Report No. 53599-AL Albania The New Growth Agenda A Country Economic Memorandum November 2, 2010 Europe and Central Asia Region Document of the World Bank CURRENCY EQUIVALENTS Currency Unit – Lek (ALL) EXCHANGE RATE December 31, 2009 – ALL 138.0 = € 1.00 WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1 – December 31 ABBREVIATION AND ACRONYMS AKEP Autoriteti i Komunikimeve Elektronike KESh Albanian National Electricity Company dhe Postare (Telecom regulator) BEEPS Business Environment and Enterprise OECD Organization for Economic Co-Operation Performance Survey and Development CA Competition Authority OSSh Retail Supplier of Electricity CAD Current Account Deficit R&D Research and Development DSO Distribution System Operator RIA Regulatory Impact Assessment EBRD European Bank for Reconstruction and RRTF Regulatory Reform Task Force Development ECA Europe and Central Asia SEE South Eastern Europe ERE Electricity Regulatory Entity SME Small and Medium Enterprises EU European Union SMP Significant Market Power FDI Foreign Direct Investment TSO Transmission System Operator GDP Gross Domestic Product SMP Significant Market Power ICA Investment Climate Assessment VAT Value Added Tax ICS Investment Climate Survey WDI World Development Indicators ICT Information and Communication WGI Worldwide Governance Indicators Technology IMF International Monetary Fund WPS Wholesale Public Supplier IPP Independent Power Producer Vice President: Philippe H. Le Houerou, ECAVP Country Director: Jane Armitage, ECCU4 Sector Director: Luca Barbone, ECSPE Sector Manager Bernard Funck, ECSP2 Task Managers: Roland Clarke and Erjon Luci, ECSP2 ACKNOWLEDGEMENTS This report was prepared by a core team led in the initial stages by Alia Moubayed and subsequently by Roland Clarke, Erjon Luci and Borko Handjiski. The team included Salvador Rivera, Gazmend Daci, Evis Sulko, Rick Hopper, Gentjana Sula, Andrea Guedes, Caterina Ruggeri Laderchi, Alexandru Cojucaru, Andrew Dabalen, Atsushi Iimi, Gareth Locksely, Martin Humphreys, Peter Miovic, Artan Guxho, Donato De Rosa, Sanjay Kathuria, Marco Ranzani and Clelia Rontoyanni. The report was undertaken under the guidance of Jane Armitage, Country Director, Luca Barbone, Sector Director, and Bernard Funck, Sector Manager, Camille Nuamah, Country Manager, and Ron Hood, Country Sector Coordinator, and the authors gratefully acknowledge their support and guidance, as well as the comments received from Indermit Gill, Regional Chief Economist and Juan Zalduendo, Lead Economist. The report also benefited from background papers prepared by Martin Melecky, Sam Mikhail and Ilir Gedeshi. Sébastien C. Dessus, Dilip Ratha, Albert G. Zeufack provided useful comments at the concept stage. Particular thanks are due to the peer reviewers of the final report: Demetrios Papathanasiou, Cevdet Denizer and Carole Garnier, in addition very useful comments and inputs were received from Lars Sondergaard and Nina Arnhold. Thanks also to Mismake Galatis and Enkelejda Karaj for support in preparing the report and with organizational and administrative matters. The report also benefited from valuable discussion with the authorities, namely Sherefedin Shehu, Selami Xhepa, Sybi Hida (Parliamentary Commission of Economy), Altin Rapaj (AKEP) and numerous officials of the Ministry of Finance, Ministry of Economy, Ministry of Education and Science, the Bank of Albania, business representatives, academics and university officials. TABLE OF CONTENTS EXECUTIVE SUMMARY ................................................................................................................................. I  CHAPTER 1:  MACROECONOMIC PERFORMANCE, THE GLOBAL CRISIS AND BEYOND ........................ 1  I.  INTRODUCTION ................................................................................................................................ 1  II.  ALBANIA'S RECENT MACROECONOMIC PERFORMANCE ................................................................... 2  III.  THE CRISIS AND THE NEW CHALLENGES .......................................................................................... 8  IV.  POLICY RESPONSES TO THE CRISIS ................................................................................................... 9  V.  ACCELERATING LONG-TERM GROWTH .......................................................................................... 11  CHAPTER 2:  EDUCATION AND SKILLS FOR AN INNOVATIVE ECONOMY ........................................... 13  I.  INTRODUCTION .............................................................................................................................. 13  II.  THE SKILLS GAP ............................................................................................................................ 14  III.  FROM BRAIN DRAIN TO BRAIN CIRCULATION .............................................................................. 17  IV.  A BIGGER AND BETTER EDUCATION SYSTEM ............................................................................... 20  V.  IMPROVING MARKETABLE SKILLS................................................................................................. 24  VI.  EDUCATION REFORM AREAS ......................................................................................................... 25  CHAPTER 3:  MODERNIZING INFRASTRUCTURE .................................................................................. 31  I.  INTRODUCTION .............................................................................................................................. 31  II.  IMPROVING CONNECTIVITY THROUGH ICT.................................................................................... 32  III.  ELECTRICITY .................................................................................................................................. 40  IV.  TRANSPORT INFRASTRUCTURE ...................................................................................................... 48  CHAPTER 4:  PUBLIC INSTITUTIONS AND GOVERNANCE FOR INVESTMENT ....................................... 51  I.  INTRODUCTION .............................................................................................................................. 51  II.  GOVERNANCE AND THE INVESTMENT CLIMATE ............................................................................ 51  III.  IMPLEMENTATION OF THE LEGAL FRAMEWORK............................................................................. 53  IV.  RECOMMENDATIONS ...................................................................................................................... 59 MAP TABLES Table 1.1: Key Macroeconomic Indicators (percent of GDP, unless otherwise indicated) ........................................... 2  Table 1.2: Rates of Poverty Reduction in Rural and Urban Areas ................................................................................ 5  Table 1.3: Albania - Balance of Payments (% of GDP) ................................................................................................ 7  Table 2.1: Education Expenditure (Percentage Structure) ........................................................................................... 20  Table 2.2: Numbers of Students by Levels of Public Education (Thousands) ............................................................ 20  Table 2.3: Spending Per Student as % of GDP Per Capita .......................................................................................... 20  Table 2.4: Wage Premia for Different Categories of Education .................................................................................. 21  Table 2.5: The Expansion of Higher Education in Albania (Thousands) .................................................................... 22  Table 2.6: Distribution of Students by Subject Area, 2006-2008 ................................................................................ 23  Table 3.1: Electricity Distribution Performance .......................................................................................................... 41  Table 3.2: Electricity Tariffs in Albania (Lek per KwH) ............................................................................................ 44  FIGURES Figure 1.1: Economic Performance of Central and Southeast Europe’s Economies ..................................................... 1  Figure 1.2: GDP Composition % (left figure) and Employment by Sector % (right figure) .........................................3  Figure 1.3: Saving and Investments ............................................................................................................................... 4  Figure 1.4: Domestic vs. National Saving .................................................................................................................... 4  Figure 1.5: Poverty Headcount Ratio by Districts in percent ........................................................................................ 5  Figure 1.6: Fiscal Balance (% of GDP) ......................................................................................................................... 6  Figure 1.7: Fiscal Revenue and Expenditure (% of GDP) ............................................................................................. 6  Figure 1.8: Credit to Private Sector and Deposits (% of GDP) ..................................................................................... 6  Figure 1.9: Growth Rates of Manufacturing Sentiment ................................................................................................. 8  Figure 2.1: Public Spending on Education and Educational Attainment Levels ......................................................... 15  Figure 2.2: Cognitive Skill Indicator (2000) ............................................................................................................... 16  Figure 2.3: Percent of Students with Basic Literacy (2000) ........................................................................................ 16  Figure 2.4: Dynamics of Brain Drain: share of Academics moving abroad as % of total Academics ........................ 18  Figure 3.1: Impact on Per Capita GDP Growth of a 10 Percentage Point Increase in ICT Penetration, 1980-2006 ...32  Figure 3.2: Internet Penetration and GDP per capita ................................................................................................... 32  Figure 3.3: Mobile Penetration In Selected Countries ................................................................................................. 33  Figure 3.4: Share of 3G Technologies (percent) .......................................................................................................... 33  Figure 3.5: Alternative Broadband Technologies ........................................................................................................ 34  Figure 3.6: Mobile Telephone Charges by Carrier in the Region ................................................................................ 35  Figure 3.7: Fixed Telephone Charges, October 2009, Euro cents ............................................................................... 35  Figure 3.8: Broadband prices, Euro per month, 2mbps Subscription .......................................................................... 35  Figure 3.9: Electricity Supply and Load Shedding ...................................................................................................... 41  Figure 3.10: Albania: Electricity Prices, € Cents Per KwH ......................................................................................... 43  Figure 3.11: Comparative Electricity Prices, 2007, € Cents Per KwH ........................................................................ 43  Figure 3.12: Distribution Losses, Metering, and Collection ....................................................................................... 45  Figure 3.13: Forecast Supply and Demand for Electricity in Albania, Under the New Regulatory Framework ......... 47  Figure 3.14: Average Price for Base load Power at the European Energy Exchange .................................................. 47  Figure 4.1: BEEPS 2005 and 2008: Percentage of Firms Indicating a Problem .......................................................... 53  Figure 4.2: Bribe Frequency and Bribe Size – Cross Country Evidence from BEEPS Surveys ................................. 54  Figure 4.3: Formal Regulation, Implementation Practices and Income Levels ........................................................... 54  Figure 4.4: World Governance Indicators for Albania ................................................................................................ 55  Figure 4.5: Regional Comparison on Selected WGI Sub-Indicators ........................................................................... 55  Figure 4.6: Perception of Consistent and Predictable Interpretations of Laws and Regulations ................................. 58  BOXES Box 1.1: Population, Labor and Migration .................................................................................................................... 4  Box 1.2: The Role of Statistics for Policy Credibility ................................................................................................. 10  Box 1.3: Fiscal Rule Options ....................................................................................................................................... 11  Box 2.1: Innovation and Growth ................................................................................................................................. 14  Box 2.2: Mobilizing Academic Networks through the Brain Gain Program ............................................................... 19  Box 2.3: The University System in Albania ................................................................................................................ 22  Box 2.4: The Faculty of Vocational Studies, University of Durres ............................................................................. 28  Box 3.1: ICT Development and Human Capital .......................................................................................................... 36  Box 3.2: Good Practices for Promoting Broadband Access ........................................................................................ 38  Box 3.3: Electricity-Intensive Manufactures in Albania ............................................................................................. 43  Box 3.4: Electricity Transmission Arrangements in Albania ...................................................................................... 46  Box 4.1: Arbitrary Decisions and Uncoordinated Actions .......................................................................................... 56  EXECUTIVE SUMMARY Introduction 1. Since 1998 Albania has experienced an important transformation that has lifted it into the ranks of upper middle income countries and has allowed a sharp reduction in poverty. Growth averaged more than 6 percent per year between 1998 and 2010 – the best performance in Europe. This helped to reduce absolute poverty by half, with the headcount rate falling from 25 percent of the population in 2002 to 12 percent in 2008. The recent period of global turmoil has dampened growth somewhat but not as sharply as in many other countries. 2. Becoming an upper middle income country signals an important shift in the nature of challenges Albania faces going forward. Much of the recent growth is attributable to a marked shift of workers from agriculture to services and manufacturing. This inter-sectoral redeployment of labor from low to higher productivity activities is welcome, but it can only be a temporary means to boost overall productivity. In Albania this process will eventually come to an end and increasingly growth will have to come from policies that support intra-sectoral productivity increases. 3. The new challenges are also reflected in the nature of Albania’s relationship to other countries in the broader global economic environment. Upper middle income countries face competition from both below and above. Below are low-wage competitors just a few rungs down on the development ladder who produce the same kinds of products and compete on the basis of cheap labor. Above are richer countries producing more complex products, using more advanced production processes and competing on the basis of innovation, adaptation and skills. Upper middle income countries like Albania are thus squeezed. They must advance or be overtaken. 4. In addition, Albania is becoming increasingly integrated into global production systems, becoming more dependent on international trade, technology and capital. Over the near to medium term the global growth is likely to be sluggish and the terms and availability of capital harder. Such external factors are becoming increasingly important for Albania to consider and adapt to. 5. These challenges suggest the need for a “new growth agenda” and this is the central topic of the report. The report is organized into four chapters. Chapter 1 gives a macroeconomic overview, examines the potential vulnerabilities of the economy and proposes measures for maintaining macro- financial stability of the economy. It further elaborates the growth challenges Albania faces as newly arrived upper middle income country. Chapter 2 describes the human capital needs of the new growth agenda and focuses on education and skills. Chapter 3 examines the backbone infrastructure, while the final chapter addresses the investment climate and factors influencing the return on investment. 6. The report provides a diagnosis of some of the key factors likely to drive future growth but without recommending specific products or areas for private investment. The report does not and cannot indicate which sectors (agriculture, tourism mining, banking, etc.) should be developed, since these decisions will be taken by private investors. The report argues instead that the role of the government in this process is that of facilitator, removing the obstacles to investment and helping to provide information and institutions that private firms require to flourish. Macroeconomic Overview and Challenges for Future Growth 7. The strong growth of the last decade was underpinned by sound fiscal and monetary policies and low macroeconomic volatility. The stable environment created by a strong policy i framework supported a major transformation of the economy in which resources moved from agriculture and old-style industry to construction and services. Albania became increasingly integrated with the economies of the surrounding countries, with a solid growth of exports, but a rising trade gap financed by remittances, privatization receipts and some concessional foreign financing and FDI. Although the growth momentum was slowed somewhat by the global economic crisis, the effects of this were partly offset by an acceleration of public spending in 2008 and 2009. 8. The last two years have highlighted the risks due to uncertainty in the external environment and the need for cautious forecasts for the purposes of budget planning. An initial underestimation of the implications of the recent global economic and financial crisis for Albania (as in many other countries) led to over optimistic growth and revenue forecasts. As a result, lower than forecast tax revenues implied increased budget deficits or the need to adjust spending plans during the process of budget execution. Unanticipated changes in either the deficit or expenditures risk inducing a loss of confidence on the part of foreign investors and lenders, whose resources will be needed to realize Albania’s growth aspirations. Moreover, the global crisis has significantly changed the appetite of foreign investors for risk. Capital is likely to be scarcer in the next few years for all developing countries. Those countries with greater macroeconomic credibility are the ones most likely to be able to access a share of the scarce capital available. 9. Fiscal policy requires an anchor—so that markets and investors are convinced of its long run sustainability. Such an anchor is particularly important when debt levels are relatively high, and in the current climate of concern about sovereign debt. For many years, Albania benefited from a prudent fiscal policy, in which deficits had been on a downward trend and the target established for debt reduction broadly ensured fiscal sustainability. These policies were accompanied by IMF-supported programs. 10. This report supports the proposal of the authorities to define a fiscal rule as a policy anchor. Such a fiscal rule would imply the adoption of realistic assumptions for the medium term macroeconomic framework and make it easier for governments to adhere to a commitment to fiscal sustainability. This in turn should increase access to financial markets at relatively low interest rates. It would also help consolidate the strong macroeconomic record of the past and enhance the credibility of the medium term budget framework. 11. It is also worth noting that savings and financial intermediation have not been a major constraint on investment and growth. Savings have been adequate to finance relatively high levels of investment, and financial intermediation has increased enormously, although for many SMEs the access to credit remains limited. The strength of the financial system is a reflection of the strong and efficient supervision regime implemented during the last decade. 12. Finally, Albania faces a challenge arising from the success of its economic development. The progress achieved over the last decade implies that the demand for the inputs necessary for the development process is growing, and it is changing in character. The analysis in the report indicates that despite progress made (for example in education reform and infrastructure investment), the most pressing constraints to further growth appear to be in the areas of human capital (particularly marketable skills), and infrastructure (connectivity, electricity supply and to a lesser degree transport). These constraints reflect rising income levels and the consequent increase in the sophistication of the goods and services produced and demanded. In effect, the demand for human capital, management skills and sophisticated infrastructure has increased more quickly than the supply. The gap needs to be closed to keep returns to investment attractive and sustain future growth. Moreover, in this more complex environment, institutional infrastructure including the implementation of laws and policies (effectiveness of public institutions) become more important. ii Education, Skills and Innovation 13. Albania began its transition with a population that had more years of schooling than was the case in other countries with a comparable income per capita. However, those educated prior to the transition, and for many years afterwards, lacked skills and ways of thinking appropriate to the needs of a fast developing market economy. Although major educational reforms have been initiated, enterprises indicate that many graduates of universities and even secondary schools are still ill-equipped for the needs of today’s workplace. 14. The challenges in the education system have become more pressing as Albania has progressed and developed. Key among these challenges is the need for effective mechanisms for the private sector to communicate its needs to the education system, and the need to shift emphasis away from inputs into education and towards educational outcomes. Some of these issues are currently being tackled through reforms initiated for secondary and tertiary education, but they should be seen as among the highest priorities in the coming years, since reform efforts are likely to take many years to fundamentally change the structure and quality of the workforce. 15. The importance of strengthening skills and education has been recognized and is being pursued through extensive government reforms initiated in basic secondary and higher education. These include curriculum reforms in basic and secondary education to make the courses more modular and introduce greater choice and active participation in improved learning environments. Particularly important in this area is the introduction of an ICT curriculum in secondary schools, together with re- training of teachers and the provision of some schools with computing labs and internet access. In higher education a process of reforming curriculum standards, introducing quality assurance and a restructuring under the Bologna process are being undertaken. In addition, short cycle, sub-degree programs are being introduced in regional universities. 16. Both quality and quantity matter. Albania has taken steps to increase the number of graduates in tertiary school. The government’s program to expand higher education has raised the number of students graduating to over 14,000 in 2009 compared with 6,000 in 2003. At current intake levels the number of new graduates annually is likely to increase to 25,000 by 2012. However, the benefits of having a large number of graduates will be lost if the quality is low and teaching methods emphasize rote learning. This is an argument for making sure that expansion of higher education does not come at the expense of quality. 17. A number of measures could be taken to increase the likelihood that the graduates of Albania’s education system are able to successfully absorb the type of knowledge that can raise the productivity of Albania’s enterprises. These would complement and support the current reform processes in higher education. The proposed response includes steps to further improve accountability in the tertiary education system and to link it better to the demands of the market. Another step is to make general secondary education universal and strengthen it by paying greater attention to the quality of teaching, helping those who are having difficulty keeping up and, in particular, accelerating and strengthening the current reforms to the ICT curriculum. 18. Reforms in education currently taking place also emphasize the importance of accountability. Indeed international experience indicates that when performance is observable, incentives and mechanisms will be generated to improve it. Therefore, the report recommends that the following detailed information be collected and published: (i) Matura examination results for each region and school; (ii) average Matura results for entrants to each program in each university; (iii) final examination results, and completion rates for each university program; (iv) follow-up surveys of the placement of iii graduates in employment; (v) an annual survey of employers to rate the performance of graduates from different universities; and (vi) an annual survey of employers on the skills required and available. 19. Publication of information would give policy makers the necessary base to judge in which areas reforms are working and where they need to be strengthened. Just as important, students and their families would become aware of differences in quality and opportunity. This would prompt more pressure to reform poorly performing institutions, not least through competitive demand for admission to above average institutions. 20. Incentive schemes could be developed to attract students and direct resources to areas where skills are lacking. This might include offering scholarships in areas such as engineering and ICT. Another possibility is to base funding on actual enrolments with a differential reflecting the relevance of the particular discipline for development. This would promote greater competition among universities for students and provide incentives to improve quality and efficiency. Finally, tuition fees could be raised to 15-20 percent of the costs of tuition (higher in disciplines in which there is an excess of graduates), but combined with means-tested scholarships and/or loans for qualified low-income students. These reforms would increase sector financing, provide incentives for students and their parents to demand value for their money, and improve graduation rates. 21. The economy would benefit from actions that encourage the return of well educated Albanians from the diaspora. Around 40 percent of the staff of the universities and research institutes has emigrated, with the numbers being even higher in the natural sciences, engineering and physics. Admittedly, much of this drain took place in the early years of transition and there are now opportunities to exploit brain circulation as many of these migrants consider returning to the country. To this end, strengthening and extending Albania’s Brain Gain program will be of crucial importance. Pushing forward with reforms of the university and research environment that would make the working conditions attractive will also encourage the return of qualified Albanian academics and professionals, and provide an incentive to induce highly qualified individuals to stay In Albania. Modernizing Infrastructure Information and Communication Technologies 22. The government is committed to developing information and communications technologies (ICT) and has made substantial efforts to set up an adequate institutional framework for ICT. The government established an independent regulatory body, now known as AKEP. The National Agency on Information Society was established in 2007 to coordinate the development and administration of state information systems and promote an information society. The government launched the “Digital Albania Initiative” in 2009 and at the same time a new Ministry for Innovation and Information and Communication Technologies (with responsibilities for electronic communications and postal services) has been created for the management of the digitalization of the society, including reforms in the information society field as well as the management and implementation of the strategy. In addition, most of the basic elements of the regulatory framework for telecommunications are in place. The telecommunication market in Albania is fully liberalized and the government privatized a national state- owned fixed-line operator, Albtelecom, in June 2007. 