Former Yugoslav Republic of Macedonia
Staff Report for the 2009 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Former Yugoslav Republic of Macedonia

This 2009 Article IV Consultation highlights that the Former Yugoslav Republic of Macedonia’s vulnerability at the outset of the global crisis was its large current account deficit in the context of the exchange rate peg to the euro. At the same time, it benefited from a small fiscal deficit, modest public debt, and significant international reserve buffers. Executive Directors have praised the Macedonian authorities for the conduct of macroeconomic policies, which contributed to a modest downturn in Macedonia’s economy relative to other countries in the region.


This 2009 Article IV Consultation highlights that the Former Yugoslav Republic of Macedonia’s vulnerability at the outset of the global crisis was its large current account deficit in the context of the exchange rate peg to the euro. At the same time, it benefited from a small fiscal deficit, modest public debt, and significant international reserve buffers. Executive Directors have praised the Macedonian authorities for the conduct of macroeconomic policies, which contributed to a modest downturn in Macedonia’s economy relative to other countries in the region.

I. Executive Summary and Staff Appraisal

1. Macedonia’s main vulnerability at the outset of the global crisis was its large current account deficit in the context of the exchange rate peg to the euro. At the same time it benefited from a small fiscal deficit, modest public debt, significant international reserve buffers, and a small banking system with limited reliance on external financing—which provided room for maneuver and limited its exposure to global financial conditions.

2. The crisis hit Macedonia at the end of 2008 through a collapse in export demand and loss of external financing. These factors caused a sharp slowdown in the economy and a decline in tax revenues. They also forced a rapid sell-off of central bank foreign exchange reserves, and raised uncertainties about the sustainability of the exchange rate peg. Currency substitution and cash outflows by residents added to pressures on reserves, while elections in spring 2009 created additional uncertainties. By May 2009 central bank reserves had fallen below €1.2 billion (75 percent of short-term debt), 30 percent down from the October 2008 peak.

3. The National Bank of Macedonia (NBRM) responded to reserve outflows by raising its policy rate from 7 to 9 percent (even as inflation fell to zero) and tightening bank reserve and liquidity requirements. These actions helped to slow credit growth and contain the loss of reserves.

4. The government curtailed planned spending increases under the 2009 budget to preserve its 2.8 percent of GDP deficit target in the face of declining revenues. It also issued an €175 million Eurobond (at 9⅞ percent) in July, which bolstered reserves and ensured sufficient budget financing.

5. By the second half of 2009 the situation had stabilized and confidence had improved. Indicators of activity flattened out or turned positive, external financing pressures eased, and by November reserves had recouped 70 percent of their earlier losses. In the banking sector nonperforming loans rose and profits fell, but capital adequacy ratios remained high and no significant liquidity pressures emerged. For the year as a whole, staff expect GDP to decline 1.3 percent, less than most countries in the region, and slight deflation.

6. Looking ahead, the slow pace of recovery in trading partners and continued tightness in external financing conditions will weigh on the economy. As a result, staff and the authorities expect only a moderate recovery to 2 percent growth in 2010. The current account deficit is expected to narrow from 13 percent of GDP in 2008 to 9½ percent in 2009 and 8 percent in 2010, while reserves are expected to finish 2009 at 90 percent of short-term debt and remain near that ratio over the medium term.

7. The NBRM’s response to the crisis has been appropriate in light of its commitment to protect the exchange rate peg. The pegged regime has served Macedonia well by providing a stable policy framework that is supportive of steady growth and low inflation. Moreover, staff analysis does not show significant exchange rate misalignment. Nonetheless, maintaining policies supportive of the exchange rate anchor is critical and the high interest rates currently prevailing are one of the tradeoffs associated with the exchange rate anchor. At this stage, further tightening does not appear warranted, given the underlying improvement in the balance of payments, weak credit growth and economic activity, and modest deflation. On the other hand, an easing of monetary conditions, which would translate into faster growth and less current account adjustment, should await greater certainty that reserves are on an underlying upward path.

8. The government’s 2009 fiscal stance is appropriate in the current circumstances. The targeted deficit (equivalent to 2.8 percent of GDP) reflects the operation of automatic stabilizers, is fully financed, and is consistent with medium-term sustainability. While a tighter stance would have helped contain the current account deficit and protect reserves and the peg, it would likely have been at the cost of lost output and employment.

