Former Yugoslav Republic of Macedonia: Staff Report for the 2014 Article IV Consultation and Third Post-Program Monitoring Discussions

Growth accelerated to 3.1 percent in 2013, driven by a positive net exports contribution. The broad policy direction is supportive of near term macroeconomic stability. The key challenge is to transition from stability into an acceleration of medium term growth. Uncertainty with respect to EU accession remains, and weighs on longer term prospects.

Abstract

Growth accelerated to 3.1 percent in 2013, driven by a positive net exports contribution. The broad policy direction is supportive of near term macroeconomic stability. The key challenge is to transition from stability into an acceleration of medium term growth. Uncertainty with respect to EU accession remains, and weighs on longer term prospects.

Context

1. The broad policy direction is supportive of near term macroeconomic stability. Presidential and parliamentary elections in April handed down a broadly unchanged mandate. Fiscal consolidation—needed to stabilize central government debt—is expected to proceed as planned, with the authorities reaffirming the targets set in the 2014–2016 medium term fiscal strategy. This is being complemented by an envisaged strengthening of the fiscal framework, through building capacity for preparing medium term expenditure frameworks and introducing multi-annual budgets, and, potentially, through the adoption of a fiscal rule.

2. The key challenge remains to transition from stability into an acceleration of medium term growth. While income per capita has almost doubled since 1998, income convergence—first interrupted by the 2001 conflict and then by the global crisis in 2008—has been slow to come (Figure 1). In that respect:

  • Important elements of the structural agenda are being put in place. The need for capital deepening, human capital accumulation and structural transformation is well understood, and underpins the authorities’ public infrastructure policy, labor market initiatives, and strategy to attract FDI.

  • Uncertainty with respect to EU accession remains. The Former Yugoslav Republic of Macedonia has been a candidate country since 2005, but a date for the start of accession talks has not been set. In the absence of a negotiation process, the European Commission continues to engage in a High Level Accession Dialogue (HLAD), looking for progress along key reform priorities in the areas of media freedom, judicial independence and electoral legislation, as well as good neighborly relations1. The 2014 progress report will be released in October.

Relations with the Fund and IMF Past Policy Advice

A two-year Precautionary and Liquidity Line (PLL) was approved on January 19, 2011. In March 2011, the authorities drew 286 percent of quota (about US$305 million). Following the expiration of the PLL in January 2013, the authorities engaged in post-program monitoring. In January 2014, the Board concluded the Ex-Post Evaluation (EPE) for exceptional access. Repayments of the PLL are due over three years in equal quarterly installments, with the first repayment of US$38 million scheduled to take place in June 2014.

Policy implementation has generally been consistent with IMF recommendations, although Fund traction on public financial management, and in particular on payment arrears, has been limited over the past few years. In line with recommendations of the 2013 Article IV Consultation, the authorities have anchored fiscal policy in a medium term fiscal strategy, which envisages a gradual consolidation, starting with the 2014 budget.

Figure 1.
Figure 1.

FYR Macedonia: Vulnerabilities and Challenges

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Source: Eurostat, IMF Regional Economic Outlook: Europe (October 2011), and IMF staff caculations.1/ Variables Public Debt, STDRM/GDP, ST/GDP, Ext Debt/GDP, Ext Debt/X, Reserve Cover STDRM are expressed in percent; variables FDI-Adjusted CA deficit, Ext Fin Req, Fiscal Balance, and Primary Gap are expressed in terms of specific indexes. A widening of the web represents increased vulnerability.2/ The adjusted growth measures the difference between each countriy’s actual growth rate and the growth rate that could expected given initial income levels.

Recent Economic Developments

3. Growth in 2013 appears to have been more job-friendly than in the past, aided by active labor market policies. The decline in the unemployment rate—down 2 percentage points to 28.6 percent by end-2013—reflects both a decline in the number of unemployed as well as an increase in the labor force. The latter is a positive indication of improving perceptions of labor market conditions. The pickup in participation rate is explained mainly by young and older workers and employment among the main working age group (25–49 year olds) has grown more modestly, suggesting that the labor market improvement is still tentative (text figure).

A01ufig1

FYR Macedonia: Labor Market Developments, 2010–12

(Percent Change)

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Source: Haver, IMF staff calculation

4. Inflation has been rapidly trending downward, driven by lower food and commodity prices. CPI inflation averaged 2.8 percent in 2013, but price growth in 2014 has been weak and consumer prices declined in April, bringing average monthly inflation to just 0.2 percent for the year to date. Average trimmed inflation over the first four months stood at 0.6 percent. Staff projects a pickup in inflation in the second half of the year, bringing average inflation to about 1 percent.

5. Foreign exchange reserves continued to decline through April. Despite a narrowing of the current account in 2013 and net FX purchases by the central bank, reserves declined EUR 200 million, or 10 percent from end-2012 levels, mostly due to negative valuation effects. In the first few months of 2014, a weak financial account has resulted in reserves declining further; the trade balance has improved some EUR 8 million through March, on the back of strong exports.