23. Still, Albania’s ICT infrastructure is perceived by many firms as inadequate to meet the challenges of a new growth agenda. The proportion of firms indicating that telecommunications were an obstacle to doing business rose from 21 percent in 2005 to 56 percent in 2008 according to BEEPS. This increase does not signify a deterioration of the infrastructure, but rather an increase in demand which has outpaced the rapid improvement in telecommunication infrastructure in the last few years. The use of iv modern ICT, such as broadband internet, is low; indeed, only 2.5 percent of the population had broadband access in 2009, clearly a marginal level when compared to other European countries or to most of Albania’s neighbors. 24. To achieve a rapid expansion of ICT both policies and investments will be needed to increase competition and infrastructure capacity. The most important steps for ensuring a competitive market will be the implementation of the Albanian National Strategy for Integration and Development, and implementation of the new law on electronic communications. The implementation of the law should lead to introduction of new technologies and services with lower prices. 25. In terms of introducing new technologies, Albania should expand more vigorously alternative network technologies, such as 3G mobile, DSL, cable TV and WiMax. For example, Albania is the only country in Europe (in addition to Kosovo) that has yet to issue a 3G license. In this regard, successful completion of the recently launched tender process for a 3G license should serve to establish this service by 2011. Introduction of other technologies, such as cable TV internet and WiMax, are foreseen in the sector policy—this should occur without delays. 26. Given the limited infrastructure capacity, local loops should be unbundled and leased at reasonable cost to alternative networks.1 This will contribute to the expansion of the conventional DSL network and will require the re-balancing of the tariffs of Albtelecom. In Albania, this segment remains under-developed and is virtually monopolized by Albtelecom. Also, the tariffs of leased lines should be cost-based. Currently, the tariffs for higher speed connections are prohibitively expensive, discouraging new entrants in this segment of the market. 27. In the medium term, the low capacity of an optical fiber terrestrial backbone will have to be addressed with new investments. The success of broadband internet access is closely associated with supporting the necessary backbone infrastructure. Albtelecom remains the only operator with national (inter-urban and urban) and international connections in place, but its network is limited to only some main axes. More effort should go into improving incentives for investing in urban and inter-urban infrastructure as well as international connections. In addition clearer definition of rules for “rights of way” such as planning in advance for pipes/ducts in new roads and their deployment in the existing roads and the use of a common facilities framework should be in place. Given the high starting costs, the state could contribute by laying fiber or ducts in infrastructure projects (e.g. roads, electricity transmission lines). 28. Finally, a demand-side “big push” may be needed for Albania to break through into a virtuous circle and boost the internet-related market. This is because the ICT markets tend to develop rapidly only once a critical mass is reached. There is extensive experience around the world with policies to spur broadband adoption. The “virtuous circle” policies of the EU are particularly relevant. Albania’s ICT-related markets, except for 2G mobile, have yet to take off. The government may be able to take the lead in creating such demand by implementing e-government, starting with e-procurement of public purchases and works. Experiences in other transition economies indicate the importance of strengthening the demand side of ICT markets. 1 Local loops are the “last mile” connection that links individual phones to the telecommunication service provider network. Owners of local loops are in a natural monopoly position and can extract excessive profits and restrict development if not appropriately regulated. v Electricity 29. Almost all of the domestically generated electricity that is supplied through Albania’s national grid is produced by its hydropower plants. During years of low rainfall, the combination of dry weather, below-cost retail tariffs, high network losses (technical and non-technical), low collection rates, and growing demand, meant that the Albanian National Electricity Company (KESh) could only maintain electricity supply at a loss or was required to implement extensive load shedding. This resulted in unreliable and sometimes poor quality (fluctuating voltage) electricity supply. 30. Responding to this situation, the authorities carried out major reforms in the power sector. The sector has seen substantial gains in the last couple of years, and in particular since a new market model was introduced in 2008. Due to improved hydro conditions, the construction of Vlora thermo power (which is close to becoming operational), the establishment of an independent regulatory entity, and the privatization of the retail distribution arm, Albania's energy sector has come a long way on the path to improved reliability and quality of the power supply. 31. The next few years will be critical in making the new market model fully effective. This will entail: (i) strengthening the financial, managerial and technical viability of the publicly owned energy companies in the supply chain and reducing the associated inter-company arrears; (ii) reducing the contingent liabilities to the government; (iii) making the recent privatization of the distribution sector effective and operational, including the newly privatized distribution company and making the investments necessary to reduce energy losses in distribution from the current high levels of about 32 percent to 15 percent; and (iv) the government seeking ways to increase generation capacity, especially through small but efficient hydro and wind-power projects, while using its more expensive thermal generation capacities as back up in extreme circumstances. 32. Tariff reform will have to take into account the impact on the poor and vulnerable sections of the population. Currently, efforts to guarantee a basic level of energy consumption for the poor are addressed both through (i) the tariff structure and (ii) subsidies offered by the social protection system. The tariff structure ensures that lower levels of energy consumption are priced at lower tariffs. In the case of Albania, the first consumption block may be too big to guarantee “life line” consumption only, while the subsidies offered through the social protection system, although well targeted, have relatively low coverage (only 12 percent of the poor benefited from the social assistance system). There is thus a need to assess the options available to guarantee basic levels of electricity consumption in the context of reform. Of the two tools currently used, the tariff structure seems too expensive an instrument to protect the poor (due to the high leakage to higher income groups). 33. Moving towards a Regional Energy Market in the medium term is also crucial. As the economy continues to grow, some new domestic generation and, crucially, participation in Regional Power Exchanges will be needed. There is consequently a need to provide an adequate institutional, pricing and investment environment. This would attract and facilitate investments in generation while taking advantage of Albania's geographic position to maximize Regional Energy Trade. The gains through reliable (“24/7”) and high quality electricity supply would apply not just to the electricity industry, but may have a positive spill-over to other spheres of government action as well. The move towards the regional energy market would also imply a transformation of KESh, to unlock the value of its assets and to turn it into a modern electricity company. Transport 34. The provision of good transport infrastructure is a vital component and critical for the expansion of trade and enhanced competitiveness. Inadequate transport infrastructure translates into vi higher costs and a competitive disadvantage for domestic producers in international markets, and higher prices for imported goods. 35. Much progress has been made in improving the road network through new investments amounting to 1.4 billion Euros in the last four years. The condition of the network has also improved considerably. Currently, two thirds of primary national roads and half of secondary national roads are in good condition, a significant improvement since 2005. 36. In the road sector, the key issue is a careful sequencing in the development of the network. The regional connections offered by the main road network are somewhat inadequate. Almost 95 percent of the regional and local roads are in poor condition. The next stage in the transport sector requires a difficult balance of continuing to develop the network where economically viable, while also ensuring that the institutional framework is strengthened to ensure that the assets, the new and improved roads, are preserved. 37. Also, Durres, the main port, is well connected with the national road and rail network, and could be competitive regionally. However, the port authorities need to pay closer attention to maintenance of the port’s equipment, facilities and structures, as well as the dredging of the port. This will allow even large ships to enter the ports, resulting in more optimal utilization of the investments made in new berths, storage areas and equipment. If the port of Durres is to become regionally competitive, Albania needs to develop a well thought-out and costed multi-year action plan that will enable the port authorities to compete for scarce budgetary funds as well as to gain leverage through public/private partnerships. 38. Finally, steps that lower trade transaction costs for trading firms serve to make export products more competitive and foreign direct investment more attractive. Specific measures strengthening trade logistics could include (i) increasing the permits available for shipments to EU countries; (ii) improving the conditions for handling consolidated cargoes; and (iii) introducing supply chain management techniques, where competition does not focus exclusively on price. On the trade facilitation side, while measures such as the average time to clear goods have improved greatly (with the time having been brought down to one or two days), additional reductions in time will require (i) the transition to electronic processing of all documents; (ii) the implementation of effective risk analysis so that only a small portion of goods are physically inspected; and (iii) the allocation of greater responsibility to importers for accurate reporting of goods. Public Institutions and Governance for Investment 39. The development of Albania’s economy has been underpinned by a substantial structural reform program. The result is that Albania has seen better overall governance, reduction in corruption and a significantly improved business environment over the last decade. For example, between 2007 and 2009 Albania’s ranking in the ease of Doing Business improved from 136th (out of 178) to 82nd. This is a reflection of government programs which have succeeded in improving the quality of institutions and the investment climate. Examples of such important measures include the introduction of a flat tax of 10 percent on businesses and individuals, strengthening of land registration and the creation of a one-stop shop for business registration. 40. But of course there is still much room for improvement. Albania is still somewhat behind other European countries in terms of overall governance (as measured by the Worldwide Governance Indicators (WGI) of government effectiveness and rule of law) despite the continued improvements made over the past five years (between 2004 and 2009, Albania’s governance indicators improved in all six vii areas of the WGI). Changing this situation is now one of Albania’s highest priorities, both for the long term growth agenda and also for successful integration with the EU. 41. A critical issue for firms is the extent to which existing laws and regulations are implemented and enforced. Albania has made considerable efforts to improve the investment climate by enacting large numbers of new laws and regulations (in accordance with requirements for EU accession). However, where laws are incomplete (lack implementation regulations) or inconsistent with each other, there can emerge a gap between the formal structures and actual implementation practices which tend to undermine the rule of law and increase uncertainty for businesses. For example despite the rise in Albania’s Doing Business ranking, the World Governance Indicator measure of government effectiveness place Albania below what would be expected for a country of its level of income. It is indeed the practice that counts for investors. 42. Clarity is also needed on the processes for enacting new laws and regulations and for reviewing the efficacy of existing ones. This could be assisted by boosting the role of the Regulatory Reform Task Force which has a mandate to formulate and monitor regulatory reform plans, and by giving it a permanent structure under the direct responsibility of the Prime Minister’s office. The completion of the inspection reform and establishing a fully functional system of Regulatory Impact Analysis (RIA) will be important. Also, a review of the process whereby policy decisions are taken and translated into law may be useful, as it would help to ensure that the necessary time and resources are available before new legislation is enacted. 43. To this end, two measures to improve transparency and predictability of Albania’s laws and regulations could be considered. First, a formal mechanism of regular consultations could take place between the private sector and the government on all important measures that affect businesses. It would help if there were a statutory requirement to publish a summary of issues raised by the private sector and how these will be dealt with prior to the enactment of new legislation. Such a mechanism would have the effect of sensitizing officials to potential problems with new legislation. Second, an administrative appeals tribunal could be setup. This would give individuals and enterprises confidence that they have the means of appealing official decisions when these appear to contradict existing laws and regulations. Of course, respecting both the consultation process and the decisions of the administrative appeal tribunal is crucial for the effectiveness of such measures. viii CHAPTER 1: MACROECONOMIC PERFORMANCE, THE GLOBAL CRISIS AND BEYOND I. INTRODUCTION 1.1 Albania has achieved impressive economic progress over the past decade with economic growth outperforming all other European transition economies. Since 1998 Albania’s economy has grown at an average six percent annually moving from a low income to an upper-middle income country. As a result, per capita rose to $3950 in 2010, a rate of growth faster than in any other country in Central or Southeast European (Figure 1.1). This is despite the slowdown experienced following the global economic crisis. However, Albania’s income level remains low in regional terms; its GDP per capita in 2009 was only 27 percent of the EU average in purchasing power terms. Hence, these high growth rates will need to be sustained for many decades to reach the EU’s income level. Figure 1.1: Economic Performance of Central and Southeast Europe’s Economies 30,000 6.1 7.0 25,000 5.0 6.0 4.5 4.1 4.0 4.0 3.9 5.0 20,000 3.8 3.1 2.9 4.0 15,000 2.7 2.7 2.7 2.6 2.4 3.0 10,000 2.0 5,000 1.0 0 0.0 GDP per  capita  (in US  $) GDP growth (annual  average  between 1998‐2010)   1.2 The economic boom of the past decade has been brought by the transformation of Albania’s economy as a result of shifting labor from low to higher productivity sectors. In the previous Country Economic Memorandum (World Bank, 2005) it was noted that growth has largely been the result of a structural transformation which created jobs in manufacturing and services while the role of agriculture decreased. This is still broadly true of growth in the last five years. Based on the experience of other fast growing economies around the world, such sectoral transformation to growth lasts for a limited period. While the growth potential of this source has not yet been exhausted, convergence to European income levels would need to come from improvements in within-sector productivity and from capital accumulation. 1.3 Stable macroeconomic policies and structural reforms have supported the successful economic transformation. A sound macroeconomic framework together with notable improvements in the business environment, energy, financial sector, tax administration and public financial management, have underpinned economic growth. These policies, combined with an acceleration of public investment in 2008 and 2009 undoubtedly served to soften the impact of the economic crisis (Table 1.1). Nonetheless the course of recovery from the crisis remains uncertain, and there is a broad consensus that returning to pre-crisis levels of growth will take additional efforts. For Albania, particularly worrying are the developments in the economies that are key importers of Albania’s goods and major sources of worker 1 remittances. These external developments have made the task of sustaining high growth more difficult for Albania’s decision makers, and additional efforts will be needed to ensure a stable macroeconomic framework and to further support investment and growth. Table 1.1: Key Macroeconomic Indicators (percent of GDP, unless otherwise indicated) 2002 2003 2004 2005 2006 2007 2008 2009 Real GDP growth 2.9 5.7 5.9 5.5 5.0 6.0 7.5 2.5 CPI inflation (annual average) 5.2 2.4 2.9 2.4 2.6 2.9 3.4 2.2 Lending interest rate (nominal, e.o.p.) 16 10.5 13.7 12.2 11.1 13.6 11.1 12 Deposit interest rate (nominal, e.o.p.) 9.3 7.6 6.0 5.6 5.5 6.3 6.9 6.8 Unemployment rate (annual average) 15.8 15 14.4 14.2 13.8 13.5 12.8 12.8 Gross savings 17.4 17.9 20 17.1 23.3 21.3 19.1 16.7 Public 0 -0.1 0.1 1.2 4.2 2.9 3.4 1.8 Private 17.4 18 19.9 15.9 19.1 18.4 15.7 14.9 Gross Investment 24.5 23.4 23.8 23.6 29.3 29.9 32.5 29.5 Total revenues and grants 24.7 24.5 24.1 24.4 25.3 25.6 27.1 26.1 Total expenditure and net lending 31.4 29 29.2 27.4 28.5 29.1 32.7 33 o/w Interest payments 4.0 4.4 3.7 3.1 2.8 2.6 2.9 .. Overall fiscal balance -6.6 -4.5 -5.1 -3.4 -3.2 -3.5 -5.6 -6.9 Public and publicly-guaranteed Debt 65 61.8 56.5 54.5 56 53.2 55 59.8 Domestic 41.7 41.1 38.5 37.9 39.1 37.7 36.5 35.6 External 23.3 20.7 18.0 16.6 16.9 15.5 18.4 24.3 Export GNFS 20.5 20.8 21.5 22.3 25.1 27.7 29.7 28.4 Imports GNFS 46.3 45.9 43.3 46.3 49.3 54.1 56.7 53.9 Current account balance -9.1 -6.7 -4.8 -7.2 -7.3 -11.2 -15.1 -15.6 Foreign Direct Investment , net 3.0 3.2 4.6 3.3 3.6 6.0 6.7 8.2 Workers' remittances 13 14.4 13.7 13.7 14.1 13.5 10.9 10.8 Broad money 65.3 65 65.7 68.5 74.6 77.3 76.1 77.5 Domestic credit to private sector 6.4 7.7 9.4 14.9 21.8 28.9 35 37.4 In local currency 1.5 1.6 2.0 3.6 6.6 8 9.7 11.9 In foreign currency 4.9 6.1 7.3 10.9 15.1 20.9 25.3 25.7 Total Private domestic credit growth 41 31 37 74.9 57.6 48.5 32.4 12.1 Note: 2009 real sector figures are preliminary staff estimates. Sources: INSTAT, Ministry of Finance, Bank of Albania, World Bank and IMF databases. II. ALBANIA'S RECENT MACROECONOMIC PERFORMANCE 1.4 In the last decade Albania experienced strong economic growth as a result of the shift of resources from agriculture to services and construction. Construction and services have been major contributors to growth, and now represent more than 60 percent of GDP (Figure 1.2). The expansion of these sectors has been driven by strong domestic demand sustained by increasing productivity, workers’ remittances and other inflows (Albania CEM, 2005). Industry has maintained its share of GDP at around 2 9 percent, initially as a result of the growth of textile and shoe manufacturing and more recently due to the expansion of construction materials (mostly cement production). The share of agriculture in GDP has been halved in just over a decade, though still remains high in regional terms. Figure 1.2: GDP Composition % (left figure) and Employment by Sector % (right figure) Agriculture Industry Construction Services Other Services Agriculture Industry Construction Services Other services 2001 2002 2003 2004 2005 2006 2007 2008 2001 2002 2003 2004 2005 2006 2007 2008 Source: INSTAT. 1.5 The continued shift of labor out of agriculture to other sectors such as services and industry has raised overall productivity. The proportion of the population working in agriculture had fallen to 45 percent in 2008 according to the recently introduced Labor Force Survey (LFS), compared with 58 percent in 2001 (census data; see Box 1.1).2 In agriculture, 70 percent of production has been for subsistence3 and value added per person has been less than one fifth of that in other sectors.4 Hence, the shift to other sectors implied increasing the share of higher productivity jobs. However, the agriculture sector remains dominant, accounting for 18 percent of GDP and about 40 percent of employment, which means there is still potential for increasing overall productivity and output through both incentives in agriculture and facilitating continuing inter-sectoral shift of labor. 2 Unfortunately there are no reliable data for the intervening years. The pattern of data in the LFS is supported by that of the Living Standards Measurement Survey (LSMS) which show the share of agricultural employment dropping over the period 2002 to 2008. 3 See World Bank, 2007. 4 All these figures should be taken as indicative because the figures on employment in agriculture are not precise. 3 Box 1.1: Population, Labor and Migration The population of Albania has not grown significantly over the past 20 years despite the high fertility rates. Between 1989 and 2008, the natural growth of population was offset by emigration. The result is that around 1 million Albanians now live abroad. Until 2000 there was actually a small fall in population, but the rate of emigration has slowed sufficiently that there has been a small rise in the population to around 3.2 million people (the level of 1989). The loss of skills from emigration has been considerable. Of the permanent migrants during 1990-2002, 47 percent had secondary schooling or more, compared to 31 percent among non-migrants. Immediately following the transition as the economy collapsed migration became a viable survival and risk mitigation strategy for many (see for example Miluka & Dabalen, 2008 Carletto & Kilic, 2008 Vullnetari, 2007). In addition, in this initial stage, the absence of the organizational and entrepreneurial skills to generate jobs for those with secondary or tertiary education exacerbated the incentives for such people to migrate. The establishment of networks abroad greatly improved information about relative opportunities in other countries, thus helping to reduce the risks and costs of migration. At the same time, the possibility of migration reduced the incentives to continue with education. Yet, despite the significant emigration, unemployment rates still remain in double digits (12.8 percent in 2008). 1.6 The strong growth was supported by a sustained increase in investment. Total gross investment has increased from 24.6 percent of GDP in 2000 to 29.5 percent in 2009, and private investment from 18 to 21.4 percent over the same period (Figure 1.3). Such levels of aggregate investment represent a considerable achievement in line with the recommendations of Growth Commission report (World Bank 2008) which found that all high growing economies in the last half a century have investment to GDP ratios above 25 percent.5 In Albania, however, the structure of investment has been skewed towards the construction sector, with only about 10 percent of GDP going to investment for production purposes up to 2006. Since then, non-construction investment has been increasing but the share of construction investment remains high. As the demand for residential constructions slows down there is significant potential for some of the saving now going to construction to find its way into other areas of production (Figure 1.4). Indeed, Albania’s return to a high and sustainable growth path depends crucially on increasing investment in such non-residential activities. Figure 1.3: Saving and Investments Figure 1.4: Domestic vs. National Saving (% of GDP) (% of GDP) Albania: Saving-Investments (% of GDP) 30 Savings 40 (national- Savings +   Public   Private   20 domestic) CAD investments investments 30 10 Workers' Savings Remittances (domestic) 20 0 Primary -10 balance 10 -20 1994 1996 1998 2000 2002 2004 2006 2008 0 1994 1996 1998 2000 2002 2004 2006 2008 Source: INSTAT, World Bank and IMF databases. Source: INSTAT, World Bank and IMF databases. 5 http://www.growthcommission.org. 4 Growth and Poverty Reduction 1.7 As a result of the sustained economic growth, poverty in Albania has fallen substantially. The absolute poverty headcount rate6 fell from 25.4 percent in 2002 to 18.5 percent in 2005 to 12.4 percent in 2008. This means that roughly 200,000 out of about 575,000 poor people in 2005 were lifted out of poverty by 2008, and this number should be even greater in 2010 as the economy continued to grow. The share of extremely poor people, defined as those with difficulty meeting basic nutritional needs, decreased from about 5 percent in 2002 to 3.5 percent in 2005 to 1.2 percent in 2008. This decline is sharper than in most other transition or middle-income countries. Table 1.2: Rates of Poverty Reduction in Rural and Urban Areas Poverty by Rural/Urban Change in poverty % change % change 2002 2005 2008 2002-2005 2005-2008 Total population in poverty 813,196 575,659 373,137 -29 -35 Urban 257,690 151,811 150,052 -41 -1 Rural 555,506 423,848 223,085 -24 -47 Source: LSMS, 2002 2005 and 2008 1.8 The reduction in rural poverty has been substantial. Table 1.2 shows that rural poverty declined by about 47 percent so that the headcount measure of rural poverty decreased from 24.2 percent in 2005 to 14.6 percent in 2008. The decline is due to a combination of remittance flows to the countryside and a shift of employment from agriculture to better paying jobs in other sectors. Compared to 2002 when poverty was present throughout the country (except the south), by 2008, significant poverty remained only in a few eastern border districts. Figure 1.5: Poverty Headcount Ratio by Districts in percent   2002 2008 6 Fraction of the population whose real per capita monthly consumption is below Lek 4891 in 2002 prices. 5 Fiscal and Monetary Policy – Pillars of Macroeconomic Stability 1.9 Sound fiscal and monetary policies have been the key pillars of macroeconomic stability. The gradual fiscal consolidation is attributable to a combination of improving revenue administration and reduced interest payments on debt. As a result, and in combination with strong GDP growth, public debt declined from 62 to 53 percent of GDP between 2003 and 2007. The trend, however, reversed in 2008 with the increase of public investment (Figure 1.6 and 1.7). Much of this was related to the Durres-Kukes road, the largest public investment operation undertaken during the transition period. The challenge for Albania is to return to a path of fiscal prudence compatible with gradual declines in public debt levels. Figure 1.6: Fiscal Balance (% of GDP) Figure 1.7: Fiscal Revenue and Expenditure (% of GDP) Privatization Receipts Foreign Financing 8 Domestic Borrowing Balance 40 6 2.4 Expenditure 4 35 2 3.8 30 0 25 -2 20 -4 -3.4 -3.3 -3.5 Revenues -5.0 -5.0 15 -6 -5.6 -6.1 -6.9 -7.0 -8 10 2001 2002 2003 2004 2005 2006 2007 2008 2009 1993 1995 1997 1999 2001 2003 2005 2007 2009 Source: Ministry of Finance. Source: Ministry of Finance. 1.10 Monetary policy has successfully assisted in keeping inflation low. After the Figure 1.8: Credit to Private Sector and Deposits turbulent 1990s, inflation has largely been (% of GDP) brought to within the central bank’s objective of 2-4 percent per year. The flexible exchange 70 rate system has proved to be a good shock 60 absorber. Although Albania initially 50 implemented a monetary aggregate targeting 37.6 regime, in practice decisions on changing the 40 35.0 28.9 monetary policy stance have been taken based 30 21.9 on a wider range of information besides M3, 20 15.2 such as: pressures coming from exchange rate 9.5 10 6.4 7.7 movements, price changes in different markets, 4.2 3.8 3.6 3.5 4.0 3.6 3.6 4.2 4.7 and demand pressures. This framework already 0 1993 1995 1997 1999 2001 2003 2005 2007 2009 resembles that of an inflation targeting regime which the Bank of Albania (BoA) is aiming to Source: Bank of Albania; Bars – credit to private sector, adopt more explicitly in the future. bottom bar is credit in foreign exchange; Line – Deposits. 1.11 The prudent fiscal and monetary policies allowed for rapid growth of the banking sector. The privatization of the largest bank (the Savings Bank) sparked a series of positive changes in the sector. The pace of financial deepening was remarkable: credit as share of GDP grew from 4.7 percent in 2001 to 37 percent in 2009 (Figure 1.8) although credit remains concentrated in large companies. 6 1.12 Structural reforms also contributed to the banking sector’s development. Consumer credit and the mortgage market have expanded, but not excessively. The conservative supervision approach adopted after the pyramid schemes’ collapse has paid off. Despite the recent increase in non-performing loans as a result of the tightening international as well as domestic economic situation, the financial system remains sound and has proven resilient even under more severe stress testing. 