pID 1J6q Project Name: Kosovo, SAM. - Economic Assistance Grant IV Region: Europe and Central Asia Sectors: Public Expenditure Management, Private Sector Development Project ID: P078380 Recipient: United Nations Interim Administration Mission in Kosovo (UNMIK) Implementing Agency: Ministry of Economy and Finance, Provisional Institutions of Self-Government (PISG), Kosovo Environment Category: U Date this PID prepared: November 11, 2002 Appraisal Date: April 14-18, 2003 Projected Board Date: June 12, 2003 Background The Kosovo conflict in 1999 severely disrupted economic activity and caused substantial physical damage to Kosovo's infrastructure. In particular, more than 50 percent of agriculture assets were reportedly -damaged or lost, and key parts of the telecommunications system were destroyed during the conflict. In addition, equipment of all types and personal property were looted extensively. Besides the conflict related damage, the previous decade of under investment had severely degraded economic infrastructure. Human capital was also eroded, especially among the younger generation, which had not had proper access to secondary and higher education. Kosovo's reconstruction and recovery has proceeded well, due to the efforts of the people of Kosovo, the efforts of UNMIK and those working in the public administration, and the strong support of the donor community. By November 1999, the World Bank and European Commission had prepared a reconstruction and recovery program for Kosovo which had an estimated total cost of $2.3 billion over the years 1999-2003. The program provided a framework for donors to help finance post conflict reconstruction and rehabilitation on a gradually diminishing basis, while putting Kosovo on a path to self sustaining economic growth. The strategy had three main objectives: (i) to develop a thriving, open and transparent market economy; (ii) to support the public administration and to establish transparent, effective and sustainable institutions; and (iii) to mitigate the irnpact of the conflict and to start addressing the legacy of the 1990s. Kosovo has been gradually progressing towards self-government. Following the adoption of the Constitutional Framework in May 2001 and the Kosovo-wide elections in November 2001, responsibility for administering the territory is now shared between UNMIK and a Kosovar self-Government. While the Provisional Institutions of Self Government (PISG) have significant responsibility in governing Kosovo, the Special Representative of the UN Secretary General (SRSG) retains the power to ensure security (in coordination with KFOR), exercise a number of specific reserve powers, and set the "broad parameters" of fiscal policy, including the overall budget. Along with the transfer of power from UNMIK to the PISG, a transfer of public sector resources is also taking place. The 2002 budget marks an important stage in the transfer of power, with more than two-thirds of general budget resources under the authority of the PISG and the municipalities; in 2001, virtually all general budget resources were under the authority of UNMIK. This presents a very significant opportunity and challenge for laying the institutional basis for sound fiscal management in Kosovo. The Government in Kosovo and its new budgetary authority come at a time when it is critical to address some fundamental questions on how to support the long-term development of Kosovo. To reach beyond recovery to longer term sustainable growth, Kosovo will need to make further progress in fundamentally reforming its economy and its public finances. Achieving the new Government's objectives of a rapidly growing economy with increased private sector employment and an overall improvement in living standards will require decisive implementation of a broad--ranging structural reform agenda. Objectives of the proposed Operation The main objective of the proposed fourth budget support operation is to assist Kosovo in the implementation of a structural reform agenda aimed at enhancing medium-term macro- fiscal sustainability, sustaining adequate public service delivery in the face of declining donor support, and promoting private-sector driven growth. The reform program to be supported by the proposed Operation works to achieve these objectives through specific reforms in the areas of budget management and the business environment. In the area of budget management, the proposed Operation would support concrete measures towards improving the transparency and accountability of public spending and the allocation of resources in line with medium-term priorities. In the area of private sector development, the operation would help to improve the business environment by making further progress on designing and implementing the private sector regulatory framework, and taking first steps to improve the efficiency of publicly-owned enterprises. Rationale for IDA involvement Following the conflict, a Transitional Support Strategy (TSS) was presented to the IDA Board of Executive Directors on October 7, 1999 (R99-178). The TSS proposed an assistance strategy to support post-conflict reconstruction and economic recovery as part of a broader international effort, as well as the establishment of the Trust Fund for Kosovo, with two allocations totaling US$60 million from IBRD's net income. The TSS Progress Report of June 27, 2000 (R2000-130) took stock of the initial implementation of this strategy and set out an assistance program for the October 2000-September 2001 period, making the case for the second tranche of the net income allocation. A second TSS for Kosovo was considered by the IDA Board on July 2, 2002, which outlined a program of targeted adjustment and investment operations in Kosovo funded by IDA grants. This TSS program is designed to focus the Bank's involvement in Kosovo in particular on building the capacity of the developing local government institutions, building on the broad based reconstruction support provided under the first TSS. The Proposed Operation was envisaged to be financed within the IDA grant envelope presented in the second TSS, under the category of post-conflict grants. Kosovo remains a post-conflict territory, within a member country, and under UN administration on an interim basis. As was the case of the previous economic assistance grants, the proposed fourth EAG IV facilitates World Bank engagement in the policy dialogue with UNMIK, the PISG and other donors, building on progress made under the first three budget support Operations. The first two grants supported the establishment of a fiscal system and helped to provide basic services in a post- conflict setting. Most notably, they supported the creation of a fully functional and effective budget management system, with modern standards of public expenditure management and transparent fiscal operations. The first two grants have also played a decisive role in assisting the authorities in the design and implementation of a functioning tax and tariff system minimizing distortions. The main objective of the third grant was to support Kosovo's private sector development program by supporting the enactment of four key commercial regulations, on (i) business organizations; (ii) the contract for sale of