This paper reviews economic developments in Moldova during 1995–98. By 1995, the fiscal deficit had been cut to 5¾ percent of GDP and annual inflation had fallen to 24 percent. Exports and imports recovered rapidly, with the current account deficit narrowing to 8½ percent of GDP. In 1996, the authorities adopted a three-year program to accelerate and deepen structural reforms and consolidate the stabilization effort. Performance in 1996 and 1997 was mixed. The annual inflation was further reduced to 15 percent at end-1996 and 11 percent at end-1997.

Abstract

This paper reviews economic developments in Moldova during 1995–98. By 1995, the fiscal deficit had been cut to 5¾ percent of GDP and annual inflation had fallen to 24 percent. Exports and imports recovered rapidly, with the current account deficit narrowing to 8½ percent of GDP. In 1996, the authorities adopted a three-year program to accelerate and deepen structural reforms and consolidate the stabilization effort. Performance in 1996 and 1997 was mixed. The annual inflation was further reduced to 15 percent at end-1996 and 11 percent at end-1997.

Moldova: Basic Data 1/

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Sources: Moldovan authorities; and Fund staff estimates.

Data exclude Transnistria.

GDP data include a staff-estimated allowance for the shadow economy.

Based on share of value added at current prices.

On a cash basis; includes the Social Fund and extrabudgetary funds.

At actual exchange rates.

I. introduction and background

1. Moldova is a small landlocked country in the northeastern Balkans, bordering Ukraine in the north, east, and south and Romania in the west. A moderate continental climate with mild winters and rich, fertile soils have favored agricultural production and processing, which currently account for about 50 percent of GDP. Following the collapse of the Soviet Union and Moldova’s independence in 1991, output dropped sharply and inflation soared, but, through mid-1998, substantial progress has been made in financial and macroeconomic stabilization. Since the Russia crisis hit in August-1998, output has further declined, macroeconomic imbalances surged and the financial situation has become fragile. Efforts are focused on regaining financial stability and sharply accelerating structural measures and institutional reforms needed to lay the foundation for recovery and sustainable economic growth.

2. Moldova was affected by a sharp deterioration in its terms of trade, the loss of traditional markets, and disruptions in payments and trade relations after the break-up of the Soviet Union. The adverse effects on output were compounded by droughts in 1992 and 1994, and an internal conflict in 1992 over the independence of the Transnistria region (the area of Moldova to the east of the Dniestr river). As a result, real GDP declined by more than 50 percent between 1991 and 1994. At the same time, annual inflation soared, peaking at almost 2,200 percent in 1992, following the liberalization of prices and the monetization of a fiscal deficit of 26 percent of GDP. In 1993, the authorities adopted a comprehensive program of financial stabilization supported by a stand-by arrangement with the Fund.

3. By 1995, the fiscal deficit had been cut to 5¾ percent of GDP and annual inflation had fallen to 24 percent. Exports and imports recovered rapidly, with the current account deficit narrowing to 8½ percent of GDP. In 1996, the authorities adopted a three-year program to accelerate and deepen structural reforms and consolidate the stabilization effort. Performance in 1996 and 1997 was mixed. While annual inflation was further reduced to 15 percent at end-1996 and 11 percent at end-1997, the cash fiscal deficit rose in 1996 to nearly 7 percent, where it remained in 1997. Reflecting this, the external current account deficit widened to 13 percent of GDP.

4. While early progress had been made in liberalizing prices, financial transactions and trade, more generally structural transformation has lagged, especially in agriculture and large-scale enterprises, notably in the energy and utility sectors. Only limited progress has been achieved in enforcing hard-budget constraints in the public sector, which has accumulated large debts and arrears on energy, wages and pensions. Barter is still prevalent in the economy, and significant offsetting operations have been supported by the government. Growth in national income has yet to be achieved on a self-sustainable basis.

5. 1998 proved to be a difficult year, as initial steps by a new government to reenergize structural reform were overwhelmed by the shock to the economy of the crisis in Russia from mid-August. Exports to BRO countries (about 2/3 of the total) dropped by 60 percent in the second half of 1998, and payments were frozen. Under this pressure, the exchange rate depreciated by 45 percent, and inflation reemerged. Notwithstanding significant expenditure cuts at the year-end, the budget deficit, on a commitments basis, remained at around 8 percent of GDP, about the average level of the previous three years. The external current account deficit widened sharply to 18 percent of GDP, and both domestic and external arrears continued to accumulate.

II. recent macroeconomic developments

A. Real Sector Developments

Output and demand

6. Real GDP1 has continuously declined through 1998, with the exception of a slight increase in 1997. On average, GDP is estimated to have fallen an annual average of around 12.7 percent per year since 1993, bringing the cumulative decline since independence to about 70 percent. The sharpest declines were recorded in 1994, 1996, and 1998, the first two owing to poor harvests and the latter reflecting a collapse in exports following the crisis in Russia in August. Estimates for 1998 showed GDP declining 8.6 percent (Table 1), reflecting a sharp drop in agricultural output and in industrial production (Figure 1).

Table 1.

Gross Domestic Product, 1993-98

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Source: Table 27.
Figure 1.
Figure 1.

Moldova: Output Indicators, 1992-1998

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Sources: Moldova Department of Statistics; and Fund staff estimates.

7. On an expenditure basis, estimates, although rough, indicate a further steady increase in the share of private consumption expenditure to over 95 percent of GDP, up from 75 percent in 1994. Gross capital formation is estimated to have increased steadily to almost 30 percent of GDP. The external resource imbalance also continued to rise relative to GDP, to around 25 percent from 20 percent in 1997. However, one welcome development has been the moderated contribution of stock holdings at around 4 percent of GDP, down from 15 percent in 1995 (Appendix Tables 27 and 28).

8. On the supply side, agricultural production declined further in 1998, by 11 percent, to about 60 percent of its level at independence. Grain production declined 22 percent from the bumper crop levels of 1997, but remained above the levels of 1994-96 (Appendix Table 29). Oilseeds and sugar declined markedly, but vegetables grew to levels not seen since 1995. Livestock and related production, with the notable exception of pigs and pork, also generally continued to decline (Appendix Table 30). Private agriculture is becoming increasingly important, as the land privatization program is implemented. Private farmers’ share of total output is estimated to have reached around 60 percent in 1998.2

9. Industrial production has not yet stabilized, falling a further 16.5 percent in 1998, although official statistics appear to overstate the decline. The 1998 decline was almost entirely in the second half, and appears to have reversed a period of stabilization, and even modest recovery, which had been evident from the second quarter of 1997 (Appendix Tables 31 and 32). Declines have been particularly marked in the inefficient heavy industry sector, while some light industry groups, notably clothing manufacture, have grown in 1998. The food processing sector was particularly hard hit by the crisis in Russia, Moldova’s principal market, as incomplete reforms continue to limit export potential to non-CIS markets.

Labor markets

10. Official labor statistics are not regarded as particularly reliable. Unemployed workers were officially recorded at some 32,000 at end-1998, or less than 2 percent of the civilian work force (Appendix Table 33). A pilot labor force study conducted in mid-1998 found a labor force of 49 percent of total population or some 1.7 million workers, and an unemployment rate of around 9.5 percent, 60 percent of which were men. However, this number also likely understates unemployment, as unpaid leave (officially around 150,000), part-time employment (officially 40,000), compounded by payments difficulties (arrears and payments-in-kind) constitute a well documented and widespread phenomenon. Workers who receive benefits constitute only a tiny fraction (about 8 percent) of those officially unemployed.

