Former Yugoslav Republic of Macedonia: First Review Under the Stand-By Arrangement, Requests for Waiver of Performance Criteria, and Extension of Repurchase Expectations

This paper discusses key findings of the First Review Under the Stand-By Arrangement for Macedonia. Macroeconomic performance of Macedonia remains strong. Through end-December 2005, the authorities met all of the program’s quantitative performance criteria. Growth has remained steady at about 4 percent. Gross reserves have risen above €1 billion, allowing interest rates on National Bank of Macedonia bills to fall since November from 10 percent to 7 percent. To complete the First Review, the authorities have committed to strong policies, including measures to correct for delays in the program’s structural reforms.

Abstract

This paper discusses key findings of the First Review Under the Stand-By Arrangement for Macedonia. Macroeconomic performance of Macedonia remains strong. Through end-December 2005, the authorities met all of the program’s quantitative performance criteria. Growth has remained steady at about 4 percent. Gross reserves have risen above €1 billion, allowing interest rates on National Bank of Macedonia bills to fall since November from 10 percent to 7 percent. To complete the First Review, the authorities have committed to strong policies, including measures to correct for delays in the program’s structural reforms.

I. Recent Developments

1. FYR Macedonia’s macroeconomic performance in 2005 was better than envisaged under the original program:

  • Real GDP growth reached around 4 percent for the second consecutive year, and employment has started to increase (Figure 1, Table 1). Excluding sectors where output is proxied by employment (which ignores productivity growth), growth was even higher, at around 6 percent. Growth was driven by strong exports, while tight fiscal policy and high interest rates at end-2004 moderated domestic demand and imports. Labor market liberalization also helped boost employment.

  • Despite higher oil prices, the price level was broadly stable in 2005. Though oil prices raised consumer prices by½ percent, lower food prices (due to WTO-required tariff reductions and foreign retail competition) more than offset this in 2005. Higher tobacco taxes raised headline inflation above 2 percent in January 2006, though this should only be a one-time price level effect.

A01ufig02

Core Inflation

(year-on-year change)

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

A01ufig02a

Consumer Price Inflation

(year-on-year change)

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Source: State Statistical Office.

Alternative Measures of Real GDP Growth

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Excludes sectors where employment is used to proxy output (government and financial services)

Table 1.

FYR Macedonia: Selected Economic Indicators, 2001-06

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

For 2004, the State Statistics Office increased preliminary 2004 real GDP growth to 4.1 percent from 2.9 percent previously reported. Final GDP growth data will be available by April 2006.

Revised definitions are used starting in 2003.

0.4 percent of GDP of the 2005 fiscal deficit is caused by the NBRM recapitalization.

Gross debt minus government’s deposits with the NBRM.

The sharp increase of Broad Money in 2001 was caused by the Euro introduction.

Debt service due, including IMF, as a percent of exports. For 2006, includes a major debt restructuring. Excludes rollover of trade credits.

Total external debt, including trade credit. For 2005, includes a Euro 150 million Eurobond issuance.

Figure 1.
Figure 1.

FYR Macedonia: Real Sector Indicators, 2000-05

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Sources: State Statistical Office; NBRM and IMF staff estimates.

2. The reported current account deficit fell sharply to 1.4 percent of GDP, low by both regional and historical standards (Figure 2, Table 2). Although higher oil prices raised the import bill by 3.3 percent of GDP, the non-oil trade balance improved by more, with strong export performance in all sectors, particularly steel due to the reopening of a large factory, and lower growth of consumption goods imports. However, much of the current account improvement comes from cash transactions at foreign currency bureaus; aside from being volatile, part of these may properly belong to the capital account (Box 1).

A01ufig03

Non-oil Trade Deficit

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

A01ufig03a

Export and Import growth

(year-on-year change)

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Figure 2.
Figure 2.

FYR Macedonia: Financial Market Developments, 2000-06

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Sources: State Statistical Office and NBRM.
Table 2.

FYR Macedonia: Medium Term Balance of Payments, 2003-10

(In millions of Euro)

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

Based on historical outcomes, official transfers for BOP projections are lower than initial budget projections.

