BANKING AND PAYMENTS AUTHORITY OF KOSOVO AUTORITETI BANKAR DHE I PAGESAVE TË KOSOVËS BANKARSKI I PLATNI AUTORITET KOSOVA BPK ANNUAL REPORT 2005

Transcription

1 BANKING AND PAYMENTS AUTHORITY OF KOSOVO AUTORITETI BANKAR DHE I PAGESAVE TË KOSOVËS BANKARSKI I PLATNI AUTORITET KOSOVA BPK ANNUAL REPORT 2005 Pristina, May 2006

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3 C O N T E N T S Covering letter of the Managing Director to SRSG 11 Members of the Governing Board, Audit Committee and Executive Committee 13 Organizational Structure of the BPK Executive Summary External Economic Environment World Economy European Union Western Balkans Domestic Economic Environment Real Sector Gross Domestic Product Prices Employment Privatization Fiscal Sector Budget Revenues Budget Expenditures Pension Scheme Financial Sector General Characteristics Developments in the Banking Sector Insurance Companies Developments Pension Funds Developments Other Financial Intermediaries Developments External Sector Financial Supervision Financial Sector Regulation Activity Supervisory and Enforcement Activity Licensing and Structure Financial Supervision Activities Formal Powers of Supervisors (Enforcement Actions) Regional and International Cooperation Services provided to the Authorities, to the financial community and to the public 91 3

4 5.1. Cash Operations and Management Services Provided to the Treasury Asset Management Services Provided to the Financial Community Payments System Kos-Giro Credit Registry of Kosovo Research and Statistics Activities Internal Developments Governance and Internal Control Human Resources Development Financial Statements of the Banking and Payments Authority of Kosovo Statistical Appendix 145 4

5 List of figures, tables and boxes Figures 1. Euro exchange rate versus GBP, USD, JPY, US Real GDP growth and contribution by components, Japanese Real GDP growth and contribution by components, Euro Area Real GDP growth and contribution by components, Inflation (change in annual HICP), Euro Area, Gross Domestic Product (y-o-y), Western Balkans, Inflation (change in annual CPI) in the Western Balkans, Euro exchange rate versus HRK, ALL, CSD, MKD, ROL, Fiscal and CA balance as % to GDP, Western Balkans, GDP growth, at constant 2002 prices, Private demand, Government demand, Donor demand, Gross National Disposable Income (GNDI), Prices (CPI), annual average, Number of registered jobseekers, flow data, Number of registered jobseekers by age, as of Cumulated revenues from the privatization process Kosovo Consolidated Budget (KCB), Kosovo Consolidated Budget Structure of revenues, 2004 and Kosovo Consolidated Budget Structure of expenditures, 2004 and Kosovo Pension Savings Trust, outstanding amounts, Structure of domestic claims (in thousand EUR), 2004 and Financial corporations claims on nonresidents, 2004 and Broad money, Commercial banks Herfindahl- Hirschman Index, Structure of Assets of Commercial Banks in Kosovo, Structure of loans by sector, Structure of loans by industry for 2004 and Maturity structure of loans, Total banking sector assets and loans as % to GDP, selected Western Balkan countries Evolution of the structure of liabilities of commercial banks in Kosovo, Structure of deposits by maturity, Structure of deposits by sector for 2004 and

6 35. Total banking sector deposits as % to GDP FOR 2005 (selected Western Balkan countries) Structure of Income, Structure of expenditures, Return indicators, Efficiency indicators, Evolution of commercial banks liquidity indicators, Maturity breakdown of commercial banks loans and deposits, as of end Evolution of Capital Adequacy Ratio (CAR) in Kosovo, Profitability indicators of some selected Western Balkan countries for year Efficiency indicators of some selected Western Balkan countries in The ratio of loans to deposits in some selected Western Balkan countries for year Evolution of other financial intermediaries lending activity, Structure of exports by countries and commodity groups, in %, as of end Structure of imports by countries and commodity groups, in %, as of end Supply of euro banknotes Supply of euro coins Soiled banknotes retained from circulation in Ratio of brand new banknotes supplied to total Reported counterfeited banknotes Evolution of Treasury and other PISG and KTA deposits, Financial resources, by origin, as of Allocation of BPK resources, as of Asset Quality of the BPK Investments, as of Evolution of the volume ICS transactions (stock data), Evolution of the value of ICS transactions (stock data), Tables 1. Main Macroeconomic Indicators, Activity of the Insurance Companies, Balance of Payments, from 2001 to Insurance Licensing Activity, Pension Funds Activity, Intermediary Licensing Activity, Financial Sector: On-site examinations conducted during the year Trainings in Kosovo during Training abroad during Financial Corporations Survey 147 6

