Republic of Moldova: Selected Issues

The composition of short-term and medium-term adjustment measures will facilitate sufficient short-term adjustment flexibility, and be consistent with medium-term fiscal sustainability. Improving debt resolution instruments will help the banks to regain confidence in lending. Meanwhile, there is a need to consider improvements in its liquidity framework. The main factors that shaped the economic growth model in Moldova in the last decade and the risks of the current growth model are outlined. Public policies can promote growth by identifying and addressing the most binding constraints to development.


The composition of short-term and medium-term adjustment measures will facilitate sufficient short-term adjustment flexibility, and be consistent with medium-term fiscal sustainability. Improving debt resolution instruments will help the banks to regain confidence in lending. Meanwhile, there is a need to consider improvements in its liquidity framework. The main factors that shaped the economic growth model in Moldova in the last decade and the risks of the current growth model are outlined. Public policies can promote growth by identifying and addressing the most binding constraints to development.

III. Factors and Features of Economic Growth 1

A. Introduction

1. This paper considers Moldova’s growth performance over the last decade and the medium-term growth outlook. It highlights the key factors that either boosted or hindered the country’s growth prospects. The paper estimates Moldova’s potential growth and the contributions of production factors to it. The analysis leads to policy recommendations focused on the need to promote export-led growth and remove obstacles for development.

2. The growth model based on expansion of domestic demand fuelled by remittances made the economy prone to “boom-bust” cycles. The pre-crisis economic growth largely reflected steady increase in workers’ remittances, private consumption, and investments in sectors producing nontradable goods and services. Imports and output of these sectors expanded at a brisk pace, while the share of exports in GDP declined. When remittances, capital inflows, and exports decreased abruptly in 2009 in the wake of the global economic crisis, the economy plunged into a deep economic recession accompanied by a sharp correction of trade imbalances.

3. The estimates of the economy’s potential growth rate rely on the production function approach. The medium-term potential growth rate is estimated at about 4 percent, while the actual growth can go above or below this level because of cyclical swings in the economy. According to the analysis, the largest contribution to growth in Moldova comes from rising total factor productivity. Expanding capital stock makes a significant contribution as well, while a declining labor force naturally subtracts from growth.

4. To sustain high growth going forward, it is essential to diversify the growth model by promoting exports and maintaining external price competitiveness. A four percent growth rate looks modest when compared to Moldova’s vast development needs and poverty reduction objectives. Sustainably higher growth rates could be achieved only through export-led growth based on a strong expansion of the tradable sectors of economy. Maintaining external price competitiveness implies keeping real wage growth in line with productivity gains and avoiding policies that lead to overvaluation of the national currency.

5. Improving the business climate and upgrading the country’s infrastructure are essential for facilitating the growth model diversification. International competitiveness rankings highlight dilapidated infrastructure and bad roads in particular as important factors hindering Moldova’s competitiveness. They also suggest the need to streamline the procedures for issuance of construction permits and land allocation, revamp labor market laws, protect investor rights and improve companies’ access to finance. Reforms in these arears can remove important obstacles to economic development. A national development strategy paper can document government reform priorities and set quantitative indicators to measure progress towards them.

6. The rest of the paper is organized as follows. Section B outlines the factors that shaped the growth model relying on domestic demand and remittances. Section C presents results of potential growth estimates using the production function method. Section D contemplates policies for improving business environment and promoting sustainable growth. Section E concludes with summary of findings and policy recommendations.

B. Features of the Economic Growth Model in Moldova

Main factors shaping growth performance over the last decade

7. Growth in Moldova accelerated in the last decade, to be interrupted only by the global economic crisis (Figure 1). The annual GDP growth averaged almost 6 percent in 2000–08, which was a considerable improvement compared with the average contraction of about 3 percent in 1995–99, not to mention double-digit decline rates in 1991–94. In the wake of the global economic slowdown, GDP contracted by 6.5 percent in 2009. The economic growth of the last decade raised the living standards in the country and contributed to high fiscal revenues and poverty reduction.

Figure 1.
Figure 1.

Moldova: Economic Developments, 1995–2010 1

Citation: IMF Staff Country Reports 2010, 232; 10.5089/9781455204908.002.A003

Source: National Bureau of Statistics; and author’s calculations.1/ Actual data for 1995-2009 and projections for 2010.

8. Growth was mainly driven by expanding domestic demand fuelled by workers’ remittances. The private consumption’s share in GDP increased steadily from 56 percent in 1995 to 93-94 percent in 2006–08. This increase in large part resulted from growing remittances, which increased from about 5 percent of GDP in the mid-1990s to 30-33 percent in 2006–08. 2 Remittances became very important for the families of those working abroad, allowing them to reach a level of consumption and well-being unattainable for them otherwise. Indirectly, through taxation of consumption and imports, remittances also helped increase the fiscal revenues.

