Public Information Notice No. 04/5

Public Information Notice: IMF Concludes 2003 Article IV Consultation with the Republic of Moldova

February 2, 2004

On January 26, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Moldova.¹

Background

Real GDP grew by 7 percent in 2002 and 6.2 percent in the first three quarters of 2003, driven by strong consumer spending, which in turn was underpinned by a marked increase in real wages and workers' remittances. Private sector investment seems to have recovered in 2003 but remains too low to support strong medium-term growth. Consumer price inflation declined to 4½ percent at end-2002, but picked-up in 2003, reaching 17 percent in the 12 months to October. The increase in inflation was driven by rapid money growth, as well as higher food and administrative prices.

The external current account deficit was 6 percent of GDP in 2002. The deficit widened in 2003, reflecting strong import growth, only partly offset by higher exports and the recorded inflow of workers' remittances. The trade deficit increased by almost 6 percentage points of annual GDP during the first three quarters of the year, compared to the same period in 2002. While foreign direct investments dropped sharply in the first three quarters, net foreign exchange inflows were strong, suggesting large unrecorded inflows, including workers' remittances. The National Bank of Moldova (NBM) intervened in the foreign exchange market to avoid an appreciation of the leu. Over the last two years, there has been no clear trend change in the nominal exchange rate. The foreign exchange purchases in 2003 allowed the NBM to keep international reserves at about two months of imports through October.

The largely unsterilized purchases of foreign exchange fueled rapid money and credit growth in 2002 and 2003. Broad money and credit to the economy grew by 34 percent and 49 percent, respectively, in the 12 month to September. To stem the inflationary pressure, the NBM tightened monetary policy in 2003 by increasing reserve requirements and its main policy interest rate. Although the REPO rate was gradually raised by a total of 3½ percent, this had little effect on NBM's net credit to banks. In September, the NBM moderated its foreign exchange purchases, leading to appreciation of the leu against the dollar.

Fiscal policy has remained reasonably tight, but external arrears started to accumulate. The general government posted a cash deficit of 1.8 percent of GDP in 2002, while net arrears of 0.9 percent were cleared. During the first three quarters of 2003, a cash surplus of 0.5 percent of GDP was recorded, reflecting robust collection of VAT and import duties, and lower-than-anticipated interest expenditures, owing to accumulation of external arrears.

With limited new external financing, external debt service continues to be a fiscal challenge. Scheduled debt service on public and publicly-guaranteed debt represents about 45 percent of projected central government revenues in 2003. Moldova suspended debt service payments to Gazprom at end-2001 and to some bilateral creditors in August 2003. The authorities' requests for individual reschedulings have met with limited success so far. Accumulated new external arrears during the first three quarters of 2003 amounted to about US$26 million.

Progress in structural reforms remains slow. In particular, there has been no significant improvement in the business climate, while corruption remains widespread. Government interference in the private sector—including formal and informal restrictions on exports of scrap metal and some agriculture goods—casts doubt over the authorities' commitment to market-oriented reforms. While the privatization of some wineries has been completed, a number of large-scale privatizations have been postponed.

Executive Board Assessment

Executive Directors welcomed Moldova's robust economic growth in 2003, but noted that the prospects for sustained economic growth are less positive. They expressed concern about weak ownership and implementation of structural reforms, and about the increasing signs of overheating—reflected in sharply rising domestic demand, imports, and inflation. However, they were encouraged by the authorities' recent decision to develop a medium-term economic strategy focused on tight financial policies, private sector development, public administration reform (including fighting corruption), and rationalization of social policies. Directors urged the authorities to develop a concrete set of measures to achieve these goals.

Directors stressed the need to adhere to prudent macroeconomic policies and to embark on a structural reform program that could provide the basis for renewed international financial support. To improve growth prospects, Directors urged the authorities to reduce administrative intervention in the economy and provide an enabling environment for business. At the same time, tighter monetary and fiscal policies would be needed to curb inflation, improve the debt dynamics, and allow a resumption of external debt service payments.

Directors noted that fiscal policy in the recent past has been prudent and that tax collection had strengthened, and encouraged the authorities to press ahead with fiscal reform. At the same time, Directors regretted the fiscal loosening implied by the 2004 budget and the increasing threats to fiscal sustainability. They urged the authorities to take additional fiscal measures to avoid further accumulation of arrears and to keep the public finances on a sustainable path, including eliminating Value Added Tax exemptions, delaying planned tax cuts, reducing non-essential current spending, and improving budget planning and public expenditure management.

Directors agreed that monetary policy should focus on keeping inflation low. They warned that the recent surge in inflation called for tighter policies. They also expressed concern that the rapid credit growth could lead to a deterioration in the quality of bank's portfolios. Directors commended the NBM for recent improvements in banking supervision and the resulting strengthening in the banking sector. Given the potential vulnerabilities, the NBM should remain vigilant in assessing the banking sector's exposure to shocks. They hoped that the upcoming Financial Sector Assessment Program will help to address remaining banking sector vulnerabilities.

Directors acknowledged that the managed float exchange rate regime has served Moldova well. They observed, however, that a nominal appreciation might be warranted if the inflow of workers' remittances continues to rise rapidly. Ultimately, external competitiveness should be improved by implementing appropriate structural policies, while maintaining a liberal exchange and trade regime. In that context, Directors urged the authorities to resist pressure for protectionist measures.

Directors expressed concern about the fiscal burden of Moldova's external debt service, particularly during the next few years when the bulk of the relatively short-term and non-concessional external debt falls due. Directors remarked that a solution to the debt problem would require a combination of further fiscal tightening, some form of debt restructuring, and additional concessional external financing. They added that additional financing is unlikely to materialize unless market-oriented reforms are implemented. They also cautioned the authorities against continued arrears accumulation, since this strategy is not likely to lead to a sustainable resolution of the debt problem. At the same time, remaining current on external debt obligations would help restore creditors' goodwill and foster renewed financial support to Moldova.

Directors stressed that the slow progress in market-oriented reforms has aggravated Moldova's vulnerability to external shocks and could undermine medium-term economic prospects. Therefore, they urged the authorities to accelerate the implementation of structural reforms in order to improve growth and poverty reduction prospects. Directors supported the authorities' intention to use the Economic Growth and Poverty Reduction Strategy Paper (EGPRSP) as the main vehicle to develop their medium-term economic strategy. They encouraged the authorities to include policies to improve the business environment and governance and to implement these policies as soon as possible. They considered that reforms should be properly timed and sequenced, and that an effective safety net with well-targeted assistance should be established.

Directors welcomed the opportunity to assess Moldova's program engagement with the Fund. They thought the Ex Post Assessment contained a balanced analysis of the country's performance under Fund programs and of the design by the Fund of those programs. They emphasized that clear evidence of a change in the direction of economic policy would be needed to facilitate Moldova's re-engagement with the international community on discussions of new programs.