Former Yugoslav Republic of Macedonia: Staff Report for the 2001 Article IV Consultation

This 2001 Article IV Consultation highlights that after three consecutive years of generally favorable performance, the economy of the Former Yugoslav Republic of Macedonia (FYRM) suffered a setback in 2001 because of a six-month security crisis. Output declined markedly and new outlays on security operations and weak revenues contributed to a large expansionary fiscal swing. Owing to a deterioration of the external current account position, the foreign exchange loss was heavy. However, the impact on reserves was cushioned by sizable privatization inflows in early 2001.

Abstract

This 2001 Article IV Consultation highlights that after three consecutive years of generally favorable performance, the economy of the Former Yugoslav Republic of Macedonia (FYRM) suffered a setback in 2001 because of a six-month security crisis. Output declined markedly and new outlays on security operations and weak revenues contributed to a large expansionary fiscal swing. Owing to a deterioration of the external current account position, the foreign exchange loss was heavy. However, the impact on reserves was cushioned by sizable privatization inflows in early 2001.

I. Introduction

1. Discussions for the Article IV consultation with the authorities of the former Yugoslav Republic of Macedonia (FYRM) were held in Skopje during November 27-December 5, 2001.1 The staff met with President Trajkovski; Prime Minister Georgievski; Governor Trpeski of the National Bank of Macedonia (NBM); all economic ministers; key senior officials of the government, the NBM, major commercial banks, the Chamber of Commerce, and labor unions; and representatives of the international community.

2. The last Article IV consultation was concluded by the Executive Board on May 10, 2000 (SUR/00/39, 5/16/00). On that occasion, and subsequently during the approval of a PRGF/EFF-supported program on November 29, 2000 (EBS/00/231, 11/15/00), Directors noted the authorities’ successful efforts in maintaining financial stability despite the difficult regional situation. However, they emphasized the importance of accelerating reforms and urged the authorities to firmly implement the reform agenda in the fiscal area and in the enterprise and financial sectors in order to underpin high economic growth.

3. The PRGF/EFF-supported program went off track in late-December 2000. The situation became further complicated as the country became embroiled in a security crisis for six months through August 2001, with far-reaching impact on the economy. A mission in June 2001 did not conclude the discussions for the first review under the PRGF/EFF arrangements. As the objectives of the program—on the macroeconomic side as well as the poverty reduction aspects2 and participatory Poverty Reduction Strategy Paper—were unlikely to be achieved in the aftermath of the crisis, and there were concerns about a slowdown in key structural reforms, the authorities requested cancellation of the PRGF/EFF arrangements on November 22, 2001. Only SDR 2.87 million of the approved access of SDR 34.45 million was disbursed/purchased under the arrangements. Subsequently, the authorities requested, and management endorsed, staff monitoring of their program of economic policies for six months starting January 1, 2002. The letter of intent and the memorandum of economic policies of the staff monitored program (SMP) were issued to the Executive Board on December 26, 2001 (EBS/01/213).

4. The SMP is meant to provide a framework for donors to give financial assistance to FYRM until a follow-up program to be supported by an upper credit tranche arrangement with the Fund can be put in place. The donor community has indicated its willingness to support post-conflict reconstruction, balance of payments need, and measures for resolving ethnic demands envisaged under a Peace Framework Agreement that was signed by the country’s political leaders in mid-August 2001. However, the convening of a donor meeting—now scheduled for March 12, 2002—was held up because of delays in meeting two political preconditions: constitutional amendments to improve the civil rights of minority ethnic Albanians were ratified by the FYRM parliament only in November 2001, and a law on local government providing greater autonomy to municipalities was passed only in late January 2002.

5. While the security situation has improved significantly since the signing of the peace agreement, the political situation remains unsettled. Pressures are mounting on the government to hold elections ahead of the normal schedule of October/November 2002.

6. FYRM has accepted the obligations of Article VIII, Section 2, 3, and 4, with effect from June 19, 1998. The country maintains an exchange restriction subject to Article VIII, Section 2(a) arising from the treatment of former frozen foreign currency savings deposits (see paragraph 43). FYRM’s relations with the Fund and the World Bank Group are summarized in Appendices I and II, respectively.

