In theory, use of the euro is supposed to help the country in Foreign Direct Investment. In reality, it brings higher interest rates, and – if Kosovo cannot accumulate reserves in a foreign currency – will bring stagnation in the economy.
While Kosovo attempts to join the European Union and the path seems quite far off, paradoxically, it belongs already to a much more privileged group within the EU – the eurozone.
Kosovo doesn’t take part in meetings of the Eurozone ministers of course, as the country has unilaterally adopted the euro. But such a situation raises many questions about how Kosovo manages its fiscal policies and whether having the euro benefits or costs the country.
One of the main challenges of a new political entity is the choice of monetary regime. The need for a sustainable currency is important in building macroeconomic and political stability. In general, most newly independent countries aim to assert their sovereignty through the creation of a national currency.
This was not the case for Kosovo, which has no domestic currency and has chosen the euro as its currency – even though the country is neither a member of the eurozone nor the EU.
Giving up monetary sovereignty: good or bad strategy?
It all depends on the country’s ability to overcome the constraints of the dollarization/euroization regime. The case of Ecuador, for example, which replaced its domestic currency with the US dollar in 2000, shows that dollarisation is not a panacea: monetary stability was achieved, but the economy is still unstable and dependent on dollar inflows from its oil exports.
According to advocates of euroization, the latter supports the development of the financial sector. In the beginning, there was no bank in Kosovo and virtually all transactions were made in cash. However, two years witnessed a rapid development of financial intermediation in Kosovo, especially the banking sector.
Between March and November 2001, six banks were established, which brought much-needed competition in the banking sector. In 2002 and 2003, seven commercial banks in Kosovo expanded significantly. Euroization permitted the reduction of cash from circulation and the development of financial intermediation.
This strategy helped to consolidate confidence in the banking system. The adoption of the euro as a national currency brought monetary stability in Kosovo and the risk of devaluation with a national currency disappeared.
The arguments against dollarization/euroization range from the claim that such monetary arrangements imply giving up the central bank’s role as Lender of Last Resort, LOLR, to claims that they involve deflationary growth dynamics, and slow down adjustments to external shocks.
In the absence of a domestic LOLR, the banking system may be extremely vulnerable. The inelasticity of the central bank money supply has a negative impact on the credit supply dynamics, and thereby on economic activity.
In the case where the central bank refuses all accommodation, interest rates may violently increase. If the country’s economy is not able to record a current account surplus to accumulate more reserves, there are persistent stagnation dynamics or a restriction of credit.
To assure a favorable growth dynamics, dollarized/euroized countries need to implement export-led growth strategies, as well as promote a high degree of trade and investment links with the issuer of the foreign currency – in the case of Kosovo, strong financial integration with the Eurozone or at the least with the ECB.
Fortunately, banks in Kosovo generally have high liquidity ratios and it is expected that the largest banks would receive liquidity support from their parent groups in emergencies.
Banks’ interconnection with parent banks in Europe
During the Covid pandemic crisis, the degree of interconnection of foreign banks with their parent banks increased, driven by increased insecurities and at the same time by the need to provide emergency liquidity lines.
However, banks’ ability to respond to a system-wide liquidity shock is limited by (i) some liquid assets are in the form of government bonds, which may not be immediately tradable; (ii) the deposit insurance is not high enough to substantially reduce the risks of bank runs.
This is why the Central Bank of Kosovo recently launched a repo and overnight liquidity facilities for banks, with a capacity of €100 million, to complement the emergency liquidity assistance. Still, according to the latest 2022 country report of the IMF, “these resources are insufficient to respond to systemic wide shocks”.
The inelasticity of the central bank money supply might have some negative impact on the credit supply dynamics, and thereby on economic activity. An apparent “paradox in credit policy” implemented by commercial banks in Kosovo is the contrast between low interest rates for deposits (negative rate for banks) and very high rates for loans (positive rate for banks).
Since no central bank is able to guarantee banks refinancing a posteriori, interest rates seem doomed to be higher than in an economy under a central banking regime.
This is occurring in Kosovo.
If the euroised country is not able to record a current account surplus to accumulate more reserves in foreign currency, there is a persistent stagnation dynamics or restriction of credit.
Dollarization/euroization thus obliges economies wishing to secure regular growth to ensure, in the medium and long term, a structural surplus of their balance of payments.
One option is a current account surplus; but this is not the most common scenario in developing economies. If the current account is of manageable proportions, it can be compensated by stable inflows of capital, for example in the shape of foreign direct investment, FDI. The important thing is to maintain net capital inflows of foreign currency over the long term.
Euroization brings vulnerability to economic shocks
Under dollarization and euroization, both monetary and exchange rate policies are removed. Vulnerability to asymmetric shocks is undeniable.
Since the adoption of the euro in 2002, average inflation has been low in Kosovo. Over the course of 20 years, the total rise in prices amounted to less than 40 per cent. However, the inflation rate may sometimes be high (for instance in 2011 and 2022) and, because of euroization, the central bank cannot conduct an active independent monetary policy.
Adjustment, in terms of economic activity and employment, tends to be particularly severe. Deprived of exchange rate flexibility and the right to juggle with interest rates, the authorities may be tempted to use fiscal policy as a counter-cycle weapon.
But fiscal activism in dollarized/euroized countries is limited. There is not much room for independent fiscal policy because there is no mechanism of deficit financing other than borrowing at market-determined interest rates.
