Public Information Notice No. 05/23

Public Information Notice: IMF Concludes 2004 Article IV Consultation with the Republic of Moldova

February 17, 2005

On February 7, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Moldova.¹

Background

Economic activity benefited from a favorable external environment in 2003-04. GDP grew by 6.3 percent in 2003, advancing to 6.5 percent (y-o-y) in the first half of 2004. Large and rising workers' remittances underpinned consumption-led growth, helping consolidate Moldova's recovery from the 1998 regional crisis. While strong economic performance in neighboring countries encouraged exports, the contribution of net trade to growth was negative. Notwithstanding the recovery, Moldova is lagging considerably behind its neighbors, partly as a result of the Transnistria conflict. Moreover, productive capacity has weakened with the steady exodus of working-age Moldovans following the 1998 crisis.

Twelve-month Consumer Price Index inflation peaked at 17 percent in October 2003, reflecting a transitory flare-up in food prices, but moderated to about 11 percent by October 2004. The appreciating leu has helped attenuate the impact from higher oil prices, but domestic spending pressures and a tighter labor market have kept non-food goods price inflation up, while rapid money and credit growth have rekindled inflationary expectations.

Despite a substantial real exchange rate appreciation, international competitiveness remains favorable. Dollar wages are well below those in neighboring countries, and exports have been growing briskly. Although the real effective exchange rate appreciated by 11½ percent (y-o-y) during the first three quarters of 2004, it remained below the end 2000 level. The official current account deficit widened markedly to 6.8 percent of GDP in 2003, but the actual deficit is likely to be smaller on account of unrecorded workers' remittances, underinvoicing of exports, and overinvoicing of imports.

Following a general government surplus in 2003, the fiscal stance loosened considerably in 2004. While tax revenues remained buoyant, owing to more aggressive tax collection efforts and higher-than-expected inflation, projected nontax revenues and grants fell short of expectations, and primary expenditure exceeded original budget projections. The budget was revised in October 2004, and now staff projects a general government deficit of 1.1 percent of GDP for 2004, compared to a deficit of 0.4 percent of GDP in the original budget. With limited fresh external financing and lower-than-expected privatization receipts, the government increased recourse to bank financing and continued to run up arrears to some bilateral creditors, but resumed interest payments to the Paris Club. Recent external debt restructuring agreements—notably a buyback of Gazprom promissory notes—together with the leu appreciation, resulted in a marked decline in the external debt/GDP ratio.

Monetary policy was also expansionary in 2004, on account of continued large inflows of remittances. With inflation moderating in 2004, the National Bank of Moldova (NBM) stepped up its foreign exchange purchases and, as a result, international reserves hit a record high of US$392 million at end- September, finally reaching pre-1998 levels. Despite more intense sterilization efforts, by end-October both reserve and broad money were growing at over 30 percent (y-o-y).

Progress in structural reforms remains slow, while high transaction costs continue to hold back private sector-led growth. Some progress has been registered in fiscal reforms, and in revising the legal framework affecting investment, microfinance, audit, accounting, and leasing. Nevertheless, despite efforts to simplify licensing and business registration, there has been no significant improvement in the business climate. Moreover, the privatization program has stalled, while corruption remains widespread and governance weak. Government interference in the private sector—including formal and informal restrictions on exports of certain agriculture goods—casts doubt over the authorities' commitment to market-oriented reforms. The completion of the Economic Growth and Poverty Reduction Strategy (EGPRSP) is a step in the right direction, but implementation has been slow and uneven.

Executive Board Assessment

Directors welcomed the recent recovery of the Moldovan economy, the moderation of inflation, and the strengthened external position. At the same time, Directors expressed concern about the fragile basis of the recovery, and agreed that the key challenge ahead is to create an environment supportive of private sector development and foreign investment that will help promote sustained growth, domestic job creation, and poverty reduction. Accordingly, Directors urged the authorities to assign top priority to revitalizing structural reforms and reducing government intervention in the economy, while ensuring that macroeconomic policies are geared to stem inflationary pressures and underpin long-term growth. Directors also highlighted the importance of efforts to resolve the conflict in Transnistria.

