Former Yugoslav Republic Of Macedonia: Staff Report for the 2006 Article IV Consultation

Macedonia showed an economic recovery owing to its macroeconomic policies. Executive Directors appreciated the sound fiscal policies and efforts in bringing inflation under control and increasing international reserves. They stressed the need to reduce unemployment and keep the account deficit under control. Executive Directors stressed that the best way to meet these challenges would be by maintaining the country’s hard-won macroeconomic stability, accelerating structural reforms and prudent and well-coordinated monetary and fiscal policies, and liberalizing the labor market.

Abstract

Macedonia showed an economic recovery owing to its macroeconomic policies. Executive Directors appreciated the sound fiscal policies and efforts in bringing inflation under control and increasing international reserves. They stressed the need to reduce unemployment and keep the account deficit under control. Executive Directors stressed that the best way to meet these challenges would be by maintaining the country’s hard-won macroeconomic stability, accelerating structural reforms and prudent and well-coordinated monetary and fiscal policies, and liberalizing the labor market.

I. Introduction

1. With economic performance improving following a decade of low growth, and elections in July, the Article IV consultation took place at an opportune but sensitive time. Despite recent improvements that owe much to generally sound policies (Box 1), FYR Macedonia still faces the considerable challenge of achieving sustained rapid growth, lowering unemployment, and reducing current account vulnerability. With financing constraints easing, pressure to relax macroeconomic policy is also increasing. Tax cuts and spending initiatives proposed during the election could jeopardize the hard-won record of stability. The discussions gave a chance to reassess the macroeconomic policy stance and to devise policies that will accelerate growth in a lasting way. By seeking the views of the current government, the opposition, unions and business leaders, this consultation should help shape the new government’s economic program.

2. While conditions are improving, understanding economic performance and assessing monetary and fiscal policy is complicated by data deficiencies. National accounts data are available with considerable delay, and prone to revision, creating uncertainty over the forces determining growth. Trade performance and competitiveness are hard to gauge, with volume figures for 2005 indicating an exceptionally large contribution of net exports, difficult to reconcile with production-side GDP estimates. Increased conversions of foreign currency into denars at exchange bureaus are also hard to interpret. Are these current account transactions, such as increased remittances from abroad, tourism and informal exports? Or do they reflect capital inflows or the conversion of so-called mattress money? Aside from making this report’s macroeconomic analysis more tentative, these statistical uncertainties caution against fine-tuning monetary and fiscal policy, increasing the premium on keeping macroeconomic policy stable and relatively simple.

II. Background

A. The Medium-Term Problem: Stability But Low Growth

3. Since independence in 1991, FYR Macedonia has faced severe challenges on top of the normal problems of transition. Hyperinflation in the early 1990s, trade embargoes, regional conflict, and the 2001 internal security crisis have compounded the problems of restructuring and creating a market economy. The starting point also was weak: within Yugoslavia, Macedonia’s economy was the poorest, specialized in very few, mainly traditional, sectors, with an unemployment rate of around 20 percent.

4. Despite these challenges, conservative fiscal policy and the fixed exchange rate have controlled inflation. After a 16 percent devaluation in 1997, the de facto peg to the DM and later the euro has remained intact. Since 2002, inflation averaged less than 1 percent. Save during crises, the fiscal deficit has been low, keeping gross public debt to 40 percent of GDP.

Implementation of Past Fund Policy Advice

The Macedonian authorities have generally been responsive to the Fund’s advice since the last Article IV consultation http://www.imf.org/external/np/sec/pn/2003/pn0363.htm and the ex-post assessment of the long-term use of Fund resources http://www.imf.org/external/np/sec/pn/2004/pn0497.htm.

Fiscal policy: Consistent with staff advice, the authorities pursued fiscal consolidation and reversed spending increases associated with the 2001 security crisis, to achieve sustainable medium-term fiscal and external positions. Revenue administration and public financial management have been strengthened, including by widening the coverage of the treasury single account, giving the Ministry of Finance power to control line ministries’ spending, and improving procurement. While budget arrears are under control, progress containing health sector arrears has been mixed. Fiscal decentralization is on track, but local government financial management needs to improve.

