Statement by Yuriy Yakusha, Alternate Executive Director for Former Yugoslav Republic of Macedonia and Mihai Tanasescu Senior Advisor to Executive Director February 27, 2008

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. The average inflation rate was 2.3 percent, although it started to pick up recently owing to a relatively high increase in food prices, reflecting the global trend. On the expenditure side, the authorities will improve the quality of spending and redirect public spending to more productive uses, such as health, education, and infrastructure.

Abstract

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. The average inflation rate was 2.3 percent, although it started to pick up recently owing to a relatively high increase in food prices, reflecting the global trend. On the expenditure side, the authorities will improve the quality of spending and redirect public spending to more productive uses, such as health, education, and infrastructure.

On behalf of the Macedonian authorities we thank staff for their contribution to the policy dialogue and their analysis and recommendations. The authorities value their close cooperation with the Fund, and are of the view that the consultation process has worked well and has focused on topics of importance to the Macedonian economy. This third review of the Stand-By Arrangement provides again a good opportunity to focus on the economic issues aimed at strengthening macroeconomic stability, and intensifying structural reforms.

Economic performance and outlook

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. From a longer-term perspective, the Macedonian economy continued to exhibit solid growth, averaging around 5 percent over the past years. For 2007 the growth rate is expected to reach between 5 and 5.5 percent, propelled by industrial production, in particular of iron and steel, trade and transportation. At the same time, private consumption and investment picked up, benefiting from lower taxes and a friendly business climate. The average inflation rate was 2.3 percent, although it started to pick up recently due to a relatively high increase in food prices, reflecting the global trend. Unemployment has continued to decline, but the official unemployment rate remains high at 34.2 percent in the third quarter of 2007. However, more than 50,000 jobs, or around 10 percent of the total 2007 employment, have been created in the last seven quarters, showing that implementing strong structural reforms will attract further foreign direct investment, and reduce unemployment. Savings have been healthy, aided by improved government savings, which, in turn, helped maintain a rising investment share in the economy. FDI and portfolio investments have correspondingly also been strong, and together with the higher private transfer inflows resulted in an increase of international reserves to 1.5 billion euro, higher than the program projection, besides the early repayment of the external debt, which has declined to around 35 percent of GDP. The current account deficit was only 2 percent of GDP. Looking forward, prospects for growth remain good. Over the medium term the real GDP growth is expected to reach around 6.5 percent, and inflation is projected at a relatively low level. Higher growth and investment, especially FDIs, is expected to temporarily widen the current account deficit. to around 6 percent of GDP in 2007, and employment is projected to increase by about 4 percent per year with a further decline in unemployment. Following a possible invitation for membership in NATO, and accelerated procedures for membership in EU, FDI could rise and the convergence process could accelerate even further, allowing for an additional pickup in potential growth.

Fiscal policy

The authorities have implemented a successful policy of fiscal consolidation over the past few years, in agreement also with staff and in the context of the successfully completed first two reviews of the Stand-By Arrangement. In 2007, the general budget ran a small budget surplus, of about 0.6 percent of GDP, well above the 1 percent deficit target. This fiscal consolidation was due to a strong revenue overperformance and expenditure savings. However, two supplementary budgets implemented in the last quarter of 2007 increased public spending, particularly in education, health and infrastructure, and allowed the reduction of arrears in these sectors. The 2007 fiscal consolidation was possible because the main element in the authorities’ economic reform agenda is simplifying the tax system, improving its efficiency, and reducing the tax burden. In January 2008 the authorities further reduced personal and corporate income tax rates from 12 to 10 percent, and they introduced a simplified corporate income tax for small businesses, with a flat rate based on turnover. On the expenditure side, the authorities will improve the quality of spending and redirect public spending to more productive uses, such as health, education and infrastructure. For 2008 the authorities are committed to maintaining macroeconomic stability, and the fiscal deficit target of 1.5 percent of GDP is in line with the program.

The authorities acknowledge staff’s concerns regarding the pension increase by on average 15 percent after the Parliament had passed the budget, but are committed to continue the fiscal consolidation and to fit these measures within the 1.5 percent of the GDP deficit target already approved. The 2008 budget and the medium-term fiscal strategy already incorporated a wage bill increase of 10 percent in each of the next three years, starting in October 2007. The tax reform implemented in the last two years led to improved revenue collection; tax revenue in 2007 exceeded the program target by 3 percent of GDP. In this respect, the authorities expect the increases in the wage bill to be funded in full from current tax revenues, and the latest data for January 2008 show an overperformance in total revenues, especially from VAT. The data for January 2008 also demonstrate that the collection of pension contributions overperformed, and the authorities expect that the pension contributions will continue to follow the rising trend from November last year. The authorities are consistent with their commitment to fiscal discipline, and they believe that overperformance in social contributions will finance the cost of the pension increase that was announced in January 2008 (0.5 percent of GDP), safeguarding the 2008 deficit target. Tax administration reform is currently well underway. The Public Revenue Office has intensified arrears collection, and improved tax collection from both large and small taxpayers. It has designed a clear strategy for improving tax administration and for making more information available to taxpayers. Furthermore, the new IT system introduced in the Pension Disability Fund has bolstered revenue collection, and preparation of legislation harmonizing the base for healthcare contributions with pension and employment contributions will strengthen the collection of social contributions and reduce the labor tax wedge. The customs administration reform and the implementation of the second phase of fiscal decentralization will strengthen the fiscal reform and will allow the local governments to increase their revenues. All these reforms in the tax administration will allow the authorities to keep fiscal policy as the main policy tool to ensure macroeconomic stability and debt sustainability.

