Report No. 44170-MK FYR Macedonia Moving to Faster and More Inclusive Growth A Country Economic Memorandum (In Two Volumes) Volume II: Main Report and Annex June 9, 2009 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CONTENTS 1 .A ........................................... . INTRODUCTION ................................................................................................................................. INCREASING GROWTH AND REDUCING POVERTY IN FYRMACEDONIA 1 1 B. POVERTY ISSUES .............................................................................................................................. 3 c. GROWTHAND TOTALFACTOR PR~DUCT~V~TY MACEDONIA ............................................. 5 D. INFYR IMPROVING MACEDONIA'S FYR FWEWORK FOR GROWTH ....................................................... 11 D. IMPROVINGEFFICIENCY PUBLIC EXPENDITURE IN ........................................................................ 18 CONCLUSIONS ................................................................................................................................ 20 2.EA . B ..MANAGING MACROECONOMIC RISKS ............................................................................................. 23 INTRODUCTION ............................................................................................................................... 23 ............................................................................................... 24 B.1 Rising food prices and agriculture............................................................................................. 24 RISING FOODAND ENERGY PRICES C.B.2EXTERNAL Energy Prices and Subsidies...................................................................................................... 26 D. VULNERABILITIES........................................................................................................ BALANCE PAYMENTS IMPLICATIONSOF REMITTANCES AND PRIVATETRANSFERS OF ................27 29 33 3.E EXPORTPERFORMANCE: . CONCLUSIONS................................................................................................................................ ......................................... A. ............................................................................................................................... A SYMPTOM OFWEAK COMPETITWENESS 35 B. INTRODUCTION 35 EXPORT THEIMPACT ..................................................................................................... 40 PERFORMANCE................................................................................................................. 35 C. C.1. Market Access Issues: Macedonian Exports and Imports ........................................................ OF TRADEPOLICY 40 D.C.2.THELOGISTICS The Regime for Agriculture....................................................................................................... 43 EASING THE CONSTRAINTSTO EXPORTS ....................................................................................... 44 E ...................................................................................................... 46 E.1. Demand and Supply: the Logistics Environment ...................................................................... ENVIRONMENT 46 E.2. Logistics Performance and Problems ........................................................................................ . E.3.CONCLUSIONS AND POLICY OPTIONS............................................................................................ 52 Value-Creating Logistics ........................................................................................................... 47 50 4.F A.THEINVESTMENT............................................................................................................................... CLIMATE: PREPARING FORFASTER GROWTH ................................................. 55 INTRODUCTION cB. . GROUNDREALITIES:BENCHMARKING, ................................................................................................................. INDUSTRYPERCEPTIONS ................55 STUDIES, INVESTOR 56 D. THE FOREIGNINVESTOR 60 ..................................................... 64 E. PERCEPTIONSOF SMALL FIRMS AND THEIR ROLEINGROWTH ................................. F. A TWO-PRONGED POLICY THAT SUPPORTS FDIAS WELL AS SMALL FIRMS ............................................................................................ 68 67 F.1. Contract Enforcement................................................................................................................ CRITICAL CROSS-CUTTING REFORMS 68 71 F.3. Reforms that Promote Business and Retail Competition........................................................... F.2. Property Rights and the Business Environment ........................................................................ 72 5.G FINANCEIN . CONCLUSIONS AND POLICY IMPLICATIONS ................................................................................... 73 ..................77 A. FYRMACEDONIA: IMPROVING ITS CONTRIBUTION TO DEVELOPMENT c. B. OVERVIEW...................................................................................................................................... 77 THEVOLUME AND COST OF CREDITTO THE PRIVATE SECTORINFYRMACEDONIA ...................78 FACTORS AFFECTINGTHE COSTAND VOLUMEOF CREDITTO THE PRIVATE SECTOR ..................82 C.1. Introduction................................................................................................................................ 82 C.2. Stabilization and the Cost and Volume of Private Sector Credit............................................... 83 C.4. Issues o f Risk, and its Relation to the Infrastructure for Information, and Collateral ...............87 C.3. The Changing Structure o f the Banking Sector and the Cost o f Credit..................................... 85 C.6. Non-bank Intermediaries: Leasing, Saving Banks, Capital Markets, and Pensions ..................93 C.5. Bank Risks and Regulation: The Balance between Risk and Credit Growth ............................ 91 D. IMPROVING SERVICES ......................................................... ACCESS NON-CREDITFINANCIAL TO 93 95 6.E.INFRASTRUCTURE............................................................................................................................... . CONCLUSIONS AND GOING FORWARD ........................................................................................... ISSUES ECONOMY FOR A SMALL ........................................................................ 97 A B. INTRODUCTION 97 TELECOMMUNICATIONS ................................................................................................................. 98 D. c. OTHER INFORMATION AND COMMUNICATIONS TECHNOLOGY ........................................................................................................................... 105 ................................................... 103 E. AIR TRANSPORT ................................................................................................................... 109 F. GROUNDTRANSPORT ELECTRICITY ................................................................................................................................ 111 114 7.GIMPROVING . SUMMARYOF POLICY RECOMMENDATIONS ................................................................................. ...................................................... A. THE PERFORMANCEOF THE LABORMARKET ............................................................................................................................. 117 B. INTRODUCTION 117 c. NON-LABOR THECURRENT LABORMARKET SITUATION ................................................................................ ......................................................... 119 D. INCOME AND LABOR FORCEPARTICIPATION 124 ....................................................................... E. SKILLS AND THE QUALITY OF THE LABOR FORCE 126 WAGES AND LABOR TAXES ......................................................................................................... 131 8.F . CONCLUSIONS .............................................................................................................................. 134 MICROECONOMIC IN GROWTH: LESSONS AGRO-PROCESSING, TEXTILESAND ISSUES INFORMATION ................................................................................................................. FROM A. TECHNOLOGY 137 INTRODUCTION ............................................................................................................................. 137 C. B. THEAGRO-PROCESSING SECTOR................................................................................................. GARMENTSAND TEXTILES........................................................................................................... 137 141 D . E. INFORMATION TECHNOLOGY ................................................................................................ (IT) 144 KEYSUCCESSFACTORS, 145 BIBLIOGRAPHY ................................................................................................................................... POTENTIAL CONSTRAINTS, AND GOVERNMENT POLICY ..................... 201 Tables Table 1.1: Labor Market Indicators by Location and Poor/Non.Poor. 2002.2006 ....................................... ............................................... 4 6 Table 1.3: FYR Macedonia: Potential Impact o f Policy Changes on Growth ............................................ Table 1.2: FYR Macedonia and SE Europe: Growth and TFP Comparisons 17 Table 1.4: Deviation Between Budgeted / Actual for Various Expenditure Items ..................................... 19 Table 2.2: Mode o f Sending Transfers........................................................................................................ Table 2.1: FYR Macedonia: Selected Macroeconomic Indicators.............................................................. 23 31 Table 2.3: Use of Remittances .................................................................................................................... 31 32 Table 3.1: Indicators o f Trade Performance in FYR Macedonia and Selected Countries .......................... Table 2.4: Estimation o f Marginal Import Demand Elasticities to Private Current Transfers.................... Table 3.2: Market Shares in EU27 Apparel Imports (percent) ................................................................... 37 Table 3-3: Wages and Value-Added Exports............................................................................................... 39 Table 3.4: MFNTariff Schedules for Selected CEFTA Countries in 2006 ................................................ 39 41 Table 3.5: Structure o f Industrial Imports in Terms o f MFNApplied Tariff Rates (in million o f US dollars and percent) ................................................................................................................................................. 42 Table 3.6: Tariff Rates, Net Exports and Share o f Preferential and Non-Preferential Agricultural Imports ..................................................................................................................................................................... 43 Table 3.7: Weekly schedule o f Consolidated Cargo Lines o f..................................................................... 51 Table 3.8: Price Indications of Full Unit Load and Consolidated Cargo Transports of an International Logistics Provider in Skopje ....................................................................................................................... 51 Table 4.1 : FYR Macedonia's Doing Business Indicators 2008-2009 ......................................................... 57 Table 4.2: Percentage o f Firms Indicating a Major or Moderate Obstacle in Doing Business: 2002 and 2005 ............................................................................................................................................................. 58 Table 4.3:FDI Inflows to South EasternEurope in millions.................................................................... Table 4.4: Structure and Transition Matrix of Firm Size............................................................................ 61 65 Table 5.1: SEECountriesLendingInterestRate, 2005 and 2007, percent per year ................................... Table 4.5: Distributionof Value addedand Employmentby Countriesand Firm Size in 2004.................66 Table 5.2: SEELendingInterestRate and Spreadover DepositRate........................................................ 82 Table 5.3: FYR Macedonia:Share of Largest Banks inBank Assets......................................................... 85 Table 6.1:Air TransportCosts by Origination/Destination(U.S. dollars) ............................................... 85 106 Table 6.2:Landingand Lighting Fees inthe Region ................................................................................. Table 6.3: FYRMacedonia:Transportof Goods by Roadsand Railways(Millions ofton-km) .............110 108 110 Table 6.5: FYR Macedonia:Electricity Consumptionby Customer Category......................................... Table 6.4: FYR Macedonia:Comparison betweenCorridorsX and IV................................................... 111 Comparators, 2006' ................................................................................................................................... Table 7.1: Summary Labor Market Indicators, 15-64 Year Olds, FYR Macedonia and Regional Table 7.2: UnemploymentRates by Age Group and Gender, 2004 and 2006.......................................... 118 Table 7.3: Quarterly HouseholdIncomeby Source andby Labor Force Status of Head, 2006 ...............124 123 Table 7.4: Average Labor Costs With and Without Hot Meal Allowance, Western BalkanCountries, 2005 ................................................................................................................................................................... 132 Table 7.5: Labor Tax Wedge for Various Income and Family Situations (Including Mandatory Fringe Table 8.1: Indicatorsof Agro-ProcessingCompanies Interviewedand the Sub-sector............................ Benefits), FYR Macedoniaand Other Western BalkanCountries, 2007.................................................. 133 Table 8.2: Indicatorsof InformationTechnology Companies Interviewed.............................................. 138 144 Figures Figure 1.1: Comparison of Growth in FYR Macedonia with SEE and EU10 Countries.............................. Figure 1.2: EnrollmentRates Into Secondary Educationand GDP Per Capita .......................................... 1 10 Figure 1.3: OverallInfrastructureReforms and GDP Per Capita ............................................................... 11 Figure 1.4: Trade Opennessand GDP Per Capita. and Changes in Trade Openness 2000-06 ...................13 Figure 1.5: CompetitionPolicy Reformsand GDP Per Capita................................................................... Figure 1.6: Banking Sector Efficiency and GDP Per Capita ...................................................................... 14 Figure 1.7: Perceptionsof Political Risk and GDP Per Capita, and Change over 2000-06........................ 15 16 Figure2.1: Importsand Exports(G&S), 1991-2007(percentof GDP)....................................................... 27 Figure 2.2a:-2.2b Current Account and Trade Balance (percent of GDP), and Financing of the Trade Balance(percent oftrade balance) ............................................................................................................. -27 Figure2.3: Net Cash Exchanged, Net FormalRemittancesandNet Total FormalTransfers ($ 10 Millions) ..................................................................................................................................................................... 30 Figure2.4: Growth Rate of Demand and Supply of ForeignExchange2004-2008 ................................... 33 Figure3.1:Trade and GDP Growth in SmallEconomies (lessthan 10 millionpopulation)...................... Figure3.2: MFNTariffs Rates by ProcessingLevel .................................................................................. 36 40 Figure3.4: Rankings on Components ofthe LogisticsPerformanceIndex 2007....................................... Figure3.3: Obstaclesto Doing Business: DifferencesbetweenExport...................................................... 45 48 Figure3.5: Border Crossing Times BetweenGreece and FYR Macedonia ............................................... 48 Figure4.2: PrivateSector Share in GDP vs. Skills and EducationConstraint, 2005 ................................. Figure4.1: BEEPS Perception Gaps -- Slovakia and FYR Macedonia, 2005 ............................................ 59 59 Figure4.4: Percentageof Firms Identifying Factors as an Obstacle, by Firm Size.................................... Figure4.3: DifferencesBetweenForeignand Domestic Firms(major obstacle)....................................... 62 Figure 5.2: Credit to the Private Sector in SEE Countries (percent of GDP, June 2005 and 2007) ...........79 Figure5.la: PrivateCredit/GDP Per Capita2005 ...................................................................................... 67 ........80 Figure 5.4: FYR Macedonia: CommercialBankAssets 2002-07............................................................... Figure 5.3: FYR Macedonia: InterestRateson CB Bills and Denar Loans and Deposits 2002-2008 81 84 94 Figure 6.1: Telephone and InternetDensity in 2005 andMobile Phone Density 1995-2006..................... Figure 5.5: Branches and ATMs per 100.000 People in Selected Countriesin 2005 ................................. 99 Figure 6.2: Various TelecommunicationsRates, 2007 and 2008.............................................................. 100 102 Figure 6.4: InternetSubscriptionRates, 1995-2006 ................................................................................. Figure 6.3: Competitionand Efficiency in 3G Auctions .......................................................................... 103 104 Figure 6.6: Air TransportTraffic in FYR Macedonia............................................................................... Figure 6.5: InternetUtilization Rate of Firms........................................................................................... 105 Figure 6.7: Airfare Reductionfrom 2004 to 2007 .................................................................................... Figure 6.8: InternationalTourism inECA Countries................................................................................ 105 107 Figure 6.9: Agribusinessand InfrastructureCosts: A Case of Sweetheart Rose Production.................... Figure 6.10: FYR Macedonia:Road and Railway Traffic ........................................................................ 107 Figure 6.11: FYR Macedonia:Toll Collectionby RoadFund.................................................................. 109 111 Figure6.12: ResidentialElectricity Tariff ................................................................................................ Figure7.1:UnemploymentandEmploymentRates, 15 Years and Older, ............................................... 113 Figure 7.2: PopulationProjectionsby SelectedAge Groups, FYR Macedonia, 2005-2040 .................... 117 118 Figure 7.3: Female ParticipationRates by Location, Education,and Age, 2004-2006 ............................ Figure7.4: EmploymentRatesby Age Group and EducationalAttainment, 2004-2006......................... 121 122 Figure 7.5: UnemploymentRate by Age Groups UsingAlternateDefinitions ........................................ 123 Figure 7.6: Participation Rates Among Household Heads and Married Women by Whether Household Figure 7.7: Adjusted Returnsto Education, Wage Earners Aged 15-64, 2006......................................... Receives PrivateTransfers, 2006.............................................................................................................. 125 Figure 7.8: Students Enteringand Graduatingfrom Tertiary Education, 1990-2005............................... 126 Figure 7.9: Annual PercentageChange inNominalNet Wages, 1997-2007............................................ 129 Figure 8.2: MacedonianGarments Exports(World, $million) and Share in EU-27Imports...................142 Figure8.1: FYR Macedonia:ComparativeCosts and Wage Developments............................................ 132 142 Boxes Box 1.1: Is FYR Macedonia's Growth Underestimated?............................................................................. Box 1.2: The GrowthCommissionReport: Habitsof Successful Economiesa............................................ 2 7 Box 1.3: The Slovak Republic's GrowthSuccess Story............................................................................... Box 1.4: Special RevenueAccounts(SRAs) .............................................................................................. 9 Box 2.1: Macedonian Agricultural Reforms and Policies........................................................................... 19 25 Box 3.1:Data Quality Issues....................................................................................................................... 41 63 Box 4.2: The Debateon Incentivesand FDIin an EUContext.................................................................. Box 4.1: Feedbackfrom Prominent`Failed Investors'............................................................................... Box 4.3: Ungroundedobjectionsleadto longdelays in collections........................................................... 64 Box 7.1: LaborMarketData in FYR Macedonia...................................................................................... 70 120 Box 7.2: Ireland- FromTroubledEconomy to `Celtic Tiger' via Investments in Skills.......................... 127 Box 8.2: Tikves -Growththrough Value-addedProduction.................................................................... Box 8.1: FYR MacedoniaMust ImplementBetter Standardsfor FoodProducts..................................... 139 140 Annexes Annex 1.1:NATO and EU Accession Effectson Growth................................................... 153 Annex 1.2: Analysisof FYR Macedonia's Growth PotentialBasedon InternationalEvidence ......... Annex 2.1: Balance of Payments. 2000-2008................................................................... 156 Annex 2.2: Allocation of Remittances and the GrowthPotential............................................ 160 161 Annex 3 1:Exports andAverage Annual GrowthRates in Exportsof Goods and Goods & Non Factor Services................................................................................................................. 163 Annex 3 2: Market Shares of Merchandise Trade for WESTERN BALKANS and Other Comparators .................................................................. Annex 3.3: Sharesof Exportsand Imports of Goods & Services in GDP (in YO)............................ in the World and EU-27 Markets. 1996-2006 165 166 Annex 3.4: FYR Macedonia's Service Exports and Imports by Major Sector, 1996- 2006........................................................................................................................................... 167 Annex 3.5: The Impact of SEE-7 Export Demand, Competitiveness and Product Diversification in World Markets........................................................................................................ 168 Annex 3.6: Shares of Factor Intensityin Exportsby SEE Country and Other Selected Group in World Markets (in %)........................................................................................................ 169 (based on World Import Data).............................................................................. Annex 3.7: The Largest Exports and Growth in FYR Macedoniaby SITC 2-Digit Sector, 1996-2006 170 Annex 3.8: EU-27 Market Shares of Apparel and Clothing by SEE Country and Other Comparator, 171 Annex 3-9:Conditions in Market Access Underthe SAA and CEFTA 2006........................... 1990-2006............................................................................................................ Annex 3.10: FYR Macedonia's Importsand ImportTariffs for Selected Products ........................ 172 173 Annex 3.11: Selected HS 6-Digit Items with MFN Tariff Rates Exceeding 30 Percent and their Imports in 2006 (in thousands of US dollars).................................................................. 174 Value by Export CommodityGroups.............................................................................. Annex 3.12: The Logistics Environment in FYR Macedonia Number of Declarations and Export 175 Annex 4.1: Surveys of Potentialand ExistingForeignInvestors .......................................... 177 Annex 4.2: Feedback Site Selection and Start-up Experiences of Johnson Controls and Johnson Annex 4.3: Pricesof Selected Goods, inEuro............................................................... Matthey (as of April 2008)....................................................................................... 179 Annex 6.1: A Simple Endogenous Growth Regression for Small Economies........................... 181 Annex 6.2: Telecommunications Industriesin FYR Macedonia.............................................. 182 184 Annex 6.4: Air TransportSector in FYR Macedonia........................................................... Annex 6.3: Firm Cost Performanceand InfrastructureServices........................................... 189 Annex 6.5: Electricity-Intensityof FYR Macedonia's Economy.......................................... 192 Annex 7.1: Mean Hourly Wages [in Dinars] by Sub-Group, FYR Macedonia 2006*............... 196 Annex 7.2: RegressionResultson Determinationof Wages by Selected Age Groups, LFS, 2006... 198 199 Annex 7.3: FYRMacedonia's State of Implementationof the BolognaReforms (Bologna Scorecard)............................................................................................... 200 ACKNOWLEDGEMENT This reportwas prepared by a core team led by Sanjay Kathuria, and consistingof James Hanson, Evgenij Najdov, Martin Melecky, Atsushi Iimi, Borko Handjiski and Gordon Betcherman. Primary responsibilities were: Overview and Main Report (Sanjay Kathuria); Chapter 1 and 2 on growth and macro issues (Martin Melecky and James Hanson, with core inputs and background papers from Evgenij Najdov; and Sarosh Sattar for Chapter 1); Chapter 3 on exports (Sanjay Kathuria, with background papers from Evgenij Najdov, Tapio Naula, consultant and Bartek Kaminski, consultant); Chapter 4 on the investment climate (Sanjay Kathuria, with background papers from David Brown, consultant, Mens Legis Cakmakova Advocates, consultant, and EvgenijNajdov); Chapter 5 on finance (James Hanson with core inputs from Martin Melecky and Evgenij Najdov); Chapter 6 on infrastructure (Atsushi Iimi, with core input from Borko Handjiski); Chapter 7 on labor markets (Gordon Betcherman, with core input from Toby Linden, Nina Arnhold and Bojana Naceva, and with the support of Diego Angel-Urdinola and Victor Macias, consultant); Chapter 8 on industry case studies (James Hanson, with a background paper from Michal Gorzynski, and core inputs and a background note from Evgenij Najdov). In addition, David Bernstein provided detailed guidance to the team on the legal issues in Chapters 4 and 5; and Victoria Stanley prepareda note on landmarkets for Chapter 4. Trade data was providedby Francis Ng, and other data and analytical support were provided by Olga Vybornaia. In addition, Evgenij Najdov provided detailed comments as well as last minute updates and other supplements on the entire report; and Borko Handjiskidid the same for the Infrastructurechapter. The consultant reports dealt with logistics (Tapio Naula), trade policy (Bartek Kaminski), investor and failed investor survey (David Brown), contract enforcement (Mens Legis Cakmakova Advocates), labor issues(Victor Macias), and industryanalysis (MichalGorzynski). The report was prepared under the supervisionof Bernard Funck, Sector Manager, and under the overall guidance of Jane Armitage (preceded by Orsalia Kalantzopoulos), Country Director and Luca Barbone, Sector Director. The team enjoyed excellent support from Mismake Galatis (who did the desktop publishing) and Jasminka Sopova (logistics support for the team's missions in FYR Macedonia). The report benefited from very useful comments by Markus Repnik, Fernando Montes-Negret, the European Commission (Jose Leandro, peer reviewer), Nikica Mojsoska Blazevski (peer reviewer, Ministry of Finance, Government of FYR Macedonia), Erika Jorgensen (peer reviewer), Paul Brenton (peer reviewer), Ardo Hansson, Ronald Hood, Andreas Schliessler, Peter Johansen and Danijela Vukajlovic-Grba. The team would also like to acknowledge the support of Fatmir Besimi for his comments and arrangingmeetings in Tetovo. The team would also like to thank the Government of FYR Macedonia and the Central Bank for hosting the World Bank teams and providing liberal access to information and data and their time, as well as the business community, private sector companies and academics who gave generously oftheir time. 1. INCREASING GROWTHAND REDUCING POVERTY INFYR MACEDONIA A. INTRODUCTION 1.1. Between 1998 and 2004 FYR Macedonia's GDP growth averaged 2.2 percent, but it has been rising in recent years, to an average of 4.7 percent over 2005-08. The low average growth since 1998 reflects the negative shock in 2001 (domestic political conflict) and slow recovery from it (Figure 1.1). However, even in the last few years, FYR Macedonia's growth remains at the lower bound of growth inthe EUlOcountriesas well as other SEEcountries. F i m r e 1.1: ComDarisonof Growth in FYR Mac4 lonia with SEE and EUlO Countries 7.5 / 7.5 5 5.0 2.5 2.5 0 0.0 -2.5 -2.5 -5 Y -5.0 Bulgaria Czech Republic -+- BiH ...*...Albania Hungary - +--Poland Romania Slovenia A Croatia -Macedonia ~ .L - Slovaka -a10 mdian -Macedonia -Median -. c. excluding Macedonia Serbia 1.2. FYR Macedonia has made solid progress in some key human development areas over the past fifteen years but poverty remained about 19 percent in 2006, based on the latest household survey available to the team. The poverty rate reflects low employment and education levels and has not been reduced despite the rise in employment between 2002 and 2006. Poverty was dispersed throughout the country and inequalitywas moderateby international standards. 1.3. This chapter will analyze FYR Macedonia's low GDP growth and ways to increase it by alleviating the growth constraints it faces, as well as the key issues in reducing poverty. The higher growth in 2007 and projected for 2008 could be taken as an indicator of improved future prospects. However, questions remainas to whether this higher growth is robust enough to survivethe less favorable external conditionsthat FYR Macedoniais facing and likely to face in the near future and what needs to be done to reduce constraintsto higher growth. 1.4. The outline of the chapter is as follows: The next sectionlooks at poverty and inequality issues. Section C examines FYR Macedonia's past growth in terms of total factor productivity analysis, drawing the connectionwith labor and capital, and within these broad factors, human capital and infrastructure. It also compares FYR Macedonia's growth to a successful regionalcomparator, Slovakia. Section D section benchmarks FYR Macedonia's performancein important policy areas that could affect growth relative to comparator countries. It also estimates how much improved performance in these areas could raise potential growth. Section E looks at efficiency in public expenditure and public investment, important issues in raisinggrowth. SectionF summarizes these analyses and makes some initial recommendations. 1 1.5. The key findings are as follows. Significant poverty reduction in FYR Macedonia will require sustained, job-creating growth. In addition, the quality of education needs to be improved across all groups of the population to improve labor productivity and reduce the numbers o f the working poor. Future growth needs to come from higher investment and improving productivity, and improvements in human capital. This will require policies aimed at increasing competition and export performance, reducing political risk, and improving efficiency o f public spending will be essential. Quality public investment, especially in infrastructure and education, is a necessary complement of profitable private investment, but needs to be enabled by improved efficiency and continuing fiscal sustainability. Also, improvements in structural policies are neededto successfully cope with an increasingly competitive and difficult external environment. Box 1.1: I s FYR Macedonia'sGrowth Underestimated? FYR Macedonia's GDP growth probably is not underestimated significantly, despite FYR Macedonia's large informal sector. FYR Macedonia's Statistical Office (SSO) follows the UNNACE and Eurostat methodology and adjusts for underreportingand the informal sector in the GDP accounts; the adjustment was about 18 percent of GDP in 2006 (SSO, 2006, pp. 17-18 and 74-79). Even if these estimates of the level o f the informal sector are too low, it is unlikely that growth is underestimated., A large underestimate of growth, as opposed to an underestimate o f the level o f GDP, would meanthat the informal sector and underreportingwere growing faster than GDP, which is consideredunlikely, as discussed below. ' Alternative macro indicators also suggest that GDP growth is not significantly underestimated. The most common approachfor estimatingthe undergroundfinformaleconomy is through currency usage, an approachpiloted by Feige (1986, 1989, 1990). It has been used in over 100 countries, including transition economies; its rationale is that undergroundfinformalactivities would avoid transactions that go through financial institutions.In other words, an unusual rise in currency usage would suggest faster growth in the informalhnderground economy, than in GDP.2 Macedonian data shows that currency usage has actually declined - nominal GDP has grown faster than denar currency usage since 2002/2003, unlike most transition countries in the region (NBRM, 2006, p. 88). FYR Macedonia's unusual fall in denar currency usage might be explained by many factors, e.g. a decline in government cash expenditures, an increase in financial services, or a faster rise in euro use. The Macedonian data suggest that euro use would have had to rise faster than in other transition countries simply to keep constant the ratio of denar- plus-euro cash usage to Macedonian GDP. In other words, Feige's cash-usage-approach suggests that FYR Macedonia's GDP growth is not underestimated significantly. Another way to check for GDP growth underestimation is to compare it with the growth of physical consumption of some goods. If physical consumption o f some good(s) were to grow rapidly, compared to GDP, this would suggest an underestimate of GDP growth. One simple example is the production of electricity for household use (including losses of electricity to take into account non-billed or non-collectedusage). Typically, the income elasticity of electricity usage is in the 1-1.25 range. In the case of FYR Macedonia, total distribution of electricity rose about 3 percent annually in 2003-2006; distribution for household consumption by an average of about 3.5 percent ann~ally.~These figures are consistent with the SSO's estimated average GDP growth rate of 3.7 percent in this period. Finally, a consistency check between employment in the household survey and GDP growth suggests no major rise occurred inthe ratio of employment to the labor force, which would have been needed for a major rise in the underground economy. Recently the ratio of employment to GDP did rise, but that was associated with an increasein GDP growth, again consistent with the argumentthat GDP growth is not underestimated. ' The largest absoluteadjustmentsin 2006 were in wholesale and retail trade, manufacturing,and construction. 2. More formally, this approach would involve econometric estimatesof the demand for currency, but for purposes of this box it seems sufficient to use the ratio of domestic currency to GDP as discussed. 3. The growth rate of electricity power for householduse is roughlythe same whether "other" productionis includedor excluded in productionofpower for household use. 2 B. POVERTY ISSUES 1.6. FYR Macedonia has made solid progress in some key human development areas over the past fifteen years. Life expectancy is high compared to other countries in the Europe and Central Asia region, and health and education indicators have shown significant improvements. FYR Macedonia's urban and rural populationshave good (though not universal) access to services such as water supply and electricity, compared to other lower middle income countries. Correspondingly, the quality of life indicators suggest reasonable progress toward a significant level of wellbeing within a period of social and economicupheaval. 1.7. Nonetheless, poverty affected 19 percent of the population according to World Bank calculations using the latest household survey data available to the team' (2006).2 There was relatively little rural-urbanvariation in poverty rates: 18 percent of the urbanpopulationand 21 percent of the rural population fell below the poverty line in 2006. In addition, though total poverty remained stagnant, extreme poverty (i.e,, food deprivation) increased during 2002-2006, rising from 4.5 percent to 7.3 percent of the population. Consumption inequality at 0.40 in 2006 (Gini coefficient) howeverappears moderate compared to international averages. Nevertheless, there are other elements of inequality (such as educationoutcomes, see below) which needto be addressedto reduce poverty further. 1.8. Speaking broadly,continuing high poverty can be explained by insufficientgrowth and low- productivityjobs. Slow growth in the last decade actually has not created enough newjobs to offsetjobs lost in the post-transitionprocess of restructuring. Over 1996-2004, employment (LFS data) declined by 2.6 percent. Despitethe rapid increase in employment thereafter (Chapter 7), just under 40 percent of the working-age population was employed in 2006, the lowest rate in the ECA region barring Kosovo (see table 7.1 for this and other regional comparisons of labor market outcomes-as noted in Chapter 7, there are some issues with the employmenthnemployment data). The jobs that have been created have often been poorly paid--they are mostly in agriculture or textiles--leadingto the phenomenon of the `working poor' (see below, and Chapter 7). 1.9. Poverty rates were unresponsive to the economic growth in FYR Macedonia during 2002- 2006. Real GDP per capita grew on average by 3.5 percent per year during 2002-2006, yet poverty was virtually stagnant at about a fifth of the population. In 2006, the share of the populationliving below the poverty line was 19.1 percent. Though poverty fell over 2002-2004 from 19.0 to 18.5 percent, this downward trend has not been sustained. In fact, overall poverty even rose slightly over 2004-2006, despite the steady 4 percent GDP growth realized over this period. A particular concern is that despite economic growth, extreme poverty has been rising. Thus, growth has helpedthe moderate poor to some extentyet worsened circumstances for those at the bottom ofthe incomedistribution. 1-10. Poverty rates also did not respond much to the significant increase in employment rates among the poor. FYR Macedonia is characterized by high unemployment and low wages, the latter usually reflecting low productivityjobs. During2002-2006,employment rates for the poor increased from 28 to 38 percent (Table 1.1). In other words, among those who work, 38 percent are poor. Employment rates for the poor in rural areas and secondary urban centers rose by 6 and 11 percentage points respectively. This increase in employmentreflectednot only an increase in labor force participationrates IAccordingto the SSO HouseholdBudgetsurvey numbers,per capitaconsumptionin 2007 does not appear to have changeddramaticallysuggestingthat a majorreductionin unemploymentis unlikelydespitehighergrowth. 2The State Statistical Officedoes not report official absolute poverty rates but only relative povertyrates, which are not comparable over time. The absolute poverty rates are computed by World Bank staff and are based upon an internationally accepted methodology for computing consumption aggregates and absolute poverty. In 2006, this poverty line was 102 denars (currentprices)per day per capita. 3 but also lower unemployment rates. Despite these improvements, employment rates among the poor remained significantly belowthose ofthe non-poor, which inturn are low by internationalstandards. Table 1.1: Labor Market Indicators by Location and Poor/Non-Poor, 2002-2006. Employmentrates Activity rates Unemploymentrates 2002 2006 2002 2006 2002 2006 FYR MACEDONIA 42.2 46.3 62.9 65.9 32.9 29.8 POOR 28.2 37.6 57.9 63.0 51.3 40.3 Skopje 22.0 34.3 57.4 56.8 61.6 39.6 OtherUrban 29.9 36.0 69.5 66.3 57.0 45.7 Rural 29.7 40.9 51.3 61.9 42.1 34.0 NON POOR 45.7 48.1 64.1 66.5 28.7 27.6 Skopje 44.9 49.4 64.7 66.0 30.7 25.0 OtherUrban 45.5 48.4 66.3 70.5 31.3 31.4 Rural 46.4 46.9 61.6 62.9 24.7 25.4 Source: World Bank staff calculations based on HBS 2002 and 2006. Note: HBS labor market data is not completely consistent with LFS data (see Box 7.l),because of different sampling methods and definitions. Also, the HBS is not designed for calculation of labor market statistics and is better used to understandthe differences in labor marketoutcomes betweenvarious groups. 1.11. Poverty particularly affects households with low employment and education. As in most countries strong determinants of consumption per capita include household size and the number of employedpersons in the household. Thus, households where the dependency ratio (householdmembers divided by employed members) is high are more likely to suffer from poverty; this is especially true in householdswith three or more young children. Furthermore, householdheads with primary educationor less are much more likely to have high poverty rates compared to those with secondary or higher education. And, due to past under-investment in education, the share of the population with post- secondary school education is low. 1.12. Inequality increased somewhat during 2002-2006, with increases in both urban and rural inequality. The Gini coefficient for FYR Macedonia increased from 0.38 to 0.40 during this period. In 2002, rural inequalitywas slightly lower than in urbanareas. However, by 2006 this had reversed and the Gini coefficient for rural areas (0..41) was slightly higher than in urban areas (0.39). This pattern of increasing inequality is reflected in the fall in the share of the poorest quintile in total consumption expenditures, from 6.2 percent to 5.5 percent during 2002-2006.With the exceptionofthe top quintile, all other population groups saw their share of total consumption fall. (The richest quintile saw their share of consumptionincreasefrom 44.0 percentto 46.2 percent). 1.13. Reduction in poverty rates will depend on sustained, job-creating growth and on improving quality and education outcomes across all groups. While stagnant poverty implies that the fruits of growth have eluded large segments of the population, certain groups-women, youth and the non- Macedonian ethnic groups-have been left out more than others. For example, female employment and participationrates are among the lowest in the ECA region (3 1 percent employment rate in 2006, versus 48 percent for males). Lack of sufficient education is a major factor in unemployment-the employment rate was only 31 percent for those with primary or less education, compared with 77 percent for those with post-secondary education. In addition, educationoutcomes appear to be unequal.About 70 percent of the ethnic Macedonianpopulation had completed secondary education, but only 40 and 60 percent of other ethnic groups had done so (2004 HBS). With compulsory secondary education introduced in September 2008, these numbers should improve. Significant poverty reduction in FYR Macedonia will require sustained growth, so that sufficientjobs are created. Thesejobs will need to pay adequate wages, 4 so that the employed earn enough to climb or stay out o f poverty. And thesejobs will have to be created more uniformly across different groups-including women, youth and different ethnic groups-in order to promote inclusion as well as to have an impact on aggregate outcomes on employment and poverty. Note that the high unemployment constitutes an untapped source o f GDP growth. 1.14. The impact of higher international food and energy prices in 2007 and part of 2008 was partly mitigated by rising wages and employment, but the poor would nevertheless have been affected.Nominal wages increased by about 10 percent annually in 2007 and 2008, and employment also rose somewhat. Nevertheless, the price increases are likely to have affected some groups adversely. The group most vulnerable to these relative price shocks would be the landless poor. Farmers, being suppliers as well as consumers, may even be better off overall, depending on what they produce and consume. Social assistance programs directly targeted to the vulnerable groups are the most efficient way to mitigate the impact o f higher food (as well as energy) prices. In this context, the Government's proposed reform and consolidation of its social safety net program (it plans to introduce a new, conditional cash transfer program) is a step in the right direction. Such a reform would also help mitigate the impact on the country's population of the ongoing global economic crisis. c. GROWTH AND TOTALFACTOR PRODUCTIVITY IN FYRMACEDONIA Capital and Labor 1.15. A now-standard approach to analyze GDP growth is Solow's well-known breakdown of growth into what is attributable to the growth of capital, employment and a residual called the increase in total factor productivity (TFP). Specifically, GDP Growth = a Net Investment + b Increase in Emdovment + Increase in TFP, Capital Stock Employment where a and b are the percent change in output for each percent change in capital and employment (output elasticities), respective~y.~ The equation follows the classic empirical analysis of Solow, 1957. Two factors are used for simplicity. Later studies added more factors, and other elements like R&D naturalresources, government size, infrastructure, etc. The actual, residual estimate o f increased TFP involves significant measurement problems. The productivity of units of labor and capital (measuredat base-year prices) may increase (see e.g. Denison, 1962; and Jorgensenand Griliches, 1967) and theoretical and empirical issues exist in estimating the capital stock. There are also problems with estimating TFP in economic cycles, including the possibility of technological changes that may cause "real" business cycles. Estimated capital and (employed) labor stocks do not change as rapidly as cyclical GDP, so estimatedTFP in individual years typically varies more than output. Real business cycles are based on the idea that the changes in TFP reflect shifts in technology, rather than aggregate demand and failures of markets to clear. See Kydland and Prescott (1982). In economies transitioning from a system o f centrally planned to a market-based system, these problems are even greater: series are short, precluding econometric estimation of parameters, and reforms may have made much of the earlier capital (and, perhapsthe labor) stock obsolete-equivalent to a sudden rise in depreciation or a negative TFP shock. Given the heroic assumptions that are necessary to cope with these issues, the results are best considered indicative.Nonetheless, the TFP estimates for FYR Macedonia and the other countries are suggestiveof some basic issues. 5 FYR Macedonia FYR Macedonia Average 1996-2005 2005-2006 SEE 7 countries 1997-2005 GDPGrowthYOp.a. 2.3 4.0 4.2 RoleofLabor % 4 78 -14 RoleofCapital% 16 18 42 TFP Growth-Residual 80 6 72 YO 1.16. Thus an increase in TFP represents the residual part of growth unexplained by capital and employment growth. It can be interpreted as "disembodied" technical progress, improved resource allocation, changes in human capital and other qualitative factors related to capital or labor, or more productiveuse of inputs as a resultofreforms. 1.17. FYR Macedonia's GDP growth has been slow and, surprisingly if one considers the experience of other countries, much of its growth reflectsthe (unexplained) slow rise in TFP - only 1.8 percent per year (Table 1.2, Column 1). Capitalgrowth has been low: between 1996and 2006, gross fixed capital formation in FYR Macedonia has only averaged about 17 percent of GDP, with small variations around the average. Hence, the estimated capital stock rose slowly. The Growth Commission has argued that the investment rate should be 25 percent or more to achieve rapid growth (see Box 1.2). Employment rose and fell over the last 10 years and was actually 3 percent lower in 2004 than in 1997. Including an estimate of the (low) growth of human capital would increase only slightly the contribution of employment (and lower TFP slightly). Putting all these together, GDP growth averaged less than 2.5 percent per year between 1996 and 2005. 1.18. I n 2005 and 2006, FYR Macedonia's growth rose somewhat and a change occurred in the pattern of growth, mainly a rise in employment (Tablel.1). Measured employment rose by over 4 percent annually, perhaps partly as a rebound from the employment drop in 2004. Thus, measured employmentactually grew slightly faster than the 4 percent averagegrowth in GDP in these two years. In addition, the estimated capital stock grew slightly faster than in the past. As (an accounting) result, the contribution to growth of increases in TFP fell to almost zero in 2005-2006. Although the growth in employment is promising, especially noting the higher GDP growth in 2007 of 5 percent and the further rise projected in 2008, care should be taken in interpreting these outcomes as a permanent change in potential growth rather than a continuation of the cyclical recovery, especially given the likelihood of a moredifficult externalclimate inthe future (Chapters 2 and 3). 6 Box 1.2: The Growth CommissionReport: Habits of SuccessfulEconomies' The Growth Commission's report (httn://www.growthcommission.org) argues that "growth is not an end in itself. But it makes it possible to achieve other important objectives of individuals and societies. It can spare people en masse from poverty and drudgery. Nothing else ever has. It also creates the resources to support health care, education, and the other Millennium Development Goals to which the world has committed itself. The report makes the case that growth is a necessary, if not sufficient, condition for broader development, enlarging the scope for individualsto be productiveand creative."(p. 1) The report identifies some of the distinctive ingredients involved in successful growth in 13 countries that have sustained 7 percent growth for 25 years and other countries that have beenless successful: Involvement with the world economy. The world economy offers developing countries a deep, elastic market for their exports and allows countries to specialize in new export lines and improvetheir productivity in manifold ways. It also provides opportunities for inward technology transfer and foreign direct investment. High rates of investment, perhaps 25 percent of GDP or more, predominately financed domestically and includinginfrastructureinvestmentof perhaps5 percent of GDP or higher. Investment in education, training, and health, with private and public spending in these areas as high as 7-8 percent of GDP. Increasinglycapable, credible, and committed governments that are supported by the public and wedded to the goal of high and inclusive growth, but pragmatic in their pursuit of it and which ensure equality of opportunity and reasonable socialsafety nets. A policy environment favoring high levels of investment, job creation, competition, mobility of resources, and efficient urbanization. This environment should include a reasonable degree o f macroeconomic stability. Equality of opportunity and reasonable amounts of equity and social protection, particularly in economic transitions, in terms of income and access to basic servicesand training. In addition, the Commission advises that the cost of pollution be considered from the outset, even if the toughest environmental standards of the rich countries are not adopted. The report also calls on developing countries to wean themselves off fuel subsidies, which impose a mounting fiscal burden as energy prices rise, diverting money that would be better spent on neglected public infrastructure. While these elements are important to sustained high growth, the report recognizes that it "does not provide a formula for policy makers to apply-no generic formula exists. Each country has specific characteristics and historical experiences that must be reflected in its growth strategy. But the report does offer a framework that should help policy makers create a growth strategy of their own. It will not give them a full set of answers, but it should at least help them ask the right questions." (p. 2) a/ The Commission's report was the product of two years of inquiry and debate by 19 experienced policy makers, academics and business people, mostly from developing countries, and two Nobel Laureates, including Michael Spence who chairedthe commission. They heard from leading authorities on various topics ranging from macroeconomic policy to urbanization in 12 workshops and through numerous papers. The Commission's work was supported by the governments of Australia, Sweden, the Netherlands, and the United Kingdom; the William and Flora Hewlett Foundation; and the World Bank Group. 1.19. Regionalcomparators have grown faster than FYR Macedonia on average, reflectingboth higher capital growth and higher TFP increases. Capital growth contributed an estimated 1.76 percent per year on averagedto their GDP growth (42 percent of GDP growth) compared to 0.36 percent per year 7 (16 percent) for FYR Macedonia (Table 1.2). The higher contribution of capital to the comparators' growth reflects their higher (gross fixed) investmentrates-an average of 24 percent of GDP from 1996- 2005, compared to 17 percent in FYR Macedonia. Employment in the regional context has declined on average in four of the seven countries since the "trough" in GDP after the switch to a market-based economy. Inthis respect, the slow growthof employment in FYR Macedoniais not unusual. 1.20. The increase in TFP among the regional comparators averaged 3 percent per year (72 percent of GDP growth), much higher than the 1.8 percent average per year for FYR Macedonia. Taking into account boththe larger increase in capital and the higher TFP in the rest of the region, output grew much faster in the other countries in the region than in FYR Macedonia; an average of 4.2 percent annually in the seven comparatorcountriescomparedto 2.3 percent annually in FYR Macedonia. 1.21. Comparing FYR Macedonia and Slovakia, a high growth performer in the region, further highlights the differences in the fundamentals of growth and raises some other issues. Slovakia is one of the success stories in the transition economies; from 1998-2007 it averaged 4.8 percent growth and, in 2005-2007, 7.7 percent, compared to 2.8 and 4.4 percent for FYR Macedonia, respectively. Slovakia's gross fixed investmenthas averagednearly 29 percent of GDP over the last decade (3 Ipercent over 1996-2000), compared to 17 percent for FYR Ma~edonia.~Thus Slovakia's higher growth has at least partly been driven by higher investment and lower consumption rates. Slovakia's exports and imports are now each over 80 percent of GDP, and its openness ratio (the sum of exports and imports of goods and services to GDP) has typically been about 50 percentage points of GDP higher than FYR Macedonia's. Its GNFS exports to GDP ratio in 1996 (53 percent) was higher than FYR Macedonia's in 2006 (50 percent). Finally, Slovakia's success reflects not only higher investment but investments in infrastructure,good endowments of human capital, followed later by major policy reforms(Box 1.3). The Slovak experience also conforms to the findings of the Growth Commission (ZOOS), viz., that high investmentincluding effective public investment, a well educated labor force, and openness to the world economy are highly importantfor rapid growth(Box 1.2). 1.22. In sum, the foregoing simple analysis suggests that improvement in the basic forces underlying growth - investment and employment - will be needed to raise FYR Macedonia's growth rate. First, the low rate of investment needs to be increased, through improvements in the investmentclimate (discussed briefly below and in more detail in chapter 4) and public investment.An improvement in the investment climate and continued improvements in the financial system could also lead to more of remittancesgoing into investment, as discussed in Annex 2.1. And approachesto increase public investment in a fiscally sustainable way are discussed in section E. Second, employment growth has been low and measuredunemploymenthas remained high for some time, to some extent reflectingthe obstacles to employing more workers such as taxes on labor (Chapter 7). In the last few years, employment growth increased; hopefully this will continue. However, this employment growth, particularly in 2005, may partly reflect the last phase of what was at first a slow recovery of employment after the 2001-2002 shock. Moreover, the rise in employment in 2005-2006 was accompanied by an offsettingfall in TFP growth, so the increased employmentwas not associated with as much GDP growth as might have been hopedfor. It also remains to be seen to what extentadditionalnumbers from the many non-participantsin the labor force and the still-large measured unemployed actually will be willing and 4A question arises here whether domestic savings could be a binding constraint to increased investment rates and thus growth. This is not likely to be the case. For instance,the FYR Macedonianbankingsector is a net depositor of funds abroad (see chapter 5 for further details), and the current account deficit (the gap between domestic savings and investment) had been declining until recently and been moderate in 2005 and 2006 in the regional context. If investment rates rise (which would happen if return on investment increases), then corporate savings are likely to also increase to finance this investment; householdsavings may also respondto the financial sector improvements. Also, part of the investment increase would probably come from FDI, which would be financed at least partially throughforeign savings. 8 able to work productively, and how well they will be equipped with productive capital by higher investment. I Box 1.3: The Slovak Republic'sGrowth Success Story After the end of the Communist regime, the Slovak Republic rapidly changed from a centrally planned economy to a market-orientedeconomy. In terms of industrial production, it switched from arms manufacture during the Communist era to car and electronics industries-it has been described as the "Detroit of the East" (The FinancialTimes, February 20, 2007). Accordingto Standard and Poor's ratings, it has become a leader in Central Europe. Total FDI inflows to Slovakia reached US$14.747 billion as of 30 June, 2006. FDI has occurred in export-oriented sectors, improving productivity and keeping the external deficit under control. These outcomes reflect high investment, a well educated labor force, and a host of reforms in infrastructure; education, the labor code; taxes, investment incentives, and banking, finance and financial infrastructure. When starting the transition to a market economy, the Slovak Republic's main comparative advantage was relatively good education attainment, both quality and coverage. Foreigninvestors have found that the Slovak Republic has a top-quality labor force, efficient and productive-indeed, the high skill and competitive labor costs have been prime reasons for very high FDI in Slovakia's automotive sector5,and Slovakia now has the highest per-capitacar production in the world. The higher education system graduates 75,000 new specialists per year (1.2 percent of the population). The standard of education in primary schools is among the highest in Central Europe. Slovakiais also in the forefront regardingsecondary education, with 92 percent enrollment rate in upper secondary education in 2006. Tertiary education is growing very substantially, from 20 percent enrollment in 1995, to 29 percent in 2000, and to 45 percent by 2006. Building on initial comparative advantages, the momentum of reforms in Slovakia picked up in 1998, and especially after 2002. Reforms included industrial restructuring and privatization, tax policy reform, and reforms in pensions, healthcare and education. Fiscalconsolidationcontributedto a steady decline in the size o f government. All these factors contributedto Slovakia's growth success. Among the best known of the major policy reforms introducedis a new system of taxation: all types and amounts of income are taxed at a flat rate of 19 percent; there is no double taxation and a zero percent dividend tax. Banking sector reforms have includedprivatization and by December 2006 foreign ownership had reached 97 percent of the system. In the area of businessreforms, Slovakiahas made major progress in reducing the time for business registrationand trade licenses (as has FYR Macedonia). The Slovakian Investment Incentives Program (2007) enables faster and more transparent negotiationbetweenthe government and foreign investors, so that a company can easily determine the potentialamount of state aid. Human Capital 1.23. Improving the human capital (educational achievements) of the labor force will be importantfor higher Macedoniangrowth. Human capital has been shown to be an important factor in $ various studies o f growth that augmented the basic, simple growth formulation discussed above6,as well as numerous other studies of economic development. The recent recommendations of the Growth Commission, 2008, underscore the role of increased investment in higher education. In these studies, secondary education has typically been used as an empirical proxy for human capital. 1.24. In FYR Macedonia, secondary education enrollment currently seems to be reasonable although skilled labor is already often considered in short supply (Chapters 7 and 8). Some evidence on the role of higher education and the existing situation in FYR Macedonia is shown in the left panel of Figure 1.2, which shows the relationship between 2006 per capita GDP (constant 2000 US$)and average secondary enrollment rates in 2000-2006 for some selected countries. It shows that countries with higher 5See Jakubiak et al (2008) for adiscussion of the car industry in Slovakia. 6For example, see Jorgensenand Griliches, 1967;and Denison, 1962 9 secondary enrollment rates have higher per capita GDP levels7 The right panel o f Figure 1.2 shows increases in secondary enrollment rates for selected ECA countries over 2000-2006. Macedonian secondary enrollment rates are at the average o f ECA comparators in terms o f GDP per capita (viz. the left panel). 1.25. FYR Macedonia's improvement in education seems to falling behind its neighbors, however. Over the last ten years FYR Macedonia falls below the median improvement in selected ECA countries as shown in the right panel o f Figure 1.2. For instance, Bulgaria's per capita GDP is $2249 with the average secondary enrollment rate o f 88 percent and an improvement in the enrollment rate of 0.8 percentage point. FYRMacedonia at $1947 per capita GDP, 81 percent average enrollment rates, and an improvement o f 0.6 percentage point will need more than 10 years to catch up with Bulgaria in terms o f education, provided Bulgaria does not improve. Slovakia's growth success highlights the positive growth effects o f its endowments o f human capital, and steady improvements over time in tertiary education enrollment. Chapter 7 discusses the issues in the education sector and reforms that will help enhance higher education in FYR Macedonia. While the introduction of compulsory secondary education as o f 2008 should help FYR Macedonia, Chapter 7 also emphasizes the qualitative side o f education, an area where FYR Macedonia lags. Figure 1.2: Enrollment RatesInto Secondary Educationand GDP Per Capita 100 lll_l_- Estonia 111 95 Belarus I Georgla AIbania 5 85 Hungary E g 80 Romania c Croatia 75 y 0 0013x + 78.346 R2= 0 267 ' Bulgaria Azerbaijan Lithuania I 65 Macedonia,FYR 0 5000 10000 15000 GDP per capita I .o 5 0 0 5 1 1 5 %change in secondary enrollment rates Note: average enrollment rates over 2000-2006, changes in enrollment rates from 2000-2006, and per capita GDP in2006 at constant 2000 USdollars; Source:WDI Databaseofthe World Bank Infrastructure 1.26. At present, FYR Macedonia's infrastructure is roughly on par with comparator countries, but this situation will not last if infrastructure reforms and the flows of infrastructure investment remain below those in those countries. Infrastructure capital is another factor that has sometimes been added to the basic factors explaining growth; at various points the Growth Commission report emphasizes the need for infrastructure to grow rapidly to sustain high GDP growth. Here the discussion is divided into infrastructure reforms, which can help stimulate private infrastructure and improve its contribution to growth and welfare, and public infrastructure investment (discussed in Section E in the context o f the efficiency o f public spending; Chapter 6 discusses details o f infrastructure by type). As shown in the left ~ 7 The graph does not imply causality. However, most cross-country studies of economic growth consider secondary education levels as a background factor for any analysis of growth-low secondary education levels are associated with lower growth. 10 panel of Figure 1.3, higher overall infrastructure reforms appear to be significantly associated with higher per capita GDP. Given FYR Macedonia's GDP per capita in 2006 ($1947, constant 2000 US $), its index of overall infrastructure reforms (EBRD) is at the average for the ECA region. It is significantly higher than the 1.33 value for Belarus (GDP per capita $2066), but also significantly lower than the 3.33 value for Romania(GDP per capita $2437). 1.27. In terms of recent improvements, FYR Macedonia is in the median range but is significantly behind immediate comparators such as Romania, Bulgaria, Bosnia and Herzegovina, and even Albania, as shown in the right panel of Figure 1.3. The current infrastructure may have been sufficient for the period of slow growth, but Chapters 4 and 6 point out that businesses have increased their criticism of infrastructure. Even the few recent years of faster growth brought up some potential bottlenecks; and the exporting sector had more concerns on infrastructure than the non-exporting one. As the comparison with Slovakia illustrates, improving its infrastructure could allow FYR Macedonia to take more advantage of its central location (See Chapter 6 for a detailed discussion). Figure 1.3: OverallInfrastructureReformsand G )PPer Capita 4.5 Romania Slovak Republic Slovenia 4 Estonia Croatia Bulgaria 23.5 E Bosnia and HeRegOVina Albania Uzbekistan - ee Russian Federation 3 3 Lithuania Latvia 2 Kazakhstan $2.5 Hungary -.- Azerbaijan IC E Ukraine y = 0.0002~+ 2.0169 Poland E 2 Macedonia. FYR a, R2 0.5002 Georgia 0 Czech Republic 1.5 KyrgyzRepublic Tajikistan Serbia 1 Montenegro 0 5000 10000 15000 Moldova Belarus GDP per capita Armenia 0 0.5 1 1.5 2 progress on infrastructure reforms 1997-2007 Note: EBRD overall infrastructurereforms index in 2007 and its changes over 1997-2007, and per capita GDP in 2006. Source: EBRD and the WDI Databaseof the World Bank D. IMPROVING FYRMACEDONIA'S FRAMEWORKGROWTH FOR 1.28. Other explanations of growth emphasize the role of the institutional and incentive framework in increasinggrowth and removingthe constraints to growth. Going beyond the simple TFP approach, this approach to "explaining" growth uses cross-country regressions and looks at constraints to growth, essentially taking the stock of capital and the labor force and its human capital as given. Following this approach, this section benchmarks FYR Macedonia against its comparators in terms of some of the usual framework indicators. It looks at the indicators both in relation to the 2006 level of per capita GDP,9 and the progress FYR Macedonia has achieved on these indicators relative to 8For example, see Lucas, 1998;Barro, 1991;World Bank, 1993;and Growth Commission, 2008. 9Bivariate cross-country regressions are used for this purpose, focused on the Europe and Central Asia (ECA) regionas defined by the World Bank. 11 other countries in the ECA region over the last ten years. It draws on Annex 1.2, Chapter 4 on the investmentclimate, and the successful growth story ofthe Slovak Republic presented in Box 1.3. 1.29. I t should be noted that it is probably not sufficient to bring FYR Macedonia's indicatorsin line with comparators'. First, the current situation has been associated with slow growth. Second, good current indicators do not imply further, automatic improvements.Given FYR Macedonia's situation-a small, landlocked country (albeit with potential advantages of location next to the EU), facing a difficult international environment, it will probably be necessary to over-achieve in the framework areas to improvehigher long-rungrowth. Openness 1.30. One important factor in growth seems to be economic openness to the world economy and it will be important for FYRMacedoniato sustain the pace of increasingopennessand graduallyshift the emphasis to increasingexports rather than imports. Openness, particularly in terms of exports, is an indicator of the competitivenessof an economy's production." The left panel of Figure 1.4 suggests that a higher degree of trade openness, (exports plus imports over GDP) is significantly associated with higher GDP per capita. FYR Macedonia performs somewhat better than the average on this indicator", i.e., better than comparators at similar GDP per capita levels.I2 In terms of the dynamics of openness shown in the right panel of Figure 1.4, FYR Macedonia is among the top four performers concerning increasing openness over 1996-2006, together with the Slovak Republic, Hungary and the Czech Republic. The latter countries are at much higher GDP per capita and their trade openness is also significantly higher. 1.3 1. Of course, the key question is what policies allow greater openness, since openness is an outcome of policy reforms, and this is the subject of discussionin Chapter 3. 1.32. There are some significant questions regarding FYR Macedonia's pattern of increased openness which may partly explain why, though openness is high, growth has been low. First, FYR Macedonia's imports have increased relativeto its exports(a relatively small part of the explanation is the effect of FYR Macedonia's high measured remittances on consumption imports, see Chapter 2). Thus, FYR Macedonia's increased openness reflects high imports rather than export-led growth. High imports may be less growth-inducing if imports do not contribute to the country's increasedproductioncapacity either through physical capital accumulation or technological innovation. Indeed, in many countries fast growing imports have signaled some risk of an unsustainable boom, an issue discussed in Chapter 2. In addition, the recent boom in commodity and metalprices could have biasedthe cross-countrycomparison due to its positiveeffect on commodity and metal exporters.The resultingbias is likely positivefor FYR Macedoniawhich is an exporter of metals but, as discussed in Chapters 3, 4, and 6, to some degree FYR Macedonia's success in metals exports has reflected its subsidized electricity prices. Chapter 3 of the lo Although some disagreement exists in the literature regarding the link between openness and faster growth, a recent study by BillmeierandNannicini,2007 providesa new approachthat validatesthis link. I' Note that this comparison is different from the earlier one vis-a-vis Slovakia, since the latter has a much higher per capita income currently. Also, Slovakia is a high perfomer, whereas Figure 1.4 describes an average relationship. l2 Nevertheless,this picture is somewhat biasedby the presence of large economies such as Kazakhstan, Russiaor Romania, who in the limit might never become as open as small economies such as FYR Macedonia. For Russia (GDP per capita $2620)and Romania(GDP per capita $2437)the trade openness indicator reaches only 55 and 78 percentrespectively.On the other hand, Montenegro(GDP pc $205l), Belarus(GDP pc $2066),Bulgaria(GDP pc $2248)are significantly more openthanFYRMacedonia- 129percent, 124percentand 147percentrespectively. It appears that for a small economy like FYR Macedonia a higher degree of openness is critical for increasing economicgrowth and incomeconvergence. 12 report focuses on FYR Macedonia's trade in more detail, in particular export performance and competitiveness, and highlights the importance o f further reduction in barriers to trade (especially non- preferential trade) and logistics costs (as well as other issues such as improvements in the business climate) for increased exports. Figure 1.4: Trade Opennessand GDPPer Capita, and Changes in Trade Openness2000-06 180 f 120 y = 0 0064~+ 88 1 80 R' = 0 2637 _-, 0 2000 4000 6000 8000 10000 12000 14000 GDP per capita I -80 -60 -40 -20 0 20 40 60 Changes in Trade Openness Note: trade openness (exports plus imports per GDP) in 2006, changes in trade openness over 2000-2006, and per capita GDP in2006. Source: WDI Databaseofthe World Bank Competition 1.33. FYR Macedonia needs to improve on pro-competitive reforms to support faster income growthand to not fall behind its comparators in upcomingyears. The left panel o fFigure 1.5 shows a negative association between the lack o f pro-competition policy reforms (lower value means better pro- competitive reforms) and GDP per capita. FYR Macedonia is slightly better than the average on this indicator than comparators, Le., other ECA countries with similar,per capita GDP (slightly below the regression line). However, to increase its potential growth FYR Macedonia needs to move further below the regression line, as, for instance, Romania did recently. As seen in the right panel o f Figure 1.5, the pro-competitive environment (reforms) actually worsened in FYR Macedonia over 2001-2005.'3 In contrast, Slovenia and Slovakia improved significantly over the same period; Slovenia is an outstanding performer in this respect. The competition policy agenda is part o f Chapters 3 and 4: the former focuses on competition in the international context, and Chapter 4 discusses the BEEPS results that anti- competitive practices were the second highest concerns o f Macedonian business. l3 See Miroudot et al (2007). The index worsened from 0.57 in 2001 to 0.59 in 2005. This recent OECD working paper finds that the index of competitive reforms worsened in FYR Macedonia over 2001-05. The index is a compilation based on 13 different indicators of investment, trade and competition policies. The indicators encompass several from the Doing Business database. It is possible that the situation may have started improving since the index was compiled, given the significant improvement in the Doing Business indicators on starting a business, and trading across borders. 13 Figure 1.5: CompetitionPolicyReformsand GDPIPer Capita 0.9 1 0.8 - $.- 0.7 - @ y -4E-05~+ 0.6861 Rz= 0.468 1o.6 E Serbia and fvbnte 0.5 - .-200.4 - c) c) % 5 0.3 - 0.2 - n. 0.1 - , 0 3000 6000 9000 12000 15000 GDP per capita -0.15 -0.09 -0.03 0.03 0.09 Improvent (-) in Pro-competitive reforms index Note: OECD pro-competitivereforms index in 2005 and its changes over 2001-2005, and per capita GDP in 2006. Source: OECD andthe WDI Databaseof the World Bank Finance 1.34. FYR Macedoniawill need to sustain its above average position in bankingsector efficiency to complement its possibly higher pace of income convergence in the future. As shown in the left panel of Figure 1.6, higher banking sector efficiency is associated with higher per capita income levels. FYR Macedonia is above the average on this front given its GDP per capita -its efficiency is above the regression line. Also, the right panel of Figure 1.6 shows that FYR Macedonia is among the better performers concerning improvements in banking sector efficiency over 1997-2007. Nevertheless, some other countries with slightly higher GDP per capita, such as Belarus, Kazakhstan, Russia or Lithuania, managedto increase the efficiency of their bankingsystems even more. Further qualitative improvements in the bankingsector and the financial sector in general are needed to ensure that FYR Macedoniakeeps up with its comparators. This qualitative improvement should complement the quantitative growth of private credit to GDP since 2001. Despitethe above-averagebankingsector efficiency, the 2005 BEEPS results report the cost and access to finance as key concerns of businesses. While things have improved since then, faster and sustained growth in FYR Macedoniawill demand that the financial sector is better able to serve the needs of small firms (the backbone of the economy) and the possible changingpatterns of growth (given the need for diversification, see Chapter 3). This will mean second generation financial sector reforms, focusingon institutionalchange as well as enhancingcompetitionfurther. Chapter 5 of the report discussesthe issues inthe financial sector and the effectiveness of financial intermediation. 14 Figure 1.6: BankingSector Efficiencyand GDP Pe Capita 6.5 6 + R isliln Federatlon 21 .