1. Since the beginning of 1994, the government has been implementing a bold program to restore macroeconomic stability and support a rapid transition towards a market economy. The reform strategy has been designed around the discipline of a fixed exchange rate coupled with structural reforms to create market institutions, consolidate private ownership, and reduce the cost of doing business. Financial support from the International Monetary Fund, the World Bank, the European Union, and other bilateral donors has been key to the successful implementation of the program. An adverse regional environment notwithstanding, the post-independence decline in output has been arrested, price stability has been restored, relations with all external creditors have been normalized, and an extensive structural reform agenda has been implemented.

2. To enhance the conditions for growth and a sustainable reduction in unemployment, the government intends to continue pursuing the medium-term strategy outlined in the original Policy Framework Paper for the period 1997–99. Together with the staffs of the IMF and the World Bank, a revised program for 1998–2000 has been developed (summarized in Table 1) for which the government is seeking continued support in the form of a second annual arrangement under the IMF’s Enhanced Structural Adjustment facility (ESAF) and a Social Sector Adjustment Credit (SSAC) from the World Bank, in addition to other ongoing adjustment and investment lending.

3. The adjustment strategy in 1997 relied on a tightening of the fiscal stance to support a reduction in the current account deficit without a change in the nominal exchange rate. With cost competitiveness having improved steadily since 1995 as a result of price stability and restructuring in the enterprise sector, export growth was expected to contribute significantly to external adjustment and to lead a recovery in output from its depressed level. Meanwhile, structural reforms were advanced on a broad front: the privatization program was kept up; measures to restructure the largest commercial bank were implemented; the labor laws were amended; laws to streamline bankruptcy proceedings and the execution of claims were introduced; a restructuring program was begun in the agricultural sector; the external trade regime was liberalized further; and changes were made to social benefits in order to improve the sustainability of the social safety net and its targeting to the most needy.

4. However, while broad price stability was maintained, real GDP growth of 1.5 percent in 1997 fell short of the 5 percent target. Part of the growth shortfall reflected a competitiveness problem that was revealed in the first half of the year when the balance of payments remained under strain despite evidence that the economy was stagnating. Thus the denar, which had maintained its parity against the deutsche mark since early 1994, was devalued by 14 percent in July. The devaluation was supported by a wage freeze in order to ensure the maximum boost to competitiveness. Strong fiscal backing was also provided through supplementary expenditure cuts and measures to strengthen tax compliance, although the original fiscal targets proved unobtainable due to a large revenue decline in the first half of the year. Since the devaluation, price stability has been maintained, the foreign exchange reserves have increased, and exports and output have begun to recover.

5. The disappointing growth performance in 1997 also reflected the continuing problems in the enterprise and banking sectors. With privatization well advanced, low profitability and rising inter-enterprise and wage arrears were to a large extent the result of poor corporate governance and insufficient enterprise restructuring. At the same time, the recycling of bank credit to loss-makers perpetuated very high real interest rates (around 20 percent), starved profitable enterprises of working capital, and added to the fragility of the banking system. The government places priority on addressing these problems in its updated economic strategy.

A.  Overall Strategy and Macroeconomic Framework

6. The government’s strategy for 1998–2000 aims to improve living standards by consolidating private ownership and strengthening market-based institutions. Macroeconomic policies will focus on providing a stable financial environment to engender enterprise adjustment, reduce interest rates, and promote investment and jobs. The structural policy agenda will focus on measures to strengthen corporate governance and bank lending practices, while a radical overhaul of the size and structure of public expenditure will place the fiscal accounts on a more sustainable footing and provide room for a reduction in the excessive direct tax burden. Emphasis will also be placed on developing financial markets in order to foster savings and enhance monetary control, on removing barriers to trade and foreign investment in order to promote the transfer of needed capital and technology, and on removing labor market restrictions.

7. GDP growth is projected to average 5 percent a year in 1998–2000 (Table 2). In 1998, growth mainly results from an increase in exports as a result of the devaluation. Thereafter, productivity-enhancing structural reforms and lower interest rates are expected to foster continuing strong export growth and an increase in investment to 20 percent of GDP in 2000 from 17 percent of GDP in 1997. Financial policies will ensure that annual inflation is at or below 3 percent, while official reserves are projected to increase to three months of merchandise imports by end-2000.

