Former Yugoslav Republic of Macedonia: Staff Report for the 2003 Article IV Consultation and Request for Stand-By Arrangement

This paper evaluates the 2003 Article IV Consultation and a Request for a Stand-By Arrangement (SBA) for the Former Yugoslav Republic of Macedonia (FYRM). The Article IV policy discussions focused on regaining a sustainable fiscal and external position, restarting economic growth and job creation, and addressing vulnerabilities resulting from public sector indebtedness, banking sector fragility, and euroization of bank and government balance sheets. FYRM has also requested IMF support of the program under an SBA in the amount SDR 20 million.

Abstract

This paper evaluates the 2003 Article IV Consultation and a Request for a Stand-By Arrangement (SBA) for the Former Yugoslav Republic of Macedonia (FYRM). The Article IV policy discussions focused on regaining a sustainable fiscal and external position, restarting economic growth and job creation, and addressing vulnerabilities resulting from public sector indebtedness, banking sector fragility, and euroization of bank and government balance sheets. FYRM has also requested IMF support of the program under an SBA in the amount SDR 20 million.

I. Introduction

1. A staff team1 visited Skopje during January 22-February 7, 2003 to hold Article IV consultation discussions and reach understandings on policies for a Fund-supported program (Appendix I). The authorities have requested a stand-by arrangement in the upper credit tranches in the amount SDR 20 million (29 percent of quota) during the period from Board approval through June 15, 2004 (Appendix II).

2. The country is gradually stabilizing after the 2001 security crisis which ended with the August 2001 Ohrid peace framework agreement (PFA). Ethnic violence has receded. The new government, a coalition including representatives of both major ethnic groups, marked its hundredth day in office during the mission. After some initial teething problems, the government is functioning more effectively although it continues to face challenges in bringing ethnic Albanians, including members of former armed groups, into the political mainstream in the face of opposition from many ethnic Macedonians. A high-profile anti-corruption campaign has strong public support, but is seen by the opposition as politically motivated.

3. FYR Macedonia 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. FYR Macedonia’s relations with the Fund are summarized in Appendix III. After the cancellation of FYR Macedonia’s PRGF/EFF on November 22, 2001, the authorities requested staff monitoring of their policies for six months, starting January 1, 2002. In the event, fiscal execution departed significantly from the policies in the staff monitored program owing mainly to a large public sector salary increase and payments to investors in collapsed pyramid schemes.

4. The last Article IV consultation was concluded by the Executive Board on March 4, 2002 (SM/02/56). On that occasion Directors stressed the need to return to fiscal probity, accelerate structural reforms, and adequately fund implementation of the peace agreement.

II. Background

5. In the three years before the 2001 security crisis economic activity grew by 4 percent a year on average and the unemployment rate came down significantly (text figure), while prices were stable. This favorable performance reflected some progress with structural reforms in the context of sound macroeconomic policies. Restrained fiscal policy made room for private sector expansion while inflation was in low single digits, anchored by the de facto peg of the denar to the deutsche mark. Foreign exchange reserves increased as a result of a few large foreign direct investments and relatively moderate current account deficits.

6. The security crisis, which erupted in the spring of 2001, halted growth and disrupted macroeconomic balance. While the loss of life and destruction of property were limited, the crisis slowed structural reform and sapped business confidence. Real GDP declined by 4½ percent in 2001 and a further 1½ percent (year-on-year) in the first six months of 2002 (Table 1; Figures 1 and 2).

Table 1.

FYRM: Selected Economic Indicators, 1998-2004

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

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

Estimate.

Percentage change relative to December of previous year.

January-November 2002.

January-September 2002.

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 include Federal Republic of Yugoslavia and Bulgaria.

Figure 1
Figure 1

FYRM: Selected Economic Indicators, 1996-2003 1/

Citation: IMF Staff Country Reports 2003, 131; 10.5089/9781451826012.002.A001

Sources: Macedonian authorities; and Fund staff estimates.1/ Data for 2002 are estimates; and data for 2003 are projections.
Figure 2
Figure 2

FYRM: Real Sector Developments, 1998-2002

Citation: IMF Staff Country Reports 2003, 131; 10.5089/9781451826012.002.A001

Sources: Macedonian authorities; and Fund staff estimates.

7. Government spending ballooned during the crisis—and in the run-up to elections in 2002. Security spending, though partly financed by an emergency financial transactions tax, nonetheless propelled the general government deficit to 7¼ percent of GDP in 2001 (compared with a surplus of 1¼ percent of GDP in 2000).2 A fiscal consolidation planned for 2002 did not materialize owing to the postponement of security personnel demobilization and a pre-election spending surge (Tables 2 and 3). The impact of the deficits was cushioned by a large inflow of proceeds from telecoms privatization in 2001 and donor finance (to support the PFA) in early 2002.

Table 2.