11. Agriculture continues to be the largest employer (in reporting enterprises of 20 or more workers), at around 40 percent of total employment, followed by education and manufacturing at 14 percent and 12 percent, respectively. Together agriculture and manufacturing have given up 8 percentage points of their overall share in total employment to the service sectors since 1995. This is almost certainly an under representation of the shift in employment to the service and informal sectors, as overall employment reported has declined by around 20 percent since 1995 (Table 2).

Table 2.

Employment by Sector, 1995-98

(in thousand)

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Source: Data provided by the Moldovan authorities.

Wages and Prices

12. The secular trend to widened wage differentials continued in 1998, with wages in the financial sector averaging more than 2.5 times the level in the next highest industry group, a 30 percent increase in real terms (Appendix Table 34). The lowest wages were recorded in forestry (about US$26/month), with wages in the health and education sectors next lowest (around US$33/month). Official economy-wide wage data indicate an average monthly wage in 1998 of Mdl 252, up 15.3 percent, or about 7 percent in real terms. In US dollar terms, the average wage actually declined slightly in 1998 to US$47. Reflecting the surge in inflation in late 1998, as well as the sharp depreciation of the exchange rate, average monthly wages in December reached Mdl 350, an increase of 43 percent over December 1997, 21 percent in real terms. In the first half of 1999, wages rose in nominal terms, but at end-May were down 5 percent in real terms, year-over-year, and amounted to the equivalent of US$26.

13. Consumer price inflation had been reduced to virtually zero up until the Russia crisis in August 1998. Reflecting a disciplined monetary policy, inflation had been on a steady downward path since the introduction of the leu in 1993 (Appendix Table 35 and Figure 2). However, as a result of the crisis in Russia, strong pressures mounted in the exchange market, investors pulled out of the treasury bill market and the central bank was obliged to step in with emergency liquidity for the government. Inflation surged to over 8 percent monthly in November/December 1998 before easing considerably in early-1999. While the overall average CPI increased 18.3 percent in 1998, the subcomponents behaved very differently. Prices for food, non-food, and services rose by 11.4 percent, 20.7 percent and 34.2 percent, respectively. The much sharper rise in the price of services, reflected adjustments in tariffs for energy and utilities to near cost-covering levels. Following an updated household budget survey in 1997, the relative shares of food, nonfood and services were adjusted as of January 1999 with a shift of 8 percentage points from non-food to food.3

Figure 2.
Figure 2.

Moldova: Prices, 1994-1999

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Sources: Moldova Department of Statistics; and Fund staff estimates.

B. Fiscal Sector

Background

14. Since 1995, Moldova’s fiscal performance has been erratic (Table 3 and Figures 3 and 4). Total revenues have oscillated between 32.1 percent of GDP in 1996 and 36.3 percent of GDP in 1997. Expenditures have increased from 38.8 percent of GDP in 1995 to 42.8 percent of GDP in 1997. The cash balance deteriorated steadily between 1995 and 1997. Improved revenue performance in 1997 allowed for a reduction in domestic expenditure arrears amounting to 2.9 percent of GDP and this led to a significant improvement in the budget balance on a commitments basis. In the period 1995-97, financing options were diversified; access to foreign financing and domestic bank and nonbank credit reduced reliance on central bank financing.

Table 3.

General Government Budget, 1995-98

(In percent of GDP)

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Sources: Information provided by the authorities; and IMF staff calculations.
Figure 3.
Figure 3.

Moldova: General Government, 1994-1998

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Source: Data provided by authorities; and Fund staff estimates and projections.
Figure 4.
Figure 4.

Moldova: Fiscal Indicators, 1994-1998

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Sources: National Bank of Moldova, Ministry of Finance; and Fund staff estimates.1/ Cash basis; includes Social Fund operations on gross basis.

15. Moldova’s public finances deteriorated in 1998, largely due to poor revenue collection. Expenditures were compressed on a cash basis, and the government failed to limit expenditure commitments. The cash deficit of the general government reached 3.0 percent of GDP (as opposed to the program target of 2.4 percent of GDP), a significant improvement with respect to 1997. Nevertheless, this cash improvement contrasts sharply with the deterioration of the commitments balance. The deficit reached 8.1 percent of GDP on a commitments basis, relative to the program target of 7.3 percent of GDP. In 1998, the end-year stock of domestic expenditure arrears reached Mdl 1,109 million, or 10.9 percent of GDP (Appendix Table 36). In the first half of 1999, the commitments deficit reached 5.1 percent of annualized GDP, while the cash deficit reached 2 percent of GDP. Domestic expenditure arrears continued to be accumulated, but some progress was made in clearing external interest arrears.

Revenues

16. The revenues of the general government were 34.6 percent of GDP in 1998, a drop of 1.7 percent of GDP relative to 1997. Tax revenues were 29 percent of GDP. The financial crisis in Russia had an adverse impact on economic activity and foreign trade and the revenue loss in VAT, excises, and customs was estimated to be in the neighborhood of 2 percent of GDP in 1998. Despite these losses, the share of VAT revenues in GDP rose from 9.4 percent in 1997 to 11.1 percent in 1998 (Appendix Table 37). The increase in VAT collection was due to the elimination of many exemptions.4 Despite the increase in excise taxes, their share in GDP fell from 5.0 percent in 1997 to 3.7 percent in 1998, due in part to falling exports to Russia and weak customs administration. Profit and personal income tax yields also fell—from 5.2 percent of GDP in 1997 to 4.0 percent of GDP in 1998—and nontax revenues were lower as a share of GDP in 1998 relative to 1997, largely reflecting the fall in privatization receipts in 1998. In the last quarter of 1998, the improvement in tax revenues, despite the larger-than-expected slowdown in economic activity, was due primarily to netting operations totaling Mdl 541 million, against Mdl 690 million for the whole year, or approximately 6.8 percent of GDP.5

17. Revenues remained weak in the first half of 1999, particularly VAT, excises and foreign trade tax revenues. This was primarily due to noncompliance, and the slowdown in economic activity and foreign trade caused by the Russian crisis. Poor revenue collection may also be attributed to political uncertainty after the resignation of the government in February 1999. Contraband in petroleum, tobacco, and alcohol products has seriously undermined collection, particularly VAT and excises. Tax administration was improved in the first half of 1999 with the establishment of 30 mobile and 17 fixed fiscal posts along the Transnistrian administrative border. Approximately Mdl 3.5 million was collected in the first month of operation of the fiscal posts.

Expenditures

18. On a cash basis, expenditures fell from 42.8 percent of GDP in 1997 to 37.3 percent of GDP in 1998, On a commitments basis, however, expenditures were 42.4 percent of GDP, an increase from 39.9 percent of GDP in 1997. The accumulation of domestic expenditure arrears accounted for 82 percent of the total change in arrears.6 The main component of expenditures—social spending—fell from 16.4 percent of GDP in 1997 to 13.2 percent of GDP in 1998 (Appendix Table 38). This reflects, to a large extent, measures to rationalize health and education spending, and the accumulation of domestic expenditure arrears, particularly wages and salaries.