8. Strong import demand driven by the expected recovery in economic growth and high debt service payments to official and commercial creditors will continue to place demands on the external balance of payments. Assuming a stable regional situation, higher export earnings will provide part of the needed financing, while anticipated direct investment receipts will contribute further resources. Nonetheless, additional resources from the international community will be needed to ensure that the balance of payments is fully financed.

B.  Fiscal Policy and Budget Reforms

9. The key objective is to bring the structure of taxes and expenditures in line with the country’s development needs. This will require a radical overhaul of expenditures involving reductions in public sector employment, the elimination of inefficiencies in the health and education sectors, and reforms to social benefit programs to ensure their long-term affordability. At the same time, the tax system will be modernized and direct tax rates lowered in order to reduce disincentives for job creation. At all times, a prudent fiscal stance will be observed with any deficits being matched by external financing of capital expenditures.

Taxation Policies

10. In view of an unexpected collapse of revenues in the first half of the year, tax policy in 1997 focused on measures to enhance tax compliance. These had two main components: a one-time tax amnesty and the use of the Bureau of Payments Operations (BPO) to automatically deduct social security contributions from enterprises’ accounts. The measures have so far proved successful. In addition, excise taxes on cigarettes, which had been so high as to encourage tax evasion, were cut sharply, the corporate profit tax rate was halved to 15 percent, and the profit tax surcharge earmarked for the Public Water Management Authority was revoked. The customs administration has been brought under the purview of the Ministry of Finance and, with technical support from the IMF and World Bank, is well advanced in implementing the ASYCUDA electronic data management system. There was no room to begin lowering social security contribution rates in the 1998 budget. However, in a move to encourage job creation, the government introduced a limited scheme to exempt new employees from social security contributions.

11. A key element of the government’s tax reform agenda is the replacement of the sales tax by a broad-based VAT. The Ministry of Finance has established a VAT developmental unit and is in the process of developing the necessary regulations and training tax administration staff. The government will submit final VAT legislation to parliament by mid-1998 with a view to full implementation at the beginning of 1999. Technical assistance from the IMF and bilateral donors has been arranged in this regard.

12. Additional reforms will focus on: rationalizing personal income tax exemptions; replacing various corporate tax preferences, including those for foreign investors, by a single investment expenditure allowance; introducing a profits tax carry-over provision; replacing the taxation of bank lending spreads by a VAT on financial services; and, over time, establishing an effective global income tax. The elements of the BPO responsible for withholding personal income and social security taxes will be merged with the tax administration department into a new Central Treasury Office, which will be provided additional resources to broaden the coverage of the growing private sector. In order to generate resources for budgetary priorities, special revenue items—including earmarked taxes (such as stamp duties) and administered fees (such as passport fees and legal penalties)—will be transferred to the general account in the 1999 budget.

13. These tax reforms, combined with a rationalization of public sector expenditure, should allow the government to reduce tax and social security contribution rates, beginning in the 1999 budget. Combined with projected macroeconomic developments, these reductions should allow government revenue to fall from 38.9 percent of GDP in 1997 to 35.5 percent of GDP in 2002.

Expenditure Policies

14. While export and agricultural subsidies have been largely eliminated and the public sector wage freeze extended into 1998, broader public expenditure reforms in 1997 were overshadowed by the need to re-balance expenditures with the lower-than-budgeted revenues. Maintaining fiscal balance came at the expense of discretionary expenditures, particularly investment programs, which will need to be restored. Recognizing the need to reduce the size and cost of the public sector, the government received technical assistance from the IMF in 1997 on options for restructuring public expenditures.

15. The current level of public expenditure is more commonly seen in countries with much higher per capita incomes. A correspondingly high level of non-discretionary spending, especially on wages, constrains budget policy and the ability to push through needed tax cuts. Building on recent technical assistance from the IMF, the government intends in 1998 to prepare a comprehensive public expenditure plan. The reform plan for the central government will address the structure of line ministries, the level of budget sector employment, and the public sector salary structure. Rationalization of the education sector will not be done in a way to undermine the quality of education. Nor is it the expectation that cuts in public employment would translate one-for-one into higher unemployment as the focus will be on spinning off publicly-provided services into the private sector. At other levels of government, the government will introduce measures to rationalize the health sector and social security benefits (see Section IV). Our ongoing reform plans for public expenditure will be developed with the support of the World Bank through an expenditure management study and, subsequently, a public sector adjustment lending operation.

