Republic of Moldova
2010 Article IV Consultation and Staff Report for the 2010 Article IV Consultation, First Reviews Under the Extended Arrangement and Under the Three-Year Arrangement Under the Extended Credit Facility, and Request for Modification of a Performance Criterion: Staff Report; Staff Statement and Supplement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Moldova.
Author: International Monetary Fund
Publication Date:
29 Jul 2010
eISBN:
9781455204915
Language:
English
Keywords:
ISCR; CR; development policy loan; government; staff appraisal; policy; core inflation; exchange rate; monetary policy; debt service; foreign currency; Global
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The Moldovan economy is recovering steadily following the recession triggered by the global crisis. The key challenge is to ensure fiscal, financial, and external sustainability while igniting new engines of growth. Monetary policy strikes the right balance between keeping inflation low and supporting the recovery. The monetary policy framework could benefit from more flexibility. Stepping up exports is a key to achieving high and sustainable growth over the medium term. Bringing the energy sector to financial sustainability should remain high on the government’s agenda.

Abstract

The Moldovan economy is recovering steadily following the recession triggered by the global crisis. The key challenge is to ensure fiscal, financial, and external sustainability while igniting new engines of growth. Monetary policy strikes the right balance between keeping inflation low and supporting the recovery. The monetary policy framework could benefit from more flexibility. Stepping up exports is a key to achieving high and sustainable growth over the medium term. Bringing the energy sector to financial sustainability should remain high on the government’s agenda.

I. Introduction

1. Massive capital inflows in 2006-08 lifted growth but also created macroeconomic vulnerabilities amid hesitant progress in Moldova’s transition to a market economy. Booming remittances, FDI, and credit boosted domestic consumption and investment, and growth averaged over 5 percent. However, large capital inflows permitted an expansion of the current account deficit to 17 percent of GDP, fueled double-digit inflation, and caused a substantial real effective exchange rate (REER) appreciation. The loss of competiveness, combined with a Russian embargo on wine imports from Moldova in 2006-07 and a drought in 2007, dampened export growth. Despite some progress in structural reforms, the economy remained overregulated and hampered by relative price distortions. High barriers to entry and low competition in a number of sectors kept domestic prices of many goods and services significantly above regional levels. In contrast, utility tariffs generally remained well below cost-recovery levels, leading to substantial arrears and underinvestment.

2. The global crisis abruptly curtailed capital inflows and external demand, forcing current account adjustment and a recession. Reflecting an abrupt decline in remittances, FDI, and exports, domestic demand and imports collapsed, and real GDP fell by 6½ percent (Figure 1). Although the leu depreciated significantly, deflation pressures persisted. The current account deficit almost halved to 9½ percent of GDP; nonetheless, a large external financing gap opened. It was filled by running down the reserves of the NBM and financing from international financial institutions. Credit to the economy declined, and the share of nonperforming loans (NPLs) in the banking sector tripled since end-2008; one medium-size bank failed.

Figure 1.
Figure 1.

Moldova: Real Sector Developments, 2001-09

Citation: IMF Staff Country Reports 2010, 234; 10.5089/9781455204915.002.A001

Sources: IMF, World Economic Outlook, April 2010; and IMF staff calculations.1/ Includes change in inventories.
Figure 2.
Figure 2.

Moldova: Fiscal Developments, 2001-09

Citation: IMF Staff Country Reports 2010, 234; 10.5089/9781455204915.002.A001

Sources: IMF, World Economic Outlook, April 2010; and IMF staff calculations.

3. Despite two rounds of parliamentary elections in 2009, political uncertainty persists. The July elections led to the formation of a new four-party coalition government with a narrow majority that proved insufficient to elect a President of the republic under the current rules. The authorities intend to hold a referendum on a Constitutional amendment that would prevent such gridlock in the future and to call early elections afterwards, in late 2010.

4. The authorities have sought to strengthen economic integration with the EU and other development partners. Moldova and the EU are partners within the European Neighborhood Policy (ENP), and an action plan, supported by a Partnership and Cooperation Agreement, lays out the strategic objectives of cooperation based on effective implementation of political, economic, and institutional reforms. A Consultative Group meeting in March 2010 confirmed the partners’ willingness to extend significant financial and technical assistance in support of the authorities’ reform agenda.

Implementation of Past Fund Policy Recommendations1

The authorities’ responsiveness to past Fund advice has been mixed, with three distinct phases. Four reviews were completed under the previous PRGF-supported program before it went off track in late 2008. During this period, the authorities generally agreed with the Fund’s advice, except for the prescription against heavy management of the exchange rate. Afterwards, major disagreements emerged. Fiscal policy deteriorated significantly, with sizable pre-election hikes in current spending, while monetary policy was kept too tight until mid-2009, attempting to defend an overvalued exchange rate. Structural reforms stalled as well. Since late 2009, however, macroeconomic policies—in the context of the new ECF/EFF-supported program—have been reoriented toward restoring fiscal, financial, and external sustainability and supporting growth with significant fiscal adjustment under way, the adoption of a new monetary policy strategy focusing on price stability, and a revitalization of structural reforms. Despite some weaknesses, data provision is adequate for surveillance, and Moldova subscribes to the SDDS (see Informational Annex, section III).

