## _cr10232

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### Fiscal consolidation, strategy, and implementation
- Budget consolidation is the cornerstone of the IMF-supported program (2010–2012) with protection for public investment and essential social spending.
- Key policy framing:
  - Short-term: implement expenditure rationalization (government wages, goods and services, transfers) and revenue-enhancing measures to broaden the tax base, reduce exemptions, and improve tax administration.
  - Protect: vital public investment and well-targeted social benefits.
  - Medium-term: complement short-term measures with structural reforms in public sector wages and employment, education, pension and health care, and revenue administration.
- Summary of adjustments sought:
  - (i) Rationalization of current primary spending and measures to increase efficiency and impact of public sector services through public administration reforms while meeting critical infrastructure needs and better targeting social spending.
  - (ii) Tax policy complemented by tax administration measures intended to broaden the tax bases and improve compliance.
  - (iii) Reforms to keep entitlements affordable and alleviate financing pressures on the social security system.
- Stylized fiscal facts and objectives:
  - The structural fiscal balance has considerably deteriorated; without adjustment, primary deficits would persist after the crisis wanes and the output gap closes.
  - More than 20 advanced and 30 emerging economies have achieved improvements in structural primary balances of at least 5 percent of GDP at least once in the last four decades.
  - Primary expenditures have increased by over 16 percent of GDP in the last decade.
  - Checklist for design and implementation emphasizes pace of adjustment, financing constraints, operational targets (structural vs annual balance), consolidated public sector coverage, and choice of high-quality permanent measures.

### Public administration, wage bill, goods and services, and education
- Public administration and wage system:
  - Public administration spending was 5.4 percent of GDP in 2009.
  - Short-term measures in 2009 included modifying and postponing unaffordable wage increases, keeping budgetary sector employment to efficient levels, elimination of permanent vacancies, and optimizing number of employees.
  - A new performance-based wage system for public sector employees is planned to be introduced in 2011.
  - Government objective: bring the wage bill below 10 percent relative to GDP by 2012-13 to protect critical current non-wage spending and public capital expense and approach CEEC average (~9 percent).
- Public sector wage bill statistics and features:
  - Public sector wage bill rose substantially in 2009 to close to 12 percent of GDP.
  - The public wage bill accounts for 26 percent of total general government expenditures.
  - The ratio of average public sector wage to GDP per capita surged from 1.2 to almost 1.7 between 2008 and 2009.
  - Public sector wages were 90 percent of private sector wages in 2009.
  - Public sector employment stood at 6.6 percent of population in 2009; proportion of public to overall employment is 21 percent.
- Goods and services:
  - Spending on goods and services reached 10.2 percent of GDP in 2009 (up from an average of 7.9 percent of GDP over 2001–08).
  - Authorities’ program calls for substantial reduction in allocations for low-priority goods and services and procurement and internal financial control reforms to be introduced by end-2010.
- Education sector:
  - Education spending rose to 9.5 percent of GDP in 2009 and roughly to 21 percent of total expenditures.
  - Education accounts for 62 percent of general government employment (excluding Social and Health Funds’ employees); public administration accounts for 21 percent.
  - Education employment per population: 4.1 percent in Moldova compared to 2.7 in CEEC.
  - Education wage bill in 2009: 6.1 percent of GDP; 13 percent of total general government expenditures; 52 percent of the total general government wage bill.
  - Structural deficiencies:
    - Number of students decreased by 27 percent in 2007–08 compared to 2002–03, while number of schools declined by about 3 percent.
    - Student/teacher ratio of 13 compared to a European norm of 18.
    - Non-teaching to teaching staff ratio average is 37 percent, above a European average of 27 percent.
  - World Bank proposals and pilots aim to tighten monitoring of education employment registry and accelerate school network optimization.
  - Fiscal impact estimates of education measures should be included in the Government’s MTEF.

### Capital spending, project planning, and social assistance
- Capital spending trends and targets:
  - Capital spending averaged about 16 percent of total government spending in 2000–08 or 6 percent of GDP, before falling to 11 and 5 percent respectively in 2009.
  - 2009 overall capital spending was revised down from over 7.5 percent of GDP in the 2009 Budget to 5 percent.
  - Medium-term policy target: bring the ratio back up to 7.5 percent of GDP beginning in 2012.
- Project planning and institutional issues:
  - Annual budget documentation contains detailed lists of projects, but institutional fragmentation exists (different units for donor-financed and budget-financed projects).
  - MOF division dealing with capital investment financing faces capacity constraints and lacks routine progress reports.
  - Recommended improvements: target project prioritization, monitoring and evaluation; establish a single unit to manage investment project planning; redirect monitoring toward routine progress in achieving project objectives.
- Roads and infrastructure:
  - Road maintenance budget in 2009 was well below minimum requirement.
  - Reform of road maintenance financing and increased funding were conditions for external partner financing.
  - Government mobilized external sources (including MCC) for road rehabilitation and maintenance.
- Social assistance reform:
  - Key reform objective: improve targeting by moving from a categorical system to a proxy means-tested scheme.
  - Ministry of Labor, Social Protection and Family aiming for a take up rate of at least 2/3 by end-2010.
  - Phasing out nominal compensation scheme intended to reduce leakages and free resources for poverty-targeted assistance.
  - Means-tested heating subsidies beyond 2010 would be consistent with the new scheme if fiscal neutrality is ensured by donor funds.

### Tax policy and tax administration
- Tax structure and policy findings:
  - Revenue performance looks reasonably sound; VAT yields are high, especially VAT on imports.
  - PIT and CIT perform below average.
  - Zero-rate on reinvested profits in 2008 reduced CIT revenues to 1.1 and 0.7 percent relative to GDP in 2008 and 2009 respectively.
- Program tax measures:
  - Increase excise rates on alcohol, cigarettes, and fuel in 2010 expected to yield about ½ percentage points of GDP on a permanent basis.
  - Reinstatement of the CIT from 2012 with a low single rate and a broad, uniform base is planned.
- Tax administration priorities and IMF TA (next 2–3 years):
  - Modernization of IT systems and STI organizational structure.
  - Improve taxpayer compliance and develop agency-level compliance strategy.
  - Establish a Risk Management Unit (RMU) to coordinate compliance strategy using modern risk management concepts.
  - Support compliance with audit programs, large taxpayer programs, arrears collection, and taxpayer services.
  - Garner donor support for IT reform and development of management tools for compliance risk management.
- Taxpayer and compliance issues:
  - Progress in tax administration reform slowed in 2009; STI weaknesses include weak audit and taxpayer services and lack of strategy to address major revenue risks.
  - Underreporting of wages for social security contribution purposes is noted.

### Pension system: fiscal and social sustainability, reforms, and scenarios
- Recent developments and risks:
  - Near 20 percent increase in pension expenditures in 2009 is alarming and increases state budget transfers sharply in percent of GDP in 2009 with further pressure projected in 2010.
  - Pension spending rose to 7.2 and 9.1 percent of GDP in 2008 and 2009 respectively (1999 level was 4.4 percent of GDP).
  - Pension system dependency ratio (pensioners per 100 insured persons): 2008: 59; projected 2050: 86.
  - Moldova’s average old-age pension at 26.4 (27.4) percent relative to gross wage (35.1, on a net basis) is below an ILO standard of 40 percent.
- Historical contributions, expenditures, and balances (percent of GDP):
  - Contributions 1/: 2004: 6.4; 2005: 6.6; 2006: 6.8; 2007: 6.8; 2008: 7.2; 2009: 7.8; 2010: 7.3
  - Expenditures: 2004: 5.9; 2005: 7.2; 2006: 7.0; 2007: 7.0; 2008: 7.2; 2009: 9.1; 2010: 8.9
  - Overall balance: 2004: 0.5; 2005: -0.5; 2006: -0.1; 2007: -0.2; 2008: 0.0; 2009: -1.3; 2010: -1.6
  - Pension expenditures relative to GDP (percent): 1999: 4.3; 2000: 5.2; 2001: 4.7; 2002: 5.5; 2003: 5.7; 2004: 6.2; 2005: 7.2; 2006: 7.3; 2007: 7.4; 2008: 7.2; 2009: 9.1
- Systemic weaknesses and compliance:
  - Benefits determined on declared wages rather than paid contributions, weakening compliance and creating incentives for underreporting.
  - Suspension of retirement age increases in 2003 and ad-hoc benefit increases threaten fiscal sustainability.
  - Average covered wage in 2008 stands at 75 percent of average wage (suggesting underreporting).
- Short-term policy priorities:
  - Strengthen contribution–benefit link, avoid contribution amnesties, improve enforcement of contributions, raise contribution levels for self-employed and farmers.
- Structural reform scenario (summary):
  - Valorization: 50–50 wage-price formula (50% wages, 50% inflation).
  - Accrual rate: reduce by 20 percent from Baseline (from 1.4% up to 30 years of service, 2% beyond 30 years to 1.12% up to 30 years, 1.6% beyond 30 years).
  - Retirement ages: increase from 62/57 years for men/women (Baseline) to 65/60 years for men/women (Reform Scenario) with legislative increases in 6-month increments.
  - Collection/coverage: assume baseline collection broadly unchanged, self-employed pay contributions based on average wage, farmers pay contributions based on 50% of average wage.
  - Expected outcomes: improved social sustainability and a sustainable financial balance relative to a baseline of deteriorating replacement rates; raising retirement age and higher compliance materially improve sustainability.
- Additional reform objectives:
  - Reestablish valorization of past earnings in the pension formula.
  - Redefine disability pensions in compliance with ILO definitions and reduce disability beneficiary share growth (currently close to 21 percent).
  - Eliminate privileged pension schemes and stop ad-hoc pension increases.
- Replacement rates (selected comparison):
  - Moldova: 44.9 (1995), 26.4 (2008)
  - Regional average: 40.4 (mid 1990s), 32.7 (mid 2000s)

