## _cr06345

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---

### Current Account and External Vulnerabilities
- From 1995-2004, the current account deficit averaged 6.3 percent of GDP.
- In the first half of 1995-2004, the average trade deficit was close to 13 percent of GDP; in the second half it deteriorated to 19 percent of GDP as private transfers increased.
- During 2000-2004, exports increased by 4 percent of GDP while imports increased by almost 10 percent of GDP.
- In 2005, the current account deficit fell sharply to 1.3 percent of GDP despite a 40 percent increase in private transfers and higher oil prices.
- External vulnerabilities:
  - Large and persistent current account deficits contributed to a sharp increase in external debt from 1995 to 2004 and to a steady decline in the reserve coverage ratio.
  - The political crisis of 2001 reduced external financing and worsened vulnerabilities; capital inflows recovered from 2004 onwards and reserve coverage was reversed only in 2005 due to the sizable improvement in the current account.

### Export Performance
- Export growth and composition:
  - During 1995-2000, average export growth was 9.5 percent, raising exports’ share in GDP from 32 to 46 percent.
  - The 2001 political crisis caused a severe contraction in output and exports lasting until 2004; only in 2005 did export share of GDP return to pre-crisis levels.
  - Macedonian exports are highly concentrated: iron and steel, textiles, and food, beverages and tobacco account for about 60 percent of total exports.
  - Recent recovery drivers: reopening of a large steel factory in 2004 and removal of protectionist barriers in Serbia in 2005 improved iron and steel and "other" exports.
  - Despite recovery since 2004, FYR Macedonia has lost market share in world imports since 1995, especially in the US market.
- Manufacturing specialization analysis:
  - The 15 largest manufacturing sectors (accounting for 80 percent of Macedonian manufacturing exports in 2005) show Macedonia’s export shares increased in many sectors where the economy is specialized, but those sectors themselves have lost global share — explaining the decline in Macedonia’s share of world exports.

### Assessing Competitiveness

Indicators of wage and cost competitiveness
- Wage comparisons:
  - Wage costs in manufacturing are higher in Macedonia than in other Balkan countries.
  - Wage costs in Macedonia are twice as high as in Bulgaria, and about 40 percent higher than in Serbia.
  - Only Croatia has higher wage costs than Macedonia.

Price competitiveness and REER assessments
- Price competitiveness:
  - Real exchange rate indicators show price competitiveness has improved over the last decade.
  - The 1997 devaluation caused a sharp real depreciation, but did not noticeably affect average current account deficit or stop the decline in export shares.
  - The unit labor cost measure of the real exchange rate shows considerable improvement because productivity gains in manufacturing have outpaced wage increases.
- Equilibrium REER estimates (three approaches):
  - PPP approach: the exchange rate is undervalued relative to its PPP level; the PPP-based exchange rate index is below the level predicted given Macedonia’s relative income.
  - Macroeconomic balance approach:
    - Underlying current account balance estimated to range between 0 and -3.1 percent of GDP, depending on treatment of officially recorded private transfers.
    - Structural current account estimated around -2 percent of GDP (using equation from Chinn and Hito (2005)).
    - To align underlying and structural current accounts, the REER would have to depreciate by at most 4 percent — a modest adjustment within margins of error — suggesting the REER is broadly in line with fundamentals.
  - Econometric estimates (VECM and structural determinants):
    - Structural determinants (openness, government consumption, relative productivity) explain the trend decline in the REER.
    - If relative productivity had remained at 1994 levels, the equilibrium REER would be now 15 percent higher than the current estimated value.
    - Fiscal consolidation depreciated the equilibrium REER by 3 percent.
    - Increase in openness depreciated the equilibrium REER by 2.5 percent.
    - Historical movements:
      - The 1997 devaluation created a real undervaluation, but subsequent appreciation pushed REER above equilibrium during 2000-2001.
      - From 2002-2004 the REER was broadly in equilibrium; by end-2005 the REER appears slightly undervalued.
- Chinn and Hito (2005) coefficients used for structural current account estimation (selected):
  - Government budget balance (share of GDP) 0.22 [0.08]***  
  - NFA as share of GDP 0.06 [0.08]***  
  - Relative income -0.01 [0.07]  
  - Relative dependency ratio (young) -0.03 [0.014]**  
  - Average GDP growth 0.33 [0.23]  
  - Trade openness 0.01 [0.01]  
  - Dummy for Oil exporting countries 0.03 [0.01]***  
  - Dummy 1990 0.03 [0.01]***  
  - Dummy 2000 0.03 [0.01]***  
  - Dummy 2003 0.05 [0.01]***  
  - Constant -0.03 [0.02]*  
  - Significance: * significant at 10%; ** significant at 5%; *** significant at 1%

Structural competitiveness
- Institutional and business environment indicators:
  - World Bank Business Environment rankings identify difficulties in starting and closing a business, enforcing contracts, and hiring and firing workers relative to regional peers.
  - World Economic Forum indicators place Macedonia among the less competitive countries in the region.
  - The evolution of rankings suggests structural reforms to date have not meaningfully improved competitiveness.

### Conclusions and Policy Implications (Competitiveness and Exports)
- Synthesis:
  - Price competitiveness (level of REER) is broadly appropriate at present based on PPP, macroeconomic balance, and econometric estimates.
  - Structural competitiveness problems are significant and are the main constraint to improving export performance and sustaining higher growth.
- Policy recommendations:
  - Address structural impediments to competitiveness: improve business environment constraints, enforcement of contracts, and labor market regulations.
  - Strengthen productivity-enhancing reforms to improve long-run structural competitiveness.
  - Maintain macroeconomic policies that keep the REER broadly aligned with fundamentals while supporting structural reforms to diversify export specializations.
- Short vs medium-term:
  - A more competitive exchange rate might improve short-term export performance, but sustained improvements require enhanced productivity, resource reallocation to higher value-added sectors, and reforms to improve the business environment.
  - FDI and domestic private investment are key; boosting investment will depend on successful structural reforms.

### Economic Growth in FYR Macedonia: Performance and Prospects — Key Findings
- Historical growth performance:
  - By 2005, output was only 4 percent above its 1991 level.
  - Output growth from trough to 2005 averaged 2.2 percent per annum; averaged 2.9 percent per annum excluding 2001.
- Growth accounting (Cobb-Douglas framework):
  - Contribution of capital accumulation over the last decade: 0.4 percentage points.
  - Average contribution of capital for closest peers: 1.6 percent.
  - Private capital accumulation in recent years has been less than 20 percent of output (the lowest in the region).
  - Between 1996 and 2000, TFP contributed an estimated 84 percent of Macedonia’s output growth.
  - For 1996–2005, TFP contributed 80 percent of output growth.
  - Average TFP growth in Macedonia is below regional experience; TFP contributed about 2 percent on average in Macedonia versus about 4 percent in close peers Croatia and Bulgaria.
- Synthesis summary bullets:
  - Private sector capital accumulation has been the lowest in the region; boosting private investment is crucial for medium-term growth.
  - Employment growth has not been an important source of growth; raising employment is important given high unemployment.
  - Total factor productivity growth has been poor and is the key driver for improving Macedonia’s growth performance.