- 5.5 0 0 Vacedonla, FYR E 5 I0 ' $ 4.5 m zc y = 0 0 0 0 1 ~ + 4 2 1 2 6 &I 4 R2= 0 1682 3.5 * ++++ 3 0 2000 4000 6000 8000 10000 12000 14000 GLP per capita I Serbi -1 -0.5 0 0.5 1 1.5 2 2.5 Improvements In Banking sector efflclency Note: WB Banking sector efficiency index in 2007 and its changes over 1997-2007, and per capita GDP in 2006. Source: the WDI Database of the World Bank PoliticalRisk 1.35. FYR Macedonia needs to reduce the perceptions of its political risk in order to boost domestic private investment and FDI. As shown in the left panel of Figure 1.7, it appears that lower perceivedpolitical risk (more points means greater perceived risk) is significantly correlated with higher GDP per capita. FYR Macedoniais perceivedto have more political risk than average comparator country with similar GDP per capita.The Kosovorelateddevelopments, the Greek veto over NATO membership as well as the domestic political tensions suggest continued presence of these risks. Such perceptions of political risk can hinder growth in FYR Macedonia, especially in regard to increased private domestic investment and FDI, as pointed out in Chapter 4. Moreover, over 1997-2007the perceptions of political risk in FYR Macedonia do not seem to have improved much. Securing membership in NATO and commencing EU accession negotiations could possibly provide signals that improve the political risk of the country. There is some indication that the mere signaling effect of the EU accession process has helped growth in the countries that entered the process in 2000, by indicating an improvement in countries' institutions.There is too little data andtoo much cross-countrydifference however to be able to say much about the impact ofNATO membership(See Annex 1.1). 15 Figure 1.7: Perceptionsof PoliticalRiskand GDPiPer Capita, and Change over 2000-06 80 + 270 Lu ;60 .-Lm50 u) y=-0.0057~+66.818 -E40 0 30 20 + 10 0 I / 0 2000 4000 6000 8000 10000 12000 14000 GDPper capita -40 -30 -20 -10 0 10 Changes in Political Risk PotentialBenefits of Improving the Policy Framework, Human Capital and Infrastructure 1.36. How much additional growth might occur if FYR Macedonia managed to improve the framework of its economic policies and increase human capital and infrastructure? The approach taken here is a simple one, solely for the purpose o f illustration. It assumes FYR Macedonia makes certain policy changes and then calculates their potential impact using the coefficients o f the impact of policy differences from the recent cross- country regression analysis by Loayza et al., 2005. Specifically, the illustration o f this sub-section focuses on the following structural changes and policies investigated in Loayza et al. (2005): education, financial deepening, trade openness, government burden, and infrastr~cture.'~ 1.37. The first set of simulations suggests that FYR Macedonia could boost its present growth by about 0.65 percent annually if it brought its framework and human capital and infrastructure in linewith Slovakia. Currently, FYR Macedonia falls behind Slovakia especially on trade openness (by 37 percent and as noted FYR Macedonia's performance may be overstated), financial deepening (by 20 percent) and education (by 9 percent) as shown in the second column o f Table 1.3. On the other hand, FYR Macedonia has a significantly smaller government. Regarding stabilization policies, which include price stability, cyclical volatility and overvaluation o f the real effective exchange rate, FYR Macedonia is rated similar to Slovakia, as seen in the third column o f Table 1.3. The fourth column o f Table 1.3 shows the result o f assumed policy changes by FYR Macedonia that eliminate the negative gaps between FYR 14 Note again that this work is illustrative only and involves applying cross country estimated coefficients (over a number of years) to derive growth conclusions-it does not take into account how these conclusionsmight change if the other countries changed in the future, nor does it indicate how long the growth impact will be sustained. Loayza et al. investigate a number of other policy variables; this sub-section focuses on the variables considered important for FYR Macedonia. The Loayza et al. regressions also include estimates of the impact of convergence, cyclical reversion, and external conditions, but these factors are not the focus of this chapter since it focuses on factors within the influence of domestic policy. For more details, includingthe definitions of these variables, see Annex 1.1 and Loayza et al., 2005 16 Macedonia and Slovakia. In other words, FYR Macedonia's education index is increased by 9 percent, financial depth by 20 percent, trade openness by 37 percent, and public infrastructure by 0.4 percent. These improvements in education, financial deepening and trade openness would, hypothetically, generate growth gains o f 0.16, 0.13 and 0.36 percentage points, respectively, or a total of 0.65 percentage points o f growth. For the sake o f completeness, the effect o f changes in the stabilization policies were also estimated, but the changes and the coefficients are small, so these changes have little effect. Table 1.3: FYR Macedonia: Potential Impact of Policy Changes on Growth Growth Determinants Estimated relative MK coefficient to MK MK MK MK Loayza et. scenario scenario scenario scenario a1(2005) 2007 (%) Slovakia, (1) (1) (2) (2) Structural policies and institutions 0.65 2.03 Education (secondary enrolment rate, in logs) o.o 72 -9.06 9.06 0.16 50.00 0.86 Financial depth (private credit /GDP, o.oo66 -19.81 in logs) 19.81 0.13 50.00 0.33 Trade opemess ((X'IMYGDP, in 0,0096 -37.03 37.03 logs) 0.36 50.00 0.48 Governmentburden(G/GDP, in logs) -0.0154 -43.69 0.00 0.00I 0.00 0.00 Public infrastructure (mobile phone o.oo71 subscrip. per 1000people, in logs) -0.42 0.42 0.00 50.00 0.36 Stabilization policies 0.04I 0.00 Lack of price stability (log[ 1OO+infl.rate]) -0.0048 -4.18 0.00 0.00 0.00 0.00 Cyclical volatility (st. dev of output I gap) -0.2771 0.12 -0.12 0.03 0.00 0.00 E E R overvaluation (+I (log[actual REEWequilibrium -0.0061 0.60 -0.60 0.00 0.00 0.00 REERI) 1.38. A second scenario is based on the assumption that FYR Macedonia is more ambitious and manages to improve the structural policy indicators by 50 percent; the illustrative result is an increase of over 2 percentage points in FYR Macedonia's growth rate. This can be seen in the seventh column o f Table 1.3. 1.39. Qualitative factors are however equally important for growth, and mean that the projected increase of 2 percentage points in growth is not implausible. The assumed 50 percent improvement in indicators should not be seen as an overly ambitious increase since these indicators are narrowly focused on one quantitative aspect o f a structural policy, and ignore qualitative factors, which are as important as quantitative ones in affecting growth outcomes. For example, education is not only about enrollment- quality o f education (as measured, for example, in scores on standardized international tests, is equally important for growth). These issues are discussed in Chapter 7. The qualitative sides o f trade openness and financial deepening are elaborated on in Chapters 3 and 5. Qualitative aspects o f infrastructure are discussed in Chapter 6. Finally, the burden o f government can be further significantly reduced by increasing efficiency o f government spending which is discussed in the following section. In addition, there is a whole agenda o f growth effects associated with the micro-economics o f the business climate in the country (which is hard to capture in cross-country regressions), and this is examined in Chapter 4. 17 1-40. In sum, there is no single policy framework that is substantially out o f line in FYR Macedonia, but various improvements could raise growth one o r two percentage points. Such an increase in growth would be significant in terms o f its impact on per capita GDP, convergence and poverty reduction. And as discussed below, such improvements may be necessary, given the increasingly difficult external environment FYR Macedonia faces. D. IMPROVING EFFICIENCYINPUBLIC EXPENDITURE 1.4 1. Public investment is a necessary complement to private investment in enhancing a country's growth potential, but must be done efficiently and within the context o f fiscal sustainability. Public spending in infrastructureand education is a necessary prerequisitefor achievinghigh expected returns on private investment and hence high private investment levels. The Growth Commission, 2008, notes that investment rates of 25 percent or more in fast-growing countries have included appropriate amounts of public spending in infrastructure; these governments have also invested in social sectors including education. 1.42. Inadequate public investment partly explains FYR Macedonia's low overall investment levels and growing infrastructure concerns. General government capital expenditure in fixed assets over 2003-2008 was 2.3 percent of GDP, with total investment including capital transfers being 3.8 percent of GDP (this figure may overstate capital expenditures). The capital expenditure is in any case well below the 4.5 percent of GDP average for the other CEE transitioneconomies. This has hinderedthe country from catching up with more advanced transition economies both in terms of size and quality of public asset^.'^ Also, the government policy of subsidies and cross-subsidies in the electricity sector has diminishedthe incentives for further investment in electricity production capacities and networks; more recently, these subsidies have required government budgetary support, implying reduced capacity for public investment. With low government investment, there are indications that inadequate infrastructure has held back exports. And the significant increase in business complaints between 2002 and 2005 regarding infrastructure (these represented 22 percent of firms in 2005) even with the modest growth of that period, suggests that FYR Macedonia was already beginning to overuse its stock of infrastructure (see Chapter 6 for details). 1.43. To address these infrastructure gaps and the likely greater concerns as growth picks up pace, increases in Government expenditure should be "financed" by greater efficiency in spending and reallocation o f non-priority expenditures. In order to maintain fiscal sustainability, these gaps should be addressed by greater efficiency in spending, reallocation from other non-priority expenditures, and cooperation with the privatesector, in order to maintainfiscal sustainability. 1.44. Some gains are possible from reallocation o f expenditures from lower-priority activities; efficiency gains may be more substantial. Expenditurerationalization may be limited given the rigidity of the existing spending patterns discussed in IMF, 2007. The recently implemented across-the board public sector wage increase of 10 percentI6and a 10-20 percent increase in pensions further reduced the options for reallocation of expenditures. There is however some scope for generating additional fiscal space through better management of the Special Revenue Accounts, see Box 1.4. An additional issue, of l5The road and rail networks, while denser than most EasternEuropeancountries, lag behind those in the EUlO. The average FYR Macedonianhigh-school was constructedin 1966, while the health infrastructure is increasingly becoming obsolete. Most recently, budgetary allocations for infrastructure improvements have been considerably increasedbutthis will take time to be implementedandstart showingresults. l6The increase is part of a policythat saw a 10percentincrease in2007 and a plan to further increase wages by 10 percent in2009. 18 course, i s electricity subsidies (taking into account the long run marginal cost o f capacity addition) in the context o f higher international energy prices (see Chapter 6). The Growth Commission Report, 2008, concludes that money spent subsidizing energy consumption in developing countries would be better spent on education and infrastructure. In addition, such subsidies bias the capital investment in long-lived assets away from energy efficiency and may negatively bias the structural evolution o f the economy. Also, improved collections can help-for example, the Government is making efforts to increase toll road ollections, with some signs o f recent success (Chapter 6). Box 1.4: SpecialRevenueAccounts (SRAs) SRA accountscapture revenuesof Budget users for services from "commercial activities" or delegatedfunctions as well as grants received. The budgeted deficits from SRA transactions averaged around 28 percent of the budgeted deficits of the central government during 2005-2007. More realistic SRA expenditure projections would open more fiscal room for financing of other Government projects. This calls for better integration of these funds into the budget preparation and execution processes of the Government. Underperformance on capital expenditures from SRAs largely explains the inability to meet capital expenditure targets. Poor budgeting is the most likely explanation: budget users are overoptimistic on the amount of services they plan to provide as well as donor- financed projects they are able to implement. Also, budget execution is poor: in-year revisions to projections appear very limited (in-year supplement Budgets typically contain similar numbers to the original Budgets) suggestingthat SRA Budgetsusers do not monitor execution well and reallocate the fiscal space accordingly. A few factors mitigate the overall macro-fiscal risk of poor oversight over these accounts: (i)SRAs represent only around 10 percent of government revenues, ii)expenditures must be matched by revenues and iii)regulations prohibit spending from SRAs on some categories (i.e. they can not be used for payment of wages or transfers). As aresult, SRAs disproportionately affect capital expenditures. 1.45. Improving public investment management will require numerous changes. One, poor selection o f projects decreases the impact o f public investment. Two, implementation o f budgeted projects suffers delays. Three, public procurement is generally accepted to be inefficient and subject to abuse. Four, monitoring and evaluation is only gradually evolving. Improvement would start from a coherent framework to guide government overall and sector spending, including capital expenditures, which is only gradually emerging. Given these problems, increasing capital expenditures inthe current institutional set-up is not likely to yield the maximum benefit. 1.46. In the meantime, while fiscal space is being created, a lot could be accomplished by improvingefficiency of ongoing investment. Capital expenditures are guided by the Public Investment Program (PIP) - a 3-year rolling document. However, it is not entirely clear how projects end- l a 4 :DeviationBetween Budgeted up being included in the PIP; how they contribute Actual for Various ExpenditureItems towards the goals o f the government, and if the (in Percent) projects are adequately costed-out and analyzed. As 2005 2006 2007 a result, projects with incomplete documentation Expenditures -5.5 0.8 4.4 and unresolved issues (these typically include Core Budget -0.8 3.O 6.3 unsettled expropriation, poor project design etc.), Current -1.8 3.9 4.1 and poor financial results are often included. Capita1 11.2 -7.5 29.0 Second, actual capital expenditures rarely exceed sRA -38.8 -21.6 -19.4 80 percent o f budgeted amounts (see Table 1.4)." Current -15.0 -6.8 -6.1 This under execution, around 1 percent o f GDP on Capital -67.4 -42.0 -45.9 average over the last few years, largely explains the over-performance on the fiscal accounts. Third, a "Even2007isnotanexception;althoughsome lastminutetransferstopublicenterprisesweremade,theamounts allocated within the in-year SupplementBudgets were substantially below budgetedamounts. 19 recent World Bank CFAA noted that while the legal framework for public procurement is largely adequate; the process is marredby serious deficiencies in implementation, poor capacity in implementing agencies, and weak appeals processes. According to the 2005 BEEPS, the percentage of firms that reported giving unofficial payments to obtain government contracts in FYR Macedonia is similar to that in SEE and higher than the EU8. In addition, procurement irregularities are some of the most frequent findings of the State Audit Office reports18.Fourth, the recent World Bank Public Expenditure Review, 2008b, noted that government capital expenditures are very inefficiently managed. For example, in the transport sector, funds are managed by monopolistic firms with very little planning, poor managerial capacity, and almost non-existentoversight over how funds are used. 1.47. Public-private partnerships (PPPs) could also provide funding for infrastructure without increasing overall government expenditures; however, the associated financial risks have to be managed properly. PPPs are an effective way to introduce private sector efficiency in service delivery to sectors traditionally dominated by the public sector. An enabling environment for PPPs requires political stability, good macroeconomic policies, and the rule of law, within a sector framework that is credible, transparent and fully competitive. Such a framework should also ensure that government liabilities, if necessary, are minimized and defined ex-ante very clearly. A recent survey by the European Investment Bank found that the majority of PPPs undertaken in the absence of such an enabling environmenthave been unsuccessful. E. CONCLUSIONS 1.48. FYR Macedonia's lagging growth, relative to regional comparators, reflects a low rate of investment. Investment is low not only compared to countries in the region but worldwide-in 2005 it was in the lower quarter of the investmentrates in all developingcountries.The recent increases in gross investment rates need to be increased further and sustained in order to enable high, sustained growth. Various studies, most recently the Growth Commission, 2008, indicate that sustained high growth depends on investment rates of 25 percent of GDP or more, including a reasonable amount of infrastructure.To raise FYR Macedonia's growth, and probably even to maintain it (because capital, including infrastructure capital is becoming insufficient) more capital is needed to equip additional workers and bring in new, embodiedtechnology. Infrastructureinvestment is also becomingan increasing issue. 1.49. Poverty ratios were stagnant over 2002-06 given the low economic growth and low productivity of jobs. FYR Macedoniaprobablyneedsto sustain its growth rates above 5 percent in order to create enoughjobs and so reduce poverty. Jobs created need to pay higher wages to allow workers to improve their standard of living. This means, in turn, improvement in worker skills and education, and improved access to education across different groups of the economy, including women, youth and non- Macedonians. 1SO. Employment growth has been low until recently,the proportion of the populationemployed remains low, and regional comparators are raising the levels of education in the labor force faster than FYR Macedonia, outcomes that must improve to raise growth and reduce poverty. The scope and quality of education needs improvementto achieve higher income and faster growth, especiallygiven the changing nature of global competition. Various studies, including the Growth Commission, 2008, point to the need for higher education. High levels of quality education have been a basis for the high growth of bothIreland(Chapter 7) andthe Slovak Republic. 18According to the 2006 SA0 Annual Report, 15.3 (16.8) percent of all irregularities identified during its audits of 2004 (2005) accounts were relatedto improper implementationof the Law on Public Procurement. Irregularities in publicprocurementwere identifiedin35.7 (43.3) percent of all audit reports. 20 1.5 1, Improvingproductivitygrowth will be important; it depends not only on the above changes in capital and labor but improvements in the policy framework. Of particular benefit would be policies aimed at further improving export openness, reducing political risk, increasingcompetition and improvingthe efficiencyof public spending (see also the World Bank 2008b Public ExpenditureReview). Increased infrastructureand educational investments are desirable but would require improved efficiency and reallocation in public spending to maintain FYR Macedonia's current low public debt and debt sustainability. 1.52. While in some cases the framework for economic growth seems reasonable relative to comparators, this is not enough for two reasons. First, the existing policies have only led to slow growth, suggesting more needs to be done to achieve higher growth (of course, once the international economy has returned to pre-crisis growth rates), not only in investment and education but structural policiesas well. Second, improvementsare neededto meet the challenges of an increasingly competitive and difficult externalenvironment.For example, even the current increase in growth rates is raisingissues about infrastructure. Higher international food and energy prices (in 2007 and early 2008), and the ongoing downturn in metal prices are raising questions about subsidies and exports. In the absence of improvedpolicies, any accelerationof growth is likely to quickly run-upagainst constraints. 21 2. MANAGING MACROECONOMIC RISKS A. INTRODUCTION 2.1 FYR Macedonia has followed prudent macroeconomic policies with g- >d result Fiscal policy has been relatively tight and monetary policy, while maintaining parity with the euro, has responded quickly to limit any threat of inflation (see Chapter 5). As a consequence, inflation was low, with prices rising a total of less than 6 percent between 2003 and 2007, and external debt remains low (around35 percent of GDP) and sustainable. Table 2.1: FYR Macedonia: Selected Macroeconomic Indicators 2000 2001 2002 2003 2004 2005 2006 2007 2008p GDP Growth, real, in % 4.5 -4.5 0.9 2.8 4.1 4.1 4.0 5.9 5.3 CPI Inflation, period average, in 'YO 5.8 5.5 1.8 1.2 -0.4 0.5 3.2 2.3 8.3 Current account deficit, as % of GDP -2.7 -6.9 -10.0 -4.0 -8.4 -2.7 -0.9 -3.3 -12.5 Central govt. balance, as 'YOof GDP 2.5 -6.0 -5.3 -0.1 0.4 0.2 -0.5 0.6 -0.9 Public debt, as % of GDP 48.0 48.8 43.0 39.0 36.7 39.5 32.9 24.8 20.8 External debt, as %of GDP 43.2 43.5 43.3 39.8 38.7 39.1 37.8 35.7 Real effective exchange rate, CPI based, 2000= 100 loo,o 92.5 90.2 89.4 87.8 85.2 84.2 82.8 Notes: Some 2008 numbers (in italics) are estimates. Source: WB WDI Database and IMF. 2.2 Recent data suggestscontinuedgood growth in the first three quarters of 2008, but a recent slow down accompaniedby concerns about substantialdeterioration in the current account and the composition of the balance of payments. Growth in GDP in 2008 is estimated to have slowed-down slightly compared to 2007 (Table 2,1), largely due to developments in the last quarter of 2008. Inflation (year-on-year) in 2008 was up compared to the recent past, but after hovering around 10 percent in March-April 2008, it fell to 4.1 percent by December. With the fall in internationalprices of petroleum and food recently, inflation in early 2009 has reversedto levelsprior to the food and energy prices shocks. The current account deficit had improved in recent years but deteriorated in 2007, a trend that worsened substantially in 2008. However, muchhigher FDI inflows and draw-down of foreign exchange reservesof commercial banks have financed the higher current account deficit and allowed for a slight increase in central bank reserves in the first three quarters of 2008 (but reserve cover of imports has declined). Reserves have since declined considerably. Over the longer term, there has been a significant and growing trade gap, varying from 19-22 percent of GDP in recent years, financed to a large extent by rising private transfers; however, these transfers slowed in late-2007 and the first half of 2008. The NBRM responded to the recent inflation, balance of payments developments and the rapid growth in household credit with measures to tighten monetary policy (raising interest rates in Central Bank bill auctions and introducing stricter liquidity risk regulations) and introducing additional reserve requirements for banks with increases in consumer credit growth above 18 percent per annum. The government ran a fiscal surplus in the first ten months of 2008 of 2.6 percent of GDP, but intensive spending in the last two monthsof the year ledto a deficit of 0.9 percent of GDP for the year as a whole, which might have put further pressureon the reserves. 2.3 The ongoing international financial crisis highlightsthe risks representedby a deteriorating balance on trade in goods and services and the current account. FYR Macedonia, like most other economies, has been affected by the ongoing financial crisis, and before that by the price shocks in food 23 and energy.'gWhile international prices have receded recently, they remain high (especially prices of agriculture) comparedto the past.The ongoing financial crisis and the decline in projectedworld demand (including the decline in metal prices) will result in a decline in FDI, foreign financing, domestic credit flows, and exports for FYR Macedonia.These developmentshighlight the risks posedby the deterioration in the current account in 2008, including the drop in private transfers (official remittances as well as transfers and transactions through the exchange offices) in 2008 and the overall large deficit in goods and services. Mitigating these risks will require, above all, acceleration of the structural reform agenda to improve FYR Macedonia's competitiveness. In addition, continued vigilance will be needed with respect to monetary managementand stresses on banks; and further reforms in the financial sector will help credit flow to the privatesector (see Chapter 5). 2.4 This chapter will analyze the impacts of rising food and energy prices and changes in the balance of payments composition; it will also suggest policies that will ease the risks these developments entail. The outline of the chapter is as follows: Section B will analyze the rise in food prices, includingtheir links with FYR Macedonia's agricultural sector. It also includes a brief subsection on rising energy prices, which are also dealt with in Chapters 1, 3, and 8. Section C will examine the changing balance of payments composition and the associated risks, followed by a section on the important issues pertaining to remittances and private transfers. Finally, Section E will provide conclusions and summarize the recommendations. Chapter 5 will look at the financial sector, including the link betweenmacroeconomic issues and the financialsector. B. RISINGFOOD AND ENERGY PRICES B.l Risingfood pricesand agriculture 2.5 The rise in world food prices in 2007 and the first half of 2008 has been attributed to the interaction of various factors. These include, (not necessarily in order of importance: i)the shift to bio- fuels, arising from energy prices and subsidies, ii)weather conditions iii)restrictionson food exports in some countries, and iv) cost increases in energy and other inputs. While world output is likely to rise eventually, many consider a return of prices to previous (relative) levels unlikely over the short- to medium-term (see e.g. OECD/FAO, 2008). Investing in agriculture development and revitalization in individual countries, and maintainingopen and predictabletrading regimes will be crucial for increasing global output and securing stable markets for producers and competitive prices for consumers (see also Chapter 3). 2.6 FYR Macedonia's inflation in late 2007 and early 2008 was pushed up substantially by the worldwide rise in food prices, as has occurred in many countries around the world. Food price inflation rose to 20.4 percent in April 2008 (year on year figures) before falling to 15.9 percent in September, still much higher than the overall CPI inflation of 8.3 percent. Other countries in the region also experienced rises in inflation and food prices to varying degrees. For example, Serbia and Bulgaria experienced slightly higher increases in domestic food prices than FYR Macedoniaand higher inflation, while other countries in the region experienced both lower increases in domestic food prices and lower inflation than FYR Macedonia.In general, the differences in the rises in domestic prices reflect a variety of country-specificcircumstances and policiesrelated to food prices, as well as developments and policies outsidethe food sector. 19 Rising prices of food and energy represent imported threats to low inflation. High world energy prices have raisedthe priceoffuel andthe costs of electricity subsidies to firms andconsumers inFYRMacedonia. 24 2.7 The government's response, appropriately, was largely limited to soft measures to reduce the impact of rising food prices2'; later on in 2008, measures were also taken to tackle fuel price increases. The authorities negotiated a "gentlemen's agreement" with retail producers to limit profit margins on certain essential goods, allowed temporary duty-free import of wheat and unrefined oil, intervened with state reserves of these products, and temporarily increased cash transfers (social assistance) to the most vulnerable. Such responses aie considered to be the least distorting (World Bank (2008~)and Alam, Kathuria and Vybornaia (2008). Attempts to control food prices, such as trade restrictions or price controls, would be distortionary and reduce domestic farmers' incentives to increase output. Also, in order to mitigate the impact o f higherfuel prices, the authorities reduced a number o f fees (customs handling, pay-tolls, vehicle registration and insurance etc.), and in September 2008 provided one-off fuel subsidies to farmers. The easing of international food and fuel prices, together with the effect of government policy measures, helped reduce overall CPI inflation to 4.1 percent in December 2008. Box 2.1: MacedonianAgricultural Reforms and Policies Reforms in the agriculture sector can help FYR Macedonia obtain some benefit from the higher food prices. These reforms would start from the basic premise that FYR Macedonia should depart from the agriculture policy objective of achieving self-sufficiencytowards high-value production based on the comparative advantages in the sector. FYR Macedonia's potential in agriculture stems largely from its favorable climate conditions and topography as well as tradition. However, output has stagnated in the transition period and in 2007, it barely reachedthe levels ofthe early 1990s. The underdevelopmentof markets for productionfactors is akey constraint. Issues exist with all productioninputs. Farm land i s overly fragmented, which prevents economies o f scale in the sector. The mana ement o f state-owned land through over-regulatedleases is an additional constraint. Labor is usually abundant, but access to capital and raw materials is more problematic. Banks have been reluctant to 8 finance agriculture projects (typically they would require urban real-estate as collateral because rural land and structures cannot really be used as collateral). The market for raw materials and other inputs (seeds, fertilizers etc.) has been over-regulated and monopolized. As a result, productivity-increasing investments (use of fertilizers, certifiedseed, post harvesthandlingequipment, etc.) have been extremely limited. While trade has been liberalized, Macedonian producers have been unable to take full advantage of the liberalization because of sectoral problems. In particular, the 2001 SAA with the EU as well as regional trade integration(recently consolidated under CEFTA 2006) largely opened up the markets of participatingcountries to Macedonian agricultureproducts (see Chapter 3). However, while certain restrictions still exist, most Macedonian agro-processors' inability to meet quality and safety standards and resolve their storage issues is the bigger problem(Chapter 8). Neededreforms in the sector are many, and in some cases basic. They include: reforms in land policy (privatizing state-owned land, improving land leasing rules, and allowing foreign ownership); regulatory reform (enabling easier registration and access to agro-chemicals, plant and animal genetic material, enforcing agriculture land ownership tax and hrther liberalizingtrade). Issues relating to the Common Agricultural Policy (CAP) are crucial. FYR Macedonia needs to adopt the two pillars of the CAP, and create adequate institutional capacity for its implementation.The policies should focus on incentives that do not distort market signals and encourage farmers to maximizeprofits; such policieswould avoid the risksof locking FYR Macedonia's agriculture into its current uncompetitiveand inefficient productionpatterns, for example by inappropriate, excessive subsidies. These policy issues are discussed in greater detail in World Bank (2006a). ' Still, labor shortages are being reported during peak seasons as labor seasonally migrates to better-paying jobs in EU countries. 20 The impact of rising food prices has also been partly mitigated by rising wages and employment, although the poor will be affected(see the poverty section o f Chapter 1). 25 B.2 EnergyPrices and Subsidies 2.8 Although international electricity prices have increased over the last couple of years, the impact on Macedonian electricity prices has been limited by subsidies. FYR Macedonia produces around 3/4 of its electricity (largely from coal plants and some hydro production) at a relatively low variable cost of around EUR20-25 per MWh. Regional electricity markets have been tight in 2007 and 2008 and import prices may have reached around EUR80 MWh (before falling to around EUR70 MWh recently), reflecting the higher prices of energy world-wide (at least until mid 2008) and increasing transmission right charges arising from the limited transmission capacity in the region. Through large cross-subsidies (especially relative to the market price) and a small direct subsidy from government to MEPSO (0.4 percent of GDP in 2006), the state-owned transmission operator, householdconsumers and light industry receive a price much below the sustainable cost-recovery tariff, while until 2008, large commercialusers(metal producers and cement) too receivedfavorable prices (see Chapter 6 for details). 2.9 Currently, the subsidy does not threaten fiscal stability, but it has impaired the ability and incentives to invest. The effective subsidy increasedwith the increase in international energy prices, and will increase further if local production grows less than local demand. Also, the cross-subsidies have reducedthe ability of FYR Macedonia's electricity producers to invest, Le., the price charged is belowthe long-run marginal cost. Beginning in January 2008, the subsidy to large users has been eliminated and FYR Macedonia intends to gradually eliminate all cross-subsidies and establish prices at full cost- recovery levels, under the Athens treaty, starting 2010 (see Chapter 6).*' The phased reduction in subsidies would gradually create more space for investment in the budget, as well as in the producer and transmission companies' accounts. While international energy prices have declined more recently, it would be desirable for FYR Macedoniato continue to reduce the subsidies and target them better, for the reasonsdescribed above. 2.10 To the extent the exports of industrial electricity users slow because of energy re-pricing, increased exports of other products or production of import substitutes will be needed to limit deterioration in the trade balance. Metal exports represent about 40 percent of FYR Macedonia's exportsand until recently, their internationalcompetitivenesspartly reflectedthe subsidy-drivenreduction in their costs (Chapters 3, 6). The reduction of the subsidy will raise their costs and depress their margins. Until recently, buoyant world prices have helped to maintain profits of Macedonian metal producers, but their profits have largely disappeared recently and a number of producers have either reduced or completelyshut-downproduction. Thus, a slowdown in world demand, which startedto occur in the latter part of 2008, has made these firms unprofitableor at least reduced profitability significantly, and also required significant adjustments in production. Given lower earnings from metal exports, other exports or production of import substitutes may need to increase to offset this reduction in exports of metals to avoid deteriorationinthe balanceoftrade. 2'Raisinghouseholdelectricity prices is of course a major political issue and will generate claims from all sides about their inability to pay higher prices. The impact on poorer households could be offset by various social programs. One option involves setting "lifeline" prices, Le., low rates for small users. Another option involves a direct cashtransfer to poor households. 26 C. EXTERNALVULNERABILITIES 74 - - ---- - - - - -I--- ---I- pricesimportedof byfood andMacedonia,particularlycontributedenergy, bothto a FYR 6o - 70 deteriorating trade deficit in the first half o f 60 . 2008. In the second half of the year, falling metal prices for exports contributed to the trade 5o deficit, despite the decline in food and energy 40 m. 9 rP 4 `u Q prices from their peak levels. In addition, with 30 - u. 8 more of the consumer income spent on food and 20 - fuel imports (demand for which i s quite lo inelastic); less was available to spend on local 0 1 I I I , , , , , , , , , , , , , 2.12 Developments in 2008 are only an intensificationof FYR Macedonia's traditional net trade deficit in goods and services during the current decade. Exports o f goods and services fell steadily between 2000 and 2003 as a percentage of GDP and only began to climb again in 2004 (Figure 2.1). Meanwhile, imports (goods and services)22 were roughly constant in 2001-2003 and then rose, on some occasions at a higher rate than exports. As a result, in 2006-2008 the trade deficit widened. Figure2.2a:-2.2b Current Account and Trade Balance (percentof GDP), and Financingof the Trade Balance (percent of trade balance) I 100 90 80 70 60 50 40 30 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2000 2001 2002 2003 2004 2005 2006 2007 - Primte Transfers, as % of TB II.-TradeBalance(G&S),as%ofGDP +FDI, -4-Portfolio Inwstment,asYOofTB as % of TB -arrent Account, as % of GW 1 Note: current account balance, trade balance (goods and services), and shares of private transfers, portfolio investment and FDIas percentageofthe trade balance. 22 Only about 20 percent of goods imports correspondto machinery and equipment Thus, increased imports do not represent much of a buildupo f capital. 27 2.13 Despite the widening trade gap in 2006 and 2007, the overall current account was kept in check by private transfers (Figure 2.2a and Annex 2.1). Thus far the trade deficit has largely been financed by private transfers in the current account, and, very recently, FDI and portfolio investment in the financial account. In the last few years, there have been substantial inflows at the foreign exchange offices, which the government treats as private transfers/ remittances (Section D). These developments kept externaldebt moderate and allowed reservesto rise. 2.14 Recent developments raise concerns regarding both the trade balance and the dependence on financing from private transfers (discussed in the next section). On the export side, 40 percent are metals, which to some extent reflectedsubsidized energy; the elimination of this subsidy as of 2008 could have already impactedthese exports, as noted(Chapters 3 and 6); in addition, the external demand shock has also led to a decline in such exports. Garments are another large fraction of exports; they have done well so far in an increasinglycompetitive world market. However, they are basically low-skill intensive projects and could be subject to pressure from new developments in China, India and current, low-wage exportingcountries (see Chapters 3 and 8). In addition to export concerns, import growth has been high (often faster than GDP) and the impact of higher food and energy prices on imports creates further risks for the trade account, even with the recent declines in these prices from peak levels. Another issue is the dependence on private transfers for financing the trade deficit. Private transfers declined in 2008. On the financialaccount, FDI has largely dried out since the last quarter of 2008. All this has led to a reduction in reserves. 2.15 Reducing subsidies on energy prices will not curb consumption much. Since demand for energy is not very price-elastic, rising prices (induced by reduction in subsidies, for example) are not expected to curb consumptionmuch. In FYR Macedonia,the possibility of a quantity effect arising from higher prices is in any case curtailed, since full pass-through of electricity price increases (fuel prices, however, are adjusted every two weeks) has been limited so far to the largest users (about 30 percent of total consumption of electricity, see Chapter 6). Thus only a small (direct) reduction in the trade deficit could be generated through the effect of increased prices.(On the other hand, the indirect negative impact on overall exports of higher energy pricescould be relatively large.) 2.16 In the short run, supplies of exports and import substitutes are unlikely to be elastic, so the authoritieshave to manage the balance of paymentscarefully. Giventhe euro-peg policy, increases in exports and import-substituteswill occur only as aresultof lower costs that make Macedonianproduction more competitive (neglecting the impact of the world demand which could be negative given current developments). In the short run, these costs are likely to be relatively fixed. It is unlikely, for example, that costs of import-competinggoods could fall enough to substitute much for existing imports, or that exporters will be able to lower prices enough to increase their competitivenessmuch. Thus, in the short run, the government may find it necessary to reduce the current account deficit (note that ajudgment on this will also take into account the comfortable level of reserves and external debt). This would require a reduction in aggregate demand, by tighteningmonetary and fiscal policy, as is already occurringto some degree (at least on the monetary policy front).23 2.17 Estimates from a macroeconomic model suggest that output rigidity and slow adjustments to changes in aggregate demand could be major problems in FYR Macedonia. Melecky and Najdov (2008) estimate a small structuralmodel using data for FYR Macedoniaand Slovakia. The main finding is that the estimated elasticity of inflation to increases in aggregate demand in FYR Macedonia i s about 23 The IMF (2009) has also recently warned of the threat to growth sustainability arising from external vulnerabilities. See http://www.imf.org/external/pubs/ft/scr/2OO9/crO96O.pdf. 28 twice that in Slovakia. This means that a given increase in demand will induce twice as much o f an increase in marginal costs in FYR Macedonia relative to Slovakia, and thus a two times higher increase in prices. In addition, the persistenceo f the impact of an increase in aggregate demand in FYR Macedonia is significantly higher than in Slovakia. Such findings imply a need to reduce rigidities and support the structural reform agenda of this report. 2.18 In the longer run, the balance of payments could be put on a more stable footing by increased exports, growth of efficient import substitutes, and more FDI. These developments would entail policies discussed in more detail in the subsequent chapters, particularly Chapter 3, on exports, Chapter 4 on the investment climate, and Chapter 8, which studies a few industries in some depth. Such policies would also lead to a higher rate of growth. D. BALANCEOFPAYMENTSIMPLICATIONS OFREMITTANCES PRIVATETRANSFERS AND 2.19 Although the trade deficit widened in 2006-2007, it was largely financed by current transfers, but recent developments suggest a change in that equation (Figures 2.2 and 2.3). The major part of private transfers, the net-purchase of foreign exchange at exchange offices, which can include unrecorded remittances and hidden exports (e.g., purchases o f goods and services by day visitorsFfell sharply recently, after growing for the last few years. The question is whether this decline i s a short-run phenomenon that will be reversed-perhaps reflecting temporary inflation fears and political concerns of those who have been converting funds at the exchange offices-or a more permanent development. 2.20 Private transferdremittances represent an important factor in both FYR Macedonia's balance of payments and developmentfinancing, as in many other countries. From a macroeconomic perspective, these transfers support the current account balance; from a microeconomic perspective, the transfers provide significant support to about a third o f the population, including ethnic Albanians, according to the HBS. For these households, remittances are very important as a share of their income.24 Note however that there is a sizable discrepancy between the micro and macro numbers for remittance^.^^ Going by the latter, the remittances are probably helping a much larger percentage of the population than revealed by the HBS. The transfers can also contribute to growth by overcoming business constraints related to access and cost of finance. 24 FYR Macedonia's 2006 Household Budget Survey estimates that "income from abroad" accounted for only 4.5 percent of disposable income of households, on average. This ratio has been largely stable. Still, the overall ratio masks the importance of remittances for certain households. For about 34 percent o f recipients interviewed in the 2007 survey commissioned by the CentralBank, receipts constituted 10-30percent of disposable income; for around 15 percent they constituted 90-100 percent of disposable income. In the HBS, too, for households receiving transfers, this was a very importantsource of income (see Chapter 7). 2s Extrapolating the 4.5 percent figure from the HBS yields an estimate for overall remittances of around $250 million (multiplying 4.5 by the value of final household consumption expenditure in the national accounts). This figure is less than halfofthe calculationoftotal `macro' remittances (formal and informal) done later inthe chapter. 29 2.21 During 2005-07, current transfers, as Figure2.3: Net Cash Exchanged,Net Formal defined by Macedonian statistics, averaged 18.6 percent of GDP, up from an average of Remittancesand Net Total Formal Transfers ($10 around 13.8 percent of GDP in 2000-2002. Millions) While recorded remittances and other transfers 140 I represented around 5.4 percent of GDP, net 120 - I purchases of foreign exchange by exchange .I l1 offices were about 12.3 percent of GDP, over 2005-07 (see Figure 2.3 for the amounts in US$). The strong seasonal pattern of the private transfers may reflect the personal delivery of remittances when migrants visit FYR Macedonia. 0 - I I I ' ' ' 2.22 Private transfers are difficult to - - 98 99 00 01 02 03 `Cashexchanged formal transfers -- 04 05 06 07 08 Formal remittances quantify and disentangle, and may not -Total represent only remittances. In all countries, private transferdremittances go through both formal channels and informal channels such as FYR Macedonia's foreign exchange offices.26 In FYR Macedonia, although a considerable amount of remittances may indeed go through informal channels and eventually end up in the exchange offices, the net purchases at exchange offices probably reflect various types of transactions. For example, some o f the flows may be export transactions (including cross-border shopping or under-invoicing o f exports),27 or capital transactions, such as transfers for investment, speculation, or real estate transactions. In addition, the flows may represent conversions into and out of foreign currency holdings (currency substitution). 2.23 The 2007 survey of recipients and senders of remittancessuggest that only about 1/3 of the 2007 inflow at exchange houses were "true" remittances, a proportion much lower than in 2002. According to the 2007 survey, 38.6 percent of remittance transactions go through banks and other formal channels (Table 2.2), while the rest is remitted informally. Multiplying the BOP figure for formal remittances (NBRM) by the survey's ratio of informal to formal remittances (1.6), yields an estimate of informal remittances of about US$400 million. This represented only around 1/3 o f the inflow o f foreign exchange in exchange offices in 2007. The same analysis with the 2002 data suggests that informal remittances could explain the entire exchange offices turnover, which suggests that there has been an increase in inflows of non-remittances at exchange offices. Correspondingly this approach would suggest that a substantial part of the funds going through the exchange houses were not remittances, but used for other purposes such as those discussed in paragraph 2.22. The sensitivity o f flows through the exchange houses to political developments supports this view (paragraph 2.29) 26 Internationally, the most frequent reasons for using informal channels are their lower cost, lack of access to financial intermediaries in the sender's or recipient's country and desire for anonymity. Recently, remittances have begunto go through banks' ATMs-the remittanceprovider gives an ATM cardto the recipientthat can be used at a local ATM to withdraw money from a foreign account. Such transactions are o f course impossibleto distinguish from foreign touristsusing ATMs. 27 For example, according to the Central Bank analysis, FYR Macedonian retail prices for certain agriculture produce are 10 times higher than their reported export prices. Also, between 2003 and 2007, the number of export customs declarations increasedby around 2.5 times while the value of exports only doubled which further supports the argument in favor of increased under-invoicing.Exporters may use under-invoicing because financial account transactions are not fully liberal, Le., exporters are requiredto repatriate and convert their export receipts into denars (unless they are usedto finance imports). 30 Personaldelivery 56.4 Personaldelivery 44.0 Through Banks 15.7 Throughformal non-Bank channel 15.2 Delivery by friend / relative 25.6 Through Banks 23.4 Other 2.3 Delivery by friend or colleague 15.4 , Delivery throughvisiting relative 0.7 Other 0.9 2.24 The remittances identified in the household surveys were largely to finance current expenditures while very little is allocated to investments according to both surveys (see also the complementary analysis in Annex 2.2). Three quarters of recipients o f remittances in the 2007 Survey indicated that meeting current expenditures is the most important use of the transfers (Table 2.3). According to the same survey, starting a business with remittances was somewhat important for only 5 percent of recipients. 2.25 The NBRM's analysis of remittances largely supports the foregoing hypotheses and findings. It found strong correlations between the net FX-purchase by exchange offices and household consumption-the exact impact is discussed further below-and imports of consumption goods, as well as the number of tourists and exports of food products. Not Most Important Least Family needs 54.6 Saving 60.5 13.7 16.6 9.2 House maintenance 13.O Current spending 7.7 74.1 14.5 3.7 Investments 15.3 Family celebrations 69.2 5.6 17.0 8.3 Savings 3.1 Cars (durable goods) 90.2 1.5 4.8 3.6 Housingpurchase/ construction 9.2 Constructionof homes 85.0 8.8 4.7 1.5 Other 4.8 Housingmaintenance 70.8 5.7 13.5 10 Business start-ups 92.7 2.6 2.6 2.1 Realestate purchase 98.3 0.7 0.3 0.7 Portfolio investment 98.4 0.3 0.6 0.7 Loans 97.3 0.2 1.o 1.5 Other 90.6 1.6 2.8 5.O 2.26 An estimated import function involving current private transfers provides some further evidence on the positive correlation between imports and remittances and other private transfers but suggests that the proportionate relationship may be as low as 25 percent. A "long-run" relationship was estimated between imports of good and services, and the individual components of the private current transfers, taking into account GDP and the real exchange rate (REER). Overall, private current transfers were found to be significantly positively correlated with imports, supporting the NBRM result. However, a 10 percent increase/decrease in private current transfers is expected to result in about a 2.3 percent increase/decrease in imports (Table 2.4). Regarding the impact of individual components of the current transfers, both remittances and other private transfers are significantly correlated with imports. However, again the size o f the response is low. In both cases a 10 percent increase in remittances or other transfers is estimated to raise imports by about 1.5 percent.28 Thus, although there is a statistical **Regardingthe other factors, the regression estimates (Table 2.4) indicatethat a 1 percent increase in real GDP is expected to boost imports by almost 3 percent.Appreciation of the real exchangerate by 1 percent increasesimports by about 0.6 percent, although the statistical significance of this estimate varies across the forms of the private transfer. 31 relationship between remittancesand imports along the lines discussed above, it is much less than one- to-one. In other words, the statistical estimates suggest that if private transfers were to fall sharply, imports are unlikely to fall as much, implying that the current account will deteriorate. Table 2.4: Estimationof MarginalImport DemandElasticitiesto Private Current Transfers IM IM IM IM GDP 2.518 3.162 3.185 2.999 (0.584)* ** (0.435)* ** (0.637)*** (0.555)*** REER 0.698 0.585 0.961 0.189 (0.349)** (0.437) (0.467)** (0.594) Private current transfers 0.234 (0.081)*** Remittances .--__ 0.154 (0.069)** Currency exchange 0.135 -_-__ (0.077)* Otherprivate currenttransfers ____- _ _ _ _ _ ----_ 0.156 (0.069)** Notes: Estimatedby dynamic OLS (DOLS (1,l)); Sample: 199743 to 200742 ***, **, * indicatesignificance at the lpercent, 5 percentand 10percentlevel, respectively. 2.27 Genuine remittances appear to be a relatively stable source of foreign exchange inflows, according to the 2007 survey. Furthermore, a study of remittancesof migrants in Germany found the migrantsfrom former Yugoslaviahave a higher probability for remitting comparedto migrantsfrom other countries (Holst, Schafer and Schrooten, 2008). Fluctuationsdepend mostly on the economic situation of the sender and the needs of the recipient. Furthermore, immigration appears to be continuing. Thus, it would be reasonable to expect genuine remittances to grow over the medium term, at least until the migrants integrate themselves into the foreign country. 2.28 Nonetheless, private transfers could vary sharply in the short run (Figure 2.3) creating some vulnerability for the balance of payments. The exchange office market serves various other purposes for economic agents. Although confidence in the domestic currency and the financial sector is still growing following its collapse in the early 1990s, some people still prefer holding savings in foreign currency and out of the banking sector and use the exchange offices for their transactions. Finally, exchange offices are widely used for transactionsin the informal economy, which may be large (Box 1.1 and Schneider, 2005). The estimated results in Table 2.4 suggest that a decline in private transferswould be far largerthan the correspondingdecline in imports, meaningthe balanceof payments would worsen if transfersfall. 2.29 Regardless of the nature of transfers, both transfers and more generallythe supply of and demand for foreign exchange appear to be sensitive to non-economic developments. Periods of stability appear to result in a strong amount of transactions supplying foreign exchange (buying denars) and low demand (buying foreign exchange in exchange for denars). The reverse occurs in periods of uncertainties. These developments may be reflected also in the banking system. For example, the developments in 2007-2008-Kosovo, increasinginflation fears, early elections, etc. -were accompanied not only by a rise in demand for foreign exchange but also a shift away from denar deposits into foreign exchange deposits Figure2.4. 32 2.30 Maintaining political and Figure2.4: Growth Rate of Demand and Supply of macroeconomic stability could thus ForeignExchange2004-2008 be crucial for sustaining the large 140 7 foreign exchange inflows in the 2004 Referendum -___ future. An additional challenge is to 120 increased uncertai shift transfers away from current 103 expenditures into investments. Finally, 60 international evidence suggests that the 60 more migrants integrate in the guest 40 country the less likely are they to remit or return and start a business. While 20 difficult, there are ways to benefit from 0 the skills and resources of migrants (see -20 Chapters 7 and 8). There are already -40 positive experiences in FYR Macedonia (two firms visited during the preparation of the report were set up by returning migrants) which should be further -Annudgrwth rated supply dfwex -Annualgrwth ratedderrandfwfwex encouraged. 2.3 1 Sources of trade deficit financing other than current transfers, in particular FDI,will need to increase, if the trade deficit in goods and services continues to grow, or an adjustment will be necessary. The trade deficit could be alternatively financed through portfolio investmentor FDI (though that would entail more imports as well). However, reliance on portfolio investment, particularly short- term flows, could mean hot money, which has been a dangerous strategy for many MICs around the world, includingthe EUlO countries, due to a potentially rapid reversal in the flow. FDI, in particular, is desirable not only as source of balance of payments finance but as a direct source of capital and technology. Therefore, the ability to attract FDI will be crucial when looking ahead, not only to help finance the current account deficit but also increasethe growth ofthe economy. E. CONCLUSIONS 2.32 Macedonian macroeconomic policies have been prudent and aimed at low inflation and economic stability with good results, but now the economy faces new challenges. Inflation was low and the current account deficit declined over 2005-2006. However, slowly growing exports and rising imports led to an increasing trade deficit that was financed largely by the rise in recorded private transfers. This balance of payments composition was an issue, both in terms of exports' limited contribution to GDP and employmentgrowth, and the risk that private transfers, whose motivation is not really very clear, might slow down (as indeedhas happenedin 2008). 2.33 Inflation had shot up as a result of higher food and energy prices in 2007 and early 2008, but it has declined since then. Beginning in 2007, the current account deficit has widened. The private flows and FDI which financed the trade deficit have slowed recently, resulting in loss of reserves beginninginthe last quarter of 2008. 2.34 More fundamentally, while the deterioration of the current account may reflect the rise in international prices and adverse terms of trade, there is also a more fundamental issue of the degree to which the worseningtrade deficit represents an underlyingdecline in competitiveness. 33 2.35 For sustained growth and to reduce pressures on the external front, exports will need to grow faster (Chapter 3) and more stable external financing, such as FDI, will be necessary. More FDI will be needed to improve export performance (net of associated imports), encourage import substitution, and help finance the current account in a more sustainable fashion. This renders the structural policy agenda, the core subject of this report, more critical because of the impact of ongoing energy re-pricingon competitiveness of firms, and because exchange rate flexibility is not available as a policy instrument. In addition, the global financial crisis means that countries that offer enhanced competitiveness may be relatively less affected by the decline in international capital flows, again requiringacceleration of structuralpolicy reforms. 34 3. EXPORT PERFORMANCE:A SYMPTOM OF WEAK COMPETITIVENESS A. INTRODUCTION 3.1 FYR Macedonia's exports have been growing, but this growth is the slowest among all the Western Balkancountries over the last decade, and also slower than its EUlOneighbors. To some extent, at least in national accountingterms, this contributes to FYR Macedonia's relatively slow growth over this period. Moreover, FYR Macedonia's trade deficit is large and growing (Chapter 2), a trend that usually raises alarms about competitiveness and macroeconomic stability. The structure of merchandise exports is weighted towards unskilled and natural resource intensive products, which is a symptom of lack of competitiveness in more sophisticated products. In addition, FYR Macedonia depends heavily on garments and metals, sectors which are vulnerable to competition from lower-wage countries or to a downturn in global prices of metals as well as re-pricing of energy inputs in FYR Macedonia. Given historical trends, as well as ongoing developments in FYR Macedonia, garments and metals may no longer be able to providethe foundationfor overallexport growth in FYR Macedonia. 3.2 The previous chapter looked at the macroeconomic issues dealing with the trade deficit and its financing, and concluded that faster export growth is critical to the sustainability of the external account. This chapter argues the case for export-ledgrowth in asmall economy-indeed, that more exports are the only source of sustainable GDP growth in FYR Macedonia-and, to that end, provides some policy optionsto accelerate exports. 3.3 Accordingly, the approach in the chapter is to better understandthe constraintsto stronger export growth. Section B analyzes the past performance and sustainability of growth of FYR Macedonia's exports. Section C looks at trade policy, including the regime for agriculture, in a European as well as regional (CEFTA) context. Section D examines firms' perceptions of export constraints. Section E asks whether the logistics environment poses constraints to FYR Macedonia's trading community, and also evaluates the current state of provision of (outsourced) logistical services. Section F summarizes and providessome policy options. B. EXPORT PERFORMANCE*' 3.4 Trade and especially exports are critical for growth, the more so for small economies like FYR Macedonia. Small countries gain more than larger ones from trade-induced expansion in market size, which makes the effect of trade on per capita income and rate of growth on small countries much larger (Helpman 2004). Simply put, exports allow small economies to produce more than they need domestically, and, since they cannot produce everythingthemselves, to pay for imports that they cannot produce competitively. Imports allow consumers to access the best productsat the cheapest prices, and provide competition for domestic production as well as access to technology. FYR Macedonia's small market and modest tourism and natural resources potential make exports of goods and other services the only source of sustainable GDP growth. Figure 3.1 shows, for small economies (with less than 10 million population), the positive relationship between GDP growth and trade growth, and the somewhat stronger relationshipof GDP growth with export growth. 29The issues raised'inthis section relate to longer-term growth o f exports. The decline in external demand since late 2008 has rendered FYR Macedonia even more susceptible to the issue of dependence on metals and garments exports. While world demand should eventually recover, these problems will remain unless addressed. 35 20 0 20 0 150 - - 150 - A 5 e 0 0 0 0 1 0 0 100 200 300 400 500 0 0 50 100 150 200 250 300 350 Realgrowthof exports and mports Realgrowth of exports 3.5 While respectable, FYR Macedonia's export growth has been inadequate in many ways, with relatively low growth, declining competitiveness (with a recent recovery), and a rising trade deficit (see Table 3: 1). The dollar growth of its goods and goods and non-factor services (GNFS) exports has beenthe lowest of all the countries in the region over the last decade, despite metal price increases in recent years. FYR Macedonia's GNFS exports grew by an average of 7.5 percent annually over 1996-06, versus 12.3 percent for the Western Balkans and 13.2 percent for EU8 countries. Its relativeperformance in the region does not change in the more recent period either, even though its export growth picked up significantly startingfrom 2003. Infact, in constant 2000 prices, FYR Macedonia's GNFS export growth drops from 3.9 percent for 1996-06 to 2.2 percent for 2000-06, since recent exports were proppedup by metalprice increases (annex 3.1).30 As noted, at least in accountingterms the slow growth of exports is an important factor in FYR Macedonia's slow growth. However, within GNFS, services perform somewhat better, with the nominal growth rate of service exportsbeing 13.4 percent for 1996-06, and rising to 15.2 percent over 2000-06 (annex 3.4). Within services, travel, and computer, telecom and other services have grown significantly since 2000 (see chapter 8 for a discussionof the IT sector). 3.6 Macedonian goods actually lost export market share over 1996-06, the most telling indicator of international competitiveness. Their share in world imports peaked at 0.026 percent in 1998, falling thereafterto 0.0141 in 2003, and recoveringthereafterto reach 0.0201 percent in 2006. Over this period, neighboringcountrieshave gained market share, including Bosniaand Herzegovina,whose goods exports value overtook FYR Macedonia's in 2004, and Serbia (Annex 3.1 and 3.2). EU8 countries do very well, improvingtheir world market share from 1.6to 2.7 percent between 1996 and 2006. 3.7 There are signs of a recovery starting 2003-2004, but still short of the peak. More recently, FYR Macedonia'sworld market share has started recovering, although at 0.02 percent in 2006, it was still well below its 1998 peak market share of 0.026 percent. The recovery appears to have continued into 2007 and the first half of 2008, with the (estimated) nominal growth of goods exports at 40 percent in 2007, versus nominal growth rates between 17 and 23 percent inthe previous four years (see Annex 2.1). The concern here is that export growth was too concentrated in metals, which raises sustainability concerns (see below). In the last quarter of 2008, exports fell by 15 percent in nominal terms, reflecting the impact of the crisis. Also, the comparative data until 2006 shows that despite this recovery in market 30Growth rate is calculated by the least squares method, which gives weight to each year's growth performance. Thus, if the calculation is done over 1999-2006 (so that FYR Macedonia's high exports in 2000 do not bias the result), FYRMacedonia's average export growth falls to 1.9percent. 36 share, most of FYR Macedonia's neighbors have gained even more market share (Annex 3.2 and Table 3.1). Table 3.1: Indicators of Trade Performance in FYR Macedonia and Selected Countries GNFS Export Goods Export Share (%) in Share (YO)in Deficit in Deficit in Growth96-06 Growth96-06 World Goods World Goods GNFS GNFS (percent) (percent) Imports 1996 Imports2006 (%GDP,1996) (%GDP,2006) Albania 22.0 15.3 0.0060 0.0064 22.9 24.1 BosniaandHerz. 15.3 19.6 0.0081 0.0276 60.3 21.7 Croatia 10.2 8.8 0.0672 0.0731 9.5 8.9 FYRMacedonia 7.5 5.9 0.0233 0.0201 10.3 18.7 Montenegro 32.9 Serbia 12.5/a 0.0328h 0.0480h 7.4 19.7 SEE-5 (all above 12.3 13.5 0.1374 0.1536 15.6 16.1 countries) EU-8 13.2 14.8 1S859 2.7258 3.0 1.1 Slovak Republic 14.4 15.6 0.1735 0.3050 10.6 4.6 Ireland 11.3 8.3 0.8354 1.2400 -12.0 -13.1 Notes: a/ Refers to 1997-2006; b/ Serbia and Montenegro. Growth rates are least squares. A minus sign in the deficit figure indicatesa surplus. Source: Annexes 3.1.3.2 and 3.3 and WDI database 3.8 Export decomposition shows that FYR Macedonia's exports have increased because of demand factors and not competitiveness in the period 1996-06. Annex 3.5 shows that overall, increased demand in existing markets and products was solely responsible for its export increase over 1996-06. In most cases, growth of exports to a market was less than total import growth in that market. On the other hand, many neighboring countries gained significantly in competitiveness (Bulgaria, Romania, BiH, and Turkey). Slovakia's export increase saw significant contributions from demand, competitiveness as well as diversification factors. As discussed below and in Chapters 2 and 8, recently metals and garments exports seem to have gained market share but this reflects particular factors and is unlikely to be sustainable; correspondingly, most other exports continue to suffer from issues of competiti~eness.~~ 3.9 FYR Macedonia's net deficit in GNFS is rising over time (see Chapter 2). In itself, this was not a problem, since private transfers have kept the current account deficit manageable and, combined with FDI inflows, external debt moderate (around 35 percent of GDP). However, external sustainability may become a concern given the drop in private transfers and FDI. Also, faster growth demands an increase in the growth of exports, which raises issues of competitiveness. Between 2001 and 2003, exports grew slower than GDP. However, this trend reversed since 2004.32The question to be posed is whether this increase is temporaryand based on reversiblefactors such as metalprice inflation rather than a sustainable increase in quantity and/or quality of exports.33 31 FYR Macedonia's recovery of world market share started in 2004, with the share crossing that of 2000 in 2006. However,as amplifiedbelow, the rise in exports is concentratedinmetals, andto a lesser extent, garments. 32 Goods (GNFS) exports were 37 (48.6) percent of GDP (all dollar figures) in 2000, 31.2 percent (40.3) in 2004, and 38.6 (49.8) percent in 2006. In 2007, this ratio rose by about 6 percentage points, with increase in export volumes of about 20 percent.Owingto the financialcrisis, the ratiohas stagnatedin2008. 33For example, as notedbelow, garmentshave gainedmarket share recently (althoughagain, the question is whether this canbe sustained). 37 3.10 An illustrative calculation suggests large gains for GDP with improved world market shares. Had FYR Macedonia maintained its 1998 share of world merchandise trade of 0.026 percent, its 2006 GDP could have been higher by 15 percent in dollar terms.34 3.11 FYR Macedonia's export compositionrenders future export growth vulnerable. The share of its merchandise exports that are capital-intensive (CI) and skill labor (SL) intensive have declined from 36 percent in 2000 to 32 percent in 2006 (Annex 3.6). This means that it is more reliant on natural- resource and unskilled-labor-intensive products today than it was at the start of the decade.35 This is a problem because unless countries move up the value chain, it allows lower wage countries to catch up once the technology for production (interpreted broadly to include organization of production) gets diffused (witness the explosive growth of garments in Bangladesh in the 1980s). Indeed, Slovakia continued to increase its share of capital and skill intensive products, from an already-high 61 percent in 1996 to 66 percent in 2000 and 72 percent in 2006; all EU8 countries followed the same pattern on average (see also Kathuria, 2008).36 3.12 The concentration of export growth in garments and metals adds to the vulnerability. Between 2002 and 2006, 53 percent of the dollar growth of FYR Macedonia's exports came from metals and metallic scrap, and another 17 percent from apparels (Annex 3.7). This renders its future export growth peculiarly vulnerable, as elaborated below. This is not to say that an increase in garment or metal exports would not be welcome-indeed, in the short-term, this would be very important to provide continued momentum for exports-but that policy-makers would need to think creatively as to how to enable diversification and growth in other sectors. 3.13 Metal production is highly energy-intensive, rendering overall costs sensitive to energy pricingU3'Reportedly, cheap energy (along with capacity inherited from SFR Yugoslavia days) has been one of the attractions of locating companies in sectors such as metals in FYR Macedonia, over-riding its land-locked circumstances that require incurring high transport costs for transport of bulk inputs and outputs. The ongoing changes in energy prices in FYR Macedonia render metals and other energy- intensive sectors such as cement vulnerable. At the very least, these changes would cut into profits,38and could hurt metal-producing sectors more when metal prices return to a more `normal' growth trajectory (a process that started in the second half o f 2008) by reducing their room for maneuver. This does not mean that energy-intensive production cannot survive in FYR Macedonia. But it does, at the very least, make the future more uncertain for these sectors and by implication, for continued export growth, let alone faster export growth. 3.14 The recent decline in world demand only highlights the vulnerability of Macedonian exports. While the data is not conclusive, since the events are recent, the decline in the dollar value of 34 Assuming a simple, linear relationship between imports and exports, where a 1 percent increase in exports is related to a 0.974 percent increase in imports. 35This is not to deny that natural resourcescan spawnhigh technology methods, such as ore in Australia. 36Of course, FYR Macedonia will also face competition as it moves up to more skill-intensiveproducts- but here it would at least face lesser (albeit significant) pressurefrom low-wage countries, 37 During visits to companies, World Bank staff was informed that in the case of one cement producer, electricity and fuel accounted for 80-90 percent of variable cost. For one steel producer, electricity costs were reported as over 55 percent of variable costs (other than metal scrap). Inthe case of the former, for example, a doublingof electricity costs alone could increase total variable costs by 40-45 percent (assuming electricity accounts for half of energy costs, and assumingno other increasesin costs). 38For example, accordingto data filed in the Stock Exchange, the operating profit to revenue ratio for USJE cement fell from 37 percent in Q1 2007 to 27 percent in Q1 2008; corresponding declines for Makstil were from 5.3 to 4.7 percent (following declines in 2007 from 2006 levels). Such developments date prior to the onset of the current global economic crisis. 38 FYR Macedonia's goods exports of 44-45 percent in January and Februa 2009 appears larger than the declines in most countriesfor which data was availableby end April 2009. This may have happened, for 2 example, because metals have been particularly strongly affected in the ongoing global economic crisis. These events have led to cuts in production and, in some cases, even temporary closures in metal firms and mines inFYR Macedonia. 3.15 Garment exports have bucked the trend in the region so Table 3.2: Market Shares in EU27 Apparel Imports (percent) 1990 1996 2000 2006 far, but again the question relates Asia 38.9 45.1 47.1 59.6 to the future. Exports from SEE Western Balkans 2.5 2.3 1.9 countries, on average, declined after FYRMacedonia _8.4_ 0.54 0.55 0.57 2003, a trend hastened by the MFA Source: UNCOMTRADE abrogationin 2005 (Annex 3.8). The decline in EU8 countries' share has been steeper, owingto wage pressure. Onthe other hand, Macedonian garments' EU market share rose from 0.50 percent in 2003 to 0.57 percent in 2006. Can this trend continue?While details of the sector are discussed in chapter 8, it should be notedthat in the long-run, it is highly unlikely that any country in Europe or its neighborhoodwould be able to keep its market share even in EU imports, let alone in other parts of the world. Eventhe shares of Turkey, Tunisia and Morocco have declined in recent years. Asia's share rose from 39 to almost 60 percent over this period (Table 3.2 and Annex Table 3.8). 3.16 Additionally, being in the EU neighborhood, FYR Macedonia's relatively high wages are subject to upward pressure. Indeed, its wages (2005 data) were higher than in Albania and perhaps Serbia, and, more problematically, Bulgaria and Romania (see Table 3.3 and chapter 7) - the latter Table 3.3: Wages and Value-Added Exports already scoring significantly higher on ease of Doing CI+SL(%) Wages Business (45 and 47 respectively vs. 71 for FYR Country 2006 2005 Macedonia).Moreover, FYR Macedonia'swages have Albania 11.9 54.0 been increasing relatively quickly in 2006 and 2007. Bosniaand Herzegovina 39.5 100.0 Further pull can be expected from faster-rising wages Bulgaria 31.9 64.7 in the EU8 neighborhood (see chapter 7). The FYRMacedonia 32.1 109.3 experience of EU8 countries shows how wages can Romania 45.3 100.7 increase quickly as investment flows rise both before Note: Regionalaverage=100. The export share is and after EU accession. Along with neighbors' assumedto be the same inboth RSand FBiH. competition,FYR Macedoniais also likely to be vulnerable to low-wageAsian competition, as European and its own domestic markets open up further. It is this combination of relatively high wages and low share of capitaland skill-intensiveproductsthat renders FYR Macedoniavulnerable. 3.17 FYR Macedonia does not participate much in producer-driven supply chains. Its exports of parts and components (P&C), which is one way to show participation in the international supply chain and which are driven by common ownership of vertically integrated production chains, has been negligible. As a share of total manufacturedexports, P&C exports declined from 3.9 percent in 1996to 3.2 percent in 2005. This was very similar to other SEE5 countries. However, neighboringcountriesthat have achieved dynamic export growth have participated actively in P&C trade. In EU8 countries, the P&C share in total manufactured exports rose from 12 percent in 1996 to 20 percent in 2005 (see Kathuria, 2008, for moredetails). 39Thus, declines in dollar export values in January and February2009 were of the order of 20-25 percent for East Asian countries; for Turkey (25-26 percent), Poland(34-39 percent), South Asian countries (16-20 percent); South Africa(34-37 percent)andso on. 39 3.18 Not surprisingly, P&C trade is highly correlatedwith FDI. Foreign-ownedfirms invest different parts of their productionchain in different locations, depending on competitive advantage, and then bring all supplies together in a hub or assembly location. Given its low FDI levels, FYR Macedoniahas been unable to plug into such productionchains. This raisesthe question as to what it takes to attract FDI(see chapter 4). 3.19 Overall,FYR Macedonia'sexports have not providedthe driver to growththat is needed in a small economy. Growth of exports has been low over the last decade compared to SEE5 and other neighboring countries and to some extent that explains FYR Macedonia's slow growth. Its export composition makes FYR Macedoniavulnerable to competition and downturns in global metal prices (as is being seen already), and to the impact of energy re-pricing. All these are symptoms of lack of competitiveness in a somewhat broader range of products.Thus, lack of diversification in exports should be lookedat not as the fundamental problem, but rather as an outcome of inadequate productivityand cost efficiency in exporting either more products or exporting existing products in larger volumes. The next section will assess the roleof trade policy in FYR Macedonia'scompetitiveness. c. THEIMPACTOFTRADE POLICY 3.20 Trade policy is important in export growth. Obviously, polices that discriminate against exports reduce the incentives to export and invest in exporting. But protection of import-competingindustries indirectly hurts exports, by diverting resources and investors from exporting activities, and into less efficient (in a macroeconomic sense) productionof import substitutes. The same goods could be obtained at lower resource cost by switching resources into production for exports and buying the goods as imports. 