Statement by YuriyYakusha, Alternate Executive Director for Former Yugoslav Republic of Macedonia and Vladimir Monteanu, Senior Advisor to Executive Director

This paper discusses the Former Yugoslav Republic of Macedonia’s Second Review Under the Stand-By Arrangement and Request for Waiver of Performance Criteria and Rephasing of the Program. The 2007 fiscal deficit target increased modestly to 1 percent of GDP. Taxes were cut and budget quality improved, but there remain fiscal risks, in particular in delivering the planned reduction in transfers and subsidies. Over the medium term, the government aims to keep the fiscal deficit below 1½ percent of GDP, cutting overall government spending by 2 percent of GDP while raising public investment.

Abstract

This paper discusses the Former Yugoslav Republic of Macedonia’s Second Review Under the Stand-By Arrangement and Request for Waiver of Performance Criteria and Rephasing of the Program. The 2007 fiscal deficit target increased modestly to 1 percent of GDP. Taxes were cut and budget quality improved, but there remain fiscal risks, in particular in delivering the planned reduction in transfers and subsidies. Over the medium term, the government aims to keep the fiscal deficit below 1½ percent of GDP, cutting overall government spending by 2 percent of GDP while raising public investment.

April 27, 2007

On behalf of the Macedonian authorities we thank staff for the constructive policy dialogue since the new government took office last August, and for the valuable advice, which is helping them in the policy formation process.

Macedonia’s economic performance under the program has remained strong, reflecting the authorities’ commitment to build on the progress made and to advance the reform agenda to a level which will help accomplish full integration into the European community. Real GDP growth is estimated by staff to have reached 4 percent in 2006, with exports being the main engine of growth. More recently, increasing internal demand has also contributed to growth. The authorities’ prudent economic policies helped safeguard the hard-won macroeconomic stability and boosted market confidence, while broad-based growth, in combination with labor market liberalization contributed to a modest but consistent increase in employment. Fiscal policy remained disciplined allowing Macedonia to meet the program deficit target of 0.6 percent of GDP, and to further improve its external debt sustainability. Although inflation is higher than in previous years, largely due to one-off factors, including an increase in excises and household electricity prices, it remains low, at 0.8 percent (y-o-y) at end-March 2007. The external position continued to improve, owing to stronger exports, buoyant private transfers, and higher-than-anticipated privatization proceeds. This also led to an increase in international reserves.

The economic outlook for 2007 and for the medium-term remains favorable. To ensure a firm foundation for continued fiscal sustainability, the authorities’ macroeconomic framework is prudent in assuming 4½ percent real GDP growth. At the same time, the authorities believe that their ambitious structural reforms will take hold quickly and the real GDP growth may reach 6 percent in 2007. The government’s macroeconomic framework allows a modest increase in the budget deficit, while preserving fiscal discipline and debt sustainability. Inflation is expected to decrease slightly in 2007 and will reach 2 to 2.5 percent over the medium term. The current account deficit will remain sustainable and the gross international reserves will continue to grow.

Although progress has been made since the new government took office, the main economic challenges facing the authorities are to turn around the weak business climate through structural reforms, to increase productivity growth, to foster entrepreneurial activity and to reduce rigidities in the labor market. The authorities share staff’s view that a continuedstable macroeconomic policy is necessary to sustain growth, and remain committed to address the underlying structural weaknesses, by improving institutional capacity and enhancing financial market development.

Against this background, the authorities request the completion of the second review and waivers for non-observance on structural performance criteria, as well as rephasing of remaining purchases. Also, they reaffirm their intention not to make the purchase under the SBA.

Fiscal policy

The authorities continued their strong track record of prudent fiscal policy, comfortably meeting the program’s deficit target despite a shortfall in non-tax revenues. Underexecution of capital expenditures, savings on goods and services and higher tax revenues offset this shortfall (unpaid telecom dividend of about 0.8 percent of GDP), and allowed to reduce arrears in healthcare. Simplifying the tax system, improving its efficiency, and reducing the tax burden is a key element in the authorities’ economic reform agenda. Along with these principles, shortly after coming to office the new government launched an ambitious tax reform, which envisages the introduction of flat and lower personal and corporate income tax rates, while broadening the bases of these taxes to contain revenue losses. To this effect, the personal and corporate income tax rates were unified at a flat 12 percent in 2007, and will be reduced to 10 percent in 2008, with a zero tax on reinvested profit. In addition, important reforms aimed at streamlining revenue administration, including the introduction of harmonized bases for social security contributions and the elimination of customs declaration fees, will be implemented.

The authorities share staff’s concerns regarding the revenue losses associated with these reforms and have introduced a number of compensatory measures. To this effect, the tax base was broadened by abolishing some existing exemptions from the corporate income tax. Also, the double deduction for investment in fixed assets from the corporate income tax law has been eliminated, and fees on gambling establishments and taxes on games of chance have been increased. On the expenditure side, steps were made to redirect government spending to more productive use, including reduction in spending on furniture and cars. In addition, wage expenditures are expected to decline by 0.2 percent of GDP, bringing the total effect of these compensatory measures to 0.6 percent of GDP. Furthermore, the authorities are pleased to report that tax revenues for the first quarter of 2007 have overperformed by 12 percent, compared to staff’s more conservative expectations.