7. FYRM’s statistical data, particularly in the areas of real sector, government finance statistics, and balance of payments, suffer from weaknesses that hamper analysis and program monitoring (Appendix III). The authorities have made efforts to redress the gaps, with technical assistance from the Fund and EuroStat, but progress has been slow. Reflecting institutional weaknesses, progress in the preparation of General Data Dissemination System (GDDS) metadata since the designation of a GDDS coordinator in March 2001 has been slow.

II. Background and Recent Developments

8. After three consecutive years of generally favorable performance, the FYRM economy suffered a setback in 2001 because of the security crisis. Output declined markedly. New outlays on security operations and weak revenues contributed to a large expansionary fiscal swing. Owing to a deterioration of the external current account position, the foreign exchange loss was heavy, though the impact on gross international reserves was cushioned by sizeable privatization inflows early in the year (Table 1). However, slippage on the stabilization front was discernible even before the eruption of the security crisis. The following end-December 2000 performance targets of the PRGF/EFF-supported program were not met: net bank credit to the general government (performance criterion), central government budget balance (indicative target), personnel expenditures financed from special revenue accounts (benchmark), and preparation of a plan for divestment of non-core government activities (structural benchmark).

Table 1.

FYRM: Selected Economic Indicators, 1999-2002

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Sources: Data provided by the FYRM authorities; and IMF staff projections.

Percent change relative to the same period of the previous year.

Percent change relative to December of previous year.

Percent of the annual GDP.

Assumes that financing gap is filled by donor support.

Data as reported under the PRGF/EFF-supported program (EBS/00/231), except ratios to GDP that are based on a nominal GDP calculated by applying the growth expected under the program to the actual 2000 outturn.

Total debt of the general government; includes liabilities assumed by the government upon the sale or closure of loss-making enterprises and associated with the cleaning up of Stopanska Banka’s balance sheet prior to its sale.

Includes foreign currency deposits.

Includes receipts from privatization of telecommunications company of US$323 million in January 2001.

Debt service due, including IMF, as a percentage of exports of goods and services.

An increase means appreciation of the denar. Partner countries exclude Federal Republic of Yugoslavia.

9. Real GDP declined by an officially estimated 4½ percent in 2001, though the labor market does not appear to have been adversely affected. Economic activity weakened as a result of a sharp erosion of consumer and business confidence and a drought-induced agricultural slowdown. The contraction of output was broad-based, but excluded the government sector where activities were boosted by the security-related operations. Inflation was driven mainly by higher food prices, and slowed only slightly to 5.3 percent for 2001 as a whole. The annual labor force survey, conducted in October 2001, indicates a fall of 1.7 percentage points in the unemployment rate to 30.5 percent. The number of jobseekers registered in the employment bureau dropped by about 3½ percent in the 12-month period ended September 2001. These trends reflect a buoyant informal economy and the recruitment of a large number of reservists in the police and the army. Employment in the registered enterprise sector fell by about 4 percent during the same period. Wage pressure in the registered enterprise sector was muted in 2001, as reflected in a decline in real wages of nearly 2 percent (Figure 1 and 2).

Summary of General Government Fiscal Developments, 2000-01

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Figures for ratio to GDP for the 2001 budget are based on a nominal GDP that is calculated by applying the growth expected under the PRGF/EFF-supported program (EBS/00/231) to the actual 2000 GDP outturn.

Figure 1.
Figure 1.

FYRM: Economic Activity Indicators, 1998-02

Citation: IMF Staff Country Reports 2002, 047; 10.5089/9781451826005.002.A001

Sources: Data provided by the FYRM authorities; and IMF staff projections.
Figure 2.
Figure 2.

FYRM: Prices, Wages, and Unemployment, 1998-01

Citation: IMF Staff Country Reports 2002, 047; 10.5089/9781451826005.002.A001

Sources: Data provided by the FYRM authorities; and IMF staff projections.1/ Includes education, science, culture and information; health and social security; and bodies of state administration, local administration, political parties, social organizations and associations.2/ Covers the period January-September 2001.