### Banking sector, monetary policy transmission, and liquidity framework
- Banking sector stress and indicators:
  - Since September 2008, asset quality deteriorated quickly; over a sixth of bank loans were non-performing at end-April 2010.
  - By end-April 2010:
    - banks’ net interest margin widened to about 10 percentage points;
    - net credit to non-government at constant exchange rates declined by 16 percent.
  - Recent capital increases helped keep the average capital adequacy ratio at over 30 percent.
  - Required reserves represent about 6 percent of bank assets; NBM securities, overnight deposits at the NBM, and government bonds comprise about 16 percent of bank assets.
  - Quantitative sensitivities:
    - Reducing required reserve ratio by one percentage point would release about MDL 0.3 billion, or 0.8 percent of bank assets; if invested in loans, contribute to about 1½ percent credit growth.
    - A 100 basis point base rate change would affect bank profits by some MDL 4 million per month (~0.7 percentage point change in return on equity over one year), and a 100 basis point increase in loan rates (with inelastic demand) could raise return on equity by about 3 percentage points.
    - Conversion of additional FX assets accumulated since the crisis could provide some USD 200 million (over 4 percent of GDP); only about one half could be converted without breaching net FX open position limits.
- Monetary transmission evidence (VAR results and interpretation):
  - Base rate changes affect market rates with full effect passed through in 3–4 months; pass-through to lending rates is delayed.
  - Over 2003–08 the pass-through to lending rates is closer to 1 with a lag, but full-sample pass-through is relatively small.
  - Interest rate channel to GDP and inflation is inconclusive; replacing GDP with credit yields clearer responses: credit growth declines after interest rate increases (bottoming after four quarters); credit shocks raise inflation with peak after 4 quarters.
  - Exchange-rate-to-inflation pass-through is small and subject to statistical uncertainty given short samples.
- Policy and operational recommendations:
  - Improve liquidity framework and consider alternative FX market arrangements (explicit recommendation): "Alternative FX market arrangements, such as limited short-term FX swap lines with the NBM would help de-link monetary policy from exchange rate smoothing while also allowing banks to focus on their core business of lending with less concern about FX liquidity."
  - Strengthen debt-resolution instruments: speedy bankruptcy procedures, efficient collateral collection and disposition, quick out-of-court loan workout tools.
  - Encourage credit bureau development and better project appraisal tools.
  - Complement NBM strategy with communication, transparency, regular NBM bill auctions, increased presence in money markets, and emphasis on base rate as reference.
- Banking sector table excerpts (verbatim series):
  - Assets39.439.137.636.637.839.939.339.5
  - Cash1.81.91.71.82.12.22.12.2
  - Claims on NBM8.17.15.25.44.36.16.26.0
  - required reserves6.95.85.15.12.32.42.42.5
  - Loans to non-government, net23.823.522.820.920.320.219.919.9
  - gross loans to non-government25.024.724.222.322.022.422.222.3
  - provisions-1.1-1.2-1.4-1.5-1.7-2.2-2.3-2.3
  - Deposits27.927.225.324.224.926.426.326.3
  - Borrowing3.74.14.34.55.46.05.35.3
  - Capital6.87.07.16.86.86.97.17.1
  - Capital adequacy ratio, percent30.832.232.932.831.732.332.632.7
  - Regulatory capital, MDL billions6.46.66.76.56.56.66.76.8
  - NPL ratio, percent 2/4.65.28.010.514.616.317.417.5
  - Past due-to-gross loans, percent4.65.511.412.316.517.720.319.2
  - Net open FX position, MDL billion 30.10.10.00.00.0-0.3-0.5-0.5
  - in percent of regulatory capital1.71.6-0.6-0.10.5-5.1-6.9-6.9

### Growth model, potential growth, and development priorities
- Potential growth estimates:
  - Medium-term potential growth rate estimated at about 4 percent.
  - Crisis of 2009 reduced potential GDP growth by about 2 percentage points (from an average of 5.2 percents for 2007–08 to just 3.2 percent for 2009).
  - Current projections: about 4 percent on average over 2010–15.
- Features of past growth:
  - Annual GDP growth averaged almost 6 percent in 2000–08; GDP contracted by 6.5 percent in 2009.
  - Private consumption’s share in GDP rose from 56 percent in 1995 to 93-94 percent in 2006–08.
  - Reported remittances rose from about 5 percent of GDP in the mid-1990s to 30-33 percent in 2006–08.
  - Labor productivity increased alongside GDP growth; agriculture accounted for about 28 percent of employment in 2009 and about 8 percent of GDP.
  - Investment share rose from about 15 percent in 2000 to 34 percent in 2007–08; FDI reached 11–12 percent of GDP in 2007–08 then collapsed in 2009.
- Risks and constraints:
  - Remittance-dependent model is vulnerable to boom-bust cycles; remittance decline in 2009 precipitated sharp contraction.
  - Trade deficit rose to about 53 percent of GDP in 2007–08, largely financed by remittances.
  - Dilapidated infrastructure (roads, irrigation) and a problematic legal/administrative environment identified as binding constraints.
- Growth-enhancing policy directions:
  - Diversify away from remittance- and consumption-led growth toward export-led growth in tradable sectors.
  - Maintain wage policy linked to productivity; avoid excessive real exchange-rate appreciation.
  - Mobilize domestic investment and attract FDI into tradable sectors; address infrastructure bottlenecks.
  - Use diagnostics (international rankings, surveys) to identify binding constraints and set clear priorities.
- Illustrative external loan scenario (Box 1):
  - US$1 billion loan disbursed in equal annual installments of US$100 million starting from 2010, with at least 30 percent domestic component and one job per US$5 thousand of domestic component.
  - Estimated impact: projects financed by a US$1 billion loan can boost economic growth by up to 0.3–0.6 percentage points per year compared to baseline.
  - Only about 80 percent of the foreign loan amount converts into new capital stock.

### Monitoring, measurement, and policy sequencing
- Monitoring and targets:
  - Transparent targets are important; regular fiscal/monetary statistics, MDGs, and international competitiveness indicators can serve as monitoring tools.
- Policy sequencing for reforms:
  - Short-term: expenditure rationalization, revenue administration improvement, strengthen contribution–benefit link in pensions, and targeted social assistance.
  - Medium-term: public administration and civil service reform, education optimization, tax base broadening and CIT reinstatement, pension parametrical reforms (valorization, accrual, retirement age), capital spending restoration to 7.5 percent of GDP beginning in 2012.
  - Institutional reforms: single unit for investment planning, modernization of STI IT systems, RMU for tax compliance, credit bureau development, and improved debt-resolution frameworks.

*Italic: Extracted from content unit _cr10232_ as presented in the source document.*

### Appendix 1. Basic Data – Moldova Pension System ............................................................ 29

### _cr10232 - Appendix 1. Basic Data – Moldova Pension System ............................................................ 29

### A. Introduction
- Moldova faces fiscal sustainability issues due to pre-election spending hikes and the global economic crisis, necessitating a genuine fiscal consolidation plan.
- Large fiscal imbalances resulted from sharp pre-election increases in wages and pensions and loss of revenue from the slump in economic activity.
- Comprehensive fiscal consolidation plans need to be implemented and monitored to maintain confidence in the budget’s ability to finance itself and, in the longer run, fiscal solvency.
- Failure to implement consolidation would destabilize expectations and weaken the effect of current international budget support.

Key policy framing:
- Short-term: implement expenditure rationalization (government wages, goods and services, transfers) and revenue-enhancing measures to broaden the tax base, reduce exemptions, and improve tax administration.
- Protect: vital public investment and well-targeted social benefits.
- Medium-term: complement short-term measures with structural reforms in public sector wages and employment, education, pension and health care, and revenue administration. A medium-term setting allows some upfront costs (e.g., optimizing the school network).
- The structural fiscal balance has considerably deteriorated; without adjustment, primary deficits would persist after the crisis wanes and the output gap closes.
- The ongoing IMF-supported program (2010–2012) envisages a significant but gradual and balanced structural fiscal adjustment to guard against a deepening recession.

Summary of the adjustments sought:
- (i) Rationalization of current primary spending and measures to increase efficiency and impact of public sector services through public administration reforms while meeting critical infrastructure needs and better targeting social spending to protect the most vulnerable.
- (ii) Tax policy complemented by tax administration measures intended to broaden the tax bases and improve compliance.
- (iii) Reforms to keep entitlements affordable and alleviate financing pressures on the social security system.

Structure of the chapter (as presented):
- Section II: country experiences with large and successful fiscal adjustments.
- Section III: rationalization and reforms in public administration and public sector spending (wages, education, protection of infrastructure and targeted social spending).
- Section IV: specific revenue-enhancing measures, focus on revenue administration reforms.
- Section V: medium- to long-term structural reforms and risks to social security spending (demographics, pensions, health care).
- Section VI: conclusions on efficient and equitable medium-term measures and institutional approaches for sustained outcomes.

### B. Fiscal Adjustment—Design, Country Experiences and Stylized Facts
- A checklist of design and implementation issues can guide Moldova’s adjustment plan (see Box 1 for detailed checklist items).
- Large and successful fiscal adjustments are common: more than 20 advanced and 30 emerging economies have achieved improvements in their structural primary balances of at least 5 percent of GDP at least once in the last four decades (IMF 2010a, Tables 5a–5b).
- Empirical lessons:
  - Current expenditure–based adjustments (government wages and transfers) have tended to be more successful than cuts in public investment.
  - Alesina and Perotti (1997): in successful cases, one-fifth of spending cuts affected public investment, whereas the largest cuts (accounting for half of the total) focused on wages and transfers.
  - Tsibouris and others (2006) found similar consolidation patterns.
  - Adjustments should not be too prolonged to avoid reform fatigue.
  - External conditions, monetary and exchange rate policies, and structural reforms complement fiscal consolidation.

Policy implications for Moldova:
- Given past expenditure slippages and moderate-to-high adjustment needs, initial emphasis on expenditure measures—especially on wages and transfers—should be complemented by tax administration reforms.
- Historical experience suggests the estimated amount of fiscal action required should be achievable, but priorities must reflect social, political, and administrative feasibility.
- Structural reform options to evaluate and pursue: government wages and employment, education, social transfers and subsidies, pension and health systems.

### Box 1 — Checklist for design and implementation of a fiscal adjustment plan (items listed in source)
- How much to adjust, under realistic budget assumptions? Carefully propose a plan that delivers a credible change in fiscal flow balances while garnering public and market confidence.
- Is the pace of adjustment sufficiently ambitious to avoid reform fatigue? A balanced frontloading can leverage post-crisis resolution to restore sustainability.
- Are financing constraints taken into account? Scarce financing has been a motivator to size and speed of adjustment in Moldova; liquidity pressures in 2009 called for relatively fast and large upfront adjustment.
- Is the operational target for the fiscal adjustment path well-defined, well-understood, and has adequate institutional coverage? Improvement in the annual overall fiscal balance is easily understood; a structural target requires separating cyclical and long-term activity movements. Consolidated public sector coverage is desirable.
- Does the composition of adjustment take into account the size of the public sector? Primary expenditures have increased by over 16 percent of GDP in the last decade, moving Moldova considerably up the spending scale relative to neighboring CEECs; with an oversized public sector, past experiences emphasize consolidation on the expenditure side, relying on cuts in government wages and transfers.
- Are high-quality measures chosen for the adjustment? Good quality measures foster long-term growth and efficiency, minimize distortions, improve supply side incentives, and are permanent—important for supporting a “new growth” model.