1 See PIN for the 2007 Article IV Consultation at http://www.imf.org/external/np/sec/pn/2008/pn0837.htm

II. Recent Developments

5. The economy is steadily recovering from the 2009 recession:

  • Growth is returning faster than expected. A strong pick-up in industrial production and in external trade in late 2009, helped by the removal of many trade restrictions and exchange rate depreciation, continued in early 2010. Consumer demand is recovering as well. As a result, GDP grew by 4.7 percent in Q1 2010, supported by replenishment of business inventories, private consumption, and net exports. Unemployment, however, reached 9.1 percent, in part owing to seasonal fluctuations.

  • Inflation rose in early 2010, pushed up by necessary energy tariff adjustments, higher excise taxes, and exchange rate depreciation. In May, it amounted to 7.9 percent relative to a year ago, which was comparable to neighboring countries (chart). Core inflation remained contained at 5.1 percent. The exchange rate has broadly stabilized after the seasonally high demand for foreign exchange in Q1 subsided; recently, it has been moderately depreciating against the U.S. dollar and appreciating against the euro.

uA01fig03
Sources: National authorities; and IMF staff calculations.

  • After falling until 2007, poverty has remained broadly stable in the recession. Remittances helped reduce overall poverty in the boom years to 25.8 percent of the population in 2007, with notable improvements in infant and maternal mortality rate and access to clean water, while extreme poverty declined to 2.8 percent. Although wages and pensions continued to increase, there was a sharp fall in remittances and rise in unemployment, and on balance overall poverty increased slightly in 2008-09. The launch of the targeted social assistance system in the second half of 2009, on the other hand, helped reduce extreme poverty further to 2.1 percent (Table 8.).

6. Since late 2009 the authorities have been implementing their ambitious Economic Stabilization and Recovery Plan:

  • Fiscal policy has embarked on an adjustment path. The 2009 deficit (6.4 percent of GDP) came well below projections. Revenue benefitted by an upsurge in VAT, while the authorities realized some expenditure savings relative to budget commitments. The adjustment continued in early 2010, supported by robust revenues and by expenditure restraint. At the same time, vulnerable households saw a large increase in funds for social assistance, allowing their guaranteed minimum income to rise by 23 percent in 2010. Enrollment in the new targeted social assistance program is rising fast as well.

Contribution of Growth and Policy Measures to the Change in the Fiscal Balance, 2009 1/

article image
Source: IMF staff estimates.

Change relative to program targets, in percent of GDP

  • The NBM tightened policy somewhat in response to the deteriorating inflation outlook. The NBM is in the process of gradually moving from a money-based monetary policy framework to inflation targeting. In January 2010, the NBM announced an inflation target of 5 percent with a narrow ±1 percent deviation band. When this target became threatened by rising headline inflation, the Bank raised its policy rate by 200 basis points to 7 percent (Figure 3); however, the monetary stance remains accommodative.

  • Structural reforms have been reinvigorated. The authorities have scrapped a number of export and import restrictions and simplified customs controls, licensing requirements, and procedures for business registration and liquidation. The energy regulator ANRE raised energy tariffs to cost-recovery levels.

Figure 3.
Figure 3.

Moldova: Money, Prices, and Interest Rates, 2005-10

Citation: IMF Staff Country Reports 2010, 234; 10.5089/9781455204915.002.A001

Sources: National authorities; and IMF staff calculations.

7. After a deep contraction in 2009, economic activity in the Transnistria region is recovering, but gas-related external debt remains a major concern.1 Following the global economic crisis, exports fell by about 37 percent in 2009, and workers’ remittances declined by a quarter; industrial production and investment slumped by similar magnitudes. Reflecting the revival in external demand, industrial output increased by nearly 9 percent in the first four months of 2010 (compared with the same period of 2009). Massive subsidies to ailing enterprises propelled the budget deficit to 22 percent of GDP in 2009. This was financed by the accumulation of external arrears that pushed external debt to over 300 percent of the region’s output. About three quarters of this debt is made of arrears for gas payments to the Russian supplier Gazprom, which is estimated to have reached some US$2.0-2.2 billion at end-2009.

III. Performance Under the Program

8. All performance criteria and indicative targets for end-March 2010 were observed, and all structural benchmarks were implemented, albeit one of them with a delay (SMEFP Table 2 and 3). In particular, the authorities put in place an action plan for a speedy expansion of a means-tested social assistance scheme, which has already led to increased enrollment. Meanwhile, the NBM analyzed and shared with Fund staff the results of the diagnostic studies of all banks completed by an external auditor, which confirmed the banks’ stable condition. The NBM also prepared legal amendments to the laws on financial institutions and deposit insurance to strengthen the bank resolution framework. These amendments have been approved by the Government and submitted to Parliament for adoption, the first set with some delay.

IV. Outlook

9. The short-term outlook is cautiously optimistic. GDP growth is projected to reach 2.5 percent in 2010 and 3.6 percent in 2011, supported mainly by the projected recovery in external demand from the major trading partners Russia and Ukraine and by the ongoing liberalization and deregulation of the economy.2 The cumulative impact of two rounds of adjustments in domestic energy prices will continue to keep inflation high in the next few months, but this effect should be short-lived, and inflation should ease toward 6 percent by mid-2011. The rise in international energy prices and the gradually recovering domestic demand could widen the current account deficit to 10½ – 11¼ percent of GDP in 2010-11 as growing imports outweigh the rebound in exports and remittances.

