Former Yugoslav Republic of Macedonia
First Review Under the Precautionary Credit Line
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The report says that Macedonia continues to pursue sound economic policies that are consistent with the program supported by the Precautionary Credit Line (PCL) arrangement. The authorities strengthened debt management policies and improved access to external funding and developed a domestic public debt market. This will help Macedonia to meet its financing needs from private market sources in future. The PCL plays a valuable role in supporting market confidence by signaling Macedonia’s commitment to prudent policies and strengthening its reserve buffers.

Abstract

The report says that Macedonia continues to pursue sound economic policies that are consistent with the program supported by the Precautionary Credit Line (PCL) arrangement. The authorities strengthened debt management policies and improved access to external funding and developed a domestic public debt market. This will help Macedonia to meet its financing needs from private market sources in future. The PCL plays a valuable role in supporting market confidence by signaling Macedonia’s commitment to prudent policies and strengthening its reserve buffers.

I. Recent Developments and Outlook

A. Political Developments

1. The ruling coalition won a majority in the June 5 general elections. While it lost some seats and fell short of their previous two-thirds majority, the coalition has a majority of 71 out of 123 seats. The new government continues to be led by Prime Minister Gruevski, and the economic team remains broadly unchanged. The government formally took office on July 28 for a period of four years.

B. Economic Developments and Outlook

The 2011 economic outlook is broadly in line with the program. The main changes are somewhat lower growth (by ½ percent); a higher current account deficit (by 1 percent of GDP) matched by higher FDI; and higher inflation (by 1½ to 2 percentage points).

2. Growth is expected to rise to 3 percent this year. The 2010 recovery was led by a surge in exports that more than offset weak domestic demand. This year domestic demand is expected to kick in, supported by lower interest rates, the recent moderate resumption of bank credit, and employment gains. Headline inflation in 2010 was 1.6 percent but rose to 4.1 percent in June 2011, mostly due to food and fuel prices (core inflation was 1 percent). Staff expects annual inflation for 2011 to be 4 to 4½ percent.

uA01fig01

Quarterly GDP Growth Rates

Citation: IMF Staff Country Reports 2011, 280; 10.5089/9781463902988.002.A001

uA01fig02

Current Account, Financial Account, and Changes in Gross Reserves

(Millions of euros)

Citation: IMF Staff Country Reports 2011, 280; 10.5089/9781463902988.002.A001

Sources: Authorities’data; and IMF staff estimates.

3. The current account deficit is expected to widen this year and to be financed largely by FDI. Staff projects the deficit will widen to 5½ percent of GDP in 2011 in response to the pick-up in domestic demand and higher fuel prices, with FDI of some 5 percent of GDP providing most of the financing. Gross international reserves excluding the PCL purchase declined by €50 million in the first five months of 2011, and are expected to increase over the remainder of the year due to seasonal patterns and a planned sovereign debt issuance. End-May reserves including the €220 million purchase stood at €1.88 billion (112 percent of end-2010 short-term debt at residual maturity). Net international reserves were €1.44 billion at end-May, €293 million above the indicative target under the PCL. The spreads of Macedonia’s 2015 Eurobond over Bunds have narrowed since mid-2010, similar to the trend in other non-euro area countries in the region (Figure 2).

Figure 1.
Figure 1.

FYR Macedonia: Recent Economic Developments

Citation: IMF Staff Country Reports 2011, 280; 10.5089/9781463902988.002.A001

Sources: Haver, SSO, NBRM and IMF Staff estimates.1/ Excluding food, tobacco, fuels and heating.
Figure 2.
Figure 2.

FYR Macedonia: External Sector Developments

Citation: IMF Staff Country Reports 2011, 280; 10.5089/9781463902988.002.A001

Sources: Bloomberg; Authorities’ data; and IMF staff estimates.1/ 12-month moving average of imports.

4. The banking sector remains in overall sound shape, and credit growth is moderate. As of end-March, 2011, the capital adequacy ratio remained stable at nearly 17 percent, while non-performing loans (NPLs) had started to decline. Deposits continued to provide the main source of bank funding, exceeding loans by a significant margin. Profitability turned negative in the first quarter of 2011 as provisioning against NPLs (primarily at one medium-sized bank) more than offset profits of the three large banks. Both deposits and private credit have been growing at moderate rates (some 8 percent year-on-year in May).