Other considerations:
- Are external factors (if existing) fully leveraged?
- Are supporting institutional and structural reforms in place?
- Do sub-national levels of government contribute to the adjustment?
- Are distributional effects taken into account?
- Is there a strategy to mobilize broad-based political and public support and communicate about the adjustment strategy?

### C. Rationalization and Protection in Spending (introductory points from the source)
- With structural deficits built from past expenditure slippages and revenue losses, the scale and composition of fiscal adjustment must be tailored to ensure feasibility and durability.
- Expenditure rationalization initially is most advantageous, boosted by tax administration reforms.
- Short-term measures are necessary to stop deterioration of fiscal balances, but must be integrated into a medium-term fiscal framework for durable solutions.
- Structural reform areas requiring evaluation and policy action to generate fiscal savings include: government wages and employment, education, social transfers and subsidies, pension and health care.

### Key numeric and programmatic references (as stated in source)
- Structural fiscal adjustment under the ongoing IMF-supported program (2010–2012).
- Primary expenditures have increased by over 16 percent of GDP in the last decade.
- More than 20 advanced and 30 emerging economies achieved improvements in structural primary balances of at least 5 percent of GDP at least once in the last four decades.

_Italic: Extracted from: Appendix 1. Basic Data – Moldova Pension System; sections I–III and Box 1 as presented in the source document._

### 10.      Budget consolidation forms the cornerstone of the recent IMF-supported

### _cr10232 - 10.      Budget consolidation forms the cornerstone of the recent IMF-supported

### Fiscal strategy and priority framing
- Budget consolidation is the cornerstone of the recent IMF-supported program, with protection for public investment and essential social spending.
- The fiscal adjustment program is set out in the MEFP (IMF Country Report 10/32) and lays out in detail the strategy for deficit reduction over the course of the three-year program (2010-2012).
- Expenditure restraint is echoed in the Government’s Economic Stabilization and Recovery Plan.
- Priority expenditure measures emphasize fiscal impact, implementation, and tradeoffs; complementary reform options extend beyond the short term.
- Target expenditure areas for savings include the public sector wage bill and employment, goods and services, subsidies and transfers to households; growth-enhancing capital spending should be protected.

### Current spending rationalization — public administration and wage system
- Public administration spending was 5.4 percent of GDP in 2009, compared to an average close to 9 percent in neighboring countries.
- Implementation of public sector reforms has suffered delays; a reform of the civil service salary system was delayed by economic and political developments in 2009.
- The public administration system in Moldova includes State administration offices, autonomous Territorial Administrative Units (TAU), and two Security Funds.
- Short-term measures taken in 2009 included modifying and postponing unaffordable wage increases, keeping budgetary sector employment to efficient levels, elimination of permanent vacancies, and continuing optimization of the number of employees in the budgetary sector.
- Root causes—predominantly linked to insufficient control over employment levels—remain to be addressed.
- Public administration and civil service reform to sharply improve delivery of public sector services is a policy priority; previously proposed World Bank suggestions to pursue include:
  - finalize a civil service remuneration system;
  - review effectiveness and efficiency of service delivery systems that are big spenders (i.e. education) and develop a strategy for streamlining service provision;
  - introduce systems of internal controls in public administration entities to raise efficiency and limit corruption.
- A new performance-based wage system for public sector employees is planned to be introduced in 2011.

### Education sector — spending, employment, and inefficiencies
- Education spending rose to 9.5 percent of GDP in 2009 (almost double a CEEC average of just over 5 percent) and roughly to 21 percent of total expenditures (compared to a CEEC average of close to 13 percent).
- Fast increase in education spending occurred despite a rapidly falling number of students, indicating entrenched inefficiencies.
- Employment distribution (excluding Social and Health Funds’ employees): education accounts for 62 percent of general government employment and public administration for 21 percent.
- Education employment per population: 4.1 percent in Moldova compared to 2.7 in CEEC.
- Education wage bill in 2009:
  - reached 6.1 percent of GDP;
  - represented 13 percent of total general government expenditures;
  - constituted 52 percent of the total general government wage bill.
- Stylized structural deficiencies in the education system:
  - Number of students decreased by 27 percent in 2007–08 compared to 2002–03, while number of schools declined by only about 3 percent over the same period.
  - Student/teacher ratio of 13 compared to a European norm of 18.
  - Non-teaching to teaching staff ratio average is 37 percent, above a European average of 27 percent.
  - Lack of financial incentives to reduce staffing levels.
- World Bank pilot study in two rural districts aims to tighten monitoring and enforcement in the public education employment registry; combined with Ministry of Education optimization (incentivizing class and school mergers) and Government-approved World Bank proposals to accelerate school network optimization.
- Fiscal impact estimates of education measures should be included in the Government’s medium-term expenditure framework (MTEF).

### Public sector wage bill — trends, affordability, and targets
- The public sector wage bill rose substantially in 2009 to close to 12 percent of GDP, making it the second highest in CEEC.
- The average public sector wage grew by almost 20 percent in real terms in recent years.
- The public wage bill accounts for 26 percent of total general government expenditures, compared to an average of 21 percent in selected CEEC.
- The ratio of average public sector wage to GDP per capita surged from 1.2 to almost 1.7 between 2008 and 2009; comparable country levels (Estonia, Latvia, Lithuania) are close to 1.0.
- Public sector wages were 90 percent of private sector wages in 2009.
- Public sector employment stood at 6.6 percent of population in 2009; proportion of public to overall employment is 21 percent.
- Government objective: bring the wage bill below 10 percent relative to GDP by 2012-13 to protect critical current non-wage spending and public capital expense and to approach the CEEC average of just below 9 percent.

### Goods and services spending and procurement controls
- Spending on goods and services reached 10.2 percent of GDP in 2009 (an increase of almost 30 percent from an average of 7.9 percent of GDP over 2001–08), substantially larger than a CEEC average of 7.3 percent of GDP.
- Growth rate of this expenditure component averaged 26 percent a year between 2001 and 2008; growth moderated to close to 4 percent in 2009.
- Authorities’ program calls for substantial reduction in allocations for low-priority goods and services, while safeguarding critical maintenance and inputs for line ministries.
- To avoid arrears and unaffordable commitments, procurement process controls and internal financial control reforms are to be introduced by end-2010 to rein in spending in 2011 and beyond.
- Strengthen communication between the MOF and spending line ministries during the budget process and continue the move from input-based line item budgeting to a results-based programmatic approach.

### Medium-term and longer-term reform options and recommendations
- Medium-term and long-term measures to improve public sector efficiency include:
  - Rationalize the structure and improve the efficiency of government operations via a comprehensive review of size, functions, staffing, and payment structures across government organizations.
  - Outsource non-core functions (e.g., transport, security, maintenance) and consider outsourcing functions in finance, accounting, and information technology and communication (ITC) where efficient; source of cost savings is private sector efficiency.
- Address composition and transparency of the salary system: make competitiveness of remuneration across job categories more consistent and reduce the weight of “years in service” in favor of human capital and job complexity criteria, particularly for public health employees.
- Link short-term wage-containment measures to medium-term structural reforms to control employment levels while maintaining competitive wages to attract qualified staff.

_Italic source: Content unit _cr10232 - 10.      Budget consolidation forms the cornerstone of the recent IMF-supported_

### 24.      Capital spending in relation to GDP which has been rising since 2001 declined

### _cr10232 - 24.      Capital spending in relation to GDP which has been rising since 2001 declined

### Capital spending trends and adequacy
- Capital spending in relation to GDP, which had been rising since 2001, declined for the first time in 2009.
- Capital spending had averaged about 16 percent of total government spending in 2000–08 or 6 percent of GDP before falling to 11 and 5 percent respectively in 2009 (in close comparison to CEEC averages of 12.4 and 5.1 in 2009).
- The 2009 level is assessed as insufficient given Moldova’s large development needs.
- Overall capital spending was revised downward from an initially approved ratio of over 7.5 percent relative to GDP in the 2009 Budget to 5 percent.
- Medium-term policy target: bring the ratio back up to 7.5 percent of GDP beginning in 2012.

### Project planning, monitoring, and institutional issues
- Annual budget documentation contains detailed lists of proposed investment projects and related maintenance expenditures, but considerable fragmentation remains in the institutional framework with possible overlap in functions.
- Different units are responsible for donor-financed and budget-financed projects, complicating planning.
- The MOF division dealing with capital investment financing faces capacity constraints and seems to focus on ensuring financial compliance rather than progress in achieving project objectives; routine progress reports are lacking.

### Road maintenance and infrastructure financing
- The road maintenance budget during 2009 was well below the minimum requirement to avoid further depreciation.
- Reform of road maintenance financing and a large increase in funding for road maintenance have been conditions for road investment financing by external partners.
- Perception: critical infrastructure needs are largely unmet and state assets, roads in particular, have suffered massive physical deterioration; sustained long-term economic growth and social development is at risk unless the road network is rehabilitated and maintained (World Bank 2010a).
- Government response: recently mobilized investment funding to rehabilitate the road network from external sources (including MCC), and to mobilize funding needed for maintenance of roads.

### Recommended improvements to capital budgeting
- Target project prioritization, monitoring and evaluation processes associated with the capital budget.
- Establish a single unit to manage investment project planning to help resolve institutional fragmentation.
- Redirect monitoring focus toward routine progress in achieving project objectives as capacity is built.

### Social assistance
- Key reform objective: improve targeting of social assistance benefits by moving from a categorical system to a proxy means-tested scheme to ensure benefits reach the most vulnerable.
- Urgency recognized in IMF Country Report 10/32 due to adverse social consequences of the global economic crisis on the poor.
- Phasing out of the nominal compensation scheme is intended to reduce leakages and free up fiscal resources for poverty-targeted social assistance.
- The Ministry of Labor, Social Protection and Family has prepared the analytical basis and infrastructure to support the new scheme; steady work continues toward achieving a take up rate of at least 2/3 by the end of 2010.
- Budget flexibility: energy allowances allocated to low-income beneficiaries while ensuring fiscal neutrality via newly committed donor funds; means-tested heating subsidies beyond 2010 would be consistent with the new scheme.