A01ufig2

Inflation

(Percent)

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

A01ufig3

Reserve Developments in 2013

(Bil. denars)

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Source: NBRM.

6. Credit growth has been gathering pace. The banking sector has remained healthy, with capital adequacy ratios hovering around 17 percent, and liquidity ratios around 30 percent. Monetary conditions remained accommodative throughout 2013, with the main policy rate reduced twice, in January and July, to 3.25 percent and the successive relaxation of reserve requirements for long-term deposits and specific categories of liabilities (Box 1).

As a result, overall credit growth started strengthening in the second half of 2013, bouncing back to 7.5 percent year-on-year in March. However, dynamic mortgage lending growth contrasts with still weak lending growth to the corporate sector.

7. The nominal cash budget deficit target for 2013 was met, resulting, nonetheless, in a higher than targeted deficit as a share of GDP. The 2013 deficit reached 4.1 percent of GDP, some 0.2 percentage points above the authorities’ revised target. Revenue underperformance relative to the budget was about MKD 9 billion—a notable 1.9 percent of GDP, of which roughly half was due to a one-off clearance of VAT refund arrears. Expenditure adjustment was spread across goods and services, transfers, and capital expenditure.

8. As of end-April, growth in expenditures had outpaced that of revenues, resulting in a cumulative budget deficit of 2.5 percent of GDP. A third of the way through 2014, expenditure stood at 33 percent of the total budget. As in 2013, subsidies and other transfers were frontloaded, with almost 50 percent of the budgeted amount spent in the first four months. On the revenue side, early weakness in revenues reflects divergent developments: strong collections of PIT and social contributions seem buoyed by a continued improvement in labor market conditions; CIT performance has also been strong, likely reflecting the effect of legal changes to fight evasion; these positive developments have not, however, offset weaker VAT revenues.

FYR Macedonia: Central Government Budget Execution, Jan-Apr 2014

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Notes:

Excluding revenues from lending.

Including Tax Revenues (SRA).

Excluding profits from financial institutions.

Including profits from financial institutions.

Excluding lending guarantees.

Outlook and Risks

Baseline outlook

9. Growth is expected to gather pace—to 3½ percent this year—and to broaden. Private consumption will be supported by household credit, employment growth, and higher public wages and pensions, while investment will be bolstered by large public infrastructure projects. The contribution of net exports will turn negative again as higher investment-related imports offset the positive impact of increasing exports. In the medium run, the growth in private demand should moderate while the contribution of external demand should strengthen along with improving export capacity. Current fundamentals could support growth of 4 percent over the medium term; a realization of planned investment would raise growth potential.

10. Credit conditions are expected to continue improving. Private sector credit growth of about 7 percent per year seems feasible, particularly as risk aversion in the system abates. Credit supply appears driven by banks’ expectations on the outlook (Box 2); thus, a perceived improvement in growth prospects should help sustain credit growth. Increased competition from smaller banks looking for market share gains and the assumed normalization of the situation of foreign parent banks NBG (Greece) and NLB (Slovenia) would support that baseline.

11. Reserve losses are expected to halt and partially reverse in the second half of 2014. The current account deficit is expected to widen to about 4.5 percent of GDP, driven by a rebound in imports—partly reflecting stronger investment, partly higher imports of services linked to the implementation of foreign-financed construction projects—and slightly declining private transfers. FDI inflows are expected to pick up to about 3.8 percent of GDP, notably reflecting the impact of several big projects in the free trade zones. The financial account would be buoyed by inflows to the public sector both from external multilateral (World Bank) and bilateral (Chinese EX-IM Bank) project loan disbursements. This should allow for a gradual buildup of reserve assets in the second half of 2014, which, however, is not expected to fully offset the losses recorded in the first quarter.

12. The balance of payments position is expected to gradually improve over the medium term, preserving reserve adequacy. Export growth is expected to progressively outpace import growth, reflecting the expansion of export production capacity (notably in the free trade zones) as well as some import substitution. After peaking at 5.6 percent of GDP, the current account deficit should progressively improve in line with the trade balance, and despite slowly decreasing private transfers. Along with continued public sector borrowing, this would allow for an acceleration of GIR accumulation.

13. Central government debt is expected to stabilize, but debt of non-financial SOEs is projected to increase to almost EUR 1.4 billion by 2019. Local governments have limited debt; staff does not project a change in this trend and expects general government debt to remain close to central government debt of EUR 4.3 billion at end-2019. The Macedonian Bank for Development Promotion (MBDP)—which has intermediated about EUR 250 million for SME financing from the EIB since 2009—has contracted a new EUR 100 million credit line at the end of 2013, but no new financing is expected. Overall, staff projects public sector debt to increase from 44 to 55 percent of GDP in the period 2014–19 (text graph).