9. The government has set a target of 2.5 percent of GDP for the fiscal deficit in 2010 and 2 percent of GDP or lower for the medium term. Staff view the 2010 target, which is modestly contractionary in cyclically adjusted terms, as appropriate in light of financing constraints and the need to strike a balance between supporting growth and containing external imbalances. Over the medium term, staff advise a fiscal deficit of below 1.5 percent of GDP in order to maintain debt at moderate levels that will support policy flexibility under the peg.

10. Looking forward, Macedonia’s key risks arise from its still sizable current account deficit, in the context of the exchange rate peg. The failure of exports and FDI to recover as expected, or persistent global financial strains, could put renewed pressures on foreign exchange reserves. On the upside, progress towards EU accession could bolster foreign investment and ease external financing pressures.

11. The authorities have indicated that they do not intend to seek Fund support at this time but are prepared to do so if needed in the future. The government has said it views the Fund as a possible option for financing in the event of future balance of payments pressures.

12. It is proposed to hold the next Article IV consultation on a 12-month cycle.

II. Impact of Crisis and Policy Response

A. Context: Macrofinancial Vulnerabilities and Strengths

13. Macedonia’s main vulnerabilities on entering the crisis were its external imbalances in the context of an exchange rate peg. The current account had widened from near-balance in 2006 to a deficit of 13 percent of GDP in 2008 despite little movement in the real exchange rate, due to rapid import growth (partly related to FDI) and a worsening terms of trade. The exchange rate regime reduced flexibility to adjust to external shocks, and the economy was highly euroized. Meanwhile, elections scheduled for spring 2009 added an element of uncertainty.

Source: WEO, INS and IMF Staff Estimates

14. Macedonia benefited from a broadly sound banking system, a low level of public debt, and a significant foreign exchange reserve buffer. The banking system was relatively small and well capitalized, and relied on domestic deposits rather than external sources for funding. Public debt was a little over 20 percent of GDP, half of which was long-term loans from official lenders. Meanwhile, €1.7 billion of foreign exchange reserves (115 percent of short-term debt) at end-September 2008 provided a significant buffer.

B. Impact of Global Crisis

15. Growth, which had already been slowing, turned negative in the last quarter of 2008, driven by an abrupt fall in exports and industrial production.1 However, by the second quarter of 2009 initial signs of stabilization were evident in production, exports and retail sales, and quarterly GDP growth (seasonally adjusted) turned positive. Compared to other countries in the region, the recession was shallower and appeared to have bottomed out more quickly.

Sources: SSO; and IMF staff estimates.
Sources: Respective statistical offices; and IMF staff estimates.
Figure 1.
Figure 1.

FYR Macedonia: Recent Economic Developments

Citation: IMF Staff Country Reports 2010, 019; 10.5089/9781451826166.002.A001

Sources: NBRM; SSO; and IMF staff estimates.
Figure 2:
Figure 2:

FYR Macedonia: External Sector Developments, (2008–09)

Citation: IMF Staff Country Reports 2010, 019; 10.5089/9781451826166.002.A001

Sources: NBRM; and IMF staff estimates.
Figure 3:
Figure 3:

FYR Macedonia: Banking Sector Developments

Citation: IMF Staff Country Reports 2010, 019; 10.5089/9781451826166.002.A001

Sources: NBRM, and IMF staff estimates.

16. Inflation started falling in late 2008 due to the decline in food and energy prices and to slowing growth. By October 2009 headline inflation was -2.4 percent and core inflation (excluding food and energy) was near zero.

17. The current account deficit initially widened, but started to adjust in the second quarter of 2009. Adjustment was delayed because exports were hit quickly but imports initially remained high, while net private transfers fell as a result of cash exchange house outflows.2 By the second quarter imports began to contract sharply at the same time as the decline in exports leveled off. Meanwhile, private transfers bottomed out and began to rebound in the second quarter, helped by the successful resolution of election uncertainties.

Sources: SSO and IMF staff estimates.

