II. POLITICAL, ECONOMIC and SOCIAL CONTEXT A. Political
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II. POLITICAL, ECONOMIC AND SOCIAL CONTEXT A. Political Environment 4. Kosovo declared its independence on February 17, 2008. By mid-December 2009, Kosovo had been recognized by 63 countries and had become a member of the IMF and the World Bank Group. Kosovo has also been granted the status of potential candidate by the status- neutral European Union (EU). The United Nations Interim Administration Mission in Kosovo (UNMIK) still acts under the United Nations Security Council Resolution (UNSCR) 1244. However, Kosovo authorities are of the opinion that this resolution is no longer relevant, and the national authorities govern under the Constitution of the Republic of Kosovo. The Constitution, which pledges to build an equal, inclusive, and multiethnic society, was ratified on April 9, 2008, and became effective on June 15, 2008. In October 2008, the UN General Assembly requested an advisory opinion from the International Court of Justice (ICJ) on whether Kosovo’s declaration of independence was in accordance with international law. Since then, the Court adopted its first procedural order and has heard arguments from countries with views (both for and against) on the legality of Kosovo’s declaration of independence. The ICJ is expected to issue its non-binding advisory opinion in this matter in the first half of 2010. 5. Kosovo has moved towards greater security and stability in recent years, but international actors continue to play significant roles to address lingering post-conflict security challenges and risks. Ethnic Albanians, who represent more than 90 percent of Kosovo’s population, overwhelmingly support independent statehood. However, ethnic Serbs, who comprise 4 to 6 percent of the population, tend to question the legitimacy of Kosovo’s government and institutions. In this context, the central government has limited control over northern Serb- dominated municipalities and enclaves, and the risk of tensions remains significant. However, the substantial – albeit evolving – international presence minimizes these risks. A NATO-led peace- keeping force (KFOR) has maintained a strong contingent in Kosovo, with 14,500 soldiers from 32 NATO and non-NATO countries. KFOR focuses on maintaining security in North Mitrovica and overseeing the newly established Kosovo Security Force. In 2008, an International Civilian Office (ICO) was established to oversee Kosovo’s compliance with Constitutional guarantees on the rights of ethnic communities. Though the drawdown of UNMIK is expected to be completed by end-2009, this mission continues to facilitate dialogue with Belgrade, monitor developments on the ground, support a field presence in Mitrovica, and supervise border crossings to and from northern Kosovo. Since December 2008, EULEX, the EU-led status-neutral mission, has gradually assumed UNMIK’s police, judicial, and customs duties. EULEX currently has about 2,500 international and national employees in Kosovo, including in Serbian-dominated areas. The multi-ethnic Kosovo Police Service also plays a vital role in maintaining security and stability in the country. 6. The largest political parties in Kosovo are the centre-right Democratic League of Kosovo (LDK), and two parties having their roots in the Kosovo Liberation Army (KLA): the centre-left Democratic Party of Kosovo (PDK) and the centre-right Alliance for the Future of Kosovo (AAK). In addition, the centre-left Reformist Party, ORA, was formed in 2004 and the new Kosovo Alliance was formed in 2006. Kosovo Serbs formed the Serbian List for Kosovo and Metohija (SLKM) in 2004 and won several seats, but have boycotted Kosovo's institutions and never taken their seats in the Kosovo Assembly. 7. Following the November 2007 elections, Kosovo’s government has been dominated by the PDK and the LDK, with the former naming the Prime Minister and Speaker of the Assembly, and the latter the Presidency. In addition, three ministries are administered by minority political parties, in accordance with the provisions of the Constitution. The next general elections were announced for 2011 by the President and the ICO, which provoked a public dispute with opposition parties that had requested an earlier date. Nationwide municipal elections were implemented in November 2009 and were free of violence and generally considered to be well-managed and fair. The Central Elections Commission was fully responsible for organizing the elections, albeit with support from the Organization of Security and Cooperation in Europe (OSCE) mission in Kosovo. The outcome of the elections confirmed the dominant position of the PDK and LDK in Kosovo politics, although the main opposition party, AAK, gained strength in Western Kosovo. Notably, representatives of the Serb community participated in elections and assumed local government positions in some 3-4 municipalities although Serb participation continued to be very limited in Northern Kosovo. 