Economic and Social Reforms for Peace and Reconciliation

Prepared by the World Bank

February 1, 2001

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Against the background of the lost decade of growth and the institutional and political challenges outlined above, policy priorities lie in stabilizing macroeconomic conditions, making provision for essential public services - administration, education, and health - and setting the stage for private sector led recovery and long-term growth. The policies being pursued by UNMIK as the interim civil administration are designed to these ends.

The fundamental conditions for macroeconomic stability have been laid by permitting the unfettered use of a hard currency, the deutsche mark (‘Euro’), in all transactions without disturbing the legal status of the dinar. This policy will serve to shield Kosovo substantially from the inflation being experienced in the rest of FRY. The inflow of diaspora funds seen at present will provide resources for reconstruction and investment and will be a stabilizing factor. The local Kosovo budget that has been prepared by UNMIK will be financed fully through local taxation and donor budget support contributions: thus, the fiscal stance will also add to stability. A treasury with proper controls over expenditures has been established within UNMIK.

Box 2: Reforms Over the Medium Term

The major expenditure items in the budget relate to administration (civil service, judiciary, law and order), education, and health. Schools were re-opened in September 1999 and health centers and hospitals are functioning again. UNMIK has reconstituted a judiciary, established a self-defense force - the Kosovo Protection Corps – as well as a police force and a civil administration in the major spending sectors has been built up. Education, health and social assistance strategies this chapter contains a summary of the state of play, the essential priorities, and suggested policy reforms in each of the economic and social sectors covered by this report.

UNMIK is making progress towards establishing a public administrative structure intended to deliver adequate public services to the population of Kosovo, within the available budgetary resources complemented by donor support. As noted above, such progress includes the establishment of the Joint Interim Administrative Structure (JIAS) that provides for the participation of both Kosovars and international staff in administration. Within the JIAS can be found the Kosovo Transition Council – a 36 member body of politicians – that can be thought of as a rudimentary national assembly with consultative powers; a smaller deliberative body of 11 technocratic members, the Interim Administrative Council; as well as a Council of Ministers consisting of the two co-heads of each of the 20 departments (akin to ministries) -- an international and a Kosovar co-head. A notable institutional achievement was the establishment of the Central Fiscal Authority (CFA) and a budget management system that is able to provide resources in a timely manner and ensure that these resources are spent efficiently and transparently for the purposes intended. In addition, progress is being made to improve coordination in the reconstruction efforts, given substantial needs for capital investments and donor commitments and financial support to finance these needs.

The key institutional development at this stage in ensuring effective budget outcomes and effective service delivery over time relates to the link between the policy formulation process and planning and budgeting within a coherent budget strategy and expenditure framework. The link between policy, planning and budgeting becomes essential in the specific circumstances of Kosovo given a unique multinational administrative structure and substantial donor involvement in financing a considerable part of the recurrent budget needs and the entire capital investment needs. The present separation of the recurrent and capital budgets, with the former being financed partly through local taxation and partly through external donor assistance and the latter entirely from donor support, inhibits the formulation of a coherent budget strategy undermining the effective and efficient use of budgetary resources.

The Budget Balance for 2000 and Estimates for 2001 ¹

In the year 2000, the financing gap is estimated to be DM 200 million. Underlying this estimate is a revenue performance of DM 18.6 million per month in 2000 as compared to DM 7.6 million per month in 1999 and expenditures of DM 35.3 million per month in 2000 as compared to DM 21.7 million per month in 1999. Thus, the self-financing of the budget was estimated to rise strongly in 2000, with the financing gap as a proportion of expenditures falling from 65 percent in 1999 to 47 percent in 2000.

Developments in the first two months of 2000 showed an extremely weak revenue performance, with significant shortfalls in all categories of revenues, particularly excises. Though the causes of these developments are not fully understood, it is likely that the tax coverage gap related to the Montenegro boundary line led to large leakages. UNMIK has, as noted, now set up a tax post at the Montenegro boundary line and expects to meet its budgeted revenue estimates on the basis of the new taxes to be instituted and improved tax administration and coverage.

Following the poor performance of the first two months, revenue collections rose markedly. Excise taxes have shown strong increases due to the application of unified tax rates for heating oil and petroleum products. Hotel Food and Beverage Tax is now fully operational. Although its collections remain small, the experience gained through its administration was an ideal training ground for the staff and taxpayers for future inland taxes such as presumptive tax. Total revenues have shown significant improvements and are slightly above the pro-rata figures in the ten months ending October 2000.

The 2000 budget proposed a strong rise in overall expenditures (but at a rate less than the rise in tax and fee revenues) centering on education, health and social assistance. The key objectives of the education budget were to ensure full enrollment, initiate steps towards a unified curriculum, enhance pre-service teacher training, reform the Pristina university, and undertake comprehensive school mapping. The budget also funded the preschool sector. The major objectives for the health sector were strengthening primary care and building up the physical facilities for health care. The social assistance budget focused on assistance delivery to the most needy, particularly elderly over age 70, single parent families and families with a handicapped person.

Expenditure estimates for the 2000 budget rested on the assumption of DM 273 per month for the average public sector wage (a rise of nearly 50 percent in relation to those who received wages in 1999) and a fall in public employment (particularly in education and health sectors) of an estimated 10 percent. There was also the intention to develop retraining and counseling for redundant public sector employees and to establish a framework for unemployment insurance in future years.

The budget outturn for the ten months of 2000 as described above show that this limit of DM200 million in donor financing for the year as a whole is achievable, assuming that: (i) recent positive trends in revenue collections are maintained till the end of the fiscal year; and (ii) on the expenditure side there is partial catch-up in under-spending, with discipline on wage and subsidy spending being exerted in the rest of the year. On the other hand , any additional surpluses coming as a result of better than expected revenue performance should be used to ease up pressures on the next fiscal year by paying off arrears for the electricity imports as well as using some of the resources to support redundancies which otherwise must be financed out of the year 2001 budget. It is clear that additional donor budgetary support would not be required till the end of the year, opening the way for medium-term sustainability in the Kosovo local cost recurrent budget.

Table 4: Summary Budget Accounts
(in millions of deutsche marks)

Revenue projections for year 2001 assume improvements in both tax policy and tax administration and are expected to increase by 45 percent compare to 2000, to DM 344 million. Although such an increase is significant, it is necessary to ensure that Kosovo moves towards self-sufficiency and becomes less dependent on donor financing, especially for the recurrent expenditures. Increasing revenues in 2001 would be achieved by a broadening of the tax base and removal of the large distortions associated with the existing customs tariff structure. Measures are proposed towards the adoption of a modified VAT from mid-2001 and an extension of the tax base, therefore, to domestic production of goods and services. The abolition of the customs tariff from the time VAT is introduced, with the rate of the VAT being set to be revenue-neutral, will eliminate significant distortions in the current revenue raising system and help raise economic efficiency. Finally, the establishment of the legal framework for private sector development would open up opportunities for employment, growth and higher tax yields.

