WORLD BANK GROUP Gearing up for a More Productive Future November 2021 Kosovo Country Economic Memorandum  1 Kosovo Country Economic Memorandum Gearing up for a More Productive Future Table of Contents Acknowledgments 7 Acronyms  8 Executive Summary 10 Overview 12 Macroeconomic Overview 26 Raising Firm Productivity 44 Raising Farm Productivity 58 Improving Education Quality 70 Removing Regulatory Barriers to Competition 80 Boosting Exports 90 Boosting Foreign Direct Investment 106 2  Figures Fig 1. Growth Volatility, 2008–19, Fig 21. Human Capital Index, 2020 Fig 39. Employment by Sector, Percent p.28 p.39 Average Shares, 2012–19, Fig 2. Consumer Price Inflation Fig 22. Worldwide Governance Percent p.61 Volatility, 2010–19, Percent indicators, 2019, Index = –2.5- Fig 40. Agricultural Labor Productivity, p.29 2.5 p.39 Kosovo and Peers, Constant Fig 3. Domestic Bank Credit to the Fig 23. GDP per Capita Projections 2010 US$ p.61 Private Sector, 2010 and 2019, Based on Structural Changes, Fig 41. TE and SE Scores in Agriculture, Percent of GDP p.29 US$, 2020–60 p.41 2017 p.62 Fig 4. Financial Soundness Indicators, Fig 24. TFPR, Sales, and Value Added Fig 42. Mean TE and SE Scores by Farm 2011–20, Percent p.30 per Worker, 2013–17, Percent Size, Kosovo, 2017 p.63 Fig 5. Real GDP Growth, 2010–19, p.46 Fig 43. GDP and Commercial Loan Percent p.30 Fig 25. TFPR Growth, 2014–17, Percent Shares by Sector, 2018 p.63 Fig 6. GDP per Capita, 2009–19, US$, p.47 Fig 44. Density Distribution of TE and Percent p.31 Fig 26. Active Firms by Size, Average, SE, Kosovo, 2017 p.64 Fig 7. Actual and Potential Growth, 2010–18, Percent of Total p.47 Fig 45. TFP Growth by Farm Size Percent, 2010–19 p.31 Fig 27. Turnover Comparisons by Firm Kosovo, 2015–17, Percent p.64 Fig 8. GDP per Capita Projections, Size Relative to EU Averages, Fig 46. Agricultural Value Added US$, 2019–59 p.32 2018; Index EU=100 p.48 (Percent of GDP) and Spending Fig 9. Kosovo’s Economy, Shares of Fig 28. Employees in Active Firms, (Percent of Public Spending) Value-added, 2010 and 2019, 2010–18, Thousands p.49 Compared with Peers, 2017 Percent p.32 Fig 29. Firm Age and Employment p.65 Fig 10. Kosovo’s Economy, Growth By Number of Fig 47. Direct Payments to Farms by Employment Shares, Average Employees at Birth (Size Class) Economic Size, Kosovo, 2017, 2012–19, Percent p.33 p.49 Percent p.66 Fig 11. Drivers of Demand-side Fig 30. Kosovo Firm Density Relative to Fig 48. Agriculture Spending by Growth, 2010–19, Percent Western Balkan and EU Peers, Function, Kosovo, € Million at p.34 2018 p.50 Current Prices, 2014–19 p.66 Fig 12. Drivers of Supply-side Growth, Fig 31. Survival Rates by Firm Age, Fig 49. Mean TE Scores by Farm Size 2010–19, Percent p.34 Percent of Total Firms p.50 and Subsidies, Kosovo, 2017 Fig 32. Net Firm Entry and Exit Rates p.66 Fig 13. Investment as a Share of GDP, 2008–19, Percent p.35 p.51 Fig 50. Mean TE Scores by Farm Fig 33. Exporters and Importers, Products and Subsidies, Fig 14. Share of Public and Private Percent p.52 Kosovo, 2017 p.67 investment, 2010–19, Percent p.35 Fig 34. Gender of Firm Decision- Fig 51. Agribusiness Firms by Product, makers, Percent of Total Firms Kosovo, 2018, Percent p.68 Fig 15. Decomposition of GDP into its Drivers, 2008–19, Percent p.36 p.53 Fig 52. Agri-food Trade, Kosovo, Fig 35. Loans to the Private Sector 2014–18, Percent of Goods Fig 16. Diaspora-Related Flows, by Term, Average 2015–18, Trade p.68 2009–19, Percent p.36 Percent of Total p.54 Fig 53. Population by Age, Percent and Fig 17. Unemployment, Kosovo Fig 36. Productivity and Access to Average Age, Years, 2020–60 and Comparator Countries, Credit p.55 p.72 2009–18, Percent p.37 Fig 37. Agricultural VA, Compared Fig 54. Gross Enrollment by Level, Fig 18. Unemployment, 2012 and to Structural and Aspirational Percent p.73 2019, Percent p.37 Peers,a 2008–19, Percent p.60 Fig 55. Lower and Upper Secondary Fig 19. Net FDI, US $Million, 2004–19, Fig 38. Structure of Gross Value Added Enrollment, Countries Rates Percent of GDP p.38 in Kosovo and Comparators, Compared, Percent p.73 Fig 20. Net FDI by Sector, ¤Million, 2010 and 2019, Percent p.60 Fig 56. Proficiency in Math and 2008–19, Percent of GDP p.38 Science, TIMSS 2019, 4th Graders p.74 Fig 57. Students Not Functionally Fig 75. Composition of Kosovo’s Fig 90. Technology and Literate in Reading, PISA 2018, Services Exports, 2010–19, Innovation Responses of Percent p.74 Percent p.92 Businesses to the COVID-19 Fig 58. Matura 12 Exam Results by Fig 76. Exports of Goods and Services Crisis, Comparison to Peers, Municipality, 2019, Percent p.75 per Capita, Current US$, 2018 Percent of Firms Reporting p.93 Adjustment p.102 Fig 59. Spending on Pre-university Education p.75 Fig 77. GDP (PPP) and Exports of Fig 91. Buying or Ordering any Goods Goods and Services per Capita, and Services over the Internet, Fig 60. Education Spending, Total in Logs, 2018 p.93 2018–20, Percent p.102 Government Spending, and GDP Compared, 2019 p.76 Fig 78. GDP (PPP) and Exports of Fig 92. Digital Regulatory Readiness Goods per Capita, in Logs, Scores p.103 Fig 61. Municipal Per-Student Costs, Pre-university Education, Euros 2018 p.94 Fig 93. Fixed Broadband Penetration, p.76 Fig 79. Exporter Premium p.94 2020 4Q, Percent p.103 Fig 62. Municipal Student-Teacher Fig 80. Composition of goods export Fig 94. Fixed Broadband Penetration Ratios p.77 by chapter in 2010, million by Municipality, 2020 4Q, euros p.95 Percent p.104 Fig 63. Estimated Impact of COVID-19 on PISA Scores p.78 Fig 81. Firms Exporting Services and Fig 95. Made or Received Digital Export Value, US$ Millions, Payments in the Past Year, Fig 64. Estimated Impact of COVID-19 Total Firms, 2013–18 p.96 Respondents Age 15+, Percent on the Socioeconomic p.104 Achievement Gap p.78 Fig 82. Firms and Exports by Sector, Average 2013–18, Percent p.96 Fig 96. Reasons for Not Having a Bank Fig 65. Market-based Competition Account Respondents Age 15+, Score p.82 Fig 83. Median Export Value per Firm Percent p.105 Fig 66. Anti-monopoly Policy Score and GDP per Capita (PPP), Current US$, in Logs p.97 Fig 97. Net FDI Inflows Compared, US$ p.82 Million, 2004–19 p.108 Fig 67. PMR Indicators: Overall Score Fig 84. Products Exported and Destinations Served, 2013–19 Fig 98. Kosovo’s Greenfield FDI p.83 p.97 Overview vs Comparators Fig 68. Decomposition of the PMR p.109 score p.84 Fig 85. Total Products Exported and Destinations Served per Firm, Fig 99. Kosovo: FDI Inflows by Sector, Fig 69. PMR Subindicator for ¤Millions, 2007–19 p.110 Average by Country p.98 Distortions Introduced by Fig 86. Firms Entering and Exiting Fig 100. Remittances and FDI, Percent State Ownership: Score and Foreign Markets, 2014–18 p.99 of GDP, 2008–19 p.110 Composition, Percent p.84 Fig 87. Entry, Exit, and Net Turnover Fig 101. Comparison of Total Annual Fig 70. PMR Subindicator for by Country, Percent of Total Labor Costs for Varying Skill Administrative Burdens on Goods Exporters p.99 Levels by Activity, Euros, 2019 Start-ups, Percent p.85 p.111 Fig 71. PMR Subindicators for Fig 88. Employment Growth, Firms by Sector Surviving 5 Years, Fig 102. Comparison of Infrastructure Professional Services p.86 Average Staffing, 2017–18 and Factor Input Determinants Fig 72. PMR Sub-indicators for p.111 p.101 Network Sectors, index=0-6 Fig 89. Technology and Fig 103. Comparison of Determinants of p.88 Innovation Responses of Political Risk p.112 Fig 73. PMR Subindicator for Retail Businesses to the COVID-19 Distribution p.89 Crisis, Percent of Firms Fig 74. Decomposition of Kosovo’s Reporting Adjustment p.101 Trade Balance, €Billion, 2004–20, Percent of GDP p.92 Tables Boxes Table 1.  Five-Year Transition Box 1. Kosovo has made Matrix by Firm Size, significant progress 2012 and 2013 Firm since 1999 p.40 Cohorts, Average p.48 Box 2. The Productivity Table 2.  Ratio of Productivity Measures Used in in “Laggard” (90th Analysis of Kosovo percentile) to Firms p.46 “Frontier” (10th Box 3. Drivers of Agricultural percentile) Firms Productivity: by Sector and Size, Methodology and Data Average 2012–18 p.52 Sources p.62 Table 3.  TFPR in Micro- Box 4. Decoupling p.69 Enterprises Relative Box 5. Methodology and to Other Firm Classes Structure of the 2018 p.53 OECD-WBG Product Table 4.  Access to Credit by Market Regulation Firm Class, Average, Indicators for Kosovo 2015–18 p.54 p.83 Table 5.  Potential Correlates with Productivity in Kosovo p.55 Table 6.  Estimated and Actual Input Slack, Kosovo, 2017 p.67 Table 7. Agribusiness Enterprises in Kosovo, 2014–18 p.68 Table 8.  Kosovo: School Facilities with Inadequate Infrastructure by Type of Issue, 2016 p.77 © 2021 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. 6  Acknowledgments The team was led by Aslı Şenkal (macro overview, firm-level analysis and export dynamics, synthesis report), and consisted of Richard Record (overview), Besart Myderrizi (macro overview); Lucio Castro and Leonardo Iacovone (firm dynamics and export dynamics); Matias Belacin (export dynamics); Silvia Mauri, Demetris Psaltopoulos, and Kostas Tsekouras (agriculture); Angela Demas, Syedah Aroob, Mrike Aliu, and Paul Calu (education); Cesar Borja Galan Santos and Maciej Drozd (competition); Harald Jedlicka, Yan Liu, Zenia Ann Rogatschnig, and Dayo Ojalaye (FDI); Ian John Douglas Gillson and Karen Muramatsu (services trade); Vicky Chemutai (goods trade and trade policy); Oya Pınar Ardıç Alper, Gynedi Srinivas, Francesco Di Salvo, and Nenad Bosiljic (e-payments); Lillyana Sophia Daza Jaller and Martin Molinuevo (digital trade regulatory framework); Violane Konar-Leacy and Mimoza Miftari (trade facilitation); Natalija Gelvanovska Garcia (Digital Connectivity); Tehmina Khan (synthesis report). Blerta Qerimi, Edith Kikoni, Thanh Thi Thanh Bui, and Fisnik Salihu provided inputs to different chapters. The external communications support from Lundrim Aliu and administrative and operational support from Mismake Galatis, including formatting of several background notes, and administrative support from Leah Laboy, Mjellma Rrecaj, and Ivana Bojic are acknowledged with thanks. Anne Grant edited the main manuscript, firm productivity, agriculture, and education background papers, and Barbara Karni edited the FDI and trade policy background papers. The main report and accompanying materials were designed and typeset by Vigan Kada. The CEM project was guided by Linda Van Gelder, Massimiliano Paolucci, Jasmin Chakeri, and the Western Balkans Country Management Team. The team is also grateful to reviewers, especially Enrique Blanco Armas, Donato de Rosa, Habib Rab, Bledi Celiku and Martha Licetti (World Bank), and Gabriel Di Bella (IMF). Support provided from the Global Facility on Growth for Development by the Republic of Korea for the Kosovo Productivity Survey and the Umbrella Facility trade trust fund for the trade analysis are gratefully acknowledged. The team is also grateful for comments from representatives of the EU, USAID, several business associations, and firms. The team also thanks the Ministry of Finance, Labor and Transfers, Central Bank of Kosovo, Ministry of Economy, Ministry of Agriculture, Forestry, and Rural Development, Ministry of Education, Science and Technology, Ministry of Trade, Entrepreneurship, and Industry, Ministry of Economy, Kosovo Agency of Statistics, and Kosovo Customs Agency for their excellent cooperation and timely response to data requests. Background papers prepared for this report: Increasing Firm Productivity Raising Farm Productivity Enhancing Human Capital by Improving Education Removing Regulatory Barriers to Competition Boosting Exports Boosting Foreign Direct Investment  7 Acronyms ARKEP Autoriteti Rregullativ i Komunikimeve Elektronike dhe Postare BPS Business Pulse Survey CEM Country Economic Memorandum CBK Central Bank of Kosovo EU European Union FADN Farm Accountancy Data Network FDI Foreign direct investment FYR Former Yugoslav Republic GDP Gross domestic product GVC Global value chain HCI Human Capital Index ICT Information technology and communications KAS Kosovo Agency of Statistics KBRA Kosovo Business Registration Agency KCD Kosovo Customs data KCR Kosovo Credit Registry data KESP Kosovo Strategic Plan KTR Kosovo Tax registry data LSI Law on Strategic Investments LP Labor productivity PP Percentage point SE Scale efficiency SOE State-owned enterprise MICS Multi-indicator cluster survey MFI Microfinance institutions MPO Macro Poverty Outlook MTEF Medium Term Expenditure Framework NIS National Innovation system TC Technical change TE Technical efficiency TFP Total factor productivity TFPR Total factor productivity revenue OECD Organisation for Economic Co-operation and Development PISA Programme for International Student Assessment PMR Product Market Regulations POE Publicly Owned Enterprises SMEs Small and medium enterprises STEP Skills measurement program STRI Services Trade Restrictiveness Index TIMMS Trends in International Mathematics and Science Study VA Value added WDI World Development Indicators 8   9 Executive Summary Gearing Up for a More Productive Future Kosovo, one of the youngest countries in an aging Europe, While spending on education has more than doubled, the took its first steps on the road to greater prosperity a quality of human capital needs to improve. Kosovo spends quarter of a century ago. However, to reach the current 4.6 percent of GDP and 16 percent of total government living standards of aspirational peers, like Latvia, Estonia, spending on education, similar to comparators. But only Lithuania, the Czech Republic, and Slovenia, in the next 23 percent of pre-school children are on track in terms of two decades, Kosovo must accelerate its growth by expected literacy and numeracy skills. stepping up reforms. Doing so would not only accelerate And barriers to women’s economic empowerment need Kosovo’s growth but speed up a successful recovery from to be lifted. Only 20 percent of women actively participate the COVID-19 pandemic. in the labor market. Women’s participation in the economy Kosovo’s economy has experienced significant growth as entrepreneurs is also quite limited. in recent years. In the last 25 years, per capita income Proximity to major markets in Europe and a youthful increased more 10-fold from about US$400 in 1995 to over population provide an opportunity for growth. Kosovo US$4,000 today. Despite progress, per capita income per is one of the youngest countries in an aging Europe. Trade capita is still only 12 percent of the average EU member facilitation and logistics connectivity are getting better. state or 20 percent of aspirational peers. On current trends, Proximity to a large and affluent market, low taxes and Kosovo will only reach the income that its key aspirational labor costs, a resilient and liquid financial sector, and peers have today in about thirty years’ time. strong ties with its diaspora will help support growth. The COVID-19 pandemic has triggered Kosovo’s first ever recession in 2020. Like the rest of the world, COVID-19 pushed Kosovo into a deep recession in 2020, its first since independence. A prolongation of the pandemic has the potential to slow the pace of growth going forward Yet, with the right reforms, Kosovo can and have a long lasting impact on the economy, particularly gear up for a more productive future. by eroding human capital. Harnessed in the right way at the right time, Lack of jobs is a major impediment to inclusive growth. Kosovo’s strengths could prove a catalyst for Only 2 in 5 people of working age are participating in the accelerating growth to achieve higher living labor market and 1 in 4 people can’t find a job. On a positive standards. A package of reforms to (1) entrench note, dynamism increased with 10,000 formal jobs added macroeconomic stability and sound governance; to the economy on average annually between 2015 and (2) increase firm productivity; (3) raise farm 2018, doubling 2011-2014 job creation. productivity; (4) enhance human capital; and (5) boost exports, competition and private And productivity in businesses and on farms is too low. investment, especially foreign direct investment Labor productivity is only a third of that of an average EU (FDI), could see Kosovo closing the gap with its company and the average farm could produce the same amount aspirational peers much sooner. of output using 70 percent less inputs. Business is dominated by small enterprises that often fail to grow and survive. 10  Increasing Firm Productivity Reduce administrative burden, regulatory uncertainty and continue to improve access to finance Strengthen the national Raising innovation system and Farm Productivity foster digitalization Reallocate public support Remove barriers to measures to facilitate women's participation agricultural scale economies in the economy Target measures to competitive farm enterprises to support value chains Enhancing Speed up land titling and Human Capital invest in modern irrigation to sustainably manage natural resources Optimize the school network and re-orient spending to reduce infrastructure gaps and improve quality Boosting Improve learning Exports, Competition assessments to guide and and Investment motivate teaching quality Improve regional Accelerate plans to digitalize integration and promote education delivery it as a springboard for global integration Modernize the investment promotion ecosystem to attract and retain quality investments Improve trade facilitation and connectivity including Entrenching for digital trade Macro Stability and Reduce barriers to Sound Governance competition Improve the e ciency of public spending through better targeting Increase revenue mobilization by reducing exemptions and leakages Strengthen rule of law With the right and judicial system reforms, Kosovo can gear up for a more productive future  11 Overview Kosovo has come a long way since gaining independence two decades ago, and today is classified as an upper middle- income economy. In the last 25 years, income per capita in Kosovo increased more than 10-fold from US$400 in 1995 to over US$4,000 in 2019. This impressive growth was built on The Kosovo the reconstruction of physical assets, a strong commitment Country Economic to creating a market economy with sound institutions, and a Memorandum (CEM) desire to connect to the rest of the world. investigates current Before the COVID-19 pandemic, stable economic growth drivers of growth and helped to improve living standards and reduce poverty. In the decade leading up to the pandemic, real GDP growth sets out a reform agenda in Kosovo averaged 3.6 percent, faster than several regional for a more productive peers. Poverty fell by 7.8 percentage points between 2012 and future. 2017. However, there remains a large income gap between Kosovo and the average European Union member state, and this gap is closing only at a slow pace. Kosovo’s income per capita is only 12 percent of the average EU member or 20 percent of aspirational peers (Latvia, Estonia, Lithuania, the Czech Republic, and Slovenia). At Kosovo’s estimated current potential for growth, reaching the today’s living standards of aspirational peers would take more than 30 years. Similarly, despite considerable progress in poverty reduction, around 2 in 10 Kosovars still live on less than US$5.5 per day. The pandemic interrupted Kosovo’s development journey, triggering the country’s first recession since independence. Kosovo, like the rest of the world, is experienced one of the deepest recessions in 2020. The pandemic will likely a have long lasting impact on the economy, in particular by eroding human capital. INCREASING RAISING ENHANCING Firm Productivity Farm Productivity Human Capital Business regulations, Value chain integration Education Access to finance Sustainable use of Skills development Digitalization natural resources Labor force participation Improved public spending 12  Reforms undertaken today will both shape the recovery In the long term, the most important driver of convergence from COVID-19 and pave the way to a more sustainable, in living standards is sustained productivity growth. resilient, and inclusive growth path. Kosovo needs a Between 2009 and 2019, Kosovo on average invested 28 new reform agenda that builds on Kosovo’s strengths to percent of its GDP, more than aspirational peers. In addition, transform the current model which is based on consumption between 2012 and 2019, 60,000 jobs were added to the and unproductive investments, to one which is driven by economy, which pushed up the employment rate from 25.6 productivity and human capital. to 30.1 percent. However, despite an improved labor market and investment performance, between 2015 and 2019 total Carefully leveraged, Kosovo’s strengths—a young factor productivity (TFP) increased by an average of just 0.5 population, proximity to a large, affluent, and aging market, percent when measured using firm level data. Maximizing the good digital connectivity, low labor costs, a resilient and returns on investment in physical and human capital requires liquid financial sector, and strong ties with its diaspora— sustained improvement in productivity—the efficiency with could carry Kosovo to higher living standards, faster. This which firms and farms transform their inputs into outputs. requires, transitioning to a growth model that better utilizes Kosovo’s human capital potential, enabling firms and farms to Improving educational and labor market outcomes grow and increase their productivity to maximize the returns could accelerate convergence to higher incomes. Poor to investments in physical capital, and leverages higher educational outcomes, low labor force participation and connectivity through exports, more competition and foreign high unemployment have limited the contribution of human investment. capital to growth. In 2019, only 2 in 5 of Kosovars of working- age participated in the labor markets and 1 in 4 people looking The Kosovo Country Economic Memorandum (CEM) for a job could not find one. Low labor force participation in investigates current drivers of growth and sets out a Kosovo is largely driven by the gender gap, as only about 1 in 5 reform agenda for a more productive future. For Kosovo to of women actively participate in the labor market. achieve and maintain higher growth, greater emphasis needs to be placed on enhancing human capital and improving productivity. Kosovo’s firms and farms need to operate at higher levels of efficiency, with deeper efforts to remove regulatory barriers, ensure efficient allocation of scarce financial and natural resources, and embrace digitalization. Human capital institutions need to more effectively transform Kosovo’s youthful population into a productive workforce. And only by improving trade and connectivity, by strengthening market competition and promoting high quality investment can Kosovo take full advantage of the GEARING UP for a more opportunities provided by its location. Finally, a fundamental requirement for sustainable and inclusive growth is a stable macroeconomic environment and the effective rule of law. productive ENTRENCHING future BOOSTING Exports, Competition Macro Stability and and Investment Sound Governance Trade facilitation Foundational Inclusive Competition policy requirements Resilient Investment promotion Sustainable growth eco-system in Kosovo  13 INCREASING Only a more dynamic private sector can carry Kosovo to higher living standards. Sustained job creation and economic growth Firm will depend on the country’s ability to create an environment where productive firms can thrive. The recent dynamism in growth is encouraging but it is not enough to create a vibrant Productivity private sector that would shift Kosovo to a more sustainable, inclusive, and resilient growth path. Firms in Kosovo are overwhelmingly small, and few survive long enough to reach higher levels of efficiency, grow, and create better jobs. Between 2015 and 2018, an average of 10,000 net formal jobs were created every year, about twice the number created between 2011 and 2014. However, the landscape of firms is still dominated by low-productivity micro and small enterprises that fail to grow. Over a five-year period, more than 70 percent of micro firms remained micro. As a result, firm density (the number of firms per inhabitant) and average firm size are both lower than would be expected given Kosovo’s level of development. Firm survival, especially for micro enterprises, is also much lower than in comparator countries. The average annual net rate of firm creation in Kosovo—the difference between firm entry and exit— was close to zero, a symptom of a pronounced lack of dynamism for such a young economy. Furthermore, few women participate in the economy as entrepreneurs, which further erodes Kosovo’s potential productive capacity. Improvements in firm productivity could pave the way for better opportunities for Kosovar citizens. Labor productivity in Kosovo is only a third of the average for EU companies and between 2012 and 2017 its growth was negative. During the same period growth in TFP, though positive, averaged only 0.5 percent, delaying Kosovo’s aspirations to close the income gap with the EU. There is also a wide gap between the most and least efficient firms. Global links through foreign investment and exports are also not strong enough to push Kosovo to a higher and more resilient growth path. Furthermore, the pandemic-induced recession has hit the real sector hard. Hence, the pandemic may worsen slow productivity growth. Incentivizing digitalization of firms could increase productivity and improve market access. The COVID-19 pandemic has accelerated digital adoption of firms. Between April and June 2020, about 25 percent of Kosovar firms increased their use of digital platforms and 7 percent invested in digital solutions. However, large firms invested the most in digital solutions, innovation, and use of digital platforms. Now, incentivizing and enabling digitalization is crucial for Kosovo’s micro and small firms so that they do not fall behind. Though Kosovo has a strong regulatory pillar for digital trade, gaps still to be addressed relate to e-ID, online consumer protection, and intermediary liability. Kosovo’s stable financial sector is well-placed to support a more dynamic private sector. Better access to credit could facilitate more investment and innovation to enhance productivity growth. Lower credit constraints would also enable more productive firms to expand or new firms to enter the market, contributing to productivity growth. Between 2010 and 2018, domestic credit to the private sector in Kosovo increased from 35.4 to 44.1 percent of GDP, but still fewer than a third of firms have access to financing through formal channels and more than 70 percent of credit to the private sector consists of short-term loans. Improving access to finance could facilitate firm growth and enhance export potential. 14  RAISING More productive farms would create jobs and promote more efficient use of natural resources. Kosovo farms, especially Farm those that are micro and small, do not transform inputs into outputs efficiently. An average farm could produce the same amount of output using 70 percent fewer inputs; Kosovo farms Productivity are simply not technically efficient. Although larger farms are more efficient, there are few of them; some 75 percent of all farms in Kosovo are small. Specialized farms could drive growth if agricultural and land market constraints are removed. Farms specializing in high- value crops like horticulture are more efficient but struggle to grow and exploit economies of scale due to a dysfunctional land market and credit constraints. Surprisingly, Kosovo is also not benefitting from its demographics: unlike in neighboring countries, its younger farmers are not the most productive. Furthermore, relatively high public spending does not necessarily promote higher productivity among farmers who receive agricultural subsidies.  