Republic of Moldova
Fourth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Request for Waiver of Nonobservance of Performance Criterion: Staff Report; Staff Supplement; and Press Release

This paper examines the Republic of Moldova’s Fourth Review under the Poverty Reduction and Growth Facility and request for Waiver of Nonobservance of Performance Criterion. Investors have been attracted by Moldova’s low costs, and export prospects have improved with the resumption of wine exports to Russia and a new trade agreement with the European Union. Inflation is the main concern. While rising inflation partly reflects regional trends in food and energy prices, strong demand has been adding to inflation pressures.


This paper examines the Republic of Moldova’s Fourth Review under the Poverty Reduction and Growth Facility and request for Waiver of Nonobservance of Performance Criterion. Investors have been attracted by Moldova’s low costs, and export prospects have improved with the resumption of wine exports to Russia and a new trade agreement with the European Union. Inflation is the main concern. While rising inflation partly reflects regional trends in food and energy prices, strong demand has been adding to inflation pressures.

I. Introduction

1. With the growth outlook positive, inflation is the main challenge. The economy has shown resilience in the face of successive shocks, including a Russian ban on imports of Moldovan wine and a sharp increase in the price of imported natural gas in 2006, and last year’s drought. Growth is expected to recover strongly in 2008, with good prospects for the harvest and strong FDI inflows. Macroeconomic stabilization remains the key concern, with inflation under pressure from higher food and energy prices globally, but also from strong demand growth on the back of a recent surge in capital inflows reminiscent of that seen earlier in EU accession states. Demand pressures have also contributed to a widening of the current account deficit to 17 percent of GDP in 2007. The deficit nonetheless remains more than financed by long-term capital, in part reflecting a welcome structural shift from remittances to foreign investment as Moldova evolves into a transition economy. The deficit should gradually unwind, helped by a new trade agreement with the EU, and a resumption of wine exports to Russia.

2. Performance under the program has been satisfactory. All end-March quantitative PCs and indicative targets were observed, and all structural PCs were implemented, with the exception of a PC on adopting legislation on the STI, which was implemented with a small delay in June 2008. Given the temporary nature of the deviation, staff supports the authorities’ request for a waiver of non-observance of this PC.

3. Political pressures have started to build in the run-up to national elections early next year, but so far remain contained. The authorities’ strong commitment to the PRGF arrangement and prospects of growing financial assistance from the EU and international donors has so far supported reform. However, calls to raise spending have strengthened. In the meantime, Prime Minister Tarlev and his cabinet resigned on March 19, to make way for a new government headed by former deputy prime minister Ms. Greceanii, who has been a strong supporter of reform.

II. Recent Developments

4. Growth in 2007 was slightly weaker than expected due to the drought. Growth in 2007 is now estimated at 4 percent based on preliminary numbers. Nonagricultural GDP growth, however, remained strong at 9 percent. Early data for 2008 suggest continuing strong investment-driven demand, with investor interest in Moldova boosted by low labor costs and an acceleration of the privatization program.

5. But inflation is rising. Rapid growth in food prices, due to the drought and global price trends, was compounded by NBM’s slow response to rising inflationary pressures. Inflation reached 16 percent in April, up from 13 percent at end-2007, eroding the real interest rates. Core inflation (non-food, non-energy CPI) also rose to 12 percent in April, compared with 11 percent at end 2007, suggesting strong second-round effects from the drought and mounting demand pressures. At the same time, there are few signs of price pressures in real estate and assets markets as seen elsewhere in the region, and wage growth, at 8 percent in real terms, remains moderate given productivity gains.

Source: Moldovan authorities; IFS; and Fund staff calculations.

6. The current account deficit widened in 2007, but remains more than covered by FDI and long-term debt flows. The recently released preliminary balance of payments data show the current account deficit at 17 percent of GDP, compared to 9 percent previously estimated (Box 1). Strong FDI-driven domestic demand and the impact of the drought on net agricultural imports have undoubtedly played a role. But the main driver was a shift from remittances (which appear in the current account) to foreign investment (capital account) as discussed in Country Report No.08/139.1 Other capital flows also grew sharply, reflecting in part transfers from parent banks abroad to local subsidiaries to help meet increased reserve requirements, but also higher trade credits. At the same time, large errors and omissions (4 percent of GDP) make analysis of the preliminary balance of payments data difficult as part of these flows may be eventually reclassified into remittances as in the past.

Competitiveness in Moldova

Competitiveness in Moldova remains adequate as described in Country Report No. 08/139. Despite demand pressures, the wider trade deficit in 2007 largely reflects the impact of the drought, and FDI-related imports. The real effective exchange rate is broadly in line with fundamentals, and remains only modestly above its level in 2001, in contrast to regional competitors. At the same time, labor productivity has been growing quickly.


