Report No. 44170-MK FYR Macedonia Moving to Faster and More Inclusive Growth A Country Economic Memorandum (In Two Volumes) Volume I: Overview June 9, 2009 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CONTENTS SYNOPSIS ...................................................................................................................................................... 3 OVERVIEW .................................................................................................................................................... A. 5 B. INTRODUCTION:GROWTHAND POVERTY REDUCTION................................................................ ............................................................................................ 5 B.l. Growth andInvestment Beganto Respondto EconomicReforms.......................................... ECONOMIC REFORMSANDGROWTH 8 8 B.2. ...but there are New ChallengesAhead.................................................................................... 9 C. B.3. Elements of a Virtuous Circleof FasterandInclusiveGrowthinFYR Macedonia...............11 RAISINGINVESTMENTFORSUSTAINED, GROWTH............................................................................................................................... AND ITS PRODUCTIVITY FASTERANDMORE INCLUSIVE C.1. Investmentand EconomicGrowth in FYR Macedonia.......................................................... 13 13 C.2. Encouragingmore PrivateInvestmentand FDI, by Improvingthe InvestmentClimate........14 C.3. Improving Government Investment in Infrastructure............................................................. 17 D.C.4.ENHANCINGPROSPECTSFOREXPORT-LEDGROWTHTo IMPROVE Finance: SupportingEmergingGrowthDrivers ..................................................................... 18 DEMAND 20 D.1. The RoleofTrade PolicyandLogisticsinExports................................................................ FORHIGHER PRODUCTION...................................................................................................... EFFICIENCY AND ENSURE 20 D.3. ImprovingLaborMarketOutcomes for ExportsandPovertyReduction............................... D.2. Improving InfrastructureServices for Exports........................................................................ 23 E. CONCLUSION................................................................................................................................... 27 30 Tables Comparators. 2006 ........................................................................................................................................ Table 1: Summary Labor Market Indicators. 15-64Year Olds. FYR Macedoniaand Regional Table 2: FYR Macedonia:SelectedIndicators............................................................................................. 6 9 Table 3: FDIInflowsto SouthEastern Europein millions ...................................................................... 14 Table 4: Indicatorsof Trade Performancein FYR Macedoniaand Selected Countries............................. 21 Table 5: Market Shares inEU27Apparel Imports(percent) ...................................................................... Table 6: Air Transport Costs (U.S.dollars) ................................................................................................ 21 25 FiPures ................................. Figure2: Gross FixedCapitalFormation(% of GDP, 2005) ..................................................................... Figure 1:Comparison of Growth in FYR Macedoniawith SEE and EUlO Countries 6 Figure 3: FYR Macedonia:InterestRates on CB Bills and Denar Loans and Deposits2002-2008 ...........13 Figure4: Mobile Phone and InternetDensity 1995-2006........................................................................... 24 18 Figure 5: Airfare Reductionfrom 2004 to 2007 ......................................................................................... 25 Figure 6: Electricity Intensityofthe Economy ........................................................................................... ....................................................................................................... 27 Figure 8: EmploymentRates by Age Group and EducationalAttainment, 2004-2006.............................. Figure 7: ResidentialElectricity Tariff 27 28 Boxes Box 1: European Integrationand SustainedGrowth................................................................................... 11 Box 3: A Typical Small Firm in FYR Macedonia...................................................................................... Box 2: The Growth CommissionReport: Habitsof Successful Economies............................................... 