Consistent with their commitment to fiscal discipline, the authorities are taking steps to address problems in health and energy sector finances, to ensure that these will not require additional transfers from the budget later in the year. In this context, Health Insurance Fund (HIF) arrears were cleared in 2006, while non-HIF central government arrears will be kept close to their end-2004 level. In the same vein, the authorities put a lot of emphasis on short-term expenditure rationalization, which goes to the core of their fiscal program. For this the authorities seek IMF assistance.

In light of the strong budget position, in 2007 the authorities are repaying around EUR 180 million of Macedonia’s external debt, by drawing down part of the Government’s significant foreign currency deposits. This will improve the structure and level of the public debt and will create important interest savings in the budget.

Looking forward, fiscal policy will continue to be the main policy tool to ensure macroeconomic stability and debt sustainability. The authorities stand ready to tighten the budget in the second half of 2007 if risks to meeting the fiscal target emerge or the current account deteriorates. To prevent spending one-off revenues, they will cap the contribution of the telecom dividend, which is also consistent with their plan to liberalize telecommunications.

Exchange rate and financial sector

The National Bank of the Republic of Macedonia (NBRM) continues to support the economic program by maintaining a de facto pegged exchange rate regime backed by an adequate level of international reserves. The exchange rate serves well as a nominal anchor, and in combination with a prudent fiscal stance has helped contain inflation at low levels. Average inflation increased to 3.2 percent in 2006, largely due to one-off factors, including an increase in excises and in household electricity prices last September. Central bank interest rates remain stable at around 5½ percent. Deposits in local currency and credit to the private sector grew by 36 percent and 30 percent respectively. Macedonia’s external position continued to improve, with stronger exports in virtually all sectors offsetting the higher import bill for investment goods. This, also supported by buoyant capital inflows, allowed the central bank to further increase its international reserves to €1.4 billion.

The authorities remain committed to safeguarding the NBRM’s independence and strengthening its financial soundness. To this effect, the law on the NBRM was amended, allowing it to retain 70 percent of its profits when general reserves are below the statutory limit, and then 15 percent after that.

In order to promote financial market development and to improve its soundness, the authorities have prepared a comprehensive revision of the legal framework in line with international best practice. Along with enhanced licensing requirements, the new Banking law strengthens bank governance, increases minimum capital requirements, and tightens provisions on connected lending. It establishes a clear framework for consolidated supervision and for corrective action and/or resolution of weak or insolvent banks. The new law protects the central bank’s decision-making powers in the areas of banking licensing, receivership and bankruptcy from reversal by the courts. It also allows foreign bank branching, which in the authorities’ opinion will enhance competition and deepen financial intermediation.

In light of increasing credit growth, in particular lending denominated in or indexed to foreign currency, the NBRM took steps to strengthen banking supervision by tightening prudential guidelines for bank lending. They also improved the tax treatment of banks’ loan loss provisions by making specific provisions fully tax-deductible. Furthermore, the NBRM has started the implementation of its Supervisory Development Plan, which aims to migrate to a more risk-based, anticipatory approach to banking supervision. Actions were taken to improve the NBRM’s supervisory capacities. To this effect the NBRM has increased the resources of the supervision and banking regulation department, and stands ready to add more resources if needed.

Attracting FDI and improving the business climate

Macedonia has made substantial progress on the structural reform front, however the authorities recognize that it is time for the next generation of reforms. While the reform agenda remains broad and ambitious, regulatory reform, liberalization of telecommunications and improving the business environment are at the top of this agenda. Attracting greenfield foreign direct investment by leading international companies is a key objective of the authorities’ economic program. In 2007, they will formulate a national program to stimulate investments, which will identify priority measures and activities necessary to attract high quality FDI for the period 2007-2010.

In close consultation with the business community, and drawing on the expertise of the World Bank, the authorities introduced the “regulatory guillotine” initiative, in November 2006. This initiative aims at simplifying the regulatory regime and improving the quality of regulations affecting business activity. Under this process, all laws and by-laws regulating economic activity are being currently reviewed and the unnecessary ones will be abolished by end-September 2007.

The authorities strongly believe that strengthening the legal system, property rights, and contract enforcement is key to achieving sustained private sector-led growth and improving the business climate. In this regard, they plan to complete full registration of real estate property and land by end-2008. This will provide legal security to investors and will allow for use of land as collateral, which will help to expand credit. In addition, they will improve contract enforcement by reducing the backlog of court cases.

One of the centerpieces of the reform program, which the authorities believe will have a major impact on the business environment, remains the ambitious judicial reform. Effective implementation of several new laws, including the Law on Enforcement, the Law on Courts, and the Law on Misdemeanors, will increase the independence and the efficiency of the country’s judiciary. Last but not least, the authorities remain committed to further liberalize the labor market by reducing the labor wedge and promoting part-time work.

Former Yugoslav Republic of Macedonia: Second Review Under the Stand-By Arrangement and Request for Waiver of Performance Criteria and Rephasing of the Program: Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for the former Yugoslav Republic of Macedonia
Author: International Monetary Fund