Republic of Kosovo: 2015 Article IV Consultation-Staff Report; Press Release; and Statement by the Executive Director for Republic of Kosovo

KEY ISSUES Context: Following a six-month political stalemate, the largest two parties reached an agreement in December to form a grand coalition, which enjoys a comfortable majority in parliament. The remittances-fueled growth is set to continue in the near term, but deep challenges remain in view of Kosovo's narrow export and productive base, low employment ratios, and incomes that are among the lowest in Europe. Fiscal Policy: Following very generous pre-electoral promises, gradual fiscal adjustment is required to preserve the credibility of the fiscal rule and safeguard low public debt levels. Measures should focus on arresting the rapid growth in unproductive current spending, so as to reduce the deficit while creating space for priority areas such as infrastructure, education, and health. Financial Sector: The banking sector has remained well-capitalized, liquid, and profitable. Good progress has been made in enhancing banking supervision as well as the Emergency Liquidity Assistance (ELA) framework. Given low credit penetration, the main challenge is to harness available liquidity so that banks can further support investment and growth: this will require improvements in the weak judiciary, as well as tackling the sizable informal economy. Structural Issues: The key structural challenge is to address the large wage and non- wage competitiveness gap. Gradually deflating high public sector wages will help with the former. As for the latter, the focus should be on tackling the large skills gap by enhancing educational quality—particularly vocational training—and complementing de jure improvements in the business environment with de facto progress. Upgrading energy infrastructure, including a new power plant, is important to avert a future energy crisis. Previous IMF advice: Implementation of Fund advice remained strong throughout the Stand-By Arrangement, which expired in December 2013. However, measures contrary to the spirit of the arrangement were taken immediately after the program's expiry. This is the first Article IV consultation since July 2013.