1.13 Notwithstanding the long track-record of macro-stability the level of euroization/dollarization remains high, which limits the room for policy maneuver. Changes in perceptions and preferences among economic agents often come with a long time lag, and that has been the case in Albania as well. Hence, despite the low inflation, the share of loans in foreign currency (FX) remains above 70 percent which can put a constraint on potential adjustments of the exchange rate, depending on the extent of mismatches between FX assets and liabilities. Unfortunately, statistics on the exact degree of currency mismatches of debtor balance sheets are very limited.7 According to BoA, credit to the service sector constitutes more than 50 percent of total credit followed by construction with 20 percent. Foreign currency funds are an important source of financing for construction and for some services (like tourist resorts), although the income in local currency is not negligible (Luci et al., 2006). Tradable Sector Yet to Become a Driver of Growth 1.14 Exports have not been a major source of growth so far, but financing the large trade deficit has not been brought in question. Since 1998 exports of goods and services have increased from 10 percent to 30 percent of GDP, with manufactured exports (dominated by textiles and footwear) experiencing the most rapid growth.8 Yet, Albania’s net exports have not improved much as the growing exports were offset by rising imports (Table 1.3). The trade deficit has stayed above 20 percent of GDP. About half of it has been covered by remittances. FDI, with the exception of privatization receipts, has been modest, financing on average only a fifth of the trade gap. Other capital inflows, largely of unidentified sources, which may include unrecorded remittances, cover a third of the current account deficit with the remaining part financed mostly by concessional loans. Table 1.3: Albania - Balance of Payments (% of GDP) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Current account -4.7 -6.9 -9.1 -6.7 -4.8 -7.2 -7.3 -11.2 -15.1 -16.1 Trade balance -21.7 -22.8 -26.2 -25.3 -21.8 -23.8 -24.0 -27.2 -27.3 -26.2 Goods -22.2 -25.0 -26.0 -23.8 -21.1 -21.7 -23.1 -27.2 -28.1 .. Services 0.5 2.2 -0.1 -1.5 -0.7 -2.1 -0.9 0.0 0.8 Remittances 11.7 11.9 13.3 14.4 13.7 13.7 14.1 13.5 10.9 10.7 Capital account 4.8 3.4 7.4 6.4 7.0 6.5 7.6 10.7 12.7 13.1 FDI 3.9 5.0 3.0 3.2 4.6 3.3 3.5 5.9 8.0 8.2 Other capital 1.4 -1.1 2.0 1.5 1.1 2.4 3.2 3.9 0.6 -0.1 Loans -0.5 -0.6 2.3 1.7 1.3 0.7 0.8 0.8 4.6 5.0 Source: Bank of Albania. Note: 2009 preliminary data. 7 See for example Luci, Muco, and Sojli, 2006, who estimate that the overall currency mismatch of Albanian companies could be as high as 41 percent of their assets. 8 In 2008, textiles and footwear constituted 43.3 percent of total exports and over 60 percent of manufactured exports. 7 III. THE CRISIS AND THE NEW CHALLENGES 1.15 Albania has been successful in managing the initial impact of the global economic crisis and is one of the few countries in Europe that has preserved positive growth rates. The limited public and private reliance on foreign funds helped avoid the need for a major adjustment to the sudden freezing of international financial markets. The long period of macroeconomic financial stability helped authorities preserve public confidence while easing the liquidity situation. Also, the expansionary fiscal policy of the last two years consisting of substantially higher public investment and also rising wages and pensions, which facilitated the consumption smoothing.9 1.16 However, the economic recession abroad and the uncertain recovery, have several implications for Albania’s medium-term economic outlook. There are two channels of immediate relevance through which the EU economies, and particularly those of Greece and Italy, affect Albania: (i) remittances; and (ii) tradable goods, through both volumes and prices. 1.17 Remittances from Albania’s Figure 1.9: Growth Rates of Manufacturing Sentiment diaspora depend on EU’s economic performance. Inflows in 2009 already 20 60 declined by 3 percentage points of GDP compared to 2007 (see table above). 10 40 Ifo.Ger.gr (t-2) --- red line Remittances in turn constitute a critical Alb.ind.gr - blue liine driver of Albania’s domestic demand. 20 0 Econometric estimates suggest that for the overall economy (excluding 0 agriculture) a 10 percent decline in -10 remittances would lead to a 3.6 percent -20 reduction in domestic demand, as -20 provide by the index of sales.10 The -40 sectors affected the most by remittances 2 0 01 q 1 2 0 03 q 1 2 0 05 q 1 x 2 0 07 q 1 2 00 9 q 1 are construction, services and food, which are also the key contributors to Albania’s GDP. It is believed that the Albania, Italy, Germany (Ifo) sharp contraction in construction has party been a result of declining inflows Sources: Bank of Albania, IFO Institute (Germany), and The from workers abroad. Institute for Studies and Economic Analyses Institute (Italy) 1.18 The EU’s economic performance also affects Albania through the tradable sectors. The ties with EU economies appear to be particularly strong for Albania’s processing industries and construction. The industry response elasticity to EU growth rates is 4 while construction has an elasticity of almost 8. The significance of these links is also evident using business sentiment indexes instead of the broader EU growth rates. The sentiment about Italy’s manufacturing is strongly correlated to the Albanian manufacturing confidence index with a 6 month lag (Figure 1.9). The same holds for services. 9 Although personnel expenditures apparently declined in the fiscal accounts from 6.2 to 5.5 percent of GDP, this is entirely due to the reform of the health financing system according to which personnel expenditures are no longer distinguished and classified under the same category as before. Thus, health insurance expenditure increased from 1 to 2 percent of GDP. 10 While it is recognized that the Index of Sales is not a perfect indicator of demand (and for example excludes agriculture), it is strongly correlated with aggregate demand and is used in the absence of any other quarterly index of demand. 8 1.19 European countries have gone through a severe recession and the recovery could be sluggish. The EU is Albania’s most important export market so the recession in Europe had serious implications for Albanian exporters. For example, the extractive industries had a surge in exports until early 2008, but a drop in demand abroad and fall in prices at the start of the crisis caused a sharp contraction both in terms of output and employment (although the recent recovery is promising). IV. POLICY RESPONSES TO THE CRISIS 1.20 A fiscal stimulus has been recommended for many countries to offset the negative implications of the financial crisis. For countries like Albania the appropriateness and size of a fiscal stimulus should be assessed against four factors: (i) the risk of financial distress; (ii) the extent and distribution of the contraction of domestic demand; (iii) the effectiveness of fiscal stimulus; and (iv) the available fiscal space. At the same time, fiscal stimulus policies should go hand in hand with the continuation of the structural reform agenda. 1.21 Fortunately, Albania has not been put in a position that calls for substantial expansionary policies of the sort that have been applied in many European countries. During the recent crisis Albania did not face the risk of a major financial meltdown that would have required a bailout as happened in many parts of Europe. That still holds. Moreover, there are other reasons for not rushing to establish new expenditure programs seeking short-term impact. First, rapidly implemented programs risk being poorly targeted to groups or sectors that really need them thus wasting resources. Second, the effectiveness of a broad fiscal stimulus will be undermined by leakage into imports, which in the case of Albania represent around a half of GDP. Third, unless backed by external funding, an expansionary fiscal policy may lead to real currency depreciation, either in the form of higher relative prices, or through a nominal devaluation (or both). These could have negative consequences for the financial sector and the poor. All these factors point to the need to carefully assess all the costs and benefits of any expansionary fiscal measure. 1.22 Albania may also face tougher external financing constraint in the future, reinforcing the need for careful management of public funds. In addition to the overall contraction of available resources worldwide, there are some factors specific to Albania that may present problems for further large external financing. Excluding privatization receipts, FDI in Albania barely exceeded 3 percent of GDP. In 2007 and 2008 it jumped to 4.5 and 5.5 percent of GDP respectively as a result of the increase in the capital of few foreign-owned banks. Attracting FDI in sectors other than banking, and telecom, has turned out to be difficult. Privatization options are also becoming exhausted. Moreover, further borrowing would be constrained by the already high level of indebtedness and the ceiling (on public debt) of 60 percent of GDP stipulated in the 2008 organic budget law. Enhancing the Credibility of Policy 1.23 One of the major lessons of Albania’s macroeconomic management has been the importance of maintaining credibility. Over the last decade it became clear that prudent bank supervision, monetary policy, and fiscal policy build investors’ confidence and in turn stimulate growth. For many years until 2007, Albania benefited from a prudent fiscal policy under which deficits had been reduced, and a target for debt reduction established which broadly ensured fiscal sustainability. The policy was supported by IMF programs which contributed to overall credibility helping to ensure the availability of financing at relatively low costs as well as contributing towards a stable exchange rate. 1.24 A macroeconomic framework for the post crisis environment requires credible forecasts. Basing a budget on an extrapolation of output and revenue growth trends similar to those of the past, risks overestimating tax revenues and hence underestimating budget deficits. This could lead to disruption in 9 the public investment program, interest rate increase and reduction in the flexibility of the authorities to handle unexpected shocks. For instance, the budget originally proposed for 2010 had overly optimistic projections of revenue that exceeded the outcome in the early part of 2010 by 20 percent. Recognizing the weaknesses of the initial budget for 2010, the government’s mid-year budget review has introduced several modifications and the fiscal framework was adjusted downwards. If the initial assumptions had been more realistic, the mid-year drastic changes would have been avoided, thus maintaining confidence and certainty in the economic environment. Realistic projections are indeed crucial as the global crisis has significantly changed the appetite of foreign investors to take risks. 1.25 Thus, going forward, maintaining a credible macroeconomic framework will remain critical. In this regard, a fiscal rule could be introduced as an anchor for enhancing the effectiveness and credibility of the medium term budget framework. Such a rule signals a commitment to a rules-based framework at all spheres of economic policy. While its introduction would not yield immediate returns (e.g. lower borrowing rates) as it takes time to anchor market expectations (as happened in Albania in the case of monetary policy), it is nevertheless a move in the right direction that signals Albania’s commitment to preserving its good macroeconomic record of the past. To be meaningful it would have to be accompanied by increased credibility of national statistics, since these would constitute the basis for monitoring any fiscal rule (Box 1.2). Box 1.2: The Role of Statistics for Policy Credibility Comprehensive and timely statistics are essential for both macroeconomic policy making and maintaining confidence in policy decisions. Statistics serve various agents in different ways: policy makers need them to understand the needs for actions and their impact, domestic firms need them to be able to follow market trends, and also foreign companies need them to be able to make investment decisions. Albania has made significant progress in improving its national statistics. The recent publication of quarterly GDP data, the labor force survey and the development of social statistics are important achievements and have brought Albania closer to other countries in the region. Some areas where further progress is needed include the expenditure side of the national accounts and more detailed data on investment, in particular with respect to the composition of investment. As highlighted during the recent crisis, confidence in the accuracy and timeliness of statistics is critical. International experience (Fellegi, 2004) indicates that some of the measures that substantially increase confidence in national statistics are: 1. Ensuring the formal independence of the statistical agency, including merit-based appointments and a clear mandate to make data publicly available. 2. Regular publication of statistics according to a predefined schedule. 3. Publication of the methodology for calculating statistics. 1.26 There are already some potential elements of fiscal rules written into law. Currently, there are borrowing limits from the central bank, and more recently a public debt ceiling of 60 percent as a ratio to GDP was introduced into the Organic Budget Law of 2008 (in line with European and Monetary Union criteria).11 However, there is no mechanism on how to correct the path of public debt before the 60 percent ceiling has been reached. In the meantime, Albania has made good progress in establishing a three year rolling budget framework through the Organic Budget Law of 2008. This is a key prerequisite for the successful adoption of an effective fiscal rule. But to make it effective consideration could be given to introducing it into a constitutional law such as the Organic Budget Law or at least for it to become a 11 Law No. 9936, dt. 26.6.2008 “On Management of Budgetary System in Albania”, Article 58. 10 permanent and core feature of the Medium Term Budget Plan. Examples of fiscal rules are shown in Box 1.3. Box 1.3: Fiscal Rule Options A recent IMF paper, Jonas (2010), suggests two options of fiscal rules that could be considered for Albania. Debt Rule The first option is to introduce a debt rule which consists of setting deficits to ensure a growth rate of nominal public debt lower than that of potential nominal GDP growth. and where: D is nominal public debt measured in Lek, Yp is projected nominal GDP and  represents the speed by which the authorities want to reduce the debt ratio overtime. If  equals 1 the debt ratio to GDP should remain unchanged otherwise the closer to 0 the stronger the downward debt adjustment. The operating target by which the authorities would control the desirable debt growth is primary balance. In practice given that interest rates are reasonably predictable and assuming a stable exchange rate, this would translate into a nominal deficit target. Given the relatively high growth rates of Albania, in the long run this rule should not be very restrictive in terms of raising new debt. At the same time it allows public debt to GDP ratio to come down to comparable levels to emerging markets economies ratios which are on average below 50 percent of GDP vis-à-vis 60 percent of Albania at the moment. Assuming a neutral scenario of interest rates and exchange rate remaining stable at current levels, primary balance consistent with an unchanged debt to GDP ratio (=1) should be at around -1 percent of GDP. A moderate reduction of public debt (=0.8) results in primary balance equal to 0. A more ambitious reduction of debt ratios would require government to run primary surpluses. Expenditure Rule The second option proposed is an expenditure rule which freezes the ratio of total expenditure to GDP at a certain level over time, with a correction mechanism to adjust for revenue fluctuations. In other words, nominal expenditures would increase at the same rate as potential nominal GDP. Just fixing this ratio does not necessarily discipline deficits and debt ratios unless it is complemented with a corrective mechanism that takes into account revenue shortfalls other than for cyclical reasons. Therefore, if the debt ratio diverges from the target, the growth rate of expenditures could be corrected with a fraction of the potential growth rate: (Yp /Yp) with 0<<1. According to Jonas (2010) calculations, for debt-to-GDP ratio to come down without having to correct the expenditure growth rate (=1) the elasticity of revenue to GDP growth would have to remain permanently above one, which is difficult given the improvements in tax administration and collection eventually get exhausted. Another complication of the expenditure rule is the extent to which it applies in case spending is cyclically sensitive or needs to be protected from frequent changes. If the reduction of debt is an important objective, the extent of the coverage needs to be broad. Being tied to nominal potential GDP growth rates, both rules allow automatic stabilizers to work well. Moreover,  fiscal rules do not exclude the flexibility of countercyclical adjustments provided they have gained enough credibility and there is a pre-announced mechanism for it. Eventually the credibility of any fiscal rule depends  critically on the strong political commitment to fiscal discipline.  V. ACCELERATING LONG-TERM GROWTH 1.27 Albania’s transformation from an agricultural low-income to an upper-middle income country has mostly been driven by the reallocation of labor from agriculture to other activities. The 11 process of reallocation of resources from agriculture to services, construction and manufacturing can continue for a limited period, but in the future the inter-sectoral shift will become less important and growth will be need to sustained through improvements in within-sector productivity as well as from accumulation of physical and human capital. 1.28 As noted earlier, the impressive growth record of the past decade has been supported by both a strong and stable macroeconomic framework as well major progress in structural reforms. Among the most significant reforms that have taken place in recent years are the following:  Business climate: a one-stop-shop called the National Registration Center, a credit registry and introduction of a flat tax, together with administrative simplification of the tax regime.  Financial sector: strengthened financial supervision and changes to the legal and regulatory framework of the banking system to improve the execution of collateral and credit risk management.  Infrastructure: unbundling of the electricity network, privatization of the distribution system, and introduction of a best practice legal framework for telecommunications.  Public administration: introduction of electronic procurement in the public sector and introduction of a law on concessions. 1.29 In addition a number of other reforms have been initiated. Among them a proposal to introduce a system of Regulatory Impact Assessment for new laws, a Bankruptcy Law and reform of the Inspection System. These reforms have been combined with an improvement in overall governance compared with a decade ago, which has been conducive to supporting and sustaining the growth process. 1.30 Assigning increased priority to complementary factors of production so as to allow for continued productivity improvements, will be essential to sustaining rapid growth and achieving convergence to European income levels. Broadly speaking these complementary “factors of production” fall into three groups: (i) human capital, (ii) physical capital (telecommunications, electricity, and transport infrastructure), and (iii) the quality of institutions. 1.31 The first two groups may be described as inputs to the production process, and the third as affecting the returns to investment and production. Developing these factors would increase the capacity and incentive to adopt technology and organizational methods which raise productivity and increase competitiveness. Complementarity of the factors is given by the fact that they are not easily substitutable, and that the lack of one or more of the factors (for example skilled labor, reliable electricity or telecommunications infrastructure) will render the others less productive. 1.32 The balance of this report aims to identify policies relating to these critical three complementary factors that can contribute towards Albania’s “New Growth Agenda”. The next chapter will address perhaps the most important factor for sustained growth: building human capital through education and skills. The following chapter aims to illustrate the need for ensuring electricity supply as well as to provide guidance on how to incorporate information and communication technologies (ICT) in the growth agenda. Finally, the last chapter will explain the importance of formal and informal institutions in promoting investment and productivity growth. 12 CHAPTER 2: EDUCATION AND SKILLS FOR AN INNOVATIVE ECONOMY I. INTRODUCTION 2.1. Improving productivity through investment and technology adoption depends on having the necessary human capital—which is formed through education and skills. It is important to note that particularly in developing countries, innovation is not about basic research and development, but rather about introducing new knowledge in doing business by individuals with education and skills, such as for creative thinking and problem solving.12 In the 2008 Business Environment and Enterprise Performance Survey (BEEPS) more than half of firms reported lack of such skilled labor as an impediment for doing business and this is almost certainly an underestimate of the problem.13 While many firms may recognize that they need a manager, IT specialist, accountant or engineer, they may not appreciate that they are also missing opportunities to reorganize production processes, introduce new products or enter new markets (see Box 2.1 on Innovation and Growth). In addition, in the 2009 Investment Climate Survey (ICS), 51 percent for large firms, 41 percent for exporters, and 48 percent for foreign-owned firms reported skills as a major obstacle. These shares were higher than in the other transition economies. More innovative firms were more likely to be concerned about workforce education. Over 35 percent of firms that acquired new technology cited workforce education as a major constraint. This finding is particularly significant since these are the categories of firms which are likely to be the sources of future growth of productivity and employment. 2.2. The importance of education and skilled labor for the country and for economic development is well recognized in Albania. As a result major and wide ranging education reforms were initiated in 2006. In basic and secondary education these included: i) curriculum reform, to make curricula more modular and relevant, including particularly the introduction of a modern ICT curriculum in basic and secondary schools, and eventually the equipping of all schools with computer labs and internet, i) improved teacher training, so that teaching methods focus more on creativity and discussion rather than the uncritical transmission of knowledge, ii) more equitable distribution of resources across regions, iii) improvement of learning conditions, with less crowded classrooms and less need for multiple shifts in schools, iv) the increase in teachers’ average salaries by 67 percent (or 49 percent in real terms) between 2005 and 2009, and 12 For example a recent study of innovation practices notes that “innovation needs not necessarily to be identified with the introduction of new technologies but can result as well from non-technological innovation (such as new business practices) and mechanisms to foster technological diffusion. This is even evident when the role of general purpose technologies such as ICT is taken into account.” See Chandra, Eröcal, Padoan, & Braga, 2009. 13 BEEPS, developed jointly by the World Bank and the European Bank for Reconstruction and Development (EBRD), is a survey of several thousands of firms in transition countries (including 300 Albanian firms) that examines a wide range of issues about the business environment. 13 v) renewal of the content and administration of the Matura examination on leaving secondary to improve relevance and ensure objective results. 2.3. In addition, major reforms of higher education have also been initiated. In higher education the focus has been on the effective adoption of the Bologna process for modular education which is compatible across Europe, the expansion of the numbers of students in higher education and the introduction of short-cycle, sub-degree programs in regional universities. Further curriculum reform and reforms to make universities more accountable are envisaged. The higher education reform is based upon linking to the European education strategy as articulated in the Europe 2020 Strategy. This strategy targets growth founded on innovation, education, training and lifelong learning and the digital society. Indeed Albania’s integration into the international economy will depend on these factors. Central to this strategy is the idea of enhancing the performance of Europe’s higher education institutions and promoting student mobility and employability across countries.14 It promotes recognition of non-formal and informal learning, as for example is envisaged under the Albanian Qualification Framework. It is also closely linked to the Bologna Process of developing a European Higher Education Area, in which qualifications are portable across countries and mutually recognized. Albania joined the process in 2003 and so committed itself to ensuring that its degrees (Bachelor, Masters and Doctorates) are structured and have curricula compatible with those in other European countries. Box 2.1: Innovation and Growth Innovation should be understood not as producing new knowledge but rather in terms of products, processes and organization which are new to Albanian firms. A study of how countries, such as Korea, managed to catch up with the developed world distinguishes three main sources of innovation. One is the acquisition of technology that already exists abroad. A second is the domestic creation of relevant new knowledge. The third is the dissemination and effective use of this new knowledge throughout the economy, whether it has been created locally or imported from abroad. (Dahlman, 2009). Innovation then is heavily dependent on the creation and transmission of knowledge and indeed it will be seen that creation of an innovation framework for a country such as Albania depends fundamentally on the sharing of knowledge and information, in which the state can play a major role as a facilitator. The dissemination of knowledge is particularly important, given that in most developing countries there is often a huge disparity in productivity levels across firms in a given industry. Dahlman quotes studies in Brazil and India showing that the average productivity in many industries is only one tenth of the productivity of the leading firms in the same area. Innovation depends on human capital and the acquisition of relevant skills rather than basic research. For example. Lundvall (2008) argues that the successful catching up of Japan, Korea and Taiwan placed strong emphasis on engineering skills used to absorb international technology through learning by doing. Hence, a principal task for higher education is to contribute to collective entrepreneurship – that is to produce graduates with the right skills. This point is also made for research in an official study of innovation in the UK, in which it is argued that the most important role of research for innovation is not the new knowledge that it produces, but the ability to use new knowledge (see Salter & et al., 2000).  II. THE SKILLS GAP Education Attainments 2.4. Albania began the transition with a population with more years of schooling than that in other developing countries with a comparable income per capita. However, in the initial years of 14 See Europe 2020: A European Strategy for Smart, Sustainable and Inclusive Growth (European Commission, 2010). 14 transition, both the resources devoted to education and its quality declined. It is only recently that these trends are being reversed through the major reforms being carried out at all levels of the education system. Albania spends less on education as proportion of GDP than other countries in the region (at 3.5 percent of GDP in 2009), compared with 4.6 percent on average in Eastern Europe, and although in recent years spending on education has been increasing. In addition, spending per student at primary and secondary levels is among the lowest in the region. In 2005, the population on average had completed 8.6 years of schooling, which is low in comparison with an average of 12 years in the EU-10 countries,15 and 14 years in the OECD. This is now slowly being reversed as the average expected schooling of those currently entering the education system is 12.2 years. 2.5. Albania has the lowest proportion of people with completed tertiary or secondary education (48.7%) compared with an average of 62 percent in the Balkans.16 While secondary and tertiary enrollment rates have increased in recent years (from 51 to 60 percent between 2005 and 2009 for secondary education and from 22 to 37 percent in tertiary education) they are still lower than in the rest of the region.17 Moreover, the aggregate figures hide a huge disparity between urban and rural secondary education as in rural areas secondary enrollment remains at 26 percent while in urban areas in 2009 it reached 88 percent. In addition, rural students perform worse than their urban peers recording an average of 7 points less in the Matura (end of secondary school) literature exam.18 Figure 2.1: Public Spending on Education and Educational Attainment Levels Public spending on education Educational attainment of people 15-64 years old Expenditure per student as a percentage of GDP per capita 70 Primary level Secondary level Tertiary level 60 Azerbaijan 5.2 Azerbaijan 8.0 Kazakhstan 8.0 50 Kyrgyz Rep. 7.6 Kazakhstan 9.9 Azerbaijan 11.2 Tajikistan 9.4 Kyrgyz Rep. 14.3 Tajikistan 11.8 40 Romania 10.7 Tajikistan 14.4 Latvia 15.9 30 Albania 11.3 Slovak Rep. 15.2 Lithuania 17.2 20 Primary Kazakhstan 12.0 Albania 15.9 Estonia 18.3 10 Slovak Rep. 15.3 Romania 16.0 Albania 19.7 0 Secondary Ukraine 15.8 Latvia 19.3 Poland 21.4 Tertiary Lithuania 16.6 Lithuania 20.5 Kyrgyz Rep. 21.9 Estonia 19.4 Poland 22.2 Slovenia 22.0 Croatia 19.7 Estonia 23.0 Romania 23.7 Poland 23.7 Hungary 23.2 Hungary 23.8 Slovenia 25.1 Ukraine 24.3 Slovak Rep. 24.2 Hungary 25.6 Croatia 25.3 Ukraine 25.5 Moldova 33.6 Slovenia 32.0 Croatia 30.7 Latvia 37.3 Moldova 40.7 Moldova 41.4 Source: WB central database, social indicators, Education Source: Labor Market Reviews, ETF Key Indicators, Eurostat. spending for Albania refers to 2009, for other countries, most recent data available (usually 2007 or 2006). 