16. The government recognizes the need to start servicing frozen foreign currency deposits in order to foster confidence in the banking system. It plans to do this by issuing tradable securities in exchange for the deposits, a move which should help to develop financial markets. The government will keep cash repayments low over the next few years to avoid undermining the fiscal and balance of payments position. To help reduce the need for cash repayments, the government will investigate ways to exchange frozen foreign currency deposits for government assets such as land and privatization shares.

17. Control over the planning and execution of the budget will be enhanced in a number of ways. First, the Ministry of Finance will allocate more resources to improve budget analysis and forecasting as a first step toward developing a system of program budgeting. Second, a Central Treasury Office, separate from the Budget Department and incorporating all treasury functions currently performed by BPO will be established during 1998–99. Third, computerized reporting of commitments will be extended to line ministries by end-1998. Fourth, integration into the budget of the various extra-budgetary funds—including the Bank Rehabilitation Agency, the Road Fund, the Privatization Agency, and counterpart funds of foreign assistance—will be reviewed so as to improve overall financial control. Fifth, an integrated Management Information System for health facilities and the Health Insurance Fund, supported under the World Bank Health Sector Project, will be developed. Given successful implementation of the government’s reforms, expenditure is projected to decline from 39.4 percent of GDP in 1997 to 35.5 percent of GDP in 2002.

Public Investment Program

18. The government’s investment program emphasizes economically viable projects consistent with the need to maintain macroeconomic stability in the medium term. Implementation of the Public Investment Program (PIP) in 1997 slipped, given the severe fiscal constraints, and general government investment was only 1.5 percent of GDP. Projects expected to have been started/completed in 1997 have been rescheduled in the government’s updated PIP for 1998–2000. This plan identifies 51 projects, of which 38 are new, in the areas of water resources, telecommunications, energy, transport, education, environment, health and social services. The estimated cost for the general government and public corporations is $900 million. The government intends to finance about 19 percent of the cost of the projects in the PIP out of its own resources. A further 64 percent of the financing is expected to be raised from external donors and creditors, with the remaining 17 percent being raised from domestic private sources. The government will selectively implement projects identified in the PIP depending on the availability of appropriate financing. The Ministry of Development will continue its yearly updates of the PIP and prepare reports on the progress and financing of PIP projects. Budgetary resources and guarantees will be provided only for investment programs included in the PIP. The government will work on building technical capacity to analyze and improve the quality of the PIP and seek long-term technical assistance for this purpose.

C.  Monetary Policy and Financial Market Development

19. The government does not believe there is a case for moving away from an exchange-rate based monetary policy at this stage, particularly given the importance of exchange rate stability in the formation of inflationary expectations and the difficulty of estimating money demand in a small, open economy. Since the devaluation, the strains in the foreign exchange market have dissipated and monetary growth has recovered. Interest rates remain high, but this largely reflects structural problems. While the appropriateness of the exchange rate level will remain under review, productivity growth and cuts in labor taxes are expected, over time, to enhance competitiveness and cement the sustainability of the balance of payments.

20. With further technical assistance from the IMF, the National Bank (NBM) is designing a plan to eliminate bank-by-bank credit ceilings and to achieve monetary control through more efficient indirect instruments. A prerequisite is to deepen the market for NBM bills through enhancing their yield and liquidity characteristics, as well as to increase the transparency of deposit auction procedures. In order to facilitate development of a secondary market, bills in a paper form will be issued. The NBM and Ministry of Finance will also explore issuing treasury bills and the possibility of introducing repurchase operations with short-term commercial and government paper. In conjunction with these plans, the NBM will make a clear distinction between lending to banks in distress and lending through its deposit auctions, so as to achieve a more market-based allocation of NBM credit. Accordingly, interest rates on the NBM’s Lombard facility will be raised to at least the level of overnight interbank interest rates. Pre announced prudential ceilings will remain the only restrictions on the size of banks' cumulative access to deposit auctions, and these will not be frequently changed. Liquidity management will focus instead on developing the market for bills, which will also allow the elimination of time deposit taking by the NBM. The NBM will continue to support development of the inter-bank money market by encouraging participation and reducing costs. Reserve requirement ratios for sight and term deposits will be unified and the rate of remuneration on required reserves raised.