Unit Labor Costs

(Manufacturing, USD/month)

Citation: IMF Staff Country Reports 2008, 320; 10.5089/9781451825183.002.A001

Sources: ILO; Moldovan authorities; and Fund staff estimates

Labor Productivity

(Index; 2000=100)

Citation: IMF Staff Country Reports 2008, 320; 10.5089/9781451825183.002.A001

Sources: WEO; and Fund staff estimates

Moldova also remains competitive in lower value-added industries, such as textiles. The following table lists textile export rank, textile exports, USD earnings per month, and UDS GDP per capita. Also included is the 2008 Doing Business Rankings. It shows that compared to what are considered its main competitors for lower value-added business, Moldovan labor costs are low, although the business environment has room for improvement.

Textile Export Competitiveness

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7. The policy response in early 2008 was mixed. Monetary policy was slow to react to higher inflation, while weak spending controls in the first two months of the year required a sharp fiscal correction in March.

8. The monetary authorities have continued to play catch-up in responding to higher inflation. While the NBM gradually increased the sterilization interest rate from 13.5 percent in November to 17 percent in March, the real rate has been gradually eroded. The reserve requirement was raised, but only marginally. More positively, the NBM slowed the build-up of reserves in the first quarter of the year, allowing the currency to appreciate against the dollar, although there was little movement against the euro. Despite these measures, excess liquidity remains and credit growth is strong, adding to demand pressures.


Real Effective Exchange Rates: Country Comparison


Citation: IMF Staff Country Reports 2008, 320; 10.5089/9781451825183.002.A001

Source: WEO; Fund staff calculations

9. Fiscal policy has slipped, although the end-March PC on the consolidated budget was met. While revenue growth remained robust in January and February, lack of expenditure controls caused spending to surge 11 percent in real terms compared with 2007. With the wage bill contained, most of the excess spending was on current expenditure on goods and services, as well as increased transfers to farmers for seeds and fertilizers in response to cash shortages following the drought. Moreover, project spending lagged behind projections because of capacity constraints, accentuating the shift toward current expenditures. However, despite these slippages the end-March programmed surplus of 0.4 percent of GDP was achieved, as the government cut back spending sharply in March, delaying expenditures to April, and import-related revenues continue to overperform.

Figure 1.
Figure 1.

PRGF Performance, 2007–08

(In millions of lei, unless indicated otherwise)

Citation: IMF Staff Country Reports 2008, 320; 10.5089/9781451825183.002.A001

1/ In accordance with the TMU, the deficit target for Q1 2008 was adjusted by the amount of shortfalls in foreign loan disbursements.Sources: Moldovan authorities; and Fund staff calculations.

10. Potential domestic payment arrears are building up, as difficulties in maintaining cost-recovery tariffs for heating continue. The municipality of Chisinau, in breach of the Civil Code, introduced a retroactive tariff of lei 456 for the period of December 4 to April 14, from the tariff of lei 540 introduced at the time of the last review. As a result, Termocom, the heating producer, is seeking compensation equivalent to lei 200 million that puts further pressure on the consolidated budget. These arrears were in breach of the indicative target on non-accumulation of domestic arrear.

11. Debt is broadly sustainable. The March Article IV and Third Review DSA suggests presently-envisaged borrowing can be accommodated. The debt-sustaining non-interest current account deficit is estimated at 20 percent of GDP. Given the positive growth outlook, implementation capacity is likely to be more of a constraint than debt sustainability, with loan disbursements consistently running behind projections.

III. OUTLOOK And Policy Discussions

A. Macroeconomic Stability under Pressure

12. Growth prospects remain positive, with risks on the upside. Growth is projected at least 6-7 percent in 2008. Demand is projected to remain strong, even with the expected tightening of policies, on the back of an upsurge in FDI inflows. Robust growth in nonagricultural GDP continues, and agriculture is expected to bounce back from last year’s 35 percent drop.2 However, while a good harvest may help to ease inflation, especially for food, the end-year target of single-digit inflation now appears beyond reach. As a result, the medium-term disinflation path has been revised up by 2.5 percentage points in 2008 and 2009, and by 1 percentage point in 2010. Inflation is now targeted to be reduced below 12 percent by end-2008, with some upside risk, and to single digits in 2009.

Medium-Term Outlook, 2005–10

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Sources: Moldovan authorities; and Fund staff estimates and projections.

13. The current account deficit is projected to recover only marginally in 2008. The resumption of wine exports to Russia is expected to be somewhat slower than previously expected. Nevertheless, non-wine export growth in 2008 is expected to remain strong. While remittances are likely to be affected by the global slowdown, the impact is likely to be moderate as past experience in Moldova suggests that remittance growth tends to be countercyclical, as workers abroad cushion shocks within the country. Higher official international transfers for farmers for seeds and fertilizers will also help the current account position. The current account is projected to remain fully covered with long-term capital inflows, boosted by accelerated privatization.