9. Rising labor productivity became one of the main factors underpinning GDP growth. In all years, labor productivity increased more or in line with the GDP growth rate. This in part reflected rising productivity in the growing sectors of economy and in part resulted from labor shedding by depressed sectors. Large labor outflows came from agriculture, which exhibited poor productivity. Even after shedding a lot of excess labor, agriculture accounted for about 28 percent of Moldova’s employment in 2009 while producing only about 8 percent of its GDP.

10. The GDP expansion of the last decade was accompanied by steady decline in the local labor force. Facing low salaries and high unemployment at home, many Moldovan workers opted for job opportunities outside the country, and up to 40 percent of the labor force works abroad (Cuc et al. (2005)). The Moldovan local labor force decreased from 53 percent of population in 1995 to only 36 percent in 2008, while the unemployment rate declined from 14 percent to 4 percent over this period. Unemployment increased to about 6 percent in 2009 because of the economic crisis and return to Moldova of some migrants who lost jobs abroad.

11. Rising domestic investments and FDI also contributed to economic growth (Figure 2). Over the last decade, the share of investments in GDP more than doubled from about 15 percent in 2000 to 34 percent in 2007–08. A large contribution came from increasing foreign direct investments (FDI). They reached 11–12 percent of GDP in 2007–08, but collapsed in 2009 in the wake of the global crisis.

Figure 2.
Figure 2.

Moldova: GDP and Investments, 1995–2010 1

Citation: IMF Staff Country Reports 2010, 232; 10.5089/9781455204908.002.A003

Source: National Bureau of Statistics; and author’s calculations.1/ Actual data for 1995-2009 and projections for 2010.

12. Sectors producing goods and services for domestic consumption expanded fast, while key sectors producing tradables stagnated. Value added in financial and other services, wholesale and retail trade and construction expanded at a brisk pace. On the contrary, agriculture and industry stagnated, and their share in GDP steadily declined from 54 percent in 1995 to only 20 percent in 2009. 3 The notable exception was the transport and communications sector, where fast expansion reflected both domestic and international demand, including for transit through the country.

The costs and risks of Moldova growth model

13. The growth model relying on domestic demand fuelled by remittances as its main engine is particularly vulnerable to “boom-bust” cycles. In general, the economies that receive higher levels of remittances experience higher rates of output volatility (Chami et al. (2006, 2008)). In Moldova this became painfully clear in 2009, when the remittances dropped in the wake of the global economic crisis. This led to a sharp decline of the domestic demand and economic activities largely financed by remittances, such as residential construction. Ultimately, this contributed to a sharp GDP contraction.

14. Even after the projected rebound after the crisis, the growth model based on remittances will be subject to known constraints. Going forward, the role of remittances cannot increase much beyond its maximum of 2006–07. The share of Moldova’s labor force working abroad is already very high and cannot increase much further. In addition, the usual patterns of remittances flows suggest that they peak at a certain time in a worker’s career and can even decline thereafter, as workers get entrenched in their destination countries and gradually lose ties with their country of origin (Chami et al. (2008)).

15. Naturally, those working abroad do not pay taxes and social contributions in Moldova, which adds to domestic imbalances. With direct taxation of workers’ remittances or salaries abroad being all but impossible, the central and local budgets have to rely on heavy taxation of consumption and imports. 4 This can lead to higher level of domestic prices compared to neighboring countries. For the national pension fund, having large share of the labor force abroad implies higher dependency ratio and higher burden on those working in the country.

16. The current growth model also created sizable external imbalances requiring large precautionary holdings of international reserves. Expansion of private consumption fuelled by remittances naturally led to rising share of imports in GDP, while the share of exports steadily declined reflecting deteriorating international competitiveness. 5 As a result, the trade deficit ballooned from about 26 percent of GDP in 2000 to 53 percent of GDP in 2007–08 and was largely covered by remittances. When the remittances and capital inflows collapsed in 2009, this prompted sharp correction of trade imbalances and necessitated massive interventions by the National Bank of Moldova (NBM) in support of the national currency. To have capacity for such interventions, NBM has to maintain large international reserves, amounting to nearly 28 percent of GDP at end-2008. This was one of the highest ratios among the transition economies of the Southeastern Europe and CIS (Figure 3).

Figure 3.
Figure 3.

Moldova: International Comparisons, 2008

Citation: IMF Staff Country Reports 2010, 232; 10.5089/9781455204908.002.A003

Source: IMF World Economic Outlook Database.Includes countries in Southeastern Europe and CIS (plus Mongolia) with GNI per capita of US’5,000 or less as of 2008 (according to World Bank’s World DeveIopment Indicators).