18. International reserves fell 30 percent through mid-year before subsequently recouping most of their losses. A sharp decline in financial inflows, coupled with the lagged current account adjustment, forced the NBRM to intervene heavily to protect the peg. FDI fell sharply, while banks increased their foreign assets, in part reflecting the switch of depositors from denar to euro deposits. Altogether, the NBRM sold some €500 million from October through May, when gross reserves reached a low of under €1.2 billion (75 percent of short-term debt). Starting in June inflows improved, with the government’s €175 million Eurobond issue, a reversal of commercial bank foreign asset accumulation, and the SDR allocation of €60 million (which the authorities have used to augment NBRM reserves). By end-October reserves had risen to above €1.5 billion (94 percent of short-term debt), recovering most of their losses of the previous year.


Banking Sector Stability

Macedonia experienced a considerable credit boom prior to the global crisis, similar to other European emerging markets although somewhat later and on a smaller scale. Bank loan growth averaged 30 percent annually between 2004–08. Nonetheless, the sector remains relatively small with assets at 62 percent of GDP. The sector’s small size, substantial liquidity, and high capital adequacy have allowed it to absorb the effects of the global economic crisis well.

A key strength of the sector is a reasonably conservative business model. Bank assets are primarily loans (62 percent of total) and highly liquid assets like Central Bank bills, accounts with foreign banks and short term Treasury bills (15 percent of total), rather than riskier (and potentially illiquid) trading securities. On the liability side, funding sources are stable: resident deposits account for 76 percent of total liabilities versus foreign liabilities at 9 percent, a third of which is subordinated debt.

The recession and tighter monetary policy nonetheless weighed on the banking system. Between September 2008 and September 2009, deposit growth fell from 25 percent yoy to 0 percent and lending growth fell from 29 percent to 6 percent. From June 2008 to June 2009, nonperforming loans rose from 6.9 percent to 8.6 percent of total loans, return on equity fell from 19.1 to 4.3 percent (on the back of higher provisioning), and foreign exchange deposits rose from 53 percent to 61 percent of total deposits.

Despite these adverse development, risks appear contained.

  • Liquidity Risk–The loan to deposit ratio is 97 percent as of June 2009, suggesting a stable source of funding. Ample liquidity means that, in aggregate, banks could cover a sudden loss of 23 percent of short-term liabilities with highly liquid assets.

  • Interest Rate Risk–Direct exposure to rate risk via higher funding costs is low because 87 percent of bank loans to households are adjustable rate as of end-2008. However, there is indirect credit risk via the impact of higher rates on borrower capacity to repay.

  • Exchange Rate Risk–The aggregate banking sector has a net neutral foreign exchange position (and each bank’s net open foreign exchange position is limited to 30 percent of own funds). However, indirect credit risk arises because 57 percent of loans as of June 2009 are foreign exchange denominated or indexed, most of which appears to be unhedged.

  • Buffers. The system’s capital adequacy ratio remained stable at 16 percent in June 2009, compared to the legal minimum of 8 percent and the NBRM’s recommended 12 percent. Nonperforming loans are 67 percent provisioned as of June 2009. Meanwhile, required reserves at the NBRM are 10 percent on denar deposits, 13 percent on foreign exchange deposits, and 20 percent on foreign exchange indexed deposits, providing another buffer.

The central bank conducts quarterly stress tests and the system remains solvent even under extreme adverse scenarios (an increase in NPLs of 50 percent, a 20 percent depreciation, and a 5 percentage point rise in interest rates). The NBRM also conducts on-site examination of asset quality and lending practices at the three largest banks, which account for 66 percent of assets.

19. The banking system absorbed the crisis without significant pressures on capital or liquidity, despite a rise in non-performing loans and lower profitability. Due to their relative insulation from the global financial system, banks were affected by the crisis mainly through its impact on the real economy, and through the NBRM’s tightening measures in response to the crisis, rather than directly from external funding pressures. Overall, risks in the banking sector appear to be contained (Box 1).

Sources: Respective central banks and IMF staff estimates.
Sources: Respective banking supervision departments and IMF staff estimates.

C. Policy Response

20. The Government curtailed planned spending increases to achieve its 2.8 percent fiscal target for 2009 in the face of revenue shortfalls resulting from the economic slowdown (Box 2). Overall real expenditure is expected to decline 0.8 percent relative to 2008. Compared to other countries in the region, the spending cuts in Macedonia are relatively modest. Staff believe the revised revenue projections remain optimistic. However, the government is committed to underexecution of spending as necessary to achieve the deficit target of 2.8 percent of GDP for 2009.