Total expenditures in the 2001 budget are estimated at DM 480 million or about DM 50 million over the expected outturn for 2000. These estimates represent a modest increase in the overall expenditures, mainly in civil administration and expenditures to support the new decentralized structure of municipalities; such expenditure tightness is clearly supportive of self-sustainability of the budget over the medium term. There are no planned increases in wage levels. However, major risks will remain in the next year’s budget and in the medium term, if the structural issues in year 2000 budget are not addressed. They include (i) bringing employment to a sustainable level for 2001, especially in health and education that have been running in excess of planned levels, even in year 2000; (ii) reduce transfers to the utilities by reducing employment and preparing an implementation plan for introducing cost recovery measures: (iii) preparing a fiscally sustainable redundancy policy and implementing employment reduction measures consistent with the policy; (iv) carefully implementing an adequate fiscal decentralization plan consistent with the local government capacities for taking over financial management responsibilities.

Consistent with the self-sustainability principle and tight fiscal scenario in the year 2001 budget, donor support is projected at DM 162 million. Donor support will, thus, fall not only in absolute terms as compared to 2000, but also sharply as a proportion of expenditures (51 percent in 2000; 32 percent in 2001). The rise in the self-financing of the budget is, of course, a necessary condition for an eventual successful "exit" by donors from providing budgetary support. Other conditions are being created for a successful exit: the infusion of new technologies and skills in fiscal and banking system management and supervision (to name but the two most important developments thus far) and the creation of institutions of governance and management. Keeping fiscal spending within the limits of medium-term sustainability as determined by the likely capacity to raise domestic revenues and obtaining external funding for investment will be critical. Instruments and institutions of economic management of this kind are being constructed to be durable whatever may be the eventual political settlement applied to Kosovo.

Initial fiscal spending was organized in an ad hoc fashion, outside the context of a fiscal framework and budget planning process. It was directed to financing the stipends of some health employees and judges in an effort to quickly address urgent needs. In response to the existing situation the establishment of a Central Fiscal Authority with the functions of a finance ministry was identified as a first priority

The Central Fiscal Authority (CFA) was established by regulation 1999/16 at the end of 1999. After making an impressive start in December 1999 it is functioning admirably despite extremely difficult and complicated circumstances. Its main divisions for budget, treasury, tax policy and tax administration became operational within a very short period and are performing important functions including: (i) budget preparation and monitoring; (ii) execution of budgetary transactions through the Treasury Single Account (TSA) and their financial control; (iii) formulation of tax policy and the management of tax and customs revenues. In addition, the CFA has hired and trained many local staff who already performs several routine tasks in the budget and treasury divisions, as well as a large number of tax inspectors. These functions are being performed under a newly established legal and regulatory framework which includes regulations and procedures on the functioning of the divisions, procedures on expenditure authorization, accounting and reporting, regulations on procurement of goods and services as well as tax legislation and procedures on revenue collection and administration. Internal audit capability reporting to the highest level of UNMIK is also under preparation.

Despite this impressive progress challenges remain to complete the development of budget management institutions. The budget and treasury system should be extended beyond UNMIK's spending departments and the budgetary transactions should be carried out as appropriate by the spending units. This requires further developments in the treasury and payments system. It also requires significant strengthening of budget and financial management capacities to the spending units to ensure a transparent and accountable use of budgetary resources. This last link in the expenditure chain is being worked on by the CFA and UNMIK in cooperation with the Banking and Payments Authority. Although the 2000 budget was prepared in consultations with the spending departments, formal procedures need to be developed to guide the budget formulation process for 2001 and beyond. Moreover these procedures should include recurrent and investment expenditures in order to ensure an integrated approach to budget planning, the formulation of a coherent budget strategy, and better coordination of foreign donors that finance entirely investment expenditures.

The task of a finance ministry in the circumstances of today’s Kosovo is an exceptionally difficult one. This applies to budget formulation as well as execution. The fiscal base is uncertain in view of the difficulties in projecting real rates of growth of the economy from a very low base under conditions of major institutional changes. Customs and tax administrations are being reinforced, but uncertainties surround their capacity, speed of strengthening, and willingness to apply the law fairly.

Closing the two major tax gaps, with the boundary line with the rest of FRY (Montenegro and the rest of Serbia) and FYR Macedonia effectively is important. A tax point was to have been established at the boundary point with Montenegro on January 1, 2000, but this was not done until March; the delay is estimated to have cost DM 20 million in revenues. The tax post will likely take some time to function effectively. There appears to be widespread evasion of excise taxes. With respect to FYR Macedonia, the budget assumed the repeal of the preferential trading arrangement, but steps to this end have not been taken. Delay in closing this gap is leading to revenues losses associated with both Macedonian goods and false certificates of origins on goods purporting to be of Macedonian origin.

Prompt institution of domestic coverage for sales and excise taxes and the payroll tax were planned for early 2000. It is now the intention to introduced a modified VAT in mid-2001 and therefore to extend the tax base to some domestic goods and services. The payroll tax was delayed by legal controversy over whether local staff of the UN system could be covered.

Adhering to the public sector wage bill as given in the budget. There are pressures to raise overall wages and to change relativities. A higher average wage is unsustainable over the medium term and would lead to an irresponsible budget. The budget estimates are based on a significant fall in public employment, particularly in education and health to eliminate ghost workers. Achieving this will be difficult given the strong sense of entitlement to a job and public opinion that calls for a mainstreaming of all parallel system workers. At best, it may take considerable time.

There are likely to be pressures for subsidies to public enterprises in order to re-start certain enterprises (regardless of their ultimate economic viability) or to greater-than-budgeted subsidies to the electric sector to make up for possible slow cost recovery and non-payment of charges. A significant reduction in the bloated labor force of the electricity company is essential; as a first step, a reduction of about 25 per cent is planned for 2001. It is essential to stick to budget limits for subsidies to public enterprises.

As implementation of capital investment projects progresses, there will be pressure on the Kosovo Consolidated Budget for higher proportions of operating expenses to go towards maintenance of the investments, particularly in the case of roads and other infrastructure. This could also be a significant issue in the utilities sector, although in principle that pressure should be contained within the operating costs and pricing structure of the utility providers.