### Tax structure and tax policy reforms — findings
- Revenue performance looks reasonably sound; the tax system does not appear overly burdensome.
- High revenue from VAT, especially VAT on imports; high VAT collection partly due to unfavorable treatment of imports of investment goods.
- Personal and corporate income taxes (PIT and CIT) perform below average.
- Adoption of a zero-rate on reinvested profits in 2008 reduced CIT revenues to 1.1 and 0.7 percent relative to GDP in 2008 and 2009 respectively.
- Current challenge: regain revenue lost due to the crisis and secure more stable revenue sources through tax policy focused on broadening the tax base by reducing exemptions and raising excise rates closer to neighboring countries.

### Tax policy measures in the program
- Authorities’ program relies mainly on adjustments in excises toward neighboring-country levels and a reinstatement of the corporate income tax (CIT) from 2012 onwards.
- Increase in excise rates on alcohol, cigarettes, and fuel in 2010 is expected to yield about ½ percentage points of GDP on a permanent basis.
- Reinstatement of the CIT from 2012 with a low single rate and a broad, uniform base across sectors and regions is considered necessary to complete structural fiscal adjustment and diversify the tax base.

### Tax administration — issues and priorities
- Reforms in tax administration should be emphasized to restore long-term fiscal stability and improve the investment environment.
- Progress in tax administration reform slowed significantly in 2009, partly due to political turmoil; modernization of IT systems and organizational structures, and better tax compliance management systems were delayed.
- STI (State Tax Inspectorate) weaknesses: weak audit and taxpayer services programs and lack of strategy to address major risks to revenue performance.
- Taxpayer compliance risks heightened by financial pressures on businesses and taxpayers; example: large increase in tax arrears in 2009.
- Other avoidance issues: underreporting of wages for social security contribution purposes, leading to lower contributions collected.

### IMF technical assistance priorities (next 2–3 years)
- Modernization of IT systems, critical for day-to-day work and increasing taxpayer compliance and revenue collections.
- Modernization of STI’s organizational structure.
- Improving taxpayer compliance.
- Recommended actions:
  - Actively assess major risks to revenue and prioritize and allocate resources to address those risks; develop an agency-level compliance strategy protecting major revenue tax bases while balancing enforcement and support for businesses hit by the recession.
  - Establish a Risk Management Unit (RMU) to coordinate STI efforts to develop and implement a taxpayer compliance strategy; use modern risk management concepts developed in EU and OECD.
  - Back up the compliance program with strong risk mitigation tools, including audit programs, large taxpayer programs, arrears collection programs, and taxpayer service programs.
  - Garner significant donor support for a major IT reform program and development of management tools for compliance risk management.

### Pension system — fiscal and social sustainability
- Near 20 percent increase in pension expenditures in 2009 is alarming; similar raises could be detrimental to the system’s financial balance unless offset by reforms.
- World Bank analysis: the pension system seems fiscally sustainable but socially unsustainable given low pension benefits; alternative parametric reforms were presented (change valorization cum indexation, reduce accrual rate, increase retirement age and equalize across genders/groups, improve contribution collections, increase contributions for farmers and self-employed).
- 2008 government draft strategy aimed to strengthen link between benefits and contributions, unify contribution rates, reduce privileges, and tighten disability pension rules; documents not finalized and concrete measures not specified.
- Phasing out early retirement privileges in civil service and judiciary is part of the IMF-supported program: raise retirement age for these occupations by 6 months every year until it reaches the regular retirement age.
- Pension system ran moderate deficits over 2005–08; the financial gap surged in 2009, increasing state budget transfers sharply in percent of GDP in 2009 and projected to edge higher in 2010.
- Contributing factors: recession-related reduced contribution growth in 2009 and discretionary policies such as indexation (Swiss formula) that allowed a large increase in pension payments in 2009; additional top-ups in 2008–09 also contributed.

### Pension contributions, expenditures, and balances (percent of GDP)
- Contributions 1/: 2004: 6.4; 2005: 6.6; 2006: 6.8; 2007: 6.8; 2008: 7.2; 2009: 7.8; 2010: 7.3
- Expenditures: 2004: 5.9; 2005: 7.2; 2006: 7.0; 2007: 7.0; 2008: 7.2; 2009: 9.1; 2010: 8.9
- Overall balance: 2004: 0.5; 2005: -0.5; 2006: -0.1; 2007: -0.2; 2008: 0.0; 2009: -1.3; 2010: -1.6
- Source of table data: Government of Moldova, National Social Insurance House.
- 1/ Based on Staff estimates of an effective 'pension' contribution rate.

### Long-term pension challenges and metrics
- Pension spending rose to 7.2 and 9.1 percent of GDP in 2008 and 2009 respectively, more than double the 1999 level (4.4 percent of GDP) and above the 2008 CEEC median of 7.3 percent of GDP.
- Pension system dependency ratio (pensioners per 100 insured persons): 2008: 59; projected 2050: 86 (driven by declining contributors and early retirement).
- Moldova’s average pension (old-age) at 26.4 (27.4) percent relative to gross wage (35.1, on a net basis), noted as below an ILO standard of 40 percent; low benefits reflect non-valorized pension base after 1998.

*Italic: IMF Country Report content unit _cr10232 - 24. Capital spending in relation to GDP which has been rising since 2001 declined*

### 46.      Numerous challenges and flaws remain in the pension system.

### Numerous challenges and flaws remain in the pension system.

### Pension system underperformance and compliance issues
- Benefit adequacy underperforms primarily due to a lack of valorization of past incomes for new retirees in the pension formula.
- As a partial and temporary offset, the accrual rate has been raised against the recommendations of the 1998 reforms.
- Benefits are determined based on declared wages rather than paid contributions, weakening tax compliance and creating a tax avoidance problem.
- The incentive to participate and contribute to the system remains weak.
- Ad-hoc regulation through the annual Budget law and introduction of benefit increases regardless of the indexation rule may, over the long-run, threaten fiscal sustainability.
- Suspension of retirement age increases in 2003 and the lack of action following the Government’s 2008 draft strategy documents leave much work to be done.

### Replacement rates (mid 1990s and mid 2000s)
- Table 9: Moldova and Selected Countries: Replacement Rates (mid 1990s and mid 2000s) — Rates reflect general average of pension benefits in percent of gross wage.
  - Estonia: 25.0 (1995), 28.8 (2005)
  - Latvia: 62.6 (1994), 33.1 (2005)
  - Lithuania: n.a. (1995), 30.9 (2005)
  - Bulgaria: 31.0 (1995), 42.9 (2004)
  - Romania: 43.1 (1994), 27.6 (2005)
  - Moldova: 44.9 (1995), 26.4 (2008)
  - Average: 40.4 (mid 1990s), 32.7 (mid 2000s)

### Reform objectives and general guidance
- Aim: at least halt the decline in the replacement rate while safeguarding sustainability.
- Key goals: maintain a reasonable rate of return on pension contributions and adequate coverage without generating fiscal imbalances.
- Raising statutory retirement age should form the starting point; combine short-term measures and longer-term structural reforms.

### Short-term measures (fiscal savings and compliance)
- Strengthen incentives through a tighter link between contributions and benefits.
- Avoid contribution amnesties.
- Improve compliance through adequate contribution enforcement.
- Raise contribution levels for self-employed and farmers.
- Note: Compliance with contribution requirements is low. Average covered wage in 2008 (as per NSIH) stands at 75 percent of average wage which suggests an underreporting of wages for social contributions purposes.

### Structural measures (long-run fiscal and social sustainability)
- Reestablish valorization of past earnings in the pension formula, supported by an adequate indexation pattern.
- Redefine pension disability in compliance with the ILO definition to stimulate employment of disability pension beneficiaries (this is already one of the declared Government measures).
  - Disability beneficiaries have increased as a share of total pension beneficiaries to a current ratio close to 21 percent, up from 16.4 in 1999.
- Stop ad-hoc pension increases—beginning in 2004 and recently, exceptional measures have contributed to a more than doubling of the pension system costs over the last decade.
- Eliminate emerging privileged pension schemes with large differences in benefits from general schemes.
- Gradually increase retirement age for both genders to 65/60 and then equalize at 65.
  - With men’s life expectancy at only 64.6 at present, equalization can first be targeted at 62 years but later raised to 65, consistent with the anticipated increase in life expectancy (69 years for men by 2025).

### Pension reform scenario summarized
- Valorization: based on a 50–50 wage-price formula (50% wages, 50% inflation).
  - A stronger wage component relative to baseline yields larger replacement rates, but higher pension expenditures and a larger financial gap relative to GDP.
  - Full wage valorization combined with a Swiss type (or full wage) indexation can be fiscally unsustainable without offsetting reforms.
- Accrual rate: reduced by 20 percent from Baseline (from 1.4% up to 30 years of service, 2% beyond 30 years to 1.12% up to 30 years, 1.6% beyond 30 years) to improve fiscal sustainability.
- Retirement ages: increase from 62/57 years for men/women (Baseline) to 65/60 years for men/women (Reform Scenario), with gradual implementation (legislated increase in 6-month increments).
- Collection rate: Reform assumes baseline contribution collection rate broadly unchanged, while self-employed pay contributions based on average wage and farmers pay contributions based on 50% of average wage.
- Minimum pension indexation and benefit indexation: 50% wages, 50% inflation in both Baseline and Reform Scenario.
- Expected outcomes: a sustainable financial balance observed along with an improvement of pension social sustainability compared with a baseline of deteriorating replacement rates; positive financial gap over the next 40 years.
- Financial balance definition: difference between reported revenues from contributions and expenditures components.
  - An effective pension contribution rate example: multiplying the ratio of pension to total social insurance expenditures with the overall social contribution rate of 29 percent; for example, in 2009 this would yield an effective rate of 24 percent (83% * 29%). (IMF staff calculations.)

### Updated simulations and quantitative insights
- Updated pension reform simulations reflect post-crisis data and assumption changes and cover: valorization of wage history, raising retirement age, improving compliance and collection, and minimizing redistributive features to strengthen contribution incentives.
- Prior reported results (World Bank (2009b)) indicate that:
  - Raising retirement age significantly increases sustainability (expenditures would remain below 8 percent of GDP over the medium- to long-run).
  - Higher compliance and collection materially improve the pension balance.

