Mission Concluding Statements
Republic of Moldova and the IMF
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INTERNATIONAL MONETARY FUND
December 16, 2005
The main purpose of this mission has been to conduct discussions for the 2005 Article IV consultation between the IMF and the Republic of Moldova. Such consultations are required for all countries that are members of the IMF, and the Concluding Statements of the missions are often published. The mission welcomes the decision of the authorities to agree to publication of this Concluding Statement.1 The mission has also initiated discussions on a new program that could potentially be supported by the IMF's Poverty Reduction and Growth Facility (PRGF). PRGF discussions will continue during a follow-up mission tentatively scheduled for February.2 This Concluding Statement covers the Article IV discussions only.
1. A staff team from the International Monetary Fund (IMF) visited Chisinau during December 1-16, 2005. We are very grateful to the authorities for the warm hospitality and excellent cooperation we received during the mission.
Recent Economic Developments
2. The Moldovan authorities have established a considerable degree of macroeconomic stability in 2005, despite the challenge of managing significant inflows of remittances from Moldovans working abroad. At the same time, the authorities have made progress in implementing their Economic Growth and Poverty Reduction Strategy (EGPRSP) and the EU-Moldova Action Plan, both of which aim to raise living standards by improving economic institutions and the environment for private sector investment.
3. Economic growth continues to be robust, and inflation has abated somewhat. At the same time, the sources of growth—household consumption and construction—remain heavily dependent on inflows of remittances (now equal to some 30 percent of GDP), as well as strong wage growth. Real GDP growth in 2005 is expected to be in the neighborhood of 7 percent, as it has been since the start of the decade. After peaking at over 14 percent in April 2005, inflation is now projected at around 10 percent (December -to-December), despite a pick-up in non-food (especially energy) prices in mid-2005.
4. Fiscal policy has continued to support the effort to bring inflation down. The general government is expected to post a cash surplus of around ½ percent of GDP in 2005, about the level of 2003-04, mainly as a result of better-than-expected indirect tax receipts and some welcome spending restraint on the part of the government.
5. The National Bank of Moldova has tightened monetary policy in 2005, aiming to bring inflation down. Sterilization efforts were stepped up in the second quarter, and have been maintained, as the authorities sought to rein in the inflationary pressures stemming from rising inflows of foreign exchange. Reserve money growth slowed from 48 percent (year-on-year) at end-January to near 20 percent in the fourth quarter, though credit growth has remained robust.
6. Higher energy prices have had a significant impact on the balance of payments. The current account is expected to have worsened significantly during 2005 to a deficit of about 5 percent of GDP, from under 3 percent in 2004. At the same time, import growth has continued to be strong, partly because of higher energy prices, but non-fuel imports have grown as well, fueled by inflows of remittances from Moldovans working abroad and by strong domestic wage growth.
Near term prospects and macroeconomic policies
7. Growth is likely to slow marginally in 2006 and over the next several years, given the impact of higher energy prices and emerging tightness in labor markets. Avoiding a more pronounced slowdown will depend on a continued recovery in investment, particularly of the private sector. Making progress with the authorities' reform agenda as set out in the EGPRSP and the EU-Moldova Action Plan will facilitate stronger investment flows by improving the business environment and clarifying the role of government in the economy.
8. The monetary authorities should aim for inflation in the single-digit range. The IMF's work in other countries suggests that higher inflation would tend to undermine investment while adversely affecting the poor, who are not well-equipped to cope with price volatility. Inflation is, after all, effectively a tax on their holdings of domestic currency. But achieving single-digit inflation in an environment of strong foreign exchange inflows will demand continued sterilization efforts by the National Bank, as well as tight fiscal policy.
9. Fiscal policy in 2006 should remain cautious both to support lower inflation and to avoid crowding out private sector investment. Containing the budget deficit to very modest levels will support the goals of monetary policy and reduce pressure on the balance of payments. But it is perhaps even more important to contain the size of the government, which has grown significantly in recent years. General government expenditure has risen from around 33 percent of GDP in 2003 to about 37 percent in 2005, suggesting that it is now time to examine carefully the quality and composition of government spending.
10. The 2006 budget contains several positive structural features. A number of tax exemptions have been eliminated, while relations between the budget and the NBM have been placed on a sounder footing. In particular, for the first time, the government has begun to repay outstanding credits to the NBM, while transfers of central bank profits will now, as in other countries, take place only once per year on the basis of audited accounts. The budget has also begun to accumulate resources needed to help settle outstanding arrears to external creditors. On the other hand, a large increase in budget sector wages is envisaged, which will limit resources available for a higher pace of investment growth—including in roads and other infrastructure projects—and could limit the possibility of cushioning the blow of higher energy prices for vulnerable groups. Raising budget sector wages to this extent will also complicate the task of achieving lower inflation and worsen the balance of payments.
11. Higher energy prices will impact the budget in two ways. First, they raise the cost of electricity, natural gas and oil products procured by the state at all levels. But higher energy prices will also give rise to pressures for additional subsidies and transfers. Any new subsidies should fit within the macroeconomic framework corresponding to this situation, be time-bound (meaning they will automatically expire at a predetermined date in the future), and be targeted on the most needy groups of the population. Higher energy prices have a role to play in encouraging conservation, so subsidies should also not distort the price paid by consumers for energy products.
