The Moldovan authorities thank staff for the dedicated and constructive discussions during the Second Review under the IMF Program and on the 2017 Article IV Consultation, as well as for the continuous helpful technical assistance.
The authorities’ reform agenda will continue to be supported by the Fund’s Extended Fund Facility and Extended Credit Facility arrangements, which enjoy broad political support and are backed by a Parliamentary majority. The program remains broadly on-track. All end-June performance criteria were met by significant margins. Although with some delays, many structural benchmarks were implemented as well. The short-term objectives of the program -consolidating the economic and financial stability, by cleansing the financial sector, and enabling a strong regulatory and supervisory environment- remain the authorities’ priorities. For the completion of the second review, several upfront actions in banking and fiscal areas have been implemented successfully.
Recent Economic Developments and Outlook
Economic stabilization has been underway since 2016. Following 0.5 percent y-o-y economic contraction in 2015, real GDP grew by 4.3 percent y-o-y in 2016. In 2017, it is expected to increase by 3.5 percent supported mainly by robust private consumption and recovery of investment. The budget position is sound. Disciplined fiscal policies and revenue overperformance enabled additional priority spending, while public debt remains sustainable. Unemployment is low reflecting, however, widespread labor migration and low labor force participation. Inflation has been above the upper limit of the central bank’s target of 5 percent +/- 1.5 percentage points since April and accelerated to 7.3 percent in November. The inflationary pressures are projected to ease as supply side shocks unwind, leading inflation to return to target in early 2018. Gross reserves increased substantially, to 2,726 million US dollars in November, thus ensuring import coverage to over 5 months.
The outlook is positive and the authorities conservatively assume a GDP growth of 3 percent in 2018 and 4 percent over the medium term. Growth will be ensured by a dynamic development of public investment, more active promotion of exports to the EU market and higher foreign direct investments on the back of improved financial intermediation and business climate. The fiscal deficit will remain in line with program parameters while the risk of debt distress will stay low. With improved external competitiveness, the current account deficit, projected to reach 6.3 percent of GDP for this year, will gradually decline to 5.0-5.4 percent of GDP over the next five years.
Lower than programmed capital spending and 15 percent higher budget revenue was reflected in a cash surplus in September of 0.6 percent of GDP. Higher revenues have been ensured primarily by improved tax administration, supported through the implementation of the long-awaited tax administration reform and measures to tackle the shadow economy. Although public capital expenditure increased significantly compared to last year, the authorities believe it will not reach fully the cascaded objectives for 2017, mainly due to slower implementation of foreign financed projects. With this, the augmented fiscal deficit for 2017 will undershoot the planned level and reach 3.1 percent of GDP versus 3.7 percent projected.
The recently approved 2018 budget will target the agreed level of augmented fiscal deficit of 3.3 percent of GDP and it is in line with the fiscal rule as required by the Fiscal Responsibility Law. The budget was built under the assumption of a 7.8 percent increase in revenues, expected to be generated largely by further improved fiscal discipline and tax collection and higher taxes and fees, due to better macroeconomic conditions, as well as anticipated grants. Accordingly, a boost in revenues will make it possible to further expand the spending in priority areas such as public investment (mostly in infrastructure of national and local roads and development in agriculture), education and social protection.
Although the fiscal position is solid, Moldova’s spending and investment needs - which are crucial to supporting future growth and competitiveness - continue to be greater than the available resources. While increased from about 10 percent in 2016, the share of capital expenditure in total spending runs modest and will amount to about 13 percent of total budget spending in 2017-18. Over the medium term, considering the expected sizable decrease in budget support grants, the fiscal consolidation efforts will be crucial to create additional fiscal space to meet a greater array of domestically expenditure needs, including the growth-enhancing public spending. For this purpose, the Medium-Term Budget Framework (2018-20) is built around a gradual fiscal consolidation path through broadening and deepening the tax base and enhancing tax compliance, as well as ensuring a resourceful management of the public finances.
The authorities’ efforts and political capital will be further channeled into endorsing fiscal-structural reforms which should position the economy in a better state for the future. These reforms will encompass curbing tax evasion and further enhancing the tax administration, transparency, compliance risk management and audit function. With the objective to mitigate the risks and improve the transparency of fiscal policies and associated risks, the authorities published their first Fiscal Risk Statement (FRS) which accompanied the 2018 budget. With the view to enhance the public procurement process, the E-Procurement platform, now in pilot mode, is expected to be launched in 2018, while the recently created National Agency of Solving Complaints represents an important step towards further improving the public procurement system. Additionally, the authorities embarked on drafting new Tax and Customs Codes which will be brought in line with the EU directives, including in terms of regulating excises and VAT. Given the ageing and shrinking of the work force the pension reform, effective as of April, 2017, foresees increasing the retirement age to 63 from 2019 for men and from 2028 for women, improving coverage and compliance, and introducing a systematic indexation of pension benefits without ad-hoc increases. It also envisages bringing the entire public sector under a single contribution scheme.
The banking sector is overall well capitalized and profitable. However, banking assets grew soberly against the background of a reduction in the loan portfolio and high current liquidity indicators. The poor quality of earlier issued loans is one of the main challenges faced by the banks, although high capital adequacy and profitability levels create adequate reserves for possible risks. To this end, the banks will continue to implement the agreed remedy plans with the aim to enhance the monitoring and reporting frameworks, and strengthening the bank governance and internal credit risk policies.
The National Bank of Moldova (NBM) kept focusing on improving the soundness of financial institutions, with the primary goal to strengthen the banks’ governance, financial conditions and risk management. From this perspective, important progress has been achieved with the transfer of bank ownership to fit-and-proper shareholders. The NBM’s efforts in gaining full shareholder transparency are moving from the larger banks to smaller ones. Solidification of the related party identification process is another priority for the NBM in unwinding of related-party lending, which is expected to be completed on a twofold dimension - enhanced legal, procedure and policy framework alongside the improved IT operational toolkit.