FYRM: Central Government Operations, 2000-2004 1/

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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. These costs are financed off-budget during 2002-04.

The Ministry of Finance records wages and allowances of reservists during 2001-03 under goods and non-labor services.

Excludes foreign-financed capital expenditure projects. These projects are included in the general government operations (Table 3).

Expenditures by the Ministry of Defense and by the Ministry of Internal Affairs.

Table 3.

FYRM: General Government Operations, 2000-2004 1/

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

Includes all donor funded investment projects carried out by government institutions except a large share of the costs of implementing the Peace Framework Agreement (PFA). Most of tiie PFA costs are financed off-budget during 2002-04.

The Ministry of Finance records wages and allowances of reservists during 2001-03 under goods and non-labor services.

Expenditures by Oie Ministry of Defense and by the Ministry of Internal Affairs.

8. These privatization and donor receipts—together with monetary tightening—made it possible to maintain the exchange rate peg and keep inflation low against the backdrop of large fluctuations in monetary aggregates. The uncertainties arising from the security crisis put significant pressure on gross official reserves. A surge in foreign exchange deposits in late 2001 related to the introduction of the euro was followed by a partial withdrawal (about a third of the original increase) during the first half of 2002 (Tables 4 and 5; and Figure 3) and electoral uncertainties further increased the pressures in the foreign exchange market in late 2002. But the availability of extraordinary sources of financing in 2001-02, and the NBRM’s tight monetary policy stance, enabled FYR Macedonia to emerge from the crisis with foreign exchange reserves equivalent to 60 percent of broad money or 125 percent of the estimated gross financing requirements for 2003.

Table 4.

FYRM: The National Bank Accounts, 1998-2003

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Includes reserve requirements on foreign exchange deposits; scheduled to be introduced in the second quarter of 2003.

Table 5.

FYRM: Monetary Survey, 1998-2003

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Sources: The National Bank of Macedonia; and staff projections.

A loss of foreign reserves equivalent to about Denar 2.1 billion is assumed following the repayment of frozen foreign currency bonds in 2003.

The decline in the second quarter of 2003 reflects the introduction of reserve requirements on foreign exchange deposits with a corresponding increase in the NFA of the NBRM.

Includes denar loans with foreign exchange indexing clause; i.e. about 25 percent of total private sector denar lending at end-2002.

Includes deposits of extra-budgetary funds and public entities outside the central government.

Adjusted for the removal of fully provisioned loans from banks’ books.

NFA of DMBs include required reserves on FX deposits.

FX assets of DMBs include NFA, required reserves on FX deposits, loans in foreign currency and, from 2001, denar loans with FX indexing clause

Figure 3
Figure 3

FYRM: Monetary and Financial Indicators, 1998-2002

Citation: IMF Staff Country Reports 2003, 131; 10.5089/9781451826012.002.A001

Sources: Macedonian authorities; and Fund staff estimates.

9. The external current account deteriorated sharply during the crisis (Figure 4, Table 6). Exports, always volatile due to a high concentration in steel and textiles, declined in 2001 and remained low in the first half of 2002, as a result of problems with market access and an overhang of uncertainty associated with the crisis and the September 2002 elections.3 The current account deficit (excluding transfers) widened to 8 percent of GDP in 2001 and to over 10 percent of GDP in 2002, reflecting a surge in imports, a slow pickup in exports, and some one-time factors.

Figure 4
Figure 4

FYRM: External Sector Developments and Competitiveness, 1996-2002

Citation: IMF Staff Country Reports 2003, 131; 10.5089/9781451826012.002.A001

Sources: Macedonian authorities; and Fund staff estimates.1/ A sharp increase in imports took place prior to the introduction of the VAT in March 2000.
Table 6.

FYRM: Balance of Payments, 2000-2004

(In millions of U.S. dollars)

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

Projected trade credits are included in the projected errors and omissions and short-term capital.

Private sector arrears. Clearance of technical arrears to Paris Club (US$4.3 million at end-2002) is included in debt service due for 2003.

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

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

Medium-term and long-term debt including IMF.

Assumes disbursement of US$180 million in BOP support in 2003-04 (grants: US J53 million; loans: US$100 million; IMF: $27 million).

10. Notwithstanding a few large pre-crisis investments, foreign investors have been lukewarm, and it seems unlikely that large FDI inflows can be relied upon to continue. Political interference and corruption as well as regional instability have made FYR Macedonia an unattractive place to do business (Figure 5, EBRD transition score). Allegations of corruption associated with several privatizations in the late 1990s, and the ensuing litigation, sent a negative signal to prospective investors.

Figure 5
Figure 5

Cross-Country Comparison of Selected Economic Indicators

Citation: IMF Staff Country Reports 2003, 131; 10.5089/9781451826012.002.A001

Sources: EBRD Transition Report 2002; and World Economic Outlook.1/ Average of EBRD index scores across various measures of transition including liberalization, privatization, enterprise reform, infrastructure, financial institutions, and legal environment.

