Republic of Moldova: Joint IMF-World Bank Debt Sustainability Analysis

This paper discusses Moldova’s request for a Three-Year Arrangement under the Extended Credit Facility and request for an Extended Arrangement. The economy remained overregulated and hampered by relative price distortions. High barriers to entry and low competition in telecommunications, trade, and food processing have kept domestic prices significantly above international prices of many consumer products. In contrast, utility tariffs generally remained well below cost-recovery levels, leading to substantial arrears and underinvestment. The crisis and pre-election spending hikes resulted in a large increase in the fiscal deficit.

Abstract

This paper discusses Moldova’s request for a Three-Year Arrangement under the Extended Credit Facility and request for an Extended Arrangement. The economy remained overregulated and hampered by relative price distortions. High barriers to entry and low competition in telecommunications, trade, and food processing have kept domestic prices significantly above international prices of many consumer products. In contrast, utility tariffs generally remained well below cost-recovery levels, leading to substantial arrears and underinvestment. The crisis and pre-election spending hikes resulted in a large increase in the fiscal deficit.

Debt Sustainability Analysis

The joint IMF-World Bank low-income country debt sustainability analysis (LIC DSA) indicates that Moldova’s risk of debt distress is low at present, but additional factors increase vulnerability compared to the previous DSA. Under the baseline scenario, the debt burden will temporarily increase in the medium term as a result of significant financing contracted by the government to counteract the effects of the economic crisis. The indicator of net present value (NPV) of the debt-to-GDP ratio could temporarily breach its indicative threshold under two of the conventional stress tests, but other indicators remain below their respective thresholds. However, large private sector debt and potential large borrowing on non-concessional terms signal elevated risks and warrant a continuing careful approach to external financing.

1. The DSA presented here reflects the macroeconomic framework underlying staff projections under the program supported by a blend of Extended Credit Facility -Extended Fund Facility Arrangements (ECF/EFF) and extended until 2029. It assumes that the implementation of prudent macroeconomic and structural policies, including a fiscal framework that aims to reverse recent structural fiscal deterioration, and adoption of the flexible exchange rate policy, will help Moldova recover from the economic crisis and resume sustainable growth.10

IV. Background

2. Reflecting strong growth, Moldova’s total external debt burden has declined in recent years, helped by the shrinking public debt.11 At end-2008 public debt was low and was mostly owed to multilaterals and Paris Club creditors on concessional terms, without significant rollover risks. The ratios of debt service to exports and to fiscal revenues more than halved since 2006 and remain reasonably low. In the recent review of debt limits in Fund-supported programs, Moldova has been classified as a higher-capacity country, reflecting progress made in upgrading capacities for managing domestic and external public debt, reforming public administration, and improving transparency and accountability in the public sector. This progress is important, taking into account the significant borrowing that Moldova intends to contract from its international partners in the next few years.

uA02fig01

Composition of external debt, 2000-2008

Citation: IMF Staff Country Reports 2010, 032; 10.5089/9781451825190.002.A002

Moldova: Composition of External PPG Debt, 2008

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Source: Moldovan Ministry of Finance, National Bank of Moldova and Fund staff calculations

3. At the same time, private sector borrowing remains high. Between 2004 and 2008, the external private debt increased from 33 to 40 percent of GDP, two-and-a-half times the size of the public and publicly guaranteed (PPG) external debt. This increase was mainly caused by rising external exposure of the banking sector, both on a short-term (currency and deposits) and on a long-term (credits) basis. The majority of non-bank debt is short-term, and consists of trade credits, arrears and other payment liabilities, mostly for the imports of natural resources. The latter emerged in part as a result of heating tariffs set below cost recovery levels, which created a sequence of domestic and (later on) external payment arrears. This debt could potentially become a fiscal liability of up to 3 percent of GDP, since the heat production and distribution companies that are not paying for energy resources are publicly-owned companies.

uA02fig02

Evolution of external of private sector debt

(percent of GDP, unless indicated otherwise)

Citation: IMF Staff Country Reports 2010, 032; 10.5089/9781451825190.002.A002

4. The long-term debts of the non-banking sector are loans. Their share in total non-bank debt has been rising since 2005, reflecting mainly the increasing share of foreign owned companies operating in Moldova. The share of private debt is very high by international standards, significantly exceeding the levels observed in other LICs and developing economies.

uA02fig03

Private external debt, cross country comparison, 2000-2009

(percent of GDP)

Citation: IMF Staff Country Reports 2010, 032; 10.5089/9781451825190.002.A002

V. Macroeconomic Framework

5. The international financial crisis has worsened Moldova’s macroeconomic outlook significantly since the 2008 DSA exercise. In 2009, FDI came to a halt, domestic investment contracted sharply, and recession in the trading partners caused a severe decline in exports and remittances, contributing to a collapse in domestic demand. As a result, the economy went into a recession and external and fiscal financing gaps emerged. The baseline macroeconomic projections in this DSA take into account the expected sizeable fiscal and external adjustment, supported by significant borrowing in the near future in the context of the IMF arrangement (Box 1).12 Higher borrowing needed to fill the gaps will temporarily increase debt ratios, reversing recent gains in lowering the debt burden.

