Recent economic developments

The key development since the completion of the last review is the improvement in external outlook and the higher growth perspective. The authorities’ decisive adjustment measures, in part unpopular with the general public, in combination with donor support, and an improving external environment helped to weather the effects of the shocks. Despite a doubling in the price of natural gas, albeit somewhat lower than initial expectations, and thanks to a gradual diversification of export markets, and buoyant remittances¹, real GDP grew at 4 percent in 2006, exceeding staff’s more conservative projections. GDP growth is expected to further increase to 5 percent in 2007, and will be sustained at this level over the medium term.

The headline inflation continued to decline and reached 10.4 percent (y-o-y) in June, from 14.1 percent at the end of 2006, while the cumulative inflation during the first six months of 2007 was 3.9 percent compared to 7.4 percent during the same period of last year. The NBM’s disinflation efforts have been supported by a prudent fiscal policy. The tight fiscal stance in combination with sound debt management also helped to maintain the improvement in debt sustainability, following last year’s Paris Club agreement to reschedule Moldova’s bilateral debt.

Some progress has been achieved in restoring economic relations with the Russian Federation, and the authorities hope that a resumption of wine exports will follow the recent decision to allow other agricultural products on the Russian market. At the same time, encouraging progress has been made in diversifying exports. The preliminary data for January-May 2007 indicate that the EU, including Romania and Bulgaria, became the main export market for Moldovan goods. Thus, exports to the EU market accounted for 50.9 percent of total exports for the first five months of the year, while the share of exports to the CIS market decreased from 46.2 percent to 37.3 percent during the same period.

Monetary policy

Robust foreign exchange inflows, and a still high level of dollarization, continued to present challenges to the monetary authorities. Against this background, additional efforts were required on behalf of the National Bank of Moldova (NBM) to rein in inflation. The NBM’s stepped-up sterilization operations pushed real interest rates into positive territory, and supported by appreciation of the leu, led to a decline in y-o-y inflation by about 4 percentage points in the first half of 2007. As noted in the staff report, this indicates that the authorities’ end-year goal of single-digit inflation is attainable. Despite of this positive development, the authorities understand that interest rates may need to remain relatively high until disinflation is entrenched, and stand ready to further tighten the monetary policy stance if needed.

To achieve its monetary objective - price stability - the NBM will apply indirect monetary policy instruments, which will be facilitated by the strengthened capital position of the NBM, and by the transfer of the remaining deposits of the health and social funds to the single treasury account in the National Bank. The NBM will continue to maintain a floating exchange rate and will intervene on the foreign exchange market mainly to smooth out volatility in the exchange rate. The exchange rate flexibility will enhance the economy’s ability to absorb external shocks. At the same time, the authorities expect that by the end of the year international reserves will increase to a level equivalent to about three months of prospective imports.

The NBM is considering the possibility of moving to an inflation targeting (IT) framework at an appropriate point in the future. In this context, it is taking a number of steps to improve the monetary policy framework, and thus to lay the groundwork for IT. When carrying out sterilization of excessive liquidity, the NBM will announce either a maximum interest rate, or the volume of intended sales. To improve coordination between the NBM and the Ministry of Finance and strengthen liquidity management capacity, a joint NBM-MoF liquidity managing committee was created. Furthermore, beginning with the 2008, the law on the budget will no longer oblige the NBM to roll over treasury bills, instead, this issue will be decided at the joint NBM-MoF liquidity committee. In order to ensure that the NBM will have the tools to conduct monetary policy, by September 30, 2007, the Ministry of Finance and the NBM will adopt a plan for securitizing the stock of government debt owed to the NBM by end-March 2008.

Fiscal policy

Fiscal policy remains prudent, despite growing pressure to increase expenditures on badly needed infrastructure investments and on current expenditures, in an environment of rising poverty and an exodus of population. Fiscal performance continued to be strong with overall tax revenues reaching 33.8 percent of GDP in 2006 due to growing VAT receipts on imports, improved tax administration and compliance. The same tendency persisted in the first half of 2007. The state budget revenues overperformed against the target by 3.8 percent. Acknowledging the importance of fiscal policy in supporting the overall macroeconomic stability, the authorities remain committed to a prudent fiscal stance. This has been clearly reflected in the authorities’ decision to approve a supplementary budget, which allows allocation of excess revenues collected only through April, although it is expected that the strong revenues will persist for the rest of the year.

To finance the increase in public sector wages, which are insufficient to attract and retain qualified employees, many of whom have opted instead to work abroad resulting in a tight labor market and increasing capacity constraints, the size of the general government wage bill will be set at about 10 percent of GDP. In the same vein, the government intends to begin a medium-term program of public employment rationalization. As a first step in this direction, the Parliament has already approved a reduction in staff of the National Army and institutions under the Ministry of Defense by 600 people. Furthermore, the government will prepare by end-September 2007, a multi-year concept paper, the goal of which is to reduce public employment while attracting and retaining the best performing and most promising staff.