21. Phasing out bank-by-bank credit ceilings will be backed up by enhanced bank supervision. In this context the NBM will submit to its Executive Council guidelines for dealing with failing financial institutions, ensure adequate staffing for off-site supervision, develop a basic training program for supervisors, increase the number and frequency of on-site inspections, and introduce tougher accounting standards and audit requirements for banks. In the same vein, the deposit insurance scheme will be modified to lower the potential for moral hazard by imposing a specific denar cap on amounts insured and clarifying that the fund will make payments to depositors of insolvent—and not illiquid—banks.

D.  Banking Sector and Payments System Reform

22. A large stock of non-performing loans that is perpetuated by the recycling of bad loans to loss-making enterprises is a major factor keeping interest rates high. To head off potential systemic problems, and to bring pressure on banks to strengthen their lending practices, the NBM has stepped up its monitoring of bank lending to delinquent debtors. Some of the largest individual bank exposures to bad debtors will be reduced through enforcing prudential regulations governing single-exposure limits, which came into effect at end-April 1998. In other cases, the NBM will carry out on-site inspections of all banks that do not heed advice to provision new lending to delinquent debtors; in the case of enterprises with debt that is already more than 50 percent classified in category D or E, banks will be expected to fully provision all new lending. The NBM will complete full audits of the three largest commercial banks shortly after the middle of 1998.

23. To further ensure more healthy relations between banks and enterprises, regulations on exposure to connected parties will be strictly enforced and banks will be required to sell equity acquired through debt-equity swaps. Banks will be expected to take the lead under the new Bankruptcy Law in forcing delinquent enterprises into bankruptcy.

24. NBM credit to the largest commercial bank, Stopanska Banka, has been successfully restricted, 360 employees of the bank have been laid off, and the large short-term debt of Stopanska to the NBM has been exchanged for government bonds held by Stopanska. The expected sale to foreign investors of a majority shareholding in Stopanska potentially represents a big step toward more independent, profit-oriented banking. However, mindful of past slippages in the timetable for selling the bank, Stopanska’s credit ceiling and its restriction on access to NBM liquidity will remain in place until the sale has been completed.

25. The government intends to set up a new export bank. It will not be a deposit-taking institution and its initial capital will be limited to DM 30 million. The bank will operate on commercial terms and any development activities will be limited to on-lending lines of credit from official foreign agencies. The bank will be barred from doing business with enterprises that are not current on their loans to commercial banks.

26. To complement the new Law on Executing Claims, the government will approve a new law on movable collateral in 1998. This should strengthen institutions and judicial practices related to lending and improve loan recovery rates. The government will also establish a credit bureau that will disseminate information and analysis on the financial condition of companies. Continuing technical assistance will be sought to improve risk management, credit appraisal, loan administration, and accounting standards.

27. A move toward a more decentralized payments system that is consistent with supporting financial sector development is well advanced. Corporations can now submit large value payment orders though commercial banks as opposed to solely the BPO, and the BPO fee on interbank transactions through the NBM has been eliminated. Further reforms will focus on eliminating the restriction on legal entities to have only one payments system account, gradually lowering the threshold for large value payment orders that can be intermediated through commercial banks, and shifting the credit risk in the settlement system from the NBM to commercial banks. The ultimate goal is to have banks take over complete administration of all accounts and fully implement a real time gross settlement system by 2000. Responsibility for the withholding of wage taxes will be shifted during 1998–99 to a Central Treasury Office under the Ministry of Finance. Also the BPO’s responsibility to seize assets of debtors will be shifted to commercial banks acting under the guidance and within the jurisdiction of appropriate bankruptcy courts, once the government has reviewed legislation on the enforcement of commercial contracts and implemented measures to improve the efficiency of judicial procedures.

E.  Privatization and Enterprise Restructuring

28. The privatization of over 1,200 enterprises identified for divestiture has been completed and the process for the few remaining enterprises is underway. Nonetheless, enterprise performance has yet to turn around, investment is stagnant, and foreign investor interest remains muted. It is true that many of the reforms that have been put in place will take several years to come into full flower. Nonetheless, the keys to more effective structural adjustment are to further improve corporate governance through consolidation of ownership and to allow the new bankruptcy procedures to operate.