Although some progress has been made during the last few months, capacities for strategic policy formulation at the sector spending departments of UNMIK remain weak. A systematic process that defines main sector policy objectives and priorities and ways to implement them should be institutionalized as part of the overall budget formulation process. This would require strengthening capacities for:

• Setting overall objectives in the sector;

• Defining the appropriateness of public service provision in the sector consistent with these objectives and the overall economic program; and

• Defining strategic programs in the sector and identifying priorities for which budgetary resources (recurrent and investments) will be needed consistent with the overall resource framework.

The objective is to be able to have the right information and analytical work for the preparation of short strategy statements for each sector that can be used as an input into the preparation of a comprehensive budget strategy and expenditure framework and presented for discussions to a high level inter-sectoral decision making body and subsequently to the donor community.

The establishment from UNMIK of the new Department for Reconstruction (DOR) has been a positive step in an effort to coordinate the donors and the reconstruction efforts in Kosovo. However, this department was created outside the CFA, with a mandate that goes well beyond just the coordination of the reconstruction efforts and into the formulation and implementation of a strategy for reconstruction. This organizational structure does not encourage an integrated planning and implementation process. While it is necessary to review, evaluate and coordinate external financed projects, there is a risk that such an exercise, usually reflected in the preparation of a donor-funded Public Investment Program (PIP) would be accorded undue priority. As a result, the investment planning process would focus primarily on the need for donor coordination, thereby crowding out the vital need for the preparation of a comprehensive and integrated budget strategy that reflected the priorities of an overall program.

As a first step towards a more integrated process the mandate of the DOR should be revised to serve as a department for project coordination and evaluation (including maintaining formal contacts with the donor community) and ensure consistency between investment projects, policy priorities in the sector and overall program. It is vital that policy formulation and implementation should be left with the spending departments. DOR should, however, maintain responsibility for creating an information database and strengthening capacities for project evaluation, especially in the sectors where most of the donor financing is being directed.

Linking the policy formulation process with planning and resources (budgeting) in a resource constrained environment such as the one in Kosovo, requires that difficult decisions are taken on inter-sectoral and intra-sectoral tradeoffs, consistent with the policy objectives within the sectors and consistent with UNMIK's overall program. These broad policy and program tradeoffs can be made by a decision making body at the center of the administration that has the right incentives to make the necessary tradeoffs and has adequate authority to enforce them. Such a body should be the forum to ensure that policy formulation and budget decisions are made in the right sequence and also serve as a mechanism for ensuring accountability during the implementation of sector strategies and priority programs and ensure that intended results are being achieved.

The introduction of a simple, neutral trade regime was considered to be important in stimulating private sector led economic growth and reconstruction, and in creating the conditions for healthy exports. Moreover, in the absence of adequate administrative machinery to collect taxes on consumption and incomes, UNMIK saw the introduction of the customs/external trade regime as the major source of revenue for the local recurrent budget of Kosovo.

The key characteristics of the trade regime are: First, a uniform tariff structure of 10 percent was introduced. This tariff structure is commendable in its simplicity and the low rate involved. The principle of the uniform tariff rates was, however, compromised by the simultaneous introduction of duty exemptions on some agricultural and medical products. Also compromised were the major advantages of a regime of uniform tariff rates such as neutrality in protection afforded to various stages of production and the reduction in opportunities for rent seeking. Second, the foreign trade regime is devoid of non-tariff measures (NTMs) and quantitative restrictions (QRs). Third, a further advantage of the system is that its registration procedures of traders (exporters, importers and forwarding agents) and licensing are non-discriminatory and transparent. There is no state trading and foreign trade activity is open to all firms. There are no non-automatic licenses and the existing regime offers limited, if any at all, opportunity for bureaucratic micro-management of foreign trade.

Although the Kosovo foreign trade regime has the right institutional design, and low and almost uniform tariff rates, a number of policy concerns arise.

• First, an important weakness of the trade regime stems from the recognition of the preferential trade agreement between FRY and FYR Macedonia. Granting of preferential status to FYR Macedonia has distorted trade flows and led to revenue losses for two reasons: FYR Macedonia has been traditionally an important trading partner of Kosovo; and a considerable portion of total imports into Kosovo transit through FYR Macedonia. The latter has provided opportunity to falsify certificates of origin.

• Second, the lack of complete coverage through tax collection points (TCPs) at the boundary lines of Kosovo and the rest of FRY provide a strong incentive to traders to reroute shipments through Montenegro and points across the rest of Serbia and thus narrow the tax base.

The two policy concerns outlined above could be addressed by removing the customs tariff altogether. UNMIK has undertaken to abolish the customs tariff at the same time as the introduction of a value added tax (expected to be in mid-2001) with the VAT to be set at a rate to ensure revenue neutrality. This decision is a major step towards removing the significant distortion that arises from the FYR Macedonia preferential trade arrangement and the treatment of commerce from the rest of Serbia as well as from Montenegro. Such a step would broaden the tax base and lead to a reduction in the disparity of taxes levied. A unified VAT rate of, say, 20 per cent, would result in a reduction of around 6 percentage points in the customs cum sales tax on imports (other than from FYR Macedonia) and a rise of 5 percentage points in the sales tax on imports from Macedonia and commerce flowing in from the rest of Serbia and Montenegro. Excise taxes would continue to be levied on all excisable goods regardless of origin.

• Third, at present, sales and excise taxes on goods are applied to imported goods only. Since these taxes are levied only on imports, they constitute trade measures; they discriminate against imports. It is entirely understandable that under current conditions of weak local capacity and lack of an internal tax administration, there was no other tax base other than imported goods. The intention of UNMIK to widen the tax base to domestic products when VAT is introduced is welcome. The imposition of VAT on domestic goods will level the playing field vis-à-vis imports and diminish incentives for evasion.

• Fourth, while the 10 percent ‘almost uniform’ tariff rate is very low by the standards of least developed countries, the aggregate burden of border taxes is quite considerable. The sales tax of 15 percent is applied on the post-tariff value of imports. Thus, the actual ‘tax burden’ for non-food, non-medicine products amounts to 26.5 percent ad valorem. For products subject also to excise taxes with rates varying between 5 and 50 percent, total payment rises even further since excise is calculated on the basis of the value of imports post tariff tax.

Such tax burdens are not unusual; they prevail in many countries, developed or developing. However, several problems emerge: By recognizing the preferential trade agreement between FRY and FYR Macedonia signed on October 7, 1996 and the granting of preferential status to FYR Macedonia (Section 16 of the AD 1999/01), a potential source of evasion and consequent loss of revenues has been created. Imports originating in FYR Macedonia are not subject to custom duties, as noted above, but only to a 1 percent ad valorem customs fee. Thus, the fee lowers total tax on non-excise goods from 26.5 percent ad valorem to 16.2 percent that amount to the loss in revenue 10.3 percent of the value of imports from FYR Macedonia. On products subject to excise tax, the losses are higher ranging between 16 and 11 percent of the value of imports of these products.