12 13 Note: for Bibliography.see Main Report ACKNOWLEDGEMENT This report was prepared by a core team ledby 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 investmentclimate (Sanjay Kathuria, with background papers from David Brown, consultant, Mens Legis Cakmakova Advocates, consultant, and Evgenij Najdov); 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 EvgenijNajdov). Inaddition, David Bernstein provided detailed guidance to the team on the legal issues in Chapters 4 and 5; and Victoria Stanley prepared a note on landmarkets for Chapter 4. Trade data was providedby FrancisNg, 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 (Michal Gorzynski). The report was prepared under the supervision of 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 Blazhevski (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. SYNOPSIS 1. While this report deals with medium and long-term growth issues rather than the challenges posed by the world financial crisis, the structural policy options presented in the report become even more important in that context, and can help to partially mitigate the impact of the crisis on FYR Macedonia. 2. Steady improvement across a range of structural policies is likely to ensure sustained growth payoffs for FYR Macedonia, which will help it to catch up with its neighbors and reduce poverty. FYR Macedonia is already on the right track, and no single policy is substantially out of line with comparators. However, improvements across a range of structural policies could lead to an increase in the annual growth rate by over 2 percentage points. This will require a long-termplanninghorizonand stayingthe course on reforms, where the policy anchor providedby the EUacquis communautaire can be very useful. While persistent poverty presents a challenge, the possibility of faster, sustained growth provides a real opportunityfor FYR Macedonia to bring about a serious reduction inpoverty. 3. FYR Macedonianeeds to build on its recent success and grow even faster to raise incomes and provide more jobs, which together with more human capital will reduce poverty. Growth has increased recently, but not enoughto reduce poverty-the povertyrate stayed at about 19 percentbetween 2002 and 2006. While the reported unemployment rate has declined since 2005, at about 34 percent in 2008, it is the highest in Eastern Europe, excluding Kosovo. Thus, while faster growth is neededto create more jobs and reduce poverty, the share of higher-skilled jobs in overall job creation also needs to increase, which in turn means improvementin worker skills and education to enable higher productivity. 4. At the same time, the economic climate facing FYR Macedonia is becoming riskier for exports, the current account and external financing. Exports face problems because of the impact of ongoingre-pricingof energy, especiallyon metals; the ongoingfall in metals prices that account for about 40 percent of FYR Macedonia's exports; andthe low skill content of the export basket, renderingexports such as garments vulnerable to low-wage competition. In addition, the current account deficit has deteriorated sharply; moreover, it has been kept manageable in the past by private transfers, which can vary sharply, and FDI inflows, which though financing the deficit recently, can also be erratic. Finally, the financial sector, while supervised prudently and less exposed to the ongoing international financial crisis, is not immune to these developments. All this implies a challenging agenda for the imperative of faster, export-ledgrowth inthe midst of a difficult world environment. 5. Sustainable, faster growth will depend on higher and more productive investment, including both physical investment and human capital, and increases in export growth. FYR Macedonia's fixed investment rate has been very low compared to other countries in and outside the South East Europe (SEE) region, and this has been an important factor in its low growth. Faster growth will depend on an increase in the quality and quantity of fixed investment, encouraged by further improvements in the climate for private investment and finance, and by more efficient, higher public infrastructureinvestment. Also, to ensure demand for what is produced, more of the investment and the economic framework will need to be directed towards exports (with higher skill content) and efficient import-substitution. As mentioned above, FYR Macedonia will also need improved human capital, to improve export competitiveness, labor productivity and to make growth more inclusive. To keep higher investment and external accounts sustainable, much of the incremental investment will need to be financed by higher domestic savings which could be encouraged by further deepening of the financial sector as well as improvements inthe investmentclimate(to boost corporate savings). 