29. The government is taking the lead in addressing the problems in 12 large loss-making enterprises that either remain in majority public ownership or that will revert to public ownership because of non-payment of privatization installments by the current owners. The plan is to restructure and sell the enterprises to strategic investors by early 1999. Those that cannot be sold will be liquidated. To facilitate the government’s plan, an external advisor is being appointed and the current law on the Privatization of Social Capital has been amended to eliminate biases toward employee and management buyouts and remove price restrictions on the direct sale of enterprises. The government can potentially offer large packages of shares in additional enterprises by combining the equity holdings of government agencies such as the Bank Rehabilitation Agency and the Pension Fund. Unviable enterprises that cannot be sold will be liquidated. Effective privatization will also be enhanced by enforcing the deadline for banks to divest shares acquired through debt-equity swaps.

30. The ability of managers to block sales of shares to outsiders remains an important barrier to improving ownership structures despite efforts in 1997 to eliminate restrictions inherent in the company law. The government has therefore amended the company law again to address remaining loopholes and remove restrictions on secondary share trading for all companies. As a complementary measure, it will require that registries of shares are not kept by companies but are held independently in the central share registry and a mechanism for trading shares in book-keeping form be instituted. A one-stop agency to assist foreign investors will also be set up and regulations in the legal code that might deter foreign investors streamlined. The legal apparatus for enforcing commercial contracts will continue to be reviewed and mechanisms for resolving business disputes and enforcing bankruptcies strengthened. To this end, technical assistance will be required to train and educate judges.

31. To further strengthen financial discipline in the enterprise sector the government will re-examine the seniority of wage claims over commercial creditors for illiquid firms. The government will also re-examine the possibility of providing time-limited incentives, including tax relief and discount on shares, to convert wage arrears of longer than two months into equity, and will continue to adhere to its policy of not taking over obligations for severance payments by enterprises or for clearing their wage arrears. Additionally, the government will initiate bankruptcy proceedings against enterprises which are in arrears on their payments to the tax authorities and the public utilities.

32. Property rights need further strengthening. To this end, the government intends to approve two laws on Land Use which will promote a more efficient market for properties, and develop freer and better functioning land markets in both rural and urban areas. Concurrently, a new law on restitution and denationalization of property nationalized after 1944, should make it possible to transfer state-owned land to the private sector.

F.  External Policies

33. International trade will be an important source of medium-term growth and the government is committed to further enhancing the openness of the economy and removing distortions in the trade regime. To achieve its objectives, the government has concluded a Trade and Cooperation Agreement with the European Union as a first step towards an association agreement and has signed several bilateral free trade agreements with regional trading partners. Supported by the World Bank SAL, the granting of discretionary exemptions by various government ministries has ceased, export subsidies have been eliminated, and reform of the customs administration has continued. Average tariff levels and tariffs and/or surcharges on items which were previously subject to quotas and special levies will continue to be lowered over the medium term. In 1998, a revised customs code will be enacted, a trade policy unit will be established within a central economic ministry, and the government will accept the obligations of Article VIII, Sections 2, 3 and 4 of the IMF's Articles of Agreement.

G.  Sectoral Policies

Agriculture

34. The agricultural sector will continue to be an important contributor to growth and employment. Recognizing that market forces are the key for sustainable agricultural growth, the government is implementing a series of policies aimed at reducing interventions in input and output prices and reorienting its role to support private sector development. Supported by structural adjustment lending from the World Bank, important parts of this agenda have been advanced including elimination of price premia and input subsidies, rationalization of the operations of the Agency for Strategic Reserves, and privatization and restructuring of agro-kombinats to improve their profitability and enhance the competitiveness of agricultural input and output markets.

35. The government’s efforts will continue to focus on the liberalization of prices and trade restrictions, reform of land tenure and transfer, and completion of the agreed program for privatizing and restructuring agro-kombinats. The level of protection of agricultural products will be reduced further. The World Bank is supporting these efforts in the context of continued adjustment lending as well as a credit for financing the reorientation of agricultural extension and veterinary services towards private sector operations, and a loan for the rehabilitation of irrigation works and development of water users’ associations.