5. The main risk continues to come from potential disturbances in the peripheral euro area economies. With a quarter of the system’s total assets, the share of Greek-owned banks is among the largest in the region (similar to Bulgaria and Albania). Greek banks in Macedonia are financed primarily by resident deposits, with minimal funding from their parents, and they do not hold Greek assets. Exposure through trade channels is moderate, with 7½ percent of 2010 exports (2½ percent of GDP) destined for Greece, while Greece is not a major source of remittances or FDI inflows. More broadly, if troubles in the periphery lead to significantly weaker growth and more distressed financial conditions in core euro area economies, this would damage growth prospects in Macedonia and could put renewed pressure on the fiscal and external accounts.

C. Policy Developments

6. The authorities slightly exceeded their end-May 2011 indicative target for the fiscal deficit under the PCL. The fiscal deficit was 6.46 billion denars (1.4 percent of annual GDP), 0.06 billion denars (0.01 percent of GDP) above the end-May indicative target. Tax revenues rose 7.3 percent in January-May relative to 2010 levels, somewhat below the annual 9.3 percent pace envisioned in the budget. Expenditures also grew at a slower pace than the annual budgeted increase, despite some front-loading of agricultural subsidies and the (modest) costs of holding the elections.

7. The NBRM has held the policy interest rate steady at 4 percent since last December. In the face of higher inflation from food and fuel prices and the prospect of further ECB rate increases, the NBRM is on hold after a series of cuts from a peak of 9 percent two years ago. Governor Bogov assumed office in May 2011 and reaffirmed the NBRM’s commitment to follow policies that are consistent with the de facto exchange rate peg to the euro.

Figure 3.
Figure 3.

FYR Macedonia: Banking Sector Developments

Citation: IMF Staff Country Reports 2011, 280; 10.5089/9781463902988.002.A001

Sources: NBRM and IMF staff estimates.

II. Policy Discussions

A. Purchase Under the PCL and Improved Debt Management Strategy

8. The authorities discussed the circumstances that gave rise to their decision to purchase under the PCL last March. In their request, the authorities represented the emergence of an actual balance of payments need. Their meetings with external banks had led them to conclude that, due largely to the uncertain outcome of the impending elections, they faced impaired access to external markets, where at best they would pay a large premium over secondary market spreads on their outstanding debt. They noted that in a thinly traded market, secondary market spreads were not a reliable guide to the cost of issuing new debt. Moreover, they would have been unable to make credible commitments to foreign investors on a road show to support a bond issue. Finally, they believed that the advice of the anti-corruption commission against issuing a Eurobond prior to the election added to the risks. The authorities had also met with domestic banks to explore possibilities for tapping domestic markets to help meet financing needs. However, they concluded that this was not a feasible alternative, given the small size of the domestic T-bill market; the preference of domestic banks for 28-day central bank bills, which were better suited to their liquidity needs; and a reluctance of the large banks to increase their sovereign exposure, in some cases due to risk retrenchment by their parents.

9. While acknowledging the uncertainties associated with the elections, staff emphasized the importance of developing more robust debt management practices and strategies to ensure more secure access to market financing. With respect to external debt, the authorities should seek to increase liquidity of their debt instruments, manage rollover risk, and take advantage of favorable market conditions early to pre-finance future needs. With respect to domestic debt, the authorities should review institutional structures and market practices to ensure they are aligned with market development goals; lengthen the yield curve, even if this requires higher interest rates initially; tailor debt instruments to the needs of pension funds; and seek to enhance the liquidity of secondary market trading, which would help to increase domestic investor interest. To attain these objectives, close cooperation between the ministry of finance and the central bank would be essential.

10. The authorities were confident that they would be able to meet future financing needs from market sources, now that the elections had been concluded, and they agreed with staff on the need to improve debt management. They committed to publishing a report that will lay out a road map for debt management reform, developed in consultation with Fund staff, which will be a structural benchmark for the second review under the PCL arrangement. Key steps in the road map would be expected to provide the basis for future structural benchmarks under the arrangement. The authorities also requested technical assistance from the Fund in the area of debt management, and a Fund technical assistance mission is expected to visit Macedonia in the early fall.