While substantial effort was made with preparing for the transfer of systemic banks’ control to fit and proper shareholders, a foreign strategic investor announced already its intention to acquire an initial stake of over 39 percent in the third-largest bank with a possibility to further expand its presence. In the meantime, a group of reputable foreign investors maintains their interest in the largest bank, while the authorities put all efforts to make the transaction possible in the Spring of next year. In that vein, amendments to a set of laws have been approved in order to facilitate the sale of shares and ensure irreversibility of the previous cancelled shares. Looking ahead, the NBM’s linked actions will be channeled at setting a new framework centered at further removing the concerted and unfit shareholders from the banking sector, and ensuring the fit and proper certification of incoming shareholders and managers.
Enhancing the legal framework, including through its alignment to the EU standards was high in the NBM reform agenda. The recently approved new banking law, developed in line with Basel III (EU CRD IV/ CRR) standards, is the core piece of legislation for setting in place a better prudential and supervisory framework in the banking system, including through shifting to risk and principle-based supervision. The law, to be implemented gradually and starting in January 2018, will boost the banking system’s resilience and make it attractive to foreign investors. Furthermore, great focus will be placed on the promotion of the already drafted secondary regulatory framework and the implementation of COREP reporting system.
Moreover, following the approval of several amendments to the legislation to align it with the 2016 Law on Central Security Depository (CSD), including to streamline the transition period to a single CSD, the authorities undertook additional measures to ensure efficiency and soundness of the securities settlement and registry infrastructure. They developed a comprehensive methodology for verification of integrity of legal records of shareholders. The verification itself will be backed by an appropriate financing mechanism and procedures, which will support the related public awareness campaign, to be completed by March 2018. Meanwhile, the CSD logistic and organizational activities are being rolled out.
Monetary and Exchange Rate Policies
Following a sharp deceleration during 2016, inflation gained pace in the first half of 2017 engendered mainly by higher food prices due to adverse weather conditions during the Spring, energy prices and the tariffs’ rises on some regulated services. While the inflationary pressure was less pronounced in Q3, the annual inflation mounted above the target, being however placed within the interval delimited by the outer bands stipulated in the inflation consultation mechanism. The appreciation of the leu against the US dollar played an important role in absorbing the inflationary pressure. In the NBM’s view, with the dissipation of the supply-side shocks, the annual inflation rate will decline rapidly and may fall below 5 percent in 2018.
In response to these estimates, the NBM lowered gradually the policy rate by 250 basis points to 6.5 percent. Also, in order to sterilize the persistent excess liquidity (upheld by subdued financial intermediation combined with a recovery in deposits) and improve the transmission mechanism of monetary policy decisions, the NBM increased the reserve requirement ratio to a record high of 40 percent. Despite this increase, the excess liquidity remains substantial, which could be converted eventually into commercial loans given the favorable interest rates. Nevertheless, the banks’ credit portfolio is still modest, although there are signs of lending recovery in the recent months, largely in domestic currency.
The NBM advanced with enhancing the liquidity forecasting framework through improving the accuracy and consistency of macroeconomic data. The formalization of the data exchange between the Ministry of Finance and the NBM represents a part of these strides and envisages the exchange of information on the cash flow to the central budget and projections within the single treasury account (STA).
In line with the inflation targeting framework, the NBM maintains a flexible exchange rate, with interventions aimed at absorbing the seasonal excess supply and preventing disorderly exchange rate movements without resisting market trends. The abundance in foreign exchange over the year allowed the NBM to restore its international reserves, following the significant losses experienced with the banking crisis.
Business environment and reforms agenda
Far-reaching structural reforms, including in line with the Deep and Comprehensive Free Trade Agreement with the EU and as part of the recently adopted Country Partnership Framework with the World Bank, are vital to make the country more resilient, more stable and successful. The implementation of such reforms requires robust state institutions. Consequently, the authorities embarked on restructuring the state apparatus with the aim to ensure a sound structure to better promote and implement the government’s reform agenda alongside the rationalization of public wages and employment. They reduced the number of ministries from 16 to 9 and replaced the Deputy Ministers with non-political state secretaries, while the next phase of the reform will aim at optimizing agencies subordinated to the government.
The authorities have been working recently to foster investments and address the accumulated challenges in the real sector in order to unleash sustainable private sector-driven growth. An important step in this regard will be the adoption of recently discussed measures to ease the regulatory environment for business, although significant bottlenecks in doing business persist. The contractual relationships between the employer and the employee have been liberalized. The overlapping controls against the same risk criteria were excluded and the number of control bodies has been reduced from 58 to 18. The total number of permits and licenses required to start and conduct a business was cut by about a quarter, while the burden of reporting on salary payments and related taxes was lessened by consolidating the number of reports. Moreover, the implementation of “single window” solutions is ongoing and substantial progress has been achieved in simplifying the procedures for orderly liquidation of business.
The authorities put a lot of emphasis on diversification and safeguarding energy security, which will contribute to reducing riskiness of investment in the country. As such, in addition to the new laws on electricity and natural gas adopted in 2016, the Parliament adopted the new Energy Law in July 2017, aimed at strengthening the political, functional and financial independence of the regulator - an important step for the implementation of the EU’s Third Energy Package.
The authorities remain fully committed to safeguarding the attained macroeconomic and financial stability. They will continue to extend the track record of sound and prudent economic policies, as well as tackle the challenges and reduce vulnerabilities through keeping policy implementation on track. The Fund-supported program remains an important tool to achieve these goals.