Former Yugoslav Republic of Macedonia -- Concluding Statement of the 2006 Article IV Mission

June 5, 2006

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

June 5, 2006

Macedonian economic performance has started to improve. For more than a decade, economic growth was sluggish, in part the result of external shocks. However, in the last couple of years, growth has reached 4 percent or even higher, inflation has remained under control, the current account deficit has narrowed, international reserves have increased, and structural reforms have been initiated. To raise living standards more decisively toward European levels, the authorities now need to focus on sustaining and accelerating these achievements. As a first condition, this will require maintaining the country's hard-won macroeconomic stability. But for growth to accelerate and jobs to be created, this will need to be accompanied by more ambitious structural reforms: enhancing financial intermediation with sound banking supervision, improving the business climate and, underlying all these reforms, improving institutional quality.

The Medium-Term Challenge: Achieving Rapid Sustained Growth

1. For much of the Former Yugoslav Republic (FYR) of Macedonia's independence, fiscal and monetary policies have been relatively stable. Despite numerous shocks, fiscal policy has generally been disciplined. Monetary policy has been guided by the fixed exchange rate, which has successfully delivered low inflation. By keeping government debt to sustainable levels, fiscal policy has supported the fixed exchange rate regime.

2. Until recently, this stability in macroeconomic policies has been slow to translate into rapid output or employment growth. Since the mid-1990s, growth has averaged only 2 percent, well below other transition economies. Output has only recently reached its pre-transition level. The unemployment rate is one of the highest in the region.

3. However, it would be wrong to conclude from this that growth would have been higher if only monetary and fiscal policies had been more expansionary. Macedonia is a small and open economy. Experience from around the world shows that in such countries fiscal expansion soon leaks into higher imports and loss of international reserves. Monetary loosening would also result in reserve loss, depreciation, and inflation. Expansionary macroeconomic policy cannot generate a lasting improvement in living standards.

4. Spending the recent increase in international reserves also would not generate any lasting improvement in growth. To some extent the increase in reserves is due to privatization receipts. Since these sales will not recur, the proceeds are best saved (for example by repaying external debt) rather than spent. This strategy is already producing substantial economic benefits, by improving confidence in the fixed exchange rate and causing interest rates to fall.

5. To reach the country's full growth potential and to raise living standards, macroeconomic stability and structural reform need to work together. The government has implemented several important reforms in recent years, including the strengthening of customs and tax administration, labor market liberalization, introduction of the one-stop shop for registering companies, and privatization of electricity distribution. The ground work for judicial reform has also been completed. However, to sustain and accelerate growth a more ambitious pace of reform is needed.

6. Macroeconomic stability and ambitious structural reform, consistent with intensified efforts toward EU accession, could raise growth significantly. With ambitious reforms, capital inflows and investment (including Foreign Direct Investment (FDI)) should strengthen and growth could accelerate faster than envisaged under the program. Since imports are much larger than exports, the resulting increase in import growth rates would cause some widening in the current account deficit. However, as much of this should be FDI-financed, vulnerability should be less of a concern. Fiscal policy needs to keep to the 0.6 percent of GDP deficit target, to prevent overheating and contain the current account deficit.

7. However, if structural reforms slow and fiscal policy is allowed to loosen, the economy could quickly deteriorate. Weaker commitment to structural reform could slow growth back toward the low historical average. Failure to resist pre- and post-election pressures to raise public sector wages and pensions or for major tax cuts would raise the fiscal deficit. Government debt ratios would increase, while the fall in domestic savings would increase the current account deficit. Financial market confidence and capital inflows would worsen, and the fall in international reserves could again become an issue.

Statistical Issues

8. Understanding economic performance and assessing monetary and fiscal policy is complicated by data deficiencies. National accounts data are available only with a considerable lag, making it hard to understand the forces determining growth. Trade performance and competitiveness are also hard to gauge, with volume figures indicating an exceptionally large contribution of exports to growth difficult to reconcile with GDP estimates from the production side. Increased conversions of foreign currency into denars at cash exchange bureaus, a major contributor to last year's current account improvement, are also hard to interpret. Do these reflect increased remittances from abroad and, if so, how permanent are they likely to be? Or do they reflect capital inflows or the conversion of so-called mattress money? Efforts to improve statistical data are taking place, and the mission looks forward to their continuation, supported by additional resources. However, aside from making the macroeconomic analysis which follows more tentative than it could be, these statistical uncertainties caution against fine-tuning monetary and fiscal policy. This increases the premium on keeping macroeconomic policy stable and relatively simple.