Exchange rate: Although agreeing in principle on the need for an exit strategy, either towards greater flexiblity or a harder peg, the authorities have continued with the “soft peg”, which has worked well so far.

Structural reforms: Labor market flexibility and the business climate have improved. Privatization has continued and should improve corporate governance. Trade has been further liberalized. EU candidate status should catalyze the authorities’ structural reform efforts, many long advocated by the Fund.

5. However, macroeconomic stability has been slow to translate into rapid output or employment growth:

  • Since 1995, growth has averaged only 2 percent, well below other transition economies, so that GDP has only recently reached pre-transition levels. By the late 1990s, growth had picked up to around 4 percent, but this improvement was interrupted by the 2001 conflict. International reserve shortages have also increased growth rate volatility.

  • Recorded unemployment in 2005 reached 35 percent. Employment has barely increased since 1995. Nevertheless, wages appear quite high for the region, suggesting that insiders are protected from competition. With two-thirds of the unemployed more than four years out of work, high youth unemployment, and low labor force participation, much of the unemployment is structural; reducing it will thus be difficult.

uA01fig01

Output Growth and the Current Account

(1990-2005)

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Source: MSSO.
uA01fig02

Real GDP

(1990=100)

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Source: WEO

6. Besides various shocks, high real interest rates and low foreign direct investment have slowed growth, suggesting underlying structural problems:

  • Interest rates have been relatively high, despite low inflation. High real interest rates have limited private credit growth, despite low financial intermediation. The fixed exchange rate has induced considerable volatility in NBRM rates; bank lending and deposit rates have largely ignored these, weakening monetary transmission.

  • The stock of foreign direct investment is very low, less than US$600 per capita at end-2004. This is lower than the regional average, and substantially below that in Bulgaria, Croatia, and Romania. The gap between actual non-privatization and potential FDI (using regression estimates) is also substantial.

uA01fig03

Private Sector Credit Growth and Credit as share of GDP, 2005

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

uA01fig04

Real Bank Lending Rates, 2005 1/

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Sources: National authorities.1/ Uses 2005 inflation rates as a proxy for expected inflation.

South Eastern Europe: Cumulative FDI

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Sources: UNCTAD, Demekas et al. (WP/05/110).

FDI gap is defined as a difference between actual and potential non-privatization FDI stock based on the data for 2003, where potential FDI is derived using coefficients from a regression of gravity and institutional variables, with institutional variables at their best practice levels.

7. In the past, persistent current account deficits created reserve shortages and rising external debt. From 1995 to 2004, the current account deficit averaged more than 6 percent of GDP, any improvements typically proving short-lived. Reserve cover fell to less than 3 months of imports by 2004, and external debt rose above 40 percent of GDP. Higher private transfers from migrants (mostly foreign currency cash conversions) both boosted imports and financed the resulting trade deficit.

uA01fig05

FYR Macedonia: Current Account Balance

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Source: NBRM.
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FYR Macedonia: Trade Balance and Private Transfers as share of GDP

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Source: NBRM.

Macedonian Migration and Remittances

Though reported remittances are half the size of exports, information on their size and determinants is incomplete. Official figures for the number of Macedonians living abroad are outdated, dropped from the 2002 census as politically sensitive after the 2001 security crisis. ILO data only report those who obtained working visas from foreign embassies in Macedonia (112 in 2003). Data from recipient countries give an estimate of roughly ½ million, though the further back the generations the weaker the ties. If true, this would represent 20-25 percent of the population, even higher than in other migrant European countries like Moldova.

Lack of official data makes it difficult to assess whether emigration has accelerated. Unlike in other countries, increased migration has not increased wage pressure since unemployment remains high. Private transfers (which in Macedonia include remittances and cash exchanged in bureaus assumed sent by migrant workers) have doubled in the last five years, to almost 18 percent of GDP in 2005. Remittances seem stable and countercyclical, consistent with an altruism motivation. In contrast, cash exchanged is procyclical, and may reflect portfolio diversification.