### Growth Prospects, Regression Results, and Scenario Estimates
- Panel regression framework:
  - g_i,t = α + β y_{i,t-1} + γ NEO_{i,t} + δ INST_{i,t} + χ MACRO_{i,t}.
  - Institutional quality measured by ICRG index (0–100) and World Bank Governance Indicators; scatter regression: y = 12.847x + 65.745, R^2 = 0.8276 (relating World Bank Governance Indicator to ICRG index).
- Key regression insights:
  - Conditional convergence: growth higher the lower initial GDP per capita.
  - Greater capital accumulation or lower population growth raise economic growth.
  - Raising capital accumulation from 22 to 25 percent of GDP is associated with increased growth (text notes diminishing returns).
- Table 2: Selected coefficients and statistics (significance legend: ** = 1 percent, * = 5 percent)
  - Log initial GDP per capita β: -0.40 * , -0.83 *
  - Log capital accumulation γ0: 4.59 *, 5.38 *
  - Log population growth γ1: -4.65 *, -4.76 *
  - Government balance δ0: 7.98 *, 7.20 *
  - Inflation δ1: -0.0002 **, -0.0001 **
  - Broad money share in GDP δ2: 1.37 **, 1.37 **
  - Institutions χ: ...0.08 **
  - Adjusted R2: 0.38, 0.42
  - Possible Macedonia growth (in percent): 3 to 4, 3 to 6
- Scenario estimates for FYR Macedonia’s potential growth:
  - Baseline numerical substitution:
    - initial GDP per capita: 6000 US dollars;
    - ratio of capital accumulation to GDP: 0.22;
    - population growth: 0.5 percent;
    - government balance: -0.6 as a percent of GDP;
    - inflation: 2 percent;
    - ratio of broad money to GDP: 0.5;
    - institutional quality indicator: about 50.
    - Resulting growth rate: about 3 percent.
  - Policy/scenario effects:
    - Raising capital accumulation by 3 percentage points → increased real growth of about 0.7 percentage points.
    - Continued broad money expansion from a ratio to GDP of 0.5 to 0.75 → consistent with increase in real growth of 0.3 percentage points.
    - Combining the above suggests annual GDP growth of close to 4 percent.
    - Improving institutional performance from 50 to 70 might be associated with an increase in growth to the 5-6 percent range.
  - Caveats: non-linearities and fiscal crisis influences may alter outcomes; institutional endogeneity may affect estimates.

### Growth Determinants — Marginal Effects and Institutional Impact
- Quantitative magnitudes reported:
  - Reducing the central government deficit by one percentage point raises economic growth by less than 0.1 percentage points.
  - Reducing inflation has a minute influence on economic growth.
  - Raising the level of financial intermediation by 10 percent of GDP (broad money ratio from 0.5 to 0.6) will increase economic growth by slightly more than 0.1 percentage points.
  - Institutional quality:
    - ICRG index example: increasing institutional quality from 40 to 50 might raise long term growth by up to 0.8 percentage points (noting alternative estimates give 0.3 or 0.5 percentage points and the 0.8 figure is an upper bound).

### Unemployment: Measurement, Structure, and Policy Directions
- Official unemployment rate: around 37 percent in 2005.
- Alternative measures and ranges:
  - Employment Fund (EF) registered unemployment: 51 percent.
  - Correcting for grey economy using Schneider (2005) estimate (~37 percent): LFS and EF unemployment rates would drop to 15 and 34 percent respectively.
  - EF data excluding recipients of health insurance only: 15 percent.
  - Household consumer survey (HCS) estimate: unemployment around 24 percent.
  - Most reliable estimate argued to be around 25 percent (HCS preferred).
- Labor market characteristics:
  - Sclerotic insider-outsider problem: very low flows from unemployment to employment and very high long-term unemployment rates.
  - Youth unemployment about 65 percent for ages 15 to 24.
  - Average unemployment higher for women (~38 percent) than men (~35 percent).
  - Hidden unemployment signaled by wage arrears around 15 percent of total wages.
- Causes and institutional drivers:
  - Large grey economy (estimated one third to almost one half of the formal sector) driven by poor judiciary and weak enforcement.
  - Labor market regulation: 2005 reforms liberalized fixed-term employment, streamlined layoff procedures, eased part-time employment rules, but minimum social contribution discriminates against part-time work.
  - Free health insurance for registered unemployed discourages formal employment and biases registration incentives.
- Policy recommendations to reduce unemployment:
  - Enhance sustained GDP growth to create long-term employment.
  - Create incentives for formal sector activity: judicial reform, completion of the cadastre, increased transparency, stronger audit and labor inspection.
  - Finance reduction in the tax wedge by increasing VAT to capture grey economy sales.
  - Merge PIT and social contributions by 2008 to simplify collection and free resources for enforcement; abolish minimum social contribution to encourage part-time work.
  - Reassess subsidies and investment incentives: abolish opaque investment schemes and non-transparent subsidized land practices.
  - Use public works programs to screen unemployed from grey economy workers and as eligibility screening for unemployment benefits.
  - Reform education: improve school quality, reduce skill mismatches, and prioritize vocational and training programs.

### Financial Intermediation and Banking Sector — Stylized Facts and Constraints
- Financial depth and interest rates:
  - FYR Macedonia’s ratios of broad money, private sector credit and bank capital to GDP remain below the CEEC average.
  - Advertised retail lending rates have averaged about 20 percent over the last decade.
  - Ex-ante lending-deposit interest rate spread remains around 2 percentage points above OECD levels.
- Banking system structure and asset quality (selected figures):
  - 20 banks and 14 saving houses.
  - Around 48 percent of total assets are controlled by foreign majority owned banks.
  - As of end-2005, banks’ NPLs amounted to around 18 percent of total loans and some 97 percent of them were provisioned.
  - Foreclosed assets average 20 percent of banks’ own resources; for 5 banks foreclosed assets are well above 50 percent.
  - In 2005, share of non-earning assets ranged between 1.5 and almost 50 percent of banks’ total assets, average close to 8 percent.
  - Aggregate banking system has been in structural liquidity surplus since 2001.
- Institutional and legal framework weaknesses:
  - Secured transactions system: defects — time for enforcement, lack of simplicity, weak courts, corruption, and registration complexity.
  - Insolvency regime: medium quality; new Bankruptcy Law in late-2005 improves timelines and roles but implementation capacity remains weak.
  - Reform and transparency scores below CEEC averages (selected comparisons: banking sector reform 2.7 vs CEEC 3.4; transparency score 2.7 vs CEEC 4.0; transparency rank 103 vs CEEC 64).
- Interest rate spread decomposition (2001–05) — main quantitative findings:
  - For the banking system as a whole in 2005, system spread was 6.03 percent and overhead costs accounted for about 5.89 percentage points of that spread.
  - Provisions added between 2 to 3 percentage points to spreads.
  - Non-interest income reduced spreads substantially — by about 6 to 8 percentage points — often associated with extraordinary transactions.
  - Profit margins, taxes, deposit insurance, and reserve requirements added relatively little to spreads.
  - Heterogeneity: spreads declined for the 3 largest banks and majority foreign owned banks; smaller and domestically owned banks saw increases in effective spreads.
- Panel regression results (1997Q4–2005Q4, 20 banks, quarterly) — selected coefficients and interpretation (significance legend: * Significant at 1 percent level; ** Significant at 5 percent level; *** Significant at 10 percent level):
  - R-square weighted: 0.89 (Lending Rate), 0.80 (Lending Deposit Rate), 0.68 (Private Sector Credit Growth).
  - Log(Total Assets): -3.22* (Lending Rate); -2.03*** (Deposit Rate); -10.45 (Credit Growth).
    - Doubling a bank’s balance sheet implies lending rate declines by more than 2 percentage points and the spread narrows by about 1.5 percentage points (derived).
  - Market Share: 0.30** (Lending Rate); 0.20*** (Deposit Rate); 0.78 (Credit Growth).
    - Spreads and lending rates increase by about 0.2 to 0.3 percentage points for every percentage point increase in market share — evidence of market power effects.
  - NPLs/Total Loans: 0.21* (Lending Rate); 0.22* (Deposit Rate); -1.28* (Credit Growth).
    - Every percentage point increase in NPL ratio raises spreads/lending rates by about 0.25 percentage point and reduces credit growth.
  - Money Market Interest Rate: 0.17* (Lending Rate); 0.13** (Deposit Rate); -0.82*** (Credit Growth).
    - Monetary policy transmission: money market rates significantly affect lending rates and credit growth.
  - AR(1): 0.79* (Lending Rate); 0.78* (Deposit Rate); 0.75* (Credit Growth).
- Policy recommendations for financial intermediation:
  - Reduce operational (overhead) costs to materially lower interest rate spreads.
  - Address asset quality and NPLs to reduce provisioning costs that add between 2 to 3 percentage points to spreads.
  - Enhance sustainable non-interest income sources while monitoring extraordinary transactions that temporarily reduce spreads.
  - Improve accounting and reporting standards (move toward IFRS) to increase transparency and reduce measurement errors.
  - Allow banks to grow and rationalize overhead costs (mergers and foreign entry) to benefit from economies of scale, while guarding against market dominance.
  - Enhance credit information sharing, banks’ risk management, and prudential supervision.