### Key pension system statistics (selected entries from Appendix 1: Basic Data - Moldova Pension System)
- GDP (millions of Moldovan lei): 1999: 12,322; 2000: 16,020; 2001: 19,052; 2002: 22,556; 2003: 27,619; 2004: 32,032; 2005: 37,652; 2006: 44,754; 2007: 53,430; 2008: 62,922; 2009: 60,043
- GDP real growth (percent): 1999: -3.4; 2000: 2.1; 2001: 6.1; 2002: 7.8; 2003: 6.6; 2004: 7.4; 2005: 7.5; 2006: 4.8; 2007: 37.8; 2008: -6.5
- Average wage (Moldovan lei): 1999: 305; 2000: 408; 2001: 544; 2002: 692; 2003: 891; 2004: 1,103; 2005: 1,319; 2006: 1,697; 2007: 2,065; 2008: 2,530; 2009: 2,748
- Average old age pension (Moldovan lei): 1999: 858; 2000: 614; 2001: 640; 2002: 672; 2003: 718; 2004: 337?; 2005: 397?; 2006: 458?; 2007: 566?; 2008: 680?; 2009: 1? (source table entries for some years include formatting irregularities in the source)
- Average replacement rate of old age pension (average pension to average salary; percent): 1999: 28.0; 2000: 21.1; 2001: 25.8; 2002: 24.1; 2003: 24.5; 2004: 30.5; 2005: 30.1; 2006: 27.0; 2007: 27.4; 2008: 26.3; 2009: 29.1
- Total number of pensioners: 1999: 682,217; 2000: 668,923; 2001: 649,240; 2002: 623,284; 2003: 620,582; 2004: 617,203; 2005: 617,040; 2006: 621,096; 2007: 620,023; 2008: 622,203; 2009: 624,120
  - Total number of old age pensioners: 1999: 535,186; 2000: 516,861; 2001: 495,841; 2002: 472,556; 2003: 468,135; 2004: 460,822; 2005: 457,320; 2006: 459,717; 2007: 458,795; 2008: 455,724; 2009: 457,920
  - Total number of invalidity pensioners: 1999: 111,735; 2000: 113,022; 2001: 115,526; 2002: 115,220; 2003: 117,085; 2004: 119,925; 2005: 123,719; 2006: 125,676; 2007: 126,538; 2008: 128,083; 2009: 130,227
- Number of contributors relative to population 15-64: 1999: 0.57; 2000: 0.54; 2001: 0.59; 2002: 0.60; 2003: 0.49; 2004: 0.50; 2005: 0.48; 2006: 0.44; 2007: 0.65; 2008: 0.57; 2009: 0.53
- Total social insurance revenues (Moldovan lei): 1999: 907,853; 2000: 1,343,295; 2001: 1,604,288; 2002: 2,215,955; 2003: 2,734,439; 2004: 2,947,860; 2005: 3,696,000; 2006: 4,347,650; 2007: 5,157,229; 2008: 6,362,838; 2009: 7,573,599
  - Contribution revenues: 1999: 781,233; 2000: 1,004,966; 2001: 1,274,780; 2002: 1,602,083; 2003: 1,971,751; 2004: 2,464,150; 2005: 2,949,200; 2006: 3,661,511; 2007: 4,332,654; 2008: 5,432,582; 2009: 5,587,161
- Total social insurance expenditures (Moldovan lei): 1999: 880,055; 2000: 1,326,418; 2001: 1,453,562; 2002: 1,890,778; 2003: 2,176,221; 2004: 2,768,883; 2005: 3,697,774; 2006: 4,378,060; 2007: 5,244,559; 2008: 6,315,100; 2009: 7,599,149
- Pension expenditures (social insurance budget, Moldovan lei): 1999: 530,000; 2000: 813,853; 2001: 857,864; 2002: 1,187,261; 2003: 1,490,486; 2004: 1,901,009; 2005: 2,694,615; 2006: 3,125,881; 2007: 3,751,594; 2008: 4,535,952; 2009: 5,438,842
- Pension expenditures relative to total social insurance contributions (percent): 1999: 67.8; 2000: 81.0; 2001: 67.3; 2002: 74.1; 2003: 75.6; 2004: 77.1; 2005: 91.4; 2006: 85.4; 2007: 86.6; 2008: 83.5; 2009: 97.3
- Total pension expenditures relative to GDP (percent): 1999: 4.3; 2000: 5.2; 2001: 4.7; 2002: 5.5; 2003: 5.7; 2004: 6.2; 2005: 7.2; 2006: 7.3; 2007: 7.4; 2008: 7.2; 2009: 9.1

### Policy priorities and sequencing
- Short-term: strengthen contribution–benefit link, enforce collection, avoid amnesties, adjust self-employed and farmer contribution bases.
- Medium- to long-term: reinstall valorization of past wages, adequate benefit indexation, redefine disability pensions per ILO, eliminate privileged schemes, gradually raise and equalize retirement ages to 65.
- Ensure package preserves fiscal sustainability while improving social adequacy; combine retirement-age increases with measures that improve compliance and adjust accrual rates.

*Source: IMF staff report content from _cr10232 - 46. Numerous challenges and flaws remain in the pension system.*

### 1.      This chapter discusses Moldova’s monetary policy transmission in the context of

### _cr10232 - 1.      This chapter discusses Moldova’s monetary policy transmission in the context of

### New monetary policy strategy and transmission challenge
- In January 2010, the National Bank of Moldova (NBM) announced a new monetary policy strategy with a stronger focus on setting and achieving specific inflation objectives.
- The success of the strategy depends on the NBM’s ability to influence the economy; this is uncertain for a developing small open economy where conventional channels can fail due to: insufficient competition, weak institutions, and shallow financial markets.

### Background: macroeconomic and financial structure (2000–09)
- Growth averaged 5 percent over 2000–09, with negative shocks in 2006, 2007, and 2009.
- Inflation fell from around 40 percent to almost zero at end-2009, with low double-digit levels over 2003–08.
- Financial deepening and banking sector structure:
  - Bank deposits and credit to the private sector increased from about 12–14 percent of GDP in 2000 to 40 percent in 2009.
  - Fifteen commercial banks were operating in Moldova at the end of 2009; all but one privately owned with high foreign participation.
  - The five largest banks accounted for about two-thirds of total assets.
  - The licence of one bank (InvestPrivat Bank) was revoked in June 2009.
- Financial market characteristics and constraints:
  - Financial intermediation constrained by burdensome legal debt recovery, lack of credit information, and administrative barriers to collateral.
  - Secondary bond market, interbank activity, and equity market are in their infancy.
  - Cash accounts for about 25 percent of broad money.
  - Bank loans are essentially the only significant source of funding to domestic private firms other than their cash flows.
- Reserve and deposit structure:
  - Required reserves currently at 8 percent of bank deposits.
  - The portion of reserves that exceed [5] percent of deposits are remunerated at the overnight deposit rate for domestic currency and an average market rate for foreign currency.
  - Time deposits make about 50–70 percent of total deposits in domestic currency.
  - Credit maturities: bulk between 6-month and 1-year.

### Monetary instruments and key interest rates
- Main facilities and instruments:
  - The NBM base rate—the reference rate for the main short-term monetary policy operations, including overnight credit and deposit facilities at the NBM.
  - NBM Certificates, with maturities of up to 1 year, but limited to maturities of 7–28 days over 2000-09.
  - Repo operations based on state securities and NBM deposits to banks with maturities typically between 6 and 12 months.
  - T-Bills of various maturities but overwhelmingly below 1 year (majority issued in 21, 91, 182, and 364 days; occasional small 2-year and 3-year bonds).
  - Interbank market operations, mainly overnight and up to 14-day loans.
  - Deposit and credit by commercial banks provided in both domestic and foreign currency; households and firms producing for the domestic market are generally not allowed to borrow in foreign currencies.
- Interest rate observations (2000–10):
  - Periods 2001–02, 2005–2006, and 2008-present saw significant divergence across instruments: base rate, bank lending rates, and bank deposit rates remained high while interbank rates and T-Bill yields tumbled, reflecting excess liquidity even as the NBM kept the base rate high.
  - Since late 2008 the NBM significantly lowered the base rate; deposit rates fell in line, but bank lending rates responded very slowly and the loan-deposit spread widened—potentially due to increases in NPLs and credit rationing.

### VAR quantitative analysis: interest rate and exchange rate channels
- Methodology:
  - Standard vector auto-regression (VAR) methodology with Choleski decompositions; preferred lag structures chosen by Akaike and Schwartz information criteria.
  - Monthly VARs (2000–09) for base rate, interbank rate, and commercial lending rate; quarterly VARs (2000–09) for models including real GDP and/or credit, CPI, MDL/USD exchange rate, and average commercial lending rate. Period 2000–03 excluded from some models due to exceptional behavior; a dummy variable for 2009 was used where appropriate.
- Findings on transmission to market and retail rates:
  - A change in the base rate has an immediate and significant effect on the market rate, with the full effect passed through with a lag of 3–4 months.
  - A change in the base rate has a delayed effect on the lending rate; a change in the interbank rate has a quicker effect on the lending rate, consistent with base rate → market rates → lending rates.
  - Estimated pass-through of base or interbank rate to lending rate is relatively small over the full sample; when restricted to 2003–08 the pass-through is closer to 1 with a lag.
- Findings on transmission to output, credit, and inflation:
  - The relationship between interest rates, GDP, and inflation is inconclusive; different sub-samples produce significantly different results, possibly reflecting supply shocks, structural changes, and short sample length.
  - Replacing GDP with credit to the private sector yields clearer relationships:
    - Growth of credit to the private sector declines following an increase in interest rates, with the effect bottoming out after four quarters.
    - An increase in credit leads to higher inflation with the peak achieved after 4 quarters.
    - A shock to credit leads to a drop in interest rate (potential simultaneity); preferred model specification partially controls for this by letting only lagged variables enter the credit demand equation.
  - Exchange rate channel:
    - A positive shock to the exchange rate (i.e., depreciation) has a small positive and persistent effect on inflation, implying pass-through to prices slowly increases over time.
    - These exchange-rate-to-inflation estimates are subject to considerable statistical uncertainty; one cannot reject the hypothesis that the effect is not significantly different from 0 given the short sample.