The challenge of diversifying the economic growth model

17. To sustain high growth over the next decade, it becomes essential to diversify Moldova’s growth model. The challenge is to switch the focus from growth in sectors producing nontradable goods and services for local consumption fuelled by remittances to export-led growth in tradables based on new investments and expansion on external markets. This is required to sustain the increases in labor productivity, stabilize or even raise local employment, and eliminate the need for labor migration abroad. Diversifying the growth model will help improve Moldova’s external competitiveness, boost exports, and alleviate the external and domestic imbalances.

18. Prudent wage policy linked to productivity increases should be an integral part of the diversified growth model. Often led by large salary increases in the public sector, double-digit annual wage increases became a norm for Moldova in the last decade. Exceeding both productivity gains and consumer price hikes, such increases added to inflation pressures, but were not effective in reversing labor migration. Going forward, the challenge is to closely link wage growth to productivity gains in the public sector and in the economy in general.

19. Maintaining policies that prevent the exchange rate from excessive appreciation also play an important role in supporting external competitiveness. Rapid real effective exchange rate appreciation in the second half of 2008 eroded external competitiveness in the eve of the crisis. This excessive strengthening of the national currency was reversed only in 2009, when the nominal exchange rate depreciated and price deflation occurred.

20. The ability to mobilize domestic investment and attract FDI is a necessary, but not sufficient condition for the successful diversification of the growth model. Investments from foreign and domestic sources amounted to as high as 34 percent of GDP in 2007-08. However, they mainly went to the sectors producing nontradables and, in fact, entrenched the existing growth model. To promote the new growth model, the investment attractiveness of sectors producing tradables should improve considerably.

21. Advancing structural reforms and liberalizing trade holds the key to attracting new FDI for Moldova. A study by Demekas et al. (2005) estimated the gap between “potential” and actually received FDI in Moldova at as much as 77 percent in 2003, which was the second-largest among the 14 countries covered in the paper. The study estimated the potential FDI using both “gravity” model variables (such as country size, population, proximity to markets, etc.) and the “best” values of policy variables affecting FDI (infrastructure reform index, trade liberalization, taxation level, etc.). These results suggested that Moldova could benefit more than most countries in Southeastern Europe from a sustainable improvement in policies.

C. Potential Growth Rate Estimates

Results of production function estimates

22. After the crisis of 2009 the growth prospects of Moldova deteriorated significantly (Table 1). 6 The higher pre-crisis GDP growth to a large extent reflected a cyclical increase in growth rates based on remittances-driven expansion of the domestic demand. The crisis led to a sharp contraction of remittances and collapse of FDI. It also prompted downward revision of medium-term projections for new private investments in Moldova, given the current global outlook. As an outcome, the crisis led to potential GDP growth rate reduction of about 2 percentage points, from the average of 5.2 percents for 2007–08 to just 3.2 percent for 2009. The estimated medium-term potential growth rate declined from about 5¼ percent just before the crisis to in the same way. While the medium-term projections of the potential GDP of Moldova complied in 2007–08 before the crisis yielded the rate of about 6 percent (not included in the table below), the current projections are for about 4 percent on average over 2010–15.

Table 1:

GDP Growth and Contributions, 1996-2015


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Source: National Bureau of Statistics; and Staff calculations.

23. Depending on the business cycle phase, the actual growth can be above or below its potential level (Figure 4). Strong growth rates in 2004–08 pushed the actual GDP above potential and—in hindsight—look unsustainably high. Increases in both actual and potential GDP in these years resulted in part from high level of new capital investments boosted by record-high FDI inflows to Moldova. When the crisis hit Moldova in 2009, the actual GDP declined sharply. At the same time, the crisis impact on the main production factors was largely limited to a decline in new investments without, however, leading to decrease of the existing capital stock. Therefore, the estimated potential GDP continued to expand even in 2009, though at a lower rate. As a result, Moldova swung from a positive output gap of as much as 8 percentage points in 2008 to a negative gap of about 2 percentage points in 2009. On current projections, it will take several years after the crisis for the negative gap to close and the actual output to catch up with the potential.

Figure 4:
Figure 4:

GDP Growth in Moldova

Citation: IMF Staff Country Reports 2010, 232; 10.5089/9781455204908.002.A003

24. According to the estimates, the largest contribution to potential growth over the last decade came from increasing productivity (Figure 5). The gains in total factor productivity (TFP) contributed 3–4 percentage points to the potential growth rates. The increasing capital stock added up to 3 percentage points to potential growth, with the highest contributions in 2007–08. At the same time, the decline in labor force—largely reflecting labor migration from Moldova to neighboring countries—subtracted roughly 1 percentage point from the potential.