*Source: IMF staff estimates and analysis extracted from _cr06345 (chapter: "Export Performance and External Competitiveness in FYR Macedonia"; selected issues on growth, unemployment, and financial intermediation).*

### 1. Current Account and External Vulnerabilities..........................................................11

### 1. Current Account and External Vulnerabilities

### Introduction
- Sustaining faster growth and reducing unemployment in a small open economy like FYR Macedonia depends on improving export performance.
- Improving export performance requires enhancing competitiveness, distinguished as:
  - "Price competitiveness" — associated with the level of the real exchange rate that ensures internal and external balance (FEER).
  - "Structural competitiveness" — related to long-run productivity of the economy.

### Current Account Balance and External Vulnerabilities
- Findings:
  - From 1995-2004, the current account deficit averaged 6.3 percent of GDP.
  - In the first half of 1995-2004, the average trade deficit was close to 13 percent of GDP; in the second half it deteriorated to 19 percent of GDP as private transfers increased.
  - During 2000-2004, exports increased by 4 percent of GDP while imports increased by almost 10 percent of GDP.
  - In 2005, the current account deficit fell sharply to 1.3 percent of GDP despite a 40 percent increase in private transfers and higher oil prices.
- External vulnerabilities:
  - Large and persistent current account deficits contributed to a sharp increase in external debt from 1995 to 2004 and to a steady decline in the reserve coverage ratio.
  - The political crisis of 2001 reduced external financing and worsened vulnerabilities; capital inflows recovered from 2004 onwards and reserve coverage was reversed only in 2005 due to the sizable improvement in the current account.

### Export Performance
- Findings:
  - During 1995-2000, average export growth was 9.5 percent, raising exports’ share in GDP from 32 to 46 percent.
  - The 2001 political crisis caused a severe contraction in output and exports lasting until 2004; only in 2005 did export share of GDP return to pre-crisis levels.
  - Macedonian exports are highly concentrated: iron and steel, textiles, and food, beverages and tobacco account for about 60 percent of total exports.
  - Recent recovery drivers: reopening of a large steel factory in 2004 and removal of protectionist barriers in Serbia in 2005 improved iron and steel and "other" exports.
  - Despite recovery since 2004, FYR Macedonia has lost market share in world imports since 1995, especially in the US market.
- Analysis of manufacturing specialization:
  - Analysis of the 15 largest manufacturing sectors (accounting for 80 percent of Macedonian manufacturing exports in 2005) shows Macedonia’s export shares increased in many sectors where the economy is specialized, but these sectors themselves have lost global share — explaining the decline in Macedonia’s share of world exports.

### Assessing Competitiveness

#### Indicators of Wage and Cost Competitiveness
- Findings:
  - Wage costs in manufacturing are higher in Macedonia than in other Balkan countries.
  - Wage costs in Macedonia are twice as high as in Bulgaria, and about 40 percent higher than in Serbia.
  - Only Croatia has higher wage costs than Macedonia.
- Price competitiveness:
  - Real exchange rate indicators show price competitiveness has improved over the last decade.
  - The 1997 devaluation caused a sharp real depreciation, but did not noticeably affect average current account deficit or stop the decline in export shares.
  - The unit labor cost measure of the real exchange rate shows considerable improvement because productivity gains in manufacturing have outpaced wage increases.

#### Estimates of the Equilibrium Real Effective Exchange Rate (REER)
- Methodology:
  - Three approaches used: PPP approach, macroeconomic balance approach, and econometric techniques (vector error correction framework using real interest parity and structural fundamentals; Hodrick-Prescott filters used as proxies).
- PPP approach:
  - The exchange rate is undervalued relative to its PPP level: the PPP-based exchange rate index is below the level predicted given Macedonia’s relative income.
- Macroeconomic balance approach:
  - Underlying current account balance estimated to range between 0 and -3.1 percent of GDP, depending on treatment of officially recorded private transfers.
  - Structural current account estimated around -2 percent of GDP (using equation from Chinn and Hito (2005)).
  - To align underlying and structural current accounts, the REER would have to depreciate by at most 4 percent — a modest adjustment within margins of error — suggesting the REER is broadly in line with fundamentals.
- Econometric estimates:
  - Structural determinants (openness, government consumption, relative productivity) explain the trend decline in the REER.
  - If relative productivity had remained at 1994 levels, the equilibrium REER would be now 15 percent higher than the current estimated value.
  - Fiscal consolidation depreciated the equilibrium REER by 3 percent.
  - Increase in openness depreciated the equilibrium REER by 2.5 percent.
  - Historical movements:
    - The 1997 devaluation created a real undervaluation, but subsequent appreciation pushed REER above equilibrium during 2000-2001.
    - From 2002-2004 the REER was broadly in equilibrium; by end-2005 the REER appears slightly undervalued.

#### Structural Competitiveness
- Findings from survey-based indicators:
  - Structural impediments to external competitiveness are apparent in World Bank Business Environment rankings: difficulties in starting and closing a business, enforcing contracts, and hiring and firing workers relative to regional peers.
  - World Economic Forum indicators place Macedonia among the less competitive countries in the region.
  - The evolution of rankings suggests structural reforms to date have not meaningfully improved competitiveness.

### Conclusions and Policy Implications
- Synthesis of findings:
  - Price competitiveness (level of REER) is broadly appropriate at present based on PPP, macroeconomic balance, and econometric estimates.
  - Structural competitiveness problems are significant and are the main constraint to improving export performance and sustaining higher growth.
- Policy implications (inferred from analysis and findings within the source):
  - Address structural impediments to competitiveness (business environment constraints, enforcement of contracts, labor market regulations).
  - Strengthen productivity-enhancing reforms to improve long-run structural competitiveness.
  - Maintain macroeconomic policies that keep the REER broadly aligned with fundamentals while supporting structural reforms to diversify export specializations.

*Prepared by Eva Gutierrez; chapter: "Export Performance and External Competitiveness in FYR Macedonia."*

### 17.      The analysis in this paper suggests that price competitiveness is broadly

### 17. The analysis in this paper suggests that price competitiveness is broadly appropriate at present, but structural factors are major impediments to future improvements.

### Price competitiveness and export performance
- Real exchange rate developments and price levels
  - The real exchange rate has depreciated steadily.
  - Compared to countries with similar incomes, the Macedonian price level is low.
  - Staff estimates indicate the exchange rate is broadly in line with macroeconomic fundamentals.
- Wage and cost competitiveness
  - Direct wage comparisons across countries suggest a cost competitiveness problem, though data heterogeneity makes comparisons difficult.
- Export shares and specialization
  - Macedonian manufacturers have succeeded in maintaining or increasing their share in exports to some partners.
  - Specialization in sectors with low value added and a declining share in total global trade has resulted in a decline in total export share, indicating a structural competitiveness problem.

### Policy implications and recommendations
- Exchange rate vs. structural reform
  - A more competitive exchange rate might improve short-term export performance, but sustained improvements require:
    - Enhanced productivity.
    - Resource reallocation to more dynamic, higher value-added sectors.
    - Reforms to improve the business environment.
- Investment and transformation
  - FDI and domestic private investment are key to achieving necessary economic transformation.
  - Boosting investment will depend on the successful implementation of structural reforms aimed at improving the business environment (discussed more fully in Chapter II of these Selected Issues).
- Productivity trends
  - Contrary to most transition economies, productivity in Macedonia declined in the last decade vis-à-vis trading partners, although this trend has started to reverse in the last 3 years.

### Appendix I — Macroeconomic balance approach: equilibrium REER estimation
- Method summary
  - The fundamental equilibrium exchange rate is defined as the exchange rate that equates the current account to the structural savings/investment balance in the medium term.
  - Estimation steps: (i) underlying current account (adjusted for output gaps and lagged REER effects); (ii) structural current account from fundamentals; (iii) exchange rate that brings underlying to structural current account.
- Underlying current account (export/import volume equations)
  - Using Isard et al. (2001) methodology for non-oil export and import volumes, the estimated Macedonian underlying current account ranges between 0 percent and -3.1 percent, depending on the treatment of private transfers as current account or capital account transactions.
  - The exchange rate is assumed to remain at prevailing levels; WEO projections were used for 6 year ahead values of real absorption.
- Structural current account (Chinn and Hito (2005) panel equation)
  - Substituting FYR Macedonia values yields an estimated structural current account balance of about -2 percent of GDP.
  - The relatively large share of young and old population, and the net foreign asset position are main factors explaining the estimated -2 percent structural current account deficit.
- Implication for REER misalignment
  - Given exchange rate elasticities in export/import volume equations, to align the underlying and structural current accounts the real exchange rate would have to depreciate at most by 4 percent.
  - Since 4 percent is within a +/- 10 percent range of the fundamental equilibrium exchange rate, the current real exchange rate is considered to be broadly in equilibrium.