11. The authorities stated their intention to repay the PCL purchase early, provided market financing conditions are favorable. However, they did not believe it was advisable to repay this fall, in light of the continued level of external risk and the more immediate priority of securing market funding for the 2012 budget.

B. Fiscal Policy and Financing Plan

12. The authorities reaffirmed their 2011 fiscal deficit target of 2.5 percent of GDP, an indicative target under the arrangement. Staff noted that revenues through May were growing at a somewhat slower pace than the annual growth rate assumed in the budget, which could mean that adjustments would be needed to meet the target. The authorities were optimistic that revenue growth would improve as the economy picks up steam. Nonetheless, in the event that revenues fall short of budgeted levels, they were fully committed to reduce discretionary spending, and in the event of a significant shortfall, they would consider passing a supplementary budget calling for lower spending. In this context, the authorities noted their strong track record in achieving their deficit targets through expenditure restraint, including in 2009–10 when revenues performed poorly due to the economic downturn.

13. The 2012 budget will focus on investment spending, while reducing the deficit moderately. A key objective of the new government is to increase investment spending, including roads, railroads, gasification, and other energy infrastructure. Staff emphasized the importance of accommodating investment spending within an overall deficit of 2.2 percent of GDP, consistent with the undertakings in the PCL request. This gradual reduction in the deficit remains appropriate in light of the cyclical upturn, the need to build fiscal space for future downturns, and to stabilize debt ratios. Moreover, the risk of financing constraints such as those that emerged in 2011 argues for contained deficits. The authorities agreed that their 2012 budget would target a deficit of 2.2 percent of GDP, with further reductions in outer years. To make room for investment spending, current expenditure will be kept under tight control, including a continued freeze of public sector wages. The government has committed to raising the general wage level by 5 percent in December 2012 (effective in January 2013), which will partially compensate for the erosion in real wages since the onset of the wage freeze in 2009.

14. The authorities plan to issue external debt in the fall to meet remaining needs for 2011 and pre-finance 2012 needs. The debt issue would cover remaining 2011 amortization needs (€50 million) and at least a portion of the 2012 deficit. Amortization of domestic structural bonds in 2012 (€30 million) would be met through net T-bill issuance. The authorities affirmed that they would issue debt even if market conditions turn less favorable and interest rates rise from present levels (secondary market yields on the 2015 Eurobond maturity are currently around 5.5 percent, some 350 basis points over Bunds), so long as market access remained open. In this context, staff emphasized the importance of issuing preemptively to cover future needs rather than waiting in the hope that conditions would turn more favorable. The authorities agreed, while remarking that if conditions are unfavorable they would also look at the option of issuing T-bills to cover remaining 2011 needs.

Central government financing

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Note:

The assumed amount of the fall 2011 external borrowing (130 mn EUR) is used to cover remaining financing needs in 2011 and finance part of the deficit of 2012.

The assumed Eurobond issuance of 2012 (300 mn EUR) covers the remaining deficit financing of 2012 and pre-financing of the Eurobond falling due in January 2013.

15. The authorities reported that they are also in discussions with the World Bank on a Policy Based Guarantee (PBG), which would partially guarantee an external debt placement and reduce interest costs. Staff advised that they should avoid a situation where they remain out of the market pending completion of the PBG, which could be delayed, and thereby miss an opportunity to issue when markets are open and rates are favorable. The authorities agreed that they would only seek a PBG if they were confident it could be finalized and financing realized in 2011.

C. Monetary Policy and International Reserves

16. The authorities believed that the present level of the policy rate, at 4 percent, was appropriate, and that risks were tilted toward a future rate increase. Staff shared the authorities’ views, in light of the absence of pressures on foreign exchange reserves or signs of underlying price pressures. Key factors that the NBRM considers in setting rates include levels and trends in international reserves (the overriding factor), price pressures and the degree of slack in the economy, and interest rates in the euro area. In the view of staff:

  • The present level of international reserves is broadly adequate, and underlying trends in the balance of payments are supportive.

  • Core inflation remains near 1 percent and real wage growth over the past year has been contained. Credit growth has been moderate. Meanwhile the output gap remains negative, with projected 2011 GDP some 1.4 percent below potential.

