Moldova–2010 Article IV Consultation, Concluding Statement
May 12, 2010
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
This note summarizes the mission’s preliminary observations and recommendations. Its main purpose is to elicit views on policy issues that will be reflected in the staff report to be discussed by the IMF’s Executive Board. The mission is grateful for the collaboration it has received from the authorities and representatives of the private sector, labor, and civil society.
1. Over 2006-08, Moldova saw strong growth accompanied by rising macroeconomic vulnerabilities, and hesitant progress in its transition to a market economy. Buoyant domestic demand, financed by booming remittances, credit, and FDI, resulted in an average growth of over 5 percent but also widened the current account deficit and generated inflation pressures. The real effective exchange rate (REER) appreciated substantially and, together with exogenous shocks, dampened export growth. Despite some progress in structural reforms, the economy remained overregulated and hampered by relative price distortions. High barriers to entry and low competition in telecommunications, trade, and food processing kept domestic prices significantly above international prices of many consumer products. In contrast, utility tariffs generally remained well below cost-recovery levels, leading to substantial arrears and underinvestment.
2. The global crisis brought a deep recession in 2009. Reflecting a sharp decline in exports, remittances, and FDI, domestic demand and imports collapsed, and real GDP fell by 6½ percent. Although the leu depreciated significantly, deflation pressures persisted. The current account deficit almost halved to 9½ percent of GDP; nonetheless, the country struggled to cover its external financing need. It was met by running down the reserves of the National Bank of Moldova (NBM) and financing from international financial institutions. Credit to the economy declined, and share nonperforming loans (NPLs) in the banking sector tripled since end-2008; one medium-size bank failed.
3. The economy has been recovering since late 2009, reflecting improved external market conditions and recent trade liberalization. Real GDP rebounded strongly in Q4 2009, led by industry, transport, and trade. Helped by the removal of many trade restrictions, exports and imports rose year on year for the first time in five quarters. Recent data suggest that the recovery gained further speed in early 2010. However, energy tariff hikes, the depreciation of the leu, and increases in excises have pushed inflation to 8 percent in April 2010, with core inflation at 5½ percent.
The recovery is gaining speed, but risks remain
4. The short-term outlook is cautiously optimistic. We project GDP growth at 2.5 percent in 2010 and 3.6 percent in 2011, supported by the strengthening demand in major trading partners. Higher-than-expected international energy prices will be pushing inflation up in the next few months, but we expect this effect to be short-lived, and inflation to ease toward 6 percent by mid-2011. The rise in energy prices and the gradually recovering domestic demand would widen the current account deficit to 10½ – 11¼ percent of GDP in 2010-11 as rising imports outweigh the rebound in exports and remittances.
5. The new external environment is a drag on potential output growth. We reduced our estimates of potential growth to 4 percent (from 5-6 percent previously) as private investment and FDI are expected to strengthen only gradually given current global projections. Sizable productivity gains supported by the envisaged structural reforms and large infrastructure public investment will underpin medium-term growth.
6. Downside risks still prevail. Weak growth recovery in the EU could depress remittances and exports, while international energy price spikes could stoke inflation. Deteriorating loan quality could restrain bank lending, hindering the recovery. Should reforms falter, withdrawal of donor support could re-open large balance of payments gaps. On the upside, the recent liberalization and deregulation of the economy may provide a larger and quicker–than-anticipated growth impulse.
Policies to restore and maintain stability and support the recovery
7. Restoring fiscal sustainability is a precondition for sustainable growth. Fiscal year 2009 saw a large deterioration of the structural fiscal balance, stemming mainly from the significant unaffordable increases in public wages and pensions. Domestic sources of budget financing were nearly exhausted, necessitating a call for assistance to the international community. The authorities then embarked on a path to gradually restore fiscal sustainability at a pace matching the economy’s speed of recovery. They have appropriately chosen restraint in the public wage bill and spending on goods and services, while raising social assistance to protect the vulnerable and public investment to address infrastructure bottlenecks, a type of spending with significant contribution to growth.
8. On the current trends, the gradual consolidation envisaged for 2010 strikes the right balance between fiscal policy objectives. The budget deficit would be reduced by 1 percent of GDP compared to the revised outcome of 2009. Most of the emerging revenue overperformance will be appropriately saved to keep the envisaged structural consolidation on track and to contain the widening external current account deficit. Additional resources are provided for investment and enhancement of the social safety net to mitigate the poverty impact of higher energy tariffs.
9. Further fiscal action is needed in the medium term. We recommend that the structural budget deficit be gradually eliminated in view of low private savings and the budget’s limited access to external financing. On the current outlook, this would imply increasing the general government’s overall balance by some 5 percentage points of GDP over the next four years. Such an increase in government saving would also help assure international development partners that the public sector lives within its means and does not add to external imbalances. Given the oversized public sector for the economy’s current level of development, we would suggest that fiscal strengthening be achieved mainly by restraining and prioritizing current spending. In particular, large spending categories could be scrutinized more stringently to find savings and reform efforts could focus on quality rather than scale.
