Public Information Notice No. 03/63

Public Information Notice: IMF Concludes 2003 Article IV Consultation with the former Yugoslav Republic of Macedonia

May 20, 2003

On April 30, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the former Yugoslav Republic of Macedonia.¹

Background

The negative effects of the 2001 security crisis on growth persisted in the early months of 2002, but a turnaround in performance took place in the second half of the year. Real GDP declined by 2 percent, year-on-year, in the first six months of 2002, but a recovery in key sectors is estimated to have increased growth for the year as a whole to 0.5 percent. Industrial output picked up, particularly in the textile and steel industries. Peaceful elections and a decline in ethnically-based violence raise hopes that investor confidence is returning.

The fiscal consolidation planned in the original 2002 budget did not materialize mainly because expenditures departed significantly from the budget. The fiscal deficit in 2002 reached 5.8 percent of GDP, only 0.5 percentage point of GDP below the 2001 level.

The external current account worsened. Exports remained low in the first half of 2002 reflecting problems with market access and lagged effects of the crisis, but they recovered some of the lost ground in late 2002. Notwithstanding the gradual but steady improvement in exports, the current account deficit (excluding transfers) widened to 11.3 percent owing to a surge in imports and a number of one-time factors. As a result the loss of foreign exchange was heavy, but the impact on reserves was cushioned by exceptional financing: privatization receipts in early 2001 and donor support following the 2002 donor conference.

FYR Macedonia succeeded in maintaining the de facto exchange rate peg against the backdrop of large fluctuations in monetary aggregates. Electoral uncertainties and a weakening of fiscal discipline in the second half of 2002 increased the pressures in the foreign exchange market, but the availability of exceptional financing sources and the National Bank of the Republic of Macedonia's (NBRM) tight monetary policy stance enabled FYR Macedonia to maintain a comfortable level of foreign exchange reserves-4 months of imports and 100 percent of private denar broad money at end-2002-and reinforce the credibility in the exchange rate peg. Annual inflation rates, anchored by the peg, remained in single digits.

FYR Macedonia's track record in structural reforms remains mixed. The banking sector has strengthened but still has deep-rooted weaknesses. Non-performing loans are close to a third of the total and small banks remain weak, but profitability indicators are improving. However, the high degree of euroization of banks' assets and liabilities makes the assessment of banks' vulnerabilities particularly complex. The trade regime is fairly open. Free trade agreements have been signed with neighboring countries and with the European Union, and Parliament has recently ratified the WTO accession treaty. Efforts to downsize the public sector through divesting non-core activities and reducing employment in the public sector administration have been put on hold by the commitment of the signatories of the peace framework agreement (PFA) to increase the representation of minorities. Corporate governance in the enterprise sector remains weak. On one hand, many old firms survive with substandard performance, and progress in winding up a few large loss-making enterprises has been slow. On the other hand, profitability has improved among small and medium-size new firms.

The main policy challenges ahead are to reduce macroeconomic imbalances while implementing the PFA, address fiscal and external vulnerabilities, and generate the conditions for growth. Tackling these issues will require a combination of fiscal adjustment and structural reforms. The strategy of the new government envisages maintaining the de facto exchange rate peg, reducing the fiscal deficit over a two-year period (partly through clawing back in 2003 the non-recurrent aspects of the 2002 outlays), and putting in place reforms to strengthen private sector growth. To support implementation of such a program the authorities have requested a Stand-by arrangement covering the period from April 30, 2003 to June 15, 2004.

Executive Board Assessment

Executive Directors shared the authorities' view that the main priority in the former Yugoslav Republic of Macedonia is to boost economic growth and reduce unemployment following the sharp recession caused by the 2001 security crisis. In this regard, they welcomed the authorities' intention to focus on achieving a stable macroeconomic environment and strengthening the business climate in order to stimulate private investment; and they endorsed the strategy for achieving these objectives, which involves reining in the fiscal deficit, maintaining the de facto fixed exchange rate, addressing corruption, restarting structural reforms, and pressing ahead with the implementation of the Ohrid Peace Framework Agreement.

