendations of the upcoming Financial Sector Assessment Program.

Directors commended the progress made in strengthening the public finances in recent years. They welcomed the adoption of a 2005 budget that appropriately aims at further debt retrenchment in anticipation of a likely decline of concessional assistance, and the authorities' intention to use future large privatization proceeds solely for debt reduction and investment. They supported the emphasis on curtailing current spending to a level commensurate with a realistic projection of recurrent revenue, thus providing resources for investment. Directors also welcomed the authorities' commitment to refrain from across-the-board public wage increases and to formally repeal wage indexation before the 2006 budget. They encouraged efforts to build capacity in expenditure management and to monitor public investment.

Directors emphasized the importance of accelerating the reform of fiscal institutions and of capacity building. They noted the steps taken in this direction in the 2005 fiscal package and other ongoing initiatives. Priority also needs to be put on broader reform of tax administration to boost tax compliance and mobilize revenue. A few Directors recommended reform of the tax system to give more weight to income taxes. In addition, increased efforts are required to reduce the size of the informal economy. Directors also called for a strengthening of the budget process and of expenditure and debt management.

Directors were encouraged by the progress made in privatization and electricity sector reform, but noted that the unfinished reform agenda remains large and urged the authorities to intensify structural and institutional reform. In particular, further progress is needed in infrastructure provision and other measures to improve the investment climate, including a stepped-up fight against corruption. Directors observed that while indicators of absolute poverty have improved in recent years owing to income growth, efforts to strengthen the safety net and targeting of social programs are well placed.

Directors welcomed the findings of the Ex Post Assessment, which indicate that Fund engagement in Albania has been successful in achieving macroeconomic stability with robust economic growth. They believed that strong ownership of policies has been the key to this success. Most Directors considered that, given the extensive remaining reform agenda, the authorities' intention to seek a successor three-year arrangement with the Fund is well-placed. They noted the Ex Post Assessment's conclusion that the Fund needs to remain engaged with Albania at the present time, given the need to build capacity in macroeconomic management, catalyze donor assistance, and mobilize domestic support for reforms. Directors stressed that the authorities would need to remain committed to pursuing their reform objectives and develop a sound strategy for exiting from the use of Fund resources. These will be important considerations in any decision regarding a follow-up arrangement, and will require a political commitment to move the reform agenda forward.

Directors stressed the need to improve the quality and timeliness of Albania's statistics. They welcomed the technical assistance provided by the Fund and other donors, and encouraged the authorities to persist in their efforts in this area.