3.21 Viewed in this light, there are several issues that need to be addressed, although FYR Macedonia's trade policy seems not to suffer from major overall distortions at first glance. Taken together, resolvingthese issues would constitutea substantial package of reforms,as outlinedbelow. C.1. Market Access Issues: MacedonianExportsand Imports bilateral restrictions. Annex 3.9 summarizes the market access 8 regimes for both the EU and CEFTA 2006 countries. 5 4 0 Intermediate 3-23 FYR Macedonia's 3 domestic market has been given 2 I some breathing space by the EU, 0 until 2011. By 2011, FYR Albania BIH Croatia Macedonia EU 40 In 2006, industrial imports from the EU were subject to preferential rates at 42, 50 and 70 percent of applied MFN rates except for those products already zeroed in 2001 and 2006 (steel products) (see annex 3.9). Thus, imports o f industrial products under the SAA worth around US$ 1.7 billion (or 85 percent of the total) were not fully liberalized in2006. 3.24 While average MFN tariffs are low, dispersion of rates is relatively high. Table 3.4 shows that simple and weighted average tariff rates are lower in FYR Macedonia compared to other CEFTA 2006 countries. However, FYR Macedonia has the highest dispersion of tariffs, which creates distortions (see below). Note that, in addition, the quality o f data in many cases is inadequate, so that tariff dispersion in actual practice may be higher than what is shown in the customs data, since there may be issues relating to evasion o f duties (see Box 3.1). Box 3.1: Data Quality Issues The quality of statistics is a handicap for doing rigorous analysis and, by implication, policy-making. For example, EU25 exports to FYR Macedonia (EU statistics, recorded f.0.b.) in 2006 were recorded at $1,884 million, but imports into FYR Macedonia (FYR Macedonia statistics, recorded c,i,f,), which should be higher because of the cif-fob difference, were only 1,650 million. On the other hand, FYR Macedonia's imports from the ROW were $1,751 million, 260 percent higher than recorded exports of $673 million. There are also large differences between Macedonian export data and EU import data for many countries such as Greece, Bulgaria, Germany, Italy, etc. While there are always issues on data recording at both ends, the very large differences in the export and import data between partners does not inspire confidence in the quality of statistics. Whether these reflectjust inefficiencies inthe system or incentives to wrongly classify, under-report or over-report, cannot bejudged with current information. It bears hrther investigation. 3.25 MFNtariffs on primary and final goods are higher,while those for intermediategoods are lower, broadly speaking (Figure 3.2). Ideally, tariffs should be low and the same for all commodities, so that there is no discrimination between products, but countries often try to encourage domestic value- added by increasing tariffs with the level of processing. In FYR Macedonia, apart from the structure of tariffs, the average deviation in tariffs was 2.04, higher than other CEFTA countries except BiH (2.32); the EU CET has a deviation of 0.43. While these MFN tariffs are increasingly offset by preferential tariffs for SAA and CEFTA 2006 imports, it should be noted that the potential for distortions always exists at the level of individual sectors and firms.40 Table 3.4: MFNTariff Schedules for Selected CEFTA Countries in 2006 Simple Average Weighted Average Standard Deviation Maximum rate Albania 6.22 6.70 5.59 15.0 Bosniaand Herzegovina 7.69 6.37 4.61 15.0 Croatia 2.38 1.15 5.92 55.0 FYR Macedonia 5.46 4.16 9.17 60.0 Serbia 8.09 6.03 7.73 30.0 EuropeanUnion 1.72 1.62 3.99 74.9 Source: UNCTAD TRAINS database 40To take a hypotheticalexample, plastic articles for packinghave a simple average MFN tariff of 10.1 percent, but these deter imports from the rest of the world, so that weightedappliedtariffs are 3.6 percent. Even so, this implies a sizeable quantity of ROW imports out of the total imports of $23 million (so that the weighted average can go up from 0 to 3.6 percenttsee annex 3.9. Firms using such plastic articles from the ROW (say, sauce makers) would suffer negative protectionif they are protected by, say, a 5 percent import duty on sauce imports from the EU. EU exporters, on the other hand, would probably enjoy a zero or very low tariff on use of such plastics in their sauce production. 41 3.26 Preferences on imports to the EEA (EU, EFTA and Turkey) have resulted in some trade diversion. This can be seen in table 3.5, which shows that where the MFN duty rates were less than 5 percent (at a time when the preference margin was between 0 and 70 percent o f MFN rates), the imports from the rest of the world (ROW) formed over 40 percent o f total imports in those categories. Where the MFNduty was 5 percent or higher, the rest of the world sharewas only 16 percent. This suggeststhat if the higher MFN duties were reduced, there could be some increase in imports from the rest o f the world. By implication, this would mean cheaper inputs on the whole for exporters and for consumers. Note, however, that overall import volumes are higher (68 percent of total industrial imports) for products with lower MFN duties (one of which is oil, which has a zero MFNduty), which means that the trade diversion effect applies largely to 32 percent o f all industrial imports. Table 3.5: Structureof Industrial Imports in Terms of MFNApplied Tariff Rates (in million of US dollars and percent) MFNapplied Importsfrom Importsfrom Importsfrom Total imports tariff/direction of imports EEA ($m/%) SEE-6 (%m/%) ROW ($m/%) ($m/%) 15 percent or more 47 4.3 18 68,657 direction of imports(%) 68 6 26 100 share in total (%) 2.4 1.6 1.6 2.1 10 to less than 15 percent 190 46 30 265,420 direction of imports (YO) 72 17 11 100 share intotal (%) 10 17 3 8 5 to less than 10 percent 552 39 119 708,849 direction of imports(%) 78 5 17 100 share intotal (%) 28 14 11 21 1 to less than 5 percent 472 60 637 1,168,98 1 directionof imports(%) 40 5 55 100 share intotal (%) 24 22 59 35 Less than 1 percent 690 124 274 1,087,180 direction of imports (%) 63 11 25 100 share in total (%) 35 45 25 33 Sources: Kaminski (2008), based on UN COMTRADE Statistics (trade data) and UNCTAD TRAINS database (tariff data). EEA: European Economic Area; ROW: rest of the world. 3.27 FYR Macedonia would benefit from adopting the EU CET4' for industrial products and reduce to zero its duty rates on industrial imports under the SAA. Since 80 percent of industrial imports originated from either SEE6 countries or the EEA, FYR Macedonia's MFN tariffs provide little protectionto its firms and are largely redundant (average protection on EUimports was 8 percent in 2006, and zero on SEE imports). Its tariff structure can also hurt its firms, because it exposes domestic producers to different tariff levels than those faced by firms operating in EU markets and is potentially biased against export development. And it has also allowed for some trade diversion. 3.28 Lowering of MFN rates to EUlevels (tantamount to forming a customs union with the EU) would address the above distortions, reduce tariff dispersion, and, combined with reducing industrial import duties under SAA to zero, lower prices of imports and help improve competitiveness of Macedonian producers.42O f course, such a virtual customs union with the EU 4 1Note that the EC does not support this view. It argues that FYR Macedonia should use the time until accession (when tariffs will become unified with the CET) to support growth anddevelopment of local firms, by keepingMFN tariffs at higher levels. 42 Furthermore, with the prospect of joining the Pan-Euro-Med cumulation system, which bans the use of duty drawback mechanism, the adoption of the EU CET by FYR Macedonia would encourage sourcing from Mediterraneanpartners. Pan-EuropeanEconomic Area includes countries covered by the pan-Europeancumulation system-the EU-27, the Member States of the European Free Trade Association (Iceland, Liechtenstein, Norway 42 would be even more effective if also implementedin all CEFTA 2006 countries. This would help in the process of creating a more effective single economic area within the CEFTA 2006 countries (see Kathuria, 2008). C.2. The Regime for Agriculture 3.29 Agriculture contributes around 10.8 percent to FYR Macedonia's GDP, and about 20 percent (including beverages and tobacco) to merchandise exports. It may have potential to contribute even more to exports, if the infrastructure that supports agriculture can be developed further (see chapter S), and if the agriculture trade regime can be liberalized, at least for CEFTA countries. Table 3.6: Tariff Rates, Net Exports and Share of Preferentialand Non-Preferential Agricultural Imports Share Share Share Total Simple Wtd. Av. Wtd. Av. Product of of of Imports Exports Share in av. tariffs tariffs EEA SEE6 ROW (US% in YOof agricultural MFN (EEA (ROW (YO) (YO) (YO) `000) imports imports (YO) tariff imports) imports) Edible fruits (HS 0806 through 0814) 58 27 16 1,286 3731 0.2 26.4 47.1 26.7 Edible vegetables (HS 07) 51 19 30 4,777 1090 1.1 26.4 6.8 14.8 Dairy products(HS 04) 46 53 1 25,982 24 5.8 8.5 4.4 0.9 Preparations of meat, of fish or of crustaceans(HS16) 50 36 14 26,992 35 6.0 3.4 2.9 1.4 Preparations of cereals, flour, starch (HS 19) 53 47 0 27,265 16 7.4 15.5 3.1 0.8 Preparations of vegetables, fruit, nuts (HS 20) 58 26 16 21,123 110 4.7 20.7 17.0 18.8 Miscellaneous edible preparations (HS 21) 64 33 2 39,564 31 8.8 14.3 14.0 14.1 Beverages, spirits and vinegar (HS 22) 46 51 2 18,605 439 4.I 18.9 13.1 16.1 Total above 54 40 6 165,595 109 46.1 14.9 9.7 12.6 Note: Weighted average tariff rate on imports from the EU should not imply that Macedonian importers paid these duties: some items were imported duty free within quotas; and, second, some items might have been subject to preferential rates. Sources: Kaminski (2008), based on UNCOMTRADE Statistics (trade data) and UNCTAD TRAINS database (tariff data). 3.30 FYR Macedonia's regime for agriculture is more restrictive than in the case of industrial products, a pattern similar to many other countries as well as the EU. While trade in agricultural products with Serbia, Kosovo, Montenegro and Bosnia is largely duty-free and some quotas apply for Croatia43,MFNtariffs on imports from other preferential partners as well as the rest of the world are very high. High MFN tariff rates on agricultural products that potentially can be inputs to processing of agricultural products, an area in which Macedonian producers appear to have some competitive edge, can constrain development of these operations. For instance, tomatoes are subject to a 50 percent MFN tariff rate; peas, beans, apricots, cherries, and peaches to 45 percent MFN rates; and carrots, plums, and strawberries to 40 percent rates (Annex 3.1 1). Simple average MFN rates for agriculture exceeded 15 percent, with maximum rates ranging between 30 percent and 50 percent and with a standard deviation of and Switzerland) and Turkey. With the extension of cumulation rules to Mediterranean partners of the EU, it is referredto as Pan-Euro-Medcumulation system. 43In agricultureproducts, the CEFTA 2006 did not bring in additional liberalization compared to the bilateral free- trade agreements that existedprior to the CEFTA 2006 ratification. CEFTA 2006 largely replicates the provisionsof these bilateralagreements. 43 15.3 percent.44The tariff structure is complicatedfurther by its `seasonality', with off-seasonrates being about half ofthe growing season MFNrates that are listed inAnnex 3.11. 3.31 Given high MFN rates, trade diversion can be expected. Table 3.6 shows that some of the lowest penetration rates of rest of the world imports arise in areas where MFN tariffs are high- beverages, miscellaneous preparations, and cereal preparations. Rest of the world penetration is also relatively high in two high MFN tariff categories (fruits, vegetables), suggesting scope for additional importsfrom the rest of the world. 3.32 In addition, the data shows higher protection preciselywhere FYR Macedonia appears to be more competitive, which appears redundantand increasestransactionscost. The highest level of protection is for fruits and vegetables, exports of which were 37 and 11 times higher than imports (Table 3.6). The motivation for such a pattern appears to be protection: higher MFN tariffs are levied where domestic production is strong (i,e., where relative exports are high). In practice, of course, preferential imports including zero duty imports from some former Yugoslav republics(except Croatiaand Slovenia), reduce the actual level of protection. For example, average tariff protection vis-aTvisselected ex- Yugoslav countries (who had a market share of 40 percent) was zero. Not only does this tariff structure not provide the protection that is intended for it, it also complicates administration by having, for example, multiple tariff rates for the same product (thus, the same product can have four different tariff rates-an MFN peak, MFN seasonal, preferentialEU, or CEFTA rate). 3.33 The time may be opportune to extend free trade in agriculture (zero duties, no quotas) to other countries in CEFTA 2006. Given the earlier rise in food prices, countries may find it easier to handle lobbying against more open trade in agriculture. Given the institutional set-up in CEFTA 2006, FYR Macedonia would need to negotiate open trade with countries including Croatia, Albania and Moldova, bilaterally (trade with the other ex-Yugoslav countries is already open). Complementary measures such as acceleration of the process of mutual recognition of sanitary and phyto-sanitary(SPS) standards, throughsynchronizedharmonizationwith the acquis communautaire,would also help. 3.34 Liberalizing the regime for agriculture can have multiple benefits. This report suggests that FYR Macedonia (and much of this would apply to other countries) would gain from agriculture liberalization because it would: (i)improve market access and certainty for Macedonian exporters; (ii) increase consumer welfare in FYR Macedoniathrough access to cheaper food; (iii)reduce although not eliminate trade diversion; (iv) improve the competitiveness of the Macedonian agro-processing sector; and (v) reducetransactions cost of foreign trade within CEFTA countries. D. EASINGTHECONSTRAINTSTO EXPORTS 3.35 Firms that are export-intensive have somewhat different concerns compared to those that largely sell on the domestic market. The BEEPS 2005 data showed that a large fraction of firms that are export-oriented(more than 50 percent of their output) complainedabout tax rates, costs of financing, contract violations, customs and trade regulations, and electricity and telecommunications (Figure 3.3). Interestingly, most o f these were also those areas where the gaps in perception between export-oriented and domestically-orientedfirms45 were the largest. One interpretation of the chart is that exportingfirms face a far more demanding market, and so are more concerned about both cost and quality of output, as 44The list of products fully liberalized on the date of entry of the SAA was rather short and the list of products subjectto a reducedtariffrate (70 percentof appliedMFNtariff rates) is long. 45Ifthe exportingfirms' concerns are El, E2, etc, andthe domestic firms' concerns are D1, D2, etc., the gaps are presentedas positive gaps in the order El-Dl, E2-D2(and not Dl-El). In other words, we focus here onthose areas where export-oriented firms' concerns dominate. 44 well as timely delivery. For example, contract violations are inimical to timely delivery; high costs of telecommunicationsand of course high-cost financing and high tax rates can cut into profits; quality and costs of electricity can interfere with output cost and quality. Most of these issues are dealt with later in the report (Chapters 4 and S), and will not be repeated here. However, the following section will deal with issues relatingto logistics, includingcustoms andtrade regulations. Figure 3.3: Obstaclesto DoingBusiness: Differencesbetween Export and Domestically-OrientedFirms (BEEPS 2005) Differences Between Export-Intensive Firmsand Others 1 Cost of financing Teleconnunicallonr Eeclricny Tax rates Custom and trade Cantract violations regulations t by customrs B suppliers L H Exports >=50% Exports <50% ~ i 3.36 Macedonian firms seem to be less inclined towards exports. The dynamics of firm entry and exit in exports and the size of firms could be potentially important, if evidence on other countries is anythingto go by. In the BEEPS 2005 sample of firms, 70 percent of firms reportedzero exports, and 80 percent reported exports of 10 percent or less.46On the other hand, researchon European, Colombianand Chilean firms suggests that what matters most for a country's export performance is how many of its firms engage in exports.47While many firms who start exporting do not continue to do so, a few do continue, and grow very rapidly to becomethe superstars of the future. For example, in Colombiaduring the period 1996-2005,over half ofthe growth in exports came from firms that were not initially exporters. Also, the analysis for Chile suggests that the number of firms exporting a product, or to a market, increases the chances that a firm will introducean existing product to a new market, or a new productto the same market. 3.37 This suggests that a larger number of firms involved in exports would help provide greater dynamism to overall export. What this means is that the barriers to entry into exports need to be reduced as much as possible, so that more firms can start exporting easily. Also, given the finding that large and often the newly-arrived superstar firms tend to dominate exports, reduction in the barriers to exporting and other barriers to firm growth (Chapter 4) would help firms grow, as it is hard for firms to grow beyond a certain point in a small economy like FYR Macedonia, without exporting. Mayer and Ottaviano (2007) suggest that even small trade costs matter, since they reduce the number of exporters. Some of these issues are brought up in the following paragraphs as well as in the next section on logistics costs. 46 This is corroboratedby more recent data in a report in `Kapital', a weekly publishedin FYR Macedonia(No.1, June 2008 special edition). The report notesthat in 2007, only about 2000 firms hadexports exceedingUS$lO,OOO. Also, the 100 largestexportingfirms accounted for over 50 percent of exportsin2007. 47See Eaton et a1 (2007) for Colombia, Mayer and Ottaviano(2007) for Europe andAlvarez et a1 (2007) for Chile. 45 3.38 Careful export promotion can help reduce costs for exporters and potential exporters. A strong dialogue between the government and the exporting community can help create better understanding about the barriers facing potential exporters and expansion of existing exporters. Dependingon the outcome of this ongoing dialogue, the government may consider offering a few pilot services to the exportingcommunity, such as informationon overseas markets and buyers, or basic export information to first-time exporters (such as regulatory compliance issues, standards, trade finance, customs issues, etc.). These services should be assessed for their usefulness after a year or two of operation before a decision is taken to widen their depth and breadth. Analysis of the experience of export promotion agencies in 88 countries4' suggests that export promotion that is combinedwith other activities such as investment promotion is usually more successful. For FYR Macedonia, this means that Invest FYR Macedonia could possibly take on this function on a pilot basis. Experience also suggests that the private sector should be closely involved in the oversight function for this export promotion activity; and that the promotion should focus on non-traditional exports rather than attempt to promote overallexports. 3.39 Sector studies done for this report point to several other concerns of firms for improving standards, agriculture extension services, and some aspects of the investment climate. Intensive interviews of firms in three different sectors-agro-processing, textiles and garments, and information technology-were conducted for this report. This analysis indicates that providing support to the agriculture sector through extension services, investingin facilitiesto encourage adoptionof EUfood and veterinary standards, and improvingagriculturetechnology and infrastructurewill helpto improve quality and quantity of agricultureraw materials.This can be done where possible in a partnershipmode between the government and groups of firms, using EU funds where available. Firms also indicated the need for improvements in land titling, contract enforcement, andjudicial services. All these issues and others are considered in more detail inChapters 4 and 8. E THELOGISTICS ENVIRONMENT49 3.40 Efficient logistics are a lifeline for a small, landlocked economy. Efficient logistics are required to ensure that exports do not suffer from cost or time delays vis-a-vis competing countries; to ensure efficient imports, that are needed for exports (even more in small countries); and to provide competitive imports for consumptionand domestic production. High import logistic costs are analogous to protection @e., are an implicit export tax) and bias the economy away from exports. Logistics are becomingincreasingly importantfor competitiveadvantage, inthe wake of increasingglobalization, more production-sharing, and shortening product life-cycles. For FYR Macedonia, a small, land-locked economy, these issues are even more important: it faces higher transport costs than competitors; it needs to import more to export, given limited domestic production; and since it is small, does not easily find a place in foreign investors' priorities. E.1. Demandand Supply: the Logistics Environment 3.41 There are 3270 registered exporters and 8660 registered importers in FYR Macedonia. These legal entitiesset the basic demand for trade logisticsservices. 48See Lederman et al (2006) for a summary of what works and what does not work in export promotion, based on a survey and analysis of 88 countries and data analysis from 119 countries. The authors also provide a very useful list of referencesfor further study. 49 This section is based largely on the background paper done for this report, see Naula (2008). The author conducted a field audit with local traders, logistics providers and the authorities, in January 2008. Also see World Bank (20070, Connectingto Compete. 46 3.42 Certain sectors account for a disproportionate share of logistics work (shipments, clearances, handlings, etc.). As annex 3.11 shows, vegetables, chemicals, and miscellaneous exports account for a far greater percentageof transactions than export value. Imports are naturally more diversified and therefore highly intensive in logistics work. While efficient logistics are very important for all firms, they are even more important for the export industries mentioned above. Since the traded amounts per transaction are typically low, transaction costs are high. These industries should therefore be well represented in government consultation processes on policy actions for trade facilitati~n.~~ 3.43 On the provider side, FYR Macedonia's traders rely primarily on road transport (annex 3.12), although air and rail transport can be strategically important-air transport for its potential role in breaking into new markets (chapter 6). There are approximately ten logistics providers in the 300-strong association of international freight forwarders, the rest mainly being customs brokers. There are 69 bonded warehouses, but the business in this segment is modest. E.2. LogisticsPerformanceand Problems 3.44 FYR Macedonia's Logistics Performance Index (LPI)*' ranks average among the neighbouring non-EUmember countries-its rank o f 90 inthe LPI is lower than Croatia's 63, or BiH's 88, but better than Serbia and Montenegro's 115 (Figure 3.4). The results may largely reflect FYR Macedonia's "logistics country image" - perceptions by international logistics operators worldwide. This image may well be poorer than what the recent reforms e.g., in customs, would give reason to expect. However, while local experts present a more positive evaluation of customs performance, there is clearly much to be done (see below). 50 While there i s no data on the size distribution o f firms involved in foreign trade, there i s data on the size distribution in production.The number of small firms in the economy has increased significantly over 2002-06; and their share in value-added also rose over the period (chapter 4). This data, combined with the low traded amounts per transaction in many industries, impliesthat smaller firms account for the majority of exporting transactions, and perhaps importing transactions too. Nonetheless, small firms are less involved in exports than their share in value- added would suggest, as seen earlier. 5 'The LPI is a recently launched set of logistics indicators (World Bank 2007g). The results are based on the perceptions of 845 forwardingagents from 150different counties. Globally, Singapore, a major global transport and logistics hub, ranks first in the LPI. At the other extreme are low-income countries, particularly the landlocked countries of Africa and Central Asia. There are also significantdifferences among developingcountries with similar incomes:countries where trade is more critical performbetter than others with similar incomes. 47 Figure3.4: Rankingson Componentsof the LogisticsPerformanceIndex2007 --C.Singapore,rank=l 4-Slovenia.rank=37 5 4.5 4 3.5 3 2.5 2 I Customs Infrastructure International Logistics Tracking& Domestic Timeliness shipments competence tracing logistics costs 3.45 Physical borders crossings are not a big obstacle, although there is room for improvement. According to an audit by the customs authorities in February-March2007, 54 percent of transport units passed the Greece-FYR Macedoniaborder crossing point within three hours and 84 percent within six hours. Sevenpercent ofthe unitsneedmorethan ten hoursto pass(Figure 3.5).52 Figure3.5: Border CrossingTimes BetweenGreece and FYR Macedonia 200 150 number of freight vehicles 100 50 I 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10 -11 -12 -13 -14 -15 -16 -17 -18 -19 -20 -21 -22 -23 -24 Border crossing time, hours Source: MacedonianCustomsAdministration 52 Project "Laufzette" was implemented to measure processing time for freight vehicles at the border crossings Bogorodica(FYR Macedonia) - Evzoni (Greece) during 26th February 2007 - 5th March 2007. Figure 3.5 shows transport times with and without TIR carnets (the TIR Conventionestablishes Customs transit procedures allowing unhindered goods transport under customs seal, based on an international guarantee with only minimal customs control at the borders). 48 3.46 Issues arise in customs clearance procedures.Usually, there are two customs procedures. The first procedure is when a cargo load i s transited under TIR or other customs guarantee to inland customs warehouses. The second procedure (the customs clearance) is undertaken at the warehouse. Even if both clearances are made through electronic interface to Customs (Asycuda), the process takes a minimum of two days. Shipments from consolidated loads can hardly ever be customs cleared and delivered on the day o f arrival. The problem seems to lie in the fact that Customs inspectors visit a bonded warehouse only when the cargo is downloaded and initially cleared into a bonded area. In practice, the inspection can be conducted only one day after the arrival of the goods, at the earliest. The actual inspection time is not an issue. 3.47 A major cause of delays is also that a proper risk management system is yet to take root, although such an initiativewas launched in the Customs a few years ago. Although the situation has improved, the Customs currently physically inspect between 20-25 percent of all shipments. Faster clearance procedures are possible through the so-called simplified customs proceduress3,but this option is not frequently used. In EU countries, use of risk management procedures, which change the mindset from control to facilitation, mean that only 5 percent of shipments are typically inspected. 3.48 These procedural problems may well explain why FYR Macedonia's LPIranking in customs is as low as 126, compared to its overall LPIrank o f 90. 3.49 Perhaps the most serious concern relates to non-Customs inspections, the main source of delays. Thus, phyto-sanitary inspections, veterinary inspections, and market inspection^^^ rely on 100 percent checking of all goods, and take a minimum of one day for clearances (but this is concurrent with the customs delay). Accelerated mutual recognition within CEFTA, of sanitary and phyto-sanitary standards as well as certification procedures, through synchronized harmonization with the acquis communautaire, could help in reducing clearance times. Similarly, extension of such harmonization to Turkey would also be useful, given that Turkey is a significant source o f food importss5.By the same logic, given that a large share of food imports are sourced from the EU area, which already has in place stringent product standards, it seems unnecessary to subject such imports to elaborate physical inspections. 3.50 Ongoing reforms in customs should help. The development projects currently under way in MacedonianCustoms are having some impact-for example, between the 2007 and 2009 Doing Business Reports, FYR Macedonia's rank on trading across borders improved from 127 to 64, owing to a decline of 15 and 20 days respectively in the total time taken for export and import and reduction in the number of documents required. But much remains to be done-compared to OECD countries, for example, FYR Macedonia still requires more documents and procedures take more time to complete. 53 The simplified customs procedure (SCP), introducedin2007, allows shipments to go directly to an importer after presenting a declaration at the border crossingpoint. Firms operating on an SCP can move their shipments directly to their warehouses upon submitting transfer declaration at the border. They have to submit information about departing or arriving shipments 48 hours prior to their arrival at the border to the Customs. To take advantageof the SCP, a firm has to demonstrate full compliance with tax laws. Once screening is satisfactory, it pays an administrative fee and obtains an authorization valid for three years. It is also obliged to submit summary informationon its foreign trade activities every ten days. Yet, according to Customs' information,only a handful of companies have so far applied for the SCP. ''Checkinghas 54 for labeling,weights, issues to do with consumer protection,etc., Turkey opened accession negotiations with the EU and will need to filly align with the acquis, and to implement EU's product and food safety standards. However, it has not yet opened negotiations on the chapters ``free movement of goods" (product standards) and "food safety, veterinary and phytosanitary policy" (food standards). 49 3.51 Overall, faster customs and physical clearances would be crucial to reduce implicit protection and support the needed export growth. Speedy implementation of risk management systems in Customs and other inspections, and faster physical clearances are requiredto minimize import clearance times and reduce the implicit tax on exports. This would encourage hrther growth of export sectors that are already leveraging logistics (such as garments), as well as those that can leverage FYR Macedonia's advantages such as location and production traditions (such as in agro-products). They would also help spur the growth o f the logistics industry, since consolidation of shipments is made much more difficult by the clearance procedures (see next sub-section). E.3. Value-Creating Logistics 3.52 The concept of creating value in logistics refers to shared mutual interest of a logistics provider and a logistics services buyer. The value is created by consolidating several logistics needs under one service provision entity, such as a transport unit, a public warehouse space or a general customs guarantee. In FYR Macedonia, there is a natural market for outsourcin logistics services, given the large number of transactions and small size of firms involved in trading." The value created as a result of specialization and reaping economies of scale is shared by the logistics provider and buyer. For FYR Macedonia's traders, this means that goods could be imported faster and cheaper, which would reduce the implicit tax on imports and so encourage exports. This sub-section discusses the status of value creating logistics services in three important sub-markets of third party logistics: consolidated transportation services, public warehousing services and customs-related services. Consolidatedtransportationservices 3.53 Consolidated cargo transportation (also known as less than container/trailer loads or LCLLTL) services are very commonly used in developed countries. It is a process o f consolidating cargo from several exporters, each having insufficient cargo for a full container load." 3.54 The service process is considerably more complex than transportation of full unit loads. L C L L T L services enable shippers however to choose the most favourable shipment size and frequency and optimize logistics costs and service level for customers. Usually consolidated transportation services are used for shipments, which are smaller than 2500 kgs. Bigger shipments are transported directly, without unloadingcargo in terminals. 56Customs statistics show that over 2003-07, FYR Macedonia's traded export and import value has increasedmuch faster than the number of declared shipments (for example, around 3 % fold increase in export declarations, but around2% fold increase in export values). 57Inbrief, the process includes: Collection of shipment inthe country of export usingthe domestic transport system; Unloadingthe shipment into exporting customs terminal; Export clearance and consolidationwith other shipments for internationaltransport; Loading the shipment to international transport unit; Internationaltransportation of the consolidated unit; Unloading shipments into importing customs terminal; Deconsolidation of the shipments and import clearance by importer; Unloading shipment from the customs warehouse; Delivery of the shipment in the country of import 50 3.55 There are no major obstacles (other than the issue of customs and Table 3.7: Weekly scheduleof Consolidated CargoLinesof physical clearances) for consolidated an International LogisticsProviderin Skopje trahsportation services, but services Departure day Cities served in terms of geographical coverage and Import Thursday Cologne (Germany)- Skopje frequency of departures are poor. Thursday Ljubljana(Slovenia)- Skopje Markets are reached through hubs, Friday Salzburg(Austria)-Skopje which are located mainly in Austria, Wednesday Salzburg(Austria) -Skopje Germany and Italy. Only a handful of Wednesday Sofia (Bulgaria) - Skopje logistics firms provide the service and Export Friday Skopje-Salzburg(Austria) not all of them operate with fixed or Source: expert interview. daily schedules(Table 3.7). 3.56 The potential for efficiency gains is suggested by the differences between full truck loads and consolidated loads. Table 3.8 shows that the market prices for consolidated shipments (typically less than 2,500 kg) are reasonable, but transportation times are relatively long, especially to locations where no direct consolidated services are available, such as Berlin and Milan (7 days for consolidated service, versus 3 days for full truck load).58Traders would clearly benefit if more direct consolidated services were available(expected to occur gradually as volumes increase). Table 3.8: PriceIndicationsof FullUnit Load and ConsolidatedCargo Transports of an InternationalLogisticsProviderin Skopje Full truck load, door to door 1000 kg, door to door Market rate Market rate for full truck Typical for 1000 Typical load (= 80 transport kg= 3 cbm, transport From To cbm), EUR time, days FCA CPT EUR time, days Skopje Berlin 1550 3 Skopje - Berlin 430 7 Berlin Skopje 2850 3 Berlin -----Skopje 400 7 Skopje Tessal. 450 1 Skopje Tessal. 170 2 Tessal. Skopje 500 1 Tessal. Skopje 170 2 Skopje Milan 1300 3 Skopje Milan 400 7 Milan ------ Skopje 1950 3 Milan Skopje 420 7 Source: expert interview Publicwarehousing services 3.57 Internationally, warehousing is one of the most outsourced logistics activities. Exporters and importers usually try to find the most efficient distribution concept to make their products available to their customers as fast and as economically as possible. Public warehousing is an alternative to maintainingown physicalwarehouses. 3.58 Public warehouses can either stock goods under customs control (non customs-clearedgoods) or goods in free circulation (customs-cleared goods). Also, the market served could either be national (customs-cleared goods) or regional. In FYR Macedonia, the business is practically limited to bonded warehousing services for the domestic market for most product groups. In the textile industry, however, there are well developed warehousing solutions, which are integrated with foreign customers' supply chains: products are first importedfor production, and re-exportedto overseas customers (see chapter 7). 58The large difference between export and import prices reflects the significantly greater demand for importsthan for exports. 51 3.59 While FYR Macedonia is not likely to become a large logistics hub, some regional distribution activities might be attracted, particularly those serving neighbouring areas like Southern Serbia, Kosovo and Northern Greece. However, this is complex and expensive. In order to be feasible, all clearance procedures would need to be streamlined to the extreme-for example, all clearances, both customs and physical, would need to be completed within a few hours of arrival of the goods consignment. Among other things, this would require full implementation of risk management procedures. Customs-related services 3.60 Customs-relatedservices includetypically the following activities: 0 Providing customs guarantees for transportation of non-customs cleared goods, for example when a truck-load from a border crossing point transits to an inland customs bonded warehouse. 0 Operatinga customs warehouse and providing public bonded warehousingservices. 0 Customs brokerage: preparing customs declarations, submitting customs data to customs through electronic interface (Asycuda) for release, paying customs payments on behalf of client, providingsimplified customs clearances. 3.61 The customs-related services in FYR Macedonia seem to be reasonably efficient, and 65 percent of shipments use customs brokerageservices.The availability of simplified customs clearance procedures andthe fact that a Customs broker can make customs payments on behalfofthe client indicate modem customs brokerage practices. Qualified brokers can handle approximately20 clearances per day on average, which is not far from many EU countries such as Latvia (25 clearances). Some inefficiency arises from the Customs IT system Asycuda, which is slow and out-dated. 3.62 However, the industry needs significant consolidation. Consolidation of the logistics industry and provision of "one-stop-shop" services are global trends, which have greatly changed the business in recent years. However, in FYR Macedonia, a vast majority of the international freight forwarders are actually dealingwith customs clearances only, and customs-related services are important business for all forwarders.There are morethan 300 customs brokers, most of them small companies. This is not idealfor logistics buyers. One reason for slow consolidation of the industry is the requirement that logistics providersmust place customs guarantees for each of the above three service functions separately. A more practical way would be to introduce a single guarantee system or "general customs guarantee" under which all functionscould be performed.It would allow more flexible and efficient use of guarantees. Also it would probablyencourage small logisticsprovidersto merge into larger units. F. CONCLUSIONSAND POLICY OPTIONS 3.63 Exports are the only source for sustained economic growth in FYR Macedonia, a small country. Unfortunately, being land-locked, its products face higher transaction costs to reach customers, and it therefore has to work harder to drive exports. On the other hand, it does have an otherwise favorable location, being in the midst of the EU, the largest market in the world, and its long-term development prospects are enhanced by prospective EU accession, as previous accession experiences have shown. Thus, the overall impact of location could be positive or negative, depending on how FYR Macedonia handlesthe situation. 3.64 Export performance so far, with one or two exceptions for specific products, has lagged that of neighboring countries and been unable to provide a fillip to growth, except recently. And even this below-average export growth has been too dependent on metals and apparels, both of which are 52 vulnerable-metals to world price and ongoing domestic energy re-pricing and apparels to increasing competitionfrom Asian countries. One demonstration of this vulnerability could be the rather sharp fall in exports duringthe ongoingglobal economic crisis. 3.65 These emergingweaknesses in exports would require urgent remedial measures that target both priceas well as non-pricefactors. Policy optionsthat couldbe considered include: 0 Reducinglabor taxes (chapter 7), a measurethat can in the short-term help to improve export competitiveness overall, since FYR Macedoniais vulnerableto competition from lower-wage countries. The measure would also partially mitigate the impact of energy re-pricing on energy-intensive firms, and reduce the handicap of small firms, who pay proportionally higher percentageof wages as taxes. 0 Moving towards the establishment of a single CEFTA-wide market with at least one freedom-that for movement of goods-to reducetransactioncosts, reduce protectionand so improve prospects for exports, attract FDI, and lower prices.Inturn, this would entail: 9 Adopting the EU Common External Tariff to replace the current MFN tariffs, and reducing industrial import tariffs under the SAA to zero, to reduce tariff dispersion and trade diversion, and improveexport competitiveness. 9 Pushing for a free trade regime in agriculture, at least within CEFTA 2006 countries, along with mutual recognition of SPS standards and certification procedures (through synchronized harmonization with CEFTA countries and Turkey with the acquis communautaire), to improve input access for agro-processingfirms and improve market access for exports and reducetransactioncosts. 0 Lowering barriers to entry into exports, since the `superstars of the future' often tend to emerge from a new set of firms. This includesaction to lower the cost of entry into exports, particularlyfor potential exporters, such as a careful, target-orientedpilot program on export promotion, located within Invest FYR Macedonia; and action to improve standards, rural export-orientedinfrastructureand agricultureextension services. 0 Improvingcustoms clearances and physical inspectionprocedures (including introducingrisk management systems, supportingwider usageof simplified customs procedures, and reducing delays in physical inspections), to reduce the implicit tax on exports, minimize the costs of tradingand encourage entry into exports, and enable faster growth of logisticsoutsourcing. 0 Reducingdelays in phyto-sanitary inspections, veterinary inspections, and market inspections which rely on 100 percent checking of all goods, and take a minimum of one day for clearances. Solution should also include reviewingthe necessity for such inspections when goods are importedfrom the EU, for example. 0 Allowing a single guarantee for all logistics functions, to encourage efficiency and reduce costs of outsourcing, and promote consolidationof the logistics industry. 0 Helping the logistics industry to evolve to provide constantly-improving services, to minimize the costs for customers, of whom the majority (at least numerically) tends to be small firms. Actions here could include introducing a clear regulatory framework that stipulates the roles and responsibilities of buyers and sellers of logistics services, to tackle 53 issues relating to liabilities of carriers; and helping the industry to constantly monitor and benchmark the industry's performance. 0 Taking further action on other issues that are relevant for exports, dealt with in other parts of the report. For example, exporting firms are more concerned about contract violations, land titling, cost of financing, electricity and telecommunications, which are the subjects of chapters 4-6. And adequacy of skills could be a looming issue, already evident in the IT sector (Chapters 7, 8). 0 FDI is critical for exports, since it brings in improved technology. FDI in supply chains also helps domestic firms, especially the predominant smaller firms, to overcome marketing constraints. The ability to attract good quality FDI is dependent first on a good investment climate and adequate infrastructure;consideration of incentives should only come in later, if necessary. These issues are discussed in Chapter 4. 3.66 Addressing these constraints should help raise the growth of exports and, in time, allow diversification towards a mix of more skill-based products and a more broad-based pattern of export growth. This, in turn, will help to reduce the dependence on vulnerable products such as garments and iron and steel and also improvethe prospects for a secular improvement inthe terms oftrade. Inthe short- term, of course, garments and iron and steel will continue to dominate exports, and policies outlined above, especially those that can be implementedover the next year or so, such as reducinglabor taxes and improving customs clearances, can help to prevent erosion in their competitiveness. Also, closer approximation to EU's trade policy and standards will help FYR Macedonia's accession prospects and ease the adjustment needed in the post-accessionenvironment. 54 4. THE INVESTMENTCLIMATE:PREPARINGFORFASTER GROWTH A. INTRODUCTION 4.1 A good investment climate is needed for higher investment and growth. Low domestic and foreign direct investment is a major weakness in FYR Macedonia. The average fixed investment rate in FYR Macedoniawas about 17 percent of GDP over 1996-2006 (18.2 percent in 2006), much lower than the 23-24 percent rates for EU10 countries. Faster, sustainedgrowth demands an increase in investment, to equip workerswith additional capital and to bring in new, embodiedtechnology (see Chapter 1). While the investmentrate appears to be picking up recently, it needs to grow and sustain at high levels, as the Growth Commission(2008) suggests. 4.2 Improving the investment climate is a key precondition to meet the economic "Copenhagen" criterion for EUaccession-to have a functioning market economy able to cope with competitivepressure and market forces within the Union. Inaddition, some key aspects of the investmentenvironmentare part of other (political) accession criteria (e.g., rule of law), and in many other areas the policy measures will requirealignmentwith the acquis (e.g. competitionpolicy). 4.3 There have been some significant recent successes in areas relating to the investment climate. FYR Macedonia was one of the top five reformers in the world in Doing Business 2008, reflecting reducingthe time for starting a business, reducingcorporatetax rates and simplifying tax procedures. It also started applying a regulatoryguillotine to licensing procedures, and customs reformsare ongoing. It introduced a new law for improving contract enforcement in 2006. It also successfully attracted two major, high profile foreign investors, Johnson Controls and Johnson Matthey, in automotivecomponents; and has signed Memoranda of Understandingwith French, Turkish and Italian investors; and has also attracted investors in the food processingindustry. Doing Business 2009 records further progress, with FYR Macedonia'soverall rank improving further, from 79 in2008 to 71 in2009. 4.4 However, Doing Business focuses on only one part of the business environment. Sustained investment also demands macroeconomic stability, infrastructure, human capital, finance, and so on. Bringingthese dimensions into the analysisrequires, for example, feedback from firms, as well as surveys and comparisons across country experiences to complement the Doing Business data. Such an approach shows in order to accelerate private-sector and export-led growth in FYR Macedonia, further improvementswill be needed in contract enforcement, pro-competitionreforms, humancapitalformation, infrastructure services, financial services, land titling and access to land and building permits, land use policies, and the process of work permits for foreigners. This draws on FYR Macedonia's own experience as well as that of other countries, which suggestthat faster, private-sectorled growth in the future is likely to accelerate firms' demand for inputs into productionsuch as infrastructure, human capital, finance, and for policiesthat facilitate ratherthan constraingrowth. 4.5 To rapidly converge to per capita income levelsof around $10,000, FYR Macedoniawill need to address the problems that firms complainabout most (and are likely to complainabout in the future), and to ensure that they do not affect more than a small minority of firms. For FYR Macedonia,this will also mean payingparticular attention to the concerns of small firms, which comprise 99 percent of all firms. Unlike in many other countries, small Macedonian firms seem to have problems in growing (and in starting to export), affecting the dynamism of the economy and rendering these firms vulnerable to 55 competition(such as in the dairy sector, see Chapter 8).j9 Thus, while firm entry is not a problem, doing businessand growing, despite recent improvements, remains a concern. 4.6 Inthe past, energy subsidies were one factor in attractinginvestment in certain sectors like metals and cements. Owing to the ongoing adjustment in energy pricing to market-driven levels, FYR Macedonia will face additional challenges to attract investment.The response to this emerging situation will have to come from improvements inthe investmentclimate and business productivity, reducinglabor taxes (see Chapter 7), as well as improving government investmentexpenditures. 4.7 This chapter exploresthe priorities for reform arising from business surveys and case studies of foreign and domestic investors. The initial part of the chapter deals with the diagnostics,focusing first on the universe of all firms, followed by foreign firms and small firms. Thus, Section B looks at ongoing and possible future concerns of business, using the BEEPS surveys6'. Section C focuses on the foreign investor, analyzing the feedback from some prominent investors and a few 'failed investors' (primary information collectedfor this report), and also looks at the role of incentivesin attracting FDI. Section D focuses on the expected role of small firms in an emerging economy, and the constraints faced by small firms in FYR Macedonia.Section Eproposes a twin strategy that focuses both on small as well as foreign firms. After the diagnostics, section F picks up on some of the critical cross-cutting reforms identified earlier-ontract enforcement,property rights, and reformsthat promote competition-and suggests some options for reform (or points to other parts of the report where relevant, such as Chapter 8 which summarizes case studies ofthree sectors). Section G summarizes and concludes. B. GROUNDREALITIES:BENCHMARKING,INDUSTRY PERCEPTIONS STUDIES, INVESTOR Doing BusinessIndicators 4.8 The Doing Business indicators (which are based on the legal framework and implementation performance) show that FYR Macedonia has made significant strides in many areas that it covers, but lags well behind in some key dimensions. Table 4.1 shows that FYR Macedonia improved its overall ranking from 79 in the 2008 rankings to 71 in 2009, out of 181 countries. Within the universe of countrieswith small populations(population of less than 3.9 million in this case), FYR Macedoniaranked at 30 out of 59 countries in 2008. Most significantreforms over the last few years have taken place in the realm of starting a business. Areas where Doing Business indicates lagging performance include employing workers, dealing with construction permits, closing a business, and registering propertyn6' Some of these issues will come up later in the chapter. j9 While competition is to be welcomed, the point here is that firms are constrained from competing on an equal footingwith foreign firms owingto the constraintsto growthandtakingadvantage of scale economies. 60 The Business Environment and Enterprise Performance Survey (BEEPS) was developedjointly by the World Bank and the European Bank for Reconstruction and Development. Based on face-to-face interviews with firm managers and owners, BEEPS is designedto generate comparative measurementsin such areas as corruption, state capture, lobbying, and the quality of the business environment, which can then be related to specific firm characteristicsandfirm performance. 6 ' Interpreted in a broader way, the situation in the area of employing workers may be somewhat better than that indicatedby the Doing Business methodology. In general, the data may be less indicative of FYR Macedonia's average situation, since the vast majority of firms are very small (see sectionD inthis chapter), whereas DB surveys enterprisesthat are larger (for example, in 'employingworkers', the surveyed company should be a limitedliability company that has 201 employees). Also, most recently, the authorities adopted changes to the Labor law which introduce greater flexibility in labor relations by extending the duration of fixed-term contracts and limiting restrictionson night shifts andannual leave entitlements. 56 4.9 To get a Table 4.1: FYR Macedonia'sDoingBusiness Indicators2008-2009 complete picture o f the Ease of... 2009 2008 investment climate, Doing Business 71 79 Doing Business needs to Startinga Business 12 21 be complemented by Dealingwith ConstructionPermits 152 151 studies of industries and Employing Workers 125 130 firms, investor RegisteringProperty 88 94 perception surveys, and GettingCredit 43 51 other relevant analysis ProtectingInvestors 88 84 that can provide PayingTaxes 27 32 information about Trading Across Borders 64 76 macroeconomic stability, Enforcing Contracts 70 81 infrastructure, finance, Closinga Business62 129 130 skills, etc. " Industry Studies 4.10 For the purposes of this report, three industry case studies were conducted in early 2008, including detailed case studies of firms in these industries. While details of the findings and industry- specific concerns are discussed in Chapter 8, some important common themes that emerged were: One, availability of skills i s already a constraint to expansion for many firms, especially in IT, and even for firms wanting to move upscale in garments production. One short-term option, that of importing skills from overseas, was provingto be ineffective owing to long delays ingranting work permits for foreigners. Two, poor land titles are a constraint for accessing credit, especially rural credit, and also reduce incentives to invest in land. Three, enforcement of contracts i s a concern for many o f the firms interviewed, and also affects access to credit (Chapter 5) and telecom costs (Chapter 6). All these issues are discussed later in this Chapter and in other parts of the report. The BusinessEnvironmentand EnterprisePerformanceSurvey (BEEPS) 4.1 1 Governments pay close attention to business perceptions and opinions about the investment climate, This is because perceptions influence investment decisions, partly because they are the investors' reality, but also because perceptions are a valuable pointer to real problems. Many different surveys o f perceptions are available, but the messages are not very different, which imparts more credence to the results. Perhaps the best-known survey in the ECA region is the BEEPS, the last one having been done in 2005 (one is ongoing in 2008).63 4.12 The problems o f doing business changed very significantly between 2002 and 2005. In 2002, FYR Macedonia was recovering from civil strife, and emerging from a year o f negative growth. In this situation, business was most concerned about potential macroeconomic instability (Table 4.2), and regulatory policy uncertainty. By 2005, when the next survey was done, the situation had improved 62 Although FYR Macedonia ranks very low on this indicator, firms seem to be able to declare bankruptcy quite easily, which meansthey are effectively closed. They do this, for example, to evade debt (see sectionEl). 63 Are the 2005 survey results relevant? The government has beentaking action on many of the issues identified in 2005 and earlier, so it might be argued that the reform priorities would have changed. While this is possible, this chapter argues that: (i)the key problems identified are likely to remain, since they are not subject to easy fixes- even as there are changes in emphasis on each issue, given progress since 2005; (ii)the higher growth seen since 2005 could easily have exacerbated some of the problems, including infrastructure; (iii)comparing with a higher- income and higher-growth country like Slovakia (see next sub-section) provides one clue as to where future problems may lie for FYR Macedonia. Also, when making final recommendations in Section F, the BEEPS results arejuxtaposed with more recent information from domestic and foreign firm case studies. 57 significantly, and growth, for the second successiveyear, was in the 4 percent range. Cost o f finance was the biggest concern, followed by concerns about anti-competitive practices. Tax rates were more o f a concern in 2005 as compared to 2002, as was functioning o f the judiciary. Thus, as Table 4.2 shows, the problems of doing business problems changed in a very big way, since 2005 was a more `normal' period, in which concerns such as finance, anti-competitive practices, contract violations, etc., dominated. 4.13 Many other areas, including infrastructure, Table 4.2: Percentageof Firms Indicatinga Major or Moderate posed growing problems. Obstacle inDoingBusiness:2002 and 2005 The percentage of firms 2005 2002 citing energy as a cost of finance 62 62 Macro instability problem for doing Anti competitivepractices 57 61 Uncertainty of regulatorypolicies business rose from 13 to Contract violations 56 50 Functioningofjudiciary 24 percent between 2002 Corruption 54 49 Corruption and 2005; for telecom, Functioningofjudiciary 53 48 Taxrates from 11 to 24 percent; Tax rates 53 45 Anti-competitivepractices and for transport, from 16 Access to finance 50 45 Customsadmin. to 19 percent (Table 4.2). Memo: Infrastructuresectors O f course, all the major Telecommunications 24 10 problem areas in 2005 Electricity 24 13 were those where the Transportation 19 16 perceptions of constraints Source: BEEPS2002 and 2005 increased compared to 2002, in some cases significantly. Finally, areas where perceptions improved significantly include macroeconomic instability (as might be expected after the conflict ended), uncertainty about regulatory policies, and organized crime. Gazingintothe Future 4.14 Ideally, policy-makers would like to have a crystal ball about the future and anticipate business problems before they arise. Fortunately, there are some ways to at least develop some hypotheses as to what these might be. One approach would involve comparing the perceived constraints vis-a-vis a benchmark (more advanced) country, provided the methodology for gauging the constraints is the same. The BEEPSenables such an approach, since it is done across all emergingeconomies in ECA. 4.15 The comparison in Figure 4.1 shows large gaps in 2005 in business perceptions of constraints between FYR Macedonia and Slovakia, the reference country. The biggest gaps were seen in cost of finance (35 percentage points more firms complained in FYR Macedonia than Slovakia), access to finance as well as business licensing (3 1 percentage points), corruption (29),64tax rates (27) and customs and trade regulations (27). This can be interpreted as saying that if FYR Macedonia is to emulate many elements of Slovakia's model of development (a good role model in the neighborhood, see chapter 1); it may have to make considerable progress in the above areas. Another way of saying this is that to rapidly 64Corruption is a complex and multi-facetedissue and not amenableto easy fixes. FYR Macedoniahas nevertheless improvedits rankings in the Transparency Internationalcorruption indices recently, from 105 in 2006 to 84 in 2007 and further to 72 in 2008. It is also ranked at the top amongthe Western Balkancountries except Croatiain the latest World Bank Governance Indicators,but lower than all the EUlO countries. Thus, in 2007, it was ranked 13`h among 18 countries of EUlO and the Western Balkans, see httrx//info.worldbank.orP/Povernance/wgi/mc chart.asp. Further reduction in corruption will require addressing the underlying causes over the long-term, in a multi- dimensional framework, including but not limited to taxation, customs, courts, procurement, asset declarations, etc. Slovakia, the comparator country, has had notable successes in dealing with corruption (see World Bank 2006d, Anti-Corruption inTransition3). 58 converge to per capita income levels of around $10,000, FYR Macedonia may need to ensure that problems in cost o f and access to finance, licensing, taxation, etc., are not widespread and do not affect more than a small minority of firms-failing to do so may result in significant constraints to rapid growth. These reforms will be a particular challenge given the dominance of small firms in overall GDP. It should be noted that in all the above areas (and one or two other areas), Slovakia saw dramatic Figure 4.1: BEEPS Perception Gaps -- Slovakia improvements in the BEEPS indicators over and FYRMacedonia, 2005 2002-05, which would have contributed to its significant and steady increase in the growth rate: from 4.8 percent in 2002 to 6.6 percent in 2005, and to over 10 percent in 2007. Also, 30% while there is no doubt that FYR Macedoniahas improved since 2005 in all the areas where there 20% is a big gap (finance, licensing, etc.), Slovakia 10% would have also improved. The point is in order to continue to grow, FYR Macedonia 0% would need to close the gaps in constraints faced by business (using Slovakia as a suitable comparator). If adequate improvements are not made and a significant fraction of firms - complains about the business environment in critical areas, this is likely to affect growth. 4.16 Does the absence of infrastructure and human capital in the perception gaps imply that these are not priorities for reform? Not really. The answer lies in the distinction between stocks and flows. It is quite plausible that while the stocks of infrastructure and human capital were more or less adequate in 2005 (corresponding gaps between BEEPS perceptions in Slovakia and FYR Macedonia were not in the top six list), they may become constraints if faster growth (as happened in 2007 and likely in 2008) is sustained, unless investments keep pace with GDP growth. 4.17 the perceivedinfrastructure, On constraints Figure 4.2: Private Sector Share in GDP vs. Skills and Education Constraint, 2005 were increasing, and much faster than other countries in Private Sector Share in GDP (%) vs Skills and Education Constraint, 2005 the region (Chapter 6). Between 2002 and 2005, the average increase in the share o f firms citing infrastructure constraints was 72 percent (or an average of 9 percentage points, see BEEPS Table 4.2). Moreover, exporting firms had far greater problems 1 50 55 60 65 70 75 80 85 with infrastructure, with 52- Private Sector Share in GDP, % 57 percent of firms citing telecommunications and electricity as obstacles (see Chapter 6). On the other hand, government investment as well as overall investment has been low, despite picking up recently, which implies slow increase or even depletion in the overall stock o f infrastructure (Chapter 1). Another way of saying this is that the contribution of capital to GDP growth needs to increase significantly if GDP growth is to improve and then sustain itself (Chapter 1). 59 4.18 On human capital, the concern has to do with quality and the ability of labor supply to keep pace with private-sector-ledgrowth (see also Chapter 7). While most ofthe newjobs in recentyears have been created in low-skill activities, there are concerns about supply of skilled labor, which can impede faster, sustained growth. Several factors point to this. One, the case studies done for this report showed skill constraints emerging in ICT and apparel sectors (Chapter 8). Two, firms that showed faster growth in exports and output reportedmore problemsin finding workers with the right skills (BEEPS 2005). Three, the demand for labor can increase very rapidly with rising FDI and increasingintegrationwith the EU, as the experience of EUlO countries shows. Four, there is a strong relationship between private sector activity and skill constraints. Countrieswith more private firms, on average, find skill availability to be a greater constraint, given that private firms are more productive and dynamic than socially-owned enterprises (see figure 4.2 and Kathuria, 2008). Since FYR Macedonia's share of the private sector in GDP is around 65 percent (EBRD data), there is still plenty of room to increase this share (Albania and Bulgariahave 75 percent). Five, if and when this private sector-ledgrowth increases, the poor quality of education outcomes in FYR Macedoniacould result in wages for skilled labor being bid up to levels that would slow down such growth. 4.19 In addition to the above, sustained export growth will demand moving up the skill chain towards more skill-intensiveproducts,which again calls for improvingeducation outcomes as well as training (see Chapters 3, 7). C. THE FOREIGN INVESTOR ForeignInvestmentPerformanceand Perceptions 4.20 FYR Macedonia's FDI inflows have been low. With roughly 4 percent of the population65of South East Europe, FYR Macedoniaaccounted for only 1.3 percent of FDI in the region in 2006 and 0.66 percent in 2005.66Its FDI stock per capita was 1028 per capita (Table 4.3), lower, for example, than Serbia, Montenegro, Bulgaria, Romania, and the average for SEE countries. While FYR Macedonia witnessed a surge in FDI in late 2007 and the first three quarters of 2008 (US$412 million inthe first half of 2008 compared to US$ 104 million in the same period of 2007), the challenge is to sustain this, even abstracting from the ongoingglobal crisis. Inaddition, giventhat capital flows are currently at a premium (FDI inflows into FYR Macedonia slowed significantly in the last quarter of 2008), countries that offer enhanced competitiveness including a sound investment climate would probably be relatively less affectedby the decline in capitalflows. 4.21 Foreign investor perceptions confirm the above picture. A survey of 304 existing and potential investors from Asia, North America and Europe in 2006 (see FIAS (2007)) found that6': 0 Only 2 percent of potentialinvestorshad good or rather good knowledgeof FYR Macedonia's business environment (compared to Albania's 3 percent, BiH's 7 percent, Romania's 32 percent); and more internationalmanagers (nearly 50 percent) reported that they had `very bad knowledge' about FYR Macedonia's business environment compared with other countries (see Annex 4.1, Figure A). (This would likely have changed now because of the government's aggressive foreign investment promotioncampaign in 2007 and 2008). 0 Optimism about the future was strong for SEE as a whole, but 8 percent of international managers expected FYR Macedonia's investment attractiveness to decline over the next three 65Source:UnitedNations DepartmentofEconomic and Social Affairs, 2007. 66Source: Vienna Institute of International Economic Studies, 2007 67The SEE sample includes Romania, Bulgaria, Croatia, Serbia, Bosnia and Herzegovina, Montenegro, FYR Macedonia,Moldovaand Albania. 60 years, a higher percentage than any other country. Also, in terms of investor optimism about the future, FYR Macedonia was far below average, and only higher than Albania and Moldova. Table 4.3:FDI Inflows to South EasternEurope in millions 2000 2001 2002 2003 2004 2005 2006 2007 FDI stock per (est.) capita Albania 155 232 143 158 278 224 259 300 603 Bosnia & 159 133 282 338 534 421 338 400 676 Herzegovina Croatia 1,138 1,502 1,197 1,785 990 1,425 2,838 2,500 4,577 FYR 189 493 83 84 126 80 279 240* 1,028 Macedonia Serbia 55 184 504 1,204 777 1,265 3,504 3,500 1,119 Montenegro 5 76 44 53 393 644 600 1,943 Bulgaria 1,103 903 980 1,851 2,736 3,103 4,104 4,000 2,047 Romania 1,147 1,294 1,212 1,946 5,183 5,213 9,082 7,000 1,432 Slovakia 2,089 1,768 4,397 1,914 2,441 1,694 3,324 ... 3,339 South East 3,946 4,746 4,477 7,409 10,678 12,124 21,048 18,500 1,636 Europe Source: Vienna Institute of InternationalEconomicStudiesFDIdatabase. * Actual figures basedon NBRMdata, March2008. 4.22 Political and economic stability is an overarching influence on site selection, when analyzing the factors that investors look for when makingtheir decisions to invest. According to the FIAS survey cited above, 42 percent of surveyed investors believed that political stability should be the top priority in improving FYR Macedonia's investment attractiveness. This is confirmed in other surveysa6'A combination of the results of these surveys shows that most companies are attracted by domestic market size, even if they are export-oriented, since it anchors their investment and reduces the risk of depending on exports. FYR Macedoniacannot offer this attribute, although its regional integrationwithin CEFTA and EU accession path can help, at least partially, to overcome this handicap. Other factors include EU economic and regulatory harmonization, and cost and quality of labor (more details in Annex 4.1 and FIAS 2007). Some ofthese issues will be dealt with inmore detail below. Feedback from "Johnson and Johnson" 4.23 There has been much fanfare surrounding the two recent large FDI projects won by FYR Macedonia. Both Johnson Controls (JC) and Johnson Matthey (JM) are global leaders in their respective fields in automotive components. JC's initial $40 million investment in automotive instrumentation printed circuit boards is slated to create about 150 jobs. JM's $75 million investment in catalytic converters could create about 300 jobs. It would be interestingto see to what extent the pre-investment expectations of these firms are being met, and what challenges they face during implementation. A synopsis of such feedback alongwith the reasons for site selectionis presentedinAnnex 4.2. For example, a survey of ChiefExecutiveswas done inthe mid 199Os, askingabout site selectionpriorities in the automotive and electronic industries in Central and EasternEurope. The survey is relevant because at the time of research, the Czech Republic was at a broadly similar stage in the pre-accessionprocess as FYR Macedoniatoday (see Annex 4.1 for details). Another survey cited in FIAS (2007), done by AT Keamey, points to market size and politicalstability as the top determinantsofFDIinSEE countries. 61 Figure 4.3: DifferencesBetween Foreign and Domestic Firms (major obstacle) 50% 45% 40% 35`/o 30% 25% 20% 15% 10% 5yo 0Yo Axess to Title or Customs Uncertainty h t i - land leasing of and trade about competitive land reguIations regulation practices policies Source: BEEPS 2005 4.24 Although there have been a number of positives, significant concerns have surfaced in these two cases. For both companies, decisive factors in favor of FYR Macedonia includedeconomic and political stability, cost efficiency allied to labor availability, the provision of suitable property and a pro-FDI Government (see also Box 4.1 which echoes many o f these issues in the case of a prominent `failed investor'). Low taxes, incentives and training grants also played key roles. However, implementation experiences highlight the lack of progress in land and building issues (one of the companies was granted planning permission the week the building was completed, and the other had to draw on high-level political support to sort out simple planning, environmental impact assessment and building control issues). Another major problemarea that has surfaced is the inordinately longtime that it takes foreigners to get work and residency permits. 4.25 In addition, the BEEPS 2005 data shows that there are some areas where there were significant differences between the perceptionof foreign-owned and domestically owned firms already operatingin FYR Macedonia. A significantly larger percentage of foreign firms complained about major obstacles arising from anti-competitive practices, uncertainty about regulatory policies, customs and trade regulations,andtitle of and access to land. 4.26 To provide compensation for their relatively inadequate investment climate, governments try to attract foreign investment by offering a range of incentives. This approach often succeeds in attracting foreign firms, but it could occur after a `race-to-the-bottom', where the highest bidding country wins out. A cost-benefit analysis is rarely undertaken in this process. In general, FYR Macedonia, like other countries, would benefitfrom providing incentivesthat are limited in scope and duration, transparent, and subject to an ex-ante evaluation, so that the country has some idea about the trade-offs it is getting into. Box 4.2 provides more detailed considerations and an approach to dealing with the issue of incentivesin the EUcontext. 62 Box 4.1: Feedbackfrom Prominent `Failed Investors' 3ne of the few identified69failed investor companies, Hella KGaA Hueck (a leader in automotive lighting technology, from Germany), decided to invest in Romania in 2007 after having shortlisted FYR Macedonia as well. An interviewwith the head o f the company's site selection team i s summarized below. The clinching factor in Hella's decision appearedto be the number and quality of IT-relatedgraduates. Craiova in Romania, a city with half o f Skopje's population, got the nod owing to strong faculties within the University of Craiova (25,000 students) in disciplinesof interest to Hella: Hella is in fact working very closely with the University. Some other companies could also fall within the category o f failed investors, though none went as far as Hella in the selection process. FIAS' Invest in the Western Balkans (IIWB) initiative in Vienna has motivated several companies to visit FYR Macedonia, but the constraints encountered thus far tended to relate more to the product and place rather than price and promotion. Sojitz Europe, the subsidiary of a leading Japanese plastics company, could not find a suitable partner. Julius Heywinkel, a prominent German automotive components company, was concerned that FYR Macedonia could not meet their plastic injection molding quality standards. Schomacker Federnwek, the German truck suspension producer, was also concerned about quality standards. Paris-based Teleperformance, a leader in the provision of customer relations management and business process outsourcing solutionswith 72,000 people, chose Tirana on account of the ability to more readily recruit Italian-speakingstaff. Synopsis of Hella Feedback on how FYR Macedonia rates vis-a-vis Romania Cost of labor EU membershipwill hrther inflate wage costs in Romania, giving Skopje a slight edge; this will be short-lived given that limited supply will also inflate IT salaries in Skopje. Availability of Labor Craiova (Romania) has a deeper and wider pool of I T graduates. However, Hella has concerns about the brain drain acceleratingin both countries. IT-related skills Hella was certainly not convinced that it could readily find the quality of programmers it needed in Skopje. Economic policy and Hella was not convinced that there existed a broad political consensus about the political stability importance of FDI and so had some qualms about a possible change in government, Governance/ Corruption The Hella team noted that FYR Macedonia had a poorer ranking within the Transparency International index (Macedonian - 84`h; Romania - 69Ih;2007) but added it would expect to see similar levels of `incentive seekingbehavior' in both countries. Taxes Tax was `not an issue'. The company had mixed views about the appropriateness of being encouraged to establish operation within the Technological-Industrial Development Zone (TIDZ). Incentives/Training grant The company was specifically interested in training grants and other subsidies to help keep operating cost moderate during the start-up period. However, none of this could compensate for concerns about skills availability. Status of EUaccession EU membershipwas not a major factor. On the one hand, it could be a disadvantage if it accelerates the `brain drain' but on the other hand it could mean freer movement of IT professionals NATO Membership Membership was not a site selection issue although Hella appreciated how important it was for FYR Macedonia 69The system of keeping logs and records on prospective investors (so that follow-up can be done systematically) in FYR Macedoniais very inadequate. This makes it much harder to identify genuine failed investors. 