The Statement of the IMF Representative

I. Introduction

1. The six-month security crisis in early 2001 inflicted enormous economic costs on FYR Macedonia. Output declined markedly, the fiscal situation deteriorated, and foreign exchange reserve loss was heavy. The authorities took fiscal and monetary policy measures to contain the negative impact of the crisis and persevered with structural reforms in many areas. However, the crisis made it difficult to comply with the IMF-supported program under the PRGF/EFF arrangements, leading the authorities to cancel the arrangements.

2. The economy should pick up with the implementation of the peace framework agreement and the six-month stabilization program, that is being monitored by the IMF staff since January 1, 2002 at the authorities' request. Although there is no sign as yet of an upturn in activity, the fiscal and external reserves positions have improved in recent months, to a greater extent than envisaged by an IMF mission in November 2001. However, FYR Macedonia faces major challenges over the medium term of strengthening the fiscal position, against a backdrop of strains on both revenues and expenditures, and creating a strong foundation for growth through further progress with structural reforms and efficient use of privatization receipts.

3. Whereas, prior to the crisis, the exceptional external financing requirement was small, a need for substantial support has now emerged for post-conflict reconstruction, measures agreed under the peace framework agreement, and the balance of payments. Donor support is critical for sustaining the peace agreement, easing the adjustment burden, and putting the authorities and the economy on a footing to address the medium-term challenges.

4. For its part, the IMF is helping FYR Macedonia deal with the adverse macroeconomic effects arising from the security crisis. An IMF team will visit Skopje in early May to review developments under the staff monitored program, and would be prepared to initiate discussions at that time on a successor IMF arrangement with the aim of extending and strengthening the present stabilization effort. Reaching agreement on an IMF-supported program and gaining access to IMF resources will require the authorities to adopt durable measures that would ensure a sustainable medium-term macroeconomic framework and to reinforce efforts to address the structural weaknesses of the economy.

II. Impact of the Security Crisis

5. Economic activity contracted in 2001, by an officially estimated 4½ percent, mainly as a result of a sharp erosion of consumer and business confidence triggered by the security crisis. Employment in the enterprise sector also declined but, with the recruitment of a large number of reservists in the police and the army, the unemployment rate dipped slightly to 30½ percent. Inflation, driven by higher food prices, remained around 5½ percent.

6. The budget came under pressure owing primarily to additional spending on security operations but also partly to some cyclical weakness. Partly to offset the pressures, the authorities gave up on the tax-cutting measures originally envisaged for June, and introduced in mid-year a new tax on financial transactions. Nevertheless, with security-related spending reaching nearly 7 percent of GDP, the general government recorded a deficit of 6 percent of GDP in 2001 (about 3/4 percentage point of GDP lower than the outturn forecast in the memorandum of economic policies of the staff monitored program).

7. During the six-month crisis period, gross foreign exchange reserves declined by nearly US$200 million (28 percent of total reserves at the beginning of the year). The crisis induced a sharp drop in net inflows of private transfers, unrecorded inward transactions, and short-term trade credits. Exports also suffered, but the fall was more than offset by a severe compression of imports. A tightening of monetary policy in the second quarter and the signing of the peace framework agreement in August helped restore confidence in the denar and improve the external position. Gross official reserves increased by some US$40 million in the last four months of 2001.

8. The impact of the crisis on foreign reserves was cushioned by sizeable privatization inflows (US$323 million or 9½ percent of GDP) in early 2001, that had been earmarked for specified expenditures over 3 to 4 years but were partly diverted to purchase military hardware. Excluding the net saving of the privatization proceeds, the underlying reserves at end-2001 were equivalent to 3.7 months of next year's imports, down from 4.5 months at end-2000.

9. Because of the complications created by the security crisis, the progress toward divesting non-core government activities and resolution of loss-making enterprises-long-standing objectives of past arrangements with the IMF-was slow. However, progress in reducing employment in public administration, strengthening bank supervision, and reforming the payments system was notable.

III. The Staff Monitored Program and Recent Developments

10. The Memorandum of Economic and Financial Policies of the staff monitored program has been circulated earlier to the donor community. The program has been structured around the following objectives for 2002: real GDP growth of 4 percent; average annual inflation falling to 2½ percent; the external current account deficit, excluding grants, narrowing by 1 percentage point to 9¾ percent of GDP; and underlying gross official reserves increasing to 4 months of next year's imports of goods and services. Only partial data are available on progress to date under the program. During January-February, the dynamics of gross official reserves was better than programmed, and budget revenues and expenditures were in line with expectations. However, with no sign as yet of a turnaround in industrial activity, there is a downside risk to the growth forecast.