3 4 OVERVIEW^ The ongoing financial crisis and the preceding food and fuel price crisis have buffeted the world economy, and FYR Macedonia, like most other economies, has also been affected. While the impact of the price shocks on FYR Macedonia's inflation is now receding, prices, especially of food, are likely to settle at levels much higher than those that prevailedbefore the shocks. The ongoingworld 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, among other things. FYR Macedonia needs to minimize the disruptions of these possible events. These should be tackled, above all, by acceleration of the structural reform agenda outlined in this report, which will improvethe economy's competitiveness. With internationalinvestmentand capital flows likely to be at a premium, countries that offer enhanced competitiveness may be relatively less affected. In addition, while the financial sector has been well managed in FYR Macedonia, enhanced transparency, information sharing and reporting from both lending and borrowing institutions could help credit flow to the private sector. With the largecurrent account deficit and uncertainprospects in the near term, and the ongoing decline in FDI and other financing, continuedvigilance will also be neededwith respect to monetarymanagementand stresses on banks. A. INTRODUCTION:REDUCTION GROWTHANDPOVERTY 1. FYR Macedonia has enjoyed many successes since independence. Life expectancy is high compared to other countries in Europe and Central Asia at similar income levels, and health and educationindicatorshave shown significantimprovement. FYR Macedonia's urban and rural populations enjoy good (though not universal) access to services such as water supply and electricity, compared to other lower middle incomecountries. The country has been largelypeacefulsince the civil strife of 2001, and has taken advantage of this window of opportunity to catch up with structuralreforms. These efforts have been recognized in many ways. FYR Macedoniawas ranked among the top five reformers in the world in Doing Business 2008, climbed a further nine positions in Doing Business 2009, and saw solid improvement in Transparency International rankings over 2006-08. The economy has gradually responded to these new circumstances, with GDP growth averaging4.7 percent over 2005-08 (5.9 and 5.3 percent in 2007 and 2008, respectively), versus 2.2 percent for the period 1998-2004. It became an EU candidate country in late 2005. These are significant achievements for a countrythat was once considered one of the poorest republicsin the former SFR Yugoslavia. 2. But regional comparators show that growth could have been faster. Despite the recent increase, GDP has grown more slowly than in the new member states or in the countries of the Western Balkans (Figure 1). Between 2003 and 2007, real GDP rose by a cumulative 18 percent in FYR Macedonia, versus 24 percent in the Western Balkans (population-weightedGDP). While it is true that FYR Macedonia suffered from the 2001 civil strife, most countries in the Central and East European region also suffered from various post-transitionproblems, but have been able to recover more quickly. For example, Bulgaria, Croatia and Slovakia had bigger dips in real GDP during transition. And, until recently, Bulgaria(until 2002) and Romania(until 2001) had lower or similar per capita incomes as FYR Macedonia. IWhile this i s intended to be a self-standing Overview of the CEM, it focuses on the policy aspects of the report. For the detailed diagnostics, readers are referredto the accompanyingMainReport. 5 Figure 1: Comparisonof Growth in FYRMacedoniawith SEE and EUlOCountries I 7.5 7.5 5 5.0 2.5 2.5 0 0.0 -2.5 -2.5 - -5 -5.0 Bulgarla 8 Czech Republic -+- BiH .-.*...Albania 6 Hungary - +.-bland - * Croatla x Romania Slovenia 1 Slovaka N 1 0 median -Macedonia -Macedonia -Median -.e-. excluding Macedonia Serbia 3. Despite solid gains in some key human developmentareas over the last fifteen years, FYR Macedonia has enjoyed less success in reducing poverty and unemployment. The most recent household survey data available to the team shows that poverty affected 19 percent of the population in 2006, the same as in 2002.2 Similarly, although reported unemployment has declined in recent years, it remains very high. The State Statistical Office (SSO) estimates unemployment at around 34 percent for 2008, down from 37.3 percent in 2005. Table 1: Summary Labor Market Indicators, 15-64 Year Olds, FYRMacedoniaand Sources: ILOKILM 2007; Eurostat; IMF; World Bank staff estimates. 