Macedonia’s Response to Past IMF Advice

At the time of the 2008 Article IV consultations (concluded in December 2008), Directors welcomed Macedonia’s strong economic growth and improved business climate. But they expressed concern about increasing macroeconomic and external vulnerabilities, highlighting the widening current account deficit and the increase in public sector wages. In this context they expressed concerns about plans to increase the fiscal deficit from 1.1 percent of GDP in 2008 to 2.8 percent in 2009 and stressed that the priority of monetary policy should be to protect the exchange rate. At the time of these recommendations, 2009 growth was expected to be 4 percent and the current account deficit to be 13.3 percent of GDP.

Events unfolded differently than anticipated in December 2008, as the global crisis spilled onto Macedonia’s economy, leading to a mild recession. Meanwhile, the current account began to adjust and is projected to fall to 9.5 percent of GDP in 2009 and to be on a downward path over the medium term.

The government largely allowed automatic stabilizers to work, while cutting public spending in response to declining revenues, including a freeze on public sector wages and employment. The end result was a budget that staff expect to be roughly neutral in cyclically adjusted terms. Meanwhile, the central bank tightened monetary policy through higher interest rates and tighter prudential requirements in order to arrest the loss of foreign exchange deposits and protect the exchange rate peg. In light of the economic downturn, these policy responses appear to be broadly consistent with the underlying advice of Directors.

21. The budget deficit is expected to be financed fully from external sources (mainly the Eurobond). There will be no net domestic financing, as expected net issuance of T-bills and T-bonds of some denar 5.4 billion (1.4 percent of GDP) is offset by repayment of structural bonds.3 In mid-2009 the Treasury began to issue foreign exchange linked T-bills to reduce its financing costs, and these now account for close to 90 percent of the T-bill stock (which totals some 3 percent of GDP). This likely contributed to the recovery of reserves by providing banks with liquid domestic foreign exchange assets. It also shifted foreign exchange risk to the government.

Source: WEO Data, Oct. 2009Note: Countries ordered descreasingly with the real expenditure
Source: WEO Data, Oct. 2009.Note: Countries ordered by the change in the fiscal balance.

22. The NBRM took several steps to stop the outflow of foreign exchange reserves by tightening credit conditions. First, it imposed liquidity requirements in January, with banks given a timetable for coming into compliance. Second, it hiked its policy rate (one-month central bank bills) by 200 basis points in April. Third, it raised reserve requirements on bank deposits in June. These measures helped to rebuild reserves both directly (banks brought back assets held abroad to meet higher reserve requirements) and indirectly by slowing bank lending. Macedonia’s monetary tightening stood out among the countries in the region, which generally reduced interest rates and relaxed reserve requirements. This tighter stance was required due to the need to protect the peg in the face of declining reserves, and it was feasible because bank balance sheets were sufficiently healthy to absorb these measures.

Monetary Policy: September 2008–June 2009

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Sources: Respective Central Banks; and IMF staff.

For the currency board countries, interest rate movement refers to market rather than policy rates.

III. Macroeconomic Outlook

23. Output is projected to contract 1.3 percent in 2009 and expand 2 percent in 2010.

  • The 2009 outlook is based on the presumed stabilization of activity in the second half of the year—as suggested by economic indicators of production, sales, and confidence—and on improved global economic prospects. Compared to other countries in the region, the projected downturn is mild.

  • The 2010 outlook is based on the recent signs of revived momentum in the economy, the modest recovery expected in trading partners, improved conditions for external financing, and the contained impact of the crisis on the banking sector in Macedonia.

  • The government expects a smaller contraction of 0.6 percent in 2009, while the NBRM expects a 1.6 percent contraction. The government shares the staff’s outlook for 2010.

Sources: WEO and IMF staff estimates.

24. Inflation is expected to be -0.8 percent in 2009. Core inflation (excluding food and energy) is expected to be close to zero. Prices are expected to rise somewhat over 1 percent in 2010 as the effects of food and energy fade and economic growth resumes.

25. The current account deficit is expected to narrow in 2009 and continue to do so over the medium term. FDI should recover towards pre-crisis levels, and foreign exchange reserves are expected to stabilize near 90 percent of short-term debt.