goods; (iii) pledges; and (iv) foreign investment. Description of the proposed Operation The conduct of fiscal policy will remain critical to ensuring macroeconomic stability, a conducive investment climate, and equitable growth in Kosovo over the medium term. While the adoption of a hard currency has played a critical role in bringing about macroeconomic stability, it is also putting a larger burden on fiscal policy. Given the political and legal uncertainties surrounding borrowing, and without a monetary policy instrument, the fiscal policy stance will depend critically on a strong domestic revenue effort, a careful calibration of expenditures to support both public investment and critical social expenditures, and importantly, continuing donor support to the budget, albeit at a lower level.In this context, and in an environment of declining donors' support, Kosovo's main challenge will be to implement policy measures that are critical to achieving a fiscally sustainable reform program fostering private sector-led growth. The proposed operation will support measures towards maintaining fiscal discipline and the allocation of resources in line with medium-term priorities. The first three years of budget management in post-conflict Kosovo have seen the establishment of a commendable framework for public expenditure management. However, budget development in Kosovo has until recently been more compliance focused and aimed at fiscal discipline rather than at mechanisms to enhance the efficiency and effectiveness of public spending. While sticking to the previous record of fiscal discipline, it is now time to start looking for mechanisms that will systematically encourage more effective efficient spending allocation. The proposed operation would also seek to support measures that would improve the efficiency of existing public spending. Vital extra spending on operations and maintenance, and capital investment, can only be financed if cost savings are implemented elsewhere. Subsidies to public enterprises are currently high and crowding out other spending. With public wage spending in excess of 6% of GDP, the public sector wage bill needs to be kept constant as a share of GDP. The transparency and accountability of public spending also needs to be improved in Kosovo, and the EAG IV will support measures to this end. While many transparency milestones have been established over the past three years, key gaps in achieving a truly transparent and accountable public expenditure system include the lack of framework financial management legislation, delays in the establishment of the Auditor General's Office, and weak internal auditing functions. The promotion of private sector activity will be vital to Kosovo's economy, and the proposed operation will also seek to support reforms to improve the environment for business. Over the past three years, the Authorities have made substantial progress in putting in place a legal and institutional framework to promote and support private sector activity. UNMIK passed regulations on Business Organizations (a quasi-company law), Foreign Investment, Profit Taxes, a Board for Establishment of Accounting Standards, and Pledges (for movable property) . The regulation on Pledges is supported by a pledge registry which became operational in February 2002. However, despite this progress, Kosovo has yet to establish an adequate business environment to protect and enforce property rights and contracts, facilitate stable entry and exit of firms, and promote financial intermediation. This environment increases risks for private investment, encourages firms to remain in the informal economy, and constrains financing for firms to the extent that property rights and transactions are not yet fully secure. Access to finance is a crucial constraint on firms, and for many SMEs real estate is their most significant asset, although they have no means to leverage these assets given the lack of secure property rights and a reliable framework for commercial banks to secure collateral. Without access to finance and secure property rights, firms have few incentives to become legally recognized, formal entities. This in turn constrains the ability of the Government to expand its revenue base through the collection of profit and wage taxes. The operation will be an IDA grant coordinated by the Ministry of Economy and Finance, one of the Provisional Institutions of Self Governance, and UNMIK. Environmental Category The proposed operation is not expected to result in any negative impact on the environment. For the purposes of Operational Directive 4.01, it has been placed in Category U, which does not require an environmental assessment. Poverty Category The proposed operation will have positive impacts on poverty. Through improving the allocation of resources in line with medium term priorities and ensuring adequate and sustainable service delivery, public spending should progressively be targeted towards improving access to and the quality of services to the poor. Improvements in the accountability and transparency of spending will also reduce the potential for waste and misappropriation of public resources. Improved delivery of basic, services such as health and education will complement measures to promote private sector activity and provide employment and income, which will be particularly important as donor assistance ramps down. Benefits and Risks The proposed EAG IV will provide a range of potential benefits, in addition to the positive impacts on poverty described above. First, it will assist the authorities in articulating a coordinated economic policy reform agenda backed by a consistent macroeconomic framework. Second, it will support reforms aimed to improve transparency in public finances and better target public expenditures. Third, policy measures to promote private sector development and thus drive productivity and growth will be a key component of the overall reform package. The proposed EAG IV also entails external, political and implementation risks. The operation would tackle difficult political reforms in a complicated institutional setting. There are risks associated with the implementation of the economic reform effort itself that largely are linked to weak local capacity. There are also various risks of policy implementation. Budgetary systems and mechanisms, including tax administration and collection, are still at a formative stage. Strong pressures also are being felt to raise wages, maintain over-manning in public services and utilities and increase overall spending to amounts that would not be sustainable in the medium term. There is also considerable uncertainty about growth prospects and the macroeconomic scenario is associated with substantial risks. Finally, the EAG IV tackles issues which have proved difficult in other economies in transition. Contact Points: Ms. Marina Wes Sr. Economist The World Bank 1818 H Street , NW Washington, D.C, 20433 Telephone: (202) 458 1390 Fax (202) 522 2754 The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458 5454 Fax: (202) 522 1500 Note: This is information on an evolving project. Certain components may not be included in the final project. This PID was processed by the InfoShop during the week ending May 2nd.