PRESS RELEASE
Statement by IMF Staff at the Conclusion of the Article IV Consultation and the PRGF - EFF Review Mission to Albania, April 26 - May 11, 2006

This statement presents the conclusions of the IMF mission that visited Albania to conduct an Article IV consultation and the first review under the PRGF/EFF program. The Article IV consultation focused on the medium-term strategic issues facing Albania. The government shared staff's assessment that the key goals are: maintaining macroeconomic stability; furthering fiscal reform with a view to enhance revenue collection; strengthen debt management and simplify the tax system; containing credit growth; broadening the export base; improving conditions in the electricity sector; and undertaking a wide range of institutional reforms. Under the IMF program, the quantitative and structural performance criteria except that related to KESH were met. Agreement has been reached on the quantitative and structural targets for the next program review, as well as on the broad principles underlying the planned 2006 supplementary budget; however, a final decision on the size and structure of this budget should not be made until July this year.

Albania's macroeconomic performance since the turn of this decade has generally been good. Growth has been rapid and inflation has been reduced. These positive developments owe much to sound frameworks for fiscal and monetary policies. Fiscal policy has been appropriately restrictive, with an emphasis on containing net domestic borrowing and lowering public debt. The absence of fiscal dominance has supported the Bank of Albania's monetary policy framework, which has successfully kept inflation in a 3�1 percent target range.

Despite these notable achievements, the economy remains vulnerable on several fronts because of a culture of tax evasion, large and short-term domestic public debt, poorly regulated and supervised non-bank financial institutions, and weak anti-money laundering and countering the financing of terrorism capacities.

Macroeconomic policies
Notwithstanding past successes, macroeconomic stability could potentially be affected by rapid credit growth and export shocks. Macroeconomic policies need to be adjusted to mitigate the resulting high non-tradable goods inflation and current account deficit. As a first step, stronger prudential and supervisory measures are needed to contain credit growth. These should be complemented by an appropriate tightening of the fiscal stance in the supplementary budget. An interest rate hike at this time is not necessary.

Growth and Institutions
Catching up with middle-income countries will require further major reforms. To sustain high growth with macroeconomic stability and create the conditions for a significant expansion of the export sector, the quality of public and private institutions will have to improve. Reforms that help reduce corruption, formalize the economy, and make the business environment more inviting are essential.

As institutional capacity is limited, the government needs to concentrate on its core functions while promoting the private sector in other areas. Growth enhancing institutional reforms should focus on areas where Albania lags its new competitors, such as property rights and contract enforcement. This will require improving access to title registration; attacking corruption, including in the court system; training judges that deal with commercial cases; and making it easier for banks to execute collateral.

Regarding non-core areas, the mission strongly supports the authorities' intention to adopt a new strategy for the energy sector that will promote increased private sector involvement, including the privatization of electricity distribution. Without these reforms, the energy sector will remain a significant risk to growth over the medium term. The privatization of oil companies, INSIG, and Albtelecom should also be pursued without delay.

Fiscal Strategy
The authorities' strategy to keep the government small but make it more efficient while improving the quality of public expenditures is appropriate. Reforms should focus on strengthening fiscal management to decrease fiscal vulnerabilities and pay down public debt.

The authorities' goal to contain total public expenditure of the general government at about 30 percent of GDP over the medium term should be achievable. Enhancing the efficiency and quality of public spending and developing an institutional framework that ensures value for money, will, however, require a substantial effort and is an ongoing challenge. To that end, the medium-term expenditure framework and the National Strategy for Socio-Economic Development need to be integrated effectively within the budget process.

A balance needs to be struck between undertaking priority expenditure on infrastructure, education, and health on the one hand, and reducing public debt on the other. The medium-term fiscal adjustment path envisaged by the authorities results in a gradual reduction in public indebtedness, but this path could be buffeted by shocks leaving Albania vulnerable. It will therefore be important to use a considerable part of the revenue gains from tax administration reforms to reduce debt relative to GDP more decisively if these gains turn out to be significant.

Tax policy and administration reforms should support growth and improve the business environment by eliminating distortions and reducing compliance costs. Apart from a reduction in high social security contribution rates and the elimination of customs tariffs on imported equipments, there is no room for cuts in statutory tax rates at this time. Rather, the immediate priority is to simplify the tax system, broaden the tax base, and create a culture of tax compliance. If successfully implemented, these steps will create room to cut tax rates in the future. Revenue administration reforms are also essential to reduce vulnerabilities. Progress made so far in improving customs administration and strengthening the Large Taxpayers Office is encouraging but continued efforts are needed to consolidate these improvements.

