Directors emphasized that fiscal consolidation is the near- and medium-term policy priority for Albania. They advised the authorities to implement an expenditure-based fiscal rule to anchor a credible medium-term debt reduction strategy. Directors encouraged the authorities to implement further expenditure and revenue measures to achieve the required fiscal consolidation. A better macroeconomic framework built on more realistic revenue projections would help avoid the repeated budget slippages of the past.

Directors noted that Albania’s flexible exchange rate and inflation targeting regime have served the economy well. Going forward, monetary policy should remain cautious, and coordinate with fiscal policy to anchor inflation expectations and safeguard growth prospects. Directors noted the staff’s assessment that the exchange rate appears to be broadly in line with fundamentals, and stressed that strong fiscal consolidation efforts can help foster external sustainability.

Directors commended the resilience of Albania’s banking system during the crisis, although cautioned that heightened risks, including from possible regional spillovers, called for macro-prudential policy to stay ahead of the curve. A key near-term priority is the swift resolution of the high level of non-performing loans and other crisis legacies. Directors encouraged the authorities to continue to enhance the monitoring of banks and the development of the local currency market to build buffers. They underlined the need to step up crisis preparedness, including by further development of the contingency planning framework.

Directors urged the authorities to re-invigorate structural reforms to improve the business environment and thereby boost productivity and growth, especially by securing property rights, land titling, and improving contract enforcement. They noted that high-quality economic statistics are essential to improve policy making.

Background

Albania has weathered the global crisis well, as sound policies implemented during the pre-crisis years provided policy space to mitigate the crisis fallout. The crisis also ushered in the needed rebalancing of the economy, and the very large external imbalance has narrowed. The financial system overcame heightened stress in the immediate aftermath of the crisis and avoided a credit bust, though asset quality declined.

The post-crisis environment has posed significant policy challenges. GDP growth is projected to be around 2.5 percent in 2011, decelerating from above 3 percent in 2009 and 2010. The budget has repeatedly underperformed, prompting large cuts in mid-year budget reviews in both 2010 and 2011, and public debt is approaching its statutory limit of 60 percent of GDP. Despite improvements, external imbalances remain elevated, and foreign demand could not fully offset the domestic demand drain. Politics remain divisive and threaten consensus on reform including measures needed to progress with European Union (EU) candidacy. Short-term risks are elevated given Albania’s large exposure to the euro-area periphery.

The key challenge is to make the policy framework consistent with the achievement of external sustainability, thereby reversing the decline in total factor productivity (TFP) growth. Fiscal consolidation is the near- and medium-term policy priority, and requires credible measures and sustained efforts. Contingency planning with respect to euro-area periphery developments is essential to safeguard the financial stability, while critical structural reform challenges must be addressed.