Former Yugoslav Republic of Macedonia
2008 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the former Yugoslav Republic of Macedonia
Author: International Monetary Fund
Publication Date:
18 Feb 2009
eISBN:
9781451826159
ISBN:
9781451826159
Language:
English
Keywords:
ISCR; CR; information annex; annex; information; government; current account deficit; foreign currency; central bank; interest rate; percent of GDP; Current account deficits; Global
Download PDF (723.1 KB)

The staff report for the 2008 Article IV Consultation of the Former Yugoslav Republic of Macedonia discusses economic developments and policies. The new government’s economic program aims to raise growth further, but does not address these vulnerabilities. Plans to increase the central government deficit permanently to about 2 percent of GDP or perhaps even higher risk worsening external vulnerabilities. The main risk to growth and macroeconomic stability is the widening current account deficit.

Abstract

The staff report for the 2008 Article IV Consultation of the Former Yugoslav Republic of Macedonia discusses economic developments and policies. The new government’s economic program aims to raise growth further, but does not address these vulnerabilities. Plans to increase the central government deficit permanently to about 2 percent of GDP or perhaps even higher risk worsening external vulnerabilities. The main risk to growth and macroeconomic stability is the widening current account deficit.

I. Introduction and Executive Summary

1. Macroeconomic vulnerabilities are growing, while the expiry of the Fund arrangement in August means the loss of an important macroeconomic policy anchor. Performance under the program has generally been good, especially at first (Table 1). Growth this year is expected to reach 6 percent, up from 5 percent in 2007, while living standards and employment have improved. However, a shift to more expansionary policies increased external vulnerabilities, with the current account deficit rising to a projected 14 percent of GDP this year. As a result, international reserves are projected to fall below three months of imports, and other indicators of external vulnerability are worsening.

Table 1.

Effectiveness of Fund Policy Advice

article image
article image

2. The new government’s economic program aims to raise growth further, but does not address these vulnerabilities. Plans to increase the central government deficit permanently to about 2 percent of GDP (in the election manifesto) or perhaps even higher (the new government’s revised plan presented during the mission) risk worsening external vulnerabilities. Though the fixed exchange rate regime has served the economy well, under these new policies it may come under pressure. The mission therefore called for containing the current account deficit by limiting fiscal expansion to allowing the automatic stabilizers to work. Together with some monetary tightening, this would protect the peg.

3. Although the mission took place before the intensification of international financial turmoil, its focus on policies to reduce external vulnerability remains relevant. However, the turmoil means that this report’s projections have greater than normal uncertainty. If the turmoil continues, they are subject to considerable downside risk.

II. Recent Developments

A. Real Sector

Growth has been strong, but inflation and the current account deficit have worsened

4. Growth has picked up, led by stronger domestic demand and increasing investment, in part FDI related (Figure 1, Table 2). In 2007 improved terms of trade and remittances boosted incomes and domestic demand. This raised growth to 5 percent. Though these favorable shocks have reversed, in the first half of 2008 growth increased to 6 percent (led by construction, wholesale and retail trade) while industrial production growth reached double digits. Strong investment (in part reflecting higher FDI) and the high unemployment rate (still around 35 percent; discussed in Country Report 06/345) suggest few capacity constraints and considerable scope for continuing this favorable supply response. But there is plenty of room for catch up.

Figure 1.
Figure 1.

FYR Macedonia: Real Sector Indicators, 2004–08

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

Sources: State Statistical Office; NBRM; and IMF staff estimates.
Table 2.

FYR Macedonia: Selected Economic Indicators, 2004–08

article image
Sources: Data provided by the authorities; and IMF staff projections.

Movements in 2005 and 2006 reflect the issuance of a Euro 150 million Eurobond and repayment of the London club debt. Net debt is defined as gross debt minus NBRM deposits of the central government.

Weighted averages for December of each year. For 2008, the data is for September.

For 2008, the data is as of October.

Debt service due including IMF as percent of exports of goods and services. Excludes rollover of trade credits.

Total external debt, including trade credit. Revised methodology applied to data beginning in 2004.

Data for 2008 is through end-September.

Data for 2008 is through end-June.

uA01fig01

Contributions to Growth, 2004–08

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

Sources: WEO; and IMF staff estimates.
uA01fig02

Real GDP

(Index, 1997=100)

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

uA01fig03

Real GDP growth

(2003-08 average)

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

Sources: NBRM; WEO; and IMF staff estimates.