### Chinn and Hito (2005) coefficients used for structural current account estimation
- Macroeconomic determinants — Coefficients [Errors]
  - Government budget balance (share of GDP) 0.22 [0.08]***
  - NFA as share of GDP 0.06 [0.08]***
  - Relative income -0.01 [0.07]
  - Relative income squared 0.01 [0.11]
  - Relative dependency ratio (young) -0.03 [0.014]**
  - Realtive dependency ratio (old) -0.01 [0.012]
  - Financial deepening -0.01 [0.007]
  - Terms of Trade volatility -0.03 [0.03]
  - Average GDP growth 0.33 [0.23]
  - Trade openness 0.01 [0.01]
  - Dummy for Oil exporting countries 0.03 [0.01]***
  - Dummy 1980 0.01 [0.01]
  - Dummy 1985 0.00 [0.01]
  - Dummy 1990 0.03 [0.01]***
  - Dummy 1995 0.01 [0.01]
  - Dummy 2000 0.03 [0.01]***
  - Dummy 2003 0.05 [0.01]***
  - Constant -0.03 [0.02]*
  - Significance: * significant at 10%; ** significant at 5%; *** significant at 1%

### Appendix II — Econometric estimation of structural determinants of the real exchange rate (VECM)
- Conceptual determinants included in the long-run REER relationship
  - Net foreign assets (NFA): higher NFA → more appreciated currency.
  - Relative productivity (Balassa-Samuelson effect): higher tradable-sector productivity → appreciation.
  - Trade openness: more openness → real depreciation via lower tradable prices.
  - Government expenditure: higher government spending → appreciation via higher nontradable prices.
  - Terms of trade: wealth and substitution effects; empirical link is weak in some studies.
  - Real interest rate differentials: capture aggregate demand, productivity, and monetary policy effects.
- Data and sample considerations
  - Periods analyzed: full period 1995:Q1-2005:Q4 and shorter period 1998:Q3-2005:Q4 to abstract from the 1997 devaluation and address data availability.
  - Many series exhibit unit roots (Augmented Dickey-Fuller test failed to reject unit-root).
  - Johansen maximum likelihood tests found evidence of at least one cointegration relationship.
  - Due to short sample, TOT and NFA were found not significant and were dropped from preferred specifications to preserve degrees of freedom.
- Preferred VECM estimation results (cointegrating vector and error correction)
  - Cointegrating Vector (1995q3-2005q4 / 1998q3-2005q4)
    - FISC(-1) 0.02 / 0.01  [ -5.3 ] [ -4.6 ]
    - RGDPPC(-1) 2.74 / 1.98  [ -9.3 ] [ -7.6 ]
    - OPEN(-1) -0.01 / 0.00  [ 8.4 ] [ 5.7 ]
    - C 3.68 / 4.02
  - Error Correction: α -0.29 / -0.41  [ -2.4 ] [ -2.4 ]
  - Short-run dynamics (selected coefficients and t-statistics)
    - D(REER(-1)) 0.13 / 0.19  [ 0.9 ] [ 1.0 ]
    - D(REER(-2)) 0.02  [ 0.1 ]
    - D(FISC(-1)) 0.00 / 0.00  [ -0.7 ] [ -1.1 ]
    - D(FISC(-2)) 0.00  [ -1.5 ]
    - D(LRRGDPPC(-1)) -0.10 / -0.53  [ -0.3 ] [ -1.3 ]
    - D(RRGDPPC(-2)) -0.45  [ -1.5 ]
    - D(OPEN(-1)) 0.00 / 0.00  [ 0.3 ] [ 2.0 ]
    - D(OPEN(-2)) 0.00  [ 2.8 ]
  - Exogenous variable
    - RIRR_EU 0.00  [ -0.4 ]

*Source: IMF staff estimates (extract from _cr06345 - 17. The analysis in this paper suggests that price competitiveness is broadly appropriate at present, but structural factors are major impediments to future improvements.).*

### References

### _cr06345 - References

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- Garcia Pascual, Antonio, 2003, “Assessing the Equilibrium Real Effective Exchange Rate: The Case of Bolivia,” mimeo, IMF.
- Isard, Peter, Hamid Faruqee, Russell Kincaid, and Martin Fetherston, 2001, “Methodology for Current Account and Exchange Rate Assessments,” Occasional Paper 209 (Washington: International Monetary Fund).
- Lane, Philip and Gian Maria Milesi-Ferretti, 2000, “The Transfer Problem Revisited: Net Foreign Assets and Real Exchange Rates,” Working Paper 00/12 (Washington: International Monetary Fund).
- Lane, Philip and Gian Maria Milesi-Ferretti, 2006, “The External Wealth of Nations Mark II: Revised and Extended estimations of Net Foreign Assets and Liabilities 1970-2004,” Working Paper 06/69 (Washington: International Monetary Fund).
- MacDonald, Ronald and Luca Ricci, 2003, “Estimation of the Equilibrium Exchange Rate for South Africa,” Working Paper 03/44 (Washington: International Monetary Fund).
- MacDonald, Ronald and Jerome Stein, 1999, Equilibrium Exchange Rates, Boston, MA; Kluwer Academics.
- Pavia, Claudio, 2001, “Competitiveness and the Equilibrium Exchange Rate in Costa Rica,” Working Paper 01/23 (Washington: International Monetary Fund).

### II. Economic growth in FYR Macedonia: Performance and prospects — Key findings and analysis

#### A. Introduction
- Macroeconomic stability has been a notable achievement for FYR Macedonia since transition, but growth performance has been poor.
- Determinants of long-run growth highlighted: macroeconomic stability and strong institutions.
- A determined reform effort could bring medium-term output growth in Macedonia to 5-6 percent per annum.

#### B. Historical growth performance: sources of growth
- FYR Macedonia: output trough defined as 1996 for the post-transition analysis due to employment data concerns in 1995.
- By 2005, output was only 4 percent above its 1991 level.
- Output growth from trough to 2005:
  - Averaged 2.2 percent per annum.
  - Averaged 2.9 percent per annum excluding 2001.
- Growth accounting framework used: Cobb-Douglas technology with output Yt as function of Kt, Ht, Lt, and At where α and β represent elasticities with 0<α+β<1. Growth decomposition:
  - gY,t = gA,t + α gK,t + β gH,t + (1−α−β) gL,t.
- Assumptions for capital stock: capital stock at output trough assumed twice the level of GDP; depreciation rate assumed 8 percent per annum.

#### C. Sources of growth — empirical findings
- Capital accumulation:
  - Contribution of capital accumulation to FYR Macedonia’s growth over the last decade: 0.4 percentage points.
  - Average contribution of capital for closest peers: 1.6 percent.
  - In recent years, private capital accumulation in Macedonia has been less than 20 percent of output, the lowest in the region.
  - Possible reasons: uncertain property rights, high real interest rates, institutional shortcomings.
- Employment (labor input):
  - Employment growth contributed only a small amount to economic growth, despite high unemployment—indicating scope for employment-led growth once institutional and labor market reforms occur.
- Total Factor Productivity (TFP):
  - Between 1996 and 2000, TFP contributed an estimated 84 percent of Macedonia’s output growth.
  - For 1996–2005, TFP contributed 80 percent of output growth.
  - Average TFP growth in Macedonia is below regional experience since the end of the transitional recession.
  - TFP contributed about 2 percent on average in Macedonia versus about 4 percent in close peers Croatia and Bulgaria.
  - Dynamics: TFP tends to be more important at the beginning of the recovery; Macedonia’s TFP dynamics broadly in line with peers though the 2001 security crisis was a setback.
- Investment to GDP ratios:
  - Regional series (years from output trough) indicate Macedonia’s investment-to-GDP ratios are low relative to peers (chart description retained in source).

