World Bank Document

Document of The World Bank

FOR OFFICIAL USE ONLY Public Disclosure Authorized

Report No. 41 209 -XK

INTERNATIONAL DEVELOPMENT ASSOCIATION

INTERIM STRATEGY NOTE Public Disclosure Authorized FOR

KOSOVO

FOR THE PERIOD FYOS

November 9,2007 Public Disclosure Authorized

South East Europe Country Unit Europe and Central Asia Region Public Disclosure Authorized

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be disclosed without World Bank Authorization The date of the last Interim Strategy Note: March 30,2006

CURRENCY EQUIVALENTS (Exchange Rate Effective November 9,2007)

Currency Unit = Euro €1 = 1.45US$ US$1 =€0.68

GOVERNMENT’S FISCAL YEAR January 1 - December 3 1

ABBREVIATIONS AND ACRONYMS

AAA Analytical and Advisory Assistance ADA Austrian Development Agency AMIK Association of Microfinance Institutions in Kosovo BEEPS Business Environment and Enterprise Performance Survey BETA Business Environment Technical Assistance CBAK Central Banking Authority of Kosovo CRLP Clean-up and Land Reclamation Project DCC Donor Coordination Center DFID Department for International Development DP Development Partners EAR European Agency for Reconstruction EC European Commission ECA Europe and Central Asia EFSE European Fund for South-East Europe EPIP Education Participation Improvement Project ESTAP Energy Sector Technical Assistance Project EU European Union FDI Foreign Direct Investment FPSG Fiscal Policy Support Grant FSFA Financial Sector Fiduciary Assessment GDP Gross Domestic Product GTZ German Technical Co-operation HPD Housing Property Directorate IDA International Development Association IFC International Finance Corporation ILO International Labor Organization IMF International Monetary Fund ISN Interim Strategy Note IPA Instrument for Pre-accession KBA Kosovo Bankers’ Association KCB Kosovo Consolidated Budget KDSP Kosovo Development Strategy and Plan KEK Energy Corporation of Kosovo KFOR Kosovo Force (NATO) KfW German Development Bank KPA Kosovo Poverty Assessment FOR OFFICIAL USE ONLY KTA Kosovo Trust Agency LPTAP Lignite Power Technical Assistance Project MEST Ministry of Education, Science and Technology MFI Micro-finance Institutions MIGA Multilateral Investment Guarantee Agency MTEF Medium-Term Expenditure Framework NATO North Atlantic Treaty Organization NBFI Non-Banking Financial lnstitutions NGO Non-Governmental Organization OSCE Organization for Security and Cooperation in Europe PEMTAG Public Expenditure Management Technical Assistance Grant PEFA Public Expenditure and Financial Accountability PFM Public Financial Management PISG Provisional Institutions of Self-Government POE Publicly Owned Enterprises PTK Post and Telecommunication Company RTK Radio Television of Kosovo SAP Stabilization and Association Process SESA Strategic Environmental and Social Assessment SFRYPAYG Socialist Federal Republic of Yugoslavia Pay-As-You-Go STM Stabilization and Association Process Tracking Mechanism SRSG Special Representative of the Secretary-General SWAP Sector Wide Approach TSS Transitional Support Strategy UN UnitedNations UNMIK United Nations Interim Administration Mission in Kosovo UNSG United Nations Secretary General UNSC United Nations Security Council USAID United States Agency for International Development VAT Value Added Tax

Vice President: Shigeo Katsu Country Director: Orsalia Kalantzopoulos Task Team Leader: Ranjit Nayak, Bruce Courtney Lead Economist: Ardo Hansson

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.

TABLE OF CONTENTS

EXECUTIVE SUMMARY ...... i

I. INTRODUCTION ...... 1

I1. POLITICAL. ECONOMIC AND SOCIAL CONTEXT ...... 1 A . Political Environment ...... 1 B. Economic Environment ...... 2 C . Socio-economic Environment...... 4 D. Governance Issues ...... 5 E. Media and Civil Society ...... 6

I11. KOSOVO’S KEY DEVELOPMENT CHALLENGES ...... 7 A . Fiscal Sustainability ...... 7 B. Structural Policies for Growth ...... 7 C. Education ...... 8 D. Financial Sector ...... 9

IV. PROGRESS UNDER PREVIOUS PROGRAMS AND LESSONS LEARNED ...... 9 A . World Bank Support Since 1999 ...... 9 B. Current Portfolio ...... 10 C . Other Donor Support ...... 11 D. Lessons Learned ...... 12

V . WORLD BANK ASSISTANCE STRATEGY ...... 13 A . Education Innovation...... 13 B . Financial Sector Technical Assistance ...... 14 C. Risks...... 15

Tables Table 1: Main Economic Indicators. 2004-07 ...... 3 Table 2: Kosovo Proposed Grant Program (July 2007 .June 2008) ...... 15

Annexes Annex 1 .Implementation of FY06- FY07 ISN Results Matrix ...... 17 Annex 2 .Kosovo At A Glance ...... 19 Annex 3 - Selected Indicators of Bank Portfolio and Management...... 21 Annex 4 - Summary ofNonlending Services ...... 22 Annex 5 - IDA Operations Portfolio ...... 23

EXECUTIVE SUMMARY

1. This Interim Strategy Note (ISN) covers the period of FY08. In the event that a change in the status of Kosovo takes place during this period, preparation of a successor strategy would begin depending on the clarity of the relationship between a post-status Kosovo and the World Bank Group.’ This ISN builds on the previous ISN (FY06 - FY07) and the Transitional Support Strategy (FY04 - FY05). Both of these strategies shifted focus from post-conflict reconstruction towards ensuring KOSOVO’Slong-term economic development. This ISN is also compatible with the Draft 2007 Kosovo Development Strategy and Plan (KDSP) and the 2008-10 Medium Term Expenditure Framework (MTEF) prepared by the Kosovo Authorities*. ii. Parliamentary and municipal elections have been called for November 17, 2007. Should these elections take place, a government is expected to be formed following a period of coalition negotiations. Meanwhile, discussions on KOSOVO’Sstatus continue under the auspices of the Contact Group, with a troika of mediators from the European Union, the United States, and the Russian Federation. The troika is expected to report by December 10, 2007 to the United Nations Secretary General (UNSG). There are widespread concerns in the international and regional circles that an uncoordinated settlement of KOSOVO’Sstatus would potentially have political and security implications in the Western Balkan countries. The evolving political climate is likely to have impacts on the sustainability of the reform agenda of Kosovo. The current ISN, therefore, remains limited in its scope and strategically targeted until there is greater political clarity. iii. This ISN continues to be founded on the two pillars of the previous ISN: (i)developing new sources and a higher quality of economic growth; and (ii)ensuring macroeconomic stability through sound fiscal policy and public finance management. The effective management of ongoing operations in education, energy, environment, public expenditure management, and business and cadastre development will be critical for achieving results in both these pillars. iv. Two new projects are envisaged in this ISN to carry forward the Bank’s recent emphasis on human development and private sector development. These projects were selected in recognition of lessons learned in the past to strategically channel IDA grants to a limited number of projects based on the quality and strength of institutions, the macroeconomic situation, client commitment and donor participation. In education, donor support has been limited in recent years despite the fact that in KOSOVO’Scomplex social, historical, political, and economic circumstances, investment in human capital is critical not only for poverty reduction and growth, but also for maintaining peace and stability. The proposed $10 million Institutional Development for Education project would mobilize and guide donor support to the implementation of two sector strategies: Strategy for Development of Pre-University Education in Kosovo (2007-20 17) and Strategy for Development of Higher Education in Kosovo (2005-2015). The proposed $2 million Fhncial Sector Technical Assistance grant will also build on a program of coordinated donor assistance to support regulation, supervision and capacity building in the financial sector.

MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON AN INTERIM STRATEGY NOTE FOR KOSOVO

I.INTRODUCTION

1. The ISN will cover the FY08 period (from July 2007 to June 2008). If the status of Kosovo changes prior to June 2008, then a new assistance strategy will be developed dependin on the clarity of the relationship between a post-status Kosovo and the World Bank Group. !3 Since FY2000 when the World Bank started its operations in Kosovo, 25 grants totaling $119 million have been approved by the Bank’s Board for programs across a range of sectors. The proposed strategy, which would be financed by an IDA grant allocation of SDR 8.2 million (approximately $12 milli~n)~,is designed to deepen the impact in two areas - education and finance, rather than scatter support across multiple sectors.

2. The strategy builds on the ISN FY06 - FY07 and the Transitional Support Strategy FY04 - FY05. It draws upon work undertaken by the Provisional Institutions of Self Government (PISG) and the United Nations Interim Administration Mission in Kosovo (UNMIK) on the Draft 2007 Kosovo Development Strategy and Plan (KDSP) and the 2008-10 Medium Term Expenditure Framework (MTEF) which outline the long term policy and spending framework for Kosovo. The ISN is developed in cooperation with the European Commission (EC) and bilateral and multilateral donors who are partners in the Bank’s ongoing programs.

3. The proposed strategic and highly targeted support in education and finance are framed within the key PISG development priorities. These two sectors, by virtue of their demonstration of gradual yet steady improvements in the capacity of institutions, client ownership and effective donor partnerships, relative to other sectors, create the ground for further investments to deepen development impact within the limited IDA resource available for Kosovo. These proposed projects are consistent with the two pillars of the previous ISN: (i)developing new sources and a higher quality of economic growth; and (ii) ensuring macroeconomic stability through sound fiscal policy and public finance management. The effective management in a very challenging political economy environment of ongoing operations in education, energy, environment, public expenditure management, and business and cadastre development will be critical for achieving results in both these pillars.

11. POLITICAL, ECONOMIC AND SOCIAL CONTEXT

A. Political Environment

4. Kosovo is under the administration of UNMIK under the terms of the UN Security Council Resolution 1244 (1999). According to the constitutional framework’ the Special

Kosovo is currently under the administration ofthe United Nations Interim Administration Mission in Kosovo (UNMIK) under the terms of UN Security Council Resolution 1244 (1999), and is currently eligible for IDA grants based on its status as part of Serbia. This amount includes SDR 1.6 million in IDA resources back loaded from FY07. Constitutional Framework for Provisional Self-Government adopted by UNMIK on May 15,2001. Representative of the Secretary General (SRSG) remains the ultimate legal authority of Kosovo. The transfer of responsibilities from UNMIK to the PISG has continued steadily, however, the capacity of the PISG to effectively discharge responsibilities remains variable across the sector ministries.

5. The SRSG has announced that parliamentary and municipal elections in Kosovo will be held on November 17, 2007. These would be the third parliamentary elections in Kosovo (the first took place in 2001, and the second in 2004). The SRSG announced that should the November 17 elections interfere with the ongoing status negotiations, then elections would be postponed in consultation with the Unity Team (a bi-partisan team leading the status discussions on the Kosovo side). The majority of ethnic Serbs are unlikely to participate in the elections since, unlike in the previous elections, they lack the support ofBelgrade.

6. Discussions on KOSOVO’Sstatus continue under the auspices of the Contact Group: with a troika of mediators from the European Union, the United States, and the Russian Federation. Following more than a year of unsuccessful negotiations between Serbia and Kosovo, UN Special Envoy Martti Ahtisaari tabled a proposal for KOSOVO’Sstatus to the UN Security Council on April 3, 2007. After deliberations, the UN Security Council (UNSC) visited Kosovo and Serbia in late April, and the mission report, together with elements ofa draft Security Council Resolution superseding Resolution 1244 currently in force, were discussed. However, agreement on these proposals was not reached. By December 10, 2007 the troika will report to the United Nations Secretary General. Meanwhile tensions remain high.

7. There are widespread concerns in the international and regional circles that an uncoordinated settlement of KOSOVO’Sstatus would potentially have political and security implications in the Western Balkan countries. The evolving political climate is likely to have impacts on the sustainability ofthe reform agenda ofKosovo. The proposed new projects for this ISN, therefore, are strategically targeted to two sectors until there is greater political clarity.

B. Economic Environment

8. KOSOVO’Seconomy has begun to converge with the rest of South East Europe (SEE), but the donor sector continues to exert a major influence on macroeconomic developments. In the years following the conflict a surge in donor support contributed to rapid economic rebound. However, as the donor sector subsequently declined, growth slowed. As the post- conflict boom of 2000-04 has subsided, KOSOVO’SGDP growth has stagnated, with the scaling back of the donor and UN presence serving to counteract the positive effects of increasing domestic investment. 2006 saw some positive signs, however, with growth, driven by increased private investment and consumption, recovering to 3 percent, and a number ofKosovo companies in the metals sector increasing exports on the back of the regional boom in commodities production and processing. The economy continues to be fully euroized, except in those areas with ethnic Serb majorities, where the Serbian Dinar is generally used.

9. A combination of a conservative expenditure rule, under-spending on the capital budget, and buoyant revenues brought KOSOVO’Sfiscal balance into surplus in 2006 and swelled the government’s accumulated cash deposits to around €245 million (just under 10 percent of GDP) by mid 2007. From a low base, Kosovo has continued to increase general government revenues rapidly, from 27 percent ofGDP in 2004 to 3 1 percent in 2006, though they

The Contact Group is comprised of the United States, the Russian Federation, the United Kingdom, France, Italy, and Germany.

2 still remain heavily reliant upon indirect taxes collected at the border. Spending, meanwhile, has been steeply curtailed - falling from 33 percent of GDP in 2004 to 27 percent of GDP in 2006 - and as a result, the Kosovo Consolidated Budget (KCB) swung sharply from a deficit of over 6 percent ofGDP in 2004 to a surplus of3.5 percent ofGDP in 2006. The decrease in government expenditure over 2004-06 has been due in part to a conservative policy on recurrent spending, which has fallen every year; but it has also been due to persistent problems with the execution of the capital budget, which was intended to benefit from the fiscal space thereby created. In 2006, for example, a deficit of 3.5 percent of GDP was budgeted; but a combination of buoyant revenues and an execution rate for the capital budget of only 70 percent meant that a surplus of the same magnitude was in fact returned.

Table 1: Main Economic Indicators, 2004-07 2004 (e) 2005 (e) 2006 (e) 2007 (p) National accounts Real GDP growth 2.0 -1.0 3.1 3.5 GDP per capita (euros) 1,156 1,105 1,118 1,150 Investment (percent of GDP) 30.2 28.8 31.3 35.1 Gross domestic savings (percent of GDP) -13.5 -20.0 -20.7 -21.7

General government budget Overall balance (percent of GDP) -6.1 -3.2 3.6 6.5

External accounts Trade balance (percent of GDP) -43.4 -47.4 -50.1 -53.6 Current account balance (percent of GDP) -32.7 -34.8 -34.6 -38.2 Foreign assistance (percent of GDP) 14.8 16.6 14.6 14.2 Remittances (percent of GDP) 9.7 12.4 15.5 16.7

Prices CPI inflation -14 -1.4 1.5 2.0

Memorandum: GDP (millions of euros) 2,27 1 2,207 2,273 2,378 Note: Datafor 2004-06 are estimates; data for 2007 are projections. Current account balance is before foreign assistunce. Sources: IMF and World Bank staffestimates.