Monetary policy and financial sector reform

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 together with a prudent fiscal policy has helped contain inflation at low levels. The inflation path in the Macedonian economy in 2007 does not resemble developments in the previous years, and does create a potential challenge for monetary policy. Inflation started to accelerate as of August 2007 and reached 6.1 percent on year-on-year basis in December. The largest part is explained by supplyside factors such as a pick-up in food and energy prices, with core inflation remaining low at 1.2 percent y-o-y. Inflation expectations are currently stable, but the risks, from wage increases, increased domestic demand, and acceleration of credit growth, are present and stress the need for strong vigilance from the NBRM. In this respect the Central Bank recently increased the interest rates on their own bills from 5.08 percent to 5.25 percent, to absorb liquidity from the domestic banks. It should be said at the outset that external vulnerability remains manageable, and the recent international financial turmoil did not directly affect the Macedonian banking system. Its indirect impact, on the other hand, could lower economic growth and worsen the trade deficit or weaken remittances. However, the external position remains strong, the current account deficit is lower compared with the program projection, and the international reserves have increased, representing around 4 months of imports.

The authorities remain committed to safeguarding the Central Bank’s independence. The new draft NBRM law was sent to the EU Commission and ECB last October, and meanwhile the Ministry of Finance has made procedural consultations with the Secretariat for Legislature and the Ministry of Justice. Once the opinion from the EU institutions is received, the law will be ready for submission to the Government and subsequently to the Parliament for adoption. The primary objective of the Central Bank, under the new law, will remain to achieve and maintain domestic price stability, and it will retain full autonomy in reaching that goal.

In order to promote financial market development, the government is currently implementing a financial sector reform package, with the intention of making Macedonia more attractive for foreign banks. Some recent developments indicate significant steps forward in the process of strengthening banks’ governance, tightening provisions on connected lending, and establishing a framework for consolidated supervision. At the same time, the NBRM is implementing a new framework to strengthen the banking supervision through its supervisory development plan, for assessing risk profiles of the commercial banks, and also to issue accounting guidelines in line with the new chart of accounts and formats for banks’ financial statements.

Structural reforms, and improving the business climate

Macedonia has made significant progress on the structural reform side, and a number of these reforms were already mentioned when considering the government’s fiscal plan. Other notable areas include plans for regulatory reform, liberalization of telecommunications, privatizations and railway restructuring. Attracting greenfield foreign direct investment is a main objective of the authorities’ economic program, and the modifications of the law on Technological Industrial Development Zones will bring it closer to the EU acquis, and should attract leading international companies, creating new jobs and reducing unemployment.

In consultation with the business community, the authorities simplified business regulations, establishing the “one-stop-shop”, and reduced the time required to register a business from five days to four hours. They have eliminated the requirement to deposit paid-in capital before registering a limited liability company. As a result business registration increased from about 7,000 in 2005 to more than 11,000 in 2007. The authorities are committed to strengthen the legal system of property rights, and they made good progress drafting, in consultation with the World Bank, a new law on the Real Estate Cadastre, improving the quality of services provided by the Cadastre office, and facilitating the use of land as loan collateral, which will help lower borrowing costs and expand credit.

One of the most important reform programs is in the electricity sector. The authorities strongly believe that improving the electricity sector’s finances and eliminating budget subsidies will increase private sector participation and will improve financial discipline. In this regard, in collaboration with the World Bank, the authorities developed a strategy that will identify priority investments in the energy sector, and a plan for obtaining the necessary financial resources. The government will furthermore accelerate private-sector involvement in the energy sector, by privatizing small and medium-sized hydro-electric plants, and starting new tenders for the construction of a number of new hydro-power plants. The government decided that starting January 2008, large energy users have to pay import prices for electricity, eliminating subsidies. It also decided to start liberalizing prices for enterprises over the next 2-4 years. Last but not least, the authorities remain committed to further liberalizing household prices, but in a gradual manner, avoiding sharp shock.

Finally, we would like to express the authorities’ commitment to continuing implementing the necessary reforms for improving the business environment and attracting foreign investment, reducing unemployment and strengthening the macroeconomic stability.