Macroeconomic Assumptions behind the DSA

During the projection period (2009–2029), real GDP is projected to grow by 3.4 percent on average. After the initial decline of 9 percent in 2009, growth will gradually rise to an average of 2.3 percent in 2010–2011 and to 5 percent in 2012–2014, led by a rebound in exports, investment and remittances. In the long-run, the negative output gap will close and growth will decline to 4 percent.

Inflation is projected to remain in single digits, increasing somewhat in 2010 as the economy recovers, but subsiding to 4 percent in the long-run (as measured by the GDP deflator). This projection assumes sound public sector policies and strong commitment of the National Bank to preserving price stability.

Exports are expected to be an important driver of growth. They are projected to accelerate in the medium term, as the trading partners recover from the recent crisis, internal restrictions on exports of wine and other agricultural products are removed, and Moldova makes full use of the autonomous trade preferences agreement with the EU. In addition, structural reforms aimed at improving the business environment, demonopolizing telecommunication services and expanding access to broadband internet should result in strong growth of services, in particular software development. As a result, exports of goods and services are projected to reach 59 percent of GDP in 2029.

Imports are projected to expand as well, fuelled by intermediate imports needed for the exports sector, as well as driven by the rebound in investment and private consumption. In the long-term, however, growth of imports will subside somewhat as domestic production of tradables expands.

Remittances are projected to gradually recover from the depressed 2009 level in the medium-term. In the long-term, however, as the economy develops, more employment options are available domestically, and migrants abroad lose ties with the home country, remittances are projected to decline relative to GDP from 32 percent to 29 percent of GDP.

The current account deficit is projected to widen in the short run, and to stabilize around 8-9 percent of GDP in the medium and long term. It will be financed by FDI that is expected to recover to the pre-boom levels of 7.2 percent of GDP in the long run, supported by structural reforms aimed at improving the business climate.

The primary fiscal deficit is projected to decline in the medium term as a result of fiscal consolidation undertaken by the authorities. In the long run, revenues are projected to increase by 3.2 percent of GDP, while rationalization of primary noninterest expenditures will cause their decline by 4.4 percent of GDP, resulting in a primary surplus of 0.1 percent of GDP.

Borrowing assumptions reflect the gradual shift of Moldova away from concessional financing. Concessional loans are projected to decline from 88 percent of total borrowing in 2015 to 23 percent in 2029. At the same time, borrowing from commercial sources is projected to increase, reaching 55 percent of the total in 2029.

6. The macroeconomic assumptions differ with respect to the previous DSA due to the impact of recent global crisis. Key changes include a significantly lower GDP growth in the medium and long term on account of effects of the 2009 crisis, as well as a lower inflation rate. Recent reforms introduced by the government are projected to facilitate exports of agricultural products and exports of services, resulting in higher share of exports to GDP in the long-run than envisaged in the previous DSA, and a smaller current account deficit.

VI. External Debt Sustainability under the Baseline and Alternative Scenarios

7. All external debt ratios remain well below the thresholds under the baseline scenario, but the PV of the debt-to-GDP ratio temporarily breaches the threshold under two stress scenarios (Figures 1A2A, Tables 1A4A).13 Large borrowing in the next three years needed to fill the external and fiscal financing gaps will result in a temporary but significant increase in the level of external PPG debt to 35 percent of GDP in 2012. Due to the initial low levels of debt, the PV of the debt will not breach the threshold under the baseline scenario but could exceed it under two stress scenarios (lower non-debt creating flows and a decline in the growth of exports).14 These extreme scenarios, however, assume that exports do not pick up before 2012 after the 2009 collapse and remittances decline further from the very depressed 2009 levels. Taking into account the ongoing recovery in Moldova’s trading partners, as well as the dismantling of trade restrictions by the new government, exports are not likely to remain stagnant. Remittances, which before the 2009 crisis were one of the highest in the world as percentage of GDP, are also unlikely to decrease any further, mitigating the risks.

Figure 1A.
Figure 1A.

Moldova: Indicators of Public and Publicly Guaranteed External Debt under Alternative Scenarios, 2009-2029 1/

Citation: IMF Staff Country Reports 2010, 032; 10.5089/9781451825190.002.A002

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in 2019. In figure b. it corresponds to a Terms shock; in c. to a Exports shock; in d. to a Terms shock; in e. to a Exports shock and in figure f. to a Non-debt flows shock
Figure 2A.
Figure 2A.

Moldova: Indicators of Public Debt Under Alternative Scenarios, 2009-2029 1/

Citation: IMF Staff Country Reports 2010, 032; 10.5089/9781451825190.002.A002

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in 2019.2/ Revenues are defined inclusive of grants.
Table 1A.

Moldova: External Debt Sustainability Framework, Baseline Scenario, 2006-2029 1/

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Includes both public and private sector external debt.

Derived as [r - g - ρ(1+g)]/(1+g+ρ+gρ) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and ρ = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes.