10. The new external environment is a drag on potential output growth. Staff has reduced their estimates of potential growth to 4 percent (from 5-6 percent before the global crisis) as private investment and FDI are expected to strengthen only gradually given current global projections and labor migration abroad continues, albeit at a declining rate. Sizable productivity gains supported by the envisaged structural reforms and large public investment in infrastructure will still underpin medium-term growth (Box 5).

11. Downside risks still prevail and have increased lately. A growth slowdown in the EU could depress remittances and exports, while international energy price spikes could stoke inflation. Deteriorating loan quality could restrain bank lending, hindering the recovery. Political instability could hold reforms back, leading to a withdrawal of donor financing that could reopen large balance of payments gaps. On the upside, the ongoing liberalization and deregulation of the economy may provide a larger–than-anticipated growth impulse.

Medium-Term Outlook, 2007–15

article image
Sources: Moldovan authorities; and IMF staff estimates and projections.

12. The authorities shared staff’s assessment that the current exchange rate is broadly in line with fundamentals, while business climate-related measures of competitiveness indicate a need for deep structural reforms. The exchange rate regime is classified as “floating”. Staff estimates of the exchange rate position—subject to the usual caveats of considerable uncertainty– –range from an overvaluation of 7 percent to an undervaluation of 1 percent, with an average overvaluation of less than 5 percent. Moreover, unit labor costs in manufacturing remain competitive in comparison with Moldova’s neighbors. Broader measures of competitiveness, however, do call for further structural reforms, as discussed at a seminar with the World Bank and the authorities (Box 2.). Agreeing with this assessment, the authorities pointed out that their current structural reform program is aimed specifically at improving international competitiveness of Moldova’s goods and services.

Competitiveness and the Equilibrium Exchange Rate

After a real effective depreciation of about 20 percent since the peak in February 2009, CGER-type analysis suggests that the leu is broadly in line with fundamentals. Under various versions of the macroeconomic balance approach, the estimated current account norm ranges between -5.8 and -7.7 percent of GDP, encompassing the projected 2015 underlying current account deficit of 7.5 percent of GDP. This implies an assessment range between moderate overvaluation and slight undervaluation. Under the external sustainability approach, the most recently observed net foreign liability position of 75 percent of GDP at end-2009 suggests a current account norm of -5.6 percent of GDP, which translates into an overvaluation of 6.8 percent. Finally, the deviation of the current real effective exchange rate from its historical average points to a minor overvaluation.

uA01fig04
Sources: WEO; and IMF staff calculations

Quantitative Exchange Rate Assessment Results

article image
Sources: Moldova authorities; and IMF staff calculations.

Using Rahman’s (2008) coefficients.

Using Lee et al.’s (2008) coefficients.

Average deviation of the CPI-based REER between 2010-M1 and 2010-M4 from its five-year historical average (2005-M4 to 2010-M4).

While external price competitiveness seems by and large restored, broadly defined competitiveness needs to improve further. Labor costs have remained low, but Moldova still ranks below its regional competitors in terms of enabling business environment. Over the last three years, the situation in Moldova has not improved much based on its World Economic Forum (WEF) ranking or EBRD indicators. Thus, enhancing competitiveness requires further structural reforms, particularly those related to improving investor protection, removing structural impediments to financial sector development, and investing in infrastructure to lower production and distribution costs.

uA01fig06

Unit Labor Cost

(Manufacturing, US$ per month)

Citation: IMF Staff Country Reports 2010, 234; 10.5089/9781455204915.002.A001

Source: ILO, Moldovan authorities and Fund staff estimates

World Competitiveness Ranking

article image

The Global Competitiveness Report, WEF.

Transition Report, EBRD. Simple average of competition policy, and entreprise, banking sector and infrastructure reform sub-indices.

13. Debt is sustainable at present, but vulnerabilities remain (Appendix I). The debt sustainability situation has not changed significantly since the last debt sustainability analysis (DSA) was issued in January 2010. Updated projections suggest that Moldova’s risk of debt distress remains low. Public and publicly guaranteed debt is moderate at 31 percent of GDP at end-2009 and is projected to peak at 36 percent of GDP in 2011. The sizable development partner support pledged at the Consultative Group meeting in March 2010 (US$2.6 billion over five years) is equally split between grants and low-interest loans and would thus not impair debt sustainability; absorptive capacity is more likely to be a binding constraint. The previously contemplated large loans from China and Russia did not materialize. The identified external debt of state-owned enterprises amounts to only 0.4 percent of GDP and is treated in the DSA as implicitly government-guaranteed.3 Private sector external debt, of which only 15 percent is owed by the banks, is being rolled over smoothly. However, total external debt is projected to reach 77 percent of GDP in 2011, and debt services would exceed 20 percent of exports of goods and services a few years later. Debt-related difficulties could then arise should external nondebt financing recede.

V. Policy Discussions

14. While recovering from the crisis, Moldova has a long way to go. In the short term the main task for macroeconomic policies is to strike the right balance between supporting the output recovery, restoring fiscal sustainability, and maintaining financial and external stability. In the medium term, the challenge will be to facilitate the transition from a state-dependent remittance-driven economy to a market-based export-led one. With this agenda in mind, discussions focused on policies to:

  • maintain progress in fiscal adjustment, while opening space for priority investment and well-targeted social assistance;

  • support the recovery after the deep recession in 2009, while containing inflation pressures in the face of large cost-push shocks;

  • ensure stability in the financial system given remaining risks and foster a resumption of bank lending; and

  • raise the economy’s potential growth rate by implementing long-overdue structural reforms to stimulate private investment, strengthen competitiveness, and facilitate exportled growth.

