Public Information Notice No. 02/25

Public Information Notice: IMF Concludes 2001 Article IV Consultation with the former Yugoslav Republic of Macedonia

March 8, 2002

On March 4, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the former Yugoslav Republic of Macedonia (FYRM).¹

Background

After three consecutive years of generally favorable performance, the FYRM economy suffered a setback in 2001 because of a six-month security crisis. Output declined markedly. New outlays on security operations and weak revenues contributed to a large expansionary fiscal swing. Owing to a deterioration of the external current account position, the foreign exchange loss was heavy. However, the impact on reserves was cushioned by sizeable privatization inflows in early 2001. In the aftermath of the crisis, FYRM requested cancellation of the Poverty Reduction and Growth Facility/Extended Fund Facility arrangements. Subsequently, the authorities requested, and management agreed, that the IMF staff monitor their economic program for six months starting January 1, 2002.

There was a broad-based decline in real GDP of 4½ percent in 2001. Inflation, driven mainly by higher food prices, slowed only slightly to 5.3 percent. The unemployment rate fell by 1.7 percentage points to 30.5 percent, reflecting a buoyant informal economy and recruitment of a large number of reservists in the security forces.

The fiscal outturn in 2001 was substantially worse than anticipated in the original budget. Because of the crisis, additional spending on military equipment and on security personnel amounted to 6¾ percent of GDP. Tax receipts were lower than forecast in the budget in nominal terms, reflecting a weaker economy. In the second half of the year, the authorities embarked on a public investment program funded from privatization receipts. Partly to offset the pressures on the budget, the authorities postponed revenue-reducing measures originally envisaged for June, and introduced on July 1, for a six-month period, a new tax on financial transactions. Thus, the general government deficit in 2001 is estimated at 6 percent of GDP, implying an expansionary fiscal swing of 8½ percent of GDP relative to 2000. Of the swing, about 3 percentage points can be attributed to revenue-reducing measures introduced in early 2001 and the impact of cyclical factors.

The external current account deficit (excluding grants) is estimated to have widened by about 5 percentage points of GDP to 10¾ percent of GDP in 2001. The trade balance improved, as imports were severely compressed on account of lower domestic demand and more than offset a marked decline in export earnings, but there was a sharp drop in net inflows of private transfers. Thus, since the beginning of the crisis in late February through end-December, gross official reserves declined by about US$160 million (about 22 percent of total reserves at the beginning of the year). However, owing to receipts of US$323 million from the privatization of the telecommunications company in January, gross foreign exchange reserves remained at a relatively comfortable level of US$779 million, equivalent to 4.7 months of next year's imports, at end-December 2001.

The National Bank of Macedonia (NBM) was challenged in the conduct of monetary policy by the expansionary fiscal stance and an erosion of market confidence in the denar. Pressure on the foreign exchange market, which initially appeared in early 2001 following a fiscal-policy induced expansion of liquidity, intensified with the onset of the security crisis, and peaked in mid-June. Experiencing substantial foreign exchange loss, the NBM tightened monetary policy during May-June: the remunerated reserve requirement was increased and the interest rate on 28-day central bank bills was more than doubled to 20 percent. In addition, in August, the period for surrendering export proceeds was shortened from 180 days to 30 days. These initiatives and the signing of the peace framework agreement helped restore normalcy in the foreign exchange market by mid-August. Subsequently, the NBM lowered the interest rate on bills by 5 percentage points to 15 percent.

There was notable progress on the structural front. As part of civil service reform, in the first half of 2001, gross employment in the public administration was reduced by 6½ percent, through voluntary separation and early retirement. In the banking sector, the regulatory framework of bank supervision was strengthened further and "problem" banks took steps to improve their operations. The reform of the Payments Operations Bureau (ZPP) was completed by end-2001. However, the progress toward divesting non-core government activities and resolution of loss-making enterprises was slow, in part because of the complications created by the security crisis.

Executive Board Assessment

Executive Directors noted the enormous economic costs of the six-month security crisis in 2001: output declined markedly; the fiscal position deteriorated, owing to new outlays on security operations and weak revenues; and foreign exchange reserve loss was heavy. Moreover, despite the authorities' fiscal and monetary measures in mid-year to contain the negative impact, the crisis had made it difficult to comply with the PRGF/EFF-supported program, leading the authorities to cancel the arrangements.

Directors welcomed the authorities' formulation of a six-month stabilization program—being monitored by the Fund staff from January 1, 2002—and the prospects of substantial donor assistance. However, they observed that the FYRM faced significant challenges over the medium term. They stressed the importance of firm implementation of the Staff-Monitored Program, and hoped that the authorities would put together a policy package that could be supported by a successor arrangement with the Fund. Directors noted the importance of regional cooperation to strengthen the foundations for progress over the medium term.

While welcoming the authorities' commitment in the 2002 budget to reverse the large fiscal swing of the previous year, Directors underscored the need for further consolidation over the medium term to safeguard external sustainability and government debt dynamics. Spending pressures are likely in the coming years for modernization of the armed forces, realigning of the wage structure of civil servants, reform of the pension system, and for agreed measures under the peace framework agreement. Moreover, Directors stressed the need for durable measures to follow the current temporary adjustment measures in the 2002 budget. In this regard, Directors urged the authorities to eliminate the financial transaction tax by end-2002 and to consider introducing from 2003, base-broadening and tax rate adjustments of the VAT as well as strengthening its administration.

Directors also stressed the importance of further strengthening expenditure management and control. They encouraged the authorities to set up a framework for monitoring the budget's expenditure commitments and payment arrears. Directors saw efficient use of privatization receipts, especially on public investment programs, as vital to establish a strong basis for growth.

Noting that monetary policy initiatives at the height of the crisis had helped to restore confidence in the exchange rate anchor, Directors recommended that the central bank should continue to lower interest rates on its bills, as fiscal consolidation efforts take hold.

Directors agreed that FYRM's external competitiveness is broadly appropriate, but recommended that the exchange rate level and regime be kept under close review, especially if exports do not respond quickly as the peace framework agreement is implemented. In particular, Directors observed that maintaining the exchange rate anchor could be a challenge, once capital and financial transactions are liberalized later in the year. In these circumstances, greater flexibility in fiscal policy and the labor market will be needed to address any shocks to the economy. Directors encouraged the authorities to increase the operational independence of the central bank to cope with such exigencies over the medium term.

Directors noted that the health of the banking system remains fragile, notwithstanding improvements in the regulatory framework and supervision. They considered it important that the next stage of banking reforms focus on consolidating and improving transparency and governance. Directors welcomed the measures taken so far to combat money laundering and tackle the financing of terrorism, and encouraged the authorities to continue their efforts. They also welcomed the central bank's interest in a Financial Sector Assessment Program.

Directors stressed that continuing structural reforms would be key to improving the prospects for strong economic growth over the medium term. They welcomed the authorities' plans to find an early solution for loss making enterprises through sale or closure, and emphasized the need to do so in a transparent manner that ensures sustainable enterprise restructuring. Directors cautioned that the envisaged devolution of fiscal responsibilities to municipalities must be done in an orderly fashion, so as not to undermine fiscal soundness and the ongoing reforms or compromise delivery of services.

Directors recommended the authorities to improve further the quality, scope, and timeliness of statistics, and encouraged the authorities to expedite the preparation of relevant meta data for participating in the General Data Disseminating System.