Mission Concluding Statement 

Albania: Staff Concluding Statement of the 2022 Article IV Mission

October 10, 2022

The Albanian economy has weathered multiple shocks since 2019 relatively well. Although Albania’s direct exposures to Russia’s war in Ukraine are limited, with twin deficits and high government debt, Albania now faces challenges stemming from soaring international food and energy prices, tighter global financial conditions which are likely to persist, and the economic slowdown in Europe. Prudent policy and vigilance are required to stem rising risks and entrench the positive momentum in the economy.

• Fiscal consolidation, underpinned by a sound Medium-Term Revenue Strategy, is vital for rebuilding room for policy maneuver and reducing demand pressure. Fiscal support should be temporary and targeted to the vulnerable. Strengthening the efficiency and credibility of public finances remains crucial for preserving market confidence and mitigating higher borrowing costs
• Further monetary tightening is needed to tame inflation. Higher interest rates and the changing landscape of the financial system call for enhanced vigilance to safeguard financial stability.
• Even as Albania grapples with pressing short-term challenges, the authorities need to step up their efforts on structural reforms to lift Albania’s potential for sustainable and inclusive growth.

Outlook

Following a strong rebound in 2021, the Albanian economy has maintained positive momentum this year despite the shock to the global economy from Russia’s war in Ukraine. We project the economy to grow by 3.7 percent in 2022 on the back of robust activity in tourism, real estate, and services. Growth is projected to slow to around 2 percent in 2023, reflecting tighter financial conditions, the slowdown in Europe, and the necessary withdrawal of policy support.

Inflation has risen sharply and has become increasingly broad-based. Headline inflation is expected to peak in the coming months, only beginning to recede in 2023 before returning to the Bank of Albania’s (BoA) target of 3 percent by mid-2024, as international commodity prices stabilize, fiscal and monetary policies tighten, and growth slows. Our current projections assume that the monetary policy rate will rise to 3-3.5 percent in 2022 and 4-4.5 percent in 2023.

The outlook is subject to considerable uncertainty and risks are tilted to the downside. International food and energy prices could further increase. Higher and more persistent inflation could further weigh on real income and weaken growth prospects. Drastic tightening in global financial conditions could hamper Albania’s access to financing. The economy is also vulnerable to unfavorable weather conditions and reversal in the rise of real estate prices.

Policy Priorities

Fiscal policy needs to rebuild buffers fast—based on raising tax revenue—and reduce demand pressure while providing targeted and temporary support to shield the vulnerable from the impact of the rising cost of living.

With last year’s economic rebound, the government has rightly embarked on fiscal consolidation. We support the July budget revision which provided additional targeted assistance to the vulnerable and reduced the deficit target. Public debt is projected to decline further to about 68 percent of GDP in 2022. Any higher-than-expected revenue should be saved for faster debt reduction.

Given Albania’s high public debt, large gross financing needs, and rising borrowing costs, the government needs to take advantage of the still positive momentum to rebuild fiscal policy buffers fast. This would also reduce the pressure on monetary policy to raise interest rates even more to tame inflation and facilitate external adjustment. To this end, we recommend the government to aim for at least a zero primary balance in 2023, hitting the requirement in the Organic Budget Law one year ahead of time, and reach a primary surplus of 1.5 percent GDP by 2024. If downside risks were to materialize, automatic stabilizers should be allowed to operate and further temporary, targeted support to the vulnerable should be deployed.

The fiscal consolidation needs to be underpinned by a sound Medium-Term Revenue Strategy (MTRS) to raise tax revenue, which is among the lowest in percent of GDP in the region. Given the prospect of elevated inflation in 2023, raising more tax revenue would create room for further targeted and temporary assistance to the vulnerable without increasing the budget deficit target. For the longer term, higher revenue is also necessary to support Albania’s development needs. We urge the authorities to finalize and implement the MTRS without further delay. The strategy should be designed and seen as the blueprint of Albania’s tax reforms, replacing the hitherto piecemeal approach to tax policy changes. Beyond the revenue gains, the stability and predictability of the tax system will make revenue administration easier and help improve the business environment. In this context, we reiterate our concerns on the proposed tax amnesty law, given money laundering and governance risks as well as the adverse impact on tax compliance.

The authorities are encouraged to fully leverage the existing social protection framework to better target and improve the coverage of support to ensure adequate access for those who need it the most. While existing social protection structures have worked relatively well, more can be done to further improve their effectiveness and reach.

Strengthening the efficiency and credibility of public finances remains crucial for preserving market confidence and mitigating higher borrowing costs

Reforms are needed to align Public Investment Management (PIM) and Public Private Partnership (PPP) processes, with full integration into the normal budget cycle. We call for redoubling efforts to strengthen the Ministry of Finance and Economy’s (MOFE) capacity to play the role of an effective gatekeeper role in project selection and to engage actively in evaluation and monitoring. We look forward to the authorities’ third Public Finance Management (PFM) strategy, which will address incomplete reforms and setbacks in commitment controls and arrears prevention, as well as paving the way for incorporating green PFM practices. We welcome the progress made in enhancing coordination of cash and debt management and highlight the importance of an effective implementation of the latest debt management strategy. In addition, efforts to monitor, assess, and manage fiscal risks should be stepped up and capacity in this area be further enhanced.