• Fifth, a clear case can be made for a wider use of specific taxes (in a simple and transparent manner) in place of ad valorem taxes - with the exception of coffee, all excise taxes are in ad valorem terms (Table 2). Since Kosovo uses the deutsche mark as the main transaction currency, the ‘inflation’ argument against specific taxes does not apply.² In the absence of sophisticated control techniques, the advantages of specific taxes are considerable: they are simpler and thus easier to implement and more difficult to evade; and they remove the incentive to under-invoicing, which is particularly strong in case of high excise rates.³

Of considerable concern is that in two aspects the trade regime presents a significant impediment to Kosovo’s nascent exports. The first is legal or institutional in nature – the formal recognition by trading partners of Kosovo’s trade regime and, in particular, trading arrangements in the context of the Stability Pact; the second, certain disincentives to exports arising from the trade and tax regimes.

The de facto establishment of a customs territory by UNMIK was neither accompanied nor followed by its de jure recognition. Its legal status as a foreign trade entity continues to remain vague and issues arising from this ambivalence tend to be addressed on ad hoc rather than systemic basic. As a consequence, Kosovo does not show up in Customs Codes of any country including that of its preferential trading partner—FYR Macedonia. Except for the EU (see below), Kosovo’s trade and customs regime is treated as a part of the FRY trade and customs regime, despite the institution of its own trade regime by UNMIK, and its exports are subject to the same conditions of access as those faced by exporters from Serbia or Montenegro.

With the entry into force of the Council Regulation No. 2007/2000 (18 September 2000), the EU has formally recognized UNMIK as an autonomous customs territory "… in accordance with UNSC Resolution 1244 (10^th and 11^th preambular" and linked to the EU’s Stabilization and Association Process.⁴ The Regulation has extended trade preferences to Kosovo, which previously were limited to Croatia and Bosnia-Herzegovina.⁵ It has also considerably widened trade preferences already applied by removing the remaining tariff ceilings for industrial products and by improving conditions in access to EU markets for agricultural products.⁶ Once UNMIK-CS has effective procedural and organizational procedures harmonized with the EU for issuance certificates of origin, they would then be accepted by EU Customs provided that appropriate measures are taken.

But as long as the trade status of Kosovo is not clarified by other countries (especially its neighbors), preferential access to EU markets alone will not suffice to trigger export growth. Therefore, UNMIK, in cooperation and support of the EC, should obtain for products originating in Kosovo duty-free access to markets in at least Albania, Bulgaria and countries of the former Yugoslavia – Bosnia and Herzegovina, Croatia and Slovenia. One possibility would be to accomplish this goal through integration into the existing network of bilateral free trade agreements among Balkan countries. For instance, both Bulgaria and UNMIK customs territory have free trade agreements with FYR Macedonia. The immediate step should be for Bulgaria and Kosovo extending the same rules in their mutual trade as in their trade with FYR Macedonia. Similarly, UNMIK should accord free trade access to Albanian exporters in return for a similar treatment of Kosovar exports

The fiscal disincentive to exports arises from the fact that the trade regime does not provide for a scheme for rebate of tariffs and taxes on imported inputs used for exports, thereby unwittingly penalizing exports, in particular, inward processing activities. Typically, such activities are an important source of employment and growth in transition economies, especially in the initial phases.⁷ Moreover, by not introducing schemes that support exports specifically – duty drawbacks, rebates, in-bond manufacturing or temporary admission – the trade regime makes it less attractive, perhaps quite unattractive, for foreign firms to establish processing activities in Kosovo.

The customs service remains understaffed. It came into being with hiring of 14 customs officers – previously with FRY Customs Administration – on August 3, 1999. By the end of August it employed 42 ex-FRY customs officers. With subsequent recruitment its staff rose to 90 customs officers by March 2000. While the Kosovo customs administration under the FRY regime was probably overstaffed (around 200 customs officers and administrative supporting staff), the current level seems to be well below levels needed to cover all crossing points as well to open one or two inland customs processing stations. Estimate suggests that at least 30 more customs officers would be needed to perform these functions.

Despite an impressive record of implementing customs control, the customs service does not have adequate administrative capacity to process shipments efficiently in all CBPs and a TCP. Technical problems at the border augmented by the absence of in-land customs clearance facilities and warehouses have often created disorderly conditions at CBPs and further delayed their opening. While UNMIK has established the trade regime and customs administration with commendable speed, especially given the need to control borders and begin to raise local revenues, the deficiencies in design and practice noted above should be promptly addressed if distortions are to be minimized and fiscal revenue increased.

The preceding discussion suggests three major issue-areas that should be given consideration: the status of Kosovo in terms of international economic relations; external trade policies; and tax policy. The broad recommendations are: (i) that the Kosovo trade and customs regime should be recognized internationally as autonomous customs territory for foreign trade purposes; (ii) that the trade and customs regime should be modified as to make more friendly to exports and consequently imports; and (iii) that incentives for evasion of tariffs and duties should be minimized.

On September 2, 1999, UNMIK issued a regulation permitting the use of foreign currencies for payments and contracts in Kosovo, thereby setting aside FRY restrictions on the use of foreign currencies for domestic transactions as well as FRY capital controls. Foreign currencies may now be freely and legally used for payments and contracts in Kosovo. The legal tender status of the FRY dinar under FRY law is unaffected: thus, all payments may be made and contracts discharged in dinars if the payer so wishes. No other currencies are to be given legal tender status. Deutsche marks or dinars may be used for tax and other official payments; the use of deutsche marks is encouraged with dinar use in such transactions being subject to an administrative fee to cover administrative and handling costs. No consideration is being given by UNMIK to the creation of a Kosovo currency.

As residents of Kosovo have long been conducting business in foreign currencies, overwhelmingly the deutsche mark, the UNMIK regulation acknowledges and legalizes current practice. The continued recognition of the dinar as the legal tender will maintain existing law. Granting legal tender status to any other currency requires the consent of the central bank issuing the currency in question and, in any case, appears unnecessary, it being sufficient to permit the circulation and use of that currency within Kosovo. It is also not necessary for Kosovo to issue its own currency; reliance upon a hard foreign currency will serve the purpose of a stable medium for transactions and for savings - two important pre-conditions for the revival of a private market based economy. By mid-2000, the deutsche mark was being used overwhelmingly as the currency of Kosovo, with the dinar playing an extremely minor role.

The banking industry that was left at then end of the spring 1999 conflict was exceptionally weak, with little capital, technical ability, few deposits or performing assets, but with strong local interest in reviving banks or establishing new ones (the 1989 nostalgia being very evident). Of the local banks, Vojvidanska and Economika banks had been operational in making limited payment transfers and some other limited activities, but were highly short of capital and liquidity. Two other local banks, Bankkos and Yugobanka, have not conducted banking operations for over one year now and their viability remains highly unlikely.