4. Low growth and low productivity are critical in explaining this lack of inclusion. Slow growth has created too few new jobs to offset jobs lost in the post-transition process of restructuring. Over 1999-2004, employment (Labor Force Survey data) declined by 2.6 percent. Despite the rapid growth in employment thereafter, in 2006, just under 40 percent of the working-age population was employed, the lowest rate in the ECA region barring Kosovo (see Table 1 for this and other regional comparisons of labor market outcomes). The jobs that have been created have mostly been poorly paid * Thisabsolutepoverty ratio is as computedby World Bank staff. In2006, the poverty line on which this was based was 102 denars (current prices) per day per capita. 6 (largely in agriculture or textiles), leadingto an increase in the share of the `working poor.' While 28.2 percent of the poor were working in 2002, this rose to 37.6 percent in 2006 (Household Budget Survey data).3 Unequal education and job outcomes mean that some groups participate even less in economic activity. Women, youth and the non-Macedonian ethnic groups have not participated fully in economic growth-female employment and participation rates are among the lowest in the ECA region, for example (33 percent employment rate in the first two quarters of 2008, versus 49.5 percent for males). Lack of sufficient education is a major factor in unemployment-the LFS data shows that the employment rate (35-64 year olds) was only 31 percent for those with primary or lower education in 2006, comparedwith 77 percentfor those with post secondary education. The outcomes on educationand the labor market also differ by ethnicity and geography: about 70 percent of the ethnic Macedonian population had completed secondary education, but only 40 and 60 percent of other ethnic groups had done so (2004 HBS). This disparity is reflectedinemployment rates-while ethnic Macedonian poor had an employment rate of about 30 percent, those of other poor ethnic groups varied from 15 to 22 percent. Even after controlling for education, other ethnic groups had inferior labor market outcomes. Similarly, across regions within FYR Macedonia, employment rates varied from 28 percent in Kumanovo to 64 percent in Strumica in 2006 (a traditionally agricultural region). Tetovo has the lowest level of female participation in the country. Finally, in 2006, 90 percent of ethnic Macedonian wage-earners enjoyed permanentjobs, versus 69-77 percent for other ethnic groups. 5. FYR Macedonia needs to grow faster to raise incomes and provide more jobs, which, accompanied by more human capital, will reduce poverty. Faster growth is needed, first and foremost, for reducing poverty, since it will create more jobs. But the pattern of growth also needs to change, and createjobs that will pay higher wages and allow workers to improve their standard of living. In turn, this means improvementin worker skills and education (across all segments of the population) to enable higher productivity. Faster growth will of course mean more rapid convergence: in 2007, FYR Macedonia's per capita GDP, at purchasing power standards, was 29 percent of the EU27 average, compared with 42 percent for Turkey, and 55 percentfor Croatia, the other candidate countries (Eurostat). Finally, while the persistent poverty presents a challenge, the possibility of faster, sustained growth provides a real opportunity to make a serious dent in thepoverty numbers. 6. Sustainable, faster growth will depend on higher and more productive investment, including both physical investment and human capital, and increases in export growth. FYR Macedonia's fixed investmentrate has beenvery low compared to other countries in and outside the ECA region, and this has been an importantfactor in its low growth. Faster growth will depend on an increase in the quality and quantity of fixed investment, encouraged by further improvements in the climate for private investment and finance, and by more efficient, higher public infrastructureinvestment. Also, to ensure demandfor what is produced, more of the investmentand the economic framework will needto be directed towards exports (with higher skill content) and efficient import-substitution. As mentioned above, FYR Macedoniawill also need improved human capital across the population, to improve export competitiveness, labor productivity and to make growth more inclusive. To keep higher investment and external accounts sustainable, much of the incremental investment will need to be financed by higher domestic savings which could be encouraged by further deepening of the financial sector as well as improvements in the investment climate (to boost corporate savings). All this will translate into more specific policy recommendations,as will be seen later inthis Overview andthe mainreport. Note that HouseholdBudget Survey data on the labor market data is not fully consistent with Labor Force Survey data, which is the accepted source for labor market data. The HBS is better used to understand the link between poverty andthe labormarket. 