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.
The Moldovan authorities appreciate the constructive dialogue with the Fund management and staff over the years. They attach great value to the close relationship with the Fund, whose advice continues to support the policy formation process in Moldova.
Recent Developments and Outlook
After several years of strong growth, in 2009 Moldova was severely hit by the global economic crisis. Moreover, the economic crisis overlapped with a political crisis causing a major contraction of the economy. GDP is estimated to have decreased by about 9 percent, compared to a close to 8 percent growth in 2008. This huge swing was mostly result of a weak demand in trading partners, which caused a severe downturn in exports and worker remittances. The BOP moved from a surplus to a sizable deficit as FDI and other capital inflows fell dramatically. Even though deflation pressures emerged and persisted for a good part of 2009, monetary policy remained rather tight as the central bank was defending the leu, thus tightening liquidity and depleting its foreign reserves. On top of that, the crisis and pre-election spending hikes brought about a large and widening fiscal gap as revenue dropped, notably the VAT and foreign trade taxes, while current fiscal expenditure was substantially increased in the run-up of the elections.
The financial system, dominated by the banking sector, remains stable, although the recession has negatively affected the quality of the credit portfolio in many banks. The significant decline in credit, along with capital increases in a number of banks, has brought the average risk-weighted capital adequacy ratio (CAR) of the system to nearly three-times the required minimum of 12 percent. However, the nonperforming loans are on the rise, even though their doubtful and loss components remain low. One medium-sized bank became insolvent in June, mostly because of a high portfolio concentration in recession-hit sectors, as well as some risk management irregularities. The National Bank of Moldova (NBM) has responded by stepping up supervision and regulation. Banks have been requested to undergo a diagnostic study performed by an independent reputable audit firm to assess the quality of their assets and review their risk management methods. The NBM has also initiated close and enhanced monitoring of bank activity on the basis of monthly bank reports on financial soundness indicators and stress tests.
With regard to 2010, the macroeconomic objectives are influenced by the expected gradual recovery in Moldova’s trading partners. The authorities expect the recession to be over by the first quarter of 2010, allowing the annual growth rate to rebound to 1.5 percent. Monetary policy is aimed to achieve (and sustain over the next few years) inflation around 5 percent. The current account deficit is expected to widen modestly to slightly above 10 percent of GDP as imports are boosted by higher prices of imported energy and a recovery in investment.
Over the medium term, the economy is expected to recover to its potential, with growth reaching about 5 percent by 2012. Inflation is projected to remain stable in mid-single digits, anchored by growing credibility and transparency of monetary policy. Remittances will grow slowly back to their 2008 level over the medium term. The current account deficit is expected to stabilize around 10 percent of GDP—a level that should be readily financed by FDI and official assistance, which would also help reserves grow to adequate levels.
Program Objectives
While it could be argued that the economic crisis was triggered by an external shock, the new government acknowledges that the policies ran in the first half of 2009 were unsustainable and led to a sharp deterioration of the economy’s fiscal and external position. The stated overarching objective of the authorities is to improve the well-being of the population by promoting sustainable growth and reducing poverty. At the same time, the authorities realize that in the current juncture they need to undertake urgent measures to stabilize and rebalance the economy. To this end, the authorities request Fund-supported arrangements to restore fiscal and external sustainability, preserve financial stability, and support growth. In addition, the authorities are committed to wide and far-reaching structural reforms to raise the economy’s potential.
The economic crisis, exacerbated by a political turmoil following the April elections, led to delays in implementation of market-oriented reforms and a properly targeted social safety net for the poor. A number of sectors of the national economy are still excessively regulated with high barriers to entry and low competition. In response to the economic crisis, the new government launched an Economic Stabilization and Recovery Plan, which puts forward strong measures intended to help enterprises and households overcome the economic crisis.
The measures envisaged in the plan, a large part of which are included in the MEFP, aim to stabilize public finances, restart economic growth, and protect vulnerable households. In particular, to create a modern European public administration, a series of reforms have been launched to streamline and enhance the efficiency of the civil service. To provide a boost to trade and promote competition, the authorities have removed many formal and informal export and import restrictions.
Fiscal Policy
The Moldovan authorities are firmly committed to a prudent and transparent fiscal policy. They are fully aware that this is a challenging task given that the program should seek to balance the needed sizable fiscal adjustment with large public investment and social spending needs. In this regard, the authorities are struggling to avoid any further build-up of fiscal pressures, while ensuring smooth execution of the budget so to prevent distortion of the economic activity. In order to quickly fix some of the problems, the new government adopted a number of policy decisions to reduce the budget deficit for 2009 as much as feasible. A first step in this direction was postponing wage increases for employees of the budgetary sector as envisaged in the Budget System Wage Law.