19. Given the revenue losses in the second semester of 1998, expenditure cuts of over 2 percent of GDP were implemented in the fourth quarter. These cuts were concentrated in the capital budget, the road fund, the fund for support of agriculture, and compensations for price increases. Debt service increased as a share of GDP from 3.7 percent in 1997 to 4.2 percent in 1998, primarily because of an increase in domestic interest payments in the second half of the year.

20. In the first half of 1999, expenditures were compressed on a cash basis, including social spending. Progress has been made in improving the efficiency of health and education spending.7 The 1999 budget introduced a salary freeze and a partial hiring freeze to contain wage costs.8 It also reduced subsidies to the agricultural sector, introduced cuts in defense spending, and reduced compensations for heating and energy and other privileges. Total employment in the public sector was reduced from 332,000 to 309,300 in 1998.

Social Fund Operations

21. Social Fund revenues, including transfers from the State budget, fell from 10.2 percent of GDP in 1997 to 9.1 percent of GDP in 1998 (Table 4). Excluding transfers from the State budget, Social Fund contributions increased as a share of GDP between 1997 and 1998. In-kind collections also contributed to improving revenue performance in the second semester of 1998, totaling nearly 3 percent of GDP in 1998. As in 1997, Social Fund expenditures constituted the second largest expenditure category in the general government budget in 1998. These expenditures nevertheless fell by 1.4 percent of GDP to 9.0 percent of GDP in 1998 on a cash basis. On a commitments basis, however, Social Fund expenditures reached 9.7 percent of GDP.

Table 4.

Social Fund Operations, 1995-1998

(In Percent of GDP)

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Sources: Information provided by the authorities; and IMF staff calculations.

Includes fines and penalties.

22. Social Fund collections were below the program target in the first half of 1999. Expenditures were compressed on a cash basis due to this shortfall in revenues. On a commitments basis, however, expenditures exceeded the program target, due to the accumulation of Mdl 87 million in arrears. Transfers from the State budget were also below the budgeted amount.

Financing

23. Non-inflationary sources of finance have been limited since the third quarter of 1998. Central bank credit and the buildup of external and domestic expenditure arrears were the predominant financing instruments in 1998. A sharp contraction in domestic credit resulted in negative financing from banks and nonbanks. Limited access to foreign credit and sizeable amortization payments resulted in negative foreign financing. The accumulation of foreign arrears reached 2.7 percent of GDP in 1998. In the first half of 1999, there was negative direct credit from commercial banks and the deficit was financed domestically through central bank credit and the sale of securities to commercial banks. Sizeable amortizations limited net foreign financing. The treasury bill market had been under pressure since the third quarter of 1998, but stabilized in the second quarter of 1999, albeit at a lower level of activity and a steeper yield curve.

Institutional Reform

24. In 1998, the Law on Administrative and Territorial Organization of the Republic of Moldova was passed and reduced the number of regional governments from the existing 38 rayons to 11 units. This consolidation is expected to reduce public sector employment by approximately 14,000 and payroll costs over the medium-term. To improve budget execution and expenditure management and control, a treasury system was established in January 1998 and subsequently extended to the 11 regional governments.9 A Large Taxpayers Unit (LTU) was created within the State Tax Inspectorate in 1998 to improve tax administration, fight widespread tax evasion, and boost collection. However, little progress was made in 1998 to improve customs administration.

25. With regard to the Social Fund, in 1998, all collection responsibilities, both, in cash and in kind, were transferred to the State Tax Inspectorate. A Law on Public Pensions was also passed in 1998, and implemented in January 1999, and aims at improving the financial sustainability of the current pay-as-you-go system by increasing the retirement age, eliminating privileges, and increasing individual contributions in line with benefit entitlements.

C. Money and Banking

26. Developments in the money and banking sector can be separated into two very distinct periods. Through mid-1998, the pursuit of a restrained monetary policy, along with institution building and monetary and banking reforms, had produced a sustained reduction in the inflation rate to near zero, a broadly stable, market-determined exchange rate, and strong demand for domestic financial assets. The strength of public confidence in the leu was evidenced by a steadily declining velocity of money and a relatively low level of dollarization. Interbank money markets were developing and indirect monetary control instruments had been introduced.

27. However, strains were building as a result of the continued high budget deficit and associated financing needs, and a build-up of external debt and arrears. Further, favorable world capital market sentiment toward emerging market debt had begun to shift. Thus, Moldova found itself in a vulnerable position when, in mid-summer 1998, the Russian crisis hit. The announcement of a default by the Russian government on its treasury securities shook the Moldovan money market and the freezing of export proceeds from Russia placed the financial system in a crisis. Notwithstanding vigorous NBM attempts to stabilize the situation, money and banking conditions dramatically reversed. The demand for money fell, there was a virtual collapse in the demand for domestic financial assets, and a rapid dollarization.

Pre-Russian crisis developments

28. The first three quarters of 1998 saw continued progress in monetization, financial deepening and reducing inflation. However, pressures were building, especially those relating to perceptions that large fiscal and external imbalances were not consistent with a stable nominal exchange rate. Reserve money (RM) declined through most of 1998, as the seasonal drop in the first quarter persisted with the NBM selling its foreign reserves into a declining market; by end-September, the RM stock had fallen 24 percent. Official reserves, which stood at US$366 million at end-1997, declined steadily to US$210 million at end-September 1998—52 percent of beginning RM stock. In April, NBM credit to the economy, largely in support of agricultural activity, rose sharply but was maintained broadly constant thereafter through end-July (Appendix Tables 39 and 40).

29. While base money was declining, the money multiplier (M3) rose steadily from 1.67 at end-June 1997 to 1.96 at end-September 1998, as excess bank reserves dropped from over 10 percent of deposits in mid-1997 to around 2 percent for most of 1998. This drop in excess liquidity reflected the development of the interbank money and secondary treasury bill markets following the removal of the transactions tax on treasury securities as well as the inclusion in the required reserves calculation of up to 2 percent of deposits in the form of cash-in-till, introduced in early-1998. The currency deposit ratio continued to decline steadily through mid-1998 to 115 percent of leu-denominated deposits, or 81 percent of total deposits. The slow but steady decline in currency use continued through mid-1998, but remained high at 45 percent of M3 (broad money, including foreign currency deposits). Foreign currency deposits, which had long remained broadly stable through mid-1997 (at about 10 percent of M3) jumped in the third quarter of 1997 and again in the second quarter of 1998 to US$55 million from US$ 30-35 million in mid-1997 (Table 5).

Table 5.

Monetary Indicators, 1995-99

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30. Broad money (M3) growth in 1998 was subdued, especially through the third quarter, declining 9 percent over the year. M2 (excluding FCD), which was down 7 percent through end-June 1998, dropped 15 percent in the third quarter, reflecting sharp drops in both leu deposits and currency in circulation, and declined 22 percent for the year as a whole. Inflation in the first nine months of the year was virtually nonexistent; the small price increase of 3½ percent in the first half was offset by equivalent price declines in the third quarter reflecting a stronger-than-usual seasonal decline in produce prices. Demand for money remained strong through mid-1998, with a decline in the velocity of circulation of M2 continuing on a steady downward trend of 5-10 percent on an annual basis (Figure 5).

Figure 5.
Figure 5.

Moldova: Money and Inflation, 1993-1999

(In percent)

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Sources: Moldova Department of Statistics, National Bank of Moldova; and Fund staff estimates.1/ Excluding Foreign Currency Deposits; six month backward moving average of monthly growth.