  • The current account deficit appears on track to fall from 13 percent of GDP in 2008 to 9½ percent of GDP in 2009, on the back of declining trade deficits and stable private remittances and other transfers. For 2010 and over the medium term exports are expected to recover further, supported by resumed growth in trading partners, a rebound in metals prices from the lows of early 2009, and ongoing structural reforms that are improving the business climate. Meanwhile import growth is expected to be contained due to modest growth of output and credit in Macedonia, and to restrained fiscal policies. The current account deficit is projected to narrow to 8 percent of GDP in 2010 and to 5 percent by 2014.

  • Foreign direct investment is projected to fall by more than 50 percent this year, in line with other countries in the region. This is partly compensated by portfolio inflows (the Eurobond) and the SDR allocation, but net financial inflows are still expected to fall some €300 million below last year’s levels. International reserves are projected to decline €100 million this year, to €1.4 billion or 88 percent of ST debt. In 2010 and over the medium term FDI is expected to bounce back towards (but still below) the peak levels of 2007–08, supported by continued structural reforms and, potentially, progress towards EU accession. Together with disbursement of an €100 million EIB loan and further adjustment of the current account, this is expected to support a modest increase in reserves, which would remain near 90 percent of short-term debt in 2010 and over the medium term.

Sources: WEO and IMF staff estimates

IV. Policy discussions

A. Fiscal Policy

26. Staff viewed the authorities’ fiscal targets for 2009 (2.8 percent of GDP) and 2010 (2.5 percent of GDP) as appropriate. The authorities felt that such deficits were needed to support growth and protect public investment. Staff’s view that these deficit targets are appropriate is based on the following considerations.

  • These deficits mainly reflect the operation of automatic stabilizers. The moderate contraction in adjusted terms in 2009 and 2010 is appropriate in light of financing constraints and the need to contain the current account.

  • Given the modest levels of public debt, fiscal deficits on this scale do not threaten fiscal sustainability.

  • The government has already secured financing for 2009 through the Eurobond issue.

FYR Macedonia: Cyclically-adjusted Fiscal Balances

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Source: IMF staff estimates.Note: Automatic stabilizers are the difference in the cyclical balance between the current and the previous year. The fiscal impulse is the difference in the cyclically-adjusted balance between the current and the previous year (a positive fiscal impulse means a cyclically-adjusted contraction). Cyclical adjustment of fiscal balances is done with respect to both output and absorption gaps as described in the Selected Issues Paper, Ch. 3.

27. The 2010 budget may be somewhat optimistic in its revenue assumptions. The budget, released in mid-November, is based on the same 2 percent growth assumption as projected by staff. However, it assumes 0.9 percent of GDP more buoyancy on tax and nontax revenues than expected by staff. If revenues fall short of budgeted levels, staff expect the authorities will underexecute spending (primarily capital outlays) in order to meet the 2.5 percent of GDP deficit target. Revenues will be affected by a 1.5 percentage point cut in social contribution rates and changes in the corporate income tax, with a combined impact estimated at -0.3 percent of GDP.4 The government’s announced freeze on public sector employment and wages for a second consecutive year and strict control over goods and services outlays will help to contain expenditures.

FYR Macedonia: 2010 Budget Revenue Assumptions Compared to Preliminary Staff Projections

(In percent of GDP)

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Sources: IMF staff estimates.

28. Securing financing for the 2010 fiscal deficit target may be a challenge. Domestic financing sources are limited due to the small domestic debt market. The government is reluctant to borrow too much from this market, lest private lending be crowded out. Foreign official financing from development banks5 and bilateral donors will provide valuable support. In addition it will likely be necessary to seek private external financing (possibly another Eurobond), provided market conditions are sufficiently favorable. While some further accumulation of private external debt may be appropriate, Eurobonds create rollover risks that need to be managed. In the medium term the public sector will need to carefully manage the build-up of external market debt, including through a strengthening of its debt management infrastructure, with official financing expected to continue to be important and the domestic debt markets potentially playing an increased role over time.

Central Government Financing

(In millions of euros)

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Sources: MoF; and IMF staff estimates.

29. Staff recommended that fiscal deficits be limited to below 1.5 percent of GDP in the medium term. A 1.5 percent ceiling would maintain debt ratios at moderate levels (well below the median for emerging markets and near the median of emerging market countries with exchange rate pegs) and provide flexibility to follow countercyclical policy over the business cycle (Box 3). The government agreed with the need to reduce deficits over the medium term, but felt a ceiling of 2 percent of GDP would be more feasible in light of the need to increase investment spending.