63 Box 4.2: The Debate on Incentives and FDIin an EUContext Governments all over the world use incentives-including tax concessions, training grants, provision of land and buildings, etc., to attract FDI-in the hope that this will generatebenefitsto the domestic economy in excess of the foregone revenues. The strongest theoretical argument in favor of such incentivesrests on potentialspillovers of technology and skills to local firms (if it was merely employment, domestic firms could do as well as foreign). However, the potential spillovers can only be realized if domestic firms have sufficient skills and motivation to absorb foreigntechnology and skills (Blomstrom and Kokko, 2003). In a practical sense, it is difficult for any governmentto eschew altogetherthe use of incentives, given how widely prevalent these have become. Indeed, in the EU, while certain kinds of incentives are `kosher', all EU members need to have an EU compliant incentives and state aid regime. FYR Macedonia, unlike previous enlargement countries (which had to fully comply with state aid rules only on the date of accession), has already had to start aligning its state aid regime (chapter 8 of the acquis) with the EC, and state aid is part of its SAA with the EU. Thus, its capacity to provide incentives is already circumscribedby the acquis. Achieving compliance with EU state aid rules will require both legal amendments and institution building measures. Whereas the law on state aid has been aligned with the acquis, the law on technological-industrial development zones remains incompatible with EU state aid rules. In particular, the nature and selectivity of state aid in these special zones need to be changed to achieve full compliance. Moreover, implementation and enforcement will require further strengthening of the administrative capacity of the Commissionfor Protectionof Competitionand building awareness among all public bodies (state aid grantors). Exclusivity rights over long periods can well conflict with the EC competition acquis, based on Articles 86 and 87 o f the EC Treaty. The acquis takes a strong view against exclusivity rights which distort competition. Revoking such rights or benefits could be very costly, as FYR Macedonia found in the case o f OKTA. The state had to pay over 40 million euros, some 1 per cent of GDP, for abolishing OKTA's exclusivity right for imports of crude oil. The agreements with MAT (expiring in2009) and the telecoms companies (terminatedrecently), could also prove costly. Avoiding such type of contracts in the hture (including with investors in the special economic zones) would help avoid similar problems inthe future. Overall, EU policy towards state aid has been shifting towards "horizontal" (cross-sector) objectives. The three most important horizontal objectives in the EU are environment, regional aid and R&D, accounted for 57 percent of total state aid. Other important areas include SMEs, employment and energy. There are no limits per se on the amount of state aid, but the aid has to be well targeted. In 2005, the EU Member States granted more than 60 billion of state aid, which is some 0.6 percent of GDP. The amount of state aid in the I O new member states was even higher, 0.9 percent of GDP. FYR Macedonia, given its stage of development, would do well to emulate this, focusingon the horizontalobjectives while limitingthe amount of state aid. In addition to commitments under the acquis, Macedonian policy-makers would maximize the chances of generating net benefit to the economy from incentives if they filter each investment, ex-ante, through the technology and skills spillover lens. Considerations in evaluation could include: i)the extent of planned local purchases by the foreign firm; ii)the demand for high-skilled workers from the local economy; iii)the firm's plans to get involved inthe local economy e.g., with universitiesto help improvethe quality and targeting of teaching. In addition, government should ensure that there are no opportunities for rents if the firm also intends to sell domestically. D. PERCEPTIONS OF SMALL FIRMS AND THEIR ROLEINGROWTH 1.27 Small firms are essential for the growth and dynamism of any economy, and more so for small countries like FYR Macedonia. Small and new firms bring in new ideas and competition for established firms, and some of them eventually join the ranks of the leading firms. Of those that stay small, many establish synergistic relationships with large firms, supplying goods and services to them, while the large 64 firms often help them to access finance and technology. Many small firms do not survive; but their dynamism means that many others do survive and grow, some eventually joining the leagues of the largest firms intheir countries. 4.28 Unfortunately,FYR Macedonia's industrial structure does not evolve from this virtuous pattern. FYR Macedonia's economy is dominatedby small firms-so far so good-but most seem to be unable to grow and contribute dynamically to the economy. They are faced with many problems, some of which affect them differently from larger firms-these included corruption, anti-competitivepractices of other firms, contract violations, etc. (see below). In addition, small firms' involvement in exports, a recurring pattern in successful export growth, is very low (Chapter 3). And their lack of growth hurts exports as well, since, after a point, growth is virtually synonymous with exports in a small economy. 4.29 Macedoniandata shows high new firm entry rates and reasonable survival rates. Total number of firms operating rose from 36,514 in 2002 to 48,779 in 2006, an increase of 34 percent.Micro-level data from the Central Registry shows that around 30 percent of the firms operating in 2004 and 2006 were established in the previoustwo years. Such birth rates would compare well with European countries.70 However, around 25 percent of small and medium size firms which were active in 2002 disappeared by 2006.7'At the same time, only between 60-66 percent of small and medium firms in 2002 which were still active in 2006 remained in the same group of enterprises. Most of the ones that changed groups actually fell in size. 4.30 Most firms however seem unable to grow. Table 4.4 shows Table 4.4: Structure and Transition Matrix of Firm Size that 25,3 13 firms survived into 2006 2006 from 2002 (starting from a total of Micro Small Medium Large Total 36,514 in 2002). Only a third of 2002 Micro 22,826 670 45 3 23,544 such firms reported increased Small 391 755 72 5 1,223 employment between 2002 and Medium 64 78 269 7 418 2006, with the others reporting no Large 6 7 26 89 128 change or a reduction in Total 23,287 1,510 412 104 25,313 employment. Around 97 percent of Note: The rows show firm status in 2002; the columns show firm status the micro firms (less than 10 in 2006. For example, 670 micro firms in 2002 became small firms in workers) in 2002 remained micro 2006; and 391 small firms in 2002 became micro in 2006. Source: World Bank staff calculations based on micro-level firm data from firms in 2006. Only around 3 CentralRegistry. Definitionsby size are basedonly on employmentand percent of micro firms grew into differ from SSO methodology. small firms and only around 0.2 percent into medium sized firms by 2006. While small firm growth is a problem in most countries, the relativenumbers in FYR Macedoniaseemto providemore cause for worry. 4.3 1 The increasingdominance of small firms is already evident in past data. The share of small firms (SSO definition) in the total number of firms rose from 97.9 percent in 2002 to 98.6 percent in 2006, and their share in value-added rose from 47.3 to 53.3 percent over the period, while that of large firms declined.72Over the last decade, there has been a decline in the number of, and employment in, large ' OWhile data is not directly comparable, average entry rates of new firms were around I O percentfor 18 European countries (Eurostat Statistical Books,2007 edition, page25). 7' To some extent, the firms that disappeared may have registered under another name and identity number, especially since inrecent years it hasbecome mucheasier to start a new firm. 72 Definitions differ.Inthe analysis of the micro-level data from the Central Registry, firms were classified by size only according to the number of employees. Entities with less than 10 employees were classified as micro enterprises, between 10-50 employees as small, while those between 50-250 employees were mediumenterprises. 65 entities, accompanying structural reforms in the railways, electricity distribution, iron and steel and metal miningand processing. 4.32 Lack of growth i s also seen inthe low contribution o f larger firms to value-added, especially in a comparative context. Table 4.5 shows that 99 percent of Macedonian enterprises were (again reflecting good entry conditions), a structure similar to the Czech Republic and Poland. However, medium and large firms contributed only 52.5 percent to overall value added (and 36 percent to employment) in FYR Macedonia; the figure was 63.5 percent in the Czech Republic and 73 percent in Poland. Post-entry, Macedonian firms seem to suffer from roadblocks which lead to their growth being stunted. In fact, 96 percent of the small firms in FYR Macedonia are actually micro firms, with less than 10 workers. Ifanything, this pattern may be reinforced with the reforms that are now taking place. Doing Business data (Table 4.1 FYR Macedonia's Doing Business Indicators) shows that entry conditions have been greatly eased, with FYRMacedonia ranked 12'h in the list o f countries. But in many other areas, the country continues to lag significantly, creating hurdlesfor small, new firms to grow. Table 4.5: Distributionof Value added and Employmentby Countriesand Firm Size in 2004 No. of enterprises Employment Value added Small Medium Large Small Medium Large Small Medium Large EU-27 98.8 1.1 0.2 50.6 16.9 33.1 39.0 17.9 43.0 Bulgaria 98.2 1.6 0.3 50.6 21.0 28.3 30.1 19.3 50.5 CzechRepublic 99.1 0.8 0.2 50.2 18.7 31.1 36.5 20.2 43.3 Estonia 96.6 3.0 0.4 Lithuania 97.0 2.7 0.3 48.8 26.3 25.0 Latvia 95.2 4.3 0.6 43.4 27.9 28.7 31.0 25.7 43.3 Hungary 0.1 27.8 48.1 Poland 98.9 0.9 0.2 51.8 18.5 29.7 27.2 20.6 52.2 Romania 97.1 2.3 0.5 35.7 22.5 41.8 25.4 19.1 55.5 Slovenia 98.4 1.3 0.3 21.6 Slovak Republic 93.1 5.5 1.4 28.7 22.5 48.8 25.1 17.3 57.6 FYR Macedonia 99.0 0.6 0.4 63.8 13.6 22.6 47.5 13.0 39.5 Source: EuropeanBusiness, Facts and Figures, 2007 Edition - Eurostat StatisticalBooks (p.30). For FYR Macedonia, staff calculationsbasedon SSO SNA information,data is for 2005. Datarefers to non-financialbusiness economy. 4.33 A stylization of the evolution o f industrial structure could be that firms are able to enter new businesses easily, but not many get into exports. Thereafter, many o f these small firms die, but even more take their place. Over time, the share of small firms in value added grows, but only because of their sheer numbers. Only very few o f these firms become medium-sized, and even fewer grow large enough to challenge the dominance o f existing large firms and provide the next generation of business leaders. 4.34 In this context, it is useful to look at the constraints faced by small firms in particular, which is possible in BEEPS. Figure 4.5 shows that in 2005, small firms (less than 49 workers) faced Entities with reported employment above 250 employees were classified as large. According to the SSO methodology, a small enterprise has less than 50 workers and revenues and fixed assets below Euro 2 million. A medium sized entity employs up to 250 workers and has revenues (fixed assets) of less than Euro 10 (1 1) million. All other entities are classified as large enterprises. Enterprises in the financial sector as well as state bodies are considered large by default. 73 According to SNA information from the State Statistics Office (SSO). Data refers to non-financial business economy, defined as NACE sectors C to Iand K. 66 disproportionateand significant problems in the areas of corruption, anti-competitive practices of other firms, and contract violations. In addition, the cost of finance was a concern for more than 60 percent of the small firms (even more so for large firms, but large firms have diversified sources of finance)74.On the other hand, larger firms seem to be concerned about tax rates and regulatory policy uncertainty, and also more worried than small firms about tax administrationand macroeconomic instability. Figure 4.4: Percentage of Firms IdentifyingFactorsas an Obstacle, by Firm Size I n 7 n . I Source: BEEPS 2005 4.35 Given that small firms have tended to stay small, the above can also be interpretedas indicating some of the key constraints to small firm growth. These constraints seem to affect additional revenue creation and profitability. On the other hand, the key problemsofthe larger firms appear to be either those that affect business predictability or erode profitability (taxes reduce profits for firms that make profits, and in that sense are ex-post issues). Of course, given that 74 percent of the firms in the 2005 BEEPS sample were small, the concerns of small firms are very muchthose of the overall sample (see Table 4.2). Ifsmall firms are to grow bigger and play a more dynamic role in the development of the Macedonian economy, policy would need to relieve at least some of the key constraints for small firms (see also Chapter 3 for a similar issue on exports). In addition, all firms, whether big or small, are likely to face increasing skillconstraints as they grow, as documented in Chapters 7 and 8. E. A NO-PRONGED POLICY THAT SUPPORTSFDIAS WELLAS SMALL FIRMS 4.36 FDI is clearly attractive for host governments, the presumption often being that once a few foreign firms come in, economic problems are on their way to being solved. While it is true that foreign firms can create pressure for reforms,they can also do the reverse, pushingto preserve any advantages or rents that policy may have explicitly or implicitly granted to them (an example beingthe pressure to keep high tariffs on Australian car imports once foreign firms became entrenched producers in Australia; another example is the telecom privatization in FYR Macedonia in 2000, where the new private monopoly was able to delay effective competition in the market till recently-see Chapter 6). If these pressurescan be resisted, the experience of many countries shows how FDIcan be a factor in a country's prosperity.The example of Slovakia's overall success shows not only the importanceof high investment, a well-educated labor force, etc., but how these factors can help the economy to reap high benefits from the foreign investment. 4.37 Governments often pay special attention to foreign firms, but a policy that focuses on economic reformsand infrastructurethat benefitoverall export-orientedgrowth is likely to prove more beneficialto ~~ ~ 74 Note howeverthat reformshave occurredinmany areas in finance, as elaboratedin chapter 5, so the situation has improvedsignificantly since 2005. However, these and other, second generationreforms need to continue in order that banksrespondbetterto the needs ofnon-traditionalclients. 67 the economy. In fact, research shows that reforms encourage FDI. A recent paper, for example, finds a strong effect of structural reforms on FDI (Campos and Kinoshita 2008). This reinforces the earlier message, viz., FDIpolicy should focus first on structural reforms and provisionof infrastructureand only then on incentives. This would also make it more likely that FDI would focus on genuine comparative advantage rather than reapingrents. In addition, reforms that improve education, infrastructureprovision and the environmentfor small firms will also enable the economy to extracthigher benefitsfrom FDI. 4.38 Thus, in FYR Macedonia, the economic policy framework should focus on reforms that will support small domestic firms as well as FDI. Small firms are the backbone of the economy, and giving weight to their concerns would be highly appropriate. At the same time, these policies will encourage FDI, which is importantto move up the technology ladder, improve productivity and diversify production and exports. As stated in the previous section, these FDI firms can and should develop in synergy with local firms, which will also depend on structural reforms. 4.39 As far as overseas investmentpromotiongoes, it is apublic good that most governments supply. With more general awareness of FYR Macedonia having been built up recently as a result of the government's promotion campaign, future FDI promotion would benefit from being more targeted, such as by working with emerging and existing industry clusters and showcasing their progress. Also, streamlining the internal organization of investment promotion within FYR Macedonia and clearly delineatingresponsibilitieswould help to reduce costs and improve investor confidence. Finally, a pilot program for export promotion of non-traditional sectors, as noted in Chapter 3, could be a useful additionalrole for InvestFYR Macedonia. F. CRITICAL CROSS-CUTTINGREFORMS 4.40 Thus far, the chapter analyzesthe concerns of different kinds of firms. Not surprisingly,there are common concerns as well as those that are more specific to the type of firm. Many of the issues raised are dealt with in the thematic chapters of the report. This section deals with some of the most important cross-cutting reforms identified above (and in the industry studies in Chapter 8) and not analyzed elsewhere inthe report, and suggests options for reform. F.1. Contract Enforcement 4.41 Contract violations are a serious concern in FYR Macedonia, almost peculiarly so. In BEEPS 2005, 56 percent of firms found contractviolations to be a pr~blem,~'up from only 37 percent in 2002. The similar average figure for SEE firms was 46 percent in 2005. Duringthe field survey of firms in 2008, many complained about non-payments (see Chapter 8).76 Also, the case studies on contract violations done for this reportY7'on which this section is based, suggest that there is much scope for improvementin contract enforcement. 4.42 Why are contract violations a problem?One, becauseof the effect on the overall reputationof the country (can affect FDI as well as domestic investment), since respect for contracts is one of the basic tenets of doing business. Two, it affects business expansion, since firms faced with potential broken contracts tend to do business with those they know and trust. Three, it also reduces the extent to which 75Includingfirms reportingthis problemas a moderateobstacle or major obstacle. 76Despitethe undoubtedimprovementin contract enforcement(as notedin this section and also recorded in World Bank, 2008d, "Doing Business ZOOS"), significant problemsremain. 77 This section is based on analysis and case studies of contract violations done by Mens Legis Cakmakova Advocates, Skopje. 68 large firms trust their suppliersand providethemwith technology and finance, a common phenomenon in many countries (see Chapter 5).78 Four, it also affects lending by banks, both because repayments are uncertain, andthe solvency of a borrower is not easy to gauge when the latter is facing court litigation on outstanding contracts. Again, these problems are magnified if more and more firms are trying to grow (notice the almost 20 percentage point increase in BEEPS above), in a context of faster overall economic growth. 4.43 Better enforcement of contracts can help not only to reduce the time and expenses related to contract enforcement, but also reduce contract violation in the first place (i.e., delinquent behavior, ex- ante). In FYR Macedonia, on the other hand, contract enforcement is a long and costly procedure, unpaid debts are a common feature, courts are cloggedwith debt cases, exacerbatingdebt collection procedures and providingincentivesfor public and private entities to build up debt. 4.44 Outstanding debts and court disputes among legal entities are widespread, and involve both private and public entities. Privatefirms owe tax and social service paymentsto state authorities; in some cases, parts of the broader public sector owe privatefirms (and sometimes other parts of the public sector) for delivered goods and services. While debts of households towards public utilities (both private and state-owned) are an important feature of the Macedonian business environment, this section focuses on contract enforcement relating to debts between businesses, and between businesses and financial creditors.(See Chapter 6 for issues relatingto non-payment of telephone bills by individuals). 4.45 To address some of these concerns, the authorities passed a new law on enforcement of court decisions, which entered into force in May 2006. The new law abandons the requirement for courts to approve enforcement decisions-once a court decision is passed, and the period for voluntary settlement expires, the court decision becomes enforceable. Second, the creditor can use a private enforcement agent" to collect claims from the debtor. Third, enforcement allows recourseto all property of the debtor, unlike the previous law where only the bank accounts of the creditor could be used to pay off debt. Most recently (September 2008), the civil procedure law (or Litigation Law) was also amended to strengthen provisionsrelated to delivery of summons and further shortendurationof court cases. 4.46 The new law on enforcement of court procedures has improved outcomes. Enforcing a court decision in the previous law, in force since 1997,was very slow and inefficient, and would typically take from 3 to 5 yeamgoAccording to unofficial data, only between 3 and 5 percent of court decisions were actually enforced. Recent data (from the Ministry of Justice) under the new law shows that 27 percent of the total enforcement requests were realized in 2007; the number of cases reported rose 138 percent between January-March 2007 and January-March 2008; and the value of enforced claims rose by 25 percent over the same period. This probably points to increasing efficiency of and confidence in, the system. 4.47 Despite the noteworthy efficiency gains, several legal and institutional weaknesses, some outside the judicial system, continue to hinder further improvement in enforcement of contracts. One, unclear property rights and weaknesses in the cadastre system remain a major obstacle. Enforcinga contract in a situation of unclear property rights requires additional (long) procedures to determine 78The absence of trust induces `relational contracting', but this has obviously limited growth in FYR Macedonia, unlikethe case of Vietnam, where suchcontractshave sustained a boomingprivatesector (Rodrik 2008). 79Private enforcement agents are persons with a public authorization, appointed by the Minister of Justice on a competitivebasis after passing a professional exam for executors. 80As enforcement is a right guaranteedby the EuropeanConventionfor protection o f human rights and fundamental freedoms, the weaknesses in the enforcement procedure led to numerouscases against the state before the European court for humanrights. 69 ownership status, the more so whenjudges and the cadastre staff do not seem to cooperate well with each other (see Section F2, and World Bank 2005a). 4.48 Two, while the new enforcement law reduced substantially the time to enforce a court decision, there is plenty of room to shorten court procedures (Le., to reach a court decision). The delivery of court summons is one of the biggest bottlenecksin this process. The delivery can only be done by the courts' delivery services that not only lack staff and technical equipment but, more importantly, incentives to efficiently performthe service.8' Moreover,judges rarely use their right to speed up delivery procedures by, for example, posting a notice on the court's notice board in cases where delivery attempts to the address of the party registered in the Central Registry have failed. The recent amendments to the civil procedure law should help in reducingsome ofthese delays. 4.49 Three, court procedures are also slowed by the judges not exercising their mandated authority over their cases, and poor administrative capacity in courts. Courts allegedly often accept ungrounded objections, leadingto long litigation procedures. For example, debtors often claim that they have had no relationshipwith the creditor, and the court accepts such objections (see Box 4.3). The legal requirement for all evidence to be presentedat the preliminary(or at latest the first) hearingis not always respectedby judges. Presenting new evidence during the court process prolongs the process. In addition, the courts' documentation system is outdated, which often results in files being lost. In such cases, the court requires that these documents be re-submitted, resulting in delays and more expenses. Again, the latest amendments require reopened hearings to be completed within 30 days which should help shorten court procedures. Box 4.3: Ungrounded objections lead to long delays in collections A year after delivery o f goods, the selling company had yet to receive payment from the buying company. It decided to file a warrant for payment against the debtor inthe Basic court in Kavadarci,and presentedsubstantial evidence to support its claim. Two weeks later,the court approvedthe warrant for payment. However,the debtor submitteda one-sentenceobjection, statingthat he did not know the creditor andhadnot establishedany creditor- debtor relationship. The court acceptedthis objectionand initiateda litigationprocedure. It took several months beforethe first hearing: the first two court summons was not delivered; thereafter, the debtor twice requested to postpone the hearing. At the first hearing, the debtor claimed that he had not received any goods from the plaintiff, The court asked for an expert analysis of the documents, which provedthe claim of the plaintiff, The debtor continuedto claimthat goods hadnot beenreceived.The court then requestedthe warehouse employees to be brought in as witnesses, who confirmedthat the goods had been received.After one year, the court reached a decision in favor of the creditor, but the debtor filed an appeal, which took another four months. The claim was finally enforcedafter almost two years. ISource: MLCA Case study 4.50 Four, collectingclaims is not certain even after a court decision is reached, as firms often use all possible legal loopholesto delay/avoidpayment. Debtorsoften dispose of their assets prior to the start of the enforcement procedure by dividing the firm into two new entities, one that inherits all assets and the other that takes over liabilities (and goes into bankruptcy). Inone case, a firm had to sue seven parties to collect its claim because the (single) debtor kept transferring its liabilities to other firms. Another case shows firms usingdelayed payments for working capital as long as possible, knowingthat the returnwill offset their court and interest expenses when the contract is eventually enforced through the judicial system. This problem may have escalated since the introduction of the one-stop-shop for business registration, since debtor firms can now easily transfer their assets to a newly established firm. The Practice has shown that the court delivery service has poor discipline and management, and is often used to manipulateand influencethe court process. 70 creditor is entitledto submit a law suit to annulthe debtor's transactions undertakenwithin the six months prior to obtainingan enforceable decision. However, ifthe debtor files for bankruptcyafter thejudgment, the recovery of the debtor's assets becomes more complicated with the authority to pursue and annul debtor transactions givento the trustee for the benefitof all creditors. 4.5 1 Five, enforcing a contract in FYR Macedoniatakes even longer ifthe plaintiff is a foreign party. Foreign parties are required to deposit funds as warranty for court costs, unless FYR Macedonia has signed a reciprocity agreement with the plaintiffs country of origin. Judges, on many occasions, ask the plaintiff to prove that such an agreement exists, whereas such information should be available to the court. Enforcing a foreign court's decision can also take a long time even in cases where mutual recognition of court decisions exists. Courts have to seek an opinion from the Ministry of Justice to determine ifreciprocityexists, and gettinga responsetakes a longtime. 4.52 Further improving enforcement procedures in FYR Macedonia would require legal amendments as well as changes in the "judicial culture". For example, allowing private delivery of court summons would shorten substantially court procedures. Other ways to expedite delivery could include making it obligatory for judges to allow delivery by a Notary Public if a party so wishes (currently a discretion used insufficiently by judges), and providing necessary resources to improve the court delivery service. Removing unnecessary procedures should also have a big impact (e.g. the obligation of the plaintiff to show that a reciprocity agreement with foreign courts exists). Introducing comprehensive case management systems in courts would cut down the errors and delays that occur in the current, hand-processed, system and reduce the administrativeworkload borne byjudges. (Such a system is under development and is expected to be rolled out to all courts duringthe course of 2009.) Improving judicial capacity is a longer-termprocess, but very critical to achieve efficiency gains. Trainingjudges to use the tools and authority they have within the existing laws to discipline and better manage court proceedings, provides one such example. Providing judges with at least one assistant or court clerk would also improvetheir efficiency. 4.53 Of course, avoiding court settlements is often a simpler and less expensive solution. To avoid courts, firms need to be aware of all legal remedies to collect claims. The most efficient way is to secure claims and avoid court procedures: this is done by including an "enforceable clause" in the contract. To include this clause, the contract must be prepared as an enforceable notary deed or be solemnized by a Notary Public, and involves certain costs (fee would range between 40 and 180). Mediation-a cost- saving and fast procedure-is another possibility, but has not been sufficiently used in FYR Macedonia. This owes to lack of awareness, but more importantly to other relevant sector legislation (e.g. cadastre, ministry of internal affairs, social security services, banks, etc.) not being harmonizedwith the Law on Mediation. Amendments need to be made to these laws to allow for rights, granted through a mediation procedure, to be incorporated. F.2. Property Rights and the BusinessEnvironment 4.54 Some 50 years of socialism and neglect of private property rights meant that, at the start of the 21'' century, property records in FYR Macedonia were incomplete and out-of-date. Confidence in the registration and cadastre system was low and 60-70 percent of apartments were not registered at all. Dwellings were built on state property (most private property was nationalized after WW I1 and is currently subject to restitution, further complicating matters) or other natural or legal person's property. Also, there were (and continue to be) numerous cases of unregistered ownership rights, burdens and mortgages on real estate, as well as non-transferredmortgages from the courts in the real estate cadastre. The lack of confidence and difficulty caused by incompleterecords has negative effects on private sector 71 investment and overall development of the economy: many land transactions are not registered, contributingto the overall deteriorationofthe records and a loss oftax revenue for the government. 4.55 Another direct consequence of unclear property rights is the constraints on collateral and mortgage financing, making it difficult for citizens and investors to raise funds for investment and expansion. Foreign investment, in particular, is affected by the inability of investors to find land with clear title (i.e. state land with no potential counter claims or private land with clear tenure rights), a problemthat applies to all categories of land- residential, commercial and agricultural. This can be seen in Table 4.4, where titles and access to land are a much bigger concern of foreign-owned firms than domestic ones. This could be becauseforeign firms would find it harder to `work the system', and would find more comfort in legal safeguards. However, as seen in Chapter 8, the issue of titles remains a major problemacross all types of firms, for reasons mentioned above. 4.56 The government has recognizedthat good private property rights are a sine qua non for growth and market-based development. The EU accession process also requires an equitable and efficient property market and a functioning property registration system. Since 2005, the government has been working with the World Bank's support to improvethe property market, as described below. 4.57 The government's reform priorities are inthree areas, relatingto the cadastre, landadministration, and land policy. About 84 percent of FYR Macedonia is currently included in the real estate cadastre. However, work is yet to be completed in the large cities where investorsare most likely to be interested. Speeding up the process of establishing the real estate cadastre without sacrificing data quality and completeness is a key challenge. But titling alone is not sufficient. In countries with an informal or limited formal property market, it is important to also improve the quality and efficiency of land administration services (surveying, registration) to ensure that property transactions stay in the formal system and that the system continues to provide security of ownership.The 2009 Doing Business Survey finds that FYR Macedonia takes on average 66 days to register a property (this has come down very significantly as a result of anew Law on the Cadastre, introduced in March 2008); in Serbia, this figure is 111 days; Croatia 174 days; Bosnia 128days. FYR Macedonia is ranked 88 in registeringpropertyversus 71 in the overall ease of doing business. Finally, land policy in FYR Macedonia is shaping to change from an approach geared to central control over land use, to one that refines the policy and regulatory framework for private property ownership, leasing and transfer. These include such issues as: formalizationof informal settlements and registrationof illegally constructed buildings; simplification of the process and mechanisms for access to land for investment; fees and fee structure on property transactions; land valuation and property taxation; land use planning and development control; and state land management. Of these, the government has identified security of registeredrights (indemnification); access to land for investment (including improving land use planning); and state land management as immediate priorities. F.3. Reforms that PromoteBusinessand Retail Competition 4.58 Competition is a critical element of the business environment. It can help create a level playing field for all firms, irrespectiveof size. It can help create confidencethat it is worthwhile for firms to enter the market. Competition in crucial upstream sectors (such as services) can generate low prices and better quality of services that are critical to the economy's functioning, such as pricing of telecom services. Competition can help ensure that firms are treated equally (for example, it can help avoid the situation where a state-owned utility company is softer on bill collections with a politically connected company). Competitionin downstream sectors such as retail can help keep retail prices under control and ensure that productivity improvements get passed on to the consumers, and so contributeto improve the standard of living. 72 4.59 Business Competition, A recent OECD working paper finds that the index of competitive reforms worsened in FYR Macedonia over 2001-05. The index is a compilation based on 13 different indicatorsof investment,trade and competitionpolicies.'* This is also consistent with the BEEPS story on competition, although improvements are occurring more recently. As seen earlier, foreign-owned firms found anti-competitive practices to be the single biggest obstacle to doing business in 2005 (Figure 4.2). And for the overall sample of firms, anti-competitive practices were a far bigger concern than in 2002 (Table4.2). 4.60 While competition is a very wide concept, some of its business-related dimensions are addressed in this report, especially in the chapters on finance and infrastructure. At this stage, suffice it to say that to attract more and better quality investment, and to service the anticipatedfaster growth in the future, the overall competition environment will need to improve more to alleviate the concerns of business, especiallyforeign-ownedbusiness. For example, more competitionwould help reduce prices and improve frequency of air transport, to further improve financial services and reduce telecom prices and encourage a wider range of services (Chapters 5, 6). And strengtheningof regulatorycapacity and the competition authority can help reduce perceptions of unfair regulatoryforbearance. Giventhat foreignfirms and small firms find it more difficult to `work the system', strengtheningthe institutions and competitionwill help to allay their concerns in an open and transparent manner, and significantly improve the framework for FDI and small firms. On the other hand, implementation of strict product quality standards (following EU norms) would reduce upholding firms' perceptions of unfair competition from firms that do not conformto such standards. 4.61 Retail Competition, To test the hypothesis that the Macedonianenvironment limits competition and thereby affords retailers some power to set prices, World Bank economists compared retail prices of 15 identical (and freely traded) food and hygiene goods in countries of South East Europe as well as Greece and Belgium (benchmarks). The average prices of the identified goods in SEE countries (see Annex 4.3) are, unlike what may be expected, not much lower compared to the old-EU benchmark countriesand in some cases they are even higher (e.g., for instantcoffee, tuna fish or chocolate cream). 4.62 The above data is consistent with the suggestion that there is only limited market competition in SEE countries. Producers and retailers in older EUcountriesface stiffer competitionwhich drives excess profits down. Despite growing competition in recent years, this is obviously still not the case in SEE- price variability across countries and products and the often higher prices than EU countries, suggeststhat there is some arbitrariness and therefore market power in pricing decisions. Explanations include incomplete trade integration-obstacles to trade still remain, preventingthe region from functioning as more of a single economic area and thereby reaping the fruits of contestability. And there is no single retail chain represented in all countries in the region. In addition, behind the border barriers and poor institutional anti-trust capacity increase information asymmetry and allow price discrimination. These factors, combined with the small size of individual country markets, mean that it is harder to attract large retail chains that could have helped in increasing competition and cuttinginto possible rents. G. CONCLUSIONSAND POLICY IMPLICATIONS 4.63 Governmentshave to pay attentionto a wide variety of stakeholders. They needto prioritize their tasks in order to have maximum impact on the economy. See Miroudot et a1 (2007). The index worsened from 0.57 in 2001 to 0.59 in 2005. The indicators encompass several from the Doing Business database. It is possible that the situation may have started improving since the index was compiled, given the significant improvementin the DoingBusiness indicators on starting a business, and trading across borders. 73 4.64 This report argues for a twin-pronged economic strategy that pays equal attention to the concerns of foreign firms as well as small domestic firms (which overwhelmingly dominate the size distributionof firms in FYR Macedonia). It also argues policy reforms are the most effective way to attract sustained and quality FDI. Foreign-owned firms will of course benefit from overall policy reforms. But they also seek more comfort in some other specific areas. The case studies of foreign investors, alongwith BEEPS 2005, suggest that more progress is needed in reforms that help reduce anti-competitive practices and promote increasing competition; reduce policy uncertainty; improve land titles, access to land and building permits; improvethe visdwork permit process; and alleviatepossible shortages of skills in areas such as IT. Humancapitalformation can have very high payoffs, especiallywith growing labor shortages in Europe-the example of Craiova shows how universitiescan be a decisive factor in the FDI selection process. Other examples of human capital playing decisive roles in investment decisions include the whole Ireland story, as well as the University of Cambridge in the UK attracting high-tech firms in its vicinity. 4.65 The overallclimate for private sector investmentin FYR Macedoniahas improvedin many ways, as documented in this chapter. However, increases in growth can exacerbate some problems and bring forth new ones, as even the moderate increase in growth between 2002 and 2005 showed. To support faster and more sustained growth, continued improvements will be needed in some areas that were important inthe past; and new areas, such as infrastructureand humancapital, will need more attentionto prevent growth and export bottlenecksfrom emerging. The following paragraphs provide some policy options to address concerns of foreign and domestic firms. These priorities emerge from analysis and judgment based on multiple sources of information-industry/firm studies, interviews with existing foreign investorsand lost investors, FIAS foreign investor surveys, the BEEPS surveys, Doing Business and analysis of relevantexperience of other countries. 4.66 Reduce investor uncertainty by increasing predictability of economic policies. Policy predictability improvesinvestorconfidence significantly, and any reinforcementof such predictabilitycan be useful. Reinforcingindependence and capacity ofjudicial and regulatory institutions can help in this process. In addition, the data indicates that a reduction in political uncertainty will help improve the prospects for foreign investment, in particular. 4.67 Further improve contract enforcement. Contract violations affect business expansion, trust between suppliers and buyers, and lending by banks. In FYR Macedonia, outstandingdebts and court disputes between legal entitiesare widespread. The government's May 2006 law on enforcement of court decision has shortened enforcement procedures, and led to increasing realizations and value of claims enforced. This has also led to an improvementin FYR Macedonia's Doing Business ranking in this area. However, much remains to be done to improve actual results on the ground, as suggested by case studies of firms (Chapter 8) and contract violations (this Chapterhspecially since the increasingsimplification o f registeringnew firms is making it easier for entities to strip assets and transfer these to new entities. Suggestionsto improve enforcement include: 9 Shortening court procedures (such as by allowing private delivery of court summons;fully implementing new procedures added to the Litigation Law); 9 Introducing comprehensive case managementsystems in thecourts; 9 Empoweringjudges (through trainingl) to use the tools and authority they have to better control the courtprocedures (see section F.1in this chapter for details). 4.68 Improve land titling and land use policies. Property records in FYR Macedoniaare incomplete, especially in the larger cities, despite recent progress-many land transactions are not registered, many 74 others are disputed (between people, or betweenpeople and the state, for example>-and in general, there is lack of clarity in land records. This has negative effects on collateral and mortgage financing, including rural credit, and on FDI. Foreign investment, in particular, is affected by the inability of investors to find land with clear titles. Moreover, enhanced property records is one of eight "benchmarks" that the EC has put forward as key preconditions for opening accession negotiationswith FYR Macedonia. Speeding up the government's reform program in three areas will promote FDI and credit flow: 9 Accelerating the establishment of the land cadastre, especially in large cities; 9 Improving land administrationservices; 9 Developing a modern land usepolicy so that land rights are secure and land can be usedfor investment in the context of a transparent policypamework. 4.69 Increase the pace of pro-competition reforms in several dimensions. Anti-competitive practices were ranked as the most important concern for foreign-owned firms, and the second-most important concern for small firms. The complaints on this score increased significantly between 2002 and 2005. The government would need to allay concerns relatingto unfair competition as well as cost of business services in several dimensions. For example, more competition could help to reduce prices of infrastructure services such as air transport and telecommunications and encourage a wider range of services; strengthening of regulatorycapacity and the competitionauthority can help reduce perceptionof unfair regulatory forbearance. Given that foreign firms and small firms find it more difficult to `work the system', strengtheningthe institutions and competition will help to allay their concerns in an open and transparent manner, and significantly improvethe framework for FDIand small firms. On the other hand, implementation of strict product quality standards (following EU norms) would reduce upholding firms' perceptions of unfair competitionfrom firms that do not conformto such standards. 4.70 Evaluate future FDI incentives and promotion with explicit consideration of costs and benefits, and only as secondary to overall structural reform and provision of inpastructure. The potential technology spillovers from FDI to local firms (the greatest benefit of FDI) can only be realized if domestic firms have sufficient skills and motivationto absorb foreign technology. This meansthat overall structural reforms, infrastructure and human capital improvements should take first priority in Government policy-making. When incentives are provided, policy-makers would need to keep these within FYR Macedonia's commitments under the acquis rules on state aid. In addition, any potential foreign investment should be evaluated for its interaction with the local economy, including local purchases, demand for high-skilled workers, and plans to get involved with local developments (such as interactionwith universities). Also, with'more general awareness of FYR Macedoniahavingbeen built up recently, future FDI promotion would benefit from being more targeted, such as by working with emerging and existing industry clusters and showcasing their progress. Authorities could pay close attention to these issues in evaluatingFDI, and to other specific policy concerns of foreign firms, which have ramificationsfor overalldevelopment: 9 Promoting a reform-oriented agenda (structural reforms, human and physical capital improvement) as the best way to attract high qualityforeign direct investment; 9 Evaluating costs and benefits of any FDI incentives porn the viewpoint of potential interaction with the local economy; 9 Closely monitoring the implementation of the new law that allows foreigners andforeign entities to own land (a new law was passed in Parliament in July 2008, addressing a major concern of foreign investors); 9 Reducing the time lag in awarding land and buildingpermits; 75 > Shortening theprocess and time lagfor awardingforeigners a work visa; P Streamlining the internal organization of investmentpromotion within FYR Macedonia and clearly delineating responsibilities would help reduce costs and improve investor confidence. 4.71 Finance. The overall situation has improvedsubstantiallysince 2005, with interestrates declining and more competition emerging in banking, leading to increased availability of financial services and credit. However, providing competitive credit to small firms and the agriculture sector remains a challenge.Continuationof ongoing reformsand further, second generationreforms are neededto increase private credit (especially for non-traditionalcustomers) and mobilizing more loanablefunds to strengthen savings (see Chapter 5). 4.72 Infrastructure and human capital. Firms' perception of infrastructure constraints rose significantly between 2002 and 2005 (and exportersmay already have been constrainedby 2005), and is likely to increase further if private investment and growth increase in the future, unless infrastructure services keep pace. Similarly, humancapital could quickly become a major problem for firms as growth accelerates, as the experience of EU10 countries shows. Given the long-gestationnature of investments in infrastructureand, even more so, human capital, actionto alleviate possible future constraints in these areas are likely to have high payoffs. These issues are addressedin Chapters 6 and 7. 76 5. FINANCE INFYR MACEDONIA: IMPROVING ITS CONTRIBUTIONTO DEVELOPMENT A. OVERVIEW 5.1 Credit and financial services remain a potential constraint for growth in FYR Macedonia, although the situation has improved. Since 2005, credit to firms and households grew, interest rates declined, new financial services spread and FYR Macedoniamoved into the top 50 countries on the ease of getting credit according to Doing Business 2009 (covering the period June 2007-June 2008). Nonetheless, further improvements in the volume of finance and access to financial services would contributeto higher investment, savings, and growth, as well as improved welfare. These improvements will depend on second generation reforms related to strengthening the information and collateral frameworks for credit and to further increases in competition in the financial sector, which in some cases are interrelated. Such improvements are particularly important for access to credit by smaller firms, which, as discussed earlier, are the backbone of the economy. There is also a need to emphasize how these frameworks operate in practice,which is always an issue in order to make laws and institutionshave their desired impact. Finally, it is important that the government continue with its reputation for sound monetary policy. To try to slow inflation and strengthen the system, the NBRM has recently tightened monetary policy by raising interest rates on central bank bills and introducing additional reserve requirements for banks with increases in consumer credits above 18 percent per year. At the same time, it remains important to continue the second generation financial reforms, in order to support allocation of credit to those that can and will use it best. It also remains to be seen how the turbulence in international financial markets will affect Macedonian finance; this reportdoes not deal with this issue. 5.2 Finance to the private sector is an important element in economic growth, as shown by cross country research. Most firms, particularly start-ups and small firms initially depend on "sweat capital" and retained earnings for working capital and small investments. However, their larger investments require outside finance. And, exporters need finance for pre-export costs and for investment, which are often not available from their overseas buyers. Construction of commercial buildings and housing depends heavilyon finance. 5.3 Householdwelfare depends not only on access to credit but also on the quality of deposit and payments services, the latter an important issue for remittances. Deposit services not only offer households a critical avenue for wealth accumulation; when aggregated, these household savings can also provide the most important component in increased aggregate domestic savings. The issues in payments/ remittances are important because of the importance of remittances to many households in FYR Macedoniaandthe large informal sector in the economy. 5.4 Increasing credit in a sustainable way goes beyond the standard short-run tradeoff between increased credit and stability, and, more fundamentally, reflects the longer run issues in bank risk versus bank lending. In FYR Macedonia, the concerns on the risk side of the equation have been reduced, by reasonable bank capital and liquidity ratios, the government's improvement of bank regulation and supervision, and the enactment of a strong new Banking Law. In addition, FYR Macedoniahas avoided dependence on the excessive, potentially volatile capital inflows into the banking system that has characterized some of the countries in the region. These changes should improvethe public's confidence in a sound bankingsystem, especially if accompanied by improvedperceptions of political stability, and lead to an increased ratio of bank deposits to GDP, particularly ifthe strong record on inflation in recent years is maintained. 77 5.5 On the lending side, the NBRM and the government can improve the risk-lending tradeoff and stimulate sound, lower-costcredit by further improving the frameworks for information and collateral in lending, contract enforcement generally, and competition in banking. Banks' competition for loanable funds will also lead to an increase in domestic savings. Although much has been done inthese areas, their impact depends on the details of how the frameworks actually function. Regardinginformation, it would be desirable to examine ways to improve the timeliness and identification of borrowers in the NBRM credit registry. The NBRM could also examine the possibilities for improving information on small borrowersand potential new borrowersthrough its own credit registry or a credit informationsystem run by other institutions. Regarding collateral, the cadastre needs to be finished, the timeliness of records improved, and the collateral registry made easier to use. The new collateral law is a major advance, but it seems time to examine how it is functioning in practice. These changes will help increase competition among banks for customers. This chapter focuses on these issues; it describes the factors affecting the volume and cost of private sector credit and its accessibility since 2002 and makes recommendations for sustainably increasingand improvingcredit and savings while reducingcredit costs. 5.6 Finance for FYR Macedonia's growth and development will largely depend on improvements in the domestic bankingsector. Macedonianfirms' are generally small and their outside finance comes from banks located in FYR Macedonia. Until contract compliance improves, larger firms are unlikely to provide suppliers' credit, as they do, for example, with auto parts suppliers in Japan. The small size of firms and lack of internationalratings mean direct loans from abroad are also not an option, even, in many cases, export finance from foreign buyers. The Macedoniancapital market i s small, reflectingthe small size of the country and the firms;83despite improvements, it is likely to remainsmall for some time. The fully-funded pension system hasjust begun and internationalexperience suggests that even as it grows it would be undesirable for it to provide finance directly to any but the top-rated corporations. Experience suggests that such pension systems have contributed to higher savings rates and are most effective in providing sound retirementincomes when commissions are limited to reasonablelevels. 5.7 Interviews made in conjunction with this report suggest that firms seem ready to grow, but still feel they are constrained by finance (Chapter 8). At the same time banks and the NBRM remain concerned about the riskinessof projects in the context of recent history. There are also issues related to the tradeoffs between stability and growth which are associated with the implicationsof monetary policy for the cost and availability of credit and of financial services to households.As noted, further improving the frameworks for information on borrowers and collateral definition and execution and continuing the ongoingincrease in competitioninthe bankingsectorg4represent a way to ease these tradeoffs. 5.8 The next section discusses the recent development of finance to the private sector in FYR Macedoniaand its cost, focusing on bank finance. Section C will discuss the recent factors affecting the volume and cost of bank finance and recommendations for improvements. Section D will discuss the situation in other areas of finance, in particular access to deposit and payments facilities, and Section E will offer conclusions. B. THEVOLUMEAND COST OFCREDITTO THEPRIVATE SECTORINFYRMACEDONIA 5.9 Finance for the privatesector is a major factor in economic growth. This relationshipreflectsthe link betweenthe volume and allocationof credit and other externalfinance to firms at reasonable cost and ~~ 83 Almost by definition, firms are small in a small country, have small equity, and, as a result, capital market liquidity is inherently an issue, limitingcapital market growth. See Shah and Thomas, 2003. In FYR Macedonia, small firms account for 99 percent of all firms (chapter4). 84 Increasedcompetition can also generate problems for the weaker banks, and the bank supervisor will needto be ready to intervenepromptly inweak banks, as it has recently,to maintainconfidenceinthe bankingsystem. 78 the firms' investment and innovation. The relationship i s particularly important for smaller firms. Access to credit is also important for households, to allow them to smooth expenditure and take advantage of expected future growth in incomemE5O f course, excessive credit growth can lead to problems and is to be avoided through macroeconomic policy. For FYR Macedonia, these issues are particularly important. Firms tend to be small by international standards, and depend on finance for their expansion and innovation. Figure5.la: Private Credit/GDP Per Capita Figure5.lb Private Credit/GDP per Capita 2005 Selected Countries Central and SE Europe 2005 110 100 - 6 0 90 ;:;;r., -' 0.80 - 0.70 - - 6 0.60 . * + v 050 . , ,~ 0.00 4 0.00 0 3000 6000 9000 12000 0 3000 6000 9000 12000 Per Capita GDP in2005 US$ current Per capita GDP US$, 2005 Source: IMF, InternationalFinancialStatistics, line 22d 5.10 Bank credit to the private sector in FYR Macedonia has been growing and has become roughly what might be expected for a country of its per capita income, particularly compared to countries in the region. Bank credit to the private sector has grown from 18 percent of GDP in 2002, to 26 percent in 2005, to 33 percent in 2007 and has increased further in 2008.86 Figure 5.la shows that FYR Macedonia's credit to the private sector in 2005 was already roughly comparable to a group of selected countries with per capita income under US$12,000, although somewhat below a regression line for these countries, which is affected by some low income countries with high ratios of private credit to GDP. Figure 5.1b shows that FYR Macedonia's private sector credit was also roughly what might be expected ** On the relation between growth and private sector credit, see King and Levine, 1993; Levine, Loayza, and Beck, 2000, and Levine, 1997,2003; on the relationbetween access to finance and firm and economic growth see Caprio, Atiyas and Hanson, 1996, and World Bank 2008a, especially chapters 1-3 (which also householdaccess to finance. 86 The data in this paragraph are from the standard source: the volume of private sector credit by banks, the IMF's International Financial Statistics (IFS), Line 22d. Notethat this figure for credit to the private sector includes credit to households, notjust firms, an issue discussed below. Data in some recent studies also include credit from non- banks and bonds, but these sources of finance are small for the countries with per capita income of less than $12,000 (except India) and the omission of this data is not importanthere. Inthe case of FYR Macedonia, the main non-bank intermediaries are saving houses, which had slightly more than 2 percent of the credits of banks in 2005 (NBRM, p. 7). Note also that, as opposed to the IMF data, FYR Macedonian figures for total credits include off-balancesheet assets and potential claims, such as guarantees, letters of credit, etc. and other types of uncoveredrisks, which total roughly four times as much as loans. The IMF data is used for FYR Macedoniain Figure 5.la and 5.lb for purposes o f comparison. 79 compared to countries in the region (see also Figure 5.2).87 In 2005, credit to firms represented over 80 percent of total private sector credit (NBRM, 2006, p. 27), althoughbanks' credit exposure to households had been growingand has reachedabove 40 percent oftotal private sector exposure recently.88 5.1 1 Since 2005, the ratio of private credit to GDP in FYR Macedonia has grown by about 5 percentage points per year and private credit in FYR Macedonia remains roughly in the middle of the countries inthe region(SEE8) by this measure of finance (Figure 5.2). :i E countries in the region with higher levels and faster growth of private credit. These 80 - other countries have financed their faster 70 - n private credit growth with greater 60 - Y +AI bania dependence on net foreign borrowings by 0 0Bosnia8. Hetz n A Bulgaria their banks (a net negative foreign asset 5o A position). Often these banks are Lc4 0 - A X Croatia Macedonia FRY subsidiariesof foreign banks and the loans 30 -~ i 0 Romania are from the subsidiaries' parent 20 - - +Serbia companies. Such links make it difficult to 0Slovenia 1 -+ supervise these subsidiaries. More 10 - importantly, whether such links exist or 0 - not, these capital inflows may reverse 2004 2005 2006 2007 2008 5.13 Despite increasing slightly starting in end-2008, the cost of credit in FYR Macedonia has declined over the last five years, but more slowly since 2005 (Figure 5.3). The spread between average lendingrates and deposit rates also has declined, but again more slowly in the last few years. Moreover, these average figures may overstatethe declines in rates somewhat; because, beginning in 2005, the series on interest rates reflects the inclusion of rates on loans and deposits in denars where the principal is indexed to foreign currency. The inclusion of such indexed rates tends to make both loan and deposit rates lower and limit reportedrises of rates in riskier times because the compositionof loans and deposits 87The countries in Figure 5.1b are Albania, Bulgaria, Croatia, Czech Republic, Hungary, FYR Macedonia,Poland, and Romania. In terms of the ratio of credit to the private sector to deposits, FYR Macedonia was the median country amongthose shown in Figure5.1b. 88Note that this figure i s basedon the NBRM'stotal credit figure; which is much larger than loans, as discussed in footnote 86. Consumer credits andcredit cards are likelyto be a muchlargershare of loans. 80 shiftstoward more indexed instrument^.^^ These changes inthe rates andthe spread reflect changes in the economy, monetary policy and underlyingdevelopments in the financial system, discussed in more detail in Section C. The tightening of monetary policy in 2008 is likely to slow these declines, although at the time of this report informal indicationssuggest that interest rates seem to have remainedstable. Figure 5.3: FYR Macedonia: Interest Rates on CB Billsand Denar Loans and Deposits2002- 2008 20 - -- 20 18 -~ Average Loan Rate 16 14 Average DepositRate 2 2 o r 0 Source: NBRM 5.14 The business response to these changes in interest rates and the volume of bank credit to the private sector was somewhat surprising, accordingto the EBRD-World Bank Business Environmentand EnterprisePerformance Survey (BEEPS) as discussed in Chapter 4. In 2002, business executives did not consider the costs of credit and access to finance as major issues accordingto the BEEPS. At that point, the main issues, according to business executives, were macroeconomic instability and uncertainty of regulation, perhaps reflectinguncertaintiesfollowing the 2001 conflict. The percentages of firms in FYR Macedonia that regarded the cost of finance and access to finance as issues were much lower than the average for eight Southeastern Europe Economies. 5.15 By 2005, concerns regarding the costs of finance and access to finance had shot up sharply among Macedonian business, to become two of the seven most important problems, according to the BEEPS. Sixty-two percent of firms considered the cost of finance to be a problem, nineteen percentage points more than in 2002; fifty percent of the firms considered access to finance a problem, fourteen percentage points more than in 2002. Across the SEE8 region, business executives continuedto consider the cost of finance a problem-the average share of business executives considering it a problem in the eight countries was fifty-seven percent. However, the issue had become more important in FYR Macedonia in 2005 than in any other country in the SEE8 except the then-union of Serbia and Montenegro. 89A rough estimate is that foreign exchange indexed loans account for about 25 percent of loans that are not denominatedinforeignexchange, assuming that they representabout the same percentage as they do in credits.FYR Macedoniahas about 53 percentof loans denominatedin foreign exchange or indexedto foreignexchange, which is much less than the 76 percent average for new EU member states (See NBRM, 2006, pp. 21 and 27). Data on indexeddeposits is availableinthe NBRMReportsonBankingSystemandSupervision. 81 5.16 The increase in firms' sensitivity to the cost of finance in 2005 is somewhat surprising, since borrowing rates had halved in both nominal and real terms between 2002 and 2005 (Figure 5.3). One explanation for the change in business executives' concerns may simply reflect changes in the country's situationbetween2002 and 2005. In 2002, the 2001 conflict hadjust ended. While the situationhad been resolvedand violence ended by the end of 2001, economic activity had dropped sharply and rebounded only marginally in 2002, as measured by GDP. In this situation, business executives were, not surprisingly, more concerned about the macro-economy, had in some cases defaultedon their bank loans, and were not interested in investmentor borrowingto finance it. By 2005, it is probablethat Macedonian businessexecutives hadbecome less worried about the overall situation and more readyto invest. Interest rates on loans had come down since 2002 (Figure 5.3), althoughthe drop had slowed in 2005 for reasons discussed in Section C. Despite the drop, however, business executives complained about the cost of credit much more in 2005 than they did in 2002. One question, discussed in Section Cyis why they had not declinefaster. 5.17 Since 2005, lending rates have declined further and there has been some improvementin the Table 5.1: SEE Countries LendingInterest - access to credit. However,the decline has been slow Rate, 2005 and 2007, percent per year both in absolute terms and compared to some other 2005 2007 countriesin the region, where rates seem to continue Albania 13.08 13.47 to be lower (Figure 5.3) and (Table 5.1)." While Bos. & Herz. 9.61 7.06 FYR Macedoniaranks among the top 50 in ease of Bulgaria 8.66 9.74 getting credit in Doing Business 2009, other Croatia 11.19 9.28 countries in the region have the same or better FYR rankings. Macedonia 12.17 10.23 Slovenia 7.8 5.77 5.18 Access and cost of finance still appears to Note: Refers to rate in local currency, rates; for FYR be one of the main concerns of businesses. Some Macedonia include rates on foreign exchange indexed Macedonian business executives interviewed for instruments. No data reported for Romania and this report continue to express concern about the Serbia, where inflationwas high. cost of credit in interviews. According to the SSO Source: IFS, line 60p; FYRMacedonia:NBRM. Business Trends in the Manufacturing Survey, financial problems were the third biggest constraint to increasingproduction in August 2008. SectionC discusses the various factors in the decline in the cost of credit in FYR Macedoniaand makes some recommendations for further easingthe cost of credit. c. FACTORS AFFECTING THE COSTAND VOLUME OF CREDITTO THE PRIVATE SECTOR C.l. Introduction 5.19 The cost and volume of bank credit to the private sector reflect three main factors that have been improvingover the last few years: 0 the stabilizationof the economy and its impacton interest rates and credit volume; 0 the structureofthe bankingsystem, the main source of finance; and 0 the risks in makingloans and the framework for credit information, collateral, and legal processes. 90 These cross country comparisons of credit costs are difficult, because the FYR Macedonian figures include foreigncurrencyloans inthe average andlocal currencyloans may not be easilyavailable inthe other countries. 82 5.20 The next three subsections briefly discuss each o f these factors, how they have been changing to increase the private sector's access to credit and lower its cost. The subsections also discuss reforms that would help to improve the availability and reduce the cost o f credit. A fourth subsection looks briefly at non-bank intermediaries. C.2. Stabilization and the Cost and Volume ofPrivate Sector Credit 5.21 The slow fall in interest rates in FYR Macedonia, especially in 2005, about which the BEEPS respondents complained, to some extent reflects the strong stabilization efforts o f the government, particularly the NBRM. Immediately following the 2001 conflict, the stabilization o f the economy was a key objective, specifically maintaining price stability through targeting the exchange rate." The NBRM successfully achieved the targets o f low inflation and a fixed exchange rate re the Euro-from 2002 to 2005, average inflation barely exceed 1 percent per year and the exchange has remained at about 61 employment as objective^.^^ As inflation recurred as an issue in 2008, monetary policy has been also been denars to the Euro. As stabilization was achieved, the policy shifted toward including higher growth and tightened again in 2008. 5.22 The rise in loan rates as a result o f the NBRM's stabilization measures at the end o f 2004 and much o f 2005 may be one reason why borrowers considered the cost o f credit a major issue in 2005. Beginning in July 2004, the NBRM set the CBbill rate higher.93 This policy probably played a role in the leveling off o f the lending rate (Figure 5.3). The NBRMaffected the loan interest rate through the sale o f Central Bank bills (CBbills). The CBbill rate affects the lending rate because it is an alternative to loans for the banks after adjusting for loans' additional costs in terms o f reserve requirements, capital requirements, and costs and risks o f defaults on loans. 94 Sales o f CBbills also absorb funds that otherwise might be available for lending.95 In addition, the December 2004 rise in required reserves also reduced 9'"The National Bank of the Republic of Macedonia (NBRM) was focused on achieving the legally defined primary goal - maintenanceof the price stability by conducting flexible monetary policy based on the denar exchange rate targeting strategy (againstthe Euro starting from this year)." NBRMAnnual Report, 2002, page 1, see also page 46 92 See for example, the NBRM Governor's introductions to the NBRM Annual Reports for 2003, and 2004. 93CBbills are the main policy instrument; the NBRMhas also used reserve requirementsto a lesser extent although one major increase occurred at the end of 2004. At different times the NBRM effectively set interest rates on CBbills, at other times, particularly recently, it has allowed the auction market to determine the CBbill rate from the amount ofbills it sold. The NBRMhas usedCBbills to offset the monetary effects of shifts inthe fiscal position, and variations in the current and capital accounts of the balance of payments. In particular, it used CBbills to sterilize the impact of its purchases of foreign exchange as it kept the exchange rate stable by purchasing some $1.3 billion dollars of reserves between the end of 2001 and October 2007, over 80 percent in the last three years. In addition, the NBRM and the government had agreed at one point that NBRM would sell longer term government bills for monetary purposes, to limit the increase in NBRM debt and its rollover problems (but this was suspended in 2008). In 2008, NBRMraised reserve requirementson banks with consumer credit growth exceeding 18 percent per year, to control credit growth. 94It shouldalso be noted that the CBbill rate also affectsthe deposit rate and through it, the lending rate. The CBbill rate represents the minimum that can be earned on an additional deposit, after subtracting the reserve requirements on deposits and costs of deposit-taking and buying CBbills. In 2005 the deposit rate was affected in two different ways by policy. First, the rise in reserverequirementstendedto reducethe demand for deposits and the rate on them and increased the spread with respect to the loan rate. Then, once the higher CBbill rate was sustained, the rate on deposits rose again, and the spread declined. Note also that the movements in Figure 5.3 may also reflect the changingcomposition of the data on the deposit rate, by inclusion of rates on deposits with foreign exchange clauses beginning in 2005 and depositors changing demands for deposits in local and foreign currency. The rates on foreign currency-indexeddepositsare somewhat less than rates on denar deposits. 95Note that it is difficult to say exactly how much the sale of CBbills withdraws from possible lending because, to some degree, the sale of CBbills at a high rate attracts additional funds from abroad. Thus it is hard to separate over 83 the availability of funds from lending. Thus, the NBRMdecision to tighten monetary policy and reduce the risk of inflation contributedto haltingthe decline inthe lendingrate in2005.96 5.23 The corresponding developments of the commercial banks' balance sheets are shown in Figure 5.4. These included the rise in net Figure5.4: FYRMacedonia: Commercial Bank Assets foreign assets in 2003 and 2004 that 2002-07 the NBRM was trying to offset for stabilization reasons, then the rise in I CBbills and net reserves of the commercial banks in 2005. In the last 50 n months of 2005, the stabilization 40 seems to have been judged effective c 0 and the NBRMreturnedto a policy of u 30 E 0 allowing the CBbill rate to be set by $ 20 auction. The CBbill rate declined, as n 10 did loan rates. However, with inflation picking up in late-2007 and 0 the first half of 2008, the Central 2002 2003 2004 2005 2006 Q22007 Bank moved back to volume auctions 0PrivateSector OGov. and Pub. Enterp. [DNet For. Assets and increased the CBbills rate ICbbills ENet Res. NBRM graduallyto 7 percent. Source: IMF, InternationalFinancial Statistics. 5.24 Because the CBbills remain inthe system and "crowd-out'' lendingby absorbingbanks' loanable resources, the stabilizationactivities in 2004 and 2005 continueto have an effect on the amount and costs of private sector credit even today. CBbills rose from about 1.7 percent of GDP in 2003 and 2004 to about 3 percent of GDP in 2005 and 2006, as shown in Figure 5.4.97 In addition, much of the rise in government debt reflects issues of Treasury bills for monetary purposes-this policy was suspended recently. In total, these instruments absorbedthe equivalentto about 15 percent of banks' creditto the private sector inthose years. 5.25 It should also be noted that the use of CB bills, as opposed to government debt, for monetary policy creates a number of issues. First, the central bank needs to issue CBbills to pay the interest it owes, complicatingmonetary policy and perhaps generatingmore crowding-out. As a rough rule of thumb, the stock of such debt will grow (relative to GDP) if the interest rate on the bills exceeds the nominal GDP growth rate, unless the NBRM decides to ease credit. Second, it will be difficult for the NBRM, or any central bank, to find a convenient time to repurchase the bills they have issued-it would require the unusual confluence of a period when monetary policy should be eased but international reserves are strong and growing. (The NBRM and the government have recentlymade efforts to use government debt for monetary policy purposes, as noted in the following paragraph and footnote 93. However, this was suspendedin 2008). 5.26 The changes in bank balance sheets in late 2007 and 2008 suggest that new stabilization efforts have begun in response to rising imported inflation and deterioratingexternal balances, as is necessary in the presence of an exchange rate peg. Naturally, this will raise the cost and limit the growth of private time the exogenous rises in foreign inflows and (the continued) inflows attracted by maintenance of high CBbill rates, andwhat is left after the sales o f the CBbills for lending. 96 Note once again that beginning in 2005 the interest rates illustrated in Figure 3 include instruments that have foreign exchange clauses indexingthe principal ofthe instrumentto foreign exchange, andthus, comparedto earlier data, the data beginningin 2005 may understatethe interest rate. 97Note that a constant ratio of CBbills to GDP meansCBbills are growing at the same rate as GDP. 84 credit. In2007 and 2008, average inflation has risen, reflectingto a large extent the rising import prices of food and energy. Although bank credit to the private sector credit grew, the stock of CBbills has also grown (Figure 5.5), reflectingthe renewed stabilizationefforts in response to higher inflation. In addition, government debt inthe banks hadrisen, from 2 percent of GDP at end-2005 to over 4 percent of GDP. To some extent, this rise probably reflects the agreement between the government and the NBRM for the NBRM to issue government debt for reasons of monetary policy and for the NBRM to pay the interest rate on it; further use of this approach was suspended in 2008 and the NBRM has gone back to using its own debt. As is always the case, the stabilization policy will tend to reduce the availability of private credit and raise the interest rate on it, compared to what it would otherwise be. This effect is, of course, the outcome of a stabilization policy aimed at lowering inflation and reducing external imbalances. NBRM has recently both raised the CBbill rate again and put policies in place to limit consumer credit growth, which will have similar effects. The degree of stabilizationand the instruments chosen reflect the choices on the part of the NBRMregardingthe needto limit inflation and how to do this, even if it means an increase in loan interest rates and slows the economy. C.3. The ChangingStructureof the BankingSector and the Cost of Credit 5.27 FYR Macedonia's concentrated banking sector and Table 5.2: SEE LendingInterestRate and Spread over the initially slow entry of foreign DepositRate banks (compared to the rest of the 2005 and 2007, percent per year region) may have played a role in lending interest rate spread the cost of credit, although these 2005 2007 2005 2007 factors changed in the last few Albania 13.08 13.47 7.99 7.74 years. It is generallyrecognized that Bosnia& Herzegovina 9.6 1 7.06 6.05 3.47 a major factor in the interest rates Bulgaria 8.66 9.74 5.58 6.04 on loans is the spread over the rate Croatia 11.19 9.28 9.48 6.88 paid on deposits. Spreads between FYRMacedonia 12.17 10.23 6.93 5.39 deposit and lending rates have Slovenia 7.8 5.77 4.62 2.25 declined in FYR Macedonia, as Source: IFS, line 60p, line 601(depositrate); FYRMacedonia:NBRM have lending rates, but somewhat Note: Refers to rate in local currency, rates for FYR Macedonia include more slowly than elsewhere in the rates on foreign exchange indexed instruments. No data reported for region (Figure 5.3 and Table 5.2). Romania and Serbia. 