A01ufig4

FYR Macedonia: Evolution of Public Sector Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Sources: Ministry of Finance; and IMF staff calculations.PESR debt is projected to increase from 1.5 to 6 percent of GDP in the period 2014–18, at a pace of about EUR100 million per year until 2018 for the Miladnovic-Stip and Kicevo-Ohrid motorways; debt of other SOEs is projected to decrease from 3.8 to 3.3 percent of GDP over the 2014–18 period, based on amortization of existing debt and no new investment activity.

Risks

14. Surges in global financial market volatility in 2014 are not a key near term risk, given the weak integration of Macedonia in global capital markets. Dependence on cross-border lending is less pronounced than in peer countries. The scope for portfolio investment outflows is constrained by the limited availability of equity and debt instruments; CPIS data suggest that non-resident holdings of portfolio investment liabilities are less than 2½ percent of GDP. Central government external financing requirements in 2014 (just over 1 percent of GDP) are expected to be met exclusively by official lending. The rollover of a EUR 150 million eurobond maturing in 2015 will need to be skillfully managed.

15. Nonetheless, any further stress in parent banks could lead to renewed tightening of credit conditions. The standalone strength of the systemic Greek and Slovenian subsidiaries mitigates some of this risk, as does a largely domestic deposit-based funding strategy. However, as was most acutely the case in 2012, even in the absence of funding constraints, group-level restrictions on the growth of credit portfolios in these two banks would jeopardize the recovery in credit. Implications from the AQR and stress tests of euro area banks in the context of the transition to the single supervisory mechanism (SSM) are not clear.

16. In the short run, commodity price shocks from Ukraine-related disruptions could exert some pressure on the balance of payments. Direct trade exposure to both Russia and Ukraine is low, except for natural gas. A 15 percent oil price shock, however, would have the potential to widen the current account by an estimated 1.9 percent of GDP.

17. The main macroeconomic risk over the medium term pertains to a protracted period of slower growth in advanced European economies. In a small open economy characterized by increasing real integration with Europe, notably Germany, a prolonged period of weak growth in advanced economies would further weaken FDI, depress export growth, and weigh on consumption as private transfers slow. This could, in turn, put increasing pressure on external reserves under the pegged exchange rate regime.

Policy Discussions

The authorities broadly agreed with staff’s advice on the policy mix, namely that, given the balance of risks, further monetary policy support to credit and activity would not be appropriate, and that fiscal consolidation should proceed as spelled out in the medium-term strategy, while preserving the envelope for infrastructure projects. The medium term growth agenda—and the fiscal, financial, and structural policies that would support it—were a key focus of the discussions.

A01ufig5

FYR Macedonia. Fiscal impulse, 2012–2017

(Percent of potential output)

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Source: IMF staff estimates.Note: HP stands for Hedrick-Prescott Filter. The fiscal impulse is the difference in the cyclically-adjusted primary balance between the previous and the current year (a negative fiscal impulse means a cyclically-adjusted contraction).1/ Assumes PESR investment spending of EUR 80 million a year, starting in 2014.

A. Fiscal Policy

18. In the short run, fiscal policy should be geared toward meeting the 3.5 percent of GDP deficit target. Containing the central government fiscal deficit will be important to keep debt on a sustainable path. Capital revenues will likely fall short by about MKD 1.5 billion2, but this can be accommodated within normal buffers in the budget. Staff projects a shortfall of VAT revenues of about MKD 2.5 billion, particularly in the face of weak price developments; should that risk materialize, and absent a notable overperformance of other revenues, meeting the deficit target may require further expenditure compression, particularly as some additional space may need to be created for a yet-to-be finalized debt relief program for socially vulnerable debtors.

19. The recovery is unlikely to be derailed by a tighter budget spending envelope. The effect on growth of lower spending at the central government level will be partially mitigated by the positive impact on employment and investment from large infrastructure works implemented by SOEs (text chart). Staff’s estimated fiscal impulse associated with spending by the Public Enterprise for State Roads (PESR) is about 0.7 percentage points in 2014.

20. Debt stability considerations require that the authorities continue to consolidate, reducing the central government deficit to 2.6 percent of GDP by 2016. The central government debt ratio is expected to peak at around 39.4 percent in 2018—some 3½ percent above end-2013 levels—and stabilize thereafter (see Appendix I). Overall public sector debt is projected to rise to about 55 percent of GDP in 2019, some 9 percentage points of GDP above staff’s previous baseline, about half of which is due to the envisaged infrastructure investment program. On balance, this higher path remains broadly consistent with debt sustainability given the importance of such investment to potential growth, the long- term nature of debt, and safeguards that limit fiscal risks from the Public Enterprise for State Roads. Nonetheless, it underscores the need to stabilize central government debt, as well as to focus sustainability analysis on broader public sector operations.