To ease the tax burden and promote investment, the authorities have announced a major reform of corporate income taxation, an amnesty on tax arrears, and a liberalization of the rules governing the legalization of capital. In this context, the corporate income tax rates will be set to zero, except when dividends are paid and non-business expenses are incurred. The authorities believe that in Moldova’s environment a total tax amnesty will be effective. Thus, starting with a “clean sheet” will help to reduce corruption and allow to focus all existing resources on improving the tax administration, rather than wasting them on managing the largely uncollectable historic arrears. To this effect, they intend to adopt by end-September an action plan aimed at improving the tax arrears management by enhancing the tax arrears accounting system, introducing prompt and unconditional measures to ensure forced collection of arrears, and by passing legislation for shortening and streamlining the procedure for writing off uncollectable tax arrears. Furthermore, the legislation to consolidate all domestic tax assessing and collecting activities in one agency will be adopted. The authorities are fully aware that this reform entails some risks, including to budget revenue. Therefore, they are ready, if necessary, to take compensating measures to ensure that the fiscal and macroeconomic targets in the program will be achieved.

The main purpose of the capital legalization is to reduce the shadow economy by encouraging both physical and legal persons, exclusively residents of the Republic of Moldova, excluding Transnistria, to declare their assets at market value, specifically the assets acquired during the economic decline in the 90s at very low prices. No cash is allowed to be legalized by legal persons. At the same time, the authorities recognize that the capital legalization could pose some risk for the anti-money laundering regime. To address these risks, they had extensive consultations with the main development partners, including the US, European Commission, MONEYVAL, and the Fund, and intend to accelerate the adoption of amendments to the AML legislation prepared with the latter’s assistance, while also adopting implementing regulations aimed at ensuring the AML framework remains robust.

Financial sector

The financial sector remains generally sound, and has proved resilient to the difficulties associated with the external shocks. The capital adequacy and liquidity ratios, as well as profitability of the banks remain robust. The authorities welcome the arrival of several foreign banks in Moldova, which should translate into improved competition and deeper financial intermediation. The authorities remain committed to privatize Banca de Economii (BEM) to a strategic banking investor, which will further foster deepening in the financial market. To this end, they have solicited the assistance of the International Financial Corporation in preparing to bring BEM to market shortly after completion of the evaluation.

To facilitate the development of the non-bank financial market the parliament has passed the legislation to establish the National Commission for the Financial Markets (NCFM), which will begin operations by August 31, 2007. The NCFM will be financially and operationally independent, and, once it reaches its full operational capacity, but not later than September 30, 2008, it will fully acquire the right to issue and revoke licenses for all types of supervised non-banking financial activity. In the meantime, it will have the full right to suspend the licenses of market participants in violation of prudential norms. Moreover, in order to assess the progress in improving prudential regulation, transparency in ownership of the banking sector, and supervision of the non-bank financial sector, the authorities have requested an FSAP update, which is scheduled to take place in early September.

Structural reforms

On the structural front, the authorities undertook measures aimed at enhancing the economy’s resilience to external shocks, developing the financial sector, and limiting government involvement in the economy. To this effect, the parliament approved legislation that ensures the passing on to final consumers the increase in energy prices, the legislation aimed at developing the non-bank financial market, and the law on denationalization and management of public property. Also, the second stage of the regulatory reform is carried out.

To promote trade and investments, the government is implementing its strategy for attracting investment and promoting exports during 2006–15. In this regard, the key priorities are: (i) obtaining autonomous trade preferences from the EU; (ii) conducting a detailed study of the economic implications for Moldova stemming from Romania’s accession to the EU; (iii) creating accredited laboratories for testing and ensuring quality of a number of Moldovan products in compliance with the European standards; and (iv) establishing simplified methods of accounting for small and medium-sized enterprises.

The government has also prepared a concept paper on public-private partnerships (PPP), which will offer a wide spectrum of instruments and mechanisms for cooperation and interaction between the public and private sectors to increase infrastructure investment. The concept paper envisages that contingent liabilities that could appear in this process will be transparently reported to the financial market as well as to the parliament.

Moving forward, the authorities’ main goals are to reduce poverty and improve the social assistance system², ensure macroeconomic stability, and sustain economic growth by improving public sector efficiency and the business environment. Also, attracting FDIs, which remain very low in contrast to other comparable countries in the region despite recent progress made by Moldova, is on top of the authorities’ agenda. These objectives are incorporated in the Economic Growth and Poverty Reduction Strategy Paper (EGPRSP), and in the EU-Republic of Moldova Action Plan. Beyond the EGPRSP, which expires at the end of the year, the government’s objectives will be outlined in the National Development Plan for 2008–11 (NDP). The NDP will also integrate the key external commitments of the Republic of Moldova into one basic strategy and will provide a single system for monitoring and evaluation.