September 18, 2017

The prolonged political uncertainty has taken a toll on economic growth, with investment suffering because of weak sentiment. The formation of a new government has been an important turning point. Policies should now focus on rebuilding fiscal policy buffers, and implementing critical reforms to rekindle growth and give EU accession prospects a new push.

Growth is projected to moderate to 1.9 percent in 2017. The prolonged political uncertainty resulted in a slowdown of real GDP growth to 2.4 percent in 2016, the lowest since 2012. Data for the first half of 2017 point to economic contraction driven by a sharp drop in investment. Nevertheless, export growth has remained robust, and private consumption has been resilient, helped by employment growth and rising wages and pensions. Against this backdrop, growth is projected to moderate further to 1.9 percent in 2017 and inflation expected to reach 1.2 percent, ending three years of deflation.

The medium-term outlook is favorable contingent on continued political stability and robust external demand. Real GDP growth is expected to rebound in 2018 and gradually rise to 3¾ percent over the medium term, buoyed by improved investor sentiment, expanded export capacities, and continued labor market improvement. The risks to the outlook are mostly on the downside. A slim-majority governing coalition may be tested, in the context of upcoming local elections, and renewed political uncertainty could undermine fragile confidence. There are also external risks from weaker growth in trading partners, and global policy uncertainty which could reduce exports and FDI inflows. On the upside, the strengthening of political stability may lead to a decisive push for structural reforms and enhance EU accession prospects and growth potential.

The macroeconomic policy mix should be carefully designed to rebuild policy buffers and support growth. With public debt above 45 percent of GDP at end-2016, a near doubling since 2008, fiscal consolidation is urgently needed to safeguard sustainability, rebuild buffers to tackle future shocks and make space for pressing social development and infrastructure needs. Monetary policy should remain accommodative given low inflation and stability of the exchange rate peg. Finally, structural reforms are critical to support higher growth, with the labor market, governance, and the judiciary being priority areas.

Fiscal Policy: Support sustainability and create policy space

In the absence of durable consolidation measures, the fiscal deficit is expected to widen and public debt to rise . Despite slower growth, under-execution of capital and goods and services spending is likely to keep the fiscal deficit at around 3 percent of GDP in 2017. In the medium term, the deficit is projected to rise above 3½ percent of GDP, reflecting clearance of unpaid claims, wage subsidies, and additional social protection support. As a result, public debt is expected to exceed 53 percent of GDP by 2022, with gross fiscal financing needs estimated to reach around 15½ percent of GDP.

To create policy space and maintain sustainability, gradual fiscal consolidation should start without delay. The mission welcomes the government’s intention to support employment and social inclusion, but the plan to achieve this mostly through subsidized higher wages and tax incentives risks fiscal sustainability. To ensure durable results, these objectives should be pursued through a set of policies that enhance incentives for participation in the labor market, reduce inefficiencies in social spending, and create additional space for public investment in human capital and infrastructure.

The mission recommends the following specific measures.

Reduce the labor tax wedge at low-income levels . A highly regressive labor tax system discourages low-skilled workers from entering the labor force and taking up formal employment, particularly if non-wage family income in the form of social assistance and remittances is available. To stimulate participation, the mission recommends decreasing the minimum income base for the social security contribution. This should be accompanied by strong audit processes to ensure compliance and some progressivity in income taxation to ensure revenue neutrality.

Raise additional revenues through more efficient collection of VAT and higher property and fuel taxation . The VAT collection has been deteriorating and remains significantly lower than in Western Balkan peers. Enhancing the coverage and targeting of compliance risks, improving the operation of the large tax payer office, and establishing a fully-functioning risk management unit could improve collection notably. Further revenue gains can be achieved from higher tax rates on gasoline, which is among the lowest in the region, and higher taxes on property.

Reduce current spending by cutting subsidies and reforming the pension system . Fiscal space in recent years has largely been used to increase subsidies and pensions. Untargeted subsidies should be reduced and large and widening pension deficits should be reined in through raising the statutory retirement age to the EU average, tightening options for early retirement, indexing pension to CPI inflation only, and refraining from ad-hoc increases. With only a quarter of non-pension social benefits going to the poorest quintile, social inclusion can be improved through better targeting.

The mission welcomes the government’s intention to strengthen management of public finance s and increase fiscal transparency. The authorities should transform this ambitious agenda, into a properly prioritized plan focusing on key weaknesses to improve public financial management. In addition, action should be taken to repay and prevent new arrears. The new administration has identified possible general government payment arrears and blocked VAT refunds. It is critical to verify these claims, and develop a transparent framework for their clearance. Equally important is to put in place a system that prevents accumulation of new arrears by better controlling expenditure commitments.

Monetary and Financial Policies: Safeguard macroeconomic and financial sector stability

Monetary policy should remain accommodative in the near term. With low inflation, external stability, and a still-negative output gap, tightening monetary policy at the current juncture would be premature. In recent years, external stability has been supported by an improving trade balance due to strong exports, which, along with steady FDI inflows and sovereign access to capital markets, has helped maintain an adequate level of international reserves. But the authorities should stand ready to tighten monetary policy if there are signs of inflation accelerating or pressures on foreign exchange reserves.

The banking system is healthy . Strong policy actions by the NBRM last year after a period of turbulence, were instrumental in preserving banking system stability. The adoption of Basel III standards on capital adequacy earlier this year further reinforces the capacity of the banking system to withstand shocks. The banking system is currently well capitalized, liquid, and profitable, with limited exposure to parent bank financing. However, there are balance sheet risks from a high degree of financial euroization and moderate deleveraging risks from the large presence of EU parent banks. The authorities should monitor developments closely and use micro and macroprudential tools as needed to manage risks.

Structural reforms: Strengthen growth and enhance EU accession prospects

Improving Macedonia’s medium-term growth potential hinges on decisively tackling weaknesses in the judicial system and overall governance frameworks. FYR Macedonia has experienced one of the slowest income convergence with advanced Europe in the last two decades compared to other countries in emerging Europe. Limited progress in implementing reforms, especially in the areas of governance and competition policy, has held back FDI inflows and hindered deeper integration with the European Union. The new government’s focus on reforming the judiciary, and improving the efficiency and transparency of public institutions is encouraging as is the intention to provide a level playing field for all investors. Any direct support to enterprises in the form of subsidies or tax breaks should be carefully assessed to not jeopardize fiscal sustainability.

With the projected decline in the working age population, more emphasis should be given on increasing labor participation and upgrading skills. A sizable part of the working age population, mostly women, remains outside the workforce. To improve female labor force participation, which is one of the lowest in Europe, the mission recommends increasing availability of affordable childcare, and allowing greater flexibility in family leave policies. To reduce the astronomically-high youth unemployment rate of 50 percent, more emphasis should be given to vocational training and higher investment in skills, including through active labor market policies. By contrast, recourse to minimum wage increases, as planned, could exacerbate youth unemployment, drive more people to the informal sector, adversely affect competitiveness in the export-oriented sector, and put pressure on scarce budgetary resources.

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