Banks suffer from an extreme lack of confidence on the part of the public in view of the effective confiscation of foreign currency deposits by the Belgrade authorities over the past decade and the weak management and capital positions of the banks themselves. In these respects, Kosovo is not different from some of the former republics of Yugoslavia. The revival of the banking industry will depend crucially on regaining public confidence. That, in turn, is closely related to the quality and probity of banks and bank management. The key policy steps consist of establishing firm banking supervision within the framework of a stringent banking law and, eventually, introducing limited deposit insurance. It appears likely that revived banking activity in Kosovo will originate from new entrants, whether foreign or domestic.

As of end 1999, there were no banks operating in Kosovo. One bank, the Micro-Enterprise Bank of Kosovo (MEB-Kosovo), with EBRD and IFC being equity participants, received approval to commence operations in January 2000. A second financial institution (technically a "non-bank"), the Grameen-Missione AMF, also obtained a license to operate as a micro-finance institution, although it was not active as of the second quarter of 2000. Preliminary licenses were approved by the licensing and supervisory authority in spring 2000 for three banks with a history of operations in Kosovo, but it is uncertain whether these banks would be able to qualify for permanent licenses.

In parallel to these developments there have been a number of donor-led initiatives that relate to or support credit activities. The most significant one is the creation of UNMIK’s Interim Credit Unit. This initiative is joint effort of the World Bank and European Agency for Reconstruction and it aims at channeling donors funds to small and medium enterprises. While still at an initial stage, the new ICU envisions to unload its activities and know-how into emerging private banks.

Immediate problems of the banking system include:

• The absence of banks that have been prepared to compete along commercial lines;

• The inadequacy or nonexistence of meaningful financial information and management systems in the banking (and enterprise) sector;

• The heretofore lack of adequate banking sector infrastructure (e.g., laws, judicial capacity, regulations, accounting/audit framework) to provide the needed guidelines and parameters for a well-managed and viable banking sector;

• The absence of financial intermediation (deposit-taking or lending) resulting from a lack of public confidence, past resource misallocation and politicization of bank lending, and the need for cash to finance trade and services in the largely informal Kosovo economy;

• The presence of only a small and costly range of banking services, namely transfers, which are provided more by travel companies or informally rather than through banks; and

• Allegations that fraud, money laundering and other illicit financial activity could occur if the supervision system proves not to be effective.

Success in banking reforms will depend on a number of factors: a sound legal and institutional framework to ensure incentives are in place for adequate resource mobilization; proper risk management guidelines and practices; and public confidence. There has been clear progress with respect to developing the regulatory framework for banking. The newly-instituted banking supervision agency within the Banking and Payments Authority (an umbrella body that also shelters the operation of the payments system) enforces a regulation system that prescribes conditions or responsibilities for:

• Requirements to obtain and maintain a license;

• The right of foreign banks to operate, with associated cross-country supervisory requirements;

• The authority of the Banking and Payments Authority (BPK) of Kosovo to approve banks’ governing boards, conduct on-site inspections, request any/all information as needed for supervisory oversight, require prompt corrective action when regulatory capital falls to two-thirds or less of requirements, and to appoint receivers and liquidate;
• Minimum capital of at least DM 1 million as a "narrow" bank,⁸ DM 3 million to provide basic banking services, and a higher minimum capital of DM 5 million to engage in non-DM currency futures trading, trust, investment/portfolio management, and securities underwriting and trading;
• Minimum capital adequacy requirements/ratios (to be specified);

• Exposure and concentration limits on large loans (to be specified);

• Restrictions on banks’ equity holdings in non-financial companies to 15 percent of regulatory capital per investment, and no more than 100 percent of regulatory capital in aggregate;
• Liquidity practices and risk management functions regarding interest rate, exchange rate, maturity, and asset-liability risks/gaps;

• Ownership, management, and governance guidelines based on prudent internal controls, modern management information systems, internationally accepted standards and qualifications of board members and managers, and legal, operational, financial and administrative autonomy for banks;

• Autonomous internal audit functions;

• External audits based on IAS on both an individual and consolidated basis, including assessments of the (non)viability of internal audit standards, guidelines, practices and information systems;

• Reporting to supervisory authorities to maintain a banking license;

• Prohibition on certain activities and fines and sanctions for violations; and

• Receivership and liquidation.

The supervision agency is developing a basic policy framework utilizing a CAMEL-style evaluation system to guide supervisory decisions, and then extend the scope to include a broader array of assessment factors and techniques, such as risk management and risk profiling. The manual delineates UNMIK’s expectations regarding the standards of financial condition and management practices for financial institutions, as well as evaluation methodology. The manual focuses on risk management principles and other non-financial areas, such as corporate governance, transactions with affiliates and insiders, internal controls, and issues related to regulatory compliance, etc. The manual itself will become a more comprehensive supervisory policy manual containing principles-based guidance for the assessment of risk in individual institutions and the sector. It also facilitates consistent policy application throughout the range of supervisory activities, including licensing activities/licensing, examination, and off-site surveillance. In addition, it enhances the ability of the agency to design and initiate risk-appropriate corrective actions.

The development of the policy manual also serves as the basis for continued development of the organizational structure, creation of supervision programs/cycles, on-site examinations, off-site surveillance and risk profiling activities. Additionally, the principles in the manual help guide decision-making with respect to licensing and problem bank management and resolution. It also provides the basis for periodic staff training as well as the foundation for a comprehensive training program. Lastly, the well-articulated policy structure, in conjunction with the legal and regulatory framework, provides a solid base on which the agency can sustain sound financial sector management after the withdrawal of UNMIK.

The success or failure of efforts to introduce lasting reform hinges on the efficiency of resource use, the ability to attract private direct investment into the banking and enterprise sectors and on interrelated programs for development of responsive civil institutions. Three key medium-term challenges in banking sector development are:

• Expanding Institutional Capacity for Effective Implementation of Reforms. Progress has been achieved with new banking regulations and rules. Commercial reform is also underway in support of an improved environment for contract enforcement, recognition of property rights, secured transactions and other features that will provide some comfort to lenders to take risk. The challenge now will be to develop institutional capacity in the judicial system, bank supervision, among accounting and audit professionals, and the bankers themselves.

