Recent developments

Since the last Board discussion Moldova’s economic development has continued its positive trend, building on the achievements of six consecutive years of strong growth and progressing from a decade of economic decline and rising poverty to sustained economic development and improving living standards¹. Real GDP growth slowed down but still reached 5 percent in the first six months of 2006 in comparison with the same period of the previous year. Fiscal and monetary policies aimed at containing inflation, helped to achieve budget overperformance. The prudent fiscal stance in combination with careful debt management helped to maintain the substantial improvement in Moldova’s debt sustainability, which has also been underpinned by last May’s Paris Club agreement to reschedule Moldova’s bilateral debt at Houston terms.

Advancing structural reforms, improving the business climate, enhancing institutional capacity and deepening the democratic process in line with the EU-Moldova Action Plan, remain on the top of the authorities’ agenda. The progress in this regard has been evidenced by the fast growing number of SMEs, the steady - albeit still low compared to other countries in the region - increase in FDI, satisfactory implementation of the EU-Moldova Action Plan, Moldova’s qualification for the Threshold Plan for participation in the US government’s “Millennium Challenge Account” program, as well as the continued improvement in the country’s Corruption Perception Index (CPI).

The positive momentum in the country’s development, however, has been challenged by two serious external shocks: higher energy prices, including a two-fold increase in the price for natural gas in the first six months of the year, and the ban on Moldovan wine exports to Russia (which account for about 10 percent of GDP). This has led to a slowdown in economic growth and placed pressure on the government’s efforts to meet its economic and social objectives. Subsequently, the authorities have revised the GDP growth projections for 2006 down to 4 percent from 6 percent initially envisaged in the program. This growth projection is somewhat higher than staff’s estimate of 3 present in 2006, but the authorities remain confident that a 4 percent growth is achievable.

Higher energy prices in combination with a deterioration in terms-of-trade have contributed to a spike in inflation. End-September headline inflation (y-o-y) reached 14.4 percent, and put additional pressure on public finances and the exchange rate². The shocks have also led to a further deterioration of Moldova’s external position. The volume of exports has decreased by 7.7 percent, while the volume of imports increased by 15.5 percent, resulting in spite of buoyant remittances, in a current account deficit of about 10 percent of GDP. The overall impact of the shocks on the balance of payments during 2006-2007 is estimated at about 15 percent of GDP for the two years combined. In addition, the combined impact of the shocks has resulted in tighter conditions on the foreign exchange market, impeding the central bank’s ability to meet the international reserves target. The proposed increased access under the PRGF and additional donor support will help to both boost reserves and fill the resulting financing gap.

In light of the shocks, the authorities are fully aware that to maintain hard-won macroeconomic stability, bold adjustment measures are needed. In this regard, they moved decisively to tightening the monetary and fiscal stance, while passing on to final consumers the increase in energy prices. Also, tariffs for heat and water will be gradually raised to cost-recovery level, while compensation to poor households will be further increased. These are difficult measures, in particular given Moldova’s still high level of poverty and imperfect system for targeted compensations to the poor. Nevertheless, the authorities remain firmly committed to stay the course of adjustment and increase its capacity to ensure an efficient compensation scheme. Looking forward, along with the need to enhance the economy’s resilience to further increases in energy prices, improving Moldova’s attractiveness to foreign investments, diversifying the export base and export markets, as well as moving up the value added chain and increasing productivity remain key challenges.

Fiscal policy

Despite the adverse impact of the shocks, fiscal policy has continued to perform well, with revenues achieving an overperformance of about 1.5 percent of GDP vis-à-vis the program target, in large part due to improved tax administration and compliance. In the same context, the authorities attribute the increase in VAT collection on imports in part to enhanced control over the border segment between Transnistria and Ukraine, which was possible with the support from the EU. The authorities would have preferred to use these resources for public investment, in line with their Economic Growth and Poverty Reduction Strategy (EGPRSP), which has not been fully funded in recent years. However, only a part of the excess revenues has been allocated to this purpose, whereas the remainder will be used to compensate households for higher energy prices, and to reduce the budget deficit from the originally programmed 0.8 percent of GDP to 0.5 percent.

The authorities acknowledge the importance of fiscal policy in maintaining overall macroeconomic stability, and remain committed to a prudent fiscal stance in 2007 and beyond. As a result of the shocks, the authorities anticipate a reduction in revenues, in particular in corporate profit tax, as well as an increase in the general government’s energy bill. These constraints call for additional corrective measures, and the authorities intend to do this within the budget framework agreed under the program, maintaining the budget deficit at 0.5 percent of GDP. To this effect, they will scale back the increase in public sector wages envisaged for 2007. In addition, the parliament has amended a set of laws that will allow the authorities to ensure that heating and water supply tariffs are gradually adjusted to full cost-recovery levels.

At the same time, in the event of shortfalls in the budget for 2007, they stand ready to amend the budget to preserve the agreed deficit target, although it may require reductions in priority expenditures. In the same vein, if additional external funds become available, the government intends to channel those to finance infrastructure projects.