10. Monetary policy aims to keep a lid on inflation without hampering the flow of credit. The recent NBM interest rate hikes (200 basis points) have contributed to stabilizing inflation expectations—thus alleviating second-round effects from the cost-push shocks—and calming the foreign exchange market. However, as subdued credit and domestic demand do not fuel inflation pressures at present, a pause in monetary tightening appears appropriate to reassess the inflation outlook. Further monetary action might be necessary if domestic demand recovers strongly and/or depreciation pressures persist.
11. The NBM’s monetary policy framework could benefit from more flexibility. While the inflation target should remain the primary objective, the policy horizon over which the NBM aims to bring inflation within the target band could be lengthened, and the band widened. Such flexibility would account for the transmission lags of monetary policy actions and the high underlying uncertainty stemming from Moldova’s inflation history and exposure to external shocks. Moreover, it would allow for more gradual policy reaction to inflation developments, thereby stretching over time any output costs associated with bringing inflation back to target. The success of this policy crucially depends on preserving monetary policy credibility, which calls for only a moderate lengthening of the policy horizon (from one to two years, in line with the practice in most inflation-targeting central banks) and a measured widening of the band. Clear communication of the reasons and modalities of these changes are very important so that the policy framework is not undermined.
12. Moldova’s floating exchange rate regime allows the economy to absorb external shocks and maintain competitiveness. The IMF’s methodology for assessing the level of the exchange rate suggests—on the basis of current data and projections—that the real exchange rate is broadly in line with fundamentals. We concur with the NBM’s view that efforts to actively manage the exchange rate are likely to be counterproductive, confusing the public as to the monetary policy’s true objectives and harming the economy’s exports.
13. A strong reserve cover is an important cushion against external risks. Reserve accumulation in late 2009 has partially offset the loss of reserves earlier in the year, while still leaving reserves somewhat low when measured against external debt, and the current account deficit. We thus see room for further gradual reserve accumulation as inflows pick up, without seeking to influence the exchange rate.
Financial system stability: Remaining vigilant while supporting resumption of lending
14. Financial soundness indicators suggest a stable banking system. Limited financial integration has kept Moldova insulated from international financial turmoil. Banks have remained liquid and well-capitalized, and exposure to foreign assets and institutions in distress is minimal. Moreover, low interdependency limits the systemic threat from individual bank failures.
15. However, high levels of nonperforming loans and foreign currency lending are a source of concern. Financial institutions are feeling the effects of last year’s decline in economic activity on loan quality and returns. Nonperforming loans have exceeded 17 percent, although there are encouraging signs that the ratio may have already peaked. Moreover, foreign currency loans constitute over 40 percent of total loans, exposing the borrowers and banks to certain risks.
16. The NBM should continue its vigilant hands-on supervision and proactive engagement with banks. The objective is to ensure that capital and liquidity buffers in banks remain adequate to cope with credit quality risks. Moreover, strengthening the banks’ debt resolution framework could facilitate and speed up NPL resolution, thus unclogging bank balance sheets to support resumption of lending. Contingency planning, including clear delineation of responsibilities and a framework for decision-making in case of financial distress would be useful as well.
Structural reforms to introduce export-led growth
17. The transition agenda remains unfinished. Moldova still lags behind other countries at similar level of development in important areas including investor protection, access to financing, and labor market rigidities as measured by various international rankings of business climate.
18. A reorientation toward export-led growth should be considered. In recent years, the economy has been flying mainly on the engine of remittances-driven consumption, which exceeded 110 percent of GDP in 2008. While this model of growth will remain important for the time being, it is nearing its limit, as the share of Moldova’s labor force working abroad is already high at 40 percent and migrants’ ties with the home country weaken over time. Increasing Moldova’s share in the vast markets of major trading partners in the East and West could provide a strong and sustainable boost to growth, as the experience of other economies in the region demonstrates.
19. Long-overdue structural reforms are therefore critical for strengthening export-led growth and job creation and for addressing competitiveness concerns. The authorities have already scrapped a number of export and import restrictions and simplified licensing and custom control procedures, but much remains to be done in these areas. Better protection of creditor rights would ease access to credit. Price competitiveness needs to be maintained as well, avoiding policies that lead to overvalued exchange rate and keeping real wage growth in line with productivity gains. Moreover, exposing domestic monopolies to greater competition by removing barriers to entry could lower prices and improve service. A review of the labor laws to increase hiring and firing flexibility and reduce wage rigidities would promote job creation. Such a reform program would give rise to a virtuous circle, in which rising productivity helps the country attract foreign investment and know-how, in turn boosting productivity further in addition to creating jobs.
20. In sum, Moldova’s growth prospects depend on its ability to maintain macroeconomic stability and boost its presence on external markets. Increasing public saving to restore fiscal sustainability and intensifying structural reforms to attract foreign investment and boost total factor productivity growth are thus essential for raising incomes and reducing poverty on a sustainable basis.