2.6. Cross country data suggest that Albania has a considerable gap in cognitive skills to bridge.19 The work of Hanushek and Woessmann provides an important benchmark for overall quality of 15 EU-10 refers to the 10 Central and East European countries that joined the EU in 2004 and 2007. 16 Preliminary results from Living Standards Measurement Survey, 2008. 17 Source: EEE-P M&E framework, Ministry of Education and Science. 18 Matura Conference 2009, National Assessment Centre. 19 In an empirical study comparing educational outcomes, Hanushek and Woessmann, 2008, and Hanushek and Woessmann, 2009, show strong evidence that key for growth and innovation is the development of cognitive skills (that is, the outcome of education) rather than the measures of school attainment or enrollment. Their results show that “cognitive skills have a strong and robust influence on economic growth” (Hanushek & Woessmann, 2008). Indeed they show that once cognitive skills are taken into account, empirical estimates show no impact of years of schooling on growth. They find that empirically cognitive skills contribute most to growth in countries with strong 15 basic and secondary education across countries. This was achieved by standardizing all internationally comparable tests, including particularly the PISA (Program for International Student Assessment) and TIMSS (Trends in International Mathematics and Science Study). A cross country benchmark was established for the year 2000.20 The results suggest that at that time there was a considerable gap between Albania and other countries of the region in cognitive skills. In the comparison Albania had the lowest score for cognitive skills and only just over 40 percent of students in Albania had achieved basic literacy in mathematics and science (20 percentage points less than in Macedonia which is the next lowest; see Figure 2.2 and Figure 2.3 below). While the data are old, they are still useful as they illustrate the magnitude of the education reform challenges being faced. Even with the enormous reform efforts made in recent years, these indicators are likely to change slowly. Still, it would be useful to look at the results of the PISA 2009 study in which Albania participated and which will be published at the end of 2010. It is also very important for Albania to participate in future international comparative studies so as to be able to measure the progress of and define in greater detail reforms that will help Albania bridge its skills gap. Figure 2.2: Cognitive Skill Indicator (2000) Figure 2.3: Percent of Students with Basic Literacy (2000) 550 100 90 500 80 450 70 60 400 50 40 350 30 300 20 Notes: Average test score in math and science, primary Notes: Share of students reaching basic literacy (based through end of secondary school, all years (scaled to on average test scores in math and science, primary PISA scale, where 500 is the average for OECD through end of secondary school, all years). countries). Source: Dataset from Eric A. Hanushek and Ludger Woessmann, 2009, “Do Better Schools Lead to More Growth? Cognitive Skills, Economic Outcomes, and Causation.” 2.7. Moreover, in the post transition period, not only was the quality of education low in some categories (such as cognitive skills), but it was often ill suited to a market economy. Studies of transition economies have produced empirical evidence to suggest that the quality of education and human capital tend to be overestimated in socialist pre-transition economies (Beirne & Campos, 2007) while a detailed study of skill shortages in Russian enterprises (Tan, Gimpelson, Kapelyushnikov, Lukyanova, & Savchenko, 2007) indicated that despite the fact that Russia has one of the highest proportions of the adult population with tertiary education, enterprises are nevertheless reporting skill economic institutions. They also find that the quality of education has a major impact on school attainment and enrollment as lower quality increases dropout rates. Hence, they argue that dedicating resources to improving quality will help to improve attainment. On the other hand they report that “simply attempting to expand access and attainment, say through starting a large number of low quality schools, will be self-defeating.” The arguments certainly support the emphasis of the current reform program on improving the quality and content of the curriculum and teaching methods. 20 It should be noted that Albania did not participate in the PISA 2005 study or in the TIMSS. Albania did participate, however, in the PISA 2009 study; the results of this latest PISA will likely be available at the end of 2010. 16 shortages as a major production constraint. Similarly, surveys of Albanian enterprises invariably indicate a general view that the graduates of university are ill-equipped for work. 2.8. This is part might reflect the learning methods in Albania. For instance, some studies indicate a tendency for teachers to dominate discussion and a lack of encouragement of critical thinking. These findings are consistent with a recent study of learning methods in a random sample of secondary schools in “Albania: Secondary and Tertiary Education – How Teachers Teach in Secondary School Classrooms” (Ministry of Education and Science of Albania & World Bank, 2008) which indicates that teaching is dominated by teachers talking to students with limited time for students to make independent observations or ask questions. Moreover the study notes that the vast majority of questions from teachers requires routine responses and normally has only one right answer. This, together with the large amount of time spent on lecturing and receiving information, suggests that students experience an intellectually and socially closed learning environment that has only a limited space for things such as team work or independent thinking. Similar criticism is expressed in a European Training Foundation (ETF) working paper on human resource development in Albania “Generally teachers see their work as to ‘teach’, not to facilitate students’ learning processes. The Ministry of Education’s Higher Education Strategy is also very clear in recognizing that university teaching suffers from the same problem. 2.9. More broadly, the key task for general secondary education is to move quickly with the curriculum reform that was initiated by the MoES in 2009. It will be of particular importance to monitor the progress of the reform and ensure that it embraces reform of teaching methods. This requires putting more resources into the professional preparation, development, and support for teachers. In doing so there should be strong efforts to make mathematics and science education more relevant to real life, with the mathematical and scientific content of the school curriculum placing more emphasis on problem- solving, understanding and application. These are the characteristics of the learning environment in countries such as Korea and Singapore, which consistently score high in TIMSS and PISA tests. III. FROM BRAIN DRAIN TO BRAIN CIRCULATION 2.10. Developments in higher education cannot be fully understood without taking into account the impact of migration on the sector. During the period between 1990 and 2008, about 40.6 percent of the staff of public universities and research institutions migrated from Albania. The size and intensity of this phenomenon is so high that Horvat (2004) defined Albania as one of the countries that had “the highest brain emigration rate in the world.” 2.11. In many Albanian institutions, the emigration involved the most dynamic and elite part of the Albanian research/university teams. The data show that the public university and research institutions from Tirana, especially those related to natural sciences, engineering, nuclear physics and arts, were the most affected.21 Most migrants from these institutions were male (59.4 percent), relatively young (about 35 years old) and, in contrast to the patterns for mass migration, they migrated through legal channels and with their families. Those that left had on average 8 years of work experience in the research institutions/universities they left, and 43 percent of them had completed specializations abroad. Thus, the problem is not just the loss of human capital but a weakening of the capacity for training new generations. 21 From the Polytechnic University of Tirana the brain drain for this period amounts to 58.2 percent, from the Nuclear Physics Institute it amounts to 76 percent, and from the Academy of Arts it is 60 percent. 17 2.12. Fortunately, the Figure 2.4: Dynamics of Brain Drain: share of Academics emigration of highly qualified moving abroad as % of total Academics people has abated significantly 14 since 2000 and there are even some indications of returning 12 migrants. The emigration of 22 10 academics and researchers from 8 universities and research institutions peaked during the 6 period 1991-93 following the 4 initial opening of the country, with a secondary peak in 1997- 2 99 following the political and 0 social chaos of the period (Box 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2.2 and Figure 2.4). Since then emigration has declined as a Source: CESS survey 2008. result of a variety of factors, including the improvement of the economic and social conditions in Albania (higher wages and improvements in universities), the increase in the average age of faculty, and the increasing difficulty of migrating to Western Europe. 2.13. The new challenge for Albania is to make a transition towards brain circulation. Indeed, the return of highly-skilled migrants can bring significant benefits to their countries: their newly acquired skills, financial resources and links to networks can boost productivity and economic development (Lowell, Findlay, & Stewart, 2004). So far, only 9.7 percent of highly qualified migrants of the past two decades have returned to Albania. A third of them work at the same academic/research institution they did prior to migration and the rest mostly work in the private sector. In 2008, the University of Tirana admitted, by means of a competition, 400 new lecturers, but less than 5 percent of them had completed a Ph.D. abroad. 2.14. What factors explain the low brain circulation? Surveys have typically highlighted economic factors as important determinants of migration, as well as obstacles arising from weak working conditions and weak career prospects of skilled workers. In fact, after economic and political stability, the three most important factors cited that would prompt a return to Albania are a reform in universities and research, a reduction in corruption, and investment in education and research – all of these are essentially linked to working conditions in universities. Respondents want these institutions managed by individuals selected on merit, who appreciate and motivate research and teaching. 2.15. One encouraging factor is the willingness of the Albanian diaspora to work with universities and research institutions at home. According to the survey, nearly 97 percent of the persons with a Ph.D. working in the industrialized countries are willing to collaborate with Albanian universities and 22 To understand how migration has been affecting tertiary education, the World Bank commissioned surveys of Albanian tertiary institutions, academics and researchers in Albania, and Albanian academics abroad. The first survey covered all the public universities and research institutions in Albania seeking to obtain historic information on emigration of their personnel. The second survey asked about existing academic staff about their interest to migrate, and the last survey focused on Albanians with a Ph.D. who live abroad. All the three surveys were conducted in 2008 by the Center for Economic and Social Studies (CESS), and are quoted throughout the chapter as CESS survey 2008. In addition, CESS conducted similar surveys in 2000 and 2002 which allow for in temporal comparisons. 18 research institutions. The challenge is to provide the incentives and institutions to make this cooperation possible. 2.16. Another excellent opportunity arises from the policies put forward by the government to reverse the outflow of highly skilled migrants and promote the return of those who have left―the “Brain Gain” Program. The objective of the program (see Box 2.3) is to develop incentives and policy mechanisms to promote the Diaspora’s engagement in the scientific, administrative and economic development of the country. The program was established in July 2008 with an initial budget of one million Euro to provide financial support to qualified returnees (who meet a set of criteria, e.g. at least a masters degree from abroad) as an incentive to stay and work in Albania. The program has established close cooperation with institutions of higher education and public administration and advertises vacancies offered in these institutions. Through the Brain Gain initiative a database of students and academics abroad has been established, and currently includes the contact details of about 400 people. So far about 150 people have been attracted to return under the program, of which 82 are academics. In addition, the program aims to establish academic networks with those abroad. 2.17. One prerequisite for both retaining academics and encouraging their return from abroad is the reform of the universities to improve the quality of research work. In many research areas, the quality is far from international standards. Possible options to stimulate such cooperation under the aegis of an extended Brain Gain program would be to: (i) invite Albanian academics abroad to deliver lectures at Albanian universities, act as peer reviewers for research work published in Albania, as well as to participate in committees on university reform and quality assurance; (ii) create training and consultancy opportunities, especially for the government; and (iii) promote joint research projects between local researches and those abroad. Moreover, the “Brain Gain” program’s database of Albanian students and academics abroad should be expanded and its access widened so that it serves as a resource for universities, research institutions, public administration, think tanks, and the private sector to locate highly skilled academics. Box 2.2: Mobilizing Academic Networks through the Brain Gain Program The “Brain Gain” Program is supporting the Board of Higher Education of Albania to develop and implement the new Law of Higher Education, which will make the process of inviting visiting scholars and professors less restrictive. The academic component of the Brain Gain Program is being piloted in the newly established Aleksander Moisiu University in Durres, and is supporting its academic management team to identify professors or people that have been engaged in the education field, either in the US or Canada, or elsewhere. Short-term lectures are already underway with senior lecturers from the United States coming to teach in Albanian universities. Support also goes to a series of incentives to develop a new model of academic management. Improvements are expected to increase the mobility of Albanian academics and researchers within the international scientific community for joint projects, temporary employment in universities and research institutions abroad, participation in conferences and seminars, exchange of information, and joint publications, from a base within Albania. source: http://www.braingain.gov.al/  2.18. All of the above activities require incentives and financing. They are all consistent with the initial steps proposed under the “Brain Gain” program. They would require additional financial and management resources being allocated to the “Brain Gain” program, to avoid remaining just a worthy pilot program. Programs of joint research and teaching can only be successful if universities themselves are part of, and actively participate in, their design. The emerging priority for Albania is then to see how the benefits of migration might be optimized, tapping into the educated and skilled both at home and abroad, through the creation of institutions and incentives. 19 IV. A BIGGER AND BETTER EDUCATION SYSTEM 2.19. The educational system is under pressure to meet the Table 2.1: Education Expenditure (Percentage Structure) 2006 2007 2008 2009 demands of a rapidly changing economy. In recent years, there has Total 100.0 100.0 100.0 100.0 been a tendency for education Basic and Preschool 61.7 58.5 60.4 62.0 expenditure to increase (from 3.2 Secondary General 12.1 13.0 12.7 11.7 percent in 2006 to 3.5 percent in Secondary vocational 6.6 6.7 6.2 5.8 2009). In addition, the share of Higher education 16.6 17.2 16.4 16.8 expenditures across levels of Administration and Science 3.0 4.6 4.3 3.6 education has remained broadly stable (Table 2.1).23 However, while Total % GDP 3.2 3.3 3.5 3.5 the number of students has declined Source: Ministry of Education and Science and Treasury. slowly (particularly in the younger age cohorts in basic education), the number of students in (public) higher education has increased by over 50 percent in the last five years (Table 2.2) in line with the government’s Strategy for Higher Education to expand access to all those who wish to attend (see Ministry of Education and Science of Albania, 2008). The result has been that funding per student in higher education has fallen over time from 25 percent of GDP per capita to 20 percent between 2004 and 2009 (Table 2.3). It is also notable from this data that the cost per student in vocational secondary schools is about 2.6 times that of the cost per student in a general secondary school. Table 2.2: Numbers of Students by Levels of Public Education (Thousands) 2004 2005 2006 2007 2008 2009 Basic education 541.1 501.3 501.8 483.7 512.0 494.8 Secondary total 131.1 150.1 155.4 159.3 118.1 124.0 Secondary general 107.7 120.8 124.9 129.6 96.3 104.0 Secondary vocational 23.4 29.4 30.5 29.7 21.8 20.0 Higher education 62.3 73.0 81.1 80.7 80.0 95.8 Source: Staff estimates based on data from Ministry of Education and Science and State Treasury. See footnote 24for an explanation of the break in the data between 2007 and 2008 as a result of the restructuring of secondary education. Table 2.3: Spending Per Student as % of GDP Per Capita 2004 2005 2006 2007 2008 2009 Basic education 10.2 10.6 12.5 12.4 14.0 14.7 Secondary total 13.3 12.2 12.2 12.9 17.9 15.9 Secondary general 10.3 9.8 9.9 10.5 14.7 12.6 Secondary vocational 26.6 22.1 22.0 23.5 32.1 32.7 Higher education 25.4 22.4 20.9 22.3 23.0 19.7 Source: Staff estimates based on data from Ministry of Education and Science and State Treasury. 2.20. As expected, the returns to education, in particular post-secondary, are substantial and have encouraged youth to enroll in universities. Estimates on the impact of education on wages were made for Albania using data from the Living Standards Measurement Survey (LSMS) carried out in 2005 23 It should be noted that in the tables in this section the data is affected by the reform to education which, starting in the academic year 2008/09, increased the number of years in basic education from eight to nine and reduced the years of secondary education from four to three. Hence there is a one-off increase in students in primary education and a corresponding reduction in secondary students. 20 and 2008. To distinguish the specific effects of the level of education on wages, Mincer-type equations were estimated with dummies to take account of regional variations, variation by sector, and age, as well as the number of years of experience of work or advanced schooling prior to transition. Comparable data are also shown for three neighbors. The results in Table 2.4 show broadly expected coefficients. In most cases those with secondary vocational education earn more than those with primary, although this is not always the case with secondary general education. In all cases those with higher education earn significantly more than those with secondary education. 2.21. One trend which merits further investigation is the decline in return of tertiary education among the youth. The estimates in the table above show that returns to tertiary education over primary increased from 2005 to 2008 from 47.7 percent to 51.9 percent. Similarly returns to vocational education increased from 13.5 percent to 21.3 percent over the same period. This is consistent with the survey data on enterprises reporting lack of skills being an increasingly important impediment to carrying investment and business activities. However, a reverse trend is observed for people under 35 years old: in 2005 the premium on tertiary education for those less than 35 year of age was 62.2 percent against 47.7 percent for the overall population, but in 2008 it was lower than for the overall population (46.9 percent against 51.9 percent). This implies either that salaries of young workers with primary and secondary have risen more than salaries of university graduates, or that salaries of university graduates have declined (which is not likely). The difference may also be explained by insufficient data for such analysis in the survey. Table 2.4: Wage Premia for Different Categories of Education Albania 2008 Albania 2005 BiH 2004 Macedonia 2005 Serbia 2005 All people of working age Secondary general 11.4 -0.2 -1.2 5.3 13.3 Secondary vocational 21.3 13.5 7.4 19.2 31.0 Post-secondary education 51.9 47.7 32.6 57.4 70.5 People less than 35 yrs Secondary general 6.4 2.3 -1.3 -4.1 12.7 Secondary vocational 12.1 14.7 9.9 7.6 27.6 Post-secondary education 46.9 62.2 45.6 49.2 66.1 Notes: Coefficients indicate the percentage premium of the level of education above those with primary education or less. For Macedonia and Serbia, figures are for 1-3 years and 3-4 years of secondary education, rather than for general or vocational education. Source: For Albania, staff estimates from LSMS 2005 and 2008, using Mincer type equations with additional dummies for regions, sectors and age. For other countries from Linden, Arnhold, and Vasiliev, 2008. 2.22. Albania’s public and private education at tertiary level has expanded rapidly, particularly in the last three years (Box 2.4). The government committed to providing access to all those who desire it. As a result, the number of students rose to almost 100,000 in 2008 and continues to grow; the number of students in public universities has increased by 50 percent in five years (Table 2.5). Enrollment in private universities has also recorded a sharp increase; currently, 17 percent of tertiary students are enrolled in private universities and 25 percent of new admissions were to private universities in 2009. If current intake levels are maintained, by 2012 the annual number of graduates will be three times higher than it was in 2005. 2.23. At the same time, given the relatively low quality of the higher education system, there is a concern that the expansion of enrollments may not yield the desired benefits. It is much more difficult to improve quality while at the same time expanding the system, unless mechanisms are strengthened to retrain existing teachers and recruit new teachers from abroad (e.g. through an expansion of the Brain Gain program). The problem is compounded by the fact that financing, while increasing, is not keeping pace with the increase in the number of students. This suggests that for the expansion to be 21 sustainable with the necessary quality, universities will need to increase incomes generated from other sources (including fees). Box 2.3: The University System in Albania Albania’s tertiary education system is largely based on traditional academic programs, and there is significant scope for increasing institutional diversity. It has a single public comprehensive university; the University of Tirana and two other specialized public universities (the Tirana Polytechnic, and the Agricultural University of Tirana) all located in the capital, and dominating the system as a whole in terms of enrollments and resources. The six regional public universities started as small institutions with low enrollments, traditional academic programs, and weak links to the needs of the regional economies. However the system has begun to evolve considerably and some of the regional universities have started to develop specialized academic profiles. For example the “Ismail Qemali” University of Vlora is focusing strongly on developing ICT, math and science programs. Other universities are trying to develop stronger links with regional economies and the labor markets. In addition, Albania now has 35 private higher education institutions (20 of which were established in the last two years): 32 are based in Tirana and 3 in other regions. However, only 12 are fully accredited and three others are partially accredited. All the rest are in the process of acquiring accreditation, or are too new to have started the process. Doubts have been raised about the quality of graduates from private institutions, but this is difficult to judge in the absence of either accreditation or information on student performance. Presumably many of the students enrolled in as yet unaccredited private universities believe that accreditation will be obtained or will not matter in the future. The concerns on the quality of teaching and learning in private tertiary education institutions is recognized by the Ministry of Education and Science, and for this reason the MoES is in the process of contracting a foreign accreditation agency to evaluate and rank study programs in public and private higher education institutions.  Table 2.5: The Expansion of Higher Education in Albania (Thousands) Academic year 2003 2004 2005 2006 2007 2008 2009 Gross enrollment rate (%) 18.4 21.6 24.7 28.2 29.2 29.9 37.3 Enrolled students 53.3 63.3 74.8 86.9 90.2 92.7 116.1 Full-time (public) 36.2 42.2 50.6 58.9 62.3 61.3 76.8 Part-time (public) 16.6 20.1 22.5 22.2 18.4 18.6 19.0 Private 0.4 1.0 1.7 5.8 9.5 12.7 20.3 New entrants 13.9 14.1 16.5 21.0 21.0 25.0 26.8 Public 13.7 13.5 15.7 16.7 17.2 19.2 19.9 Private 0.3 0.6 0.8 4.4 3.8 5.8 6.9 Number of students graduating 6.0 6.3 8.4 9.9 14.2 14.8 n/a Public 6.0 6.3 8.4 9.6 13.9 14.4 n/a Private 0.0 0.0 0.0 0.3 0.4 0.4 n/a Teaching staff 4.0 4.5 5.5 5.8 6.1 6.9 7.6 Private students as % of total 0.8 1.5 2.3 6.6 10.5 13.7 17.5 Private enrollments as % of total 1.9 4.2 4.8 20.7 18.2 23.3 25.6 Note: Gross enrollment ratio is shows students as a proportion of population 18-25 years old. Source: Ministry of Education database. 2.24. A careful balance needs to be maintained between allocating resources to expand the existing system and allocating resources to increasing quality. If the system is expanded too quickly, 22 then there is a risk of wasting resources if newly recruited staffs are less qualified or the expansion results in the admission of insufficiently prepared students. While it would be desirable in the long run to expand tertiary education, improving its quality should also be a priority. Too rapid expansion leads to declining quality, higher drop-out and longer completion rates (wasting more resources) as well as frustrated and unemployed graduates. Also, to sustainably improve the quality of tertiary education, stronger education at primary and secondary levels would be necessary. 2.25. The expansion of higher education is taking place from a base in which there is a potential distortion in the pattern of students relevant to the needs of the labor market. As can be seen from Table 2.6, over 60 percent of students in public universities are studying education, humanities or social sciences, while only 10 percent are studying sciences, mathematics and computing, and another 8 percent engineering or related fields. The government has recognized the importance of changing the patterns of graduates to be closer to the needs of the labor market. To this end, the Ministry of Education and Science in collaboration with public universities is currently preparing a new policy framework on university student enrollment for academic year 2010-11 which proposes a considerable reduction of number of students in areas with low labor market demand (such as social sciences) and a rapid increase of numbers of students in mathematics, science and tourism with particular focus of ICT programs. Similarly, the MoES is encouraging private higher education institutions to open new study programs in science and ICT. Table 2.6: Distribution of Students by Subject Area, 2006-2008 2006 2007 2008 Public Private Public Private Public Private Total (thousands) 81.1 5.8 81.1 9.5 79.8 12.2 Total (%) 100.0 100.0 100.0 100.0 100.0 100.0 Education sciences 10.9 1.4 10.4 0.0 9.8 0.3 Humanities and art 21.3 7.2 20.2 1.2 16.8 0.9 Social science, business and law 28.2 63.1 33.6 65.4 32.4 66.0 Science math and computing 10.1 2.4 8.7 0.6 9.9 8.0 Engineering manufacturing and 8.2 3.0 9.1 5.2 10.4 0.0 construction Agriculture and veterinary 9.1 0.0 9.4 0.0 11.1 0.0 Health and welfare 9.5 19.8 8.0 27.7 8.3 24.8 Tourism 2.6 3.1 0.7 0.0 1.3 0.0 Source: Annual Statistical Report of Education 2006-2007 and database Ministry of Education and Science of Albania, 2009. 2.26. In addition, to further support high quality, tertiary expansion, the sector is going through a major reform process. The intention of this reform is to improve quality, accountability and relevance of universities.24 However, as noted, it is important to ensure that the rapid expansion of the universities does not overwhelm the reform process, particularly with the growth of private universities which may be able to attract some of the remaining qualified staff from the public universities. Until now much of the reform effort has focused on administrative and organizational issues concerned with adopting the Bologna process on tertiary education in Europe. Substantive reforms, particularly on curriculum, teaching methods and transparent and accountable management are only just beginning, and will be critical to the future development of the sector. 