12. The budget of the Social Fund remains precarious. Pension increases in late 2004 have led to a deficit in the Social Fund budget throughout 2005. On top of this, Moldova has an aging population, while migration of workers abroad reduces the Social Fund's tax base, keeping payroll tax rates relatively high. Over time, it will be important to rationalize the Social Fund's expenditures, while developing a plan to ensure it is adequately financed.
13. The NBM should continue to be vigilant in guarding against a resurgence of inflation. The budget has a role to play in supporting monetary policy, but at the end of the day the NBM is responsible for achieving the inflation objective. Thus, the NBM must remain ready to use the sterilization levers at its disposal, as well as permit greater exchange flexibility, to support achievement of its inflation objective. Interest rates may have to rise if inflation is to be kept to appropriate levels.
Financial sector development
14. Financial stability indicators suggest the banking system is sound. While highlighting a number of weaknesses, the Financial Sector Assessment (FSAP) undertaken in 2004 pointed to a stable banking system characterized by high levels of profitability and moderate credit risk. The mission welcomes recent passage of legislation aimed at implementing recommendations of the FSAP, including to promote greater transparency in banking system ownership. At the same time, development of the nonbank financial sector has been very gradual, while in the banking sector competition from reputable foreign banks is long-overdue. Following on the advice of the FSAP, the mission sees merit in developing a transparent and competitive privatization plan for Banca de Economii.
15. The legal independence of the National Bank of Moldova needs to be enhanced in line with best international practice. For example, Moldovan legislation should be amended to establish that price stability (not "stability of the national currency," which can also refer to the exchange rate) is its primary objective, and that it may no longer lend directly to government. At the same time, the mission is concerned about recent amendments to the Anti-Money Laundering (AML) law No. 633-XV that would appear to weaken Moldova's AML regime.
16. Progress in the area of structural economic reforms seems to have accelerated—particularly those measures called for by the EU-Moldova Action Plan, which is broadly consistent with the EGPRSP. The mission particularly welcomes the authorities' efforts to establish monitoring systems for both plans that are mutually consistent, thus avoiding an undue administrative burden.
17. Public administration reform (PAR) is exceptionally important, as it aims to help determine the appropriate role of government in the economy. This reform, which will take several years to complete, is intimately related to the on-going regulatory reform designed to improve the business environment. Moldova can count on the support of its international development partners in this effort, which should begin in 2006 with comprehensive functional reviews of all levels of the central public administration. Although further staff reductions will likely be needed, it is too early to discuss the quantitative scale of any downsizing of government employment. For example, some ministries will need additional staff in coming years in order to harmonize Moldovan legislation with that of the EU.
18. The PAR should also tackle civil service legislation and government decision-making. In this effort, it will be important to ensure hiring of civil servants only on professional grounds, and conflict of interest regulations, to guarantee that government employees have protection from political pressure, yet are subject to strictly enforced rules prohibiting abuse of their power. The ideology of the PAR must clearly be to improve the provision of services by the government to the population and the business community.
19. The authorities' plans to modernize public enterprise management are very welcome. The mission welcomes the recently concluded inventory of the government's asset holdings in the economy, and their intention to reinvigorate the privatization process. At the same time, it will be important to introduce effective corporate governance for those state enterprises that remain in the hands of the state—in particular by shifting oversight over them from line ministries (which have a clear conflict of interest) to economic bodies (the Ministry of Finance and the Ministry of Economy).
20. Efforts are under way to introduce a comprehensive tax administration reform strategy. Many of the private sector's legitimate concerns about the business environment stem from the authorities' efforts to address shortcomings in tax administration. For example, the requirement that grain exports pass through the commodity exchange is an attempt to forestall underinvoicing. But in most other countries, the tax authorities themselves—without resort to a commercial body like the exchange—have adequate authority to make use of clear evidence of this practice to enforce tax compliance. Thus, stepping up the ability of the tax authorities to combat tax fraud, including risk-based selective audits and indirect methods of assessing the validity of taxpayer declarations, could serve to improve the investment climate in Moldova. At the same time, periodic tax deferrals granted by the Council of Creditors serve to undermine tax discipline, and within an appropriate period of time should be replaced by an effective bankruptcy procedure.
21. A number of structural reform priorities lie outside the IMF's sphere of competence, but are nevertheless very important. For example, creation of the national agency to promote competition seems long overdue. Further, it is essential that any land reparcelization be conducted exclusively on market principles. Finally, judicial reform seems needed, given complaints by the business community about the ability of the courts to enforce private property rights.
1 Information on the obligations of member countries under Article IV can be found at http://www.imf.org/external/np/exr/facts/surv.htm. Links to published Concluding Statements for other countries are at http://www.imf.org/cgi-shl/create_x.pl?ms. Results of previous consultations between Moldova and the IMF can be found at http://www.imf.org/external/country/MDA/index.htm.
2 The Article IV discussions will also continue at that time.
IMF EXTERNAL RELATIONS DEPARTMENT