A. Fiscal Consolidation while Protecting Investment and Social Assistance

15. Restoring fiscal sustainability is a precondition for sustainable growth. Early 2009 saw a large deterioration of the structural fiscal balance, stemming mainly from unaffordable increases in public wages and pensions (Figure 2). Domestic sources of budget financing were nearly exhausted, leading to accumulation of expenditure arrears and necessitating an urgent mobilization of resources from international development partners. The new government then embarked on a path to gradually restore fiscal sustainability at a pace matching the economy’s speed of recovery. The authorities have appropriately chosen restraint in current spending, while raising social assistance to protect the vulnerable and public investment to address infrastructure bottlenecks, a type of spending with significant contribution to growth.

16. The amended 2010 budget continues to pursue growth-enhancing consolidation with adequate social protection. Staff and the authorities concurred on the need to save most of the additional revenue brought by higher than projected growth in 2010, while increasing funds for investment and social assistance (SMEFP ¶8). The amended budget will thus provide for a 37 percent increase in capital expenditure and over 50 percent increase in social assistance spending relative to 2009. The resulting deficit of 5.4 percent of GDP broadly preserves the programmed speed of structural fiscal adjustment, including already committed grants (table). It also provides for gradual, but front-loaded clearance of domestic expenditure arrears, which were higher than expected at the end of 2009 (SMEFP Table 2). Staff expressed concern about the higher-than-budgeted spending on goods and services, which signaled difficulties in controlling the assumption of commitments by various government branches. The authorities stated that reforms in procurement and internal financial control, to be introduced in the second half of 2010, will allow them to rein in this spending in 2011 (SMEFP ¶11).

Headline and Structural Fiscal Balances of the General Government, 2008-15

(Percent of GDP)

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Source: IMF staff estimates.

Includes “internal grants” equivalent to 0.25 percent of GDP and 0.03 percent of GDP in 2009 and 2010 respectively.

Adjusted for the differential dynamics of tax bases relative to GDP when such divergences occur.

Fiscal Consolidation in Moldova1

Large pre-election spending hikes in 2009 led to the emergence of an unsustainable structural fiscal position in Moldova. The government that came to office in late 2009 has adopted a fiscal consolidation plan in the context of an ECF/EFF-supported program with the IMF. The plan envisages a significant but gradual fiscal adjustment at a speed matching the economy’s rate of recovery from the 2009 recession. This approach guards against the risk of a negative feedback loop, where the consolidation deepens the recession and causes a loss of revenue.

The plan focuses on rationalizing the government wage bill and spending on goods and services—areas where Moldova spends considerably more than its regional peers– –while protecting quality public infrastructure investment and well-targeted social assistance. This would be achieved mainly through school and class consolidation in education, a reform in civil service staffing and pay, and a new system of internal financial control in government institutions. On the revenue side, the plan relies on reintroducing (starting in 2012) the corporate income tax with a low rate and a broad base, raising excise tax rates toward the levels in neighboring countries, as well as closing loopholes and reducing exemptions to broaden the tax base. A far-reaching tax administration reform aims to expand the tax net to economic agents who had hitherto evaded it and to focus collection efforts on companies and sectors with the highest compliance risk.

Moldova and Selected Countries

General Government Expenditures, 2009

article image
Source: GFS

These measures will be essential to stop further deterioration of Moldova’s fiscal balances. To secure durable results, however, they must be complemented by further medium-term structural reforms, in particular in pension and health, to anchor long-run sustainability and prevent deterioration in fiscal balances in the future.

1 See Selected Issues, Chapter I.

17. Restraint on current spending will guide consolidation efforts next year as well. To advance the ongoing structural fiscal adjustment, the authorities plan to reduce the budget deficit to 3.4 percent of GDP in 2011, while creating fiscal space to further expand capital expenditure and increase funds for targeted social assistance (SMEFP ¶9-10). The main consolidation policy remains continuing rationalization of current spending (1¼ percent of GDP), supported by reducing budgetary sector employment further by 1¾ percent through attrition (after a similar reduction in 2010). The budget will also take advantage of gains in revenue (1 percent of GDP) stemming from the strengthening economy, increased grant assistance, and better tax collection.

18. Policy discussions on the medium-term framework focused on the appropriate fiscal stance and size of the government, and reforms needed to reach the desired equilibrium:

  • Staff and the authorities agreed that the structural budget deficit should be all but eliminated, in view of low private savings and the budget’s limited access to external financing. On the current outlook, this would imply increasing the general government’s overall balance by some 5 percentage points of GDP over the next four years. Such an increase in government saving would also ensure that the public sector does not add to external imbalances. The authorities saw an equal role for revenue increases and expenditure cuts to achieve this objective. Staff advised a greater emphasis on reducing current spending (Box 3), which is high for Moldova’s level of development (chart).

uA01fig07
Sources: WEO, April 2010; and IMF staff calculations.