21. Laying out the measures underpinning the medium term adjustment will reduce implementation risks. The planned consolidation path relies on revenue growth outpacing expenditure growth. An articulation of measures—in the context of the next medium-term fiscal strategy—will help the authorities reduce the deficit while achieving their desired growth-friendly expenditure mix. The strategy could usefully be guided by policy measures to be identified under the forthcoming World Bank-led Public Finance Review. Key considerations, in staff’s view, are the following:

  • On the revenue side, policy commitments to maintain a low-tax business environment have permanently reduced CIT revenues by about 1.2 percent of GDP since 2008. Trade liberalization has reduced customs duties by 0.6 percent of GDP over the same time horizon. Absent further tax policy changes, the revenue envelope is therefore some 1.8 percent of GDP lower than pre-crisis.

  • On the expenditure side, crisis measures, which have frozen wages and employment, have delivered a decline in the wage bill, from 5.1 percent in 2008 to 4.8 percent of GDP in 2013. Staff sees potential for upward pressure on wage spending over the medium term, as public administration resources become strained.

  • To avoid building in new permanent expenditure commitments in pensions and transfers that could jeopardize the consolidation, fiscal space for new policy initiatives should be assessed on the basis of prudent macroeconomic assumptions, particularly in the context of the current low inflation environment.

  • To strengthen the medium term expenditure framework, building explicit contingency margins under aggregate expenditure ceilings would allow for adjustments due to changes in macroeconomic and macro-fiscal forecasting assumptions and to protect against volatility of budget revenues.

22. Strengthening public investment policy remains a priority. Large investments in transport and energy infrastructure are crucial for further regional integration, competitiveness, and catalyzing further domestic and foreign private investment. The small size of domestic private sector balance sheets relative to the significant infrastructure investment needs have resulted in a public sector-led strategy, reliant on long-term financing from IFIs. While higher infrastructure spending should result in an acceleration of potential growth, the transition period toward that result is challenging and exposes the country to increased risk associated with carrying a higher debt stock. In that light, clear procedures to assess, prioritize, and monitor public investment projects should enable higher long-term economic return.

23. Public sector financing entails external and fiscal risks that should be articulated and disclosed in a debt management strategy. Hence, the medium-term fiscal strategy should be accompanied by a debt management strategy that strikes a balance between achieving an efficient mix of external and domestic financing and maintaining overall macroeconomic stability. In particular, the debt issuance and the currency financing mix should integrate the following policy priorities: preserve adequate foreign exchange reserves, minimize debt-servicing costs subject to acceptable risks, smooth the amortization profile, and avoid crowding out the private sector3. The strategy should take a broad perspective and consider contingent liabilities—most of the financing of SOEs is external, in foreign currency, and carries a government guarantee.

Authorities’ views

24. The authorities reiterated their commitment to the 3.5 percent deficit target, and saw more substantial upside risk to revenues. They noted that there were significant one-off factors, including pre-election postponement of durable goods purchases, which compressed VAT revenues early in 2014. Higher frequency unofficial data suggests that more recently an acceleration of revenue growth may indeed be underway. Thus, the authorities considered the need for a few more data points to be able to judge whether the early weakness in revenues requires a reprioritization of expenditure beyond the use of buffers.

25. More broadly, the authorities outlined their fiscal agenda for stability and growth. The authorities concurred that reducing the central government deficit to 2.6 percent is required to maintain moderate debt levels. They were cognizant of the need to preserve fiscal space for growth-critical capital expenditure: both in the budget, namely for multiyear railway and gas infrastructure projects, as well as through SOEs, for road infrastructure. In securing that space,

  • Tax policy changes are not envisaged. The authorities noted that exemptions in the tax system are limited. At the margin, and mostly on efficiency grounds, there may be scope to abolish the zero income tax rate on profits that are retained but not reinvested. Harmonization of excise taxes over the medium term, up to the EU minimum, may provide a boost. Overall, policies will focus more on improving revenue administration than increasing rates.

  • Future scope for wage and pension increases will be carefully considered. The authorities did not see any significant size distortions in the civil service that would call for a more comprehensive public administration review. A new law on civil servants, to come into effect in 2015, aims to upgrade the professionalism of public servants, establishing integrity tests and language requirements; the authorities noted that some decompression in the wage structure—increasing pay differentials—would be needed. Pressure on current expenditure from subsidies would be contained by capping the spending envelope for agricultural subsidies at EUR 150 million per year over 2015–18.

B. Monetary and Financial Sector Policy

26. Monetary policy remains the first line of defense to ensure a reserve level consistent with the sustainability of the peg4. While restrictions on capital movements and limited integration with global financial markets provide some buffers against the buildup of immediate pressures on the exchange rate, the evolution of reserve adequacy metrics warrants attention. Were pressures on reserves to materialize, the NBRM should stand ready to raise its policy rate, and to abruptly tighten reserve requirements on FX and FX-linked deposits. Given the limited size of interest sensitive flows, this would mainly induce a reversal of commercial bank foreign asset accumulation (as in 2009), and, at the margin, attract some non-resident deposits of parent companies.