7 11. Depository Corporations Survey Monetary Aggregates BPK Survey Other Depository Corporations Survey Other Financial Corporations Survey Other Financial Intermediaries Survey Insurance Companies and Pension Funds Survey Insurance Companies Survey Pension Fund Survey Other Depository Corporations Balance Sheet Assets Other Depository Corporations Balance Sheet Liabilities Euro Deposits at ODC, by Original Maturity Non-Euro Deposits at ODC, by Original Maturity ODC Loans, by Original Maturity ODC Loans, by Industry ODC Effective Interest Rates ODC Income Statement BPK Interbank Clearing System Exports and Imports, by Trading Partners Exports, by Commodity Group Imports, by Commodity Group 163 Boxes 1. The legal status of euro in Kosovo Assets and Challenges of euroisation in Kosovo The size and the intermediation role of the banking system in the Western Balkan Banking system deposits as % GDP in countries of the Western Balkan Profitability, Liquidity and Solvency of the Banking sector in selected Western Balkan countries 69 List of abbreviations ATM Automated Teller Machine BPK Banking and Payments Authority of Kosovo CAR Capital Adequacy Ratio CCIU Currency Counterfeit Investigation Unit CPI Consumer Price Index CRK Credit Registry of Kosovo EAR European Agency for Reconstruction 7

8 EBRD ECB EU FDI FYROM GDP GNDI HHI HICP ICS IMF IOPS KCB KEK KPST KTA MFE MOU NFA NPISH ODC OFC OFI PISG POS PTK RWA SME SOK SRSG TPL UNMIK European Bank for Reconstruction and Development European Central Bank European Union Foreign Direct Investments Former Yugoslav Republic Of Macedonia Gross Domestic Product Gross National Disposable Income Herfindalf Hirschman Index Harmonized Index of Consumer Prices Interbank Clearing System International Monetary Fund International Organization of Pension Supervisions Kosovo Consolidated Budget Energetic Corporation of Kosovo Kosovo Pension Saving Trust Kosovo Trust Agency Ministry of Economy and Finance Memorandum of Understanding Net Foreign Assets Nonprofit Institutions Serving Households Other Depository Corporations Other Financial Corporations Other Financial Intermediaries Provisional Institutions of Self Government Point of Sales Post and Telecommunication of Kosovo, J.S.C. Risk weighted Assets Small and medium size enterprises Statistical Office of Kosovo Special Representative of Secretary General Third Party Liability United Nations Interim Administration Mission in Kosovo 8

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11 Dear Mr. Special Representative of the Secretary General of the United Nations, Over the past years, with the assistance of international community, the financial sector of Kosovo has achieved tangible progress in providing financial services, thereby favoring the current drive to a market economy. In 2005, despite difficult economic conditions which prevailed in the Territory, the financial sector has increased the volume of its supply towards all actors, households as well as to the corporate sector. BPK helped the development of these services by providing the proper regulatory and supervisory environment, also leveling the scale of its services to the local economy. Following real GDP growth of 3.7% in 2004 largely fuelled by the large budget deficit experienced during that year, economic activity slowed down considerably in 2005, with a falling GDP of 0.5% in real terms. Only the private sector provided a small positive contribution to growth, while the external donor sector and the public sector of Kosovo brought the economy into negative grounds. Private sector activity was to a very large extent supported by a strong increase in bank lending (+37,5%). While the expansion of the banking sector has benefited from a strong supply of funds (namely an increase in deposits), this growth has nevertheless suffered from a lack of good bankable projects. In other words, money supply provides for enough funding to small and medium-size borrowers, with the exception of the long-term needs, while investment initiatives from entrepreneurs in sectors with value added are still too few. The supply of services in the insurance sector remains essentially confined to compulsory vehicle insurance contracts, with little or no expansion of other segments such as industrial risks, household insurances or life insurance. Thanks to the technical assistance provided by international agencies, the regulatory framework relating to the financial sector as a whole is close to international standards; it has been improved in many aspects but should be updated in some areas such as corporate governance and internal control. In the short term, development of a regulatory framework is also needed to support the supply of new financial services such as leasing and life insurance. In the context of an expanding lending market, the BPK has been determined in not lowering its regulatory and supervisory standards, and has shown readiness to enforce regulation in cases of noncompliance. First, the strong expansion of lending by all banks in the first half of the year led the BPK 11

12 to impose stringent guidelines to certain institutions to maintain proper levels of capital, credit risk, and liquidity. Second, to keep the soundness and safety of the system, BPK, based on its on-site reviews, has encouraged an upgrade of corporate governance procedures, internal control proceedings as well as good professional and management practices. This has led in one particular case to a process that resulted in March 2006 in revoking the license of one lending institution for noncompliance with the above rules and practices. Regarding its central banking activities, the BPK has undertaken several initiatives to improve its services to the financial community, the Provisional Institutions of Self-Government, and the public at large. For example, the quality and quantity of cash supply (euro bank notes and coins) has been elevated; a non-cash payment system (giro system) has started to operate; a credit register has been enlarged, consolidated and made compulsory; the underlying collection system for balance of payments statistics has been put in place; the research function has been upgraded, etc. Internationally, the BPK has undertaken to reduce its isolation from professional and official organizations. For example, the BPK has become a Member of the International Association of Insurance Supervisors as well as of the International Organization of Pension Fund Supervisors; it has also participated to various regional groups, including conferences of banking supervisors. The BPK has signed several Memoranda of Understanding with countries in the region. Key headways have been made in bringing local staff to top management positions in the BPK, for instance the two Deputy Managing Director positions being attributed to Kosovars in early Regarding the increasing participation of Kosovars in the Governing Board, a draft Law has been prepared with international support, and is pending enactment. In the context of the institutional changes which will occur in Kosovo in 2006 and 2007, BPK will devote its means to perform its tasks in the most independent and professional manner, with the aim of integrating the financial sector into a regional ensemble. There is no need to emphasize that it is the only way to deal with the huge challenges faced by Kosovo. These relate to the current economic difficulties that are not about to disappear at the end of the year 2006 as well as with the structural deficiencies of the local economy. In this context, I am pleased to submit to you the 2005 Annual Report of the BPK. Michel Svetchine Managing Director 12