5.28 One factor in spreads iS gellerally considered to Table 5.3: FYR Macedonia: Share of be the high concentration in the banking sector in FYR LargestBanks inBankAssets Macedonia.Concentrationis often used as proxy for low 1998-2006 competitior~.~~FYR Macedonia's largest 3 banks percent controlled about 2/3 of bank assets and the largest 5 1998 2002 2006 controlled about 75 percent of bank assets in 2006 (Table Largest3 banks 59 64 66 5,3).99 Concentration has actually increased somewhat Largest5 banks 72* 74 75 since 1998 in FYR Macedonia, and the number of banks qo01 has declineddue to of exits of smaller banks.'" 98 Generally speaking one might expect that an even distribution of bank assets would imply more competition and smaller spreads (lower loan rateshigher deposit rates), although this potential outcome is tempered by the fact that smaller banks, particularly in the early stages of financial development and computerization, tend to have larger costs. 99 By internationalstandards eventhe largebanks are small, with average assets ofabout 1billioneuros. looThe number ofbankshas declined from22 in 1998, to 20 in2002, to 19 in2006 and 18 in2008, withthe closure o f one bank by the NBRM in 2007 and the takeover of one of the smaller banks by the Bulgarian Central 85 5.29 The concentration of banking in FYR Macedonia is somewhat higher than most CEE countries. In Bulgaria, for example, the three largest banks had roughly 50 percent of bank assets in 2002. Only the Baltic countries have similar concentration ratios and their openness may decrease the impact of this concentrationon competition. Partlythe concentrationof bank assets in FYR Macedoniareflects its small size and the economies of scale in banking.Nonetheless,the potential market power of FYR Macedonia's largest banks may have contributedto the slow decline of spreads and lending rates in FYR Macedonia. This factor may have interactedwith the banks' strategy to rebuild their balancesheets after the losses on loans suffered inthe beginningofthis decade. 5.30 The past lower share of foreign banks in FYR Macedonia, compared to other countries in the region, may also have contributed to the slower fall of interest rates and spreads, but recent entry of foreign banks has now put FYR Macedonia on a par with the other countries. Foreignbanks are usually considered more efficient and typically use newer lendingtechnologiesthan domestic banks. They have used these characteristics to gain market share by offering easier loan terms and raising deposit rates comparedto domestic banks, Le., increasingcompetitionthrough lowering spreads.'" Bankswith foreign shareholding(not those of banks) may also providethese benefits but perhaps not as strongly as foreign banks (Le., those owned by foreign banks. In FYR Macedonia, foreign banks (banks with dominant foreign shareholding)representedabout 42 percent (47 percent) of the system in 2004. Their share grew to about 45 percent (53 percent) in 2006 (NBRM, 2006). In2007, their share further increasedto about 52 percent (86 percent), with the entry of a ninth foreign bank, Societe General, and the liquidation of a small local bank. Moreover, in 2008, the Bulgarian Central Cooperative Credit Bank is taking over and merging two of the smaller Macedonian banks; Austria's Steiermarkische Bank is taking over the medium-sizedInvestBanka; and Dutch-TurkishDemirHalk Bank is taking over IK Banka. In September 2008, the share of foreign banks (foreign shareholding) reached 62.5 percent (93.3 percent). Thus, the penetration of foreign banks and bank ownership by foreign shareholders in FYR Macedonia is now similar to the rest ofthe region. For example, in Croatia, foreign banks representabout 90 percent of bank assets; in Bosnia and Herzegovinatheir share is 65 percent; in Slovenia, 63 percent; and in Bulgariaover 70 percent. Of course, some of the new foreign banks in FYR Macedonia are generally less well-known than those in the other countries of the region and it remains to be seen how these new banks will operate in light of the on-goinginternationalcredit crisis. 5.3 1 To some extent, the former lower share of foreign banks and thus their lower impact on spreads may have reflecteda number of factors specific to FYR Macedoniathat are unrelatedto the openness of bank licensing in FYR Macedonia, which is generally considered best practice."* First, foreign banks may have been hesitant to enter FYR Macedonia until after the issues of the 2001 conflict clearly subsided-the political risks discussed in Chapter 1. The policies of the government and the NBRM helped rebuild this confidence, by moving towards alignment with the EU acquis, and this probably encouraged foreign bank entry. Second, the attention of potential entrants may have been diverted away from FYR Macedonia for various reasons. In particular, market players have said that Raiffeisen Bank, which has played a major role in many countries in the region, became focused on entering Ukraine, which probably diverted its attention from further entry into the Balkans.Third, many foreign banks are interested in entering only if they can acquire a large bank and the complex ownership structure of the ~~~ Cooperative Bank in 2008. In addition to banks, 12 savings houses provide deposit services and small loans, but their assets are only about lpercent of the assets of the banks. The number of saving houses has declined through closures andmerger. 101See World Bank, 2008a, chapter 2, and Gianetti and Ongena (2005). lo'FYR Macedoniaplaces no limits on the entry of foreign banks that meet the NBRM's "fit and proper" tests. The 2006 Banking Law is generally considered to incorporate best international practices and approximates EU directives. 86 remaining large Macedonian bank has made its acquisition difficult. Finally, the National Bank of Greece, after acquiring Stopanska Banka AD Skopje in 2000, focused on cleaning up the bank before starting its expansion in 2005. 5.32 Nonetheless, competition in banking has been increasing since 2003, as shown by some shifts in the relative shares o f new, foreign banks, the growth o f some o f the savings banks, and the shifts in the types of lending. Much of the increased competition has focused on smaller loans and consumer loans, which can be at least partly traced to the entry in 2003 of a new foreign bank that specializes in smaller loans.'03 New methods of assessing loan eligibility for projects are beingused, focusing on the cash flow of a project and not so much on physical collateral, and easier processing and .lower collateral requirements are beingadverti~ed."~ This focus has spread throughout the system, even to the banks with low foreign ownership. 5.33 Many o f the other large- and medium-size banks have also begun to expand aggressively in the last two years, into either small scale lending or consumer loans and credit cards, or both. The growth in credit cards has partly reflected the government's adoption o f a policy o f direct deposit for salary payments; the banks competed for these deposits by offering credit and ATM cards. Rates on loans and collateral requirements have come down, though both remain high. Banks are also using loans that have floating rates and/or indexed to foreign currencies, which may initially reduce the cost of b~rrowing."~ The increased competition may create problems for the smaller banks; despite their high capital ratios, experience in other countries has shown the vulnerabilities o f small banks. For this reason, these banks bear continued close monitoring by the supervisory authority in the current turbulent environment. Finally, rural credit, which will be important for agricultural export growth, remains an issue. C.4. Issues of Risk,and its Relationto the Infrastructurefor Information,and Collateral 5.34 The familiar debate about the lack o f risk-taking by banks versus the lack of bankable projects resonates in FYR Macedonia. Businessexecutives have what they consider are good ideas for investment. Banks consider them too risky or demand high rates and large collateral-ften in FYR Macedoniatwo or more times the loan size. One reason for banks' risk aversion may be the memories of their large losses on loans that began in the late 1990s. Another reason remains the well-known, remaining problems of non-payment between firms that banks may consider indicative of borrowers attitudes to credit as well as the difficulty that these opaque obligations create in assessing the true equity of firms. O f course improvements are occurring in these areas. In part, the decline in risk aversion reflects FYR Macedonia's IO3Pro Credit Bank, which operates in 21 countries and is part-owned by EBRD (12.5 percent) and a holding company, entered the market in June, 2003, and has now become FYR Macedonia's 5'h largest bank. It focuses on smaller loans (on average, loan size was about 3500 euros in November 2007, with over half of the loan volume under 60,000 euros) and new borrowers (30-40 percent of its growth); it finances its loans almost wholly by deposits. Inassessing loan eligibility, it focuses on the cash flow of a project.The Momosti Saving House also has been expanding rapidly in consumer and small scale industry credit; its processes are easy and its collateral requirements are similar to Pro Credit. Monosti is owned by an NGO and thus cannot become a bank. It is encountering some problems in increasing its funding to match the demand for its loans. Other countries, such as Peru, have allowed such institutionsto become banks, providedthey improve their capital position and meet the fit and proper test for banks. Allowing the Monosti Saving House to expand faster might be one way of increasing small scale lending. Banks often advertise easy loan processes, but in fact receivinga loan may oftentake over a month, particularlya mortgage loan, for reasons discussedin Section C.4. lo'Foreignexchange denominated loans or indexed loans reduce the cost of a loan, as long as there is no exchange rate depreciation because the borrower takes the exchange risk. A new law provides consumer protection for borrowers by requiringbanks to quote the full interest cost of the loan, but this is complicatedfor loans with variable interest rates or payable in foreign exchange. 87 greater political stability. Also, the entry of competitive new banks with new approaches has pushed all banks to reexaminetheir approach to risk. 5.35 The quality of credit infrastructure-information on borrowers, the ease and quality of establishingcollateral, and the ease of executing collateral after a default-affects risk. These aspects of credit infrastructure in FYR Macedoniaand the needto improvethem to improve the volume of credit in sustainable fashion are discussed below. The NBRMandthe government are consideringfurther action in many of these areas, so the discussion below is mainly intendedto raise points that should be considered in these actions. 5.36 Good information on borrowers allows lenders to distinguish between borrowers who have paid their loans promptly inthe past and more risky borrowerswith a history of default. Banks then can charge lower rates to less risky borrowers that have a good credit record. Moreover, the connection between a good payment record and lower costs of credit is an incentive for borrowersto pay promptly in order to build up a non-physicalasset-a good credit record. It is often the main asset that small businesses and consumershave. 5.37 FYR Macedonia's credit information system has been improved in the latter part of 2008, which over time should improve its ratings,which were lower than most EUcountries, as well as Serbia, Bosnia and Herzegovinaaccordingto the World Bank's "Doing Business 2009"(based on data up to June 2008). The main source of credit information in FYR Macedonia is the NBRM credit registry; the Bankers Association has also initiated a credit information system that eventually may provide information more alignedto the banks' needs (the Law on the Private Credit Bureauthat would facilitate this was adopted in mid-2008). As with most central bank registries, the NBRM credit information system focuses on improving risk management and supervision of banks and excludes non-bank data. To judge borrowers' credit worthiness, it is important that credit information is both negative (late payments) and positive (timely payments) and up-to date. The NBRM reports outstanding loan and interest balances and risk classifications of borrowerssince 1998.The improvement inthe system will amplify this informationand improve forward-looking supervision; it will also help increase access to credit and give borrowers an incentiveto remaincurrent on debt service, to build up a good credit record-a non-physical, alternative type of "asset." This data will also increase competition among banks for borrowersthat repay promptly. As is often the case world-wide, the NBRM's efforts may still face problems in compelling lenders to enter the information in a timely fashion. This problem reflects lenders' typical attempts to protect the informationon their good borrowersin order to reduce competition for them. This behavior is why banks must be legally compelledto provide credit information and the NBRMneeds to strengthen its efforts to improvethe timelinessofthe data. 5.38 The registry also faces another common problemfor credit bureaus that needs to be resolved: the lack of unique identification of borrowers. A firm can default, then re-register under another name, and start a new credit history in a very short time. Lawyers note that in the corporate registry, the basis for identification of borrowers, firms are often registeredmore than once, under different names. Firms also can easily and rapidly create new firms while undergoing bankruptcy, making the credit information system less valuable for tracking defaulters. Unique identification numbers need to be assigned to borrowers, which remainwith them even ifthey opennew firms. 5.39 Using the credit information system to improve access to credit, reduce bad loans, and increase competition for borrowerswill depend on further changes in the system. The NBRM system is naturally focused on financial intermediaries and includes no information from retailers, utilities, cell phone 106To some degree, the ratings reflect the slow development of consumer credit compared to other countries in the region. 88 operators or of trade credits between firms,'07 nor do these institutions have access to the registry. These sources have been used elsewhere in the world for information on potential borrowers and have helped improve access and the incentives for borrowers to repay their debts promptly. Hopefully, the private credit bureau and/or the Bankers' Association Bureau, which are expected to start operations soon, will contain some of this information and be allowed broad access to the registry. More sources and wider availability of credit informationwill improve the access to credit and lower its cost. In addition, lack of access to the credit information system has raised the cost of mobile phone contracts (Chapter 6). Of course, borrowersshould also have access to the informationand the right to challenge it-an important element of borrowers "rights". This access was granted for the NBRM system in December 2007 and similar, prompt access will also needto be ensured for any privatecredit bureau. 5.40 All of these issues need attention, in order to improvecredit information, reduce risks for lenders, and correspondingly reduce the cost of credit for borrowers who pay on time; the NBRM and the government in their consideration of new policies in these areas may find it desirable to investigate various options including the set up of an additional credit information system such as has been made possible by the recent legal framework for the private credit bureau. Some of the problems noted above may be eased by improvements in the Bankers' Association credit bureau that has been announced. However, legal changes may be needed to ensure that the NBRh4 and any private credit bureau that begins operation receive data from banks promptly and that private bureaus have access to the NBRM's credit registry.Inclusionof data from non-bank payments such as public utility and cell phone bills would help improve access to credit. 5.41 Improvingcontract enforcement is a critical issue in FYR Macedonia's financial sector as well as elsewhere throughout the economy (Chapters 4 and 6). Lack of rapid contract enforcement by the courts creates some specific issues in finance as well as contributingto the general problem of the weakness of the culture of repaying debts. Problems in contract enforcement affect banks' retail credit portfolio in cases where lending is done without collateral (which is the case for most micro-sized loans and credit cards). In addition, the lack of strong contract enforcement limits suppliers' credits, which have been an important factor in development in countries such as Japan (auto parts) and China (milk processors and suppliers of raw milk-an issue in FYR Macedoniaas discussed in Chapter 8). As discussed in Chapter 4, the government needs to make further effort to improve and speed up contract enforcement through the courts. As it becomes clear that lenders and the courts will enforce contracts promptly, contracts will becomemore respectedby the contractingpartiesandfinance and investmentwill expand. 5.42 Collateraldefinition representsanother significant problemin finance, partly because of problems that still exist in land titling. This issue may explain why lenders often require collateral that is two or more times the value of the loan, why it is difficult to use buildings as collateral, and, as discussed in Chapter 8, why agricultural credit is limited. While the Contractual Pledge Registry works reasonably well, especially for movable property, although some problems appear to remain in terms of the amount of documentation and checking required, which in practicemake the system hard to use. Also important are the underlyingtitling and cadastre problems in collateral based on land and other immovable property (see Chapter 4), the main types of collateral in loans. These are reported to be particular issue in the agricultural sector (Chapter 8), but even in the urban area the titles may be clouded by government ownership. These problems often inhibit the use of land as collateral, as well as its development, a particular issue that contributes to difficulties in lending to agriculture. The coverage of the cadastre is now approaching 80 percent, but lawyers report issues remain, includingthe need for better maintenance and timeliness of the local land registries. When assets change hands, there is often a one-month lag in receivingthe title legally (in addition, the system of escrow for payments for assets is weak so payments to the seller need to be made longbeforethe propertyactually changes hands; as a result, it can be hard to lo'As noted, non-complianceof contracts between firms is recognizedas a problem in FYR Macedonia. 89 determine the real ownership of the property). The new Law on Cadastre is expected to improve the registrationprocess but it remains to see how much improvementoccurs in practice. In sum, attention is still needed to titling, surveying, and conveyance, as well as property valuation and other institutional services in order to upgrade the land management systemthat forms a basis for collateral and growth of a mortgagemarket, as well as agricultural lending. 5.43 FYR Macedoniahas made a substantial effort to improve collateral execution, with the enactment of the modern 2003 Law on Collateral Pledge on secured transactions. As in much of the developing world, FYR Macedonia's court system had not been effective in executing collateral, which led to an increase in the cost of credit because borrowerscould not receiveajudgment against defaulters in timely fashion and enforce it. Judges still are sometimes lacking in experience (2/3 have been appointed after 1997), particularly in specializedcases of collateral execution and bankruptcy'08(this is exacerbated by frequent rotation of those judges that have gained experience in these cases) and, in a few cases, have been alleged to have been subject to undue influence.Thejudges have high caseloads. Lawyers were able to delay judgments through various activities permitted under the Code of Civil Procedure. However, 2008 amendments to the Civil Procedure Code (Litigation Law), if fully implemented, should begin to address some of these issues by giving judges more options to control court procedures and lawyers' actions. 5.44 The 2003 Law on Collateral Pledge was intendedto resolve these issues and to a large extent it seems to have been successful. Notice is served on defaulting debtors by notaries and once this is recorded, the creditor can take possession of the collateral, without going through the courts. As a result, uncontesteddebt claims are usuallyresolvedefficiently and promptly. 5.45 In practice, issues remain in some cases. The service of summons by notaries is reported to be sometimes slow, in part because of difficulties in identifying borrowersand debtors may move frequently and cannot be found by the notaries.Moreover, it also appears that debtors can challenge the takeover of collateral in courts, and may do so because of the benefit they receive from delay. In the event of a successful challenge, the case revertsto the courts, where cases may take one to three years for resolution and further delays may result from difficulties in enforcement. The potential cost of all of these issues must be factored into the cost of credit for a bank making a loan and may particularly affect small scale lending. Given that the law has been in place for about five years, it would be desirable to make an evaluationof its effectiveness and ways to improve it, basedon analysis of records ofthe number of cases that have been movedback into the court system and the experience of financial institutionswith the law. In light of the findings, the changes may be made and the question of commercial courts might even be reconsidered- a step in that directionwas made in the new Law on Courtsthat allows for some in-court specialization. 5.46 For small personal loans it may be useful to improve FYR Macedonia's current system of allowing borrowers to service loans through deductions from salary payments. In effect the security of employment is the collateral for a loan. In the case of FYR Macedonia, a similar approach is used, but may be slightly more cumbersome. Instead of direct deduction from payroll, the `administrative ban' grants the banks the right to ask (based on a signed agreement with the employer) for automatic deduction from payroll in case of default. Nevertheless, the approach allows small-scale lending, and is becoming more common, especially for government employees. Countries that have used this approach have also found that a consumer protection law may be desirable to ensure loan payments and risks are carefully definedand to limit the ratio of deductions to salary. 108FYR Macedoniahas droppedits former system o fseparate commercial courts. 90 5.47 It should be understood that improving the system for executing collateral is not meant to increase banks' execution o f collateral-banks do not wish to execute collateral as they are not in the business o f managing and selling collateral. Rather the threat o f speedy execution o f collateral represents an incentive for borrowers to remain current on the debts. With speedy execution o f collateral, the amounts o f collateral execution as well as the costs o f credit may decline. While the current system has improved execution, complaints suggest that in some cases the lack o f speedy processes and ability o f non-paying debtors to strip the collateralized assets, collateral execution does not represent a viable incentive for prompt debt service and correspondingly leads to banks' charging higher loan rates. Hence the need to evaluate not only the current law, which seems modern, but the actual practice. C.5. Bank Risks and Regulation:The Balance betweenRisk and Credit Growth 5.48 Generally speaking, Macedonian banks' performance improved in 2006 and 2007, they were well ~apitalized''~and had high provisions (according to data from the latest publicly available source, NBRM Report on Banking System and Banking Supervision of the Republic of Macedonia in 2007). It is worth noting that FYR Macedonia banks suffered substantial defaults after the 2001 conflict and some o f these defaults may have been placed off-balance sheet and are being provisioned-according to the NBRM, non-performing credits (which include a variety o f bank activities such as guarantees, letters o f credit, etc., as noted above) were 5.7 percent and loans in C, D, and E categories were 7.5 percent at the end o f 2007."' Indicating both that risk still remains in the banking system and the supervisors are active, the NBRMclosed one bank at the end o f2007. 5.49 Bank regulators' main concern is the risks o f loans and other credit activity; along with the makers o f monetary policy, they must make a judgment on balance between risks and credit expansion that in case o f an excess could lead to an asset bubble and a financial crisis. In Eastern Europe, the rapid growth o f private credit, in many cases funded by banks' net external borrowing for funding loans and often denominated in foreign currency, has generated macroeconomic risks. The growth o f credit to the private sector has been slower in FYR Macedonia, reflecting, as noted, differences in inflows o f external funds but also, at least partly, because o f strong regulatory activity that has been aimed at reducingfuture risks o f banking sector problems. 5.50 Two important regulations aimed at reducing risks are the large reserve requirement on net foreign borrowing and high capital requirements. These regulations reduce the risks that can arise from a 109Bank capital and liquidity ratios have declined somewhat as the share of lending in bank balance sheets rose, but the ratios are still well above required levels.NBRMhas intervenedinbankswith low capital. 'lo As noted, in analyzing Macedonian figures it is necessary to distinguish between loans and credits (credit exposures) which include not only loans but other claims and off-balance sheet assets, as well as potential claims, such as guarantees, letters of credit, etc. and other types of uncoveredrisks. Credits are roughly four times as much as loans. It is not clear whether these figures include the loans that were defaulted beginning in the late 1990s and were taken off the balance sheet, though in any case such items would be a falling percentage of assets on the balance sheet since then. One might expect that defaults are largely on loans while off-balance sheet items such as guarantees and letter of credit have much lower defaults. FYR Macedonian figures typically report credit exposure in the worst performing categories, compared to total credits-7.6 percent at end 2006 (NBRM 2006, pp. 25-26). This figure would suggest that a substantial volume of non-performing assets were off-balance sheet, since loans were less than 50 percent of assets that were on the balance sheet and about 25 percent of credits in 2006. Note also that rapid credit growth tends to reduce reported NPLs, as new loans tend not to become non-performing. This is especially true in the case of loans with a single debt service payment, which are about 15 percent of FYR Macedonian loans, and overdrafts. To some extent, the NBRM's provisioning on category A loans provides some buffer on new loans, such as the rapidly-growing consumer credit, and loanswith a single debt service payment. 91 crisis and force bank owners to pay more attention to risk. However, they also may partly explain the slow fall in spreads, as well as the slower growth of credit in FYR Macedonia."' 5.5 1 Another prudentialregulation of NBRM is the provisioningrequirementthat has been placed on almost all credits, including loans in category A and almost all assets. This provision, as opposed to a specific provision on non-performing assets, forces banks to set aside funds from profits to offset potential future defaults. General provisions represent a buffer for the banks against unexpected deteriorationsin credit quality. General provisionson loans have often been recommended as a prudential measure. However, general provisionsalso raise the cost of borrowing, assuming they are larger than the risk premium that the bank itself would have charged and neglectingtax considerations.Unless banks charged more to cover the general provision, their profit rate on credits would be reduced.Il2 5.52 In addition, it is also important to note that the Macedonian general provision may have an additional impact on loan cost because it is imposed on almost all assets, including off balance sheet assets (except assets held in top-rated foreign banks or general government debt). Generally speaking most countries that have imposed general provisions apply them only on loans-which are where most defaults occur. As a result of the more general policy in FYR Macedonia, provisions were an unusually large fraction of interest earnings (23 percent), interest and net commissions (18 percent) or year end assets (1.3 percent), compared to international ratios. In judging the impact of this policy, it is worth notingthat the ability to add-on the cost of a general provisionto the rate charged on different kinds of assets would probably be affected by the competition (in some cases with international banks) in each class of assets. Since banks are generally considered to have some ability to affect rates charged to domestic borrowers, particularlythose without access to foreign loans, the impact ofthe general provision on creditson the cost of domestic loans would likely be larger than on the cost on other assets. 5.53 In sum, the NBRM has used a number of regulations to reduce the risks of crises. It is not surprising that it is concerned about risks in banking, given FYR Macedonia's recent history. Consequently, it is difficult to argue with this policy. Nonethelessone needsto be aware of the impactof these regulations on spreads in banking and the cost of credit and volume of credit. It also should be noted again that supervisionwill become complicatedas the importance of subsidiaries of foreign banks grow, given the difficulties of Macedoniansupervisors in learningthe condition of the external owner. Memoranda of Understandingwould be a start, but they are not easy to realize between supervisors in differentcountries, especiallywhen one potentialparty is a supervisor of subsidiaries in a small country. 5.54 These issues mean that it is inappropriateto attribute high spreads solely to imperfections in the loan market, and that regulations have had an impact on spreads. It also is important not to assume that the impact of these regulationson the cost of credit, particularlythe increase in general provisions, would be low if banking were more efficient and competitive. Rather, the rise in required provisionsand other factors may absorb the gains from increased efficiency or competition that otherwise would reduce the spread between interest on loans and deposits. 'I' A reserve requirement on net foreign borrowing means less of such borrowing can be used for lending and, correspondingly, increases the cost that must be paid by on loans funded from this source. Higher capital requirements mean that loans must effectively carry a higher interest charge to cover the cost of a higher bank capital requirement.FYR Macedonia banks have on average much higher ratios of capital to assets than required, and so increases in requiredcapital probablymay not have changedspreads much.Note that the capitalrequirement does not apply to government or central bank debt, which means that higher capital requirements increase its attractivenessrelativeto privatesector credit and reduce its relativeinterestrate. 'I2Banks might also decrease deposit rates to adjust to higher provisioncosts, but in an open economy, it is hardto reduce depositrates muchfor depositorsthat haveinternationaloptionsandthey are usuallythe largestdepositors. 92 C.6. Non-bankIntermediaries:Leasing, SavingBanks, Capital Markets, and Pensions 5.55 Some attention to non-bank intermediaries may also help to improve access to credit, though international experience and the small size of such intermediaries in FYR Macedonia suggest that these institutions are not likely to have a major impact on credit costs or volume. One example, is leasing, which can be used to avoid the issues regarding collateral mentioned above, because ownership of the asset remains with the provider of finance. Leasinghas no tradition in FYR Macedoniaand, as in many countries, remains small and focused on automobile leasing. Nonetheless, leasinghas been extended to machineryand equipment in many countries, for example constructionmachinery. Improving leasingin FYR Macedoniacould be done by ensuringthey have the same tax regimeas any owner of a capitalgood (in particular depreciation, property taxes and recipients of interest) and that the leasing companies contributeto and have access to the credit informationsystem. 5.56 Savings houses are small in FYR Macedonia, as noted, but they often are a major actor in making small loans to low income depositors. The risks of this activity could be reduced by ensuring that saving houses existingaccess to the credit informationsystems is maintainedand improved. 5.57 Venture capital activities are still intheir infancy in FYR Macedonia, though some exist and have played an important role in developingsmall, productivefirms. The key to makingthese activities work better is to ensure that the venture capital firms can sell off their investments easily. This in turn means that the functioningofthe capitalmarketis important. 5.58 The capital market in FYR Macedonia, as in most small countries, is relatively small and illiquid and does not play a large role in capital formation. Small countries typically have small firms. Small firms, by their very nature, have small equity and limited market liquidity,'I3which is an important part of the reasonwhy small countriestend to have small, illiquid markets and special exchangesfor small equity stocks have not been successful. Nonetheless, it may be worth taking a dispassionate look at the incentives for venture capital firms and the possibilities for them to liquidate their investment in successful firms through the capitalmarket. 5.59 Finally, pension funds are just beginning in FYR Macedonia and represent a potential future source of longterm funds in the economy. However, at this moment the infrastructurefor this activity- bond markets, rating agencies, etc.-is lacking. Good practice, for pension regulation at this state of development is to restrict pension fund investments to safe activities, including AAA foreign firms, to protectthe contributorsto the pension fund. It would also be desirable to take a dispassionate look at the commissions to investors and the costs of regulatingthe pension funds-experience elsewhere suggests that high commissions substantially reduce the ultimate pension benefits to contributors, making the system an effective tax on labor. Commissions can be regulated directly, or competition increased by allowing contributors to invest in safe mutual funds (government bonds and AAA foreign investments) that operate with a standard-type, commission, basedon assets under management. D. IMPROVING ACCESS NON-CREDIT FINANCIAL TO SERVICES 5.60 Access to finance, not just credit but deposit and payments services is an important factor in development. As discussed in Section B, access to credit is important for growth and innovation.But for households, access not only to credit but safe deposit and payments services is important for improving welfare. Safe deposit services are important to allow households to accumulate wealth without fear of loss, in a form that is easily accessible. Payments services are important to allow households to access `I3Shah and Thomas, 2003. 93 their deposits and pay their bills easily, and to transfer funds from one part of the household to another, both internally and across border^."^ Payments services are of course a particularly important issue in FYR Macedoniawhere migrationhas been large and remittancetransfers are importantfor households. 5.61 Access to non-credit financial services is good and improving in FYR Macedonia. Deposit services, proxied by the traditional measure of bank branches per capita were high compared to other countries in 2005 (Figure 5.5). Moreover, currently most large and middle size commercial banks have indicated their intention to expand their branch network. Payments services, proxied by ATMs, are somewhat more numerous than would be expected given FYR Macedonia's per capita income. (Figure 5.5). A substantial expansion of access to electronic payments (debit and credit cards) has occurred, jump-started by the government's adoption of direct deposit of the salaries of its workers. ATMs are useful not only for payments services in a country; they also can be used to receive remittances internationallyat low cost, an importantissue in FYR Macedoniagiventhe large number of Macedonians abroad.'15A possible improvement in payments would be to encourage the formation of bank networks for ATMs. Another would be to ensure reasonableaccessto the payments system for saving houses. They operate in the low-income market, and their participationwould represent a way of extendingelectronic payments (debit cards) to small payments. Risks to the payments system from including saving houses can be minimizedby ensuring appropriate balances are maintainedfor participationin the real time gross settlements payments system. Figure5.5: Branchesand ATMs per 100,a 0 Peoplein Selected Countries in 2005 61aiiclies per 100,000 people ATMs pet 100.000 people and GDP per capita 2005 and GDP per capita 2005 8 20-( MKFYR . I 0 3000 6000 9000 12000 0 3000 6000 9000 12000 GDP per capita US$2005 GDP per capita. USg2005 Source: Beck, et al, 2005 5.62 Consumer protectionis also an issue in access to financial services. The Macedoniangovernment has already taken an important action here by requiring financial institutionsto provide a calculation of the effective rate of interest involved in all financial transactions. This should include calculations of the returns on pensions, showingthe impactof commissions. Another area, mentionedabove, is to ensurethat debt service deductions from salaries are limited to a reasonableproportionofthe salary. 'I4See World Bank, 2008a, especially Chapter 3. 'IJIn FYR Macedonia,some of the ATM networkspermit access to internationalaccounts. This permits the sender o f remittances from abroadto providethe FYR Macedonianrecipientwith an ATM card, which then can be usedto access the foreign account at low cost. This proceduremay have reducedthe recentestimates of remittances. 94 E. CONCLUSIONSAND GOINGFORWARD 5.63 The Macedonian financial sector has performed better since 2005. This improvement reflects increasedcompetitionand foreign entry in the bankingsystem andthejudicious use of bankingregulation that has given a high weight to reducing banking sector risks. While the approach is a cautious one, it pays off in situations such as the current internationalturbulence.The better performanceof the sector is also linked to the improvementsin the legislative framework to further transpose the comprehensive EU legislation in the area. Although business executives continue to express concern regardingthe high cost of credit in interviews, that cost had come down and private sector credit had grown reasonably fast, prior to the internationalfinancial turbulence of 2008. These developments reflect a combination of reduced government debt relative to GDP, easing of monetarypolicy, and increased competition, to some degree offset by stronger regulation that has limited the riskiness of lending growth, particularly credit growth basedon potentiallyvolatile foreign borrowing. 5.64 Further improvements in the institutional frameworks for credit information and contract enforcement, and further improving collateral execution would further reduce the cost of borrowing, especially for good borrowers, and reduce bad loans. In credit information, these improvements include strengthening the NBRM credit registry and private credit information systems that start up by legally compelling prompter reporting of credit history, reporting of positive credit history as well as negative data, better identificationof borrowers,and use of informationbeyond bank and savinghouse borrowing. Expanding information on payments beyond borrowing from banks and savings houses, for example, issues in contracts that reachedthe courts, payment historyon cell phones, public utilities, taxes, etc., will be helpful to expand credit access for potential small borrowers. Among these borrowers are the owners of the small businesses that constitute the vast majority o f firms in the economy. In this regard, the NBRM can consider various options, including adding information to the NBRM's existing credit registry. Alternatively, the NBRM and the government may consider ways to encourage either the BankersAssociation or a privatecredit bureau, ifit starts up, to obtain this information. Such information will allow small borrowersto build up a non-physicalasset-a sound credit history-and thereby increase the flow of credit to smaller borrowers. 5.65 In contract enforcement, the government must look at the judicial processes with an eye to making further improvements in the speed and predictability of contract enforcement. Business executives consider contract enforcement a major problem(Chapters 4 and 8). Moreover,the inability to enforce contracts deters intra-firm creditsthat have been a major factor in development of some industries in other countries. Banks' collections from non-collateralized borrowers are also affected by the efficiencyofcontract enforcement. 5.66 Finally, it would be desirable to examine how the modern collateral law that was passed in 2003 has been working in practice-some reports are that it is not effective. Further improvements in titling (including better identificationof owners) and inthe promptness with which changes in titles are recorded would also help to improve collateral definition. Better titling is also needed to establish collateral.Also, it should be understood that limitations in the ability to execute collateral, whether legal or in practice, are not a protectionof borrowers, some of whom may be willful defaulters, but hindrances to the availability of credit which raises its cost to all borrowers. 5.67 The current international financial crisis is creating new challenges for FYR Macedonia's financial system and its economy. The previous threat of rising inflation from rising internationalprices of energy and food has been replaced by falling prices of energy and commodities, including metals on which FYR Macedonia depends for much of its exports. In addition, the foreign exchange inflows and FDI that FYR Macedonia needs to finance its current account deficit are likely to decline in the current tight internationalenvironment. Finally, some of the new banks that have entered FYR Macedonia may 95 experience problems at home and may reduce planned investment or even withdraw funds from FYR Macedonia. The Government and the NBRMthus face a number of new issues and their capacity to act will be limited by the large current account deficit andthe openness ofthe economy. The NBRMwill also need to maintainits strongregulatoryand supervisorystance, not only with regard to domestic banks but also with the new foreign banks that may present more challenging issues of supervision. Whatever the new stance of monetary policy, the government and the NBRM should simultaneously undertake the measuresto improve the framework for credit discussed above, measures that will support much sounder provision of credit to its most productiveusers. 96 6. INFRASTRUCTUREISSUESFORA SMALL ECONOMY A. INTRODUCTION 6.1 Good infrastructure reduces the costs of production and transport, increases returns to private investment, and enhances competitivenessand growth.Il6 Many studies show that communications and information technology infrastructure is important in improving labor productivity (Van Ark and Piatkowski, 2004; Piatkowski, 2005; Lio and Liu, 2006). A simple econometric model using the latest cross-countrydata (Annex 6.1) reconfirms these connections; it shows that better infrastructurehas been significantly associated with higher future growth across countries. In particular, the estimation results suggest that air transport may be specifically important for relatively small economies. In this regard, Calderon (2007) estimates that productivity growth (real output per worker) would be enhanced by an average of 2.6 percentage points per year in 18 ECA countries if all their structural reforms were at the level of the regional reform leader, the Czech Republic. Of this 2.6 percentage points, 1.8 percentage pointscould be attributableto infrastructurereforms. 6.2 Infrastructure is critical for domestic investment, FDI and exports. Good infrastructure helps increase competition in the market by increasing market integration and unlocking investment opportunities. It is also a major factor in attracting FDI, where positive spillovers, such as knowledge diffusion and agglomeration of peripheral industries, are higher when the domestic market is relatively more integratedand competitive. Most importantly, good infrastructurefacilitates exports, particularly in small economies. The latter will constitutea focal point of this chapter. Evidenceon these issues includes the finding that transport costs, essentially road networks, are important for FDI (Milner et al., 2006). Closer access to motorways and accessibility to interregional demand is desirable for exporting firms (Holl, 2004). Logistics and MSTQ (Metrology, Standards, Testing, and Quality) infrastructures, which promoteexports, have both institutional as well as physicaldimensions.To some degree the Irish success story has beenattributedto adoptinga selectiveapproachto providing infrastructureincentivesto selected multinationalfirms in highvalue-added sectors, in additionto the availability of low-cost, skilled labor."' 6.3 On the face of it, FYR Macedonia's infrastructure indicators seem adequate. In the Logistics Perception Index 2007, FYR Macedonia is ranked at 90thout of 150 countries, just below Bosnia and Herzegovina and well ahead of Serbia, Montenegro and Albania. In the Global CompetitivenessReport 2007/08, FYR Macedonia's rank in both road and overall infrastructure is well ahead of all these countries. Good road transport, along with improved customs procedures, contributed to FYR Macedonia's recent success in maintaining share in world garments trade, in the face of an increasingly competitive world market (Chapter 8). The possibility of relatively easy access to inputs as well as exports by road (Corridor X) to Europewas one consideration in Johnson Matthey's decision to locate in FYR Macedonia.Telecommunicationscoverage is reasonable, though internet use is low. 6.4 Nonetheless, FYR Macedonia's recent development has exposed some infrastructure issues, including for exporting firms. Between the 2002 and 2005 BEEPS, in a period of moderate growth, the share of Macedonianfirms citing infrastructureconstraintsrose by 70 percent (see Chapter 4). Although the percentage of Macedonian firms with infrastructure complaints remained under 25 percent of the sample, the Macedonian indicators fell below the SEE average indicators in 2005, which had improved slightly. Exportingfirms reportedmoreproblems-- 52-57 percent of such firms citedtelecommunications and electricity as obstacles in 2005, compared with only 19-20 percent for domestically-orientedones. 1 I6See for example, Canning, 1998; Canning and Pedroni, 1999; Calderon and Sewen, 2004; World Bank, 1994; andworks cited inthem. "'See McCarthy,2001; BuckleyandRuane, 2006; LenihanandHart, 2006; andRomalis,2007. 97 And all these issues would likely have become even more important with the increased growth since 2005. Although in many cases FYR Macedonia's infrastructure services and tariffs may be better than some non-EU neighbors, this is not the case when compared with Bulgaria, Croatia or Romania, which are also direct competitors. Also, the EU accession process requires candidate countries to advance infrastructurereforms and prepare for the expected intense competition from multinationalinfrastructure operators within the EU Single Market context. Given FYR Macedonia's landlocked status, small size and per capita income,"' its infrastructureservices probably need to surpass the competition in order to compete effectively in exports. For example, while Macedonian telecommunicationsprices are similar to comparators, lower prices would be desirable and pressure could be created for them by greater competition. Macedonian air transport is expensive and flights are infrequent, which has drawn complaints from potential exporters (Chapter 8); greater competition and institutional reforms would bring gains. Outside the maincorridors and arteries, about 70 percent of FYR Macedonia's local roads are estimated to be in poor condition and require immediate maintenance. And, of course, major economic adjustments may be neededto reducethe cross- and direct-subsidiesinelectricity tariffs. These tariffs are well below those in the region; they have drawn FDI into energy-intensivesectors, and contributedto the large exports of energy-intensivemetalproducts(see Chapter 3). All of these infrastructureproblems are clearly affectingindividual firm perf~rmance."~ 6.5 Notwithstanding recent improvements, more is requiredto be done to ensure that infrastructure does not become a bottleneck to faster export and GDP growth. Given the long-gestation lag between investmentand delivery of infrastructureservices, anticipatingpossible future bottlenecks(such as airport capacity) and improving other lagging sectors are essential to improving FYR Macedonia's competitiveness in exports and import-substitutes. This will need timely investment, and financial viability in each infrastructuresector. It will involve a combinedeffort on the part of the government and the private sector, as discussed in Chapter 1. Government will need to improve the efficiency of its investmentand overall expenditure, and create fiscal space for increasingits investment in roads, power transmission capacity, and selectedaspects of rural infrastructure. It will also needto continue to improve the framework for private investment in infrastructure. For both government and the private sector to further contribute to sustained infrastructure development, various issues in different types of infrastructure will need to be addressed. The following sections of this chapter examine the issues in telecommunications, informationand communicationstechnology(ICT), air transport, road transport, and electricity. The sections describe each sector and then advance various recommendations for reducing costs and improvingservice. A final section summarizesthe recommendations. B. TELECOMMUNICATIONS 6.6 FYR Macedonia's telecommunicationsdevelopment speeded up and costs dropped with the end of monopoly in the mobile market and the establishment of a basic regulatory framework following EU- consistent principles. Cosmofon, owned by a Greek telephone operator, OTE, began to compete with Mobimak (a subsidiary of MakTel (or T-Home), and now renamed T-Mobile, owned by Magyar Telekom, Hungary) in the mobilemarket in 2003, andVIP (Mobilkom Austria) also entered in September 2007. The mobile phone penetrationrate has grown to about 80 per 100(Figure 6.1), reasonable for FYR Macedonia's per capita income. Stronger direct competition in the fixed line (local loop) segment began in May 2008 in Skopje with the re-launch of Ontel, under the umbrella of the internet provider, OnNet. Cosmofon also entered the fixed segment, since the process of harmonizing individual telecom concession agreements to the Electronic Communications Law was completed. However, a potential I18For FYR Macedonianhouseholds, user fees, other than electricity, are typically a higher burdenrelative to their income, than in Bulgaria,Croatia or Romania,becauseofFYRMacedonia'slower per capita income. II9 See Annex 6.3, and World Bank (20080 Policy Research Working Paper 4581, "Effects of Improving InfrastructureQualityon Business Costs: Evidencefrom Firm-LevelData". 98 competition concern emerged in 2008, since Deutsche Telekom retaining the majority of shares of MakTel through Magyar Telekom agreed to acquire additional shares of OTE, becoming the largest shareholder of OTE and thus Cosmofon. The Commission for Protection of Competition identified that the adverse effects of the merger on the continued competition in the mobile market are greater than potential pro-competitive effects (such as enhanced production efficiencies), and has ordered the sale of one o f the companies in FYR Macedonia owned by Deutsche Telecom).Izo It is hard to overemphasize the importance for FYR Macedonia of keeping the mobile market competitive. Despitethe growth of mobile phones, the country remains relatively dependent on fixed line telephony; its fixed line teledensity of about 25 per 100 people is somewhat higher than the regional comparators (see Annex 6.2 for details). There is no good reason for small urbanized countries with high population densities, such as FYR Macedonia, to continue to be highly dependent on fixed line telephones, unless this reflects real demand o f consumers. Figure 6.1: Telephone and Internet Densityin 2005 and Mobile PhoneDensity 1995-2006. I60 Fixed lines I40 Mobile I I 120 IO0 80 60 40 20 0 Sources: WDI; Transition Report; and Cullen International(2007). 6.7 Telecommunications prices have dramatically declined with the increased competition of the last five years, and especially since 2006. The nominal mobile monthly fee fell by 30 percent and the most favorable mobile rate-on-net and off-peak per minute-fell by over 50 percent over 2003-2007 (see figures in Annex 6.2). Without doubt, the end o f the monopoly was a major factor as the new entrants, Cosmofon and afterwards VIP, cut prices in the mobile market, and T-Mobile followed. Such competition, as well as the entry of alternative fixed line operators, such as OnNet, may also have contributed to reducing the fixed line monthly charge since 2005.'*' However, the fixed-to-mobile call rate remains relatively high, at about 22 U.S.cents per minute (Annex 6.2). By international comparison, long-distance and international calls are also relatively expensive. As an example of VoIP, Skype rates of terminating on FYR Macedonia are among the highest in the region (Figure 6.2). The latter points to the underlying termination charge issues in FYR Macedonia, which are discussed below, including in Section C. I2O There are pros and cons of horizontal mergers. While internationalization of mobile network operators can generate efficiency gains and new synergies based on economies of scale and scope, there is a great potential for a merged firm to abuse its dominance and follow anticompetitive behavior. In some cases, competition authorities may approve the mergers, and in other cases, merged companies are required to commit to certain structural conditions. 121 FYR Macedonia's fixed line market remains large so the universal access mechanism will emerge as an important issue. There is also a question whether fixed-line and mobile telephones are substitutes or complements. Substitutabilityrepresents a challenge for fixed line operators (Vagliasindi et al., 2006). Sung and Lee (2002) show that the rapidly growing mobile network was a substitute for the ground-based telephone network in Korea. This may be the case in FYR Macedonia. 99 350 U3 minute long distance 35 0 3 minute fixed to mobile 300 0 I O minutecallto nearcountry : 30 25 > 20 P 1 I5 7$ I O g ' m o e 3v a I $ a f aa s 9eg l $ 3 .1 1 $ z 8 I Sources; CullenInternational(2007); and Skypewebsite for February 2008 Skype call rates (www.skwe.com) 6.8 FYR Macedonia's telecommunication price structure is also becoming more diversified and differentiatedand this is likely to lead to lower average prices.All operators now offer various contract arrangements-particularly in the mobile segment-reflecting peak load pricing as well as termination- based price discrimination.'**Cosmofon is taking full advantage of termination-baseddiscrimination by setting its rate within its own network very low. A wider range of tariff schedules allows subscribers to cut their payments-low-volume customers do not have to pay high fixed (or lump-sum)fees, and large- volume consumers may be able to enjoy lower unit costs. Of course, while the growth in price discrimination has positive aspects, it may require some regulation on transparency of prices, for example, to avoidconfusionamong consumers. 6.9 Room for further price reduction through greater competition exists -two key issues are portability of numbers and arrangements for interconnection between users of two different networks. Number portability promotes competition by making it easy for users to switch to a different provider, without all the expense and complicationsof communicatingwith all contacts to inform them of the new number. The 2002 EUUniversalService Directive requires member states to ensure that all subscribersto publicly availabletelephone services can retaintheir numbers independentlyof the service provider. After several delays due to the procurement of the necessary sofhvare and other factors, number portability was introduced in September 2008. This is an important step, and it is even more important to ensure its effective implementation.Based on experiences in other countries, few subscribers would actually change their carriers unless there is an integrated system to port numbers cheaply and quickly (in less than a week). The required period for switching is in practicemore importantthan the cost of switching. In this context, the current switching time of 7 to 14 days could be shortened further to maximizethe benefits from number portability. 6.10 Interconnection is a com licated issue because it is critical for reduction of end-user costs and competition, especially entry," and it has regulatory implications. Incumbent firms in a telecommunicationsmarket do not have good incentives to charge appropriately for interconnection,in particular because it would increase competition from new entrants. Interconnection charges paid to incumbent operators can often amount to about 40 percent of expenditure for entrants. As stipulated by `22Termination-basedpricediscriminationattaches different ratesto calls to different networks(operators). 123A risk exists that operatorswould raise interconnectioncosts for other networks, increasingfinal user prices and limitingcompetition(Laffont et al., 1998). 100 the EU Directivesand WTO Agreement,124key regulatory issues for interconnectionare (i)open access to standard interconnection terms with incumbent operators, (ii) nondiscriminatory access to interconnection facilities and services, and (iii)transparent charges and independent and timely dispute resolution. On the commercial side, key are (iv) reasonable levels of interconnection charges and (v) unbundling of interconnection charges for different operational segments. On the technical side, (vi) reliablenetworkstandardsand technicalcompatibility are required. 6.11 Whether the current interconnection rates approximate reasonable rates and how much further regulationis needed are issues that remain open to argument.125The issues become more importantwhen an operator with significant market power, like T-Home (a subsidiary of MakTel), starts to diversify its operations to other market segments, such as broadband internet services. Also, in FYR Macedonia, the same parent company, Magyar Telekom (Hungary), owns T-Home and a mobile incumbent, T-Mobile. The recent acquisition of OTE and Cosmofon by Deutsche Telekom further complicated this issue (though Deutsche Telecom has been ordered to sell the Cosmofon unit). It is of particular interest that a standard contract offered by T-Mobile includes a very attractive mobile-to-fixed line rate, which is well below the own network (on-net) call rate.This may be economicallyrational, because the fixed-line base i s still large in FYR Macedonia, but it may limit competition. For this reason the regulator must ensure that interconnection and local loop charges do not include hidden cross-subsidies. Obviously transparent and sound cost accountingis critical to such regulation.'26 6.12 At least four other concerns exist about the effectiveness of current regulation.First, the dispute resolutionmechanism currently appears slow and impractical. Given the predominance of the incumbent operators in FYR Macedonia, it is difficult for entrants to negotiate with them and there is a risk of passive arbitrationby the regulator.This is an issue in many other transition countries, where the terms of access to interconnectionshave been determined in negotiationbetween operators, and strong bargaining power tends to be left to incumbent operators (EBRD, 2004), allowing high interconnection charges to remain. In FYR Macedonia, regulation of the interconnection rates really began in 2006, when the Agency for Electronic Communications(AEC) designated T-home(then MakTel) as a Significant Market Power (SMP) Operator, and approved its reference interconnectionoffer (NO). However,there is always a risk that SMP operators would dispute the technical and charging elements of interconnectionto delay effective market entry (except for on-net communications), as long as interconnectionissues are disputed. In this case, the interconnection rates in the first FUO, based on benchmarking, were prohibitively high and the FUO has since beenrevisedon several occasions. MakTel has thus far concluded nine agreements with alternative operators and charges have fallen substantially compared to earlier levels. However, MakTel disputedthe latest changes to the RIO, which were imposed by AEC, and alternative operators complained that MakTel did not implement the revised 2007 RIO in practice, which led to a court resolutionofthe dispute. MakTel finally implementedthe new RIO in 2008.'27 124 EuropeanInterconnectionDirectives(97/33/ECandthe following02/19/EC)andthe WTO Agreement. I25 The norm of single transit interconnectioncharge is probably about 0.75 euros per minute, with a maximum of 1.5 euros in high-income countries of Europe. FYR Macedonia's interconnectionrates of 0.88 euros for fixed-to- fixed and 1.96 euros for mobile-to-fixedcalls were somewhat high. Despitethe recent announcement that MakTel would reduce its interconnection fees by 20 percent with effect from June 1, 2008, its charges could still be consideredto be on the high side compared with EU member countries; the lowest single transit rates are 0.12 and 0.23 euros in Sweden and the United Kingdom. Ideally, rates should reflect long-run incremental costs (including capital costs and profits)to encourage investment in forward lookingcommon facilities. For instance,interconnectioncharges between MakTel and T-Mobiletheoretically resemble a transfer within the same company; therefore, regardless of actual operating costs, there is no incentive for MakTel to reduce interconnectionrates to other mobileoperators. The new fixed line operatorhas commented publicly that interconnectionrates have limitedits tariffstructure. 101 6.13 Second, althoughAEC has a number of attributesmakingit independent-a director appointed by Parliamentwith a five year tenure, its own financial resources from license and spectrum fees and direct accountability to Parliament'28-its political independenceneeds to be continually validated. In addition, AEC continues to lack human ~apita1.I~'Out of 95 employees, only a few have university degrees, and only four officials deal with telecommunicationsregulatory tasks (Cullen International,2007). The AEC also has difficulty retaining its staff, as its salaries are in line with public wages. While such wage levels probably do not prevent the Agency from fillingjunior and lower skilled positions, it probablyprevents it from employing and retaining high-quality skilled staff since alternative employers-i.e., telephone companies, pay much higher wages for these positions.The AEC must restructureitself, upgrade its staff, and retainqualifiedpeople in order to improveits regulatorycapacity. 6.14 Third, the legal enforceability of contracts affects telecommunicationscharges and needs to be strengthened. Telephone operators in FYR Macedonia face difficulty in expanding their services on a post-paidcontract basis because of high default rates of both individual and business customers. Defaults can be avoided by usingpre-paidtelecommunicationscontracts, but they are usually more expensive than post-paid. Post-paid subscription only amount to 10-20 percent of total mobile contracts in FYR Macedonia. Although the provided services are generally the same, pre paid users are paying 1040 percent extra for the same telecommunicationsservices-a pure economic loss arising from the risk of default, because of weak enforceability of contracts. To reduce this problem, public awareness of good governance and contract enforceability against non-payers needs to improve through accelerationof the collection and attachment process against payment defa~1ters.I~~A private credit bureau, which included data on telephone contracts, would allow telephone operators to discriminate against contract violators and banthem from use of telephone services. 6.15 Finally, FYR Macedonia needsto seek the next level of development in the Figure 6.3: Competition and Efficiency in 3G telecommunicationssector. One way would be Auctions to enhance more advanced mobile services in - 700 the 3G format. This segment has the potential 600 - 0 Gemny UK for further development and more value-added g0 500 - services on mobile phones, which could .-S 3 400 - reduce business costs.'31In January 2008, the FYR Macedonia Government issued its first 2 300 - 5! a 3G license to Cosmofon at about 10 million 2 200 - rl Italy 0 Netherlands euros, and the company started offering the gE Aurlna 100 - Belglurn --& inenmark service by September 2008. A second license cimcs 0 Swllzcsrland was awardedto T-Mobile for a similar price in 0 - 1 December 2008. However, more licenses may be needed as this segment of the market develops. In auctions to allocate the new 128 The operational budget for AEC was more than seven million euros in 2007; the majority comes from frequency fees; the rest comes from supervision, numberingand concessionfees (Cullen International,2007). 12' In monopolized markets, the regulator's aim is to simulate competition, and facilitate the dialog between the consumers and the provider. Adequate regulator capacity is crucial for the sector and its efficient functioning. A competitivesalary structure is necessaryto attract and retainedcompetentstaff. I 3 OChapters 4, 5 and 8 discuss the costs of this issue in the more generalcontext of loancontracts. 13' Many countries in Western Europe and some transition economies, such as Bulgaria, Croatia, Estonia and Romania, have already licensed the 3G mobile services. 3G networks enable to provide high-speed Internet access and smoother video telephony. In Western Europe, 3G (WCDMA) subscription is increasingquickly and eroding the GlobalSystem for Mobilecommunications installedbase(Gamer, 2007). 102 licenses, it will be important to intensify competition among numerous bidders; as experience from developed countries shows (Figure 6.3).'32 c. OTHER INFORMATIONAND COMMUNICATIONS TECHNOLOGY 6.16 The evolution of information technology now enables instant, low cost communication around the world. The internet can create new opportunities for even small and medium-sized enterprises. This includes better market information, marketing of production, facilitation o f payments and off-shore outreach, all of which significantly decreases the costs of doing business for producers who are handicapped by small size. In particular, being able to obtain and transmit information about prices and products is becoming essential in an era o f rapidly changing demands and globally integrated supply chains. All this can be done through the internet, and basing the latter on broadband technologies would make it more effective in helping FYR Macedonia develop overseas markets and be involved more effectively in international supply chains. And using logistics to create value and improve competitiveness also demands intensive use of information technology (see Chapter 3). 6.17 Despite these benefits, the rate of internet subscriptions in FYR Figure 6.4: Internet Subscription Rates, 1995-2006 Macedonia has been among the 70 lowest in the region (Figures 6.4 -a- Estonia - Lithuania and 6.5), although it has picked up -Slovak Rep Romania re~ent1y.I~~ end-2006 Internet At -- x Bulgaria -Macedonia subscribers (including dial-up, Bosnia and Herzegovina * leased lines and broadband) were a' only 13 per 100 people (ITU data), ,-7 x although this may be picking up, / according to FYR Macedonia's State Statistical w w 0 6.18 High costs and lack of 8 8 Competition explain much Of the Sources: WDI; ITU; Transition Report; and Cullen International(2007). slow development o f the internet 132Inviting multiple, competitive entrants is of great importance in any kind of auction to avoid auction failure and increase revenue, even though criticisms have sometimes been raised about specific auction designs (Klemperer, 2002; van Damme, 2002; Seifert and Ehrhart, 2005). In the case of FYR Macedonia's third mobile license allocation, there was no competition. 133The Baltic states andthe Slovak Republichave accelerated Internetpenetration since the late 1990s. Bulgariaand Romania took off around 2002. In addition to standard telecom reform, such as privatization of state-owned monopolists and price liberalization, these countries and EU countries have low Internet service charges and have succeeded in promoting new entry in broadband access services. This is of course supported by the widespread availability of wholesale access lines and competition with alternative sources, such as cable modem and dedicated leased lines. On the technical side, FYR Macedonia achieved full digitalization of the telephone and Internet network at an early stage but seems to have failedto move forward inthe internetarea. 134The SSO reportsthat, by the end of2007,20 percent of householdsreported accessto broadband internet, and the number of people who have used the Internet within the last three months increased from 25.2 percent in 2006 to 29.7 percent in 2007. Nonetheless, the majority of them (about 45 percent) rely on dial-up access, and more than half of internet users do not have home access. These figures are however not comparable to the ITU figures, and the methodology for collectingthem is not clear. 103 market.13' First, MakTels' local loop charges were prohibitive until recently; it was only in 2007 that the Government decided to require MakTel to significantly lower its local loop charges. Second, there is relatively high dependency on dial-up internet connections and underutilized access through alternative broadband connections, particularly cable lines.136Three, competition in provision o f internet services is recent, and WiMax services are even more recent.13' Accordingly, the Internet service market remains underdeveloped in FYR Macedonia: only eight internet service providers are operating at the national level in the country (there are other 24 local ISPs). In advanced countries o f the region, hundreds o f ISPs are operating and competing with each other. 6.19 In the 2005 BEEPS, Macedonian firms lagged behind their regional counterparts in the use of internet-related technologies, especially EU8 countries. Most of the firms in the sample (75 percent) were purely domestically-oriented, and only 57 percent o f these firms regularly used the Figure6.5: Internet Utilization Rate of Firms internet. However, usage was much higher in exporting firms (Figure 6.5), as g 90 may be expected. More recent data 80 suggests improvement, but again, this -2 Y 70 60 data is not comparable across '3 50 c o u n t r i e ~ . ' ~Given the importance o f ~ 40 small, domestically-oriented f i r m s in 42 L 30 production in FYR Macedonia (chapter 2g 20 I O 4), improving the productivity o f the 0 economy means that such enterprises need to adopt information technologies more widely. 6.20 For example, more intensive use Mace'donia of telecommunications could result in a Source: 2005 BEEPS. significant decrease in average business costs based on an analysis o f the 2005 BEEPS data for FYR Macedonia (see Annex 6.3). A cross-country study for the Europe and Central Asia region also shows the importance o f ICT use for productivity improvements (World Bank 2008e). Not embracing ICT and other measures to improve efficiency will leave Macedonian firms vulnerable to competition, as has happened, for example, in the dairy sector (Chapter 8). Of course, the underlying question is why firms do not do this, and this may have to do with the lack of sufficient competition and the constraints that small firms face, which may leave them pessimistic about their growth prospects and so unenthusiastic about ICT and other investments. One possible constraint, if firms did try to adopt ICT, would be the issue o f skills: can small firms really get 135See also Cullen International (2007), which reportedthat FYR Macedonia has one of the highestcosts and lowest internet penetrationrates in SEE. 136As per FYR Macedonia State Statistical Office, 47 percent of households are equipped with cable television. However, only 3-4 percentof householdsare using cable connections for the Internet access. 137 On-net, the first alternate ISP, started hnctioning in 2000. In 2007, two Worldwide Interoperability for Microwave Access (WiMax) licenses were issued to Cosmotelco and Nexcom Skopje. WiMax is an alternative last mile technology to DSL and cable for conveying data over relatively long distances (up to 30-50 kilometers). However, both companieshave failed to meet the deadlines set in the tender for starting operations. 138According to the SSO, among firms with more than 10 employees, 70 percent had access to the internet in 2007 and 42 percent had a broadband connection, up from 30 percent in 2006. 2007 data from Eurostat show that these figures lag the average for the EU-27, Ireland, Slovenia, Slovakia, and, to some extent, Bulgaria, but are about the same as Romania(again, note that the figures are not comparable). 104 educated, English-speaking labor that can turn the ICT opportunities into reality?I3' Because FYR Macedonia is a relatively small country, the Government may consider giving a boost to the broadband Internet market by adopting, perhaps through pilot programs, e-government, e-procurement (ongoing in some areas) and selective elements of e-edu~ation.'~~ Government is currently preparing a Broadband The Strategy. On the private side, the recent decision to reduce the monthly fee for renting unbundled local loop will also help to facilitate the ICT market development. D. AIR TRANSPORT 6.21 Air transport is of great importance for landlocked countries, and even more if they are small. High fares and lack of efficient air transport will make it more difficult for FYR Macedonia to be involved actively in the global division o f labor. Some recent trends in the air transport sector in FYR Macedonia look encouraging. After the downturn of 1999-2001, air traffic has been growing steadily although overall volumes remain low compared to pre-1999 levels (Figure 6.6). Recently, several foreign airlines have entered the market, raising the total number of airlines up to 14. The country ratified the European Common Aviation Area (ECAA) agreement in March 2007.14' Given increased supply and intensified competition, air ticket prices have also declined sharply since 2004 (Figure 6.7). The standard ticket prices reduced by 30 percent or more on average. The price reduction was largest for tickets between Skopje and London, less for other long-haul flights.142 Despite these improvements, transport of exports and imports by air remains among the lowest in the region and has actually declined somewhat compared to 2000. This decline may reflect the increasing ease o f road transport (see Section E). Figure 6.6: Air Transport Traffic in FYR Figure 6.7: Airfare Reductionfrom 2004 to 2007 Macedonia 10I +Air passengertranspon I 2 4 1 300 (depaned and amved) itAir Earner depanureo -s 0 250 -10 -eInternationaltounst v e6 8 -20 200 -30 E 40 4 c -50 -60 MacedonianAirlines -61 2 -70 1995 1996 1997 1998 IYYY2000 2001 2nm 2003 2004 ~ ( X ) J~ I X K To Vienna Zurich Frankfun London NewYork From Skopje Source: WDI; and Macedonianauthorities. Source: HRG FYR Macedonia Newsletter. 139 Several studies cited in Qiang, Pitt and Ayers (2004) suggest that variations in the rate of returns from ICT use depend on levels of human development. Education, in general, and the ability to read and speak English, in particular, seem to be critical in ICT adoption. For example, the report mentions that in Slovenia, 75 percent of the people who consideredthemselves fluent in English usedthe internet, while only 1 percent of non-English speakers did. 140 See World Bank (2006c), and Favaro (ed., 2008). 1 4 'The ECAA provides a comprehensive framework for aviation relationsbetween the EU and the Western Balkan states. Under this, Western Balkan states will gradually implement aviation legislationand will become part of the EU's internalair transport market probablybefore their actual EU accession. 