Increase in projections for 2005 and 2006 is due to increased projections for private sector external financing.

Private sector arrears.

Debt service due including for debt to the IMF as percent of exports of goods and services. Excludes rollover of trade credit.

Including trade credit.

3. Tight fiscal policy has contributed to the current account improvement (Table 3). The central government’s 0.3 percent of GDP surplus surpassed the program target by more than 1 percent of GDP. Revenues fell short by 1½ percent of GDP, with shortfalls in grants, Special Revenue Accounts (SRA), and social insurance collections. However, spending undershot by even more, due to under-execution of SRA spending, curbs on public employment and procurement delays. Though core central government arrears are under control, Health Insurance Fund (HIF) arrears increased by 0.1 percent of GDP during the year.

Table 3.

FYR Macedonia: Central Government Operations, 2004-06

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

Excluding contributions transfered to the 2nd pillar pension scheme that commenced in 2006.

From 2005 onwards capital revenue includes dividends, interest and other property income previously reported under non-tax revenue.

The ratios differ from the original program document due to revision of the GDP estimates.

4. Both financial market confidence and the capital account seem to be improving (Figure 3). Last year’s €150 million Eurobond—FYR Macedonia’s first—was four times oversubscribed, and followed a rating upgrade from Standard and Poor’s to BB+, one notch below investment grade. With lower government funding needs and high demand for domestic paper, treasury yields have fallen. On the capital account, long-term private borrowing and portfolio flows have increased, while banks are finally starting to draw down their deposits abroad to lend domestically. Confidence should increase further if last December’s European Council decision to grant EU candidate status leads to accession negotiations (Appendix I). However FDI remains weak, especially when compared to the region and other EU candidate countries, suggesting serious business climate deficiencies.

A01ufig04

Foreign Direct Investment

(in percent of GDP, average for 2002-04)

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Figure 3.
Figure 3.

FYR Macedonia: Financial Market Developments, 2004-06

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Sources: NBRM and IMF staff estimates.

A Surge in Private Transfers?

Although data compilation methods vary across countries, private transfers in FYR Macedonia are among the highest in the region—and grew rapidly in 2005. The increase in private transfers is explained by the increase in the foreign currency cash conversion, particularly that exchanged in bureaus, which is accelerating.

A01ufig05

Regional comparison of private transfers

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Source: IMF, WEO.
A01ufig06

FYR Macedonia

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Source: NBRM.

In FYR Macedonia such transactions are recorded in the current account since the authorities consider that cash exchange reflects transfers from migrants. However, this seems unlikely to explain the sharp increase in 2005. Without household survey data it is difficult to estimate how much of cash exchanged is truly a private transfer. Assuming that the migrant transfer component of cash exchanged in bureaus grew in line with “true” remittances (which is measured separately), total private transfers would be only 14 percent of GDP. The current account deficit in 2005 could then be as high as 4.4 percent of GDP instead of the 1.4 percent estimated.

In some sense, this calculation is conservative since it assumes all other cash exchanged is capital account: if it is informal economy trade, it should also appear in the current account. Against this, it does assume that past cash exchange transactions have been properly treated as current account.

The large increase in foreign currency exchanged might also reflect unrecorded portfolio investment or cash FDI. Alternatively, increased confidence in the denar may have prompted residents to switch their savings from foreign exchange to denars. Ahead of the Euro conversion roughly €1 billion worth of DM was converted into other currencies; however, according to balance of payments data, only half of this has been deposited in the banking system by individuals.

5. The balance of payments is much stronger than programmed, NIR exceeding the end-2005 target by €150 million (3.3 percent of GDP). The central bank sterilized roughly half of the NIR increase through selling bills. In view of stronger international reserves and the costs of sterilizing these, but also the large output gap and weak price pressures, the NBRM lowered interest rates from 10 percent in November to 7 percent by end-January.

6. Though all monetary targets were met in 2005, recent interest rate reductions and incomplete sterilization of last year’s inflows are set to translate into stronger money and credit growth (Figure 4, Table 45):

  • Financial deepening is slowly increasing, with broad money rising to close to 40 percent of GDP. Denar deposits returned to their long term upward trend after falling in mid-2005 with payment overseas of the extraordinary telecom dividend. However, the share of foreign currency deposits is high at around 50 percent.