Assumes that PV of private sector debt is equivalent to its face value.

Current-year interest payments divided by previous period debt stock.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the PV of new debt).

Table 2A.

Moldova: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2009-2029

(In percent)

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Sources: Country authorities; and staff estimates and projections.

Variables include real GDP growth, growth of GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt creating flows.

Assumes that the interest rate on new borrowing is by 2 percentage points higher than in the baseline., while grace and maturity periods are the same as in the baseline.

Exports values are assumed to remain permanently at the lower level, but the current account as a share of GDP is assumed to return to its baseline level after the shock (implicitly assuming an offsetting adjustment in import levels).

Includes official and private transfers and FDI.

Depreciation is defined as percentage decline in dollar/local currency rate, such that it never exceeds 100 percent.

Applies to all stress scenarios except for A2 (less favorable financing) in which the terms on all new financing are as specified in footnote 2.

Table 3A

Moldova: Public Sector Debt Sustainability Framework, Baseline Scenario, 2006-2029

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

General government gross debt, excluding debt of state-owned enterprises.

Gross financing need is defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period.

Revenues excluding grants.

Debt service is defined as the sum of interest and amortization of medium and long-term debt.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Table 4A.

Moldova: Sensitivity Analysis for Key Indicators of Public Debt 2009-2029

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Sources: Country authorities; and staff estimates and projections.

Assumes that real GDP growth is at baseline minus one standard deviation divided by the square root of the length of the projection period.

Revenues are defined inclusive of grants.

8. While rebound in exports, fiscal consolidation and significant levels of remittances should ensure that adequate resources for public debt service remain available, certain risks exist. While none of the indicators of debt service breaches the threshold, some liquidity pressures could emerge in the medium term when the repurchases of the ECF and the EFF are falling due as shown by an increase in ratios of debt service to exports and revenues under the extreme scenarios. In addition, significant private external debt implies that private borrowers would compete with the public sector for foreign exchange needed to service their external debt.

VII. Public Debt Sustainability under the Baseline and Alternative Scenarios

9. Under the baseline, the ratios of total public debt do not signal increased vulnerability at present. Total public debt consists mainly of external PPG debt (72 percent) hence it follows closely the dynamics of its external component. Under the baseline scenario, after the initial increase over the medium-term, the PV of total public debt-to-GDP ratio will decline to 24 percent, while the PV of debt service to revenue ratio would fluctuate around 7 percent.

10. The most significant increase of public debt indicators would materialize if the primary balance remains at the unsustainable 2009 level. Large and persistent primary gap would then lead to an explosive debt dynamics. However, the ongoing process of fiscal consolidation, combined with binding financing constraints should result in a structural reversal of the fiscal position, rendering such scenario less probable.

11. Two stress scenarios could result in a sharp increase of public debt indicators. Permanently lower GDP growth results in an ever-increasing PV of debt-to-GDP ratio reaching 87 percent in 2029, almost three times larger compared to the current level. A sharp real exchange rate depreciation could result in a spike in public sector debt but this increase would be temporary, and debt dynamics would revert to a benign pattern in the medium term.

VIII. Scenarios with Additional Non-Concessional Borrowing

12. This section explores alternative scenarios where the government increases its non-concessional borrowing by additional US$125 million a year over ten years.15 The non-concessional resources could be invested in infrastructure upgrades (e.g., roads, energy supply and distribution, water treatment, and agricultural irrigation). It is assumed that the loans will be repaid within 15 years, with 3 year grace period, and will carry an interest rate of 3 percent per annum.

Scenario 1

13. The first scenario envisages that the additional borrowing will contribute to a higher real growth rate of GDP in the medium and long term than under the baseline scenario. In the absence of specific information on the projects to be financed with new loans, it is conservatively assumed that their “domestic component” will be about 30 percent, while the remaining amount will directly translate into increased imports. Given large spare capacities in the economy after the crisis, the projects’ implementation can directly contribute to the GDP growth without rekindling inflation pressures. Therefore in the medium term, annual growth could rise by 0.5–0.6 percent under a conservative scenario, mainly as a result of higher investment, employment, and consumption during project implementation years. Additional infrastructure investment will also raise the economy’s capital stock and boost productivity, ensuring higher growth in the long run (4.5 percent, or 0.5 percentage points higher than under the baseline).

14. Exports and FDI will initially rise only in line with GDP, but then will accelerate in the long run, compared with the baseline scenario. Modest initial growth will reflect lags in improvements in infrastructure. In the long run, better infrastructure will improve Moldova’s attractiveness to foreign investors, raising FDI to 9 percent of GDP and exports of goods to 43 percent of GDP.

15. Imports will accelerate substantially over the course of the operation, causing initial deterioration of the current account (Figures 3A4A, Tables 5A8A). In the long run, however, Moldova’s reliance on imported energy will decrease due to new investment, contributing to a stabilization of imports at 79 percent relative to GDP. The current account in the long term will remain broadly unchanged from the baseline scenario (Section III).

Figure 3A.