13 As of 31 December 2005 the Governing Board of the Banking and Payments Authority of Kosovo was composed of following members: Governing Board of the BPK: Mr. Ajri Begu, Chairman of the Governing Board, Mr. Michel Svetchine, Managing Director of the BPK, Mr. Edward Nolan, Deputy Managing Director for Financial Sector Supervision, 1 Mr. Benoit Waelkens, Deputy Managing Director for Payments System, 2 Mr. Joachim Rücker, DSRSG, EU Pillar of UNMIK, Mr. Gazmend Luboteni, Professor, Faculty of Economics - University of Prishtina Mrs. Chiara Bronchi, Head of Fiscal Affairs Office EU pillar of UNMIK Audit Committee of the Governing Board of the BPK: Mr. Gazmend Luboteni, Professor, Faculty of Economics - University of Prishtina Mrs. Chiara Bronchi, Head of Fiscal Affairs Office - EU pillar of UNMIK Executive Committee of the BPK: Mr. Michel Svetchine, Managing Director of the BPK Mr. Edward Nolan, Deputy Managing Director for Financial Sector Supervision Mr. Hashim Rexhepi, Chief Supervision Officer Mr. Benoit Waelkens, Deputy Managing Director for Payments System Mr. Gani Gërguri, Chief Operation Officer Mr. Agron Dida, Inspector General 1 Replaced by Hashim Rexhepi on February 2006; 2 Replaced by Gani Gërguri on January 2006; 13

14 BPK organization chart, as of 31 December 2005 BPK 2005 ORGANIZATION CHART Governing Board Chairman: Ajri Begu 3 Executive Directors: MD, DMD, DMD 2 UNMIK represenatives: Joachim Rü cker (DSRSG) Chiara Bronchi (FAO) Individual Member: Gazmend Luboteni Office of Managing Director: - Asset Management - Institutional & Media Relations - Office of Legal Advisor - Project manager - Executive Assistant Managing Director (MD) Michel Svetchine Executive Comittee Deputy Managing Director (DMD) Edward Nolan Deputy Managing Director (DMD) Benoit Waelkens Chief Supervision Officer (CSO) Hashim Rexhepi Chief Operation Officer (COO) Gani Gërguri Banking Supervision Research & Statistics Accounting Insurance Supervision Banking Services Human Resources Pension Supervision Information Technology Administration Cash & Vault Audit Committee 2 Non Executive Directors Chiara Bronchi Gazmend Luboteni Executive Committee Supervision Committee Statistics Committee Inspector General Agron Dida Internal Audit Operations Analysis Cost Accountin g 14

15 BPK organization chart, as of 01 February

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17 1. Executive Summary The goals of the Banking and Payments Authority of Kosovo are to ensure sound, efficient and competitive financial system, efficient payments system, to conduct regular economic and monetary analysis and to inform the public on main economic developments. For this purpose, the BPK publishes for the sixth consecutive year its Annual Report describing trends in the world economy, the region, and paying special attention to the Kosovo economy and internal developments within the BPK. World economy moderated during 2005 compared to 2004 and rising oil prices with effects on inflation have contributed negatively to the global economic growth. Growth continued to be fuelled by the strong economic performance of China, accompanied by the growth of US and EU economy, although real growth in EU moderated in Western Balkan countries achieved a favorable economic development characterized by strong growth in real GDP (5.0%, on average) and macroeconomic stability. However, differences between the countries in the region regarding reforms and economic performance are still noticeable. Despite sound fiscal policies, external imbalances remain a concern. Growth in GDP in many countries was led by private consumption, mainly supported by loans from the banking sector. As a result, in some Balkan countries external balance worsened. Developments in the Kosovo economy in 2005 were not favorable. Kosovo experienced a negative real GDP growth of -0.5% mainly due to the decline of the international presence (including UNMIK and donor community). High unemployment rates and external imbalances remain key problems of the economy. According to the IMF, unemployment figures are estimated to be 30% of working age population. Current account deficit (before foreign assistance) accounted for 29.1% of GDP in The trade deficit, as one of the major issues for Kosovo economy, reached euro 854 million in 2005, or 35% of GDP. For the second consecutive year, the Kosovo Consolidated Budget (KCB) ended with a deficit. Nevertheless, this deficit was reduced in 2005 to 3.9% of GDP, against 5.3% in Much effort has been made in maintaining a balanced budget and a sound fiscal policy as the key precondition for macroeconomic stability. In this context, UNMIK and PISG, with the assistance of IMF and based on a 17