Debt-Sustainability Guidance for Medium-Term Fiscal Targets

This box assesses the appropriate public debt ratio for Macedonia and the associated annual fiscal targets (Selected Issues Paper, Chapter 3). Medium-term fiscal targets should be consistent with a sustainable debt path. One approach to assessing an appropriate public debt ratio is to look at the empirical relationship between debt ratios and the vulnerability of countries to crisis. Another approach is to view debt as sustainable if sufficient future primary surpluses can feasibly be generated to service it.

These approaches suggest a prudent public debt ratio for Macedonia would be around 25 percent of GDP based on the following considerations:

  • While there is no consensus in the academic literature on the appropriate debt target for emerging markets, it is generally accepted that emerging markets can sustain lower levels of debt than advanced economies. IMF Vulnerability Studies find a higher probability of a debt crisis in emerging economies when the public debt ratio surpasses a threshold of around 25 percent of GDP.

  • Although Macedonia’s projected end-2009 debt ratio (24 percent of GDP) is low compared to its regional peers, it is at the median among emerging markets with fixed exchange rate regimes. Constrained policies and increased vulnerability to sudden stops suggest lower debt ratios are prudent in fixed exchange rate regime countries.

  • A model-based approach to debt sustainability indicates that debt levels much above 20 percent of GDP would be imprudent in Macedonia’s case. This model imposes the requirement that the government can credibly service its debt in all circumstances and therefore that it should contain debt to the level it can sustain in the case of a negative shock to revenues.

  • The prudent level of debt also depends on interest costs. The average interest rate paid on Macedonian public debt is likely to increase from the historical 3.4 percent as the share of market financing in overall borrowing increases. The chart below shows that for a given primary balance, higher financing costs can lead to unsustainable debt dynamics. Alternatively, for a given debt level, higher interest payments raise the debt-stabilizing primary balance. (The average financing costs line assumes 30 percent of new debt is at historical costs of 3.4 percent and 70 percent is at the EM average of 7 percent. The high cost line assumes 30 percent at historical costs and 70 percent at a 9 percent rate.)

Stabilizing debt at 25 percent of GDP in the medium-term implies running annual primary fiscal deficits of around 0.4 percent of GDP (overall fiscal deficits of around 1.5 percent of GDP) from 2012 onwards, given baseline growth and interest rate projections.


B. Monetary and Exchange Rate Policy

30. The NBRM measures to tighten monetary policy in the first half of 2009 were driven by its commitment to ensure the stability of the exchange rate peg. In its view, it is necessary to protect reserve buffers, and it is too early to relax its stance in light of the still large current account deficit and the potential for further reserve losses. Staff share this assessment and believe that more evidence of external stabilization would be desirable before easing. Once external adjustment progresses and reserves approach desired levels, there will be room to begin loosening policy (Box 4 and Box 5).

31. The government believes that the NBRM stance is too cautious and that it should begin easing now. It acknowledges the risk of future reserve losses but believes current reserve levels provide an adequate buffer against that contingency. In its view, the present stance will not allow the resumption in bank lending required to stimulate a return to growth. Further, monetary policy acts with a lag, so incremental easing should begin now to support growth in 2010. Moreover, if risks materialize, both monetary and fiscal policies can respond to protect exchange rate stability. Nonetheless, the government affirmed that it respects the autonomy of the NBRM in setting monetary policy. Staff noted that maintenance of the exchange rate peg involved tensions between the goal of protecting reserves through tighter monetary policy, and the goal of supporting growth and employment through easier credit policies. Premature easing might need to be reversed, which could harm NBRM credibility as well as damage confidence.

32. The authorities remain fully committed to the exchange rate peg, which they believe has served Macedonia well, including during the crisis, and which has deep public support. They recognize the tradeoffs and reduced flexibility associated with the peg but believe it is an essential anchor for monetary policy and for safeguarding stability. Staff agreed that the exchange rate system should, with supportive policies, anchor the authorities’ objectives of stable growth and low inflation, as it has in the past. In staff’s view policies have been supportive of the exchange rate and the costs of the policies needed to protect the peg do not appear to have been excessive to date. In particular, despite high interest rates and tight monetary conditions, the economic downturn has been modest compared to other countries in the region, and the banking sector seems to have weathered the crisis in overall healthy shape. Further, the exchange rate does not appear significantly overvalued (Box 6).

