Abstract
Moldova’s near-term outlook is aimed at slowing growth and receding inflation, but the deteriorating external environment and the fragile political situation poses significant downside risks. The main drivers of growth are private consumption, investment, and exports, fuelled by remittances and rising credit, which is reflected in the improving business climate. Weak tax collection and expenditure overruns resulted in missing the performance criterion on the general government budget deficit by 0.4 percent of GDP. The indicative target on reducing general government expenditure arrears was missed marginally owing to underpayment of heating bills by the Chisinau municipality.
Since the previous review, the economy of Moldova continued to expand strongly, even though a deterioration of the external environment led to a moderation of GDP growth in the second half of 2011. Nevertheless, the consensus estimate of 6 percent GDP growth in 2011, after 7.1 percent growth in 2010, marks a second year of vigorous economic activity. Inflation fell to below 8 percent in late 2011, while core inflation remained below 5 percent. Central to this sense of stability and healthy growth is the implementation of the Fund-supported program, which has so far proceeded generally well. However, heightened uncertainty surrounds the domestic and external environment at present. The recent economic slowdown in trading partners poses additional challenges to the outlook, and especially to the export growth and remittances.
The end-September 2011 quantitative performance criteria (PCs) were met with one exception - the ceiling on the general government budget deficit was missed by 0.4 percent of GDP due to weak tax collection and expenditure overruns. The authorities and staff agreed on prior actions for the fourth review, aimed at securing the necessary 2011 budget adjustments to reach program targets, strengthening tax collection, and ensuring passage of the 2012 budget, consistent with program objectives and supported by strong tax and expenditure reforms. One structural benchmark for end-September 2011 has been delayed owing to protracted consensus-seeking internal discussions and reset for end-March 2012. All other structural benchmarks for end-September and end-December 2011, as well as one for end-March 2012, have been implemented, confirming the authorities’ commitment to the program policies and objectives, as outlined in this and previous SMEFPs.
The authorities highly appreciate the constructive dialogue with Fund staff, whose advice continues to support the policy formulation process in Moldova. They believe that the policies described in the Supplementary Memorandum of Economic and Financial Policies (SMEFP) of January 12, 2012, are adequate to achieve the program’s objectives. Nevertheless, the authorities stand ready to take any further measures that may become necessary to respond timely to unexpected changes in the external or domestic environment and will consult the Fund on the adoption of such measures and in advance of revisions to the policies contained in the SMEFP.
The authorities would like to request a waiver for non-observance of a performance criterion on the deficit for end-September 2011 PC under the EFF in the context of corrective actions that have already been taken. A modification of the same PC for end-March 2012 is also requested, mainly due to updates of the macroeconomic framework.
Recent developments, outlook and risks
Despite the recent moderation of growth, the Moldovan economy has been outperforming program projections for a second consecutive year. The main drivers of GDP growth are private demand and exports, but this positive growth also reflects the improved business climate. Gross international reserves of the central bank rose steadily and reached 3.8 months of imports at the end-2011. Public and publicly guaranteed debt declined from 30.2 to 28.3 percent of GDP in the course of 2011. The surging domestic demand widened the current account deficit to about 11.7 percent of GDP, but it is projected to decline gradually in the medium term, following expanded access to international markets and improvements in competitiveness. The net FDI inflows rebounded strongly and increased from 3.3 to 3.7 percent of GDP.
The expected slowdown in Europe is also likely to hamper growth next year, before it rebounds to its medium-term potential rate of 4.5-5 percent. While export growth has remained very strong so far, as a small open and resource-dependent economy, Moldova will continue to be susceptible to external shocks. Successful reorientation of the economy towards the tradable sector also means that the export share of the economy has increased significantly over the recent years, increasing the economy’s vulnerability to external demand shocks. This tilted the risks to the downside in the short run. On the other hand, some of Moldova’s major exports partners (Russia, Germany, and Poland) seem less affected by the crisis.
The authorities are fully aware that further competitiveness gains are essential to cushion adverse external demand developments in the medium term, and they remain committed to making further progress with structural reforms. The key priorities in 2012 are the following: (i) to normalize payments of the current energy bills; (ii) to increase energy efficiency and ensure better cost recovery in the energy sector; (iii) to reduce the state’s presence in the economy by advancing privatization plans; (iv) to complete a recovery of the transition to a system of targeted social assistance; and (v) to press forward with cutting red tape, and reduce barriers to trade.