#### D. Synthesis of historical performance — summary bullets
- Private sector capital accumulation has been the lowest in the region; boosting private investment is crucial for medium-term growth.
- Employment growth has not been an important source of growth; raising employment is important given high unemployment.
- Total factor productivity growth has been poor and is the key driver for improving Macedonia’s growth performance.

#### E. Growth prospects — panel regression analysis and projections
- Data and methodology:
  - Panel of countries uses data from 1981 to 2004 divided into 3 equal subperiods.
  - Basic panel regression specification:
    - g_i,t = α + β y_{i,t-1} + γ NEO_{i,t} + δ INST_{i,t} + χ MACRO_{i,t}.
    - g_i,t is average per capita real economic growth; y_{i,t-1} initial output per capita; NEO includes variables implied by neoclassical model; INST are institutional factors; MACRO are macroeconomic indicators.
  - Focus is on relative influence of institutions (δ) and macroeconomic policy (χ) on long-run growth.
- Institutional quality measurement:
  - ICRG index (0–100; higher is better) and World Bank Governance Indicators (approximately -2.5 to +2.5; higher is better) are closely related.
  - Scatter regression reported: y = 12.847x + 65.745, R^2 = 0.8276 (relating World Bank Governance Indicator to ICRG index).
- Regression results (summary conclusions from analysis):
  - Growth is higher the lower is the initial GDP per capita (conditional convergence).
  - Greater capital accumulation or lower population growth raise economic growth.
  - Influence of increasing investment is non-linear with diminishing returns: raising capital accumulation from 22 to 25 percent of GDP is associated with increased growth (text truncated in source at that point).
- Robustness and specification notes:
  - A number of specifications were considered; variables included only if statistically significant and results reported in Table 2 (table not reproduced here).
  - Both regressions are OLS.
  - Human capital was included in some specifications but dropped when ICRG index was included.
  - Possible endogeneity of institutional quality noted; instruments similar to Zalduendo and Batista (2004) do not significantly change results.

#### F. Policy implications (implicit from analysis)
- Strengthen institutions to raise long-run growth: institutional quality plays a vital role in driving economic growth.
- Raise private investment: increase capital accumulation from current low levels (private investment <20 percent of output) to levels closer to peers to support factor accumulation-driven growth.
- Implement labor market and institutional reforms to reduce unemployment and allow employment growth to contribute to output growth.
- Recognize complementarities between investment and TFP: policies that encourage investment may also raise productivity through learning-by-doing and organizational improvements.

*Italic: Source — _cr06345 - References; extracted pages on “Economic growth in FYR Macedonia: Performance and Prospects” from the provided PDF.*

### 0.7 percentage points.

### _cr06345 - 0.7 percentage points.

### Growth determinants and empirical magnitudes
- Government deficits and inflation are associated with reduced economic growth; financial sector development with greater economic growth. The estimated size of their influence on economic growth is small:
  - reducing the central government deficit by one percentage point raises economic growth by less than 0.1 percentage points;
  - reducing inflation has a minute influence on economic growth;
  - raising the level of financial intermediation by 10 percent of GDP (the broad money ratio from 0.5 to 0.6 say) will increase economic growth by slightly more than 0.1 percentage points.
- Institutional quality is a strong predictor of economic growth:
  - The ICRG index ranges from 0 to 100. A country increasing its institutional quality from 40 to 50 as measured by this index might expect long term growth to be higher by up to 0.8 percentage points.
  - Note: alternative estimates and endogeneity corrections suggest smaller effects—Zalduendo and Batista (2004) suggest 0.3 percentage points for an equivalent improvement; another study reports 0.5 percentage points—so the 0.8 percentage points figure should be regarded as an upper bound.

### Table 2: Estimating Medium-Term Growth in Macedonia (selected coefficients and stats)
- Dependent variable: Real per capita growth (based on growth experience of 67 countries, and 8 year periods for 1981-2004)
- Coefficients (significance: ** = 1 percent, * = 5 percent):
  - Log initial GDP per capita β: -0.40 * , -0.83 *
  - Log capital accumulation γ0: 4.59 *, 5.38 *
  - Log population growth γ1: -4.65 *, -4.76 *
  - Government balance δ0: 7.98 *, 7.20 *
  - Inflation δ1: -0.0002 **, -0.0001 **
  - Broad money share in GDP δ2: 1.37 **, 1.37 **
  - Institutions χ: ...0.08 **
- Adjusted R2: 0.38, 0.42
- Possible Macedonia growth (in percent): 3 to 4, 3 to 6
- Sources: IFS; WEO; International Country Risk Guide; and Penn World Tables.

### Scenario estimates for FYR Macedonia’s potential growth
- Baseline numerical substitution (examples used in the regression):
  - initial GDP per capita: 6000 US dollars;
  - ratio of capital accumulation to GDP: 0.22;
  - population growth: 0.5 percent;
  - government balance: -0.6 as a percent of GDP;
  - inflation: 2 percent;
  - ratio of broad money to GDP: 0.5;
  - institutional quality indicator: about 50.
  - Resulting growth rate: about 3 percent.
- Policy/scenario effects on growth:
  - Raising capital accumulation by 3 percentage points is associated with increased real growth of about 0.7 percentage points.
  - Continued broad money expansion from a ratio to GDP of 0.5 to 0.75 would be consistent with an increase in real growth of 0.3 percentage points.
  - Combining the above suggests annual GDP growth of close to 4 percent.
  - Improving institutional performance from 50 to 70 might be associated with an increase in growth to the 5-6 percent range.
- Caveats noted in the source:
  - Important nonlinearities are overlooked (e.g., increasing inflation or deficits may have greater than proportional effects on growth).
  - Possible influence of fiscal crises on output and growth is not considered.

### Institutional quality in FYR Macedonia: indicators and implications
- World Bank Governance Indicators:
  - FYR Macedonia receives low ratings on most indicators; these indicators have changed little since 1996.
  - In regional perspective, FYR Macedonia routinely measures poorly against peers.
- Corruption Perceptions Index (Transparency International), 2005:
  - FYR Macedonia ranked 103rd out of 159 countries (joint with Gambia, Swaziland and Yemen). Regional comparisons: Albania ranked 126th; Bulgaria ranked 55th.
- UNDP Early Warning Indicators (January 2006):
  - Local institutions are not trusted: over 90 percent of respondents indicate they consider corruption, misuse of public funds or abuse of power to be common amongst the judiciary and in ministries.
- Identified institutional weaknesses and priority reforms:
  - Distrust of the judiciary suggests poor property rights; continued judicial reform is recommended to improve confidence and reduce case backlogs.
  - More transparency in public office and government action is recommended; naming and shaming those attempting bribes in government procurement and sales of government property is suggested to signal less tolerance of corrupt behavior.
  - Clarifying property rights through completion of the cadastre is crucial to provide collateral, improve confidence, and raise investment.
  - Ensuring fair punishment for those successfully prosecuted on charges of corruption would act as a deterrent; concern noted about recent cases where those jailed for corruption were able to substitute a prison sentence with a fine.

### Conclusion on growth prospects
- Historical perspective and regional context explain low growth performance: investment has lagged the region and TFP has been poor.
- Encouraging local private investment and FDI and improving productivity will require confidence in the rule of law and institutional setting.
- Macroeconomic stability (low inflation, controlled government deficit) raises economic growth but its influence is minor compared with institutional strength.
- Sustained institutional reform—also relevant for preparation for possible EU accession—could help raise growth to between 5 and 6 percent.

### Unemployment in FYR Macedonia: overview and measurement
- Official unemployment rate: around 37 percent in 2005 (the highest in the region).
- Historical context:
  - Unemployment rate was close to 20 percent among former Yugoslav republics pre-transition, rose to around 35 percent during transition, and despite some employment pickup in 2005 the unemployment rate remained stable due to increased labor force participation.
- Alternative data sources and estimated unemployment ranges:
  - Official Labor Force Survey (LFS): official unemployment rate 37 percent.
  - Employment Fund (EF) registered unemployment: 51 percent (inflated by grey economy workers registering to obtain free health insurance).
  - Correcting LFS and EF for grey economy activity using Schneider (2005) estimate of around 37 percent for FYR Macedonia:
    - LFS and EF unemployment rates would drop to 15 and 34 percent respectively (assuming unemployment is reduced by 37 percent of formal employment to include grey economy activity).
  - EF data excluding recipients of health insurance only: 15 percent.
  - Household consumer survey (HCS) extrapolation (adjusting for unpaid family workers ~10 percent of employed): unemployment rate around 24 percent.
  - With estimates ranging between 15 and 51 percent, the most reliable estimate is argued to be around 25 percent (HCS preferred as least affected by incentives to register as unemployed for health benefits).
- Notes on institutional incentives and measurement bias:
  - Many registered unemployed receive only health insurance (not unemployment benefit), suggesting some are actually employed in the grey economy.
  - Some youth do not qualify for unemployment insurance due to no contribution history, complicating EF-based corrections.