  • Private credit growth remains strong, but bank profitability remains weak. Banks have rapidly expanded lending, to households and in foreign currency especially, though from a low base. Nonetheless bank capitalization, on average, remains sound although operating expenses absorb much of gross income. Though falling, almost 15 percent of loans are non-performing (but fully provisioned for); nonproductive assets (fixed and foreclosed assets) equal half bank capital, in a few banks even higher.

A01ufig07

Change in Banking Sector Credit

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Table 4.

FYR Macedonia: Central Bank Accounts, 2004-06

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

The difference between the central government financing from the NBRM in the fiscal table and in the NBRM balance sheet for 2005 is caused by denar 679 million of changes in municipal accounts.

Table 5.

FYR Macedonia: Monetary Survey, 2004-06

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

Includes foreign currency indexed.

Includes municipal and public enterprise accounts.

Includes required reserves (RR) on FX deposits.

II. Policy Discussions

7. The key challenge is to translate this achievement of macroeconomic stability into sustained and rapid growth. Within the region, FYR Macedonia is often seen as a slower growing and less dynamic economy. Structural reform, backed by a stable economic environment, is the best way to overcome this. Already in the first six months of the program, albeit in some cases with delay, the authorities have completed nine of the ten end-December structural benchmarks and three of the four structural performance criteria (LOI Table 2). Financial reporting of public health care institutions (HCIs) has been enhanced, a new one-stop shop for company registration (consistent with EU requirements) was introduced, and Parliament passed a new bankruptcy law. Even so, business environment indicators and low levels of foreign direct investment suggest considerable structural reforms are still needed for rapid growth to be sustained.

A01ufig08

Gross Domestic Product

(year-on-year change, average 2002-04)

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Figure 4.
Figure 4.

FYR Macedonia: Money and Credit Developments, 2001-06

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Sources: NBRM and IMF staff estimates.1/ Includes foreign currency indexed lending (approximately one third of total denar credit).

8. In response, the authorities have decided to keep to the program’s original 0.6 percent of GDP deficit target for 2006, while locking in most of the overperformance on international reserves. With growth and inflation on track, public spending under control, and the balance of payments and financing conditions considerably stronger (though admittedly with uncertainties over the full extent of the current account improvement), the modest fiscal easing is appropriate. The easing is also aimed mainly at the redirection of savings from public to private pensions (which would have little demand effect) and trade liberalization (Table 3). The authorities agreed to lock in two-thirds of the end-2005 reserve overperformance to protect the program from excessive monetary expansion. However, this will still allow some room to cautiously relax monetary policy in order to accommodate last year’s increase in money demand and strengthen economic recovery in 2006.

9. To help sustain growth, the authorities are accompanying this slight relaxation of macroeconomic policies with further structural reforms, key to the program strategy. On top of existing structural conditionality, the authorities made new commitments to strengthen banking supervision (in light of rapid credit growth), to improve financial controls in the health sector (to address governance problems and to reduce arrears), to liberalize the telecommunications sector (a significant barrier to trade), and to abolish unnecessary licensing requirements. In addition, the authorities have established new timetables for telecoms privatization and for harmonizing tax and social contribution bases as part of their tax administration reform. LOI Table 2 summarizes the reform strategy.

A. Macroeconomic Framework

10. The macroeconomic framework is essentially unchanged from that laid out in the budget (¶7):1

  • Growth is conservatively projected at around 4 percent. With inflows pushing interest rates and lending rates lower, domestic demand should drive growth. While the authorities emphasized the impact on investment, staff cautioned that weak enterprise balance sheets could limit this, as opposed to consumer lending where growth was set to continue. Higher employment should also strengthen consumer confidence.

  • Inflation is projected to increase to around 2 percent, but because of changes in administered prices and taxes, not growing demand pressures. Electricity price increases and higher tobacco taxes should raise consumer prices by 1½ percent. The authorities stressed that the high unemployment rate and the fixed exchange rate would help to restrain inflation.