Looking forward, the authorities will continue to improve the efficiency of the tax administration system. With technical assistance from the Fund and bilateral donors, a comprehensive tax administration reform strategy was prepared in line with the EU-Moldova Action Plan requirements. Furthermore, the authorities remain committed to build on the progress made in the budget formation process by further improving the medium-term expenditure framework.

Monetary policy

Containing inflationary pressures, fueled by strong remittances³ and increasing energy prices, has remained the main challenge facing the National Bank of Moldova (NBM) during 2006. A weak transmission mechanism as a result of high dollarization challenged the NBM’s efforts to subdue inflation. In light of these developments, the central bank has considerably tightened its monetary policy, bringing the reserve money growth from 20 percent at the end of 2005 down to about 6.5 percent at the end of September, and aims at a nominal contraction of reserve money by about 6 percent by the end of the year. To strengthen its anti-inflationary efforts, the central bank has raised the base interest rate on several occasions, including three consecutive hikes during September-December to 14.5 percent, the highest level since October 2001.

In 2007, the NBM will continue to implement a prudent monetary policy maintaining price stability as its key objective, with the aim to reduce inflation to 10 percent (December-to-December). Interest rates will become positive in real terms. To achieve these goals, the emphasis on indirect monetary policy instruments will be increased, while continuing to maintain a floating exchange rate regime and limiting interventions on the foreign exchange market only in order to reduce excessive fluctuations. Greater exchange rate flexibility will also enhance the economy’s ability to absorb external shocks.

The central bank’s efforts to rein in inflation will be supported by improved coordination between monetary and fiscal policy, resulting from the creation of the Committee on Liquidity Management which comprises representatives of the National Bank of Moldova and the Ministry of Finance. Considering a move to a formal inflation targeting framework at some point in the future, the authorities are taking steps aimed at improving the framework for monetary policy with assistance from the Fund. Also, a series of steps has been undertaken in order to modernize and make more transparent financial relations between the Ministry of Finance and the National Bank.

Safeguarding the NBM’s independence and strengthening its financial soundness remain key. With this in mind, the Parliament has approved, on December 7, 2006, the amendments to the Law on the National Bank of Moldova, which establish that the bank’s capital should be maintained at 10 percent of its monetary liabilities, and grow dynamically with the size of its balance sheet (a March 31, 2007 Structural Performance Criterion). Moreover, it is expected that by the end of the year the government will inject Lei 250 million in liquid assets to NBM capital (a December 31, 2007 Structural Benchmark). Last but not least, to ensure the NBM’s financial strength to manage monetary policy, the authorities will adopt a plan to securitize the remaining outstanding stock of NBM claims on government.

Financial sector

The financial sector remains generally sound, with strong capital adequacy and liquidity ratios, and robust profitability. The available evidence suggests that the banking system is resilient against the adverse impact of the wine ban. At the same time, the authorities concur with staff that a lack of competition and the resulting weak financial intermediation have been key bottlenecks to growth. In this regard, the authorities welcome the arrival of foreign banks in Moldova, and are confident that this will translate into improved competition and deeper financial intermediation. Privatization of Banca de Economii to a strategic banking investor will further foster this process.

While the banking sector has developed, the non-bank financial market is lagging behind. In this regard, the authorities have initiated, with assistance from the Netherlands and the Fund, the creation of a consolidated supervisor for the nonbank financial institutions. The new supervisory authority (National Commission on the Financial Market (NCFM)) will be operationally independent and firmly committed to preserving financial system stability, as well as financial sector development. It is also expected that it will remedy a number of weaknesses in the supervision of NBFIs that were identified by the previous FSAP.

Structural reforms

The authorities acknowledge that in order to surmount the current challenges and to ensure that Moldova returns to rapid economic growth, acceleration in the pace of implementation of structural reforms is critical. With this in mind, the government intends to undertake far-reaching measures to improve the functioning of the public sector and enhance the business environment. In the same spirit, special attention will be placed on measures aimed at broadening the export base and diversifying Moldova’s export markets.

The development of SMEs is one of the core elements that will lead to economic development and poverty reduction in Moldova. In this regard, an action plan for 2006-2008 was adopted last May. In a broader context, the country’s economic development will be supported by the ongoing ambitious regulatory reform, which is implemented hand in hand with the public administration reform. The latter aims at improving efficiency of the public sector and addressing red tape and corruption. Furthermore, the government will move ahead with the implementation of its strategy of investment attraction and export promotion. In this context, the authorities are working towards the conclusion of the Asymmetric Free Trade Agreement with the EU, while establishing accredited laboratories for testing and quality assurance of agricultural products, including wine, in line with EU standards.

To ensure technical infrastructure in line with EU standards, the government will prepare a draft of the Law on public-private partnership in 2007. This law will provide a large range of tools and mechanisms for collaboration and interaction between the public and the private sectors, which aim at funding public investment, including for infrastructure.