Apart from Serbia, migrants are mostly located in Switzerland, Germany, Italy, Australia, USA, and Canada. Emigration to Australia and Canada predated independence, and low remittances in Australian and Canadian dollars suggest weakening ties. With the 10 most active foreign exchange bureaus located in municipalities with highest Human Development Indices, foreign migration is not exclusively a phenomenon of poor and rural areas, though roughly half cash exchanged is in ethnic Albanian areas.

B. Recent Developments

8. Despite these severe medium-term challenges, economic performance has improved recently (Figure 1, Table 1). The authorities’ preliminary estimates (based on industrial production) suggest growth reached 4 percent in 2005, driven by strong exports, with tight fiscal policy and high interest rates at end-2004 restraining domestic demand. However, corporate income tax receipts are much stronger than expected, likely reflecting higher profitability and value added, and the increase in consumption and investment (borne out by retail turnover, car sales, and investment data) due to higher private transfers and bank lending is unlikely to have been measured fully. The true growth rate could therefore be even higher, though unemployment has fallen only marginally. Despite higher oil prices, the stable exchange rate, lower tariffs, and food prices kept average inflation below 1 percent.

Figure 1.
Figure 1.

FYR Macedonia: Real Sector Indicators, 2000-06

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Sources: State Statistical Office; NBRM; and IMF staff estimates.
Table 1.

FYR Macedonia: Selected Economic Indicators, 2003-07

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

In 2005, central government spent an additional 0.4 percent of GDP on the NBRM recapitalization.

In 2005 and 2006 the change in stock reflects a major debt management operation. Net debt is defined as gross debt minus government’s deposits with the NBRM.

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

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

9. The external position has strengthened, with gross reserves rising from €700 million at end-2004 to around €1,200 million (more than 4 months of imports, 25 percent of GDP) by May 2006 (Figure 2, Table 2):

Figure 2.
Figure 2.

FYR Macedonia: External Sector Indicators, 2000-06

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Sources: State Statistical Office; and NBRM.
Table 2.

FYR Macedonia: Medium-Term Balance of Payments, 2003-11

(In millions of Euro)

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

Private sector arrears.

Debt service due including IMF as percent of exports of goods and services. Excluding rollover of trade credit.

Medium and long-term debt including IMF.

Including trade credit.

  • The reported current account deficit fell sharply to 1.3 percent of GDP in 2005. The main factor was increased private transfers, which probably include capital account transactions (a planned STA mission will examine this further); more conservative staff estimates would put the true deficit closer to 4.5 percent of GDP. Although higher oil prices raised imports by 3.3 percent of GDP, the overall trade deficit fell by 2 percent of GDP, but is still close to 20 percent of GDP. Export growth accelerated in all sectors except for textiles, and especially in steel (which grew 30 percent) with the reopening of the largest steel factory. Higher energy imports were offset by lower imports of goods for processing, while consumption goods imports were flat.

  • Capital account developments are difficult to gauge. Abstracting from one-off items such as last year’s €150 million Eurobond and this year’s electricity privatization (€225 million, almost 5 percent of GDP), improvements are hard to discern. Long-term private borrowing and portfolio flows have increased, banks have drawn down deposits abroad to lend domestically, and EU candidacy has improved financial market confidence (Figure 3). In June, Fitch upgraded its rating to BB+ (one notch below investment grade). However greenfield FDI remains low, and mainly in nontradable sectors such as banking, telecoms, retail trade, and energy.

uA01fig07

FYR Macedonia: Destination of Exports, 2000-05

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Sources: MSSO; and IMF staff calculations.
uA01fig08

FYR Macedonia: Exports by sector, 2000-05

(in millions of Euro)

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Sources: MSSO; and IMF staff calculations.
Figure 3.
Figure 3.