### Financial sector perspective and crisis implications for monetary policy
- Importance of banks’ response: meaningful monetary transmission is largely defined by commercial banks’ response to policy actions.
- The Moldovan banking sector is undergoing significant adjustment to the post-Lehman era; understanding balance sheet, profit, and behavioral constraints is key to calibrating policy.
- Evidence from the crisis:
  - Banks generally met prudential requirements and were profitable except during the global financial crisis in 2009.
  - Developments in 2009 included increasing nonperforming loans and slow adjustment of lending rates despite lower funding costs.
- Implications highlighted:
  - Shallow financial markets, structural impediments, and crisis-induced balance sheet pressures can weaken interest rate channel effectiveness and slow pass-through to lending rates.
  - Given statistical uncertainty, micro-based empirical analyses are recommended to better assess channels such as exchange-rate pass-through.

*Prepared by Tokhir Mirzoev and Octavian Scerbatchi (Section D), and Gabriel Srour (Sections B and C).*

### 15.      With the economy entering a recession, the banks’ balance sheets were hit hard

### _cr10232 - 15.      With the economy entering a recession, the banks’ balance sheets were hit hard

### Balance sheet impact and asset quality
- Since September 2008, asset quality deteriorated quickly, and over a sixth of bank loans were non-performing at end-April 2010.
- Deposits initially plummeted owing to declining remittances and increased uncertainty, with some conversion from lei into foreign exchange (FX), which squeezed banks’ liquidity and FX reserves.
- Banks significantly tightened credit standards and initially increased deposit interest rates to stem deposit outflows.
- By end-April 2010:
  - banks’ net interest margin widened to about 10 percentage points;
  - net credit to non-government at constant exchange rates declined by 16 percent.
- Recent capital increases in several banks helped keep the average capital adequacy ratio at over 30 percent.
- Bank profits were mostly negative in the second half of 2009, with an exceptionally large loss in December due to a provisioning charge in one bank.
- Since January (year implied by context), banks returned to profitability, albeit well below pre-crisis levels.
- Ongoing concerns: high loan delinquencies and NPL ratios, limited scope to further cut interest costs, non-interest income persistently in the red, and a growing share of unsold collateral—notably real estate—on banks’ balance sheets.

### Monetary policy transmission and short-run balance sheet considerations
- The transmission from the policy interest rate became impaired; the NBM lowered its base rate by 13 percentage points in repeated attempts to ease the credit crunch, but rising NPLs kept average loan interest rates high with only a modest decline observed recently.
- The NBM released large amounts of liquidity, but much was used to build liquidity buffers:
  - Reserve requirements were cut in several steps during summer 2009, releasing about 10 percent of bank assets into the system.
  - Most released funds were invested in overnight deposits at the NBM as well as NBM and government bonds; some was placed abroad in accounts with foreign banks.
- Required reserves represent about 6 percent of bank assets.
- NBM securities, overnight deposits at the NBM, and government bonds comprise about 16 percent of bank assets.
- About 4 percent of banks’ liabilities are to the NBM, mostly in the form of loans with interest rates tied to the base rate.

### Quantitative benchmarks and transmission channels
- Required reserve ratio effects:
  - Reducing the required reserve ratio by one percentage points would release about MDL 0.3 billion, or 0.8 percent of bank assets.
  - If invested in loans, this would contribute to about 1½ percent credit growth.
  - If invested in NBM securities, this would raise banks’ return on assets by 0.3 percentage points.
- Base rate and profitability impacts:
  - A 100 basis point hike (cut) in the base rate would, ceteris paribus, increase (lower) profits by some MDL 4 million per month, or about 0.7 percentage point increase (decline) in banks’ return on equity over one year.
  - A 100 basis point increase in the interest rate on all loans will—if loan demand were completely inelastic—raise banks’ return on equity by about 3 percentage points.
  - A base rate change targeting a 10 percent decline in banks’ holding of NBM-issued claims (NBM bills and/or overnight deposits) would—if invested entirely in new loans—contribute to some 1.8 percent credit growth, while raising the return on equity by about 0.8 percentage points; if kept in cash, this would lower banks’ return on equity by some 0.3 percentage points.
- Portfolio reallocation and FX effects:
  - A 100 basis points base rate hike in early February led to some MDL 0.2 billion of new investment in NBM and government securities as of end-April.
  - Conversion of additional FX assets accumulated since the crisis would provide the market with some USD 200 million (over 4 percent of GDP).
    - Note: only about a half of this amount could be converted without breaching the net FX open position limit; conversion of the full amount would require either raising additional capital, or converting some of the FX liabilities into MDL.
- Pass-through characteristics and asymmetries:
  - Pass-through into loan interest rates is likely to be incomplete because: i) higher loan rates could increase delinquencies and banks may be hesitant to raise loan rates fully; and ii) prevalence of profit considerations over market share objectives would limit pass-through of a cut.
  - Policy rate changes are more likely to induce changes in quantity of loans with lesser impact on interest rates.
  - Interest rate pass-through is likely asymmetric: stimulating lending will be more difficult than discouraging it in the current environment.
- Higher base rates may prompt banks to invest more in NBM and government securities and could create incentives to raise additional liabilities, possibly raising deposit interest rates and attracting foreign inflows; however, high deposit rates and doubtful lending prospects imply it may take a large increase in the base rate to trigger meaningful expansion of bank balance sheets.
- The already short net open FX position (excess of liabilities over assets) implies additional external inflows would require banks to accumulate FX-denominated assets.

### Policy recommendations and looking ahead
- Strengthening monetary policy transmission in the medium term requires banks’ ability and willingness to rebalance portfolios, including lending; current response is impaired by rising NPLs and banks’ caution.
- Financial sector policies that may be needed to break the credit crunch and accelerate clean-up of banks’ balance sheets:
  - Improve debt resolution instruments, including:
    - introducing speedy bankruptcy procedures for persistently delinquent borrowers;
    - ensuring an efficient framework for the collection and disposition of collateral;
    - setting up quick out-of-court loan workout tools.
  - Encourage development of credit bureaus and investment in project appraisal tools by the banking community.
- Complementary NBM monetary policy strategy elements mentioned: communication strategy, transparency, regular auctions of NBM bills, increased presence of the NBM on the money market, and greater emphasis on the base rate as the reference rate for monetary policy.

*Source: National Bank of Moldova (text as provided).*

### 31.      Meanwhile, to help reduce market nervousness and volatility, the NBM needs to

### _cr10232 - 31.      Meanwhile, to help reduce market nervousness and volatility, the NBM needs to

### Liquidity framework and FX liquidity
- Core observation:
  - "Meanwhile, to help reduce market nervousness and volatility, the NBM needs to consider improvements to its liquidity framework."
- Description of problem:
  - "The Moldovan market seems to be dominated by erratic and/or seasonal surpluses and excesses in FX liquidity."
  - "Such variations in FX liquidity prompt banks to hold both MDL and FX cash buffers. And NBM interventions to smooth such fluctuations contaminate its communicated monetary policy stance."
- Policy recommendation (explicitly stated):
  - "Alternative FX market arrangements, such as limited short-term FX swap lines with the NBM would help de-link monetary policy from exchange rate smoothing while also allowing banks to focus on their core business of lending with less concern about FX liquidity."

- Complementary operational note (from footnote text):
  - "Despite large cuts, the deposit rate at end-February was still above the NBM’s base rate and roughly equal to the yield of 364-day T-bills, making new deposits unprofitable without new lending."

### Banking sector developments and balance-sheet indicators (selected reported series)
- Table 5 series excerpts (verbatim lines from source):
  - "Assets39.439.137.636.637.839.939.339.5"
  - "Cash1.81.91.71.82.12.22.12.2"
  - "Claims on NBM8.17.15.25.44.36.16.26.0"
  - "required reserves6.95.85.15.12.32.42.42.5"
  - "Loans to non-government, net23.823.522.820.920.320.219.919.9"
  - "gross loans to non-government25.024.724.222.322.022.422.222.3"
  - "provisions-1.1-1.2-1.4-1.5-1.7-2.2-2.3-2.3"
  - "Deposits27.927.225.324.224.926.426.326.3"
  - "Borrowing3.74.14.34.55.46.05.35.3"
  - "Capital6.87.07.16.86.86.97.17.1"
  - "Capital adequacy ratio, percent30.832.232.932.831.732.332.632.7"
  - "Regulatory capital, MDL billions6.46.66.76.56.56.66.76.8"
  - "NPL ratio, percent 2/4.65.28.010.514.616.317.417.5"
  - "Past due-to-gross loans, percent4.65.511.412.316.517.720.319.2"
  - "Net open FX position, MDL billion 30.10.10.00.00.0-0.3-0.5-0.5"
  - "in percent of regulatory capital1.71.6-0.6-0.10.5-5.1-6.9-6.9"

- Interpretive findings presented in figures and captions:
  - "Sharp deterioration of banks' asset quality since the crisis..." (Figure 6.a)
  - "... has led to a deep credit crunch, despite recent signs of deposit recovery."
  - "In response, NBM released required reserves, some of which fled the country... while also helping banks augment their domestic liquidity buffers." (Figure 6.a caption)
  - "Capital buffers have held up, helped by recent recapitalizations. But with growing provisioning, banks are barely breaking even." (Figure 6.b caption)
  - "Meanwhile, the recovery of net interest income owed to lower deposit rates... and non-interest income remains in the red, while banks are accumulating real estate." (Figure 6.b caption)

### Empirical analysis: VAR and impulse-response evidence (selected model outputs and notes)
- Vector Autoregression estimation samples and diagnostics (verbatim excerpts):
  - "Sample (adjusted): 2000M03 2009M12 Included observations: 115 after adjustments"
  - "Akaike information criterion: 8.957934 Schwarz criterion: 9.459182 R-squared0.9771560.856080.977442 Adj. R-squared0.9758870.8480840.976189"
  - "Sample: 2004M01 2008M12 Included observations: 60 Akaike information criterion: 6.139764 Schwarz criterion: 6.872784 R-squared0.8974110.9097450.948618"
  - "Sample: 2004Q1 2009Q4 Included observations: 24 Akaike information criterion: 16.41339 Schwarz criterion: 18.37682 R-squared0.8517150.9524750.9003540.909895"
  - "Source: IMF staff calculations. Table 1. Vector Autoregression Estimates; Table 2. Vector Autoregression Estimates; Table 3. Vector Autoregression Estimates; Table 4. Vector Autoregression Estimates"

- Variables and interpretation notes (verbatim):
  - "* In the chart above, baserate Ir_inbnkloan, and ir_loan represent the base, the intra-bank lending, and the lending rates respectively." (Figure 2 and Figure 3)
  - "* In the chart above, rgdp_yoy, inflation_yoy, exr$_yoy, and ir_loan represent the real gdp year-on-year growth rate, the year-on-year inflation, the lei per USD exchange rate, and the lending rate respectively." (Figure 4)
  - "* In the chart above, rcredit_yoy, inflation_yoy, exr$_yoy, and ir_loan represent the year-on-year percent change in real credit to the economy, the year-on-year inflation, the lei per USD exchange rate, and the lending rate respectively." (Figure 5)
  - "Response to Cholesky One S.D. Innovations ± 2 S.E." (figure captions)

- Impulse-response qualitative summary (from figure captions and axes annotations):
  - VAR impulse-response analysis was performed across multiple samples (2000M1-2009M12; 2003M1-2008M12; 2004Q1-2009Q4) to assess dynamic responses among base rate, intra-bank lending rate, lending rate, RGDP_YOY, INFLATION_YOY, EXR$_YOY, RCREDIT_YOY.
  - Responses are reported graphically for horizons 1 through 10 (x-axis labels "12345678910") with scales shown per figure (examples: -0.5 to 1.0; -1 to 3; -4 to 4; -30 to 30), indicating differing magnitudes across variable sets.