Post-Russia Crisis Developments

31. With the onset of the default on treasury securities by the Russian government in mid-August, the situation in Moldova deteriorated dramatically. The treasury bill market, which had been eroding for most of the year, shrunk abruptly with both domestic and foreign holders of treasury bills fleeing the market. In the circumstances, the NBM responded to avoid a default by the Ministry of Finance on maturing treasury bills and credit to government rose rapidly. Because of this, as well as to support timely external debt service payments, NBM credit to the government rose 150 percent from end-July through end-December (80 percent of RM at end-July). In the fourth quarter, external reserves fell to US$140 million (just 1.4 months of import coverage). Heavy official debt service obligations, especially in December also contributed to the reserve loss as the NBM defended the exchange rate from mid-August until end-October.

32. Reflecting the jump in credit to government, RM growth in the final quarter reached 25 percent but still represented a decline on the year of 6 percent. At the same time the NBM took strong measures to tighten liquidity. The NBM floated the exchange rate in early-November, and raised reserve requirements from 8 to 15 percent, with 13 percent to be held in a special account at the NBM (previously held in correspondents accounts). This effectively increased reserve requirements by 12-13 percent. Foreign currency deposits fell sharply in the fourth quarter of 1998 to US$48 million as confidence in the banking system was shaken. With the freezing of all export remittances from Russia and heavy withdrawals of deposits, the payments system was subjected to a severe liquidity squeeze in November/December. However, with supporting lombard and repo operations from the NBM, a generalized collapse was avoided and the payments crisis gradually eased in the first quarter of 1999. Leu deposits decreased by over 20 percent in the final quarter of 1998, but stabilized in the first quarter of 1999 and at end-June were up 10 percent over end-1998. Nevertheless, they have declined, in real terms, by 37 percent since September-1998.

33. In the first half of 1999, the monetary conditions stabilized somewhat, although the demand for leu remained weak. RM growth eased to 18 percent, most of which occurred in the second quarter, and reflected a rebuilding of foreign assets coupled with a sharp easing of credit to government and the sharp depreciation in the leu and fall in the demand for money. Inflation spiked in the fourth quarter of 1998, and averaged over 8 percent per month in November/December, and quickly subsided and with the tighter liquidity; by April the monthly rate was reduced to 0.6 percent. However, this trend was reversed in May/June with the continued weakness in demand for leu and a renewed sharp depreciation of the exchange rate. The fall in M2 velocity began to reverse in the third quarter of 1998 and rose at a year-over-year rate of almost 40 percent in the first half of 1999. There has also been a marked increase in dollarization of the economy. FCD rose again in the first half of 1999—by about one-third—although a sizable portion of this may be temporary in nature reflecting an operation for a large foreign investor. Evidence suggests that there are significant foreign exchange cash holdings by the public that have increased significantly since mid-1998, although little information is available to quantify this development (Figure 6).

Figure 6.
Figure 6.

Moldova: Velocity, the Multiplier, and Monetization, 1992-1999

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Source: Moldovan authorities; and Fund staff estimates.1/ Including Foreign Currency Deposits

34. There has been some setback to progress achieved in the structural area, most notably the implementation of market-based indirect liquidity management tools. The virtual collapse of the treasury bill and interbank money markets, coupled with the requirement that reserves be in a separate blocked account at the NBM, meant that use of the open-market operations and lombard and repo facilities all but ceased in 1999.

NBM Monetary and Banking Reforms in 1998-99

In mid-1998, several measures were undertaken by the NBM or the government and parliament at its behest to improve the efficiency of the banking and payment system. These included

  • the abolition of the restriction on only one bank account (mid-1998);

  • the limits on holdings of cash by businesses (mid-1998);

  • the abolition of the transactions tax on treasury securities of 0.3 percent (early 1998);

  • the securitization of all credit to government (December 1998);

  • the modification of the primary treasury bill auction pricing mechanism to a differential price system (October 1998);

  • an increase in the rate of remuneration of required reserves to equal the rediscount rate (July 1998, subsequently reversed in late-1998);

  • the replacement of the credit auction mechanism with open market operations (mid-1998);

  • the conversion to international accounting standards from January 1998; and

  • further, the NBM itself underwent its first external audit, completed in May 1999, of the 1998 accounts. From January 1999, the NBM accounts have been converted to a full accrual basis.

Interest Rates

35. Interest rates have risen with the crisis of confidence in leu-denominated financial instruments to levels that would be consistent with a well functioning money market. In mid-1998, the authorities allowed rates to rise on treasury securities, reflecting the government’s heavy financing need as well as some weakening of demand. Market participants in the treasury bill market interpreted the rise in yields as a sign of potential default—an expectation which was strongly reinforced by the Russian default. As a result, rates on treasury securities did not rise to market clearing rates, but net demand, as explained above, was met through credit from the NBM. In the fourth quarter of 1998, the treasury bill market shrank by two-thirds to an end-December stock (at purchase price) of Mdl 155 million. The maturity structure shifted dramatically away from the longer maturates with the virtual disappearance of maturities beyond the 91-day bill. The yield curve, which was very shallow during the first half of 1998, steepened considerably with yields on the 91-day bill rising from around 30 percent in June 1998 to 46 percent at end-October and to about 50 percent in April 1999. Short-term (7-day) liquidity management bills yields rose to over 40 percent in early-1999 before easing to 16 percent at end-June.

36. Average commercial bank lending rates rose in September 1998 to 60 percent and then to over 70 percent in December before easing sharply in early-1999 to 35 percent. This reflected the reduction in inflation as well as weak credit demand. Interestingly, the yield curve on credit has remained inverted for much of 1998-99, with new credits in June ranging from 44 percent on credits of one-month to 37 percent on credits over a year. The term structure of credits has also shifted, surprisingly, and the share of credits over one year has increased. During 1997-98 credits over a year represented around 10 percent of credit extended but in early-1999. This share has risen to more than 25 percent, which may reflect a roll-over of existing short-term credits in a difficult business environment as well as the on-lending operations of World Bank credits (Figure 7).

Figure 7.
Figure 7.

Moldova: Interest Rates, 1995-1999

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Sources: National Bank of Moldova; and Fund staff estimates.

37. Average deposit rates on term deposits rose from 21 percent in mid-1998 to around 30 percent in early-1999 before easing through May to 27 percent. Rates rose to 31 percent in June. However, these increases have little significance as leu-denominated term deposits have all but disappeared. The trend evident in mid-1997 toward an increased share of 1 year term deposits, which peaked at about one-quarter of leu deposits, was reversed in late-1997 and accelerated in early-1998, so that by mid-1998 over 80 percent of leu deposits were sight deposits, with a nominal interest rate of 2 percent, on average. Deposits in foreign exchange have also shifted, only slightly less dramatically, to sight deposits. At end-June 1999, sight deposits represented 96 percent of foreign currency deposits, 75 percent of which are non-interest bearing enterprise deposits (Figure 8).

Figure 8.
Figure 8.

Moldova: Structure of Broad Money, New Loans, and Deposits

(In percent of total)

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Source: Moldovan authorities; National Bank of Moldova; and Fund staff estimates.1/ Domestic currency only.