  • The mission welcomed the authorities’ strategy for improving tax collection. Following the recommendations of a Fund FAD TA mission, the strategy aims to introduce a risk-based audit selection, target economic agents outside the tax net, and combat tax evasion and outright fraud. Detailed operational plans for audit, arrears collection, and taxpayer services will be developed by end-2010 (SMEFP ¶11).

  • Staff encouraged the authorities to persevere with the implementation of the new targeted social assistance system as a key instrument for reducing poverty. The main existing system of social assistance, based on population categories, is poorly targeted.4 The new means-tested system, which is in the process of being phased in since mid-2009, should considerably improve targeting (at an additional cost of about ½ percent of GDP a year). Over time, the two systems should be merged into an overall means-tested system including the most vulnerable households.

  • The authorities agreed that significant reforms are needed in the social insurance system to preserve its financial sustainability, particularly regarding sick leave benefits and early retirement. To this end, two sets of legal amendments will be adopted by December 31, 2010. One of these amendments will make the mechanism for sick leave benefits more incentive-compatible by assigning the responsibility for the first day of sick leave to the employee and the second day to the employer. The other amendment will phase out the early retirement privileges for civil servants, judges and prosecutors. Staff welcomed these measures and encouraged the authorities to advance the unfinished pension reform in the medium term by broadening the contributions base, correcting the pension determination and indexation parameters, and increasing the effective retirement age. Such a reform would prevent an unsustainable decline of the already low pension replacement rate (35 percent of the net wage on average), while preserving the pension system financial sustainability (Selected Issues, Chapter I).

B. Monetary and Exchange Rate Policy

19. The NBM and staff agreed that the current monetary stance appropriately balances the need to keep a lid on inflation with the need to support the recovery. Cost-push inflation and weak demand have complicated monetary policy, and the NBM has had to search for a balance between containing inflation expectations and sustaining the still weak credit flow. The mission and the authorities agreed that interest rate hikes in early 2010 have contributed to stabilizing inflation expectations—thus alleviating second-round effects from the cost-push shocks—and calming the foreign exchange market. However, as subdued credit and domestic demand are not likely to fuel inflation pressures at present, the current moderately accommodative monetary stance appears appropriate. Further monetary action might be necessary if domestic demand recovers strongly and/or depreciation pressures persist. Moreover, staff supported the NBM’s view that interventions in the foreign exchange market should continue to aim at smoothing erratic movements, but should not resist sustained depreciation pressures.

20. There was an agreement that further development of the new monetary policy framework could strengthen policy effectiveness.

  • The NBM’s monetary strategy upholds price stability as the primary objective of monetary policy, operationalized as an annual inflation target, and the NBM’s base interest rate as the main policy instrument. In view of the still underdeveloped transmission mechanism and the relatively high degree of dollarization, the NBM and staff agreed that other instruments of monetary policy, in particular reserve requirements, could potentially be used as needed. The program design, based on a NIR/NDA performance criteria and an indicative target for reserve money, remains appropriate at present, but may be reconsidered when the transition to inflation targeting is complete.

  • Staff recommended increased NBM operational flexibility, including by extending the policy horizon to the conventional 24 months and widening the target range to accommodate large and volatile exogenous inflation shocks and the still weak transmission mechanism (Box 4). The NBM agreed, while noting that a careful choosing of the timing of these changes, as well as clear communication of their motivation would be very important to preserve the credibility of the policy framework. Furthermore, the NBM is working on amendments to the central bank law that, among other improvements, shorten the lag between the adoption and effective dates of policy changes and thus strengthen policy effectiveness.

  • Continuing extensive NBM communication, including regular press briefings and publication of monetary policy reports will raise awareness, understanding, and acceptance of monetary policy actions in the medium term.

C. Strengthening the Financial Sector

21. Financial soundness indicators suggest a stable banking system, but certain vulnerabilities remain a concern. Limited financial integration has kept Moldova insulated from the international financial turmoil. Banks have remained liquid and well-capitalized, and exposure to foreign assets and institutions in distress is minimal.5 Low interdependency limits the systemic threat from individual bank failures. However, nonperforming loans remain high at over 17 percent in April 2010—although this ratio seems to have stabilized—and their composition has deteriorated, with migration from substandard to doubtful loans (chart).

uA01fig08

Non-performing Loans

(Percent)

Citation: IMF Staff Country Reports 2010, 234; 10.5089/9781455204915.002.A001

Source: National Bank of Moldova.

Monetary Transmission in Moldoval 1

The transmission of monetary policy in Moldova is hindered by well-known structural impediments affecting developing countries. Financial intermediation is constrained by a burdensome legal system, lack of credit information on borrowers, and administrative barriers to the use of collateral. Financial markets are shallow, with bank loans essentially the only market source of private funding. A relatively high degree of financial dollarization (about 40 percent of both loans and deposits are denominated in foreign currencies) limits monetary policy effectiveness as well.

Quantitative analysis of developments over the past decade reveals a relatively weak interest rate channel. Monetary policy instruments have only a partial influence on bank lending rates. An econometric analysis suggests that increases in interest rates lower private credit and inflation (with a lag), but no statistically significant relationship can be found directly between interest rates and GDP growth.

The transmission of monetary policy was particularly impaired during the recent financial crisis. Facing rapidly falling deposits, deteriorating asset quality, and an uncertain outlook, banks significantly tightened their credit standards and increased the spread between lending and deposit rates. Successive base rate cuts and injection of liquidity by the NBM succeeded only partially in encouraging banks to loosen their lending conditions. Examination of bank portfolios suggests that under such conditions a policy rate cut can still affect lending rates by lowering the opportunity cost of other assets, but the magnitude of this effect is small.