15 ENHANCING Given Kosovo’s demographics now is a critical time to Human improve the quality of education. Kosovo is one of the youngest countries in an aging Europe, but its demographics are evolving quickly. Currently, children under 14 constitute 24 percent of the Capital population and will be joining the labor force within the next 20 years. Hence, investing in education quality today will not only improve their lives and support inclusion but would also bring large returns to the economy and lead to faster growth. Only an education system that can provide both adequate access and, more important, high quality for all can produce skills that respond to changing labor market demands. The pandemic might worsen education outcomes and widen learning gaps between different student populations. Furthermore, the worrisome dearth of school digital equipment and connectivity is likely to have a negative impact on the digital capacities of the society. Even so, the potential demographic bonus can unlock Kosovo’s growth potential and open up access to the large, advanced, and aging EU market. While Kosovo has started to invest more in human capital formation, the return on that investment is low. At 4.6 percent of GDP and 16 percent of total government spending, Kosovo’s public spending on education is similar to that of other middle- income countries. However, there are large gaps in enrollment in preschool and secondary education, infrastructure, and overall quality. Preschool enrollment is below the 20 percent national target, and secondary school coverage is not universal. Lack of access to early childhood education and low preschool coverage translate into poor literacy and numeracy outcomes at all stages of learning. Better utilization of human capital through improved education outcomes would boost growth. Only 23 percent of children aged 36–49 months are developmentally on track for literacy and numeracy. By the end of lower secondary, about 79 percent of 15-year-old students did not meet functional literacy and numeracy standards in the 2018 OECD Program for International Student Assessment (PISA); the OECD average was 23 percent. There are also significant differences in terms of access, school attainment, and outcomes between municipalities and communities, and the education gap also varies negatively with family income. As a result of these gaps, some 75 percent of firms that attempted to fill a higher skills position and 60 percent of those that tried to fill a medium- to lower-skills position were unable to find qualified candidates. 16  BOOSTING Kosovo’s location offers significant opportunities for growth Exports, and job creation through international integration. As a small economy, Kosovo would benefit from integration, both globally and regionally, to exploit scale economies. Higher exports would Competition not only contribute to growth and lower current account deficits but could also help heighten productivity due to more innovation and learning by exporting. & Investment Export competitiveness in goods is weak, with a dependence on commodities and a large trade deficit in goods. Despite some recent dynamism, Kosovo’s export competitiveness trails regional and aspirational peers. The high trade deficit in goods is partly offset by the trade surplus in services, with exports of services focused on travel and transport and driven by demand from the Kosovar diaspora. Goods exports are also concentrated in commodities, where base metal and minerals account for almost half of total export value. However, diversification is increasing, driven by agribusiness as well as other manufactured products. Though they are few, exporters and foreign-owned firms are larger, more productive, more capital-intensive, pay higher salaries, and are more likely to invest. Also, in Kosovo exporters and firms with foreign investors have demonstrated greater resilience in the face of the pandemic. These findings suggest that higher exports and FDI would not only lead to higher productivity but could also contribute to greater resilience to economic shocks. Further integration within the region through exports can act as a springboard toward the EU market—firms exporting within the region are more likely to later enter the EU market. Similarly, better leveraging the strong diaspora ties could provide an opportunity to boost exports. Enhancing the regulatory environment and increasing market competition could boost productivity. Restrictions on competition in Kosovo include state involvement in the economy, such as preferential treatment for publicly owned enterprises (POEs), design of regulatory processes, and barriers to domestic and foreign entry in regulated professions and network sectors like electricity, telecommunications, and transport. Enhancing competition, unlocking digital trade, and reducing barriers to service trade could level the playing field for firms, ease entry restrictions, and perhaps contribute to the post-COVID-19 recovery. Foreign investment can help create better jobs and spur more resilient economic growth. FDI can provide access to regional and global value chains (GVCs) that support value-added exports. Furthermore, foreign investment could ignite higher productivity growth through technology transfers, higher quality standards through backward linkages with domestic suppliers, and enhanced competitiveness. Kosovo has attracted less FDI in recent years than regional comparators. Furthermore, most of its FDI is concentrated in non-tradable sectors with limited potential for productivity spillovers.  17 A More Although the main drivers of growth are productivity, physical capital and human capital, maintaining macroeconomic stability and sound governance is necessary Productive for sustained and inclusive growth. The pandemic has weighed on Kosovo’s fiscal position and the stability of its economy. Building on strong foundations with fiscal rules and financial stability, Kosovo can safeguard its headline Future macroeconomic stability. Good governance is demonstrated in a well-functioning court system, a consistent system of law, effective application of laws and rules, a stable political climate, transparency, and established consultation procedures. Improvements in governance would not only attract more foreign investment but would also provide a more stable environment for domestic investors. With the right reforms, Kosovo can capitalize on its youthful population and proximity to major markets to achieve faster and more inclusive growth. With reforms carried out today to enhance firm and farm productivity, more efficient investment in education quality and access and unlocking the potential for international trade and integration can pave the way to faster, more resilient, and inclusive growth. The following summarizes policy recommendations, drawing upon the Kosovo CEM and the background papers prepared as part of the report. 18  Increasing Firm Productivity Kosovo’s business landscape continues to be dominated by micro and small enterprises and is characterized by low productivity, poor survival, and a lack of dynamism. More intensive efforts are needed to remove distortions, improve access to finance, encourage innovation and digitalization, strengthen competition in product markets, improve the business climate, and facilitate deeper integration into international markets. RECOMMENDATIONS Continuously reduce the administrative Incentivize women’s entrepreneurship and burden and regulatory uncertainty faced remove barriers to women’s participation by firms, e.g., through streamlining licenses in the economy through, e.g., investments and permits and improving the inspections in preschool education and child and elder regime through better coordination and care, and increasing financial inclusion by risk-based inspections. introducing a basic payment account. Strengthen the national innovation system Improve firm capabilities through targeted to foster the diffusion and adoption of programs (e.g., technical assistance to technology and investment in research and SMEs funded through voucher schemes development (R&D). or grants) to upgrade management and organizational practices. Foster digitalization of businesses by ensuring timely adoption and implementation of regulations on E-ID, data protection, and cybersecurity, and improve the coverage, quality, and affordability of Internet connectivity and related managerial capacities. Improve access to finance through non- bank financial institutions, private equity, and venture capital, ensuring uptake of Kosovo Credit Guarantee Fund guarantees and securing property rights. WORLD BANK GROUP Raising Firm Productivity November 2021 Read a summary of Raising Firm Productivity PAGE 42 Read the full paper at www.worldbank.org/en/country/kosovo Kosovo Country Economic Memorandum  19 Raising Farm Productivity Farms in Kosovo, especially micro and small farms, do not transform inputs into output efficiently. Small and more specialized farms struggle to expand to their optimal scale, probably due to credit constraints and dysfunctional land markets. Reforms are needed to improve competitiveness by encouraging aggregation of farms, greater innovation, and better management of natural resources. RECOMMENDATIONS Provide incentives to encourage aggregation Facilitate the modernization of smaller of farms and other food chain firms so that farms through better-targeted support they modernize and explore scale economies. and promote an enabling environment for small and medium-sized farms by Facilitate farm competitiveness by modifying providing advisory, training, technical, and current types of farm support; consider a information support, infrastructure, R&D, shift to decoupled farm support. and storage capacities. Reallocate public resources to farm Expedite cadastral reconstruction to activities that have higher rates of return to cover all of Kosovo by prioritizing more improve the sector’s competitiveness and economically active agricultural land and enhance incomes. cadastral zones; and invest in sustainable management of natural resources, including timely implementation of the irrigation master plan. WORLD BANK GROUP Raising Agricultural Productivity November 2021 Read a summary of Raising Farm Productivity PAGE 56 Read the full paper at www.worldbank.org/en/country/kosovo Kosovo Country Economic Memorandum 20  Enhancing Human Capital Kosovo has made significant progress in improving educational access, but the quality of education is still low at every level, as has been demonstrated by international and national test scores. There are also differences in education outcomes between municipalities, ethnic groups, and income quintiles. Businesses note the poor quality of the education system and difficulties in hiring for different skills. Given Kosovo’s demographic dividend, it is critical to improve the quality of and access to education. RECOMMENDATIONS Develop a student registry to track Develop a comprehensive plan to digitalize academic performance that includes an education delivery and ensure the equity early warning system of at-risk and poor of digital content and connectivity with performers for better targeting of services sufficient equipment and skilled and that keep students in school. supported teachers. Continue using and improving a system of Improve the targeting and coverage of the learning assessments that guides teacher social assistance scheme to reduce the instruction and motivates improvement liquidity constraints of poor families with over time, especially in lagging more children. municipalities. Take stock of and institutionalize remedial Improve spending efficiency and equity and support programs delivered by NGOs, in the sector by completing a school especially those targeted to low-income optimization study and implement it in families, minority children, and rural order to re-orient spending in education students. to reduce infrastructure gaps, improve the quality of education, and revise the school financing formula. WORLD BANK GROUP Enhancing Human Capital by Improving Education November 2021 Read a summary of Enhancing Human Capital PAGE 68 Read the full paper at www.worldbank.org/en/country/kosovo Kosovo Country Economic Memorandum  21 Boosting Export Performance Poor competitiveness and productivity in domestic markets translates into poor export performance. International integration is limited and depends on inflows from the diaspora. Leveraging regional integration and strong diaspora ties could boost exports. Policies to improve productivity and increase regional and international integration have the potential to generate higher growth and contribute to macroeconomic stability. RECOMMENDATIONS Continuously address business environment Continue to improve the business constraints to provide an enabling environment to attract higher FDI to link environment for firms to enhance with GVCs. productivity. Leverage strong diaspora ties to increase Improve regional integration and promote penetration of firms into export markets in it as a springboard for better integration the region and beyond. with EU and global markets. Prepare an action plan for e-commerce to Continue dialogue with partners on improve the regulatory framework and deepening trade integration through trade promote digital trade, facilitate e-payments, agreements with international partners. and improve digital connectivity. Reduce trade facilitation and logistics gaps. WORLD BANK GROUP Boosting Export Performance November 2021 Read a summary of Boosting Export Performance PAGE 88 Read the full paper at www.worldbank.org/en/country/kosovo Kosovo Country Economic Memorandum 22  Removing Regulatory Barriers to Competition Kosovo has made progress toward pro-competition regulation of product markets, but there is still room for improvement. Restrictions on competition in product markets include state involvement in the economy (such as preferential treatment for POEs) and barriers to domestic and foreign entry in network sectors and regulated professions. Improvements in the regulatory framework to level the playing field for all firms could enhance competition and increase productivity. RECOMMENDATIONS Improve POE governance and eliminate Reform entry and conduct regulations for POE–related barriers to competition to professional services, eliminating exclusive ensure equal treatment of private and rights and regulatory restrictions. public operators in markets where they compete. Strengthen the regulatory framework for competition policy and improve the Enhance the quality and control of the efficiency of regulatory functions to reduce regulatory process and facilitate business restrictions on competition in network registration to boost market entry. sectors like electricity, transport, and telecommunications. WORLD BANK GROUP Removing Regulatory Barriers to Competition November 2021 Read a summary of Removing Regulatory Barriers to Competition PAGE 78 Read the full paper at www.worldbank.org/en/country/kosovo Kosovo Country Economic Memorandum  23 Promoting Foreign Investment Kosovo has received little foreign investment in recent years reflecting lackluster investment competitiveness. FDI has been concentrated in non- tradable domestic- market-seeking sectors like construction and real estate that have little potential for spillovers and benefits to the domestic economy, beyond the immediate impact. A comprehensive reform program is needed to ease business environment constraints, improve governance, and build up investment promotion and after-care services. RECOMMENDATIONS Modernize the investment ecosystem to Empower KIESA as the national lead agency make it more efficient and to attract higher- for attracting investment by sharpening its quality investments. focus on delivering core investor services, improving its governance, and scaling up its Sharpen the focus of FDI attraction and provision of services to investors. retention efforts and devise an action plan to accelerate investment attraction and Establish an effective investor grievance COVID-19 recovery. mechanism to enhance investor confidence and reduce regulatory risk. WORLD BANK GROUP Boosting Foreign Direct Investment November 2021 Read a summary of Boosting Foreign Direct Investment PAGE 104 Read the full paper at Kosovo Country www.worldbank.org/en/country/kosovo Economic Memorandum 24  Entrenching Macroeconomic Stability and Sound Governance The shock of the COVID-19 pandemic is putting pressure on Kosovo’s rules-based fiscal framework and the financial sector, which has been key in sustaining macroeconomic stability prior to the pandemic. However, governance problems, including a backlogged judicial system, ineffective coordination between institutions, and poor application of regulations impede sustainable growth in Kosovo. Going forward, maintaining macroeconomic stability, and improving governance will be necessary to reduce uncertainty for investors and consumers. RECOMMENDATIONS Improve the timeliness and accuracy of Ensure effective implementation of laws national statistics to inform evidenced- through better coordination of state based policy making, in particular institutions and a well-functioning judicial the national accounts, for effective system. implementation of the rules-based fiscal framework. Continue to closely monitor financial sector health to manage exit from borrower Improve the efficiency of public spending, relief measures adopted in 2020, taking by better targeting social protection into account increased uncertainty about benefits to the poor, allocating resources to the economic recovery and asset-quality maintaining public assets, and investing in challenges generated by the COVID-19 human capital. shock; and strengthen the financial safety net through the bank recovery and Mobilize more revenue by rationalizing resolution framework to be introduced by fiscal exemptions, reducing leakages, and the new banking law. giving local authorities incentives to collect more own-source revenue Entrenching Macroeconomic Stability and Sound Governance PAGE 24  25 01 Macroeconomic Overview Sustainable growth will be built on solid macrofiscal and financial foundations, in which Kosovo has long been investing heavily. Since independence Kosovo has demonstrated its commitment to headline macrofiscal sustainability by gradually building a comprehensive rules-based fiscal framework. Headline fiscal stability, a sound financial sector, and an exchange rate anchored by unilateral euroization has led to a stable environment, as evidenced by low volatility in growth and inflation (Figure 1 and 2). Since 2012 Kosovo has also made major improvements in banking supervision and regulation and further reforms are underway to ensure financial stability. The sector has remained liquid and well-capitalized for the last decade, but financial deepening is still limited (Figure 3). Though the pandemic may now be testing Kosovo’s financial sector, before and during the pandemic it had the lowest nonperforming loans in the region (Figure 4). The pandemic has hit Kosovo hard, but early signs are of recovery in 2021. Like the rest of the world, Kosovo in 2020 experienced one of the deepest recessions in its history. Households and businesses took a painful hit from the COVID-19 pandemic. The pandemic also weighed on the fiscal position in 2020 driven by the inescapable need for economic and social response despite lower revenues. The fiscal deficit more than doubled in 2020, to 7.6 percent of GDP. Public and publicly guaranteed debt went up by 5.2 pp, reaching 22.8 percent of GDP by yearend. Though the economic recession undoubtedly erased some recent developmental gains and the path ahead is still clouded with uncertainty, signs early in 2021 suggest that the economy has started to recover. Figure 1. Growth Volatility, 2008–19, Percent 3 2 1 0 -1 -2 -3 -4 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Kosovo Structural Peers Aspirational Peers Source: Kosovo Agency of Statistics (KAS) and World Bank staff calculations1 Note: Volatility of growth is calculated using deviations of real GDP growth from its mean. The values for structural and aspirational peers are calendar-year averages. The data is stacked. 1 Structural peers are Albania, Armenia, Kyrgyz Republic, Moldova, and North Macedonia, Armenia, and Moldova. Aspirational peers are Czech Rep, Estonia, Latvia, Lithuania, Uruguay, and Slovenia. Structural peers and aspirational peers are chosen based on structural characteristics of countries. Regional peers are Western Balkans countries, Albania, Bosnia and Herzegovina, North Macedonia, Montenegro, and Serbia. All statistics presented are simple averages for these group of countries, unless otherwise noted. Due to the cutoff date of the report, the national accounts data presented does not reflect the September 2021 revision. 28 Macroeconomic Overview Figure 2. Consumer Price Inflation Volatility, 2010–19, Percent 6 5 4 3 2 1 0 -1 -2 -3 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Kosovo Structural Peers Aspirational Peers Source: KAS and World Bank staff calculations Note: Volatility of growth is calculated using deviations of real GDP growth from its mean. The values for structural and aspirational peers are calendar-year averages. The data is stacked. Figure 3. Domestic Bank Credit to the Private Sector, 2010 and 2019, Percent of GDP 120 103.5 100 85.5 80 66.4 60 52.8 54.5 49.7 49.1 47.1 . 44.6 42.1 40 37.4 31.6 . 20 0 Albania Bosnia and Kosovo North Macedonia Montenegro Serbia EUR area Herzegovina Source: WDI. Macroeconomic Overview 29 Figure 4. Financial Soundness Indicators, 2011–20, Percent 40 Capital adequacy ratio 35 NPL Ratio 30 Liquidity ratio (liquid assets to total assets,%) 25 20 15 10 5 0 Mar - 20 Jul - 20 Nov - 20 Mar - 16 Jul - 16 Nov - 16 Mar - 18 Jul - 18 Nov - 18 Mar - 19 Jul - 19 Nov - 19 Mar - 14 Jul - 14 Nov - 14 Mar - 12 Jul - 12 Nov - 12 Mar - 13 Jul - 13 Nov - 13 Mar - 15 Jul - 15 Nov - 15 Mar - 17 Jul - 17 Nov - 17 Mar - 11 Jul - 11 Nov - 11 Source: CBK. After an unimpressive showing between 2010 and 2014, growth accelerated between 2015 and 2019. Between 2010 and 2019 growth averaged 3.6 percent. Lackluster performance in the first half of the period held back Kosovo’s convergence to higher income levels (Figure 5). Growth slowed, mainly due to a halt in construction but partly because the lagged impact of the 2008 global financial crisis discouraged foreign investment. The global crisis had much less direct impact on Kosovo than on its peers, because of lower integration with the global economy. Growth accelerated between 2015 and 2019 (Figure 5), aided by positive, though moderate, productivity growth and steady formal job creation. Since 2009 Kosovo’s GDP per capita has risen by about 40 percent, a rate higher than that of some structural peers but below that of Armenia, Moldova, Latvia, and Lithuania (Figure 6). Figure 5. Real GDP Growth, 2010–19, Percent 5 - 4 - 3 2 1 0 Kosovo Structural Peers Aspirational Peers Source: World Bank macro poverty outlook (MPO) data; World Bank staff calculations. 30 Macroeconomic Overview Figure 6. GDP per Capita, 2009–19, US$, Percent 30,000 70 64 63 63 27,000 60 24,000 21,000 44 45 50 18,000 39 40 15,000 33 27 28 25 24 30 12,000 9,000 18 20 6,000 10 3,000 - 0 KOS KGZ MDA ARM ALB N.MKD LVA URY LTU EST CZE SVN STRUCTURAL PEERS ASPIRATIONAL PEERS Change - (right axis) Source: WB MPO (2021); World Bank staff calculations. If it is to catch up with aspirational peers, Kosovo must grow faster. It is promising that after 2015 the economy became more dynamic. A considerable increase in formal employment and a modest increase in TFP2 closed the output gap (Figure 7), but in the next two decades the possibility of steady growth of about 4 percent will not be enough for Kosovo to close the large income gap and match even today’s living standards of aspirational peers (Figure 8). Figure 7. Actual and Potential Growth, Percent, 2010–19 5 5 4 4 Actual growth 4 Potential growth 3 3 2 1 0 - - Source: MPO 2021 data and World Bank staff calculations. Note: Potential growth is estimated using a macrostructural model for Kosovo. 2 See Figure 30 in section 2 raising firm productivity. The economy added on average 10,000 formal jobs annually between 2015 and 2018. Macroeconomic Overview 31 Figure 8. GDP per Capita Projections, US$, 2019–59 30,000 Kosovo 25,000 20,000 Aspirational peers in 2019 15,000 10,000 5,000 - 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043 2045 2047 2049 2051 2053 2055 2057 2059 Source: KAS data and World Bank staff calculations Note: The yellow line represents projected growth for Kosovo based on average real growth of 4 percent. The structure of Kosovo’s economy resembles that of aspirational rather than structural peers. In terms of both value-added (VA) and employment, Kosovo has a much lower share of agriculture than structural peers with similar income per capita or regional peers, though with slightly higher income per capita (Figure 9 and 10). Much-lower employment in agriculture may partly explain the country’s high unemployment rates compared to peers. Services as a share of gross VA and of total employment are also much higher than in structural peers. The main engines of services growth have been the wholesale and retail sectors, driven by a consumption-led model fueled by remittances and by diaspora-driven tourism exports. In the last 10 years, industry has also become relatively more important, stimulating job creation. Figure 9. Kosovo’s Economy, Shares of Value-added, 2010 and 2019, Percent 2019 10 27 63 Western Balkans 2010 12 27 62 2019 4 27 70 Aspirational Peers 2010 4 27 69 2019 18 25 57 Structural Peers 2010 21 25 55 2019 9 33 58 KOSOVO 2010 14 30 55 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Agriculture Industry Services Source: WB MPO 32 Macroeconomic Overview Figure 10. Kosovo’s Economy, Employment Shares, Average 2012–19, Percent Aspirational Peers 6.3 28.2 65.5 Structural Peers 32.1 19.5 48.4 Western Balkans 17.5 25.4 57.2 KOSOVO 4.1 28.4 67.5 0 10 20 30 40 50 60 70 80 90 100 Agriculture Industry Services Source: WB MPO Despite relatively stable growth, poor outcomes reflect structural weaknesses in the economy: Private consumption continues to be the main engine of growth. Kosovo’s growth model still relies on consumption, aided by remittances, services exports, and social protection spending. Investment, private and public, also supports growth slightly higher than peer countries. Despite sizable investments, productivity growth was minimal, suggesting low returns on investment (Figure 16). Net exports subtracted from growth between 2010 and 2019. Before the pandemic, in the last decade Kosovo was averaging faster growth than comparator countries, but net exports have subtracted much more from growth than in both structural and aspirational peers: As imports grew from a high base of 53.5 percent of GDP during the same period, net exports subtracted more than 2 pp from growth despite the strong performance of services exports (Figure 11).3 Agriculture has been a drag on growth. While in 2010–19 in structural and regional peers agriculture added to growth, in Kosovo it subtracted from growth (Figure 12). In terms of both employment and VA, it constitutes a smaller share of economic activity in Kosovo than in countries with similar GDP per capita. Although that might suggest fast structural transformation, in fact it is caused by low agricultural productivity. Employment in agriculture has been relatively stable, but over time the productivity of its workers has been shrinking. The analysis suggests that while there have been some recent improvements in farm productivity, many farms suffer from production inefficiencies that impede faster growth.4 Services have been the main driver of growth. The contribution of industry has also been considerable—higher than in structural peers (Figure 12). 3 See trade policy overview and background note for a more detailed discussion on export-import dynamics. 4 See farm productivity overview and the background note for a more detailed discussion of dynamics of that productivity. Macroeconomic Overview 33 Figure 11. Drivers of Demand-side Growth, 2010–19, Percent 5 Gross fixed capital formation Public consumption 4 Net exports 3 Private consumption Changes in inventories 2 1 0 -1 -2 -3 -4 Kosovo Structural Peers Aspirational Peers Western Balkans Source: MPO data. Figure 12. Drivers of Supply-side Growth, 2010–19, Percent 4 3 2 1 0 -1 Kosovo Structural Peers Aspirational Peers Western Balkans Agriculture Industry Services Source: MPO data. Investment constitutes a significant share of economic activity but, as low productivity growth demonstrates, returns on investment have been low. Kosovo’s investment performance compared well with benchmark countries (Figure 13) and the recent increases in private investment are encouraging (Figure 14). However, public spending has mostly been directed to road infrastructure and private investment was mostly concentrated in non-tradable, domestic-market-seeking sectors like wholesale and retail, construction, and real estate. Very little FDI has gone into export-oriented or higher-VA manufacturing and services that would have more impact on innovation, productivity gains, or job creation. Despite the strong investment performance, the contribution of aggregate TFP to aggregate growth has been minimal, averaging 1 pp between 2008 and 2019 (Figure 15). 