7 7. Other measures will also be needed to promote more inclusion, ultimately making growth more sustainable and meaningful for all. Educationoutcomes need to improve across the board, but even more so among non-Macedonian ethnic groups. Both the current average outcomes as well as distribution of outcomes in education represent a significant untapped source of GDP growth. (On the other hand, if skills do not improve across the population, workers with low skills will be forced to work in low-wagejobs, which may not be enough for climbing out of poverty. Also, faster growth can be constrainedunless the supply of skills improves across the populationand keeps pace with the projected rise in investment). All such measures are important not only for equity and growth, but ultimately to help ensure the sustainability of growth, since inequity can lead to social and political instability, which can hurt investment and growth (see below). As pointed out in the European Commission's 2008 progress reporton FYR Macedonia, muchmoreprogressis neededon socialinclusionissues. B. ECONOMICREFORMS GROWTH AND B.l. Growth and InvestmentBegan to Respond to Economic Reforms... 8. To induce faster growth and poverty reduction, the government began a process of economic reforms around 2002, to which the economy began responding. With political stability concerns out of the way, the government embarked on a major reform program including fiscal consolidation, public sector reform, and labor market reforms, followed later by reforms in other areas of the economy. As the reforms picked up momentum, economic growth began to rebound in 2004, rising to 5.9 percent in 2007 and 5.3 percent in 2008. Employment also started rising in 2005. Exports have also accelerated since 2004 (see Table 2). Fixed investment increased, rising from 16.6 percent to 18.2 percent of GDP between 2002 and 2006 (and further to an estimated 19.8 percent in 2007); government investment also rose in 2007 (see Table 2). Some high profile foreign investorswere also encouraged to invest, in steel in 2004, and, more recently, in automotive components and food processing. 9. The faster real growth in GDP and exports reflects improvements in the overall business environment. Significantimprovementswere recordedin some key areas, includingthe following: 0 Political and economic stability. This is a critical factor in providing confidence to investors. Factors that encouraged such stability included the quick recovery from the 2001 instability, implementationof the Ohrid Framework agreement, as well as FYR Macedonia achievingEUcandidate status in 2005. 0 Finance. Since 2005, lendingrates and spreads have declined (althoughby not as much as in some other countries in the Central and East European region). Access to finance has also improved, thanks partly to an increase in competitionfrom foreign-ownedbanks. However, the global financial turmoil and the recent tightening of monetary policy are likely to make obtainingcreditmoredifficult. 0 Telecommunications. Competitionbegan in 2003 inmobile phones and accelerated in 2007 with the entry of a third competitor in the market; and stronger direct competition in fixed lines began in May 2008. Mobile telephony rates have declined significantly, especially since 2006, and fixed line costs have not increasedsince 2005, 0 Air transport. There is growing competition in air transport, reflected in a decline of 30 percent in travel costs over 2004-07, and further competitionin the offing with the signingof the European Common Aviation Agreement in 2007. But much remains to be done in this sector. 8 Overall businessclimate. There has been a steady improvement in the business climate in many dimensions, particularly as seen in recent reforms in customs, taxation, business licensing, and contract enforcement, etc. A particular subset of reforms are reflected in DoingBusiness, where FYR Macedonia's world rankingimprovedfrom 96 in 2006 to 71 in 2008; the Corruption Perceptions Index (Transparency International), where the rank improved from 105 in 2006 to 72 in 2008; and the Index of Economic Freedom (Heritage Foundation), where FYRMacedonia's rank improvedfrom 91 in 2005 to 71 in2008. Table 2: FYRMacedonia: Selected Indicators 2000 2001 2002 2003 2004 2005 2006 2007 2008 (proj.) General economic indicators GDP Growth, real, inYO 4.5 -4.5 0.9 2.8 4.1 4.1 4.0 5.9 5.3 CPI Inflation, period average, in % 5.8 5.5 1.8 1.2 -0.4 0.5 3.2 2.3 8.3 Gross domestic fixed investments, in % 16.2 14.8 16.6 16.7 17.8 17.0 18.2 19.8 of GDP Social indicators Poverty rate, Cost of basic needs method. 