14. In the medium-term, demand pressures are projected to wind down only slowly. The larger-than-expected impact of the drought will unwind quickly, and wine exports gradually recover their full potential. However, investment-driven demand for imports will continue to sustain substantial current account deficits in the near term. This is to be expected given that Moldova is at the start of the transition. Despite appreciation pressures, there is no immediate concern that Moldova will lose its competitive edge as it continues to enjoy low labor costs and rapid productivity growth. However, in the longer term, to ensure that the current account eventually unwinds smoothly, it will be essential to strengthen competitiveness by boosting structural reforms, including ongoing improvements to the business environment.

Sources of Financing of Domestic Demand

(in percent of GDP)

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Sources: Moldovan authorities, and Fund staff calculations.

B. Strengthening the Program to Face Macroeconomic Strains

15. The review addressed three main policy challenges:

  • How to arrest rising inflation and resume disinflation;

  • How to ensure the budget provides stronger support for disinflation, while preserving overall development and social objectives;

  • How to avoid a continuing build-up of quasi-fiscal arrears in the energy sector.

Reestablishing disinflation

16. In light of the up-tick in inflation, the NBM is to move more aggressively to contain demand pressures. Specifically:

  • Monetary policy has been tightened in the second quarter of 2008. Given the rising trend in inflation, the NBM raised interest rates on sterilization operations by 2 percentage points to 18.5 percent from May 30 (or to 2½ percent in real terms). Moreover, it has indicated its readiness for further rate hikes to ensure that its main policy rate remains positive in real terms until disinflation is firmly reestablished.

  • Surplus liquidity has been curtailed, to help improve monetary transmission and moderate credit growth. For that purpose, on May 23, the NBM raised reserve requirements from 16 to 22 percent to become effective from July. Correspondingly, the nominal reserve money path has been adjusted to reflect this change. Excluding the effect of higher reserve requirement, real reserve money growth is programmed to slow to about 6½ percent compared with 10 percent previously. This implies noticeable monetary tightening, consistent with the disinflation objective.

  • The NBM will strengthen its focus on inflation and move away from pursuing multiple objectives. Costs of sterilization and valuation losses due to appreciation are a matter of concern, but the NBM has committed not to sacrifice the disinflation objective for exchange rate or other considerations. The exchange rate is evolving broadly in line with fundamentals. Although the leu has strengthened against the dollar, appreciation against the euro has been less pronounced. The NBM will continue to allow the exchange rate to be determined by the market, and intervene only to avoid excessive fluctuations. By end-2008, foreign exchange reserves are projected to exceed USD 1.7 billion, which is equivalent to 3.1 months of prospective imports, and to 1.8 times foreign currency deposits.

  • NBM should step up its effort to strengthen operational capacity and its communication strategy. As pointed out by the October FSAP update, markets and the public appear confused about NBM’s true objectives and the consistency of policy measures. The authorities will benefit from a long-term advisor, who has been provided by the Fund to enhance the NBM’s analytical framework.

Figure 2.
Figure 2.

Liquidity Conditions

Leu/U.S. Dollar Exchange Rate and Foreign Exchange Purchases by the Central Bank, 2004–08

Citation: IMF Staff Country Reports 2008, 320; 10.5089/9781451825183.002.A001

Source: Moldovan authorities.

Fiscal policy is to lend greater support to disinflation:

  • The main challenge is to balance the disinflation objective with large development and social needs. With revenue overperformance compared to the budget and higher privatization proceeds, the spending appetite has risen in the preelection period. However, given mounting demand pressures, the authorities have given priority to disinflation. Parliament approved a rectified budget in June targeting a balanced budget for 2008, compared to a deficit of ½ percent of GDP previously programmed. The tightening comes from saving revenue overperformance with a switch in expenditures from goods and services to the new social assistance scheme from October 1, 2008 as well as priority public investments. The authorities and staff agreed that any further budget rectification will be discussed in the context of the fifth review, and will take into account how successful policies have been in resuming disinflation.

  • Steps have been taken to avoid a repeat of the spending overruns in early 2008. The treasury will tighten spending controls by accelerating the introduction of zero-balance accounts for spending units, and capital budgeting is to be strengthened.

  • The authorities have established an investment fund, which will accumulate privatization receipts. The fund will be integrated fully into the general government budget and be used to finance major infrastructure projects and other priority investments, such as a pension reform, and possibly costs of reintegration with Transnistria in the future.

Quasi-fiscal arrears in the heating sector are being addressed

17. Outstanding heating arrears have started to be cleared. The Chisinau administration agreed to start repaying arrears, accumulated from unpaid heating subsidies, before the next heating season begins in October. The illegal decision by the Chisinau municipality to introduce a retroactive tariff of lei 456 was challenged in the courts by Termocom, and is expected to be cancelled in the near future.