34 Macroeconomic Overview Figure 13. Investment as a Share of GDP, 2008–19, Percent 30 . 26.2 26.2 26.5 25.6 25.6 24.7 25 22.6 22.6 19.9 20 17.2 15 10 5 0 Uruguay Slovenia Latvia Armenia Modlova Lithuania Estonia Czech Albania North Kosovo Republic Macedonia Source: WDI data. Figure 14. Share of Public and Private investment, 2010–19, Percent 2019 7.5 21.2 2018 9.0 19.2 2017 9.4 18.2 2016 10.9 16.3 2015 11.9 14.5 2014 13.8 10.7 2013 17.6 8.0 2012 20.0 6.6 2011 24.3 7.4 2010 24.5 6.1 Share of public investment to GDP Share of private investment to GDP Source: KAS and MFLT data; WB staff calculations. Macroeconomic Overview 35 Figure 15. Decomposition of GDP into its Drivers, 2008–19, Percent 20 15 12.2 11.8 10 9.0 0.1 6.8 1.3 1.1 2.4 5.0 0.8 5.2 5 2.7 1.6 1.3 0.8 3.9 4.8 1.6 3.0 3.8 4.4 3.6 3.8 4.0 3.1 2.8 2.3 3.0 3.4 0 -5.9 -4.8 -8.3 -5.2 -1.6 -3.3 -5 -10 α*K ( -α) *L TFP growth GDP growth Source: KAS data, World Bank staff calculations Note: Labor share (α) is chosen as 1/3. Figure 16. Diaspora-Related Flows, 2009–19, Percent 20 18.3 18.6 18 17.3 16 14.8 14.4 14 13.3 12.6 12.2 12.4 12.0 11.8 11.9 12.0 12 11.0 11.2 11.5 11.4 10.8 10.2 10.2 10 8 7.4 6.8 6 4 3.1 3.2 2.6 2.3 2.4 1.9 2.3 2.1 2 1.7 1.3 1.1 0 Remittance inflows (%GDP) Exports of travel services (%GDP) FDI in real estate activities (%GDP) Source: CBK data; World Bank staff calculations Diaspora-related flows are a major contributor to growth and a determinant of the structure of the economy. Between 2009 and 2019, diaspora-related inflows amounted to almost 29 percent of GDP and have been an important driver of economic activity and foreign financing (Figure 16). Furthermore, in recent years, diaspora-related inflows have picked up and in 2020 cushioned the impact of the pandemic. Strong diaspora ties have contributed to stable growth, but also enabled the current consumption-led growth model. While in the coming decade diaspora-related flows are expected to continue to support growth and poverty reduction, their relative importance as a share of GDP could decrease thereafter, limiting the positive impact on growth. 36 Macroeconomic Overview Over the last decade labor market outcomes have improved in Kosovo but much less than in peers (Figure 17). High unemployment and low labor market participation coexist. In 2019, labor force participation was 40.5 percent of the working-age population, mostly suppressed by the gender gap: female participation was just 21.1 percent compared to male participation of 60 percent. In 2019, too, only 30 percent of the labor force had jobs. Although general overall unemployment was 26 percent, youth unemployment was almost 50 percent. Despite progress in recent years, unemployment has declined much less in Kosovo than elsewhere in the region (Figure 18). Figure 17. Unemployment, Kosovo and Comparator Countries, 2009–18, Percent 6 Aspirational 8 Peers 10 11 12 Structural 15 Peers 15 16 29 33 Kosovo 31 45 Source: World Development Indicators. Figure 18. Unemployment, 2012 and 2019, Percent 35 31 30 28 24 25 20 20 17 16 15 15 13 12 10 10 5 0 KOS MKD BIH MNE ALB SRB Source: National authorities. Macroeconomic Overview 37 Compared to peer countries, Kosovo has not attracted enough FDI to transform the economy. It attracted much less FDI than regional and aspirational peers (Figure 19). Labor market outcomes that were less impressive than in the rest of the region can be partly explained by Kosovo attracting less FDI. Furthermore, because most FDI was concentrated in non-tradable sectors like real estate and construction, it had little impact on GDP beyond its gestation period (Figure 20). Figure 19. Net FDI, US $Million, 2004–19, Percent of GDP Net FDI inflows, percent of GDP 6 6 1,462 5 5 5 1,279 5 4 704 743 3 3 Net FDI inflows, 542 525 in mil. USD 2 2 347 243 1 0 - - - - - - - - Kosovo Structural Peers* Aspirational Peers** Western Balkans Source: WDI. Figure 20. Net FDI by Sector, ¤Million, 2008–19, Percent of GDP 280 224 230 205 180 153 155 Real estate 133 140 121 Financial and insurance 130 118 110 95 Energy 75 75 Construction 80 62 63 64 54 60 55 Net FDI inflows 44 36 39 42 43 33 30 28 30 1714 23 15 19 15 25 14 13 9 4 13 12 1 6 5 0 0 0 -1 -20 - -17 Source: Central Bank of Kosovo. Inadequate human capital limits Kosovo’s growth potential. Although Kosovo is one of the youngest countries in Europe, the lifetime achievement of a child born there is projected at only 57 percent of that of a fully educated adult in optimal health, based on the World Bank Human Capital Index (HCI). This result is driven by substandard educational outcomes, as measured by PISA 2018 scores, and health outcomes (Figure 21). 38 Macroeconomic Overview Figure 21. Human Capital Index, 2020 0.8 0.8 0.7 0.7 0.7 0.6 0.6 0.6 . 0.5 0.4 0.3 0.2 0.1 0 OECD EU Aspirational Structural UMIC Kosovo Peers Peers Source: World Bank HCI 2020. Business climate constraints and perceptions of weak governance limit growth. In the last 10 years Kosovo has made significant progress in improving its business climate, as is reflected in higher investment climate indicators, but gaps remain. Introduction of private bailiffs in 2018 led to significant improvements in resolving insolvency, but dealing with construction permits, getting electricity, registering property, enforcing contracts, and resolving insolvency are still holding Kosovo back. Their combined impact can be a major drag on business productivity and also lead to higher informality and lower acquisition of human capital (D’Erasmo et al. 2014). Above all, perceptions of weak rule of law and governance jeopardize Kosovo’s growth potential (Figure 22). Furthermore, limited international recognition likely makes it harder to attract FDI in productive sectors and to better integrate globally through higher exports. Figure 22. Worldwide Governance indicators, 2019, Index = –2.5-2.5 Voice and Accountability Kosovo Structural Peers Aspirational Peers 2.50 2.00 1.50 1.00 0.50 Control of Political Stability and Corruption 0.00 Absence of Violence/ -0.50 Terrorism -1.00 -1.50 -2.00 -2.50 Rule of Law Government E ectiveness Regulatory Quality Source: Worldwide Governance Indicators data; World Bank staff calculations. Macroeconomic Overview 39 Box 1. Kosovo has made significant progress since 1999 Kosovo has come a long way since the 1999. After 1999, Kosovo moved swiftly to create a market-based economy by way of reconstruction, building institutions, and trade liberalization. The economy it inherited had been damaged by poor policies, broken external trade and financial links, international sanctions, a lack of investment, and damaged assets. By 2004, new commercial laws had been promulgated and a legal, regulatory, and supervisory framework for the banking and insurance sector had been set up. The new institutions were all oriented toward EU and international standards, with new public and private institutions established to support enforcement of the new laws. Between 1999 and 2003, foreign financing funded a sizable trade deficit, which in 2003 was about 125 percent of GDP. Supported by substantial foreign aid, remittances, and structural reforms, Kosovo’s GDP per capita expanded from about US$400 in 1995 to US$790 in 2003. Kosovo’s private sector was composed mostly of micro enterprises, which relied on their own funds. Based on a 2003 World Bank investment climate survey, electricity supply, informal competition, the administrative burden of responding to customs and tax administration rules, and economic and regulatory uncertainty were perceived to be the main barriers to doing business. Kosovo also moved to privatize and liquidate some publicly owned enterprises. Privatization of the Ferronikeli plant in 2005 revitalized base metal exports. By 2008, the company employed over 1,000 workers and its exports had reached almost ¤100 million—almost half the country’s exports. In the early 2000s the financial sector was also built from scratch, culminating in 7 registered banks, 10 savings and loan associations, 12 micro-finance institutions (MFIs), 4 other non-bank financial institutions, and 8 insurance companies. In the 1990s Kosovo had a dual agricultural sector, with capital-intensive agrokombinats (Socially Owned Enterprises), which produced for the Former Yugoslav Republic (FYR) market, and small labor-intensive subsistence farms. The sector was even then prone to misallocation because Kosovo was a relatively liberalized market within the controlled and subsidized FYR Yugoslavia. By 1999, the agrokombinats had already collapsed and during the conflict most of their capital, machinery, and livestock was destroyed. Agricultural productivity and yields were low because of small farm sizes, limited capital stock, lack of technical expertise, poor use of inputs, and minimal credit—only 2 percent of total credit was available to the sector. After a fast transformation period and rapid double-digit growth after the conflict, between 2005 and 2009 economic growth averaged 4.2 percent. However, Kosovo still had the poorest employment track record in Europe, with unemployment at 48 percent and employment at just 26 percent. In 2006, 49 percent of rural and 37 percent of urban households were poor (2007 World Bank Poverty Assessment) and 18 percent in rural and 14 percent in urban areas were extremely poor. Kosovo’s economy has come a long way since then. The economy is less dependent on foreign financing, employment has picked up, and higher employment, remittances, and social protection spending have reduced poverty. Kosovo has laid the foundations for a market economy, GDP per capita has increased more than 10-fold since 1995, and in 2019 Kosovo reached upper-middle-income status. It still has a long way to go, but with continued commitment to macroeconomic stability and growth-oriented reforms, it can create the conditions for even faster growth (see Figure 17) and transcend its difficult beginnings to raise the welfare of its citizens. If leveraged, Kosovo’s proximity to a large and affluent market, young population, and low labor costs and tax rates can provide an environment for higher attraction and retention of investment and should promote stronger growth of local businesses and increase their export orientation—as long as structural impediments to growth are addressed. Source: Kosovo Country Economic Memorandum, 2004 and 2010, and IMF Article IV reports (1999–2005) 40 Macroeconomic Overview Kosovo’s economy recorded its first contraction in 2020, the year that economic activity shrank for the first time, mainly because of a 51 percent drop in diaspora-related exports of travel services and investment. The rise in government consumption provided a modest positive contribution, but despite the support from higher government transfers private consumption subtracted from growth. Declared turnover dropped by 9.5 percent for the year, reflecting how heavily the crisis affected the private sector. Fortunately, policy support measures, coupled with increases in remittances and goods exports, mitigated the contraction, though the recession derailed growth. A variety of other factors also helped cushion the downturn. Goods exports were up by 21 percent—driven by higher international demand for nickel and improved access to foreign markets for non-commodity exporters. A surge of 15.1 percent in remittances and a 38.3 percent rise in public transfers boosted disposable incomes. The labor market reacted primarily by reducing working hours and compensation, according to the results of the World Bank Business Pulse Survey (BPS) conducted in 2020 Q2. Consistent with the BPS findings, tax records show that formal employment weathered the downturn. It is likely that wage-subsidy and other policy measures not only helped preserve formal jobs but also encouraged formalization. However, a 4.2 percent drop in personal income tax revenue indicates that, as a corollary to the labor market reaction, the contraction reduced formal employment compensation and working hours. Meanwhile, according to administrative data from employment centers, unemployment jumped, probably because informal jobs were lost; but the real dimensions of this increase are uncertain because registering for unemployment was a prerequisite for benefiting from government social protection measures. In 2020, despite a 28.4 percent drop in public investment, the budget deficit more than doubled, from 2.9 percent of GDP in 2019 to 7.6 percent, driven by the government’s economic and social response to COVID-19—and by a drop in revenues of almost 9 percent. The financial sector seems to have weathered the storm well, but the full impact of the pandemic will be revealed, until CBK-guided loan restructurings are phased out. To catch up to the living standards of European and aspirational countries, Kosovo needs to shift to a higher gear. Before the pandemic, Kosovo was growing close to its potential growth rate at about 4 percent. However, a real growth of 4 percent will not be sufficient for it to catch up in the next 30 years with today’s living standards of its aspirational peers. The pandemic might have slowed the progress and continues to pose risks to the outlook. However, Kosovo has a good track record of macroeconomic sustainability that it can build on to address structural impediments to growth with a strong will and a commitment to accelerate convergence. Figure 23 shows that modest increases of 2 pp in FDI, TFP, employment, and exports between 2025 and 2035, compared to the baseline scenario of 4 percent real growth, can shorten convergence by 10 years. Kosovo needs a new growth strategy to accelerate convergence. Figure 23. GDP per Capita Projections Based on Structural Changes, US$, 2020–60 45,000 Kosovo*** 40,000 35,000 30,000 Kosovo 25,000 20,000 Aspirational peers in 15,000 10,000 5,000 0 Note: The blue line represents the projected growth trajectory for Kosovo based on average real growth of 4 percent. The navy line represents an alternative trajectory is there is a modest shock of a 2 percentage point (pp) increase in net FDI inflows, 2 pp increase in employment rate, 2 pp increase in TFP, 2 pp increase in exports as a share of GDP between 2025–35 compared to the baseline. Macroeconomic Overview 41 Policy Recommendations 1. Quality and the timeliness of statistics should be improved in order to create an evidence base for policy making. In particular, improvements in the timeliness and accuracy of national account statistics are critical to the effectiveness of the rules-based fiscal framework. 2. Improvements in the efficiency of public spending, through better targeted social protection benefits and public investments, and investments in human capital are critical to enhance growth and speed up poverty reduction. Shifting resources to maintain public assets are also critical to ensure returns from existing infrastructure. 3. Mobilizing more revenue by rationalizing fiscal exemptions, reducing leakages, and incentivizing local authorities to collect more own-source revenue are crucial for Kosovo to address its large developmental needs, which have been compounded by the narrowing of fiscal space due to the pandemic. 4. As a young state Kosovo has invested in using legal frameworks to adopt best practices; now it is crucial to ensure that the laws are effectively implemented by improving the coordination of state institutions and ensuring a well-functioning court system. 5. Continued attention to monitoring financial sector health is vital to the post-pandemic recovery, in addition to strengthening the financial safety net through the bank recovery and resolution framework being introduced in the new banking law. 42 Macroeconomic Overview 02 RAISING Firm Productivity Raising Firm Productivity Over the long term, productivity is the most important determinant of income. Differences in measured inputs explain less than half of the vast cross-country differences in per capita GDP (Jones and Romer 2010). Increases in productivity—the efficiency with which firms transform inputs into outputs—define the long-term growth path and convergence to higher living standards. Understanding firm dynamics, particularly what drives productivity, and identifying related impediments to firm growth, survival, entry, and exit can guide policy makers to understand the impediments to aggregate growth and devise more comprehensive and effective policies. Improvements in productivity could pave the way to better opportunities for Kosovar citizens. Kosovo is a small, young transition economy that started from much lower income per capita than its regional peers. In the last 20 years, despite the improvements in labor market outcomes and the economy, Kosovo trails other Western Balkan countries in its ability to generate formal jobs, especially for women and the young, or to speed reduction of high unemployment (World Bank 2018). Growing from a lower base, catching up with regional and ultimately aspirational peers, will require much higher growth rates and creation of more jobs; that can only be facilitated by stronger productivity growth and a dynamic private sector. Box 2. The Productivity Measures Used in Analysis of Kosovo Firms Productivity, the efficiency with which firms transform inputs into outputs, is measured by labor productivity (LP) and total factor productivity (TFP). Change in LP, output (value added) per worker, is based on either capital deepening (supporting workers with more capital) or improvements in the human capital endowment of workers that increase efficiency. TFP is a measure of the efficiency with which factors of production are combined to produce output; it may be associated with, e.g., technological change, innovation, or management practices. These efficiency gains can occur not only within firms but also between firms because of a reallocation of resources, and market shares, from less to more efficient firms. Entry and exit can also contribute to productivity if an entering firm is more productive than the average incumbent and if less productive firms exit, leading to better allocation of resources. With firm level prices unavailable, TFPR, a revenue-based measure of TFP, is used for this analysis (see Cusolito and Maloney 2016 for a detailed description of the advantages and disadvantages of using TFPR measures). What are the data sources for firm level analysis? Detailed micro data from a variety of sources was used, and matched at the firm level where possible, to examine the characteristics and recent evolution of firms in Kosovo, with particular attention to firm productivity. This includes a dataset compiled from anonymized tax records (KTR 2010–18) complemented by data from the World Bank Kosovo Productivity Survey (KPS 2017); data on access to credit from the Kosovo Credit Registry (KCR 2010–18) to explore the links between productivity and credit; and the 2020 Business Pulse Survey (BPS) and aggregated tax records to gauge the impact of COVID-19 on firms. Figure 24. TFPR, Sales, and Value Added per Worker, 2013–17, Percent TFPR 0.7% 0.8% Value added per worker 0.8% 0.6% Sales per worker 0.0% 0.2% 0.3% 0.1% 0.1% -0.3% 0.5% -0.2% -0.5% -0.9% -1.0% 2013 2014 2015 2016 2017 Source: KTR data; World Bank staff calculations. Notes: TFPR and value added per worker are adjusted for firm entry and exit (Melitz and Polanec 2015). TFPR is estimated following Levinsohn and Petrin (2003). Figures are weighted by firm employment in the entire sample dataset. 46 Raising Firm Productivity Figure 25. TFPR Growth, 2014–17, Percent -0.4% 0.6% 1.5% 1.8% 0.1% Entry Within Covariance Aggregate Exit productivity growth Source: KTR data; World Bank staff calculations. Notes: TFPR was calculated following Levinsohn and Petrin (2006), adjusted for firm entry and exit (Melitz and Polanec 2015). Covariance refers to change in the share and average productivity of incumbent firms; within denotes the change in average firm productivity; and entry and exit refer to the contribution to aggregate TFPR of firms exiting and entering the market. The COVID-19 economic recession may worsen Kosovo’s already poor productivity growth. The health shock has made the question of how to keep smaller firms viable and productive even harder to answer. The first phase of the World Bank Business Pulse Survey (BPS) of Kosovar firms confirmed the asymmetric impacts of the COVID shock, especially in sectors under lockdown, with medium and small enterprises particularly affected. Female-run companies experienced the largest net job losses.5 In mid-2020, more than half of firms in Kosovo were already or expecting to be in arrears, with small and medium enterprises (SMEs) most financially stressed. Despite some positive developments since 2015, firm productivity dynamics problems continue to manifest themselves. After 2015, creation of jobs accelerated, driven by incumbents, and TFPR growth was marginally higher (Figure 24). A decomposition of TFPR shows that within-firm dynamism contributed by just a third of TFPR growth, far less than in other developing economies. Entrants subtracted from productivity growth while exiting firms contributed marginally, pointing out to lack of dynamism (Figure 25). In 2010–18 more than 98 percent of its firms (Figure 26) were micro (averaging fewer than 10 employees) and small (10–49 employees). However, compared to aspirational peers, firms in Kosovo are dominated by low-productivity small and micro enterprises. Measured by sales, all Kosovar firms are much smaller than those in aspirational peers6, especially medium and large enterprises (Figure 27). On a positive note, from 2015 to 2018, on average the economy added 10,000 formal jobs per year, doubling job creation in 2011–14 (Figure 28). Figure 26. Active Firms by Size, Average, 2010–18, Percent of Total Micro . ( -) . . . . Small . ( - ) . . . . Medium . ( - ) . . . Kosovo . Croatia Large . ( +) . Lithuania . Czechia . . Slovakia Source: KTR and Eurostat data, World Bank staff calculations. Notes: Figure 26: Active units are those with positive turnover. Activities included: B-N (excluding K64.2) according to NACE Rev. 2. Micro firms average 0–9 employees, small firms 10–49, medium firms 50–249, and large firms 250 and more. 5 The Kosovo BPS was conducted in June and July 2020 to gauge the impact of the pandemic in April 2020 on the real sector, in comparison to the same period in 2019; the adjustments firms made to mitigate the impact; uptake of government measures; and firm expectations for the rest of 2020. 6 For this section aspirational peers are Croatia, Czechia, Latvia, Lithuania, Estonia, and Slovakia—all EU members due to availability. Raising Firm Productivity 47 Figure 27. Turnover Comparisons by Firm Size Relative to EU Averages, 2018; Index EU=100 Kosovo Latvia Lithuania Czechia Slovenia Micro Small Medium Large ( - employees) ( - employees) ( - employees) ( + employees) Source: KTR and Eurostat data, World Bank staff calculations. Figure 27: In 2018 total turnover in euros of active businesses (except finance and insurance) divided by total active enterprises. Baseline is the EU average (indexed to 100) for countries that report aggregate turnover by firm size. Kosovar firms fail to grow. Over a five-year period, 33.7 percent of firms are born as and remain micro enterprises, 44.5 percent of the micro enterprises remain micro, and other firm classes similarly lack dynamism (Table 1). More than 50 percent of small firms remained small for five years and about 18 percent more became micro. Companies born micro and small grow faster and more sustainably than medium firms, but within each group younger firms grow faster; to accelerate job creation (Figure 29). In the last decade, the share of medium and large companies was practically unchanged. The share of micro enterprises fell from 95 percent in 2010 to 90 percent in 2018 as the share of small firms rose from 4. to 8.3 percent. There were no major changes in the shares of medium and large firms. These figures suggest that there are barriers to Kosovar company growth beyond small size. Table 1.  Five-Year Transition Matrix by Firm Size, 2012 and 2013 Firm Cohorts, Average Size class five years after the year of reference Micro Small Medium Large Economic Exit Size class at reference year (0-9) (10-49) (50-249) (250+) Births 33.7 2.6 0.4 0.1 63.2 Micro (0-9) 44.5 2.3 0.0 0.0 53.2 Small (10-49) 17.9 57.7 5.5 0.0 18.9 Medium (50-249) 5.0 12.9 63.6 4.6 13.9 Large (250+) 3.5 0.0 8.1 74.4 14.0 Source: KTR data; World Bank staff calculations. Notes: This table shows the share of firms by size class in the year of reference and five years later; we use data for the 2012 and 2013 firm cohorts to identify entrants and incumbents and track changes in the number of employees over a five-year period. To control for potential idiosyncratic shocks in a particular year, calculations are made by taking the average between the two firm cohorts. Year of reference refers to the first year the firm enter the panel, either 2012 or 2013. Economic exit are classified as those units that report positive turnover in year of reference but do not report turnover in the next two years. Size class is defined according to the number of employees of the firm in the year of reference, as noted in parentheses. 48 Raising Firm Productivity Figure 28. Employees in Active Firms, 2010–18, Thousands Thousands of YoY change employed persons YoY change 200 40,000 181 169 Total employed 160 145 155 32,000 133 persons 125 130 120 118 24,000 100 18,278 80 13,764 16,000 11,801 9,988 11,827 40 6,436 5,461 8,000 3,058 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 Source: KTR and Eurostat data, World Bank staff calculations. Figure 29. Firm Age and Employment Growth By Number of Employees at Birth (Size Class) Micro (0-9) Employment growth (%) 35 Small (10-49) Medium (50-249) 30 25 20 15 10 5 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Firm age Source: KTR and Eurostat data, World Bank staff calculations. Not only are Kosovar firms smaller but firm density, net creation and growth, and survival rates are lower. This implies severe deterrents to job creation due to constraints on private sector development. Firm density, the number of firms per million inhabitants, is considerably lower than in the EU and than would be predicted by Kosovo’s income per capita (Figure 30). Firm survival is also much lower than in comparator countries, especially among micro enterprises (Figure 31), which are less productive and have higher net firm churning and lower employment growth. Only about 74 percent of firms survive the year after they enter the market, 10 pp less than such firms in aspirational peers and the EU. Finally, the average annual net rate of firm creation in Kosovo—the difference between firm entry and exit rates—was close to zero, revealing a pronounced lack of dynamism for such a young economy (Figure 32). Raising Firm Productivity 49 Figure 30. Kosovo Firm Density Relative to Western Balkan and EU Peers, 2018 12.0 Firms per million people (log) R² = 0.3152 11.5 11.0 EU Kosovo 10.5 Comparators 10.0 Aspirational peers KOSOVO Other EU countries 9.5 9.0 9.0 9.5 10.0 10.5 11.0 11.5 12.0 GDP per capita (constant $, PPP, log) Source: KTR and Eurostat data, World Bank staff calculations. Notes: Figure 30: Employed persons in active firms (based on sales). Activities B-N (excluding K64.2) of NACE Rev. 2.Figure 31: Annual growth rate is calculated as the number of employed persons in the period of reference relative to the number employed in the year before. To increase sample size and analyze the relationship between firm age and employment growth more robustly, age is calculated as the difference of a given year relative to the year the firm was registered. Figure 31. Survival Rates by Firm Age, Percent of Total Firms 100 Kosovo EU (2020) 84.0 Czechia Croatia Slovenia 70.6 60.5 73.8 54.7 48.5 61.8 51.6 43.9 37.1 0 1 2 3 4 5 Age Source: KTR and Eurostat data, World Bank staff calculations. 