Remarks by The World Bank on Medium-Term Public Spending Priorities

Previous presentations by the Authorities and the IMF have discussed the medium-term macro framework. This intervention focuses specifically on public spending and the budget, and is based on the background document 'Kosovo: Medium-Term Public Expenditure Priorities'.

The conduct of fiscal policy will remain critical in ensuring macroecomomic stability, a conducive investment climate, and equitable growth in Kosovo over the medium term. While the adoption of a hard currency has played a critical role in bringing about macroeconomic stability, it is also putting a larger burden on fiscal policy. Given the political and legal uncertainties surrounding borrowing, and without a monetary policy instrument, the fiscal policy stance will depend critically on a strong domestic revenue effort, a careful calibration of expenditures to support both public investment and critical social expenditures, and importantly, continuing donor support, albeit at a lower level.

In the immediate post-conflict phase, public spending in Kosovo has been very high at around 50% of GDP. Around 75% of this has been donor-financed, mostly in the context of the public investment program. As Kosovo's immediate reconstruction effort is phasing down, investment and public spending needs are declining. However, Kosovo is also facing the challenges of development and transition to a market economy, a challenge complicated by particularly pronounced underinvestment during the nineties.

Private investment and FDI are likely to remain limited over the medium term, because of the incomplete legal framework and general uncertainty related to the resolution of Kosovo's final status. To meet remaining post-conflict needs and lay the basis for sustainable growth, public investment spending will need to remain higher than in neighboring economies for some time to come. Public investment needs underpinning 5% real growth are estimated at 10% of GDP in 2005, albeit declining from 35% in 2001.

Estimating the economy's investment requirements and the level of recurrent spending, and benchmarking expenditure levels against international comparators, suggests that a public spending to GDP ratio of roughly 30% would appear appropriate for Kosovo by 2005. Recurrent budget spending should stay lower than in other European economies, in the range of 20% of GDP. In the presence of KFOR and UNMIK, a number of functions that normally require budgetary financing are covered by alternative funding sources. In addition, the budget does not currently finance any debt service payments.

Local tax revenues have performed impressively since 1999, increasing from 9% of GDP in 2000 to 16% in 2001; and they can be expected to finance an increasing share of public spending. Nevertheless, in the context of lower growth and with most measures to achieve large increases in revenues already implemented, the potential for further increases will be more limited. Even with a strong local revenue effort in the medium term, tax revenues will remain insufficient to cover all of Kosovo's public spending needs.

Donor assistance will remain crucial for achieving sustainable public finances, in particular as the authorities currently have no access to borrowing. Closing the remaining financing gap will require about €500 million in new commitments over the 2003-05 period, of which €450 million would be needed to finance the public investment program. The remaining €50 million would be for general budgetary support.

Given the tight overall resource constraint in Kosovo, and in the face of declining public spending, difficult choices and trade-offs in the allocation of public spending will have to be made. The main challenge will be to develop policies that preserve macro-stability and to ensure that public services are sustainable, comprehensive, and efficiently provided.

Let me make a few specific points on areas where some of the greater tensions lie:

• Operations and maintenance spending in Kosovo is currently inadequate to maintain public assets.

• Greater capital expenditures will need to be financed by the general budget, both to provide adequate counterpart funding for externally financed projects, and to contribute to domestically financed investments.

• Relative to other economies in the region, general budget spending on health and education in Kosovo is particularly low; strategic additional investments are needed to increase access and quality, and to promote growth. In health, private spending is significant and unregulated, raising both access and quality concerns; steps currently underway to regulate private sector provision are critical. In education, targeted investments are needed to increase enrolment including of girls and minority groups.

Extra spending in these areas can only be financed if cost savings are implemented elsewhere. Subsidies to public enterprises are currently high and crowding out other spending. Rationalization plans need to be designed for all existing subsidies; as a first step, collection rates can be strengthened by enforcing payment discipline. Public sector wage and employment policies also need to be reassessed. With public wage spending in excess of 6% of GDP, there is little scope for increased payroll spending. However, with the highest paid civil servant currently only making four times as much as the lowest paid, relative to a global ratio of around seven, the salary structure in Kosovo is currently highly compressed; targeted increases are needed to attract and retain certain skills. Such increases are only affordable if steps are taken to reduce the overall level of public employment, including in education.

The efficiency of existing spending can also be improved. Efficiency gains can for instance be achieved by right-sizing and restructuring staffing in health and education, improving procurement of pharmaceuticals, and rationalizing the hospital sector. The social assistance scheme should also be restructured to reduce targeting errors.

The effectiveness of the budget as a policy tool can be strengthened further. Through the introduction of the Medium Term Expenditure Framework (MTEF) in 2002, the authorities have started to link the Government's program to the budget process. Yet, policy formulation and decision making mechanisms in Kosovo remain fragmented, and no coherent vision of budget development exists among different stakeholders. To strengthen the effectiveness of the budget as a policy tool, the MTEF should be developed further next year to improve budget coverage by integrating the recurrent and investment budgets, and to encourage line ministries to focus on ways of improving resource use within the existing sector budgets.

The first three years of budget management in post-conflict Kosovo have seen tremendous progress in improving sustainability. We look forward to working with the authorities, jointly with the IMF, EC, and other donors, in building further on this progress.