Figure 5:
Figure 5:

Contributions to Potential GDP Growth

Citation: IMF Staff Country Reports 2010, 232; 10.5089/9781455204908.002.A003

25. The estimated contributions of various factors to growth look broadly consistent with the structural properties of the Moldovan economy. After the collapse of the Soviet Union, the virtual absence of capital-intensive industry and a structural crisis in traditional branches of economy stipulated low labor productivity levels in Moldova. High unemployment and low salaries naturally led to labor migration in search of better opportunities. The outflow of labor from low-productivity sectors (such as agriculture) to more productive sectors and to employment abroad both created a drag on growth (from the shrinking labor force) and caused large sustainable increases in productivity. The contribution of capital to growth remained relatively modest reflecting the still rather low capital stock, as for many years the new investments were barely sufficient to compensate for amortization. This is broadly consistent with recent studies highlighting dilapidated infrastructure as a major obstacle to growth in Moldova (as discussed in Section D below).

Estimating Effects of External Loans on the Economy

For illustrative purposes, this box estimates the impact of a hypothetical large external loan provided on terms favorable for Moldova. Let us consider a loan of US$1 billion coming to finance infrastructure projects, to be disbursed in equal annual installments of US$100 million starting from 2010. Here, we concentrate on the loan’s impact on economic growth and abstain from assessing its impact on the debt sustainability, which should be subject to a separate analysis.

In the aftermath of the recent economic downturn, the projects to be financed by the loan will tap into the spare capacities in the economy. In view of the relatively high unemployment and output gap in the economy projected for 2010–11, disbursements and use of up to US$100 million—with a heavy import component—would probably not add substantially to inflation or wage pressures. And in 2012 and subsequent years, the economy will likely adjust to the new loans without undue shocks. Therefore, the expected contributions to growth could add up to the “baseline” medium- and long-term projections for the GDP growth, exports and other real variables.

Estimating the impact of a large loan on economic growth requires several assumptions and estimates.

  • Broadly in line with international experience, let us assume that Moldova’s “domestic component” of the loan will be at least 30 percent (i.e., about 30 percent of input and even greater share of labor for the projects financed with the loan will come from Moldova itself, and the rest will be imported).

  • Based on the labor productivity in the Moldovan economy, we estimate that the temporary increase in employment associated with the projects’ implementation will be one person per US$ 5 thousand of the “domestic component” of the projects. For the project financing of US$100 million per year, it means some 6 thousand new jobs in 2010–16.

  • During the projects’ implementation years, their “domestic component” will directly contribute to Moldova’s GDP, reflecting the contribution of construction activities, supplies production, and workers’ wages being spent domestically.

  • Because of transaction costs, however, only about 80 percent of the amount of the foreign loan will eventually convert into new capital stock in Moldova economy. The rest will cover the projects’ costs not associated with increase in capital, such as work planning and monitoring project implementation.

  • The projects’ impact on productivity of capital and labor in Moldova will be neutral in the first two years of their implementation and moderately positive starting from the third year, when the first projects will be completed and become operational.

These assumptions make it possible to estimate the possible impact of the loan-financed projects on the economy. The projects financed by a US$1 billion loan can boost economic growth by up to 0.3–0.6 percentage points per year as compared to the baseline growth rate. In the early years this will come from direct contributions to the economic activity. In the medium- to long-term it will come from the increase in the potential GDP growth rate boosted by rising capital stock and improvements in factor productivity.

Implications for the macroeconomic outlook and policies

26. The estimation results can inform the medium- and long-term growth projections for Moldova. The obtained estimate of 4 percent for the potential GDP growth rate after the crisis of 2009 can be used as the baseline growth rate for projections. While growth in certain years can be above or below this level, it can be projected to converge to it over the long run, barring profound structural changes in the economy. And the possible effects of such changes as well as positive or negative output shocks to economy can be also estimated by adding or subtracting from this potential growth rate.

27.Estimates of potential GDP and output gap provide an input for assessing the impact of cyclical economic fluctuations on the fiscal balance. Emergence of a positive output gap normally leads to cyclical improvement of the fiscal balance, while a GDP decline below potential naturally worsens it. Estimating the contribution of the cyclical economic swings makes it possible to separate it from discretionary policy measures (Appendix II).

28. The results can also help assess both downward and upward risks for Moldova’s economic outlook. On the positive side, improving prospects for capital investment can boost the potential growth rate. These improvements can come from higher than expected FDI inflows, higher domestic private investment, or higher public capital outlays. The financing for additional public investment can come from either reallocation of existing budget resources or external borrowing (Box 1 illustrates approaches to evaluating the impact of such foreign loans on growth). On the negative side, delays in implementing structural reforms can discourage investments and lead to resumption of labor migration from Moldova. And in the absence of new investment in the crumbling infrastructure, it may be challenging for the economy to sustain the productivity gains that made possible the economic growth of the last decade.