50 Raising Firm Productivity Figure 32. Net Firm Entry and Exit Rates Entry rate 25 Exit rate % of firms Net turnover rate 21.2 20 17.3 15.0 15 13.5 13.2 12.8 10.6 11.1 10.0 10 9.2 8.9 8.8 8.8 8.3 8.0 8.3 5 3.9 4.4 2.8 2.8 1.2 0.3 0.0 0.5 0 Lithuania Latvia Kosovo Slovakia Estonia EU (2020) Croatia Czechia Source: KTR and Eurostat data, World Bank staff calculations. Notes: Figure 32: Entry and exit rates are total active units that enter and exit the market divided by total active enterprises. Dismantling barriers to private sector development clears the way for higher growth and faster job creation in Kosovo. Low growth of firm productivity, low job creation by incumbent firms, and near- zero net entry all suggest significant barriers to growth. Removing the barriers to firm growth should enable a more dynamic private sector. In Kosovo, more productive firms are larger, create more jobs, and pay higher wages. More productive firms are also more capital-intensive than firms oriented to the domestic market. Higher firm TFPR—a revenue-based measure of TFP11F7—is associated with higher average revenues and more workers per company. Controlling for location and industry, firms in which more than 50 percent of shareholders are foreign or firms engaged in foreign trade are more productive. Measures taken to boost firm productivity would accelerate growth and generate more jobs and higher income through higher salaries. Foreign-controlled firms and exporters not only are more productive, create more jobs, and pay higher wages, they have also weathered the COVID-19 recession better. Kosovo firms are not yet well- connected to global markets. The share of exporting enterprises ranges, depending on data source, between 0.3 and 3.4 percent, far below averages for the EU (Figure 33) and the Western Balkans; only 6 percent have any foreign shareholders. The BPS also found that in April firms globally integrated through FDI and exports had less change in sales than domestically oriented firms. Boosting exports and FDI can generate growth and job creation that is not only higher but also more resilient. 7 See Cusolito and Maloney (2018) for further details on measuring TFP. Raising Firm Productivity 51 Figure 33. Exporters and Importers, Percent a) Percent of total firms b) Manufacturing exporters, percent of manufacturing firms Non-exporter & Importer and Only Only Non-importer exporter Exporter Importer Estonia 46.0 . % . % . % . % Latvia 27.5 EU (2020) 21.7 Lithuania 17.8 Croatia 14.2 Slovakia 9.5 Kosovo . % of manufacturing firms Czechia 4.3 Source: KTR and Eurostat data, 2020; World Bank staff calculations. Note: Exporters or importers are those companies that report €10,000 or more in exports or imports to the KTR in the relevant year. “Importer and exporter” refers to companies that both import and export in the same period. “Only exporters” or importers) are firms that export or import but do both. Figure 36B shows the number of manufacturing exporters relative to total active manufacturing firms as classified in Eurostat. Creating a business-friendly environment can generate growth opportunities for firms that are being held back more than others. The difference in labor productivity between laggard and frontier firms is quite large within certain sectors and firm sizes (Table 2). Median TFPR in the 90th percentile is 1.6 times higher than median TFPR in the 10th; the difference is much starker for LP at 90 times higher. A comparison of TFP dispersions with other developing countries such as China and India or African economies like Ethiopia and Ghana shows a much larger dispersion of technical efficiency in Kosovo (see Cirera et al. 2017). Not surprisingly, microenterprises are significantly less productive than small, medium, and large firms. Median TFPR in small firms is more than double that in micro firms and 1.3 times larger in large companies. Reducing serious misallocations across sectors and enabling a growth-friendly environment for younger firms could heighten productivity growth. Table 2.  Ratio of Productivity in “Laggard” (90th percentile) to “Frontier” (10th percentile) Firms by Sector and Size, Average 2012–18 Dimension Category TFPR Sales per worker Sector Other services 1.445 52.5 Manufacturing 1.797 52.1 Retail trade 1.646 65.9 Wholesale trade 1.878 126.7 Construction 1.328 149.7 Size class Micro (0-9) 1.456 98.7 Small (10-49) 1.540 27.4 Medium and large (50+) 1.879 23.1 Sector average 1.595 89.370 Source: KTR; World Bank staff calculations. Notes: TFPR was calculated following Levisohn and Petrin (2006), adjusted for firm entry and exit (Melitz and Polanec 2015). LP is also adjusted by firm entry and exit. TFPR and LP dispersion is calculated as the ratio between mean TFPR/LP in the 90th percentile relative to mean TFPR/LP in the 90th percentile at NACE 2-digit. 52 Raising Firm Productivity Table 3.  TFPR in Micro-Enterprises Relative to Other Firm Classes Sector Size class Ratio Manufacturing Small 1.136 Medium and Large 1.467 Construction Small 0.999 Medium and Large 1.038 Services Small 0.976 Medium and Large 1.070 Wholesale Small 1.147 Medium and Large 1.591 Retail Small 1.132 Medium and Large 1.407 Average Small 1.078 Medium and Large 1.315 Source: KTR data; World Bank staff calculations. Notes: TFPR = total factor productivity revenue. TFPR was calculated following Levisohn and Petrin (2006), adjusted for firm entry and exit (Melitz and Polanec 2015). The wide gender gap in entrepreneurship may partly explain low business density in Kosovo. Based on the Kosovo productivity survey (KPS), Figure 34 shows only 9 percent of the firms had a female decisionmaker.8 Furthermore, female-run companies have fewer skilled workers, a higher proportion of unpaid workers, and less access to credit. Too few women entrepreneurs and in the labor market in general undermine Kosovo’s growth potential. It appears that there are major barriers to women having an active presence in the economy. Addressing barriers to women entrepreneurs and women participating in the labor force could push up long-term growth. Figure 34. Gender of Firm Decision- makers, Percent of Total Firms 91% men women 9% Source: KPS data, World Bank staff calculations. Note: Figures are weighted using firm sample weights. 8 The decision maker is defined in response to the following question in the KPS: “Who makes the main decisions in the company?” Multiple responses were allowed, including founder, family member of the founder, manager, members of executive board, and gender. Raising Firm Productivity 53 Table 4.  Access to Credit by Firm Class, Average, 2015–18 Characteristic  Type Percent of Firms Size class Micro (0–9) 24.3 Small (10–49) 63.4 Medium (50–249) 72.8 Large (250 and more) 71.2 Age class Start-ups (0–2 years) 21.5 Young (3–5 years; excludes Start-ups) 28.2 Mature (6+ years) 31.2 Foreign trade Non-exporter 26.6 Exporter 57.8 Non-importer 20.4 Importer 53.9 Foreign shareholding No foreign shareholders 45.2 0.1–24.9% of total assets 42.0 25–49.9% of total assets 36.9 50–100 of total assets 54.2 Gender of decision-maker Male-run companies 45.6 Female-run companies 38.1 Sources: KTR, KCR, and KPS data; World Bank staff calculations. Since 2015, aided by financial stability, domestic credit to the private sector has accelerated, but as yet less than a third of firms have access to finance. Despite the recent progress, financial depth is shallow compared to aspirational peers. More importantly, credit is mostly short-term and is not allocated to the most productive firms. About 70 percent of loans granted have terms of three years or less (Figure 35), which suggests that the local financial system is not providing enough capital for long-term investment. More productive and larger firms in more concentrated sectors are more likely to get access to credit. Only 24 percent of micro firms have access (Table 4). Moreover, small enterprises have less access to financing than medium and large firms. Access to credit is poorly correlated with higher firm productivity, which may suggest that in the local financial system, capital is misallocated (Figure 36). Improving access to finance could aid firm growth, especially for micro, small, and female-run enterprises. Figure 35. Loans to the Private Sector by Term, Average 2015–18, Percent of Total Up to 1 year inclusive 5 years or more 2-3 years 4-5 years 43.9 13.4 12.7 10.4 1-2 years 13.0 3-4 years 6.7 Source: KCR data; World Bank staff calculations. Note: Firms not reporting municipality were excluded from the sample. 54 Raising Firm Productivity Figure 36. Productivity and Access to Credit 60% Credit access (%) 50% 40% 30% 20% 1 TFPR (log) 1.5 2 2.5 3 Source: KCR and KTR data; World Bank staff calculations. Notes: The figures plot access to credit, a dichotomic variable equal to 1 if the firm was granted any financing and 0 otherwise, against TFPR (in logs) controlling by firm size, capital stock, sector, municipality, and exporter status. Firms in Kosovo do not invest as much as EU peers in R&D and management techniques, which is a drag on firm productivity. Only 3.4 percent of firms report investing in R&D against an EU average of 14 percent and typical comparator Croatia with 7.4 percent (World Bank 2018). The proportion is especially low among micro (3.7 percent), small (12 percent), and medium enterprises (12.6 percent). Only about 6 percent of enterprises report investing in employee training and 8 percent in management training. Firms with higher R&D and capital stock-to-sales ratios are more productive in term of sales and value added per worker (Table 5). Consistent with international evidence, investment in training, especially management techniques, is also correlated with more productive firms (Bloom et al. 2010, 2013 and 2020). By contrast, firms that indicate having received subsidies from the government are less productive. Hence, improving firm productivity will depend on more private investment in R&D, physical capital, and better management. Table 5.  Potential Correlates with Productivity in Kosovo Investment in R&D Capital Stock Unpaid Workers Government Investment in (Percent of Sales) (Percent of Sales) (Percent of Total Subsidies Training Workers) Sales per worker 0.618*** 0.218*** -0.031 -0.978*** 0.293** (0.147) (0.025) (0.121) (0.233) (0.121) Value added per worker 0.488*** 0.175*** -0.338* -1.256*** 0.248 (0.182) (0.040) (0.185) (0.342) (0.160) Source: KPS data; World Bank staff calculations. Notes: This table shows the results of a cross-sectional regression of sales and value added per worker on each of the covariates, controlling for firm size, age, gender of the decisionmaker, worker skills, firm capital stock, exporter status, municipality, and sector. Government subsidies is a dummy variable equal to one if the firm receives any government subsidy and zero otherwise. Investment in training is a dummy variable equal to one if the firm reports investing in training and zero otherwise. Raising Firm Productivity 55 Firms perceive informal competition as a major barrier to growth. Informality by its nature is very difficult to measure and the estimates vary considerably based on the definition. Kosovo has made great progress in firm registrations; 95 percent of firms register when they start operating. However, underreporting of employees and revenues is perceived to be large, and 63 percent of firms surveyed identify the informal sector as a major constraint.9 Findings suggest that firms with a higher proportion of unpaid to total workers are less productive. Reducing informality requires improving the business environment, by, e.g., reducing the cost of doing business, but also incentivizing formalization, such as improving access to finance. Kosovo has shown significant progress in improving its business climate, but on some dimensions improvements are still needed, such as dealing with construction permits, getting electricity, enforcing contracts, and resolving insolvency.10 Lack of coordinated and risk-based inspections, regulatory uncertainty, underutilization of contracts, and excessive use of cash payments, in the absence of better alternatives, likely lead to higher informality. Lack of clear property titles due to unregistered property and inconsistent cadastral information, and inefficient insolvency procedures impede access to finance, which in turn reduces the benefit of formalization. A comprehensive strategy to incentivize formalization could foster firm growth, access to finance, and technology adoption. Skills are central to higher firm growth. Education in Kosovo falls short of equipping citizens with the skills they need for a productive life, as is evidenced by the poor numeracy and literacy scores measured by national and international benchmarks. According to the Skills Measurement Program (STEP) 2019, more than half of Kosovo’s firms had difficulty finding workers with the necessary skill or experience. Furthermore, nearly 60 percent of employers think that general education does not give students practical experience, and almost 50 percent think it does not build up-to-date knowledge or soft skills like discipline, timeliness, and people skills. Although employers are more satisfied with the TVET outcomes, 35–42 percent of employers think that TVET systems do not provide the skills the market needs. Further improvements of trade restrictions on goods-related services could promote higher productivity in manufacturing. Based on the recent Service Trade Restrictiveness Index (STRI), Kosovo is relatively open to services trade, with the notable exception of professional services. Kosovo can further open its services sector by easing restrictions on the temporary movement of skilled workers where there is a shortage. Kosovo can also improve sector-specific regulations to reduce services trade restrictions, especially in professional services like law and auditing. These include allowing legal professionals from other citizenships, rather than just professionals from the EU with licenses, to practice foreign and international law. 9 See Robayo-Abril (2020) for a discussion of the informal labor force in Kosovo, where the estimates range from 35 to 42.4 percent of total employment. Firms report 14 percent of workers to be unpaid—a proxy for informality in the KPS. 10 See D’Erasmo et. al. (2014) for a discussion how the impact of cost of doing business affects TFP, informality, and demand for human capital. 56 Raising Firm Productivity Policy Recommendations Kosovo needs a multidimensional policy strategy to foster growth in firm productivity. Based on the findings of the background note on firm productivity and the results of other notes prepared for Kosovo’s CEM, a comprehensive policy strategy is needed to target the three main sources of productivity growth: (1) firm productivity (the “within” component); (2) market reallocation (the “between” component); and (c) firm dynamics (entry and exit). This multidimensional pro-productivity strategy should have three main pillars: 1. The low productivity of Kosovar firms relative to the EU, aspirational economies, and Western Balkan peers suggests that it is urgent to (a) improve firm capabilities related to human capital skills (e.g., matching TVET curricula to firm demands, and strengthening the general education system to better build basic numeracy and literacy skills), and emphasizing management and organizational practices (e.g., provide training and technical assistance to MSMEs and strengthen the quality of infrastructure); (b) encourage adoption of technology and innovation and investment in R&D (e.g., by strengthening the National Innovation System [NIS]11); (c) facilitate microenterprise access to finance (e.g., among other measures, expand the role of microfinance institutions and SME guarantee funds); (d) adopt strategies to attract FDI and promote exports (e.g., build up the investment agency); (e) and reduce restrictive policies in professional services trade. The country also needs to foster digitally enabled businesses: only 9 percent of firms engage in digital-intensive activities, and the digital response of Kosovar firms, especially MSMEs, to the COVID-19 shock trailed other Western Balkan countries. 2. The declining contribution to TPFR growth of reallocation of labor to the most productive firms reinforces the need to remove barriers that prevent movement of capital, labor, and other inputs and barriers in product markets that are related, for instance, to informality (e.g., the urgency of streamlining registration, inspection, and tax procedures); competition policy (allowing private firms easier access to financial incentives and public procurement on the same terms as POEs, and improving the quality and control of regulation); unreliable and costly energy supply (e.g., streamlining access for MSMEs to the Kosovo Energy Distribution and Supply Company electricity grid); and inadequate transport infrastructure (e.g., promote investment in national and regional roads and upgrade the North-South railway corridor). Kosovo also needs to improve gender equity: only 9 percent of firms are female-run and firms with a female decisionmaker tend to be smaller and less productive, especially in manufacturing and wholesale and retail. 3. The negligible contribution of new firms to TFPR growth illustrates how important it is to foster entry of highly productive and fast-growing enterprises, just as the negative contribution of firm exits to productivity growth could be indicating the presence of high barriers to exit. The barriers already identified to entry of more productive enterprises, especially access to formal finance, and the barriers to exit of nonviable firms, such as simplified and accelerated liquidation procedures, clearly need to be dismantled. More targeted policies, improved communication, and streamlined application procedures are necessary to support MSMEs dealing with the economic effects of the COVID-19 economic crisis. Recognizing the limited fiscal resources, policies should be targeted primarily to supporting displaced workers and minimizing layoffs by firms in financial stress and confronted by heightened demand or supply shocks. Targeted policies, such as the Kosovo Credit Guarantee Fund, can be influential in addressing MSME liquidity constraints. Improved communication of public support measures and simplified application procedures to enhance uptake and reduce the regulatory administrative burden (especially inspections) are crucial not only to encourage local companies but also to attract FDI and increase exports. 11 See Cirera and Maloney 2019. The NIS incorporates local and international R&D suppliers (universities and research institutions, among others), government agencies whose work is related to R&D and innovation, and private firms investing in R&D and adopting product, process, and organization innovations. Raising Firm Productivity 57 03 RAISING Farm Productivity Raising Farm Productivity Though agriculture constitutes a small and declining share of the economy in Kosovo, it matters considerably for growth. In 2019 agriculture accounted for 6.9 percent of GDP and 5.2 percent of employment. Though still important for Kosovo, agriculture has been shrinking in terms of its contribution to both growth and job creation: Between 2009 and 19, the share of agriculture in GDP nearly halved. In real terms, farm output in 2019 fell by nearly 7 percent relative to 2009 levels and has been a drag on growth for a decade. The sector’s performance is also the worst among comparator economies over the period 2008–19, even though average growth of Kosovo’s economy has been among the strongest (Figure 37). The sector’s contribution to the economy and employment, moreover, is less than in other countries at a similar development level (Figure 38 and 39). This finding may at first suggest a faster structural transformation than expected based on Kosovo’s GDP per capita, but in fact, given relatively stable employment, the limited contribution of agriculture to the economy mainly stems from low agricultural productivity. Kosovo also ranks considerably behind similar economies in terms of farm labor productivity (Figure 40) and cereal yields. Figure 37. Agricultural VA, Compared to Structural and Aspirational Peers,a 2008–19, Percent 8.0 7.0 . 6.0 5.0 4.0 . . . . 3.0 . . . . . 2.0 . . . . . . 1.0 . . . . . . 0.0 -1.0 - . KOS - . MKD ALB KGZ ARM MDA LVA URY EST SVN LTU CZE -2.0 Agriculture, forestry, and fishing, value added (annual % growth) GDP growth (annual %) Source: WDI data, World Bank staff calculations. Figure 38. Structure of Gross Value Added in Kosovo and Comparators, 2010 and 2019, Percent 2019 10 27 63 Western Balkans 2010 12 27 62 2019 4 27 70 Aspirational Peers 2010 4 27 69 2019 18 25 57 Structural Peers 2010 21 25 55 2019 9 33 58 KOSOVO 2010 14 30 55 Agriculture Industry Services Source: WDI. 60 Raising Farm Productivity Lifting agricultural productivity will help boost growth and also carries the potential for job creation in related sectors. Higher agricultural productivity can also support downstream and upstream activities and create jobs in these sectors. This is particularly true for agribusiness, including exports, which has been growing rapidly. Anecdotal evidence suggests that companies that were able to vertically integrate in value chains grew considerably. It would also support current account sustainability, given the relatively large and growing net deficit in agricultural trade. Enhancing agricultural productivity also matters from two other perspectives: (1) growing opportunities for trade, as Kosovo is located close to a large and affluent market, and increasing FDI and integration into GVCs (of which there is currently very little); and (2) resilience to the threats of climate change, which is expected to impact both productivity and farm livelihoods if Kosovo does not implement policies to support adaptation. Figure 39. Employment by Sector, Average Shares, 2012–19, Percent 100 67.5 57.2 48.4 65.5 Agriculture 80 Industry Services 60 19.5 40 25.4 28.4 32.1 28.2 20 17.5 4.1 6.3 0 Kosovo Western Balkans Structural Peers Aspirational Peers Source: MPO Figure 40. Agricultural Labor Productivity, Kosovo and Peers, Constant 2010 US$ 30,000 24,987 25,296 25,000 22,598 20,000 18,628 17,008 15,000 12,819 10,000 6,631 5,827 5,000 , 3,798 1,813 0 KOS MKD ALB KGZ MDA LVA URY EST SVN LTU CZE Source: KAS and WDI data; World Bank staff calculations. Raising Farm Productivity 61 Improving the efficiency with which inputs are converted into output could boost agricultural production. Kosovar farms in general, micro and small farms in particular, suffer considerably from the extreme inefficiency with which farmers convert inputs into outputs. The mean technical efficiency (TE) score for the average farm is 0.27 (see Box 3), indicating that it could produce the same output using 73 percent less inputs (Figure 41). And the smaller the farm, the lower the efficiency (Figure 42). Box 3. Drivers of Agricultural Productivity: Methodology and Data Sources The drivers of agricultural productivity and its growth in Kosovo, and the implied constraints on the growth of agriculture, are analyzed using farm-level data for 2015–17 from the Farm Accountancy Data Network (FADN) individual farm database provided by the Ministry of Agriculture, Forestry and Rural Development (MAFRD). The dataset contains information about farm size, location, type, farm manager’s age, value of crops, number of hours worked, capital, cost of intermediate inputs, and other costs. Implied constraints on farm productivity have been identified by estimating technical and scale efficiency. Productivity dynamics are also assessed by decomposing changes in total factor productivity (TFP) into changes in technical and scale efficiency and technical change. Technical efficiency (TE) and scale efficiency (SE) measure the implied loss of production caused by not adopting the best production techniques and their optimal scale. Technical change (TC) measures change in the amount of output produced from the same amount of inputs. Equity in the distribution of support to agriculture is assessed from data about individual farms. FADN data on spending on agriculture in 2015 and 2017 is used to assess the distribution of different types of farm subsidies by economic magnitude, and the role of subsidies in driving efficiency and efficiency changes over time. Average subsidies for farms of different economic sizes facilitate assessment of whether the distribution of subsidies is pro-poor (small farms) or pro-rich (larger farms). The micro analysis is complemented by analysis of structural data to gauge the contribution of agriculture and agribusiness to Kosovo’s economy in terms of growth, jobs, and the external trade balance. Farms do better in terms of scale efficiency than technical efficiency on average, but that result is driven by large farms. Small and medium farms are inhibited by structural factors, notably limited access to credit. The scale efficiency (SE) score is 0.72 for an average farm which shows that farms could produce the same output using 27.9 percent less in inputs if they could move toward the most-efficient scale size. However, these estimates are mainly driven by large farms. Small farms, which constitute 75 percent of the farms in Kosovo, are not scale-efficient most likely due to credit constraints as well as market conditions; agriculture is one of the sectors most underserved in terms of credit (Figure 43). Moreover, a dysfunctional land market may also limit scale expansion. Farms are unable to both utilize inputs efficiently and benefit from scale economies at the same time. For farms whose TE is higher, SE is low. In particular, farms specializing in high-value crops such as horticulture and wine grapes seem to have high managerial competence but are unable to explore scale economies due primarily to cash-flow and credit constraints, which likely discourage investment in higher-value products. Farms specializing in field crops, milk, and grazing livestock are exploiting economies of scale relatively well (perhaps due to their comparatively high state support, which they can also use for investments) but also suffer from technical inefficiencies. Figure 41. TE and SE Scores in Agriculture, 2017 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 TE 0.272 SE 0.721 Source: FADN data; World Bank staff calculations. Note: TE = technical efficiency; SE = scale efficiency. 62 Raising Farm Productivity Figure 42. Mean TE and SE Scores by Farm Size, Kosovo, 2017 0.327 Large 0.889 0.264 Medium 0.843 0.239 Small 0.726 0.27 TE Micro 0.503 SE 0 0.2 0.4 0.6 0.8 1 Source: FADN data; World Bank staff calculations. Note: TE = technical efficiency; SE = scale efficiency. Figure 43. GDP and Commercial Loan Shares by Sector, 2018 20 Sector GDP Share (%) 15 Manufacturing Trade 10 Construction RE Ag 5 Trans Min ICT 0 0 10 20 30 40 50 60 Sector Commercial Loans Share (%) Source: KAS and CBK data, World Bank staff calculations. Note: Top eight sectors selected represented 77 percent of total commercial loans issued by value and 70 percent of production GDP in 2018. Size of circles is correlated with number of sector commercial loans. The dispersion of productivity across farms suggests significant distortions in agriculture. Like firms, there is a significant difference in TE reflected in the distance between laggard and frontier farms (Figure 44). Surprisingly, Kosovo is also not benefitting from the presence of young farmers; unlike young farmers elsewhere in the region, they are not more productive than older farmers (World Bank 2019a and b). Raising Farm Productivity 63 Figure 44. Density Distribution of TE and SE, Kosovo, 2017 4 SE 3 TE 2 1 0 0 .2 .4 .6 .8 1 Source: FADN data, World Bank staff calculations. Note: TE = technical efficiency; SE = scale efficiency. In recent years there has been encouraging improvement in TFP growth. Between 2015 and 2017 TFP went up by about 9 percent (Figure 45), mainly because large farms became more technically efficient. However, during the same period 60 percent of micro farms registered negative productivity growth. Similarly, only 40 percent of small and medium sized farms had positive TFP growth. Figure 45. TFP Growth by Farm Size Kosovo, 2015–17, Percent 10 Micro % of Farms Small Medium 7.8 Large 8 7.1 6.0 5.9 5.7 6 5.3 5.2 5.0 5.0 5.0 4.8 3.9 3.9 4 3.2 3.2 3.2 3.0 3.0 2.7 2.3 1.8 1.8 1.8 2 1.2 1.1 0.7 0.4 0.2 0 >1.6 (1.4-1.6] (1.2-1.4] (1.0-1.2] (0.8-1.0] [0.6-0.8] <0.6 TFP growth Source: FADN data; World Bank staff calculations. Note: All variables are normalized to 1 at 2015. Values greater lower than 1 indicate a negative growth rate for the variables, in 2016-17. Over the medium to long term, climate change will challenge farm productivity and incomes. Kosovo, which has been identified as a water-stressed nation, is among countries with the least developed water resources and storage infrastructure. Irrigation accounts for 41 percent of water use in Kosovo and the lack of modern irrigation infrastructure both limits growth of agricultural productivity and also heightens water stress.16F12 The lengthy drought in 2019 and the flood in 2020 in Gjilan municipality, which otherwise has rich agricultural potential, caused major agricultural losses. An underdeveloped Agricultural Knowledge and Innovation System (AKIS) undermines 12 Kosovo Water Policy Note, February 2020. 