21.4 21.7 20.5 Unemployment rate, 15-64, in % 32.5 31.1 32.4 37.1 37.4 37.3 36.3 34.9 34.0 Financial sector indicators Short-term lendingrate, in % p.a. 19.0 19.2 17.7 14.5 11.8 10.8 9.5 8.6 .... Credit to private sector, in % of GDP 18.1 18.6 18.1 20.0 23.5 25.1 30.2 36.8 42.6 Central Government finances Overall balance, in YOof GDP 2.5 -6.0 -5.3 -0.1 0.4 0.2 -0.5 0.6 -0.9 Capital expenditures, in % of GDP 2.7 3.5 3.6 4.1 3.1 3.6 3.0 3.9 4.9 Public debt, in % of GDP 48.0 48.8 43.0 39.0 36.7 39.5 32.9 24.8 20.8 External sector Exports, G&S, nominal growth rate, in YO 30.4 -13.2 -7.1 2.7 14.5 19.5 14.8 25.9 Exports, G&S, real growth rate, in % 18.6 -15.7 -5.1 -5.7 12.9 11.2 8.4 16.6 Imports, G&S, nominal growth rate, in % 37.8 -1 1.8 7.2 -2.8 19.0 9.7 15.3 23.3 Imports, G&S, real growth rate, in YO 28.6 -15.2 9.8 -15.2 16.7 6.2 11.0 17.8 Current account balance, as YOof GDP -2.7 -6.9 -10.0 -4.0 -8.4 -2.7 -0.9 -3.3 -12.5 External debt, as % of GDP 43.2 43.5 43.3 39.8 38.7 39.1 37.8 35.3 Investmentclimate and competitiveness Doing Businessranking 94 92 96 79 71 Transparency International CPI ranking ... ... .,. 106 97 103 105 84 72 Index of Economic Freedom ... ... 88 71 96 91 78 71 71 Country Credit Rating 85 84 82 Real effective exchange rate, CPI based, 100.0 92.5 90.2 89.4 87.8 85.2 84.2 82.8 2000=100 Source: WB WDI Databaseand IMF; some of the 2008 numbers (in italics) are estimates B.2. ...but there are New ChallengesAhead 10. The next set of structural challenges is likely to be posed by infrastructureand skills. It is to be expected that as an economy grows, there will be increasing demand for complementary factors of production.In FYRMacedonia, the percentageof firms (on average) citing infrastructureconstraints rose from 13 to 22 percent over 2002-05, even though GDP and, correspondingly, demand for infrastructure, grew slowly during this period. For export-intensive firms, the problem was more acute in 2005: 57 percent hada problem with electricity, and 52 percent with telecommunications. It is quite likely that as exports pick up, a necessity for higher growth, the problems of infrastructure could loom larger. 9 Moreover, there are indications that skill availability could impede faster, sustained growth (see section D3). Thus, firm surveys done for this reportindicatedskillshortages insome areas includingInformation Technology and apparel; faster growing and more profitable firms had greater problems in finding the right skills (BEEPS 2005); and experience of EUlO countries show that wages can increase very rapidly with rising integration with the EU. Moreover, sustainability of export growth would itself demand an increase in the skill content of exports. 11. I n addition, macroeconomic risks have recently emerged. Rising prices of food and energy represent imported threats to low inflation; these, however, are now receding in the wake of the internationaldownturn in commodity prices that began around the start of the second half of 2008. Thus, CPI inflation (year-on-year) rose to slightly over 10 percent in March-April 2008, but started declining more recently, reaching4.1 in December. On the externalfront, the already high trade deficit (goods and services) widened since 2006. And exports face problems because of the impact of re-pricingof energy, especially on the competitiveness of metals exports; the ongoing fall in metals prices internationally; and the low skill content of the export basket, rendering exports such as garments vulnerable to low-wage competition.The current account deficit deteriorated in 2007 to 3.3 percent of GDP and much further to around 12.5 percent of GDP in 2008 (Table 2).4 Moreover, the growing private transfers that have financedthe gap between exports and imports can vary sharply in the short run and dropped substantially in 2008. Statistical analysis suggests that imports and private transfers are positively related, but the relationship is much less than one-to-one, meaning a decline in private transfers will result in a deterioration in the current account. An increase in FDI in 2008 financed the higher current account deficit, but reserves declined over the year despite rising over the first three quarters of 2008, owing to very low FDI inflows in the last quarter. FDI can be quite variable, particularly for a small economy in the current world environment-the challenge for FYR Macedoniawill be to sustain the increase of the last few years. 