The Former Yugoslav Republic of Macedonia: Staff Concluding Statement of the 2018 Article IV Mission

November 19, 2018

The return of political stability and progress toward resolving the name dispute with Greece have tangibly raised prospects for opening European Union (EU) accession negotiations more than twelve years after gaining the candidate status. Structural reforms to address longstanding weaknesses in the labor market, judiciary, and public administration are critical to seize this opportunity and ensure a brighter future through higher productivity and faster income convergence. Macroeconomic policies should support this goal by rebuilding buffers and policy space and maintaining financial stability.

Economic activity is slowly recovering after stalling in 2017. Real GDP is projected to grow at 2 percent in 2018, supported by robust exports and private consumption, on the back of improving labor market conditions and strong household credit growth. Meanwhile, delays in large infrastructure projects, falling construction activity, and lingering uncertainties have continued to hold back investment. Overall macroeconomic conditions are favorable with low headline inflation, a declining current account deficit, and positive trends in the foreign exchange market.

Growth is expected to gradually approach 3.5 percent over the medium term. As investment recovers from a protracted downturn, real GDP growth is projected to pick up to 2.8 percent in 2019. Further increase in the medium-term is driven by planned infrastructure investment and stronger exports. Risks are tilted to the downside. Renewed political uncertainty remains a key domestic risk, which could delay the investment rebound. The economy is also susceptible to spillovers from rising protectionism in the global economy and a tightening of international financial conditions. On the upside, a decisive push for structural reforms and opening of EU accession negotiations could boost growth through higher capital inflows and enhanced confidence.

Creating Jobs and Strengthening Institutions

A sub-optimal use of the labor force is holding back growth. Despite robust job creation in recent years, reflecting government employment initiatives and expanding investment in the export zones, the official unemployment rate remains high at 21 percent, affecting particularly the youth. Skills shortages, perpetuated by poor education quality, underdeveloped vocational education, and labor emigration, are at the heart of high unemployment, 80 percent of which is long term. Meanwhile, over one third of the working age population is inactive—two thirds of them are women—further depressing labor’s contribution to growth. A sizeable informal sector is picking up the slack in the labor market, albeit at a significant cost to competition, productivity, and public finances.

A multi-pronged policy is needed to address labor market weaknesses and lift productivity growth. On the skills front, increasing secondary education completion rates, raising the quality of instruction and upgrading and modernizing the vocational educational system are key. These measures should be accompanied by strategic and long-term planning at the national level to ensure coordination between relevant ministries, educational institutions, and employers. Active labor market policies should continue to target the long-term unemployed, many of whom are young, but with a greater focus on building skills and facilitating education-to-work transition through internships and apprenticeships. The monitoring and evaluation of other employment incentives should be strengthened. To improve female labor force participation, authorities should continue with their plans to expand affordable preschool and childcare services. In addition, with an outdated census and high informality, improving statistics is critical to assessing labor market conditions.

Reforms to strengthen governance, the rule of law, and the judicial system are instrumental to improving the investment climate and supporting faster income convergence. Recent and planned legislative amendments to enhance the functioning and autonomy of the judiciary are welcome. Notwithstanding, sustained efforts are needed to translate legislative reforms into effective implementation and improve public perception of institutional quality. An impartial judiciary, a merit-based public administration, and a strong anti-corruption framework are central to that effort. These measures will help improve investment and growth by creating a more predictable business environment and retaining skilled workers, as well as unlocking EU accession negotiations.

Reducing informality should be a priority. This would require tackling tax evasion, strengthening labor inspection, and ensuring fair and predictable implementation of business regulations. While efforts to reduce cash-based activities may help combat informality, a careful approach is warranted to avoid possible adverse effects on the economy. Further increases in the minimum wage should be mindful of labor productivity growth to avoid exacerbating youth unemployment and informality.