18 realistic medium-term macroeconomic framework, have addressed the Letter of Intent to the international donor community with the intention to provide a rationale for donor support. The use of euro has provided the grounds for low inflation and stable macroeconomic environment. Policy tools should be addressed in the direction of structural changes mainly related to privatization, the rule of law, etc. The year 2005 can be considered as successful with respect to the evolution of the privatization process managed by the Kosovo Trust Agency (KTA) with the goal transforming the ownership of enterprises from social to private. In addition, one of the KTA goals remains the improvement of corporate governance of the Kosovo Public Enterprises. The financial sector in Kosovo continues to be dominated by commercial banks. On the course of 2005, banks continued to expand their branching network over the Kosovo territory, improved the services provided and increased their intermediation role. The Kosovo banking sector maintained its overall financial strength and conditions for most banks have been favorable in 2005 in terms of profitability, liquidity and capitalization. Banks are continuing to improve their role in providing intermediation to the domestic economy and the results are respectable and comparable with countries of the region. At end 2005, loans attained euro million or 21% of GDP, an increase of 37.5% compared to the end of Following the trends from previous periods, deposits in the banking sector are continuing to grow increasing the confidence in the sector. Deposits reached euro million, an increase of 20.3% over The ratio of deposits to GDP in 2005 reached 34.1%, from 27.7% in During 2005 the BPK continued to ensure an adequate supply with euro banknotes and coins for the settlement of cash transactions in Kosovo economy. The BPK also has provided banking services on behalf of and for the account of the Authorities, namely Treasury, PISG, KTA and major public utility companies. These services mainly consisted of account maintenance and payment operations excluding any credit facility. The BPK asset management in 2005 continued to be guided by the provisions of the BPK Regulation and Investment Policy implying that BPK assets were managed taking into consideration conservative risk restrictions, prioritizing safety and liquidity over income. 18

19 The BPK objective in providing services to the financial community is to foster an efficient and safe system for domestic payments. This goal is performed through the Interbank Clearing system (ICS) where the volume and the value of transactions routed through the ICS have been increasing significantly during In addition to this, the BPK in 2005 has launched Kos-giro project with the aim developing low value/high volume retail payments. This will positively contribute to the principal objective of the BPK in enhancing the efficiency of the domestic payment system by reducing cash in circulation, increasing deposits in commercial banks and improve overall liquidity. In order to improve the information infrastructure of the credit activity of the credit providing institutions, the BPK in 2005 continued the development of a modern credit registry, known as Credit Registry of Kosovo (CRK), launched at the beginning of The CRK provides credit information to the credit providing institutions on potential borrowers that will enhance the information availability on the borrower creditworthiness and improve access to credit. The BPK in 2005 has improved its function in providing to the public information on developments in Kosovo economy with emphasis in developments in the financial sector. This was achieved by improving the quality of existing and introducing new publications such as BPK Bulletin and Working Paper Series. 19

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21 2. External Economic Environment World economy World economy, based on IMF projections, moderated during 2005 compared to In particular, the real GDP growth during 2005 recorded 4.3% from 5.1% in The growth has been mainly led by the strong performance in service sector which has more than offset the slowdown of manufacturing and trade sectors. In one hand, favorable financing conditions and rising domestic demand positively contributed to growth, while on the other hand, rising oil prices and their effect on inflation have contributed negatively to the global economy. The growth continued to be led by the economic performance of China (around 9.0%), accompanied by the US economy (3.5%) and the revival of Japanese economy (2.5%) while growth in European Union (25 EU member states) moderated to 1.5%. Global consumer prices experienced a significant increase, especially at the beginning of the third quarter of 2005, driven mainly by the soaring oil prices. During the first nine months of 2005, oil prices followed an upward trend reaching at around 52.2 EUR per barrel, whereas data for the remaining part of the year show prices to have declined to, on average, 44.6 EUR per barrel. While higher oil prices negatively affected inflation, most countries managed to maintain underlying rate of inflation stable. In particular, during the last quarter of 2005, followed by the slowdown in the increase of oil prices, the CPI inflation eased somewhat and remained at a moderate levels. However, underlying inflationary pressures were especially noticeable in emerging countries vulnerable to high energy prices. Global CA imbalances have not only persisted but also increased during 2005 mainly due to the US CA deficit. Nevertheless, the global CA imbalances were somewhat countered by CA surpluses of Japan, China and Middle East countries (especially oil exporting countries resulting from the positive effects of the soaring oil prices). 3 Developments in external economic environment are based in: EBRD 2005, Transition Report; IMF 2005, World Economic Outlook; European Commission 2005, Progress towards meeting the economic criteria for accession: 2005 Country assessment, Enlargement Paper No. 26; Business Monitor International 2006, Emerging Europe Monitor South East Europe, various issues. 21

22 As for the exchange rate developments, the US dollar appreciated slightly against the Euro during 2005 while the euro appreciated markedly against Japanese yen. At the end of 2005 the euro stood at 1.19 USD which corresponds to a decline of 4.7% against its previous year level. On the other hand, at the end of 2005, the euro reached JPY or 4.6% higher compared with its level of Euro appreciated vis-à-vis the British pound and was 0.68 GBP at end 2005 which is associated with a 0.1% increase compared with the level in the previous year. Figure 1. Euro exchange rate versus GBP, USD, JPY, GBP/EUR USD/EUR JPY/EUR (right-hand scale) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: Eurostat (2006). The United States economy during 2005 experienced a robust growth, although it was slower compared to In particular, the real GDP growth in the United States averaged 3.5% which is 0.7pp lower compared to the previous year. The largest positive contribution to growth is due to domestic demand. Specifically, private consumption contributed with 2.5pp, Federal Government spending by 0.3pp while total investments contributed with 1.1pp to the US GDP growth. Negative contribution to the real growth was recorded for by the net exports with the marked deceleration in exports of goods and a strong growth in the imports. External balance on services, however, generated positive contribution to the US GDP growth and eased current account deficit. In general, higher oil prices, twin deficits - fiscal and CA deficit - accompanied by higher public debt were the main factors behind the moderation of the US output growth during 2005 (see figure 2) 22