FYR Macedonia: Assessment of Reserve Adequacy

This box seeks to assess the desired level of foreign exchange reserves in Macedonia (based on Selected Issues Paper, Chapter 1). The adequacy of reserves is a key consideration in setting the stance of monetary policy. A variety of methods including popular rules of thumb, comparisons with other emerging countries (EMs), and model based estimates suggest a target range of €1.5–2 billion.

Popular benchmarks:

  • Maintaining reserves at 3 months of imports would require €1.1 billion.

  • The Greenspan-Guidotti rule of 100 percent cover of short-term debt (remaining maturity) would require €1.6 billion.

Comparison with the medians of 51 EM countries (a comparison with 22 EM pegged regimes gives similar results).

  • To be at the median of the broad money to GDP ratio would require €1.1 billion.

  • To be at the median in term of months of imports would require €2.0 billion.

  • To be at the median reserve to short-term debt ratio would require €2.6 billion.

Model-based approach:

Based on Jean and Ranciere’s (2006) model, the optimal level of reserves for Macedonia is calibrated to be €1.8 billion. In this model, the economy is vulnerable to sudden stops of capital flows; reserves are used to smooth domestic absorption in case of a sudden stop; and reserves yield a lower return than other assets in the economy.

In addition to the above estimates of reserve adequacy, the recent experience is illustrative. Entering the crisis in the fall of 2008, Macedonia had reserves of €1.7 billion. By May 2009 reserves had fallen to a low point of below €1.2 billion as the central bank sold €500 million to defend the peg. If the NBRM had not entered the crisis with such a buffer, reserves would have fallen below the 3 months of imports benchmark, which may have intensified uncertainties and put greater pressure on the peg.

Framework for Assessing Monetary Policy

This box (drawn from Selected Issues Paper, Chapter 2) seeks to provide a framework for assessing the appropriate stance of monetary policy in Macedonia given its de facto peg to the euro (formally the peg serves as an intermediate target to help the NBRM meet its primary goal of price stability). The peg ultimately constrains monetary policy through the flow of international reserves. However, a range of policies could be sustainable in the short term, even if not in the longer run, due to imperfect capital market integration and lags between monetary policy actions and the balance of payments. This creates uncertainty in the near term about the appropriate policy stance.

Sources: NBRM; IMF staff estimates.

This degree of latitude in the short term can be seen in two ways. First, base money growth tends to grow relatively smoothly despite foreign exchange intervention purchases and sales—i.e., such intervention is sterilized rather than allowing money to move with foreign exchange intervention as might be expected in a “pure” peg. Second, domestic interest rates move independently of foreign interest rates in ways that do not appear to be fully accounted for by risk premia.

While this short-run uncertainty complicates monetary policy, sustainability of the exchange rate peg requires a policy stance that ensures adequate foreign exchange reserves to defend the peg. Thus both the level of reserves and their underlying trend need to be supportive of the peg. For example, if reserves are low and falling, policy needs to be tightened in order to 1) limit import demand, supporting a correction in the current account; and 2) attract financial inflows via arbitrage to support an improvement in the capital account. At the other extreme, if reserves are high and rising, there is room for easing monetary policy.

In staff’s view, it remains early to loosen. First, staff would advise reserve levels between €1.5 and €2 billion (Box 4), and the current level is at the bottom of that range. Second, the recent reserve increase was due in part to one-off factors and the underlying balance of payments flows are not yet clearly positive. And third, a current account deficit near 10 percent of GDP leaves the country exposed to changes in external conditions, suggesting extra caution. However, as the external adjustment process progresses and reserves approach desired levels, there will be room to begin loosening policy.

Exchange Rate Assessment

Staff analysis does not show significant exchange rate misalignment. This conclusion is consistent with that of the December 2008 Article IV report. Standard CGER analysis estimates overvaluation in the range of 6-11 percent, albeit with wide uncertainty bands in these estimates. The weak historical relationship between the real exchange rate and the current account complicates assessment of the exchange rate in the case of Macedonia. A significant current account adjustment, reversing the rapid build-up in deficits in the past two years, is now underway, albeit at a slower pace than regional comparators. While external developments are subject to substantial uncertainty in the current context, the competitiveness benefits of ongoing structural reforms and prospective EU accession, supported by the resumption of foreign direct investment (albeit at lower levels than the pre-crisis period), are expected to result in a further moderation of current account deficits.

