Public Information Notice No. 06/54

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with the Republic of Moldova

May 15, 2006

On May 5, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Moldova.¹

Background

Economic growth has continued to be robust, although the drivers of growth—household consumption and construction—remain heavily dependent on inflows of remittances (now equal to some 30 percent of GDP), as well as strong wage growth. Real GDP growth in 2005 was over 7 percent, as it has been since early in the decade. Inflation has gradually abated. After peaking at over 14 percent in April 2005, it fell to 10 percent (year-on-year) in December, despite a sharp pickup in energy prices in mid-2005.

Fiscal policy has remained tight. The general government posted a cash surplus of about 1.7 percent of GDP in 2005, about twice the level of 2004, and considerably tighter than the deficit predicted in the revised 2005 budget (½ percent of GDP). The main factors driving this fiscal performance were better-than-expected Value Added Tax revenues, delays in implementing foreign-financed project investments, disbursement of a grant from the European Union on December 29 for which expenditures had been included in the 2006 budget, and some spending restraint on the part of the government.

Monetary policy was tightened in 2005, despite continued strong inflows of remittances. Sterilization efforts were stepped up in the second and third quarters before easing in the fourth quarter, as the balance of payments weakened in light of higher energy prices and the National Bank of Moldova (NBM) moderated its foreign exchange purchases. The NBM's balance on sterilization operations rose from an average of 1.1 percent of GDP in 2004 to an average of 2.9 in 2005, reaching 3.5 percent of GDP at end-February 2006. As a result, reserve money growth slowed during the year, falling to 16½ percent at end-September, before rising seasonally in December. At the same time, broad money growth remained strong (at 35 percent for the year as a whole). Lending and deposit rates have remained high, despite plentiful liquidity on the T-bill and interbank markets. Financial sector soundness indicators have remained generally strong, reflecting partly strong economic performance of the recent years.

Moldova appears to follow an asymmetric, managed floating exchange rate regime. Since early 2004, it would appear that downward pressure is accommodated while upward pressure is absorbed by the NBM through purchases of foreign exchange. The leu appreciated in real effective terms in 2004, but with a weaker balance of payments and lower inflation than in key trading partners, this tendency leveled off in 2005. Reserves have grown as well, doubling in dollar terms since end-2003, though as a share of imports they remain modest at about 2.2 months.

The trade balance deteriorated significantly in 2005, owing in large part to the impact of higher energy prices. Energy (particularly fuel oil) imports rose in value terms by about 50 percent in 2005 (to about 5 percent of GDP), while export growth slowed modestly. The structural reform agenda has been reinvigorated by Moldova's aspirations for closer integration with Europe. The European Union-Moldova Action Plan, signed in February 2005, provides, along with the authorities' EGPRSP, a road map for advancing a broad reform agenda, including in areas public administration, public expenditure management, and management of state enterprises.

Executive Board Assessment

Executive Directors welcomed the strong economic growth and significant poverty reduction in recent years, the moderation of inflation, and the strengthened fiscal position, and commended Moldova's authorities for their commitment to structural reforms and balanced macroeconomic policies. At the same time, they noted that growth has been fueled mainly by domestic spending, which was financed by workers' remittances. Directors agreed that maintaining macroeconomic stability in light of robust inflows of remittances while diversifying the economy and bringing poverty further down remain the key challenges going forward. They also stressed the importance of improving the business environment to support greater private sector investment and thus to help reverse the large migration of labor and strengthen the external position.

Directors commended the authorities for their disciplined macroeconomic policies and considered that the short-term fiscal stance constituted an appropriate balance between the objective of supporting disinflation and meeting the need for larger public investment and social spending. Looking ahead, most Directors encouraged the authorities to repeat the fiscal overperformance of recent years, though some Directors favored devoting revenue in excess of budgeted amounts to poverty reduction and infrastructure spending if the macroeconomic environment
permits it.

Directors welcomed the authorities' efforts to modernize public sector management to improve the efficiency of government operations. They observed given the large size of the government, that the public administration reform currently underway should lead to a leaner, more focused, and transparent government structure. While Directors welcomed the decision to fully pass through energy price changes, they expressed concern about the large increases in public sector wages in 2006 and urged the authorities to ensure that the wage profile remains consistent with priorities identified in the medium-term expenditure framework.

Directors welcomed the decline in inflation during 2005. Nevertheless, they noted that inflationary pressures remain, particularly in light of the increasing energy prices and the tightening labor market, and urged the authorities to be prepared to tighten monetary policy. Directors also encouraged the authorities to permit greater exchange rate flexibility to minimize risks to the disinflation path and facilitate the economy's resilience to balance-of-payments shocks. In this context, they welcomed the authorities' decision to amend the National Bank law to establish price stability as its key objective and stressed that this legislative change needs to be matched by steps in monetary policy implementation.

Directors welcomed the authorities' renewed push for structural reforms and underscored their importance to sustain the economic revival and maintain external competitiveness. They stressed the importance to improve the environment for private initiative and investment also by reducing licensing and registration requirements and other administrative barriers and strengthen the legal and institutional framework and governance. They encouraged the authorities to accelerate implementation of the structural policies envisaged in their EGPRSP to encourage investment, reverse the current emigration trend, and use the strategy to make progress in achieving the Millennium Development Goals. Directors also noted that the EU-Moldova Action Plan—which is consistent with the EGPRSP—will serve as a useful roadmap for the ambitious reform agenda.

Directors noted that financial sector stability indicators were largely positive, but urged the authorities to address remaining vulnerabilities. They emphasized the crucial importance of financial sector development to underpin economic and employment growth. Directors considered that Moldova's financial sector, and the economy more broadly, would benefit from a presence of reputable international banking institutions. In this context, they welcomed the authorities' intention to privatize Banca de Economii. Directors also commended the authorities for strengthening the Anti-Money Laundering/Combating Financing of Terrorism framework and their objective of bringing it in line with best practices over the medium term.

Directors welcomed the sustained improvement in Moldova's external debt position and expressed hope that Moldova will be able to normalize its relations with Paris Club creditors and restructure its stock of arrears in the near future, underscoring that this would facilitate access to fresh donor financial support.

Directors were encouraged by Moldova's subscription to the Fund's Special Data Dissemination Standard as an important step to further improve transparency, timeliness, and comprehensiveness of economic and financial data.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.