64 Raising Farm Productivity competitiveness (World Bank 2018). Among other impediments to productivity are minimal use of modern technology, low credit deepening, unavailability of capital for investment (especially for smallholders), outdated production management practices, lack of market opportunities, a shortage of aggregators of products and storage facilities, and few value chains. Public spending on agriculture is higher than in countries with similar per capita incomes but is dominated by subsidies for larger farms. In 2018, total budgetary transfers to agriculture reached 7.8 percent of agricultural VA—considerably higher than other Western Balkan countries except North Macedonia. In relation to comparators, this percentage was among the highest as a share of agricultural VA (Figure 46). Direct payments are the most important category of support; in 2014–19 they averaged 48 percent of total agriculture and rural development funds (Figure 48), with subsidies mostly flowing to larger farms (Figure 47). However, the average share of capital spending in agriculture (9 percent) is much lower than specified in the national budget (25.7 percent), though investment in the sector is sorely needed. The new irrigation master plan specifies infrastructure improvements and estimates medium-term costs for irrigation infrastructure alone at €590 million, equivalent to 8.5 percent of GDP. Rural development spending in Kosovo emphasizes agri-food by supporting investments; spending on general services mainly targets improving food safety standards. On average, rural development accounts for 41 percent of support funds, among the highest in the Western Balkans, and is mainly focused on supporting rural economic diversification. But there is little spending on environmental measures, despite the country’s strategic goals for sustainable resource management. For micro and small farms, the current design of farm support does not make income smoothing easy. The distribution of farm subsidies in Kosovo is increasingly associated with farm size; larger farms seem to be expanding their share of support. Further, the shares of total support going to smaller farms, which already seem to be lower than those of farms of equivalent size in other Western Balkan countries, are declining. This raises concerns about the capacity of farm support to facilitate income smoothing for those most in need. Figure 46. Agricultural Value Added (Percent of GDP) and Spending (Percent of Public Spending) Compared with Peers, 2017 6 LTU MKD 5 (% total public spending, 2017) LVA 4 EST KOSOVO 3 ALB CZE ARM 2 ARD Spending SVN KGZ 1 0 0 2 4 6 8 10 12 14 16 18 20 Agriculture VA (% GDP, 2017) Source: World Development Indicators; FAOSTAT. Note: 2015 for North Macedonia. Raising Farm Productivity 65 Figure 47. Direct Payments to Farms by Economic Size, Kosovo, 2017, Percent 90 80 77.3 70 60 50 40 28.8 29.6 30 20.4 21.2 20 13.8 10 7.7 1.2 0 Micro Small Medium Large Farms (percent of total) Subsidies (percent of total) FADN data, World Bank staff calculations. Figure 48. Agriculture Spending by Function, Kosovo, € Million at Current Prices, 2014–19 80 Total spending 69.4 70 Direct payments 60 52.8 54.8 50.6 Rural development 50 44.5 General services 40 29.7 29.7 30.6 30 26.1 27.0 21.4 31.0 20 15.2 22.5 16.1 10 19.6 15.5 11.1 8.1 8.8 8.1 0 3.4 3.5 4.2 2014 2015 2016 2017 2018 2019 Source: MAFRD data, World Bank staff calculations. Direct payments also seem to have little impact on farm efficiency; medium and large farms that receive subsidies are in fact less technically efficient. In other words, coupled farm support does not improve allocation of resources as measured by TE (Figure 49). In fact, current types of farm support in Kosovo seem to be an additional constraint on TE and thus on agricultural growth. Farms offering high-value-added products, such as horticulture and wine perform better in terms of TE if they are not subsidized (Figure 50). Current types of subsidies improve productivity but not managerial competence. Productivity growth is higher for farms that receive subsidies, but over time farms that are not subsidized achieve much higher TE. Subsidies seem to induce productivity growth especially in larger farms. It seems that the resources, competences, and capabilities of larger farms allow them to seek and obtain subsidies without the coordination and transaction costs becoming a major burden on their businesses. Figure 49. Mean TE Scores by Farm Size and Subsidies, Kosovo, 2017 0.50 0.43 0.40 0.34 0.31 0.30 0.26 0.27 0.24 0.25 0.23 0.20 0.10 0 Micro - Micro - Small - Small - Medium - Medium - Large - Large - S NS S NS S NS S NS Source: FADN data, World Bank staff calculations. Note: S: subsidized; NS: non-subsidized 66 Raising Farm Productivity Figure 50. Mean TE Scores by Farm Products and Subsidies, Kosovo, 2017 0.50 0.44 0.40 0.35 0.30 0.27 0.28 0.28 0.26 0.26 0.23 0.20 0.10 0 Fieldcrops - Fieldcrops - Hortic/Wine - Hortic/Wine - Dairying - Dairying - Exper. Farmers - Exper. Farmers - S NS S NS S NS S NS Source: FADN data, World Bank staff calculations. Note: S: subsidized; NS: non-subsidized There is also room for major improvements in land use. Input-specific efficiency analysis found that most Kosovo farms have been using land inefficiently. Agricultural land exceeds the optimal level of use by 9.1 percent, which applies to about 40 percent of farms. Land might therefore be considered a quasi-fixed input with low adaptability to market changes, or its inefficient use might imply lack of a dynamic land market (Table 6). Table 6.  Estimated and Actual Input Slack, Kosovo, 2017 Input Mean (std. dev.) Max (Min) Percentage (std dev) Number of farms Labor 65.45 7,716 1.46 n=828 (415.67) (0.00) (0.07) Land 1.36 139 9.08 (6.76) (0.00) (0.14) Capital 39,466 8,459,652 1.95 (363,729) (0.00) (0.08) Intermediates 1,455 236,974 0.94 (11,811) (0.00) (0.23) Overheads 189.73 46,575 4.77 (1,725) (0.00) (0.71) Source: FADN data, World Bank staff calculations. Upstream links to agribusiness are growing, but several factors prevent it from reaching its full potential. Agribusiness, mainly food processing, has been growing steadily in terms of number of firms, annual turnover, and employment (Table 7 and Figure 51). Interviews suggest that companies that were able to vertically integrate were able to grow and generate jobs, which also supported primary farms. Despite considerable investment during the last decade, the export potential of food processing is limited by, among other problems, a lack of capacity to deliver products that meet international quality and safety standards, unfair competition, and minimal farmer aggregation and cooperation, which result in high costs and inconsistent quality. Kosovo also has a large agri- food trade deficit, mostly accounted for by processed foods, which heightens the importance of promoting investment in agribusiness (Figure 52). Finally, the sector attracts little FDI, which makes it harder to integrate into GVCs. Between 2007 and 2019, agriculture accounted for only 1 percent of total FDI inflows.  Agriculture offers an opportunity for international investors, since 53 percent of Kosovo’s land is considered arable. There is also potential for high-value crops due to a beneficial climate and good soil quality, low production costs, and open access to the CEFTA and EU markets. However, agriculture has as yet attracted very little FDI due to issues related to land tenure and the fragmentation of plots.13 13 Foreign direct investment note, Kosovo country economic memorandum. Raising Farm Productivity 67 Table 7.  Agribusiness Enterprises in Kosovo, 2014–18 Turnover (¤ million) Number of Employees Number of Active Firms 2014 312.2 8,004 2,055 2015 323.4 8,790 2,130 2016 360.5 10,024 2,314 2017 432.3 10,449 2,398 2018 461.6 13,156 2,942 Source: MAFRD 2019. Figure 51. Agribusiness Firms by Product, Kosovo, 2018, Percent Active Firms (%) Paper & paper products Employees (%) Wood, wood products & cork Turnover (%) Leather & its products Tobacco products Beverages Food processing Fishing and aquaculture Forestry and wood harvesting Plant & animal products, hunting & related services 0.0 20.0 40.0 60.0 Source: MAFRD 2019. Figure 52. Agri-food Trade, Kosovo, 2014–18, Percent of Goods Trade 30.0 24.3 24.1 23.6 25.0 22.8 21.7 21.3 20.0 17.4 17.1 16.2 14.6 15.0 12.1 12.8 10.0 5.0 0.0 2014 2015 2016 2017 2018 2019 Food exports (percent of merchandise exports) Food imports (percent of merchandise imports) Source: WDI. 68 Raising Farm Productivity Policy Recommendations 1. Competitiveness should be supported by redirecting current types of farm support to higher-value-added activities and to small farmers. In view of the country’s path to EU accession, a shift to decoupled farm support to reduce factor misallocation is worth considering (Box 4). Support for investments in high-value crops could considerably improve the sector’s trade deficit and enhance farm incomes. Smaller farms can also benefit from better-targeted support. Lower eligibility thresholds for direct support and simpler rural development measures could benefit smaller farms and encourage their uptake of more efficient and innovative practices. Box 4. Decoupling Decoupling is a process introduced through reform of the EU Common Agricultural Policy (CAP) in 2003. It represented a change from supporting farmers with direct payments linked to the type and volume of output produced or to areas cultivated. Decoupled support allows farmers to produce in response to market demand.  At the same time, with decoupling, to receive support, farmers must meet environmental and animal welfare requirements (cross-compliance). Through decoupling, direct payments are made as compensation for public goods provided by EU farmers, such as clean air or landscape, and as compensation for competitive disadvantages due to tighter EU quality and environmental regulations. For member states, decoupled support per hectare (ha) is determined by a variety of models, ranging from historical entitlements to a flat rate per ha. As pure lump-sum transfers, decoupled payments have no effect on production. Hence, it is considered an agricultural policy instrument that does not distort production, consumption, and international trade flows, decoupled payments are consistent with the requirements for domestic support of the WTO Green Box. Decoupled payments represent the vast majority of support the CAP provides through Pillar I. CAP Pillar II provides support to individual farmers for both on-farm and off-farm investments and for environmentally friendly land management. It also provides support to rural residents investing in economic diversification and to rural areas for certain types of infrastructure. 2. Incentives are necessary to encourage aggregation of farmers and other food chain actors. Such incentives could promote capital investments to improve productivity and more efficient use of inputs; as most farms become competitive by becoming larger. Producer associations and cooperatives could link smallholder farmers to finance and input and output markets. 3. It is important to enhance the environment to support small and medium-sized farms. Investment in the provision of public goods (e.g., advisory, training, technical, and information support; agricultural R&D; infrastructure; and storage capacity) could help smaller farms to become more efficient. The Kosovo Credit Guarantee Fund could facilitate financial deepening for agriculture. 4. Rural development and other support measures should respond to farm needs and target youth employment by providing incentives for technical change and innovation. Such measures could also differentiate eligibility and selection criteria and rates of support to take into account regional disparities and to encourage younger farmers with entrepreneurial potential. They could provide special incentives for medium-sized farms to pursue enlargement and technological and managerial modernization—complemented by measures to improve access to credit and enrich managerial skills. Targeting youth employment could both facilitate knowledge and innovation and provide incentives for investments both on and off the farm. 5. It is important to expedite cadastral reconstruction to cover the entire country, prioritizing the more economically active agricultural land and cadastral zones. This would not only promote access to finance but also help protect fertile agricultural land from illegal construction. Enforcement of the unused agricultural land tax and introduction of market-based valuation of properties could facilitate more productive use of agricultural land by creating a more dynamic land market. 6. Finally, direct development programs are needed for rural economic diversification and sustainable management of natural resources. Implementation of the irrigation master plan based on irrigation infrastructure would make agriculture more productive and would allow better use scarce water resources. Raising Farm Productivity 69 04 IMPROVING Education Quality Improving Education Quality Human capital is fundamental for inclusive and sustained growth. Increasing the knowledge and skills embodied in people provides an opportunity for a productive future and is vital for both citizens and country to thrive in an increasingly competitive global economy where major technological shifts are underway. There are also more prosaic reasons for investing in education, not least its confluence with long-term social and economic opportunity and prosperity. Advanced economies derive the bulk of their wealth from human capital—the skills, education, and health endowments of their citizens (Lange, Wodon, and Carey 2018). Efforts to increase human capital would bring perpetual returns throughout the decades to come.14 Kosovo is still a demographically young country, and is located close to an aging and affluent market. Currently, children aged up to 14 make up 24 percent of the population; they will be joining the labor force within the next two decades. In 2040, children aged 14 and under will account for only 17 percent of the population and by 2060 only 14 percent (Figure 53). However, based on the World Bank Human Capital Index (HCI)15, a Kosovar child born today is expected to realize only 57 percent of her or his productive potential as an adult, in comparison to an individual who has had the full benefits of education and health. Hence, investments in human capital and improvements in the quality of education today will not only improve the lives of students within coming decades but would also contribute to higher growth by enhancing human capital. Figure 53. Population by Age, Percent and Average Age, Years, 2020–60 100 48 8.9 10.5 12.6 15.0 17.5 19.9 22.0 24.0 26.2 90 46 67.0 66.7 80 67.0 66.6 65.7 44 64.3 62.9 70 61.5 60.2 42 60 40 50 38 40 36 30 20 34 24.1 22.8 20.4 18.4 10 16.8 15.8 15.1 14.4 32 13.6 0 30 0-14 15-64 65+ average age, rhs Source: KAS projections and World Bank staff calculations. Access to primary education is almost universal (Figure 54), but that is not true of secondary. Since 2014 gross enrollment in lower secondary has slipped from universal to 91.5 percent and in upper secondary fell in 2019 to 83.4 percent. These enrollment rates are lower than in neighboring countries (Figure 55) and are slipping despite the decline of Kosovo’s school-age population. Access to preprimary education has considerably improved, but gaps remain. Participation in preschool remains low due to lack of investment, lack of infrastructure, and lack of awareness of its benefits. About 30 percent of municipalities have no public preschool institutions, and in 2019 preschool enrollment was still a very low 11 percent, against the 20 percent targeted by the KESP (Kosovo Education Strategic Plan); only 44 public preschools and kindergartens are available in the entire country. The gap is only partly filled by private and community-based services. 14 Hanushek and Woesmann (2007) find that an increase in the quality of schooling as measured by test scores rather than school attainment explain cross-country differences in GDP per capita. Bretton (2011) finds that both test scores and average years of schooling explain income differences between countries, and economic growth. 15 For a detailed discussion of the Human Capital Index (HCI) methodology, please see The Human Capital Index 2020 update, World Bank. 72 Improving Education Quality Figure 54. Gross Enrollment by Level, Percent 100 Pre-school (3 - 5 year old) Pre-primary (5 - 6 year old) 80 Primary (Grades 1 to 5) Lower Secondary (Grades 6 to 9) 60 Upper Secondary 40 20 0 Source: KAS and World Bank staff calculations. Note: Figure 54: Data do not include population and enrollment numbers from majority-Serbian municipalities Mitrovice, Ranillug, Gracanice, and Pratesh. Data are incomplete for other Serbian-majority municipalities, including Zubin Potok, Leposaviq, Zvecan, Sterpce, Kllokot and Novoberdo. Enrollment covers both public and private preschools. Figure 55. Lower and Upper Secondary Enrollment, Countries Rates Compared, Percent Gross Enrollment Rate 120 98 101 101 100 91 92 92 90 87 88 88 81 80 68 60 40 20 0 Republic of Kosovo Armenia Montenegro Albania Serbia Kyrgyzstan Moldova Lower secondary Upper secondary Source: KAS 2019 and UNESCO Institute of Statistics 2018. Note: Figure 55: Data do not include population and enrollment numbers from majority-Serbian municipalities Mitrovice, Ranillug, Gracanice, and Pratesh. Data are incomplete for other Serbian-majority municipalities, including Zubin Potok, Leposaviq, Zvecan, Sterpce, Kllokot and Novoberdo. Enrollment covers both public and private preschools. Improving Education Quality 73 Expanding school attainment is necessary, but quality of education also matters. Early learning indicators provide insight into achievement of the skills that are the foundation for future learning and mastery of higher competencies. In Kosovo, only 23 percent of children aged 36–59 months were developmentally on track for literacy and numeracy—a 16—much lower than in neighboring and other comparator countries. Among older children basic proficiency in mathematics and science is low: The 2019 International TIMSS results showed that 27 percent of 4th graders in Kosovo were unable to pass the minimum math proficiency benchmark and 41 percent were unable to pass in science, much worse than comparator countries (Figure 56). At the end of lower-secondary about 79 percent of 15-year-old students in Kosovo performed below the functional literacy and numeracy levels in PISA 2018, one of the worst performances in participating countries and much higher than the OECD average of 23 percent (Figure 57). Because low skills development carries over to higher levels of education, adults in Kosovo have minimal literacy skills. As measured in the 2018 STEP Household Survey, nearly 1 in 7 respondents failed the core literacy test. Figure 56. Proficiency in Math and Science, TIMSS 2019, 4th Graders Latvia Science Maths Czech Republic Lithuania Armenia Albania North Macedonia Montenegro Kosovo 59 Percentage of 73 students attaining passing low benchmark Source: MICS UNICEF Figure 57. Students Not Functionally Literate in Reading, PISA 2018, Percent OECD Average . % Estonia Slovenia Czech Latvia Lithuania Uruguay Moldova Montenegro Albania North Kosovo Republic Macedonia Source: PISA 2018. OECD Inequities in access are visible between communities, foundational skills are weak, and there is a large learning gap for minorities. Attendance rates for children living in Roma, Ashkali, and Egyptian communities are much lower, averaging 84 percent in primary school versus 100 percent for the general population, 63 versus 93 percent in lower secondary, and 31 versus 87 percent in upper secondary (MICS 2019). The quality of education also varies across communities. Overall, only 40 percent of children aged 7–14 have foundational reading and numeracy skills; with Roma, Ashkali and Egyptian children having only 18 percent for reading and 13 percent for math. The learning divide widens for minority students as they grow. 16 Children are identified as being developmentally on track based on whether they can name at least ten letters of the alphabet, whether they can read at least four simple, popular words, and whether they know the names and recognize the symbols of all numbers from 1 to 10. If at least two of these are true, t the child is considered developmentally on track. 74 Improving Education Quality Disappointing and unequal outcomes are reflected across regions and income groups. Primary enrollment is considerably lower in some municipalities, such as 60 percent in Junik and 67 percent in Decan and Dragash. National Matura Exams17 exposed significant differences between municipalities in learning outcomes (Figure 58). For example, while 51 percent students in Gjilan passed in math, only 32 percent did so in Hani I Elezit. In PISA tests, students belonging to the poorest socioeconomic quintile trailed students from the richest by 45 PISA points, roughly equivalent to one year of schooling, PISA tests also showed that students enrolled in vocational training performed worse than those in general education, and the gap is much higher in Kosovo than in OECD countries. Figure 58. Matura 12 Exam Results by Municipality, 2019, Percent Percentage of students who passed Shtërpcë Malishevë Rahovec Shtime Kamenicë Novo Bërdë Lipjan Hani I Elezit Suharekë Gllogoc Kaçanik Dragash Viti Podujevë Skenderaj F.Kosove Klinë Ferizaj Junik Mean Obiliq Prizren Vushtrri Gjilan Gjakovë Mitrovicë Istog Prishtinë Deçan Native language English language Math Source: MESTI, Division for Standards, Monitoring, and Evaluation -Learning Assessments Unit. Note: Small municipalities with no graduates are not included. Serbian-majority municipalities do not participate in the Matura exams. Improving effectiveness of education spending will be instrumental in enhancing productivity growth in Kosovo over the long term. Following independence, Kosovo continuously spent more on education, but the gaps were large. Pre-university education spending has tripled over the past decade (Figure 59); in 2019 it equaled 4.6 percent of GDP and 16 percent of total government spending. This is about at par with averages for middle-income countries of spending at 4.3 percent of GDP and 16.3 percent of national spending. It is also comparable to the education spending of structural and aspirational peers (Figure 60). Figure 59. Spending on Pre-university Education Expenditure (Euros) Millions Local Capital expenditures Subsidies and transfers Municipal expenditures/ Utilities Goods and services Wages and salaries Central Capital expenditures Subsidies and transfers Municipal expenditures/ Utilities Goods and services Wages and salaries Source: World Bank BOOST data for Kosovo 2009–19. 17 Matura is a high stakes assessment that signifies that is both the end of a student’s formal secondary education and the gateway to higher or vocational education. Improving Education Quality 75 Figure 60. Education Spending, Total Government Spending, and GDP Compared, 2019 Percentage (%) . . . . . . . . . . . Percentage of . total government . . . . . . expenditure . . . Percentage of Albania Armenia Lithuania Kosovo Latvia Uruguay Estonia Kyrgyz GDP Republic Source: UNESCO Institute of Statistics. Poor allocation appears to be an issue as education spending mainly goes to wages. Local governments are responsible for 84 percent of pre-university education, and 89 percent of spending goes to wages and salaries. Spending on education has more than doubled over the last decade, primarily because of across-the-board increases in public wages (Figure 59); and although the student population has been shrinking, the number of teachers has not changed. Spending inefficiencies are also visible in the variation in municipal spending per capita, which correlates with student-teacher ratios. Though grants from the central government follow an agreed formula, there are wide differences between municipal budgets per enrolled student (Figure 61). On average, ¤757 is spent per student, but the range is from ¤702 in Fushe Kosove to ¤2,243 in Kamenice and is correlated with student-teacher ratios (Figure 62). For instance, while in 2019 there were about 35/36 students per upper secondary class in Fushe Kosova; there were as few as 1 student per class in Leposaviq. The student-teacher ratio is low for primary and secondary education—much lower than the stipulated requirements.18 Figure 61. Municipal Per-Student Costs, Pre-university Education, Euros , , , , , , , , , , , , , , , , , , , , , , , , , Fushë Kosovë Hani i Elezit Prishtinë Prizren Gllogoc Mamushë Pejë Mitrovicë Jugore Obiliq Junik Podujevë Malishevë Rahovec Kaçanik Vushtrri Klinë Ferizaj Shtime Lipjan Suharekë Istog Gjakovë Skënderaj Deçan Viti Gjilan Dragash Kamenicë Source: World Bank BOOST Data, 2019 and KAS. 18 Article III of the Administrative Instruction states that the student-teacher ratio for all levels of primary and lower and upper secondary is 1:21.3 for the majority community and 1:14.2 for minority and mountainous communities. If a class has a special education student, then from the maximal number, two students should be removed. 76 Improving Education Quality Figure 62. Municipal Student-Teacher Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Kamenicë Dragash Gjilan Viti Deçan Malishevë Obiliq Junik Rahovec Kaçanik Suharekë Shtime Pejë Prizren Gjakovë Istog Mitrovicë Total Gllogovc Klinë Mamushë Skënderaj Ferizaj Lipjan Podujevë Prishtinë Vushtrri Hani i Elezit Fushë Kosovë Source: KAS, MESTI. The high wage bill, the uneven distribution of class sizes, and average student-teacher ratios leave little room for investment in education quality. Large variations in primary and secondary class sizes and an average student-teacher ratio much lower than the 1:21 guideline leaves little room for any investments after wages are paid. Like class sizes, municipal student-teacher ratios are also expected to vary considerably (Figure 62). The variation in class-size ratios and the projected demographic changes indicate that there is room for school optimization. Quality of education is jeopardized by lack of adequate infrastructure, educational materials, and a comprehensive program for teacher development. For instance, although Kosovo is prioritizing teacher development and introducing reforms to improve teacher quality, teachers feel that schools do not have the resources to use the new strategies learned. Meanwhile, 86 percent of 15-year-old students (as assessed by PISA 2018) studied in schools that lacked such educational materials as textbooks, IT (digital) equipment, a library, and laboratory materials. Only half of Kosovo’s schools have a library. Some municipalities have only one computer for as many as 50 students. Schools have lacked sufficient digital resources to integrate distance learning and enable a resilient education system, even though some teachers have the necessary technical and pedagogical skills and the time and technical support to do so. Finally, the national school mapping exercise supported by the World Bank in 2016 revealed that 80 percent of schools lacked drinkable water or proper sanitation and 70 percent lack laboratories. Similarly, a significant portion lacked facilities for sports and recreational infrastructure and IT equipment. The dearth of proper sanitation is of particular concern in the post-COVID environment (Table 8). Table 8.  