Kosovo‘s Experience in euroisation of its economy

After the conflict, Kosovo adopted the German mark and then the euro to ensure monetary and macroeconomic stability. In 2002, Kosovo replaced the German mark with the euro, with the support of the EU and UNMIK. Euroization helped to develop the financial sector, reduce transaction costs and economic stability. Although there were costs, the benefits of financial and economic stability were great.

THE CHANGE CHALLENGES

Adoption of DEM

One of the many challenges that Kosovo faced after the war was the choice of a monetary framework. Given the great rush to cash holdings of foreign exchange currencies and the disappearance of the Yugoslav dinar as a transaction tool, not surprisingly in September 1999 UNMIK, in one of its very first Regulations on “Currencies allowed for used in Kosovo” approved the use of Deutsche Marks and other foreign currencies in Kosovo.

Actually, it was the people of Kosovo who adopted the Deutche Mark as its common currency. All that the UNMIK’s Regulation did was identify the Deutsche Mark as the currency used for formulation of budgets, financial statements, and the accounts of public organizations, agencies and institutions, including UNMIK itself. Simultaneously, this rule provided the parties with the freedom of choosing, for any contract or other voluntarily transaction, a broadly accepted currency. Furthermore, this rule removed all controls or limitation of currency exchange, possession, use, or establishment of any currency, in cash or bank accounts, located within or outside the territory of Kosovo.

Deutsche Mark was unilaterally adopted as a de facto legal currency in Kosovo, and there were no negotiations with Bundesbank in Deutschland or the European Central Bank at that time.

The adoption of the Deutsche Mark, and the subsequent adoption of Euro, is no coincidence. This followed two decades of extreme monetary instability, accompanied by a high-rate of unofficial use of German mark as a reserve value and exchange currency. During the pre-conflict period, the German mark was the most commonly use currency, and there was a significant amount of cash in circulation. The population was familiar with this currency.

Adoption of monetary structure, based on the use of the Deutsche mark was introduced as a natural choice. The usage of a stable currency was important in maintaining macroeconomic stability and it played a crucial role in rebuilding confidence in the financial sector. It also stipulated providing of significant support for the development of a strategy directed from abroad, which more than a choice was a need, taking in consideration the size of the domestic market..

Changeover from DEM to EURO

In early 2002 the replacement of the euro legacy currency in the Eurozone countries, made it necessarily also the replacement of the Deutsche mark in Kosovo. The former BPK (now CBK – Central Bank of the Republic of Kosovo) was entrusted with leading this project in terms of ensuring a swift and safe changeover to Euro, and to the lowest cost possible. The unlimited support to this project by UNMIK and EU provided the necessary and robust support for amending and approving the basic legislation.

In contrast to the “adoption” of the Deutsche mark as the main currency in Kosovo in 1999 and the legalization of its wide use, switching to euro currency was made in cooperation with the European Central Bank, as well as some national central banks of Eurozone. In fact, the introduction and EUR banknotes and coins was supposed to be done with the help and assistance from Euro Area countries.

Special circumstances faced by the authorities in Kosovo, appeared in numerous challenges in preparations for withdrawing the Deutsche mark and introduction of Euro. The high degree of orientation of cash in the economy meant that there was no direct way to assess the volume of the Deutsche mark in circulation and consequently its distribution by denomination. Based on the decisions taken by the ECB (European Central Bank), which allowed non-Euro Area banks to disperse banknotes and coins from the early December 20011, the former BPK decided to disperse about 100 million euros before 1st January 2002

BENEFITS OF EUROISATION

Support to the development of financial sector

Euroisation supported the development of the financial sector, which should have been established immediately after the war. In the beginning, there was no bank in Kosovo and virtually all transactions made in cash. In fact, for almost two years, in Kosovo there was no financial sector and the single financial entity, Micro Enterprise Bank (MEB), was specializing in microcredit. 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. Given the small size of the economy and population of Kosovo and negative experiences with banks in the past, Kosovo’s financial system is characterized by a strong participation of foreign entities. In late December 2004, Kosovo’s financial system consisted of seven banks, which operated through 247 offices, 14 microfinance institutions, 3 other non-bank institutions, 7 insurance companies and one company saving company.