Energy

36. The energy sector is still largely government-owned and controlled, with the exception of the main petroleum products distribution company. Most energy prices are administered, though they have generally been set at high enough levels to cover costs and provide a reasonable margin for capital replacement. The government is in the process of developing a strategy for the energy sector that has at its core a reliance on market mechanisms. It will acknowledge that: (i) energy prices should cover operating costs with a margin to fund future investments; (ii) energy sector companies should not rely on government financing; (iii) energy sector companies should operate as commercial entities and, where appropriate, be privatized; and (iv) energy conservation should be encouraged through cost-based pricing of energy and the restructuring of the economy, which should lead to reduced energy intensity of production. In line with its objectives, the government will prepare plans to privatize the oil refinery and the electricity company and to establish independent regulatory systems. On the investment side, with support from World Bank energy sector project, over 90 percent of the country’s hydro-power capacity will be rehabilitated, the energy management system for the electricity company—including controls, dispatch center and communications—will be improved, and the rehabilitation of the electricity distribution system will commence.

Transport and Communications

37. The shift to a market economy is resulting in less emphasis on transport-intensive industries, such as minerals, and more on higher value-added light industry, such as agro-industry. The latter will require lower transport volumes and greater use of road as opposed to rail transport. The government’s strategy is to upgrade the main road links, particularly those serving as access to ports, which are already showing incipient congestion. This will be supported by financing from the European Investment Bank. In addition, the government plans to continue the process of railway restructuring through the spin-off of non-core business and downsizing of the railway company’s operations. Recognizing that the construction of a railway link to Bulgaria cannot be justified on economic grounds, the government will review the availability of highly concessional financing for this project before deciding whether to proceed further. In telecommunications, the government is already preparing the privatization of Macedonia Telecommunications and will complete the sale of 30 to 40 percent of its shares to foreign strategic investors by 1999.

Environment

38. The government's environmental objectives, as defined in the National Environmental Action Plan, are to develop an environmental management system with adequate institutional capacity and an appropriate regulatory framework. In the context of the new Environmental Framework Law, the government is developing regulations conforming to EU standards covering environmental impact assessments, air pollution, national parks, noise, solid and industrial waste, and protected species. These regulations also seek to improve water supply and surface water quality by: upgrading water resource management and eliminating industrial effluent discharges; reducing soil pollution, improving agricultural and forest land management; and conserving and protecting biodiversity, particularly in lakes Ohrid, Prespa and Dojran. The government also intends to develop an action plan to phase in the use of unleaded gasoline based on pricing policies which discourage the consumption of leaded fuel, and national strategies for solid waste management, sustainable biodiversity conservation, and energy conservation.

39. River and lake water pollution arising from a lack of treatment of municipal sewage and discharges from heavy industry are serious concerns as they contribute to the contamination of drinking water. To address the problems, the government intends to develop sewage treatment plants for Skopje and Bitola—the two largest towns and major polluters of the Vardar River, which provides water to downstream users—supported in 1999–2000 by a loan from the World Bank and feasibility studies provided through EU Phare. The project would assist in implementing a commercial approach to the management of water supply and sewerage services, with full cost recovery of the services. Tariffs for water usage, which are currently set to recover operating costs, will be increased to allow the various water management authorities to finance capital investments out of their own resources. A project for the protection and conservation of Lake Ohrid supported by the Global Environment Facility/World Bank will be implemented jointly with the government of Albania this year. Feasibility studies for the upgrading of waste water facilities in the Lake Ohrid region will be carried out with assistance from the German government—linked to a possible loan for associated investments.

H.  Improving Macroeconomic Statistics

40. While the quality and availability of statistical data have improved since independence, the government is aware that further efforts are required. To that end, the government is strengthening the legal framework in order to provide the required legal authority to the agencies that collect and compile macroeconomic statistics by adopting an Act on State Statistics. The government recognizes the importance, in particular, of improving the compilation of balance of payments statistics and of accelerating work on the regular and timely compilation of national accounts on an SNA basis. The government is seeking technical assistance from the IMF and, in the case of national accounts statistics, the World Bank through an IDF grant.