Directors stressed that fiscal consolidation is necessary to ease pressures on the external current account, allow more rapid growth of credit to the private sector, and stabilize the public debt at 40 percent of GDP or less. They cautioned that the high share of foreign currency-denominated debt and the government's large potential liabilities increased the former Yugoslav Republic of Macedonia's medium-term fiscal and external vulnerability. Most Directors considered the stance of fiscal policy for the period 2003-04 to be adequate for achieving fiscal and external sustainability. Directors considered the envisaged rapid pace of fiscal adjustment to be important for reinforcing the credibility of the government.

Directors generally agreed that the immediate fiscal adjustment should occur mostly through a winding-down of crisis-related spending, the expiration of other non-recurrent expenditures, and cuts in recurrent spending. For the medium term, they stressed the need to reduce public sector employment and to reform treasury operations in order to strengthen expenditure control. While success in carrying out the Peace Framework Agreement will be essential to restoring business confidence, accompanying pressures on public sector employment should be resisted. Furthermore, fiscal decentralization, an important element of the Peace Framework Agreement, will have to be implemented cautiously so as not to compromise fiscal soundness and accountability. Directors welcomed the expiration of the distortionary financial transaction tax and the rationalization of the value added tax, and called for improvements in tax administration to further strengthen the reliability and fairness of the value added tax structure.

Directors observed that the de facto pegged exchange rate regime has served the former Yugoslav Republic of Macedonia well as the monetary anchor, keeping inflation low even during the security crisis. They welcomed the recent reforms to increase the transparency of the interbank foreign exchange market. Directors agreed that, for the time being, and given the current limited capital mobility, the de facto peg remains appropriate in anchoring inflation if supported by prudent fiscal policy, greater labor market flexibility, and banking sector reforms. However, Directors suggested that the appropriateness of the exchange rate regime be reviewed in light of the gradual liberalization of capital flows, and that an adequate strategy be prepared in advance for a possible exit from the de facto peg. A number of Directors felt that a more flexible exchange rate system would help mitigate external shocks and reduce the risk of financial crisis. Directors supported the authorities' cautious and gradualist approach toward capital account liberalization, and the strengthening of monetary control through auctions of central bank bills. They also called for steps to increase central bank independence.

Directors expressed concern over the extent of euroization of the banking system. They urged the central bank to maintain a proactive supervisory stance, to monitor banks' foreign exposure and liquidity closely and to maintain adequate international reserve coverage. They welcomed the intention to introduce a reserve requirement on foreign currency deposits. Directors urged the central bank to address problem banks in a decisive manner, including by closure if appropriate. They stressed the importance of strengthening market discipline and protecting depositors. They welcomed the decision to participate in a Financial Sector Assessment Program.

Directors urged the authorities to press ahead with structural reforms to increase economic growth and employment opportunities and to reduce the external current account deficit. They emphasized that enterprises should be subject to market discipline, hard budget constraints, and strengthened bankruptcy procedures. While they encouraged further privatization, they stressed the need to follow transparent procedures and to avoid insider privatization. At the same time, the business environment needs to be improved to encourage investment, through, inter alia, steps to fight corruption, increase the flexibility of the labor market, and institute transparent bankruptcy procedures. In this regard, Directors praised the authorities' decision to step up the fight against corruption and urged them to be persistent and even-handed in these efforts. They stressed the importance of broad-based progress in public sector and corporate governance. Directors also welcomed the recent steps toward greater labor market flexibility and urged the authorities to bring labor market institutions under a more comprehensive review. However, they were skeptical of the authorities' program to provide fiscal incentives for hiring: subsidies might have only a limited impact on employment and could distort firms' investment and hiring decisions.

Directors stressed the need to diversify the export base to reduce the dependence on the volatile steel and textile exports. They welcomed the former Yugoslav Republic of Macedonia's accession to the World Trade Organization. They noted that further trade liberalization will increase competition, and urged the authorities to confront this challenge by removing impediments to efficiency.

Directors welcomed the recent upgrading of the framework for combating money laundering and the financing of terrorism. They urged the authorities to take additional steps to freeze terrorist assets without delay and to fully implement the UN Security Council Resolution and Conventions on terrorism financing.

Directors welcomed the authorities' efforts toward increased transparency and compliance with best statistical practice, and their intention to participate in the GDDS and in a data ROSC module.