23 The annual rate of headline inflation increased by 3.4% in 2005 or 0.1pp higher compared with On the other hand, headline inflation fluctuated around 3% in the first half of 2005 reflecting the upward pressure of increasing oil prices. However, during the second half of 2005, headline inflation remained relatively low reflecting the moderation of oil prices. The annual inflation excluding energy and food prices did not experience any significant change compared to 2004 and remained at 2.2%. Figure 2. US Real GDP growth and contribution by components, Private consumption Public consumption Investmet Net Exports GDP 5.5% 5.5% 4.5% 3.5% % 3.5% 2.5% 2.5% 1.5% 0.5% -0.5% -1.5% % 0.5% -0.5% -1.5% Source: Eurostat (2006). The US CA deficit is estimated to represent around 6.4% of GDP which is mainly an effect of slower growth of exports of goods relative to the growth of imports. The increase in trade deficit was partly offset by a surplus generated by services and income account. The US Federal Government budget deficit declined slightly as a percentage of GDP in 2005 accounting for 2.7% (3.6% in 2004). The economy of Japan during the first half of 2005 experienced fast expansion, followed by a slight moderation during the second half of The GDP growth was estimated at 2.6% in 2005 with the largest positive contribution coming from private consumption (1.0pp) and total investments (1.0pp). Net exports have however, moderated during 2005 contributing positively by a mere 0.2pp. With respect to the price developments, consumer price deflation is continuing. Following the marked deflation during the second quarter, the downward pressures in annual CPI inflation have shown a slight weakening in the second half of 2005 which again rebounded in the last quarter. 23

24 Figure 3. Japanese Real GDP growth and contribution by components, % Private consumption Public consumption Investmet Net Exports GDP 3.5% 2.5% % 1.5% 1.5% 0.5% 0.5% -0.5% -0.5% -1.5% % Source: Eurostat (2006). 2.2 European Union European Union is one of the main trading partners of Kosovo participating with 42% in total imports. It also employees the vast majority of the Kosovo Diaspora (mostly in Germany, UK, etc). Economies of the Euro area 4 boosted by the improvement in domestic demand and net exports. Indeed GDP growth at end 2005 experienced an upturn compared to the first half of Nevertheless, estimates show that the real GDP growth in the euro area moderated to 1.3% compared to 2.1% in During the first half of 2005, the growth was hampered mainly by higher oil prices, slowdown in the growth of the world economy as well as the lagged effects of the appreciation of the euro. However, good results were recorded in the second half of the year mainly due to an increase in investments, higher private consumption and growth of exports. Regarding the developments within the euro area, the two largest economies, namely Germany and France, experienced real GDP growth of 0.9% and 1.5% respectively, reflecting a decrease in the domestic demand compared to Italy experienced a real GDP growth of 0.2%, while Portugal and The Nederland grew with 0.4% and 0.5%, respectively. Spain and Austria grew with 3.6% and 1.7%, respectively, driven by the improvement in domestic demand while in Belgium real GDP growth 4 Belgium, Germany, Greece, Spain, France, Ireland, Italy, Luxembourg, The Netherlands, Austria, Portugal and Finland. 24

25 moderated at 1.4%. In Luxemburg, real GDP growth remained robust at 4.2%, supported mainly by the external demand (2.6pp) while domestic demand contributed with 1.6pp. Figure 4. Euro Area Real GDP growth and contribution by components, Private consumption Public consumption Investmet Net Exports GDP 2.5% % 2.0% 2.0% 1.5% % 1.0% 1.0% 0.5% 0.5% 0.0% 0.0% -0.5% -0.5% -1.0% % Source: Eurostat (2006). Harmonized Index of Consumer Prices (HICP) inflation eased slightly in November compared to the first half of 2005, mainly due to the slowdown of the increase in energy prices, in particular crude oil and natural gas. Figure 5. Inflation (change in annual HICP), Euro Area, % 4.0% 3.5% HICP HICP (excluding energy and food) 3.5% 3.0% 3.0% 2.5% 2.5% 2.0% 2.0% 1.5% 1.5% 1.0% 1.0% 0.5% 0.5% 0.0% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec % Source: Eurostat (2006). 25