D. How to Boost Growth and Remove Obstacles to Development in Moldova?

Identifying obstacles to growth

29. The available literature highlights a number of main obstacles impeding economic growth in Moldova. The list of such obstacles often starts with the deteriorating infrastructure (dilapidated roads, inadequate electricity grid and water supply network, etc.). It also usually includes problematic legal and administrative environment for firms (i.e., inappropriate investment climate). For Moldovan companies, the small size of the local market imposes a natural constraint, while gaining access to markets of the larger neighboring countries can be not so easy. In addition, companies in Moldova often face high costs of financing (or cannot access it at all); experience shortage of skilled workers; and have to cut through “red tape” to obtain construction permits and get access to land.

30. Facing a multitude of obstacles, it becomes tempting to select just a few critical constraints and focus on addressing them. Based on the “Growth diagnostic” methodology developed in Hausmann et al. (2005), two recent studies by BenYishay and Wiebe (2010) and Bozu et al. (2007) attempted to identify the most binding constraints for Moldova. 7 After careful consideration of all factors, they highlighted bad roads and inadequate irrigation in agriculture as the most binding constraints.

31. To a large extent, analysis of the growth diagnostic studies relies on the international competitiveness rankings and business surveys. The indicators of “Doing Business” survey compiled by the World Bank and the Global Competitiveness Report published under the auspices of the World Economic Forum (WEF) measure business and investment climate. The Country Policy and Institutional Assessment (CPIA) indicators of the World Bank evaluate the quality of the government policies. The European Bank of Reconstruction and Development (EBRD) publishes Institutional Change Indicators measuring reform progress in 29 transition countries. There are also dedicated rankings covering some particular aspects of business environment, such as Corruption Perceptions Index published by “Transparency International”.

32. Careful consideration of the main available rankings can provide some insights on where reforms are most needed (Tables 2). The indicators from the EBRD and rankings from WEF broadly confirm that rundown infrastructure and bad roads in particular hinder Moldova’s competitiveness (Tables 3 and 4). The EBRD indicators also rate Moldova low on enterpize restructuring progress and reform of securities markets and non-bank financial institutions. WEF assigns low rankings to Moldova with regard to market size, business sophistication, and innovation. The WB rankings highlight the problems that businesses face in dealing with construction permits, employing workers, getting credit, and protecting investments (Table 5). On these indicators, Moldova ranks among the last in the list of comparable countries.

Table 2.

Moldova: Position in Selected International Rankings

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Table 3.

Moldova: EBRD Institutional Change Indicators, 2009

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Source: European Bank for Reconstruction and Development (EBRD); and author’s calculations.
Table 4.

Moldova and Selected Countries: Global Competitiveness Report Rankings, 20081

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Source: World Economic Forum (WEF), The Global Competitiveness Report, 2008-2009.

Moldova was excluded from the 2009 ranking for lack of survey data.

Rank among the 11 comparable countries included in the table (1-best, 11-worst).

Table 5.

Moldova and Selected Countries: Positions in “Doing Business” Survey, 2009

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Source: World Bank, “Doing Business” Survey.

Rank among the 12 comparable countries included in the table (1-best, 12-worst).

33. Analyzing sub-categories of the main rankings can shed light on the likely causes of poor or good performance. According to WB, the problems of dealing with construction permits mainly relate to the very high number of procedures involved and the long time needed to complete them. At the same time, the official costs of compliance with these procedures do not look particularly high (Table 6). Also according to the “Doing Business” rankings, Moldova compares unfavorably with peer countries on all indicators of labor market rigidities (Table 7). At the same time, in 2008 WEF did not rate Moldova so low on the labor market efficiency (Table 4). The reason for this may be higher emphasis placed by WEF on the actual labor market practices rather than on provisions set by laws and regulations. For example, Moldova is rated high by WEF on “Cooperation in labor-employer relations”, but gets a low mark on “Firing costs”. Moldova’s low standing with regard to the investors’ protection to a large extent reflect insufficient legal grounds for enforing of shareholders’ control over executive directors (Table 8). And the difficulties in accessing credit were due to the absence of credit bureaus or public credit registry and lack of information on credit histories. 8

Table 6.

“Doing Business”: Dealing with Construction Permits, 2009

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Source: World Bank, “Doing Business” Survey.

Rank among the countries included in the table.

Table 7.

“Doing Business”: Employing Workers, 2009

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Source: World Bank, “Doing Business” Survey.

Rank among the countries included in the table.

Table 8.

“Doing Business”: Protecting Investors

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Source: World Bank, “Doing Business” Survey.

Rank among the countries included in the table.

34. The results of the “Growth diagnostic” studies and international competitiveness rankings should be treated with a degree of caution. While the country’s position in the competitiveness rankings usually has a strong link with its already achieved level of development, the correlation with the actual or projected growth rate is difficult to find (Gorbanyov (2002)). The rankings to a large extent depend on the opinions of experts and business representatives, which may be biased or misstated. Thus it may be important to agree upfront what international indicators, if any, present the best picture of the actual situation in the country and are recognized as such by the main stakeholders. These results can be useful in attracting attention to problems in particular areas and justifying concentration of government efforts and donor assistance on addressing specific obstacles. 9

Table 9.