10. KOSOVO’Sexternal trade continues to be significantly out of balance, even by the standards of SEE. Recorded goods exports amounted to only 5 percent of GDP (€120 million) in 2006 - with exports of scrap metal dominating - while recorded imports were over 55 percent of GDP (ei .3 billion). As is the case elsewhere in SEE, the resulting very large current account deficit was financed predominantly by ODA (19.5 percent of GDP), remittances (15.5 percent of GDP), foreign direct investment associated with privatization (1 1.O per cent of GDP), and unrecorded private transfers. As is also the case elsewhere in SEE, the growth of the trade and current account deficits have been driven by private sector demand - with the conservative fiscal stance of the past two years apparently having little impact on KOSOVO’Sexternal imbalances. While these imbalances certainly pose risks to KOSOVO’Seconomic stability - and especially to its longer term development prospects - the unusual composition of KOSOVO’Sexternal financing makes it difficult to evaluate these risks with confidence. It is likely that KOSOVO’Sreliance on official and private transfers is in relative terms a more stable pattern of financing than other alternatives.

3 C. Socio-economic Environment

11. Poverty in Kosovo is widespread and has remained persistent in the first half of this decade. According to the Kosovo Poverty Assessment (KPA) 2007, about 15 percent of the population is estimated to be extremely poor, defined as individuals who have difficulty meeting their basic nutritional needs. About 45 percent report a consumption level below the poverty line, which in 2002 prices is set at 43 Euros per adult equivalent per month. The evidence collected in the KPA suggests that poverty is higher among those who live in families that are large, have many unemployed members, and have low education levels. The poor are also geographically concentrated in rural areas in the regions ofMitrovica and Ferizaj.

12. However, poverty is shallow in the sense that many people are just above or just below the poverty line. The shallowness of poverty also implies that a small positive change in incomes, through employment generating growth, can pull many people out ofpoverty.

13. Unfortunately, recent economic stagnation is reflected in the lack of progress in improving living standards. KOSOVO’Spoverty rates are very high compared to neighboring countries and unlike trends in the region, have not changed over time (though weaknesses in KOSOVO’Sdata make inter-temporal comparisons difficult). Only the top 20 percent of the population had a small positive growth in reported consumption, between 2003 and 2005, while the rest had negative growth. Among the poorest groups, the losses were substantial. The poorest fifth of the population experienced consumption loss of around 10 percent. Examining the changes in consumption separately for urban and rural areas shows that consumption declined for nearly all rural populations, while in urban areas only the bottom fifth of the population reported decreased consumption.

14. Inequality - though low - shows signs of increasing. The Gini index was about 30 percent in 2005 compared to 27 percent in 2003. As expected, urban inequality is higher than that observed in rural areas. However, over time, urban inequality has remained unchanged at 3 1 percent, while rural inequality has increased from 25 percent to 28 percent.

15. To improve welfare in the future, the KPA 2007 recommends a focus on generating high and sustainable growth including by addressing inequities in the access to secondary and higher education for the poorest population and improving urban services and infrastructure. Kosovo needs to begin the transition out of over-reliance on migration and needs to improve the targeting and expansion of the social assistance program as the revenue base of the government improves over time.

16. There is a direct correlation between poverty and education levels. As expected, poverty incidence declines with higher education of the household head. The poverty incidence for heads of households with tertiary education is 20 percent, but 1 in 2 heads ofhouseholds with primary education are estimated to live in poverty. The more educated have a lower incidence of poverty because they have better employment prospects and better pay. Over 70 percent of the people with vocational and tertiary education report being salaried employees, compared to 25 percent ofsecondary educated individuals.

17. Social assistance programs are inadequate in Kosovo because of low coverage and modest benefits per recipient household. As a result, social assistance programs have had little impact on improving the welfare of the population. However, migration and remittances have been effective mechanisms for reducing poverty in the near term. At present, about 1 in 5 Kosovars report having at least one household member who is a migrant abroad and having

4 received remittances from abroad. By comparison only 13 percent of the population receives social assistance benefits, which are targeted at the poorest groups. Those with migrants abroad also report higher levels of consumption and are estimated to be less poor. But a development strategy that is over-reliant on remittances is neither desirable nor sustainable. There is a need, eventually, to transition out of high dependence on migration and remittances.

18. Environmental pollution and contamination as a result of outdated mining practices and outdated power plants poses a serious risk to public health. Contamination of food and soil by heavy metals, particularly lead, is high. In the northern areas ofKosovo, the lead intake is as high as 15 times the EU average. Air pollution by old power generating plants, such as Kosovo A, exceed EU and international standards. World Bank support through the environment clean-up project serves to address the ash dumps (open deposits of byproducts of combusted lignite) that occupy more than 150 hectares of agricultural land impacting human health through fly ash and ground water contamination and clean-up the old gasification plant of hazardous chemical materials. Waste water management of mining and power operations remains weak, adversely affecting the ecosystem. There is an urgent need for Kosovo to get exposed and integrated into the global discussions of climate change, and importantly implement a viable environment management system that encompasses mineral and power production.

D. Governance Issues

19. The rule of law in Kosovo is undermined by serious weaknesses, including the multiplicity of sources of law. The 2006 Business Environment and Enterprise Performance Survey (BEEPS) showed that more than 50 percent of firms considered the functioning of the courts as a problem in doing business, while less than 7 percent of firms use the courts to resolve outstanding disputes - one of the lowest rates in the ECA region (SEE regional average in the 2005 survey: 39.5 percent; ECA regional average: 31 percent). The court system is under- resourced, under strain to cope with the existing caseload, and therefore unable to administer justice in an efficient manner. The latest Ombudsperson’s report refers to “an alarming high number of complaints related to the alleged corruption of judge^."^

20. Corruption remains a widespread phenomenon despite PISG efforts to implement an anti-corruption strategy and despite the adoption in 2005 of the Law on Suppression of Corruption. In the 2006 BEEPS survey, 53 percent of firms said that corruption was a problem in doing business in KOSOVO,slightly above the average level for the SEE region. According to the survey, the highest levels of corruption were reported in customs and tax administration, in public procurement, and in the courts. Public opinion surveys point to the perception of prevalent corruption in Publicly Owned Enterprises (POE) and the Kosovo Trust Agency (KTA).

21. In partnership with other donors, the Bank has supported strengthening KOSOVO’S public finance management (PFM) system. The Bank has supported PFM reforms in Kosovo through the Public Expenditure Management Technical Assistance Grant (PEMTAG) project, the PEIR, and technical assistance on fiscal decentralization. According to the PEFA Performance Assessment conducted in 2007, the public financial management system in Kosovo has developed a reasonably well-functioning treasury system which is comprehensive and able to produce timely analytical reports. The centralized budget execution, accounting and payments system linked to the treasury reduces further the risk of funds being misappropriated. In addition,

7 At the time of writing this ISN, staff have submitted a request for an IDF grant to support technical assistance to the Judicial Council.

5 the customs administration has improved efficiency and transparency over the years and good fiscal reports are being produced.

22. Despite modest progress made since the last ISN, the effectiveness and transparency of public spending continues to be undermined by weak institutions and low capacity. KOSOVO’SPFM system still lacks long-term direction and annual resource allocation does not adequately reflect national and sectoral strategies. Internal controls and audit and external audit are nascent and weak. Finally, lack of capacity and political interference in public procurement and lack of a comprehensive wage bill control and management leaves the public financial management (PFM) system vulnerable to inefficiency and corruption.