Banking system developments

38. The Moldovan banking system survived the financial crisis at the end of 1998 in a much weakened state. While there were no major bank collapses, the banking environment was considerably worse and the sector remains fragile. The steady monetization and financial deepening of the economy stopped in late-1998 and the reversal in the demand for leu has had serious implications for banks. As discussed above, and evident from Figure 7, the system now has a seriously mismatched maturity structure, with the overwhelming proportion of deposits being sight deposits. Two new foreign banks began operations in 1998 and 3 small banks were closed in 1998/99, so that the total system now consists of 21 banks. However, the sector remains highly concentrated, with the top five banks accounting for over 63 percent of assets and 65 percent of deposits at end-May 1999, broadly unchanged from end-June 1998.

39. Total regulatory capital to risk-weighted assets has risen from 34 percent to 38 percent at end-May 1999. This high ratio reflects weak credit demand in the current business conditions, and may also be overstated owing to imperfect asset ratings. Impaired credit performance has improved somewhat since June 1998 when substandard, doubtful and loss categories represented 28 percent of total credit; at end-1998, the ratio had fallen to 21 percent where it has remained through end-March 1999. However, total credit has declined 10 percent from June 1998 (a drop of 33 percent in real terms) through March 1999 and represented 61 percent of total assets, down sharply from 74 percent in June 1998, reflecting the need to raise cash and reserves by almost an equivalent amount.

40. The NBM has continued to strengthen banking supervision in a difficult environment. Three small chronically-troubled banks have been closed since mid-1998, for a total of seven so far since independence. The troubled and decapitalized Savings Bank was taken over by the government in late-1998 and a new board and management team was put in place in early 1999. The bank has the most extensive branch network and by far the largest household deposit base of any bank in Moldova. The new management is actively implementing a rehabilitation plan featuring recovery of non-performing assets, improved asset and liquidity management systems, and cost rationalization. The NBM’s supervisory efforts are handicapped by slow liquidation procedures which have absorbed qualified staff. Minimum capital adequacy standards were doubled in early-1998 and doubled again, in 2 steps, in 1999. However, inflation has eroded these increases, so that in mid-July 1999 the NBM announced a further increase would come into effect on January 1, 2001 to the leu equivalent of Euro 2.5/5.0/7.5 million for the three license grades, respectively. The minimum capital-asset ratio was raised to 10 percent effective January 1, 1999.

D. External Sector

41. Moldova’s already weak external position deteriorated dramatically in the wake of the mid-August 1998 Russian crisis. The external current account widened from 12.3 percent of GDP in 1997 to 17.7 percent of GDP, the level of gross official reserves was reduced by 60 percent to cover less than a month and a half of imports of goods and services, and the external debt (including energy arrears) increased by 13.5 percentage points of GDP to 71.5 percent of GDP. In November 1998, in the face of plummeting foreign exchange reserves, and after a period of large intervention, the authorities let the leu float freely. By the end of the year, the leu had depreciated by 44 percent against the dollar in nominal terms. In early 1999, however, owing mainly to a sharp compression of imports, the external situation begun to stabilize, though the accumulation of external arrears on debt, guarantees, and energy supplies continued. In particular, the trade deficit was sharply reduced during the first half of 1999, allowing for a small increase of foreign exchange reserves. However, the external situation remained highly unsettled and the leu continued to depreciate, by about 30 percent, in the first half of 1999.

Balance of payments

42. The main adverse effects of the Russian crisis on Moldova were felt through the trade channel, with the trade deficit widening from 15.8 percent of GDP in 1997 to 21.2 percent in 1998 (Appendix Table 41). Exports to BRO countries (the Baltics, Russia, and other former Soviet Union countries), which traditionally have constituted more than two-thirds of Moldova’s exports, dropped by about 60 percent between October 1998-March 1999 when compared to the same period in the previous year. In nominal terms, exports to BRO countries, mainly food, beverages (largely wine), tobacco, and animal products, that used to average US$50 million per month, decreased to less than US$20 million. The impact was particularly severe as Moldova has remained heavily dependent on its traditional export markets and has not diversified and reoriented its exports toward the rest of the world, which, as a proportion of total exports, remained at best stable during the period 1995-98 (Table 6). Owing mainly to the lack of an export basis, export distribution networks, and appropriate norms and standards, exports to the rest of the world, which could have benefited from the large nominal depreciation of the leu and the associated gains in price competitiveness vis-à-vis the dollar and the euro, declined by 24 percent in 1998. Outside agricultural and food products, exports were mainly limited to electrical appliances, textiles and leather products, and precision tools (Appendix Table 42).

Table 6.

Moldova: Quarterly balance of payments 1996-1998

(In millions of U.S. dollars; unless otherwise indicated)

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Source: National Bank of Moldova; and Fund staff estimates

43. On the import side, the Russian crisis resulted in a major and disorderly contraction of imports and total imports decreased by 48 percent in the six-month period following the crisis. In particular, non-energy imports, including of essential investment and intermediary inputs for the agro-industries, contracted by 54 percent. Energy imports, which constitutes about a third of total imports, were slightly less affected, despite a further accumulation of payment arrears took place, mainly vis-à-vis Russia, Ukraine, and Romania. Total external arrears on energy and other supplies, which amounted to US$221 million at end-1997, increased by 50 percent in 1998 to reach US$333 million. Despite the crisis, the share of barter in total trade remained relatively stable in 1998 at about 11-12 percent of total trade, reflecting mainly payments in kind for energy imports. The prevalence of barter and the inability or reluctance of certain Moldovan enterprises to engage in cash transactions resulted in losses through mispricing and may well have held back the reorientation of trade to the rest of the world.

44. Direction of trade statistics show that Moldova has not significantly re-oriented its exports from its traditional markets since 1994 (Table 7). In 1998, despite the collapse of the Russian market, the BRO countries and Romania still accounted for about 80 percent of Moldova’s exports, with Russia alone representing 53 percent. The share of exports outside these traditional markets, mainly to the EU and the US, has remained broadly stable to around 20 percent since 1994, reflecting the difficulty to conquer new markets in the absence of comprehensive structural reforms. While exports are likely to continue to be dominated by agricultural products, especially wine, where Moldova has a strong comparative advantage, there is scope for the volume of these exports to increase with improved marketing and reforms that encourage private domestic and foreign investments in these sectors. By contrast, Moldova’s import structure has already been substantially re-oriented toward the West. While more than 70 percent of Moldova’s total imports used to originate from the BRO countries in the early 1990s, the share has gradually declined since 1994. In 1998, for the first time, Moldova imported more from the West than from the BRO countries.

Table 7.

Direction of Trade

(in percent of total)

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Source: Data provided by the Moldovan Department of Statistics.

45. Beyond the impact of the Russian crisis, the continued widening of the current account from 6.8 percent of GDP in 1995 to 17.7 percent of GDP in 1998 reflected a structural deterioration of the domestic savings-investment balance owing in particular to a lack of hard-budget constraints in the public sector and the increased financing of government spending through arrears accumulation (Figure 9).

Figure 9.
Figure 9.

Moldova: Savings-Investment Balance and the Current Account, 1992-1998

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Sources: National Bank of Moldova; and Fund staff estimates.