“Doing Business”: Getting Credit

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Source: World Bank, “Doing Business” Survey.

Rank among the countries included in the table.

Targeting and measuring the progress of promoting growth

35. A national development strategy paper can present a perspective on the growth promotion priorities. The paper prepared in 2004 declared: “The challenge is to move from the current state of remittance based, consumption-led growth to a more balanced model, emphasizing investment and locally based import substituting and export led growth” (Economic Growth and Poverty Reduction Strategy Paper (2004), page 35). Apparently, this and many other objectives formulated in 2004 remained very relevant for Moldova ever since (seeAppendix III). The next paper prepared in 2008 covered the period until 2011 (National Development Strategy (2008)). The impact of the world economic crisis and political changes in Moldova in 2009 made it necessary to revise and update this paper. The document on Moldova’s priorities for medium-term development prepared in March 2010 for discussions with donors in the context of the Consultative Group meeting in Brussels became an important milestone in this process (Rethink Moldova (2010)). The main challenge in its further improvement is to set clear-cut priorities and group the proposed measures and actions around them.

36. Regional integration is crucial for reaping the full benefits of Moldova’s geographic location. Moldova’s trade with major partners passes through Ukraine and Romania, and further improving ties with these neighboring countries is critically important. For example, upgrading the roads in Moldova can bring the best results when combined with seamless access to the road networks of its neighbors. 10 More broadly, Moldova needs to step up integration with the European Union in the West and with the CIS countries in the East. The objective is to gain access to new export markets without compromising relationship with the traditional partners and enhance the transit potential of Moldova.

37. To measure progress towards achieving the development objectives, it is important to monitor a set of transparent targets. Sometimes regular figures from fiscal or monetary statistics can serve for this purpose. In case such figures are not available or insufficient, it may be possible to rely on the Millennium Development Goals (MDGs) in monitoring progress with regard to social variables. Finally, it may be possible to aim for improving the country’s standing on certain indicators of competitiveness as presented in the international rankings.

E. Conclusions and Policy Recommendations

38. This paper outlines the main factors that shaped the economic growth model in Moldova in the last decade. The growth model that emerged out of the economic transformation of the 1990s relied on domestic demand fuelled by remittances. This model led to brisk growth in the sectors producing nontradable goods and services and stagnation in most sectors producing tradables, with a few exceptions such as transit transportation.

39. The paper highlights the risks of the current growth model that made it unsustainable. The current growth model led to the emergence of significant external and domestic imbalances. The imbalances include a sizable trade deficit (largely financed by remittances) and an oversized public sector. The presence of such imbalances imposes additional costs on the economy and society. The costs include the need to accumulate very large international reserves and distortions in budget revenues and expenditures. Moreover, such a model is prone to disruptive boom-bust cycles. The risks have become ever more evident in the wake of the global economic crisis, when a drop in remittances led to a sharp correction of external imbalances and steep contraction of economic activity.

40. Using the production function approach, the paper estimates the potential GDP growth rate for Moldova based on current economic trends. The results suggest a medium-term potential GDP growth of about 4 percent. This is by 1-2 percentage points less than before the impact of the world economic crisis. According to the results, the largest contribution to potential GDP growth comes from rising total factor productivity. Investments in fixed capital also make a significant contribution. At the same time, the shrinking labor force predictably subtracts from the potential growth rate.

41. These estimates can help assess the impact of various policy decisions on the long-term economic growth. As an illustration, the paper presented results of assessing the impact of a hypothetical large external loan provided on terms favorable for Moldova. It estimates that infrastructure projects financed by US$1 billion loan can boost economic growth by 0.3–0.6 percentage points a year as compared to the baseline growth rate. However, the loan’s contribution to the economic growth should be compared with its impact on debt sustainability, in a detailed debt sustainability analysis.

42. The paper argued for the need to diversify the growth model. The current model based on consumption and remittances should be enhanced with the export-led growth generated by new investments in the sectors producing tradable goods and services. For Moldova, this may be the only way to boost the long-term sustainable growth rate well above 4 percent, which is important for addressing the country’s vast development and poverty reduction needs.

43. The paper outlined some macroeconomic policy challenges related to the exportled growth promotion. To prevent erosion of external competitiveness, wage policy should maintain a close link to productivity gains, and macroeconomic policies should not lead to excessive appreciation of the national currency. Government should aim to attract large FDI and mobilize domestic investment in the sectors of economy producing goods and services for exports and competing with imports. This implies the need for considerable improvement in these sectors’ attractiveness for investors.