IV. Policy Priorities

11. A major challenge for the FYR Macedonia authorities is to strengthen the fiscal position over the medium term to safeguard external sustainability and government debt dynamics and to foster private sector growth. In 2002, the authorities' aim is to reverse last year's large expansionary fiscal swing and bring down the general government deficit to 3½ percent of GDP, before expenditures on implementation of the peace agreement. Security-related spending is set to decline with the ending of the hostilities, and the authorities have adopted the following measures: maintaining the financial transactions tax for one extra year; postponing the planned implementation of a new wage structure for civil servants as well as the planned increase in child allowances; and foregoing a general wage increase in the public sector.

12. Although sufficient for achieving the fiscal target in 2002, these measures do not ensure the needed medium-term fiscal consolidation. Over the medium term, revenues are expected to come under strain and there will be spending pressure in a number of priority areas. On the revenue side, the financial transactions tax entails distortions and should not be maintained for an extended period. On the spending side, the long-standing wage freeze in the public sector has created staffing problems in the highly-skilled positions; additional claims on budgetary resources will arise on account of pension system reform and the implementation costs of the peace framework agreement not covered by the donor community; and, although a further decline in security spending is anticipated in 2003, the authorities plan to keep it above the pre-crisis level.

13. In light of these prospects, IMF Executive Directors stressed in the Article IV consultation discussion on March 4 the importance of policy changes including: (i) base-broadening and tax rate adjustments of the VAT as well as strengthening its administration; (ii) further strengthening expenditure management and control, especially by setting up a framework for monitoring the budget's expenditure commitments and domestic payment arrears; and (iii) phasing the spending of privatization receipts so as to ensure resource efficiency. These measures will be key requirements for a successor IMF-supported program.

14. The structure of the budget will undergo substantial change over the medium-term as fiscal responsibilities are devolved to municipalities. It will be important to ensure that decentralization does not undermine fiscal soundness or compromise delivery of services. An IMF technical assistance mission, with a World Bank staff also participating, will visit Skopje in mid-March to assist the authorities in devising a strategy for the process of fiscal decentralization and to review alternative means for financing local governments.

15. Pushing ahead with enterprise reform will be key to improving external competitiveness as well as to the prospects for strong economic growth over the medium-term. It will be important to ensure that the loss-making enterprises are resolved in a transparent manner that ensures sustainable enterprise restructuring and contains the fiscal costs in order to maintain macroeconomic stability.

16. Notwithstanding improvements in the regulatory framework and bank supervision, the health of the banking system remains fragile. Hence, the National Bank of Macedonia's (NBM) continued vigilance will be essential to ensure that banks strictly adhere to supervisory guidelines and prudential regulations. The next stage of banking reforms should focus on consolidation of the banking system and improvements in governance. In this context, the IMF welcomes that NBM's interest in conducting a review of the financial system under the joint World Bank-IMF Financial Sector Assessment Program.

V. Financing Needs

17. The external financing need of FYR Macedonia is large, even before taking into account the financing needs for rehabilitation and reconstruction and for implementing the peace agreement. No significant recovery in export performance is expected in 2002, owing to the perception of increased delivery risk and economic slowdown in FYR Macedonia's main trading partners. Imports are forecast to increase moderately. However, the recovery in private transfers receipts that began in the later part of 2001 is likely to carry over into 2002. Accordingly, a small decline is expected in the external current account deficit. An increase in identified project financing from bilateral and multilateral sources is foreseen. With a return to peace, trade credit and unrecorded transactions should revert to their traditional positive pattern. But, foreign direct investment is expected to fall sharply from the exceptional levels of 2001-02, which were boosted by large privatization deals. On this basis, given the authorities' objective of increasing the underlying level of gross reserves (i.e., excluding the net saving of privatization proceeds) to the equivalent of 4 months of imports, an exceptional financing gap of US$163 million is estimated for 2002 (see attached table). The reserve cover target is comparable to that prevailing in other countries in the region, and is justified in view of the prevailing uncertainties and associated risks to the balance of payments.

18. In sum, given the nature and ramifications of the security crisis, the progress in macroeconomic stabilization under IMF-supported programs in recent years, the renewed steps in this direction taken by the authorities under the six-month staff monitored program, and the authorities' intention to enter into a successor IMF-supported program, we believe that FYR Macedonia should receive generous support from the international community.