Economic activity has continued to grow at a healthy clip, led by domestic demand, which is expected to continue in 2019. Growth is expected at 4 percent in 2018, led by public investment, consumption, and services exports, financed by continued strong bank lending and remittance inflows.
In 2019, growth is projected to increase to 4.2 percent, supported by a temporary increase in public investment on the back of robust domestic demand— driven by remittances and FDI—and exports. Headline inflation remained subdued at 0.7 percent in the first nine months of 2018 but has started to pick up due to higher food and energy prices and is expected to average 0.9 percent this year and 1.4 percent in 2019. Credit to the private sector remained robust on the back of lower borrowing rates and improvements in contract enforcement.
The 2018 budget execution is expected to be largely on target and the fiscal deficit within the limits of the fiscal rule.
With GDP per capita in PPP terms at just 26 percent of the EU average (76 percent of the region) and higher population growth, much stronger growth is needed to reduce the very high level of unemployment and achieve income convergence. Inflation is expected to gradually converge to the EU average as the gains from domestic competition and cost consolidation in the non-tradeable goods sector level out. The current account deficit is expected to gradually decline as import-intensive projects wind down and export diversification continues.
Despite some improvements, several other indicators continue to point to significant competitiveness challenges. Kosovo’s trade deficit (26 percent of GDP) continues to remain the highest in the region, with its goods export share lagging behind other Western Balkan countries, despite a noticeable increase in diversification across products and trade partners in recent years.
Unemployment at around 30 percent is the highest, and labor force participation at 40 percent the lowest, in the region. Increases in gross wages have not been accompanied by corresponding gains in labor productivity. Finally, Kosovo continues to attract the lowest FDI in the region.
Revenue administration reforms to reduce high informality, tax gaps, and tax debts. Total tax debt amounts to about 5 percent of GDP, and tax gaps to around 35 percent of GDP, as estimated by the World Bank. To meet the ambitious revenue gains from tax administration reforms foreseen in the 2019 budget, collections need to be reinforced by setting quantitative and strategic performance targets, widening the tax filing requirements and late filing penalties, and improving the productivity of audits. Moreover, to support the 2019 debt collection target of ¼ of the collectable tax debt stock, collection should be centralized in one single office at TAK headquarters to improve oversight, the process systematized and complemented by automatic write-off of uncollectible debt, and enforcement actions taken on a timely basis. On the other hand, any changes to the import VAT (about ⅓ of total revenue) should retain collection with Customs and include proper safeguards to minimize potentially large revenue risks. To protect the tax base, it is key to avoid granting new exemptions or tax holidays.
Kosovo’s financial sector remains broadly sound, though liquidity is tightening. Reported capital and liquidity buffers are ample, and banks’ capacity to absorb shocks remains strong. NPLs, below 3 percent of total loans, are the lowest in the region, reflecting robust growth in economic activity, dividends from past reforms to strengthen collateral enforcement, and continued write-off of NPLs. With continued strong credit growth, the loan-to deposit ratio has increased, albeit from a low base, and with a slowdown in deposit growth (mainly in corporate deposits), liquidity is expected to tighten, especially when monetary policy in the Euro area starts normalizing. Competition for lending opportunities further compresses interest margins, though the impact on bank profits is partly offset by volume growth, higher fee income and lower operational cost. The insurance sector (3 percent of the financial system) is recovering and has returned to profitability since mid-2017, even though 3 out of 15 insurance companies are undercapitalized