### Policy implications and recommendations (extracted directly)
- Main policy recommendation:
  - "Consider improvements to its liquidity framework" and implement "Alternative FX market arrangements, such as limited short-term FX swap lines with the NBM" to:
    - de-link monetary policy from exchange rate smoothing,
    - reduce market nervousness and volatility,
    - allow banks to focus on lending rather than FX liquidity buffers.

- Operationally relevant indicators to monitor (from presented data):
  - NPL ratio and past-due loan shares ("NPL ratio, percent 2/4.65.28.010.514.616.317.417.5"; "Past due-to-gross loans, percent4.65.511.412.316.517.720.319.2")
  - Capital adequacy and regulatory capital ("Capital adequacy ratio, percent30.832.232.932.831.732.332.632.7"; "Regulatory capital, MDL billions6.46.66.76.56.56.66.76.8")
  - Net open FX position in MDL and as percent of regulatory capital ("Net open FX position, MDL billion 30.10.10.00.00.0-0.3-0.5-0.5"; "in percent of regulatory capital1.71.6-0.6-0.10.5-5.1-6.9-6.9")
  - Required reserves and claims on NBM ("required reserves6.95.85.15.12.32.42.42.5"; "Claims on NBM8.17.15.25.44.36.16.26.0")

*Source: Excerpts from the IMF staff report text and tables as provided in the content unit.*

### 3.      The estimates of the economy’s potential growth rate rely on the production

### 3.      The estimates of the economy’s potential growth rate rely on the production function approach

### Potential growth estimates and recent revisions
- The medium-term potential growth rate is estimated at about 4 percent.
- After the crisis of 2009 the growth prospects deteriorated significantly:
  - The crisis led to potential GDP growth rate reduction of about 2 percentage points, from the average of 5.2 percents for 2007–08 to just 3.2 percent for 2009.
  - Current projections are for about 4 percent on average over 2010–15.
- Depending on the business cycle phase, actual growth can be above or below potential:
  - Moldova swung from a positive output gap of as much as 8 percentage points in 2008 to a negative gap of about 2 percentage points in 2009.
  - Estimated potential GDP continued to expand in 2009, though at a lower rate, because the crisis mainly reduced new investments without reducing existing capital stock.
- Contributions to growth (production function estimates, last decade and near-term):
  - The largest contribution to potential growth over the last decade came from increasing productivity (TFP), contributing 3–4 percentage points to potential growth rates.
  - Increasing capital stock added up to 3 percentage points to potential growth, with the highest contributions in 2007–08.
  - Decline in labor force subtracted roughly 1 percentage point from potential growth.

### Features and drivers of Moldova’s past growth model
- Aggregate growth performance:
  - Annual GDP growth averaged almost 6 percent in 2000–08.
  - GDP contracted by 6.5 percent in 2009.
- Domestic demand and remittances:
  - Private consumption’s share in GDP increased from 56 percent in 1995 to 93-94 percent in 2006–08.
  - Reported remittances rose from about 5 percent of GDP in the mid-1990s to 30-33 percent in 2006–08.
  - Remittances financed a large share of domestic demand and indirectly contributed to higher fiscal revenues through taxation of consumption and imports.
- Labor and productivity:
  - Labor productivity increased more or in line with GDP growth in all years of the last decade.
  - Agriculture accounted for about 28 percent of Moldova’s employment in 2009 while producing about 8 percent of GDP.
  - The domestic labor force decreased from 53 percent of population in 1995 to 36 percent in 2008.
  - Unemployment declined from 14 percent to 4 percent over 1995–2008, then increased to about 6 percent in 2009.
  - Up to 40 percent of the labor force works abroad (Cuc et al. (2005)).
- Investment and sectoral patterns:
  - Share of investments in GDP rose from about 15 percent in 2000 to 34 percent in 2007–08.
  - FDI reached 11–12 percent of GDP in 2007–08 but collapsed in 2009.
  - Sectors producing goods and services for domestic consumption (nontradables) expanded fast (financial and other services, wholesale and retail trade, construction).
  - Agriculture and industry stagnated; their share in GDP declined from 54 percent in 1995 to 20 percent in 2009.
  - Transport and communications expanded notably due to domestic and international demand.

### Costs, risks, and external imbalances of the remittances-driven model
- Volatility and boom-bust vulnerability:
  - Growth reliant on remittances is particularly vulnerable to “boom-bust” cycles; remittance declines in 2009 precipitated sharp contraction of domestic demand and sectors such as residential construction.
- Limits to further remittance growth:
  - The role of remittances cannot increase much beyond its 2006–07 maximum given already high share of labor force abroad and lifecycle patterns of remittance flows.
- Fiscal and social implications:
  - Workers abroad do not pay taxes and social contributions in Moldova, forcing central and local budgets to rely on heavy taxation of consumption and imports.
  - This taxation approach can lead to higher domestic prices relative to neighboring countries and higher dependency ratios for the national pension fund.
- External imbalances and reserves:
  - Trade deficit ballooned from about 26 percent of GDP in 2000 to 53 percent of GDP in 2007–08 and was largely covered by remittances.
  - Collapse of remittances and capital inflows in 2009 required massive National Bank of Moldova interventions; NBM maintained international reserves amounting to nearly 28 percent of GDP at end-2008.

### Challenge of diversifying the growth model and policy priorities
- Need to shift from remittances-driven domestic demand to export-led growth:
  - Diversification requires switching focus to tradable sectors, expanding exports, and improving external competitiveness to sustain productivity increases, stabilize or raise local employment, and reduce labor migration.
- Wage and exchange-rate policy:
  - Prudent wage policy linked to productivity increases is essential; double-digit wage increases exceeding productivity gains added inflationary pressures without reversing migration.
  - Policies should prevent excessive exchange-rate appreciation; rapid real effective exchange rate appreciation in the second half of 2008 eroded external competitiveness.
- Investment mobilization and FDI:
  - Mobilizing domestic investment and attracting FDI is necessary but not sufficient: past investment largely flowed into nontradables and entrenched the existing growth model.
  - Investment attractiveness of tradable-producing sectors needs significant improvement.
- Structural reforms and trade liberalization:
  - Advancing structural reforms and liberalizing trade are key to attracting new FDI.
  - A referenced study estimated Moldova’s gap between “potential” and actually received FDI at as much as 77 percent in 2003, suggesting large potential gains from policy improvements.

*Prepared by Michael Gorbanyov.*

### 25.      The estimated contributions of various factors to growth look broadly consistent

### _cr10232 - 25.      The estimated contributions of various factors to growth look broadly consistent

### Contributions to Growth and Structural Factors
- After the collapse of the Soviet Union, the virtual absence of capital-intensive industry and a structural crisis in traditional branches of economy stipulated low labor productivity levels in Moldova.
- High unemployment and low salaries led to labor migration; the outflow of labor from low-productivity sectors (such as agriculture) to more productive sectors and to employment abroad:
  - created a drag on growth from the shrinking labor force, and
  - caused large sustainable increases in productivity.
- Contribution of capital to growth remained relatively modest, reflecting the still rather low capital stock and years when new investments were barely sufficient to compensate for amortization.
- Recent studies highlight dilapidated infrastructure as a major obstacle to growth in Moldova.

### Box 1 — Estimating Effects of External Loans on the Economy (illustrative scenario)
- Loan scenario:
  - US$1 billion loan to finance infrastructure projects, disbursed in equal annual installments of US$100 million starting from 2010.
- Assumptions:
  - Moldova's "domestic component" of the loan will be at least 30 percent.
  - Temporary increase in employment associated with project implementation estimated at one person per US$ 5 thousand of the "domestic component".
    - For US$100 million per year project financing, this implies some 6 thousand new jobs in 2010–16.
  - During implementation years, the projects' "domestic component" will directly contribute to Moldova’s GDP via construction activities, supplies production, and workers’ wages spent domestically.
  - Only about 80 percent of the amount of the foreign loan will eventually convert into new capital stock in Moldova; the remainder covers project costs not associated with increase in capital (e.g., work planning and monitoring).
  - Projects' impact on productivity of capital and labor will be neutral in the first two years and moderately positive starting from the third year, when the first projects are completed and become operational.
- Estimated impacts:
  - The projects financed by a US$1 billion loan can boost economic growth by up to 0.3–0.6 percentage points per year as compared to the baseline growth rate.
  - In early years, growth boost comes from direct contributions to economic activity; in the medium- to long-term it comes from increased potential GDP growth via rising capital stock and improvements in factor productivity.
- Note: This box concentrates on growth impact and abstains from assessing debt sustainability.

### Implications for the Macroeconomic Outlook and Policies
- Potential GDP and baseline:
  - The obtained estimate of 4 percent for the potential GDP growth rate after the crisis of 2009 can be used as the baseline growth rate for projections.
  - Growth in certain years can be above or below this level but can be projected to converge to it over the long run, barring profound structural changes.
- Use of estimates:
  - Estimates of potential GDP and output gap inform assessment of cyclical fluctuations on the fiscal balance (positive output gap → cyclical improvement; GDP below potential → worsens fiscal balance).
  - Estimation of cyclical contributions enables separation from discretionary policy measures.
- Risks and channels for deviation from baseline:
  - Upward risks: improving prospects for capital investment via higher than expected FDI inflows, higher domestic private investment, or higher public capital outlays; financing for additional public investment can come from reallocation of budget resources or external borrowing (see Box 1).
  - Downward risks: delays in implementing structural reforms can discourage investments and lead to resumption of labor migration; absence of new investment in crumbling infrastructure may jeopardize sustaining productivity gains.