24 Governance reforms (boards of trustees, leadership selection, etc.) and financing reform (per-capita funding) are also underway. Further finance reforms will need to focus on quality factors and investment in activities, equipment, and advanced training of personnel as the market mechanisms are unlikely to stimulate such investments very readily and certainly not very quickly. 23 2.27. Within these reforms universities will be required to substantially revise curricula and teaching methods. Universities will also need to establish planning and monitoring systems which look at demand for students’ qualifications and performance for each faculty. An important element in any program of broad skill development for less academically inclined secondary students should be training in information and communications technologies (ICT). In this respect the government program to equip all schools with computers and internet is a very important step forward. This will in turn facilitate Albanian firms’ wider adoption of ICT. It also provides flexibility and problem solving abilities that are required in a modern economy based on innovation. V. IMPROVING MARKETABLE SKILLS 2.28. One important challenge is to develop an institutional framework and policies to ensure the relevance of education to the needs of employers. Currently, employers and/or professional associations are not involved in decisions concerning the content of programs at universities. There are no professional program advisory committees in public universities that provide input to the design and development of programs in science, ICT, engineering or medicine. Furthermore, the funding mechanism for university programs does not include criteria to ensure such a relationship is supported, or incentives to reward labor market-related positive outcomes for university graduates such as the level of employment in jobs with affinity to the program of studies following graduation. Also, in the recent reform of the secondary school curriculum there was again no consultation with the private sector. 2.29. Underdeveloped links to the labor market are also reflected in the absence of relevant continuing education programs in Albanian public universities. Continuing occupational and professional education is one of the major mandates of universities in knowledge-driven societies. Continuing education may also involve the provision of training programs to government agencies, corporations and SMEs. The provision of customized training to enterprises can be a significant source of revenues to under-funded public institutions, and could result in the improvement of the quality and relevance of curricula of full time programs. By interacting with, and providing services to the private sector, programs can be made more relevant (for example in the use of IT skills), students acquire relevant knowledge and it is easier to retain academic staff. 2.30. There also seems to be a limited capacity for continuing education and training within firms. The lack of opportunities from the formal education system is not always offset by training within firms. In the Investment Climate Survey (ICS) 2009 only 19 percent of firms reported offering formal training. Firms seem to be reluctant to provide training to increase the human capital of workers who may then leave to competitors, or migrate. Despite that, some firms do provide on the job training, but this is hardest to do in the most needed areas of management skills. Interviews with larger firms indicated that they attempt to identify the “potential” and then use on the job training to build management capacity. Firms with foreign investment more often recruit managers from abroad. At the same time, many firms surveyed in the ICS indicated that they would be willing to host interns and participate in the development of relevant curricula and programs. 2.31. In addition to the reform of the education system, incentives by the state to stimulate investment in worker training may be beneficial. There is a strong theoretical justification for the public sector to subsidize (at least temporarily) private investments in human capital, such as firms’ training of workers, in the face of positive externalities. Without such support, firms and individuals will tend to invest suboptimal levels of resources in human capital, with negative implications for both short and long-term aggregate growth (Galor and Zeira, 1993). The additional advantage of such mechanisms, when designed and implemented appropriately, is that they provide, in the short-term, training in skills that are highly relevant to the labor market (as employers participate), while longer-term reforms to the education system are undertaken. 24 2.32. Currently two financial support mechanisms from the government have met with very little take up from firms. In the first mechanism the government supports a workplace training scheme for the unemployed, whereby employers who employ a trainee for at least a year and provide training are offered a subsidy for nine months of training. The second provides training for workers of companies that can show that the training is necessary and guarantee to maintain the employment after the training. The lack of success of these schemes is due to (i) relatively low awareness of their existence; (ii) cumbersome processes and inspections; (iii) workers involved in these schemes would have to be formally registered and, more broadly, (iv) a general lack of trust between the government and private firms. 2.33. International experience suggests that government support for training works best when firms, either individually or as members of business associations, are involved in the design and management of training programs. Such programs are much less likely to be successful if simply provided by the state. They also tend to be more successful if benefitting enterprises are paying at least part of the cost. One of the ways to deal with the issue of training externalities (i.e. poaching of trained workers) is to require a group of firms to collectively pay subscriptions to a common fund for training, sometimes partly matched by government contributions. VI. EDUCATION REFORM AREAS 2.34. The previous analysis has illustrated the needs and challenges in the provision of education and training for an innovative and knowledge based economy. These include: (i) no effective signaling mechanism for the private sector to indicate the skills required, while students also have no real information on the demand for skills in the market; (ii) potential students have no reliable information on the quality of different universities and programs; (iii) universities have neither the mechanisms nor the incentives to respond to the needs of firms for skills; and (iv) externalities make it too costly for firms to provide sufficient training, while they cannot afford to subsidize poorly resourced vocational programs through placements. 2.35. Addressing the challenges above requires action on multiple fronts; indeed, it is necessary to create institutions, provide incentives and facilitate information flows. The rest of this chapter puts forward some policy options that the authorities may wish to consider. Supporting and Enhancing Ongoing Reforms 2.36. A number of important initiatives have been introduced in the past two years to reform secondary and tertiary education and improve quality and relevance. These initiatives should be continued and further supported. They include the following: i) the restructuring of basic education from eight to nine years, together with the on-going curriculum reform, ii) the ongoing reform of higher education, but with due attention to the risks of excessive expansion on the quality of education, iii) the adoption of the concept of an Albanian Qualification Framework (AQF) to provide a road map for all academic and vocational qualifications and facilitate the transition between them, including that in harmonizing the qualification framework it brings together the private and public sectors in a dialogue on the relevance of qualifications and skills, 25 iv) the implementation of the law on higher (tertiary) education and the effective adoption of the three stage Bologna Process framework as guide for the restructuring of higher education in Albania, v) the establishment of the Accreditation Agency for Higher Education (AAHE) responsible for quality assurance and accreditation of academic programs and institutions of higher education, vi) the restructuring of the system of scientific research and development away from its focus on the Albanian Academy of Science, and line ministry-based research institutions to a more contemporary university-based system, and vii) the introduction of short-cycle, sub-degree programs in regional universities such as the vocational and occupational programs in the Faculty of Vocational Studies at the University of Durres outlined in Box 2.4. 2.37. Implementing these reforms will require considerable effort and commitment from the government, as well as financial and technical support from relevant international organizations. An example of the challenge ahead is the estimated effort needed for accreditation of all academic programs in Albania’s public universities. To date, after three years of continuous work by the Accreditation Agency for Higher Education (AAHE), only 9 program clusters have been accredited out of an estimated total of 60 clusters in the 12 public institutions in the country. Increases in resources and capacity building are necessary for the AAHE, and other education agencies, to perform their intended mandate effectively. Proposed New Reform Areas (i) Availability of Information 2.38. Some of the most important reforms refer to the publication of information and the creation of institutions for promoting dialogue on issues of education and skills. The reforms of education currently taking place emphasize the importance of accountability, and indeed international experience indicates that when performance is observable, incentives and mechanisms to improve are more easily generated. It is therefore proposed that the following information should be made available: i) the publication of the Matura examination results by for each region and school,25 ii) the publication of the average Matura results for entrants to each program in each university, iii) the publication of final examination results, and completion rates for each university program, iv) the establishment of a regular follow up survey of the placement of graduates in employment, and publication of the results, v) the establishment of an annual survey of employers to rate the performance of graduates from different universities, and publication of the results, and 25 While the Matura results are published on the internet and in the newspapers, these results are available on an individual basis but do not allow the comparison of the performance of schools and regions. 26 vi) the establishment of an annual survey of employers on the skills required and available, and publication of the results. 2.39. The expectation is that more information would support accountability and provide incentives to reform. The information available from the above exercise would give policy makers the necessary base to judge in which areas reforms are working, and where they need to be strengthened. Just as importantly, students and their families would become aware of differences in quality and opportunity. This would prompt more pressure to reform poorly performing institutions, and more demand in above average institutions. Central to such efforts would also be participation in future PISA. 2.40. Using the information above it would be possible for the government to design incentive schemes to attract students to areas where skills are lacking. For example it might be possible to offer partial scholarships, in areas such as engineering and ICT, to students with the highest Matura scores (so as to attract the better qualified students). Universities and faculties could also be provided with additional resources, for increasing the number of highly able students in such courses. (ii) Tuition fees and structure 2.41. New incentive schemes could be combined with moves towards financing universities on the basis of actual student enrolments. To promote competition among universities and provide them with incentives to improve quality and efficiency, as a first step the current funding formula could be adjusted so that instead of being based on enrolment targets, the subsidy is based on actual enrolments, with differential funding depending on the relevance of the discipline for development. This change in the formula is critical to promote competition and provide incentives. 2.42. Increases in tuition fees, particularly in disciplines in which there are an excessive number of graduates could both provide incentives in the choice of university degree and increase funds available for universities. Such increases are already permitted by law. They would provide incentives both to universities and students to perform. Setting fees at possibly 15-20 percent of the actual cost of tuition, combined with means tested scholarships and/or loans to ensure that access to universities is not unduly limited for qualified, low-income students. Taken together, these reforms would: (i) augment sector financing and potentially expand access and make it more equitable; (ii) provide incentives for students and their parents to demand value for their money; and (iii) improve graduation rates and throughput. The experience in other countries has proven that students who pay or borrow money are more likely to complete their education in the designated duration than their counterparts who receive free education. (iii) Diversification of Tertiary Education Programs and Institutions 2.43. There is also a need to diversify tertiary education, both in terms of programs and institutions. Specifically, establishing occupationally-oriented colleges in regional universities is key. This would be equivalent to those in EU and OECD countries, and would satisfy the demand for access to tertiary education by a more diverse student population. It would include students with an acceptable level of academic preparation, students from vocational secondary schools with possibly lower academic preparation, students seeking tertiary education qualifications, and students from disadvantaged groups. These new colleges would establish important bridges between vocational secondary education and tertiary education on the one hand, and between the two sectors of tertiary education on the other. Students from both upper general and vocational secondary schools with, and in some cases without, the Matura exam, will be eligible to enter the new colleges. Graduates of these institutions can, after a period of employment, or immediately after completing their sub-degree studies, continue their studies towards a 27 university degree. Such institutions could be modeled on the Faculty of Vocational Studies (FVS) in the University of Durres. 2.44. Also, developing capacity for delivering continuing education and adult education programs would be useful. To this end, it is necessary to build the capacity in all tertiary institutions to develop revenue-generating training programs for public organizations and enterprises. Establishing an incentive scheme to ensure that institutions have the autonomy to keep and invest their revenue for further capacity building initiatives would serve to support such goal. Box 2.4: The Faculty of Vocational Studies, University of Durres The FVS was established at the University of Durres, Albania’s newest regional university, in 2007. The faculty offers 2-year diplomas and 3-year vocational degrees in: Paralegal Studies, Administrative Assistant, Nursing, Dental Assistant, Automotive Technology, Construction Management, Transportation Management, and most importantly in IT Development and Management. The model for the development of the FVS is a combination of the North American community college model in that includes vocational and occupational programs in diverse fields of studies in business, technology and health services, and the French model of the Institut Universitaire de Technologie (IUT), which is a university-based institution offering mostly technology and business-based vocational and occupational programs of 2 and 3-year duration. In developing and implementing these programs, the university has adopted a number of promising reform initiatives. First, teaching in most of the above areas is provided by working professionals in the field who are hired on a part time basis. Second, the university has entered into an agreement with vocational secondary schools, car dealerships, and building contractors in the area to use their facilities for the practical training of students. Third, the course design uses a contemporary modular approach with each module assigned appropriate ECTS credits. Finally, the adoption of the “coop mode” of program design using the German model of the Beruf Akademie, which involves alternating semesters of study and work with participating employers in a 3-year program (180 ECTS credits), would be the first of its kind in Albania. The model of the University of Durres provides a powerful example of orienting programs to make them relevant to the employment market, and could be replicated in other parts of the country.  (iv) Improving the Quality and Relevance of Tertiary Education 2.45. Steps to ensure the correct balance between quality and relevance requires a multi-pillar action program, which includes:  Strengthening links with labor markets. In many countries such links include work placements with private and public sector employers during their studies, and establishing strong professional orientation programs and services. These measures give employers an opportunity to assess the knowledge, skills, and competencies of students, and the incentive to actively provide input and advice on academic program relevance. MoES could also consider providing incentives to institutions to establish Program Advisory Committees (PACs), and include employer representatives in sectors such as engineering, engineering technology, business or medicine. The mandate of the proposed PACs would include: (i) validating market intelligence about the existing and future demand for graduates of various disciplines; and (ii) providing advice on the knowledge and skills needed. PACs and similar committees are used successfully in most OECD countries.  Strengthening accreditation and quality assurance of universities and their programs. The government may want to consider separating the institutional accreditation from the program accreditation. AAHE should continue its work on institutional accreditation using the framework developed. However, program accreditation would require the involvement of international experts and professional organizations, which can add value in assessing the quality of programs and in ensuring that the employers or employer associations are included 28 in the assessment process. Assessment by an external body would also make the program accreditation more rigorous, as well as reduce the possible bias when faculty members are the only ones evaluating their peers. Additionally, it is recommended that internal quality assurance units and procedures be established in each tertiary institution to promote a culture of quality and ownership of quality assurance reforms.  Continued teacher and faculty training. For the above mentioned reforms to produce the best results, they will need to be complemented with capacity building of faculty staff. The proposed reforms in governance need to be coupled with leadership training for university faculty, in-career teacher development, and initial teacher education for newcomers. In support of these objectives, MoES may want to consider establishing a Faculty Development Institute in one of the leading universities. (v) Strengthening the Capacity of Research, Development and Innovation 2.46. As Albania progresses up the value added chain, it will need to develop its capacity to adopt and develop new technologies. This will require:  Restructuring of outdated research, development and innovation system. The key challenge facing Albania is to continue the work started in 2006 to restructure its outdated research and development (R&D) system and to translate the following guiding principles into operational reality: i) creation of an integrated system of higher education and scientific research in Albania through the integration of research institutes and university academic units, ii) creation of Research Centers located within faculties or universities, and iii) each scientific worker of this system should teach and undertake scientific research.  Increasing the role of the private sector in research, development and innovation. To this end, it is necessary to link public R&D efforts with industry needs so that their results are likely to translate into economic benefits. Further, to achieve this outcome, the enforcement of the intellectual property rights regime would need to be strengthened, the number of researchers involved in R&D increased, and science enrolment expanded. 29 CHAPTER 3: MODERNIZING INFRASTRUCTURE I. INTRODUCTION 3.1. In any economy infrastructure is a fundamental requirement for development and in modern economies ICT infrastructure is a key factor for sustained growth. Over the past decade Albania has upgraded its infrastructure substantially. In terms of “traditional” infrastructure, approximately 1.4 billion Euros have been invested in new roads since 2004 and the electricity system has been restructured. In terms of the “modern” infrastructure, mobile phones use has become widespread in recent years. As Albania now is looking towards integrating with the European economy as its ultimate objective, infrastructure development is becoming a larger priority of the new growth agenda. This chapter examines three aspects of Albania’s infrastructure: ICT, electricity, and transport. Other aspects of infrastructure such as the water sector, while important for agriculture and tourism, are not covered in this report. 3.2. ICT infrastructure, or ‘connectivity’, has been the largest driver of growth in the past two decades for those economies that have invested in it. The introduction of broadband networks and services is having a transformational effect on economic activity and social inclusion across the globe, providing a foundation for long-term economic growth and competitiveness, especially for small countries. In recent years, Albania has made considerable progress in developing some segments of its ICT infrastructure, in particular its mobile phone market. Nevertheless, it still lags very far behind in other important segments, particularly internet penetration, where accessibility and usage are only at a fraction of that in the EU or in many of Albania’s neighbors. The broadband internet penetration rate was only 2.5 percent in 2009—lower than in any other EU country and much lower even than in the second laggard (Kosovo, which had 6.4 percent broadband penetration).26 It is clear that Albania will need to accelerate the adoption of broadband, in particular if it wants to improve its competitiveness vis-à-vis its neighbors. Section II of this chapter aims to identify the causes for the underdevelopment of ICT and to offer policy recommendations how to advance quickly in improving Albania’s “connectivity.” 3.3. Electricity has been a constraint to investment and growth for many years, but Albania has undertaken several reforms in the past few years to address this issue. Major reforms have been undertaken in the sector but the goal of a fully reliable, high quality electricity supply has yet to be achieved. As electricity is a basic input for any economic activity, easing this infrastructure constraint is essential if Albania is to transform itself into a modern economy. Section III of this chapter addresses the remaining infrastructure challenges in the electricity sector. 3.4. Finally, in transport, the key issues now are to provide adequate maintenance for previous investments, participate in regional initiatives to strengthen links with neighboring countries, and improve the quality of the existing road network in rural areas. Major investments in new roads should be carefully evaluated and only undertaken if significant economic benefits can be demonstrated. However, only 46 percent of the regional and local roads in the rural areas are in reasonable condition. Thus, addressing these issues will enable Albania to reduce the ‘economic distance’ to its main markets. The focus in the transport sector should thus not be on constructing new roads, but improving what is already there and then maintaining it. This is essentially an economic management problem which requires a careful balance between continuing to develop the network where economically viable, while ensuring that the institutional framework is strengthened and all roads are preserved. These issues are covered in Section IV of this chapter. 26 Data from Cullen International, 2010. 31 II. IMPROVING CONNECTIVITY THROUGH ICT Connectivity and Its Links to Growth 3.5. Numerous studies attest to the Figure 3.1: Impact on Per Capita GDP Growth of a economic benefits of increased 10 Percentage Point Increase in ICT Penetration, connectivity, particularly through 1980-2006 broadband. For example a study by the High-income economies World Bank27 using a sample of 120 countries 1.5 Low- and middle-income economies 1.38 over the period 1980-2006 found a significant 1.21 positive relationship between broadband 1.12 penetration and GDP growth. Specifically, an 1.0 increase of 10 broadband subscribers per 0.81 0.77 0.73 hundred of population is associated with an 0.60 increase of 1.4 percentage points in 0.5 developing countries per capita GDP (Figure 0.43 3.1 and 3.2). Of course these results should be treated as indicative since in the early part of the period the only technology available was Fixed Mobile Internet Broadband fixed telephony, and for developing countries it is only in the last five years that broadband Source: Qiang & Rossotto, 2008. has become more widely available. 3.6. Perhaps not surprisingly, policy makers in Europe are Figure 3.2: Internet Penetration and GDP per capita increasingly focusing their 2008 attention on ICT infrastructure. 100 The European Commission (EC) has set an objective of accelerating SWE NLD FINDNK the roll-out of broadband and 80 GBR DEU Internet users (per 100 people) creating a competitive single market FRA BEL AUT EST SVK for information and media services 60 LVA HUN IRL CZE within the EU. Under its i2010 Croatia LTU SVNESP POL strategy, the EC targeted year 2010 Montenegro Serbia PRT GRC Macedonia, FYR ITA 40 for high-speed broadband lines B&H Bulgaria Turkey being available everywhere in 30 Albania Romania Europe, and in 2010 it set a new 20 target of having a minimum of 30 15 10 Mbps available everywhere by 5 0 2020. The EC proposed a virtuous 5000 15000 25000 35000 45000 circle of 3 components: “creation of GDP per capita (PPP) content and borderless services” leading to “increased service demand” and, eventually, to “roll- Source: Calculation based on WDI, Eurostat, and Cullen International (2010). out of a network”. 27 See Qiang and Rossotto, 2008, Economic Benefits of Broadband, in Information and Communications for Development 2009: Extending Reach and Increasing Impact, World Bank, Washington DC. 32 ICT Infrastructure in the Current Economy 3.7. As more and more firms are using mobile phones, email, websites and e-commerce, Albania’s ICT infrastructure is increasingly perceived by firms as inadequate to support Albania’s growth aspirations. The increase in the share of firms perceiving ICT to be a problem for their business does not signify deterioration in the infrastructure, but rather an increase in demand which has outpaced the development of ICT in the last few years. For example, the share of Albanian firms that use email for regular communications increased from 37 percent in 2002 to 71 percent in 2008. Albania also has a very low ranking in the World Economic Forum Global Information Technology Report Networked Readiness index (World Economic Forum & INSEAD, 2009). With a ranking of 105 out of 134 countries worldwide, it is the lowest ranking in Europe apart from Bosnia and Herzegovina. Meanwhile, on the same index, Macedonia is ranked 79, Serbia 84, Croatia 49 and Slovenia 31. 3.8. The greatest progress in ICT Figure 3.3: Mobile Penetration In Selected Countries development has been in the mobile market. Mobile telephony access has improved, and now ranks among the best in the region. The growth of the sector was spurred by the introduction of market competition through a third mobile phone operator in 2008 and a fourth in 2009. By the end of 2009, the mobile penetration rate reached 129 percent bringing Albania very close to regional and EU comparators (Figure 3.3). Moreover, the growth in the sector continues as access expands to customers in rural areas. Source: Cullen International, 2010. 3.9. However, the sector is lagging behind in terms of the technology used. As one example, 3G services are not yet offered to Albanian mobile users (Figure 3.4). In fact, Albania (in addition to Kosovo) is the only country in Europe that has yet to issue a 3G license. 3G is rapidly replacing the 2/2.5G Global System for Mobile communications (GSM) base in Europe with two or more operators offering the service in many countries. As a result, about 35 percent of total subscriptions in the EU have already moved to 3G or higher. The tender for issuing a 3G license was published in September, so the service should be in place in Figure 3.4: Share of 3G Technologies (percent) 2011. This service could become an 40 important alternative broadband network West Europe 35 and has allowed some transition and Croatia Share of 3G in mobile subscribers Bulgaria developing countries to leapfrog some 30 Romania existing ICT forms. 25 Albania 20 3.10. Also, Albania needs to greatly increase its access to broadband 15 internet. Only 2.5 percent of total 10 population or 10 percent of households 5 are using broadband internet, far lower 0 than the EU or the Balkan region which 2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 had 23.9 percent and 7.7 percent respectively. Albania lags significantly Source: Wireless Intelligence's database. even behind the least developed 33 countries in this sector (e.g., Kosovo). Moreover, practically all of the 60,000 customers are in cities as the service is still underdeveloped in rural areas. Although broadband penetration picked up strongly in 2009, the gap remains immense. 