• Creating a Virtuous Circle to Restore Public Confidence. Observance by bankers of the new prudential regulatory framework and sound governance and management practices will be needed to restore confidence and financial intermediation. Deviation from global standards may lead banks in Kosovo down the same path found in many other neighboring economies: poor asset management that undermines solvency and liquidity, triggering doubts about deposit safety. This, in turn, undermines the funding base, limits access to credit, and raises its cost through fees and higher interest rates. Sound management should reverse this process in which sound returns, which strengthen capital and liquidity, lead to a more stable funding foundation based on rising levels of depositor, shareholder, inter-bank, and regulatory confidence.

• Utilizing Changing Incentives for Management Purposes. There is a tendency on the part of older bankers in Kosovo to tolerate a return to the Yugoslav non-commercial orientation of the banking system, which relied on connected lending, excess concentration, distorted classifications, and a passive role whereby banks merely disbursed credits to their enterprise owners. The new owners and managers of banks in Kosovo should ensure the new incentive structure works profitably for them. At a minimum, this will require more and better information for strategic planning, and the ability to monitor developments in a timely manner to ensure risks are adequately understood and controlled.

Since the inception of UNMIK, the work of re-establishing a functioning payment system has passed through several stages. Of particular importance has been the establishment of the Banking and Payments Authority of Kosovo (BPK). As earlier noted, the BPK’s main purpose is to foster the development of efficient and sound banking and payments in Kosovo. At its inauguration in May 1999, the BPK was able to provide teller window exchange of DM banknotes, services to UNMIK for payments of stipends and wages; and receipt of taxes, opening and maintaining of deposit accounts for banks and official entities and the acceptance of deposits and withdrawals from those accounts of DM; and receipt of payment orders (for non-cash payments) from authorized agents of depositors and their execution (clearing and settlement).⁹

As the government’s banker, the BPK can accept deposits from the CFA and other UNMIK agencies; it also makes payments from these accounts in accordance with the instructions of the CFA and other depositors. During the initial stage, all deposits with the BPK have been in cash since it is not yet prepared to accept non-cash deposits. As the bankers’ bank, the BPK is responsible for clearing interbank payments in DM and settling them using bank deposits with the BPK.

The institutional development of the BPK and of its payment services has been delayed. The delay in developing the BPK’s ability to offer deposit and payment services and the faster than expected establishment of banks with the ability to offer such services, necessitates a re-evaluation of the BPK’s plans to use the temporary authority given to it in UNMIK Regulation No. 1999/20 to accept deposits from enterprises. A further implication of these developments is that the teller window services for government wage and salary payments and tax collections can be moved to banks more quickly than was originally envisaged.

With an increasing number of banks being licensed, the need to develop interbank clearing and settlement becomes more urgent. Since the payment system infrastructure is only in the embryonic stage of development, it has been recommended that their design from the beginning, should be based upon electronic media deposited directly with the BPK, and settled on a gross basis to ensure safe and reliable service to customers. Finally, it is recommended that an UNMIK regulation on payment transactions in foreign currencies be adopted in the near future. The objective of such legislation is to provide for a modern law establishing a firm foundation for an advanced market economy payment system to operate in Kosovo.

The absence of a proper commercial law framework and the severe problems affecting the definition of property rights makes distinctions somewhat unclear, yet it can be argued that Kosovo’s economy consists of three basic components: publicly owned enterprises; privately owned enterprises, and the parallel segment. Publicly owned enterprises formerly engaged in all sectors of the economy but predominately in the industrial sector, and generally in poor condition. The population of privately owned enterprises - much larger in number and collective output - engaged mostly in trade and services. The substantial parallel segment consists of gray market activities in trade and services on a small to medium scale. All exist today in institutionally and economically unfriendly conditions: no industrial production, no banking system, and no regulatory framework.

The sharp decline in the Kosovo GDP over the past decade can be attributed to a dramatic falloff in industrial output in a sector comprised almost entirely of publicly owned enterprises. Virtually all enterprises suffered heavy damage during this decade of disinvestment and neglect," leaving many in a severely deteriorated physical condition. Most enterprises now need significant restart capital to resume even minimal production. Enterprises also suffer from the far more serious problem of having lost their markets. This is because the rest of the Balkan region moved on economically after 1989, with FRY no longer a viable market for most products previously manufactured in Kosovo. As a result of the exclusion of the ethnic Albanians from management and skilled worker positions, the skills of the ethnic Albanian workforce are out of date.

The success of the program of economic development and reconstruction of Kosovo hinges to a large extent on the degree to which the private sector can be empowered quickly to generate growth. While the difficult political and legal issues in Kosovo are being addressed, the existing private sector will need to provide stimulus for economic growth. In addition to the rapidly growing retail and services areas, short-term growth can be expected to come largely from agriculture, agro-processing, construction, and the production of construction materials. Primary agriculture and construction, which are mostly private, should be encouraged to follow the lead of the impressive development of SMEs in the retail and services sector.

To develop the private sector, Kosovo will need to pursue three strategic paths concurrently. First, promote the growth and development of privately owned enterprises already in the formal economy. Second, embrace the parallel economy and bring it into the formal economy through a combination of incentives and requirements. And third, expand the private sector’s composition by transferring the potentially viable public enterprises to private ownership.

To support private sector development, UNMIK must assign top priority to the introduction of a regulatory environment that makes the cost of operating illegally significantly greater than operating legally. The regulatory framework should be: (i) simple, understandable, and enforceable; (ii) facilitate compliance; (iii) allow as little discretionary authority as possible to minimize scope for corruption; (iv) eliminate any duplication of existing FRY regulations; and (v) remove all discriminatory aspects of the existing FRY system. The essential elements of the framework are a business registration system, enterprise and contract laws, competition and foreign investment laws, and mechanisms for settling all kinds of disputes.

As taxation inside Kosovo is introduced, careful attention should be given to the overall tax burden on enterprises, especially given the high sales taxes levied at the border. In addition, the trade regime will need to be refined to with respect to taxes that could constrain private sector growth in Kosovo. For example, a rebate system needs to be introduced in the medium term to stimulate processing, subcontracting and consignment arrangements, which will be important to allow Kosovo to exploit its abundance of labor. Also, it is clearly not in the interest of Kosovo’s economic development to tax imported capital goods - even in the short term.

The lack of short- and long-term credit for viable productive activity has been identified in a recent survey of Kosovo SMEs as their most serious constraint. This limits the private sector to activities that require minimal investment - mainly in the services and retail sectors. Establishing a credit program based on sound economic and financial principles will be critical.

The Bank and a number of other donors have either started or are still planning to provide credit lines for SMEs. In order to ensure coherence of purpose and approach and to foster the emergence of market-based credit, UNMIK has taken the lead in developing certain principles upon which such programs ought to be based.