10. The fiscal outturn in 2001 was substantially worse than anticipated in the original budget. Because of the crisis, additional spending on military equipment and on security personnel amounted to 6¾ percent of GDP. Tax receipts were lower than forecast in the budget in nominal terms, reflecting a weaker economy, but roughly similar if measured as a ratio to GDP. In the second half of the year, the authorities embarked on a public investment program funded from privatization receipts, with outlays reaching about ½ percent of GDP by year-end. Partly to offset the pressures on the budget, the authorities postponed revenue-reducing measures originally envisaged for June (1½ percent of GDP), and introduced on July 1, for a six-month period, a new tax on financial transactions (which yielded the equivalent of about 1¼ percent of GDP). Also, foreign-financed expenditure on road construction was about ¾ percent of GDP lower than budgeted. Thus, the general government accounts recorded a deficit of 6 percent of GDP in 2001, compared with about 1 percent envisaged in the budget (Table 2 and 3).3 The fiscal outturn in 2001 represents an expansionary fiscal swing of 8½ percent of GDP relative to 2000. Of this swing, 1½ percentage points of GDP is accounted for by revenue-reducing measures that were introduced in the beginning of 2001 and another 1½ percentage points of GDP reflects the impact of cyclical factors.

Table 2.

FYRM: Central Government Operations, 2000-2002

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Source: Data provided by the FYRM authorities; and JMF staff projections.

Excludes most of the costs of implementing the Peace Framework Agreement.

Figures for ratios to GDP for the 2001 budget are based on a nominal GDP that is calculated by applying the growth expected under the PRGF/EFF-supported program (EBS/00/231) to the actual 2000 outturn.

Other taxes includes revenues from the tax on financial transactions.

The Ministry of Finance records wages and allowances of reservists under goods and non-labor services.

This amount refers to the second round of policy measures that were scheduled to be implemented in June 2001.

Includes expenses by the Ministry of Defense and by the Ministry of Internal Affairs.

Table 3.

FYRM: General Government Operations, 2000-2002

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Source: Data provided by the FYRM authorities; and IMF staff projections.

Excludes most of the costs of implementing the Peace Framework Agreement.

Figures for ratios to GDP for the 2001 budget ate based on a nominal GDP that is calculated by applying the growth expected under the PRGF-EFF-supported program (EBS/00/231) to the actual 2000 outturn.

Other taxes includes revenues from the tax on financial transactions.

The Ministry of Finance records wages and allowances of reservists under goods and non-labor services.

This amount refers to the second round of policy measures that were scheduled to be implemented in June 2001.

Includes expenses by the Ministry of Defense and by the Ministry of Internal Affairs.

11. The external current account deficit (excluding grants) is estimated to have widened by about 5 percentage points of GDP to 10¾ percent of GDP in 2001. A major contributory factor was a crisis-induced sharp drop in net inflows of private transfers. The trade balance improved, as imports were severely compressed on account of lower domestic demand and more than offset a marked decline in export earnings. Exports suffered in part because of the crisis but mainly on account of sector-specific problems in the steel industry that began in the last quarter of 2000. Excluding steel, exports were down by 4 percent. During the six-month crisis period, unrecorded inward transactions—reflecting in part purchases by KFOR and Kosovo residents during cross-border trips to FYRM—shrunk and trade credits turned negative as importers were asked to pre-pay their imports. Thus, since the beginning of the crisis in late February through end-December, gross official reserves declined by about US$160 million (about 22 percent of total reserves at the beginning of the year). However, owing to receipts of US$323 million (or 9½ percent of GDP) from the privatization of the telecommunications company in January 2001, gross foreign exchange reserves remained at a relatively comfortable level of US$779 million, equivalent to 4.7 months of next year’s imports, at end-December 2001 (Figure 3 and 4, and Table 4).4

Figure 3.
Figure 3.

FYRM: Saving-Investment Balances, 1998-02

Citation: IMF Staff Country Reports 2002, 047; 10.5089/9781451826005.002.A001

Sources: Data provided by the FYRM authorities; and IMF staff projections.
Figure 4.
Figure 4.

FYRM: External Sector Developments, 1998-02

Citation: IMF Staff Country Reports 2002, 047; 10.5089/9781451826005.002.A001

Sources: Data provided by the FYRM authorities; and IMF staff projections.1/ Exports to all European countries (including Russia, Ukraine, and Belarus) other than Albania, Bulgaria, Greece, and Turkey.2/ Includes unidentified short-term capital, such as trade credits, imports paid by drawdown of foreign-held accounts, and unrecorded remittances and exports.3/The increase in January 2001 reflects privatization receipts from the sale of a majority stake in the telecommunications company.
Table 4.