Macedonia: Estimated REER Misalignment

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Source: IMF staff estimates.

Equilibrium REER measure does not depend on elasticity.

Three complementary CGER methodologies were examined:

  • Under the macroeconomic balance (MB) approach, the current account norm is estimated to be around -3.0 percent of GDP. Depending on the assumptions used for elasticity of the current account with respect to the REER (real exchange rate), the REER needs to adjust by 6 to 7 percent to close the gap between the norm and the underlying current account in the medium run.

  • The equilibrium real effective exchange rate (ERER) approach suggests overvaluation of 11 percent.

  • The external sustainability (ES) approach points to similar overvaluation as the MB approach. In ES, the current account norm is estimated to be 2.6 percent deficit, with a real exchange rate depreciation of 7–9 percent needed to stabilize NFA.

The macro balance and external sustainability approaches both rely on a projected improvement in the current account based on export growth. This is subject to risks on both sides. On the positive side, the improvements in the business climate and the high FDI of recent years should help boost competitiveness. Further, progress towards EU accession would likely attract more foreign investment as well as improve competitiveness through regulatory harmonization. On the negative side, continued efforts are needed to address a shortage of skilled workers, infrastructure needs in roads, railroads and electricity, and regulatory and judicial shortcomings.

C. Financial Sector and Structural Reform

33. The quality of banking supervision and regulation has contributed to the stability of the banking sector. Regular on-site examinations of bank credit portfolios and stress tests have played an important role in this regard. Recent progress in implementing arrangements for crisis coordination between relevant agencies (as recommended in the 2008 FSAP update) is welcome. The NBRM agreed with the FSAP recommendations to undertake legal changes to allow it to intervene troubled banks without being subject to court challenge and to remove bank management who do not meet appropriate standards of integrity. The NBRM is working with the justice and finance ministries on the necessary legislation. Staff also encouraged the NBRM and finance ministry to find a solution that will enhance lender of last resort facilities through acceptance of a broader set of collateral, with appropriate Treasury indemnities. The creation of an insurance supervisory body is a positive development, and the authorities should move forward swiftly to make it fully operational.

34. Macedonia has made significant progress in improving its business climate, improving property rights through development of the cadastre, and reducing the labor tax burden.6 The authorities’ priority areas for reform in the future include further improvement in property rights; investment in the electricity sector; administrative reform aimed at streamlining and improving efficiency; and judicial reform to improve the speed, consistency and predictability of judicial processes.

V. Risks

35. Macedonia’s large current account deficit, in the context of the exchange rate peg, makes it dependent on continued external financing. The failure of export demand to recover as expected, renewed weakness of metals prices, or stronger than expected domestic demand and imports could cause the current account deficit to widen once more. Moreover, financial inflows could be lower than anticipated if global financial conditions fail to normalize. Such developments would put renewed pressures on foreign exchange reserves and the exchange rate peg and would also weigh on the banking sector. On the upside, rapid progress towards EU accession would improve prospects for foreign investment, which would likely ease external financing pressures and bolster reserves and the peg.

Table 1.

FYR Macedonia: Macroeconomic Framework, 2006–14

(Percentage change, unless otherwise indicated)

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Sources: NBRM; SSO; MOF; IMF staff estimates and projections.

Current account deficit.

Table 2.

FYR Macedonia: Central Government Operations, 2006-10

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Sources: IMF Staff and MoF estimates.Note: Central government refers to the core government, plus consolidated extra-budgetary funds.
Table 3.

Macedonia: Balance of Payments (Baseline), 2006–14 1/

(Millions of Euros)

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

NBRM issued revised BOP statistics in November 2008, based on new surveys and other sources.

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.

GIR in percent of S-T 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.

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

Including IMF.

Table 3b:

FYR Macedonia: Medium-Term Balance of Payments (Baseline), 2006–14, 1/

(In percent of GDP, unless otherwise noted)

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

NBRM issued revised BOP statistics in November 2008, based on new surveys and other sources.

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.

GIR in percent of S-T 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.

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

Including IMF.

Table 4:

FYR Macedonia: External Financing Requirements and Sources, 2006–14

(In millions of euros)

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Sources: NBRM and IMF staff estimates and projections.

Excluding the IMF.

Private sector and public enterprise arrears.