The statutes of the central bank make it impossible to monetize public deficits. The government budget deficit averaged 0.12 per cent of GDP between 2000 and 2017, reaching an all-time high of 7.17 per cent of GDP in 2007 and a record low of -4.58 per cent in 2004.
National debt increased from €1.2 billion in 2017 to €1.3 billion by the end of 2020 (19.6 per cent of GDP). These are low figures in comparison with other Southeast European countries. Government measures to address the crisis caused by the Covid-19 pandemic have only moderately increased the budget deficit as well as public debt.
In sum, exchange rate, monetary and fiscal policies are all removed at once. Under these circumstances, the burden of the adjustment principally falls on prices and wages.
The size of the nominal wage adjustments is usually smaller than that observed on prices. If wage flexibility proves insufficient, the volume of employment becomes the adjustment variable.
Paradoxically, FDI is in decline
As part of the euro area, Kosovo should have benefited from foreign loans with lower interest rates than other neighboring countries, by ranking Kosovo in a safer place for investors and a more stable.
Euroization was supposed to increase FDI in Kosovo. However, as underlined by Bunjaku (2015), FDI in Kosovo showed no significant increase since the adoption of the euro as the official currency. Instead, FDI in Kosovo has showed a tendency towards decline. Despite the security of the euro, euroization has not implied strong FDI.
Fortunately, Kosovo can count on two other inflows of capital to limit the balance of payments constraint and cushion the constraints of euroization: (i) the close connection with foreign banks; (ii) income from the diaspora.
The banking system in Kosovo is largely integrated to foreign banks. Of the 10 banks licensed by the Central Bank, eight are owned by foreign capital, corresponding to 85.8 per cent of total bank assets (May 2022).
The banking sector is dominated by capital of European origin, which accounts for 55.8 per cent of total assets of the banking sector. Raiffeisen Bank Kosovo and ProCredit Bank are the largest in terms of assets and show strong profits.
Banks originating from Turkey have seen a slight decline in market share, with a 16.0 per cent share in 2020. Of the 30 microfinance institutions, 13 are foreign-owned. Foreign ownership accounts for 92.1 per cent of MFI assets.
Kosovo’s economy and its euroized growth model are, therefore, heavily dependent on its large diaspora. Strong emigration since the 1990s, especially to advanced European economies and the US, is reflected in a migrant-resident ratio within the 30-40 per cent range, one of the world’s highest.
Remittances in Kosovo come mainly from Germany and Switzerland – 40.0 and 18.6 per cent respectively – of total remittances received until September 2021. A considerable amount of remittances was received also from the US (7.3 per cent of the total).
Total foreign remittances to Kosovo grew to 1.15 billion euro in 2021 from 979.9 million euro in 2020. Total foreign remittances to Kosovo increased by 5.4 per cent year-on-year to 351.5 million euro ($371.3 million) in the first four months of 2022.
In April 2022 alone, total foreign remittances reached 110.1 million euro, up from 90.5 million euro in April 2021 (Central Bank of the Republic of Kosovo, 2022).
Hospitality services targeted at Kosovars living abroad represent a substantial portion of the country’s exports of services and this is reflected in the strong seasonal pattern of economic activity in the summer months and other holidays.
Formal and informal remittances also prop up domestic incomes significantly.
Strong ties between the diaspora and the mother country helped Kosovo during the pandemic. Over 2020-21, diaspora inflows held up better than envisaged, helping cushion the shock and support the recovery. Remittances and compensation of seasonal migrants largely surpassed their pre-pandemic level in both 2020 and 2021.
In turn, the recovery of tourism flows in 2021 was much stronger than in traditional tourism-exporting countries. The number of visitors received by Kosovo through September 2021 increased with respect to its pre-pandemic level of 2019, compared to significantly lower levels for all other European countries.
Remittances received through banks increased by 14.7 per cent and comprise 15.6 per cent of total remittances received in Q4 2021. As a result of the opening of the borders and easing of containment measures, remittances through “informal” channels increased by 7.9 per cent, reaching 75.6 million euros in Q4 2021.
The challenge of the EU/Eurozone integration
Dollarization/euroization regimes imply asymmetric monetary unions. These monetary arrangements are not sustainable without a strong monetary and financial integration to the economic and political area that issues the legal tender.
Dollarization/euroization makes sense only for very small economies with sufficient commercial, financial and eventually political links with the core economy.
This is not the case of Ecuador with the US dollar, where the economy is extremely vulnerable to the constraints of dollarization.
However two institutional characteristics specific to Kosovo make it possible to cushion the weight of these macroeconomic constraints: (i) the significant presence of foreign banks; (ii) the decisive role of the diaspora, in particular through remittances.
Another important issue arises from the perspective of Kosovo's integration into the EU. Would Kosovo also directly join the very exclusive club of eurozone member countries? Logically, yes, since the euro is already the official currency of Kosovo.
But this would require that the convergence criteria for joining the euro be met first, unless an exception is made. Paradoxically, the unilateral euroization of Kosovo might not facilitate the EU accession process if these criteria for joining the eurozone were not met.
Jean-François Ponsot is Full Professor of Economics at Pacte-CNRS, University Grenoble Alpes, France. His research interests are directed towards monetary innovations and dollarization. He supervises the In-Moco research programme on the issue of confidence in times of monetary crisis and transition.
Illustrations for Prishtina Insight by Diellza Gojani.