• SME lending activities must be conducted within the newly established banking supervisory regime;

• Credit should be extended mainly for private enterprises only, based on sound credit analysis;

• Credit should be extended to enterprises in the parallel sector only after their conversion to the official economy (the lack of a functioning enterprise law or registry means that interim procedures will have to be adopted if the credit line if to be disbursed expeditiously);

• Borrowing terms extended to enterprises should not distort competition with commercial credit;

• Lending programs should be conducted so that it support the medium-term institution building needs for the banking sector;

• Donor-financed SME credit should be viewed only as a transitional measure until a healthy banking system is developed;

• Donor coordination must be maximized and overseen by UNMIK itself; and

• Similar principles should be applied to the extension of micro- and agricultural credit.

Following a decade of neglect and enforced measures, many enterprises may not be viable, and thus will need to be liquidated. Therefore it should be recognized that keeping some of these entities running would only subtract value from the economy. While ownership transformation should be a key objective for the development of the private sector, it is no substitute for outright liquidation of non-viable entities. Under this premise, and in planning for privatization, Kosovo’s socially-owned enterprises can be organized into the following categories: (i) large unique enterprises, such as the Trepca mining complex; (ii) utilities; (iii) enterprises of potential interest to foreign investors; (iv) other viable and potentially viable enterprises; and (v) non-viable enterprises.

Appropriate privatization methods may include: (i) asset sales/liquidation of the non-viable enterprises; (ii) public auctions or tenders for assets or shares for the majority of viable enterprises; and (iii) concessions or management contracts for special cases, such as Trepca. Asset sales would be the simplest to organize and the most attractive for potential investors.

Privatization progress requires resolution of several key issues, including UNMIK’s mandate, ownership of social property, treatment of workers, and treatment of claims. These issues can be resolved quickly but will require detailed procedures for enterprise preparation and privatization transactions, in addition to public support.

The ownership issue has been considerably simplified by Regulation 1999/24. This defines the applicable laws as those in force as of March 22, 1989 - except when superseded by UNMIK regulations. It is generally considered that little or no privatization under the 1988 "Markovic" law had occurred by March 22, 1989. Although the majority of enterprises subsequently affected by "enforced measures" were wholly socially owned by March 22, 1989, there currently is no mechanism to establish this as a basis for further action. Recent policy statements by UNMIK propose the establishment of an adjudication panel to rule on the structure of ownership in each enterprise.

The ownership issue has been considerably simplified by Regulation 1999/24. This defines the applicable laws as those in force as of March 22, 1989 - except when superseded by UNMIK regulations. It is generally considered that little or no privatization under the 1988 "Markovic" law had occurred by March 22, 1989. Although the majority of enterprises subsequently affected by "enforced measures" were wholly socially owned by March 22, 1989, there currently is no mechanism to establish this as a basis for further action. Recent policy statements by UNMIK propose the establishment of an adjudication panel to rule on the structure of ownership in each enterprise.

It seems appropriate to equate social ownership with state ownership and for the privatization of such property to be administered by UNMIK. In the SFRY, social ownership conferred wide powers on workers to elect their management and otherwise determine how an enterprise would conduct its business; however, workers did not have a share in the capital of the enterprise. Moreover, in the former SFRY republics that recognized social ownership, the transformation of social capital was organized by the state, with the state receiving proceeds from the sale of transformed social capital.

In the interests of speed and efficiency, it is vital to limit restructuring of enterprises to the minimum necessary. It will be important that the only restructuring that takes place before privatization should be the separation of social assets (apartments) and public assets (power plants and irrigation systems) from the economic assets of an enterprise.

In recent months UNMIK has proposed the establishment of two public agencies: one for the adjudication of claims; the other for administering the adjudication decision, taking control of and managing enterprises until their privatization. It is important that the adjudication body is a small, efficient organization, with rules of procedure that permit rapid results. It is also proposed that once ownership is established, those businesses of which the majority of the stock is publicly owned will be brought under the control of a new Kosovo Enterprise Agency (KEA). The mandate of the KEA would be to corporate the businesses and pay out any compensation according to the findings of the OAC, to take interim control of the enterprises until privatization, and to organize the privatization process, when that becomes appropriate. The KEA will be part of UNMIK, but it will report to an independent Steering Board representing all sections of Kosovar society. However, the proposal to establish the KEA flies in the face of experience with enterprise revival and privatization in transition economies. It is not advisable to have a government body being responsible for the control and operation of enterprises, even less to have such a body reporting to all sections of society, thereby permitting a conduit for pressures from workers, directors and others to press on with their vested interests. Inaction, deadlock and the preservation of enterprises are likely to result. It appears more efficient to appoint temporary management to such enterprises prior to their eventual sale or liquidation. Indeed, the privatization mandate should have clear and enforceable deadlines for preparation for sale and execution of the sale, with liquidation following on automatically should the enterprise prove to be insolvent or unsaleable.

Recent UNMIK proposals also contemplate that 10 percent of the capital of large enterprises, and 20 percent of small and medium sized be reserved for purchase by the workers. Preferential share sales to workers, however, should not be allowed to interfere with the ability of a strategic investor or dedicated management group to control an enterprise’s operations and carry out necessary restructuring. Terms for preferential share sales should also be kept simple – e.g., cash purchases rather than installment purchases. It will also be necessary to define which workers (e.g., 1989 vs. 1999) are eligible for preferential share purchases.

As a first step towards privatization, UNMIK should assert its authority over potentially viable socially-owned enterprises by confirming or replacing current enterprise directors; establishing requirements and standards for regular financial reporting (including development of a current balance sheet) and preparations for privatization transactions; limiting the ability of enterprises to dispose of assets outside the ordinary course of business; and establishing director liability and penalties for non-compliance with UNMIK regulations.

Viable enterprises should be privatized through asset sales or – if there is a need to allow share sales to workers – through share sales. There are a very small number of socially owned enterprises in Kosovo, and the even smaller number of those that are potentially viable. Preliminary estimates suggest there may be fewer than 200 potentially viable socially owned enterprises of all sizes. Simple processes which focus on speed and transparency of the process, rather than revenue generation, or even equity, should be the objective when considering what institutional arrangements are necessary to get the potentially productive assets back to work.

The formal asserting of centralized control over education content from 1990 caused the Kosovar Albanians to develop a "parallel" education system financed by remittances from abroad and by informal tax revenues collected and managed at the municipality level. Despite the remarkable efforts during the past nine years – particularly among teachers – to maintain a functioning education system under extremely difficult conditions, the quality of education delivered in the classroom has inevitably suffered. Enrollment ratios, thought to be over 90 percent in primary prior to 1989, have almost certainly declined substantially over the past decade, particularly among girls. As a result of the recent conflict and a decade of inadequate maintenance, 30 to 50 percent of school facilities is in need of reconstruction, presenting a serious constraint to re-starting the education system. Since June 1999, Kosovar Albanians have taken it upon themselves to re-start the education system. Curricula and textbooks developed under the "parallel" system will be used in the first several years while new programs can be developed based on modern teaching and learning innovations.