A number of measures are needed to strengthen the transmission of monetary policy in Moldova. Improving debt resolution instruments and development of credit bureaus would help the banks regain confidence in lending and mitigate credit rationing. Greater transparency would alleviate market uncertainty about NBM policy, while improvements in cash flow management by the NBM could also reduce interest rate volatility. Finally, promoting domestic financial markets will increase reliance on domestic currency instruments, thus strengthening the interest rate channel of monetary policy.

uA01fig09
Source: National Bank of Moldova.
1 See Selected Issues, Chapter II.

Moreover, a non-negligible share of foreign currency loans in total loans (Box 4) exposes the borrowers and banks to exchange rate and credit risks. Finally, the banks’ efforts to clean up their balance sheets is leading to a still stagnating credit stock, which in turn reduces banks’ interest income and forces them to keep the lending rates high and cut deposit rates to maintain profitability.

22. Policy discussions focused on upholding financial stability while seeking to unblock credit. The NBM and staff agreed that closely monitoring banks’ asset quality, lending and provisioning practices, and capital needs remained conditio sine qua non.

  • To ensure adequate capital buffers, the NBM has passed a regulation requiring banks to keep their statutory capital above MDL 100 million and to double Tier I capital in stages by end-2012. Moreover, distribution of retained earnings will require prior notification of the NBM and justification in terms of capital adequacy. Staff and the NBM agreed that this regulation strikes the right balance between fostering a stable bank capital base and allowing resumption of lending to support the economy.

  • There was agreement that a well-developed contingency planning framework is needed to guard against future financial sector risks. Drawing from the recommendations of a recent Fund MCM TA report, the authorities have established a high-level Financial Stability Committee with a main objective to ensure appropriate interagency coordination and demarcation of responsibilities in times of financial sector emergencies. By end-December 2010, the institutions represented in the Committee will sign a memorandum of understanding (MoU), which will provide a framework for preparing detailed operational contingency plans during 2011 (SMEFP ¶14).

  • To remove structural impediments to lending, the authorities aim to facilitate resolution of problem loans and foster company restructuring. Staff and the authorities concurred that, in addition to the still uneasy business conditions, lending is held back by bank difficulties in exercising their rights as creditors in case of nonpayment. Correspondingly, by end-2010 the authorities will prepare legal and regulatory amendments to ease collateral execution by banks and strengthen bank incentives to restructure nonperforming loans, as well as speed up restructuring of viable companies (SMEFP ¶15).

D. Structural Reforms to Raise Growth and Reduce Fiscal Risks

23. Moldova faces formidable structural challenges that constrain its growth potential. The state footprint on the economy—both in terms of direct asset ownership and regulatory burden—remains large relative to other countries in the region (chart). Significant parts of the public sector, like education and civil service, are still oversized and underperforming. Remaining stateowned companies in various sectors of economy are operating well below their potential, and some of them accumulate large debts and arrears. Crumbling infrastructure and dilapidated roads require profound repairs and new investments. Staff and the authorities shared the view that these challenges should be addressed if Moldova aims to grow out of its status as Europe’s poorest country.

uA01fig10

Transition Indicators in Selected Countries, 2009 1/

Citation: IMF Staff Country Reports 2010, 234; 10.5089/9781455204915.002.A001

Source: EBRD, Transition Report 2009.1/ Transition indicators range from 1 (little change from centrally planned economy) to 4.33 representing the standards of an industrialised market economy. Ukraine (not shown in the chart) almost coincides with Moldova on these indicators.

24. Sustaining high GDP growth over the medium-term will not be possible without a significant increase in exports. Before the recession of 2009, the economy had relied heavily on remittances-driven private consumption. While this model of growth will remain important for the time being, it is nearing its limits (Box 5). Staff and authorities shared the view that building up export potential and expanding access to the vast markets of Moldova’s major trading partners in the East and West could provide a strong and sustainable boost to growth. Consistent with this vision, the government places an emphasis on improving the business environment and agreed with the need to maintain external price competitiveness.

25. The authorities showed strong determination to continue improving the business climate and promote investment. The most important initiatives include (SMEFP ¶16):

  • Extending the option to receive VAT refunds for purchases of investment goods to investors in the entire country. Presently, investors in the two largest cities do not receive such VAT refunds (they can only use their VAT credit to offset future tax obligations). Affording them this option would unblock vital working capital and thus facilitate companies’ operations and new investment.

  • Lowering the frequency of inspections of enterprises by various state agencies to reduce red tape.

  • Introducing the “one stop shop” provision of business services in the customs administration and enabling automated data exchange and electronic document processing. Moreover, the Export Promotion Organization will begin providing a wide range of consultancy services for exporters and investors.

  • Amending the necessary legislation to simplify the procedure of converting agricultural land for industrial and trade needs, as requested by both foreign and domestic investors.

Staff welcomed these initiatives and pointed out that sustainable growth in the future will depend largely on the success of efforts to spur export-led growth.