FYR Macedonia: Financial Market Developments, 2004-06

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Sources: NBRM; and IMF staff estimates.

10. The increase in reserves allowed the NBRM to cut interest rates from 10 percent in October to below 6 percent in May. Though prompted partly by increased sterilization costs (which reached €10 million (0.2 percent of GDP) in 2005 and were set to rise significantly in 2006 with continued foreign currency purchases), the differential with euro-area rates had been high, perhaps because of residual uncertainties over the exchange rate. Banks have only partly matched the NBRM’s rate cuts, in part because they did not entirely match earlier rate increases. Credit has expanded, especially to households and in foreign currency, though from a low base and less rapidly than the region (Figure 4, Tables 3-4).

Figure 4.
Figure 4.

FYR Macedonia: Money and Credit Developments, 2001-06

Citation: IMF Staff Country Reports 2006, 344; 10.5089/9781451826111.002.A001

Sources: NBRM; and IMF staff estimates.1/ Includes foreign currency indexed lending (approximately one third of total denar credit).
Table 3.

FYR Macedonia: Central Bank Accounts, 2004-07

(In billions of denars)

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Sources: NBRM, and IMF staff projections.
Table 4.

FYR Macedonia: Monetary Survey, 2004-07

(In billions of denars)

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Sources: NBRM, and IMF staff projections.

Includes estimates of foreign currency indexed loans, estimated to be approximately one third of the total at end-September 2005.

Includes municipal and public enterprise accounts.

Includes required reserves (RR) on FX deposits.

Measured on a rolling basis as a sum of nominal GDP of four preceeding quarters including the last full quarter of each period.

11. Fiscal policy has been kept tight, though with some easing this year (Table 5). Last year’s 0.3 percent of GDP central government budget surplus exceeded the program by more than 1 percent of GDP. Special Revenue Account underperformance continued, and the authorities also curbed public employment and delayed procurement. The unusually high telecom monopoly dividend (1 percent of GDP), and advancing VAT payments by importers also contributed. The 0.6 percent of GDP deficit in the 2006 budget represents a modest fiscal easing.

Table 5.

FYR Macedonia: Central Government Operations, 2004–07

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

Excluding contributions and transfers related to the second pillar pension scheme that commenced in 2006.

The 2006 projected decline is largely due to reintroduction of the deferral mechanism for qualified importers, temporarily suspended at end-2005, and exceptionally high refunds in early 2006.

From 2006 onwards includes special taxes on tobacco products.

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

12. Though present, traditional vulnerabilities are relatively low (Table 6). External debt exceeds 40 percent of GDP, though almost all is long term and around half owed to multilaterals. Private short-term external debt is very low (only 8 percent of GDP) and consists almost entirely of trade credits. Government debt is around 35 percent of GDP, almost entirely foreign currency denominated, but with maturity averaging more than 10 years (Table 7). Parts of the banking system appear weak and a large share of intermediation is in foreign currency (with a 50 percent share of deposits). However, the level of monetization is also low, with broad money only 40 percent of GDP, well covered by gross international reserves of 25 percent of GDP. In addition, though net foreign assets are declining as banks borrow from their overseas parents, their net foreign exchange position remains positive. Debt sustainability analyses likewise suggest only limited vulnerabilities, save for the scenario based on historical averages (which includes the security crisis years) (Tables 8-9). This underlines a main theme of this Article IV: the need to break with historical growth and current account trends.

Table 6.

FYR Macedonia: Indicators of Financial and External Vulnerability, 2001-05

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Sources: Staff calculations and estimates based on the data provided by the NBRM.

2001-02 credit growth affected by loan loss provisions.

Excluding trade credit.

Table 7.

FYR Macedonia: Composition of Central Government Debt, 2005-2006

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Source: Ministry of Finance, and NBRM.

End-March 2006 preliminary outturn.

Change in stock between 2005 and 2006 reflects a major debt management operation.

Medium-term bonds issued to cover central government’s contingent commitments.

Excluding Treasury bills issued for monetary policy purposes introduced in March 2006.