26 Until June 2005 annual HICP inflation remained stable between 1.9% and 2.1% while it jumped to 2.6% in September mainly due to the upward pressure of energy prices which increased from 11.6% in August to 15.2% in September. Inflationary pressures were pronounced mainly in Luxemburg, Spain and Greece, with an average annual HICP inflation ranging from 3.3% to 3.8%. The nominal effective exchange rate of euro - measured against its 23 trading partners - shows a depreciation of the euro compared with the average of This depreciation, especially in October, was due to the depreciation of the Euro against the U.S. dollar and some Asian currencies which was partly offset by the appreciation of euro against British Pound and Japanese Yen. Similarly, the real effective exchange rate has shown depreciation compared to the 2004 average, pointing out an improvement in the euro area s price competitiveness. Euro area did not achieve very positive results concerning public finances. Five euro area member states, (Germany, Greece, Italy, Portugal and France) are estimated to have overrun the yearly deficit set with The Maastricht criteria of 3% of GDP. Primary budget deficit decreased slightly compared to 2004, reaching 2.6% of GDP while interest payments remained unchanged compared to GDP. According to European Commission forecasts, the euro area budget deficit for the 2005 is estimated to the 2.9% of GDP. On the other hand, total gross debt of the euro area grew slightly in 2005 to 71.7% of GDP (70.8% in 2004). With regards to the CA balance, euro area experienced slight weakening during 2005 despite the positive contribution of trade balance. In particular, cumulated surplus in the trade balance was around one and a half time lower compared to the previous year. On the other hand, the positive contribution of the reduction in the income account deficit to the CA balance was partly offset by the increase in the deficit of current transfers and a slight decrease in net services. These developments resulted in the reduction of CA surplus to a less than 0.1% of GDP. The exports of the euro area countries experienced an improvement mainly due to the economic growth of importing countries (especially China) and better price competitiveness of the euro area. However, the increase of imports (in value) was much larger compared to Specifically, the increase in the value of imports partly reflected higher prices of imports associated with the depreciation of euro while higher oil prices might have also contributed to the increase of the value of imports. Euro area experienced an increase in the volume of imports which is a sign of the improvement in the domestic demand in the euro area. During 2005, euro area recorded a net outflow in combined foreign direct and portfolio investment. 26

27 Other European Union Countries 5 - In 2005, real GDP growth in the United Kingdom eased to 1.6% from 3.2% in The main contribution to the growth in 2005 was due to private consumption (although it was weaker than 2004) and private investments due to a sound corporate financial position and low interest rates. However, negative contribution to a growth was recorded for by net exports which since the first half of the year experienced a significant decrease. As regards price developments, the annual headline HICP inflation in UK, after a period of a significant increase, declined to 2.0% from the peak of 2.5% in September. The inflationary pressures were accounted for by the surge in oil prices while the underlying inflationary pressures remained contained at 1.4%. The general government deficit is estimated at 3.1% (3.0% of GDP in 2004) while the CA deficit is estimated to increase to 2.3% (2.2% of GDP in 2004). Among the major economies outside the euro area, Sweden recorded the strongest GDP growth with 2.5% although it is lower compared with 3.7% in The output growth in Sweden was contributed by the increase in domestic demand of 2.3% (0.7% in 2004) while the contribution of external demand was negligible with 0.2pp compared with 3.0pp in Real GDP in Denmark grew with 2.5% (2.1% in 2004), driven mainly by private consumption and investment which was partly offset by the unfavorable external demand. Indicators for the three largest New EU member states 6 have shown that the output growth was robust in In particular, the largest output growth was recorded for by the Czech Republic where real GDP grew by 4.8%. Growth was mainly driven by the significant improvement in the private consumption and favorable external position. In Hungary, real GDP grew by 3.7% from 4.6% in the previous year driven mainly by the domestic demand and favorable external demand. Whereas growth in Poland appears to have decreased from 5.3% in 2004 to 3.4% in The main factors contributing to this slowdown are lower private consumption and unfavorable external position while investments experienced an increase during EU member states not belonging to the Euro Area. 6 Czech Republic, Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, Slovakia and Slovenia. 27

28 2.3 Western Balkans 7 Most of the Western Balkan countries are the main trading partners of Kosovo. In 2005, FYROM participated with 22% in Kosovo imports, Serbia and Montenegro with 17%, Turkey with 9%, and Bulgaria with 4%. Western Balkan countries achieved a favorable economic development with strong growth and macroeconomic stability. However, differences between countries in the region are still prevailing. Boosted by a strong contribution of the private consumption which facilitated by rapid credit growth - reflecting further developments of the banking system in some countries - real GDP grew at 5.0%, on average. This is slightly lower compared to real GDP growth of 5.4% in 2004 but higher compared to 3.9% in With regard to the output growth of particular countries within the Western Balkans, the fastest growth was recorded for by Albania (6.4%), Bulgaria (5.5%) and Romania (5.3%). Figure 6. Gross Domestic Product (y-o-y), Western Balkans, GDP (y-o-y change in %) Romania Bulgaria Croatia Albania FYROM Serbia and Montenegro Bosnia and Hercegovina Source: Business Monitor International (2006); EBRD (2005). Annual CPI inflation in Western Balkan countries increased slightly during 2005, stemmed mainly from the accelerating inflation rates in Serbia and Montenegro (only Serbia) reaching 17.5% in 2005 (13.8% in 2004). Marked increase of inflation in Serbia and Montenegro was mainly due to wages and administered price increases including the effect of the soaring oil prices during Inflationary pressures were also pronounced in Romania and Bulgaria reaching 8.0% and 6.8%, respectively. Low 7 The indicators for Western Balkans include: Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYROM, Romania and Serbia and Montenegro (excluding Kosovo). 28