All public projects need to be subject to the public investment and procurement frameworks. The authorities are urged to publish public procurement contracts pertaining to pandemic and earthquake recovery spending, the names of awarded companies, and their beneficial owners. We reiterate the need to minimize the use of normative acts to alter the budget.

The volatility in the global energy market has underlined the urgency of decisive reforms to bring the electricity sector to financial viability and reduce fiscal risks. Broad-based subsidies should be removed as they benefit disproportionately those who are better off and hinder price signals. Gradual tariff adjustments to cost recovery levels are critical and must be complemented with measures to support the vulnerable. It is also critical to enhance the electricity sector’s transparency and state-owned enterprises (SOEs) corporate governance.

Monetary policy should continue to raise interest rates while being nimble and data-driven

We support the monetary policy normalization undertaken by the BoA. Monetary conditions are still accommodative despite the consecutive policy rate increases, as real policy rates remain deeply negative reflecting rising underlying inflation and inflation expectations. With risks to the inflation outlook on the upside, monetary tightening needs to be frontloaded and further interest rate increases are warranted. Acting firmly now will help prevent a wage-price spiral, reduce the risk of inflation expectations becoming unanchored, and avoid excessive delay in tightening which may later warrant much higher rate increases. The BoA also needs to be prepared to raise the policy rate to above its estimated neutral rate if inflationary pressure does not abate. The strategy governing the pace and size of tightening should be well communicated.

Given the high uncertainty, the pace and timing of the tightening cycle need to consider evolving economic conditions. Sustained higher global commodity prices would require stronger tightening to limit second-round effects and keep inflation expectation anchored. Slower growth, faster fiscal consolidation, or a stronger reaction of core inflation to policy rate increases would instead support a more gradual tightening or an earlier pause in the tightening cycle. The exchange rate should remain flexible and continue to perform its role as a shock absorber. Sizable exchange rate depreciations (appreciations), which could be affected by the size and pace of tightening of major central banks, would require larger (smaller) monetary policy tightening.

Enhanced vigilance is vital to safeguard financial stability, as monetary conditions tighten and the financial landscape continues to change

The banking system has weathered the consecutive shocks relatively well, supported by the BoA’s ongoing efforts to strengthen regulation and supervision. But the full impact of the shocks may only become visible on bank balance sheets over time, and banks are susceptible to credit, interest rate, and exchange rate risks.

The BoA needs to continue to strengthen risk-based on-site and off-site inspections and complete focused asset quality reviews. Its ongoing efforts to enhance bank capital buffers are welcome. We call for close monitoring and management of potential risks from the robust credit growth in recent years, including rising FX lending. In this context, we welcome the BoA’s efforts to address significant data gaps on real estate and construction and call for enhanced surveillance of this sector’s impact on financial stability. Beyond the BoA’s remit, the insolvency and resolution frameworks already in force should be swiftly implemented, including out-of-court loan restructuring, to prepare for any large increases in NPLs. The long-standing impasse in bailiff reform should also be resolved.

Improving supervision and regulation, aligned with EU standards, would provide the authorities with tools to better manage financial stability risks. The presence of banks with significant shareholding by individuals and non-financial groups raises the risk of capital shortfalls, related-party transactions, and large exposures. Ensuring that market entrants have strong banking experience and meet fit and proper criteria on an ongoing basis (including their significant shareholders and controllers, beneficial owners, and senior managers) to operate in the Albanian financial system will be critical. In this context, it is important for the BoA to implement enhanced bank licensing and supervisory framework and for authorities to apply pertinent competition rules.

With the start of EU accession negotiations, efforts to strengthen governance and institutions have acquired added significance, and should be stepped up, even as Albania grapples with pressing short-term challenges

We note the progress made in the vetting of judges, other judicial officials, and prosecutors, and the authorities’ objective to keep up the pace to ensure completion by the December 2024 constitutional deadline. Measures to improve the efficiency of courts are underway, including multifaceted efforts to address shortages of qualified judges and prosecutors. We note that the review of the Anticorruption Strategy has been completed and look forward to the completion and publication of a revised strategy and action plan, expected by end of this year, after an open process of public consultations.

Albania is making progress in implementing the FATF action plan and needs to expedite efforts to address the remaining issues in order to exit FATF’s enhanced monitoring (FATF's “grey listing”). The authorities are also strongly encouraged to ensure that any new policies with potential financial integrity implications are aligned with guidance issued by FATF and MONEYVAL.

Albania needs to adapt its economy to climate change. The importance of agriculture, Albania's reliance on hydroelectricity, and its transformation into a tourism-dependent economy leave it vulnerable to the impact of climate change. Adaptation needs to be an integral part of government policy and planning. The adoption of green PFM practices and the MTRS can help finance adaptation costs and meet Albania’s climate goal of becoming carbon neutral by 2050.

We would like to thank the Albanian authorities and all our other counterparts for the close collaboration and constructive exchange of views.