Recent Developments and Prospects

9. Notwithstanding these caveats, last year saw a marked improvement in economic performance. The SSO's preliminary estimates suggest growth reached 4 percent in 2005, driven by strong exports, with tight fiscal policy and high interest rates at end-2004 restraining domestic demand. However, the true growth figure could be even higher: (i) corporate income tax receipts are much stronger than expected, likely reflecting higher profitability and value added; and (ii) the increase in consumption and investment due to higher private transfers and bank lending is unlikely to be measured fully. Despite higher oil prices, the stable exchange rate, lower tariffs, and food prices kept average inflation below 1 percent.

10. The external position is also considerably better, with gross reserves increasing to around €1,200 million (roughly 4½ months of imports, or 25 percent of GDP):

  • The official current account deficit fell sharply to 1.3 percent of GDP in 2005, but mainly because of increased private transfers, which probably includes some capital account elements. The trade deficit has declined by around 2 percent of GDP, with strong iron and steel exports, and lower consumption goods import growth offsetting higher oil prices; however, at just over 18 percent of GDP it is still high.

  • Last year's €150 million Eurobond and this year's electricity privatization (€225 million, almost 5 percent of GDP) have improved the capital account. However, greenfield FDI (as opposed to privatization-based FDI) is still very low; what FDI there is has been mainly in such sectors as banking, telecoms, retail trade and energy, which do not generate exports.

11. The improvement in international reserves has allowed some expansion in monetary and fiscal policy. The NBRM has been able to cut interest rates substantially and rapidly, from 10 percent in November to less than 6 percent, because of the increased reserves. Commercial banks have partly matched these rate cuts. Credit has expanded, especially to households for consumption and in foreign currency, though from a low base and slowly compared to the region. Fiscal policy is also modestly expansionary, last year's ¼ percent of GDP surplus giving way to a projected 0.6 percent of GDP deficit.

12. This monetary and fiscal policy easing should sustain growth in 2006, while inflation and the current account stay under control:

  • Growth in 2006 should meet the 4 percent projection. Though industrial production seems to have slowed in the first quarter, business confidence indicators have improved, new car sales are exceptionally strong, and credit growth since March has started to increase.

  • Inflation should average 3 percent. Consumer price inflation rose to 4.1 percent year on year in May, driven by supply factors such as increased tobacco taxes and oil prices, and higher than expected food prices (because of the harsh winter). Under the fixed exchange rate this price increase should only be a blip, with any pickup in domestic demand showing up in the current account. Core inflation remains well under control, and is projected at only 1 percent.

  • The official current account deficit should widen in 2006 to around 3 percent of GDP. This assumes higher oil prices, lower interest rates stimulating imports, and some slowing of last year's increase in private transfers. Main risks include higher oil prices (each $10 per barrel increase raises imports 1½ percent of GDP), steel production delays, and Chinese textile competition. On the upside, the projection for private transfers is quite conservative and the new free trade agreement with Serbia could increase exports of refined oil products.

Fiscal Policy

13. Keeping to the government's annual 0.6 percent of GDP fiscal deficit target over the medium term is essential for maintaining macroeconomic stability. First, uncertainty over the current account deficit's true size, as well as its history of volatility, caution against fiscal expansion. Second, though there are spending needs, institutional capacity in line ministries to spend additional funds efficiently is lacking. Third, rationalization of the public sector is far from complete, and needs to be done first before any spending increases are entertained. Finally, sticking to a clear fiscal anchor can create substantial credibility and expectational benefits, and provides essential support to the fixed exchange rate regime.

14. While the deficit target is likely to be met again this year, the mission regrets the recent proliferation of spending proposals from many fronts. These would worsen the composition of the budget. Recent initiatives include increased subsidies for tobacco farmers, higher health sector wages without full reform of the health sector, and benefits to workers made redundant from large firms. There are also additional proposals in the election campaign for spending increases and tax cuts. The mission is concerned at these proposals, which should not be allowed to undermine the 0.6 percent of GDP deficit target. Relying on higher telecom dividends to pay for these would be unsatisfactory, since telephone charges are exceptionally high and this revenue source will disappear once privatization is complete.

15. The authorities also need to find savings to meet medium-term fiscal challenges:

  • This year's second pillar pension system reduces social security revenues by 0.5 percent of GDP this year, rising to 0.9 percent of GDP by 2009.

  • Trade liberalization will reduce import tax revenues by around 0.1 percent of GDP.

  • Preparation costs for EU accession (initially institutional strengthening but later investment in transportation and the environment) should be small at first, but may rise later to 1-2 percent of GDP annually.

  • Loss of the telecom dividend after privatization will reduce revenues by ½-1 percent of GDP annually.

  • Public investment is only 3 percent of GDP, low by regional standards, and will face pressures to increase.