5. Inflation has risen despite the exchange rate anchor, mainly because of outside supply shocks (Figure 2). From 2002 to 2006 inflation averaged less than 1 percent, sometimes with periods of deflation. This was low given the potential for productivity convergence and associated Balassa-Samuelson effects. Inflation jumped to around 10 percent in early 2008, similar to the region, largely because of oil and food price increases (more than 30 percent of the basket) which should be one-off. Public sector wages have been increased substantially (10 percent each year for three years starting September 2007; private sector wages partially followed), as have pensions (13 percent in January 2008, a further 7.3 percent in July). Although higher inflation eroded any real wage increase, the nominal wage increases did insulate real incomes from the supply shocks. With core inflation low at around 3 percent, second-round effects on inflation have been limited, because of slack in the economy and because demand has spilled over to the current account.

Figure 2.
Figure 2.

FYR Macedonia: Inflation Developments, 2004–08

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

Sources: NBRM; SSO; and IMF staff estimates.

B. External Sector

6. The main risk to growth and macroeconomic stability is the widening current account deficit (Figures 3–4, Table 3). Both, the current account deficit’s size (more than 10 percent of GDP in the last 12 months, high for Macedonia and now comparable to vulnerable countries in the region) and its rate of deterioration are significant.

Figure 3.
Figure 3.

FYR Macedonia: External Sector Indicators, 2004-08

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

Sources: State Statistical Office; and NBRM.
Figure 4.
Figure 4.

FYR Macedonia: Recent Current Account Developments, 2006–08

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

Sources: State Statistical Office; and NBRM; and IMF Staff estimates.
Table 3.

Macedonia: Balance of Payments (Baseline), 2007–13 1/

(In millions of Euros)

article image
Sources: Data provided by the authorities; and IMF staff estimates and projections.

NBRM recently issued revised BOP statistics based on new surveys and other sources, resulting in some changes to current and capital accounts from 2003 onwards.

For 2008 and beyond, the figures include accrued interest on reserves.

Amortization payments include prepayment of London Club debt in 2006 and Paris Club debt in 2007.

Private sector arrears.

Gross international reserves in percent of short-term debt (residual basis) plus current account deficit (0 if surplus)

Revised debt series completed end-2007 resulted in upward revisions in debt stock beginning 2004. Program figures (2008) were adjusted for

Debt service due including IMF as percent of exports of goods and services. Excludes rollover of trade credits.

Including IMF.

Table 3.

FYR Macedonia: Medium-Term Balance of Payments (Baseline), 2007–13, (Concluded)1/

article image
Sources: Data provided by the authorities; and IMF staff estimates and projections.

NBRM recently issued revised BOP statistics based on new surveys and other sources, resulting in some changes to current and capital accounts from 2003 onwards.

For 2008 and beyond, the figures include accrued interest on reserves.

Amortization payments include prepayment of London Club debt in 2006 and Paris Club debt in 2007.

Private sector arrears.

Gross international reserves in percent of short-term debt (residual basis) plus current account deficit (0 if surplus)

Revised debt series completed end-2007 resulted in upward revisions in debt stock beginning 2004. Program figures (2008) were adjusted for

Debt service due including IMF as percent of exports of goods and services. Excludes rollover of trade credits.

Including IMF.

Current Account and Trade Balance Developments in 2008

(projected, in percent of GDP)

article image

7. The trade deficit is projected to rise from 21 percent of GDP in 2007 to 28 percent in 2008. Main causes include:

  • Rapid import growth. Imports of investment and intermediate goods, energy (due to increasing electricity demand since retail prices are frozen, shortfalls in domestic production, and higher world prices) and consumption have all grown rapidly. Increased exports of metals (though prices of nickel, a major export, have recently fallen sharply), and food (rebounding from last year’s drought) only partly offset this.

  • Private transfers fell more than 30 percent y/y in the first quarter, reflecting uncertainties over inflation, June’s elections, and Kosovo. With political stability returning, private transfers recovered somewhat in the second quarter.

  • A severe deterioration in the terms of trade which, after improving by 4 percent in 2007, fell 7 percent in 2008.

uA01fig04

Exports by Sector

(Billions of euro)

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

uA01fig05

Imports by Sector

(Billions of euro)

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

Sources: NBRM; SSO; and IMF staff estimates.

8. The sudden current account deterioration reflects some increase in investment, but mainly lower private savings. Investment is projected to increase by close to 20 percent, led by the government sector (SSO expenditure data through the first half of the year suggest the increase might be even larger). Saving is projected to fall by around 7 percent of GDP, financed by rapid household credit growth.

