On behalf of the authorities we thank staff for their report, analysis and recommendations. They appreciate the Fund’s advice and the presentation of the topics covered in the Selected Issues report. In general, the authorities considered the staff appraisal helpful and the consultations with the Fund productive. Some nuances in views remain, especially related to the fiscal stance, but the authorities consider that the consultations again provided a good opportunity to focus on the economic aspects aimed at strengthening macroeconomic stability and intensifying structural reforms.
In 2008, the reelected government took office for a new four-year term that is expected to see Macedonia becoming a full member of NATO, and starting EU negotiations. The ongoing discussion with the EU act as an important anchor for macroeconomic stability. In such environment, the key objective of the authorities is to speed up progress in structural reforms, supporting key growth sectors of the economy and restructuring lagging ones.
Economic performance and outlook
Macedonia’s economic performance remains strong. The country experienced more than five years of uninterrupted real output growth. Growth increased to 5.9 percent in 2007 and is expected to reach 6 percent in 2008, with industrial production growing at double digits. In 2007, improved terms of trade and increased remittances boosted incomes and domestic demand. However, the current account deficit widened to 14 percent of GDP this year, and the trade deficit is projected to rise from 21 percent of GDP in 2007 to 28 percent of GDP in 2008. Foreign direct investment rose 40 percent (y-o-y) in August, and now covers 74 percent of the current account gap, as compared to 68 percent before. Inflation has risen in the third quarter to 8.4 percent (y-o-y), but decelerated in October 2008 to 7.1 percent (y-o-y), with core inflation low at 2.3 percent in October 2008.
The recent international financial turmoil, and a shift to a more expansionary fiscal policy increased external vulnerabilities, and posed a more serious concern, both in terms of keeping sufficient international reserves under the fixed exchange rate, and of maintaining external debt sustainability. The authorities recognize the potential risks associated with Macedonia’s external imbalances, especially in light of the dimming global growth outlook and persistent strains in commodity and financial markets. At the same time, the authorities are looking to implement some fiscal stimulus in 2009 and to move ahead with improving the infrastructure and to create a positive impact on the output of the private sector in the long run.
The authorities have successfully pursued fiscal consolidation over the past several years. In 2007, the general budget ran a small surplus of about 0.6 percent of GDP, well above the 1 percent deficit target. In the first three quarters of 2008, the central government ran a surplus of almost 3 percent of GDP. The fiscal consolidation was due to a strong revenue over performance and expenditures savings. The fiscal consolidation was possible because the main elements in the authorities’ economic reform agenda are simplifying the tax system, improving its efficiency and reducing the tax burden. However, recently the government approved a budget rectification and raised the central government deficit for 2008 to 1.5 percent of GDP.
The government pledged to increase spending on public wages, pensions, agriculture and education and, with regard to the security reform, to cut social security contributions from 32 percent to 22 percent over three years. In these circumstances, the government intends to increase the deficit to 2.8 percent in 2009 and 3 percent in 2011. A deficit of this magnitude does not alter Macedonia’s sound fundamentals, including the low level of public debt. Moreover, the security reform also includes introduction of the gross wage concept, integral collection of contributions by the Public Revenue Office, and broadening the tax base, which will strengthen the fiscal consolidation at longer term. At the same time, the authorities have taken measures to control the budgetary expenditures, both at the central and local levels.
Against this background, the authorities are fully committed to improve the fiscal stance if macroeconomic indicators will deteriorate in accordance with the recent financial turmoil, and ensure that fiscal expansion will not exacerbate Macedonia’s medium-term external vulnerabilities. They agreed with staff’s recommendations in adjusting the fiscal policy, if needed.
Consistent with their commitment to fiscal discipline, the tax administration reform has intensified arrears collection and improved tax collection from both large and small taxpayers. At the same time, the customs administration reform and the implementation of the fiscal decentralization will strengthen the fiscal stance and will increase budget revenues.
Monetary policy and financial sector
The National Bank of the Republic of Macedonia (NBRM) continues to support the economic program by maintaining a de facto pegged exchange rate regime backed by an adequate level of international reserves. However, the deceleration of world growth and severe deterioration in the terms of trade related to the turmoil in international financial markets negatively affected the current account and portfolio investments, thus limiting the increase in international reserves. However, it is expected that the reserve coverage at the end of the year will remain around 3 months of import, as in 2009 import demand might be lower than expected. The inflation rate started to accelerate as of August 2007 and reached 8.4 percent in the third quarter of 2008. The largest part was explained by supply side factors such as a pick-up in food and energy prices. As commodity prices started to decrease, the inflation rate in October 2008 decelerated to 7.1 percent, with core inflation remaining low at 2.3 percent (y-o-y). Inflation expectations are currently stable, but the risks from wage increases are present and stress the need for strong vigilance from the NBRM. During 2008, the NBRM gradually raised its interest rate to 7 percent, as well as its capital adequacy requirements for overdraft and credit card loans, introduced measures aimed at discouraging the excessive credit growth of households, and broadened the base for reserve requirement, while still committing to further increasing interest rates, if needed. With increasing external vulnerabilities, the NBRM is committed to take further measures to slow credit growth and to continue to bring down the inflation rate.
The banking system remains healthy, and the recent international financial turmoil did not affect the banks directly. Its indirect impact, on the other hand, could lower economic growth and worsen the trade deficit or weaken remittances. Given the importance of financial sector stability, the authorities will work on strengthening the central bank’s role in the legal and regulatory framework, and will continue to improve supervision on the non-bank financial sector.
Macedonia has made significant progress on the structural reform side, attracting greenfield foreign direct investment, privatizing and restructuring the railway system, liberalizing the telecommunications, and improving the business climate by establishing the “one-stop-shop” and reducing the time required to register a business.
The recent measures approved by the government to reduce minimum social contributions, together with lower taxes on labor will stimulate employment and will encourage lower paid workers to enter the formal economy. The authorities will continue to improve public expenditures management, to help raise public investment to new EU member state levels, spending public funds more efficiently by integrating them into the annual budget process. Strengthening the tax administration allowed the government to improve tax collection and make more information available to taxpayers. Furthermore, the authorities will continue to harmonize the basis for social security contributions with the personal income tax, which will ease the computation burden and simplify the tax administration, and has the potential to raise additional revenues.
The authorities are committed to accelerate the electricity sector reform, by gradually eliminating the existing distortions by improving the companies’ capacity to cover their costs. In this respect, the authorities will respect the independence of the energy regulatory commission in setting prices. At the same time, after ending electricity subsidies for large-users, the authorities are committed to continue to gradually increase the electricity prices for the domestic retail sector, and to take supplementary measures to protect the poorest electricity consumers.
Finally, we would like to express the authorities’ commitment to continue to work with the international financial institutions in pursuing reforms that will help attract foreign direct investment.