Reserve adequacy ratios for Macedonia - 2011–2019

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Notes:

Suggested threshold for adequacy: 100 percent;

Suggested range for adequacy: 3–6 months;

Suggested threshold for adequacy: 20 percent;

Suggested range for adequacy: 100–150 percent

27. In this context, the authorities should refrain from further relaxation of the monetary policy stance. With credit gradually picking up, there does not seem to be further scope for monetary stimulus, especially as the experience of the past two years suggests that the transmission to banks’ lending rates works at best with considerable lags. In addition, ample liquidity in the banking sector does not call for any further lowering of reserve requirements.

28. The authorities should remain closely involved in the design of an institutional arrangement that would establish effective coordination between the SSM and non-EU members. The central bank’s intention to preserve a conservative approach to bank supervision in a changing European framework is appropriate. At the moment, the NBRM holds supervisory colleges with the Bank of Greece and the Bank of Slovenia twice a year, as well as more ad hoc discussions with Austrian supervisors. As the ECB assumes its new supervisory role in late 2014, continued good cross-border cooperation in banking supervision in the context of the SSM will be key, in light of the systemic importance of euro area subsidiaries to the domestic banking system.

29. A prompt reinstatement of the NBRM’s powers to address unfit shareholders is needed to preserve a strong regulatory and supervisory framework. A recent Constitutional Court ruling invalidated sections of the Banking Law that allow the supervisor to dispose of shares held by shareholders who have been declared unfit. The invalidated provisions were in line with international best practices, and their removal weakens the supervisory framework. Staff supports the NBRM’s chosen course of action—namely sending to the government a revised set of provisions that clarify both supervisory powers and individual property rights.

Authorities’ views

30. The authorities concurred with the need to put priority on preserving the sustainability of the peg and shifting away from further stimulating credit growth. They reiterated their commitment to tighten the monetary stance as needed in the face of any further deterioration. They emphasized that reserves were still adequate on a number of metrics, and that there were a number of upside risks to the conservative balance of payments baseline.

31. The authorities stressed the challenges to supervisory cooperation in the context of the SSM. While they would like to see their current cooperation through supervisory colleges extended to other supervisors of foreign parent banks, they expressed concerns that such bilateral arrangements might be discontinued in favor of a centralized European supervision. The authorities suggested that the EBA devote more resources to the region, in particular to support and assess the equivalence of supervisory and legal systems with respect to compliance with EU standards.

C. Growth and Competitiveness Policies

32. Cost competitiveness in manufacturing is high, and standard tools do not point to exchange rate misalignment. A simple competitiveness index, defined as productivity over gross wage, suggests that Macedonia ranks fourth out of a set of eleven regional comparators in manufacturing competitiveness. The Fund’s exchange rate assessment framework does not identify significant misalignment. The slight undervaluation signaled by the macroeconomic balance approach is driven by a low estimated current account norm (a deficit of 5 percent). By contrast, the external sustainability methodology signals a slight overvaluation of the real exchange rate compared to the level needed to stabilize the NFA position.

A01ufig6

Selected Transition Countries: Gross Wages and Productivity in manufacturing, 2012

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

FYR Macedonia: Estimated REER Misalignment

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Source: IMF staff estimates.

A negative value indicates undervaluation.

33. Nonetheless, the large structural trade deficit suggests that export and import-competing sectors remain underdeveloped, and remittances may have played a role. Large-scale migration of labor over the last two decades has resulted in sustained large private transfers, which undoubtedly bring important economic benefits, including for poverty reduction and external stability (see accompanying Selected Issues Paper). However, the increase in households’ disposable incomes associated with remittances may also support excessive consumption and import growth, exerting upward pressure on the relative price of non-tradable goods and on reservation wages. Over time, these price distortions may induce a reallocation of resources towards the non-tradable sector, thus weakening the overall competitiveness of the economy (Box 3). To counteract such dynamics, cross-country experience suggests scope for (i) setting up financial vehicles aimed at harnessing remittance flows to productive investment (such as diaspora bonds for financing capital projects), and (ii) improving infrastructure and the business environment—catalyzing diaspora investment may exact higher standards of their home country in both areas.

34. While Macedonia has risen to a notable 25th place in the Doing Business 2014 index, the private sector continues to face binding constraints. Enforcing payment discipline in both public and private sector contracts, clarifying the mandate and rights of inspection bodies, and improving firms’ access to finance are priority areas in that respect.

35. Inefficient intermediation likely carries a substantial opportunity cost for growth. Strong domestic deposit growth (as well as retirement savings within the two second pillar pension funds) has been increasingly channeled into government securities. The lending culture of banks based on physical collateral likely under-allocates credit to more dynamic entrepreneurial sectors; an upgrade in credit scoring technologies would likely help. In addition, previous staff research (SM/13/179) suggests addressing weaknesses in accounting practices in the corporate sector, encouraging more realistic valuation of collateral by banks and improving the efficiency of legal procedures.

36. To lock in the ongoing reduction in unemployment, efforts to alleviate key employment constraints should continue. Labor market institutional factors (labor market flexibility, social assistance, and labor taxation) appear in line with those of EU new member states and are therefore not likely to be the main explanatory factor of the poor labor market outcomes in FYR Macedonia.