23. The effectiveness of KOSOVO’Spublic administration remains constrained by a weak inter-departmental coordination capacity at the central government level; lack of clear pay and grading structures, and absence of job descriptions with specific qualification requirements. However, in early 2007 the government adopted a Strategy and Action Plan for Public Administration Reform. In the context of this reform, a functional review of central government has been launched with the aim of identifying areas of overlap or duplication in central government agencies’ functions. The government has also prepared a comprehensive draft law on the civil service, which - if adopted and implemented - would provide a sound legal basis for addressing many ofthe aforementioned shortcomings.

24. Finally, strong momentum for decentralizationhas emerged in Kosovo over the past years. This is due in part to the widespread recognition that the existing division ofcompetencies and resources between the central and municipal authorities needs to be revised to provide better services at both central and municipal levels. Existing fiscal and institutional arrangements are confusing, inefficient, and leave municipalities poorly equipped to deliver public services. Moreover, st iccessfiil decentralization could prove a cornerstone for peace and stability following status outcome. Successful decentralization could help defuse ethnic tensions by ensuring political representation of minorities. In August 2007, a Post Conflict Fund grant of $1.5 million for decentralization was approved to assist the Kosovo authorities in putting in place effective decentralization arrangements, consistent with any status outcome.

E. Media and Civil Societv

25. KOSOVO’Smedia, though not controlled by the Kosovo Authorities, has scope to further strengthen its role in promoting accountability among public institutions and shaping public opinion. Currently there are nine daily papers, three Kosovo-wide TV and four radio cliannels, as well as 1 11 local radio and TV broadcasters. There is one public Kosovo-wide broadcaster, RTK, while the remaining two broadcasters and all major dailies are private. The power to license broadcast media lies with the Independent Media Commission, and the print nieclia v itli the Press Council. While ensuring a conducive environment for free and independent reporting remains a challenge, there are an increasing number of media outlets which give more space to ethnic minorities providing them with relevant information on developments in Kosovo. There are an increasing number of active NGOs who operate both at the municipal and central levels, and are beginning to have alliances and networks in Europe and the US.

6 111. KOSOVO’S KEY DEVELOPMENT CHALLENGES

A. Fiscal Sustainability

26. Despite KOSOVO’Srecent good performance, fiscal sustainability remains a challenge for several reasons. First, the electricity sector remains a major drain on budgetary resources. KEK, the public electricity utility, continues to be in crisis, with both electricity theft and nonpaynient of bills at epidemic levels, and technical losses on the network remaining high. As a result, subsidies from government to cover both capital and operating costs have run at over 2% of GDP per annum over the recent years. In 2007, urgent work to open a new mine has begun, requiring budgetary funding on a still higher scale. The government, with the support of the World Bank, is actively seeking private sector investment in both the development ofthe new mine and of an associated new clean-technology power plant; but the fiscal burden of the electricity sector is likely to remain large unless the operational and financial performance of KEK is improved.

27. Second, the rapid reform of the social protection system, implemented since 2000, combined with the recent accumulation of significant cash reserves, has generated political pressures to increase expenditure on social protection through the revival of old entitlement programs and the creation of new ones. KOSOVO’Sunique governance structure enabled significant reforms of KOSOVO’Ssocial protection system, designed to ensure its long term fiscal sustainability, to be introduced early in the 2000s. The SFRY PAYG, defined benefit pension system was replaced by a flat rate non-contributory basic pension and a mandatory funded pension system; labor legislation was substantially liberalized; and social and unemployment assistance \\as modernized. Similar reforms have proved intractable in neighboring countries, however; arid with the accumulation of substantial cash reserves over the past few years, political pressure has grown for the rolling back of some of these reforms to bring Kosovo back in line with other ex-SFRY countries with less fiscally sustainable arrangements. There is building pressure to introduce a broad coverage veterans’ benefit similar to that in some neighboring countries.

28. Third, the resolution of KOSOVO’Spolitical status is likely to alter the government’s balance sheet significantly, and may imply a substantial increase in related expenditures. Upon resolution of its status, it is possible that Kosovo would need to assume a variety of costs, including substantial debt service obligations, the costs of implementing any status outcome, and the costs of taking over government functions from UNMIK. In some scenarios, the cost of such status-related obligations might total several per cent of GDP per annum. In addition there are important contingent fiscal liabilities implicit in ongoing structural reforms such as the privatization process and the effort to attract private investment to the energy sector, the iiicidence of nhich will only become clear once KOSOVO’Spolitical status is resolved.

B. Structural Policies for Growth

29. Both the stagnation of the broader economy following the post-conflict boom and the need to tind fiscal space to meet the fiscal shock of status have thrown into sharp focus the need for accelerated structural reforms. Maintaining macroeconomic and fiscal stability in the wake of the post-conflict, donor-financed boom, has been a major achievement ofthe Kosovo authorities in the past few years. Such stability is a pre-requisite for growth, and it will be important that Kosovo continues to exercise prudent macroeconomic and fiscal policies over the medium term. Kosovo additionally faces a number of competitive disadvantages relative to its

7 neighbors, i ti the form of limited access to international transport routes, dilapidated infrastructure, and a small inherited industrial capital stock. These challenges put a particular premium on accelerating structural reforms in order to make the best of KOSOVO’Sconsiderable human, physical, and natural resources.

30. Continuing to build an efficient government and administration will represent a fundamental challenge over the medium term. An efficient and responsive government and administrative apparatus is critical for the making and implementation of growth-oriented policy. Kosovo’s current governance structure, and the uncertainty about its political status, present obvious chal lenges to efficient and responsive policy-making and planning. Working with international partners to continue to improve government and administrative functions such as medium tern1 economic and financial planning, public financial management, and the provision ofcore pub1ic services, therefore remains a priority.

31. Improving the provision of infrastructure services - especially in the electricity sector - stands out as a major policy challenge. Apart from its detrimental effect on the public finances, the ongoing crisis in the electricity sector is a major constraint on growth. Over three quarters of businesses questioned in a 2006 survey cited the poor quality of electricity supply as an obstacle to doing business. Improving the provision of other infrastructure services is also a major challenge: over half of all firms surveyed also cited the poor quality and high cost of transportation and telecommunications services as obstacles. The lessons ofKOSOVO’S experience with attempts to improve the situation in the electricity sector are informative: public expenditure alone is not enough - policy and regulatory reforms to improve efficiency (and in the telecommunications sector, competition) and cost-recovery will also be essential.

32. KOSOVO’Smost valuable asset, however, is its people - and maximizing opportunities by improviiig education and health outcomes and facilitating employment is a further major development challenge. Kosovo has an unusual demographic profile for a European economy in that it is estimated that its population is young - nearly one third ofthe population is of school age - and growing at around 1.5% per annum. Kosovo will therefore enjoy a relatively abundant supply of labor over the medium term. Health and education outcomes are, however, poor, suggesting that the quality of human capital is low; and that reforms of the health and education systems would yield substantial benefits. Facilitating employment will also be important, both within Kosovo through the maintenance of the current light framework of labor regulation, and abroad througli the arrangement ofcircular migration programs.