FYRM: Balance of Payments, 1999-2002

(In millions of U.S. dollars)

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Sources: Data provided by the FYRM authorities; and IMF staff estimates.

Includes trade credits.

Private sector arrears.

Refers to deferral of debt service to Paris Club creditors from April 1999 through March 2000.

Goods and nonfactor services (GNFS).

Underlying reserves exclude net saving from privatization receipts.

Debt service due including IMF as percent of exports of goods and services.

Including IMF.

12. The NBM was challenged in the conduct of monetary policy by the expansionary fiscal stance and an erosion of market confidence in the denar. Pressure on the foreign exchange market, which initially appeared in early 2001 following a fiscal-policy induced expansion of liquidity, intensified with the onset of the security crisis. In mid-June 2001, the spreads between the official exchange rate and the rates in the inter-firm market and foreign exchange bureaus peaked at 7 percent and 12 percent, respectively (from 0.6 percent and 1.7 percent, respectively, at end-December 2000; Figure 5).5 Experiencing substantial foreign exchange loss, the NBM began to tighten monetary policy after some hesitation. During May-June, the remunerated reserve requirement was increased in two steps by 2 percentage points and the interest rate on 28-day central bank bills was more than doubled to 20 percent. In addition, in August the period for surrendering export proceeds was shortened from 180 days to 30 days, with the aim of increasing the supply of foreign exchange. These initiatives and the signing of the peace framework agreement helped restore normalcy in the foreign exchange market by mid-August. Major banks followed the NBM by slightly raising deposit and lending rates, and cut back private sector lending in the third quarter after a relatively expansionary first half. During January-August, the NBM sold nearly US$140 million (or, slightly over 4 percent of GDP) through foreign exchange market intervention. Prompted by the subsequent calm conditions in the foreign exchange market and an increased demand for bills by commercial banks, the NBM lowered the interest rate on bills in two steps by 5 percentage points to 15 percent on November 19 (Figure 6).

Figure 5.
Figure 5.

FYRM: Foreign Exchange Rate Spreads, 1998-01

Citation: IMF Staff Country Reports 2002, 047; 10.5089/9781451826005.002.A001

Sources: National Bank of Macedonia; and Exchange Bureaus.
Figure 6.
Figure 6.

FYRM: Money, Credit, and Interest Rates, 1997-01

Citation: IMF Staff Country Reports 2002, 047; 10.5089/9781451826005.002.A001

Source: The National Bank of Macedonia.1/ Includes foreign currency deposits.

13. Appreciation pressures emerged in the foreign exchange market in December 2001, as residents deposited cash foreign currency savings in banks to facilitate conversion into euros and as the demand for denars increased markedly. It is estimated that euro conversion boosted foreign exchange deposits in the banking system by about US$340 million (or, nearly 10 percent of GDP) toward the end of the year. Much of these deposits is expected to be temporary; an estimated 20 percent was withdrawn in January 2002. In a reversal of the pattern in the first three quarters of 2001, the NBM purchased US$51 million through intervention in the foreign exchange market during the fourth quarter as confidence in the denar grew and the balance of payments position improved.

14. On the structural front, progress in civil service reform, strengthening bank supervision, and reforming the payments system was notable. In the first half of 2001, gross employment in the public administration was reduced by 6½ percent (or, 4,500 persons) through voluntary separation and early retirement. In the banking sector, the regulatory framework of bank supervision was strengthened, the soundness rating of three out of the eight “problem” banks was upgraded as they showed improvement in their operation, and two problem banks merged with other banks. The reform of the Payments Operations Bureau (ZPP), including the implementation of a new payments system operated by the NBM for large transactions and the commercial banks for small transactions, was completed by end-2001. However, the progress toward divesting non-core government activities and resolution of loss-making enterprises was slow, in part because of the complications created by the security crisis.