29 levels of annual inflation rates were recorded for by FYROM (0.5%) and Bosnia and Herzegovina (1.6%). Figure 7. Inflation (change in annual CPI) in the Western Balkans, % 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% Romania Bulgaria Croatia Albania FYROM Serbia Bosnia and Herzegovina Source: Business Monitor International (2006); EBRD (2005). With regard to bilateral exchange rates (figure 8) of Western Balkan countries currencies against the euro, Romania Lei (ROL) and Albanian Lek (ALL) appreciated while Serbian Dinar (CSD) depreciated against Euro. However, other countries were successful in maintaining the exchange rate stable. Figure 8. Euro exchange rate versus HRK, ALL, CSD, MKD, ROL, HRK/EUR ALB/EUR CSD/EUR MKD/EUR ROL/EUR (right-hand scale) Thousands 0 32 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Source: Eurostat (2006). 29

30 Western Balkan countries performed well with respect to fiscal discipline by reducing their fiscal deficits in 2005, although differences exist among countries. In particular, larger government budget deficits were experienced for by Albania and Croatia while Romania, Serbia and Montenegro and Bulgaria generated surpluses in their consolidated general government balance. Due to rapid credit growth, the CA balance is continuing to deteriorate in the Western Balkan countries. The CA deficit is projected to have fallen only slightly in 2005 compared to 2004 while the largest CA deficit was recorded in BiH, Serbia and Montenegro and Romania. On the other hand, deficit increase was recorded for countries such as Albania, Romania and Croatia while it is projected to remained unchanged in Bulgaria (see figure 9). Figure 9. Fiscal and CA balance as % to GDP, Western Balkans, % Fiscal Balance, in % to GDP Current Account balance, in % to GDP 0% -5% -10% -15% -20% -25% Romania Bulgaria Croatia Albania FYROM Serbia Bosnia and Herzegovina Source: Business Monitor International (2006); EBRD (2005). Inflow of Foreign Direct Investments (FDI) seems to be reflecting the expectations for EU accession and privatization progress in the countries of Western Balkans. Particularly, large net FDI inflows have been achieved by Bulgaria, Romania and Croatia which covers over half of their CA deficit. Serbia and Montenegro have experienced net inflow of FDI however it still relies on grants and loans from international financial institutions as well as high inflow of remittances. The real GDP growth in Albania is estimated to be 6.4% (5.9% in 2004) with a private sector representing 75% of GDP. Annual inflation rate remained at 2.9% at the end of 2004 and decreased to 2.1% at the end of In 2004, the ALL appreciated by 4.9% vis-à-vis the euro and has continued to strengthen further by 2.8%, on average, during The CA deficit decreased to 5.9% in 2005 from 8.2% in 2003, reflecting positive developments in the trade balance with trade deficit being 30

31 around euro 84.3 million lower compared to Trade balance is mainly covered by worker remittances (accounting for 14% of GDP in 2004) and private and official transfers which contributed largely to the increase in the domestic demand. Regarding the fiscal developments, the budget deficit remained stable during the past three years and in 2005 it reached 4.7% of GDP (4.8% and 4.4% in 2004 and 2003). Regarding the banking sector in Albania, there are 16 banks with majority private ownership. Banking sector has increased its activities in line with the privatization of the Savings Bank, which accounted for 57% of the deposits. Assets of the banking sector account for around 58.8% of GDP. However, with deposits held by banks representing around 51.9% of GDP, credit to the domestic economy remains low, which by the end of 2005 accounted for around 14.7% of GDP. Real GDP growth in Bosnia and Herzegovina (BiH) reached 5.8% in 2005 compared to 5.0% in 2004, and 3.5% in 2003 while private sector accounts for 55% of GDP. The currency board arrangement has enabled BiH to successfully maintain price stability with inflation standing at 1.6% in However, CA imbalances remain large and accompanied with the declining foreign assistance. CA deficit has, however, declined in 2005 to 21.2% of GDP (23.3% in 2004) with FDI covering around 30% of CA deficit. External imbalances have been mainly driven first by the large trade deficit (mainly covered by private transfers), reflecting low capacity to export, and second, the expansion of credit by the banking sector that may have contributed to this increase of imports. Regarding the fiscal sector, government deficit represents 1.3% of GDP with expenditures being concentrated mainly on current rather than capital expenditures. Banking sector in BiH is dominated by banks with foreign ownership which constitute 84% of banking sector capital while five banks account for 62% of the total assets. Credit to the private sector has expanded rapidly, accounting for 17.4% of GDP, whereas deposits account for 34.1% of GDP. As a response to the credit expansion, Central Bank of BiH increased the reserve requirement from 5% to 10% in Bulgaria achieved real GDP growth of 5.5% in 2005 driven mainly by the private sector composing around 75% of GDP. Bulgaria has also been successful in maintaining macroeconomic stability supported by the currency board arrangement and adequate fiscal policy. Annual consumer price inflation went up from 4.0% in 2004 to 6.8% at end Despite strong growth and macroeconomic stability, external imbalances remain high. In particular, CA deficit was 7.5% of GDP in 2004 and increased further in 2005 to 13.8%. The worsening of the CA deficit was partly driven by the strong 31