18. The authorities are taking steps to avoid a repeat of the heating tariff dispute. According to Termocom, the cost-recovery price this winter will increase to lei 700 from the current lei 540 owing to higher prices for gas and electricity. Chisinau is not willing to pay the implied additional subsidy of about 0.4 percent of GDP, and may dispute again the reliability of cost-recovery estimates by Termocom. To avoid a repeat of the earlier situation, the government will facilitate the establishment of a mediator between Chisinau and Termocom that will have binding authority in disputes on heating tariffs. A lifeline tariff is to be introduced for low income households.

C. Other Structural Issues

Financial sector

19. The privatization of the majority state-owned Banca de Economii (BEM) is progressing well. Following the announced tender for choosing the privatization advisor on March 28, the authorities have already received a number of bids. The contract with the chosen winner will be signed by end-September, as planned.

20. The banking sector has proved resilient to external shocks, and the recent global liquidity squeeze had virtually no impact on Moldovan banks. Although foreign liabilities of the banking system noticeably increased, there appear to be no signs of carry trade or any financial difficulties. Growing external borrowing is accounted for by increased use of credit lines from IFIs as well as by capital injections in the form of loans in three foreign-owned banks from their parent banks. NFA of banks is projected to continue to decline slowly in dollar terms, though the balance sheet impact is weaker due to the envisaged offsetting effect of leu appreciation.

Other reforms

21. The public sector reform is on track. Developed in collaboration with the World Bank, the reform focuses on reducing the size of public employment, especially in education, and improving the pay structure to better align pay with skills. By end-September 2008, the government will approve the draft law, which will consolidate all forms of remuneration for civil servants into a new wage grid, and by end-December public sector employment will be reduced by 3000 people.

22. The authorities are considering accelerating the privatization agenda for Moldtelecom. This includes possibly launching the privatization tender for a strategic investor earlier than had previously been planned.

Prior Actions, Performance Criteria and Structural Benchmarks

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IV. Staff Appraisal

23. Moldova’s outlook is positive. Growth is set to recover strongly, agriculture is expected to rebound in 2008, and foreign direct investment is picking up and replacing remittances as the main driver of the economy.

24. Progress has not come without strains. Transition is bringing strong FDI-driven domestic demand, appreciation pressures, and a widening trade deficit.

25. These pressures have complicated disinflation. Driven mainly by higher food and energy prices, inflation rose to 16 percent in April. Core inflation has also been edging up and the original program objective of achieving single digit inflation by end 2008 is not likely to be reached.

26. The authorities have reacted appropriately, although with a delay:

  • Monetary policy has to play the major role. The NBM has to focus on the inflation objective. It was slow to raise interest rates and tighten reserve requirements, but its commitment to raise rates further if warranted by inflationary pressures is encouraging. The banking system appears well capitalized and sufficiently liquid to tolerate monetary tightening.

  • The exchange rate should be market determined. The NBM should limit foreign exchange interventions to smoothing out excessive fluctuations. The staff assessment raises no concerns concerning external stability, with some room for further appreciation.

  • Fiscal policy is providing support. The willingness of the authorities to tighten the fiscal stance in the run up to the elections is commendable. The revised budget does a reasonable job in balancing development needs with disinflation.

27. The heating sector continues to be a source of arrears. The decision to facilitate a mediator between Chisinau and the heating company is a welcome step as it should avoid a repeat of earlier tariff disputes, which end up burdening the budget and complicating fiscal management.

28. The current account deficit reflects recent shocks as well as the changing structure of the economy and should gradually unwind as the shocks dissipate, although FDI-driven demand pressures will take longer to play out.

29. The staff recommends completion of the fourth review and granting of a waiver of nonobservance of a performance criterion. Performance under the program has been satisfactory and the policies for 2008 are appropriately ambitious.

Table 1.

Moldova: Selected Indicators, 2005–10 1/

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Sources: Moldovan authorities; and Fund staff estimates.

Data exclude Transnistria.

For 2005, includes the positive effect of reclassification of $43 million.

Includes private and public debt.

Table 2.

Moldova: Balance of Payments, 2006–12

(In millions of U.S. dollars; unless otherwise indicated)

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Sources: National Bank of Moldova; and Fund staff estimates and projections.

Includes prospective disbursements.

Includes revaluation changes, which are not captured by changes of gross official reserves in the BoP.

Including energy arrears.

Table 3.

Moldova: General Government Budget, 2006–10

(In millions of lei; unless otherwise indicated)

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Sources: Moldovan authorities; and Fund staff estimates and projections.

Includes lei 250 mln of NBM recapitalization in 2006.