III. Report on the Discussions

15. The authorities recognized that reversing last year’s large expansionary fiscal swing and continuing to strengthen the fiscal position over the medium term would be a major challenge. The likely availability of large donor financing in 2002 would ease the adjustment burden, but durable measures would be essential to rein in the fiscal deficit progressively so as to put the external current account on a sustainable footing. Such a policy stance also would be consistent with stabilizing the government’s net debt as a ratio to GDP (projected at about 40 percent in 2002).6 They emphasized, however, that over the medium term, tensions are likely to arise in formulating policy measures because of incipient strains on the revenue side7 and spending pressures in a number of priority areas: security operations; reforms of the enterprise sector, public administration, and pension system; decompression of the wage structure of civil servants; and agreed measures under the peace framework agreement. Over the next three years, the government planned to draw down the substantial privatization receipts received in early 2001 for already earmarked expenditures. Ensuring efficient use of these resources would be vital for establishing a strong foundation for growth. The discussions with the authorities covered these issues as well as a stabilization program and external financing need for 2002. Quantitative benchmarks have been established for end-March and end-June 2002 for staff monitoring of the authorities’ program (¶s 18, 20, and 26).8

16. The policy framework for 2002 excludes new expenditures on implementing the peace framework agreement, except for a few minor items. At the time of the discussions, only partial estimates of the fiscal costs of the peace framework agreement were available (see Box). A comprehensive assessment of the costs will be possible once a road map for implementation of the measures has been determined. The authorities stressed that without donor support to cover the bulk of these costs, the implementation of the peace agreement would suffer.

A. Outlook for 2002 and the Medium Term

17. The outlook for economic growth and inflation in 2002 should improve with the cessation of hostilities. The authorities envisaged real GDP growth of 4 percent, on the basis of a revival of business confidence, reconstruction spending by the donor community, and a return of favorable weather for agriculture. The staff agreed with this assessment. However, downside risks to the growth forecast have emerged, as latest available data indicate that the expected turnaround in industrial activity in the fourth quarter of 2001 was absent. Average inflation is expected to decline to 2½ percent in 2002, taking into account the projected recovery in agriculture and lower international oil prices.

18. The impetus to growth in 2002 is likely to come mainly from domestic demand. No significant recovery in export performance is expected in the near term, owing to the perception of FYRM’s increased country risk and the economic slowdown in FYRM’s main trading partners. Textile exporters experienced difficulties in renewing purchase contracts for the fall and winter production cycles, and some had to lower prices. They expected the forthcoming contract negotiations for the next production cycle to be difficult, but were hopeful of market conditions improving in the later part of 2002. Still, the steel sector’s specific problems are unlikely to be resolved quickly. As for imports, a moderate increase is forecast. Consumption and investment goods should pick up with the rebound in economic activity and the sizeable decrease of excise duty on cars in November 2001. However, this pick up would be partly offset by a decline in security-related imports and lower oil prices. The recovery in private transfers receipts that began in the later part of 2001 is likely to carry over into 2002. Accordingly, the external current account deficit, excluding grants, is expected to narrow by 1 percentage point to 9¾ percent of GDP.

19. A sizeable external financing gap is estimated for 2002. An increase in identified financing from bilateral and multilateral sources is foreseen. But, foreign direct investment is expected to fall sharply from the exceptional levels of 2000-01, which were boosted by a few large privatization deals. With the return to peace, it is assumed that trade credit and unrecorded transactions would revert to their traditional positive pattern. The authorities indicated that their objective was to increase the underlying level of gross reserves (i.e., excluding the net saving of telecom privatization proceeds) to the equivalent of 4 months of next year’s imports of goods and services. In view of the prevailing uncertainties and associated risks to the balance of payments, they considered this level of reserve coverage—which is comparable to that prevailing in other countries in the region—essential for sustaining confidence in the de facto exchange rate anchor. On this basis, an exceptional financing gap of US$163 million would emerge, before the financing need for implementing the peace agreement. The international community has indicated its willingness to help close the financing gap via a donor meeting (¶10). Some donors—notably the World Bank, EU, and the Netherlands—have already begun disbursing assistance ahead of the donor meeting.

The Implementation Costs of the Peace Framework Agreement

After months of hostilities between FYRM’s security forces and ethnic-Albanian armed groups, a Peace Framework Agreement (PFA) was signed on August 13, 2001 between the four main political parties representing the two largest ethnic groups. The agreement aims at advancing the cause of minorities through

  • establishing rules for the use of minority languages, including the use of these at different levels of government and the allocation of funds for a new TV and a new radio station in the Albanian language;

  • ensuring non-discrimination and equitable representation of minorities in the public administration, including increasing the representation of ethnic-Albanians in the police force;

  • improving the access of minorities to primary and secondary education in their own language; and

  • promoting the development of local governments with increased responsibilities in the delivery of public services, in particular health and education.