Realizing that the share of public sector employment (over 20 percent) is too high even compared to higher-income emerging market countries, the new government decided to stick to a previous action plan aimed at optimizing the number of employees in the budgetary sector. This plan envisages reducing staff by about 10 thousand people in the period 2008-10.
Another important objective of the authorities’ program is to reduce spending on goods and services and to cut low-priority subsidies to enterprises. On the revenue side, the government has raised excises on a number of products (including gasoline, diesel, tobacco products, liquor, cosmetics, luxury cars, etc.) and raised the VAT rate on natural gas. In addition, the corporate income tax for reinvested profits, which in 2008 was set at a zero rate, will be reinstated with a low single rate (10 percent) and a broad, uniform base across sectors and regions. In order not to raise the tax burden on companies before the economy recovers from the crisis, this measure will apply to income earned from 2012 onwards.
To ensure appropriate budget financing in 2010, the authorities request that a moderate fraction of the access under the Fund arrangements be used for direct budget support. Moldova lacks access to international markets, and the domestic market for government securities has limited capacity, as experience in mid-2009 showed. The absence of Fund financing would imply either additional sharp expenditure cuts, detrimental to the economic recovery or the program’s social assistance policies, or accumulation of arrears.
Monetary and Exchange Rate Policy
The authorities’ intention is to leave monetary policy relaxed as long as the inflation outlook is in line with the NBM’s target. In that sense, there is scope for further easing in the short run. Concomitantly, the NBM has approved a new strategy upholding price stability as the primary objective of monetary policy and the NBM’s base rate as the main policy instrument. The NBM will restart open market operations, work toward enhancing its forecasting and analytical capacity, and promote transparency through regular communication with the public regarding its inflation forecast and policy stance. Also, the NBM plans to start publishing quarterly reports providing analyses of monetary policy performance as well as forecasts of inflation and key macroeconomic indicators.
Within its new framework, the NBM is committed to promote a flexible exchange rate with interventions in the foreign exchange market limited to only preventing excessive fluctuations without resisting trends. In addition, the NBM is preparing to take advantage of the easing of global financial tensions and to replenish its foreign exchange reserves to a more appropriate level. More specifically, the goal is to build a comfortable buffer against external shocks in the range of 70–90 percent of next year’s current account deficit and maturing external debt. This coverage is believed to be appropriate given the still high downside risks to external stability.
Structural Reform
To better direct its limited resources to the most vulnerable households, the new government is determined to give priority to a targeted compensation system, based on the households’ income and assets. Currently, the social assistance system covers only a quarter of the vulnerable households and any abrupt removal of nominal compensations would produce undesirable social effects. The authorities realize that for the new system to become operational, a series of concrete steps will need to be taken. In particular, the authorities will terminate, as of the beginning of 2010, granting the right to nominal compensation; freezing the nominal amount of compensations granted; and gradual elimination of nominal compensations categories. In the second stage, by end-March 2010, the government will approve a plan for a prompt expansion of the new targeted social assistance system with a view to cover at least 2/3 of all eligible recipients by end-2010. An intensive communication campaign is already underway to promote enrollment of eligible households into the new system.
The government attaches high priority to eliminating quasi-fiscal expenditure. In this regard, it’s the authorities’ understanding that heating tariffs should be kept away from the political debate and be based on cost-recovery levels. Accordingly, the current legislation has been amended to ensure de-politicization of the tariff-setting system and strengthening of the role of the independent National Agency for Energy Regulation (ANRE).
Longer-term sustainability of the pension system is another area that needs reforms. The ultimate goal is a smooth transition from the current pay-as-you-go system to a contribution-based system. To this end, the authorities are preparing concrete measures, including phasing out early retirement options for certain professional categories; extending the requirement to pay state social insurance contributions to all persons employed in Moldova; and improving the mechanism for granting the right to compensation for temporary disability. These measures aim at strengthening of the first pillar of the future pension system. With regard to the implementation of the second pillar, the authorities recognize that it will involve substantial financial costs, which will need to be viewed in the context of wider financial and technical assistance from development partners.
There are numerous measures that the authorities are already undertaking to simplify business regulations and improve the business climate. Amongst the most important are: revising the classification of regulated goods that are subject to mandatory compliance certification; implementation of a true one-stop shop for business registration; and improving the access to financing through institutionalization of an operational system for storing and disseminating credit information. The authorities strongly believe that the successful implementation of these reforms will be crucial for jump-starting the economic recovery.
Finally, the Moldovan authorities believe that the policies set forth in the MEFP are well designed and sufficient to achieve the objectives of the program. At the same time, they stand ready to take any further measures that may become necessary. In accordance with the Fund’s policy, the authorities will consult with the Fund on the adoption of these measures, and in advance of revisions to the policies contained in the MEFP.