8. In the longer-term, Kosovo is looking to deepen its integration with the EU and an agreed mechanism for monitoring progress towards this goal has already been established. While the mechanism to advance on integration for most Western Balkan countries is the EU’s Stability and Association Process (SAP), an alternative mechanism -- the SAP Tracking Mechanism (STM), established in 2002 – has been established for Kosovo, taking into account its disputed status. Between 2002 and 2006, progress towards integration was monitored regularly via an annual report. In 2006, Kosovo adopted a European Partnership Action Plan (EPAP) designed to meet the requirements of the STM and which has also been updated annually. B. Economic Environment 9. Kosovo’s economic growth has been solid since the end of the conflict, attributable in part to large public investments in post-conflict rebuilding as well as an increase in private investment (albeit from a low base). GDP growth, reflecting the massive donor-funded reconstruction effort and high public and private investment, averaged 4 percent since the end of the conflict and reached 5.4 percent in 2008. It reverted to about 4 percent in 2009 in the wake of the global economic crisis, a better outcome than in most neighboring countries, which suffered declines in output. Kosovo has established the euro as the local currency, which has led to relatively low inflation. Inflation picked up in 2008, but prices began to fall again in 2009, and it was -2.8 percent for the first three quarters of 2009. Kosovo achieved a series of budget surpluses through 2007 when the primary surplus reached 7.1 percent of GDP, due to a conservative policy on recurrent spending, rising government revenues (about 25 percent of GDP), and under-spending on the capital budget. 10. The relatively small impact of the global financial and economic crisis on real growth up to this point reflects Kosovo’s limited international integration with the world economy. Although Kosovo’s exports suffered a sharp decline (about 40 percent) in 2009 after a 4-5 year period of rapid growth, their still-small contribution (5 percent) to GDP, meant the impact on overall growth was proportionately small. The drop in external demand has been offset by rising public expenditures and output growth has been sustained by high inflows of remittances and donor activity. The banking sector has remained stable, with deposits as well as credit to the private sector continuing to grow in double digits. There is some evidence, however, that banks are now more cautious in providing loans. 11. Although Kosovo’s economy has remained resilient to the crisis, the macroeconomic outlook embodies some downside risks. Uncertain economic prospects in the EU could prolong Kosovo's economic slowdown through three main channels: (i) a weak or no rebound in remittances; (ii) continuing softness in demand for Kosovo's exports; and (iii) continued low levels of FDI entering the country. In turn, a prolonged economic slowdown could affect the banking sector, which -- though relatively stable to date -- could see an increase in non- performing loans (NPLs) and a concomitant reduction in willingness to extend credit. Finally, Kosovo faces several domestic and external political issues that have negative economic repercussions. For example, both imports and exports are hindered by the absence of customs controls in the Serb-dominated northern Kosovo, as well as by the non-recognition of Kosovo’s customs stamps and license plates by Bosnia and Serbia. Resolution of these issues is highly unlikely in the near future. 12. Given the lack of monetary policy instruments, fiscal policy is the main anchor for macroeconomic stability, but after some early gains, Kosovo’s 2008-2009 fiscal stance has given cause for concern. Kosovo achieved early successes in fiscal policy, including reforms in tax policy and administration and the introduction of new taxes and collection methods that contributed to a five-fold increase in domestic revenues between 2000 and 2004. Import-related taxes and duties collected at the borders currently account for close to three-quarters of total revenues. While revenue collection has remained relatively strong, significant deficiencies in fiscal policy and planning have become apparent in recent years including lack of clarity on policy priorities and loose management of expenditures. Poor planning and under-spending, mostly of capital expenditure, led in 2007 to a primary surplus of about 7 percent of GDP. The subsequent easing of the government’s cash position led the government to shift towards an expansionary stance in part to address Kosovo’s severe infrastructure gap and in part to cover costs of implementing commitments under the Ahtisaari package with respect to creation of new municipalities and new government departments. As a result, the budget moved to a balance in 2008 and to a projected deficit of 1.9 percent of GDP in 2009 (or close to 7% if the one-off dividend of 5 % of GDP from the telecom company is excluded). This increase was driven mostly by a larger allocation for capital projects, but also by increases in recurrent expenditures, including wages.