142 The price comparison is not easy because of high price discriminationacross routes and seasons. The standard ticket prices offered by a major operator in the FYR Macedonian market, Austrian Airlines, are referred to. The average ticket price betweenSkopje and major Europeancities is about 200 euros, regardlessof destination. 105 6.22 The most important constraints for Macedonian air transport and passenger traffic are poor internationalconnections and high passenger fares. For example, no daily direct flights exist to Germany, an important commercial partner and the country with the majority of Macedonian emigrants. There are only several infrequent(once or twice a week) flights to non-majorGerman cities, such as Cologne. There are also daily flights to Vienna, Ljubljana and Zurich. A lack of flights means that sometimes what is nominallycalled air cargo is shipped partly by road(Road Feeder Services). Although fares and fees have come down in responseto changes inthe air industry, FYR Macedonialooks much less attractiveto foreign investors-than the comparators in the region (Table 6.1).143The quality of air transportlinks is also an Table 6.1: Air Transport Costs by important factor in business location decisions Origination/Destinaton(US.dollars) (Cushman et al, 2003). In the Chapter 8 case studies of uestmation firms, internet firms complained about the cost and Frankfurt London lew York Tokyo Ireland (Dublin) 192 174 460 1,076 infrequencyof flights as an obstacleto their business. (-56.1) (-66.6) (-59.7) (-70.6) Estonia (Tallinn) 364 377 706 1,144 (-16.7) (-27.6) (-38.1) (-68.7) 6.23 Lower air costs andmore frequent flights would Hungary (Budapest) 313 283 619 895 generate more air traffic, reduce business costs and (-28.4) (-45.7) (-45.7) (-75.5) Latvia (Riga) 371 364 654 1,670 increase tourism and migrants' visits home. Better all- (-15.1) (-30.1) (-42.7) (-54.4) year-around business travel would improve the Croatia (Zagreg) 170 372 834 1,314 (-61.1) (-28.6) (-26.9) (-64.1) competitiveness of the economy. To some extent, this Lithuania (Vilnius) 372 414 717 2,020 may begin soon, owing to the ECAA agreement. For (-14.9) (-20,5) (-37.2) (-44.8) Slovak (Bratislava) 398 47 1 872 3,221 example, air traffic in the 2004 accession countries more (-8.9) (-9.6) (-23.6) (-12.O) Romania (Bucharest 367 348 799 1,286 than doubled within two years, owing to the benefits of (-16.0) (-33.2) (-30.0) (-64.9) the single air transport market (European Commission, Bulgaria (Sofia) 346 472 839 1,377 (-20.8) (-9.4) (-26.5) (-62.4) 2007). Albania (Tirana) 435 445 981 1,578 (-0.5) (-14.6) (-14.0) (-56.9) 6.24 More frequent and cheaper flights would also Macedonia (Skojpe) 437 521 1,141 3,660 promote tourism, where cost is a factor.'44Tourism is Note: Percentage differences @omthe airfares for one of the fastest growing sectors in the world economy Macedonia are shown in parentheses. Source: Author's investigation. and is a major driver of growth in many developing countries. FYR Macedonia's tourism industry represents about 2 percent of GDP and has grown since 2002. However, the number of tourists remains well below neighboringcountries (Figure 6.8) as well as pre-1999 levels, and its share of FYR Macedonia's GDP is lower than in comparator countries. In Slovenia, for example, the share of tourism in GDP is more than twice FYR Macedonia's. Of course, tourism does not reflect the quality of air travel alone, it depends on many other factors, not the least of which is the underlyingresource environment-sea shores, mountains, and skiing potential, for example. An active role for government is likely to be important in promotingtourism, as was the case in Croatia. Finally, more frequent and cheaper flights would help not only tourism but the seasonal travel of Macedonianmigrants. A particular issue is the lack of direct flights to and from major German cities, where nearly 50 percentofthe estimated migrantsreside. `43 The figures are merely a snapshot of the cheapest discount economy airfare available on the web given a particular day. They may change dependingon season and ticket restrictions,but even a momentary market situation i s expected to reflect some information on price differentials across countries. The prices are applied for one adult discount economy roundtrip between the capital city and each destination. They are collected with no airline preferences and other conditions specified. To make the prices reasonably comparable, however, the flights with more than one connection (except for FYR Macedonia) and/or more than four hour connection time required are excluded. 144 Tourist demand for air travel seems price elastic (Annex 3.4), though to some degree, particularly in cases like FYR Macedonia,this may reflect a substitutionfor tourism by ground travel. 106 6.25 Efficient air transport might even Fipure6.8: InternationalTourism inECA Countries help expand the market for export industries for FYR Macedonia. Agribusiness in Africa is an example of . Lithuania this phenomenon. Well-performing air 7 0 freight services made possible the success 6 0 story of cut-flower exports from Africa to c, EU and East Asia (World Bank, 2005b, 2007d; Diao et al., 2007). Infrastructureis playing an important role: Kenya's comparative advantage over Uganda in producing sweetheart roses comes from lower marketing, electricity and air transport costs, despite the higher labor e costs in Kenya (Figure 6.9). In general, I 0.0 the weight-value relationship and the 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 time-sensitivity of deliveries are crucial Sources: WDI; and Macedonianauthorities. dimensions in air cargo. In the Macedonian context, high value-added agribusiness and high-end garments may be possible candidates for growth industries that would use air freight and thus enable market expansion into and beyond Europe. Figure6.9: Apribusinessand InfrastructureCosts: A Case of Sweetheart Rose Production I - 64 I Source: WorldBank (2007d). 6.26 Investment and institutionalreforms should support growth in air transport and passengertraffic Infrastructure investments in the two international airports are necessary to upgrade the facilities and increase their capacities. In this regard, the implementationof the concession agreement for the airports and the associated investment by new operators will be an important element. On the institutional side, the structural separation of the Civil Aviation Agency (CAA) and the air port operators needs to be completed. Implementing the ECAA agreement by 2010 would provide opportunities to reduce air transport prices and develop air transport networks, FYR Macedonia also needs to further liberalize ground-handling and other airport services, become a full member of the Joint Aviation Authority (JAA),I4' and remove exclusivity rights granted to a Macedonian carrier. These issues are discussed in more detail in the rest ofthis section. 145The JAA is expectedto be closed in2009 andtaken over bythe EuropeanAviation Safety Agency. 107 6.27 Reforms are progressing. The Civil Aviation Agency and airport operator (Public Enterprise Airport Services) are running surpluses, thanks to progress in sector reforms.146However, the latter's revenues are sufficient to only cover operating costs, but not investment in new facilities. Airport privatization can help mobilize financial resources. The Government invited a tender for the lease of the two airports and selected a Turkish airport operator, TAV. TAV will undertake full upgrading o f Skopje Airport and partial upgrading of Ohrid, construct a new third airport near the central Macedoniantown of Stip, and operate all of these for 20 years. A good outcome o f this process will depend on public transparency, credibility, accountability and flexibility in the regulatory regime (and assuming that the final concession contract was carefully crafted). This is particularly important because a final bid for the project was only submitted by one operator, despite four international airport operators initially expressinginterest. This raises an oft-expressed concern about lack of competition in PPP auctions. It is particularly worth overseeing possible cost overruns or adverse effects from the proposed Stip Airp01-t.'~~ Latin America's experience shows that about 30 percent o f infrastructure concessions underwent renegotiation shortly after the award; renegotiation was more common in transport concessions (55 percent). The likelihood of renegotiation increases to 70 percent if the new private operator is required to make investments (Guasch, 2004). 6.28 Skopje and Ohrid airports are competitive with regard to Table 6.2:Landing and Lighting Fees in the Region landing and lighting fees, but as h & l g ffs bLwiw=Lerdrgfeefar Len15rgdli@ting m p l a n e feefar5(xalplsp noted, these fees do not provide BR7.Ytmfor tpb25 ks, BR1.tytcn, revenues for investment. The fees Belsade BR9.iWnfOrpsnesw 2 5tm BR25'tm 490 615 for landing and lighting that Nis BR7.3mupto25tcm ELR BRl.Grtar, aR2.am 490 wx) Macedonian airports charge are 9.Eytmw25ks 25%dhe low compared to the regional Ridm BR7.5tm mrgfee 375 4a competitors (Table 6.2).148 The aR7.5tmupto25tcmELR B5'tmw25brs 475 475 ~~ fees for a 50-ton plane (which is wja &11403br45wtas injLadin 4M) 403 the average plane size that lands at 4mrgfee W o o f he Skopje airport) in FYR Macedonia TEUB aR550br45wtors mrgfee fa m are 385 for landing only, and Liutliara BR125nonkrplaresa93tcns 625 625 481 for landing plus lighting. The BR7.2ltOlfor a= Government also decided in 2007 tpb33ks, 25%dtle & ~ 7 . 7 n a 7 f o r ~ ~ o ~ 3 0 1 cmrgfee n s 385 481 to reduce landing and lighting fees by 17 percent for Skopje airport BR7.Zmfor@= tpbJ)ks, %%of tle OMd ~ ~ 7 . 7 f i m f o r ~ ~ o ~mrgfee 3 0 t m 385 481 and by more than 20 Percent for Source: World Bank compilationfrom various airport authorities. Ohrid airport. The fee reduction is expected to be implemented in the first half o f 2008, once the separation of CAA from airport service operation is completed. These fees will of course be subject to change once the airports are privatized, and will depend inpart on the regulatory arrangements for the airport concessionaires. 146Skopje Airport is roughly maintaining its net income given increasing passengers. Ohrid Airport continues to make losses due to low volumes oftraffic and could be profitableonly ifforeigntourism increases considerably. 147Stip Airport aims mainly at cargo transport and may be able to become the hub airport, encouragingmore exports of fresh agricultural products from the country. However, if it turns out cost ineffective, it would be a heavy burden for the private operator to maintain the country's current competitiveness at the other two airports, especially Skopje. 14*Note, however, that with rising fuel costs, the share of airport fees in overall costs of operating air services, especially for long haul flights, is becoming smaller over time; this probably means that the quality of terminal and ground handlingservices, airport capacity including terminals and warehouses, etc, will become more important in determiningthe competitiveness of airports relativeto fees. 108 6.29 On the institutional side, FYR Macedonia's key reform agenda is to implement the ECAA agreement, which will stimulate competition and lower prices. The ECAA agreement requires member countriesto align their legislation with the EU aviation acquis. The harmonizationis being implemented in two phases, each of which aims to further liberalize the market. FYR Macedonia ratified the ECAA Agreement in March 2007. Pendingratification by all parties-which i s expected to take at least another year as all EUmember states have to ratify--the ECAA is applied on an administrativebasis. The second phase may begin in 2009 if the first phase is completed by the end of 2008, and full implementation is expected by 2010. The ECAA will replace all bilateralaviation agreements between FYR Macedoniaand EU member states, and with non-EUsignatories of the agreement, such as Croatiaand Serbia. During the first transitional phase, already occurring, all point-to-points scheduled and charter air services between ECAA signatories have already been liberalized.The adoptionof the aviation acquis will also imply new safety and security requirements for airports. 6.30 Along those lines, the immediateaviation policy priorities for the country are to: (i)complete the restructuringof the CAA; (ii)liberalize ground-handling and other airport services; (iii) become a full member of the Joint Aviation Authority (JAA); and (iv) remove exclusivity rights granted to a Macedonian carrier, Macedonian Air Transport (MAT). (The agreement between the Government and MAT, which is valid until June 2010, is not compatible with EU's competition rules applicableunder the ECAA). Once these exclusivity rights are abolished, MAT will no longer have the right to block new carriers' entry (note that despite the exclusivity rights, the Government accepted all requests for new flights inthe winter 2007/08 season, in line with the ECAA). 6.31 Another way to improve efficiency in air transport may be regional coordination with neighboringcountries in Southeast Europe. Collaboration in selectingroutes and schedulingflights will greatly reducethe current disadvantage of small carriers(see Kathuria, 2008). It would also be conducive to operatingdirect flights from the regionto more foreigncities. Regionalcooperationcan also be fruitful in air traffic management, training, aircraft registration, etc. E. GROUNDTRANSPORT 6.32 The road and railway transport sectors are importantfor FYR Macedonia, not only to improve its own transport efficiency and competitiveness, but to compete for the container traffic between Western Europe, and Greece and Turkey. FYR Macedonia's ground traffic has already Figure 6.10: FYRMacedonia: Road and Railway recovered to the pre-conflict level and Traffic experienced a considerable increase in recent years (Figure 6.10 and Table 6.3). This recovery 7oo __-+Roads, goods transported *Railways,goodstransponed reflects increased transport from Western 600 - Europe to Greece and some shift of container 500 - ~ _ _ transit traffic from Corridor IV (Thessaloniki- A0 400 -- Sofia-Hungary) to Corridor X (Thessaloniki- 2 - Skopje-Be Igrade-Hungary ). This growth is 300 likely to continue as regional economic *0°- __ k-.d,.' f " integration increases. Not only Corridor X but 100 =,/ :- . ~- also- regional connections (e.g., with Albania 0 and Bulgaria through Corridor VIII) could be 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 developedto support this integration. Sources: WDI; and Macedonianauthorities. 109 Table 6.3: FYR Macedonia:Transport of Goods byRoads and Railways(Millionsof ton-km) Roads, goods transported Railways, goods transported Avg. Growth (%) Avg. Growth (%) 2002- 2004- 2002- 2002- 2004- 2002- Country 2002 2003 2004 2005 2006 04 06 06 2002 2003 2004 2005 2006 04 06 06 Hungary 17,913 18,208 20,608 25,152 30,479 7.3 21.6 14.2 7,703 7,990 8,713 9,005 10,167 6.4 8,O 7.2 Estonia 3,974 5,099 5,824 5,548 4.3 11.8 9,330 9,283 9,567 10,311 10,418 3.1 4.4 2.8 Slovak Rep. 14,929 16,748 18,527 22,566 22,212 11.4 9.5 10.4 10,679 10,117 9,675 9,326 3,373 -4.8 -41.0 -25.0 Lithuania 10,709 11,462 12,279 15,908 18,134 7.1 21.5 14.1 9,767 11,457 11,637 12,457 12,896 9.2 5.3 7.2 Latvia 6,200 6,808 7,381 8,394 10,753 9.1 20.7 14.8 15,020 17,604 16,877 17,921 6.0 6.2 6.1 Croatia 3,663 4,124 4,373 4,387 6.2 2,420 2,745 2,733 2,835 3,305 8.1 Bulgaria 6,840 13,765 26.3 4,627 5,274 5,212 5,166 5,396 3.9 Macedonia 2,693 4,130 5,341 5,577 8,299 32.5 334 373 426 530 614 16.4 Sources: WDI; Eurostat;andMacedonianauthorities. 6.33 Maintenance of the competitivenessof Corridor X is important for continued growth of ground traffic and competitiveness of the Macedonian economy. FYR Macedonia's ground traffic is highly concentrated on internationaltransit via Corridor X and, as noted, it competes with Corridor IV (through Bulgaria). Table 6.4 providessome comparisons from Thessalonikito Nis (in Serbia). Timely completion of pending upgrades to Corridor X (one remaining upgrade needs to be completed by 2008; another section is due to be done within four years) will greatly benefit the country, through expansion of FYR Macedonia's trade, as well as transit through FYR Macedonia. Outside Corridor X, about 70 percent of FYR Macedonia's local roads are estimated to be in poor condition and need improvement in order to take advantage of the projectedgrowth in traffic within the country and to limit cost increase^.'^^ Local roads are also important for connectivity within the country, including allowing farmers and small enterprisesto compete for markets bothwithin the country as well as overseas. 6.34 Although road transit, essentially Corridor X, has grown through 2006, toll revenue was stagnant until 2007. Table 6.4: FYRMacedonia: The total amount of toll collections from Corridor X by beweenCorridors and Iv the Road Fund did not increase between 2003 and 2007, Length Number o f NumberOf border stayingaround 700-740 million denars (Figure 6.11). This (W tolls crossings was despite the increase in the toll on Corridor X by Corridor 405 13 2 CorridorIv 440 7 2 roughly 20 percent in July 2005 and the rise in traffic Source: WorldBank staff calculation. (Figure 6.10). It is important to eliminate unpaid traffic (electronic billing would be a good option) and ensure that financial resources are sufficient to maintain the quality of these roads-and this seems to have started occurring in 2008, with some changes in the governance of toll booths. Further reductions in unpaid traffic would help finance the improvementsin Corridor X that are necessary to keep FYR Macedonia competitive against Corridor IV and to reduce fiscal spending on this road corridor, enabling government to invest more in regional and local networks (see below). At the same time, the government should also consider improvements in the identified bottlenecksalong Corridor VI11 which connects FYR Macedonia with Albania in the West and Bulgaria inthe East. 6.35 To overcome the constraints posed by inadequacies in the local road network, the Government has initiated a large program of investment in Regional and Local roads, focusing on their maintenance and rehabilitation, covering 12,000 km out of the 13,300 km of total roads in FYR Macedonia. With the assistance of the donor community, including the World Bank, significant investments are plannedunder this programover the next five years. Timely allocation of financial and humanresourceswill be required `49Roadtraffic demand withinFYR Macedoniais low becausethe current figure of 160vehicles per 1,000 people is amongthe lowest inthe region, buttraffic will increase as the economy grows. 110 for an effective pr~gram."~The authorities have also announced plans to give under concessions a significantpart of the roads in the country. Success in such a venture will be challenging, and will depend on a transparent legal and regulatory framework for these arrangements, and clear definitionsof roles and responsibilitiesof all involvedparties. 6.36 Regarding railways, FYR Figure6.11: FYRMacedonia: Toll Collectionby Road Macedonia's railways freight remains Fund very low, at some 778 million ton-km, 900 even taking into account the size of 800 country. Currently 99 percentofthe traffic -8 700 on the Macedonian Railway (MZ) is d '-s % international, and 95 percent of freight 5: 600 8 revenue is generated along Corridor X. B 500 There are only two internationalpassenger 400 5 2 trains (to Belgradeand Thessaloniki). MZ 300 i s running a cash surplus and recently, 200 there has been a 10 percent increase in -8 100 container freight demand per year, 0 especially transit cargos from North to 2000 2001 2002 2003 2004 2005 2006 2007 I/ South. FYR Macedonia's railway labor productivity in per worker unit-kilometer January to mid-November, terms (both passenger and freight) stiil Source: FYRMacedoniaauthorities. remains amongthe lowest in the region(World Bank ECA InfrastructureDatabase), though it is gradually improving owing to increased freight traffic and limited labor shedding.I5'Ongoing structural reforms, such as vertical unbundling, tariff adjustment and accounting separation, would help achieve service quality improvements.There also may be potential demand from other Table 6.5: FYR Macedonia:ElectricityConsumption by sources. However, significant Customer Category additional investments should be 2005 2006 carefully considered, in light of Customer category Sector GWh % GWh % IlOkV 1.929.0 29.9 2.132.9 31.6 conservative projections of the Silmak (Ferrosilicon) 666.9 10.3 576.3 8.5 potentialdemand for rail. Usje (Cement) 97.7 1.5 106.7 1.6 MHKZletovo (Leadlzinc smelter) 3.3 0.1 2.9 0.0 Railways (Transport) 20.9 0.3 24.2 0.4 F. ELECTRICITY AIumina (Alumina) 0.3 0.0 0.3 0.0 Buchim (Copper mineand flo 59.1 0.9 95.1 1.4 6.37 FYR Macedoniais among the Feni Industry (Nickel smeltery) 540.1 8.4 614.6 9.1 Okta (Oil refinery) 59.7 0.9 57.7 0.9 most electricity-intensive economies Energetika (Heating) 339.1 5.3 412.1 6.1 in the region. This energy-intensity REK Bitolaand Oslomej mir(Coal minindenergy) 139.3 2.2 239.3 3.5 reflects, to a large degree, FYR TEC Negotino (Energy) 2.9 0.0 3.9 0.1 35 kV Macedonia's subsidized domestic 42.4 0.7 62.7 0.9 I O kV 682.6 10.6 678.3 10.0 electricity price, which remains Households, public lighteningetc. 3,783.3 58.7 3,868.9 57.3 approximately two-thirds of the average retail power price in the Total electricity consumption 6,447.5 100.0 6,751.4 100.0 Balkan states and about half of the Source: FYRMacedoniaauthorities. I5O See the recent Public Expenditure Review (WorldBank 2008b), and the project document for the roads project (WorldBank, 2008g). 15'As per Transition Report 2007, it is estimatedat 132 for FYR Macedonia in comparison with the 1989 figure; 125 for Croatia; 334 for Estonia; 107 for Latvia; and 71 for the SlovakRepublic. 111 international electricity price around the Balkan area.152This low price has favored energy-intensive exporters; indeed, it may have attracted FDI into these sectors. The large metal and cement sectors, which include major exporters, account for about 30 percent o f total electricity consumption in FYR Macedonia (Table 6.5) (though this has probably fallen recently as the ongoing crisis has disproportionately affected the large producers). Energy accounts for a very large share of costs in cement and ~ t e e 1 . ILow cost ~ ~ electricity has, until recently, played a large role in FYR Macedonia's large exports o f metals (nearly 40 percent of merchandise exports)154and cement (a much smaller, 3 percent); the electricity tariff adjustment will erode that cost advantage. 6.38 However, electricity tariffs below the cost recovery level have been eroding the quality of electricity infrastructure, too. Currently, the costs of subsidizing consumers and firms are borne by the two state-owned companies, as well as by the budget.'55Without full cost recovery, timely maintenance investment is becoming increasingly difficult. The excessive energy subsidy is also crowding out government investment in infrastructure e1~ewhere.l~~ 6.39 Under the Athens Treaty, the government is committed to gradual liberalization in tariffs to firm and consumers starting in 2010 and ending in 2015, but some steps have already been taken. The government recently increased power tariffs to large consumers, which will impinge on their profitability and their exports and require some macroeconomic adjustment to offset any decline in exports. The new tariff structure has required eligible consumers (Le., enterprises who have a 110 kV direct connection to a power transmission company, MEPSO)to purchase all o f their electricity at market prices, as of 1 January 2008, with availability of lower-cost (but still market prices, based on auctions) power in off-peak hours (night). Is'The residentialprice is about 7 US.cents per kWh (or 3 0 4 0 euros per MWh) in FYR Macedonia, 10 cents in Albania, 11.7 cents in Bosnia and Herzegovina, 10.6 cents in Bulgaria, 14 cents in Croatia, and 8.4 cents in Serbia. The internationalprice when electricity is imported to the Balkan region may reach 70-80 euros per MWh (see Annex 6.5 and Figure6.12). 153 See Chapter 3, which mentions that electricity and fuel accounted for 80-90 percent of variable costs for one cement producer, and over 55 percent of variable costs (other than metal scrap) for a steel producer. `54This figure includes iron and steel products (e.g., pig iron, ferrosilicon, ferronickel, flat rolled plated iron and tube and pipes) and non-nonferrous products (e.g., aluminumand zinc). A state-owned power generation company, Elektrani na Makedonija (ELEM), and FYR Macedonian Transmission System Operator (MEPSO), in charge of power distribution and until recently, imports, bear the cost of the low regulatedprice of energy. The wholesale price appliedfor electricity generatedby ELEM covers only the current costs and does not allow it to invest in expanding production. The recent amendments to the law enable ELEMto sell excess electricity at market prices, but this is only a partial solution. Inaddition, untilrecentlyMEPSO made huge losses from the difference between import and selling prices, when it imports electricity at the internationalprice, which is currently about EUR 80 MWh. MEPSO is selling electricity to a privatizeddistribution company, ESM EVN (owned by Austrian EVN) at a regulated price of only Euro 30 per MWh (despite being recently increased slightly, the price received by MEPSO is still low). The power transmission commission paid to MEPSO is not sufficient to offset these losses and MEPSO relied on ad-hoc budget transfers (in 2006 and 2007 transfers occurred at the end of each year). With the 2008 amendments, ELEM became responsible for imports o f energy in cases when it is unable to meet the demand for the regulated consumers, meaningthat these losses will be transferredto ELEM. 156Assuming that the international electricity price imported by MEPSO is around 75 euro per MWh, its losses in keeping residential tariff at about 30 euro per MWh would be about 50 million euro per annum, or around 0.8 percent of GDP. This is based on the assumption that in 2008, FYR Macedonia imports about 10 GWh, of which MEPSO purchases 3 GWh. Together with other types of hidden costs o f non-payment and system losses above the norm, the overallquasi-fiscal deficit is even higher. 112 6.40 Although foreign competitors of FYR Macedonia's energy intensive exporters also face high energy costs and have to raise their prices as energy prices rise, the potential increase in the prices of Macedonian exports is proportionately higher, because of Figure6.12: Residential Electricity Tariff its lower original energy prices. Residential electricity tariffs (U S cents per kWh) And while Macedonian energy- 0 2 4 6 8 10 12 14 16 18 intensive exporters may offset the Estonia higher prices to some extent, by operating at night (when energy Latvia prices are lower but labor costs Croatia may be higher) and improving Lithuania energy efficiency, it is likely that Slovak Rep their export profitability and Romania competitiveness will decline (see Bulgaria Annexes 6.3 and 6.6). Macedonia Consequently, such exports may Albania decline. Since any structural adjustment in the economy's production and associated Ireland reallocationof labor can effectively Sources: World Bank (2006b); Eurostatand TransitionReport. take place only in the medium term, shorter-termsolutions may be neededto offset possibleexport shortfalls. Since labor constitutes a major production input, this could involve decreasing the labor tax wedge, and promoting overall flexibility of the labor market (see Chapter 7). The advantage of this measure is that it is not targeted at any specific sector, and can help to improve overall cost competitiveness in the economy, especially for the smaller firms, who employ lower-wageworkers and face a disproportionatelyhightax wedge. 6.41 Other firms are not likely to be affected as much by higher energy prices. The BEEPS data suggest that a 50 percent increase in energy prices would increase the average firm's operatingcosts by only 1% percent in FYR Macedonia, disregardingany energy saving measures (Annex 6.3). In any case, firms other than the direct 110 kV consumers have been given more time to adjust: 35 kV customers prices will be adjusted in 2010, 10 kV customers in 2012; and households in 2015; until the adjustment occurs they will enjoy subsidized prices. 6.42 To reform the electricity sector, there are various issues that need to be considered, such as energy security, energy efficiency, environmentaland social considerations, and regional cooperation and competition in a power trading market. However, moving towards full-cost recovery and eliminatingthe implicit subsidy would be among the most critical steps in putting the electricity sector on a sound footing, and also improve fiscal savings. For example, consumer tariffs seem to continuewell below cost recovery levels. The current tariff of 7.2 USD cents per kWh means a 5 percent subsidy compared with the cost-recovery tariff of about 7% cents estimated in 2005 (World Bank, 2006b), let alone today's cost~.''~The adjustment process of the consumer electricity tariff in FYR Macedoniahas been sluggish compared with neighboringcountries and needs to be accelerated, especially to meet the Athens Treaty (Figure6.12 andAnnex 6.3). `57The current increase in energy and fuel costs implies that the cost-recovery tariffs in World Bank (2006b) are belowthe currentcost recovery levels. 113 G. SUMMARY OF POLICY RECOMMENDATIONS 6.43 This chapter has focused largely on policy issues of infrastructure reform rather than on the amounts of investment needed in different sectors. Partly, the private sector should take care of needed investments- especially in telecoms. In air transport, capacity enhancement is critical and the government would need to ensure that required and promised investments are generated after privatization (Le., concessions of the airports). In roads, significant amounts of government investmentmay be needed. In electricity, state-owned companies will need to be significant investors as long as they remain state- owned, especiallyin generation and transmission. Overall, as stated in chapter 1, these increases in public investments should be made from funds that result from greater efficiency in spending and re-allocation of non-priority expenditures, so as to maintain fiscal sustainability and maximize the impact of investment. The following paragraphssummarize the agenda in different sectors. Telecommunications 6.44 The main policy recommendations to reduce telecommunications prices and improve service . quality, thereby supportingoverallcompetitiveness ofthe economy, including small firms, are to: . strengthenthe regulatorycapacity ofAEC, especiallyinterms of staffingquality; ... fully implement effective interconnectionregulationto maintain fair competitionbetweenthe incumbentand new entrants; review functioning of recently introduced number portability to ensure that it is fast and reasonably priced; strengthen contract enforcement to reduce nonpayment and facilitate a move from pre-paidto post-paidcontracts; and strengthen the supply of skills in order to encourage firms, especially smaller ones, to adopt ICT (see also Chapters 4, 7, 8). Air transport 6.45 To improve opportunities for growth as the NATO and EU accessions move forward, the most . important short-termmeasures in the air transport sector would be to: ensure effective implementation of the concession contract for the airports and prompt .. upgradingof the airport infrastructureto absorb increasingtraffic; and carefully manage and overseethe contractwith the new operator; . complete the separationofthe Civil Aviation Agency from airport operators; remove exclusivity rightsof FYRMacedoniaAir Transport; and becomea full member ofthe Joint Aviation Authority. Ground Transport 6.46 To continue increasing the quality of ground transport, on which Macedonian exports and competitiveness depend, and to better integrate the domestic market (including agriculture and small .. firms), it will be importantto: ensure CorridorX is well maintainedand upgradingis completed soon; improvetoll collectionson Corridor X; and 114 . accelerate other domestic road network development, especially of local roads (the latter process has been recently initiated), and improve governance capacity in road-related institutions. This will require additional government expenditure on investment and maintenance over the next five years, supplemented by improvements in institutions responsible for road investment, maintenance and operations (see PER for more detailed recommendations). Electricity 6.47 To adjust to higher energy prices and reduce the energy-intensity of the Macedonian economy .. andthe impliedvulnerabilities, it is desirable to: graduallyadjust the corporate and residentialtariffsto full-cost recovery levels; and undertake measures to ease negative effects of the price adjustment on electricity-intensive producers by reducingcost pressures from other production inputs, especially the non-wage cost of labor. 115 7. IMPROVING THE PERFORMANCEOF THE LABORMARKET A. INTRODUCTION'58 7.1 Employment has long been a chronically serious issue in FYR Macedonia. Unemployment was among the highest in the former Yugoslav republics and continued to rise through much o f the transition period. The last World Bank (2003) Country Economic Memorandum talked about "the failure of the labor market." There has been some improvement since that time (Figure 7.1). The unemployment rate, as calculated by the State Statistical Office (SSO), has fallen by over two percentage points in the past three years but, at 33.8 percent in 2008, it was still higher than anywhere else in Eastern Europe except Kosovo. Also, there i s some evidence that the ongoing crisis has reversed some of the gains made over the last few years. The employment rate has risen by over three percentage points but was only 37.2 percent in 2008.'59 Although it is conjectured that these figures (as well as registered data) exaggerate the difficulties, no serious observers contend that that the dismal labor market picture is merely a statistical problem. Figure 7.1: Unemploymentand EmploymentRates, 15 Years and Older, 2004-2007 25 - 20 - 15 - 10 - 5 - 0 1 I I I I 2004 2005 2006 2007 --eUnemploymentrate+Employment rate Source: LFS 7.2 FYR Macedonia's labor market performance compares unfavorably with neighboring countries. This is the case even in a sub-region where labor market indicators are generally unfavorable (Table 7.1). Labor force participation in FYR Macedonia is somewhat lower than participation in the This chapter draws on a series of labor market policy notes preparedby the World Bank: see, for example, World Bank (2007~)and World Bank(2008h). 15' At the time this report was finalized, the latest labor force statistics available from the State Statistical Office were for the second quarter of 2008. They continued to show some modest gains in the labor market. Unemployment fell to around 33.8 percent and the employment rate rose to 37.2 percent. The estimates are based on data from the Labor Force Survey. It should be noted that the State Statistical Office uses a definition of 15 years and over in its calculation of labor force figures. However, in the analysis presented in this chapter, the 15-64 year definition of the working-agepopulationis used in order to make estimates comparable with internationalstandards. The 15 and older definition is used in Figure 7.1 because annual results for 2007 are not available using the 15-64 year definition. The SSO reports on the labor force survey are available at: httu://www.stat.gov.mk/english/statistiki eng.asu?ss=07.01&rbs=l 117 other SEE countries. However, it has an extremely low employment rate and extremely high unemploymentrate in comparisonwith the rest of SEE and especially with the EU. Table 7.1: SummaryLabor Market Indicators,15-64 Year Olds,FYR Macedoniaand 1. 2006 i s the latest year in which data for all countries were available at the time the report was finalized. Sources: ILO KILM2007; Eurostat; IMF; World Bank staff estimates. 7.3 The importanceof improvinglabor market outcomesis heightened by the prospect of EUof accessionand by populationaging.FYR Macedonia's candidacy for EUaccession offers the promiseof economic and social benefits. However, Figure 7.2: PopulationProjections by Selected Age Groups, FYR Macedonia.2005-2040 major improvements in the labor market will be necessary 1 1600 1 I for FYR Macedonia to take fuller advantage of its productive potential and move along the path of convergence with EU members. This 1 600 I--- .__+ j+65+ imperative will be heightened by demographic trends. Like most other countries in the region, FYR Macedonia's population is aging (Figure 2005 2010 2015 2020 2025 2030 2035 2040 7.2). According to UN Source: UNWorld PopulationProspects (2006 revision, mediumvariant) demographic projections, the working-agepopulation (15-64 years) will actually decline between 2005 and 2025 by over 40,000.'60In order to compensate for this decrease in potential labor supply, FYR Macedonia - like other aging countries- will need to pursue some combination of improved labor force quality, net in-migration, and most obviously, greater utilization of the working-age population through higher labor force participation. 7.4 FYR Macedonia has now approved a National Employment Strategy (NES) which sets an employment target of 48 percent by 2010. This is an ambitious goal relativeto the current employment rate even though far from the 2010 target of 70 percent set by the European Commission as part of the Lisbon Agenda. While the NES largely deals with issues under the jurisdiction of the Ministry of Labor, the country's jobs agenda will needto be much broader if FYR Macedoniais to meet the NES goal and, over the longer run, approach the Lisbon target. The currently difficult employment situation reflects a 160Source is the UNWorldPopulationProspects(2006 revision, mediumvariant). 161For morediscussionon adjustingto aging, see WorldBank (2007a). 118 range of constraints that exist not only within the labor market but in many sectors beyond the labor market.The foremost constrainttojob creation is low growth (see Chapter l), which is the subject of this report; other issues include efficient labor market regulations and institutions, education and training systems that develop relevant and high-quality skills, and a social safety net that offers protectionwhile encouraging employability.'62 7.5 The quality and quantity of employment are critical explanations for continued, high poverty. Not enoughjobs have been created to offsetjobs lost up to 2004. For example, between 1999 and 2004, total employmentfell by 2.6 percent(LFS data). Evenwhenjobs were created, as has beenthe case since 2005, most have been low-productivityjobs, which often are not sufficientto alleviate poverty and contribute to the pool of 'working poor.' Thus, the percentage of poor who were working increased from 28 to almost 38 percent over 2002-06, and the overall poverty ratio stagnated at 19 percent over the period. This implies that while continued and faster job creation is critical, poverty reduction also demands that this take place in higher productivityjobs. The latter involves improvementin worker skills as well as a change in the pattern of growth to sectors or product niches that can afford to pay higher wages. 7.6 This Chapter focuses on three key issues related to employment that are relevant not only for understanding FYR Macedonia's current labor market situationbut also will be importantareas for future reforms if the targets eventually are going to be met. The first two are concerned with the supply side of the labor market: the role of non-labor income (e.g., pensions, other social transfers, remittances) in determining labor force participation, and the extent to which skill shortages and skill mismatches are constraints to job creation. The other issue considered in this chapter concerns wages and labor taxes, including social insurance contributions. Before examining these issues, the Chapter begins with a statistical reviewof recent labor market developments. B. THECURRENTLABOR MARKET SITUATION'63 7.7 Labor force participation rose over 2004-2006, from 59.5 percent to 62.2 percent, and further to around 63.4 percent in 2008, but it remains slightly below rates in other SEE countries. Participationrates for men (75 percent in 2006, growing to around 76.5 percent in 2008) are at, or even slightly above, averages for the Europe and Central Asia (ECA) region. However, female participation, at 49 percent in 2006 (and relatively stable since), is lower than everywhere else in ECA, except Turkey and Kosovo.The participation of women varies considerably, with rates extremely low in rural areas, among the poorly educated, and for the young and older segments of the working-age population (Figure 7.3). Women who have attained secondary and tertiary education show between 24 and 50 percent higher probabilityof participatingin the labor force in comparison with those women who have primary or lower education. Also, female participation is significantly lower in the non-Macedonian community than among ethnic Ma~edonians.'~~The reasons for inactivity tend to differ according to the woman's situation. Among less educated women in rural areas, the large majority who are not in the labor force 162 All these elements are captured inthe MILES framework that has beenused in some recent World Bank Labor MarketAssessments, includingSerbia(WorldBank 2006). '63The analysis, based on Angel-Urdinola and Macias(ZOOS), primarily uses annualdata from the 2004-2006 Labor Force Surveys (LFS) conductedby the State Statistical Office. Inorder to provide a more up-to-datepicture of labor marketdevelopments,some analysishas also been carriedout usingthe second quarter data for 2008, which was the latest LFS micro-data available at the time this chapter was prepared. Throughout this section, the working age opulationis definedas between 15-64years ofage. p64Even after controllingfor family status, education, age, and region, women of Albanian origin have a 35 percent lower probability of participating in the labor force than women of FYR Macedonianorigin (Angel-Urdinola and MaciasZOOS). 119 report that the main reason is their housewife duties. On the other hand, better educated women in urban areas not in the labor force most often report that they are pensioners. Three-quarters of the younger women (15-24 years) who are inactive are students. Also, participation rates among youth (15 to 24) and older people (55 to 64) are significantly lower than those among adults in primary working age (25 to 54) (Figure7.3). Box 7.1: Labor Market Data in FYRMacedonia There are two sources of labor market data in FYR Macedonia: the Labor Force Survey (LFS) and administrative data from the Employment Services Agency (ESA). At the same time, the HouseholdBudget Survey (HBS), which provides information on living standards of the population,has a few questions which can shed some light on labor market status of the members of interviewed households. Each leads to somewhat different estimates of main indicators. For example, the LFS and HBS are both household surveys that collect data on labor market activities. The table below shows the main indicatorsfor 2006 (15-64 years) according to each survey. The HBS estimates are somewhat more favorable, with higher employment and lower unemployment than the LFS. This is due to differences in populationweights and definitions of the indicators. While HBS definitions of labor force status are less rigorousthan the LFS, it has been argued (e.g., World Bank 2003, Box 3.1) that the LFS may suffer from some degree of fictitious reporting that leads to an upward bias in unemployment (and an underreporting of informal employment). Still, it should be noted that HBS data should be used primarily for understanding the relationship betweenpoverty and labor market status, andnot for the estimationof total unemployment. LFS2006 HBS 2006 Labor force participation(%) 62.2 60.1 Employmentrate (%) 39.6 45.2 Unemploymentrate (YO) 36.3 24.8 Source: World Bank estimates The unemployment numbers based on registrations at the Employment Service Agency tell a more negative story than either of the household surveys. Registered unemployment at the end of December 2007 was 41,000 or approximately four percentage points higher than the LFS unemployment for the 4* quarter of 2007. It is widely understoodthat the registered unemployment figures are inflated because of people who register with the ESA for health coverage or socialassistance benefits but are not actively seeking work. Shortcomings notwithstanding,the analysis of the labor market presentedin this chapter relies primarily on the LFS because it has the most complete coverage and the most internationally agreed upon definitions of labor market variables of the various options. However, the HBS and the ESA data do have advantageson certain issues, and they are used in these cases. 7.8 Despite some recent improvements in the private sector, employment remains very low, especially among youth, women, and individuals of non-Macedonian origin. In 2006, less than 40 percent of the working-age population was employed, the lowest rate in the ECA region barring Kosovo. Employment rates for younger people (14.4 percent for the 15-24 age group and 46 percent for those aged 25-34) and for women in prime working age (44 percent for those aged 35-54) are significantly lower than that for men in prime working age (55 percent for those aged 35-54). Also, results using HBS data indicate that while poor individuals of ethnic Macedonian origin had employment rates of about 30 percent, poor individuals from other ethnic backgrounds had much lower employment rates varying from 15 to 22 percent (World Bank, 2007~). 7.9 Job creation trends have improved in recent years. The economy added 87,532 new jobs (in net terms) between 2004 and 2008. This growth was concentrated in the private sector where 151,007 jobs were created in these years. As a result, private-sector employment rose from 55 percent o f total employment in 2004 to 72 percent in 2008. Job creation has been particularly strong inthe primary sector, 120 which is predominantlyagriculture: this sector managed to create 53,342 newjobs (or 61 percent of the overall increase injobs between 2004 and 2008). On the other hand, non-private sector employment fell by 63,475 inthese years. 7.10 Much of the new employment has been low-skill work, with many of these jobs taken by young workers. Increases in employment rates have been strongest for young workers. Between 2004 and 2006, employment rates rose most for workers with low educational attainment (Figure 7.4). In the 15-34 year age group, the employment rate for workers with primary schooling or less increasedby over 5 percentage points; on the other hand, the employment rate remained flat for young people with post- secondary education. A somewhat similar patterncan be observedwith the 35-64 year age group. Figure 7.3: Female Participation Rates by Location, Education,and Age, 2004-2006 100.0 75.0- 90.0 8 v 88 89 70.0- I\ ..' 80.0 65.0- 70.0 64 ......,70 57 56 60.0 E.r. :.:. ....... ..A., ............. .A65 63 64 `/a 550 s 50.0 50.0- 50 49 47 40.0 45.0- 30.0 - 40.0- .*39................ 1 5 28 A ,+Rimry - ,,.I.' 20.0 35.0. $3.......... 10.0 or less I- Vocational o,o c..-A.. Secondary General *SecondaryUniversity Hgher or 2004 2005 2006 2004 2005 2CC6 100.0 --t15-24pars ...x...55-64 -25-54 p a r s years 80.0 . 70.0 - 60.0 . I . 61 64 63 X 50.0 . 40.0 - 30.0 - 27 28 28 + 20.0 . x.,,,,............3.................. 22 22 10.0 . 18 0 0 i 2004 2005 2006 Source: Angel-Urdinolaand Macias(2008), basedon LFS data 121 @re 7.4: EmploymentRates by Age Group and EducationalAttainment, 2004-2006 Age group 15-34 Age group 3564 02W 02005 12006 02004 02005 1 2 K 6 90 0 BO 0 -- 800 1 770 770 70 0 70 0 a? 2 600 -- a? 2 600 500 E 500 -2 EE40 0 -E04 0 0 g300 g300 W 20 0 w 20 0 t o o 100 0 0 0 0 Primaryorless Secondary Sncondary Higher or Pnmaryorless Secondary Secondary Higher or Vocational General Unlwrsity Vocational Genera Uni\ersiv wrce: Angel-Urdinolaand Macias (2008), basedon LFS data 7.11 Other measures also raise concerns about the quality of the recent job creation. The composition of employment is changing in terms of the type of employment and other measures of "job quality". An increasingshare of employment is in unpaid family work and self-employment,For the 15- 34 year age group, unpaid family work increased as a share of total employment from 12.8 percent in 2004 to 17.5 percent in 2006. This jump was almost completely due to a large increase in the primary sector. Even though it remains the dominant form of work, wage employment is declining, falling by about 5 percentage points as a share of total employment between 2004 and 2006. These changes have contributed to a deterioration of the quality of employment in the country. Results indicate that wage earners are associated with better employment quality indicators as compared to employers and self- employed. In particular, wage earners are more likely to hold permanentjobs (as proxiedby those having an open ended contract), to work full time (40 hours a week or more), and to be formal workers (as proxied by beingregisteredinthe pensionfund). Furthermore,wage earners display a lower likelihood of being in underemployment (as proxied by the share of workers wanting to work more) and a lower likelihood of havingtwo jobs (which is a signal associated with low-quality/low pay in the primaryjob). On the other hand, informality - as defined by non-registrationwith social insurance - declined slightly between2004 and 2006, from 32.4 percent to 29.7 percent oftotal employment. 7.12 Unemployment has fallen slightly but continues to be an extremely serious problem. In 2006, the national unemploymentrate (for 15-64year-olds) was 36.3 percent, almost 2 percentage points lower than in2005. It continuedto fall in 2007: inthe third quarter of 2007, it was 34.5 percent, compared to 36.3 percent in the third quarter of 2006. The official SSO estimates, based on a working-age population definition of 15 years and older, also show a decline in unemployment, from 37.3 percent in 2005 to 34.9 percent in 2007 and further to around 33 percent in the third quarter of 2008 (estimate for 2008 as a whole is around 34 percent). The differences between men and women are relatively minor (about 2 percentage points) but very large differencesexist across age groups (Table 7.3). Unemployment is extremely high among youth, at about 60 percent in 2006, although there does seem to have beensome improvement since.165While the unemploymentrate falls by 20 percentage points for the 25-34 year age group, nevertheless it was about 40 percent in 2006. For workers 35 years and older, the rate was just below 30 percent. The gains in unemployment over 2004-2006 were concentrated among younger workers (under 35 years of age). In fact, the largest decrease in unemployment occurred among people I65Inthe second quarter 2008, the 15-24 unemploymentrate was 56 percent, comparedto 63.3 percent in the same periodof2006. 122 between 15 and 34 years of age with primary education or less (10 percentage points). This is consistent with the employment increases observed for this segment ofthe labor force. Table 7.2: UnemploymentRates by Age Group and Gender,2004 and 2006 Agegroup I 15-24 25-34 35-54 55-64 Total working agepopulation UnemploymentRates-National 2004 65.1 45.1 28.9 27.7 38.0 2005 63.1 44.0 30.6 29.6 38.2 2006 59.8 40.7 29.4 28.4 36.3 Females 2004 65.1 48.0 28.8 20.1 38.5 2005 62.8 47.4 31.7 21.1 39.3 2006 61.0 43.7 30.3 21.2 37.5 Males 2004 65.2 43.1 29.0 30.5 37.6 2005 63.3 41.7 29.9 33.3 37.5 2006 59.0 38.7 28.8 31.5 35.6 7.13 The pool of unemployed workers is essentially composed of first-time job seekers and the long-term unemployed.Accordingto the LFS, 55 percent of the unemployedin 2006 indicatedthat they had never worked before.Not surprisingly, this is most prevalent among unemployedyoung people (15- 24 years) where 92 percent were first-time job-seekers. However, even among prime-age (35-54 years) workers who were unemployedaccordingto the LFS, almost 30 percent indicatedthey hadnever worked. This suggests that a substantialshare of the pool of unemployed has virtually no contact with the labor market. Further evidence of this phenomenon is the high incidence of very long-term unemployment. Excludingfirst-timejob-seekers, 91 percent of the unemployedhad beenunemployedfor at least one year and 53 percent had been unemployedfor 4 years or longer. 7.14 In fact, a significantnumber of people defined as "unemployed" Figure 7.5: Unemployment Rate by Age Groups Using are not actively searching; when Alternate Definitions , more stringent definitionsare used, 70 the unemployment rate remains 60 very high but does decline 50 significantly. According to the 40 methodology used by the State 30 Statistical Office in the LFS, 20 registering at the Employment ,o Services Agency qualifies as Total 15-24 25-34 35-54 55-64 sufficient to meet the job search condition for being defined as Standard a More actiie Most actlie 123 and or participating in ajob interview ("most active"). As Figure 7.5 shows, the unemploymentrate falls by almost 9 percentage points from the standard definition using the "more active" definition and by an additional 4.5 points with the "most active" definition). Restrictingthe definition has the larger relative effects as age increases. 7.15 There are large disparities in labor market outcomes across regions. A large variation in labor market outcomes across the country is associated with disparities in living standards and low mobility across regions.In 2006, i)unemploymentrates varied from 17 percent in Strumicato 58 percent in Kumanovo; ii)employment rates varied from 28 percent in Kumanovoto 64 percent in Strumica; and iii)participationratesvariedfrom47 percentinTetovoto 75 percentinStrumica.Notethat Strumica,a traditionally agricultural region, is the one with the better labor market indicators (although employment quality indicators are rather low in the region). Employmentquality also varies across regions. In 2006, Strumica and Tetovo hadthe lowest share of permanent employees (at 79 and 80 percent respectively) as compared to that in regions like Skopje, Bitola, and Kumanovo (at 92 percent). Informal employment (proxied by whether or not workers are enrolled in the pensionfund) was between 20 and 31 percent in regions like Strumica, Ohrid, and Tetovo versus less than 10 percent in regions like Skopje, Bitola, Veles, and Kumanovo(Angel-UrdinolaandMacias, 2008). c. NON-LABOR INCOME AND LABOR FORCE PARTICIPATION 7.16 Households where the head is not in the labor force have much higher income from social and private transfers than households where the head is in the workforce. According to the 2006 HBS, 63.6 percent of households receive income from sources outside the labor market. This includes income from capital and profits, social assistance, pensions, other types of social insurance, private transfers (including remittances), and miscellaneous sources. Table 7.4 shows the average monthly income received from these sources as well as labor market earnings, and the percentage of households receivingeach type of income. In addition to presentingthe overall picture, Table 7.4 also distinguishes between households where the head participated in the labor market and where the head did not. Not surprisingly, the former group reported earnings from works that were almost 2.3 times larger than the latter. However, households where the head was not in the labor force reported much higher (2.7 times) non-labor income. As a result, the income differential between the two types of households was only 20 percent in favor of households with working heads. Pensions represented by far the major source of non- labor income for householdswith non-workingheads. Source; Macias (2008), basedon HBSdata 124 7.17 Married women who are not in the labor force tend to be in households that rely more on social assistance, private transfers, and especially pensions than other households. As was discussed in section Bythe relatively low aggregate participationrate inFYR Macedoniais due largelyto a very low participationrate for women. Our analysis of the LFS data shows that, especially in ruralareas and among the less educated, many women indicatethat they do not participatebecause of household responsibilities. Social and privatetransfers may also play a role in decisions about the workforce participation of married women. According to the 2006 HBS data, households where the woman does not work rely more heavily on non-labor income than other households. A probit model estimated by Macias (2008) found that pension and private transfer income were both significant negative determinants of whether married women participatedinthe workforce. 7.18 Private transfers, including remittances, are received by a small percentage of households but for these households, they are a major source of income and they are associated with lower labor force participation. Only about 5 percent of households receive private transfers, including remittances. However, for some segments of the population, these transfers are much more common and are a major source of income. For example, 15 percent of households of Albanian origin reported private transfers in 2006 - in fact, Albanian households account for almost two-thirds of all households receiving transfers. Among Albanian families receivingtransfers, the average quarterly amount was 23,130 denars which is equivalentto over 36 percent of the meanquarterly income from all sources for the H B S sample of households. Figure 7.6 shows a comparison of participation rates in households that receive private transfers and those that do not. Rates are much higher in the latter group, both for household heads and for marriedwomen.166 Figure 7.6: Participation Rates Among HouseholdHeads and Married Women by Whether HouseholdReceivesPrivate Transfers, 2006 I I 82.4 80 60 57.3 40 20 0 Household heads Married women I NO primte transfer Primte transfer 1 Source: Macias (2008), basedon HBS data 7.19 Although income from social and private transfers is associated with low rates of labor force participation, it is difficult to establish a causal relationship. Families receiving income from sources outside the labor market are characterized by lower participationrates for the household head and for marriedwomen. With the available data, however, it is not possible to determine whether this finding reflects the fact that families without employed workers need to rely on other sources of income or whether income from these sources creates work disincentives. Further analysis is needed to determine the causality. '66Note that the figure for remittances emerging from the macro data is over twice as large as the extrapolated aggregate drawn from the micro data (see Chapter 2). This also implies that remittancesare probably receivedby a wider cross-section section ofthe populationthan impliedby the micro data. 125 D. SKILLSAND THE QUALITY OFTHE LABOR FORCE 7.20 Education and skills development must play a key role in ensuring a productive and appropriately skilled labor supply. To improve productivity and, thus, wages and living standards, FYR Macedoniawill need to improvethe quality of its current and future labor supply and to overcome likely shortages of well-qualified workers. Moreover, as FYR Macedonia integrates further into the European and global economies, it will need to ensure that its workforce represents a competitive advantage beyond simply low costs. Improving the efficiency and quality of secondary and higher education, and utilizing the skills in the Diaspora, will be necessary responses to these pressures. The Government has recognized the need for improvements in the skills and knowledge of the working population.A number of nationalstrategies have recently been prepared and several pieces of legislation have been passed.16' 7.21 The prevailing view is that skills are not an issue in an economy where labor demand has been so sluggish but evidence suggests this may not be the case. Various lines of analysis indicatethat some demand for skills exists in the labor market and that part of this demand is unmet. The low efficiency of higher education and the poor quality of basic education raise concerns about FYR Macedonia's current capacity to develop the emerging skills that the labor market requires. It also seems likely that migration is leading to the loss of educated Macedonians. These supply-side concerns will worsen inthe future becauseof populationaging, leadingto adecline inthe number ofyoungpeople. 7.22 Education pays off in the Figure 7.7: Adjusted Returns to Education, Wage Earners labor market, suggesting that Aged 15-64,2006 there is a demand for skilled Returns to education workers. Employment outcomes =Women nMen improve with educational LJnIMrlllhl attainment. Recall Figure 7.3 which 43 7% shows this for women and, as Higher Angel-Urdinola and Macias (2008) show, a similar pattern exists for men. Earnings also increase with educational attainment. (See Annex 7.1 for mean wages for employees , by education and other personal -10% 0% 10% 20% 30% 40% 50% characteristics.) Angel-Urdinola and x Macias (2008) calculate adjusted Source; Angel-Urdinolaand Macias (2008), basedon LFS data returns to education using a basic Mincerian-type wage specification which is estimated with the 2006 LFS data.'68The results on the adjusted effects of different levels of educational attainment (relative to primary education or less) are shown for the working-age population in Figure 7.7. For example, controlling for other personal characteristics, 4-year secondary education is associatedwith 4.8 percent higher earnings for women and 14.0 percent for men, compared to those with primary schooling or less. The advantage conferred by a I67The focus of this section is on secondary and higher education as well as vocational training. Examples of relevant laws that have been passed include the Laws on Adult Education, Higher Education, and Vocational EducationandTraining. The model regressesthe log of hourly wages on age, age squared, gender, four education categories, interactive terms including these education variables and gender, ethnicity, urban-rural, private-public sector, occupation, industry, and region. The estimates are made using OLS so selection factors are not considered. The estimation sample includesall workers in wage employmentwith non-zeroearnings.The completeregressionresultsare shown inAnnex 7.2. 126 university education is estimatedat 28.3 percent and 43.7 percent for men and women, respectively. At all levels of education, the returns for women are higher than they are for men.169 Box 7.2: Ireland From Troubled Economy to `Celtic Tiger' via Investments in Skills - Today, Ireland is widely regardedas one of the most dynamic and economically vibrant countries in Europe.This is the result of a turn-around which began in the 1960s. One of the key instruments of this turn-around was a large- scale reform o f the Irisheducationsystem andrelatedinvestmentin skills. For many years, Irelandsufferedfrom a troubled economy, with high levels of emigration peakingin the 1950s and again in the 1980s. The first wave of reforms was kickedoff by the FirstNationalEconomic Program(1958) which subsequently ledto a shift from agricultureto industry and service. Educationwas identifiedas an importanttool in this shift and as a key national investment. Educational reform occurred in various ways --the closure of small schools and morebalancedpupil-teacher ratios, reformofteacher training, new curricula with a special emphasis on science, mathematicsandmodemlanguages, and changes in schoolmanagement. One of the most striking features o f the Irish education reform has been the expansion of higher education. Enrollment increasedinabsolute terms from 20,698 students in 1965/6to 166,416 students in 2005/6. By that time, 58 percent of the relevant age cohort participatedin higher education. The step from elite to mass higher education was accompanied by an expansion of the non-university tertiary education sector. The percentage of university students in tertiary education decreased from 77 percent to 58 percent over the same period of time. Despite concerns that a significant expansion of tertiary education might fuel further emigration and unemployment, the government took an optimistic outlook in the 1980s by making further investments in the expansion o f tertiary education. Priority was given to courses which would ensure that graduates would keep up with technological changes andbe competitivewith graduates ofother countries. Despite this initial set of reforms, Irelandagain faced economic difficulties in the mid-1980s- and a new wave o f emigrationof skilledlabor. The governmentrespondedwith a range of economic initiativesanda renewedemphasis on human capital as a key factor for economic and social development. An expert group on future skill needs highlightedthe importanceof involvingemployers closely in education. Some of the skills identifiedas crucial for the 2Is`century included entrepreneurial skills, mathematics, ICT, `soft' skills like team building and communication, and foreign language skills. Standards (Le. `learning outcomes') became clearly defined for all levels and the National Qualifications Frameworkwas designed in order to allow employers and other stakeholders to get a better understanding of qualifications provided by the education system. EU Structural Funds were strategicallydeployedby the governmentinorder to supportthese large-scaleinterventions. Particular attention has been paid to upgrading the teaching profession, in terms of status and salary, targeted enrollment of high achievers, continuous professional development, and `support teams' for school planning, leadership, curricula, etc. Emphasis was placed on school autonomy and accountability so that decentralization became more than a catchphrase while capacity was built on the school level in order to support this development. Schools became increasingly inclusive, clustered their efforts around the theme of `learning how to learn' and worked more with parents. Further, the education system increasingly benchmarked its outcomes within the framework of internationalassessments. Subsequently, a highly skilled work force became a key driver of Ireland's economic success of the last decade. Havingenteredthe EEC as a net recipient of funds, Ireland had managedto become the second wealthiest member state of the EUby 2007 and a net contributor to the EU budget.Also interms of migration, Irelandhas managedthe turn-around from net emigration to becoming an immigrationcountry attracting skilled workers from Europe and beyond. Source: `A Case Study on Education Reform in Ireland.' Presentation by John Coolahan. Ankara, May 2008; `Education, Skills and Employmentfor Youth.' Presentationby Daniel O'Hare. Rome, May 2007 `69It shouldbe notedthat this regressiondoesnot account for selection effects. 127 7.23 However, these rates of return are not particularly high by regional standards and may increase further in the future. These results demonstrate that the returns to higher levels of schooling are significant. However, when these estimates are compared with results from a number of other transition countries, FYR Macedoniamust be considered as a "low returns" country. A number of other countries in the region have much higher returns, including some of the leading reformers like Hungary and P01and.I~'As the economy continues to develop, it is likely that demands for skills will increase and rates of returnto human capital will rise accordingly. 7.24 Employersin certain areas of the economy appear to have difficulties gettingneeded skilled labor. Overall, employers do not report that a lack of skills ranks highly among their operational constraints. According to the 2005 BEEPS results, only one-fifth of all firms identified lack of skills as a problem, which was slightly below the average across the Western Balkans. However, a closer look at survey evidence suggests that for companies in certain segments of the economy, acquiringneeded skills was a greater problem. The most recent survey of employers carried out by the Employment Services Agency found that almost 20 percent reported havingdifficulties filling vacancies. More specifically, the FYR MacedoniaBEEPS data show that those firms in more dynamic sectors, those experiencinggrowth in sales and exports, young firms (less than 10 years old) and those that have invested in research and development report greater problems (World Bank 2007). Again, the experience of countries that are further alongthe reformprocess is illustrative.The countriesthat have most recentlyjoined the European Union faced sharp increases in labor demand before and after accession and the supply side is now the mainconstrainttojob creationinthese countries(World Bank2007). 7.25 The tertiary education system is not producingadequate numbers of graduates because of low efficiency.The tertiary education enrollmentrate is increasing, even though the source populationfor postsecondary education is decliningquickly. The absolute number of students is increasing(the top line in Figure 7.8) and the number of first year students enrolling has almost doubled since 1990. However, Figure 7.8 also shows that the gap between the number of students entering higher education and the number graduating on time (i.e., five years later) has increa~ed.'~' No systematic research has been conducted as to the reasons for this inefficiency, but various factors appear to be relevant. Some of these are within the education system (e.g., examination process); as well, the high youth unemployment rates create a disincentive for many young people to complete their studies, even though graduates do fare much better inthe labor market than other youngpeople (see section Dand Annex 7.2). I70See Yemtsov, Cnobloch, and Mete (2006). The comparison in the text i s made against their basic specification. On the other hand, other research (Mojsoska-Blazevski, 2006) finds similar rates of return for FYR Macedonia as other countries inthe region. 171The expected length of a first degree will fall as FYR Macedonia implements the reforms under the Bologna Process and changesthe structure ofthe first degree to three or four years. 128 Figure 7.8: Students Entering and Graduating from Tertiary Education, 1990-2005 50000 45000 40000 35000 30000 25000 20000 - --- emolled graduated Source: State Statistical Office, FYR Macedonia 7.26 The BolognaProcess, which FYRMacedoniajoined in 2003 could be a powerful tool for the reform of its universities. However, this can only be the case if the implementation of the process receives more attention and is appropriately funded. The following measures need to be taken as quickly as possible in order to reform tertiary education: First, ensure that the recently passed Law on Higher Education is implementedfully. In particular, this means the integration of legally independent faculties into a unified university structure with a fully functioning accreditation system. Second, improve the graduationrate by focusing the Bologna Process to improve quality of teaching and assessment, which will increase accountability of institutions for results. Particular attention should be paid to student and internationalparticipationin quality assurance, implementationof mobility tools like the European Credit Transfer and Accumulation System, and the recognition of prior learning (see Annex 7.3 to see where FYR Macedonia stands in terms of implementation of the Bologna process). Third, introduce performance-based components in higher education funding and develop a student grants and loans scheme. Fourth, opportunitiesfor regional cooperation(e.g. with regard to quality assurance) need to be explored(for details, see Lindenet al, 2008). 7.27 The poor quality of primary and secondary education is also a concern. Macedonian students perform poorly in international assessments of skills and knowledge. The TIMSS assessment tests students in grade 8 in mathematics and science. Though performance in general rises with a country's income level, FYR Macedoniaperformance is worse than expected based on its income when compared with other European countries.FYR Macedonia's performance at grade 4 in the PIRLS assessment, which tests reading, did not improve between 2001 and 2006. In both assessments, girls performed better than boys. This may be relatedto the fact that young women receive higher returns to their education than young men (Annex 7.2). 7.28 However, FYR Macedoniais currently implementinga range of important reform measures in the field of general education. This includes a phased educationaldecentralizationprocess as well as 9-year basic education for which curricula and training modalities are now in place. While enrollment in primary education is in line with levels in the EU and is equitable across different sections of the 129 population, enrollment in secondary education is far below the EU average as well as inequitable across income groups, rural vs. urban areas, and gender. This is expected to change with the introduction of compulsory secondary education in September 2008. New curricula requirements for basic education have been introduced in foreign languages and in information technology. Also, the Government is proposing a new cash transfer program (with support from the World Bank) that ties cash transfers to school attendance, which, ifundertaken successfully, could help to improve school enrolmentof children from poor families. Additional key reforms have beenthe introduction of nationalexams (following grade 4 and 8) andthe Maturaas a standardized secondary school leavingexam. These assessmentswill provide the basis for future evidence-basedpolicy makingin education. The Maturaexam was conducted in 2008 for the first time and will be conducted on an annual basis. FYR Macedonia will also need to continue benchmarkingits education system against EU and OECD countries.This applies in particular to PISA, the assessment of competences of 15-year olds conducted by OECD in which FYR Macedonia participatedin 2001 but not in2006. FYR Macedoniashouldnowjoin again for the 2009 round. 7.29 For those in the workforce, access to training is very limited. Macedonianfirms in general provide less trainingthen the companies elsewhere in the region; for example, about 40 percent of skilled workers received training over a three-year period prior to the 2005 BEEPS compared with 53 percent in EU8 countries. In FYR Macedonia, like in all other countries, training access is very uneven. Those who receive the most trainingare those who already have high levelsof educational attainment (BEEPS 2005). For less educated workers, trainingis infrequentlyoffered. 7.30 FYRMacedonialacks an overarchingLifelongLearning(LLL) Strategy covering all levels and phasesof learning(pre-school to post retirement).As noted, the Law on Adult Educationhas been recently passed but now needs to be fully implemented.This would represent an important element in a framework for LLL. Other priorities in the area of lifelong learning would be an incentive program to improvethe quality of teaching at adult education institutions; better informationfor prospectivestudents and trainees on adult education and training options; and a transparent and fair certification system for both public and private education providers. FYR Macedonia should also attach high priority to the development of a National Qualifications Framework in accordance with developments in the EU and accession countries. Employersas well as other stakeholders will need to be involved in the preparation of this framework. 7.3 1 Given the extensive range of weaknesses identified in the Macedonian education system, a multi-facetedapproach is needed.There is likely to be a rise in secondary education enrollment because of new legislation which will make secondary education compulsory in September 2008. But improving quality at the same time is also important.The evidence on labor market outcomes by education suggests, at the very least, a shift away from 3-year vocationalprograms. Addressingthe problemof low graduation rates in higher education will require the Government to push ahead with the implementation of the Higher Education Law, especially on the quality of teaching and the management of institutions. But universitieswill need considerable support (and pressure) from the Government to implementthe reform effectively. The capacity for developing a skilled labor force is also constrained by an underdeveloped postsecondary professionaland technical system (e.g., polytechnics, community colleges). The new Adult Education Law provides an opportunity to carry out an extensive restructuringof professionaland adult education and training but the challenge will be to implement the law successfully. This will require incentive programs to improve the quality teaching at these institutions; ensuring that information is available to prospective students and trainees to enable them to make informed choices; and creating a transparent and fair certificationsystem for bothpublic and private providers. 130 7.32 Macedonians living in other countries may be a potential source of skills. Estimates of the numbers of Macedonians with tertiary qualifications living abroad vary con~iderably.'~~An international database puts the number at almost 80,000 (Docquier and Marfouk 2006); another source (World Bank 200%) puts the number at 77,500 in 2005.'73These are significant numbers, given that there are approximately 150,000 people with tertiary qualificationsliving in FYR Macedonia.While policy makers should be modest in their expectations about the extent to which the skills and knowledge of expatriates can be readily captured and used, the experiences elsewhere can be a useful guide. For example, Scotland's exploitation of its Diaspora appears to be on a successful trajectory. GlobalScot specifically targeted highly-placed individuals of Scottish origin located around the world. Perhaps the key success factor in GlobalScot is the presence of strong home country institutions which can facilitate the social network effectively through rapid response. In addition, sustained growth in the home country and the prospect of good jobs tends to attract migrants back, as the experience of India shows. Finally, policy- makers should also be concerned about tapping into migrants' business connections and accumulated knowledge,not only persuadingthem to return(Kuznetsov 2006). 