C. Education

33. lnvesting in human capital and building an inclusive and effective education system is critical for KOSOVO’Sdevelopment and eventual accession to the EU. The government has identified education as one of the key sectors in KDSP and MTEF. Education is one of the few sectors where these strategic ambitions have been articulated in detailed and credible sectoral strategies, namely the Strategy for Development of Pre-University Education in Kosovo (2007- 2017) and the Strategy for Development ofHigher Education in Kosovo (2005-2015), which have been approved by the Kosovo Authorities. Currently the Ministry of Education, Science and Technology (MEST) is elaborating an implementation framework for the strategies.

34. The education system in Kosovo faces multifaceted challenges going forward. First, there is still very limited knowledge on the quality of education received compared with other countries i ti the region since Kosovo has not participated in an international student assessment. Second, eimllinetit in secondary and higher education has remained low compared to other SEE

8 countries, and inequity among different income levels and gender has persisted. Third, there is a need for significant investment due to a young and growing population and the current low quality of educational inputs. Fourth, the management system in universities is weak, and the quality of teaching is uneven.

35. As the status of Kosovo becomes clearer, the roles and responsibility of each level of the education system needs to be clarified and adjusted, especially with regard to decentralization. Municipalities are expected to gain additional responsibilities in the future. Many of the management and administrative responsibilities for primary and secondary education are currently shared between MEST and its deconcentrated offices at the regional level (Regional Education Offices) on the one hand, and the Municipal Education Departments on the other. Education being one of the major public services provided at the municipal level, the institutional capacity building for municipalities and clarification of roles and responsibility of each level of the education system will be critical for promoting the quality of education, thereby contributing to the stability and growth of Kosovo.

D. Financial Sector

36. KOSOVO’Sfinancial sector has developed exceptionally rapidly over the past few years: ensuring that it remains well supervised and regulated is an important challenge for the authorities - especially at the current ‘juncture. A Financial Sector Fiduciary Assessment (FSFA) conducted in May 2006 highlighted a number of weaknesses in KOSOVO’Scurrent financial sector including: (i)the institutional and financial sustainability of the Central Banking Authority OF Kosovo (CBAK); (ii)the banking and the insurance sector prudential regulation, supervision, and resolution framework; and (iii)the financial sector infrastructure.

37. Tllc development of the capacity of CBAK and other financial institutions has been identified as the key to improving the efficiency and sustainability of the financial sector in Kosovo. Recently, the CBAK took major steps to strengthen the Kosovo banking sector, bringing the legislative framework for regulation into line with international best practices, and encouraging consolidation. This has led to increased foreign participation and competition in the sector. However, capacity issues in CBAK remain as do some latent risks and development challenges at the level of banks and other financial institutions. In that respect, a donor- coordinated program could bolster the sector’s stability by focusing on strengthening existing financial sectur regulatory and supervisory structures.

IV. PROGRESS UNDER PREVIOUS PROGRAMS AND LESSONS LEARNED

A. World.Bank Support Since 1999

38. Since tlic end of the conflict, support to Kosovo was outlined in three Transitional Support Strategies (1999, 2002 and 2004) and one ISN (2006). Twenty five grants, for a commitment of about $1 19 million, were provided in: economic reform and institution building; private sector development; education, health and social protection; the energy and mining sectors and associated environmental clean up; basic infrastructure and community development; and avian 11~1.These grants were financed by: e two allocations from net income to the Trust Fund for KOSOVO,totaling $60 million, as well as almost $3 million in investment income from the Trust Fund;

9 0 six grants from the post-conflict fund totaling $9.9 million to support post conflict social coliesion activities;8

0 an IDA post-conflict grant allocation of $15 million over the 18 month period from the beginning of IDA-I3 in July 2002 through December 2003;

0 an IDA grant allocation of $15 million over the period January 2004-June 2005; and

0 an IDA grant allocation of $21 million (plus $3 million for the Avian Influenza Control and Human Pandemic Preparedness and Response Project) over the period July 2005- June 2007.

39. In addition to investment and adjustment policy support, the Bank has also played a lead role, together with the European Commission, in donor coordination and the provision of policy advice and support.

B. Current Portfolio

40. The 2006 ISN proposed 3 projects the $8.5 million Lignite Power Technical Assistance Project (LPTAP), $5.5 million the Clean up and Land Reclamation Project (CLFW), and the $5 million Fiscal Policy Adjustment Support Operation. During implementation of the ISN, the latter project was dropped, both because the earlier described unexpected shift to a fiscal surplus cut near-term fiscal financing needs, and because of the challenging policy making environment during and prolonged period of status negotiations. Instead, the CLRP was expanded in scope with US$5 million and the LPTAP topped-up by US$2 million. Aljo, for IDA’S regional allocation a $3 million for the Avian Influenza Control and Human I’axiein ic Preparedness and Response Project was approved.

41. The energy and mining sectors are key to future growth in Kosovo. Abundant mineral deposits, particularly lignite, create potential for Kosovo to attract strategic foreign investors to export power to the region and to supply domestic demand. LPTAP is helping PISG strengthen the enabling policy, legal and regulatory frameworks conducive to new investments in the energy sector. LPTAP assists in attracting qualified private investors to develop lignite mines and build new capacity for lignite thermal power generation guided by the highest applicable standards of environmental and social sustainability. The initial US$8.5 million IDA grant was increased in June 2007 by US$2 million to a total of US$10.5 million, in order to cover the full actual cost of the services of (i)transaction advisors, who are doing the market research, preparing the necessary documentation to undertake a competitive and transparent bidding and evaluation process, and generally supporting the PISG in bringing the transaction to financial closure, (i ) iepal and regulatory advisors, who are assisting in preparing the key legislation, including an) ieqiiired amendments that will facilitate the proposed new mine/plant transaction; and (iii) soc ial/environiiieiital safeguards advisors, who are preparing a Strategic Environmental and Social Assessment (SESA) specific to energy sector development in the Sibovc/Obiliq region, u ii ich odd identify environmental and social issues of projected developments in the power generation and related lignite mining sectors; and will support institutional capacity building to monitor and regulate environmental impacts of mining and power generation. The transaction advisors, legal and regulatory advisors have all now been hired and begun their work.

* One of these six (the PCF grant for Decentralization) was approved in FY08 and another (the PCF for Education) was approved late in FY07.

10 Four consortia of internationally reputable companies have been prequalified as bidders for the investment.

42. The Bank is also supporting PISG efforts to address a specific environmental legacy issue related to open clumping of ashes on land. The initial US$5.5 million CLRP attracted other development partners soon after Board approval. The Dutch Government has provided Euro 3 million in co-financing for the project, which will build the capacity of environmental authorities through hands-on experience in dealing with environmental legacy matters and make land available for agricultural use and possible settlement. The project has four components. The first component is preparing the Mirash open pit mine to receive and store ash from the Kosovo A power plant’s ongoing operations, as well as store the ash removed from Kosovo A’s open ash dump. The second component is supporting the full remediation of the Kosovo A ash storage facility and mitigating the current environmental impacts related to open dumping of ash and overburden materials. The third component will reclaim about 6.5 km2 of land through reshaping and re-cultivating selected overburden dumps. The fourth component will provide project implementation support to KEK on this issue.

43. The scope of the CLRP was expanded to also include the clean up of the gasification plant with additional IDA grant financing of US$5 million approved in June 2007. This component \vi II help environmental officials in Kosovo in following international good practice for the containment, removal, packaging, and export from site for incineration or reprocessing, of about 17,500 in3 of the following chemicals: concentrated phenol, mixtures ofphenol and water, tars, oily compounds including waste oil, ammonia, benzene and methanol. By the time CLRP is completed, air pollution from the Kosovo A ash dumps is expected to be eliminated, benefiting the health of the local population. The reclamation of the overburden dumps will make land available for n.itural hat- itats, agriculture, and residential purposes. And environmental officials will have gained necessary skills to prepare plans for further clean-up activities at the gasification site, follo\i iiig the removal of the most hazardous substances.