Vulnerabilities have been growing, even before the international financial turmoil

9. External financing has been adequate but vulnerabilities were already growing ahead of the international financial turmoil (Box 1):

  • FDI has increased significantly and should cover over half of this year’s current account deficit. However, more than half of this FDI represents parent company loans, which increase external debt and are easier than greenfield investment to reverse. Around 60 percent of the FDI is in non-tradables such as real estate and financial services, which may not generate the future current account surpluses needed to repay the FDI.

  • The current account deficit may be understated, as the officially measured deficit treats all cash exchange of foreign currency into denars as current transactions. This treatment is correct for remittances and unrecorded exports, but not for capital inflows or conversion of mattress money. (Conversely at times of worsening confidence, residents converting denars into foreign currency mattress money would be misrecorded as a higher current account deficit, when really it is asset substitution. However, in this case vulnerability would still be increasing).

  • External vulnerability indicators are deteriorating (Figure 5, Table 4).

  • As in the region, a large portion of lending (around 55 percent) is either foreign currency linked or denominated. Banks transfer their currency risk into credit risk, as most borrowers are unhedged against a change in the denar-to-euro rate. This makes maintenance of the exchange rate anchor critical for financial stability. Interest rate risk is similarly transferred by banks to their customers, with rates on most credit products adjustable.

Figure 5.
Figure 5.

FYR Macedonia: Indicators of External Vulnerability, 2004–08

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

Sources: State Statistical Office; and NBRM.
Table 4.

FYR Macedonia: Indicators of Financial and External Vulnerability, 2004–08

article image
Source: Staff calculations and estimates based on the data provided by the NBRM.

Data as of 2008 Q2.

Excluding trade credit.

Implications of International Financial Turmoil

The staff is in close contact with the Macedonian authorities and financial sector representatives regarding potential spillovers from global developments.

The direct impact has been limited so far:

  • Banks rely mainly on domestic deposits rather than international credit lines to fund lending. The banking system’s loan-to-deposit ratio is well below 100 percent. Interbank lending is small (6 percent of GDP in 2007, largely overnight). Macedonian banks do not seem exposed to sub-prime lending overseas, and the domestic mortgage market is tiny (less than 3 percent of GDP).

  • Foreign bank presence has increased, but few are globally active. The two most important mother banks—National Bank of Greece, which owns the largest Macedonian bank (Stopanska Banka) and Nova Ljubljanska Banka, which owns the third largest bank (Tutunska)—appear not to have incurred major losses in the international financial crisis.

  • At €20,000, the deposit insurance level would traditionally be regarded as quite high (eight times per capita GDP, covering 75 percent of deposits).

  • Pension funds have invested very conservatively, with foreign equities just 2 percent of assets.

  • There have been no significant shifts from denar to euro deposits. The NBRM’s reserves have recently increased slightly, but commercial banks’ net foreign assets have declined.

  • Portfolio inflows have dropped significantly (1 percent of GDP in 2008), contributing to sizeable stock market declines.

However, the indirect impact could grow. Lower world growth could worsen the current account deficit, through lower export demand (60 percent goes to the EU), falling export prices (metals are 40 percent of exports), or weaker private transfers (including remittances). Major metal producers have already started to reduce production and lay off workers. Against this, lower world oil prices would help. While increasing significantly in 2008, foreign direct investment could be sensitive to tighter international credit markets, and portfolio investment is declining. Liquidity pressures in the parents of foreign owned bank subsidiaries could lead to a withdrawal of credit lines.

In short, despite its relative insulation (until recently) from international financial markets, as a small, open economy, Macedonia would not be immune to a prolonged world recession.

III. The Policy Response

10. Against the background of increasing international financial turmoil, discussions focused on: (i) the appropriateness of the government’s plans for continued fiscal expansion; (ii) the scope under the fixed exchange rate for monetary tightening; (iii) competitiveness; and (iv) structural reforms to raise potential output.

A. Fiscal Policy

Fiscal policy has turned increasingly procyclical

11. The government first took office in 2006, committed to reforming and lowering taxes. To pay for this it proposed cutting government spending by 2 percent of GDP and raising modestly the central government deficit to 1½ percent of GDP. In the event, spending increased, but revenue overperformance (and failure to execute spending) helped the government meet or surpass the deficit targets (Table 5). Rapid domestic demand growth (boosting VAT), a near-doubling of corporate income tax (paradoxical given the introduction of zero tax for reinvested profits, but perhaps explained by the government’s elimination of the double-deduction for investment), improved tax administration (formalization of the shadow economy), and higher non-tax and capital revenues all boosted revenues.