Kosovo: School Facilities with Inadequate Infrastructure by Type of Issue, 2016 Number of school facilities with inadequate infrastructure School Infrastructure Inadequacies, Criteria 1-9 Basic Education Upper Secondary C1- Unsafe & depreciated structures, nonfunctioning electricity 528 45 C2-Non-drinkable water or dysfunctional sanitation 882 111 C3-Facilities >50% depreciated or “shed schools” 17 0 C4- Three teaching shifts and overcrowded classes (>36) 37 24 C5-Facilities without laboratories 757 107 C6 -Facilities without labs and IT equipment 915 101 C7-Facilities without access for the disabled; no emergency exits 813 87 C8-Facilities with low energy efficiency 961 102 C9-Facilities lacking sports or recreational infrastructure. 977 119 Total number of facilities 1,053 164 Source: Data from School Map Report 2016, World Bank staff calculations. Improving Education Quality 77 Demographic changes (declining population, migration) provide an opportunity for savings in the education budget that can be directed to quality enhancement. There are major municipal variations in both spending and outcomes. More equalized spending per student might lead to savings that can be spent on quality-enhancing resources for schools. There is also potential for creating fiscal space for quality investments by optimizing school networks. The COVID-19 pandemic is expected to have caused substantial learning losses, pushed even more students into functional illiteracy, and widened learning gaps between student populations. Assuming a student gains 40 PISA points of learning in a year, that schools are closed for four months on average, and that remote teaching in Kosovo is only 45 percent as effective as face-to-face teaching, learning in Kosovo could drop by the equivalent of 9 PISA points in reading (Figure 63). The differential access to and effectiveness of remote teaching will also widen learning gaps, especially for students from lower socio-economic quintiles, families with several children, and students with special needs. Using access indicators from PISA 2018 data and assumptions about differentiated learning effectiveness (25 percent effective for the poorest students, 50 percent for the average, and 75 percent for the richest students), the reading achievement gap is expected to increase by 18 percent (from 45 to 53 PISA points) after only a short school closure (Figure 64). Despite the significant effort by the government to bridge the digital divide in rural areas, the connectivity of schools is still of great concern. Digital inequity is likely to have a negative impact on the digital capacities of the society over the long term. The COVID-19 situation that forced the closing of schools and delivery of education remotely illuminated how ill-prepared the system is to use digital technologies to assist learning. For instance, 125 schools (about 11 percent) are not connected to the Internet. Schools that are connected are often not equipped with Internet service for educational purposes because only administrative offices have access. Only about 50 percent of all public schools in Kosovo have a dedicated computer (ICT) class. On average in public schools in Kosovo, there is only one computer per 37.5 students—much lower than in other Western Balkan countries.19 Figure 63. Estimated Impact of COVID-19 on PISA Scores20 PISA Scores in Reading KOS KOS estimate Post-COVID Source: World Bank staff calculations based on World Bank. 2020. Simulating the Potential Impacts of COVID-19 School Closures on Schooling and Learning Outcomes : A Set of Global Estimates (English). Washington, D.C.: World Bank Group. Figure 64. Estimated Impact of COVID-19 on the Socioeconomic Achievement Gap Post - COVID Baseline PISA Scores in Reading Poorest % points in PISA scale ≈ year of schooling Richest % Source: World Bank staff calculations based on World Bank. 2020. Simulating the Potential Impacts of COVID-19 School Closures on Schooling and Learning Outcomes : A Set of Global Estimates (English). Washington, D.C.: World Bank Group. 19 See Connectivity section of the Boosting Exports background note for more information. 20 The World Bank has estimated the effects of COVID-19-related school closures on learning outcomes for 157 countries. Simulations use data on learning outcomes, years of schooling, and monthly wages to estimate the possible effects of school closures in general and across socioeconomic groups. For more information, see https://www.worldbank.org/en/data/interactive/2020/03/24/world-bank-education-and-covid-19. 78 Improving Education Quality The low quality of education is also limiting labor market outcomes and growth of economic activity in Kosovo. About 74 percent of firms that attempted to fill a higher-skilled position and about 60 percent of firms that tried to fill a medium- to lower-skilled position encountered problems because applicants lacked either skill or experience. Furthermore, nearly 60 percent of employers interviewed think that general education does not provide students with practical experience, and almost half of them note that it also does not impart up-to-date knowledge, or socioemotional skills like discipline, timeliness, or people skills. Although employers are more satisfied with the TVET outcomes, 35 to 42 percent of employers think that training systems do not equip people with the necessary skills. While the economy is demanding people with higher-level skills, the education system is still struggling to equip students with foundational skills and the socioemotional and higher-order skills required in the economy. Policy Recommendations 1. Kosovo should work to increase preschool and secondary enrollment and maintain universal primary enrollment. Expanding access to preschool requires alternative financing models beyond public provision, providing incentives to private providers, hybrid public/private models, and ensuring minimum quality standards through licensing and training.21 At lower and upper secondary, it will be important to continue supporting and to better institutionalize remedial and extra support programs delivered through NGOs (e.g., learning centers) targeted especially to low-income families, minority children, and rural students. A student registry should be put in place to better track academic performance over the student’s school career. The registry should also allow for early warning of at-risk performers for more efficient targeting of services that keep students in school. 2. Providing quality education and increasing equity of access are crucial. Kosovo needs a program of learning assessments that guides teacher instruction and motivates improvement over time, especially in lagging municipalities. Kosovo would benefit from building on the strengths of a qualified and motivated teaching force, activating a strong professional development program that caters to teacher needs and improving the quality of teaching and learning. The majority of schools across Kosovo lack the educational materials and infrastructure that ensure a safe and conducive learning environment. 3. Tackling the problems in education requires more efficient spending, starting with a review of the recommendations for improving the school financing formula supported by the Kosovo Education System Improvement Project. Prompt action should be taken to adopt those recommendations and to build municipal capacity to ensure their success. Dynamic changes in the school funding formula would incentivize learning and close the gaps between regions. That will also require improvements in monitoring and evaluation to track results, make decisions, and enforce accountability for learning outcomes. A careful study of the distribution of administrators, teachers, and specialists would support studies of optimizing municipal school networks. Retraining opportunities where there is an oversupply of teachers for subject areas or levels may help redirect them to areas where there are supply shortages. Strong teachers should also be encouraged to teach in the early grades where foundational skills are taught. 4. Finally, in the wake of COVID-19 a special effort is required to recover learning losses, protect the human capital of affected cohorts, and increase the resilience of the education system. In order to close the digital divide and reverse pandemic-related learning losses, Kosovo needs a comprehensive plan for digitizing education delivery and ensuring equity of connectivity, sufficient equipment, and skilled and supported teachers who are prepared to use technology to assist learning, especially for children from rural and minority communities or of low socioeconomic status. 21 For a complete set of recommendations for expanding early childhood development, please see: Demas, Coll- Black, Aliu, Zafeirakou, Hankey, and Gotcheva. (forthcoming 2021). A Situational Analysis of Early Childhood Development Services in Kosovo. World Bank, Washington, DC. Improving Education Quality 79 05 REMOVING Regulatory Barriers to Competition Removing Regulatory Barriers to Competition Greater competition is vital to spur productivity growth in Kosovo. Competition enables a more efficient re-allocation of market and factor resources from low- to high-productivity firms and sectors; encourages the entry of more productive firms and the exit of unproductive ones; and can boost innovation and upgrading of technologies of firms (within-firm efficiency). However, in Kosovo, firm entry and exit and within-firm improvements in efficiency actually contributed the least to the meager productivity growth between 2014 and 2017 (Figure 25). Cross-country comparisons, meanwhile, indicate that Kosovo’s domestic markets are perceived as among the least competitive across the region (Figure 65); and its anti-monopoly policies are considered among the least effective of its comparators (Figure 66). Figure 65. Market-based Competition Score Aspirational 9.4 OECD average 8.5 Albania 7.0 Serbia 7.0 Kosovo 5.0 0 2 4 6 8 10 Score 1-10, from worst to best Source : Bertelsmann Transformation Index (BTI) (2020). Note: Aspirational countries for which information was available Latvia, Estonia, Slovenia, Lithuania, and Czech Republic. Figure 66. Anti-monopoly Policy Score Aspirational 10.0 OECD average 8.7 Albania 8.0 Serbia 7.0 Kosovo 6.0 0 2 4 6 8 10 Score 1-10, from worst to best Source : Bertelsmann Transformation Index (BTI) (2020). Note: Aspirational countries for which information was available Latvia, Estonia, Slovenia, Lithuania, and Czech Republic. The COVID-19 shock has likely exacerbated Kosovo’s productivity issues, but stronger market competition can expedite the recovery. Despite government efforts to offset the impacts of the COVID-19 shock, the pandemic has affected both productive and nonproductive firms in similar ways; and the associated exit of productive firms can threaten the country’s overall productivity. As the economy rebuilds, it will be vital that markets function smoothly, and that anti-competitive firm behavior or government intervention does not cause detours from the path to recovery. Competitive product markets can help prop up a more inclusive economic recovery for the poorest households. Despite progress over the past decade in upgrading the regulatory environment for competition, there are more such barriers to competition in Kosovo’s product markets than in OECD and EU countries. Kosovo has several times redrafted its competition rules to strengthen enforcement and fully align with the EU acquis. For example, in 2010 it tightened up the antitrust rules by introducing merger review procedures and a leniency program to combat cartels. The Kosovo Competition Authority has been empowered to start investigations, conduct inspections at business premises, impose fines and remedies, and prohibit anti-competitive mergers. However, 82 Removing Regulatory Barriers to Competition competition principles are not yet fully embedded in economic policy generally. Going by Product Market Regulation (PMR) indicator (Box 5), there are more regulatory barriers in Kosovo than in OECD and EU countries, but the country performs better on the PMR indicators than neighboring countries (Figure 67). Box 5. Methodology and Structure of the 2018 OECD-WBG Product Market Regulation Indicators for Kosovo The analysis is based on aggregate PMR indicators. This detailed set of internationally comparable indicators measure the extent to which regulations foster or limit firm entry and competition in product market areas where competition is viable, and the possible distortions induced by state involvement. PMR indicators focus on the formal regulations that are on the books; they cover neither informal regulatory practices nor how well the regulations are enforced. There are two types of indicators, which overlap slightly: The Product Market Regulation (PMR) database contains a detailed set of internationally comparable indicators at economy and sectoral levels. Economy-wide indicators include distortions from state involvement and barriers to firm entry resulting, from, e.g,, public procurement policies, public ownership, price controls, tariff barriers, or discriminatory treatment of foreign suppliers. Sectoral indicators assess the extent of regulatory barriers to firm entry and competition in key sector like network industries (energy, transport, e-communications), professional services, and retail services (including retail of medicines). These sectors are vital for the entire economy because their functioning has trickle-down effects for sectors that rely on them for production inputs. To ensure cross-country comparability, the data is current as of January 1, 2020. It is derived from answers to more than 1,000 questions (based on the 2018 PMR questionnaire), which are aggregated into economywide and sectoral scores following a standardized process. The analysis relies on primary data for Kosovo collected by the World Bank and validated by the OECD, as well as comparative data for other countries collected by the World Bank and the OECD.* *Initially built by the OECD for its members and OECD-plus countries, the 2018 dataset covers 50 countries and 2 U. S. states The 12 countries that are not OECD economies are Albania, Argentina, Brazil, Bulgaria, Costa Rica, Croatia, Cyprus, Kazakhstan, Malta, Romania, Serbia, and South Africa. Figure 67. PMR Indicators: Overall Score 3 Score (0-6, from best to worst) 2.5 1.82 2 1.62 Total average 1.55 1.40 1.40 1.5 1.30 1.29 1.29 1.28 1.19 1 0.5 0 Serbia Turkey Netherlands Latvia Finland ECA average Austria Iceland Albania Costa Rica Romania Brazil Denmark Norway Australia Czech Republic Hungary Chile Poland Slovak Republic Greece France Mexico Korea Canada Cyprus Bulgaria Colombia Spain Estonia Slovenia Germany Italy Ireland OECD average Switzerland Malta Luxembourg Belgium South Africa Sweden Lithuania New Zealand Portugal EU average Croatia Japan Kosovo Kazakhstan United Kingdom Argentina Source: OECD PMR Database. Note: Absolute values from 0 to 6. Higher values are associated with more restrictive regulations. Removing Regulatory Barriers to Competition 83 The PMR data suggests that barriers to competition are mainly associated with distortions introduced by state involvement in the economy (Figure 68). Identified barriers mostly stem from restrictions related to the public ownership of firms and preferential treatment granted to POEs, leaving private firms at a disadvantage. Restrictions related to unsatisfactory regulatory design may allow for adoption of policies that protect incumbents and limit market entry. The government’s involvement in business operations seems less intense, although the use of command-and-control regulation and price controls is still significant. Finally, barriers to domestic and foreign entry persist, mostly due to competition constraints in service and network sectors (e.g., electricity, transport, or regulated professions). Figure 68. Decomposition of the PMR score PMR score (0-6, from best to worst) 0.0 0.5 1.0 1.5 2.0 44% 56% Barriers to Domestic and Foreign Entry Distortions Induced by State Involvement 24% 27% 49% 42% 37% 21% Barriers to Trade and Investment Public Ownership Admin. Burden on Start-ups Simplification and Evaluation of Regulations Barriers in Service & Network sectors Involvement in Business Operations Source: OECD PMR Database. Note: Absolute values from 0 to 6. Higher values are associated with more restrictive regulations. According to the PMR indicators, distortions introduced by POEs in Kosovo are in line with most benchmark economies but are still higher on average than in the OECD countries. Governance of POEs, the scope of POEs, and government involvement in network sectors are the main drivers of the restrictions on competition identified (Figure 69). Even though state involvement in Kosovo could be justified by the limited size of the economy and the persistence of certain market failures, such as high fixed costs, notably in network industries like electricity, telecommunications, and rail transport, the government of Kosovo also participates in competitive markets where private sector participation is more feasible, – such as manufacture of basic metals22 and urban, suburban and interurban passenger transport,23 and there the rationale for state ownership is less clear. Figure 69. PMR Subindicator for Distortions Introduced by State Ownership: Score and Composition, Percent . . . . . . . . . OECD Average % % % % 2.14 Score (0-6, from best to worst) Albania % % % % 2.26 Governance of SOEs Scope of SOEs Kosovo % % % % 2.26 Gov’t Involv. in Network Sectors Direct Control Aspirational average % % % % 2.32 Serbia % % % % 3.95 Source: OECD Economy-wide PMR indicators (2020). Note: Absolute values from 0 to 6. Aspirational countries for which information was available are Latvia, Estonia, Slovenia, Lithuania, and the Czech Republic. The OECD average covers 36 countries. 22 For instance, Trepča JSC, which is regulated by the Law No. 05/L – 120, is a metallurgical as well as a mining company. 23 See, e.g., MPOE Trafiku Urban J.S.C. SOEs in urban transport are mostly owned by municipalities. 84 Removing Regulatory Barriers to Competition Competition issues are not fully considered in the Kosovo regulatory process and the conduct of relationships between public officials and business associations is not properly regulated. Regulatory impact assessments in other countries have shown the potential for halting the application of regulations that have a negative effect on competition. However, according to the PMR data, there are major inadequacies in assessments of the impact of Kosovo’s regulation on competition. The process is also vulnerable to vested interests, such as market incumbents. For instance, the government has a platform where the laws are posted for public comment for 15 days in line with best practices. However, the interaction of interest groups with public officials while regulations are being considered is not yet regulated. Burdensome efforts to get licenses and permits impede firm entry, and the administrative burden of closing a business also seems significant. Restrictions on firm entry are entirely driven by burdensome licensing and permitting (Figure 70). Currently, there are about 480 different business licenses and permits at the central level alone, although they are being simplified with support from the World Bank Group among others. In addition, the lack of a ‘silent is consent’ rule for issuing authorizations and licenses may delay administrative proceedings, which could lead to de facto denials. Administrative hurdles also remain in the deregistration process, such as the obligation to physically collect a Tax Deregistration Certificate and submit it to Kosovo Business Registration Agency (KBRA) in 7 to 10 days, which limits the ability of Kosovo firms to formally close their businesses. Finally, despite government efforts to create a one-stop-shop in KBRA for getting information on all the notifications, permits, and licenses needed to open up a business in Kosovo, the e-signature law is not yet operational, and KBRA requires firms to go to a business registration center to submit hard copies of the necessary documents. Figure 70. PMR Subindicator for Administrative Burdens on Start-ups, Percent Score (0-6, from best to worst) Aspirational average % % 0.82 Licenses and permits OECD average % % 1.12 Admin. requirements for limited liability companies and personally-owned enterprises Kosovo % 1.17 Albania % % 1.88 Serbia % % 1.94 Source: OECD Economy-wide PMR indicators (2020). Note: Absolute values from 0 to 6. Higher values are associated with more restrictive regulations. Aspirational countries for which information was available are Latvia, Estonia, Slovenia, Lithuania, and the Czech Republic. The OECD average covers 36 countries. Kosovo’s trade and investment laws seem to discriminate against foreign firms in certain product markets. The Law on Strategic investments (LSI) gives preferential status to some sectors over others, rather than improving the entire business environment to attract investors.24 Some degree of preferential treatment persists in public procurement, where there is explicit discrimination in favor of domestic firms with regard to financial criteria: they are granted 10 more points than foreign suppliers.25 In the road freight sector, cabotage is not allowed, which protects domestic markets from international competition.26 Finally, mutual recognition agreements have not been put in place for architects and civil engineers, which also restricts competition in the professional services sector, where numerous restrictions have been imposed on domestic professionals.27 24 Art. 2 of Law No. 05/L-079 on strategic investments in the Republic of Kosovo. 25 Art. 60/A of Law No. 04/L-237 on Amending and Supplementing the Law No. 04/L-042 on Public Procurement in the Republic of Kosovo. 26 Article 44 of the Law No. 04/L-179 on Road Transport. While cabotage is restricted in most countries covered by the PMR data, including EU member states, Kosovo’s regulations on cabotage are more restrictive than the EU’s. 27 Such agreements do not exist, according to Kosovo’s International Agreement database (https://gzk.rks-gov.net/ InternationalAgreementsList.aspx). However, lawyers from the USA and the EU may exercise their profession in Kosovo by virtue of art. 40, para. 4 of Law No. 04/L-193 on the Bar. Removing Regulatory Barriers to Competition 85 An analysis of sector-specific regulations found entry barriers and restrictions on competition in service sectors, particularly for professional services. Professional services have more restrictive entry regulations than the OECD average for a variety of professions, though not lawyers (Figure 71). The requirements for accountants are more demanding in Kosovo than in other countries, which may limit the number of qualified professionals. Lawyers and notaries are subject to entry and tariff restrictions, substantially hindering competition. Kosovo limits the number of notaries by law, unlike, e.g., the Netherlands, Poland, and France. Architects and civil engineers must be members of professional chambers, even though that requirement may encourage collusive behavior to block entry of new professionals. Figure 71. PMR Subindicators for Professional Services . Albania Kosovo . . OECD Average 4.72 . . Aspirational average . . Serbia . . . . 2.15 . . . . . 1.55 1.45 . 1.40 . . . . . . . . . Lawyers Notaries Accountants Architects Civil engineers Source: OECD Sector PMR indicators (2020). Note: The PMR scale for each sub indicator is 0–6, from least to most restrictive of competition. Aspirational countries for which information was available are Latvia, Estonia, Slovenia, Lithuania, and the Czech Republic. The OECD average covers 35 economies. Iceland and Cyprus are omitted due to missing data on individual indicators. Barriers in network sectors are higher than in benchmark economies. The PMR data suggests that several regulatory restrictions also remain in network sectors, which are central to production in the broader economy (Figure 72). Empirical studies show that restrictions in services have a negative impact on TFP at the firm level, especially in countries that do not have strong institutions (Marel et al. 2016).28 Restrictions in these sectors mostly relate to lack of pro-competitive regulations. Most domestic firms see the electricity sector as a major constraint. Limited access to electricity in wholesale markets prevents effective competition. Kosovo Energy Corporation J.S.C. (KEK), a wholly owned POE accounts for more than 90 percent of the electricity generated. Private generation operators are also active, but their capacity and impact on the wholesale electricity market are small.29 In the supply segment, although there are eight licensed operators, the historical operator, Kosovo Company for Supply and Energy (KESCO), holds 100 percent of the market shares.30 Existing supply obligations arising from the bulk supply agreement between KEK and KESCO (all the electricity produced by KEK is sold to KESCO, at prices lower than imported 28 Marel, E., I. Kren, and M. Ioott. 2016. “Services in the European Union What Kinds of Regulatory Policies Enhance Productivity?” Policy Research Working Paper, World Bank, Washington, DC. 29 According to ERO’s decision of 10 December 2020 (ERO Code: V_1339_2020) on the “Evaluation of competition in the electricity market in Kosovo 2018-2019,” concentration in the wholesale market is very high (the HHI amounts to 9115) 30 See: ERO’s decision of 10 December 2020 (ERO Code: V_1339_2020) on the “Evaluation of competition in electricity market in Kosovo 2018-2019.” 86 Removing Regulatory Barriers to Competition electricity)31 prevent other suppliers from accessing the wholesale electricity market and offer competitive services in the retail market, protecting the incumbent operator.32 In addition, lack of effective tariff deregulation in retail markets for some categories of consumers, and the small size of Kosovo’s markets, may further reduce incentives to compete on electricity supply. While the regulator in 2017 issued guidelines for liberalizing the electricity sector that define the manner, criteria, and timing of deregulation of tariffs for liberalizing generation and supply, as yet there has been no significant progress.33 For transport, the regulations are aligned with the OECD average, but some restrictions remain on rail, road, and air transport. For railways, limited concession licenses and the burdens of developing a competitive freight corridor could be hindering opportunities to attract international rail freight and passenger services.34 Similarly, for roads, stringent licensing systems prevent entry for intercity bus and taxi transport, which may have a negative impact on the price and quality of services. Finally, even though Kosovo and the EU have signed an open-sky agreement in air transport, similar agreements have not been yet reached with other important markets, such as the United States, China, Japan, India, Brazil, Canada, Republic of Korea, Australia, or Mexico. Signing these agreements could not only reduce the costs of air transport to those countries but also improve trade.35 For telecoms, even though there are few regulatory restrictions on competition, Kosovo fares worse than the OECD and aspirational comparators, mostly because the state has such a large presence in the mobile sector. Although the impact of state presence is not necessarily detrimental to competition per se, it is identified by the PMR methodology as an indicator of potential market distortions. In mobile telecommunications, the historical operator Kosovo Telecom (KT), a wholly owned POE, holds a significant market position in the mobile telephony market (59 percent in terms of subscribers), which is at odds with most countries analyzed using the PMR methodology. Moreover, some regulatory restraints on competition remain. For instance, according to the information available, the telecoms regulator, Autoriteti Rregullativ i Komunikimeve Elektronike dhe Postare (ARKEP), has not yet formally assessed market dominance in the provision of wholesale mobile call origination services, which delays the application of existing regulation for preventing abuses from operators with significant market power. Moreover, some implementation issues, such as delays in assignment of spectrum, prevent potential competitors from entering the mobile segment and limits the expansion plans of current operators. 