### Labor market structure and drivers of high unemployment
- Labor market characteristics:
  - Sclerotic insider-outsider problem with very low flows from unemployment to employment and very high long-term unemployment rates.
  - Labor market mobility increased in 2005 mainly due to inflow of non-active workers into employment while long-term unemployment continued to increase.
  - Youth unemployment very high: about 65 percent for labor force aged 15 to 24.
- Demographic and skill patterns:
  - Average unemployment higher for women (around 38 percent) than men (around 35 percent); gender gap largest for low skilled labor.
  - Participation rate low compared to region but when corrected for low participation among ethnic Albanian women, participation is quite high for the region.
  - Unemployment differs significantly among ethnicities; regional mobility may be constrained by ethnic factors.
  - Higher education correlates with lower unemployment and higher participation; low skilled workers rely more on grey economy employment.
- Hidden unemployment indicators:
  - Significant hidden unemployment within firms reflected in high wage arrears (around 15 percent of total wages), relatively stable over recent years.

### Policy implications and reform directions (as identified in the source)
- For growth:
  - Raise capital accumulation (investment) to increase growth (3 percentage point rise in capital accumulation → about 0.7 percentage point higher real growth).
  - Continue financial deepening (broad money ratio increases) to support modest growth gains.
  - Prioritize institutional reforms—judicial reform, property rights clarification (completion of cadastre), transparency measures, and effective prosecution/punishment for corruption—to achieve larger increases in growth (potentially to 5-6 percent with substantial improvement).
- For unemployment:
  - Increase incentives for formal sector employment.
  - Consider changes in labor and tax legislation.
  - Reform the education system to reduce skill mismatches and raise employability.
  - Recognize that reducing unemployment is a long-run challenge given hidden unemployment and large share of long-term unemployed.

*Source: _cr06345 - 0.7 percentage points.*

### 8. FYR Macedonia’s low growth has limited the creation of new jobs to offset job

### 8. FYR Macedonia’s low growth has limited the creation of new jobs to offset job

### Causes of low growth and employment outcomes
- Political shocks and trade disruptions cited as reasons: closure of the Greek border, trade restrictions from the UN embargo on Serbia, and the Kosovo crisis.
- Structural starting conditions: economy dependent on a few traditional sectors—agriculture, steel, and textiles.
- Institutional weaknesses hampered investment and growth (see Chapter II).
- Low foreign direct investment (FDI) linked to insider/employee buyouts in privatization, limiting productivity and employment creation.

### Labor force participation and unemployment dynamics
- Participation rate has been remarkably stable at around 57 percent.
- In many other transition countries participation rates trended downward as employment fell; in FYR Macedonia the increase in unemployment was smaller than employment loss because participation remained stable.
- Possible explanations for resilient participation:
  - Low GDP growth did not allow for retiring from the workforce.
  - Free health insurance created an incentive to register as part of the labor force.

### Corporate structure, privatization, and SMEs
- Management and employee buyouts dominated privatization, limiting FDI and reducing company performance (Djankov, Murrell, 2002).
- Empirical findings:
  - Privatization to workers associated with declining productivity and low profits (Zalduendo (2003)).
  - Employment creation highest in newly created foreign-owned companies.
- SMEs:
  - Newly created SMEs show the strongest employment dynamic (World Bank (2003)).
  - Number of SMEs per capita in FYR Macedonia is in the middle range regionally, but limited access to financing constrains growth.

### Grey economy and judiciary
- Grey economy estimated at around one third to almost one half of the formal sector.
- Consequences of large grey economy:
  - Wage costs depend on ability to hide activities.
  - Loss of tax revenues reduces quality of public services, increases susceptibility to bribes, and pressures higher tax burdens on formal sector.
- Major cause of informality: poor judiciary and weak enforcement.
  - UNDP surveys indicate the judicial sector is the least trusted institution.
  - Government prepared comprehensive judicial reform (constitutional and legal changes in 2005); implementation only just started.

### Labor market regulation, benefits, and active policies
- 2005 labor market reform:
  - Liberalized fixed-term employment rules and streamlined layoff procedures.
  - Eased conditions for part-time employment, but minimum social contribution based on average full–time monthly sectoral wage discriminates against part-time work.
  - Official part-time employment around 5 percent in FYR Macedonia vs 9 percent in Croatia.
  - Government committed to reducing onerous minimum contributions over time; administrative conditions for doing so not expected to be in place before end-2007.
- Unemployment benefits and health insurance:
  - Unemployment benefits duration is somewhat longer than regional average.
  - After entitlement expires, unemployment fund pays for health insurance; alternatively low-income people can apply for social allowances that include health insurance.
  - Free health care for the registered unemployed discourages formal employment.
- Active labor market policies:
  - “Branko’s Law”: lump-sum wage subsidy of around 70 euros per month paid over 24 months; spending equivalent to more than ½ percent of GDP.
  - Such subsidies likely suffer from deadweight and substitution effects; limited evidence of long-term impact.
  - Employment Fund has limited capacity for job counseling and training; public works program started with UNDP coordination but has received little interest.
  - Public works programs can provide minimum income to long-term unemployed and serve as screening instruments for unemployment and health insurance eligibility.

### Wage costs, taxation, and competitiveness
- Despite high unemployment, wage costs (gross wages plus employers’ social contribution) are among the highest in the region except for Slovenia and Croatia.
- Possible explanations: relatively high tax wedge and strong position of trade unions in the formal sector.
- Planned fiscal/tax measures:
  - A reduction in the tax wedge could be financed by an increase in the VAT rate (VAT somewhat lower than in other countries in the region).
  - Planned merger of PIT and social contributions by 2008 to reduce administrative burden and free resources for enforcement and audit.
  - Abolishing the minimum social contribution is a precondition for shifting part-time employment out of informality.

### Education and demographics
- Education system is very weak compared to regional peers:
  - Lower tertiary enrollment ratios.
  - Test scores below other countries of similar income levels; some test scores show deterioration since the late-1990s.
  - Secondary education does not provide skills needed by the labor market (Mojsoska-Blazevski (2006)).
- Demographics:
  - Population growth faster than most countries in the region despite significant emigration.
  - Between 1996 and 2005, increase in population slightly exceeded labor force growth.
  - In absolute terms, increase in the labor force roughly equal to increase in number of unemployed.
  - FYR Macedonia: Labor market developments, 1996-2005 (in thousands/in percent) — Working age population17212; Labor force8010; Employed81; Unemployed7229. (As migration data is poor, results need cautious interpretation.)

### Policy recommendations to reduce unemployment
- Priority: Enhance sustained GDP growth to create long-term employment; natural unemployment rate likely to remain high medium-term given long-term and unskilled unemployment and hidden unemployment.
- Create incentives for formal sector activity:
  - Implement judicial reform and reallocate staff/resources to build efficient judicial institutions.
  - Finance reduction in tax wedge by increasing VAT to capture part of grey economy sales.
  - Merge PIT and social contributions by 2008 to simplify collection and free resources for enforcement; this is also precondition to abolish the minimum social contribution.
  - Strengthen audit and inspection activities, including labor inspectorate, and improve governance to reduce corruption within inspections.
  - Accelerate reduction of red-tape (e.g., abolish numerous licenses); SMEs particularly benefit.
- Reassess subsidies and investment incentives:
  - Abolish investment schemes that erode corporate income tax base and create room for tax evasion.
  - Current subsidized land practices are non-transparent, fiscally costly, and play only minor role in attracting investment.
- Labor market institutional adjustments:
  - Delink health insurance provision to the unemployed from registration status:
    - Option A: Replace insurance-based system with basic health care for all financed by tax revenues (would reduce tax wedge and free Employment Fund resources).
    - Option B: Retain insurance-based system but limit free health insurance after unemployment benefit expiry to low-income households.
  - Use public works programs to screen unemployed from grey economy workers and as eligibility screening for unemployment benefits.
  - Consider moderate reduction in duration of unemployment insurance benefits, or gradual reduction of benefits over duration; supplement with reform of social allowances so unemployed below certain income receive basic benefits.
- Education strategy:
  - Develop a comprehensive strategy to enhance education quality and provide incentives for training.
  - Prioritize improving school system quality and training for a small, land-locked country with few natural resources.
  - Use ongoing World Bank Public Expenditure Review to identify education system weaknesses and develop a reform strategy.