Future tax reforms should be introduced at a measured pace, making certain that revenue gains are sustainable and allowing room for debt reduction. The authorities envisage further reductions in tax rates to reduce distortions and promote formalization of the economy. To this end, over 2007-09, tax reforms will be reviewed every six months to evaluate progress on revenue gains and broadening of the tax base. Emphasis will be on further reductions in social security contributions while taking care to safeguard the financial stability of the pension system. In a second step, parallel reductions in personal income and corporate profit taxes are envisaged. Reductions in the VAT rate will only be considered as a last option given its relative lack of distortion, as well as important contribution to total revenue collections.

To reduce the vulnerabilities created by a relatively high level of public debt, public debt management needs to be improved significantly. An action plan should be formulated soon drawing on the recommendations of the recent IMF TA mission. The submission of a new public debt law and the formulation of a debt management strategy are the most important first steps in implementing this action plan.

Supplementary Budget
The supplementary budget is to be directed to high-quality infrastructure investments and to reduce the debt burden. In light of the strong revenue performance so far in 2006, an agreement has been reached in principle on a supplementary budget for the second half of the year that will focus on high-priority capital spending primarily road construction which is badly needed to improve poor infrastructure and to enhance growth and reduce poverty. To reduce fiscal vulnerabilities about � percent of GDP will be saved. However, the government will only decide on the size and structure of the supplementary budget in July, in consultation with IMF staff. To increase the flexibility of the budget, part of investment expenditure can be reallocated before the end of the year to capital transfers to cover future cost of expropriation of land.

The supplementary budget will also mark a step forward on the authorities' ambitious plans for tax reform. Staff supports the authorities' plan to use part of the gains from tax administration to significantly reduce social security contributions paid by employees, by up to 9 percentage points, to promote employment and participation in the formal economy. The authorities will need to consult the World Bank to ensure that the planned rate reduction does not endanger the sustainability of the pension system. The authorities also plan to eliminate customs tariffs and introduce VAT deferral for imported capital goods with a view to promoting investment. The revenue losses will largely be offset by increases in excise duties, bringing them in line with those of the rest of the region.

Financial System Stability
Albania has a strong, sound, profitable, and liquid banking system that is developing quickly, accompanied by rapid credit growth. Deepening financial intermediation is important for a vibrant and dynamic economy, such as Albania. However, this will also require careful management of the potential risks arising from rapid credit growth. The creation of a credit bureau within the Bank of Albania that is accessible to all banks and the improvement of the framework for collateral execution will be important steps in this direction.

To contain credit growth and reduce risks, the Bank of Albania stands ready to implement further measures to enhance banking supervision and prudential regulations. Specific recommendations to improve the pricing of risk by banks and tighten bank regulation and supervision (with particular focus on nonperforming loans) are contained in the aide memoire of the parallel IMF technical assistance mission of experts from the Monetary and Financial Systems Department. These actions together with the current prudent stance of fiscal and monetary policies are expected to be sufficient at this juncture. However, if necessary in the future, the Bank of Albania, after consulting with IMF staff, should stand ready to implement additional measures.

There is an urgent need to strengthen non-bank financial supervision. The current supervisory agencies are weak and lack independence. The mission therefore welcomes the authorities' plan to create a unified agency that will incorporate insurance and pension fund supervision and the securities commission. The new agency should be independent, sufficiently funded, and have a properly trained staff to make supervision effective.

Statistics
Official statistics are in need of further major improvement in order to serve as a reliable basis for policy making. National accounts statistics still contain significant weaknesses and need further improvements, including the recently revised 2004 data. The lack of timely and high-frequency labor market and wage data remains a challenge for monetary policy analysis, and further efforts are needed by INSTAT in this area in cooperation with the Bank of Albania. Furthermore, the assessment of the balance of payments is complicated by the significance of private transfers and the large informal economy.

Program issues
The performance criterion on collection and loss rates for KESH for the first quarter of 2006 was not met. While electricity supply has been restored and certain short-term alleviating measures have since been taken, further efforts are needed to bring KESH's financial performance back on track.

All other targets of the program were met and an agreement has been reached on the quantitative targets and structural conditionality for the next program review.

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The mission would like to thank the authorities for their outstanding cooperation and warm hospitality.

István P. Székely K. Ann-Margret Westin
Mission Chief Resident Representative