On August 6, the Executive Board concluded the Article IV consultation with Moldova.¹

Background

Following successful efforts during 1993-95 to establish financial stability, with the support of international financial institutions and bilateral donors, progress toward a market economy slowed in 1996 and 1997. A three year program supported under the Extended Fund Facility was approved by the IMF's Executive Board in May 1996, but lagging structural reforms and fiscal slippages have led to delays in purchases and completion of the program's reviews.

Real GDP declined by 8½ percent in 1998, as the result of a large external shock from the Russia crisis in the third quarter, exacerbated by continued macroeconomic imbalances. Fiscal discipline remained weak and resulted in arrears and high real interest rates that discouraged private sector investment. Data for 1999 indicate a further decline in the first quarter GDP of around 10 percent, as agricultural activity remained depressed.

Inflation, which had declined to very low single digit rates by end-September 1998, spiked in the fourth quarter as the leu sharply depreciated. By early-November, the NBM was forced to abandon support for the leu in the early aftermath of the Russia crisis and allowed it to float freely. The National Bank tightened liquidity and inflation decelerated sharply in early-1999. Nevertheless, the situation remained fragile, and delays in implementing structural reforms in the first quarter of 1999 as a result of a six-week domestic political crisis, left the country vulnerable. The change of government in Russia in May 1999 set off a crisis in confidence, leading to a further depreciation of the leu and a pick-up of inflation to an average of 5½ percent per month in May/June. At end-June, the rate stood at Mdl 11.5/$, which represented a depreciation of 27 percent since the beginning of the year. The rate recovered somewhat by mid-July to around Mdl11/$. The real effective rate at end-May had depreciated almost 12 percent below the level prevailing before the August 1998 crisis.

With the crisis in Russia, demand in Moldova's largest export market virtually collapsed. Exports to the CIS countries declined by 50 percent in the second half of 1998, compared with the same period of 1997, and by 65 percent in the first half of 1999. This fall in export to traditional markets could not be compensated by higher export to the non-CIS countries as producers have been slow to diversify, in part because of inexperience with marketing, poor quality, and weak corporate governance. Imports, especially energy imports, also contracted sharply declining by about 30 percent in the second half of 1998, and by 50 percent in the first half of 1999. The current account deficit for the year increased to 18 percent of GDP, compared with 12 percent in 1997. In the first half of 1999, the deficit decreased sharply to 8.4 percent of GDP on an annual basis.

The decline of the overall balance of payments in 1998 led to the accumulation of large external payment arrears. Nevertheless, Moldova avoided default on both its external and domestic obligations, without recourse to any trade, exchange or payments restrictions. Total overdue obligations on public debt and guarantees increased to $104 million as of end-March 1999. However, efforts were made in the second quarter to start repaying these arrears, which declined by about $14 million in May/June.

Weak public finance management continued as the main problem for macroeconomic policy in 1998 and the first half of 1999. Cash collections remained weak in 1998, reflecting poor tax administration, ad hoc tax exemptions, and lower than expected activity. Reflecting this, and constrained financing, expenditures were compressed, and the cash deficit in 1998 amounted to Mdl 300 million (3 percent of GDP), compared with a programmed Mdl 250 million (2.4 percent of GDP). On a commitments basis, the deficit reached 8.1 percent of GDP, relative to the program target of 7.5 percent of GDP. In the first half of 1999, the commitments deficit was reduced to 5.1 percent of GDP, while the net accumulation of domestic expenditure and foreign interest arrears resulted in a cash deficit of 2.0 percent of GDP.

With the excessive financing needs of the public sector, a large external shock, and a period of political uncertainty, monetary policy has borne an unreasonable burden. These factors have also adversely affected the demand for money and contributed to a rise in velocity. In this environment, the NBM has sought to limit the impact of excessive credit to the government at end-1998 by reducing credit to the banking system. By end-June, the demand for money had not yet stabilized, although the pressure on the payments system had eased considerably. The dollarization of the economy has deepened considerably, including large cash holdings by the public. The NBM has actively implemented its oversight responsibility, closing two small banks, taking over the Savings Bank, and increasing the minimum capital requirement.

On the structural front, energy sector reform proceeded slowly in 1998 and the first half of 1999. An agreement between the government and RAO Gazprom on a debt-equity swap in the gas sector, and the establishment of a new `Moldovagas' joint venture was reached in the first quarter. Plans are also advancing to privatize five electricity distribution enterprises by the end of 1999, on the way to the longer term goal of privatizing the entire electricity sector. Land reform proceeded well with the break-up and privatization of former state and collective farms. The complete privatization of nearly 900 former collective farms is well underway, and is expected to be completed by the end of 2000. The break-up of farms and titling of farm land to individuals was complemented by the passage in June of a law on agricultural debt restructuring. In addition, the establishment of the national cadastre continues to move forward.

Executive Board Assessment

Directors noted that Moldova had been particularly affected by the crisis in Russia. Output had fallen; inflation had risen, and the currency had depreciated sharply; the fiscal and external current account deficits had widened further; debt had reached worrying levels, and external arrears had been incurred. Directors noted that the adverse impact of external events had been compounded by domestic policy slippages, which were partly related to political uncertainties. Directors regarded Moldova's economic and financial situation as precarious. Against this background, they stressed the vital importance of resolute policy implementation, and were encouraged by the new Government's commitment to the reform process. They welcomed the structural measures taken so far, as well as the recent steps to tighten fiscal and monetary policy.

Directors emphasized that a substantial strengthening of the fiscal position was imperative in any lasting financial stabilization. They encouraged the authorities to implement with determination their revised budget plans, which called for a reduction in the fiscal deficit on a commitment basis to 3 percent of GDP in 1999. Directors fully supported the authorities' emphasis on both raising revenues and reducing expenditures, while encouraging them to protect vital social outlays as far as possible. They welcomed the recent measures to improve tax administration and compliance-including the strengthening of the new Large Taxpayers Unit, and the strengthening of the customs administration-as well as plans for improved management of the Social Fund.

Directors welcomed the recent tightening of monetary policy and stressed the need for the authorities to respond promptly if inflationary pressures intensify. They supported the authorities' decision in late-1998 to allow the exchange rate to float freely and noted the recent signs of stabilization of the exchange market. Directors were encouraged by the resolve the National Bank of Moldova had shown in exercising its supervisory responsibilities over Moldova's fragile financial system, as evidenced by the closing of certain banks, the takeover and restructuring of the Savings Bank, and further increases in capital adequacy ratios.

Directors observed that an improved financial situation in 1999 depends critically on a substantial decline in the current account deficit, and on the availability of official financing. They encouraged all parties to make strong efforts to ensure that the envisaged financing materializes. Directors noted Moldova's commendable progress in liberalizing its foreign trade and exchange regime, and encouraged the authorities to firmly resist incipient pressure for protective tariffs.

Directors stressed that it was essential that restrained financial policies be accompanied by a determined and sustained implementation of structural reforms. They were encouraged by recent measures, particularly with regard to the privatization of the energy and telecommunications sectors. They welcomed the recent privatization of Moldovagas, which had helped remove an important source of external arrears, and they encouraged the authorities to complete the privatization of the electricity enterprises.