Table 5.

FYR Macedonia: Central Government Operations, 2006–09

article image
Source: MOF and IMF Staff estimates.
Table 5.

FYR Macedonia: Central Government Operations, 2006–09 (Concl.)

article image
Source: MOF and IMF staff estimates.

Tax Policy Reform 2006–08

  • Lower personal and corporate income tax rates: flat 12 percent rate from 2007, 10 percent from 2008

  • Zero taxation of reinvested profits, with no double deduction for investment from 2007

  • Creation of technological and industrial zones with tax concessions (January 2007)

  • Harmonizing minimum social insurance contribution bases (July 2007)

  • VAT cut from 18 to 5 percent for computers, medicines, and public transport (October 2007)

  • Introduction of a presumptive turnover tax for small businesses (January 2008)

12. While the central government budget has run a surplus of almost 3 percent of GDP in the first three quarters of 2008, fiscal policy has turned procyclical:

  • Spending accelerated at the end of 2007 (especially on investment). Though the central government ran a 0.6 percent of GDP surplus in 2007, the fourth quarter had a 2½ percent of GDP deficit. Part of this spending was actually executed in 2008.

  • Pensions were increased 13 percent in January 2008, then another 7 percent in July—even though the pension system is in deficit.

  • Rather than letting the automatic stabilizers work and save revenue overperformance, July’s supplementary budget increased government spending by 4 percent of GDP to almost 40 percent of GDP (Figure 6).

  • Public sector wages were increased by 10 percent in October 2008, for the second year running.

  • While the central government deficit planned for 2008 appears low, the overall public sector fiscal deficit including losses in the electricity sector (paid for by deferred maintenance and deterioration of the capital stock) is much greater (see the Selected Issues). Perhaps by as much as 1–2 percent of GDP.

Figure 6.
Figure 6.

General Government - Regional Comparison, 2008

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 060; 10.5089/9781451826159.002.A001

Source: WEO.

The new government intends further fiscal expansion

13. Despite the worsening current account deficit and this year’s strong growth, the new government plans further fiscal expansion. In its successful June re-election campaign, the government pledged to increase spending on public wages, pensions, agriculture, and education, and to cut social security contributions substantially (reducing minimum social contributions, and reducing rates from 32 to 22 percent over three years). Improved tax administration and a higher central government deficit of around 2 percent of GDP would finance this. However, the government explained to the mission that it intended to raise the deficit even further—to 3 percent of GDP in 2009 and 4 percent in 2011—for additional infrastructure investment. Compared to the record under the Fund program of near budget balance, this plan would represent a paradigm shift in fiscal policy.

14. The staff cautioned that this planned fiscal expansion could exacerbate Macedonia’s medium-term external vulnerabilities (Table 6—Baseline Scenario):

  • The authorities’ planned 4 percent of GDP fiscal deficit in the fourth quarter will boost growth slightly in 2008, but mostly increases the current account deficit (to around 14 percent of GDP) and worsens external vulnerabilities.

  • Growth is assumed to slow to 4 percent in 2009 due to the international financial turmoil. Discussions during the mission centered on the attainability of the authorities’ medium-term 6–8 percent output growth objective (see the Selected Issues). However, even this revised 4 percent projection is subject to considerable downside risk.

  • Despite the widening of the fiscal deficit to 4 percent of GDP in 2011, the current account deficit is assumed to narrow gradually. This assumes that the previous terms of trade deterioration finally increases savings, and that past FDI boosts export supply. The government (but not the NBRM) argued the export response and current account adjustment would be more powerful.

  • However, external vulnerabilities increase significantly, with reserve cover falling below three months of imports, external debt rising from 48 percent of GDP at end-2007 to more than 75 percent by 2013, and short-term external debt increasing significantly.

  • The likelihood of a “sudden stop” and crisis would increase, particularly if the government’s plans for substantial external financing (averaging 4 percent of GDP annually) fail. Abrupt current account adjustment would follow, with growth much lower than projected in Table 6.

Table 6.

FYR Macedonia: Macroeconomic Framework (Baseline), 2007–13

(Percentage change, unless otherwise indicated)

article image
Sources: NBRM; SSO; MOF; and IMF staff projections.

Current account deficit.