  • The NBRM does not react automatically when the ECB changes rates, because of the insulation provided by imperfect credit market integration and variations in the risk premium on denar liabilities. Nonetheless, a sustained movement in ECB rates would likely call for a policy response by the NBRM.

17. In light of the favorable prospects for international reserves, the authorities agreed to an increase of €50 million in the end-November indicative target for NIR. Assuming external sovereign debt issuance this fall, they expected NIR to end the year at some €250-300 million above the original program floor, which should provide an adequate buffer. They agreed with staff that raising the floor would send a positive signal of their intention to safeguard the stronger gross reserve position resulting from the PCL purchase.

D. Financial sector Policies

18. The authorities noted that they had made progress on the macro-prudential undertakings described in their PCL request. They had passed a new NBRM law consistent with ECB and IMF advice and created a Financial Stability Council, which would improve contingency planning capabilities. They also remained committed to legal and regulatory changes to address the risk of court challenges to NBRM decisions on licensing, administration and closing of banks, close the gaps in their ability to impose fit and proper requirements on bank owners and managers, and expand the class of collateral eligible for emergency liquidity assistance from the NBRM. Staff agreed it was important to move forward with these changes, which would strengthen the authorities’ ability to respond to future financial system disruptions. Staff also agreed that the NBRM’s intention to review liquidity requirements, which were imposed in 2009 as a crisis measure, is appropriate. In this review the authorities will seek to ensure conservative liquidity buffers but not to set thresholds so high as to undermine the ability of banks—which rely primarily on deposits for funding—from making longer-term loans to the private sector.

III. Review of Qualification Criteria

19. Macedonia continues to meet the qualification criteria identified in paragraphs 2(a) and 2(b) of the PCL Decision. Economic fundamentals and policies remain sound, economic developments have proceeded broadly in line with program assumptions, and the authorities remain committed to the economic program outlined in their PCL request. Staff’s assessment at the time the PCL was approved—that Macedonia performed strongly in three of the five PCL qualification areas (fiscal, monetary and financial sector) and moderately underperformed in the remaining two (external and data adequacy)—remains unchanged.

  • Fiscal policies remain sound. The authorities kept the fiscal deficit during the first part of the year broadly in line with program targets and have reaffirmed their commitment to meet the end-year target and to reduce the deficit further next year. The fiscal deficit is moderate in international comparison. Government debt, at 25 percent of GDP at end-2010 (with an average interest rate of 3 percent) is moderate and should stabilize and then decline gradually, based on the authorities’ medium-term budget objectives.

  • Monetary policy has supported the de facto peg against the euro and delivered low inflation over a long period.1 The new NBRM governor has stated that he is committed to a continuation of these policies, whereby monetary policy will be dedicated foremost to supporting the exchange rate and ensuring adequate international reserves.

  • The financial sector and bank supervision remain sound. The banking system is relatively small, is financed predominantly by domestic deposits, and enjoys healthy capital ratios and liquidity buffers. Supervision is adequate, as assessed by the 2008 FSAP update.

  • External position and market access. Macedonia scores well on measures of external position, but vulnerabilities in access to external financing persist. The current account deficit was below 3 percent of GDP in 2010. It is expected to widen this year to 5½ percent of GDP, but to be financed mostly by FDI, leaving reserves at broadly adequate levels. Exports are growing rapidly—by 30 percent year-over-year in value in 2010 and 44 percent in the first five months of 2011. CGER analysis does not indicate significant misalignment of the real exchange rate. External debt, at 59.2 percent of GDP at end-2010, is sustainable and is expected to decline gradually in the medium term. However, the authorities’ decision to draw on the PCL when they judged external access to be inadequate illustrates the remaining vulnerability in the area of external access, which is subject to both domestic and external risks. The authorities’ commitment to improve debt management policies and practices and to deepen the domestic debt market, supported by IMF technical assistance, will help to address this remaining vulnerability and will be subject to a structural benchmark for the second PCL review.

  • The authorities are committed to improving data adequacy. The authorities have committed to subscribe to SDDS, and an IMF technical assistance mission has worked with the authorities to develop a road map and timeline that would lead to SDDS subscription by November 2012 at the latest. Progress to date includes setting up a national summary data page, starting to compile quarterly GDP in constant prices by production method, and agreement on a standard presentation for the reserves template data dissemination.