The authorities have carried out a preliminary assessment of the costs of implementing the PFA. The degree to which the costs have been fully determined depends in large measure on how much detail the PFA provides on each reform area. In addition, in some areas, discussions are still ongoing among the signatories of the PFA.

In this context, the authorities’ cost assessment in the first two reform areas listed above is well-advanced. Still pending are the identification of recurrent costs arising from the operation of the new TV and radio stations, and the maintenance costs of the new police stations. The costs of increasing the representation of minorities in the non-security-related public administration have not been completed, though resource needs have been identified to examine alternative modalities to achieve this objective (e.g. implementation timeframe and hiring policies).

By contrast, the cost assessment in the remaining two reform areas listed above is much more indicative than final, as the road map for these reforms is still being defined at a political level. The authorities have identified immediate financial and technical assistance needs, such as those required to train personnel in local governments. But key parameters of the decentralization process remain unknown. For example, the number of municipalities has yet to be defined and the modalities for decentralizing government functions have not been decided.

In sum, the costs that have been identified amount to US$70 million for the period 2002-04, or 1.8 percent of GDP over a three-year period, but many one-time and recurrent costs have yet to be identified. The costs of each reform area are listed in the table below, identifying one-time and recurrent costs. The authorities have indicated that implementation of the agreement may suffer if donors do not cover the bulk of these costs.

Peace Framework Agreement Costs

(In millions of US$)

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Notes: OT refers to one-time expenses, R refers to recurrent expenses, and T refers to total expenses. C identifies cost estimates or reform agendas that are complete, and I denotes that these estimates and agendas are indicative or in the process of being finalized, in which case the cost estimates presented are subject to change.

20. Looking beyond 2002, in the staffs view, sustaining high growth without recourse to exceptional foreign financing would require rising government saving. Economic growth at 4-5 percent annually over the medium term appears feasible as perceptions of political and security risks recede and provided prudent macroeconomic policies are maintained and efforts to address the structural weaknesses of the economy are reinforced. The Stabilization and Association Agreement signed with the EU in 2001 and the recent free-trade agreements with a host of countries should enable greater market access to FYRM’s exporters. A substantial increase in non-government investment—associated with the quest for new export markets, enterprise restructuring, and infrastructure development—is also seen as a major contributory factor to growth. Non-government saving is expected to rise, spurred by enterprise restructuring and improved governance, though not to the same extent as the increase in investment. It is further assumed that project lending by bilateral and multilateral parties will be forthcoming at the current nominal level, private borrowing and foreign direct investment will increase modestly, and that there will be no exceptional financing (except for covering the costs of implementing the peace framework agreement) from 2003 onward. On this basis, the external current account deficit (excluding grants) should reduce by 2 percentage points of GDP to 7½ percent of GDP by 2005. Under this scenario, total external debt ratio would fall slightly to 40½ percent in 2005 and debt service capacity would improve. Consistent with the external current account deficit path, the general government budget deficit would need to fall by 3 percentage points of GDP from 3.4 percent of GDP in 2002 to 0.3 percent of GDP in 2005 (Table 5 and 6).

Table 5.

FYRM: Medium-Term Balance of Payments, 1998-2005

(In millions of U.S. dollars)

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Sources: Data provided by the FYRM authorities; and IMF staff estimates.

Includes trade credits.

Private sector arrears.

Refers to deferral of debt service to Paris Club creditors from April 1999 through March 2000.

Goods and nonfactor services (GNFS).

Underlying reserves exclude net saving from privatization receipts.

Debt service due including IMF as percent of exports of goods and services.

Including IMF.

Table 6.

FYRM: Macroeconomic Framework, 1998-2005

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Sources: Data provided by the FYRM authorities; and IMF staff projections.

External current account deficit, including grants (+).

Equal to gross domestic investment minus foreign saving.

Equal to gross national saving minus net factor income and transfers from abroad.

Negative figure implies that revenue-enhancing or expenditure-reducing measures are required.

Includes domestic debt of central government and external debt of general government. Figures include bonds issued in 2001 for the frozen foreign currency deposits, as well as liabilities assumed by the government as of end-March 2000 on account of bank and enterprise restructuring, but exclude obligations for retroactive payments to pensioners.