Rebuilding Fiscal Policy Space

Public finances have weakened in the past decade, limiting policy space to counter shocks. Recurring primary deficits, driven by declining tax revenues and rising current spending, have doubled public debt over the last decade. Large fiscal financing needs, including repayments for external public debt, renders FYR Macedonia vulnerable to market conditions. Recent improvements in the fiscal position has largely been driven by under-execution of capital and goods and services spending, with the overall fiscal deficit and public debt projected to reach 2.6 percent and 50.5 percent of GDP in 2018, respectively.

The 2019 draft budget rightly intends to address pension sustainability, promote social equity, and support employment. The changes in personal income taxation increase the tax rate on capital income and rebalance labor tax burden between the highest and lowest income segments. To improve coverage and targeting of social assistance programs, the budget proposes to consolidate and replace existing benefits, including removal of parental allowance for the third child, with a means-tested guaranteed minimum income and social pension scheme. The proposed pension reforms, which include higher contribution rates, benefit re-indexation, and measures to improve equity across participants in the two pillars, will reduce the pension deficit in the medium term. The mission’s preliminary assessment suggests these measures, along with support for employment and investment, will temporarily increase the fiscal deficit to 3 percent of GDP in 2019 before narrowing to 2.4 percent over the medium-term. Under the baseline projection, public debt will peak at 54.7 percent of GDP in 2021.

A more ambitious consolidation would put public finances on firmer footing. The mission recommends achieving a zero-primary balance over the medium term to put public debt on a clear downward trajectory. If fully implemented in its proposed form, the re-indexation of pension benefits to CPI only will deliver significant fiscal savings. However, further measures such as tightening conditions for early retirement and raising statutory retirement age should be considered to ensure long-term sustainability of the pension system. In addition, improving tax compliance, particularly for VAT, and rationalizing agriculture subsidies are important not only to increase fiscal revenues but also to reduce informality.

Recent reforms to strengthen public financial management and increase fiscal transparency are encouraging and should continue. Measures to strengthen the framework for monitoring of arrears in the public sector and proposed changes to link the municipality budget to realized revenues are steps in the right direction. To increase budgetary credibility, these measures should be complemented by developing an accrual-based fiscal reporting, a more comprehensive coverage by including the SOEs and disclosing the fiscal costs of tax expenditures. Budget documentation should present greater information on the own-source activities of SOEs, medium-spending plans of budget entities, and public investment projects.

Ensuring Monetary and Financial Stability

Monetary policy has been appropriately accommodative. Against a background of moderate economic activity, low inflation, and favorable foreign exchange markets, the NBRM lowered its policy rate twice in 2018. Going forward, should the external environment worsen, the NBRM should stand ready to tighten monetary policy as was appropriately done in past episodes of turbulence.

The banking system remains healthy, but risks need to be closely monitored given underlying structural vulnerabilities. Banks are well capitalized, liquid, and profitable. The share of non-performing loans has decreased, including due to NBRM-mandated write-offs, and credit risks are well provisioned. Further efforts to gradually increase deposit denarization and carefully calibrated macro-prudential measures to reduce foreign currency lending to households would help strengthen financial system resilience.

Further strengthening of the financial stability framework is important. Banking supervision and regulations have been enhanced considerably over the past decade. Still, the in-depth financial sector assessment program (FSAP) currently being finalized by the IMF and the World Bank found scope for further improvement—including by ensuring operational independence of the NBRM, boosting staffing levels, and intensifying supervision for systemically important banks. The macroprudential policy framework would benefit from further capacity-building for systemic risk monitoring and enhanced inter-agency coordination, while ongoing efforts to modernize the crisis management and bank resolution regime should be promptly completed.

Efforts to enhance financial sector efficiency and deepen inclusion will require actions on multiple fronts. Micro, small and medium enterprises face barriers due to high collateral requirements and weak financial accounts and management. Improvements in the framework for insolvency and creditor rights, combined with support for business planning, would help alleviate these constraints. Meanwhile, the establishment of a comprehensive legal and regulatory framework for financial consumer protection would help boost confidence in using financial services.

The IMF team expresses its appreciation for the authorities’ cooperation, hospitality and candid discussions.