Chapter 5. Policy Implications
- Milan Cuc, Erik Lundback, and Edgardo Ruggiero
- Published Date:
- January 2006
What challenges do remittances and labor migration pose for policymakers? Chapter 3 provided insights into what motivates Moldovans to seek employment abroad and how they make decisions about the amount and use of remittances. Chapter 4 discussed broader ramifications of these decisions for the performance of Moldova’s economy. Now we will discuss how policies can (1) influence decisions about labor migration and remittances, and (2) deal with risks that remittance inflows pose to macroeconomic stability.
A. Structural Policies
Structural policies are central to addressing the main policy issues associated with labor migration and workers’ remittances. Recognizing that much of the impetus for migration stems from poor economic and social conditions at home, the first order of the reform agenda should be to aggressively tackle impediments to faster economic growth and private investment and address more effectively social needs of the population through better-targeted social spending programs. To moderate, and eventually reverse, the current emigration trend and Moldova’s increasing dependence on workers’ remittances, establishing a good business environment is crucial. An improved business environment would (1) strengthen the incentives for business investment in Moldova; (2) increase the expected return on investment in Moldova, encouraging FDI and bringing much-needed know-how; and (3) increase the likelihood of the more highly educated labor force seeking and finding work opportunities in Moldova. More investment, better employment opportunities, and good economic prospects would reduce the incentives for workers to leave Moldova. At the same time, with improvement in the business climate, remittances could become an increasingly important source of business financing.
A poor business environment is the main reason for the reluctance to invest in Moldova. Compared with fast-reforming countries in Central and Eastern Europe, Moldova has benefited little from FDI (Figure 35), largely because its business environment does not fare well in comparison with that of its neighbors, according to World Bank surveys. These surveys also indicate a relative deterioration of the business climate over time (Figure 36). The poor business climate and low investment have impeded creation of attractive domestic employment opportunities, leading Moldovan workers to leave. To bring about a change, this environment needs to be improved and it seems clear that with the right structural policies in place Moldova could be an attractive place for investment. It has a relatively well-educated labor force and a low-wage environment. Furthermore, it is geographically and culturally located between the two large markets of Western and Central Europe and the CIS countries. Moldova could therefore potentially be attractive to investors; for example, to those intending to process labor-intensive manufactured goods for export to Europe or to manufacturers looking for a platform to supply goods and services to the large CIS markets. Attracting foreign investors could be particularly beneficial since they typically bring advanced technology, as well as financial and marketing knowledge, which then can be absorbed by the local labor force and entrepreneurs, thereby raising total factor productivity.
Figure 35.Cumulative FDI Per Capita, 1991–2004
Sources: Moldovan authorities; and IMF, World Economic Outlook, and staff calculations. Note: FDI = foreign direct investment.
Figure 36.Business Environment
Sources: World Bank; Transparency International; and IMF staff calculations.
1From 0 to 10; a higher number indicates a better perception.
The second argument in favor of improving the business climate at home is to encourage use of workers’ remittances as a source of funding for domestic business capital formation. In all likelihood, migration and remittances will remain important for years to come. The upward trend may end, and even be reversed over time, but there will always be attractive opportunities abroad for many Moldovans, as long as barriers to work in other countries (regulatory, logistical, financial, psychological, etc.) are surmountable. Because Moldovans migrate primarily to raise the consumption level of their households, and then to invest in their future through purchases of housing and education services, encouraging them to channel their savings to more productive uses is a policy challenge. A conscious, determined, and sustained effort to improve the business environment could, however, facilitate the allocation into productive use of the increasing portions of remittances migrants intend to invest in the future. This is particularly important from a longer-term perspective, since more migrants are likely to work abroad permanently and start saving and investing in their host country.
While it is beyond the scope of this paper to discuss a desirable reform agenda for Moldova, a few areas can be singled out as key for improving the business environment. Tax and customs administration could be modernized, in particular with regard to the administration of VAT refunds—critical for exporters—and the taxpayers’ assistance function—critical for foreign investors. Legislation and regulations on licensing, registration, and certification could be simplified and aligned with European standards. Informal and formal regulations restricting trade should be phased out, and the inclination to protect sectors or specific manufacturers should be resisted.
The banking sector could play a greater role in channeling remittances into productive domestic investment. Bringing in strategic foreign investors would inject more competition into the banking sector and, more specifically, into the market for banking and financial services to households. Banks from countries with large numbers of Moldovan migrants may be interested in opening branches in Moldova and offering packages of services tailored to migrants and their families. This would encourage workers to direct a larger portion of remittances toward the banking system, making it possible for remittances to become a source of financing for productive investment in business activities in Moldova, rather than only for investment in housing and education or savings abroad. At the same time, the effectiveness of the banking system would be enhanced, as banking intermediation would increase from the current low levels.
B. Monetary Policy
Supporting structural policies will be necessary to reduce pressure from the inflows of workers’ remittances on monetary policy. Monetary policy is important in creating a stable macroeconomic environment, which would be conducive to a favorable investment climate. However, without effective structural policies, the effectiveness of monetary policy will continue to be hampered. Under these circumstances, the NBM has in principle chosen a flexible exchange rate regime, paired with a clear focus on low inflation as the overriding goal of monetary policy.