3.11. Broadband take up is rising in Figure 3.5: Alternative Broadband Technologies response to increased availability, Share of other fixed broadband technologies than DSL (%) 90 tariff reductions, and the introduction 80 of ADSL connections by Albtelecom 70 in late 2008. Whether the increase in 60 broadband penetration will continue will 50 depend upon whether the authorities can European region 40 average (33.3) maintain a transparent and competitive 30 environment among the Internet Service 20 Providers (ISPs). The availability of 10 relevant and compelling content will be critical for demand of broadband 0 Romania Hungary Italy Turkey Bulgaria Serbia Latvia Estonia Macedonia Lithuania Herzegovina Slovakia Austria Poland Slovenia Croatia Montenegro Czech Rep. Albania Bosnia & services. Expansion of service also requires creating incentives for investment in new infrastructure Sources: EC (2008), and Cullen International (2007). (backbone and last mile access technologies) and enforcing cost based leasing of existing essential infrastructure assets, such as local loops for alternative networks. 3.12. Cable TV access can be an important alternative broadband technology that Albania has yet to fully exploit (Figure 3.5). There are 38 cable TV companies in Albania, but the system is fragmented and most companies serve separate local markets. As a result, the total number of cable subscribers is negligible by regional standards and even fewer rely on cable TV for internet access. On the other hand, more than half of the households in Bulgaria, Macedonia and Romania are connected to cable TV, many of whom also use internet and telephony services. Cable TV could play a much greater role as an alternative access to broadband which would facilitate competition, reduce broadband tariffs and improve service quality in the market. Figure 3.7). Competition on the mobile market, on the other hand, increased in 2008 when the two existing private carriers AMC and Vodafone Albania (who shared the market almost equally) were joined by a new entrant, Eagle Mobile, in which the government has 24 percent stake. By June 2009, Eagle had managed to acquire 15 percent of the mobile market in Albania. The telecom regulator also capped the retail prices of certain packages of mobile subscriptions and interconnection rates. These interventions, together with the increased competition, appear to have been successful in reducing tariffs (Figure 3.6). Importantly, in general, this sector is expected to experience further continuous cost reductions due to technological advances and intensified market competition. EU member states, for instance, benefited from 10–13 percent reductions in mobile rates during 2007 (EC, 2008). 34 Figure 3.6: Mobile Telephone Charges by Figure 3.7: Fixed Telephone Charges, October Carrier in the Region 2009, Euro cents Source: Cullen International, 2010. Notes: * prices for business users, ** un-weighted average of prices of three main operators Source: Cullen International, 2010. 3.13. In contrast, broadband prices Figure 3.8: Broadband prices, Euro per month, remain excessively high and this is a major 2mbps Subscription factor for the limited take up of this service by the population and small businesses. 80 According to Cullen International (2010), the 70 66.88 monthly subscription for broadband internet in 60 50 Albania is six times higher than in Croatia, 40 10.98 45.39 almost double those in Montenegro, and 50 30 38.00 percent higher than in Kosovo (see Figure 3.8). 29.34 26.92 22.69 20 Experience from the neighboring countries has 10 shown that deep penetration of broadband can 0 Turkey Croatia Albania Serbia BiH Mont. Kosovo only be achieved by lowering the price of the service. 3.14. The high service costs can partly be Source: Cullen International, 2010. explained by the absence, or limited capacity, of terrestrial optical fiber backbone infrastructure. Optical fiber capacity is critical for rapid broadband internet expansion. Albtelecom is the only operator with national (inter-urban and urban) and international connectivity in place, but its network is limited to only some main axes. Consequently, the tariffs for high speed connections are prohibitively high, preventing new networks from entering this segment on competitive terms. While the other operators in Albania have the right to deploy national and international backbone they have largely ignored this right – an issue that needs to be analyzed. There is also duplication and unnecessary costs of networks due to imprecise “rights of way” rules. Developing the broadband (as well as mobile) infrastructure is also impeded by the uncertainties about land ownership, difficulties in obtaining construction permits and the need to maintain own generators given the uncertain electricity supply. 3.15. Cost factors have caused the internet market to be highly concentrated. In addition to Albtelecom, there are around 90 ISPs in Albania, but only a few are major players that could be considered as meaningful competitors. Most ISPs in Albania are still local and fragmented. Hence, a vicious circle arises where without affordable access to infrastructure, only a few ISPs can provide internet services and inevitably all do so at high costs; without cheap internet service, people may not be 35 aware of a variety of potential benefits from internet access and without revealed demand, infrastructure will remain underdeveloped and costly (Box 3.1). Box 3.1: ICT Development and Human Capital Developing Albania’s ICT sector may, more than other sectors, become constrained by the limited availability of highly skilled employees. It is estimated that currently only about 10 percent of students graduating from IT- related programs are employable. Consequently, ICT firms face high post-employment training costs. Two key reasons for this skills gap are (i) limited use of ICT in education generally and (ii) limitations in university technical programs including outdated curricula and limited links with the private sector. This situation generates considerable uncertainty for the ‘training employer’ since they perceive the risk of employee poaching by non- training employers. As a consequence a sub-optimal circle of inadequate skills acquisition may develop. Institutional Arrangements in the Sector 3.16. Most of the basic elements of the regulatory framework for telecommunications are in place. In 2008, the government established an independent regulatory body—the Postal and electronic communications authority, or Autoriteti i Komunikimeve Elektronike dhe Postare (AKEP).28 AKEP, which replaced the previous Telecommunications Regulatory Entity, is headed by a board of five directors appointed by, and accountable to, the Parliament. Its independence is also strengthened by the fact that it is a self-financing organization, mostly relying on spectrum and license fees. The National Agency on Information Society was established by the government in 2007 to coordinate development, administration of state information systems and promotion of an information society. The National Authority for Electronic Certification (NAEC) was established in 2008 to supervise the enforcement of this law and to monitor the use of electronic signatures in Albania.29 The Commissioner for the Protection of Personal Data was established in 2008 to ensure that personal data is managed so as to protect personal privacy.30 A National Council of Radio and Television has also been established with a responsibility for media content. Finally, a new Ministry for Innovation and Information and Communication Technologies was created for the management of the digitalization of the society, reforms in the information society field and for overseeing the implementation of the Digital Media Initiative. The government launched the “Digital Albania Initiative” in 2009, and approved a new policy paper for the electronic communication sector in May 2010 which lay forward the objectives for the ICT sector. 3.17. The telecommunication market in Albania is a fully liberalized in accordance with the GATS commitments on telecommunications that Albania made on its accession to the WTO in 2000.31 The government privatized a national state-owned fixed-line operator, Albtelecom in June 2007. AKEP has already conducted fixed and mobile market analyses, designated Albtelecom, AMC and Vodafone as operators with significant market power (SMP) in their respective markets and implemented transparent, nondiscriminatory interconnection reference regulations. Albania also established a Competition Authority (CA) in 2003. The CA investigated alleged anti-competitive practices in the mobile market and sanctioned the two mobile operators for abuse of dominance in the mobile retail market. 28 Under the law on electronic communications. 29 Under the law on electronic signature. 30 Under the law on protection of personal data. 31 WTO document GATS/SC/131, 22 November 2000. 36 3.18. The 2008 law on electronic communications sets up the ‘governance’ for the ICT sector and is largely based on the EU legislation in this area. The law strengthens AKEP’s regulatory functions in designating the undertakings with SMP, governing interconnection issues among networks and enforcing the reference offer for interconnections and local loop unbundling. It helps AKEP to ensure that competing operators of differing market positions provide communications links between their various customers on non-discriminatory and cost based terms. The law also significantly simplifies the licensing process: where networks and/or services do not require scarce resources (such as radio spectrum and numbering), operators are merely required to notify AKEP of their business intentions and service contents. Such general authorization systems have been proven to facilitate rapid expansion of various ICT-related services. Implementing the Regulatory Framework 3.19. Transparent, nondiscriminatory and cost-based interconnection is the single most important aspect of regulation to invigorate market competition in the ICT industry. This requires publishing and enforcing approved reference interconnection offers (RIO). RIOs of three SMP operators have been published since February 2009, laying out interconnection tariffs until September 2010. These tariffs are based on EU average benchmarks. Ideally, interconnection rates should reflect long-run incremental costs to encourage investment in forward looking common facilities.32 Until recently the approach of the AKEP had been to regulate termination tariffs based on the EU benchmark (EU average termination rate). Currently the mobile termination rate is 10.5 Lek/minute or 7.61 eurocent, which is 11 percent lower than EU average of 8.55 eurocent (and lower than in 13 of the 27 EU member countries). 3.20. Interconnection rates are and will continue to be a critical issue for new entrants into the market. Notably, interconnection charges paid to incumbent operators can often amount to about 40 percent of their expenditures. In addition, SMP operators always have the incentive to dispute the technical, charging and methodological elements of interconnection in court, thus preventing new entrants from effectively starting operations except for on-net communications. As a consequence new entrants face significant operator constructed obstacles to building a customer base. Experience throughout the EU and elsewhere demonstrates that setting cost-based non-discriminatory interconnection charges is a lengthy process subject to numerous challenges from SMP operators. 3.21. Ensuring good governance of the sector and transparency is a critical matter for achieving the objectives of the regulatory reforms. For example, the award of the mobile licenses has been controversial and lacking in transparency. In particular the fourth license was granted despite the fact that AKEP had declared that the rules for the international tender had been breached. There seems to be a perception that government decisions in this area are arbitrary. Another example which was of particular concern was the attempt by the tax authorities to declare Eagle Mobile bankrupt as a result of legal provisions to force the bankruptcy of any enterprise with three consecutive years of losses. A broader institutional problem has been the frequent replacement of members of the AKEP board, resulting in average terms in office of less than 2 years since 2005, compared to the legal mandate of 5 years for AKEP members of the board and its chairman. The effect of this rapid rotation diminished the perception of independence of the board. Policy Proposals for Moving Forward 3.22. The Albanian government has understood the importance of ICT and has made ICT development as one of its top priorities. The government introduced the “Digital Albania” initiative 32 AKEP has decided to use “Bottom up Long Run Average Incremental Costs” for mobile and fixed interconnection rates. 37 which calls for an acceleration of ICT penetration Albania. Achieving the objectives of “Digital Albania” will require infrastructure investment, institutional reforms, legislative improvements, capacity building and most importantly effective implementation of these policies. Widespread access to ICT by businesses and citizens, including those in rural areas, will provide a strategic input to the “new growth agenda” in a cross-cutting manner. 3.23. The importance of ensuring the effective implementation of the law on telecommunications cannot be overemphasized. It would help make market competition a reality and facilitate rapid evolution of the whole ICT market. For the effectiveness of the law, at least four elements are particularly important over the short to medium term: (i) effective interconnection regulations; (ii) number portability; (iii) fostering market competition; and (iv) “big push” toward broadband internet market development. Proactive measures are required to establish a fair competitive marketplace by removing potential entry barriers and expanding the market frontier (Box 3.2). Many of the building blocks are in place in Albania—the major challenge remains the implementation of the approved legislation and policies. Box 3.2: Good Practices for Promoting Broadband Access The OECD, based on the survey of supporting policies practiced by member countries, has identified particular policy initiatives that would promote broadband investments. These include policies to:  improve access to passive infrastructure (conduits, poles, and ducts) and to coordinate civil works as an effective means to encourage investment. In the case of Albania this may be particularly important because many rural roads still need to be rehabilitated;  ensure access to rights of way in a fair and non-discriminatory manner;  encourage and promote the installation of open-access to passive infrastructure when public works are undertaken;  allow municipalities or utilities to enter telecommunication markets. Where there are concerns about market distortion, policy makers could limit municipal participation to basic investments (e.g. the provision of dark fiber networks under open access rules); and  provide greater access to spectrum (which is a significant market barrier to wireless broadband provision) and to adopt more market mechanisms to promote more efficient spectrum use  3.24. To achieve higher penetration of high quality services at affordable prices, policy makers need to prepare the way for more intensive inter-network competition, especially on broadband. The law provides AKEP with the power to regulate the retail tariffs of designated SMP operators if AKEP finds that there is no effective competition in the relevant market. Keeping tariffs arbitrarily low may be a short-term measure to protect consumer welfare but cannot be a medium to long-term strategy. Lasting improvements can only be achieved through greater competition. 3.25. Several steps are necessary to achieve increased competition.  First, to mitigate the risk of interconnections being blocked through procedural delays, it is recommended that AKEP issue binding interim decisions for interconnection charges where disputes most commonly arise. Binding interim decisions allow new entrants’ access to the broader market during the period that methodological and charging elements are under investigation. Once the final results are obtained a netting process can be put into place to handle any differences between interim figures and final figures. The regulator can be guided by international benchmarks when making interim decisions. However, it is important that the cost-based approach be established in due course. 38  Second, to facilitate market competition in the mobile market, number portability should be introduced. This is especially true for small markets that are highly saturated. Albania’s mobile penetration already reached 129 percent by the end of 2009, and the residual market left for new operators may be limited if users’ pecuniary and non-pecuniary costs of changing numbers are significant. The new law provides for number portability with a particular regulation to be drafted by AKEP. It was expected to have been implemented by mid 2009, but it has been delayed. The government should introduce mobile (and fixed) number portability without further delay. Portability is not necessarily technically complicated or financially costly and it is commonplace throughout the EU in markets where the operators in Albania have experience. In Albania there might be some complications for fixed number portability, as there are some 70 fixed network operators, but there should be no critical problems for introducing mobile number portability. The use of the portability feature is crucially dependent on charges for porting numbers and the speed of the porting process. EU Member States’ experiences reveal that the number of days required for porting is of particular importance to the customer and thereby their propensity to port. Time required for porting a mobile number varies from several hours in Ireland and Malta to 20 days in Italy and Slovakia. Such a long porting process would naturally limit the possibility for customers to switch carriers. By introducing a one-stop-shop process and an integrated system, the time needed to port a phone number can be reduced to several days.  Third, to promote market competition, Albania needs to expand more vigorously alternative networks technologies, such as 3G mobile, DLS, cable TV and WiMax. All these initiatives are foreseen in the government’s strategy for the sector, so the next step is to speed up the implementation. One of the quick options to enhance the broadband market would be to issue 3G licenses as well as WiMax. In this regard, the tender process for the 3G license should be completed in a timely manner. There is no reason for Albania to delay the introduction of these technologies which will bring about additional market competition, lower prices and higher quality services.  Fourth, local loops should be unbundled in the fixed segment and leased at reasonable cost to alternative networks. This would contribute to conventional DSL network expansion. In Albania, this segment remains minimal and virtually monopolized by Albtelecom even though other operators have the right to build infrastructure. The tariffs of leased lines should become cost-based. If Albtelecom is crucially dependent on the DSL market for its revenue, then this might be resolved through a universal access fund (which is provided for by the law). The new law pays particular attention to Universal Service defined as a minimum set of public electronic communication services of specified quantity and quality which are available at an affordable price to all users regardless their geographic location. This aspect is particularly important given that many rural areas in Albania have not benefited from ICT developments.33 Tariffs should not however be cross-subsidized between competitive and non-competitive segments.  Fifth, more attention should go into strengthening incentives for investing in the infrastructure which in turn would allow for more competition and lower prices. This requires, in particular, clearer definition of rules for “rights of way” such as forecast for pipes 33 Universal service providers are entitled to compensation if the provision of the service causes additional costs to the provider. These are calculated as net costs for the service under the universal service scheme. A Universal Service Fund will be established and financed by levies on the annual revenues of public electronic communication networks and services provider. Of course the fund will take some time to accumulate sufficient financial resources from existing customers to provide reasonably priced services to those who are currently unserved. 39 in new roads and their deployment in the existing roads, and the use of a common facility framework should be in place. The state contribution for some of these initiatives may still be needed given the high starting costs and public good feature of these investments. The authorities should seriously consider laying fiber or ducts in all infrastructure projects (e.g. road or electricity transmission) at low marginal cost in order to enhance both the national broadband coverage and the hub potential of the country. Such infrastructure could then be exploited on an “open access” basis. A strong case exists in these circumstances for AKEP to approve a framework for infrastructure sharing, particularly in rural areas and for considerable simplification and clarification of rights of way issues.  Finally, a demand-side “big push” may be needed for Albania to break through into a virtuous circle and boost internet penetration. This is because the ICT markets tend to develop rapidly once the critical mass is reached. The greater availability of compelling content will stimulate demand. The government may be able to take the lead in creating demand by implementing e-government, starting with e-procurement which will encourage suppliers to acquire web-related skills in order to bid for government contracts. Experiences in other transition economies indicate the importance of strengthening the demand side of the ICT markets. Lithuania, for example, focused on stimulating ICT demand as a broadband development strategy especially in rural areas. The Lithuania government aims to provide broadband connections to all public administration institutions and offices. It also aims to provide broadband networks to all SMEs, through investing in 3,000 km of fiber–optic links to the rural areas as well as stimulating broadband service demand, including e-education, e- government, and e-commerce (World Bank, 2006). Demand stimulation in rural areas has shown to be more difficult, but there are possibilities there as well and Albanian Post is already developing internet public access points in rural areas. III. ELECTRICITY The State of the Electricity Sector 3.26. Over the past four years major efforts were undertaken to improve electricity supply. The reforms originated from a need to address systemic problems in the sector which became clear in the mid- 2000s as economic growth stretched the existing electricity supply system to the limits. Hydropower constitutes on average around 95 percent of Albania’s current domestic electricity generation. In the last decade, during years of low rainfall, the combination of dry weather, below-cost retail tariffs, high network losses (technical and non-technical), poor collection rates, and growing demand, meant that KESh could only maintain electricity supply at a loss, or implement extensive load shedding. An extraordinarily dry period in 2007 resulted in both supply shortages and financial losses. In 2008, with somewhat more favorable weather conditions, KESh improved the supply situation, but continued to accumulate losses and debt. At the same time, in preparation for privatization, KESh was unbundled and a new distribution company (OSSh) was established. The now privately owned OSSh handles the network operations of electricity distribution and the retail public supply service. 3.27. The role of KESh cannot be over-emphasized. KESh is the most valuable company in Albania’s energy sector in terms of market-based asset value. KESh owns about 1.4 GW of hydroelectric capacity. And yet, its asset value remains suppressed because it captures only about a fifth of its potential market revenues. Under the current market structure in Albania KESh focuses on two main activities: (i) KESh Generation which maintains the existing capacities (hydro) and produces electricity to cover end user requirements with a regulated price to Wholesale Public Supplier (WPS) and (ii) the WPS which acts as a default supplier based on the public obligation of buying electricity from KESh Generation (the main 40 producer at present), from independent power producers (IPP) with a regulated price, and from the market, to cover the needs of end users in Albania. 3.28. Billing and payment collection of Figure 3.9: Electricity Supply and Load Shedding electricity is done at the distribution level. 8 The revenue is then allocated and transferred 7 to the transmission and generation sides of the 6 Thousands    GwH system. However, high losses in distribution 5 4 combined with low collections of billed 3 electricity, resulted in KESh being paid, over a 2 number of years, on average for only about 50 1 percent of the electricity supplied through its 0 network, or around 80 percent of the electricity 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 actually billed after taking into account Generation Imports Load shedding technical and commercial losses. It should be noted that the data in this table show only the Source: KESH; 2010 is a projection. amount of electricity supplied. To arrive at the total demand figure, one needs to add the amount of the load that has been shed (Figure 3.9). 3.29. The electricity distribution system’s performance left KESh with insufficient money to invest in proper maintenance, operation, and expansion of its system. More seriously, the lack of funds prevented it from being able to pay for all of the imported electricity needed to make up for shortfalls in domestic hydropower production. The company required considerable direct transfers from the state in 2000-2004, 2007 and 2008. 3.30. The government, Table 3.1: Electricity Distribution Performance recognizing the challenges in the governance model, 2004 2005 2006 2007 2008 2009 2010p decided to restructure KESh. Total supply 100.0 100.0 100.0 100.0 100.0 100.0 100.0 It adopted a new market model Transmission 5.8 4.5 3.7 3.7 3.4 3.2 3.2 for the sector in conformity losses with its commitments as a Distribution 33.9 36.4 37.7 32.8 32.0 32.2 28.5 member of the Energy losses Community and separated the Unpaid bills 9.8 11.7 11.4 6.5 9.8 15.3 8.3 retail distribution system Paid bills 50.5 47.4 47.2 57.0 54.8 49.4 60.0 operator from KESh, making it Source: KESh Note: data for 2010 are projections. Paid bills also include a new joint stock company collection of arrears from previous years. 34 (OSSh). In parallel, the Electricity Regulatory Entity (ERE) prepared new regulations, licenses and tariff methodologies for the various participants in the reformed power sector. The privatization of OSSh was successfully concluded with the signature of a Share Purchase Agreement in March 2009, whereby CEZ, the Czech energy corporation, paid €102 million for 76 percent of OSSh shares. 3.31. The privatized OSSh operates under two thirty year licenses. These licenses are (i) a Distribution System Operator (DSO) License for 30 years with exclusive right to serve all of Albania and (ii) a Retail Public Supply (RPS) License for 30 years with exclusive right to supply electricity to tariff 34 The Energy Community international treaty is an important element of a strategy developed by the member states of South East Europe and the EU to ensure access to a stable and continuous energy supply. The creation of an area without internal frontiers for energy contributes to economic and social progress and a higher level of employment. All of the Energy Community member countries have the prospect of EU membership and the Energy Community Treaty requires members to implement the EC Directive 2003/54/EC (electricity). 41 customers. The RPS license gives OSSh the right to purchase the electricity destined for final tariff customers from the Wholesale Public Supplier (WPS), which will remain state-owned (currently as a division of KESh). WPS is obligated to supply at least 4800 GWh of electricity per year to OSSh. The purchases from WPS are carried out at a regulated tariff as is the case also for final tariff customers. The WPS will buy, at a regulated price, all of the electricity produced by KESh. If this is insufficient to satisfy the minimum that it had agreed to supply to OSSh, WPS will import the shortfall. In effect, this makes the WPS the “supplier of last resort”, responsible for the overall security of electricity supply within Albania. This model provides a strong incentive to reduce distribution losses quickly. 3.32. In addition, under the agreed Regulatory Framework, the privatized OSSh needs to meet a number of performance targets.35 Specifically, it is required to: (i) reduce distribution losses from 34 percent in 2009 to 17 percent by 2014; (ii) increase the collection rate from 76 percent in 2009 of billing to 91 percent by 2014; (iii) improve operational efficiency; and (iv) improve the quality of electricity supply. In order to make these improvements, CEZ expects that OSSh will invest around €240 million in the first five years of operation after privatization. While OSSh operated during 2009 with a tariff that is below cost recovery, the regulatory framework contains specific provisions for reimbursing OSSh for the resulting financial losses in subsequent years. 