  • Investment in training and education should be a priority. Empirical analysis5 shows that nearly two-thirds of long-term unemployment is explained by skill mismatches between supply and demand for labor. Active labor market policies and education reform have been successful in reducing the mismatch, but the effects will likely be felt slowly, as jobseekers need to acquire the relevant skills before being able to benefit from newly created jobs.

A01ufig7

Skill Mismatch Index

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Source: NBRM staff calculations and SSO.1/ Skill mismath index (SMI) is calculated as SMIt = Σj (Sjt - Djt)2Where j denotes the education degrees, t denotes the times; is the demand for labor; computed as a share of the employees belong to the eduation group j in the total number of employees in the period t, is the supply of labor, computed as a share of the active population in the education group j in the total active population in period t.
  • Strengthening supply chain linkages between newly-established foreign enterprises and domestic firms would create more job opportunities and facilitate knowledge spillovers. This would require proactive information sharing and the reduction of any costs associated with doing business with the free trade zones.

Authorities’ views

37. The authorities concurred with the view that remittances flows could contribute more to potential growth, but advised caution in interpreting remittances data. Measurement issues point to the need to draw only tentative conclusions. The authorities stressed that a non-trivial share of private transfers likely represents unrecorded exports of services, leading to an underestimation of the economy’s competitiveness. Nonetheless, the authorities concurred that there is scope to better channel these flows to productive investment. This could possibly be done by creating dedicated savings and investment instruments for the diaspora. In this context, the authorities suggested that municipal level instruments and projects are more likely to succeed.

38. The authorities acknowledged the challenges associated with excess liquidity and risk aversion in the banking sector. The structure of the banking system has certainly posed specific challenges—systemic euro area subsidiaries have faced externally-imposed portfolio restrictions, a diluted shareholding structure in a key domestic bank has likely distorted incentives, and the size distribution of banks in the system does not generate sufficient competition. Policy actions have aimed at spurring bank lending (Box 1), but also at trying to encourage alternative sources of financing—notably, the introduction of a zero reserve requirement on corporate bonds. The authorities noted that the role of the stock exchange is still limited, but they are pushing forward with a regional joint stock exchange platform which they hope would stimulate more equity financing.

39. The authorities highlighted key actions aimed at strengthening the business environment and facilitating job growth. The Law on Financial Discipline, aimed at improving liquidity in the private sector, came into effect on May 1. A newly established inspection council will govern all inspection bodies, previously under the jurisdiction of separate line ministries; the goal of the reform is to reduce lobbying pressure and upgrade the professionalism of the inspectorates. Significant efforts have been made in cleaning up unemployment registers to improve the targeting of active labor market policies. The authorities have also looked to outside experts to help in developing policy tools for effective development of domestic private sector linkages with FDI firms.

Post-Program Monitoring

40. Macedonia’s capacity to repay remains adequate. Risks are broadly balanced:

  • Upside risks to FDI and public sector inflows. The baseline forecast for foreign direct investment is conservative. At 3¾ percent of GDP per year over the medium term, projected FDI flows are about one percentage point of GDP below their historical average. Public sector borrowing is mainly linked to the implementation of investment projects articulated with already secured lending commitments, from official and private sources. The baseline reflects staff’s lower bound estimates for these flows, as well as upper bounds estimates for possible outflows in the forms of imports of services.

  • Uncertainty associated with the rollover rates of trade credit and intercompany loans. These flows account for the bulk of short-term external liabilities, and projections conservatively assume repayment of the stock accumulated in the preceding years. Rollover rates for these flows have remained stable throughout the global crisis—at about 95 percent—as well as through 2013. Shocks seem unlikely, but at 20 percent of GDP, the stock of short term debt does represent a source of vulnerability.

FYR Macedonia: External Financing Requirements

(Millions of euros, unless specified otherwise)

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Sources: NBRM; and IMF staff estimates.

Excluding the amortization of MLT intercompany loans, which is included in FDI (net).

Including the capital account balance, net errors and omissions, currency and deposits, portfolio investments, and discrepancies between ST debt flows and stock data.

Staff Appraisal

41. The authorities should continue their efforts to achieve the 2014 central government deficit target of 3.5 percent of GDP, even in the face of weaker revenues. Containing the central government fiscal deficit will be important to keep debt on a sustainable path. Any effect on growth from spending cuts at the central government level to safeguard the target should be mitigated by the positive impact on employment and investment from large infrastructure works implemented outside the central government budget. In addition, prospects for recovery seem firm: external demand is still supportive, export growth is strong, and a number of factors—higher pensions, employment, public sector wages, as well as a healthy pace of credit growth—will provide support to private consumption.