46. Moldova was also affected by the Russian crisis through financial channels, although the limited access to international financial markets prior to the crisis has somewhat confined the extent of contagion effects. In particular, the direct impact on the banking sector has been muted, as holdings of Russian GKOs by Moldovan banks had been severely limited by prudential regulations. The direct financial impact was also limited by the fact that the NBM had no reserves in Russian commercial banks. However, Moldova suffered from the broader impact of the crisis on foreign investors’ risk assessment of the region. Following two years of strong and increasing net capital inflows, the capital account turned slightly negative in 1998. In particular, after the issuance of the Eurobonds and state bonds to Gazprom for a total of US$237 million in 1997, no new portfolio investment was mobilized in 1998, while a strong redemption of treasury bills held by foreigners took place. Other short term capital flows, including trade credits, also turned negative in 1998.

47. This decline in short term financing could not be compensated by the mobilization of higher medium and long-term financing. In particular, medium and long-term disbursements from multilaterals and official creditors declined somewhat in 1998 to about US$80 million. Also, while foreign direct investment increased in 1998 to about US$90 million, the level remained below that registered in other transition economies in central and eastern Europe. This reflected Moldova’ uneven track record of reform as well as a lack of transparency in the tax system and the conduct of tenders.10 In particular, international tenders for major enterprises in the energy, tobacco and telecommunication sectors have so far been disappointing or delayed (Table 8).

Table 8.

Moldova: Financing of Current Account Deficit and Amortization, 1995-98

(In millions of U.S. dollars)

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Sources: National Bank of Moldova; and Fund staff estimates.

48. As a result of these trade and financial shocks, the overall external balance deteriorated by 20 percent of GDP in 1998. The overall balance changed from a surplus of US$ 67 million in 1997 to a deficit of US$ 311 million in 1998. This led to a sharp loss of foreign exchange reserves (US$226 million) and the further accumulation of large external payment arrears (US$153 million) on account of public debt service payments (US$50 million) and energy payments (US$103 million), mainly to Russia.

Trade regime

49. Moldova’s trade regime is quite liberal. By 1996, import quotas had been eliminated and the number of import tariff band had been reduced to five, with a maximum tariff rate of 20 percent with few exceptions. However, in 1997, tariffs were raised on a number of goods, including capital goods, and taxes and restrictions were introduced on exports of grapes, unbottled wines, cereals, sunflowers seeds, and raw tobacco. As a result of these tariff increases, the simple average tariff rate (excluding alcohol, tobacco, and vehicles) rose from an estimated 6.3 percent to 11.6 percent (Table 9). Steps were taken in late 1998 to reverse this increasingly restrictive trade policy. Items in the 50 percent tariff rate category were reduced to 40 percent and the export bans and taxes were eliminated together with the seasonal tariffs on fresh fruits and vegetables and export licensing requirements. More importantly, with the 1999 budget, a maximum tariff rate of 15 percent was introduced without exception while all non-energy imports became subject to a minimum tariff rate of 5 percent, including imports from the CIS countries and Romania. As a result, since the beginning of 1999, the tariff structure features a simple three-tier system of 5, 10, and 15 percent and the simple average tariff rate is estimated to have been reduced to 8.6 percent. Furthermore, the consolidation of tariff rates resulted in a sharp decline of tariff dispersion, which is estimated at 5 percentage points, in 1999.

Table 9.

Import Tariff Developments 1/

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Sources; Information provided by the Moldovan authorities; and Fund staff estimates.

Based on 4,015 import categories, excluding alcohol, tobacco, and vehicles.

Preliminary estimates based on the measures adopted with the 1999 budget.

Tariff rate dispersion is the standard deviation of tariff rates from their mean.

50. Moldova has accelerated its negotiations for accession to the WTO with a view to membership by January 1, 2000. Following the last meeting of the Working Party in April 1999, bilateral negotiations on market access for goods and services were almost completed. Further negotiations were still needed concerning agricultural subsidies. In addition, Moldova has already free trade agreements will all CIS countries and Romania. It also signed an agreement on partnership and cooperation with the EU in late-1994.

External debt

51. As a result of the accumulation of large current account imbalances, Moldova’s external debt has grown at a rapid pace from virtually zero in the early 1990s to slightly above US$1 billion or 54.6 percent of GDP at end-1998 (Table 10 and Figure 10). Including arrears on energy supply, Moldova’s total external debt was almost US$1.4 billion at end-1998 (72.6 percent of GDP). Debt service payments rose to 27.6 percent of exports of goods and nonfactor services during the period. Major official creditors are the IMF, the World Bank, Russia, the EU, the United States, Japan, and Romania. Moldova was granted IDA eligibility by the World bank in April 1997 and became ESAF-eligible on March 23, 1999. In July 1997, following a favorable rating from international rating agencies, the authorities issues a five year US$75 million Eurobond. They also issued US$140 million of state bonds, in 1997 to reduce the stock of energy arrears to Gazprom (Table 10).

Table 10.

Moldova: External Debt Indicators, 1993-1998

(in millions of US dollars)

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Sources: National Bank of Moldova; and staff estimates.
Figure 10.
Figure 10.

Moldova: External Debt Indicators, 1993-1998 1/

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Sources: Moldovan authorities; and Fund staff estimates.1/ Excludes enterprises sector arrears to energy suppliers.

52. Moldova has accumulated large external arrears on energy supplies and debt obligations. As of end-1998, total arrears amounted to US$417 million (22.5 percent of GDP). Arrears on energy and other supplies, mainly to Russia, Ukraine, and Romania, reached US$333 million (18 percent of GDP). Arrears on public debt and public guarantees amounted to US$84 million at end-1998 and increased further to US$104 million at end-March 1999, of which US$21 million was interest payment arrears. The authorities were engaged in a number of negotiations to restructure these overdue obligations, mainly to Russia. In May 1999, a heavily discounted buyback operation of the US$140 million bonds to Gazprom was completed. In the meantime, a second issuance of state bonds to Gazprom worth US$90 million was contemplated following the agreement on a debt-equity swap in the gas sector, whereby Gazprom acquired a majority interest in Moldovagaz in return for the clearance of US$47 millions of arrears. A protocol rescheduling agreement with the Russian authorities was initialed in April 1999—though not ratified—covering the bulk of the Russian debt, including that to Oneximbank.11 Also, a rescheduling of the debt owed to Romania was agreed in July 1999. Other rescheduling discussions were launched with commercial creditors.

Exchange market and exchange arrangement

53. The Moldovan leu registered a remarkable period of stability from its inception on November 29, 1993 until August 1998. Following an initial modest depreciation, the official Mdl/US$ nominal rate remained within the 3.85-4.86 range between December 1993 and September 1998. During this period, the leu had depreciated in real terms against the currencies of the BRO countries, but appreciated against the currencies of other countries. However, while the exchange rate had already been under some pressure prior to the Russian crisis, the latter precipitated a major change in Moldova’s foreign exchange regime. In an attempt to preserve the managed float and the relative stability of the leu, the NBM pursued, from August to October 1998, a policy of exchange rate stabilization (at around Mdl 4.8/dollar), involving daily intervention of more than US$1 million of official reserves. Despite this heavy intervention, the exchange rate continued to depreciate by about 25 percent during August-October 1998 (Figure 11).

Figure 11.
Figure 11.

Moldova: Competitiveness Indicators, 1994-1999

Citation: IMF Staff Country Reports 1999, 110; 10.5089/9781451824933.002.A001

Sources: National Bank of Moldova, Moldova Department of Statistics, IMF IFS; and Fund staff estimates.1/ Increase indicates appreciation.