44. Tlie ongoing portfolio also includes the Business Environment Technical Assistance project (BETA) US$7 million, the Public Expenditure Management Technical Assistance project (PEMTAG) UW.5 million, and the Energy Sector TA (ESTAP 111) US$ 2.5 million Grant. Also, iii May 2007 a PCF grant of $0.7 million for Education Participation Improvement was approved; and in August 2007 a PCF grant of$1.5 million for Decentralization was appr~ved.~

45. Overa II, the portfolio has continued to perform well with development objectives and iniplenien tation progress of all projects under implementation rated satisfactory. Of the 22 prqlects completed since 1999, only one -the Pilot Line of Credit to Small and Medium- Sized Eiiterprises project, closed in 2004 - was rated unsatisfactory. In addition to financing project in\ cstnitiit, the Bank has also completed a substantial amount of analytical work, including, amongst others, Kosovo Financial Sector Fiduciary Assessment, two Kosovo Poverty Assessmaits. Public Expenditure Fiduciary Assessment, Public Expenditure and Institutional Review, ROSC on Accounting and Auditing, PEFA Performance Report, Kosovo Economic Memorandum and Kosovo Heat Market Study.

C. Other Donor Support

46. The Bank partners with several donors in its work in the financial sector. The European Agency for Reconstruction (EAR) in Kosovo has recently approved a grant for private

The Decentralization grant brings the number of PCF grants approved to six for $9.9 million.

11 sector development. The IMF and USAID provide CBAK with technical assistance towards strengthening its on-site banking sector supervision. The KfW supports the development of a deposit insurance fund. Through the ongoing Business Environment Technical Assistance (BETA) project, the Bank is providing TA to improve the institutional business environment at the central and local level; and, the development of a property rights framework for the Kosovo Cadastral Agency (KCA).

47. Despite the urgent need to improve the quality of education as a basis for economic growth and social stability in KOSOVO,education has not attracted much donor support during the last seven years. However a number of donors have been active in small scale interventions in Kosovo’s education system during the past few years. EAR supports the development of tlie school infrastructure, vocational education and capacity building for advancing the Bologna Process in higher education. The European Commission (EC) plans to further faci I itate the integration of Kosovo into the Bologna Process. The Austrian Development Agency (ADA) supports the establishment and development of Kosovo Accreditation Agency. The German and Swiss governments (through GTZ and Swiss Contact respectively) assist the development of vocational education.

48. Ministry of Education, Science and Technology has begun to take a stronger leadership role in coordinating development partners (DPs) in education, and the interest from the DPs to support education in a coordinated manner is growing. MEST appointed staff fully dedicated for coordination of DPs, and organized several coordination meetings and a workshop or1 a sector-wide approach in education in Septembers 2007. The Prime Minister’s Office is also keen to promote a better coordination and harmonization through the Donor Coorclifiiati\,ii Cdnter (DCC). The DPs are initiating a joint feasibility study for a sector-wide apprcv 11 (5’,V~,p) i i education in Kosovo.

49. l

D. Lcssons Learned

50. Key lessoiis have been learnt from the Bank’s operational experience, analytical work, and client survey” in Kosovo. Lessons have also been drawn from the Bank’s experience in other countries in the region. These lessons include the following:

(i! i caigetcd focus O!I ecoiiomic growth is critical to effective development in Kosovo. Ncar iy half of the clieiit survey respondents placed economic growth and job creation as tlie top development priority for the Bank in Kosovo. The Bank’s poverty assessment noted that given the shallowness of poverty in Kosovo sustained employment generating

loAccording to the survey, (lie Bank has developed sound working relationships with its major stakeholders and is percci\cil io lia\c a Iiiglil!. rclevant role in Kosovo. A large majority of respondents support Bank involvement in critical developnient areas, Ixir‘icularly in the economy and private sector development, and want the Bank to be more involvcd in Kosovo‘s devciopment agenda. Creating the basis for sustained economic growth, strengthening the energy sector. reducing poverty and strengthening the private sector were seen as important areas for the Bank to focus upon. Whilc tlie Dank’s tinancial resources were highly valued, more than one-third of respondents believed the Bank’s knou-ledgc to be its greatest contribution.

12 growth should have a large impact on reducing poverty. The poverty assessment also noted tlie strong correlation between poverty and education levels.

(ii) Kosovo has a legacy of poor environmental practices while exploiting its natural resources, particularly in the mining and energy sectors. As lignite resources and the energy sector are pillars of future growth, proper environmental and social measures need to be implemented to ensure public support and optimize benefits.

(iii) There is a clear need to build capacity in post-conflict environments to ensure that aid is uti I ized effectively. Effective and functioning institutional structures must be put in place and nurtured. Hence, donors need to ensure that expatriate provided services do not substitute for a real and sustainable transfer of knowledge to local institutions.

(iv) With limited availability of IDA resources, clear results are difficult to see if grants are divided in support of too many directions. Furthermore, as the Bank moves deeper into tlie development phase from the post-conflict reconstruction, the goal should be to be more selective in its involvement and also towards leveraging its resources through joint or parallel co-financing.

V. WORLD BANK ASSISTANCE STRATEGY

51. The main thrust of this ISN forms part of a longer-term strategy begun under the FY04 TSS and carried forward in the FY06-07 ISN. Clearly, in the timeframe of one fiscal year, the implemeiitation of tlie ongoing portfolio in this challenging environment will be crucial for achieving restilts iii the two pillars of the strategy: (i)developing new sources and a higher quality of ecciioiiiic gro\\.tli. aild (ii) ensuring macroeconomic stability through sound fiscal policy and public tiiimcc rnaiidgeinent. Given the limited IDA grant allocation, implementation of the Bank's smtegy also re1 ies on strategically chosen analytical work, partnership with other donors, and technical assistairce financed by the Post Conflict Fund."

52. 'This ISN builds on tlie ongoing operations with the following two proposed projects:

A. Education Innovation

53. The World Bank will help Kosovo build institutional and management capacities and system necded for education quality improvement, in line with the government pre- university and higher education strategies. The first phase of the Bank's support, a US$10 million ii Lestmeiit project for education, will support the government in building and stretight'i,iiie LIICilztii utional and management capacities at the Ministry of Education, Science 311d 7 CC!,I L~~r~~>~(?.IFST), municipality and school levels as a foundation for improving the qualit., .,i ~~~Itica~ii~iiiii dit: long-term. This will be carried out in the context of post-status Koso\ o anii xcoiiipanj ing new legal framework for educational management. Specifically, the projeLt will aim to: (i) support the new government to improve the design and organization of its education system, including the legal framework, regulations for all levels and devolved financing mechanisms, (ii) build and strengthen management capacities of the relevant departments of the MEST to improve the quality of education, (iii)develop school mapping, school investment and maintenance plans and standard designs, and construct a pilot model

Given the sI1oi.L tiineli.nnie Cor the new ISN and the unfinished agenda on the previous ISN result matrix, the result matrix ofthc FY06-1.*1'07 ISN will continue for the new ISN. See Annex 1.

13 school using the new standards, and (ii)strengthen the management capacities both at the MEST and institutional level for higher education.