7.33 A program for attracting migrants back could draw on FYR Macedonia's own experience. Some of the firms interviewed in preparingthis report had owners who had returnedfrom overseas. For example, one of the owners of a small firm in the Tetovo region had returned from Germany a few years ago, to start a metal-based furniture factory. He had bought depreciated machines from his former employer to start off his business in FYR Macedonia, drawing on his technical knowhow and financial savings. The fact that this happened in a much more difficult environment in FYR Macedoniashows that at least some people living overseas could come back, given the right conditions. Convincing them may require improving the investment climate, supplemented by active programs that seek to provide and exchangeregularinformationwith the diaspora. 7.34 Easingwork visas and negotiatinga CEFTA agreementon skilled labor movement can also help. The process for foreignersto secure work visas handicapsfirms' investmentdecisions, and needsto be streamlined(see Chapter 4). Also, an agreement on free movement of skilled labor within the CEFTA countriescan help, and could be negotiatedbilaterallyto beginwith (see Kathuria, 2008 for details). E. WAGES AND LABOR TAXES 7.35 Official statistics indicate that real wages have been increasing relatively quickly in recent years. Accordingto SSO wage data, real wage growth was modest throughthe early years of this decade, but increasedsubstantially in 2006 and 2007. Figure 7.9 shows the nominalgrowth in average net wages. Real net wage growth was 4 and 5.5 percent, respectively, in 2006 and 2007. In 2008, despite high growth in nominal wages of over 10 percent, real wages grew less than 2 percent, owing to high inflati~n."~Despite high unemployment, FYR Macedonia's wages can face further upward pressure 172Those livingoutsideFYR Macedoniawith less thantertiary qualifications couldalso be a potentialsourceofnew skills and ideas; even the low-skilled, if they were employed in the formal sector, will have had exposure to new methods of organization and management of firms. They remain low-skilled only in relation to others in their countryofresidence. Inaddition, more educatedpeopletendto migratemorethan others. Using 1999-2005 data on migrationfrom 18 Central and East European countries to the EU, we find that the change in the tertiary educated population is negatively associated with the change in the intensity of migration. The estimated regression coefficient is -0.28 (however, the R-squareis low, and other influenceson tertiary education have not been taken into account, so this result should be taken as indicative). This analysis supports the conclusionthat there is a large pool of educated workers overseas. 174The source of official wage data is the TRUD-1 survey carried out monthly by SSO. TRUD-1 samples about 3,600 entities andreportingunits. Unlike some of the establishmentsurveys in other WesternBalkan countries, the 131 because of low skills among much of the Figure 7.9: Annual PercentageChange in Nominal Net Wages, 1997-2007 unemployed, and the pull exerted by YQYX growing wages in the 9.0 neighboringregion(see also Chapter 4, and 6.0 World Bank 2007b). 3.o 7.36 Labor costs are slightly above the 0.0 SEE region averages when the hot meal 4.0 allowance is included. Table 7.5 compares .6.0 FYR Macedonia with 1937 1998 1W Zoo0 2001 2002 2W3 2W 2005 2oa6 2007 other countries in the Western Balkans as Source: WorldBank calculations based on TRUD-1 data well as Bulgaria and Romania for 2005.'75It should be noted that there are issues of data reliability in many of the countries and of comparability across countries. However, these data indicate that, when labor costs are defined as wages plus taxeshocial contributions, FYR Macedonia is below all of these comparator countries except Bulgaria and Albania. However, when the hot meal allowance is included, which is the relevant indicator to judge labor cost to the employer, the picture changes somewhat, with FYR Macedonia below only Bosnia and Herzegovina (Federation) and Montenegro. Until recently, in FYR Macedonia, the hot meal allowance was an obligatory benefit, non-taxable to 20 percent of the average nationalnet average. Table 7.4: Average Labor Costs With and Without Hot Meal Allowance, Western Balkan Countries,2005 meal allowance Source: Arandarenkoand Vukojevic (2008) TRUD-1has maintaineda fairly representativesample in the face of economic changes, which has led to relatively reliablewage estimates (Arandarenkoand Vukojevic 2008). "'Thisi s the latest date for which comparable data were available for Arandarenko and Vukojevic 2008. It does include FYR Macedonia's subsequent tax reform but, at the same time, does not include the recent high wage growth. 132 7.37 Social contributions represent an important source of overall labor costs. FYR Macedonia has recently implementeda flat personal income tax which is now set at 10 percent, which is among the lowest rates in the region. However, overall labor taxation remains relatively high because of the social contribution^.'^^ Infact, accordingto the 2007 budget, these contributionsaccount for almost one-third of all government revenues. The high social contributions are characteristic of the other former Yugoslav republicsand, indeed, many countries in ECA where Bismarckiansocial security systems are financed by payroll-basedcontributions.Until recently, the social insurance contributionrate was 32 percent of gross wages, of which 21.2 percent was for old-age pensions and disability, 9.2 percent for health insurance, and 1.6 percent for unemployment in~urance.'~~The payroll reform launched recently and described in more detail in paragraph 7.40 addresses a number ofthese issues. 7.38 The labor tax wedge is especially high for low-wage labor, largely because of the minimum social contribution. Table 7.6 shows the tax wedges in 2008 (including mandatory fringe benefits in earnings) for FYR Macedonia and compares these with the tax wedges in the other Western Balkan countriesfor differentearninglevelsand family situation^.'^^ Throughoutthe region, labortax wedges are high- although somewhat lower in Albania and BiH-RS than in the rest of the countries.Generally, there is a lack of progressivity in all of these labor tax regimes because of an absence of income-related deductions and credits. This is true in the case of FYR Macedonia.Moreover, the situation is aggravated because the effective social insurance contribution rate for low-wage earners is higher than the statutory rate becauseof the minimumsocial c~ntribution."~ Table 7.5: Labor Tax Wedge for Various Income and Family Situations(Including Source: Arandarenko and Vukojevic (2008) and Leibfritz (2008). 7.39 High tax wedges are a disincentivefor formal employment,with the effect strongest for low- wage labor. A high tax wedge acts to reduce employment because of its effects on both labor demand and labor supply. To the extent that social contributionsand personal income taxes raise total labor costs, they decrease employer incentivesto formally hire workers or to fully declare their earnings. At the same `76This discussion of labor taxation is basedon Leibfritz (2008) and Arandarenko and Vukojevic (2008). I77In fact, the calculationof socialcontributionswas quite complicatedbecause they were computed by grossing up net wages, which are the basis for wage-setting. Reformsjust launched (see paragraph 7.40) seek to simplify these calculations, and will be a useful input into makingthe system more transparent and understandable. 178 The labor tax wedge is calculated as income taxes and combined (employer-employee) social security contributions, minus cash benefits, as a percentage of total labor compensation. It measures the gap between the total labor costs ofthe employer andthe employee's take-home pay. The bases for these minimum contributionsare percentagesof average gross wages. Currently, these are different for the various types of contributions although there are plans to harmonize the bases.The wage base for the minimum pension contributionand the minimum contributionfor unemployment insurancehave been 65 percent of the national average wage while the minimum contribution for health insurance has been 65 percent of average sectoral wages adjustedby complexitycoefficients; since mid-2007 the minimum base for the health insurance is 50 percent of the nationalaverage and it is plannedto raise it to 65 percent from July 2008, although the final decision has not yet beentaken. 133 time, by cutting take-home pay, a high tax wedge reduces incentives for workers to participate in the formal labor market or to fully declare their wages. Because of how the elasticity of labor supply and demand and the final incidenceof labor taxes (Le., who actually pays) vary along the wage distribution, the negative employmenteffects of a high tax wedge tend to be strongest for low-wage labor.'" This also means that small firms, who pay lower wages, are more affected by the structure of labor taxes, with a higher percentage of wages due as taxes. Besides creating incentives for under-reportingwages and/or employment, it offers another reason for most firms not beingable to grow, as chapter 4 documents. 7.40 The Government has recently launched a reform of the payroll system and the social contributions. The reform reduces the tax wedge for lower-wage workers, broadens the tax base by including fringe benefits, harmonizes income bases for social security, and moves from a net wage to a gross wage basis for calculating contributions. These reforms should have positive effects on the labor market in general, and for unskilled and young workers, in particular. However, the plan also includesan across-the-board cut in social contributionsby 10 percentagepointsover the next three years which raises the issue of the fiscal costs of these measures and (possibly) the need to find other revenue sources or reducinggovernment spendingto ensure fiscal discipline and macro stability. F. CONCLUSIONS 7.41 The employment situationhas improved somewhat but still remains a very serious problem that will requiremulti-sectoralresponses.Over the last three years, the labor market has improvedwith some increase in employment and reductions in unemployment. However, FYR Macedonia's labor market indicators are still among the worst in ECA and far from the levels in EU countries. Moreover, much of the recent increase in employmenthas been in relatively low-skill, low-qualityjobs. The roots of the country's employment problem are widespread and involve factors both outside and inside the labor market. Many of the factors outside the labor market are dealt with in the rest of this report. Without intendingto be comprehensive, this chapter has focused on three potential constraintsto employment - disincentivesarisingfrom non-laborincome, skills deficiencies, and labor costs andtaxation. 7.42 Households without actively employed members rely heavily on social and private transfers; however, it is difficult to determine whether these transfers are a disincentive to work. Given FYR Macedonia's low participationrates, especiallyfor women, an important question is whether non-labor income affects labor supply decisions. Not surprisingly,households where the head is not inthe labor force have much higher income from social transfers, especially pensions, and private transfers -- and much lower earnings -- than households where the head is in the workforce. Married women who are not in the labor force also tend to be in households that rely more on pensions and private transfers than other households. Private transfers, including remittances, are received by only a small percentage of households but for these households, they are a major source of income and they are associated with lower labor force participation. Although the analysis has established these associations between non- labor sources of income and non-participation in the workforce, further work would be needed to determine the causaldirectionofthis relationship. 7.43 Although a lack of workforce skills is a problem only in specific segments of the labor market, this is likely to become a more serious constraint to employment in the future. Employer surveys show that skills are a much less important barrierthan many other factors. However, for the more dynamic segments of the economy, some evidence is emerging that a lack of skills and/or skill mismatches are already a constraint.Moreover, ifthe experience ofthe new EUmembers is a guide, FYR Macedonia can expect that skills will become a more important issue as reform proceeds. Population See BetchermanandPages (2007) for a hller discussion. 134 aging will only increase the supply-side pressures. To prevent skill constraints from becoming a constraint to faster growth, FYR Macedonia would need to address the issue of skill development urgently, giventhe long gestation lagfor skill development. 7.44 Over the longer run, important reforms will be needed at all levels of the education system to ensure that FYR Macedonia's workforce is competitive regionally and internationally. Since education andtraining reform is longprocess, it is importantto act now. Improving the quality of primary and secondary education would provide a necessary foundation. New reforms to modernize curriculum, improvetesting, and decentralizeeducation system management will all be positive steps, if implemented effectively. Low enrollment in secondary education has also been an issue but this is expected to change with the new legislation making secondary education compulsory. Addressing the problem of low graduation rates in higher education will require the Government to push ahead with the implementation of the Higher Education Law. The new Adult Education Law provides an opportunity to carry out an extensive restructuringof professionaland adult education and training but, again, the challenge will be to implementthe law successfully. 7.45 Labor costs are a concern, primarily becauseof the hightax wedge for low-wage labor. FYR Macedonia's overall labor costs are in the middle range of Western Balkan countries. Since 2006, however, real wages have been increasingat a significantly higher rate than was previously the case (in 2008, however, real wage growth slowed down despite high nominal wage growth, owing to higher inflation). Moreover, the current structure of social contributions merits close attention. The regime is regressive, with effective contribution rates highest for low-wage labor. Given the sensitivity of disincentivesfor young and unskilledworkers -- who currently have very poor employment prospects -- employment to labor costs in this segment of the wage distribution, the high tax wedge creates serious to find formal jobs. Policy options that would reduce this tax wedge would improve labor market outcomes, andthe Government'srecent reformsfor reformingsocial contributionsare consistent with this objective in some ways. However, because of the proposed across-the-boardcut in contribution rates, the fiscal costs need to be carefully assessed and other revenue sources or government spending cuts may be neededto ensure fiscal disciplineand macro stability. 7.46 A major challenge for policy-makers will be to address the large inequities in labor market outcomes across regions, genders, and ethnic groups. Results in this chapter highlight large disadvantages for women, youth, and minority groups with low levels of education. This raises concerns about the exclusion of these groups from the labor market and participation in the economy. A mix of factors, such as discrimination, culture, and precarious employment conditions (Le. low demand, low- wages, and low quality) coupled with high reservation wages resulting from private transfers and pensions provided by the extended family; may be contributing to low employment rates among youth and unskilledwomen, and especially among those from minority (often disadvantaged) groups. Also, the lack of convergence across regions in employment outcomes points to weaknesses of equilibrating mechanisms such as wage adjustments and interregional migration. In principle, workers from worse performing region could migrate to better performing regions. However, there seems to be low internal migration flows in FYR Macedonia. Understandingwhy this occurs is important for achieving a better functioningand more inclusive labor market. 135 8. MICROECONOMIC ISSUESINGROWTH: LESSONSFROMAGRO- PROCESSING,TEXTILES AND INFORMATION TECHNOLOGY A. INTRODUCTION 8.1 This Chapter focuses on lessons and issues for FYR Macedonia's growth from three sectors: 0 a basic sector-agro-processing-that now has more complicateddimensions; 0 a traditional sector for FYR Macedonia-textiles and garments-that faces global challenges; and 0 a cutting-edgesector-information technology(IT). These sectors thus have very different characteristics, face differentchallenges and raise different issues. 8.2 Analysis o f these sectors' development and prospects is instructive not only for their future growth but to illustrateissues in other sectors in the economy. This chapter is therefore not an attempt to "pick winners". Rather, it draws lessons from the performance, key success factors, and the barriers and constraints to growth in these three sectors to draw conclusions for these sectors as well as for the economy in general. The analysis draws on intensive, firm-level interviewsof importantand diverse firms in each of these three sectors, done as part of the preparationof this report. These interviews enable in- depth insights to complement the analysis in other parts of the report. The report also draws on other World Bank studies, particularlythe recent report on agriculture(World Bank 2006a). 8.3 The following three sections of the Chapter deal with Agro-Processing, Garments, and Information Technology in turn. The Chapter's final section draws together overall conclusions and recommendationsfor these and other sectors. B. THEAGRO-PROCESSINGSECTOR 8.4 Agro-processing is often considered a "traditional" sector, but in fact firms' success in a globalized world economy often depends on using modern, sometimes high-tech methods. Specifically, growth in the current, competitive world economy depends on the efficiency o f collecting high-quality agricultural raw materials; processing them using modern, sometimes capital intensive, techniques; complying with high standards; and distributing the output rapidly while maintaining minimal inventories. Often distribution is international.Flower exports are a well known example of these issues: although flowers may be easy to cultivate, their successful commercialization involves many of these factors. The government often has an important role in facilitating these sectors but government credits are usually not a factor in success, particularly in FYR Macedoniawith the financial system continuing its development along the lines described in Chapter 5. 8.5 This section deals with three sub-sectors in agro-processing: dairy products, wineries and fruit and vegetable processing. These sub-sectors are characterized by different levels of concentration:high in dairy and wine products, less so in fruit and vegetable processors. The dairy industry is the only one of the three that has experienced foreign investment, thus far. However, foreign investors have been interested in fruit and vegetable processing, as well as in other food processingsectors (not covered here). 8.6 In dairy products, consolidationand entry of foreign investment has occurred with about half of the output now supplied by the four largest firms, although some 60 small firms remain. The industry's structure reflects to a large degree developments that go back to the mid-l990s, when one of the two major dairy processingfirm went bankrupt and the other firms, often as small as 1/50thof the size of the 137 largest firms, were privatized to managers and employees; since then other small firms have started. These firms were locally focused and enjoyed protectionfrom imports not only from tariffs but costs of distribution.Productquality and technology in the sector were weak. 8.7 The structure of the dairy industry and its prospects changed dramatically in 2007, beginning a process towards modernization along the lines described above. Foreign investors, in concert with domestic investors, completed a green-field investment that went very smoothly, including not encounteringany problems of land purchase or permits.Other foreign investors bought the existing large dairy and made investments in other firms. As a result of the rise in processingcapacity, demand for raw milk inputs rose, especiallyhigher quality raw milk. However, the supply was limited and the priceof raw milk rose sharply (this also coincided with the increase in world food prices). In order to deal with the price rises, secure inputs, and improve their quality, the two largest firms and a few of the smaller ones made collection arrangements and supply contracts with farmers' groups, including the provision of storage equipment. In some cases, they even made some loans to farmers, in order to by-pass the difficulties that farmers had in obtaining credit arising from the problems in using rural land and structures as collateral (Chapters 4 and 5). Nonetheless, the higher prices contributed to a further inflow of imports,"' which accounted for about 40 percent of the market by end-2007. 8.8 Although the growth of the dairy sub-sector was weak in 2004-2006(Table 8.1), its prospects for future growth may be better but depend on attainmentof EUrules on safety, hygiene and control of food products that will allow export (Box 8.1). Recently, the foreign investmentwhich triggeredthe growth in the dairy sector over the last year encountered severe financial problems (mostly related to unsound business decisions rather than developments in the agriculture sector) and went bankrupt, leaving behind several farmers in financial distress. Regardless of its failure, some of the strategies put in place by the . foreign investment (such as focus on quality, expansion to new products and markets) continue to be relevant and offer useful lessons for the dairy and other sectors (see section E in this chapter). With the start of the process to improvethe domestic supply chain, imports fell inthe first half of 2008. The farms, given longer-termcontracts with the large firms and the new infrastructure, are expected to expand their productionof higher-quality,raw milk. Table 8.1: Indicators of Agro-Processing Companies Interviewed and the Sub-sector Interviewed Firms Sector as a Whole Revenue Employment Production Exports$ m. Imports$ m. Increase Increase Increase Increase Increase 2004-2006 2004-2006 2004-2006 2004-2006 2004-2006 Dairy (5 firms) -9.8% 4.6% 4.2% 2.5 7.5 Fruits and Vegetables (4 firms) 17.6% -4.5% 17.8% 45.8 1 Wineries (1 firm) 36.5% -32 % -14.0% 13.1 1.7 Sources: Sample: World Bankcalculations, from Company Registry;ProductionandTrade: SSO Notes: Productionin Dairyrefers to tons of milk production.In h i t s and vegetables, it refers to total tons of juices, tomato pureeandketchup, andpasteurizedvegetables. 8.9 How the smaller, local dairies will grow in this context is unclear-some sort of consolidationis likely to occur. Smaller firms are likely to face a tightening of supply of raw milk and increased competition, as well as problems in making a good case for financing for modernization and getting external know-how in this tougher market. Nonetheless, these firms will need to upgrade to cope with a As noted, prior to 2001 importswere limitedby protectionand foreign suppliers' high costs of distribution inthe small market.In 2004, after FYR Macedonia's accession to WTO, imports from CEFTA and EFTA rose and then rose again inthe nextthree years inresponseto domestic supply problemsandrisingprices. 138 shrinking local market for their traditional products as consumers move to higher quality products. One solution may be offering niche products. Cooperation is another option, for example, by establishing common collection points for farms and for distribution networks. Public intervention may be useful to stimulate such structures and in co-financing assistance programs to help these firms implementhygiene regulations. Box 8.1: FYR MacedoniaMust ImplementBetterStandardsfor FoodProducts FYR Macedoniamust implement European rules for safety, hygiene and control of food products (especially in milk and dairy products) to export to the EU, which is an important challenge for Macedonian food processing companies. Ifthe companies do not meet the standards, their exports will soon be restrictedto only a few (non- EU) neighboring countries, and even here there may be a lack of demand as these countries are increasingly applyingEU standards. A key example is the dairy industry.Accordingto the EU milk "rulebook", ' bythe end of2009 producersof dairy products must introducea system for automatedfilling and closingof containers. By end of 2012 the full range of milk safety standards must be fully introduced. At present only the two largest dairies meet these standards although a few medium dairies are in the process of adapting to EU standards. The vast majority of the small companies do not meet the standards and their lack of resourcesand low technology will make it difficult to attain these. Moreover, Macedonian dairy companies are likely to face increasing import competition from foreign producers that use higher standards. Inaddition, the Macedonian institutionsresponsible for implementationof veterinary and sanitary regulations need to be developed further. Their improvement will contribute to an improvement in the current low quality of raw material inputs and, consequently, in the quality of the final products. In that context, the survey respondents pointed to the need for better equipped laboratories that could impose (effectively controlling) quality, hygiene, and veterinary standards on raw material suppliers and milk producers. Such improvements in laboratories and policiescould help stimulate the necessary investmentsinthe sector to increasequality. Such issues of standardsexist in many industries, and are related to problems inMetrology, Standards, Testingand Quality (MSTQ). These problems include i)the unavailability of certain types of testingor calibration services; (ii) non acceptance/recognition of the validity of tests performed in FYR Macedonia due to the absence of mutual recognition agreements between the national accreditation body (which accredits domestic testing labs and conformity assessment bodies) and the membership-based regional and international accreditation associations; and (iii)the costs imposed by re-certificationand conformity assessment requirements stemming from regulatory differences between FYR Macedonia's standardsandthose ofthe EU or other trading partners. ' The EU milk rulebook defines how farms should be built, the equipment and milkingrooms, and how milk should be kept and transportedto producersof dairy products. 3.10 The winery sector is more traditional than the modernizing dairy sector, and has shown little Jolume growth (to some extent because o f weather conditions); it has yet to experience any foreign investment. The largest 6 firms account for an estimated 80 percent of production and, though some are large compared to regional wineries, they are small compared to major Australian, Chilean, Italian and French firms. The rest of the sector's output is accounted for by some 35 firms that are even smaller. About half o f the firms export, mostly bulk wine; total exports are around 50-60 percent of the sector's production.'82The largest firm has improved technology recently and its growth has been good, even though the sector appears to have not grown in volume terms (Table 8.1). This firm has moved to increase the share o f bottledwine in production, which is more profitable than bulk wine (Box 8.2) and some other ,firms are also moving in this direction (which together with weather conditions may at least partly explain the lower output). Imports have a minimal share o f the domestic market, probably reflecting the lack of 182The top three export markets are Germany, Serbiaand Croatiabutthere are exports to more than 26 countries. 139 external interest in the small market but also high protection. In sum, the winery sector as a whole seems to have experienced a comfortable existence and reasonableprofits without much competition in the local market, but growth has been low. Some of the wineries may experience problems, particularly as competition grows in the bulk international wine market and iftariffs on imports are reduced (MFN tariff on wine is 60 percent; wine from the EUfaces the same tariff; wines from Serbia, BiHand to some extent Croatia receive preferential treatment and pay zero or reduced duties). While some growth can occur domestically as Macedonian consumers move up- market, the potential for high growth lies in nternational sales o f branded products. Box 8.2: Tikves - Growth through Value-added Production Little recognitionwas given to Macedonianwines (even in the SFR Yugoslavia) until recently. Most Macedonian wine producers concentrated on bulk wines, including Tikves, which was one of the most important bulk wine suppliers in the Balkans. But bulk wine has no brand recognition, making it difficult for Tikves, and Macedonian producers in general, to add value to their product. The bulk wine market is also highly competitive and proving increasinglyless profitable as new producers begin wine production. Recently, Tikves' new owners and management (a group of shareholders and managers formerly from Skopje brewery) decided profits could only be increasedby shifting emphasis from bulk wine to bottledwine. They made large investments in new machinery and replacedtheir old vineyards, as a few other wineries are now doing. Their shift was helped by anew law on wine productionand the Macedonianproducers' increasedability to export to the EU. Tikves' share of bottled wine in productionhas gone from 30 percent of production in 2004 to 50 percent in 2007. Due to this change, the company's income rose 36 percent over 2004-2006, and increasedeven faster in 2007, even though the volume of productionactually decreasedbetween2004 and 2007. Tikves's strategy to move up-market shows what can be done in a small economy: focus on niche productionwith higher value added, often for exports, and make the necessary investmentsin modernization.This strategy requires attention to high standards, and cooperation with internationalmarket chains. It also involves continuous effort in publicizing the product. At the same time, the difference between Tikves and some o f the newer wineries, on the one hand, compared to the rest of the wine sector (which has not grown), on the other, illustratesthe risks of not movingup-market andhavingto compete on pricealone inhighly competitivemarkets. 8.11 The fruit and vegetable processing sector has about 50 small and medium sized firms (by even Macedonian standards) that dominate the local market and export. Thus far there has been no foreign investment, although some foreign firms have expressed interest. The sector has experienced much higher growth than GDP over 2004-2006 through exports (Table 8.l), account for an estimated 60 percent which of output. Some o f the larger producers have done well through links to international supermarket chains, including production that is sold under their labels. Such producers have already met foreign product certification requirements. But unbranded products may face more competition in the future from lower- cost producers. 8.12 According to firm interviews, the principal current problems in the sector are the supply o f raw materials, reflecting underinvestment in production of raw materials. Local farm production is limited. Import tariffs are high for raw materials grown in FYR Macedonia (Chapter 3), and all packaging must be imported (the tariff on packaging materials varies, see annex 3.10, and there is significant import from the MFNtariff areas, where the tariff is higher).There are also issuesregardingthe ownership and use ofland by farmers and factories for expansion, as well as for loan collateral (Chapter 5). The farms themselves often use obsolete technology and are fragmented. Also the sector's supporting infrastructure for inputs (storage facilities, freezers, packing facilities) is not well developed, though this is not a major issue at the 140 moment because of the small size of production-raw materials are typically processed during the peak season.Nonetheless, these factors have slowedthe shift toward highervalue-added output. 8.13 In sum, export growth will continue to be critical to sustaining the agro-processing sector's growth, but a number of obstacles need to be resolved, particularly for the small firms. Export growth would be helped by the market connections of foreign investors; at the moment the small size of most Macedonian firms makes it difficult for them to develop foreign markets. Foreign investment may also contributeto consolidation in the sector. c. GARMENTS TEXTILES AND 8.14 The FYR Macedonia garments and textiles industry has undergone a major structural shift that has allowed it to remaina significant part of Macedonianindustry despite growing world competition.At the end of the 1980s, the industry in FYR Macedoniaconsisted of large, integratedfirms coveringyarn, fabric and apparel production, based on protection, with domestic wool and cotton production, and abundant, low-skilled labor. Two decades later, the over-sized, protectedfactories have been replaced by numerous small-scale garments factories exporting much of their production into an increasingly competitive world market. Production and employment are significantly below their late 1980s' levels, largely because of the loss of the yarn and fabric productionsegments but employment in garments has actually risen somewhat over recent years. 8.15 The garments and textiles sector (now dominatedby garments production) nonetheless represents a major part of Macedonian industry (40 percent of employment in manufacturing)and exports (over 20 percent of total exports, second behind iron and steel). Production is concentrated in the segments of cut- and-make and cut-make-andtrim apparel, in which raw materials are supplied by the buyer, processedin FYR Macedoniaand re-exportedagain.The most important export products are shirts, blouses and pants. Major destinations for these products are Germany (50 percent), Greece (19 percent), the Netherlands, United Kingdom and Italy. 8.16 The changes over the last two decades reflectedthe sector's positiveadjustment to the challenges and opportunities it faced. The challenges included the loss of the SFR Yugoslav market; the opening of the Easternblock to trade (which meant not only a loss of a large market but also new cheap competition from these countries); the growth of Chinese and other low wage garments and textiles exporters, which had an increased impact on the world market with end of the Multi-Fiber Arrangement export quotas in January 20O5.lg3 On the other hand, opportunities were FYR Macedonia's quota-free access to the EU under the 1997 agreement with the EU and its relatively generous quotas in the U S market. In 2001, the sector was unbundledand restructured,with early privatization beinga source of strength.Ig4 8.17 One factor in the competitivenessof Macedoniangarment producers has beenthe low direct cost of garment production.According to a 2002 survey on costs in garment produ~tion'~~,the subcontracting costs per minute in FYR Macedoniawere 0.07 in 2002, which put the country in the lower end of the distribution (Figure 8.la). Indirect evidence suggests costs have remained stable since 2002. This low direct cost in turn partly reflects the flexibility of wage and employment contracts after the sector was restructured.As a result, employment actually has grown in garments (from 32,000 in 2000 to 34,000 in 2006), although averagewages in the sector had fallen to about 40 percent of the nationalaverage in 2006 I83In addition, the political events of the 1999 Kosovo crisis and the 2001 domestic conflict affected garments production and sales temporarily. Early privatization helpedStip, the mainproductioncenter inFYR Macedonia, to remain competitive, incontrast with the fortunes of Leskovac,a majortextile cluster in Serbia. See ESI(2007). SECO Sector Consulting, Market Survey 2002. 141 (see Figure 8.1b).lg6Also, real wages fell 60 percent in real terms over 1990-2006 compared to an estimated real wage decline of 25 percent in the rest of the economy.'*' This information is consistent with Chapter 7, which showed that newjobs have recently been created primarily in low-skill segments. Unfortunately, the low and decliningreal wages meanthat the garments sector couldwell be contributing increasingnumbers to the poolof working poor. Figure 8.1: FYR Macedonia:ComparativeCc 8.la --Subcontracting Costs per minute 3.lb-Wage Developments in FYR Macedonia 16,OW0 - 14,000.0 - I 12,000 0 .' 10,000.0 - / 6.000.0 - e + + Botswana + milippines 6,0000 - --- --I -----' 4,0000 7 10.05 - Belarus : 2000 2001 2002 2003 2004 2005 2006 2007 -Net w age, econory average-- Netw age, apparelsector Source: Left panel: SECO Sector ConsultingMarket wvey 2002; Right panel: State Statistics Office 1 8.18 In addition to its low direct costs, FYR Macedonia's competitiveness reflects its efficiency in managing the process of productionand logisticsof the re-exportmodel of garment production. Oftenthe first run of garments is produced in low- wage countries and shipped well before Figure 8.2: Macedonian Garments Exports (World, the season. A second production run is $million) and Share inEU-27 Imports made for better-selling garments in production centers close to the final 650 market, where time-to-market and 600 quality is of the essence. In FYR 550 Macedonia, this process is often 500 managed by agents who make 450 arrangements to import the raw materials, havethe final garments made, and then re-export them to the markets. These agents are commonly closely 250 0.25 integrated into their global customers' 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 supply chains, and provide both -Eq~orts, in USD million --C Share in EU-27 imports manufacturing services (quality control, inventory management and order Source: UNComtrade The decline inrelativewages in garments owes to the flexibility of wage contracts, the surplus labor arising from the decline in yam and fabric production, and the sector's integration into world markets (implying that external conditionsplay a big role in setting wages inthe sector). Higher wage growth in other sectors could be explained by the presenceof a large government sector (where wage-setting is different); lower level o f internationalcompetition insome sectors; and, insome cases, productivity growththat allowedhigher wages to be paid. "'In Bulgariaand Romania, two countries with large apparel sectors, tighter labor market conditionshave reduced the internationalcompetitiveness of apparel production. 142 processing) as well as traditional logistics services. Finally, the whole operation depends on rapid customs processingfor both imports and re-exports.'88 8.19 As a result, FYR Macedoniahas remained competitive in certain segments of the garments and textiles industry. Its garments and textiles exports have risen and it is the only country (other than Serbia and Montenegro together) in SEE8 to have increased its share of world garments markets since 2004 (Figure 8.2 and Annex 3.8). 8.20 Nonetheless, the Macedoniangarments and textiles industry faces future challenges. Competition from other countries will remain fierce. This is particularly true to the extent that Chinese and Indian garments producers begin to compete in "second runs" through use of air transport. Moreover, the experience of other countries in the region as well as interviews with local firm managers and agents suggest that an affordableand qualified laborforce is increasinglybecominga constraintfor the industry. 8.21 At the same time, two factors will help FYR Macedonia meet these challenges. First, FYR Macedonia's greater integration in world trade is improving the industry's prospects. Cumulation of origin is beingextended to traditionalsuppliers of fabric usedby Macedonianapparel producers. With the recent amendment to the Stabilizationand Association Agreements with the EU, Turkey was included in the diagonal cumulationof origin. The country is also expected to join the Pan-European-Mediterranean system of diagonal cumulation. Second, greater competitionamong retail chains in EU markets is likely to further shift production towards smaller scale, just-in-time orders. As a result, FYR Macedonia's proximity to markets, reliability of producers and ability to deliver productsrapidly and with only limited additional quality controls is off-settingpressures to lower costs. FYR Macedoniaalso has an opportunity for its agents and producersto incorporatemore value-added into the sector's output, by movingto higher quality garment lines and getting into additionalstages of the productioncycle, such as organizing supply of materials, quality control, packaging, etc. 8.22 Although the sector is generally regardedto have reasonabletechnology, further investments and some computerization will be needed to keep pace with more sophisticated demands in the future. As noted, there are issues of skilled labor suppl Also, the current fragmentation of the sector into a very large number of largely small scale factories" may require some consolidationin order to maintain and improve responsivenessto buyers. Exactlyhowthis will occur-under pressurefrom the agents or though mergers and takeovers-remains to be seen. The establishment of the Macedoniantextile association is a good first step inthis direction, but a lot remains to be done. 8.23 Regardless of the transformation of the garments industry, being able to transport, deliver and clear goods fast will be critical. This means fast and efficient customs and logistics services, which can considerably reduce costs and compensate for small scale. Macedonian customs authorities already provide a relatively easy and fast way of clearing (or temporarily importing) goods for re-processing; however, further improvements are possible, especially in dealing with consolidated transports of less- than-container lots (see Chapter 3). Further development of the infrastructure sector can additionally improve competitiveness of Macedonian garments by reducing transport and administration costs (Chapter 6). 8.24 In sum, significant opportunities exist for Macedoniangarments producersto continue to operate successfully in the new globalizing environment. While the garment sector is unlikely to be a driving Interviewees commented favorably on the changes in customs that have speeded up container-sized garment traffic substantially. Less-than-container-sizetraffic has improved but could benefit from further speed-up (see chapter 3). 189There are over 1400manufacturingandtrading firms inthe textiles andgarments sectors inFYR Macedonia. 143 force of stronger economic activity in the future, it can remainan important employer and a stable source of foreign currency inflow. However, significant issues remain, within the apparel sector, and the wider economy, in orderto support future growth of the sector-see Chapter 3 for a discussionof these. D. INFORMATION TECHNOLOGY(IT) 8.25 The Macedonian IT sector has grown rapidly, over 40 percent between 2004 and 2006, but the growth and profitability appears to be concentrated in the largest and most export-oriented firms. The sector is composed of about 400 firms, employing about 4,000 people, but only 4 are among the largest firms in FYR Macedonia and 10-15 of major importance in the industry; the rest typically employ less than 10 worker^.'^' In addition to these IT firms, another 4,000 people are estimated to be working inthe IT departments of businesses and the public sector. The larger IT firms will be responsible for the growth, competitiveness,andjob creation of the sector, as they have beenover the last three years. Much of the revenues of these firms come from sales of hardware (imported, there is no productionof hardware in FYR Macedonia),buttheir realbusinessandtheir competitivenessis inthe installationofthe hardware with the associated software design. If they are unable to do this competitively, relative to international firms, then local firms will lose boththeir softwareand hardware market shareto internationalfirms. 2004 2005 2006 % Change 2004-2006 Revenues % growthy-0-y Nine Firms I 27.6% I 6.9% I 34.0% 143.0% Group I (large, export-oriented,I 137.1% I 23.8% I 67.8% I 107,7% foreign owned) Group I1 (next largest, less export 10.4% 0.9% 18.3% 19,5% oriented, domestic owned) Group 111 (small, mix of export and -12.6% -5 -9% 11.9% 5.3% domestic, domestic owned) Employmentpercent growthy-0-y Nine Firms I 32.8% I 15.5% I 14.4% I 32.1% GroupI 163.0% 21.1% 79.1yo 116.9% GroupI1 8.6% 8.6% -11.0% -3.3% Group111 28.9% 28.6% -7.9% 18.4% Nine Firms 4310 3991 4675 8.5% GroupI 4585 4686 4390 -4.2% GroupI1 5160 4796 6376 23.6% Group 111 1294 947 1151 -11.1% Group I 543 1202 1213 123.4% Group I1 1103 883 975 -1 1.6% Group111 300 232 491 63.4% Net profitability GroupI 3.8% 15.8% 15.8% Group11 11-8% 8.3% 6.2% Group111 1.5% 2.0% 7.2% I9Owww.idc.com. 144 8.26 The recent growth of the Macedonian market has stimulated foreign competition and foreign direct investment, includingthe takeover of one of the largest, most dynamic firms, and interest in other firms.Igl Previously, the small size of the market meant foreign firms were not interested and international vendors sold through local affiliates. The increasedcompetitionis now beingreflectedinthe lowerprofits ofthe domestic-orientedfirms, and some ofthem may be forcedto exit. 8.27 At the same time, the prospects for local firms in the sector look reasonable, if they can remain competitive with potential foreign entrants and imports, or link up with foreign suppliers. Foreign investorsmay become interested in tie-ups to take advantage of knowledgeofthe local market. Demands will remain for external support in banking and communications and information technology, for upgrades as well as some support for IT divisions within these firms in maintenance. In addition, the government has initiated intensive computerization of public administration, computerization of schools and is making IT a major subject in primary schools. Substantial room for growth also exists from increased demand by the private sector and households. Finally, the increasingpressure on Macedonian firms to meet quality standards would imply reliance on automated processes and greater use of IT. All these develo ments will increase spending on computer products, which is currently among the lowest in the region.19P E. KEYSUCCESSFACTORS, POTENTIAL CONSTRAINTS, AND GOVERNMENT POLICY Introduction 8.28 Growth in the three sectors described above, and in the Macedonian economy generally, will depend on exports, or efficient import substitution. Growth of the domestic market has been slow and the income elasticity of domestic demand for agricultural and textile products is less than one. This means that growth of these sectors will tend to be even less than the domestic economy, unless their exports grow or they substitute for importedproducts. Although Macedonianfirms may increase revenues in the local market by upgradingproducts, e.g., dairy products and wines, and in a few cases replacing imports, e.g., dairy, the real future lies in substituting Macedonian products for European products, in FYR Macedonia and abroad. This is particularly true because even a small increase in the share of FYR Macedonia in Europe's imports represents a substantial increase in output for FYR Macedonia. The importance of such export growth has been shown in the recent increase in FYR Macedonia's growth, when export growth led GDP growth. With increased exports, and specialization along lines of- comparative advantage, FYR Macedoniawill be able to buy additional imports, grow faster, and benefit from nationalfactor productivity gains, as occurred in EastAsia inthe 1980s and early 1990s. 8.29 Macedonian producers have some advantages in exporting but they need to be exploited. The country's locationis close to the EUand the Balkans throughground transport and it has tariff-free access in most cases. Telecommunicationsare reasonable. Labor costs are low compared to the EU, though not necessarily compared to some Balkan countries (costs are at the middle range of Western Balkan countries, but have been increasing rapidly since 2006, see Chapter 7). As an EU candidate country, funding will be available to develop the economy's infrastructure further. Duties have been lowered on imports and exports and customs procedures are beingmodernized. The government's economic strategy and EU accession prospects provide a general incentiveto exports (although, correspondingly, this also means that some import-competingsectors may be unable to compete with enhanced imports), and the effectively fixed exchange rate means other government policiesmay have to be usedmore intensivelyto 1 9 'This firm was alreadyproducinga majority of its revenuesfrom its Belgradeoffice. Another large firm hadbeen a mixedforeign-domesticjoint venturefor some time. 19' At presentper capitaspendingon IT products is only USD41, substantially belowthe EUaverage. 145 facilitate adjustment. This may be particularly true as foreign exporters begin to take interest in the Macedonianmarket, for example in IT where the government is undertaking intensive computerizationof public administrationand the education system. Rules on FDI, which may be a way of increasingexports back to the foreign investor's home country market, are not burdensome (they do include the necessary environmentalsafeguards). 8.30 At the same time, Macedonianexporters face competition, not only from existing producers in their export markets but foreign producers seeking customers in the same markets. Moreover, according to the firm-level interviews, Macedonian exporters and producers who have efficiently substituted imports, face a number of constraints and barriersto their expansion, both within their own operations, and inthe framework providedby government. 8.31 The remainder of this section discusses how firms have responded to these advantages, the constraints and issuesthat face future increases in exports, and the possible changes in government policy that would improvetheir prospects. Performance of the Three Sectors 8.32 The growth performance of the sectors and firms interviewed differed significantly. Exports accounted for half of the sales of wineries, and fruit and vegetable processing firms. The garments and textile industry is export oriented (over 90 percent of production) and accounts for about one-quarter of FYR Macedonia's total exports. The best IT performers were also export-oriented. Only the dairy industry was not a major exporter, and imports accounted for a significant portion of the Macedonian market. But, even in this sub-sector, improved performance accompanyingconsolidation has begun to reduce imports and increase exports (given the negative recent development in the dairy industry, sustainingthis trend will be challenging). Thus, as a whole, many firms in all of these sectors and sub- sectors seem externallycompetitive at the moment. 8.33 On the other hand, growth of the sectors and firms differed significantly over the period-the production value of exporting IT firms, the modernizingwinery, and the fruit and vegetable processing sectors grew much faster than nominal GDP in the period 2004-2006. Garments also posted strong growth after recoveringfrom the loss of markets during the 2001 conflict. On the other hand, the dairy industrystagnated, the general winery sector saw a decline inthe volume of output (to some degree due to a drought; also, a few wineries are also in the process of upgradingquality), and the performance of the non-exportedorientedfirms inthese sectors was not as good as the exporters. 8.34 Thus, some sectors appear to have built on their international competitiveness to grow, while others did not. Analyzing the sector developments further, IT benefited from a substantial rise in demand internationally as well as domestically, from communicationsfirms, the increase in computerization of financial firms and the government's start-up of an intensive computerization of public administration, which was particularly tapped by the best firms. The potential domestic demand for IT services remains large. Although garments and textiles did not grow as much, the sector did surprisingly well in a world market that became increasingly competitive as a result of the end of MFA and the surge in Asian (especiallyChinese) exports, actually increasing its market share in its largest market, the EU. 8.35 The differences in success depended to a large degree on how the firms have adjusted to the characteristics of their products in a globalizedworld economy and, in particular,exportingor com eting effectivelywith imports.All three agro processingsub-sectors saw a mixtureof import competition" and export potential(dairy), if not already exporting a substantial portion of production(fruits and vegetable The importcompetitionreflectsthe opening ofthe economy following accessionto WTO, CEFTA and EFTA. 146 processing, wineries). In fruit and vegetable processing and the winery that modernized, growth was strong, especially when tie-ups were made with foreign marketers. Similarly, garment producers were able to defend their position and grow by managing (sometimes with agents) the logistics and quality necessary to succeed in the modern garment industry. IT firms of course have a natural link with foreign firms in the hardware they sell, but the fastest growing firms have established their own reputationfor quality software at low cost. In the dairy market, imports increased temporarily and the sector experienced some consolidation. But domestic production is now recoveringsome of its market share. On the other hand, some of the dairy firms, fruit and vegetable producers and wineries may face problems. Constraintsto exports, growthand investment 8.36 One factor constrainingexpansion seems to be a limited supply of quality raw materialinputs. At present the majority of interviewed agro-processing firms commented that they had problems meeting domestic and foreign demand because of limited supply and poor quality of domestically produced raw materials. The issue of lack of input supply is most obvious in the case of the dairy industry, where expansion of manufacturingactivity faced a fixed supply of high quality raw milk. To some degree this problem is being solved by cooperative, long-term, off-take agreements between the dairy producers and the farmers and some investment by the dairy producers in infrastructurefor the farmers. Both of these solutions are likely to lead to an increased supply of good-quality raw milk. However, these solutions have so far involved large dairy producers and a few small, specialized dairies with good resources and management.Most individual small dairy producers lack the capacity and the resourcesto carry out such arrangements, they would need to form dairy cooperatives themselves and upgrade their productive capacity, which may be difficult. Wineries' slow growth may reflect the lack of quality raw materials. In the future, the winery sector may grow by displacing sales of home made spirits, with the small local vineyards shifting their grape productionto sales to wineries. However, the quality of grapes could be an issue in this case as well as for exports. Fruit andvegetable processorshave done well so far, but they too lack good quality raw materials and the supporting infrastructure(storage, freezers, etc.). Hence, future growth in this sub-sector may be constrained unless farmers receive incentives to upgrade their production and cooperation improves between agro-processors and farmers. In addition, standards are often an issue (Box 8.1) 8.37 Importedraw materialscan probably represent at least a partial solutionto the potential limits on input supply for agro-processing. This is a strong reason for extending full liberalization in agricultural productswithin CEFTA countries(see Chapter 3). Of course, imports of agricultural or dairy-based raw materials for re-export after processing face the same problems of infrastructurefor storingthe materials as domestic raw materials. In other areas, inputsare easier to import.While import tariffs are not high on average, MFN tariffs are higher than those from preferential suppliers, and in some cases MFN imports are substantial (see Chapter 3). For example, in the case of packaging materials, a re-examination of protectionmay be needed. Such protectionmay give importedagricultural products a cost advantage over local agro-processors, for example because of cheaper packaging. In the case of garments, imported textiles are already beingused-the textile industry has already shrunk by more than half andthe garment industry already is taking advantage of low-cost imported materials. The import regime-tariffs and customs procedures-has been effective for garments, although efforts are still probably needed to improvethe speed of customs procedures for non-containerlots. The quality of the import regime played an important role in attractingforeign investment by Johnson Matthey (producers of catalytic converters that will basically build a factory to use importedraw materials for export to the EU). The trade regime also seems reasonable for the IT industry, where the domestic sector is already based on providing software solutions for the use of importedhardware; no major hardware is produced in FYR Macedonia, nor is it likely to be. 147 8.38 A second emerging constraint to expansion is appropriate 1ab0r.l~~ Garments and IT firms face constraints on labor supply that could limit their growth. The growth of the garments trade will occur by moving up-scale, which a few firms have done, but for the industry as a whole, growth will depend on skilled workers who are capable of cutting and sewing medium quality garments rapidly. The number of such workers is limited. The IT sector also faces a major labor supply problem-while quality of the Macedonian IT professionals is generally recognized as high, their numbers are limited. Macedonian universities are turning out good graduates in IT but the existing IT faculties are unable to meet the demands ofthe Macedonian ec~nomy.''~The supply ofprofessionals is limited and government programs to increasethe number of IT graduates will take time to fructify. Moreover, the salaries in the IT industry are diverting potential professors into the sector and limiting the teaching faculty and thus future graduates. Resolving labor scarcity problems in IT will be necessary for Macedonian firms to take advantage ofthe expected increase in demand for IT in public administrationandeducation. 8.39 Using foreign IT personnelmay help allow Macedonian IT firms to expand, but it will depend on the availability of visas and work permits for temporary IT workers-about which there were several complaints (as also documented in chapter 4). Using such workers will help Macedonian firms grow, increase their profits, and maintain their penetrationin export markets until the planned increase in the number of Macedonian IT graduates occurs. . 8.40 A third factor limiting Macedonian firms, particularly in exporting, is their small size, which limits their ability to establish a brandmarket and may make financing difficult. Macedoniansuccess in exports of fruit and vegetable processors, wines, garments, and IT products and services has essentially been based on "word of mouth" and, in the case of wines and fruits and vegetables, demand from Macedonians abroad. Macedonian firms are usually too small to advertise or establish a brand or presence in foreign markets. Thus, they are essentially limited to demand for their services and products by foreign customers who have heard of them; they cannot generate demand easily. This situation contrasts with, for example, Jamaican Red Stripe beer, the single brewery firm in a small country that successfully built a growing market inthe USthrough advertising. 8.4 1 Financingfor expansionhas been to some degree an issue, but the increased access of SME firms (Chapter 5) should ease this problem. At the same time, problems of rural credit remain an issue, to some degree, because the land titles are unclear and thus land is considered not good collateral (Chapter 4). Nonetheless, the increasedaccess of SMEs has even permittedsome small dairies to take creditsthat they have on-lent to dairy farmers, taking repayment in the form of lower prices on raw milk supplied by the farmers. However,this solution is not generally popular, owing to the risk of non-complianceof contracts (see chapters 4, 5) and about which some interviewees c~mplained.''~To the extent that financing is needed for infrastructure for multiple farms, EU accession funds may be available (e.g., IPARD fund). This issue is discussed below, inthe sub- section on government policy. 8.42 FDI and tie-ups with foreign firms are ways that small Macedonian firms can ease these problems. Foreign investors have entered the dairy industry; however, FDI seems further away in fruits 194 Apart from the firms includedinthis chapter, two other small firms producingmetalproductswere interviewed for the purposes ofthis report. Bothfirms reportedproblemsof finding skilledlabor. I95The number of graduates of technical sciences faculties (including IT) increasedfrom an annual 528 in 2002 to 763 in 2006 (NSS). However,assumingthat the sector's rate of growth inthe next few years will amount to at least 20 percent, the economy (IT sector and employees of IT departments inprivatebusiness and the public sector) will need at least 800-900 new IT specialists per year. In academic year 2006/2007 there were only 69 teachers (full time and associate professors, docents) registered at faculties of Electrical Engineering and Information Technologiesat public andprivate universities. `96The issue of non-compliancewith contracts will probably be a factor limitingFDI integration into the economy (Chapter4). 148 and vegetables processing, and even further away in wine. Moreover, entry of large foreign firms may lead to issues of adjustment and consolidation in the sector. Foreign investment has also occurred in the IT sector, which will improve these firms' access to markets. Another way to reducethe handicapof size is production under license and selling production back to the license owner. Finally, cooperation with foreign supermarkets and local distributors can also help. The issue then is how firms can best pursue these different possibilities.The fruits and vegetables sub sector seems to have done this much better than the winery sector, where much of production is not branded. This may partly explain the differential growth of the two sectors. Obviously one way to improve connections is for firms and trade groups to use the internet,lg7 another, citedby one interviewer, is to attend trade shows. 8.43 A fourth potential constraint to growth is meeting international standards in food exports (and exports in general). The issues for the dairy sector, described in Box 8.1, are critical but they will also be important for other agro-processing sectors. Some of the fruit and vegetable producers already meet internationalstandards and wine exports comply with the new wine law. The most successful companies so far have access to good quality supplies (it often requires investments in their suppliers such as in collection points, storage with refrigeration, etc.), and use modern technology and good/effective organizational and sanitary regulations (e.g., confirmed by I S 0 and HAACP certificates), which allows them to receive certificates for exportto the EU.As notedabove, this will partly depend on improvingthe quality of inputs; one way to achieve this goal may be through greater cooperationbetween farmers and agro-processors, but this may be difficult to achieve betweensmall dairy producers and small farmers. As noted, EUaccession funds may be usedto help improve compliance with these standards. Governmentpolicy 8.44 Government policy could relievethe constraints to growth in a number of ways. This sub-section identifies some areas for effective support and changes in government policy, in many cases mentioned by the interviewedfirms. 8.45 Changes in government policy could contribute to alleviating some of the constraints in manpower and inputs.Inthe case of manpower, inthe short run, liberalizationof employment regulations and visas for foreigners would helpto ease immediate supply constraints inthe IT sector, especially given the programmed increase in demand for computerization in public administration and education. Such liberalization would allow the firms to retain their market position and grow and help staff the universities. Visa liberalization may also be helpful if the government decides to embark on a more intensive agricultural extension program. For the longer term, the government needs to implement effectively, its planned expansion of IT studies in the public universities and consider ways to facilitate expansion by private universities. The expansion of IT education must also maintain standards, which will be helped by greater use of foreign manpower. Despitethe satisfactoryreputation of Macedonian IT professionals, the interviewed firms expressed some concern regarding the quality of current graduates. In addition, at a more general level, the poor overall education outcomes in the country mean that the efficiency of government spending needsto improve at all levels of education; and quantitative outcomes such as the percentage oftertiary education students graduatingon time needto increase (see Chapter 7). 8.46 Improvement in land policy would help to ease the constraints on agricultural inputs. Part of farmers' difficulty in accessing credit is their lack of good titles to land (and buildings on the land) that can be used as collateral. The lack of titles not only reduces the availability of credit, it also reduces the incentive for capital investments by farmers in land they farm. "'TheFYR Macedonianwine industry is updatingits web site andprovidesreasonable information. 149 8.47 The improved access to land may help domestic producers expand and may also lead to an increase in foreign direct investment in agriculture, but much depends on how the changes to the law on ConstructionLand are implemented. Foreign investors were only permittedto have land-use rights, not land ownership rights,'98i.e., they may only acquire rights for buildings and rights for other immovable assets to be used for their business activities. As a result, foreign investorswere often more interested in taking over existingproductionplants or combiningwith local firms, rather than green field investments on their The 2008 changesto the Law on ConstructionLandallow foreign companies and citizens much more rightsto acquire land, but its impactwill depend on how the implementationof the law occurs in practice. 8.48 A more general effort to reduce constraints to expansion would involve government support for cooperation and investment among agro-processing firms to increase the quantity and quality of agriculturalraw materials, as well as strengthening of standards and relatedgovernment institutions. Such support would include programs to help farmers increase their livestock and improvethe quality of milk and fruits and vegetables. Some examples are agricultural extension services and cooperationbetween the sector and educational institutions; investment to encourage adoption of EU sanitary and phyto-sanitary standards, and veterinary standards; and improvement of technology and infrastructuresuch as freezer storage warehouses, collection point networks, etc., for cooperatives of smaller farms and processors.2oo Such activities are usually considered to have substantial externalities and would also help in the adjustment of FYR Macedonia farms to a more competitive environment and higher standards (World Bank, 2006a). EU accession funds, when available, and contributions by participating groups of firms could be used to finance these activities.20'Ensuringcompliance with EU standards on hygiene, safety and weights and measures will depend on strengthening of the existing government institutions and coordination between them, as needed. In addition, the government may wish to consider sector-specific promotion, and correspondingly moving away from general promotion of foreign investment in FYR Macedonia. 8.49 Improving the agriculturalsector in the process of accession to the EU will depend on an active government agenda(See also World Bank, 2006a), as mentionedabove. The Rural DevelopmentStrategy and the Rural Development Program have been drawn up and budgetary and human resources will need to be alignedto them. This is likely to involve a realignmentof public spending toward infrastructureand agricultureextension (as notedabove) and an upgrade of the staff in the Ministry of Agriculture, Forestry and Water Economy (MAFWE). In addition, the localagency that is requiredto access the funds from the EU's IPARD202(for which FYR Macedonia is eligible) and to preparepotentialbeneficiaries(farmersand rural entrepreneurs) for such assistance, needsto be accredited. These requirements alone will necessitate a sizeable increase in public expenditures in agriculture, perhaps as muchas 4 millionannually. 8.50 An improvement in various areas of public administration was also considered to be helpful to business operations by a number of interviewees.As notedabove, land titling is an issue. Another area is the need to improve judicial services. In the agricultural sector, improving public service delivery, especially in areas that will improve yields and facilitate trade, such as animal health, extension and I98Price Waterhouse Coopers, "Doing business and investing in FYR Macedonia 2006/2007", 2006. Chapter 4 discussesthese issues inmore detail. 199Two ofthe largestforeign green-fieldinvestmentsinthe agro-sector were with local participation. 200 Landissues complicatefirms developingsuch infrastructure ontheir own. 201 In2008 the FYR Macedoniangovernment allocated 45 million(up from 27 millionin2007, itself four times more than in 2006), to be distributed to approximately 55,000 farmers. The requirementfor getting a subsidy is the certificate on producedand deliveredquantity o f products.However, as notedinchapter 2, this systemrisks locking in existing, often inefficient, production. Policies should instead try to avoid distorting market signals and encourage farmersto maximizeprofits. 'O' Instrumentfor Pre-Accessionfor RuralDevelopment 150 agricultural research, will yield large benefits (World Bank, 2006a). Issues of uniformly implementing existingregulationson weights andtaxationwere raisedby ago-processors.Finally, tender specifications and rules on public tenders need to be upgraded-often tenders in IT seemed to be aimed at realization and do not includeenough consideration of testingthe quality of the service providedby the IT. Without such tests, the IT solutionsprovidedby low cost bidders may not be useful. 8.5 1 Finally, enforcement of contracts is a general issue that was cited by a number of intervieweesin the sectors discussed here and is discussed in Chapter 4. Moreover, this is not only a problem in interactions between firms; it is also a problem in access to credit (Chapter 5) and telecoms (Chapter 7). Better legalenforcement of contractswould lower costs in many areas. 151 152 Annex 1.1: NATO and EUAccession Effectson Growth I s There a PositiveGrowth Effect from the Start of EUAccession negotiation^?^'^ 1 . There is some evidence of a general pickup in GDP growth for the group of countries that began in negotiations in 2000; no such evidence shows up for the 1999 group of countries. *04One major group of countries started their EUaccessionnegotiations in 1999205and another in 2000206.Hence, we split the analysis into two periodsto take into account possible qualitative differences across the two groups. In Figure A, we plot the median2'' GDP growth in the countries after the start of their EU accession negotiationsand mark the start of the negotiationswith a black vertical line. In the left panel, the median GDP growth remains essentially flat after 1999 for the first group of countries with a slight decline during2001-2002 and a recent pickup during 2006. This does not indicate any significant growth impact ofthe EUaccession negotiations.Inthe right panel of FigureA, the median GDP growth has been increasing since 1999 for the 2000 group of countries. This can be partly due to the general decline in GDP growth in 1999. However, the full recovery from this decline was achieved in 2000 and since then the median GDP growth has been increasing continuously along a linear trend without any significant common fluctuations.This trend inmedian GDP growth has beenbounded for most of the time by Latvia on the upside and Slovakia on the down side, where especially in 2006 GDP growth in Slovakia picked up and convergedto the 2000 group's median growth. Figure A: Historical Cross-Country GDP Growth Comparison around the start of EUAccession Negotiations 10.5 9 7.5 8 .- 6 C 4.5 3 1.5 0 -1.5 1998 1999 2000 2001 2002 2003 2004 2005 2006 - 4 EU(15countries) ----Estonia *-Poland98(median) - 1998 1999 2000 2001 2002 2003 2004 2005 2006 -Czech-Hungary - - - Republic ----Latvla W -EU(15countries) - - --LithuaniaBulgaria Slovenia Romania -Slomkia Neaot + Negot 00 (median) Sources: EUROSTAT; WDI Database, World Bank. 203 It is however not necessarily the start of negotiations that pushes growth as much as a clear perspectiveon EU membership. Obviously, this perspectivemakes a quantitative analysis harder. This annex should therefore not be seen as settling the debate, one way or the other. Rather, it is indicative, and shows that there are positive tendencies from allying with anchors such as the EU, but there are also many other factors that affect growth and development. It also follows that EU negotiations and membershipwill not resolve all development concerns of a country. '04 For the 1999group the actual negotiations startedat the end of 1998. '05 Estonia, the Czech Republic, Hungary, Poland and Slovenia. '06 Bulgaria, Latvia, Lithuania, Romania, Slovakia. '07 We use the median measure instead of a simple average, since the former has a lower breakpoint, is.,is not so affected by outliers, like Estonia's GDP growth in the 1999group of countries. 153 2. One possible explanation of the different experience of the two groups of countries is the presumablyhigher quality of public institutionsin the 1999 group of countriespotentiallyassociated with its higher income per capita.The average income per capita (GNI per capita, Atlas method(current US$)) was US$5,804 for the 1999 country group in 1999, and US$ 2,678 for the 2000 country group in 2000. This means that expected reforms within the EU accession negotiation period are probably less powerful in propellingfuture GDP growth of the 1999 group of countries, which are at a relatively higher stage of development and with relatively higher quality of institutions. FYR Macedonia's income per capita is about 85 percent of that of Bulgaria(GNI per capita Atlas method US$, 2004)208,a member of the 2000 group of countries with the lowest income per capita, and 27 percent of the EU27 average per capita GDP (in PPS terms; Euro Stat News Release, December 2007). Ifthe contributionof the expected reformsduringEUaccession negotiationsis at least as high for FYR Macedoniaas for the 2000 group of countries, the growth impact of the start of EU accession negotiations will be positive. In addition, althoughgrowth did not pick up significantly in the 1999 country group after the start of the negotiations, the group still showed increasedconvergence to the EU15 as demonstrated by the increasinggap between the growth rate of the EU15 and the median growth rate for the 1999 country group (see Figure A). The income convergenceto the EUl5 is even stronger for the 2000 country group. I s There a PositiveGrowth Effect ofNATO Membership? 3. There is not enough evidence to conclude that NATO accession exerted a positive impact on growth, for either the 1999 or the 2004 country groups. Recently, there were two groups of countries that joined NATO, in 1999 and 2004.209Figure B shows the real GDP growth over the period 1998-2006 for the 1999 NATO group in the left panel and for the 2004 NATO group inthe right panel. The dates of NATO accession are marked by black vertical lines. The median GDP growth of the 1999 NATO group declined after NATO accession for two consecutive years, in 2000 and 2001, before rebounding to an upward growth trend. Of course, other effects on growth need to be factored in-for example, Poland's real GDP growth was already on a decline prior to its NATO accession, and this decline stopped only in 2001. Hungary's real GDP growth was rather stable over the 1998-2006 period(around 4.5 percent), and the Czech Republic's growth was recovering till 2000 from a currency crisis in 1997, and then experienced yet another slowed down during 2001-2002, along with Poland. The median growth of the 2004 group declined slightly after 2004 and then increased to about 8 percent, which hints at some positive impact of the NATO accession within the context of the few historical observations between 2004 and 2006. For Estonia and Latvia, the pick up in GDP growth after NATO accession is more notable. However, median GDP growth for these countries was on a linearly increasingtrend since 2000 andthis couldbe taken to meanthat the contributionofNATO accession is marginal, ifany. 208 And it is about 75 percent of GDP per capitaof Bulgariain current US$terms. '09 The 1999 NATO group of countries comprisesthe Czech Republic, Hungary and Poland, and the 2004 NATO group ofcountries consist of Bulgaria, Estonia,Latvia, Lithuania,Romania,Slovakiaand Slovenia. 