3.33. A key challenge is to establish the credibility of the new arrangements. In particular, consumers’ incentives to comply with connections, metering and payments have been impaired because of the long history of unreliable service in the sector. Hence, it will be important that the authorities support measures taken by OSSh to increase collections and to raise prices towards the full cost recovery. Critically, ERE has committed to gradually raise the weighted average end-user tariff by 15 percent in real terms from January 2010 until the tariff reaches cost recovery levels. OSSh will be reimbursed for any financial losses until the end of 2012 while tariffs remain below cost recovery. Tariffs in subsequent years are projected to decline as the company meets its progressively ambitious distribution loss and revenue collection targets set out in the Regulatory Framework. Impact of Low Quality Electricity on the Private Sector 3.34. Prior to 2008 the inadequate reliability and quality of the electricity supply was cited as a significant impediment to doing business. Because of the power outages, many firms purchased (oil) generators to guarantee continued production, which in turn increased their cost. Moreover, because of the high voltage fluctuations, firms that used sophisticated equipment (sensitive to voltage) had to purchase additional equipment (e.g. inverters, stabilizers etc.) to prevent damages or destruction. Even though the additional equipment could offer protection from change in voltage, many firms express reluctance to invest in sophisticated equipment. 3.35. While electricity supply is much improved, with relatively few interruptions to the power supply (and none because of a “shortage” of electricity), many firms retain their protection systems or perceive use of sophisticated equipment as a risk (Box 3.3). As a result, many heavy electricity users have been unwilling to use the grid electricity or electricity supplied by public suppliers (WPS- KESh and RPS-OSSh). 35 The Regulatory Framework is stipulated in the Share Purchase Agreement signed between the government and CEZ, with a Partial Risk Guarantee of the World Bank that guarantees that the regulatory authority (ERE) will comply with the schedule of tariff increase in line with cost recovery and provided CEZ achieves its performance targets. 42 Box 3.3: Electricity-Intensive Manufactures in Albania A cement factory established in 2007, Seament, does not rely on KESH for electricity, mainly because the supply is not reliable. It purchased captive diesel generators (three units of 8 MW) and imports its diesel by truck from Macedonia. Its variable power generation cost is estimated to be as high as 16 Lek per kWh because of high international oil prices, but the continuity and stability of electricity supply are essential for the company. A steel manufacturer, Kurum, which is one of the largest power consumers receiving about 5 percent of the electricity generated by KESh, Although Kurum, an “eligible customer”, can import electricity directly from abroad (bypassing WPS/KEHs), it choose not to although it faced significant outages. The chrome manufacturer ACR in Elbasan, which is another large and “eligible” consumer, has been supplied by an eligible supplier for more than four years. In this case the electricity was imported from abroad. During 2010 one company (Titan) has already begun to be supplied from abroad and another will soon do so. Both companies are cement factories. 3.36. Restoring credibility in the reliability of electricity supply is thus crucial. In fact, despite relatively low nominal tariffs for publicly supplied electricity (at about 10 Lek per KwH), the actual cost to firms using diesel generators is usually at least three times higher—and yet many still opt for this more expensive option (Figure 3.10 and 3.11, as well as Table 3.2). Captive generator owners also have to import fuel from abroad in small lots. The ERE estimates captive generation (diesel) costs at 44.14 Lek/KwH. In addition, demand fluctuations by different types of customers cannot be pooled. If the grid- based power supply was more reliable, these inefficiency costs could be easily avoided. Figure 3.10: Albania: Electricity Prices, € Figure 3.11: Comparative Electricity Prices, Cents Per KwH 2007, € Cents Per KwH 25 20 15 10 Industrial Residential 5 0 Note: Refers to typical tariffs for medium business Source: Eurostat. users, and consumption above 300KwH for residential. Sources: KESh and ERE Addressing the Remaining Risks and Challenges 3.37. The electricity system should be able to fully meet Albania’s demand in the medium-term and provide reliable 24 hour supply of electricity. Demand for energy is expected to increase at a somewhat slower pace in the post-crisis period. Moreover, the market (especially households) is now close to saturation, while additional supply will become available as distribution losses are reduced. It is expected in the next few years that the demand for electricity will be in the range of 7,000-7,500 GWh. Out of this, KESh can cover 4,000-5,000 GWh through domestic generation, with the remaining demand being covered by imports. 3.38. The government should seek effective ways to increase generation capacity, especially through small projects. Numerous ‘unsolicited’ concessions have been awarded for small and medium hydro-power projects under the concessions law. Yet, despite awarding 90 such concessions, totaling several hundreds of megawatts, only one of these is actually operating and a further five are under 43 development. Many of these concessions are likely to have breached their terms and could be revoked by the government as non-performing. But the real problem with the unsolicited concessions is that many are poorly prepared and may sometimes be purchased for speculative purposes rather than motivated by serious business propositions. A review of the performance of the ‘unsolicited’ concession granted would allow the authorities to terminate those that have already breached the terms of their agreements and limiting their use in the future. 3.39. As an alternative to granting concession to unsolicited proposals, the government could take the lead in the preparation of detailed technical specifications for such projects and then auction them transparently. A successful example of a well prepared solicited bid is the Ashta hydro-power project. The project is a large public-private partnership in which Verbund, Austria’s largest electricity company, won a 35-year concession to build and operate the Ashta plant—the first major hydropower plant built in Albania in 30 years. Verbund will invest more than $220 million in the project which will have an installed capacity of 48 MW and average generation of 220 GWh per year. The same approach could also be followed for wind energy, where interest also seems to be high. The government should review the potential for public-private partnerships in electricity that could bring new investments, including foreign, in the sector and add several to hundreds of MW of low-carbon capacity. 3.40. KESh could also be transformed into a source for new investments in energy supply. Lack of funds for investments in modernizing existing facilities and Table 3.2: Electricity Tariffs in Albania (Lek per KwH) exploring new projects has kept Classification 2006 2007 2008 2009 2010s KESh operating well below its High Voltage potential. This could be addressed Budgetary 4.5 4.5 7.0 7.5 8.5 through a partnership with a strategic Private 4.5 4.5 7.0 7.5 8.5 investor. In the past, the company, Medium voltage rather than creating a strategic vision Budgetary 9.4 9.4 9.5 9.5 11.5 for improvement, has tended to react Private 7.0 7.0 8.0 8.0 9.1 to problems in an ad hoc basis and Low voltage frequently in reaction to weather Budgetary 10.0 10.0 12.0 12.0 14.0 developments. Further, it continues Private 8.0 8.0 9.5 9.5 10.5 to be open to undue political Low volume domestic 7.0 7.0 7.0 7.0 7.7 High-volume domestic 7.0 7.0 12.0 12.0 13.5 interference. These constraints must Average Tariff (Lek) 7.2 7.0 7.9 8.4 9.5 be overcome for KESh to become a Average Tariff (€ cents) 5.9 5.6 6.4 6.3 6.9 modern company that will contribute Source: ERE; s-scheduled. positively to Albania’s growing energy needs. Finally, there is also a need to enhance the efficiency and future development of the transmission system as well. 3.41. The main risks in the electricity sector for the future are essentially of a regulatory and institutional, rather than of a technical, nature. While additional thermal capacity may be useful to provide a strategic backup in extreme circumstances, the most important issues are to ensure that: (i) the regulator maintains an environment in which the OSSh is able to invest in maintaining the distribution network (which would bring down distribution losses), (ii) adequate pricing policies are introduced to have resources available to cover variations in hydro-power production, and (iii) the government looks for ways to increase generation capacity, especially through small hydro and wind-power projects. The establishment of a stable electricity supply will reduce business costs and facilitate investment, particularly in sophisticated electronic equipment, which is most sensitive to unreliable electricity supplies. 44 3.42. The regulatory framework needs to ensure that tariffs are set to cover the long run costs of electricity supply, while taking into account the impact on the poor and vulnerable population. This has been broadly achieved for retail tariffs following successive tariff increases in 2008 to 2010 after a period of stagnation and even reduction of tariffs in 2006 and 2007. Poor households spend on average 7 percent of their budgets on electricity, a share which is lower than in other neighboring countries (in Serbia, for example, it is 12 percent due to a greater reliance on electricity for heating purposes).36 Nevertheless, the share appears to be rising (by 43 percent between 2005 and 2008). 3.43. Currently, efforts to guarantee a basic level of energy consumption for the poor are addressed both through (i) the tariff structure and (ii) subsidies offered by the social protection system. The tariff structure ensures that lower levels of energy consumption are priced at lower tariffs. This type of tariff structure can be designed so as to guarantee that households can cover their basic energy needs. However, while an estimated 79 percent of the poor consume within the limits of the low tariff block, 64 percent of the non-poor also consume within this limit. This suggests that the first consumption block might be too wide as a “lifeline” consumption level; in other words, it does not seem to target well the poor. In addition, electricity subsidies are offered through the social protection system, mainly through the poverty focused program Ndihma Ekonomike. However, only 12.4 percent of the poor benefit from these social protection measures. Although the targeting of Ndihma is quite effective (56 percent of the benefits reach the bottom quintile), the overall coverage under this program is quite low (targeting only 21 percent of the bottom quintile). Moreover, there is the additional requirement under this program that subsidies are conditional on uninterrupted electricity payments. Unfortunately, this disproportionately affects poor households as it makes it more difficult for them to qualify for assistance. 3.44. Moving forward, the policies for Figure 3.12: Distribution Losses, Metering, addressing the poor may be restructured in order and Collection to have a more targeted and efficient impact. Of 50% the two tools currently used, the tariff structure seems 45% too expensive an instrument to protect the poor (due 40% 35% to the high leakage to higher income groups) and the 30% subsidies through the social assistance seem to be 25% 20% relatively ineffective due to the low coverage. Thus, 15% an important task going forward to ensure the political 10% 5% viability of the tariff structure will be to design a 0% system which provides some protection for the 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 poorest segments of the population without providing Total Losses %  of supply Non‐collection %  of bills subsidies to the rest of the population. Such an approach would probably include the need to avoid Sources: KESh, OSSh, and ERE lower tariffs for industrial or budgetary consumers compared with residential consumers. 3.45. The new tariff structure is necessary but not sufficient to ensure financial viability for the energy sector. Distribution losses should be reduced to the level of Albania’s neighbors which are around 15 percent of total energy supply from the current levels of over 30 percent (Figure 3.12). Then, revenue collection rates need to increase to 93 percent from the current rates of around 85 percent. It is expected that these targets can be achieved by 2014, but this will require a number of measures largely by OSSh. First, universal metering will be essential to ensure that consumers are aware of the marginal costs of consumption (in particular this will contribute to curbing over-consumption, including heating by electricity), and also to establish transparency and fairness in the billing system. A second element of loss 36 Spending more than 10 percent of the household budget on energy (overall, not only on electricity) is typically seen as a sign of stress; thus, a 10 percent threshold is assumed to identify households in “energy poverty”. 45 reduction and increased billing is that state entities should be required to pay their bills on time. There is evidence that the increase in non-collection of bills during 2009, while the privatization process was being completed, was due to public sector entities not paying their energy bills. However, it now appears that OSSh is being proactive in cutting the energy supply to non paying institutions, and that this will help raise the collection rate. 3.46. Additional policies of other stakeholders would also help achieve the above mentioned objectives. First, the government can make an important contribution by making it clear that it supports OSSh’s efforts to cut service to delinquent payers and in particular to sanction public entities that fail to pay utility bills. Second, tariff policy should not be used as means to subsidize the industry. Historically there was a tendency to favor low tariffs for industrial customers with high voltage connections (110 kV or higher). Although these rates were raised from 2008 to 2010 (see Error! Reference source not found.), they are still lower than those offered to medium and low voltage customers. This is acceptable to the extent that costs of delivering high voltage supplies are lower than for medium and low voltage supplies. However, it is important that lower tariffs are not used as a device to subsidize unnecessarily certain enterprises or industries, as it may encourage an unsustainable expansion in energy-intensive industries and distort resource allocation. As has been noted earlier, most existing firms are indeed willing to pay higher prices in order to have secure energy supplies. 3.47. Charging for high voltage supplies according to cost would also provide incentives for eligible customers to purchase electricity directly on the regional international market (Box 3.4). Purchasing from OSSh would still continue to be one of the options, as long as service quality is maintained. Related to this, another way for Albania to go toward such a liberalized market mechanism is to establish a transmission rights market. In spite of relying on market outcomes in neighboring countries, the Transmission System Operator (TSO) may need to develop its own auction mechanism to allocate transmission rights, which could raise sufficient revenue to invest in and maintain the transmission system properly. Box 3.4: Electricity Transmission Arrangements in Albania Albania’s power system is currently connected with three neighboring countries: Montenegro (220 kV), Kosovo (220 kV), and Greece (400 kV). It was faced with a capacity constraint for importing electricity during 2005-2008. Recent investments in upgrading the Montenegro connection (a new 400 kV interconnection line of € 43 million) and northern transmission lines (€ 12.5 million) will remove major transmission capacity constraints in the short term. A new 400kV interconnection line between Albania and Kosovo is expected to be completed within the next two to three years. Additional investments would be needed over the long term for a 400 kV line to Macedonia and a possible extension with Italy via a DC submarine cable line. Currently, Albania’s Transmission System Operator (TSO) has not yet introduced its own competitive bidding for the allocation of transmission rights. If there is any extra capacity, large consumers (eligible customers) can import electricity from private power producers/suppliers, paying the market transmission capacity price, which currently refers to the auction result in Montenegro and Serbia. It ranges from 1 to 10 euro per MWh, depending on the season. In addition, power purchasers have to pay a uniform transmission fee of 0.5 Lek per KwH to the TSO for transmission and auxiliary services which for 2010 is 0.6 Lek/kWh. The transmission fee in practice applies only to OSSh and Eligible Customers. To ensure the financial sustainability of transmission, the TSO needs to be able to implement its own competitive bidding to allocate transmission capacity to power purchaser/traders (including KESh), as required by EU standards. Another important action that would increase the viability of the TSO as well as give a positive signal to existing and new generation entities, would be to also adopt a transmission fee for domestically generated energy. 46 Figure 3.13: Forecast Supply and Demand for Electricity in Albania, Under the New Regulatory Framework 10,000 Net Demand 9,000 Net Supply Delivery from Transmission 8,000 7,000 6,000 5,000 4,000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: KESh. Note difference between supply and demand refers implies load shedding. 3.48. The regulatory framework set up following the privatization of OSSh Figure 3.14: Average Price for Base load Power at the established targets for losses reduction European Energy Exchange and increasing collections. It is 80 projected on this basis that by 2011 the 70 Average price € per MwH system will have the capacity to meet all 60 current demand, and that the continued 50 reduction of losses until 2015 will enable 40 the system to meet the increased demand 30 (Figure 3.13). The tariff framework 20 provides sufficient resources for imports 10 in normal hydrological years, but even in 0 the case of additional imports, domestic Q3  2000 Q1  2001 Q3  2001 Q1  2002 Q3  2002 Q1  2003 Q3  2003 Q1  2004 Q3  2004 Q1  2005 Q3  2005 Q1  2006 Q3  2006 Q1  2007 Q3  2007 Q1  2008 Q3  2008 Q1  2009 Q3  2009 energy prices are close to those prevailing in the European Energy Exchange even at their peak levels Source: European Energy Exchange (Figure 3.14). 3.49. In the long run, however, Albania needs to facilitate more investment in power generation capacity and strengthen distribution links with the regional energy network. Along with a tariff structure motivating consumers to use electricity more wisely, further reductions in transmission and distribution losses will help cover the supply gap for the next three or so years. As the economy grows, and once the distribution losses are taken care of, the demand for electricity would likely increase proportionally. A rough calculation indicates that if Albania’s economy grows 5 percent per annum, the amount of installed capacity required in the next 5 years might be around 470 MW. Even if growth slows down to 2 percent, some additional 180 MW may be required. Without new investments, Albania’s power sector would not be able to provide reliable electricity in the long term. 47 3.50. Importantly, hydrology is uncertain, and international electricity prices may continue to be highly volatile. This means that it remains unclear how much capacity should be secured for stable electricity distribution and how much capacity could be developed on a commercial basis. 3.51. Albania should explicitly address this uncertainty with clear contingency plans. In principle, a financial contingency plan is already in place. At the time of privatization the ERE approved a regulatory statement that contained a stabilizing mechanism, where KESh’s tariff as the Wholesale Public Supplier, would take into account the higher costs of borrowing from the market to finance dry period purchases. But the provision has so far not been enforced. Alternatively, if the government wishes to intervene in such situations by helping KESh to access cheaper funds, it can do so. However, this would amount to a back-door subsidy, which would benefit those who consume more. The most neutral way forward is to have uniform tariffs which are raised in periods of shortage to induce customers to use power efficiently. Many businesses would be willing to accept higher tariffs in exchange for a stable supply of acceptable quality, while residential tariffs could be raised on consumption above a certain number of KWh per month (the “lifeline”) so as to both protect the poor and curb excessive demand. Higher tariffs for customers requiring stable electricity supplies may also encourage some large customers to contract for electricity supply directly from abroad, and thus reduce the mismatch between supply and demand for the rest of the customers. 3.52. In sum, further development of the energy sector would build on the substantial progress made in recent years should cover several areas. These include market liberalization for large customers, strengthening of the transmission backbone to act as a true system operator, attracting private sector investment in less strategic generation assets, and reinforcing the capacity of the regulator. It should also include a clear road map to implement short and medium term policy actions along the following lines:  In the short-term the focus should be on: (i) strengthening the financial, managerial and technical viability of the energy companies and reducing their inter-company arrears; (ii) reducing the contingent liabilities to the government; (iii) implementing the obligations arising from the privatization of the distribution sector, including carrying out investments to reduce energy losses; and (iv) looking for ways to increase generation capacity, especially through small hydro and wind-power projects.  In the medium-term it will be important to find a strategic partner for TSO. Then, as the economy continues to grow, some new domestic generation and participation in Regional Power Exchanges will be needed. The move towards the regional energy market would also imply a transformation of KESh which should unlock its value and transform it into a modern electricity company. IV. TRANSPORT INFRASTRUCTURE Introduction 3.53. The provision of good transport infrastructure is critical for the enhanced competitiveness. Inadequate transport infrastructure translates into higher costs and a competitive disadvantage for domestic producers in international markets, and higher prices for imported goods. A crucial component, in addition to good physical infrastructure, is “soft” trade infrastructure. This involves a wide range of activities centered on lowering trade transaction costs for firms engaged in global commerce. As such, trade facilitation involves much more than trucking goods across national borders or shipping a package by sea transport. National frontiers impose a complex set of procedural 48 requirements on trade and logistics, including in terms of distribution, consolidation of cargo, warehousing and border clearance to in-country and payment systems. This section briefly describes the main issues in the transport sector and provides some recommendations to maximize the gains of investments in the sector. The Road Network 3.54. The condition of the road network has improved substantially. The first five year review of the Albania National Transport Plan (ANTP) shows that the actual conditions are the following: one third (31%) of the primary sections and half (49%) of the secondary sections of the national roads network are in less than good condition, with 55 percent and 5 percent, respectively, in very good condition. This is a significant improvement from 2005 when 67 percent of the national road network was in a poor or very poor condition. Regional and local roads have been found to be in a particularly bad condition and so the government is focused on a considerable investment program to improve access for rural communities. In addition, there is much work to be done in implementing the new Albania Design and Construction standards, which would improve the quality of the network and bring in modern operation and maintenance standards. 3.55. The condition of the network and heavy infrastructure investments indicate the importance of good management of these assets. The main issues are: (i) provision of sufficient funds for routine and scheduled periodic maintenance; (ii) enforcement of axle-load limits, which otherwise contribute to the premature decline of even those pavements where money was being spent; (iii) preparedness for a significant increase of traffic volumes; and (iv) wise utilization of the available limited funds, with use of new techniques to try and improve efficiency of expenditures, such as maintenance through output and performance based contracting as well as surface dressing.37 3.56. Consequently, the key issue over the medium term would be to maintain the network and to continue strengthening the institutions in the sector. The focus in the transport sector requires a difficult balance between continuing to de-bottleneck the network where economically viable, while also ensuring that sufficient resources are allocated to preserving the assets. This is essentially an economic management problem—putting mechanisms in place to ensure that the costs and benefits of future investments in transport infrastructure are fully evaluated, that capacity to maintain the road network is developed, that the efforts are well coordinated both internally and with Albania’s regional neighbors, and that the work to be done is properly sequenced as part of a fiscally sustainable budgetary envelope. The Port Sector 3.57. Albania is served by two primary deep-sea ports at Durres and Vlora. There are also two secondary ports at Shengjin and Saranda, used mainly by coastal shipping. The Port of Durres is the country’s primary commercial port. It currently handles general cargo, containerized cargo, dry bulk (cereals, minerals, coal, cement, and clinker), liquid bulk, and ferries (passengers and roll-on-roll-off cargo). The liquid bulk handling, however, will be shifted to a new port facility in Puerto Romano. 3.58. The maintenance of equipment, facilities, structures, infrastructure and dredging of the port has generally been neglected and poorly funded both in Durres as well as in other ports. Durres experiences up to around 30 cm of sedimentation each year. Yet maintenance dredging of port access channels and basins is not carried out on a regular basis. The lack of such dredging has resulted in the channel only being available to low draught vessels. Larger vessels cannot enter into the port anymore which has hindered port development and prevented full utilization of the investment made in new 37 These are being piloted in a transport project supported by the World Bank. 49 capacity on berths, storage areas and equipment. In addition, space is constrained and handling capacity limited. 3.59. The port is well connected with the national road and rail network, and could be competitive regionally. The principal access to the port is the Durres-Tirana expressway (constructed in 2001). The main routes for freight transport via road are Durrës-Tirana-Elbasan (and further to the border with FYR Macedonia), Durrës/Tirana-Lezhe-Shkodër-Podgorica in Montenegro, Durrës/Tirana-Vlorë (and further south to the border with Greece), and the important new connection Durrës-Milot-Morine- Kukës to Kosovo. 3.60. In sum, if the port of Durres is to become regionally competitive, it needs to be given adequate resources (or have a public/private partnership) to remove the existing bottlenecks and to improve its services. Trade Facilitation 3.61. Despite considerable progress, customs clearance processes could still be improved significantly. There is not yet a fully paperless system and it is still necessary to submit hard copies of the import declaration forms shortly after the electronic submission. In general, there are few cargo inspections at the border. Instead these are performed at inland clearance points, and there remains a tendency to physically inspect nearly 100 percent of a shipment rather than applying a system of sampling. Risk analysis is not used effectively. In general, customs reform continues to face problems with the implementation of (i) electronic processing of documents; (ii) risk analysis which would allow a focus on high-risk cargo; and (iii) transferring greater responsibility to importers and exporters for clearing their cargoes in a transparent manner. Measures aimed at enhancing customs performance could include: (i) segregation of import and export traffic from third country transit traffic; (ii) simplification of document processing; and (iii) reallocation of border staff at the borders according to both the volume of traffic and the level of risk. 3.62. The logistics industry in the region consists primarily of simple trucking and warehousing services provided by shippers or outsourced to third parties. As the main markets are neighboring countries, shipments involve direct truck movements from point of production to the ultimate buyer, without intermediate storage. Logistics service providers are small and competitive, but make little use of information technology that is a critical dimension of modern integrated logistics services. The sophistication of logistics services will increase, once there is demand and greater specialization in supply chains. In general, even Albania’s “large” trucking companies are small with only a few companies having fleets larger than 25 vehicles. One of the constraints faced by truckers in Albania is the limited number of regional (CEMT) and bilateral permits. There is limited demand for airfreight, as delivery times to the EU, the main market outside the region, are similar between road and air transport. Initiatives to strengthen logistics include (i) increasing the permits available for shipments to EU countries; (ii) improving the conditions for handling consolidated cargoes, as at present customs procedures require clearance of each individual consignment separately; and (iii) the introduction of supply chain management techniques, where competition does not focus exclusively on price. 