Moldova: From Consumption-based to Export-led Growth1

Before the crisis of 2009, growth was mainly driven by expanding domestic demand fuelled by migrants’ remittances. The share of private consumption in GDP increased from 56 percent in 1995 to more than 90 percent in 2006–08. The trade deficit ballooned from about 26 percent of GDP in 2000 to 53 percent of GDP in 2007–08. It was largely covered by remittances, which jumped from about 5 percent of GDP in the mid-1990s to more than 30 percent in 2006–08.

The growth model based on remittances is subject to well-known constraints. As much as 40 percent of Moldova’s labor force is already working abroad, and this ratio can increase further only moderately. Moreover, migrants’ ties with the home country weaken over time, and remittances decline. The outflow of labor and relatively subdued outlook for loan-financed private investment and FDI drag potential GDP growth down to about 4 percent over the medium term, which looks modest when compared to Moldova’s vast development needs and poverty-reduction objectives.

uA01fig11

Contributions to Potential GDP Growth, 1996-2015

Citation: IMF Staff Country Reports 2010, 234; 10.5089/9781455204915.002.A001

Source: IMF staff calcultions.

To boost Moldova’s growth potential, it is essential to promote export-led growth. Lowering the costs of doing business, including by cutting red tape and facilitating compliance with business regulations, as well as upgrading the country’s run down infrastructure, are critical for attracting investments to the sectors producing tradable goods. Maintaining external price competitiveness by keeping real wage growth in line with productivity gains and avoiding policies that could lead to large overvaluation of the national currency is equally important.

1 See Selected Issues, Chapter III.

26. The annual progress report on implementation of the National Development Strategy (NDS) will reassess Moldova’s development objectives and reinvigorate the poverty reduction efforts. Drafted in 2007, the NDS was designed to spearhead the development agenda for 2008-11. However, the economic crisis and political instability in 2009 disrupted its implementation. By end-October 2010, the government plans to issue a report that will reflect on the recent progress in poverty reduction and update the objectives for 2011 (SMEFP ¶22).

27. The financial condition of the capital’s heating company, Termocom, remains a large fiscal and social risk. In line with past program conditionality, the energy regulator ANRE now sets the tariff for heating and has raised it twice in 2010 in response to the higher price of imported natural gas. While this tariff should allow Termocom to adequately cover its current expenses, the company’s large historic arrears continue to weigh on the financial performance of the whole sector. To find a solution to this problem that considers the interests of all involved parties, the authorities will prepare a restructuring plan for the thermal energy sector, including Termocom, by end-2010. Until then, it was agreed that creditors will allow the company to operate normally, provided Termocom remains current on its 2010 liabilities (SMEFP ¶19). To mitigate the impact of higher energy tariffs on the most vulnerable, the central government will provide support alongside the municipal assistance scheme until the new targeted social assistance system has been fully deployed.6

28. The mission welcomed the authorities’ decision to resume efforts to divest the remaining large state enterprises, where private involvement could lower prices and improve service. Specifically, they plan to reopen the divestiture of Moldtelecom, the largest telecommunications operator, whose privileged position distorts the telecommunication market. The authorities indicated that they are considering such an operation within a wider reform process to develop the whole sector. In addition, the authorities will begin preparing other public companies for divestiture, in particular in air and rail transportation (SMEFP ¶20). Staff agreed that all these operations need to be carefully prepared and launched when the international investor interest in Moldova returns.

29. The trade regime is generally open and the authorities are working on further expanding openness and simplifying procedures. Moldova is a member of the WTO, CIS and CEFTA. It has concluded sixteen agreements on market access within the CIS and the Pact on Stability in South-Eastern Europe. Since early 2008, it has also enjoyed Autonomous Trade Preferences (ATPs) with the EU, which provide unlimited and duty free access to the EU market for all products originating in Moldova, except for certain agricultural products. The European Commission has recently launched a free-trade-area feasibility study, which would be a core element of a possible future Association Agreement. Meanwhile, the authorities have already liberalized meat and dairy imports by simplifying the cumbersome system of permits introduced in 2007. They intend to continue trade liberalization by eliminating customs duties on many raw materials and investment goods from 2011 on.

VI. Program Issues

30. The program design and monitoring mechanism will remain broadly unchanged. The review schedule and phasing of disbursements is outlined in SMEFP Table 1. The amended 2010 budget will be passed as a prior action. The authorities are requesting modifications of the performance criterion on the budget deficit for September 2010 and the program’s indicative targets for September and December 2010 that reflect the amended budget and the improving macroeconomic outlook (SMEFP Table 2). New performance criteria and indicative targets have been proposed for March 2011. The structural conditionality—existing and proposed—is summarized in Table 3 of the SMEFP.

31. Safeguards. The updated assessment completed on June 3, 2010 concluded that the recommendations of the 2006 safeguards assessment have been implemented. Recent developments of the NBM operations have strengthened the need for an independent oversight of the bank and a legal framework for lending to local banks. The updated assessment provided a set of recommendations in this regard, focused on mitigating new risks and further strengthening the NBM safeguards framework.

VII. Staff Appraisal

32. Moldova is on the right track:

  • Growth is coming back, supported by a strong export rebound. Manufacturing, trade, and agriculture are recovering steadily.

  • The ECF/EFF-supported arrangement is on track. Program implementation under the First Review has been strong, and the authorities’ policies for the remainder of 2010 aim to continue the stabilization efforts and support the recovery.