A flexible exchange rate regime helps in absorbing variations in the inflows of workers’ remittances. Although these inflows are generally more stable than many other foreign exchange inflows, such as FDI and commodity price–sensitive exports, they are still quite unpredictable. This implies that adopting a fixed exchange rate regime would be more demanding and entail some risks. It would require a clear commitment to policies consistent with such an arrangement, not only from the NBM, but also from the government, and it would have to be backed up by strong political support. At this point, such commitment and support do not appear to be present. Furthermore, a fixed exchange rate regime in an environment of rapidly growing inflows of remittances could contribute to a false sense of stability, potentially leading to dangerous imbalances.
The NBM has chosen low inflation as the overriding goal of monetary policy, because it still seems to be the best option, although it cannot be characterized as an inflation-targeting regime.27 Combined with strong structural policies, prudent fiscal policies, and increased de facto and de jure independence of the NBM, such a strategy could be successful.
As described in Chapter 4, the NBM has not fully focused on low inflation; it has also tried to resist the nominal appreciation pressure on the leu stemming from the large inflows of remittances. The motivation has been to preserve competitiveness. However, there are several reasons monetary policy cannot do much to improve competitiveness. First, and most important, monetary policy only affects competitiveness in the short term, and the end result of attempts to prevent a nominal appreciation of the leu may be nothing but higher inflation and an unchanged real exchange rate down the line. Higher inflationary expectations imply that the effect of monetary policy on competitiveness is likely to be short lived, and an undesirable wage-price spiral may develop. Second, considering that the exchange rate is likely to be undervalued, risk of inflation may be a more important concern at this point. Third, Moldova has chosen to adopt a flexible exchange rate regime, and the NBM has clearly stated its intention to keep inflation down. It is important to live up to this commitment in order to build up credibility, and let the market, by and large, set the exchange rate. There may be room for interventions to smooth short-term fluctuations, but this should not be at the risk of accelerating inflation and damaging credibility.
For the same reasons, there is a limit to what monetary policy can do to make Moldova a more attractive place to invest and work. While a depreciation would reduce the cost of labor, it is not likely to make Moldova more attractive, since there is not much slack in the labor market, and lower dollar-wages could not be sustained. Nominal leu-wages would have to increase and the end result would only be higher inflation. Moreover, to the extent that dollar-wages are lowered for a period, it will then become even more attractive to work abroad, which may encourage additional emigration. At a more fundamental level, competitiveness can be viewed as the ability of the economy to generate increases in incomes through higher investment and productivity growth—something that monetary policy cannot affect directly. What is needed is higher productivity in Moldova and higher real returns on investment. That cannot be achieved without structural policies to improve the business environment.
C. Fiscal Policy
The short-term beneficial effects of emigration for the government financial position offer a margin for maneuvering a countercyclical macroeconomic policy. Emigration, by alleviating unemployment and providing a safety net to the population, has eased pressures on the budget, while boosting consumption- and import-related tax revenue collection. This newly created cushion provides an opportunity to strengthen fiscal policy’s countercyclical role without jeopardizing medium-term fiscal sustainability. Such a strategy will require that tax revenue increases not be automatically used for new spending initiatives. Rather, it may be appropriate to increase fiscal saving when the domestic economy is overheating and inflationary pressures are on the rise. Thus, fiscal policy would lend more effective support to the central bank’s efforts to control inflation.
Although there is uncertainty about the future evolution of the number of contributors and beneficiaries in the pension system, the analysis above suggests some practical steps that could be taken to strengthen its viability.
- Efforts should be directed at broadening the contribution base by bringing a greater number of contributors into the system. The government decision to lower contribution rates (from 30 to 28 percent by 2006) is aimed at encouraging greater participation in the plan. In addition, the authorities intend to engage the business sector in a debate over Social Fund reform, including by seeking ways to broaden the contribution base while lowering rates.
- The link between contributions and benefits should be strengthened. This was one of the main objectives of Moldova’s pension reform, to be achieved initially through a blended system, in which benefits would depend increasingly on past contributions. However, the weight of past contributions in determining pensions remains relatively small. Greater weighting of past contributions would make the link between contributions and benefits more transparent, encouraging greater participation. It would also signal to those who choose to stay outside the system—including those who have decided to seek employment abroad—that they would need to assume greater responsibility for financing their own retirement.
- The current demographic imbalance caused by labor migration may require that the pension system be financed partly through temporarily higher state budget transfers. Linking pension benefits to lifelong contributions can ensure that the system will be self-financing in the long run. However, it may not be feasible to match the contemporaneous contribution collection with the benefit payments, if one-third of the labor force is working outside the country. Raising contribution rates, which are already prohibitively high, or lowering old-age pensions, which—at less than 30 percent of an average wage—are relatively low, do not seem like practical options. Hence, some thought may be given to using some of the additional fiscal revenue generated from taxation of workers’ remittance-financed consumer spending to supplement state budget transfers to the pension fund.