41. Through creating the conditions for rapid economic growth, the government’s objective is to achieve a lasting reduction in poverty (Table 3). However, the task of poverty reduction will be made difficult by the persistence of high unemployment, already (by some measures) over 30 percent, and by the need to ensure the affordability of benefit programs. The government remains committed to providing a comprehensive system of health, education, and social security benefits. Where reforms are warranted, emphasis will be placed on the targeting of benefits to ensure protection of the most vulnerable members of society.

A.  Pension System

42. Pension expenditures remain high, particularly given the relatively young population structure. Initial early retirement policies for laid-off workers combined with a declining contribution base have exacerbated imbalances in the pension system, despite wholesale reforms of recent years, including a lowering of minimum benefits for new retirees at the beginning of 1997. Simulations indicate that the aging population will lead to a future destabilization in the finances of the Pension Fund unless the structure of benefits is changed further. To put the pension system on a more sustainable basis, the government intends to: (i) continue to increase the retirement ages for men and women; (ii) place retirement on an age exclusive basis, subject to a minimum number of contribution years; (iii) index benefits below wage growth; and (iv) reduce the rate for accumulating the pension base used to specify public pension. There will be no increases in the contribution rate. World Bank assistance in the context of the SSAC is being requested to support these reforms.

43. At the same time, the government is preparing plans—in conjunction with the World Bank—to develop and introduce a private pillar of the pension system. The design of future private pension schemes will be developed by a steering committee comprising members of the Ministry of Finance, the NBM, the National Securities and Exchange Commission, and the Pension Fund. It will be based on actuarial and financial scenarios. New regulatory bodies will be formed to implement the required legislation and regulations related to the tax treatment of pensions and to the management, administrative, and investment guidelines for pension funds.

B.  Social Assistance

44. The government has been active in improving the adequacy and targeting of the means-tested social assistance program for persons capable of work and, with World Bank support, has improved its poverty monitoring capacity. This program, along with supplemental programs for the elderly and disabled, is the main vehicle for protecting the poor. With additional support in the context of the SSAC, the government plans to start tackling some of the second generation problems confronting the program including reducing the 22 percent rural-urban benefit differential that, according to recent work on the poverty line, is far greater than is warranted. Targeting of benefits also needs to be further strengthened as some ineligible households continue to participate in the program. The government intends to revise the Social Assistance Decree to: (i) equalize rural and urban social assistance levels in a budget neutral way, based on a new single national poverty line; (ii) revise and simplify scale rates; (iii) remove "exact percentages and rate" from the law; (iv) increase penalties for fraudulent claims; and (v) introduce work incentives by limiting full benefits to two years and reducing benefits over the next two years to 70 percent and 50 percent, respectively. After four years, individuals would re-qualify only after two years of non-receipt of benefits.

C.  Labor Market Policies and Unemployment Benefits

45. The low demand for workers in the formal sector can be attributed in part to the high payroll taxes required to finance the social insurance system, but also to excessive regulation of the hiring and firing process under the Law on Employment and Unemployment Insurance and the Labor Relations Law. These regulations contribute to high labor costs and likely impede private market development. To promote greater flexibility in the labor market, the government revised both laws in 1997. During 1998-99, it will further amend the Labor Relations Law in order to reduce cash benefits by encouraging shorter maternity leave, ease restrictions and simplify processes for terminating workers, and improve the flexibility of collective bargaining to reduce rigidity in wage-setting. The changes will allow private labor markets to operate with minimum necessary regulations by the law.

46. Previous amendments to the Law on Employment and Unemployment Insurance strengthened work incentives by reducing the amount and duration of benefits for some unemployed persons, in particular lowering the replacement rate from 50 to 40 percent for those who receive benefits for more than 12 months. They also reduced the role of the Employment Bureau and the state in matching workers to jobs. However, individuals with more than 25 years of service can still receive unemployment benefits until retirement. The government intends to amend the Employment Law further in 1998 to reduce the special benefits for long-tenured workers and to prevent employers from receiving unused benefits of newly-hired workers. These reforms are being supported by the World Bank's SSAC. In the future, the government will also review mandatory vacation leave, sick pay, and maternity benefits which are very generous by other countries’ standards and which significantly add to employment costs.