42. Over the medium term, the planned course for fiscal policy remains appropriate; laying out the measures underpinning the adjustment will reduce implementation risks. The planned reduction of the deficit to 2.6 percent of GDP in 2016 remains appropriate. An articulation of the measures to contain expenditure—in the context of the next medium-term fiscal strategy—will help the authorities reduce the deficit while achieving their desired growth-friendly expenditure mix. Continuing to base annual budgets on prudent macroeconomic assumptions, particularly in the context of the current low inflation environment, will avoid overstating fiscal space. Strengthening public investment policy to better assess, prioritize, and monitor public investment projects should enhance the transparency of the decision-making process and enable higher realization of budgeted capital spending, a long-term economic return, and a sustainable public debt position. The associated increase in public sector debt underscores the need to continue reducing the central government deficit, as well as to focus sustainability analysis on broader public sector operations.

43. The medium-term fiscal strategy should be accompanied by a debt management strategy. The public debt management strategy should ensure that the government’s financing needs are met at the lowest possible cost consistent with a prudent degree of risk, but also reach for broader objectives, namely, consistency with monetary and fiscal policy goals and the development of an efficient market for government securities. In line with international best practices for sound debt management, the objectives and relevant measures of risk and cost should be publicly disclosed, and the impact of contingent liabilities on the government’s financial position should be considered.

44. The focus of monetary policy has appropriately shifted away from providing stimulus to preserving reserve adequacy in the context of the euro peg. With credit gradually but so far convincingly picking up, and with ample liquidity in the banking sector, a more accommodative stance would be counterproductive in the face of a baseline drawdown of reserves and risks to export growth and investment from lower euro area growth.

45. The financial system remains liquid and relatively healthy, but structural factors impede more efficient intermediation. Strong domestic deposit growth has been increasingly channeled into government securities. The banking sector landscape – dominated by three large banks facing various shareholder-imposed constraints and a fragmented segment of very small banks—has likely distorted incentives and limited competition and innovation. A lending culture based on physical collateral likely results in inefficient allocation of credit and constrains financing for more dynamic entrepreneurial sectors.

46. An effective framework for continuing close cooperation with foreign supervisory authorities will be needed in the context of the SSM. The authorities should remain closely involved in the design of an institutional arrangement that would establish effective coordination between the SSM and non-EU members. In light of the systemic importance of euro area subsidiaries to the domestic banking system, preserving the established level of cooperation between home and host country authorities will be important.

47. The jobs and growth agenda should remain a central policy concern. A determined effort to alleviate key business environment constraints should invigorate the domestic private sector and may have important catalyzing effects on diaspora investment. Key in that respect would be proper implementation and monitoring of recent initiatives to enforce payment discipline in both public and private sector contracts, as well to upgrade the professional status of inspection bodies and clarify their mandate. Important progress in targeting and designing labor market activation policies should be sustained. Strengthening supply chain linkages between newly-established foreign enterprises and domestic firms would create more jobs and facilitate knowledge spillovers.

48. The Former Yugoslav Republic of Macedonia should remain on a standard 12-month Article IV cycle.

Credit Support Measures, 2012–2013

Credit growth has dropped sharply since mid-2008. Credit to the private sector grew rapidly in the mid-2000s, reaching 44 percent year-on-year in May 2008, funded by an equally rapid growth of domestic deposits. As the global crisis hit in late 2008 and the first half of 2009, severe current account pressures elicited a rapid and sharp policy tightening response. Credit growth fell to under 3½ percent and has averaged 5¾ percent through 2012–2013.

A01ufig8

Private Sector Credit

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Sources: Haver; FSI; EBRD; and IMF staff estimates.

Starting in 2012, the monetary policy stance was gradually eased. Since early 2012, the main policy rate has been reduced by 75 basis points down to 3.25 percent in three steps (May 2012, January and July 2013). The change in the policy stance was pursued against the backdrop of a weak growth outlook and contained inflationary pressures, expectations for a moderate current account deficit, and financial inflows that allowed for a further accumulation of international reserves.

This was complemented by a series of macro-prudential measures:

  • Starting in January 2012, the reserve requirement on time deposits with contractual maturity above two years was reduced to zero, to encourage long-term saving and release banks’ assets for lending. A zero reserve requirement ratio was also applied to liabilities on denar repo transactions to foster the development of a market for this instrument.

  • Effective January 2013, with the objective to further stimulate anemic private credit growth while also strengthening the balance of payments, the central bank lowered reserve requirements by the amount of new loans to domestic net exporters and electricity producers.

  • In July, reserve requirements on liabilities in domestic currency were lowered again while those on short-term FX deposits were tightened, with the dual objectives of stimulating deposit growth in local currency and encouraging long-term foreign capital funding of domestic banks.

Additional credit support measures were taken in late 2013. The NBRM adopted a decision aiming at deterring banks from overbidding the central bank’s monthly auctions and requiring banks bidding above their potential to place the difference in seven-day deposits. It also abolished the remuneration of required reserves (1 percent on domestic currency and 0.1 percent on foreign currency).