IV. Other Issues and Program Modalities

20. A safeguards assessment was completed in May 2011. It found that a good governance framework is in place, and that safeguards within the NBRM have been strengthened further since the 2005 assessment. Going forward, it recommended reinforcing existing governance practices, and implementing an internal risk management framework. To facilitate this, and to enhance oversight over audit activities, the NBRM Council has set up an independent audit committee, chaired by a non-executive Council member, in line with the assessment’s main recommendation.

21. The timing of the first PCL review has been affected by the election calendar. The first review under the PCL would normally be scheduled with the objective of completion by the Board immediately prior to the lapse of the six-month anniversary of the approval of the arrangement (July 19). However, this was not feasible due to the timing of the June 5 elections and the time needed to form the new government. The delay has provided an opportunity for the new economic team, which was formally installed on July 28, to sign off on the authorities’ policy commitments. Due to the delayed review, Macedonia’s right to make purchases under the arrangement lapsed on July 19 and will be restored only upon completion of the first review. The date for the second review is envisioned for January 18, 2012, immediately prior to the one-year anniversary of approval. The indicative targets and any other conditionality for the third and final review (envisioned for July 2012) will be set in the course of the second review.

22. Macedonia’s capacity to repay the Fund remains strong. The main risks continue to stem from potential spillovers from financial stress in the euro area, calling for caution in macroeconomic and financial policies. Nonetheless, Macedonia’s external debt position and service are expected to remain manageable, even if the PCL were to be fully drawn. Furthermore, the authorities’ sustained track record of repayment, together with implementing sound policies and a sound institutional policy framework, provide additional assurances with respect to Macedonia’s capacity to repay the Fund.

V. Staff Appraisal

23. Macedonia remains on track with the economic program supported by the PCL. Economic and financial sector developments have proceeded broadly as envisaged under the program. While the indicative target on the fiscal deficit was missed by 0.01 percent of GDP, the authorities’ commitment to meet the end-year deficit target is credible in the view of staff, based on the small size of the deviation and the authorities’ track record of meeting their fiscal deficit targets. Monetary policy remains supportive of exchange rate stability, and the indicative target on NIR was met with an ample margin.

24. Macedonia continues to meet the PCL qualification criteria. Staff’s assessment is that performance is strong in three of the five qualification areas—fiscal policy, monetary policy, and financial sector soundness and supervision. There is moderate underperformance in the remaining two areas of external position and market access, and data adequacy. While the external position is solid, the purchase under the PCL illustrates the vulnerability on market access. The authorities are committed to addressing this remaining vulnerability through their initiative to improve debt management and secure more reliable access to external and domestic capital markets. Nonetheless, external risks remain high, and the PCL arrangement provides an important added buffer for Macedonia. The authorities are also committed to improve data quality and have put in place a plan that will lead to SDDS subscription within the program period.

25. On the basis of Macedonia’s performance to date under the PCL, and the authorities’ commitments to continue their overall sound policies while addressing remaining vulnerabilities, staff recommends completion of the first review.

Table 1.

FYR Macedonia: Macroeconomic Framework, 2007–16

(Year-on-year percentage change, unless otherwise indicated)

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Sources: NBRM; SSO; MOF; IMF staff estimates and projections.
Table 2.

FYR Macedonia: Central Government Operations, 2006–11

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

FYR Macedonia: Balance of Payments, 2008–16

(Millions of euros, unless otherwise indicated)

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Source: NBRM, IMF Staff Estimates.
Table 4.

Macedonia, FYR: External Financing Requirements, 2008-16

(Millions of Euros unless specified otherwise)

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Source: NBRM; and IMF Staff Estimates.

Excludes: i) amortization of MLT intercompany loans, which is included in FDI (net), and ii) amortization of sovereign Eurobond, which is included in Porfolio investment (net).

Includes capital account balance, net errors and omissions, and discrepancies between ST debt flows and stock data.

Table 5.

FYR: Macedonia - Central Bank Survey 2007-2011

(Local Currency Billions unless specified otherwise)

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Source: NBRM, Staff Estimates
Table 6.

FYR: Macedonia - Monetary Survey 2007-2011

(Local Currency Billions unless specified otherwise)

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Source: NBRM, Staff Estimates