Press Release No. 16/513

IMF Executive Board Concludes Article IV Consultation with Former Yugoslav Republic of Macedonia

November 21, 2016

On November 9, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation[1] with the Former Yugoslav Republic of Macedonia, and considered and endorsed the staff appraisal without a meeting on a lapse of time basis.[2] 

The economy has been growing at a solid pace on the back of strong domestic demand and exports with real GDP now 16 percent above its pre-crisis level. In 2015, GDP growth picked up to 3.8 percent from 3.6 percent in 2014. In 2016H2, growth slowed to 2.2 percent due to investment contraction and weaker credit growth reflecting political uncertainties. Unemployment rate continues to decline. Headline inflation has hovered around zero for the last two years while core inflation turned positive at end-2015. Reflecting exports from the technological and investment zones (TIDZ) and lower oil prices, the trade deficit has narrowed in recent years. 

Overall fiscal deficit improved in 2015 to 3½ percent of GDP from 4.2 percent in 2014. Higher profit tax revenues, including one-off collections, and under-execution of capital spending helped achieve the fiscal consolidation. Large under-execution of capital spending continued in 2016H1. The government adopted two supplementary budgets during July‑August which together raised the 2016 overall fiscal deficit target to 4 percent of GDP compared to 3.2 percent in the original budget. Public debt is projected to reach almost 48 percent of GDP in 2016. 

Credit growth remains robust particularly to households. Some slowdown was experienced reflecting both policy measures and political uncertainties. In May, the NBRM increased the policy rate by 75 bps to 4 percent, and took macro-prudential measures to stem deposit outflow and euroization pressures. These policies combined with FX interventions successfully stabilized the exchange rate, although lost household deposits have not fully returned to the system. Lending rates continued to decline despite increase in the policy rate. The official reserve coverage has improved due to the recent issuance of external sovereign bond, and is projected to strengthen further over the medium term on the back of improving trade balances, strong FDI and other financial inflows. 

Executive Board Assessment 

The economy has endured a number of shocks in the last two years, including a prolonged political crisis. Growth has so far shown resilience benefiting from accommodative policies, low commodity prices, sustained foreign investment and improving labor market conditions. However, the prolonged domestic political crisis is beginning to take a toll on confidence and the country’s EU accession prospects.    

GDP growth is projected to soften in 2016 but pick up in the medium term contingent on return of political stability.  Assuming elections in December followed by stability, growth is expected to pick up to 3.2 percent in 2017 and further in the medium term benefiting from infrastructure and foreign direct investment, continued improvement in labor market and some strengthening of credit growth. In addition to political uncertainties, the outlook faces a number of other downside risks, notably a slowdown in external demand and renewed financial turmoil in Greece. 

Fiscal policy space has largely been depleted amidst rising risks. The fast rise in debt since 2008 is mostly due to rising primary deficits which, in turn, reflect a combination of low tax rates and low collection efficiency on the revenue side, and inefficiencies in social spending and subsidies on the expenditure side. For 2016, staff projects a widening in the overall fiscal deficit to 4 percent of GDP. In the medium term, without measures, overall fiscal deficit is projected to stay around 3½ percent of GDP with public debt reaching almost 55 percent of GDP. Meanwhile, rising borrowing costs, high fiscal financing needs and recent sovereign downgrading by Fitch have raised near-term fiscal risks. Public finances also face long‑term challenges from population ageing. 

Fiscal consolidation should start without delay. To counter risks and create fiscal policy space, consolidation should start now to stabilize public debt-to-GDP ratio below 50 percent. For 2016, given caretaker government and little time left in the year, a small consolidation of 0.4 percent of GDP is recommended relying on scaling back of goods and services spending and collection of VAT arrears. For 2017–18, a consolidation of 1¼ percent of GDP in the cyclically-adjusted structural primary balance is recommended. 

Medium-term fiscal consolidation should rely on high-quality measures. In the last two years, improvement in the cyclically-adjusted fiscal balance has mostly relied on under-execution of capital spending. To produce durable results and enhance confidence, particularly in light of the authorities’ intention to introduce a fiscal rule, consolidation should be based on durable measures. On the revenue side, this entails raising collections, particularly that of VAT, by strengthening coverage, targeting compliance risks, improving the operation of large tax payer office, and establishing a Risk Management Unit. On the expenditure side, a reduction of subsidies and transfers together with greater efficiency in health and education spending would yield the required savings. 

Ensuring sustainability of the pension system is an important medium-term goal. Despite earlier parametric reforms and introduction of a multi-pillar system, the PAYG (pay-as-you-go) system faces significant financial imbalances due to population ageing and cuts in the contribution rate. The pension deficit, which is sizable at 4½ percent of GDP, is projected to more than double by 2030 without further reforms. To ensure sustainability, the authorities are encouraged to consider raising statutory retirement age given the sizable gap with the EU average, revising indexation to mostly link to the CPI in line with many countries in the EU, implementing policies to increase labor force participation, and increasing contribution rates. 

Current monetary policy stance is appropriate. Historically low interest rates have helped sustain robust private sector credit growth and domestic demand without jeopardizing external stability. Given still-negative output gap, low core inflation and moderate real exchange rate undervaluation, low policy rate is appropriate. However, in case of pressures on the exchange rate or risks of deposit outflows, the monetary policy stance may need to be tightened by raising the policy rate along with stricter macro-prudential policies. Official reserves are deemed adequate and projected to improve in the medium term on the back of strong exports, continued FDI and other financial inflows. 

Continued vigilance is required for an otherwise healthy and profitable banking sector. Banks are well-capitalized and profitable. Structural liquidity in the banking system is ample and, according to NBRM’s latest stress tests, provides strong buffers to withstand severe deposit outflow shocks.  Macro prudential policies have been successful in maintaining banking system stability through recent episodes of deposit and exchange rate pressures. Continued vigilance is needed to preserve this record. 

Efforts to reduce high structural unemployment should continue. Benefitting from active labor market policies and broad-based growth, overall unemployment rate has declined by 10 percentage points since 2008. However, at 24 percent, unemployment is still high and mostly structural reflecting a shortage of skilled labor. Active labor market policies targeting on-the-job training are bearing fruit and should be continued mindful of fiscal costs. 

Policies to attract FDI have contributed to net exports and growth.  Competitive wages, reduced regulations and financial benefits have attracted sizable FDI in recent years. While these flows have contributed to investment and exports, spillover into domestic economy is considered limited. To ensure broad-based benefits and sustainability of the FDI-led growth strategy, complementary reforms to remove impediments faced by the domestic private sector, such as constrained access to finance and unpredictability of business environment, are recommended.