Directors observed that Moldova's recent rapid economic growth has benefited from a favorable external environment as well as from large and rising workers' remittances. While the short-run outlook remains positive, they pointed to the risks of excessive dependence on remittances, as well as to impediments to sustained growth in the medium term. These include: emerging labor shortages and increasing capacity constraints resulting from large-scale emigration; rising inflationary pressures from strong inflows of remittances and rapid wage growth; a difficult business environment; and vulnerability to external shocks.

Directors stressed that the acceleration of structural reforms will be crucial for sustaining the economic recovery and improving external competitiveness. They noted that structural reforms have stalled, and urged the authorities to speed up implementation of the structural policies envisaged in their Economic Growth and Poverty Reduction Strategy, with a view to encouraging investment, reversing the current emigration trend, and channeling remittances into productive use. This will need to involve decisive efforts to reduce government intervention in the economy, revamp the privatization process, phase out excessive regulation, and reform the public sector, with a view to improving service delivery. While the recently approved anti-corruption strategy is a step in the right direction, Directors stressed that strong implementation of this strategy will now be essential to demonstrate ownership and underpin the reform effort.

Directors recommended a tighter fiscal stance than that envisaged by the authorities. This would support the central bank's efforts to control inflation and make room for current external debt service, thereby preventing a further accumulation of arrears. To ensure sustainability, fiscal policy would benefit from a more forward-looking perspective and greater emphasis on a medium-term expenditure framework that provides for adequate resources for poverty-related purposes. Directors commended the authorities' efforts to strengthen the budgetary process and improve tax administration, and also emphasized the need for measures to broaden the tax base, including through the removal of tax exemptions. The importance of efforts to strengthen the long-term viability of the pension system was also highlighted.

Directors recommended that monetary policy place greater emphasis on the inflation objective. Given the recent rapid credit growth and strong foreign currency inflows, it will be important for the National Bank of Moldova to tighten its stance, including through greater sterilization efforts, if needed, to counteract rising inflationary pressures. Ensuring the independence of the National Bank of Moldova would help achieve the low-inflation objective. While the buildup of reserves from low levels was desirable, a number of Directors suggested that a nominal exchange rate appreciation would be appropriate if foreign exchange inflows continue to grow rapidly, and that going forward, a more flexible exchange rate policy would serve Moldova well in absorbing external shocks. However, some Directors expressed reservations about allowing the exchange rate to appreciate at this time, based on concerns about competitiveness and uncertain flows of remittances. To improve competitiveness, Directors called for further efforts to remove remaining impediments to trade.

Directors were encouraged to note that Moldova's financial sector indicators are largely favorable, but urged the authorities to address remaining vulnerabilities in line with the FSAP's recommendations. In particular, they called for a reduction in the government's role and administrative interference in the sector, for more transparency in the ownership structure of financial institutions and corporations, and for efforts to address remaining weaknesses in the AML/CFT framework.

Directors commended the authorities for successfully restructuring some of Moldova's external debt and reducing the overall debt burden. They welcomed the resumption of interest payments to Paris Club creditors, but stressed that the outstanding arrears still need to be resolved, and looked forward to continued efforts to normalize relations with external creditors.

Directors noted that Moldova's official statistics are generally adequate for surveillance. They encouraged the authorities to address the remaining shortcomings—notably regarding price and national accounts statistics—with support of Fund technical assistance.

Directors looked forward to maintaining a close policy dialogue on the reform priorities with the Moldovan authorities in the period ahead. They emphasized that the effective implementation of a credible and well articulated reform program in line with the EGPRSP, together with restrained short-term policies, will be essential for building the track record necessary for securing possible new financing from the Fund.