16. The incoming government should act quickly to address these medium-term fiscal challenges. Close to 80 percent of government spending is non-discretionary. This share needs to be lowered substantially to create flexibility for new initiatives. Rather than simply increase spending and create new institutions to meet EU priorities, spending needs to be reallocated. The best way to do this is through reorganizing the functions of government, which should be championed at the highest levels of government.

Monetary Policy

17. The mission supports the NBRM's gradual interest rate reductions under the fixed exchange rate regime, made possible by the accumulation of foreign reserves. However, the scope for further rate cuts seems limited given the uncertainty over the current account deficit, the slow transmission to bank lending and deposit rates and to credit growth, and because the differential with Euro rates is quite small compared to historical averages. With sterilization costs manageable, the NBRM should continue to sterilize further inflows in line with the monetary program. The further issuance of treasury bills for monetary policy purposes, especially with longer maturities, can help this process.

18. Despite the history of current account deficits, price competitiveness seems broadly appropriate at present. The real exchange rate has depreciated somewhat and, compared to countries with similar incomes, the Macedonian price level is low. Analysis indicates that the real exchange rate's current level is broadly in line with macroeconomic fundamentals. Although export market shares have declined, disaggregated data show this is largely explained by specialization in products with declining world market shares. Correcting this will require a reallocation to sectors that are growing more rapidly and with higher value added, through improving the business environment which would encourage FDI.

Structural Reforms for Growth and Employment

19. Though macroeconomic stability is a precondition, structural reform and improving institutional quality are also key if sustained growth of 5-6 percent is to be achieved. Since 1996, growth has averaged only 2 percent. Despite high unemployment rates, employment growth has been low, explaining part of this poor performance. Investment has been low too, but increasing investment from its current share of 22 percent of GDP to 25 percent of GDP, closer to the regional average, is likely to only raise the growth rate by around ⅔ of a percentage point. Productivity improvement is the most durable way to promote more rapid growth, and this is best achieved through building institutions that support a market environment. This will promote the transfer of ideas and best practices, especially through increased foreign direct investment, and allow existing labor and capital to be used more efficiently. Looking ahead, the scope for employment growth is also considerable, which should further boost output growth rates.

20. The wrong way to improve productivity and attract new investment would be to grant special concessions, such as offering tax breaks or subsidies to individual firms. Incentives schemes offering special treatment for investors do not succeed in attracting long term investment. The mission cautions the authorities against granting concessions (be it free economic zones, selling land below market prices, or direct subsidies to produce) to individual firms. Aside from governance concerns, these result in investments that typically create little value added, erode the tax base, and encourage other investors to seek similar special treatment. These practices also harm those firms which had decided earlier to invest based on the country's fundamental merits, and so ultimately can deter productive investment.

21. The right way is to create an attractive environment for all investors, domestic and foreign, large or small, that attracts investment projects on their merits. Unfortunately, measures of the business environment, like the governance indicators prepared by the World Bank—covering areas such as the costs of opening and closing a business, hiring and laying off workers, and contract enforcement—rank FYR Macedonia poorly against its neighbors. There has also been little change in the last ten years, suggesting little reform effort, but also considerable scope for higher growth. The most important actions needed to improve governance and lower the costs of business include:

  • Continue judicial reform. The government has amended many laws, and even the constitution, to introduce a comprehensive judicial reform. A coherent and credible strategy to implement these changes is needed, to reduce the backlog of court cases and to improve governance in the judiciary.

  • Enhance transparency of government action. Greater and more freely available information can promote better governance. The new Law on Free Access to Information should promote greater transparency. Electricity discounts should be offered to firms based not through individual negotiation but by clear rules based on rational and objective criteria. Abolishing discretionary power to sell state-owned land through direct negotiations would also strengthen governance.

  • Liberalize the telecoms sector. Aside from being an EU requirement, this is also important for reducing the cost of doing business. Publication of information on the internet and greater use of e-government can improve governance and efficiency, but these will only become effective once the high cost of telecommunications and internet access is brought down.

22. The government also needs to develop plans for reducing unemployment. Though the headline rate exaggerates the problem, mainly because informal workers register as unemployed to claim health benefits, the underlying unemployment rate still likely exceeds 25 percent. Last year's labor law reform should help, but unemployment is still a serious economic and social problem. More rapid economic growth is the most effective way to reduce unemployment, but in addition the following reforms should be considered: (i) reducing the labor tax wedge by funding healthcare by general taxes instead of social contributions on payroll; (ii) eliminating licensing requirements which should encourage the growth of small and medium-term enterprises; (iii) promoting part-time employment by phasing out minimum social contributions (which are based on minimum salaries assuming full time work for the whole month); (iv) reforming the education system to create human capital attractive to the needs of employers. Steps should also be taken to measure unemployment more accurately, by de-linking health benefits from unemployment registration, using existing public works projects to screen those who are truly unemployed, and using sanctions made possible by the judicial reform to encourage registration in the formal economy.