44. Public policies can promote growth by identifying and addressing the most binding constraints to development. These constraints could be identified based on the international competitiveness rankings, local business surveys, and results of diagnostic studies. The available evidences highlight the importance of addressing the country’s dilapidated infrastructure and bad roads in particular. They also suggest the need to streamline the procedures for issuance of construction permits and land allocation, revamp labor market laws, step up enforcement of property rights, strengthen investor protection and improve companies’ access to finance. Regional integration is critically important for gaining access to the new markets and connecting to the transport networks of the larger neighbors.

Appendix I: Production Function Approach to Estimating Potential Growth in Moldova

45. Estimating the potential growth and key factors contributing to it requires a few broad assumptions. Following the literature (e.g., Loukoianova and Unigovskaya (2004), Dudine (2006)), we assume that the output production in Moldova can be presented with a standard Cobb-Douglass production function. This function relates output to the stock of physical capital, the labor force, and total factor productivity (TFP):

Yt=AtKtαLtβ ,(1)

where Yt is output (i.e., real GDP measured in constant prices), Kt is physical capital stock, Lt is the labor force, At is the level of TFP, and α and β are the elasticities of output with respect to labor and capital. Taking natural logarithms of both parts of this equation, we can obtain:

yt=at+αkt+βlt ,(2)

where lower-case letters represent the natural logarithms of variables. Furthermore, by taking first differences, one obtains another form of the same equation:

Δyt=Δat+αΔkt+βΔlt ,(3)

where Δ indicates the increase at time t of the natural logarithm of a variable. Equations (2) or (3) can be directly estimated using standard cointegration or regression methods.

46. The available data for Moldova provided data for estimating the time series for labor force and stock of capital. For capital, we combined the data for the capital stock as of 1995 (the earliest data available), the new gross fixed investment reported in the national accounts, and a standard assumption on the physical depreciation of capital:


where δ is the rate of capital depreciation (assumed to be 5 percent), and It is the new gross investment in year t. For labor, we took the actual employment data reported by the NBS and smoothed them with the Hodrick-Prescott (HP) filter to eliminate fluctuations caused by the business cycle. 69

47. In view of short data span and multiple structural breaks during the transition period, we decided to calibrate rather than estimate the production function for Moldova. Using the annual data starting from 1995 and even adding the projections up to 2015 gave us only 21 data points, which is usually too few for the regression analysis to produce robust results. In addition, fast structural changes in Moldova economy during the transition process and under the impact of major crises in 1998-99 and in 2008-09 did not augur well for reliability of coefficients obtained by regressions. In our regression analysis, we obtained coefficients that either did not make economic sense or were not statistically significant.

48. The elasticities of output to changes in labor force and capital stock can be estimated using the wage bill share in GDP and the constant return to scale assumption. We estimated the wage bill in economy by multiplying the average wage by the total employment numbers. With the ratio of wage bill to GDP increasing steadily over the last decade (Figure X), we selected its average value corresponding to 2000-08 period as the most representative for Moldovan economy:


We also assumed constant return to scale, which means that simultaneous increase of labor supply and capital stock would lead to a proportional increase in output:


49. The TFP contribution to growth can be estimated as a residual. With the assumptions outlined above, we estimated the contributions of the capital and labor to the output using the Equation 1. And the residual, which is the difference between estimated contribution of capital and labor and observed or projected GDP growth for each year, we assigned to the TFP contribution. To obtain the potential GDP estimates and projections, we smoothed the TFP series thus obtained using HP filter and used it in Equation 1.

Appendix II. Assessing the Contribution from Automatic Stabilizers to Fiscal Balance 70

50. The contribution to the change in the overall fiscal balance from automatic stabilizers can be assessed by calculating the change in the cyclical balance between two consecutive years. The cyclical balance in year t can be calculated as the difference between the overall balance in percent of GDP (OBt) and the cyclically-adjusted balance in percent of potential GDP (CAOBt). The cyclically-adjusted balance in percent of potential GDP can be computed as:


where GAPt is the output gap, calculated as the ratio of output to potential GDP minus one. ηRt and ηGt are revenue and expenditure budgetary-sensitivity parameters defined as:


where εR and εG are revenue and expenditure elasticities with respect to the output gap assumed to be constant over time, and RtYt and GtYt are ratios of primary revenue and expenditure to GDP.

51.Hence, the contribution from automatic stabilizers is, effectively, the first difference (change between the two consecutive years) of the output gap multiplied by the difference of revenue and expenditure budgetary-sensitivity parameters, namely:


The estimates for εR and εG for a number of advanced OECD countries are available from Girouard and André (2005). If εR and εG are not available, revenue elasticity εR assumed to be equal to 1, thus effectively assuming that share of revenues in GDP remains unchanged, and, therefore, revenues rise or decline in line with the GDP. And expenditure elasticity εG can be assumed to be equal to zero, which is broadly equivalent to assuming that the budget spending is not linked to the GDP changes. This is broadly true in cases when the vast majority of regular budget spending is set in nominal terms and is not automatically adjusted in line with changes in GDP (though discretionary adjustment may be still possible).