Supply- and Demand-Side Drivers of Credit Growth

A decomposition of credit developments in recent years confirms that supply-side factors relating to bank balance sheets—namely, capital and liquidity—have not played a key role. Using quarterly data from bank surveys over the period 2006Q2–2013Q4, we replicate for Macedonia the methodology implemented in the October 2012 GFSR1 to disentangle the influence of supply- and demand-side factors on credit growth. First, the supply-related tightening of credit standards is regressed on explanatory variables standing for various balance sheet indicators as well as banks’ expectations on outlook, for various categories of loans. Setting all but the coefficients on balance sheet-related variables to zero allows for the construction of a filtered series standing for ‘pure’ supply-side developments, exclusively reflecting capitalization and liquidity constraints. Second, overall credit growth is regressed on the filtered supply-side variable and an overall demand variable, controlling for hysteresis effects. The overall decomposition indicates that mortgage, consumer and corporate lending have all been primarily driven by demand-side developments, while balance-sheet related constraints have exerted a constant but moderate drag on growth.

Risk aversion by banks appears to be the most critical supply-side factor. In comparison with other countries, most balance sheet characteristics are found to be generally insignificant to explain changes in credit standards. In contrast, however, for each category of loans, banks’ expectations regarding overall economic activity turns out to be the most significant explanatory factor behind the tightening of credit standards. These results are fully consistent with the observation that banks are very liquid and well capitalized, but may be excessively risk averse.

1 IMF (2013), Global Financial Stability Report – Transition Challenges to Stability, Chapter 2, October 2013.

The Macroeconomic Impact and Drivers of Remittances in FYR Macedonia

In order to explore the macroeconomic impact of remittance flows in FYR Macedonia, we estimate a mixed-frequency structural VAR model1, over the 2005–2013 period. The model consists of two blocks—a home economy and a foreign economy. The foreign economy block includes real EU GDP. The domestic economy block includes the following six variables: real GDP, real consumption, NT/T prices, transfers, worker’s remittances, and 3 month interest rate differentials. Note that we decompose private transfers into “workers’ remittances” and “other transfers” to explore to what extent measurement issues might affect our findings. We use a zero restrictions identification to impose no spillovers from the domestic economy to the external block, and compute the impulse response functions (IRF) to different exogenous innovations2.

Key results are as follows:

  • 1) Remittances appear to be countercyclical with respect to Macedonian GDP and pro-cyclical with respect to EU GDP. A countercyclical response to shocks in the domestic economy is consistent with a stabilizing role of remittances and in line with findings in the literature. Noteworthy is the role of “push” factors—the elasticity of the response to EU shock is significantly higher.

  • 2) Remittances are interest-sensitive. An exogenous increase in the interest rate differential encourages migrant workers to choose their home economy for saving.

  • 3) Remittances do put some upward pressure on the internal real exchange rate. The IRF analysis presents mild evidence of Dutch disease effects on the Macedonian economy. Shocks to remittances push the prices in the non-tradable goods sector higher than in the tradable goods sector; however, the elasticities are small.

  • 4) Finally, the results are robust to different specifications of the “remittances” variable. Subcomponents of remittances respond similarly to different exogenous shocks, although the magnitude of the response is different: i.e., the IRFs of workers’ remittances exhibit a smaller elasticity than other transfers’ IRFs.

1 See Solmaz and Taheri Sanjani (2014).2 See accompanying Selected Issues Paper for a full description of the model and methodology.
Figure 2.
Figure 2.

FYR Macedonia: Real Sector Developments, 2008–2014

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Sources: Haver; SSO; and IMF staff calculations.1/ Note: the percent balance is the difference in percentage shares between the ‘positive’ and ‘negative’ assessments on the current business situation.
Figure 3.
Figure 3.

FYR Macedonia: Credit Developments, 20008–2013

(Percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Sources: NBRM; and IMF staff calculations.
Figure 4.
Figure 4.

FYR Macedonia: Monetary Policy Developments, 2004–2013

(Percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Sources: NBRM; Haver Analytics; and IMF staff calculations.
Figure 5.
Figure 5.

FYR Macedonia: Banking Sector Developments, 2008–2013

(Percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2014, 231; 10.5089/9781498376549.002.A001

Sources: NBRM; and IMF staff calculations.
Table 1.

FYR Macedonia: Macroeconomic Framework, 2010–2019

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

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

Total Public Sector (including MBDP, municipalities, public sector non-financial enterprises; w/o NBRM).

Table 2.

FYR Macedonia: Central Government Operations, 2012–2019

(Billions of denars)

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Sources: IMF Staff and MoF estimates.Notes:

Excluding revenues from lending.

Including Tax Revenues (SRA).

Excluding profits from financial institutions.

Including profits from financial institutions.

Excluding lending guarantees.

Resulting from excluding: (i) revenues from lending from total expenditure; and (ii) lending guarantees from current expenditures.

Table 3.

FYR Macedonia: Balance of Payments, 2010–2019

(Millions of euros, unless otherwise indicated)

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Sources: NBRM; and IMF staff estimates.