23. Sustained growth also requires a sound and well-functioning financial system. The number of banks and savings houses is very high for the country's size, suggesting considerable room for consolidation. By and large, the banking sector is adequately capitalized and liquid, though some weaknesses associated with the high level of non-earning assets and high operating costs persist, which lower bank profitability. With poor powers of creditor enforcement, banks have preferred to hold government paper rather than to lend; the recent reduction in NBRM rates could strain profitability in the less efficient banks. Foreign bank penetration is moderate, with most of the entrants from neighboring countries, and focused on providing services for their nationals' businesses. No major foreign bank has entered the market.

24. While much progress has been made, to enhance financial intermediation the authorities should consider: (i) continuing to strengthen banking supervision (especially in light of risks associated with foreign currency lending); (ii) revising the banking law to make it more in line with international best practice and EU directives; (iii) improving implementation of the law (especially bankruptcy and contract enforcement) to nurture a credit culture; (iv) strengthening transparency and corporate governance (for banks and also enterprises); (v) enhancing competition in the banking system (through entry of foreign banks, including allowing those from countries meeting high supervisory standards to open branches); (vi) increasing minimum capital adequacy ratios while enforcing the gradual write off of foreclosed assets; (vii) improving the quality of financial reporting and auditing; (viii) reducing intermediation costs (ending taxation of provisioning for bad loans and remunerating reserve requirements at closer to market rates); (ix) enhancing the functioning of the credit registry within the central bank.

25. Finally, the mission would like to thank the Macedonian authorities, parliamentarians, union leaders, and representatives of the business and academic communities, for their hospitality, helpful discussions, and cooperation. We look forward to returning to Skopje for discussions after the elections.

Table 1. FYR Macedonia: Selected Indicators, 2003-2007

  2003 2004 2005 2006 2007




  (Percent change)

Real economy


Real GDP

2.8 4.1 4.0 4.0 4.0

Consumer prices


  period average

1.2 -0.3 0.5 2.9 2.0

  end of period

2.6 -2.0 1.8



Real wages, period average

3.6 4.4




Unemployment rate (average)

36.7 37.2 37.3




Government finances

(In percent of GDP, unless otherwise indicated)

Central government balance 1/ 2/

-0.1 0.4 0.3 -0.6 -0.6

  Revenues (including grants)

38.4 36.5 35.8 33.8 34.5


38.5 36.1 35.6 34.4 35.1

Central Government debt 3/



39.0 36.6 40.2 34.9 34.6


34.9 32.5 32.5 20.2 21.0

Money and credit


Broad money (M3, percent)

18.0 16.1 14.9 20.5 23.0

Short-term lending rate (percent)

14.5 11.8 11.7



Interbank money market rate (percent)

6.8 8.3 9.2




Balance of payments

(In millions of Euro, unless otherwise indicated)


1,203 1,343 1,642 1,833 1,912


1,953 2,237 2,496 2,847 3,001

Trade balance

-750 -894 -853 -1,015 -1,089

Current account balance


  excluding grants

-227 -389 -114 -209 -290

  (in percent of GDP)

-5.5 -9.0 -2.5 -4.2 -5.6

  including grants

-137 -334 -62 -151 -201

  (in percent of GDP)

-3.4 -7.7 -1.3 -3.1 -3.9

Overall balance

14 -19 340 478 120

Official gross reserves

710 717 1,123 1,602 1,699

  (in months of following year's imports


  of goods and services)

3.3 2.9 4.1 5.5 5.6

External debt service ratio 4/

24.2 14.7 13.0 25.8 20.3

External debt to GDP ratio (percent) 5/

37.7 40.2 47.1 45.7 46.3

Exchange rate


Real effective exchange rate (CPI-based)

-0.1 -1.6 -3.3



Sources: Data provided by the authorities and IMF staff projections.

1/ Revised definitions are used starting in 2003.

2/ In 2005, central government spent an additional 0.4 percent of GDP on the NBRM recapitalization.

3/ In 2005 and 2006 the change in stock reflects a major debt management operation. Net debt is defined as gross debt minus government's deposits with the NBRM.

4/ Debt service due, including IMF, as a percent of exports. For 2006, includes a major debt management operation. Excludes rollover of trade credits.

5/ Total external debt, including trade credit. For 2005, includes a Euro 150 million Eurobond issue.


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