### Conclusion
- Multiple factors underlie FYR Macedonia’s high unemployment: low growth, structural transition problems, institutional weaknesses, large grey economy, weak judiciary, education deficiencies, wage cost/tax wedge issues, and demographic pressures.
- Reducing unemployment requires broad-based policies: pro-growth measures, incentives for formal economy activity, and strengthening labor market institutions.
- Positive steps already taken include moderate growth recovery since 2004, 2005 labor market reform, and measures to free resources for targeted active labor market policy.
- Areas needing further attention: education system reform, addressing high wage costs, and better coordination of unemployment benefits with the social system.

*Source: _cr06345 - 8. FYR Macedonia’s low growth has limited the creation of new jobs to offset job*

### REFERENCES

### _cr06345 - REFERENCES

### References
- Dabla-Norris, Era et al., 2005, “What Causes Firms to Hide Output? The Determinants of Informality,” Working Paper No. 05/160 (Washington: International Monetary Fund).
- Djankov, Simeon and Murrell, Peter, 2002, “Enterprise Restructuring in Transition: A Quantitative Survey,” in Journal of Economic Literature, Vol. XL, September 2002.
- Martin, John and David Grubb, 2001, “What Works and for Whom: A Review of OECD Countries’ Experiences with Active Labor Market Policy,” IFAU Working Paper 14.
- Lehmann, Hartmut, 1995, “Active Labor Market Policies in the OECD and Selected Transition Economies,” Policy Research Working Paper 1502 (Washington: The World Bank).
- Mojsoska-Blazevski, Nikica, 2006, “Unemployment in Macedonia: Improving the Efficiency of Job-Matching Through the Reform of the Public Employment and Education Systems,” (mimeo).
- Rutkowski, Jan, 2005, “Enhancing Job Opportunities: Eastern Europe and the Former Soviet Union,” (Washington: The World Bank).
- Verme, Paulo, 2004, “Constraints to Growth and Job Creation in Low Income CIS Countries,” (Washington: The World Bank).
- World Bank, 2003, “FYR Macedonia Country Economic Memorandum: Tackling Unemployment” (Washington: The World Bank).

### IV. Financial Intermediation in FYR Macedonia — Summary of Conclusions and Policy Recommendations
- Prepared by Kevin Ross and Alessandro Giustiniani.
- Core premise:
  - There is considerable evidence that low levels of financial intermediation are an obstacle to economic growth.25
  - Financial intermediation is essential to private sector development and affects savings and investment behavior.
- Financial deepening:
  - FYR Macedonia does not compare favorably with other countries in the region; ratios of broad money, private sector credit and bank capital to GDP remain below the CEEC average (Figure 1).
- Interest rate spreads and lending rates:
  - Ex-ante lending-deposit interest rate spread remains around 2 percentage points above OECD levels.
  - Advertised retail lending rates have averaged about 20 percent over the last decade.
- Analytical approach:
  - The chapter examines financial, institutional and legal framework characteristics; performs an accounting decomposition of interest rate spreads for the system and subsets of banks; and estimates panel regressions of individual bank lending rates, spreads, and credit growth.
- Preliminary conclusions (selected):
  - Persistent weakness in banks’ balance sheets, the legal environment, credit discipline and implementation of the legal framework underlie low financial intermediation.
  - Improvements in banking sector competition and efficiency are slow; high operating costs and a heavy, albeit falling, burden of inherited non-performing loans (NPLs) continue to prop up interest rates and spreads.
  - Corporate taxes, reserve requirements on banking deposits, and deposit insurance do not appear to have substantially retarded financial intermediation.
  - As banks have grown and gained economies of scale, they tend to lower interest rates and spreads.
  - Although banks appear, on average, well capitalized and liquid, this does not seem to have affected lending rates.
- Policy recommendations (implications drawn from conclusions):
  - Allow banks to grow and rationalize overhead costs—e.g., through mergers and acquisitions and/or foreign entry—to help reduce lending rates and spreads, while guarding against abuse of dominant positions since larger market share can allow higher lending rates and spreads.
  - Enhance credit information sharing, banks’ risk management policies, and prudential supervision to address the explanatory power of NPLs.

### B. A Few Stylized Facts of the Banking System
- Market structure and competition:
  - FYR Macedonia has 20 banks and 14 saving houses—one of the highest numbers of credit institutions relative to population in the region.
  - Market concentration indicators (Herfindahl-Hirschman Index (HHI) and share of total bank assets held by the five largest institutions) suggest the banking market is somewhat more concentrated than in other CEECs.
  - Panzar-Rosse H-statistics suggest a relatively low level of competition; results for FYR Macedonia tended to be negative and significantly different from zero, though not fully conclusive due to model instability.
- Foreign bank presence:
  - Around 48 percent of total assets are controlled by foreign majority owned banks, primarily from neighboring countries.
  - Limited presence of first-tier international banks; transfer of know-how and best practices from abroad has been slow.
  - Signs in 2006 of renewed interest in mergers and acquisitions and foreign purchases of existing banks.
- Non-performing loans and non-earning assets:
  - As of end-2005, banks’ NPLs amounted to around 18 percent of total loans and some 97 percent of them were provisioned.
  - Foreclosed assets average 20 percent of banks’ own resources; for 5 banks foreclosed assets are well above 50 percent.
  - In 2005, share of non-earning assets (foreclosed and fixed assets) ranged between 1.5 and almost 50 percent of banks’ total assets, with an average close to 8 percent.
- Productivity and profitability:
  - Deposits and assets per employee are below the regional average—indicating low banking sector productivity.
  - Between 2000 and 2005, number of banks declined from 23 to 20, while employment increased by more than 20 percent.
  - Profitability ratios (return on assets and return on equity) have improved but remain below regional averages.
- Liquidity and asset allocation:
  - Aggregate banking system has been in a position of structural liquidity surplus since 2001.
  - Under the pegged exchange rate regime, surplus liquidity is removed through issuance of central bank bills at relatively high interest rates, which compete with loan placements to consumers and enterprises.
- Special bank types:
  - Several small banks function as “pocket banks” for enterprise groups or individuals, used for treasury operations, cheap liquidity, and equity investment.

### C. The Institutional and Legal Framework
- Reform and transparency scorecard (Table 2 highlights):
  - Macedonia’s scores:
    - Banking sector reform: 2.7
    - Non-bank financial institutions: 2.0
    - Secured transactions law: Some defects
    - Quality of insolvency regime: Medium
    - Implementation gap: -21
    - Transparency (score): 2.7
    - Transparency (rank): 103
  - Average CEEC values for comparison:
    - Banking sector reform: 3.4
    - Non-bank financial institutions: 2.7
    - Secured transactions law: Some defects
    - Quality of insolvency regime: Medium
    - Implementation gap: -16
    - Transparency (score): 4.0
    - Transparency (rank): 64
- Key institutional weaknesses affecting intermediation:
  - Deficiencies in bank and non-bank sector reform indicate significant gaps in meeting BIS standards in bank lending and supervision, and IOSCO standards in securities laws and regulations.
  - Secured transactions and collateral framework:
    - The secured transactions system falls short of requirements for a modern market for secured credit.
    - Time for enforcement, lack of simplicity, weakness of courts, corruption, complexity and cost of registration are major drawbacks.
    - Amendments to the collateral law in early 2005 made some improvement, but banks report more work is needed.
  - Insolvency regime and implementation:
    - Insolvency legislation (2004 survey) is in only average compliance with OECD best practices.
    - A new Bankruptcy Law passed in late-2005 introduces improvements: strict timelines, defined jurisdictions between trustees, creditors and judges, strengthened trustee training and accreditation, and procedural safeguards.
    - Implementation capacity remains weak—the implementation gap remains high—limiting positive effects on credit culture and financial intermediation.