154 7 - 12 - 6 - / O - -2 - f I I I -1 . -4 - 1998 1999 2000 2001 2002 2003 2W4 2005 2006 1998 1999 2000 2001 2002 2003 2004 2005 2006 ----Estonia ----Czech Republic Hungary -BulgariaLaha - - - Lithuania - - - -Poland +median -Romania NATO99 Slomkia +bkdian SloueniaNATO 04 Sources: EUROSTAT; WDI Database, World Bank. 4. When extrapolating the evidence to FYR Macedonia in 2007, differences in development and political risk should be considered. On the political stability front, NATO membership could benefit FYR Macedonia more substantially. The implicit link from NATO accession to an improved perceptionof political stability seems to rest in the minds of many policy makers and the public in FYR Macedonia. This also implies an expectation that NATO accession could attract additional FDI and further boost economic performance of the country.Although the empirical evidence does not give much support for such expectations, reductionof the relatively higher political risk of the country, as perceived by foreign investors, could have a positive impact on FYR Macedonia's FDI and output performance. Note however that some of the foreign investors that were interviewed for this report did not consider NATO to be a major factor in their investment decisions (Chapter 4 and Annex 4.2). 155 Annex 1.2: Analysis of FYR Macedonia's Growth Potential Based on International Evidence 1. Growth regressions typically try to explain real GDP per capita growth by means of selected determinants which can be classified into different groups. We choose to follow Loayza et al. (2005) in this respect and focus on the determinants o f transitional convergence, cyclical reversion, structural policies, stabilization policies, and external conditions. The transitional convergence represents the catching-up effect o f a country with relatively lower GDP per capita with more developed countries (with higher GDP per capita). The cyclical reversion controls for the current state o f the business cycle, i.e., if actual GDP i s already far above potential GDP, its growth is expected to slow down and gravitate back to potential GDP. Note that the growth potential of the catching-up effect will not be unlocked unless appropriate structural and stabilization policies are in place. Similarly, the strength o f cyclical reversion can be significantly weakened if potential GDP increases as a result o f better structural and stabilization policies. The structural policies are characterized here, as in Loayza et al. (2005), by a measure o f the level o f education, financial depth, trade openness, government burden, and public infrastructure (see Table A for the specific variables used). The stabilization policies are represented by (lack of) price stability, cyclical volatility, and overvaluation o f the real effective exchange rate. The impact o f external conditions is approximated by growth in the terms of trade. 2. The considered growth determinants and their quantitative improvementsare listed in the first column of Table A. The second column o f Table A summarizes the impact o f the individual determinants on GDP growth as estimated by Loayza et al. (2005). For instance, as education improves (secondary enrollment rate rises), the growth potential o f the given country is predicted to increase. In the last four columns o f Table A, we carry out the following exercise: given the change in structural and stabilization policies from 2001 to 2006 in FYR Macedonia and the Slovak Republic, what is the predicted increase in the growth potential in these two countries? For this, we calculate the average levels o f the individual growth determinants for 1997-2001 and 2002-2006, and the difference in these two averages. These figures are presented in the third and fifth columns of Table A for Slovakia and FYR Macedonia, respectively. Then we use the estimated coefficients from Loayza et al. (2005) to calculate the contributions to the growth potential o f each country, which are presented in the fourth and sixth column o f Table A for Slovakia and FYR Macedonia, respectively. 3. The most significant improvement in Slovakia from 1997-2001 to 2002-2006 was in secondary enrolment rates which rose by 8.6 percent. Other improvements are rather mild compared with some o f the improvements achieved in FYR Macedonia but occurred consistently across all areas o f structural policies. All together, the predicted increase in Slovakia's per capita growth is around 0.94 versus the actual change in the growth rate o f 2.21 percent, which o f course includes impact o f a much broader range o f factors. 4. The contributionfrom structural policies to FYR Macedonia's growth potentialis estimated at 0.45 percentage points. The largest improvements in the segment o f structural policies were achieved in financial deepening and public infrastructure. The only other structural policy that improved, although marginally, over the period was education. Overall, FYR Macedonia is predicted to have increased its growth potential by 0.88 percent compared with the actual average GDP growth increase between 2001 and 2006 o f 1.18 percent (GDP per capita in constant international dollars). 156 Table A: Comparisonof growth potentialbasedon estimated growth regression - - - FYR Predicted Estimated Slovakia Predicted % change increase Macedonia increase Growth Determinants coefficient % change in GDP Loayra et. over 1997- in GDP over 1997- growth, al (2005) 2001 and growth, 2002-06 Slovakia 2001 and FYR 2002-06 Macedonia Transitional convergence 0.00 0.00 Initial GDP per capita (in logs) -0.018 0 19 0.00 0.06 0.00 0.35 0.25 Initial output gap (log[actualGDP/potentialGDP]) -0.237 -1.50 0.35 -1.06 0.25 stitutions 0.25 0.45 Education (secondaryenrolmentrate, in logs) 0.017 0.15 146 0 03 Financial depth (private credit /GDP, in logs) 0.007 3.51 0.02 76 00 0 50 Trade openness ([exports+ importsyGDP) 0 010 2 63 0.03 -0.48 0 00 Government burden (gov. consurnption/GDP, in logs) -0.015 -2 13 0 03 8 73 -0 13 Public infrastructure (mobile phone subscribers per 1,000 people) 0.007 3.08 0 02 8.75 0 06 Stabilization policies 0.21 0.15 Lack of price stability (log[lOO+infl.rate]) -0.005 -2 78 0.01 -1 31 0 01 Cyclical volatility (st. dev of output gap) -0.277 -0.76 0 21 -0 55 0 15 REER overvaluation [+) (loalactual REEWeauilibrium . . . -_ REER]) -0 006 1 36 -0.01 1.25 -0 01 0.12 0.03 Terms of Trade (growth rate, price of exports/ price of imports) 0.072 1.66 0.12 0.44 0.03 Source: WorldBank WDI Database, authors' calculations 5. Overall, between 2001 and 2006, FYR Macedonia seems to have generated a somewhat lower increase in its growth potential than Slovakia. The most striking difference across the improvementsin the Slovak Republic and FYR Macedoniacan be observed in the segment of structural policies. On the one hand, there were consistent, though rather gradual, improvements across all structural policies in the Slovak Republic; on the other hand, there were uneven changes in FYR Macedonia's structural policies, with major improvements in some structural policies and marginal change in others. This comparison may suggest that FYR Macedonia should focus on consistent and steady improvements in a range of structural policies. Of course, all the quantitative changes in growth determinants discussed have a qualitative side to them that needs to be kept in mind (see also Chapter 1 for further discussion of this). 6 -. The next exerrise rnmnares TWR Mnrprlnnia's" levels nf arnwth dpterrninanh tn thnrn nf -__-_--._- -_----___ - --- *.-------..- -__-_ r---- --,-." .,_b"" ........... ..I --1- *".v .---"I v- Slovakia at end-2006, using the 5-year average of the growth determinants. The interest lies in seeing what could happen to FYR Macedonia's growth potential if it manages to improve and catch up with Slovakia with respect to the growth determinants on which it is lagging behind. Hence, Table B shows the list of growth determinants identical to those in Table A, and their relative levels for FYR Macedonia vis-a-vis Slovakia. The relative levels of the growth determinants and their contributions to the differential between FYR Macedonia's and Slovakia's growth potential are reported in the third and fourth columnof Table B. 157 Table B:Relativegrowth potentialrelativeto Slovakia and hypotheticalgrowth scenario Estimated FYR Predicted Macedonia difference FYR Potential Growth Determinants coefficient Macedonia increase Loayza et. relative to in long- scenario in GDP at (2005) Slovakia, term GDP 2006 (%) growth (11 growth 0.01 0.00 -0.018 0.01 0.00 0.00 -0.23 0.23 gap (log[actualGDP/potentialGDP] -0.237 0.95 -0.23 -0 95 0.23 Structuralpolicies andinstitutions 0.03 0.65 Education(secondaryenrolment rate, in logs) 0 017 -9.06 -0.16 9 06 0 16 Financialdepth (privatecredit IGDP, in logs) 0.007 -19 81 -0.13 19 81 0 13 Trade openness ([exports+ imports]/GDP) 0.010 -37.03 -0.36 37.03 0 36 Government burden (govt. consumptionlGDP, in logs) -0 015 -43.69 0 67 0 00 0.00 Public infrastructure (mobile phone subscribers per 0.007 -0.42 0.00 0.42 0.00 -0.02 0.04 Lack of price stability (log[lOO+infl.rate]) -0.005 -4.18 0 02 0.00 0.00 Cyclical volatility (standarddev. of output gap) -0.277 0 12 -0.03 -0.12 0 03 REER overvaluation (+) (log[actual REEWequilibriumREER]) -0.006 0 60 0.00 -0.60 0.00 Externalconditions -2.43 2.43 Terms of Trade (growth rate) 0.072 -33.74 -2.43 33 74 2.43 I Predicted long-term growth differential between FYR Macedonia andSlovakia -2.63I 3.34 Source: World Bank WDI Database, authors' calculations. 7. By 2006 FYR Macedonia falls significantly behind the Slovak Republic on all considered structural policies except for the government burden. The third and fourth columns of Table B show that real GDP per capita of FYR Macedonia is about 53 percent of that of Slovakia. However, it is importantto realizethat strong transitional convergence can only materializethrough improvedstructural and stabilization policies, and favorable external conditions. Regarding the gaps in structural policies between FYR Macedoniaand Slovakia, FYR Macedoniaappears to have about a 0.03 percentage point higher growth potentialdue to `better' structuralpolicies-this is attributable purely to a 43 percent lower government burden in FYR Macedonia compared to Slovakia. On all remaining structural polices FYR Macedonia lags behind the Slovak Republic significantly, with an exception of public infrastructure where the negative difference is only 0.42 percent. Policies where FYR Macedonia lags furthest include trade openness, where it is 37 percent behind Slovakia; education, where it lags by 9 percent; and financial deepening, where it lags by about 20 percentdespite the recent improvementsinthis indicator. 8. FYR Macedonia does not lag Slovakia in terms of stabilization policies in any significant way, but terms of trade movements have hurt its growth. FYR Macedonia appears to have experienced lower price instability by about 4 percent, somewhat higher cyclical volatility by about 0.12 percent, and a somewhat more overvalued currency, compared with Slovakia. The relative slowdown in terms of trade deteriorationwas significantly stronger in Slovakia relativeto FYR Macedonia by about 34 percent. This could be attributedto Slovakia's success in export diversification and its ability to attract FDI. 9. Overall, long-term growth, arising from the relative levels of growth determinants, is predicted to be higher for Slovakia by 2.63 percentage points. This prediction is at its higher bound 158 due to the very large predicted contribution of external conditions to the relative growth differential between FYR Macedoniaand the Slovak Republic.Nonetheless, it shouldbe notedthat the actual growth differential is close to the predictedlevel-it was 2.88 percenthigher in Slovakiaby end-2006. 10. I f FYR Macedoniawas able to eliminate the negativegaps in growth determinantsvis-a-vis the Slovak Republic the predicted increase in its growth potentialwould be around 3.34 percentage points. Suppose that over the medium term FYR Macedoniawould be able to catch up with Slovakia in terms of all the structuraland stabilization polices on which it lags behind. What would be the resulting increase in FYR Macedonia's growth potential? We perform the calculation for this exercise and show the results in the fifth and sixth column of Table B. It should be noted, however, that some of the determinants of growth are largely out of control of national authorities, such as the initial output gap or the terms of trade growth, so that the results have to be interpreted with this caveat in mind. If FYR Macedonia was able to eliminategaps on the structural policy determinants of growth, this would result in an increase of FYR Macedonia's growth by 0.65 percentage points per year. This would imply that FYR Macedonia would be able to grow in a sustainable manner at 0.65 percentage points higher than it grew up until 2006. In Chapter 1, another simulation exercise using the same model shows, as is to be expected, that higher increases in the structural policy indicators can lead to further increases in sustainable growth in FYR Macedonia. 159 Annex 2.1: Balanceof Payments,2000-2008 (inUSDmillion,unlessotherwisenoted) 2000 2001 2002 2003 2004 2005 2006 2007 2008 I.CurrentAccount -79 -249 -364 -156 -451 -103 -34 -346 -1,191 GOODS, net -691 -527 -806 -851 -1,139 -1,063 -1,285 -1,630 -2,552 Exports, fob 1,321 1,155 1,112 1,363 1,675 2,041 2,396 3,349 3,971 Imports, fob 2,012 1,682 1,918 2,214 2,814 3,104 3,681 4,979 6,523 SERVICES, net 49 -19 -22 -7 -54 -34 28 35 2 Inflow 317 245 253 380 452 515 601 818 1,012 outflow 268 264 275 387 507 549 573 783 1,009 INCOME, net -46 -41 -31 -34 -37 -59 -14 -134 -90 CURRENT TRANSFERS, net 609 338 494 736 780 1,052 1,237 1,383 1,448 Official 132 49 97 104 70 65 74 30 72 Private 477 289 398 632 710 987 1,163 1,352 1,376 11.Capital and FinancialAccount 22 250 374 190 432 111 26 388 1,191 CAPITALACCOUNT, net 0 1 8 -7 -5 -2 -1 5 -18 FINANCIAL ACCOUNT, net 22 249 366 196 437 113 27 383 1,210 Direct investment, net 197 460 92 89 320 40 402 449 594 Portfolio investment, net 0 0 0 5 13 238 93 156 -72 Other investment, net 89 -134 134 153 124 250 -91 -79 641 Trade credits, net 139 -64 82 72 90 131 5 -3 2 43 Loans, net 11 -114 -7 61 9 123 -20 -167 242 Currency and deposits, net -109 21 36 9 -4 -24 -104 12 299 Other, net 48 22 24 11 28 20 28 108 57 Gross official reserve (- = increase) -264 -77 140 -51 -19 -415 -376 -143 47 111.Errorsand Omissions 57 -1 -10 -34 19 -8 8 -42 0 Memorandum items GDP 3,587 3,437 3,791 4,630 5,368 5,815 6,373 7,927 9,52 1 CurrentAccount, as % of GDP -2.2 -7.3 -9.6 -3.4 -8.4 -1.8 -0.5 -4.4 -12.5 FDI, as YOof GDP 5.5 13.4 2.4 1.9 6.0 0.7 6.3 5.7 6.2 Reserves, in months of imports of G&S 3.7 4.7 4.0 4.1 3.5 4.4 5.3 4.7 3.4 Source: NationalBank o f Republic o f Macedonia, Statistics Department 160 Annex 2.2: Allocation of Remittancesand the Growth Potential 1. In 2006, the inflow of official remittances into FYR Macedonia was about 3.25 percent of GDP.*" Although this percentage is much lower than in Albania or Bosnia and Herzegovina, where the inflow reaches almost 14 percent of GDP, the remittances inflow constitutes a significant resource of finances which can have potentiallya notable impact on GDP growth. For comparison, the inflow of FDI into FYR Macedonia amounted to 6.6 percent of GDP in 2006. The potential growth impact of remittances depends on their allocation. The 2002 survey of migrant workers, conducted for an academic project by Dr. Dzaferi, estimated the allocation of migrants' transfers shown in Table 2.3 in the main report, repeatedhere for convenienceas Table A. 2. The estimates indicate that about 55 percent of the Table A: Allocationof Migrants Transfers migrants' transfers are spent on (i)Immediateconsumption 54.6 % immediate consumption, thus (ii)Maintenanceofhousing 13.0Yo potentially increasing inflationary (iii)Investment(typenotdefined) 15.3 % pressures. If the spending goes to (iv) Savings with banks 3.1 Yo non-tradables, appreciation of the (v) Purchase/constructionof homes 9.2 Yo MKD in real terms and decreased (vi) Other 4.8 Yo external competitiveness is Source: 2002 survey expected. Alternatively, if consumptionspending is concentrated on tradable goods and services, imports may increase as a result of capacity constraints or competitiveness of domestic production. Moreover, Table A indicates that over 20 percent of the migrants' transfers are spent on housing. This could affect the price of non-tradables in the CPI and contribute to appreciation of the exchange rate. A possible overvaluationof the MKD relative to the currencies of FYR Macedonia'strading partners would then be an impedimentto eliminationofthe existingtrade deficit. 3. The resented estimates of the allocation of remittancesare broadly consistentwith those of CEA (200S).p" These estimatethe allocationto consumptionspending, capital investmentand savings to be 63.8 percent, 15.8 percent and 20.4 percent. The propensityto save 20.4 percent from remittances in FYR Macedonia is about the same as the savings rate but low compared to a typical figure in the internationalcontext (a savings propensity of almost 40 percent). The offered explanation in CEA (2008) is that remittances are seen as a permanent inflow and, consistent with the permanent income hypothesis, are thus mostly consumed. Alternatively, this may reflect a difference between the Macedonian emigrant and other emigrants who may intend to return home; an emigrant intendingto return home is likely not only to send funds to those who remain behind, but to build a home or a business. These explanations could be tested ifthere is a recession in the host countries and results injob losses and the ability of the remitter to sustainthe volume of current remittances. 4. To see how the remittances allocated to investment contribute to the growth potential of FYR Macedonia,we look at the correlationof remittanceswith disaggregated investment.Namely, we analyze how changes in remittances correlate with investment in construction, machinery and equipment, and other investment. The latter series are plotted in Figure A and cover the period 1994 to 2006. Figure A shows that the inflow of remittances experienced a major spike in 1995, as did the changes in other investment. 'Io This is the amount that officially enters the country as remittances through the financial channels (BOP). Estimatinghow much of the remaining 15 percent o f GDP that occurs through private transfers (viz. BOPdata) are actuallyremittances is problematic,but an attempt has beenmade in Chapter 2. CEA (2008). A Study on Determinants and Trends in Remittance Flows in Macedonia. Center for economic analyses. Skopje, FYR Macedonia. 161 5. Most of the Figure A: Changes in remittances,and disaggregated investment remittances that are allocated 200.00 to investment seem to go to construction investment. We estimate the correlationbetween 150.00 the remittances inflow and the individual components of 100.00 investment. The highest estimated correlation is between 50.00 remittances and construction investment of 0.29. This is closely followed by the 0.00 correlation with other investment of 0.28: the -50.00 correlation with investment in 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 machinery and equipment is --eConstruction Other --eRemittances(inflow) Machinery and Equipment 0.09. We make the assumption that the estimated coefficients could be usedas relative weights for computationof the relativeallocation into the respective investmentcomponents.We thus estimate that about 45 percent of the remittancesthat are allocatedto investmentgo to construction,thus supportingthe housingboom; about 43 percent goes to other investment2'*;and about 12 percent is spent on machinery and equipment. Also, CEA (2008) estimates that most of the capital spending goes to constructionof homes and real estate, and only small portionis usedfor businessstart-ups. 6. To encourage more remittances into investment, changes in policy along the lines recommended in Chapter 1 to stimulate investment and saving would be appropriate. As noted, in FYR Macedonia, the propensity to save out of remittances of about 20 percent is about 20 percentage points lower than the internationalaverage of 40 percent, for various reasons. Policy actions to enhance remittances' allocation into savings or directly into investment are the same as those discussed in Chapter 1 to stimulate investmentand savings in general, namely: (i) maintainingmacro stability, (ii) promoting competitiveness in the banking (financial intermediary) sector, both in the savings and credit segments, and (iii)encouraging higher expected returns on investment through improvementin the businessclimate and appropriate taxation of productionfactors. 212 Other investment includes spending on (i)cultivation assets (investments in farming (including live stock) and forestation); (ii)non-material (intangible) fixed assets which include mining explorations, software, entertainment, literary or artistic originals, and other non-tangible assets; (iii)Major improvements of land; and (iv) costs associatedwith transfer of ownership. 162 - T 0 0 N d t: v! : : " e -I m 2 : : I-" N CQ : : P m \o : : 3 N m : : 2 01 m :: 2 d P :: E ..a CI E S 41 I I .e c 44 2 2 TUC Q. C e C ci TS e2 a L Q. C aL I 4 U sa r; CI tee 4 U c U c 4 U c c s r c Q c r Q b c f r I/J cca .-c L F f c r s9 c fc c cE 0 : .esQ b m m 8 cU : c L k r a : - M 'ica U : 0 9idmNo o q o ! ? W N U .e Q 2cc E 9 U t se I- 4 m w CI 'E8 -zE I- e wa E Q) E b 3 \o 0 0 N 0 0 C N \o z QI - \o 0 0 N C C C N \o m z - \E 0 C N 0 C N C \o z QI - n 92 a c1 sa E - 0WN N m w V I N r n ? N c ? z0q0N-r--oow 0 q 0 0 " N N . m W m ' " c ? - ~ + W o o o - : - : P-9 N m ? b ~ 8 m q 3 2 0 VI : - N 00 I- s zd Annex 3.9: ConditionsinMarket Access Under the SAA and CEFTA 2006 SAA Industrial products: Agricultural products All industrial products have duty-free to Excluding fisheries products now subject to 70 EEA markets. percent of MFN rates; products from HS Chapters 7-8 are subject to specific tariffs but not tariffs ad valorem. Except for 'baby beef products, Macedonian remaining agricultural products do not face tariff exportsto EU barriers, but wines and spirits subject to a separate agreement. Processed agricultural products covered by Protocol 3 products enter duty free. Three different groups of products and Three groups of products (plus a protocol) schedules depending on sensitivity: (1) according to their sensitivity listed in Annex IV: non-sensitive-zeroed on June 1,2001: (2) (a) zero upon entry into force of the interim trade less sensitive list of Annex Isubject to 10 agreement; (b) zero within quotas and s.t. 70 points reduction annually (50 percent of percent of MFN rate above quota; (c) progressive MFN tariff rates in 2006 and 30 percent in reduction of tariff rates in 2001-2002 levied on 2008); and (3) most sensitive products imports within quotas to 70 percent of MFN listed in Annex I1with a delayedreduction applied tariff rates on these products in 2003. of 20 percent the third year into the SAA and 10 percentage points reductions Protocol 3 covers processed agricultural beginning in the fifth year (Le., 2006, products-these were either zeroedor reducedover Macedonian when preferential rates were at 70 percent a three year period to 80 percentl65 percent69 imports from of MFN and 50 percent in2008). percent ofthe basic rates or 90/80/70 percent ofthe EU basic rate. Two protocols: one covering textiles (HS. 50-63) with duties that would be reduced at a pace of 7 points per year beginning with a 30 percent reduction in 2002 (in 2006 at 42 percent of the MFN and 28 percent in 2008); and another one on steel products (HS 72) with 20 point reductions annually beginning in 2002 (zeroed in 2006) All to be eliminated at latest by January 1, 2011. CEFTA 2006 Industrial products: Agricultural products All tariffs abolished except for some Different commitments under bilateral agreements: exports to Moldova now s.t. 40 percent of duty- and quota-free access to markets in BiH, exports MFN rates to be abolished on January 1, Montenegro, Serbia and UNMIK;quotas and MFN 2009 tariff rates (eliminated within quotas) to other CEFTA markets All tariffs abolished except for some Different commitments under bilateral agreements: imports from Moldova now s.t. 40 percent duty- and quota-free access for products of MFN rates to be abolished on January 1, originating in BiH, Montenegro, Serbia, and Macedonian 2009 UNMIK;duty-free quotas on selected imports from imports Albania, Croatia and Moldova (if above either reduced or full MFN rate), otherwise MFN tariff rates in place. Further concessions should be made no later than May 1,2009. Source: Extracted from the SAA and CEFTA 2006 agreements. 172 Annex 3.11: Selected H S 6-Digit Items with MFN Tariff Rates Exceeding 30 Percent and their ImDorts in2006 (inthousands ofUS dollars) MFNtariff H S 2 EEA31 SEE6 ROW WLD (YO) 200210 Tomatoes,whole or inpieces 119 0 0 119 50 200290 Other 36 129 112 277 50 220421 Incontainers holding2 1or less 102 95 3 199 50 220429 Other 17 25 20 63 50 220430 Other grape must 0 23 0 23 50 070490 Other 13 0 0 13 45 070810 Peas (Pisum sativum) 0 0 0 0 45 070820 Beans (Vigna spp., Phaseolus spp.) 13 0 5 19 45 071021 Peas (Pisumsativum) 3 228 0 23 1 45 071022 Beans(Vigna spp., Phaseolus spp.) 3 66 0 69 45 071029 Other 1 0 0 1 45 Spinach, New Zealand spinach and 071030 Orache spinach 2 3 0 5 45 071090 Mixturesof vegetables 6 241 0 246 45 071130 Capers 2 0 0 2 45 080711 Watermelons 21 43 2 66 45 080719 Other 3 1 2 6 45 080910 Apricots 0 0 0 0 45 080920 Cherries 0 0 0 0 45 080930 Peaches, includingnectarines 4 0 0 4 45 220410 Sparklingwine 220 53 0 273 45 080810 Apples 64 4 22 89 44 070610 Carrotsandturnips 78 2 0 79 40 070690 Other 1 0 0 1 40 080940 Plumsand sloes 5 1 0 6 40 081010 Strawberries 29 0 0 29 40 190430 Bulgurwheat 4 0 0 4 40 190490 Other 19 1 0 20 40 200110 Cucumbersand gherkins 10 70 0 80 40 200310 Mushroomsof the genus Agaricus 56 14 197 268 40 200390 Other 11 0 0 11 40 200551 Beans, shelled 3 0 0 3 40 200559 Other 4 49 1 53 40 200560 Asparagus 0 0 2 2 40 200590 Other vegetables and mixtures ofveg 366 129 60 554 39 090420 Fruitsofthe genus Capsicumor Pimen 18 61 28 107 39 200580 Sweet corn 2 16 9 27 38 200490 Othervegetables and mixtures of veg 5 15 3 22 38 040900 Natural honey 17 8 4 29 36 070410 Cauliflowersand headedbroccoli 10 1 0 10 35 070420 Brusselssprouts 0 0 0 0 35 070930 Aubergines (eggplants) 16 0 0 16 35 070940 Celeryother than celeriac 0 0 0 0 35 071010 Potatoes 9 0 0 9 35 071151 Mushroomsofthe genus Agaricus 77 0 7 84 35 200540 Peas (Pisum sativum) 144 345 0 489 34 071080 Other vegetables 16 48 0 64 34 174 Annex 3.12: The Logistics Environment in FYR Macedonia Number of Declarations and ExportValue by ExportCommodity Groups. FigureA 100 % 80 Yo ria Other products m Chemical products 60 Yo 0Vegetable products 0 Prepared foodstuffs and 40 Yo tobacco Mineral products Base metals and articles 20 Yo 0 Yo Number of Export Total declared export declarations in 2007 value in 2007, m MKD Source: Macedonian Customs - A.KeydataonMacedoniantransportsector Table 2002 2003 2004 2005 2006 Length of railroads, km 696 696 696 696 696 Number of locomotives 54 57 57 56 56 Number of freight vehicles in road transport 20213 190042 15196 14702 13545 Number of road tractors 4105 3952 3194 3339 3411 Departedair-freight, tons 522 429 444 484 464 Arrived air-freight, tons 1613 1365 1315 1133 1206 Transport work by railways, mton-kms 334 373 426 530 614 Transport work by road, m ton-kms 2693 4130 4004 3930 6732 175 Table B: Number of TIR213Carnets Issued by the International Road Union to local associationsof selected countries. 2001 2002 2003 2004 2005 2006 2007 Bulgaria 211,000 252,000 303,000 313,000 349,000 394,500 140,000 Estonia 97,000 90,000 91,000 56,000 43,000 47,000 5 1,000 Slovakia 31,100 28,050 34,800 18,450 20,900 23,050 22,550 FYR Macedonia 22,100 29,300 27,400 27,400 27,700 31,550 20,300 Greece 22,000 29,400 23,600 40,500 33,200 30,700 19,800 Serbia 8,800 12,100 Serbia and Montenegro 2,050 5,350 5,000 Slovenia 19,300 17,800 18,600 22,000 6,550 16,400 12,000 Croatia 7,900 9,800 7,650 9,700 9,500 9,300 6,300 Albania 250 500 400 400 800 800 800 Source: UNECE, 2008 The Convention on International Transport of Goods Under Cover of TIR Carnets [TIR). It enables international transportation of goods without time-consuming Customs border checks. TIR statistics reveal that Macedonian road hauliers are relatively active in international traffic. The largest association for road hauliers "Makamtrans" has 1150 members 176 Annex 4.1: Surveys of Potential and Existing Foreign Investors 1. A FIAS (2007) survey of potentialand existing investorsfound that 50 percent of these investors had a very bad knowledge o f FYR Macedonia's business environment (Figure A). To influence such perceptions, the Government launched a major drive, promoting FYR Macedonia as a business destination. Figure A: Level of Knowledge of Business Environment: FYR Macedonia Compared 45 40 35 30 25 20 15 10 5 0 Source: Emst & Young Attractiveness of South Central & South East Europe2006 -World Bank Report 2. In terms of the factor conditions influencing the site selection of automotive and electronic companies, the findings of the research undertaken by McInvest Economic Development in the mid 1990s, focusing on the Czech Republic, although dated in some respects, highlight a couple of features which are still very pertinent within a Macedonian context. The research, funded by the EC Phare Program, was extensive in that the Chief Executivesof 2,500 automotive and electronic companies with sales over 20 million throughout Europe (including American and Japanese subsidiaries) were asked to prioritize the factors influencingtheir site selection process for new capacity, particularly in Central and EasternEurope. The findings are presented in FigureB below. 3. The salient points ofthis researchrelateto four factors in particular: Automotive and electronicsalso representtwo of Invest FYR Macedonia'starget sectors; At the time of the research, the Czech Republic's EU accessionprocesswas at a similar stage to that of FYR Macedonia's current status; The research also took place at a time when the Czech investment promotion agency, CzechInvest, was at a similar stage of development to that of InvestFYR Macedonia; and 0 The research coincidedwith the final phase of privatizationat a time when annual greenfield investment flows were negligible. 177 4. Arguably, had this research exercise been repeated for South East Europe in the first quarter of 2008, it is most unlikely that the sequence ofthe factor priorities would change. Consequently, the survey results, particularly taken in association with the extremely low level of awareness of the country as an investment location, in significant part, explain the low flows of FDI within those segments into FYR Macedoniathus far. Given a choice, the preference of most investors is to establish operations in a large domestic market, within which additional sales leverage benefits can be achieved while political and economic stability representedthe overarchingsite selection influencer. 5. Until this current Government came to power Figure B: Key Factor Conditions Influencing Site Selection Process in 2006, feedback indicates that FYR Macedonia did not meet most potential Key Factors influencing investors' stability Investment Decision / Site Selection Process thresholds. It should be noted that the percentage O h Pnlitieul and figures in the graph in Figure B represent the share of companies giving a particular factor condition top priority. From the feedback the World Bank consultant received when interviewing both recent investors and lost investors it was clear that NATO membership was not a factor influencing their Czechlnvest Research - 2,500manufacturing companies (automotive& respective investment electronics) in Western Europe contacted 15% response rate - - decisions albeit the companies involveduniversally acknowledgedthe importanceofNATOto the Government andpeople of FYR Macedonia. 178 Annex 4.2: Feedback Site Selection and Start-up Experiences of Johnson Controls and Johnson Matthey (as of April 2008) FactorConditionimpactingon Summary ofFeedback from Investors site selection and start-up Access to international and Given they are/will be exporting 100 percent of output - regionalmarket market accessibility - especially-to Western Europe was of critical importance. Cost of labor Cost savings were a key driver and therefore labor cost was also a critically important factor. Availability of Labor Another critically important factor - one of the investorshad become concerned by increasingstaff turnover within several oftheir CentralEuropean plants. Linguistic skills This was important for both - specifically the command of English. IT-relatedskills This was a mid-priority issue given both companies were expectingto extensivelytrain staff. Economic policy and political This was and still is of paramount importance prompting one stability of the respondents to admit that his main concern about investing in FYR Macedonia is the risk of the current Government losingpower. Governance / Corruption One of the companies has encountered `incentive seekers' but thus far has found solutionswithout havingto pay bribes Taxes The 10 year corporate tax break, within the Technological- Industrial DevelopmentZones (TIDZs), was a key influence on bothcompanies' site selection processes. Incentives Incentives helped to clinch the deal in one case. The other company had tentatively selected the Czech Republic where they did not expect or seek the maximumlevelof incentives. Quality of life and provision of While the quality of life ranks reasonably favorably, the lack internationalschooling of internationalschoolingis a serious concern Training grant For bothcompanies this was a very importantconsideration. Status of EUaccession For both companies it was the tariff free access to the EUthat was of overriding importance - as to when FYR Macedonia becomesan EUmember, this was not so important NATO Membership NATO membership did not feature prominently within the site selection processes albeit both companies recognize how important the issue is for the people of FYR Macedonia and the Government in particular. Implementation experience Planning and Construction This was a very weak area in the implementationexperience. Permits One of the companies was granted planning permission on the week its building was completed. The other had to draw on high-level political support to sort out planning, 179 environmental impact assessment and building control issues (which would be considered basic in the majority of Central European countries). These experiences highlight lack of progress inthis area. Linkages with local academic This was very importantto bothcompanies institutions Ability to source locally Both investments are relatively independent and this was not a substantive issue. Nevertheless, both companies have impressive corporate social responsibility track records and one of them is actively seeking ways to enhance the value of its intermediates by utilizing the services of a Macedonian pharmaceuticalcompany. Provision of work and residency The Financial Controller of one of the companies has been permits trying, unsuccessfullyfor over 9 months thus far, to secure a work and residency permit. This highlights the huge gaps which still exist between laws / government ruling and effective implementation/ enforcement. Customsandtrade regulations One company had problems aligning their international customs and shipping procedures with the local customs office. However, the local customs authority has been very responsive. 180 Annex 4.3: Prices of Selected Goods, in Euro AL BA HR MK ME RS BG RO BE EL Colgate 1.6 1.8 1.9 2.0 1.6 1.5 1.6 1.4 1.6 2.3 toothpaste, 75 ml Ariel Mountain Spring 6.9 5.4 8.7 6.5 6.1 5.7 7.1 7.1 . . . . . . detergent, 3 kg. Calgonit 3.3 6.7 5.3 4.2 5.7 5.2 5.9 5.7 3.2 5.8 tabs, regular Toblerone 1.1 1.1 1.4 1.0 1.0 1.2 1.1 1.2 1.2 1.1 100gr. Nescafe 5.9 5.7 6.8 4.6 5.7 5.8 4.9 7.0 5.7 5.2 regular, 200 gr. Headand Shoulder 3.3 4.8 4.9 4.2 4.3 4.8 4.2 4.6 6.1 4.9 Ocean energy, 400 ml. FructisGamier 2.2 2.5 2.2 2.3 2.1 2.4 2.5 2.5 3.0 2.8 250 ml. Rio Mare - tuna fish 2.4 2.7 2.8 2.2 2.7 2.6 2.1 2.8 2.3 2.1 regular, 160gr. Always 1.6 1.1 1.6 1.6 1.7 1.1 1.4 1.9 2.0 2.4 ladies pads Nutella 2.5 3.0 3.1 2.3 2.8 3.5 3.2 2.3 2.2 1.8 chocolate cream, 400 gr. Hellman's ... 1.4 1.5 1.0 ... 1.4 . . . . . . . . . 1.3 mayonnaise, 235 gr Palmolive . . . . . . . . . 2.0 2.0 2.0 . . . . . . 2.0 ... detergent, 500 ml. Amstel 0.6 . . . . . . 0.6 ... 0.8 0.4 . . . . . . 0.3 beer, can, 0.33 1 Ritter Sport ... 1.2 1.3 0.9 ... 1.5 ... 1.1 1.3 1.2 chocolate, 100gr. Note; AL - Albania; BA -Bosnia and Herzegovina; HR- Croatia; MK -FYR Macedonia; ME-Montenegro; RS- Serbia; BG-Bulgaria,RO-Romania, BE-Belgium and EL-Greece. 181 Annex 6.1: A SimpleEndogenousGrowth Regressionfor SmallEconomies 1. With cross-country data for 2003-06, a simple endogenous growth model is estimated by an instrumental variable technique. The dependent variable is the four-year period average growth rate of GDP per capita. All independent variables but initial GDP per capita and human capital are assumed endogenous and instrumented by their one-period (4-year) lagged values. To maximize the sample, four infrastructurevariables are used: electricity installed capacity per capita, teledensity, Internet subscription rate, and air freight traffic.214Air transport infrastructure stocks are difficult to measure but assumedto be represented by air freight traffic in ton-km. Population growth and trade openness are also included as endogenous explanatory variables. The whole sample is divided into halves by population size; the threshold of 10 million is selected to maintain the sample sizes The summary statistics are presented in Table A. 2. With data for all countries, the effects of electricity generation capacity and air transport on economic growth are found significant. Trade openness also has a positive impact on growth. For growth o f small economies, air transport seems to be a particularly important infrastructure. By contrast, relatively large economies may benefit more from electricity infrastructure (Table B). Table A: Summary Statistics for Growth Regressions Sub-sample= Sub-sample= Population< I O million Population> I O million Obs. Mean Std.Dev. Min Max Obs. Mean Std.Dev. Min Max GDP per capita growth (YO) 61 4.39 3.59 -1.40 19.47 62 3.83 2.70 -6.62 9.58 Populationgrowth(YO) 61 1.00 1.12 -1.20 5.28 62 1.19 0.88 -0.86 3.51 Trade openness (YO) 61 85.84 42.41 32.62 324.07 62 63.14 34.49 20.58 191.91 Power installedcapacity per capita (kW) 61 1.19 1.18 0.03 5.83 62 0.70 0.77 0.00 3.68 Teledensity (per 100) 61 76.38 53.69 1.43 193.99 62 57.87 51.26 1.05 155.86 Internetsubscription (per 100) 61 21.96 20.11 0.07 77.18 62 16.93 19.01 0.17 65.03 Air freight (billion tons times km) 61 0.36 1.15 0.00 6.83 62 1.68 4.94 0.00 36.34 Initial GDP per capita 61 9,072 11,285 186 48,558 62 6,304 9,290 128 36,672 Initial humancapital 61 84.23 23.37 21.66 144.54 62 73.95 32.87 8.43 156.39 East Asia & Pacific 61 0.16 0.37 0 1 62 0.16 0.37 0 1 Europe & Central Asia 61 0.43 0.50 0 1 62 0.29 0.46 0 1 Latin America & Caribbean 61 0.13 0.34 0 1 62 0.13 0.34 0 1 Sub-SaharanAfrica 61 0.11 0.32 0 1 62 0.19 0.40 0 1 Low-income countries 61 0.11 0.32 0 1 62 0.27 0.45 0 1 Lower middle-incomecountries 61 0.30 0.46 0 1 62 0.27 0.45 0 1 Upper middle-incomecountries 61 0.25 0.43 0 1 62 0.21 0.41 0 1 Memorandum item: Population(million) 61 3.65 2.70 0.09 9.72 62 90.20 214.00 10.10 1,310 214 Road infrastructurevariables, such as road density, are relatively limited. It has been found that the sample size would be reducedto some 70 ifa roadvariable is included.However, roaddensity, as expected, has apositive effect on economic growthifit is includedinthe modelalone. 215 The conventional threshold may be 2 million of populations for small economies. However, such a definition would resultinthe small sample probleminour framework. 182 Table B:InstrumentalVariable Estimationof Growth Equation Sample= Sub-sample= Sub-sample= All Population< I O million Population> I O million Populationgrowth (%) -0.279 -0.276 -0.593 -0.635 -0.453 -0.435 (0.5 18) (0.522) (0.551) (0.585) (I.142) (1.144) Trade openness(%) 0.015 ** 0.015 ** 0.008 0.009 0.003 0.005 (0.006) (0.006) (0.01 1) (0.0 12) (0.009) (0.009) Power installedcapacity per capita (kW) 0.804 ** 0.771 ' 0.744 0.661 1.125 1.307 ** (0.3 36) (0.417) (0.484) (0.591) (0.593) (0.557) Teledensity(per 100) -0.028 -0.03 1 -0.049 -0.061 ' -0.026 -0.0 16 (0.021) (0.022) (0.030) (0.035) (0.031) (0.028) Internetsubscription(per 100) 0.007 0.027 -0.028 (0.034) (0.061) (0.032) Air freight (billion tons times km) 0.096 * 0.092 1.084 ** 1.093 *' 0.05 1 0.061 (0.053) (0.051) (0.5 38) (0.546) (0.045) (0.043) In(Initia1GDP per capita) -2.136 **' -2.131 *" -2.380 * -2.283 -1.602 -1.521 (0.783) (0.785) (1.240) (1.289) (1.348) (1.412) Initial humancapital -0.017 -0.0 17 -0.0 12 -0.015 -0.021 -0.020 (0.015) (0.0 15) (0.030) (0.032) (0.017) (0.017) East Asia & Pacific 0.426 0.384 -1.590 -1.901 2.214 ** 2.296 *** (0.809) (0.862) (1.441) (1.728) (0.990) (0.990) Europe& CentralAsia 2.501 '* 2.545 ** 2.753 2.746 2.401 *' 2.096 (1.145) (1.1 75) (1.913) (1.936) (1.146) (1.230) Latin America& Caribbean 1.262 1.258 0.8 18 0.732 1.432 1.388 ' (0.8 19) (0.825) (1.492) (1.566) (0.822) (0.826) Sub-SaharanAfrica -1.392 -1.403 -1.345 -1.378 -1.279 -1.219 (0.904) (0.909) (1.330) (1.366) (1.625) (1.660) Low-incomecountries -7.923 *'* -8.056 *** -10.182 *** -10.341 '* 4.579 -3.943 (2.660) (2.676) (3.906) (3.873) (3.3 88) (3.678) Lower middle-incomecountries -3.891 ** -3.966 *' -5.879 *'* -6.029 *" -1.843 -1.513 (1.770) (1.750) (2.195) (2.125) (2.095) (2.174) Upper middle-incomecountries -1.722 -1.773 -3.360 *' -3.553 " 0.020 0.23 1 (1.378) (1.369) (1.673) (1.666) (1.385) (1.394) Constant 24.769 "* 24.893 *** 30.325 **' 30.256 *** 19.410 '* 18.1I 3 '* (5.780) (5.823) (10.339) (10.441) (8.159) (9.019) Obs. 123 123 61 61 62 62 R-squared 0.413 0.412 0.494 0.494 0.430 0.437 F-statistics 5.93 5.60 3.45 3.24 19.15 14.22 Note that the dependentvariable is the average GDP per capitagrowth ratefor 2003-06. The robust standard errors are shown in parentheses.*, **,and *** indicatethe IO%,5% and 1% significance levels, respectively. Source: Author's calculation. 183 Annex 6.2: TelecommunicationsIndustriesinFYRMacedonia Recent developments 1. FYR Macedonia's telecommunicationsdevelopment was laggingbehind in structural reforms; as per EBRD's Transition Report 2007, FYR Macedonia was ranked among the poorest infrastructure reformersfive years ago, ratedat "2.3" (Figure A). 2. In spite of the recent vigorous momentum of the reform agenda in the mobile market, FYR Macedonia's telecommunication system remains unusually dependent on fixed line telephony, compared with the regionalcomparators (Figure B). FYR Macedoniahas about 25 per 100people of fixed-line tele- density, which is slightly higher than Lithuania(23), the Slovak Republic (21), and Romania (19). More advanced countries tend to have a larger fixed-line installed base. In outgoing telephone traffic terms, more than 70 percent of calls originate from fixed lines. Many other countries in the region have about 40-60 percent. The main reason is obviously the delayed introduction of effective competition in the mobile segment. Indeed, mainline tele-density has turned gradually downward since 2003. It can also be interpretedto meanthat fixed-line telecommunicationsmight continue to be relatively attractive, possibly in terms of prices and quality. Unless this reflects real demand of consumers, it means that the cellular- phone market would still be undervalued. FigureA: TelecommunicationsReformIndex FigureB: Share of MainlinesinTelecom Users B$4 5 , 100% 4 0 80% 3 5 1 & 3 0 60% E 1 2 5 40% 2 20 2 E5 20% I 5 0% Source: EBRDTransitionReport. Sources: World Bank WDI database; EBRD Transition Report. 3. In the last five years, the prices declineddramatically in nominalterms. The mobile monthly fee declinedfrom 12-14 U.S.dollars in 2003 to about 10 dollars in 2007 (Figure C). The off-peak mobile rate in the same network dropped from 15 to 4-6 U.S. cents per minute (annex Figure D). Because of competitive pressures from new entrants in the mobile market, even a fixed-line operator, MakTel, has kept its call rates somewhat competitive.The fixed line monthly charge gradually increasedto rebalance telephone rates until 2005, and since then it has been unchanged (Figure E). A series of price reductions explainthe recent accelerationintelecommunicationsubscription. 184 Figure C: TelephoneMonthly Fee in FYR FigureD: Mobile Off-peak Rate in FYR Macedonia Macedonia ..................-Fixed line -T-mobile - ................................ .......... ................................................... ................................................... t Source: Macedoniantelephone operators. Source: Macedoniantelephoneoperators. 4. FYR Macedonia's telecommunication price FigureE:Fixed Line Call Rate (Peak) structure is becoming more diversified and differentiated, as in high-income countries. Off-peak ................................. --L ong distance (per minute) prices are approximately half o f peak rates (Figure ....... -~ --Fixed mobile (per minute) ....................... IO F). In addition, on-net mobile rates are generally ..........1.................... "TY.? ...................... lower than off-net prices (Figure G). Notably, ....1.7.:........................... . > - - - ~ --.-.-.-- Cosmofon is significantly discounting own on-net E a calls. This can be considered a strategic device to compete against an incumbent. By contrast, a _--- .... TJ 4I ............................................................ contract offered by the incumbent mobile operator :* .r-L-:-.:.... ./. ............................ includes a nondiscriminatory rate for both on- and off-net calls. Source: Macedoniantelephone operators. Figure F:Peak and Off-peak Telephone Prices Figure G:On- and Off-Net Mobile Rate .......................................... -T-mobile(on-net) - (off-net) .......................................... -......Cosmofon(off-net) (on-net) 0.g g gs $ ? n g g @ p . . . . . . . . . . . . . . . . . . . - 0 F i w w H W W W W W , Source: Macedoniantelephone operators. Source: Macedoniantelephone operators. 185 Estimatinga demand functionfor telecommunications services 5. Following McFadden (1974), Berry (1994), Nevo (2001) and Iimi (2005), a discrete consumer choice model is applied for the Macedoniantelecommunicationsmarket, The following indirect utility function of consumer i who subscribes to telecommunicationsservicej at markett is representedby: u,],=a,Monthly,, +aJJnitRate,, +xIJp +y In +{,, +E,, N,,-, where Monthly and Unit Rate represent j ' s standard monthly charge and unit rate, respectively. A consumer is supposed to select a subscription plan from fixed-line, prepaid mobile and postpaid mobile telecommunications.Two mobile brands are available, T-Mobile and Cosmofon; the third operator, VIP, who entered inthe market in 2007, is excluded from the analysis due to lack of sufficient data. To control for product heterogeneity, firm-specific fixed-effects and a dummy for prepaid contracts are included in xj,. It is assumed that each consumer potentially chooses her own telecom carrier every quarter, though not many customers end up with changingtheir represented by markets t. +is quarterly data from 2001 Q1 to 2007 Q4 are the lagged number of subscribers to planj, which aims to capture conventionalnetwork externalities. 6. The equation can be estimated by the following market share equation (Cardell, 1997): InsJI-Ins,, =a,Monthly,, +a,UnitRate,, + p +y In XI, N,,-, + where s,, is j ' s market share and so is the market share of alternative choice, i.e., not subscribing any telecommunications services. The potential market size is assumed to be defined as twice the total population; people can potentially have both fixed and mobile telephones. Inthe sample, populationdata are interpolatedfrom yearly data. 7. This share equation is estimated by the instrumental variable estimator, because prices are potentiallycorrelated with unobservedproduct characteristics in and thus endogenous inthe equation. The two price variables are instrumentedby the average telecommunicationsprices, which are definedas the operator's quarterly revenues per connection, in FYR Macedonia's neighboring countries, Albania, Bulgariaand Croatia. 8. There are several important findings; first, the price elasticity of unit rates are found negative as expected, except when using the on-net off-peak rates (Table C). The elasticity is estimated at 0.4 to 0.7 in absolute terms, depending on specification, when evaluated at the mean values. It is also found that fixed-line telecommunications(MakTel) is less favored. Between two mobile brands, an incumbent, T- Mobile, seems to have the advantage of attracting more consumers. Prepaid contracts are found more attractive in FYR Macedonia.This may explain the unexpected positive coefficients of monthly fees; all attractivenessof low monthly fees (in fact, zero for prepaid contracts) seems to be capturedby the prepaid dummy. Finally, it has been found that network externalities have an important role to play in enhancing the networkand market shares. This is consistent with theory. Notably, telecommunications subscription means that a service, not (durable) good, is purchased by consumers (seeNevo (2001) and Iimi (2005) for hrther details). 186 Table A: Estimated Telecommunications Demand Function in FYR Macedonia (IV estimation) (I) (2) (3) (4) (5) (6) (7) (8) Monthly fee 0 18 ** 0.17 '* 0 36 0 19 ** (0.09) (0.07) (0.63) (0.08) On net peak rate -3.57 ' -2.91 *' (2.13) (1.16) Off net peak rate -2.03 *' -1.94 '** (1.05) (0.49) O n net offpeak rate -25.72 12.01 (74.82) (14.01) Offnet offpeak rate -4.44 * -3.06 *** (2.55) (1.11) MakTel -2.31 **' -0.95 '** -1.56 '** -0.46 "' -4.92 0.88 -1.68 '** -0.37 "' (0.83) (0.29) (0.50) (0.07) (10.72) (1.30) (0.55) (0.07) T-Mobile -0.06 0.08 -0.17 -0.01 0.61 -0.58 -0.20 -0,04 (0.17) (0.09) (0.12) (0.05) (2.55) (0.59) (0.12) (0.05) Prepaid 2.45 ** 0.66 *** 1.96 '** 0.43 *" 5.00 -0.75 2.22 *** 0.36 *** (0.94) (0.25) (0.69) (0.10) (10.42) (0.96) (0.79) (0.12) WN,,., 1 0.97 "* 0.83 '" 1.03 *** 0.88 *'* 0.70 1.21 *** 1.00 *.* 0.87 '** (0.12) (0.06) (0.08) (0.03) (1.18) (0.32) (0.10) (0.04) Cons -2.01 '** -0.66 "' -1.88 **' -0.62 *** -2.68 -1.20 ** -2.15 "* -0.74 "* (0.67) (0.13) (0.58) (0.09) (2.90) (0.53) (0.60) (0.08) Obs. 103 103 103 103 103 103 103 103 R-squared 0.939 0.981 0.956 0.990 0.313 0.882 0.952 0.990 F-statistics 260.23 1021.23 356.42 1964.31 23.07 161.72 328.62 Note that the dependentvariable is the market share of carrierj, The standarderrors are shown in parentheses. *, **,1959.55 and *** indicatethe IO%, 5% and 1% significancelevels, respectively. Source: Author's calculation. Competitionand supply conditions inthe telecommunications sector 9. One measure of competition indicates a Figure H: Degree of Competition in Mobile degree of competition in FYR Macedonia's Markets I telecommunications sector (Figure H). At the Populationper mobile operator (million) same time, however, telephone carriers seem to 0 1 2 3 4 5 6 extract large profits: it is a worldwide Estonia phenomenonthat the telecommunicationsindustry Hungary Latvia is very profitable. The basic reason i s that the cost Croatia Lithuania structure of telecoms is opaque, and dramatic Slovak Turkey decline in costs is unlikely to be translated into a Romania correspondingly dramatic fall in retail service Ma~edonla Bulgaria prices (Newbery, 2000). Thus, MakTel's earnings Bornla ~ Albania before interest, taxes, depreciation and Denmark Austria amortization (EBITDA) margin exceeded 45 Greece percent, which was much higher than that of its Sweden Swimland parent company, Magyar Telekom. Source: Staff calculations. Smaller index means implies competition,accordingto this interpretation. 10. Such high profitability might be an indication of incumbent's monopolistic behavior and limited real competition. Whether the realized profits are excessive can be examined by calculating the market-based cost of capital under the capital asset pricing model: here, the rate of return on investment required by private operators has to be increased by 10-1 5 percent in developing countries because of uncertainty about regulatory decisions (Le., so-calledbeta coefficient)and a highcountry risk premium. 187 11. However, high profit margins based on excessive prices are highly inefficient and should be lowered. As shown in Figure I,the latest cross-country data strongly support a constant and high price elasticity of demand of about 0.8. FYR Macedoniais enjoyinghigh revenues with medium-sizedsupply. Even if "prices" become lower, telecom operators will continuereceivinghigh revenues as in many high- income countries (Figure J)."' However, an important difference is that the high-volumeequilibrium has a much smaller economic loss (i.e.y deadweight loss); higher demand elasticity tends to result in creating larger economic inefficiency. FYR Macedonia has gradually moved toward a high efficiency system in recent years; but this process needs to be accelerated. It is of particular importanceto motivate operators to constantlyreduce prices and supply more, while maintainingthe granted incentive scheme. Figure I:EstimatedTelecom Pseudodemand FigureJ: Telecom Revenue Function 0 4 L -L 0 3 i o 2 d I! 01 Telecom revenue ecom revenue in - h income counfnes 0 I O IO0 1000 IO000 0 500 IO00 I500 2000 2500 In(Teledens1ryper 1,000) Teledenrity per I.000 Source: Author's calculationfrom WDI and ITU data. Source: Author's calculation. 12. On the cost side, total labor productivity in the Macedonian Figure K:Total Labor Productivitvof Telecom Sector telecommunications industry is mixed. Notably, it is shown that in ECA countries firms' entry also plays an important role n 5 700 in boosting productivity in telecoms- ` 600 related industries (World Bank, forthcoming). In FYR Macedonia, the E6P500 number of total telephone subscribers per fm 400 worker is about 600, which is lower than 300 c more advanced countries, such as the Q 200 Czech Republic and Estonia, but may be s 100 comparable with Croatia and Albania 0 (Figure K). By segment, however, FYR Macedonia's mobile telecom productivity i s among the lowest at only 1,000 contracts per worker, possibly due to Source: Author's calculation from WDI and ITUdata. delayed introduction of effective competition. The fixed-line segment has relatively high labor productivity. It is true that smallcountries (e.g., Irelandand Estonia)tend to have lower labor productivity than largereconomies, because ofeconomies of scale inthe industry.However, even compared with these countries, FYR Macedonia may have room to improve efficiency by roughly 30-50 percent in mobile telecommunicationsprovision,which would help bringabout further market price decreases. For simplicity, the argument does ignorepossibleheterogeneityinsupply costs. 188 Annex 6.3: Firm Cost PerformanceandInfrastructureServices Estimatingthe Impact of Increased EnergyPrices on Firm Costs 1. The 2005 BEEPS for FYR Macedoniaindicates that normal firms are spending about 7 percentof their total operating costs for energy and fuel (Table A). The survey covers 200 enterprises in various industries,of which about half providedthe cost structure includingthe share of energy expenses in total costs. The energy intensity varies from sector to sector and even within each sector. On average, transport, real estate and hotels and restaurant are the three most energy-intensiveindustries.The energy share in the manufacturing industry ranges between less than 1 percent and 30 percent with a mean of about 6 percent. In absolute terms, following transport (which mainly consumes fuel rather than electricity), manufacturingand mining are two large energy consumers(Figure A). Several manufacturers are spending more than US$ 800,000 a year for energy. Table A: Energy and Fuel Expenditure Share FigureA: Energyand Fuel Expense by Sector in OperatingCosts --3 1 4 Share o fenergy expenditures in total .c) v) 1 2 Obs. operating cost * a Mean Dev. Std' Min Max 0 10 B Mining 2 2.36 2.91 0.30 4.42 =I0 8 Construction 8 2.06 1.66 0.21 4.71 Manufacturing 29 5.95 7.39 0.46 30.67 Transport 9 16.05 14.75 0.47 40.75 Trade 36 5.49 4.90 0.53 17.56 Real estate 7 12.16 16.16 1.04 46.67 Hotels & rstaurant 6 14.22 11.63 3.72 33.68 Other services 9 3.22 1.92 0.47 5.71 Total 106 6.94 8.80 0.21 46.67 Source: 2005 BEEPS. ISource: 2005 BEEPS. 2. The following flexible translog cost function is estimatedwith the BEEPS data: where C denotes total operatingcosts, Y is an output, and W, is ith input price. Output is measured by total sales, because no physical output variable is available in the database. Three inputs are considered: labor, energy and fuel and other cost, which is also referredto as capital in general. Unit labor price W, is obtained by dividing total wage expenses by the number of employees. The energy price WEis calculated by dividing energy and fuel expense by total sales, because there is no information on the actual consumption of electricity or fuel. "Capital" potentially consists of various costs, and the unit price of input capital (WK)is computed by dividing the operating expenses other than wages by the amount of assets, more preciselytotal asset replacement costs. 3. The cost function is estimated by a seemingly unrelated regression (SUR) technique under the following conventionalsymmetry and homogeneity assumptions for a well-behavedfunction: 189 By Shephard's lemma, the factor i's share intotal operatingcost is obtained: 4. Table B shows the SUR estimation results; the coefficients are Table B: Estimated Cost Function of FYR Macedonia broadly consistent with economic theory. The manufacturing industry seems to be (1) (2) systematically more costly at the 10 Coef. Std.Err. Coef. Std.Err. percent significance level (see column P Y 0.897 (0.100) '** 0.917 (0.088) '** (2)). Based on the estimated parameters, Prr 0.015 (0.015) 0.012 (0.014) the (operating) cost elasticity can be P W L 0.829 (0.056) ''* 0.843 (0.054) '** calculated. Evaluated at sample means, the P W E -0.303 (0.047) *'* -0.318 (0.047) *" elasticitywith respect to energy expense is P W L W L -0.042 (0.024) * -0.043 (0.024) ' estimated at 0.025. Thus, a 50 percent P W L W E 0.168 (0.009) *I* 0.166 (0.009) **' increase in energy prices would likely P W L W K -0.159 (0.013) *** -0.156 (0.013) '*' increase operating costs by about 0.015 (0.010) 0.014 (0.010) 1% percent for the average firm (Table PP W W E W E E W K 0.017 (0.011) 0.020 (0.011) * C).218The overall cost for the economy is PWL 0.007 (0.007) 0.004 (0.007) approximately 90 million US. dollars or P W E 0.006 (0.007) 0.007 (0.007) 1.9 percent of GDP a year, assuming that Construction -0.014 (0.159) some 100 firms in our sample represent Manufacturing 0.048 (0.159) 0.076 (0.047) ' the entire population of firms-about Transport -0.212 (0.187) 55,000-in FYR Macedonia. Trade 0.019 (0.162) Realestate 0.008 (0.191) 5. The impact of electricity price Hotels & restaurant -0.146 (0.181) adjustments could be high, and firms have Other services -0.118 (0.184) to undertake more energy efficiency Cons -1.404 (0.347) "* -1.536 (0.296) "* measures over the medium to long run. Obs. 89 89 FYR Macedonia's residential electricity Chi-squared Cost equation 13396.4 *** 12675.6 *** tariff must increase through structural Labor share equation 412.7 *" 398.6 *" reform and market liberalization--the Energyshare equation 888.0 *** 882.0 "' current residentialtariff of 7.2 USD cents Note that the dependent variable is thelogarithmic operatingcost. per kWh is even below the cost recovery The standard errors are shown inparentheses. *, ** and *** tariff, estimated at about 7% cents in 2005 represent the IO%,5% and 1% level significance, respectively. (World Bank, 2006b). The adjustment Source; Author's calculation. process in FYR Macedonia is clearly sluggish compared with neighboringcountries (Figure 6.12 in the report). The ongoing electricity price adjustment is likely to curtail a cost advantage of not only energy-intensive industriesbut also domestic small andmedium-sizedenterprises ingeneral. 2'8Note however that these estimates do not reflectthe problems likely to be faced by the large, electricity-intensive metal and cement firms. Metal firms are facing problemsboth from the input side (energy price adjustments) and on the output end (falling metalprices). 190 Table C: Implied Cost Elasticity Elasticity Std. Err. Energy expense 0.025 (0.011) ** Labor expense 0.326 (0.018) **' Source: Staff calculations see equation(1) Estimatingthe impactof InformationTechnology use on firm costs 6. The coefficients of the dummy variablesfor informationtechnologiesare shown in Table D.The coefficient of email, though not statistically significant at usual levels, is positive. Fax appears relatively costly for firms, and mobile telecommunicationswill have a large efficiency impact. Taken together, the impacton costs of usage of mobile phones, emails and fixed line telephony can be significant, and cannot be overlooked as firms strive to become more competitive. Macedonian firms should pay particular attention to this, given their small average size, and the fact that telecommunication tools can help overcome some of the handicaps imposed by small size. The experience of other countries in the region shows that ICT use can play a bigpart in productivity improvements(World Bank 2008e). Table D: Estimated Coefficients of InformationTechnologies Coef. Std. Err. Fixedline telephone -0.054 (0.120) Fax 0.287 (0.103) *** Mobile phone -0.291 (0.148) ** Email ** -0.083 (0.053) " and *** indicatethe 5% and 1% significancelevels, respectively. 1/ The p-valueis 0.11. Source: Staff calculations. 191 Annex 6.4: Air Transport Sector in FYR Macedonia Potentialdemand for air transport in FYRMacedonia 1. There are three potential areas for Macedonian air transport: seasonal travel, tourism, and business travel. First, the majority of the seasonal current demand is generated by Macedonian emigrants living in Western and Central Europe (Figure A). This will continue to be important for the air FigureA: Migrated MacedonianCitizento EU transport demand in FYR Macedonia. As far as Nkmber Countries, 2o01-05 migrants to EU countries are concerned, about half of Macedonian emigrants seem to have migrated to Germany, followed by Slovenia, Austria and Switzerland. Although various seasonal flights are already served, several routes are still ",uy underdeveloped between FYR Macedonia and these countries, especially Germany. There now exist daily flights from Vienna, Ljubljana and Zurich. Czech Airlines is operating between Prague and Skopje but only five days a week. Malev flies to 29 4% Budapest, Turkish Airlines to Istanbul and JAT to Belgrade. There is no direct connection to any major Source; Eurostat. cities in Germany. It may be expected that the EU accession of FYR Macedonia would trigger certain outflows of workers at least in the short run, boosting highly seasonal air transport demand. Notably, Germany has received 40 percent of total migrants from new EUmember countries. 2. Further, air transport demand could be generated from recovering tourism. The international tourism demand is influenced particularly by air transport costs. The most recent study shows that the demand elasticity with respectto airfares could reach 5.9 in the Russian case (Algieri, 2006). The demand elasticities of U.K.tourists are estimated at 1.8 to 2.2, depending on destination (De Mello et al, 2002). As tourism is a "luxury good," travel cost elasticities are normally expected to be relatively high in a range Table A: Number of Tourists by Country from 0.04 to 4.3 in absolute terms (Witt and Witt, Origin 1995). 2o02 2o06 Change Share (%) (Yo) 3. However, the international airfares are merely Total 441,712 499,173 13.0 318,851 296,816 -6 9 one of the determinants of tourism demand. The Domestic Foreign 122,861 202,357 6 4 7 1000 existing literature indicates that tourism demand is Serbia & Montenegro 23,239 41,208 7 7 3 2 0 4 more influenced by origin country's income (Le., Greece 14,677 30,835 1101 152 income effect) and tourists' living costs in the Bulgaria I1,703 17,421 48 9 8 6 Albania 9,086 16,188 18 2 8 0 destination. The average income elasticity may be about Slovenia 3,837 9,228 I40 5 4 6 2%, and the elasticity of destination costs is 0.7. The Croatia 4,097 8,817 1152 4 4 income effect is fairly exogenous given EU growth, but USA 6,997 8,215 18 3 4 1 Germany 6,084 7,659 25 9 3 8 the tourist living cost in FYR Macedonia could be Turkey 5,180 6,922 33 6 3 4 decreased in various ways, for instance through U K 3,916 5,3 18 35 8 2 6 facilitating competition and coordination among travel Italy 3,076 4.651 51 2 2 3 Netherlands 2,016 3,509 88 9 1 9 agencies and hotels. Austria 1,919 3,490 81 9 1 7 France 2.542 3,133 23 2 1 5 4. Cross-price elasticities of international tourism Czech 927 2,l 08 127 4 I O demand are also very high. In the 1J.K.case, it is shown Russia 1,246 1,998 60 4 1 0 Hungary 1,985 1,535 -7.6 0 9 that iftravel costs to visit Spain increases, people easily Source: FYRMacedoniaauthorities. change their destinations to Portugal or France (De 192 Mello et al., 2002). Similarly, Macedoniantourism must compete with neighboringcountries, especially Croatia, Bulgariaand Greece. Where do tourists come from to FYR Macedonia?The majority come from neighboring countries e.g., Serbia, Montenegro, Greece and Bulgaria, though they may not use air transport. Besides them, Slovenia, Croatia, United States, Germany and United Kingdom are among the top countries (Table A). These areas might constitute potential demand for air transport, and the Netherlands, Austria, the Czech Republic and Russia may also have growing demand for visits to FYR Macedonia. 5. Given intense competition across countries and relatively high destination costs of FYR Macedonia, the country may need to pursue the less price-elastic demand, such as small-scale high-end tourism. FYR Macedonia's tourism has gradually taken off since 2002. However, the number of tourists visiting FYR Macedonia has been far below the levels of neighboring countries. Also, the small size of the country would result in unfavorabledestination costs for travelers.It is a challenge howto develop the high-endtourism market.It must of necessity depend on irreplaceabletourism resources, such as nature in FYR Macedonia's case. The active role of the government is also essential in elaborating and implementing strategic master plans of tourism development and marketing, as experienced in Croatia (Cizmar and Lisjak, 2007). 6. Finally, the demand of business travelers has the largest growth potential consistent with future economic development ofthe country.FYR Macedonialooks roughly 70 percent less attractiveto foreign investors than the comparators in the region. Notably, however, business travelers are less price-elastic and all-year-around; this segment of demand will enable air carriers to operate on a scheduled basis. A current critical problem for FYR Macedonia is that there is no sufficient all-year-around demand to maintain scheduled flights preferably on a daily basis. It is a question in which direction causality runs; user-unfriendly air transport in terms of connectivity and frequency is certainly a constraint against foreign investment, but more importantly, without buoyancy in foreign investment, more frequent air operations could not be realized. progress of the economy's trade and investment 40 -- +--L'*uDn'a LatW integration to the EU. Causality could potentially $g8 30 - 35 --+CroatiaMaced0"M 7;;::; run in both ways between economic integration - and business travel demand. Based on the ;25 international experience, EU accession would v - @ 2o likely bring about a significant increase in B scheduled flights, because of the required a 15 liberalization of air markets as well as the 10 tp integratedtrade and investmenteffects (Figure B). The number Of passenger and freight air flights dramatically increased in new EU member states 22 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 and even candidate countries. Bulgaria - ,%urce; World Bank WD1 database- experiencedapickup in air flights even before the accession. Competitionand Market Performancein the Air Transport Sector 8. Intensifiedcompetition is expected to reduce air ticket prices; this will be a challenge for small airlines, including the MacedonianAir Transport (MAT). The market is becoming more efficient. Price discrepancy cannot be any longer large between air carriers. As a result, MAT appears to have been 193 losing price competitiveness, The relative price of MAT flights used to be much cheaper than competitors, However, MAT prices for short-haul flights to Vienna and Zurich became almost comparable to competition by 2007, and the tickets for other distant destinations tend to be more expensive (Figure C). Hence, thanks to recent market liberalization the market is becoming more efficient, but MAT needs to make more efforts toward operational efficiency and external competitiveness. Figure C:Market Flight Prices by Destination (Skopje-Vienna) (Skopje-Zurich) - 600 Airlines -Aurmnn Airlines 500 --Ausman Macedoninn Airliner 5011 --MaccdonianAirlines 600 -Austrian Airliner 500 --Macedoman Airlines d L 100 n/ (Skopje-New York) 1000 900 -Ausmm -- Airlines Maosdonian Airlines 800 Source: HRG FYR Macedonia Newsletter. 194 9. Notably, however, even if MAT remains a small air carrier, it might be able to concentrate on some niche routes in the ECAA. The current operation is centered on Zurich and Vienna (Figure D). But it can be diversified geographically, corresponding to the changing and growing demand from various cities, as indicated above. In order to realize such diversification, the EU and E C A A accession would be necessary. Figure D: MacedonianAir Transport Operation by Destination - OZurlch MVlenna - 0Dusseldorf 0Rome Mlstnnbul 0Hamburg Berlin 0Amsterdam L 2004 2005 2006 2W7 Source: Macedonian Air Transport. 195 Annex 6.5: Electricity-Intensity of FYR Macedonia's Economy 1. Large electricity consumers in FYR Macedonia used to benefit from the subsidized domestic tariff, which is set at about 30 /MWh. This has been one o f the main reasons for FYR Macedonia's high electricity intensity per GDP, partially indicating the existing energy inefficiency or overuse o f electricity (Figure A). In M a y 2007, 110 kV customers started procuring 55 percent o f demand for electricity from the international market, while as o f January 2008, these entities started procuring their entire demand from the open market. The market price was twice as high as the domestic regulated price. For instance, the average electricity price at the European Energy Exchange (EEX) was 48 /MWh in 2006 and 30-40 /MWh in 2007 (Figure B). Due to critical lack o f electricity in Hungary and the Balkan region, the wholesale price is currently 10-20 /MWh higher for Balkan states than the EEX rate in Germany. Given the high international commodity prices and the regional supply-demand position, this trend is not likely to change dramatically in the short term. Figure A: Electricity Intensity of the Economy Figure B: Average Price for Base load Power at EEX per Quarter 4 O . - . - N N O yl x 0 0 0 0 0 0 x z z x z g g* *gv i l g h * g o \gD pg. ps.g Source: World Bank WDI database. 6 6 6 5 S 6 6 5 3 6 6 5 3 5 3 Source: EuropeanEnergy Exchange. 2. The May 2007 and January 2008 adjustments had an immediate impact on several heavy electricity users, increasing their energy expenditure. Whether each industry could maintain competitiveness depends on production efficiency, transport costs and the international market prices. Despite firm efforts to save energy use, some external competitiveness might be eroded, particularly in metal products, which are primarily exported abroad. A steal maker spends more than 30 percent o f variable costs on energy. One o f the main metal exports from FYR Macedonia is flat rolled iron, o f which the average export price has been only less than 20 percent lower than the importable price. Beyond this margin, the industry would lose competitiveness. By contrast, the other energy-intensive industry, cement, looks less vulnerable to increases in factor prices. The relative price o f exportable to importable has been 60-70 percent, because o f high transport costs o f lime and cement products. High transport costs, together with the relatively small domestic market given the existing production capacity in FYR Macedonia, will help preserve domestic competitiveness. Inthe beverage industry, which also consumes a lot o f electricity in production, high horizontal product differentiation and territorial restriction (exclusive distribution) agreements would likely assist domestic producers in continuing to supply products competitively. 196 3. In the case of FYR Macedonia, importantly, iron and steel products (e.g., pig iron, A: FYRMacedonia's Exports ferrosilicon, ferronickel, flat rolled plated iron, 2003 2004 2005 and tube and pipes) and non-nonferrous products ken and steel 250.5 401.8 529.7 ( e g , aluminum and zinc) are the country's largest Non ferrous metals 5.2 7.2 40.7 foreign exchange earner. These products Total 255.7 409.0 570.4 contribute about 20 percent to total exports (Table '% of total expofls 14.6 18.9 21.9 A). They are potentially presumed most %of GDP 5.5 7.6 9.9 vulnerable to electricity price increases, though Sources: Source: World Bank WDI database; and firms' competitiveness differs depending on WITS d ~ ~ d ~ s e . individual circumstances after all. In order to sustain the national external strength in this sector, it seems necessary to further promote energy efficiency, develop local demand and concentrate on high-value products. 197 Annex 7.1: Mean Hourly Wages [in Dinars] by Sub-Group, FYR Macedonia 2006" Women Men Total Total 54.2 71.8 64.4 Age group 15-24 51.9 64.1 58.9 25-34 50.4 74.9 64.1 35-54 54.8 70.2 63.6 55-64 61.7 76.3 71.2 Education Primaryor less 37.7 80.4 65.8 SecondaryVocational 41.8 54.5 50.6 SecondaryGeneral 49.4 65.1 58.2 Higher or University 76.4 91.5 84.0 Strata Rural 47.9 78.7 69.4 Urban 56.0 67.9 62.3 Region Skopje 63.1 70.9 67.4 Bitola 52.7 61.3 57.4 Veles 51.6 59.7 56.4 Kumanovo 47.6 60.4 55.7 Ohrid 59.1 79.9 72.7 Strumika 47.4 54.3 50.9 Tetovo 59.7 108.7 95.8 Shtip 43.9 54.2 49.0 Ownership Non-private 63.6 69.8 67.4 Private 46.3 73.5 61.1 Occupations Managers, Public 97.1 88.8 90.1 Officials Professionals 83.2 95.6 88.8 Technicians 60.3 72.0 66.0 Clerical 65.3 67.4 66.4 Serviceshales 47.4 66.7 59.3 Skilled agricultural 40.9 48.7 46.8 workers Non industrialproduction 38.9 79.6 73.7 Operators 37.3 58.0 47.1 Basic Occupations 39.7 56.9 49.3 Source: Angel-Urdinola and Macias (2008), basedon LFS data *Includesall non-agriculturalwage employees between 15-64 years of age with positiveearnings. 198 Annex 7.2: Regression Results on Determination of Wages by Selected Age Groups, LFS,2006 Dependent variable: log(hourly wage) Age groups Variable 15-64 25-34 35-54 25-54 25-64 Age 0.008 0.009 -0.030 0.004 0.002 (0.004)** (0.086) (0.o19) (0.007) (0.005) Squaredage -0.000 -0.000 0.000 -0.000 -0.000 (0.000) (0.001) (0.000) (0.000) (0.000) Male 0.259 0.218 0.266 0.275 0.273 (0.025)*** (0.061)*** (0.030)* ** (0.027)*** (0.025)* ** Secondaryvocational 0.068 -0.035 0.071 0.058 0.078 (0.025)*** (0.053) (0.028)* * (0.025)** (0.024) *** SecondaryGeneral 0.130 -0.020 0.161 0.123 0.140 (0.019)** * (0.044) (0.021)*** (0.019)*** (0.0 1ti)*** Higher 0.240 -0.069 0.262 0.217 0.250 (0.028)*** (0.065) (0.033)*** (0.030)*** (0.028)* ** University 0.428 0.215 0.461 0.404 0.437 (0.029)*** (0.063)*** (0.035)** * (0.031)*** (0.029)*** Secondaryvocational male * -0.118 -0.105 -0.104 -0.128 -0.117 (0.035)*** (0.079) (0.042)* * (0.037)*** (0.035)* ** Secondarygeneral male * -0.090 -0.025 -0.099 -0.100 -0.092 (0.028)*** (0.066) (0.034)*** (0.030)*** (0.028) *** Higher male * -0.1 10 0.194 -0.1 10 -0.096 -0.117 (0.039)*** (0.120) (0.046)** (0.043)* * (0.039)*** University male * -0.146 -0.024 -0.175 -0.146 -0.154 (0.033)*** (0.078) (0.039)* ** (0.036)*** (0.032)*** Urban 0.029 0.054 0.021 0.028 0.035 (0.01I)** (0.022) ** (0.014) (0.012)** (0.0 12)*** Private -0.026 -0.097 -0.0 10 -0.033 -0.024 (0.01I)** (0.025)*** (0.014) (0.o12)* ** (0.012)* * Observations 8751 2020 5293 7313 8205 R-squared 0.34 0.35 0.34 0.33 0.34 Robuststandard errors in parentheses *significant at 10percent;** significantat 5 percent;*** significant at lpercent Other controls:occupation, economic sector, region. 199 Annex 7.3: FYR Macedonia's State of Implementation of the Bologna Reforms - by 2010. 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World Bank and EBRD, BusinessEnvironmentand EnterpriseSurvey (BEEPS), variousyears. Yemtsov, R., Cnobloch S.R., and Mete, C., 2006. Returns on Schooling in Transition Economies.World Bank, Washington, DC. 208 THE CITY OF SKOPJE Skopje serves as the 21°E To 22°E 23°E Municipality Capital Nis for each of these This map was produced by the Map Design Unit of The World Bank. SUTO Municipalities. To The boundaries, colors, denominations and any other information ORIZARI BUTEL Pristina shown on this map do not imply, on the part of The World Bank GJORCE GAZI S E R B I A Group, any judgment on the legal status of any territory, or any PETROV BABA endorsement or acceptance of such boundaries. FORMER YUGOSLAV REPUBLIC OF CHAIR MACEDONIA SARAJ KARPOSH SKOPJE Pelinci Pelinci AERODROM To Pernik KISELA Staro CENTAR Rankovce VODA Nagorichane Kriva Vratnica Chucher- Lipkovo Palanka B U L G A R I A Sandevo Kumanovo SELECTED CITIES AND TOWNS Tearce MtMakedonska s. Jegunovce Kratovo Osogovske MUNICIPALITY CAPITALS* SKOPJE Arachinovo Kamenica 42°N Tetovo Probistip NATIONAL CAPITAL 42°N Zheino Ilinden Delcevo To Bogovinje Blagoevgrad THE CITY OF SKOPJE Brvenica Sopiste Petrovec Kocani Bregainica Studenichani VVaar Sveti Obleshevo RIVERS Nikole (Cheshinovo) VinicaVinica Mt. Korab Vrapchishte Zelenikovo rddar Zrnovci MAIN ROADS Karbinci (2,753 m) Gostivar Lozovo Pehcevo RAILROADS VelesVeles Stip Malesevske Mts. Berovo MUNICIPAL BOUNDARIES INTERNATIONAL BOUNDARIES Chaska Rostusha Radovis (Mavrovo & Zajas Rostusha) Oslomej Gradsko *In most cases, the names of the municipalities Debar Makedonski Kicevo Brod Rosoman are identical to their capitals. Where they Konche differ, the municipality is shown in green italic. Centar Drugovo Negotino Vasilevo Zupa Vraneshtica Dolneni Kavadarci Bosilovo Demir Kapija Strumica Novo ALBANIA Crni Drim Plasnica Krusevo Selo To Prilep Petrich BelchishtaSopotnica Krivogashtani Valandovo (Debarca) Star Dojran Vevcani Demir Hisar (Dojran) Lake To Crna Bogdanci Elbasan Struga Dojran t n. Gevgelija Ohrid Mogila M Resen Lake FYR Ohrid Bitola Novaci 41°N i d z e G R E E C E MACEDONIA Lake N 41°N NOVEMBER Prespa IBRD Medzitlija 0 10 20 30 Kilometers 33438R1 0 5 10 15 20 Miles To 2006 To Thessaloniki Korçë To Kozáni 22°E 23°E