Towards Increased Development Financing
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It is simple mathematics: if Kosovo succeeded in raising growth rates from currently about 3.3 per cent to, say, 5.0 per cent, the country would reduce the time required to double national income from 21 years and 4 months to 14 years and 2 months. This is a difficult but not an impossible task, even if it means complementing the underlying growth model—presently based on remittances and public investments—with policies aimed at attracting private-sector investments at the scale required to increase overall productivity. In this endeavour, banks play a central role. Data suggest—as contained in a solid body of economic research—a strong causality between access to credit and an economy’s (productivity) growth. In the Kosovo-specific context, there are two distinct views on whether banks play a sufficiently active role as development financiers.
One stresses high interest rates (including an unusually large spread between deposit and credit rates), conservative lending decisions, and a financial sector dominated by the quasi-oligopoly of three large, foreign-owned banks. This view would be consistent with (i) banks restricting credits to salary earners and a limited number of enterprises deemed credit-worthy, thus leaving important sectors of the economy without (or with insufficient) access to bank financing; and (ii) levels of, and differentials in, interest rates that exceed those prevailing elsewhere in Southeast Europe. Indeed, central bank data show that, for years, the interest rate spread has hovered around 10 percentage points and, as such, at levels considerably higher than in neighbouring countries.
The other view describes the financial sector in Kosovo as having been astonishingly resilient to the dramatic deterioration in the external environment. Its eight banks have remained well-capitalised and liquid. Throughout the crisis, deposits and credits grew steadily, with deposit-to-loan ratios and non-performing loans (NPLs) having remained relatively low. At the same time, banks maintained adequate loan-loss provisions against adversely classified loans, meaning that NPLs have a limited impact on the banks’ ability to keep on providing credits to the private sector at the present rate.
Both characterisations are not a contradiction but, instead, flipsides of the same coin. Like in any other country, financial institutions in Kosovo seek to earn profits; they have an inherent interest in providing loans to businesses and households and taking advantage of the spread between credit and deposit rates. Higher loan-to-deposit ratios—at the same level of risk—imply increased profitability, not least against the backdrop of untapped demand for increased lending activities. Only about one of ten private-sector investments in Kosovo are (co-)funded by bank credits, most others remain self-financed.
In the debate on the banks’ role in financing development, the core question relates to the underlying reasons as to why they have been willing to buy government securities (which cannot be used for minimum reserve requirements) at rates of 2–3 per cent (depending on maturity), while restricting credits to the private sector at interest rates in excess of 13 per cent. The combination of three factors appears to explain this—a priori paradoxical—phenomenon.
First, whereas banking systems have been struggling almost everywhere in Europe, the largely deposit-funded financial institutions in Kosovo have remained profitable throughout the crisis. For this reason, they appear to try to “stay low” to preclude the deleveraging of their own balance sheets. Second, too many enterprises with potentially “bankable” projects have not yet made the decision to formalise their activities, thereby blocking access to bank financing. And third, too few projects are, in fact, viable—partly because of insufficient collaterals, (the perception of) excessive risk, inadequate business plans, or inacceptable levels of financial reporting.
In all three areas, reforms are ongoing. The structural health of the financial sector, complementing sound fiscal policies, represents a critical ingredient to Kosovo’s socio-economic development potential. It is thus crucial that the central bank—with the professionalism and prudence shown in banking supervision—continue to foster growth and stability in the banking sector. This would help to bolster foreign parent banks’ confidence in their subsidiaries’ abilities to remain profitable. Further, recent improvements in the overall business environment, as reflected in the latest Doing Business survey, have made it easier for firms to transition into the formal sector, thereby increasing the pool of potential bank clients. Ongoing cadastre reforms—enabling small and medium-sized enterprises (SMEs), including in the agricultural sector, to provide collaterals to banks—should do the same. Inversely, policy measures to improve financial reporting, auditing, accounting, and financial literacy will make it easier for banks to evaluate firms’ balance sheets, a difficult task in an environment of high informality, permitting especially SMEs to demonstrate that their project proposals are indeed feasible. Through various projects, the World Bank is supporting Kosovo with many related reforms.
An additional factor contributing to the Kosovo-specific costs for credits have been the high rates that banks have had to offer on deposits, exceeding those in the eurozone. Here, one needs to ask why the private sector, especially Kosovo’s diaspora, has not taken more advantage of this situation. One reason seems insufficient confidence in the security of deposits. However, with the recent establishment of a deposit insurance fund, also supported by the World Bank, the authorities have sought to address this obstacle. There is now an institutional architecture in place that spans a safety net guaranting the savings of about 90 per cent of depositors. This will further increase their perception of security and should allow for deeper financial intermediation—a leading indicator of long-term economic growth.
A strengthened economic environment opens opportunities for increased competition and should gradually lead to a reduction in interest rates. As barriers are being removed, motivations inherent in any private enterprise will convince banks to take advantage of available business opportunities, resulting in stiffer competition amongst them. Thus, irrespective of whether financial institutions feel comfortable in the current “equilibrium”, they are about to enter into a new—and more dynamic—era of development finance.