54. By end-October, the demand for foreign currency had increased substantially as domestic and foreign investors left the treasury bill market, notwithstanding the NBM’s tightened monetary policy. On November 2, in an attempt to regain control of monetary policy and stem the outflow of reserves, the NBM announced formally that it was ceasing its intervention in support of the leu. The NBM also announced that the daily fixing of the official rate was abolished. It is worth noting that no restrictions of an administrative nature were taken. After the initial shock, the exchange rate stabilized at around Mdl 8.5 per dollar by the end of the year after having nearly reached Mdl 10 per dollar in November. Following a period of relative stability at the beginning of 1999, the exchange rate depreciated again sharply in May/June to around Mdl 11-12/US$ reflecting mainly the fragility of public finances and political uncertainty in Russia. In real effective terms, the exchange rate rose by 23 percent in September 1998, with large intervention to support the rate, before depreciating by about the same magnitude by the end of the year. By end-May, the real effective exchange rate of the leu had depreciated almost 12 percent below the level prevailing before the crisis. By comparison, the Russian ruble depreciated by more than 40 percent during the period, the Ukrainian hryvnia appreciated by 6.6 percent and the Romanian leu depreciated by 21.8 percent. While the leu has appreciated somewhat vis-à-vis the Russian ruble since mid-1998, Moldova’s price competitiveness remained quite favorable with monthly average wages of around US$25 in mid-1999.

55. Moldova accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Fund’s Articles of Agreement on June 30, 1995. Since then, Moldova’s exchange system has remained free of any restrictions on current account transactions. As mentioned above, since November 2, 1999, the exchange rate of the leu is determined on the basis of supply and demand in the foreign exchange market (independently floating), with the central bank limiting its intervention to purchase foreign exchange to meeting its reserve target. Institutions eligible to deal in foreign exchange are authorized banks and foreign exchange bureaus, which set their own buying and selling rates in their foreign exchange transactions. There is no exchange tax or exchange subsidy and there is no official cover of forward operations in the forward exchange market. The NBM has concluded bilateral agreements on settlements with the central banks of the BRO countries. Moldova is also a member of the Payments Union within the CIS. Export proceeds are required to be repatriated within 180 days, though there is no surrender requirements. Capital account transactions require licenses and/or registrations from the NBM. The system is fairly liberal with regard to inflows and nonresidents

E. Structural Policies

56. Structural reforms proceeded in fits and starts in Moldova during 1998-1999. Reforms slowed in the run-up to parliamentary elections in March 1998, but were reinvigorated by a pro-reform majority coalition in parliament and a new government which took office in May. However, with the onset of the Russian financial crisis in August, the policy focus shifted somewhat to crisis management. Efforts resumed in late-1998, with a particular focus on the measures to address the preparations to break-up and privatize the energy sector, which has long been a serious handicap to financial stability and transformation. Land reform efforts accelerated throughout 1998. Unfortunately, the process was again thrown off track in early 1999 with the resignation of Prime Minister Ciubuc and an extended period of political uncertainty leading up to the formation of a new government in mid-March. The implementation of structural reforms has again been energized and is now focused on completing the privatization of the energy and telecommunications utilities and the liquidation of the former state and collective farms.

57. In mid-July 1999, the long-awaited privatization of the public gas company took place. The Russian gas supplier, Gazprom, took a majority stake in Moldovagaz, comprising 50 percent plus one share, and assumed responsibility over operations and collections for all future gas deliveries. The Moldovan government remains a minority shareholder, with 36 percent of the company, while the administration of the breakaway Transnistira region holds 14 percent. The intention of the authorities is to sell the stake held by the government as well, if possible to a western energy services company. This measure represents a major breakthrough because the gas sector has been the source of a considerable build up of external arrears and quasi-fiscal deficits.

58. Another key component of energy sector reform is the demonopolization, break-up, and privatization of the electricity sector. The former state monopoly electric utility, Moldenergo, was broken into separate firms specializing in generation, distribution, and transmission activities. An independent energy regulatory agency was set up in mid-1998, with tariff setting authority. The agency has adjusted tariffs several times to closely reflect costs. An international investment bank has been contracted as a privatization advisor for the five distribution companies (in three groups), which will be offered for tender later this year. The EBRD and IFC are supporting the project. Three generation units will be offered for sale in the first quarter of 2000, while the transmission enterprise, Moldtranselectro, will remain in state hands. Yet another component is the privatization of the state fuel company, Tirex Petrol, whose individual privatization and debt restructuring plan was recently approved by parliament. The firm should be sold by end-year. The two district heating companies, one covering the city of Chişinău and the other providing services to regional cities, are being broken up and converted to municipal utilities.

59. Privatization has also moved forward with the implementation of the 1998-1999 privatization program approved by parliament. Several larger sized Moldovan firms have been sold for cash and debt assumption to strategic investors, most notably a cement mill to a leading producer, Lafarge, a leather processing firm, several textile producers, a pharmaceutical plant, a number of wineries and a hotel in Chişinău.12 While initial efforts to sell a forty percent stake in the state telephone monopoly, Moldtelecom, via an EBRD-supported tender failed in 1997-1998, preparatory steps to launch a second tender for a majority stake to a strategic investor have been taken. An international financial audit of the firm is underway and a technical audit will follow. The government recently approved a law to establish an independent regulatory agency, and the EBRD and IFC intend to support the privatization with a convertible loan and technical support.

60. One of the most important, and largely successful, structural reform efforts to date has been the privatization of agriculture through the liquidation of the former state and collective farms and distribution of titled land to individual farmers. This project, which has received substantial financial and technical support from USAID and the World Bank, was initiated in 1997 as a pilot involving 73 farms. The program was expanded nationwide in 1998, and aims to complete the distribution of titles to more than 1 million farmers in 2000. As of mid-1999, over 900 state and collective farms have been included in the program and are at various stages of the process; 400 farms have reached the stage of liquidation, and land titles have been issued to around 200,000 farmers. The efforts have been closely coordinated with a World Bank supported project to create a national cadastre, and 38 regional cadastre offices have been set up to register land titles and transactions.13

61. Legal reforms have been proceeding although at a slower-than-expected pace, most notably regarding the long delayed Civil Code, a draft of which was finally presented to the government in late July after three years of work by a special commission. The bankruptcy law, last amended in 1997 is being applied but with some difficulty owing to court personnel and administrative bottlenecks. Nevertheless, some 100 firms are in the bankruptcy process. Also the collateral law was recently amended to improve the efficiency of land transactions, including mortgages, foreclosures and simultaneous recording of sale and purchase documents. The land market is increasing in activity, especially transactions in enterprise land.

III. fiscal federalism in moldova14

A. Introduction

62. Moldova is a unitary State with two levels of government. Sub-national governments comprise 38 middle-tier jurisdictions (rayons), excluding Transnistria, and local governments (municipalities, cities, villages, and communes). Each sub-national unit has a separate budget, which is consolidated with the State budget and the Social Fund in the general government accounts. Local spending in these sub-national units is financed by local tax and non-tax revenues, and transfers and grants from the State budget.