31 The agreement was concluded in the context of universal supply obligations provided by the previous Law on electricity (article 18 of Law no. 03 / L -201 on electricity). The contract is available at the Ministry of Economic Development’s webpage: https://me.rks-gov.net/repository/docs/MARREVESHJE_PER_FURNIZIM_ME_ SHUMICE_-_tetor2012_KKDFE.pdf 32 Ibid. The expected operationalization of the recent agreement between Albania and Kosovo to integrate their day-ahead markets in late 2021 could enhance competition by increasing access to wholesale markets, although its impact may be limited. 33 See: ERO’s decision of 10 December 2020 (ERO Code: V_1339_2020) on the “Evaluation of competition in electricity market in Kosovo 2018-2019. See also: Energy Community Secretariat (2020), WB6 Energy Transition Tracker. See also: Energy Community Secretariat (2021), WB6 Energy Transition Tracker 34 Trainkos J.S.C. –an SOE vertically integrated with the operator of railroad infrastructure, Kosovo Railways Infrakos J.S.C.— is the only licensed operator for passenger transport and one of the two companies licensed to provide freight services. See: Railway Regulatory Authority (2019), Annual Report; available at: http://arh-ks. org/desk/inc/media/C4075402-140C-4042-941B-B1A517393E8C.pdf 35 For instance, in the US, the reduction in transport costs as a result of the open-skies agreements in the 1990s is estimated at 9 percent, and the increase in trade was estimated at about 12 percent. Removing Regulatory Barriers to Competition 87 Figure 72. PMR Sub-indicators for Network Sectors, index=0-6 . OECD Average Aspirational average Albania . . Kosovo Serbia . . . . . . 2.00 . 1.86 1.82 . . . 1.54 . . . . . . . . . . . Total network sectors Energy* Transport Ecomm Source: OECD Sector PMR indicators (2020). Note: PMR Scale for each subindicator is 0–6, from least to most restrictive of competition. Aspirational countries for which information was available are Latvia, Estonia, Slovenia, Lithuania, and the Czech Republic. The OECD average includes 35 economies. Iceland and Cyprus are omitted due to missing data on individual indicators. The energy subindicator shows the cumulative PMR score for the electricity and natural gas subindicators for each country or group. However, Kosovo’s score refers to regulatory restrictions on electricity; as the gas sector is still under development. Kosovo’s regulatory framework on retail distribution is less restrictive than that of its peers, which is in line with the sector’s performance over the last decade (Figure 73). Though, regulatory restrictions remain, particularly for the retail sale of medicines. Nonprescription medicines seem to be subject to the same regulations as prescription medicines and can be sold only in pharmacies.36 This practice is at odds with most OECD countries, where regulations on the sale of over-the- counter drugs are more flexible because they are generally considered less risky. Self-care medical devices (i.e., medical devices that do not require the involvement of a health professional, such as blood pressure gauges) are subject to similar restrictions. Improved inspections could mitigate the risks of market liberalization, such as the sale of counterfeit or dangerous medicinal products. Other minor restrictions, such as the regulation of shop opening hours, could also limit consumer access to goods and services. 36 See Article 2, para. 2 of Administrative Instruction (Health) No. 11/2015 Retailers for Medicinal Products and Medical Devices. Nonprescription medicines fall within the definition of a medical product, as ascribed in Article 3, para. 1 of Law No. 04/L-190 on Medicinal Products and Medical Devices. 88 Removing Regulatory Barriers to Competition Figure 73. PMR Subindicator for Retail Distribution 0 0.2 0.4 0.6 0.8 1 1.2 1.4 Albania 0.78 Serbia 0.82 Kosovo 0.84 Aspirational average 0.99 OECD average 1.25 Source: OECD Sector PMR indicators (2020). Note: Aspirational countries for which information was available are Latvia, Estonia, Slovenia, Lithuania, and the Czech Republic. The OECD average includes 35 economies. Iceland and Cyprus are omitted due to missing data on individual indicators. Policy Recommendations 1. Reduce POE-related barriers to competition to ensure a level playing field for private and public operators in markets where both can compete on the merits. Short-term measures would be to improve SOE governance by preventing participation of representatives of sector regulators on supervisory boards; and ensure participation of qualified professionals through an open application process; reduce state subsidies, such as soft loans) to POEs; and revise the Law on Public Procurement. 2. Build up the regulatory process and facilitate business registration to boost market entry. There is scope to enhance the quality and control of the regulatory process by (a) drafting a clear regulation on interactions between regulators and interest groups; (b) strengthening the Regulatory Impact Assessment of new laws through cost and benefit analysis and review by an independent authority; and (c) putting in place an effective e-ID system to allow fully online registration of businesses. 3. Finally, Kosovo needs reforms in specific sectors to eliminate regulatory barriers to competition and avoid anticompetitive practices. That includes a comprehensive review of entry and membership regulations for professional services (to increase market entry and reduce the costs to firms) and removing pre-defined fees for professional services. More importantly, the government should also ensure full liberalization of the electricity market by deregulating tariffs in the supply segment for all consumers and consider reviewing the incumbent’s priority access to wholesale markets. In the transport sector, it is essential to lift entry restrictions that artificially limit the number of operators (e.g., for intercity buses or taxis) and allow free competition on prices. Lastly, ensuring the enforcement of pro- competitive regulation is essential to boost competition. For instance, in telecommunications, spectrum bands should be offered in a timely and transparent manner, and market studies should be carried out in the mobile call origination services market to encourage new operators to enter. Removing Regulatory Barriers to Competition 89 06 BOOSTING Exports Boosting Exports Countries open to international trade tend to grow faster. International trade can foster productivity through three main channels: (1) Higher exposure to trade can increase domestic competition and lead to better allocation of resources between firms and higher churning of unproductive firms (Melitz 2003, Melitz and Ottaviano 2008). (2) Increased competition from imported products can incentivize innovation, leading to productivity gains within firms. (3) Exporting can expand production opportunities and allow firms to explore new technologies to serve and compete in larger markets. Consumers also gain from having access to wider variety and better-quality products at lower prices. Trade in Goods and Services Kosovo’s trade balance has improved over time as services exports helped offset the large trade deficit in goods. Between 2009 and 2019, Kosovo’s exports averaged 23.5 percent of GDP. Services exports constituted the major share of exports at 17.9 percent of GDP; goods exports amounted to 5.6 percent (Figure 74). Despite the significant increase in service exports over time, apart from 2011 and 2017 net exports continuously subtracted from growth (Figure 75). Though export growth outpaced import growth because imports grew from a lower base, during the last decade the contribution of net exports to growth on average remained negative. Services exports have contributed considerably to growth, but they remain concentrated in diaspora-related activities, such as travel and transport. Figure 74. Decomposition of Kosovo’s Trade Balance, €Billion, 2004–20, Percent of GDP 5 0 -20 27 26 27 31 28 29 28 29 32 0 34 35 37 37 37 35 36 Trade balance 39 (% of GDP), rhs -40 Goods exports Goods imports Services exports -5 -60 Services imports 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: CBK, WDI. Figure 75. Composition of Kosovo’s Services Exports, 2010–19, Percent 100 Goods-related 90 Financial 80 Transport 70 Royalties 60 Travel 50 ICT 40 Construction 30 Other Business 20 Insurance 10 Personal 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Source: Estimates based on data from IMF BOP/IIP. 92 Boosting Exports In the absence of monetary policy levers, improved export performance would enhance the resilience of Kosovo’s economy to external shocks. The economy is connected to the rest of the world through remittances, travel exports, and FDI in real estate and construction, which in turn are driven by diaspora dynamics and base metal prices. Further diversification of services exports to modern services and goods exports to products other than commodities would lead to a more sustainable current account and provide a policy lever for macroeconomic stabilization. Poor export performance reveals the underlying weaknesses in the firm landscape. Kosovo’s total exports have underperformed regional peers and trail aspirational peers even when services exports are accounted for (Figure 76). Kosovo’s exports per capita are less than one-third of the average Western Balkans country, suggesting that Kosovo’s poor export performance is not driven by regional dynamics but by a lack of competitiveness; lower GVC integration through FDI; and perhaps limited international recognition. Export performance in general is also below what would be predicted by Kosovo’s income per capita (Figure 77). The poor performance is more evident for goods exports (Figure 78). Figure 76. Exports of Goods and Services per Capita, Current US$, 2018 Slovenia 21,747 Slovak Rep. 17,792 European Union 17,588 Czech Rep. 17,549 Estonia 17,294 Lituania 15,097 Latvia 10,719 Croatia 7,601 Uruguay 4,909 Montenegro 3,883 Serbia 3,742 North Macedonia 3,737 Bosnia and Herzegovina 2,459 Albania 1,682 Moldova 1,377 Kosovo 1,288 Kyrgyz Rep. 481 Source: World Bank data; World Bank staff calculation Note: Exports of goods and services divided by total population. Measures are in current US$. Figure 77. GDP (PPP) and Exports of Goods and Services per Capita, in Logs, 2018 14 R² = 0.8958 12 10 8 6 4 GDP per capita, PPP (log) 2 6 7 8 9 10 11 12 Low income Middle-lower income Upper-middle income High income Aspirational peers Comparators Kosovo Source: World Bank and CBK data; World Bank staff calculations. Note: GDP per capita is measured at PPP and current US$, while exports of goods and services are measured at current US$. Variables are transformed into logs. Boosting Exports 93 Exporters tend to be more productive, larger, and more capital-intensive; pay higher salaries; and have higher access to credit (Figure 79). Exporters are 5.5 percent more productive than non-exporters in terms of TFPR. Firms that export also have 51.4 percent higher VA per worker and on average sell 71.4 percent more per worker than non-exporting firms. The average exporting company has 118 percent more employees than the average non-exporting firm and pays wages that are 15.6 percent higher. The capital stock per worker in exporting companies is 13.4 percent higher than in non-exporters, and the fraction of exporting firms investing tends to be higher by 12 pp than among non-exporters. Exporters have 4.6 percent more access to credit. Figure 78. GDP (PPP) and Exports of Goods per Capita, in Logs, 2018 Exports of goods per capita (log) 12 10 8 6 R² = 0.7935 4 GDP per capita, PPP (log) 2 6 7 8 9 10 11 12 Low income Middle-lower income Upper-middle income High income Aspirational peers Comparators Kosovo Source: KAS and World Bank data; World Bank staff calculations. Note: GDP per capita is measured at PPP and current US$; exports of goods are measured at current US$. Figure 79. Exporter Premium 118.5 Gap between exporters and non-exporters (%) 120 100 80 71.4 60 51.4 40 20 15.6 13.4 12.0 5.5 2.9 0 Log TFRR Log value added Log sales Log Log wage Log capital Investment Credit per worker per worker employment per worker per worker access Source: Kosovo Customs and Kosovo Tax Registry data; World Bank staff calculations. Note: In the spirit of Bernard et al. (2007), the exercise regresses a group of firm performance measures on two dummy variables that classify firms according to their exports and on the log of employment to control for firm’s size. The first dummy variable equals 1 if the firm exports goods and 0 otherwise, and the second equals 1 if the firm exports services and 0 if not. The baseline category is non- exporters. The specification also controls for year effects, industry fixed effects (four-digit level of NACE Rev. 2, except for TFPR and VA per worker, which are at macro-sector level), and geographic fixed effects (municipality level). Exporting is more difficult for micro firms. On average, 4.4 percent of firms exported each year in 2013–19, but only 2.9 percent of micro firms did, compared to 20.9 percent of small companies and 34.3 percent of medium and large firms. Thus, exporting is highly and positively correlated with firm size. 94 Boosting Exports Goods exporters are concentrated in specific activities, such as utilities, manufacturing, mining, communications, and agriculture. Metal and minerals account for the lion’s share of export value, but beverages, plastics, vegetables, and leather products also constitute a substantial share of Kosovo’s goods exports. Exports of metal products accounted for almost 37 percent of average total export value for 2013–19) and mineral products for nearly 20 percent. Within these broad categories, ferro-alloys (14% of total export value), electrical energy (9%), ferrous waste and copper (11%), and zinc and lead ores (4%) are the most traded products. Nevertheless, food and beverages (8%), rubber and plastics (8%), and vegetable products (6%) also represent significant shares of exports; with manufactured plastics, water, and beer the top non-commodity exported products. Figure 80. Composition of goods export by chapter in 2010, million euros 2010 2019 4 4 4 6 4 63 35 13 10 3 10 13 Base metals and Vegetable products Machinery, Processed food, Mineral products Plastics, rubber an articles of base metal appliances, electrical beverages and tobacco darticles thereof Source: CBK and World Bank staff calculations. Exporters of services performed better than goods exporters in 2013–18, both in number of exporters and the value traded. Based on KTR data, the number of services exporters doubled between 2013 and 2018, and export value tripled. Exports of services grew steadily and quickly, amounting in 2018 to US$137 million, 200 percent higher than in 2013. As Figure 81 shows, services export value grew steadily in the last four years of the period; goods exports grew more slowly.37 37 Since firms selling goods abroad are recorded both in the KCD and the KTR, the remaining exporters in the KTR are likely to export services. Nevertheless, it is worth mentioning that even the KTR does not cover the whole universe of services. For instance, in some industries, such as hospitality or retail, it is difficult to determine whether or not a sale is an export since it depends on the customer’s residence. However, for other transactions, exports are easily distinguishable as they are sold to firms outside the country’s bounds. This section refers to those exports in particular. Furthermore, the KTR does not provide information on the type of services exported or the destination, so this section provides an overview of the exporters of services. Finally, due to data availability, the period is 2013–18. Boosting Exports 95 Figure 81. Firms Exporting Services and Export Value, US$ Millions, Total Firms, 2013–18 700 160 Exports (million US$) Firms 643 600 140 137 120 500 573 126 530 100 400 456 101 92 80 300 362 314 72 60 200 40 46 100 20 Firms (left) Export value (right) 0 0 2013 2014 2015 2016 2017 2018 Source: Kosovo Tax Registry data; World Bank staff calculations. Note: Firms exporting services are firms whose exports are recorded in the Kosovo Tax Registry but not in the Kosovo Customs Database in the year of reference. The period (2013–18) is set by data availability. Peak in 2014 is due to a jump in exports of transportation and storage. Wholesale and retail, communications, and professional and administrative services contributed the most to growth of services exports. Together they account for 76 percent of total exporters of services and 92 percent of services export value. Five sectors dominate Kosovo’s service exports; others contribute only marginally. Wholesale and retail trade accounts for one- third of total service exports, proportional to the share of firms exporting. However, transportation, communications, and administrative activities contribute to export value disproportionately: their share in total services exports is almost twice their share in total services exporters (Figure 84). Figure 82. Firms and Exports by Sector, Average 2013–18, Percent a) Exporters of services b) Services export value Wholesale and retail trade Transportation Manu- Wholesale and retail trade Administrative and and storage facturing 30.1 support services 32.1 11.5 8.0 11.3 Information and communication Professional, 22.7 scientific Construction Other and technical Professional, scientific and 6.9 sectors activities technical activities (E, Q, K, B, D,P, L, O, r) 6.9 15.8 5.0 Other Transportation and storage sectors 20.8 (E,Q,K, Administrative B,D,P,L, Information and communication O, r) 12.3 and support services 2.4 4.6 Construction Other services 1.8 Source: KTR and World Bank staff calculations. 96 Boosting Exports Figure 83. Median Export Value per Firm and GDP per Capita (PPP), Current US$, in Logs Median export value per firm (USD, logs) 14 13 12 11 R² = 0.0421 10 ALB HRV MKD 9 KOS 8 7 6 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0 10.5 11.0 11.5 GDP per capita (PPP, current US$) Kosovo Comparators Aspirational peers Low income Lower middle income Upper middle income High income Source: KCD and Exporter Dynamic Database data; World Bank staff calculations. Note: The figure shows the average export value of the median exporter per country reported in the World Bank Exporter Dynamic Database for the period 2010–14 (latest period available) and GDP per capita at PPP in current US$. Averages corresponds to 2013–19 for Kosovo. Dot colors are defined by country income level classification elaborated by The World Bank (lighter: lower income; darker: higher income). Firms in international trade export goods worth US$200,000 annually (average 2013–19), but 50 percent export less than US$11,500. The average firm exports almost 20 times as much as the median exporter and dispersion in size is quite large. For instance, considering the activities where there is a sufficient number of exporters (i.e., they account for more than 1 percent of the total), the median for exporters of vegetables, food and beverages, and mineral products is three to four times higher than the wide-sector median. This provides some evidence of competitive advantages in agriculture and food production. Exporter performance in the remaining sectors does not differ significantly, with most having a median export value of less than US$ 15,000. Figure 84. Products Exported and Destinations Served, 2013–19 1,900 Products Destinations 180 1,800 1,721 1,722 160 1,700 1,642 1,639 1,603 140 1,600 1,531 1,466 120 1,500 1,400 100 83 82 69 72 73 1,300 65 80 59 1,200 60 1,100 Products (left) 40 Destinations (right) 1,000 20 2013 2014 2015 2016 2017 2018 2019 Source: Kosovo Customs data; World Bank staff calculations. Note: The figure shows the number of different products exported at the HS 2012 six-digit level. Compared to 2013, in 2019 goods exporters in Kosovo reached more destinations with more products. The variety of products exported increased from an average of 1,500 between 2013 and 2018 to 1,700. During this period, new companies entering foreign markets led to product diversification. The number of destinations served also rose as exporters became better able to enter and explore new markets (Figure 84). Nowadays, Kosovar companies export goods to nearly 80 different destinations, 40 percent more than in 2013. Nearly one-third of the Kosovar exporters sell a single product to a single country, which suggests that exporter survival is influenced by the dynamics of a specific market (product-destination performance). However, multi-product and multi-destination Boosting Exports 97 firms account for the largest share of exports. Just 5 percent of firms are responsible for more than 40 percent of total goods export value. These firms serve five or more countries and export five or more products. A 10 percent more LP (sales per worker) is associated on average with exporting to 1.4–1.6 new destinations. More experienced firms and regular exporters (incumbents) also serve more destinations. Similarly, a 10 percent increase in LP is associated with exporting 4.3–6.2 more products and, again, incumbents tend to export more products. Firms with greater geographic and product diversification are more likely to survive in foreign markets. Exporters in Kosovo serve fewer destinations and have a smaller bundle of exports than in comparator and aspirational countries. Besides a lower median export value, exporting firms also ship a smaller variety of products and serve fewer destinations than the average exporter in similar countries like North Macedonia or Albania (Figure 85). Figure 85. Total Products Exported and Destinations Served per Firm, Average by Country 10 Products Destinations 9 8 7 6 R² = 0.3035 5 4 HRV EST 3 2 MKD 1 ALB KOS 0 0 2 4 6 8 10 12 14 16 Low income Lower middle income Upper middle income High income Comparators Aspirational peers Kosovo Source: Kosovo Customs Data and World Bank Exporter Dynamic Database ; World Bank staff calculations. Note: Averages are for 2010–14 except for Kosovo (2013–19). Vertical and horizontal grey lines indicate the simple mean of all plotted countries and the red fitted line shows the relationship between the number of destinations served and products exported per firm by country. Finally, dot colors are defined by country income classification by The World Bank (lighter: lower income; darker: higher income). Survival is difficult for Kosovar exporters. After entering a foreign market, only half the entrants survive the next year. Five years after entry, only 16 percent of goods exporters are still exporting. More than 600 firms start exporting goods each year, and an average of 500 exit (Figure 86). Between 2014 and 2018, new exporting firms increased by one-third, from 505 to 678 firms—but the number of exits rose faster (by 43 percent), suggesting that businesses that engage in international trade found it difficult to survive. The exporting scale of entrants is small: in 2014–19 median exports averaged US$5,300 and the mean was US$30,300—relatively low compared to the average exporter. Along with the decline in median and average exports, entrants’ exports have been falling. Mean and median exports in 2019 were nearly one-third less than in 2014 and the lowest value of the whole period. Even when entrants tend to be smaller than the average exporter and they export small quantities to fewer countries (Albornoz, Calvo Pardo, Corcos and Ornelas 2013), a decline in export value may also reveal that Kosovo’s businesses are facing barriers to exporting. 98 Boosting Exports Figure 86. Firms Entering and Exiting Foreign Markets, 2014–18 700 674 678 Entry Exit 614 625 600 547 534 505 496 500 437 443 400 300 200 100 0 2014 2015 2016 2017 2018 Source: KCD data; World Bank staff calculations. Note: A firm enters if it exports in the year of reference but did not in the year before; a firm exits if it exports in the year of reference but not in the following year. According to these definitions a firm can enter and exit a market in the same year. New exporters sell their products to the region and to EU members. Western Balkan countries are destinations for 55 percent of new Kosovar exporters and their export value. The EU is the destination for 42 percent of new entrants but only 26 percent of entrants’ total export value. Serbia, Albania, Switzerland, Germany, and North Macedonia are the top five destinations for entrants’ products. Firms that have already exported to Western Balkan countries have a higher probability of entering other markets. Hence, exporting within the region is the first step in exporting. Experience and information help businesses to overcome the challenges of exporting. Kosovar entry into exporting is relatively high in comparison to regional peer and middle- income countries. Kosovo has the second-highest entry rate among comparator and aspirational peers. Even compared to countries outside the region, its exporting entry rate (new exporters divided by total exporters) is higher. Furthermore, the net entry rate, net of exits, is slightly above similar countries except for Estonia (Figure 87). Figure 87. Entry, Exit, and Net Turnover by Country, Percent of Total Goods Exporters 60 57.3 Entry Exit 50 Net entry 41.0 40 38.4 36.0 36.1 36.3 33.5 32.1 32.7 33.5 30.0 29.1 30 28.2 20 10 6.0 7.5 4.9 3.9 3.6 0 Upper-Middle Albania Croatia North Macedonia Kosovo Estonia Income Countries Source: Kosovo Customs and Exporter Dynamics Database; World Bank staff calculations. Note: Entry rate is calculated as the number of new exporting firms divided by the total number of goods exporters in the year of reference; exit rate is the number of exporters of goods quitting the activity in that period divided by the number of total goods exporters of goods in that year. Net entry rate is the entry rate minus the exit rate. Figures are averages for 2010–14 for all countries except Kosovo (2014–19). Boosting Exports 99 Retaining new products and markets is difficult: only a few remain active years after entry. Kosovo’s goods exporters face challenges in sustaining exports of new products and keeping new markets open (i.e., new product-destination combinations). After entry, the fraction of new products and of product-destination combinations that are active drops steeply. Four years after entry, only 9 percent of new products and markets are still active. Destination survival follows a different pattern: 75 percent of total incumbent firms that start serving a new destination survive the first year, and 25 percent are still active there four years later. Differences in survival rates relative to firm, product, and product-destination are likely to be due to less experimentation, as most exporting firms only serve markets in the Western Balkans, Germany, and Switzerland. First years in international markets are challenging, but ultimately obstacles fade. Once firms manage to survive, the chances of surviving an additional year improve. It appears that a significant part of the selection process occurs in the first years after entry but that may also involve a learning mechanism: as firms survive, they are learning how to succeed in a new market, which improves their chances of succeeding for another year. Productivity, network effects, and country-product diversification are all important for surviving. All else being constant, a 1 percent increase in LP leads to a 2.5 pp higher probability of exporter survival. Network effects explain the success of individual firms entering a market. Firms that export the same product to a given destination raise the probability of a firm surviving in exporting that product to that destination, which suggests information or financial spillovers. Country diversification is also a factor in driving market survival. Conditional on LP, exporting the same product to more destinations or exporting different products to the same market is associated with a higher probability of survival. Entering a market usually has both fixed and experimentation costs (learning how to meet regulatory and demand requirements costs time and money), but it may also improve the firm’s experience in foreign markets. Thus, improvements in productivity could also support export orientation. Integration through FDI facilitates export performance. Larger net FDI flows are positively associated with a higher probability of survival—promoting business opportunities for domestic and foreign investors also help firms establish ties in international markets. Goods exporters are less financially constrained than exporters of services and non-exporters. Banks are also more likely to provide credit to firms that export product-destination combinations where there are established ties. Nearly 60 percent of total good exporters accessed credit each year between 2015 and 2018, doubling the non-exporter uptake rate and 14 pp higher than exporters of services. Moreover, despite accounting for less than 5 percent of total firms, exporters of goods constitute more than 37 percent of total credit; non-exporters account for 93 percent of firms, but only 56 percent of available credit. The fact that credit allocation is higher among exporters than non-exporters means that average and median disbursed loan amounts are also larger. The average credit disbursed to goods exporters is 5.8 times larger than average credit to non-exporters and 1.4 times larger than credit to exporters of services. The median loan amount is US$98,750 for goods exporters, US$53,500 for exporters of services, and US$22,250 for non-exporters. Access to credit supports entry to markets outside the region. Firms that access credit are more likely to sell outside the region than those with no credit access. New ventures have both fixed and variable costs linked to market exploration, regulatory requirements, and productive processes (e.g., adapting products and investing in machinery and equipment). Besides firm productivity, financial constraints seem to deter market diversification. For goods exporters, access to credit is associated with better performance. Credit increases with firm productivity, the number of destinations served, and the number of products exported. Larger and more capital-intensive exporters also tend to have more access to credit. It appears that credit allocation is more efficient for goods exporters than for the private sector as a whole. Moreover, loan terms have been improving for goods exporters. On average, terms for credit are now eight months longer, although 50 percent of firms still can only access credit with maturities shorter than two years; and interest rates on credits to exporters of goods are down 2.3 pp. Goods exporters not only have more access to credit but its conditions have eased. 