11. While there were significant structural reforms in the financial sector and trade regime, FYR Macedonia’s track record in enterprise reforms has been weak. Most socially-owned enterprises were sold to insiders rather than to strategic investors with capital and know-how. Many old firms survive with substandard performance (see text table), and progress in winding up a few large loss-making enterprises has been slow. On the other hand, profitability has improved and the large number of firm closures and start-ups suggest a dynamic small- and medium-sized sector.

Indicators of Enterprise Performance 1/

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Surviving films are firms that existed throughout the period 1994-2000. Dying firms are defined as firms in existence in 1994 but that ceased to exist before 2000. New firms are firms that were created after 1994.

12. The banking sector has strengthened but still has deep-rooted weaknesses. AH but one of FYR Macedonia’s 21 banks (including the two largest) are now private and several banks (including the largest one) are foreign-owned. The banking sector remains concentrated: the two largest banks, taken together, account for nearly two thirds of deposits. Loan quality and profitability have recovered significantly from the low levels reached in 2001, but non-performing loans are still close to a third of the total and some small banks remain very weak. As in many Central and Eastern European countries, a high degree of euroization of banks’ assets and liabilities—with some 40 percent of credit to the private sector denominated in or indexed to foreign currency—potentially exposes banks to greater credit risk associated with their clients’ unhedged exposures, higher liquidity risks, and increased systemic risk.4

13. Unemployment has been persistently high. Official unemployment figures—above 30 percent for the past decade—are widely understood to overstate unemployment by as much as one-half: firms underreport their employment and unreported workers register as unemployed in order to receive benefits and health coverage. In part, the unemployment is structural, as suggested by exceptionally high rates of long term unemployment and unemployment among minorities and the young. An important underlying factor is that labor market practices—including generous severance packages and unemployment benefits—inhibit job creation by raising hiring costs and reducing the incentive to seek work. But unemployment also has a cyclical component and has tracked overall developments in the enterprise sector (text figure in paragraph 5).

14. While Macedonia’s incomplete reforms, high unemployment, and large current account deficit raise the issue of competitiveness, quantitative indices do not give a clear signal of a problem. Labor costs in 2000-01 were lower than in most former Yugoslav countries, although higher than in some other transition economies (text table). Moreover, indicators of real effective exchange rates (REER) do not show an erosion of competitiveness relative to 1998-2000, the period when Macedonia’s growth was strongest (see Figure 4).5

US Dollar Wages and Wage Bill Ratios

(Average for 2000-2001)

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15. Growth and exports recovered in the second half of 2002. Industrial output picked up, particularly in the textile and steel industries, and confidence appears to be returning. Real GDP is estimated to have increased by 2 percent (year-on-year) in the second half of the year. Textile exports are back to pre-crisis levels and metals exports have increased. In the run-up to the mission, international reserves were declining, reflecting the weakening of fiscal discipline and, apparently, concerns that the new Fund-supported program would be accompanied by an exchange rate adjustment. The exchange market pressure eased in February and interest rates have come down.

III. Discussions with the Authorities

16. Against this background, discussions focused on the main policy challenges: reducing the large current account and fiscal imbalances stemming from the security crisis and its aftermath (allowing for the need to support the PFA), addressing vulnerability to domestic and external shocks, and generating growth and employment. Tackling these issues will require a combination of fiscal adjustment and structural reform, in the context of an appropriate regime for exchange rate and monetary policy.

17. The authorities and the mission agreed on macroeconomic projections that assume a gradual return to pre-conflict growth rates, some 4 to 5 percent, over the medium term (text table). This is supported by analytical work summarized in Box 1. The projections envisage a recovery of private investment to pre-conflict levels as confidence in political stability is gradually restored. Non-government saving, which declined with the economic slowdown in 2001-02 (presumably reflecting consumption smoothing) is assumed to rise gradually to about its pre-conflict rate as GDP growth returns to trend (Tables 7 and 8). With foreign savings expected to decline relative to GDP from their unusually high 2002 levels (as no more large privatizations are in prospect and external financing for the peace process is expected to taper off), the general government fiscal deficit (excluding grants) would need to decline by about 3 percentage points of GDP over the medium term to generate the public savings to finance the needed public investment levels. Official project lending, private external borrowing, and foreign direct investment are expected to increase gradually, and no exceptional foreign financing is expected beyond 2004 (Figure 6). Inflation is projected to stabilize in the range 2½-3 percent per year in the medium term.

Table 7.

FYRM: Macroeconomic Framework, 1998-2007

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

External current account deficit, including official grants (+).

Equal to gross domestic investment minus foreign saving.

In 2001-02, includes security related expenditures and compensation to the depositors from failed pyramid schemes.

Includes domestic debt of central government and external debt of the public sector. 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.

Gross debt net of general government deposits in the banking system.