63. The Moldovan government is currently implementing a series of institutional reforms aimed at rationalizing public sector operations and strengthening intergovernmental fiscal relations. In 1998, the Moldovan Parliament passed the Law on the Administrative and Territorial Reform, which reduced the number of sub-national units from the existing 38 rayons to 11 regional governments, effective July 1, 1999. These regional governments comprise 9 judets, an autonomous regional authority (UTA Gagauzia), and the Municipality of Chişinău. The Law on Local Public Finances, passed by Parliament in July 1999, deals with the assignment of expenditure functions and revenue sources to the new regional and local governments, and their relationship with the State budget through revenue-sharing arrangements. In conjunction with the Law on Local Public Administration,15 the Law on Local Public Finances also contains provisions on tax administration, expenditure management, and budget execution.16

64. This section undertakes a brief examination of the current system of intergovernmental fiscal relations in Moldova. The impending changes are also analyzed to highlight the main improvements in the new system over the current system of intergovernmental fiscal relations and decentralized public sector provision.

B. The Current System

Revenue sources and expenditure functions

65. The assignment of tax bases to sub-national governments in Moldova is in accordance with general public finance principles. Broad, mobile tax bases are assigned to the State budget and narrow, immobile tax bases are assigned to regional and local budgets. The main tax bases assigned to sub-national budgets (rayons and local governments) are personal income, real estate and land taxes.17 Sub-national budgets also collect non-tax revenues in the form of royalties and fees for the use and exploitation of natural resources, user charges for goods and services provided locally, and land fees and duties. The State budget collects excises, the road tax, and foreign trade taxes,18 Due to their tax assignments, the rayons enjoy considerable tax autonomy: own tax revenues amounted to 46.9 percent of their total revenues on average in 1998.19 Non-tax revenues totaled 12.5 percent of rayons’ total revenues, on average, in 1998. Transfers from the State budget constitute another important source of revenue for sub-national budgets. Vertical imbalances—or the share of grants and transfers from the State budget in the total revenues of sub-national governments—amounted to 40.7 percent on average in 1998 (Table 11).20 These vertical imbalances vary significantly across rayons: transfers from the State budget ranged from nearly 16.8 percent of total revenues in Chişinău to 72.2 percent in Leova.

Table 11:

Fiscal Decentralization Indicators, 1998

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Sources: Ministry of Finance; and IMF staff calculations.

The share of tax and non-tax revenues in total revenues (net of transfers).

Includes capital revenues.

The share of transfers from the State budget in total revenues (net of transfers).

Weighted average.

66. Local budgets are relatively large when compared to the State budget The revenues of sub-national governments totaled 34 percent of State budget revenues, Mdl 186 per capita or 6.7 percent of GDP in 1998. Rayons spent 11 percent of GDP in 1998. With regard to expenditure functions, the rayons financed approximately two-thirds of education spending, and approximately 60 percent of health spending in 1998. The fiscal stance of sub-national governments also differs from that of the central government. Local budgets had a cash surplus of Mdl 59 million in 1998 (or Mdl 16 per capita) whereas the State budget had a cash deficit of Mdl 300 million (or Mdl 79 per capita) (Table 12).

Table 12:

Sub-national Governments’ Budget, 1998

(in per capita terms)

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Sources: Ministry of Finance; and IMF staff calculations.

Includes tax (net of transfers), non-tax, and capital revenues.

Expenditures minus revenues (net of transfers).

From the State budget to local budgets.

Weighted average.

Revenue sharing arrangements

67. The revenues of the corporate income tax and VAT are shared between the State and local budgets.21 The State budget is entitled to 50 percent of corporate income tax revenues, and the local budgets keep the remaining 50 percent.22 In the case of VAT, the local budgets’ share of total revenues ranges between 20 and 30 percent.23 24

68. The revenue-sharing system in Moldova is inefficient and deepens vertical imbalances between State and local budgets. In the current system, intergovernmental transfers are aimed at bridging the gap between local revenues and expenditures. The system is inefficient for a number of reasons:

  • When revenue sharing is aimed at filling the gap between sub-national governments’ total revenues and expenditures, local budgets face the incentive to inflate expenditures and engage in perennial negotiations with the central government to attract more transfers from the State budget. Revenues are therefore diverted from the State budget, leading to a misallocation of resources between the State and local budgets.

  • Gap-filling revenue-sharing systems also induce local budgets to under-utilize their own tax bases and finance local spending with resources transferred from the State budget. As a result, the cost of public sector provision can be exported to other jurisdictions by shifting the financing burden from local tax revenue mobilization to transfers from a common pool of sharable taxes.25

  • The current gap-filling system does not equalize expenditure functions or revenue mobilization capacity among sub-national units on a per capita basis. Regional inequalities are therefore perpetuated.26 This is because the demand for public goods and services tends to be higher in richer rayons, leading to more transfers from the State budget for the same level of revenues. In this case, richer rayons may receive more transfers in per capita terms than poorer rayons. The rayons also face little incentive to collect more local taxes in line with the rising demand for government provision of public goods and services. In the current system, the central government is also unable to ensure minimum provision standards throughout the country.27

C. The New System

Revenue and expenditure functions

69. In the new system, the assignment of tax bases to sub-national governments remains broadly unchanged. As in the current system, the main taxes assigned to sub-national governments are personal income, real estate, and land taxes. The State budget collects excises, the road tax, and foreign trade taxes. The revenues of the corporate income tax and VAT are shared between the State and local budgets according to a revenue-sharing formula. The shares (deductions) have nevertheless changed in the new system. The State budget is entitled to 30 percent of corporate income tax revenues, and local budget keep the remaining 70 percent. In the case of VAT, local budgets are entitled to 20 percent of total revenues.28

70. In terms of expenditure function assignments, the new system has deficiencies. There is potential overlap in the assignment of road construction and maintenance spending functions between judges and local governments.29 The legislation is also unclear as to whether judets or local budgets should fund secondary education (lyceums and gymnasiums),30 and health spending (medical centers and local clinics).31 The legislation is also unclear as to the assignment of maintenance expenditure functions between judets and local governments. Co-financing may be envisaged in these areas as long as institutional arrangements are in place and a suitable co-financing formula is defined.

Revenue sharing arrangements

71. In the new system of local public finances, revenue sharing is aimed at equalizing expenditure levels among sub-national jurisdictions on a per capita basis. In addition to the changes in the parameters of the revenue-sharing formula, the main improvements of the new system over the current gap-filling system of revenue sharing are as follows.

  • The new system defines per capita expenditure norms for each sub-national unit. Resources are then transferred to these jurisdictions to close the gap between per capita revenues and the respective per capita expenditure norms, rather than the actual expenditures of each sub-national unit (Table 13). Table 14 presents the expenditure norms for each new sub-national unit using 1999 estimates.32 By shifting emphasis from actual spending to expenditure norms in the revenue-sharing formula, a minimum level of provision of public goods and services can be ensured, despite differences in revenue mobilization capacity across sub-national units.

  • The new system excludes local tax and nontax revenues from the revenue estimates used in the revenue-sharing formula (Table 15). This encourages sub-national governments to fully utilize their local bases and non tax sources of finance. Tax effort is encouraged as revenues collected locally are not shared horizontally with other regional governments. A stronger association is therefore created between the costs and benefits of public sector provision.

Table 13:

New Revenue-Sharing System, 1999 1/

(In per capita terms, unless otherwise indicated)

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Sources: Ministry of Finance; and IMF staff calculations.

Under the Law on the Administrative-Territorial Reform and the Law on Local Public Finances.

1999 estimates.

Expenditures minus revenues (net of transfers).

Revenue gap times population.

Weighted average.

Table 14.

Sub-national Government Expenditure Estimates by Category, 1999

(In thousands of lei)

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Sources: Ministry of Finance; and IMF staff calculations.