50 CHAPTER 4: PUBLIC INSTITUTIONS AND GOVERNANCE FOR INVESTMENT I. INTRODUCTION 4.1. This chapter examines the role of public institutions and governance in determining investor sentiment and behavior. The previous two chapters underlined the significance of human capital and physical infrastructure for investment and economic growth. This chapter discusses how public institutions and governance affect the level and certainty surrounding the returns on private investments and by extension their impact on overall economic growth. 4.2. Uncertainty lowers the returns to investment, so investment will be increased if firms can be relatively certain of the current and future investment climate. In general, potential sources of uncertainty come from: existing and future tax rates, uncertainty about the possibility of bribes and informal payments, changes in laws and regulations or in their application, anti-competitive practices by incumbent firms, uncertainty about the price and availability of key inputs (particularly from public infrastructure), and uncertainty about the enforceability of property rights (particularly land and commercial contracts). All of these items may be summarized as being part of the “soft infrastructure” of the economy “consisting of institutions, regulations, social capital, value systems and other social and economic arrangements” (Lin, 2009a). Firms which try to move into new products (or technology) face the uncertainty of the cost structures that they will face. In such environment, entrepreneurs focus on investments that can yield large profits very quickly.38 This may not be optimal from the perspective of longer run economic growth. Accordingly, the rest of this chapter will assess the level of development of Albania’s soft infrastructure, its perception by firms, and will offer recommendations as to what may be done to strengthen the certainty of the investment climate. II. GOVERNANCE AND THE INVESTMENT CLIMATE 4.3. Albania has seen major improvements in its investment climate in recent years. This is a reflection of the strong focus of the government programs in this area. As a result, Albania has made notable achievements: its ranking in the World Bank’s Ease of Doing Business Indicators improved from 136th in 2007 to 82nd in 2009. Among the most important reforms include: i) introducing a flat (10 percent) tax on businesses and individuals, and improving tax administration, ii) simplifying the establishment of a business by the creation of a one-stop shop (the National Registration Centre) which has streamlined the process and reduced time for starting a new business, iii) reducing time for registration of land transfers from 47 to 30 days for properties not previously registered, 38 This is very closely linked to the difficulties of transferring technology and know-how from foreign investment as there is often an implicit assumption that technology is simply a set of information which can be transferred. However, there is strong theoretical and empirical evidence that in countries that are far from the production frontier (as is Albania) the discovery of cost structures is itself costly and requires investment. In turn, there is a risk of losing the investment if costs prove to be unsustainable or, alternatively, profits may be quickly eroded if costs do not decline. See Hausmann and Rodrik (2003) on the theoretical approach and Amsden (2001) on the empirical experience of technology transfer. 51 iv) introducing new procurement and concessions laws, v) modernizing customs systems, vi) establishing a public credit registry, and vii) strengthening investor protection through a new company law and the approval of a new bankruptcy law. 4.4. The measures above are part of a comprehensive regulatory reform strategy initiated in 2005. It includes policies that are still being implemented, such as the introduction of Regulatory Impact Assessment (likely to begin in 2011) and a reform of inspections and licensing. These reforms, in addition to those described in the previous two chapters, undoubtedly contributed to the high economic growth rates. Nonetheless, the evidence examined in this chapter suggests that as the economy has developed, so have the expectations of business whose needs are increasingly focused on the predictability of the investment climate. 4.5. Despite the important reforms carried out so far, there appear to be factors that make private investment uncertain, hence less attractive. The findings of the Investment Climate Survey (ICS) and of the 2008 BEEPS provide some clues (Figure 4.1). In the 2008 BEEPS the five most important obstacles to doing business were: electricity (cited by 81 percent of enterprises), corruption (66%), tax rates (62%), telecommunications (56%) and skills and education of workers (53%) (See Figure 3.1, right panel). In the ICS, the five top constraints to investment were electricity (38%), informality (15%), political instability (7%), corruption (7%) and tax rates (7%).39 4.6. It should of course also be noted however that after the surveys were conducted the government made major improvement in the electricity supply. In addition, tax rates are probably the least problematic despite the high scores. It is notable that the proportion of firms perceiving tax rates as an obstacle has declined considerably since 2005 (when 84% reported this as a problem) and is one of the lowest among transition economies. Similarly, there has been much improvement in a number of indicators when comparing the 2005 BEEPS and the 2008 BEEPS, such as in the functioning of courts. 4.7. After the input factor constraints (infrastructure and human capital), which were discussed in the previous two chapters, the ICAs also show areas for improvement in public institutions and the extent to which enterprises can be certain of the “rules of the game”. The ICA surveys suggest that even with the significant progress in the investment climate and in overall governance, there is still considerable room for improvement, particularly when compared with other transition countries. For example, among the sources of uncertainty are arbitrary changes in regulations (which are often inconsistent with other laws) and the lack of due process for the approval of regulations and laws, as well as frequent changing of public officials, who are often themselves unfamiliar with the rules. Indeed many entrepreneurs argue that such changes generate considerable uncertainty and increase the perceived risks for investments. This is despite the fact that corruption, as measured by the extent of bribe taking and giving, has diminished significantly (in the 2009 ICS only 37 percent of firms reported that it was necessary to make informal payments to get things done, down from 76 percent in 2002 and 58 percent in 39 There are two methodological differences between the BEEPS and the ICS surveys. The first is that BEEPS refers to obstacles to doing business in a broad sense while the ICS refers to obstacles to investment. The second is that in the BEEPS survey enterprises may list all the issues which they consider to be obstacles for doing business while in the ICS each enterprise could name only the principal obstacle they are facing. 52 2007).40 These differences are also evident in the progress between the 2005 and 2008 BEEPS surveys (Figure 4.2). Indeed, these surveys show that Albania has made remarkable progress even though it still ranks behind some of the other countries in the region. Clearly, these are positive developments in which it is necessary to build further. Figure 4.1: BEEPS 2005 and 2008: Percentage of Firms Indicating a Problem 2005 2008   8 4% 6 2% T ax ra tes T ax ra tes 7 1% 66 % C o rrup tion C o rrup tion Sk ill s a nd e du ca tion 39 % Sk ill s a nd e du ca tion 53 % o f wo rk ers o f wo rk ers 6 2% 8 1% E lec tric ity E lec tric ity 45 % 41% A cc es s to fin an ci ng A cc es s to fin an ci ng C rim e, t he ft a nd 21% C rim e, t he ft a nd 35 % di sorder di sorder 6 5% 4 5% T a x ad m ini st ra tio n T a x ad m ini st ra tio n 21% 5 6% T e le co m m un ic atio ns T e le co m m un ic atio ns 58 % 39 % C o urt s C o urt s 2 6% 4 3% A cc es s to la nd A cc es s to la nd B us ine ss li ce ns es 38 % B us ine ss li ce ns es 31% a nd p erm its a nd p erm its 27 % 33 % T ra ns po rt T ra ns po rt 29 % 29 % La bo r reg ul atio ns La bo r reg ul atio ns C us to m s a nd tra de 5 5% C us to m s a nd tra de 3 0% reg ula t io n s reg ula t io n s A lb A lb 0% 2 5% 5 0% 75 % 10 0 % 0% 2 5% 5 0% 75 % 10 0 % SEE SEE EC A EC A Note: Europe and Central Asia (ECA) comprises all transition economies and Turkey. Source: BEEPS 2008. III. IMPLEMENTATION OF THE LEGAL FRAMEWORK 4.8. One of the critical issues for firms is the effectiveness with which public institutions implement existing laws and regulations. Albania shows a degree of regulation (formal rules as expressed by the percentile ranking of the Doing Business indicator) consistent with a country of its GDP per capita (Figure 4.3 (a)). However, implementation practices measured by the Worldwide Governance Indicators (WGI) 2008 are below what is expected of a country at its stage of development (Figure 4.3 (b)).41 In other cases, the improvements to the business environment have come mostly through changing 40 Albania has also improved significantly in the Transparency International Corruption index, rising from 111th place out of 180 countries in 2006 to 85th place in 2008. 41 The Worldwide Governance Indicators are aggregates of numerous sources and surveys which assess governance over six dimensions: voice and accountability, political stability and absence of violence, government effectiveness, regulatory quality, rule of law, and control of corruption. The overall rating is a composite of the six dimensions and allows the ranking of countries according to the quality of governance. The indicators for 2008 are published in Kaufmann, Kraay, and Mastruzzi, 2009. 53 the legal framework (in particular simplifying procedures to start a business and introducing effective bankruptcy legislation), but this implementation gap between the formal framework and the practice is ultimately what matters when making investment decisions. Figure 4.2: Bribe Frequency and Bribe Size – Cross Country Evidence from BEEPS Surveys Source: BEEPS42 Figure 4.3: Formal Regulation, Implementation Practices and Income Levels (a) GDP per capita and formal regulation (b) GDP per capita and implementation practices GBR DNK DNK Georgia IRL SWE FIN CHE AUT ISL NLD FIN ISL SWE DEU GBR CHE IRL BEL FRA EST DEU BEL LTU LVA Macedonia, FYR AUT FRA NLD Slovenia EST PRT ESP Azerbaijan CZE 80 KGZ Armenia Bulgaria 80 SVK HUN HUNPRT SVK GRC Romania Slovenia LVA LTU POL BLR ITA ESP Croatia KAZ Montenegro TUR POL Montenegro Bulgaria TUR 60 Doing Business CZE Georgia ITA 60 Romania Albania Serbia Macedonia, FYR Armenia WGI Moldova Serbia Croatia B&H 40 B&H GRC 40 Albania RUS Moldova Ukraine RUS KAZ Azerbaijan Ukraine 20 UZB 20 UZB TJK KGZ TJK BLR 0 0 5 6 7 8 9 10 5 6 7 8 9 10 Log GDP per capita (PPP) Log GDP per capita (PPP) Note: Indicator of formal regulation is the percentile Note: Implementation practice refers to average of ranking on 2010 Doing Business, GDP per capita refers government effectiveness and rule of law indicator of to 2008. World Governance Indicators, 2008. 42 Adapted from the forthcoming BEEPS IV Report: Corruption and Regulatory Burden in ECA. 54 4.9. Similarly, the governance indicators suggest that in the areas which affect investment, such as the rule of law and corruption, Albania scores lower than other countries in the Balkan region. Specifically, the WGI note that major progress has been made in the application of the rule of law in Albania, but the country still lags behind in regional terms (Figure 4.5). Where the rule of law is ineffective and firms are subject to arbitrary decisions by officials, firm management will have to spend more time and resources than would otherwise be the case in dealing with officials to obtain favorable decisions. That said, it is important to note that rule of law indicators have been improving sharply (Figure 4.4), which is consistent with the evidence shown earlier from BEEPS surveys. 4.10. Perhaps not surprisingly, the perception of corruption among the public is diminishing. In its annual survey of corruption, the Institute for Development Research Alternatives (IDRA, 2009) found that the proportion of the public reporting corruption among officials as “widespread” had fallen from two thirds in 2005 to half in 2009. Customs officials and tax officials are viewed as the most corrupt with 72 percent and 69 percent perceiving them to be corrupt, but this was notably lower than the corresponding figures for 2005 (87% and 83%). 4.11. Still, an area where more improvement seems to be needed is in the implementation of the legal framework. There are indeed many areas of overlapping and contradictory legislation. This is particularly the case with respect to the registration and property rights related to land where officials are required to interpret the law. This can result in inconsistencies and apparently arbitrary decisions, which undermine the rule of law (Box 4.1). Figure 4.4: World Governance Indicators for Figure 4.5: Regional Comparison on Selected WGI Albania Sub-Indicators   Note: The six governance indicators are measured in units ranging from -2.5 to 2.5 with higher values corresponding to better governance outcomes. Source: www.govindicators.org. 55 Box 4.1: Arbitrary Decisions and Uncoordinated Actions Below are a few brief examples of cases in which arbitrary or uncoordinated decisions are taken and which tend to undermine the integrity of the legal framework and the confidence that businesses may have in laws being upheld and enforced. Enforcement of Bankruptcy Law The Directorate of Taxation launched automatic bankruptcy proceedings against 27 businesses in 2009, including foreign owned business. Bankruptcy proceedings were launched under the Tax Procedural Code adopted in May 2008 which states that a company which has a negative net income for three consecutive years is automatically deemed bankrupt. The proceedings were withdrawn following explanations from the companies concerned. Although the tax authority was willing to rectify the situation, the launch of the proceedings in the first place raised concerns about arbitrary government actions. The Tax Directorate acted without proper consultation to determine the facts of the situation. The Finance Ministry itself accused the Tax Directorate of failing to follow proper procedure by not applying Article 104 in of the 2002 Bankruptcy Law. The Law requires a review of the ability of a company to pay its debt as an essential precondition for the initiation of bankruptcy proceedings. If this has been done, neither company would have qualified for the initiation of bankruptcy proceedings. An incomplete Bankruptcy Law The Bankruptcy Law was amended in 2008 and provision made for a national agency (authority) to deal with bankruptcy cases. The Agency has not been established yet. According to the EC 2009 progress report "no cases of implementation of the Bankruptcy Law were reported. Bankruptcy procedures are still not used, which hampers the efficiency of market mechanisms" Use of reference prices, wages and employees As part of the drive to increase tax collection, there is widespread use of reference prices (for imports) wages (for personal taxes and social security contributions) and even numbers of employees (for taxes and social security contributions). While the intent is apparently to reduce informality and tax evasion, the effect is to make taxation decisions more arbitrary and subject to the decisions of individual officials. It also implies that the tax system is becoming less rule based and more dependent on an arbitrary patchwork of norms. Difficulty in refunding VAT In order to raise revenues the government often refuses to refund VAT to enterprises which have overpaid VAT or are entitled to refunds on exports. The decision is arbitrary and has no legal basis. The effect is to undermine confidence in the administration of the tax system.  Land and Property Market 4.12. One aspect of the rule of law which is of particular importance concerns the property market. The kinds of problems that can present impediments to the efficient running of a property market include lack of legal documents, overlapping claims, a slow and unpredictable court system, and lack of coordination among government agencies. In Albania, the peri-urban areas seem to present the most challenges, particularly where property owners have not taken part in the legalization process. There are also significant contradictions in the legal frameworks governing restitution of property, its registration and the initial privatization of property which imply that property rights in land are subject to both contradictions and uncertainty pending the possible overhaul of the entire legal framework. 4.13. As a result of the uncertainty surrounding decisions on property ownership, many transactions of property occur outside the formal legal framework. When property disputes arise, and there are many now reaching the courts, there is no clear means of resolving them. While some businesses are willing to take the risk in the expectation that the problems will eventually be resolved, others, 56 particularly foreign investors, are deterred from making investments. In the 2008 BEEPS 43 percent of firms reported access to land as a major problem, compared with only 26 percent in 2005, which is higher than in other countries in the region. 4.14. While the legal framework for immovable property (which covers contracts, transactions, registration, administration and planning) appears to be adequate, the practice shows it is not operating fully. It is estimated that up to one third of all buildings in Albania are illegal due to the occupier’s lack of clear title to the land and/or lack of an appropriate construction permit. 4.15. Legalization of land occupancy and buildings constructed without permits is a critical process, which could clarify ownership and remove some of the obstacles to the efficient running of the property market. The implementing agency – ALUIZNI – is well resourced, but has completed less than a third of the applications for legalization submitted so far. Meanwhile illegal occupation and construction appears to be continuing, and indeed is encouraged by the protracted legalization process. Illegal occupation and construction falls into many sub-categories, such as squatting on private or state land, encroachments onto privately owned land, absence of building permits, and breaches of construction permits. Many buildings in Tirana are regarded as illegal (restricted) because they have unauthorized extensions, preventing them from being sold or used as collateral. Failure or inability to act decisively to prevent illegal occupation and construction has led to the continuation of these practices, now noticeable in coastal areas that have high tourism potential. Demolition of illegally constructed buildings remains problematic, with responsibility for much of the work lying with municipalities, which are under- resourced and inexperienced in this area. 4.16. Without a comprehensive legal settlement process on land issues, together with a credible commitment to enforce settlements, land availability and investment will continue to be constrained. Lack of clarity for property rights in land affects all other areas of property rights through a general reduction in the credibility of the rule of law and legal institutions. Predictability and Stability of Regulations 4.17. The extent to which public officials are able to uphold the rule of law is partly related to capacity and personnel management. Despite much of the improvement noted earlier, there is a perception among firms and the general public that arbitrary decisions by officials are evidence of rent seeking and corruption. However, the problem may be as much an issue of limited management capacity, unclear procedures, and a lack of understanding by many officials of the purpose of laws and regulations exacerbated by high turnover of civil servants within the administration. 4.18. Notwithstanding the source of their origin, surveys of firms point to the key issues that added most to costs and uncertainty. These were: the introduction of new laws and regulations with immediate effect, without prior training of officials or prior information to enterprises to allow smooth compliance; the lack of consultation prior to enacting regulations; the enactment of laws and regulations which contradict existing laws and therefore require official interpretation; the lack of mechanisms to appeal administrative decisions; a general lack of confidence in the judicial system; and the unwillingness of officials to abide by judicial rulings. In the ICS survey, more than 70 percent of firms disagreed with the proposition that public officials’ interpretations of the laws and regulations are consistent and predictable. Essentially, this is seen as a major binding constraint for firms’ decision-making regarding long-term investment. 57 Figure 4.6: Perception of Consistent and Predictable Interpretations of Laws and Regulations governm ent officials interpretations of the Strongly diasgree law s and regulations are consistent and predictable large strongly agree medium tend to agree tend to small disagree strongly micro disagree 0 10 20 30 40 50 0 10 20 30 40 50 60 percent of firm s percent of firm s Source: Investment Climate Survey, 2008. 4.19. The evidence also suggests that micro firms and SMEs are on average significantly more affected by inconsistency and unpredictability of officials’ interpretations of the laws and regulations (Figure 4.6). In 2007-08, senior management of firms spent on average 18 percent of their time on dealing with requirements imposed by government and about a third of firms spend more than 25 percent of their time on the former (although interestingly larger firms tended to dedicate more management time than smaller ones). In addition, the burden appears greater for exporters which tend to spend on average 27 percent of their time dealing with legal requirements. 4.20. The burden on businesses stems from informal enforcement practices, including inconsistent and unpredictable interpretation of regulations or arbitrary enforcement by the judicial system. The distortions imposed by informal regulatory practices lead to the imposition of a “time tax” and a “bribe tax” on firms, as they expend time and money to deal with government officials in order to increase the chances that regulations are favorably interpreted. This both raises operational costs and reduces time horizons for investment. The more unstable the environment, the more uncertain are future returns, and hence the more heavily they are discounted. Even when the intention is not to extract rents but simply to implement policy, the effect is to produce an environment in which corruption can flourish. The Rule of Law and the EU Accession Process 4.21. The implementation and enforcement of the legal framework has acquired additional significance in the context of the EU accession process. In the latest progress report issued by the European Commission on Albania’s path to EU membership, the EC (European Commission, 2009) states that the key barriers that emerge are precisely in the area of the rule of law and property rights. The report notes for example “a tendency by the executive to exert control over independent institutions, in particular the judiciary, raised concerns”. It also emphasizes the importance that is attached to ensuring that judicial proceedings can be effectively instituted against anyone regardless of position held in order to ensure the credibility of the fight against corruption. The report concludes that judicial reform remains at an early stage, and that the justice system continues to function poorly due to shortcomings in independence, transparency and efficiency. 4.22. To make progress in Albania’s EU accession aspirations the country needs to place a stronger emphasis on the implementation of laws and on strengthening the quality of its institutions. The EC progress report for Albania notes in numerous areas that although legislation has 58 been approved, the necessary implementing regulations have not; also, enforcement is at times lacking. It notes for example that neither initial property registration nor an inventory of state land earmarked for compensation have been completed, and that unresolved issues regarding the compensation of former owners continues to hamper progress. Then, in the area of tax policy, the report draws attention to the need for consultations with business and civil society “to avoid the uncertainties resulting from frequent changes to the legislative framework.” 4.23. The EU’s assessment also notes that overall little progress has been made in improving the public administration. It reports particularly that the Civil Service Law is undermined by the large number of contract employees and the politicization of appointments. It concludes that further progress is needed to establish an independent merit-based and professional civil service. The ICA complements the importance of this finding by showing that: (i) firm productivity is negatively affected by problems with the efficiency of courts, the extent of corruption, and time consuming relations with bureaucracy; (ii) exporting firms are more likely to be negatively affected by a lack of predictability over enforcement of rules and the time required to comply with regulations; and (iii) employment creation is negatively affected by the lengthy process of compliance with government regulations. 4.24. Meeting the EU standards in terms of the rule of law and the quality of public institutions will in turn stimulate investment and growth. The benefits of EU accession lie as much in the improvements in institutions and the quality of government as in the direct benefits of market integration and financial resources available from the EU. As progress is made, the economic benefits of these reforms will be felt even prior to EU membership. Thus, as the government continues to make progress in these areas, businesses will start to enjoy the benefits of institutional reforms in the form of increased investment and economic opportunities. It should be clear however that moving towards EU membership requires that real progress is made (as opposed to only reforms of the legal framework). Indeed, it is the actual implementation what will be assessed for EU membership. Slow progress may, in addition to slowing the EU accession process, provide a negative signal to both domestic and foreign investors as to Albania’s investment climate. IV. RECOMMENDATIONS 4.25. Albania has made major progress in improving public sector governance and the investment climate in recent years. The effect of the government actions has been confirmed by surveys of Albanian firms. However, a gap remains between Albania and more successful countries in the region, so intensifying the focus on these areas should be a high priority, both because of the positive impact on investment and growth, and its crucial role for successful integration with the EU. Probably one of the key issues to be addressed to reduce the costs and uncertainty of investment is that of ensuring that the public institutions and their officials adhere to and enforce the laws and regulations—and, more importantly, that they are also perceived as doing so. The recommendations of this report are:  Improve the clarity on the processes for enacting new laws and regulations and for reviewing the efficacy of existing ones. This could be accomplished through boosting the role of the Regulatory Reform Task Force (RRTF), which has a mandate to formulate and monitor regulatory reform plans, and giving it a permanent structure under the direct responsibility of the Prime Minister’s office. In addition, completing the inspection reform and establishing a fully functional system of Regulatory Impact Analysis (RIA) is important. However while both these measures are necessary, the first may have little impact on its own, while the second may take considerable time.  Review the process whereby policy decisions are taken and translated into law. This would mean that, in addition to the regulatory impact assessment, new proposals are also 59 assessed for their consistency with the existing legal framework. Moreover, the complexity of implementation should be realistically assessed. This would help to ensure that the necessary time and administrative resources are available before new legislation is enacted and that adequate timetables for the elaboration of implementing regulations are in place.  Establish regular consultations between the private sector and the government on all important measures that affect businesses. In addition, the government should have a statutory duty to publish a summary of issues raised by the private sector and how these will be dealt with if the new legislation were to be enacted. Such a mechanism would be a prerequisite for both the effective functioning of the RRTF and the establishment of an effective RIA process. It would have the effect of sensitizing officials to potential problems with new legislation (and possibly avoiding conflicts with existing legislation).  Establish an administrative appeals tribunal. This would give those adversely affected by decisions of public institutions the possibility of appealing them. It would go a long way to resolving the feeling that individuals and enterprises have no means of appealing against government decisions, even when these appear to contradict the laws and regulations.  Improve the consultation process and the enforcement of the decisions of the administrative appeal tribunal. 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