47. With the on-going support of the World Bank Social Reform and Technical Assistance Project, the government is implementing several active labor market measures to tackle the problem of structural unemployment and help those unemployed as a result of enterprise restructuring to re-enter the labor force. These include: promoting a more extensive market-driven program for training and re-training of workers, offering small business development services and incubators, and promoting community-based economic development initiatives.

D.  Education

48. The education system requires modernization if it is to cater to the needs of a market-based economy. At present, the wage bill in the education sector consumes an excessively large share of available resources and leaves little room for expenditure on materials and investment and maintenance of schools. While average student/teacher ratios for both primary and secondary education are close to OECD levels, there are a large number of overly-specialized secondary programs and a high ratio of non-teaching to teaching staff. The government plans to address some of the problems of the education sector through preparation of an education sector strategy. The World Bank and several bilateral donors are providing support to help re-orient educational programs, provide textbooks and materials, improve teaching skills, upgrade management skills, evaluate programs, and upgrade the infrastructure.

E.  Health

49. The publicly-funded universal health care system has come under considerable financial stress in recent years. The Health Insurance Fund (HIF) has been unable to exercise effective expenditure control such that the quality of health care has declined and large arrears to suppliers have accumulated. The generous eligibility and benefit provisions of the HIF add to pressure on expenditures: the benefit package includes virtually all types and levels of care; large categories of individuals are exempt from co-payments; and co-payment rates are not set at levels sufficient to reduce over-consumption and promote lower cost primary care.

50. Health reforms envisaged for 1997 were stymied by organizational changes in the government. To restore financial balance to the health system and improve the quality of care, a Health Insurance Law will be adopted in 1998 which will, inter alia: (i) establish an autonomous Health Insurance Fund governed by a representative board; (ii) establish a framework for introducing a capitated primary health care system, a basic benefits package, revised co-payment user charges policy for health services, and a referral system by primary care providers for outpatient specialist and hospital care; and (iii) reduce sick pay costs for employers. A new Drug Law will also be adopted which will allow for streamlined registration of drugs, implementation of reference pricing based on generic products, adoption of essential drugs lists for public sector reimbursement, and competitive bidding procedures for public sector drug procurement. The government’s reform efforts are being supported by the World Bank’s ongoing Health Sector Transition Project and the SSAC.

51. The government is grateful for the substantial and useful technical assistance that has been provided in the last few years. Further external technical support will be needed to deepen structural reforms and flesh out the detailed implementation of many of the envisaged measures. To this end, the government has prepared an updated report indicating specific technical assistance requirements for 1998–99. Financing for technical assistance is being sought from the donor community.

52. The last bilateral agreement under the July 1995 Paris Club rescheduling agreement was signed in January 1998. Agreement with London Club creditors on the rescheduling of outstanding commercial debt inherited from the former Socialist Federal Republic of Yugoslavia was reached in 1997.

53. The recent devaluation of the denar, together with a stable macroeconomy and the strong structural reform program supported by the ESAF arrangement, should provide for a reduction in the current account deficit in 1998 and over the medium term. Export growth is projected to remain strong as the export sector shifts away from the reliance on traditional markets to new opportunities arising from increased trade integration in the Balkan region and with the European Union. Hence, despite strong import growth due to large capital spending in the transport and industrial sectors, the current account deficit is projected to decline from 8.3 percent of GDP in 1997 to about 6.5 percent of GDP in the year 2000.

54. To meet the programmed increase in reserve cover to three months of merchandise imports, the external financing requirements for 1998–2000 are estimated at US$1.3 billion (Table 4). Most of the financing needs are expected to be met by direct investment, commercial bank borrowing, and other private inflows (US$606 million), official transfers and grants (US$72 million), and disbursements from multilateral institutions and bilateral creditors (US$496 million). While privatization receipts could fill much of the residual financing needs (US$130 million), in view of the uncertainties the government is requesting further commitments of bilateral support.

55. The external debt burden is large but not excessive. In 1997, medium- and long-term external debt amounted to US$1.1 billion (34 percent of GDP) and total debt service was US$127 million, or 9.6 percent of exports of goods and services and 3.8 percent of GDP. The country will continue to limit the amount of new debt that it contracts or guarantees on non-concessional terms under the ESAF-supported program. By 2007, external debt is projected to decline to 17 percent of GDP and the debt service ratio to 5 percent of exports.