11. The current account deficit is projected to widen to around 4 percent of GDP in 2006 while capital flows (excluding privatization and debt prepayment) stabilize. Slower export growth, higher domestic demand and the full year oil price effect are expected to raise the current account deficit by 3 percentage points, back towards the original (sustainable) program path.

12. Despite strong export growth in almost all sectors and the reduction in the non-oil trade deficit, competitiveness is still an issue (Box 2). In the past, large and persistent trade deficits and declining world export market share pointed to possible competitiveness problems. The authorities argued that this reflected a lack of dynamism in the manufacturing sector, operating in an economic environment that hampers private investment and where technology transfer through FDI has been limited. Sectoral data suggests that this may reflect patterns of specialization: Macedonian exports have been concentrated in sectors whose world market shares are declining (Box 2). The authorities reaffirmed their belief that the current exchange rate regime had worked well, pointing to recent real exchange rate depreciation, the improvement in the current account, and the effectiveness of its nominal anchor role (Figure 5). Structural reform, for example last summer’s labor legislation, and measures to improve the business environment were the best ways to improve competitiveness. These issues will be discussed more fully in the forthcoming Article IV consultation.

A01ufig09

World Export Market Share

(in percent)

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Source: DOTS.
Figure 5.
Figure 5.

FYR Macedonia: Exchange Rate Indicators, 2000-05

(2000q1=100) 1/

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Sources: Eurostat; IFS; and IMF staff calculations.1/ Deviations from past REER (ULC) indicators can be explained by revisions of trade weights (based on 1999–2001 data for exports and imports of goods; partner countries comprise Austria, Bulgaria, Croatia, France, Germany, Greece, Italy, Netherlands, Russia, Serbia and Montenegro, Slovenia, Switzerland, Turkey, United Kingdom, and United States), new data that allowed staff to base the ULC analysis on the manufacturing sector for all partner countries, and changes in the methodology that make the REER (ULC) fully consistent with that used for the REER (CPI) and REER (PPI).

B. Monetary Policy

13. Before adjusting rates again, the NBRM wanted to gauge the effects of last year’s interest rate cuts on domestic demand and the current account (¶8). The largest banks had already lowered lending rates in response to last year’s rate cuts; other banks were likely to follow. With credit growth projected to increase to about 23 percent this year, from 20 percent in 2005, the NBRM intended to keep rates on hold while it assessed the impact on credit and money growth.

Export Performance, 1995-2004

A01ufig10

Macedonia’s exports by main categories

Citation: IMF Staff Country Reports 2006, 188; 10.5089/9781451826098.002.A001

Detailed analysis of Macedonian manufacturing exports suggests that competitiveness problems may reflect specialization patterns.

Using export data from the Comtrade database, we looked at the evolution of the share of Macedonian exports in world exports from 1995 to 2004. Macedonian export share increased in those sectors in the right hand quadrants.

We compared this to the evolution of these sectors’ shares in world manufacturing exports. The sectors in the two bottom half quadrants are those whose share in total world manufacturing exports have declined. The graph indicates that Macedonian exports have increased most in the manufacturing sectors where the economy is specialized (measured by the size of the bubble), such as textiles, clothing, iron and steel. However, these sectors are losing share in world manufacturing trade, explaining why FYR Macedonia’s share of total world exports has fallen. Low FDI levels compared to the rest of the region, partly due to shortcomings in the business environment, may also explain this pattern of specialization in non-dynamic sectors.

14. The NBRM agreed to revise the 2006 NIR and NDA targets in light of last year’s increase in money demand, to prevent excess monetary expansion (¶16-17). With strong overperformance to date and a fairly conservative inflow projection for 2006, the original program targets allow too much room for monetary expansion. Though receipts from the 2005 eurobond were used to pay off London club debt (€120 million), privatization receipts and continued strong performance of transfers suggest that reserves could increase above the original program targets. To prevent this from leading to excessive monetary expansion, the authorities and staff agreed to tighten the end-year targets by €100 million, two-thirds of the end-2005 overperformance, while at the same time increasing the privatization adjuster by €50 million to reflect uncertainties over timing and size of receipts. However, the staff cautioned that the reserve increase could be higher than the revised program, in which case monetary control might require more sterilization. The issuance of treasury bills for monetary policy purposes (structural benchmark) would help here, as would the NBRM’s commitment to maintain its prudent monetary policy if reserve overperformance continued (¶8).