54. The Bank, together with other development partners, aims to introduce a nascent form of a sector-wide approach (SWAP) in supporting education in Kosovo. Supporting a locally owned program in tlie education sector through a SWAP in a comprehensive and coordinated manner, rather than a compartmentalized project, provides an opportunity for the Bank and other stakeholders to assist the government in steering and sequencing the reform activities, using scarce resources efficiently and effectively, and focusing on outcomes. Nevertheless, from tlie fiduciary perspective, a full-fledged SWAP such as the use ofthe country systems of procureinent or the pooling of funds in Kosovo may be premature. The proposed investment project will be a SWAP from the sector strategy perspective, however, the financing will remain as parallel (on budget) to the government and other partners, and the procurement will be according to the Bank’s guidelines. At tlie mid-term ofthe project, or at any appropriate time, tlie feasibility and appropriateness of tlie use of country systems will be assessed again. Setting ob-jectives, monitoring indicators, reporting on activities and results will be harmonized. Joint review niissions with other development partners will be organized.

55. The proposed operation builds on tlie IDA grant financed Education Participation Improvement Project (EPIP (2003-2006) and tlie second Education Participation Improvement Project (EPIP 2) currently financed by the Post Conflict Fund (approved in May 2007). EPIP helped to strengthen the institutional capacities of schools to develop and implement school improvement plans and increase community participation in school management. EPIP-I1 will support Kosovo iii tlie years following status outcome in fostering inclusiveness and tolerance in education tlii ouyh the continuation ofthe School Development Grants, and by strengthening the capacir ies of muiiicipalities through the introduction ofMunicipal Development Grants.

B. Financial Sector Technical Assistance

56. The proposed Financial Sector Technical Assistance (TA) Project will address a few key challenges in KOSOVO’Sfinancial sector that threaten the sector’s long term stability and development. Contributing in coordination with other donors to the long term stability and development of tlie fiiiancial sector is part of the Bank’s fiduciary responsibilities and its role in promoting long-term economic growth. The negative externalities and the long lasting damage that potential financial sector problems create on economic growth and poverty further justify the Bank’s participation in ensuring financial sector stability.

57. In coordination with other donors, the project will focus on areas identified as key issues for (lie sector’s stability arid development. Over the last year, several donor coord tiiatim nieetiiigs were held to coordinate assistance in the financial sector. The European Agency for lieconstruction (EAR) in Kosovo has recently approved a grant for private sector development; the IMF and USAID have been providing ongoing TA to CBAK especially to strengthen its on-site banking sector supervision; and KfW is providing TA to develop a deposit insurance fund. Tliro~iglian ongoing Business Environment TA project, the Bank is providing TA to strengthen tlie financial sector infrastructure (the registries), while through post FSFA nonlending TA, tlie Bank has provided targeted financial sector assistance. However, despite active donor support in the sector, some critical areas have not been supported which if not addressed could undermine the long term stability of the sector. In particular, donor assistance to CBAK has mostly focused on Strengthening its onsite supervision ofbanks with a particular attention on credit risks. While this was relevant in the context of a fragile banking system until very recently, it is iiow necessary to strengthen CBAK’s capacity to monitor other banking sector risks and also other financial institutions.

58. The proposed project will build upon achievements of recent Bank projects and analytical work in Kosovo. The project will assist the financial sector authorities of Kosovo to continue implementing the reform agenda laid out in the FSFA and noted in CBAK’s technical assistance matrix. It will draw upon the successful non-lending TA provided to KOSOVO’S financial sector authorities in FY07 as follow-up to the FSFA. The project is expected to have the following components: (i) strengthen CBAK’s institutional and financial capacity and sustainability; (ii) strengthen CBAK’s capacities to supervise bank and non-bank financial institutions; (iii) strengthen the microfinance industry; and (v) strengthen the capacity of the Koso\!o Bankers Association to provide training to local banks.

GRANTS US$ AAA (mill.) Education Innovation Project 10.0 Policy Note on Public Investment Management

Financial Sector TA 2.0 Policy Note on Public Expenditure in Education

Corporate Governance ofPublicly-owned Enterprises

Health Financing Reform Study

Youth Employment Study

Programmatic Poverty Assessment

Agricultural Public Expenditure Review +-I Total I 12.0 I I C. Risks

59. The proposed ISN takes place during a period of high political, economic and social uncertainties. As Kosovo is at a critical juncture, the proposed strategy focuses on a limited number of sectors with substantial economic and social impact. The high volatility requires that the Bank remains agile in adapting its assistance strategy in the near and medium-term.

60. The miin political risk relates to the status outcome, which if not well managed, could increase domestic instability and exacerbate regional fragility. Expectations and tensions surrounding resolution of KOSOVO’Sfuture political status have heightened. The acceptability of the eventual outcome by all Kosovar and Serbian citizens, and their regional neighbors, will be central to regional stability and the continued path toward EU integration. A settleinent that is perceived as inequitable could lead to fragmentation and division.

61. The main economic risk is failure to sustain the needed fiscal adjustment. While the authorities have succeeded in redressing fiscal imbalances in recent years, resisting the adoption offiscally unviable revisions to social programs may prove difficult.

62. A related risk would arise if Kosovo were unable to reduce its significant external imbalances to sustainable levels. This could arise from a combination of weak export

15 opportunities, inability to contain domestic deinand, and building new external debt obligations. The proposed strategy works to directly mitigate such risks by developing new export activities.

63. Finally, there are several important strategy-specific risks. For the proposed operations these include:

(9. The change in the leadership of the implementing agencies might affect the ownership of the strategies and the proposed operation in this strategy.

(ii). In the education sector, potential increased responsibilities of municipalities after the status outcome might not be backed with proper training, financial or human resources. Also, the potential introduction of block grants to municipalities (without any partition between education, health and general spending) after the status outcome might decrease education spending at the inunicipal level, and might result in lack ofnon-wage recurrent budget to support improving the quality ofeducation.

(iii). In the financial sector, potential political interference risks the independence and impartiality of the supervisory and regulatory bodies.

64. As for the ongoing operations continuing from the previous ISN and TSS, the risks include:

6). Inadequate attention to energy demand management and or delays in opening ofthe new mine could compromise or impair longer term sector prospects. The Government and KEK must ensure rigorous implementation of the Action Plan for improving performance in billings and collections and reducing non-technical losses and initiate and fund the development ofthe new mine.

(ii). Weak public expenditure management could lead to squandered or inappropriate use of future revenues obtained from the new power investments. The Bank supports a sequenced program of activities to improve KOSOVO’Sstewardship of public funds including the ongoing PEMTAG project and a two volume Public Expenditure and Institutional Review.

(iii). Capacity constraints could result in ineffective policy implementation or slippages. Institutional capacity within the young Kosovar institutions is limited. The ISN supports capacity-building initiatives in several key ministries, CBAK, and other agencies but more coordinated and better focused support from the international community will cmtinue to be required.

(iv). inadequate public awareness, dialogue and ownership on key issues could hamper strategy implementation. With Bank support, the Government has begun to design and implement a clear communications strategy to interact more effectively with stakeholders on the long-term benefits of lignite power development for Kosovo including transparency iti public revenue management; implementation of European social and environmental standards and safeguards; and linkages between demand management improvement and enhanced reliability ofelectricity supply.

65. The ISN program is expected to conclude at the end of FYOS or until a change in the status of Kosovo. Following status and/or clarity on the future relationship between a post-status Kosovo and the Bank, a new assistance strategy for Kosovo will be prepared.