### Identifying Obstacles to Growth
- Key obstacles highlighted in available literature:
  - Deteriorating infrastructure (dilapidated roads, inadequate electricity grid and water supply network).
  - Problematic legal and administrative environment for firms (inappropriate investment climate).
  - Small size of the local market and difficulties accessing larger neighboring markets.
  - High costs of financing or lack of access to finance.
  - Shortage of skilled workers.
  - Burdensome procedures to obtain construction permits and access to land.
- Growth diagnostic findings:
  - Two recent studies (BenYishay and Wiebe (2010); Bozu et al. (2007)) identify bad roads and inadequate irrigation in agriculture as the most binding constraints.
- International indicators and survey signals:
  - EBRD indicators and WEF rankings broadly confirm rundown infrastructure and bad roads hinder competitiveness.
  - EBRD rates Moldova low on enterprise restructuring progress and reform of securities markets and non-bank financial institutions.
  - WEF assigns low rankings to Moldova on market size, business sophistication, and innovation.
  - World Bank "Doing Business" rankings highlight problems in dealing with construction permits, employing workers, getting credit, and protecting investments.
  - Specific diagnostic details from "Doing Business":
    - Dealing with construction permits: Moldova shows a very high number of procedures and long time needed to complete them, while official costs of compliance do not look particularly high.
    - Employing workers: Moldova compares unfavorably with peer countries on indicators of labor market rigidities; WEF 2008 rated Moldova higher on labor market efficiency, suggesting divergence between legal provisions and actual practices.
    - Protecting investors: low standing largely reflects insufficient legal grounds for enforcing shareholders’ control over executive directors.
    - Access to credit difficulties were due to absence of credit bureaus or public credit registry and lack of credit history information.
  - First credit bureau in Moldova became operational in early 2010; it will likely take several years before it accumulates a meaningful database and its information use in credit decisions is fully established.
- Caution on rankings:
  - Country positions in competitiveness rankings often correlate with level of development; correlation with actual or projected growth rate is difficult to find.
  - Rankings rely on opinions of experts and business representatives and may be biased or misstated.
  - Important to agree upfront which international indicators best represent the actual situation and are recognized by stakeholders.

### Targeting and Measuring Progress in Promoting Growth
- Strategic documents:
  - 2004 Economic Growth and Poverty Reduction Strategy Paper: emphasized moving from remittance-based, consumption-led growth to investment- and export-led growth.
  - 2008 National Development Strategy covered period until 2011; impact of world economic crisis and 2009 political changes necessitated revision.
  - March 2010 document prepared for donor discussions (Rethink Moldova (2010)) is an important milestone; main challenge is to set clear-cut priorities and group proposed measures around them.
- Regional integration:
  - Crucial to reap the benefits of Moldova’s geographic location.
  - Moldova’s trade with major partners passes through Ukraine and Romania; upgrading roads brings best results when combined with seamless access to neighbors’ road networks.
  - Need to step up integration with the European Union in the West and with CIS countries in the East to gain access to new export markets without compromising traditional partnerships and to enhance transit potential.

*Source: _cr10232 - 25.      The estimated contributions of various factors to growth look broadly consistent*

### 37.      To measure progress towards achieving the development objectives, it is

### _cr10232 - 37.      To measure progress towards achieving the development objectives, it is

### Monitoring progress and targets
- Transparent targets are important to measure progress towards development objectives.
- Regular fiscal or monetary statistics can sometimes serve as monitoring indicators.
- When such figures are not available or insufficient, Millennium Development Goals (MDGs) may be used to monitor social variables.
- Improving the country’s standing on international competitiveness indicators and rankings can also be an objective.

### Conclusions: growth model and risks
- The growth model in Moldova over the last decade relied on domestic demand fuelled by remittances.
- This model produced brisk growth in nontradable goods and services and stagnation in most tradable sectors, with exceptions such as transit transportation.
- The model generated significant external and domestic imbalances:
  - A sizable trade deficit (largely financed by remittances).
  - An oversized public sector.
- Costs and vulnerabilities linked to the imbalances:
  - Need to accumulate very large international reserves.
  - Distortions in budget revenues and expenditures.
  - Proneness to disruptive boom-bust cycles.
- The global economic crisis illustrated these risks: a drop in remittances led to sharp correction of external imbalances and steep contraction of economic activity.

### Potential GDP estimates and contributors
- Using a production function approach, medium-term potential GDP growth for Moldova is estimated at about 4 percent.
  - This is by 1-2 percentage points less than before the impact of the world economic crisis.
- Largest contribution to potential GDP growth comes from rising total factor productivity (TFP).
- Investments in fixed capital also make a significant contribution.
- A shrinking labor force subtracts from the potential growth rate.

### Impact of hypothetical large external loan
- A hypothetical infrastructure program financed by a US$1 billion loan on favorable terms is estimated to boost economic growth by 0.3–0.6 percentage points a year compared to the baseline.
- The loan’s contribution to growth needs to be weighed against its impact on debt sustainability via a detailed debt sustainability analysis.

### Need for diversification and export-led growth
- The paper argues for diversifying away from a remittance- and consumption-based model toward export-led growth generated by new investments in tradable sectors.
- For Moldova, export-led growth may be the only way to raise the long-term sustainable growth rate well above 4 percent, important for addressing development and poverty reduction needs.

### Macroeconomic and structural policy implications
- To prevent erosion of external competitiveness:
  - Wage policy should maintain a close link to productivity gains.
  - Macroeconomic policies should avoid excessive appreciation of the national currency.
- Government should aim to:
  - Attract large FDI.
  - Mobilize domestic investment in sectors producing goods and services for exports and competing with imports.
  - Improve attractiveness of tradable sectors for investors.
- Public policies should identify and address binding constraints using:
  - International competitiveness rankings.
  - Local business surveys.
  - Diagnostic studies.
- Evidenced priority constraints include:
  - Dilapidated infrastructure and bad roads in particular.
  - Need to streamline procedures for issuance of construction permits and land allocation.
  - Revamp labor market laws.
  - Step up enforcement of property rights and strengthen investor protection.
  - Improve companies’ access to finance.
  - Regional integration to gain access to new markets and transport networks of larger neighbors.

### Appendix I — Production function approach (method and parameters)
- Production modeled with a Cobb-Douglass production function: Yt = At Kt^β Lt^α (equation notation preserved in source).
- Log-linear and first-difference forms used (equations (2) and (3) in source).
- Capital stock reconstruction:
  - Kt = (1−δ) Kt−1 + It, with δ assumed to be 5 percent.
- Labor series:
  - Actual employment data from NBS smoothed with the Hodrick-Prescott (HP) filter to remove business-cycle fluctuations.
  - Alternative approach using total labor force (employed plus unemployed) without smoothing produced broadly similar potential GDP levels.
- Calibrated rather than estimated production function due to short data span (21 data points using 1995–2015) and structural breaks (crises in 1998–99 and 2008–09).
- Elasticities:
  - α (labor elasticity) set to 0.54, based on average wage-bill share in GDP for 2000-08.
  - β (capital elasticity) set to 0.46 from constant returns to scale assumption (β = 1 − α).
- TFP contribution estimated as the residual: observed/projected GDP growth minus estimated contributions from capital and labor; TFP series smoothed with HP filter and used in production function to obtain potential GDP.

### Appendix II — Contribution of automatic stabilizers to fiscal balance
- Cyclical balance in year t = overall balance in percent of GDP (tOB) − cyclically-adjusted overall balance in percent of potential GDP (tCAOB).
- Cyclically-adjusted balance formula (as presented in source): tCAOB = tOB − [Rt ηt + Gt ηt]*tGAP (notation preserved from source).
- Output gap (tGAP) = ratio of output to potential GDP minus one.
- Revenue and expenditure budgetary-sensitivity parameters:
  - ηRt = (1 − Rt/Yt) Rε
  - ηGt = (1 − Gt/Yt) Gε
- Rε and Gε are revenue and expenditure elasticities with respect to the output gap (assumed constant).
- Contribution from automatic stabilizers (AS) equals the first difference of the output gap multiplied by the difference of the revenue and expenditure sensitivity parameters:
  - AS = Δ(tGAP) * (ηRt − ηGt)  (notation preserved).
- In absence of Rε and Gε data, a simple assumption:
  - Rε = 1 (revenues rise/decline in line with GDP).
  - Gε = 0 (budget spending not linked to GDP changes).
  - Under this simplification, contribution from automatic stabilizers can be computed as: AS = ΔtGAP * (Gt/Yt)  (notation preserved).

### Appendix III — Excerpt from the Economic Growth and Poverty Reduction Strategy Paper (2004-2006): Sustainable and Inclusive Economic Growth (pages 34–35)
- Current growth largely based on labor export; remittances drove fast domestic consumption growth.
- Consumption-led growth, given supply rigidities, attracted imports, widened the trade balance, and contributed to inflation.
- Growth quality affected by unbalanced economic structure, monostructural exports, and low fixed capital investment.
- Challenge: shift from remittance-based, consumption-led growth to a balanced model emphasizing investment, import-substitution, and export-led growth.
- Remittances should be seen as potential development finance and investment opportunity within an enhanced business environment.
- Better policy to encourage investment in small and medium enterprises and export/import-competing enterprises to generate income and employment.
- Needed actions to change paradigm:
  - Attract significant investment, primarily in processing industry and infrastructure.
  - Mobilize new sources and factors of growth to diversify the economy and replace labor export with export of goods and services.
- Business and investment environment is crucial:
  - Pursue stable, transparent and efficient regulatory policy.
  - Develop competition.
  - Support small and medium-sized business.
  - Mobilize domestic investment potential (labor migrants’ savings, banking resources, shadow sector resources, capital leaving the country).
- Infrastructure recovery and development (roads, water supplies, heating, electricity and gas, telecommunications) are main focus to smooth regional socio-economic imbalances and improve living standards.
- Feasible annual economic growth targets are estimated between 5–10%:
  - 5% growth per annum as a moderate scenario.
  - 8–10% as an optimistic scenario.
  - Macro analysis supports feasibility of these targets (as stated in source).

*Source: _cr10232 - 37.      To measure progress towards achieving the development objectives, it is*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10232.pdf_