Active labor market policy will be another pillar in gaining additional competitiveness. Following legal amendments in July 2011, the authorities discouraged excessive dependency on social aid and promoted an active and flexible labor market. Unemployment insurance benefits in the labor market were re-based on actual - as opposed to average economy-wide - wages, and prior employment required for eligibility for unemployment benefits was lengthened from six to nine months. The authorities will consider making participation in public works mandatory for recipients of unemployment benefits. New legislation to delink the wages in the economy from the minimum guaranteed wage was passed in late 2011. The new medium-term National Development Strategy, which aims to reduce poverty and boost the economy’s potential, will be adopted by the Parliament by end-March 2012.
Despite the progress achieved so far, Moldova’s authorities are aware of the fact that economic stability and sustainability remain vulnerable to a number of political risks. They acknowledge that the absence of an elected President raises political uncertainty and this poses downside risks to investment and growth, although the ruling coalition has a majority in the Parliament.
Fiscal Policy
In the last quarter of 2011, the immediate priority of the authorities in the fiscal field was to address the slippages, and pave the way to a programmed medium-term fiscal adjustment. In consultation with Fund staff, a number of measures were implemented on both the revenue and expenditure sides to restrain current expenditure and lock in savings from capital under-spending, while clearing the backlog of unpaid agriculture subsidies. Monthly inspections of high-risk taxpayers were intensified and the program for voluntary compliance with respect to VAT and payroll tax payments will be extended to all large taxpayers. The 2011 budget was amended with a view to keeping the deficit within the projected trajectory of 1.9 percent of GDP, which remained consistent with the structural adjustment path of the program. Although slowing economic activity led to missing marginally the end-December indicative target on the deficit by 0.16 percent of GDP, the authorities managed to reverse more than half of the fiscal slippage recorded in September 2011.
The fiscal policy strategy for 2012 remains unchanged and in line with the program. It aims at continuous improvement in the efficiency of current spending while boosting public investments, in line with the long-term priorities. Building on the already described ambitious structural reform agenda and the recent efforts to strengthen the budgetary performance, the authorities aim to complete the fiscal adjustment by lowering the budget deficit to about 0.9 percent in 2012 and to 0.75 percent in the medium term. They plan to eliminate the budget’s dependence on exceptional levels of external assistance, while relying on growth-friendly policy measures. To this end, the authorities adopted a comprehensive tax policy reform package, including re-introduction of the corporate income tax with a low rate of 12 percent accompanied by accelerated asset amortization, extension of cash VAT refunds for new purchases of investment goods to the entire country, and adjustment of selected excise duties in line with the EU integration agenda.
The objective of the authorities to increase the effectiveness of the public sector also gave rise to a number of key reforms. The implementation of the ambitious reform to rationalize parts of the education sector while improving quality continues in close cooperation with the World Bank. The legal amendments set to unblock further optimization of the sector and achieve a reduction of the net fiscal cost by 0.5 percent of GDP upon completion will be adopted by the Parliament before end-March 2012. Other structural reforms, rationalizing the use of health care and improving public procurement will proceed as already planned in the SMEFPs.
In consultation with staff and the World Bank, the mechanism for allocating capital expenditure will be revamped during 2012 and applied starting in 2013. The new fiscal responsibility law will introduce a rule-based fiscal framework to underpin fiscal discipline and improve transparency of public finances in line with the best international practices. It will be adopted by the Parliament by end-March 2012 as a new organic budgetary law.
Monetary and Financial Sector Policy
Inflation pressures and substantial excess liquidity in the banking system prompted several hikes of the policy interest rate and reserve requirements during 2011. This helped the National Bank of Moldova (NBM) to contain annual inflation within the single digits. The waning impact of earlier surges in international food and energy prices, together with the expected slowdown of domestic and external demand, has considerably improved the inflation outlook in late 2011 and early 2012. The NBM has already cut its policy rate by 150 bps in December-January and just announced a further 200 bps cut as the inflation outlook has improved faster than expected. The NBM remains vigilant because of high volatility in the domestic foreign exchange market and the existing growth of monetary aggregates. In 2012, legal and operational aspects of monetary policy making in Moldova will be strengthened further, in line with the best international practices.
In parallel, the authorities continue improving transparency of the banking system, contingency planning, and financial stability framework, thanks to technical assistance from the World Bank and IMF staff. Legal amendments to ensure full transparency and disclosure of the ultimate controllers in banks in line with the Basel Core Principles and Financial Action Task Force standards will be developed by end-March 2012 and are expected to be passed by the Parliament by end-June 2012. The government approved the long-delayed legal amendments to enhance the speed and predictability of collateral execution by credit institutions and to strengthen their incentives to restructure non-performing loans. Their parliamentary adoption is envisaged before end-March 2012.