Annex 2 - Kosovo at a Glance Kosovo at a glance Europe & Lower- POVERTY and SOCIAL Kosovo Central middle- (est.) Asia Income 2006 Population, mid-year (millions) 1.9 473 2,475 GNI per capita 1,654 4,796 2,037 GNI (US$ bllions) 3.1 2,421 4,813 Average annual growth, 2000-06 Population (%) 1.5 0.0 0.9 Labor force (%) 0.6 1.4 Most recent estimate (latest year available, 2004-06) Poverty (% of population below national poverty line) 37 36 Urban population (% of total population) 37 36 47 Life expectancy at birth (years) 74 69 71 Infant mortality (per 1,000 live births) 35 28 31 Child malnutrition (% of children under 5) 5 13 Access to an improved water source (% ofpopulation) 92 81 Illiteracy (% of population age 15+) 6 3 11 Gross primary enrollment (% of school-age population) 93 103 112 Male 93 104 113 Female 93 102 110 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1985 1995 2005 2006 GDP (US$ billions) 2.7 2.9 Gross domestic investmenVGDP 28.8 31.3 Exports of goods and serviceslGDP 9.2 11.7 Gross domestic savingslGDP -20.0 -20.7 Gross national savingslGDP -6.1 -3.3 Current account balancelGDP -34.8 -34.6 Interest paymentslGDP 0.0 0.0 Total debtfGDP 0.0 0.0 Total debt servicelexports Present value of debVGDP Present value of debtlexports 1985-95 1995-05 2005 2006 2007-10 (average annual growth) GDP -1.0 3.1 4.2 GDP per capita -2.7 1.4 2.5 Exports of goods and services

STRUCTURE of the ECONOMY 1985 1995 2005 2006 (% of GDP) Agriculture Industry Manufacturing Services Private consumption 89.0 91.6 General government consumption 15.3 15.3 Imports of goods and services 58.0 63.7 1985-95 1995-05 2005 2006 (average annual growth) Agriculture Industry Manufacturing Services Private consumption 4.4 5.9 General government consumption -10.4 3.0 Gross domestic investment -7.6 12.1 Imports of goods and services 6.2 13.0

Note: All data for Kosovo are estimates Sources: Most Kosovo data from IMF pre-mission briefing note tables, 09-07 ECA and LMI from DDP

19 Kosovo

PRICES and GOVERNMENT FINANCE 1985 1995 2005 2006 Domestic prices (% change) Consumer prices -1.4 1.5 Implicit GDP deflator -1.8 -0.2 Government finance (% of GDP, includes current grants) Current revenue 28.5 31.3 Current budget balance -3.2 3.6 GDP deflator CPI Overall surplusldeficit -3.2 3.6 I I

TRADE 1985 1995 2005 2006 (US$ millions) Total exports (fob) 69 140 Food Other fuel Manufactures Total imports (cif) 1,349 1,586 Food Fuel and energy Capital goods 2005 Export price index (1995=100) Import price index (7995=100) IExports Imports Terms of trade (7995=700) I

BALANCE of PAYMENTS 1985 1995 2005 2006 Current account balance to GDP (%) (US$ mi//ions) j Exports of goods and services 250 334 Imports of goods and services 1,587 1,823 Resource balance Net income 45 55 Net current transfers 794 862 Current account balance -498 -573

Financing items (net) - Changes in net reserves lIL01-50 - Memo: Reserves including gold (US$ millions) Conversion rate (DEC, /oca//US$) 1.2 1.3

EXTERNAL DEBT and RESOURCE FLOWS 1985 1995 2005 2006 (US$ miilions) Total debt outstanding and disbursed lBRD IDA Total debt service IBRD IDA Composition of net resource flows Official grants Official creditors Private creditors Foreign direct investment Portfolio equity World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

Note All data for Kosovo are estimates 9/14/07 20 Annex 3 - Selected Indicators of Bank Portfolio and Management

CAS Annex B2 - Kosovo Selected Indicators* of Bank Portfolio Performance and Management As Of Date 1012512007

Indicator 2005 2006 2007 2008 Portfolio Assessment Number of Projects Under Implementation a 7 7 6 6 Average Implementation Period (years) 1.4 2.0 1.4 1.7 Percent of Problem Projects by Number a, 14.3 0.0 16.7 16.7 Percent of Problem Projects by Amount a' 15.4 0.0 14.1 14.1 Percent of Projects at Risk by Number a* 14.3 0.0 16.7 33.3 Percent of Projects at Risk by Amount a, 15.4 0.0 14.1 21.8 Disbursement Ratio (%) e 44.7 18.6 23.7 5.8 Portfolio Management CPPR during the year (yeslno) Supervision Resources (total US$) 195.0 484.0 1,027 241 (A) Average Supervision (US$/project) 33 69 128 40

Memorandum Item Since FY 80 Last Five FYs Proj Eva1 by OED by Number 15 10 Proj Eva1 by OED by Amt (US$ millions) 11.8 11.8 % of OED Projects Rated U or HU by Number 6.7 10.0 % of OED Projects Rated U or HU by Amt 0.0 0.0 a. As shown in the Annual Report on Portfolio Performance (except for current FY). b. Average age of projects in the Banks country portfolio. c. Percent of projects rated U or HU on development objectives (DO) and/or implementation progress (IP). d. As defined under the Portfolio Improvement Program. e. Ratio of disbursements during the year to the undisbursed balance of the Bank's portfolio at the beginning of the year: Investment projects only. * All indicators are for projects active in the Portfolio, with the exception of Disbursement Ratio, which includes all active projects as well as projects which exited during the fiscal year.

21 Annex 4 - Summary of Nonlending Services

CAS Annex B4 - Summary of Nonlending Services - Kosovo AS of mte 1012~~07 muct Completion FY Cost (US$OOO) Audience a Objective

Recent completions

Analytical Support to Status Negotiator 2007 62 Don PS Financial Sector Fiduaaty Assessment TA 2007 201 Gov/l DA KWPS Health Management Accountability TA 2007 48 Gov//Don/lWPub KWPSPD Programmatic Poverty Assessment 2007 227 Gov//DodlWPub KWPSPD Policy Note on Public Investment Management 2008 41 Gov//Don/lWPub KG/PSPD

Underway Health Finanang Reform 2008 62 Gov//Don/lDNPub KWPSPD Kosovo Youth and Employment Assessment 2008 62 Gov//Don/lDNPub KWPSPD Policy Note on Corp Governance of Publidy-owned Enterprises 2008 41 Gov//Don/lDNPub KWPSPD Decentralization TA (PCF Grant) 2008 51 Gov//Don/l WPub KWPSPD Education TA (PCF Grant) 2008 nb Gov//DodlWPub KWPSPD Kosovo HD Policy Notes 2008 134 Gov//DonllDNPub KWPSPD Policy Note on Public Expenditure in Education 2008 31 Gov//DodlDNPub KWPSPD Policy Note on Decentralization 2008 31 Gov//Don/lDNPub KWPSPD Programmatic Poverty Assessment 2008 98 Gov//Don/lWPub KWPSPD

Planned

Programmatic Poverty Assessment 2009 95 Gov//Don/lDNPub KWPSPD Programmatic Public Expenditure Review 2009 100 Gov//Don/lDNPub KWPSPD a. Government, donor, IDA, public dissemination. b. Knowledge generation, public debate, problem-solving.

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SERBIA ˆ any endorsement or acceptance of KOSOVO To Nis such boundaries.

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SELECTED CITIES* O To Durrës H U N G A R Y

A SLOVENIA NATIONAL CAPITAL R O M A N I A CROATIA PROVINCE BOUNDARY To Bitola BOSNIA AND HERZEGOVINA SERBIA Adriati INTERNATIONAL BOUNDARIES Black

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APRIL 2007