Reduction of cash from circulation

Reduction of cash from circulation was one of the main objectives of the former BPK. Change from DEM to EUR provided a unique opportunity to achieve this objective and at the same time helped to strengthen the banking system. Former BPK planned to let free the exchange amounts up to 1,000 DM, and imposed a fee of 2 percent fee for amounts between 1,000 and 10,000 marks, it was also the maximum amount allowed exchange cash. Amounts that exceed 10,000 DEM should be placed as bank deposits in euros. At the same time, every effort was made to facilitate the role of enterprise sales at Deutsche mark removal from circulation through a natural process.

Setting maximum limits on the amounts of exchange, as well as clearly defining the deadline period of dual currency circulation, greatly encouraged holders of cash to deposit their money in banks, rather to risk not to be exchanged in time. This strategy was accompanied by incentives from banks, which have already improved and multiplied their services to attract new clients to open their accounts. Although this scenario seems simple, its implementation posed some problems. The most important, of course, was the continuing lack of confidence in the banking system. This was hurt most by a still limited access of banking services. At this time, commercial banks in Kosovo had available only 24 offices, while the former BPK operated through a network of 23 offices, of which more than a half were small local agencies, which were opened only with limited hours, and 7 groups of mobile banks.

Disposal of the euro was successfully completed on 28 February 2002. Thus, from this moment, Kosovo’s economy is “euroized” completely and effectively. Euroisation often defined as the adoption of the euro as legal currency and official currency by the authorities of a country outside the euro zone. This definition also implies that the authorities decided to reject their instruments of monetary policy and to abandon their national currency. Given the widespread use of informal Deutsche mark and its role UNMIK accepted this option as a “fait accompli” (a completed fact).

Monetary Stability

At the time when Kosovo chose euroisation, the country put a sound monetary foundation that was needed for economic reconstruction, social and political development in the years to come.

The adoption of the euro as a national currency brought also monetary stability in Kosovo. The risk of devaluation of the national currency disappeared. CBK, which acts as a fiscal agent of the Government of the Republic of Kosovo, does not take any exchange risk, and manages the official reserves. These reserves are mainly invested in euro zone countries, in the central banks and financial institutions with good rating. Kosovo’s economy faces no significant exchange risks. In the same way, euroisation has prevented Kosovo in having dual exchange rate of the currency, legal and informal.

Reduction of the transaction costs

The introduction of the euro significantly simplified and reduced transaction costs both within and outside of Kosovo, especially when considering the importance of trade within the economy of Kosovo. Neighboring countries, mainly former Yugoslav republics, remain the main trade partners of Kosovo. However euro currency, the same as Deutsche Mark before 2002 is widely used in the region.

Macro-economic stability

Euroisation in Kosovo had also some long-term policy objectives. Euroisation in Kosovo was expected to foster economic stability, solve the problem of reliability, and mainly to increase fiscal discipline by eliminating the possibility of reproducing the money to cover fiscal deficits. After a longer period of time this will lead to increased foreign direct investment.

Generally, euroisation was expected to foster economic integration, which has adopted the euro with the economies euro emission countries, in this case with the whole euro area. The adoptive country would already have a stronger economy or political ties with the country issuers. Euroisation in Kosovo did not follow this pattern, since it was a direct result of political and economic disintegration of the former Yugoslavia, and the intervention of the United Nations. But looking at the future, it should actually accelerate the full integration of Kosovo in the Euro Area..

Euroisation Cost

Although there were positive effects on the economy, the Euroisation also brought costs. Even if we exclude the cost of changing the initial euro held in cash, the loss of income from the “right of the older”, and the cost of the opportunity of holding cash reserves in the Central Bank, leads to significant cost for Kosovo. However, costs can be considered affordable, compared with the advantages of euroisation.

After the unilateral adoption of the euro, CBK maintains available cash reserves in order to supply the economy, which can be used in exceptional circumstances.

If euroisation did not solve all the financial problems in Kosovo and has brought restrictions on running an independent monetary policy, its advantages are undoubtedly positive mainly because the use of the euro has contributed to the stability of the overall financial sector.

[1] Exctracted from the speech of the former Managing Director of BPK, Mr. Michel Svetchine at the Fifth International Conference, held on 24-25 of March 2005, from the Bank of Albania.