100 Boosting Exports Spotlight: Digital Trade Kosovo has an opportunity to digitalize firms; promote digital trade in both goods and services; leverage recent investments in digital connectivity; and provide opportunities for its young people. The recent dynamism in ICT and professional services suggests that Kosovo is developing a comparative advantage in modern services, which could be facilitated through faster digital adoption. The data on job creation in the five years after firm entry reveal that the most dynamic activities are information and communication, with an average job creation of 6.7 employees, and professional services, 4 employees (Figure 88). Figure 88. Employment Growth, Firms by Sector Surviving 5 Years, Average Staffing, 2017–18 Manufacturing 2.8 Construction 2.4 Wholesale and retail trade 2.4 Transportation and storage 3.2 Accommodation and food services 1.4 Information and communication 6.7 Professional, scientific and technical activities 4.0 0 2 4 6 8 10 12 14 Source: KTR data; World Bank staff calculations. Notes: Difference between the number of employees and the number of employees five years later are conditional on the firm “surviving” or reporting sales in the previous year. We report activities in which more than 10 companies enter the market. See Annex 1 for more detailed sector classification. Following the pandemic, both consumers and firms throughout the world turned to digital solutions to adapt to the new environment; Kosovo was not an exception. The first wave of the World Bank BPS shows that globally, 34 percent of firms increased use of the Internet, social media, and digital platforms in response to the pandemic, and 17 percent invested in new equipment, software, or digital solutions (Figure 89). In Kosovo, firm responses focused on increasing use of platforms, and to a lesser extent innovating in products and services, though these reactions were weaker than in Moldova and Albania (Figure 90). Policies targeted at digitalization can further expand business opportunities by providing access to larger markets; could foster productivity through technology adoption; and could also promote formalization. Promoting digitalization could also enable Kosovar firms, especially micro and small enterprises, to access both domestic and international customers through e-commerce. Figure 89. Technology and Innovation Responses of Businesses to the COVID-19 Crisis, Percent of Firms Reporting Adjustment 34 35 30 25 21 20 17 15 10 5 5 0 Increased use Investment in Other products Innovation into of digital platforms digital solutions innovation health products Source: BPS. Boosting Exports 101 Figure 90. Technology and Innovation Responses of Businesses to the COVID-19 Crisis, Comparison to Peers, Percent of Firms Reporting Adjustment 73 Kosovo % 80 Moldova Albania 60 40 29 25 19 20 20 12 7 0 Increased use of digital Invested in digital Innovated in products platforms solutions or services Source: BPS. Kosovar consumers seem more ready for digital trade than Kosovar firms, which seem to trail regional peers in adopting digital technology. The number of citizens using the Internet to order goods and services for private use is constantly increasing. The percentage of people making an e-commerce purchase in the previous three months rose from 16.9 percent in 2018 to 35.4 percent in 2020—and the number of people who never bought or ordered online dropped from 63.6 to 43.1 percent (Figure 91). Figure 91. Buying or Ordering any Goods and Services over the Internet, 2018–20, Percent 70 2018 63.6 59.1 2019 60 2020 50 43.1 40 35.4 30 22.7 20 16.9 10.2 10 7.4 7.9 5.3 2.7 1.8 0 Within the last 3 months Between 3 months and More than 1 year ago I never bought or ordered a year ago Source: KAS data. Against this background, the CEM assesses readiness for digital trade in three areas— the regulatory environment, digital connectivity, and e-payments—and provides detailed recommendations.38 A comparative review of the main regulations on digital trade shows that Kosovo’s regulatory framework is advanced but there are still gaps. Adoption and implementation of the draft Law on Electronic Identification and Trust Services in Electronic Transactions is a priority to recognize an advanced electronic signature that is technologically neutral and would increase flexibility, reduce transaction and operational costs, and allow payment service providers to contract with merchants remotely to offer payment acquisition services. It would also facilitate remote contracts internationally by ensuring mutual recognition. Also central to facilitating digital trade would be an online dispute 38 See trade policy background note for a more detailed assessment and recommendations. 102 Boosting Exports resolution mechanism adopted through the Law on Consumer Protection, which would make it possible to resolve cross-border claims online, strengthening institutional capacity to seek EU recognition of Kosovo’s data protection regime as adequate. There is also a need to operationalize the advanced regulations on data protection and cybersecurity and expand the regulation on intermediary liability to extend the scope of liability rules to intellectual property rights to balance liability for digital platforms. Figure 92. Digital Regulatory Readiness Scores Kosovo 17.5 Kosovo Electronic Western Balkans documents Albania World Bosnia and Herzegovina HIC MIC Croatia Intermediary Electronic Montenegro liability signature North Macedonia Serbia Armenia France Online Kazakhstan consumer Cybersecurity protection Kyrgyzstan Moldova 0 5 10 15 20 Data privacy Source: World Bank staff calculations Note: The above figure only analyzes what is in the books, but not the implementation of the legal framework. Widely available and affordable high-speed Internet access, in which Kosovo has already invested, is a prerequisite for the digital economy. Broadband and affordable access to Internet services is generally available across Kosovo. At yearend 2020, Kosovo had the highest broadband penetration in the region and beyond. However, three digital connectivity challenges remain: (1) International Internet connectivity is a problem. The poor quality of broadband connections translates into slow fixed broadband download and upload speeds. A mixture of private and public sector solutions is needed to plug Kosovo more securely into Internet backbones. (2) While Kosovo has made significant progress in expanding rural coverage, access of municipalities is still highly unequal. As for mobile coverage, Kosovo has made considerable progress but still trails the rest of the region, as it also does in terms of the share of faster 4G technology. (3) Kosovo needs to promptly put in place the foundation for adoption of mobile network 5G technology, which is set to shape the digital economy opportunities for years to come. Addressing these issues would facilitate digitalization of firms, in particular digital trade, and could also help reduce differences in economic activity and opportunity within the region. Figure 93. Fixed Broadband Penetration, 2020 4Q, Percent Kosovo 129 Greece 96.4 US 92.6 Montenegro 89.5 Germany 86.5 North Macedonia 81.3 Serbia 71 Croatia 70.2 BiH 68.9 Italy 68.6 Turkey 67.6 Austria 63 Albania 58 Moldova 48.6 0 50 100 150 Source: ARKEP Quarterly Report, ARKEP, 2020 4Q Boosting Exports 103 Figure 94. Fixed Broadband Penetration by Municipality, 2020 4Q, Percent 285 300 258 250 200 178 164 160 161 149 141 133 150 125 115 108 99 95 94 89 89 89 89 88 100 85 82 80 65 64 62 60 61 56 57 53 46 44 43 50 17 14 0 0 ZubinPotoku FushëKosova Graçanica Novobërda Leposaviqi HaniiElezit Rahoveci Kamenica Ranilugu Kaçaniku Juniku Dragashi Podujeva Skenderaji Zveçani Deçani Suhareka Gjakova Kllokoti Shtërpc Obiliqi Prishtina Prizreni Mamusha Drenasi Istogu Malisheva Parteshi Shtime Lipjani Gjilani Mitrovica Vushtrria Ferizaji Klina Peja Vitia Source: Telegeography, ARKEP (2020)39 Electronic payment instruments are central to digitalization and digital trade. Cash is the dominant means of payment in Kosovo, especially for retail payments; access to and use of e-payments are rare (Figure 95). Many consumers do not have a bank account and cite lack of funds as the main reason for not having one and 25 percent of them perceive the services to be expensive (Figure 96). ATM and POS infrastructure are not as developed as in the rest of the region. Card tokenization solutions are one of the innovations anticipated in the market and use of digital channels to access and operate accounts is growing. Broader use of e-payments requires introducing the updated digital e-ID process, introducing a basic payment account to allow broader access to financial instruments to domestic citizens, providing access to the Interbank Payment system, CBK’s continuous monitoring of the market, support for the interoperability of emerging payment solutions, and support for establishing domestic operations for international payment service providers. Use of e-payments could be motivated by heightened intergovernmental coordination of the promotion of digital channels, creating a framework to collect e-commerce statistics, financial education campaigns to increase consumer trust in electronic payments, and establishing an innovation hub as part of FinTech. Figure 95. Made or Received Digital Payments in the Past Year, Respondents Age 15+, Percent Germany 98 United States 91 Italy 90 Croatia 83 Greece 74 Serbia 66 North Macedonia 66 Turkey 64 Montenegro 60 Bosnia and Herzegovina 50 Moldova 40 Kosovo 39 Albania 29 0% 20% 40% 60% 80% 100% 120% Source: 2017 World Bank Global Findex Survey. 39 GlobalComms Database. TeleGeography. Accessed on May 4, 2020; Kosovo data based on ARKEP 104 Boosting Exports Figure 96. Reasons for Not Having a Bank Account Respondents Age 15+, Percent of insu cient funds 27 someone in the family has an account 26 financial services are too expensive 23 financial institutions are too far away 12 of lack of necessary documentation 12 of lack of trust in financial institutions 8 of religious reasons 4 of no need for financial services ONLY 3 % age 15+ 0% 20% 40% Source: 2017 World Bank Global Findex Survey. Despite some recent dynamism for exporters of both goods and services, poor export performance compared to the region and countries with similar income levels suggests continuing constraints on trade. Policy Recommendations 1. Address business environment constraints to provide a welcoming environment not only for potential exporters, but for all firms. Boosting trade necessitates complementary policies to promote higher competitiveness through tackling informality, upgrading skills, improving access to finance, enabling e-payments, continuously improving the inspections and the licensing and permits regimes. In addition, operationalization of the quality infrastructure is necessary for Kosovar firms export to be able to access but also survive in international markets. Take measures (e.g., supplier development programs) to improve the productivity of local suppliers to increase spillovers from multinational corporations and attract higher FDI to link with GVCs. 2. Improve regional integration and promote it as a springboard for better integration with EU and global markets. This requires reducing trade facilitation and logistics gaps and effort is needed to reduce non-tariff barriers faced by Kosovar firms. Eliminating terminal fees; reducing technical barriers to trade by fostering the recognition of Kosovar certificates and licenses; harmonizing sanitary and phytosanitary testing reports; and establishing a risk management unit in the food and veterinary agency are crucial to promote exports. Also leveraging the strong diaspora ties could facilitate entering into new markets. 3. Continue dialogue with international partners to deepen trade integration through trade agreements, both through multilateral and bilateral efforts. 4. Create an e-commerce action plan to address regulatory gaps and their implementation, facilitate e-payments, and increase digital connectivity. This would also facilitate further digitalization of Kosovar businesses in the post-COVID environment and contribute to recovery through boosting productivity. Boosting Exports 105 07 BOOSTING Foreign Direct Investment Boosting Foreign Direct Investment Increasing FDI can help foster higher job-creating growth in Kosovo. For a young and small economy where domestic capital is scarce, additional FDI could be transformational for generating more and better jobs and higher and more resilient growth. FDI can also facilitate access to regional and global value chains, ultimately supporting value-added exports and productivity growth. Exposure through FDI to multinational firms that are typically more productive has also been linked with spillovers and with increased incentives to innovate. Indeed, companies with significant FDI participation are larger in terms of staffing, pay higher wages, and are more productive and capital-intensive.40 Furthermore, FDI firms in Kosovo were more resilient to the COVID-19 crisis, demonstrating the importance to the economy of attracting and retaining FDI.   The potential realignment of global production networks and supply chains post-COVID is a new opportunity for Kosovo. Since independence, Kosovo has improved its investment legal framework and entered into regional agreements to increase trade and investment. For instance, Kosovo signed the CEFTA in 2007 and ratified the Stabilization and Association Agreement (SAA) with the EU in 2016, as part of which it agreed to a European Reform Agenda (ERA) with promoting FDI and improving the business environment among the priorities. The 2016 National Development Strategy (2016) sets increasing FDI as a major policy objective. The next few years will be pivotal in determining whether Kosovo can leverage both its proximity to some 500 million consumers in EU markets and the opportunities opening up for exporting more complex products through near-shoring and GVC reconfiguration, related, e.g., to medical equipment and other items manufactured in the Western Balkans. Current levels of FDI inflows are too low to transform Kosovo’s economy. FDI has declined since the global financial crisis in 2008/09 (Figure 97) and is significantly below comparator groups41 in both absolute terms and adjusted for the size of economy. In contrast, regional comparators North Macedonia and Serbia have in recent years benefited from rising FDI and active integration into GVCs, as to a lesser degree has Bosnia and Herzegovina. In these cases, the benefits of FDI are evident in the improved technology structure and the skill-intensity of their exports. Figure 97. Net FDI Inflows Compared, US$ Million, 2004–19 500 millions of euros 450 441 384 400 370 369 341.7 350 309 287 280 300 272 255 254.6 250 229 220 200 151 150 100 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: WDI In Kosovo, greenfield FDI projects—which tend to create the most jobs—are small compared to those of regional and aspirational peers (Figure 100). Kosovo’s FDI announcements42 peaked at US $1.4 billion in 2008 and have declined ever since. In 2003–19, an average of just 5 projects a year were announced in Kosovo, compared to 49 for aspirational comparators, 29 for regional comparators, and 9 for structural comparators. Project size also averaged a comparatively small US$181 million and, although increasing somewhat in recent years, is still much lower than in comparator countries. 40 Kosovo Country Economic Memorandum, Productivity Background note. 41 Regional peers: Albania; Bosnia and Herzegovina; North Macedonia; Montenegro; and Serbia; Structural peers: North Macedonia, Albania, Kyrgyz Rep, Armenia, Moldova, Timor Leste; Aspirational peers: Latvia, Uruguay, Estonia, Slovenia, Lithuania, and Czech Republic 42 Based on the Financial Times fDi Markets database, the most comprehensive database tracking greenfield FDI announcements. As the data is based on media announcements of FDI projects, not all greenfield FDI projects are fully captured, and capital expenditures and job creation figures are often estimated. Such data is, however, useful for understanding trends and comparing with other economies. 108 Boosting Exports Figure 98. Kosovo’s Greenfield FDI Overview vs Comparators a) Number of Greenfield FDI Projects: Kosovo vs. Comparators b) Greenfield FDI Values: Kosovo vs. Comparators (2003-2019) (2003-2019) 20 Number of greenfield projects per $1 billion of GDP 60 average no of projects 18 18 17 49 50 16 14 14 40 12 11 29 30 10 8 20 6 10 4 10 5 2 0 0 Kosovo Regional Structural Aspirational Kosovo Regional Structural Aspirational Source: fDi market database; World Bank staff calculations.43 The flow of FDI into low-productivity services generated limited spillovers to the rest of the economy. Between 2007 and 2019 about 43.2 percent of FDI went to real estate and related services. FDI in real estate has mostly consisted of residential investments by the Kosovar diaspora. Investment opportunities in agriculture, manufacturing, and natural resources have not been tapped, and inflows into financial services have fallen (Figure 99). As a result, there have been few technology transfers, links to exports, integration into GVCs, or other types of spillovers that investments in efficiency-seeking sectors could have provided. With equity rather than debt or investment earnings mostly financing these investments, reinvestment has been minimal because investors have stayed cautious. COVID-19 adds to the uncertainty. Remittances, on the other hand, finance a large share of Kosovo’s current account. Between 2007 and 2020, personal remittances were nearly three times the size of FDI inflows, which amounted to only ¤3,826 million (Figure 100). According to a World Bank survey (2016),44 in Kosovo remittances primarily fund consumption (66 percent); only 1 percent went into entrepreneurial activity. Although Kosovo’s external dependence on diaspora-related financing—remittances and diaspora-related tourism—is a vulnerability, managed properly, some of the remittances could be turned to productive use. 43 As noted on the Financial Times fDi Markets website, fDi Markets tracks information on capital investment and jobs directly associated with an FDI project, but as companies do not always release information on the exact investment amount or job creation numbers, fDi Markets uses an econometric model to estimate the jobs and investment data where the actual value is not known. 44 Baseline survey on the financial behavior of remittance beneficiaries in ECA (World Bank 2016). Boosting Exports 109 Figure 99. Kosovo: FDI Inflows by Sector, ¤Millions, 2007–19 500 Millions of euros Other services and activities Real estate activities Financial and insurance activities 400 ICT Accommodation and food service activities Transportation and storage 300 Wholesale and retail trade Construction Electricity, gas, water 200 Manufacturing Mining and quarrying Agriculture, forestry and fishing 100 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 -100 Source: Central Bank of Kosovo data; World Bank staff calculations. Figure 100. Remittances and FDI, Percent of GDP, 2008–19 14 13.5 12 11.7 11.3 11.6 11.2 11.1 10.5 10.5 9.9 10 9.3 8.8 8.5 8.2 7.5 7.9 8 6.8 6 4.7 4.7 4.2 4 2.9 3.3 3.4 2.7 2.2 2 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Net FDI inflows Net Remittance Inflows Source: CBK. Kosovo has some inherent strengths that could draw in FDI, but they are offset by a relatively unattractive business environment and infrastructure gaps. Benchmarking Kosovo’s performance on FDI location determinants45 reveals some relative strengths, including a young population, high Internet access, and such labor cost advantages as low tax rates relative to regional peers (Figure 101 and 102). As a small market, Kosovo can attract very little market-seeking FDI, but its real potential lies in attracting export-oriented FDI. However, such binding constraints on business as inadequate and costly access to electricity, transportation inadequacies, skills mismatches, and skills and infrastructure gaps are major obstacles to attracting more FDI, along with high levels of informality (Figure 102).46 45 The benchmarking uses FDI determinants documented in the literature as having an impact on both the quantity of FDI and a country’s characteristics, such as, e.g., trade, labor and knowledge intensity. It uses internationally available indicators from the World Bank Doing Business Report, World Bank Enterprise Surveys, Worldwide Governance Indicators, and other available datasets. 46 Please see the CEM, Raising Firm Productivity background note for a more detailed discussion. 110 Boosting Exports Figure 101. Comparison of Total Annual Labor Costs for Varying Skill Levels by Activity, Euros, 2019 9,000 Production - Maintenance operative/Operators (highly skilled) Euros Production operative/Assemblers/Operators (skilled) 8,155 8,000 Production operative/Operators (unskilled) 6,983 7,000 6,226 5,890 5,756 6,000 5,413 5,331 5,043 5,000 4,572 4,635 4,324 4,394 4,157 3,915 3,821 4,000 3,702 3,052 3,227 3,000 2,000 1,000 0 Kosovo The Republic of Bosnia and Albania Serbia Montenegro North Macedonia Herzegovina Source: World Bank, Western Balkans Investment Policy and Promotion Project. 2019. IBM-PLI calculations based on data from Towers Watson, EY tax guides, ILO, IMF, Eurostat and local statistics. These challenges are compounded by inadequate policy and institutions. Kosovo is challenged by political instability, perceptions of high corruption and ineffective governance, which have likely discouraged FDI inflows. In relative benchmarking Kosovo falls short on the rule of law, regulatory quality, control of corruption, government effectiveness, and political stability (Figure 103). The risks related to doing business in Kosovo have likely contributed to the more cautious approach of investors. Figure 102. Comparison of Infrastructure and Factor Input Determinants Individuals using Access to Electricity Transportation the Internet electricity a major a major (% of population) (% of population) constraint constraint 1.5 Standard Deviation 1.0 0.5 0 -0.5 -1.0 -1.5 Regional -2.0 Structural Aspirational -2.5 -3.0 Source: WDI and Enterprise Survey data; World Bank staff calculations. Note: The two graphs benchmark Kosovo’s performance against the simple average of regional, structural and aspirational peer countries in 2019. The y-axis shows how many standard deviations Kosovo performs relative to each peer group. Boosting Exports 111 Figure 103. Comparison of Determinants of Political Risk Regional 0.4 Standard Deviation Structural Aspirational 0.0 -0.4 -0.8 -1.2 -1.6 Rule of Law Regulatory Quality Control of Government Political Stability Corruption E ectiveness Source: WDI and Enterprise Survey data; World Bank staff calculations. Note: The two graphs benchmark Kosovo’s performance against the simple average of regional, structural and aspirational peer countries in 2019. The y-axis shows how many standard deviations Kosovo performs relative to each peer group. Addressing the investment environment constraints, weaknesses in the rule of law and making its institutions more effective are crucial if Kosovo is to attract investors. In recent years Kosovo has entered into regional trade and investment agreements to open markets and strengthen investor protections. Strategic investments were supported by prioritizing projects that meet minimum investment thresholds in certain sectors. However, rather than being sufficient such efforts are likely to cause further distortions. Foreign investors in Kosovo warn that lack of full adherence to the rule of law and inadequate enforcement of contracts may undermine the effectiveness of the LSI (American Chamber of Commerce in Kosovo 2020). More generally, systematic structural reforms that address the political and governance risks, low quality of FDI institutions, and enhance the strategic focus of investment attraction efforts will likely have the best results. Policy Recommendations 1. Draw up a clear FDI strategy that targets higher-value-added sectors and segments that deliver tangible benefits to the Kosovar economy;  and foster closer coordination between government agencies involved in investment. This would help offset shortcomings of the LSI47 and could help to guide sector prioritization and target reform efforts based on both clear objectives and what is realistic in terms of identifying new niches for investment that have higher export, value-added, technology and jobs content. The strategy could also prioritize the elimination of deal-breaking investment climate constraints so as to systematically restore investor confidence. Kosovo currently has 10 industrial parks, 8 of which are not yet fully developed, and the strategy should clarify their role in promoting FDI. 2. Empower the investment promotion agency KIESA to operate more effectively and tighten coordination between government agencies. KIESA’s mandate and reporting lines should be reviewed to better deliver core investor services in line with international best practices and ensure that KIESA is well-governed by appointing a board of directors. The agency also needs strategic and budgetary support from the Prime Minister’s Office, better strategic and technical guidance from the lead agency for investment, the Ministry of Trade and Industry, and closer partnerships with other line ministries. Investor feedback also suggests scope to improve services, by, e.g., proactive generation of investment leads, support to investor entry and establishment in a location, and eventually expansion or retention of FDI. 3. 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