In addition, this implies that the spending items that can be expected to change automatically depending on the cyclical swings in economy–such as unemployment benefits–are negligibly small. In this simple case, the contribution from automatic stabilizers can be computed as:


Appendix III: Excerpt from the Economic Growth and Poverty Reduction Strategy Paper (2004-2006):

Sustainable and Inclusive Economic Growth (pages 34–35)

52. Current economic growth is based to a large extent on the export of labor. The remittances provided by this labor have led to fast growth in domestic consumption. Because of rigidities in the domestic supply of goods and services, consumption-led growth has attracted imports, widening the trade balance, and contributing to inflation. The quality of economic growth in Moldova is affected by an unbalanced structure of the economy, by monostructural exports, and by low investments in fixed capital. Such a growth paradigm does not provide a basis for the sustainable growth needed to reduce poverty.

53. The challenge is to move from the current state of remittance based, consumption-led growth to a more balanced model, emphasizing investment and locally based import substituting and export led growth. The vision for the future involves seeing remittances as a potential source of development finance and an opportunity for investment within an enhanced business environment. Better policy will encourage investment in small and medium enterprises. Import substituting and export led enterprises will generate income and employment, using improved market opportunities opening up in traditional markets, and in new markets. This process will be stimulated by the emphasis being placed in the Strategy on private sector development and an enabling, deregulated business environment, which allows business to prosper.

54. To change the paradigm and quality of growth will require mobilization of new sources and factors of growth by attracting significant investment, primarily, in the processing industry and in infrastructure, for the diversification of the structure of the economy, and the replacement of labor force export with the export of goods and services.

55. The progress and growth rate of the country’s economic development will depend mainly on the business and investment environment, which is being formulated at the national and local levels. In the medium-term, it is increasingly important to improve the business and investment climate by pursuing a stable, transparent and efficient regulatory policy, by developing competition, and by supporting small and medium-sized business. This will help mobilize the domestic investment potential of the economy consisting of the labor migrants’ savings, the resources of the banking system, of the shadow sector and of capital leaving the country.

56. The improvement of conditions for sustainable growth throughout the country including the recovery and development of infrastructure will be a main focus (infrastructure in this context includes roads, water supplies, heating, electricity and gas, and telecommunications). This will permit the smoothing of socio-economic imbalances between the Center and regions, and the improvement of living standards in smaller cities and villages. The task is to emphasize the development of the economic potential of regions, as well as making business more active in localities, and attracting investments to regions.

57. Based on economic transformation similar to the above, it is estimated that annual economic growth targets of between 5–10% are feasible, 5% growth per annum being a moderate scenario, and 8–10% being an optimistic scenario. Analysis in the macro section (…) supports the view that these targets are feasible.


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Prepared by Michael Gorbanyov.


The increase in reported remittances could have resulted in part from improved statistics coverage.


Agriculture and industry are the key sectors of Moldovan economy that produce tradables–the goods and services that can be exported or compete with imports in the domestic market. On the contrary, nontradables are the goods and services that normally cannot be exported and are produced for domestic consumption only.


Moreover, if the set of policy instruments is not sufficiently varied, the presence of remittances may lead to higher inflation, as the government increasingly relies on the inflation tax (also known as seigniorage) to tax remittances (Chami et al. (2006)).


The Russian ban on wine imports from Moldova introduced in 2006–07 also played a role. It was triggered by disputes about quality of Moldovan wine products.


Appendix I outlines the methodology for estimating potential growth in Moldova.


These two studies presented an exhaustive list of obstacles and discussed how they affected growth in Moldova; see also World Bank (2005).


The first credit bureau was established and became operational in Moldova in early 2010. It will likely take several years before the bureau accumulates a meaningful database and the practice of using its information in the credit decisions is fully established.


The paper by BenYishay and Wiebe (2010) apparently provided justification for the U.S. Millennium Challenge Corporation’s financing of roads and irrigation investments.


Equally important are arrangements for safe transit of loads through the breakaway region of Transnistria.


Unfortunately, using the reported historical data for the stock of fixed capital for 1995-2008 did not lead to plausible results (the resulting changes in the capital stock were negative for nearly all years), hence the need for recalculation. For labor, we also tried an alternative approach of using the total labor force data (employed plus unemployed people) without smoothing, which led to broadly the same results in terms of potential GDP level.


Prepared by Philippe Karam using IMF Occasional Paper (2009), Appendix V.

Republic of Moldova: Selected Issues Paper
Author: International Monetary Fund