Thus, in terms of provision of educational inputs (which say little about learning outcomes), the past nine years and the recent conflict have taken a serious negative toll. Few teachers, professors or administrators – with the important exception, perhaps, of those living abroad - have benefited from any organized professional skills upgrading. Even prior to 1989, pre-service teacher training lacked a methodological focus and education administrators were not exposed to modern public sector management skills. Basic textbooks for primary and general secondary education were reported to have been generally available to most students, financed through external contributions, but their pedagogical and physical quality is said by teachers to be lacking, and many of these books were destroyed or lost during the recent conflict.

Priorities in education can be expressed in two broad categories:

• The need to restore a minimally acceptable learning environment to children currently in schools, and

• The need to define a new education system and policies that will serve children in Kosovo for generations to come.

The education system in Kosovo needs to begin a transition that has been underway in many of its central and eastern European neighbors for the past seven to eight years. While comprehensive, locally driven strategy and policy development will take time to evolve, there are a number of key priorities and objectives that an eventual education strategy would be expected to address.

Education governance and financing. The key to establishing an efficient distribution of responsibilities and functions across levels in education is twofold: first, to allocate to the center the authority for policy/strategy formulation and for ensuring equity of access (redistribution to disadvantaged areas) and the quality and consistency of educational programs; and, second, to ensure that lower levels are given the responsibility and authority (including budget and expenditure authority) to implement programs flexibly and creatively within established norms. A priority should be to continue a policy of decentralization to ensure the authority of municipal officials to manage the majority of resources for education. The design of a system of fiscal devolution for education in Kosovo would include two crucial elements:

• Once the relative priority for education has been determined at the center in competition with other sectors and priorities, the distribution of resources for education to the municipalities could be carried out in the form of block grants on the basis of a per student budget formula. Such a formula-approach to education funding – common in Western Europe and North America and recently adopted in Hungary, Poland and the Czech Republic -- would help ensure equity (all children would be entitled to equal funding) and provide a powerful incentive to municipal officials to manage education resources efficiently. The formula can be adapted to take into account existing disparities (separate urban and rural budgeting norms, for example), and to allow additional spending for programs in low performance areas. A centrally mandated public pay scale for teachers and other employees in education could also be maintained under such an arrangement. The introduction of per student funding would also contribute greatly to transparency in terms of allocation of resources across ethnic groups.

• Despite the tradition of local management and financing councils, priority would have to be given to supporting municipality governance structures to develop their public administration skills and for re-defining the role of local school boards and parent associations -- which are mandated without much description in informal Kosovar Albanian legislation. Local school boards, in particular, should be expected to play an important role in ensuring accountability in the definition of local priorities and the expenditure of funds to achieve those priorities.

The central ministry’s role in ensuring educational standards and consistency within a fiscally devolved system is discussed below in the curriculum and assessments section.

Higher Education Governance. The University of Kosovo operates as a loose association of faculties, academies, colleges and institutions, each with a legally autonomous status and management structure. This dispersal of authority in what should be a single institution has led to a redundancy of programs, personnel, and facilities across faculties which diverts resources from improving the quality of teaching and learning. The weakness of the university rectorate also hinders an effective prioritization of programs in the face of a changing economic and social environment and allows autonomous faculties to resist systemic reforms aimed at investing efficiency gains in improving the quality of programs. As the university is re-established and new legislation is drafted over the coming months/years, authorities in Kosovo should make the university compatible with European standards in university governance and management. The key will be not to allow direct investments in single faculties to re-enforce the inefficiency and redundancy of the current governance structures. Further, specific higher education programs, which respond to particular development needs or skills shortages – such as the development of programs for medical, business administration and public administration programs – should be a high priority.

Curriculum and Assessments. There is an awareness among leading professional educators that educational programs at all levels are characterized by a dense and ambitious body of knowledge to be learned, leaving little flexibility to focus on thinking and learning skills or to deal with children with varying capabilities. In order to make the education system responsive to changes in the skill needs of the labor market, reforms will be needed not only in what is learned in school but in how it is learned. The authority for developing and monitoring a curriculum framework and modern learning standards should be placed at the center. Agreement among all stakeholders on an institutional mechanism and process for beginning this fundamental effort should be a priority for the coming year.

Teaching. There is complete agreement among education authorities that top priority should be given to upgrading the teaching skills of nearly all the estimated 22,000 primary and secondary school teachers currently serving the system. Local authorities and donors should balance support between the need to re-define pre-service teacher training curriculum and re-structure delivery mechanisms for in-service training – reform initiatives which should start soon – with the need to provide at least some remedial training to existing teachers with a degree of urgency over the next year or two. Donors and NGOs should play a major role in helping to organize both medium term teacher training reform and offering urgent skills training to teachers in the short term.

Secondary and Vocational Education. As currently designed, the secondary system in Kosovo is out of alignment with the emerging market economy’s need for broad-based skills, labor flexibility and continuous learning. It is crucially important for donors not to rush into the re-establishment of the current secondary system until local authorities have developed a strategy for secondary reform. Focus should then be put on the medium term objective of developing new broad-based programs and on an extensive re-training program for the existing secondary teaching force.

A reform of secondary technical/vocational education will also necessitate commensurate reforms in the field of adult training and two-year higher education technical/professional programs. The goals are to develop a network of training suppliers (public university, private-for-profit, semi-public, NGOs,), to bring social and private sector partners into the governance of adult training, to complement government funding with cost recovery, and to facilitate the availability of labor market information.

The health system in Kosovo has traditionally been financed by pay-roll and profit contributions to a health insurance fund (HIF), and service delivered through a tertiary hospital in Pristina, five other district hospitals, "health houses" (a form of polyclinic) and small primary health care (PHC) clinics. The prevailing model of medical practice is excessively specialized, yet out of line with modern clinical practice. Family medicine and nursing practice need a great deal of development.

After 1989, HIF management, and policy and regulation were centralized to Belgrade, with district office functions in Pristina and four other districts of Kosovo. Ethnic Albanians were dismissed from management and senior medical positions. The HIF covered only around half of the ethnic Albanian population, many of whom ceased to pay contributions and lost HIF coverage. Ethnic Albanians set up a parallel system to provide PHC through the Mother Theresa Society (MTS); delivered parallel training of 700 doctors and 1200 nurses; and delivered services through private practice financed from user fees. Since June, the MTS system has largely collapsed, and there appears to be little desire to restore it. Many Albanian doctors have moved to the hospitals, claiming rights to restitution of previous employment, or to specialist training positions denied to them during the past 10 years. Thi