32 growth in imports of both consumer and investment goods and the increase of oil prices. With regard to the fiscal sector, general government balance ended with a surplus of 2.0% of GDP in 2005, which in turn contributed to the decline in external debt to 63.6% from 69.1% of GDP in The banking sector of Bulgaria has a significant role in the economy with total assets accounting for 77.5% of GDP. During 2004, the banking sector in Bulgaria has further deepened its role in financial intermediation. Therefore, due to the rapid credit growth during 2004, credit to GDP reached around 35% while contributing consequently to the increase in domestic demand and imports. In line with the growth in credit, deposits reached around 50% of GDP. In 2005 National Bank of Bulgaria has imposed credit ceiling by increasing the minimum reserve requirement based on the average growth of credits. This consequently eased the credit expansion to 27.6% of GDP while deposits reached 56.6% of GDP. The Croatian economy continued to decelerate with a real GDP growth of 3.7% in 2005 (3.8% and 4.3% in 2004 and 2003, respectively), while the share of the private sector to GDP reached 60%. Annual inflation rate at end 2005 grew by 3.7% (2.7% in 2004) mainly due to the upward pressure of oil and food prices. Low inflation accompanied by the stable exchange rate of Kuna against Euro has helped Croatia achieving macroeconomic stability, although external and fiscal imbalances continue to exist. Following a significant decrease in 2004 (to 4.8% from 7.2% in 2003) CA deficit increased slightly in 2005 reaching 5.2% of GDP. By contrast, government budget deficit declined to 4.2% in 2005 (4.9% in 2004). Taking into account its role for the Croatian economy, the banking sector is well developed with assets representing 109.9% of GDP. Private credit to GDP increased by 62.9% which was accompanied with the increase in deposits by up to 72.7% of GDP. Due to a large inflow of capital which put large pressures in the appreciation of Kuna, Croatian National Bank (CNB) introduced marginal reserve requirements on banks foreign liabilities. The real GDP growth of the Former Yugoslav Republic of Macedonia (FYROM) in 2005 is estimated to be 4.0% compared to 2.9% and 2.8% in 2004 and Private sector is increasing its share to GDP to 65% in In 2004, FYROM experienced an annual consumer price deflation of 0.1% whereas in 2005 it remained unchanged at zero. As a result of the policy established by the Central Bank in maintaining stable exchange rate of Denar against Euro, the exchange rate remained stable at the narrow band of MKD to 1 EUR during The CA balance of FYROM is 32

33 continuously experiencing deficits which in 2004 increased to 8.2% and was followed by a slight decrease to 6.5% of GDP in High external imbalances were driven mainly by the high trade deficit, although it declined by 28.7% in 2005 compared to The CA deficit is manly financed by workers remittances that account for 12% of GDP while net FDI inflow is continuing to remain low. The general government experienced a deficit of 0.5% of GDP during 2005 with public debt remaining relatively low at around 50% of GDP. The financial sector in FYROM is dominated by the banking sector. In 2005, FYROM banking sector consisted of 20 banks, three of which composed 65% of total banking sector assets (two of them are foreign owned), 75% of loans and 65% of total deposits. Although the number is high, the intermediation role of banks is relatively low with private credit accounting for 20% of GDP while assets account for 61.6% of GDP. The share of total deposits is also low as a percentage of GDP, as at end 2005 they represented 33.0% of GDP. Romania experienced a robust GDP growth of % which eased in 2005 to 4.6% driven mainly by the domestic demand. At the end of 2005, annual consumer price inflation declined to 8.0% from 9.3% in 2004 following the strong appreciation of the LEI against the Euro. CA deficit accelerated to 7.6% in 2005 compared to 7.4% and 6.4% in 2004 and 2003, respectively. The main factor deepening the CA deficit was the increasing trade deficit that weakened mainly due to the high domestic demand and the appreciation of the currency. Romania experienced high inflow of FDI which was a result of the privatization of some enterprises by foreign investors. The consolidated government budget experienced a surplus of 1.0% of GDP due partly to the high growth and improvement in tax collection. The real GDP growth of Serbia and Montenegro (Serbia only) eased somewhat in 2005 to 5.8% from 8.6% in Annual inflation reached 17.5% at the end of 2005 from 13.8% in 2004 which was mainly driven by administered prices and high wage growth accompanied by the existing high domestic demand. The Dinar depreciated against euro by 14.9% in 2004 and 15.5%, on average, during Reflecting slower GDP growth, domestic demand reduced and hence contributed to the narrowing of the trade deficit. As a result, CA deficit narrowed as well and in 2005 it accounted for 8.5% of GDP from 14.5% in Worker remittances represented around 14% of GDP while net FDI inflow doubled during 2005 (around 4% of GDP in 2004) mainly due to the privatization of state owned banks. General government budget gradually decelerated from 3.1% in 2003 to 0.2% in 2004 and generated a surplus of 1.4% of GDP in The banking sector in Serbia consisted of 40 banks, 14 of which were foreign. Despite the large number of banks, credit to GDP reached 32.2% while 33

34 deposits accounted for 39.0% of GDP. Total assets of the banking sector in Serbia made up 61.4% of GDP by the end of Regarding the Montenegro, there is a different picture concerning GDP and price stability. Namely, the real GDP growth for 2005 is estimated to reach at 3.5% a 0.5pp higher relative to The prices (year-on-year average) increased with 1.8pp over 2004, standing at 3.6% in Real GDP growth in Turkey in 2005 accounted for 5%, similar to GDP growth in Inflation shows improvements recording a decrease to 6.9% in 2005 from 8.4% in Since 2001, when the CA recorded a positive balance of 2.4%, there is continuous decline reflecting a CA deficit. Compared to the previous year, CA deficit in 2005 somewhat smoothed with 0.3pp, while still accounting for 5.3% of GDP. 34