C. Fiscal Policy and Reforms

15. The 2006 budget targets an overall deficit of 0.6 percent of GDP, a widening of almost 1 percent of GDP from 2005, in line with the program (¶9):

  • Revenues relative to GDP are projected to fall by 1.4 percentage points. Tax revenues fall by 1 percent of GDP from 2005, as part of the social security contributions move to new private pension accounts, and import duties decline with trade liberalization. Non-tax and capital revenues and grants are projected to fall by 0.4 percent of GDP because of last year’s extraordinary telecom dividend.

  • Expenditures relative to GDP are projected to fall by ½ percentage point. Wage growth is contained, while decentralization lowers central government spending on goods and services. Transfers are projected to fall by 0.4 percent of GDP as real pensions decline (in line with the existing formula) and welfare program targeting improves. Capital expenditures increase by 0.2 percent of GDP.

  • Though representing a slight loosening compared to the 2005 outcome, staff viewed the deficit target as appropriate. Last year’s surplus was exceptional, driven by one-off factors such as the telecom dividend and delays in public investment. Given the improvement in the current account and low government debt ratios, staff agreed that it was appropriate for the authorities to stick to the fiscal consolidation path agreed in the program, while being ready to adjust policies later if necessary.

16. The staff regretted the authorities’ ad-hoc resort to tobacco tax increases to finance new spending. Tobacco taxes were raised early this year to finance tobacco farmer subsidies and the health sector, on top of the increases already in the budget. This would increase cigarette prices by more than 30 percent. The staff expressed concern at the accommodation of spending pressures outside the budget cycle, cautioning that the substantial price increase would encourage smuggling. In response, the authorities argued that tobacco taxes were below EU levels and health concerns justified an increase. To limit earmarking, they also pledged that money would be transferred to the health sector only if indirect revenues exceed budget projections, and would be used to pay for existing underfunded national health programs (which would help clear arrears).

17. The authorities agreed to monitor the costs of the second pillar pension system, introduced this year, in case offsetting measures were later needed. Higher than anticipated take up of the second pillar (private) pension scheme will reduce social insurance contributions to the government, creating a 0.3 percent of GDP pensions deficit in 2006. However, this reallocation of savings should not increase domestic demand, and the reduction in future obligations will lower future pensions deficits, improving government solvency. Given the authorities’ record of fiscal overperformance, and with revenues likely to be higher (the budget estimates both the telecom dividend and new tobacco tax conservatively), the staff agreed that it would be premature to require offsetting fiscal measures now. Nevertheless, the authorities reiterated their commitment to meeting the program’s deficit target and to including any necessary measures in a supplementary budget (¶9).

18. The staff welcomed progress in reforming tax administration (¶13). Despite the delay in filling senior positions, reform is well on track: the organizational structure has been changed (in line with FAD recommendations) to improve registration, enforcement and audit; the law on tax administration will become effective in April 2006; and preparations for the large taxpayer unit (due by end-July) are almost complete.

19. The authorities plan to harmonize the base for personal income tax and social contributions in two phases, reflected in program conditionality (¶13). Full harmonization is central to the tax administration reform, and will require abolishing the presumptive minimum salary base for social contributions. Given limited capacity to audit wages, the government argued for a two-step approach: starting January 1, 2007, the social contribution bases (which vary tremendously across sectors, representing considerable cross-subsidization) would be harmonized and simplified (a performance criterion will be set at the Second Review); social contribution and personal income tax harmonization would start January 1, 2008 (a performance criterion will be set once the details of the strategy are agreed). Staff agreed that the phased approach was the best way forward given capacity constraints, but emphasized the need to merge social contribution and personal income tax collection within the PRO, a key long-term goal.

20. H