33. The recovery has only just begun, however, and considerable challenges lie ahead:

  • External and domestic developments pose risks to the outlook. A slow recovery in major partners or spikes in international energy prices could test the recovery and the policy framework. Political uncertainties could slow the implementation of reforms and hinder growth and stability prospects.

  • The economy remains in need of significant structural transformations. Reforms are needed to promote investment and export-led growth, while the public sector badly needs expenditure rationalization and restructuring.

34. The amended 2010 budget will pursue fiscal consolidation in a difficult environment. Saving most of the unbudgeted revenue while providing additional funds for social protection and investment strikes the right balance between fiscal policy objectives. The overspending on goods and services is worrisome; decisive and timely reforms in procurement and internal financial control are needed to rein it in.

35. Further strong and sustained fiscal action is needed over the medium term. The structural budget deficit should be essentially eliminated in view of low private savings and the government’s limited access to external financing. This implies increasing the general government’s headline balance by some 5 percentage points of GDP over the next four years. Given the oversized public sector, fiscal consolidation should be achieved mainly by restraining and prioritizing current spending, supported by measures to enhance revenue collection and remove tax policy distortions.

36. The authorities’ commitment to a long-overdue tax administration reform is welcome. The reforms, which draw on Fund technical assistance, should help raise revenue collection while reducing the compliance burden on most taxpayers.

37. Monetary policy strikes the right balance between keeping inflation low and supporting the recovery. While headline inflation may remain elevated for a while, pushed up by past energy price adjustments, core inflation remains contained within the NBM target range. On current trends, domestic demand should not be a source of inflationary pressures soon, and international energy prices have stabilized recently, alleviating upside risks. The current moderately accommodative monetary stance appears thus appropriate for the time being.

38. The monetary policy framework could benefit from more flexibility. The policy horizon over which the NBM targets inflation could be lengthened and the band widened to account for the transmission lags of monetary policy actions and the high uncertainty stemming from Moldova’s inflation history and exposure to external shocks. The success of this policy will crucially depend on preserving monetary policy credibility, which calls for clear communication of the reasons and modalities of these changes.

39. While external price competitiveness does not raise major concerns, broader measures of competitiveness suggest a need for deep reforms. After the reversal in 2009, the real exchange rate appears to be broadly in line with fundamentals, and the labor costs/productivity combination compares favorably within the region. Broader measures of competitiveness, however, call for further structural reforms to improve the business environment, accelerate financial sector development, and invest in infrastructure. Such reforms would give rise to a virtuous circle, in which rising productivity helps the country attract foreign investment and know-how, in turn boosting incomes and productivity even further and creating new jobs.

40. Vulnerabilities of the financial sector appear manageable, but contingency planning and reforms to remove impediments to lending will be important to strengthen stability and development. The NBM should continue its vigilant hands-on supervision and proactive engagement with banks to ensure that capital and liquidity buffers remain adequate to cope with credit quality risks. A structured framework for contingency planning for financial emergencies would improve the financial system’s resilience to shocks. Strengthening the banks’ debt resolution framework could facilitate and speed up NPL resolution, thus unclogging bank balance sheets to support a resumption of lending.

41. The transition agenda remains unfinished. Moldova still lags behind other countries at similar level of development in important areas including investor protection, access to financing, and underdeveloped infrastructure as measured by various international rankings of business climate. Recent progress in liberalization and deregulation, especially in international trade, has been encouraging, but it is just the first step in a long journey.

42. Stepping up exports is a key to achieving high and sustainable growth over the medium term. The growth model relying on expansion of the domestic consumption fuelled by remittances is nearing its limits. To sustain high GDP growth going forward, Moldova needs to build up export capacities and expand access to the large markets of its neighbors.

43. Bringing the energy sector to financial sustainability should remain high on the authorities’ agenda. The maintenance of cost recovery tariffs for heating and other energy inputs helps buttress the weak financial condition of the energy sector. However, broader and more comprehensive reforms—including resolution of historic arrears and preparing companies for private ownership—are needed to put the sector on a truly sustainable footing. Staff has encouraged the authorities to work with the World Bank and other partners on these issues.

44. Staff recommends completion of the first review and approval of the request for modification of the performance criterion for end-September 2010. Performance under the program has been strong, and policies for 2010 remain appropriately ambitious. Staff also supports the establishment of the proposed performance criteria for end-March 2011.

45. It is proposed that the next Article IV consultation with Moldova be held in accordance with the Executive Board decision on consultation cycles.

Table 1.

Moldova: Selected Indicators, 2007–15 1/

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Sources: Moldovan authorities; and IMF staff estimates.

Data exclude Transnistria.

Includes private and public debt.

Table 2.

Moldova: Balance of Payments, 2007–15

(Millions of U.S. dollars, unless otherwise indicated)

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Sources: National Bank of Moldova; and IMF staff estimates.

In 2010, includes about US$150 million (SDR 95 million) direct budget support from the IMF.

Includes revaluation changes, which were not captured by changes of gross official reserves in the BOP.

Table 3.

Moldova: General Government Budget, 2008–15

(Millions of Moldovan lei, unless otherwise indicated)

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Sources: Moldovan authorities; and IMF staff estimates and projections.

Includes "internal grants" equivalent to 0.25 percent of GDP and 0.03 percent of GDP in 2009 and 2010 respectively.

In 2009, an EU project grant of €15 million was reclassified as budget support given that no actual expenditure took place.

In 2010, includes US$150 million direct budget support from the IMF.