IMF Executive Board Concludes 2008 Article IV Consultation with the Former Yugoslav Republic of MacedoniaPublic Information Notice (PIN) No. 08/146
December 8, 2008
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On December 1, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the former Yugoslav Republic of Macedonia.1
Growth has picked up, led by stronger domestic demand and increasing investment. In 2007 improved terms of trade and remittances boosted incomes and domestic demand. This raised growth to 5 percent. Though these favorable shocks have reversed, in the first half of 2008 growth increased to 6 percent (led by construction, wholesale and retail trade) while industrial production growth reached double digits. Strong investment growth, in part reflecting higher foreign direct investment (FDI), and the high unemployment rate, which is still around 35 percent, suggest few capacity constraints and considerable scope for continuing this favorable supply response. But compared to the region, past economic growth has been tepid, and there is plenty of room for catch up.
Inflation has risen despite the exchange rate anchor, mainly because of external shocks. From 2002 to 2006 inflation averaged less than 1 percent, sometimes with periods of deflation. Inflation jumped to around 10 percent in early 2008, similar to other countries in the region, largely because of oil and food price increases. Higher nominal wage increases prevented a fall in real incomes.
Through 2007 the sharp increase in foreign exchange reserves resulted in monetary policy easing. From 2005 to 2007, the central bank's gross reserves increased by €400 million (almost 7 percent of GDP). Though offset partially by sales of central bank bills, the central bank's purchases of foreign exchange increased the supply of denars. This pushed central bank bill rates below 5 percent and commercial bank lending rates to less than 10 percent. With competition intensifying, credit growth increased to almost 40 percent, stimulating domestic demand and imports, and also potentially increasing risks in the banking system. To contain these risks, in 2008 the central bank started to tighten monetary policy. The National Bank of the Republic of Macedonia (NBRM) has gradually increased central bank bill rates to 7 percent, raised capital requirements for overdrafts and credit card loans, and introduced controls on household credit growth.
In 2006 and 2007 the central government budget was broadly in balance, but fiscal policy is turning increasingly expansionary. Tax revenue increased despite substantial tax cuts, owing to improved tax administration, domestic demand growth (which boosts VAT), and a near-doubling of corporate income tax revenues. Fiscal policy plans for the remainder of 2008 and the medium-term are expansionary. For 2008, the fiscal deficit target of 1.5 percent of GDP in 2008 represents an expansion of 2.1 percent of GDP compared to 2007. The government intends to raise the fiscal deficit in the coming years.
The current account deficit has widened sharply, and has become the main risk to continued growth and macroeconomic stability. Both the size of the current account deficit-around 14 percent of GDP projected for this year-and the speed of its deterioration are of concern. This deterioration has three main components: a rising trade deficit, falling private transfers, and lower net factor income due to a large telecom dividend payment. Indicators of external vulnerability, such as international reserve cover of imports, or of short-term foreign debt, have also weakened.
Recent international financial turmoil poses additional uncertainties. There has been little direct impact, since Macedonian banks do not seem exposed to subprime lending overseas and rely mainly on domestic deposits rather than international credit lines to fund lending. However, the indirect impact is likely to grow. A slowdown in the world economy could worsen the current account deficit through reduced export demand, falling export prices, and weaker remittances, and could also threaten growth.
Executive Board Assessment
Executive Directors welcomed FYR Macedonia's strong economic growth, supported by improvements in the business climate and a surge in foreign direct investment. Progress has also been made in improving living standards and reducing unemployment. At the same time, Directors expressed concern about increasing macroeconomic and external vulnerabilities. The current account deficit has widened dramatically, as a result of worsening terms of trade and rapid increases in pensions and public sector wages, public investment, and household credit. While the direct impact of the global financial crisis on FYR Macedonia's financial sector has been limited so far, the indirect impact is growing. Export demand has started to fall, and lower foreign direct investment, portfolio investment, and remittances could create additional balance of payments pressures.
Against this background, Directors emphasized the need for fiscal discipline. They noted the role automatic stabilizers could play in reducing macroeconomic vulnerabilities. This could be facilitated by saving this year's revenue over-performance and limiting discretionary spending. Directors encouraged the authorities to reconsider plans for further increases in the fiscal deficit in 2009 and beyond. Reversing the planned fiscal expansion would help reduce external vulnerabilities, lessen the risk of a "sudden stop" in external financing in the event of an unanticipated shock, and reduce the burden on monetary policy. Directors welcomed the authorities' commitment to stand ready to adjust the fiscal stance should macroeconomic indicators deteriorate markedly.
Directors welcomed the recent increases in interest rates and measures to curb credit growth and slow down the deterioration of the current account deficit. They considered that, despite the constraints of the exchange rate peg, the central bank still has room for maneuver, and they welcomed, in this regard, the authorities' commitment to take further action as necessary. Directors encouraged the authorities to replace credit controls by an increase in reserve requirements or capital requirements on riskier loans. They stressed that the priority of monetary policy should remain to protect the exchange rate.
Directors agreed that the exchange rate peg has provided a useful nominal anchor and remains appropriate for FYR Macedonia's small, open economy. They highlighted the importance of disciplined macroeconomic policies and their timely adjustment in order to preserve external stability. They cautioned that pre-announcing expansionary fiscal deficit targets over the medium term could constrain the flexibility of fiscal policy in safeguarding the exchange rate peg. Directors emphasized the need for the authorities to remain vigilant on external borrowing, given the currently high level of external debt and the low reserve coverage.
Directors commended the authorities for significant progress in improving banking supervision. They noted that implementation of the Financial Sector Assessment Program (FSAP) update recommendations would further strengthen financial sector supervision and address gaps in nonbank supervision. Noting that residents' unhedged foreign exchange borrowing remains a significant vulnerability, Directors called for the development of contingency plans in case of spillovers from the international financial crisis on Macedonia's financial sector. They looked forward to the prompt passage of new legislation strengthening the central bank's power in dealing with troubled banks and enhancing its independence.
Directors welcomed the government's efforts to improve the business climate, attract foreign direct investment, and stimulate employment. They considered it essential to reinvigorate privatization plans, address the budgetary and trade deficit problems caused by artificially low electricity prices, and strengthen the social safety net to protect the poorest consumers. Directors also encouraged continued fiscal reforms aimed at improving public expenditure management and strengthening tax administration.