### D. Interest Rate Spread Decompositions
- The chapter proceeds to undertake accounting decompositions of interest rate spreads for the system and subsets of banks and to estimate panel regressions of individual bank lending rates, spreads, and credit growth (text of decompositions and regression results follows in subsequent sections).

*IMF staff document: _cr06345 - REFERENCES*

### 15. The various cost and non-interest income factors determining interest rate

### 15. The various cost and non-interest income factors determining interest rate spreads

### Accounting decomposition and key identity
- Interest rate spread (Li − Di) is decomposed from bank income and balance sheet items into components measured relative to deposits (D):
  - Components: reserve requirements (rr), profit margin (RoA), overhead/operational costs (oc), provisions (prov), taxes (tax), deposit insurance (d), non-interest income (nii), and a residual (e) reflecting flow/stock errors.
- Algebraic identity (as presented):
  eniidtaxprovocprrii
  DL
  +−+++++≡−
- Appendix derivation (expressed in words):
  - Profit before taxes (P) = interest income (II) + non-interest income (NII) − interest expense (IP) − operating cost (OC) − provisions for loan losses (Prov) − taxes (Tax) − deposit insurance (DI).
  - Dividing by deposits (D) and substituting average loans (L) and assets (A) produces the spread expression including RoA and the residual e.
- Interpretation: spreads increase with higher costs (reserve requirements, operations, provisions, taxes, deposit insurance) and profits, and decrease with higher non-interest income.

### Data quality and measurement issues
- Effective interest rate data are used (ex-post from income and balance sheet), but data quality can affect decompositions:
  - Difficulty identifying true interest-bearing assets and liabilities.
  - Accrual accounting and periods with negative interest revenues (to reflect unrecoverable accrued interest on NPLs) create timing inconsistencies.
  - Recapitalization of a major bank in 2001 contributed to large residuals in decompositions.
- Recommendation implicit in text: improve accounting practices (for example, move to IFRS) to increase transparency and accuracy.

### Decomposition results (2001–05) — main findings
- Aggregate/system-wide patterns:
  - Operational costs have been the main driver of interest rate spreads across bank groups.
  - For the banking system as a whole in 2005, overhead costs added about 5.9 percentage points to a spread of 6.0 percent.
  - Provisions added between 2 to 3 percentage points to spreads, reflecting high NPLs.
  - Non-interest income reduced spreads substantially — by about 6 to 8 percentage points — often associated with extraordinary transactions.
  - Profit margins, taxes, deposit insurance, and reserve requirements added relatively little to spreads.
- Heterogeneity across bank groups:
  - Interest rate spreads have declined for the 3 largest banks and for majority foreign owned banks; smaller and domestically owned banks saw increases in effective spreads.
  - The 3 largest banks made the greatest headway in reducing operational costs over time.
  - Little difference in the impact of operational costs on spreads between foreign and domestically owned banks.
  - Smaller and domestically owned banks tended to rely more heavily on non-interest income and enjoyed higher profit margins, possibly due to limited competition.
- Specific numeric examples cited in text:
  - In 2005 the system spread was 6.03 percent and overhead costs accounted for about 5.89 percentage points of that spread.
  - Non-interest income reduced spreads by about 6 to 8 percentage points.

### Panel regressions on spreads, lending rates and credit growth — specification
- Data and period:
  - Quarterly panel of 20 Macedonian banks covering 1997Q4 to 2005Q4.
- Dependent variables: lending rates, interest spreads, private sector credit growth.
- Bank-specific explanatory variables:
  - log of banks’ total assets (size), market share, non-performing loans over total loans (NPLs), liquid bank assets over total assets (liquidity ratio), capital adequacy ratio, and an ownership dummy (foreign vs domestic).
- Macroeconomic controls:
  - Money market interest rate, industrial production.
- Estimation method:
  - Feasible generalized least squares correcting for cross-section heteroskedasticity; standard errors robust to general heteroskedasticity.
- Models include autoregressive errors (AR(1)).

### Panel regression key quantitative results and interpretation
- Model fit:
  - R-squared statistics indicate that approximately 70 to 90 percent of individual bank variability in lending rates, interest spreads, and credit growth can be explained by the included factors.
  - Reported R-square weighted: 0.89 (Lending Rate), 0.80 (Lending Deposit Rate), 0.68 (Private Sector Credit Growth).
  - R-square unweighted: 0.53, 0.49, 0.74 respectively.
  - Number of observations: 572, 571, 477 respectively.
- Selected estimated coefficients (estimated coefficient with reported significance):
  - Log (Total Assets): -3.22* (Lending Rate); -2.03*** (Deposit Rate); -10.45 (Credit Growth).
    - Interpretation example: if a bank’s balance sheet doubles, the estimate suggests the lending rate declines by more than 2 percentage points and the spread narrows by about 1.5 percentage points (derived as 0.69 times the coefficient).
  - Market Share: 0.30** (Lending Rate); 0.20*** (Deposit Rate); 0.78 (Credit Growth).
    - Interpretation: spreads and lending rates increase by about 0.2 to 0.3 percentage points for every percentage point increase in market share.
  - NPLs in Total Loans: 0.21* (Lending Rate); 0.22* (Deposit Rate); -1.28* (Credit Growth).
    - Interpretation: spreads and lending rates rise by about 0.25 percentage point for every percentage point increase in NPL ratio; higher NPLs reduce credit growth.
  - Liquidity Ratio: 0.03 (Lending Rate); 0.07 (Deposit Rate); -0.04 (Credit Growth) — not statistically significant.
  - Capital Adequacy: 0.03 (Lending Rate); -0.24 (Deposit Rate); -0.24 (Credit Growth) — not statistically significant.
  - Foreign Bank dummy: -0.47 (Lending Rate); -0.14 (Deposit Rate); 6.74 (Credit Growth) — not statistically significant.
  - Money Market Interest Rate: 0.17* (Lending Rate); 0.13** (Deposit Rate); -0.82*** (Credit Growth).
  - Industrial Production: 0.02* (Lending Rate); 0.02* (Deposit Rate); -0.07 (Credit Growth).
  - AR(1): 0.79* (Lending Rate); 0.78* (Deposit Rate); 0.75* (Credit Growth).
  - Constants: 53.54* (Lending Rate); 33.88*** (Deposit Rate); 21.75*** (Credit Growth).
  - Note: significance legend — * Significant at 1 percent level; ** Significant at 5 percent level; *** Significant at 10 percent level.
- Behavioral and policy-relevant inferences:
  - Larger banks have lower lending rates and spreads, reflecting economies of scale.
  - Increased market share (controlling for size) is associated with higher spreads and lending rates, suggesting market power effects.
  - Higher NPL ratios increase spreads and lending rates and reduce credit growth.
  - Foreign ownership does not appear to have a statistically significant impact on spreads, lending rates, or credit provision in these regressions.
  - Liquidity and capital adequacy ratios do not have statistically significant impacts on spreads, lending rates, or credit provision—possibly reflecting that high liquidity and solvency reflect limited intermediation rather than profitability or new capital.
  - Monetary policy transmission appears to work: money market rates significantly affect lending rates and spreads; industrial production affects lending rates and spreads.

### Policy implications and recommendations (as implied by findings)
- Reduce operational (overhead) costs to materially lower interest rate spreads, since operational costs are the dominant contributor to spreads.
- Address asset quality and NPLs to reduce provisioning costs that add between 2 to 3 percentage points to spreads.
- Enhance sustainable non-interest income sources while monitoring extraordinary transactions that temporarily reduce spreads by about 6 to 8 percentage points.
- Improve accounting and reporting standards (move toward IFRS) to reduce measurement errors and residuals in decompositions and improve transparency.
- Monitor market structure: market share gains can raise spreads; competition policy and entry may be important to limit market power effects.
- Maintain effective monetary policy, as money market rate changes transmit to lending rates and credit growth.

*Source: Author’s calculations from income statement and balance sheet data of the Macedonian banking system (as presented in the chapter “15. The various cost and non-interest income factors determining interest rate spreads”).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06345.pdf_