12. Mitigation of these risks will require acceleration of structural reforms along with continued vigil on monetary management and stresses on banks. To mitigate the above risks, and to enable faster growth, exports will need to grow faster. More FDI also will be needed; it will improve export performance (net of imports), encourage import substitution, and help finance the current account on a more sustainable basis. Given that the government has opted to maintain the exchange rate, the structural policy agenda, the core subject of this report, becomes more critical, even for short run adjustment. Structural reforms are equally urgent to tackle the immediate challenges posed by the ongoing international financial crisis-with FDI and capital flows likely to be at a premium, countries that offer enhancedcompetitiveness are likely to be relatively less affected.This should be complemented by continued vigil in monetary management and monitoring of possible stresses on banks. In a difficult financial environment, implementingmeasures to further improve the framework for credit provision in FYR Macedonia (as part ofthe structuralreformagenda) will also be very useful. 13. Sustained, faster growth will therefore require continued and in many cases acceleration in key reforms to enable export-led growth. Key issues include selected elements of the investment climate, finance, infrastructureservices, skills and the labor market, trade policy and logistics, and are discussed below. The EUaccessionprocess will providea policy anchor for this growth-indeed, there is a large overlap between the requirements of accession and the policies needed for sustained, inclusive growth (see Box 1). The IMF (2009) has also recently cautioned against the risks to continued stronggrowth arising from the growing current account imbalance. See http://~~~.imf.org/externa~uubs/ft/scr/2009/cr0960.udf. 10 Box 1: EuropeanIntegrationand Sustained Growth There is a large overlap in the agenda for meetingthe goals of faster and inclusive growth and becomingpart of the EU. Membership ofthe EuropeanUnionrequiresthe existence ofa functioningmarket economy, and the capacity to cope with competitive pressure and market forces within the Union. It also requires alignment with the comprehensive acquis communautaire, which now covers 35 areas (chapters). The CEM recommends the adoption and implementationof various policies and institutions embodied in the EU acquis (and in the various steps-ofthe accessionprocess). The report also presentspolicy options for improving the investment climate andboostingproductivity to enable Macedoniancompaniesto survive in and reapthe benefits of the highly competitiveEuropeanenvironment. At the same time, the accession process provides a policy anchor and helps to keep up the momentum o f reforms, which would have a positive impact on prospects for sustained growth. Much of the growth impact is felt not so much through the country's access to EU Single Market (this predates candidate status), but from the improved investment climate that would result from aligning Macedonian policies and institutions with those of the EU. FYR Macedonia's deeper integration into the EU prior to accession should also help foster improvements in FDI flows, competitionandknowledge/technology transfer. B.3. Elements of a Virtuous Circle of Fasterand InclusiveGrowthinFYR Macedonia 14. This reportsuggests that a virtuouscircle of faster, self-sustaining and inclusive growthwill contain several, inter-relatedelements. The analysis presentedin the report suggests that in the future, the current weaknesses in growth will need to be addressed, especially on inclusion issues. And for faster growth, more investment will be needed, directed more towards exports and efficient import-substitution than is currently the case. More exports (and efficient import substitution) are needed because efficiency considerations mean production increases will need to be concentrated along FYR Macedonia's lines of comparative advantage. Exports. In a small country, growth has to be export-led. FYR Macedonia's investment and the economic framework will need to be directed towards exports (and efficient import- substitution). This will ensure that growth will be achieved with the lowest rate o f investment and demand will exist for the increased output that will result from higher investment. Thus, exports need to outpace GDP growth significantly, with greater reliance on exports of products other than metals. Inclusion. A more inclusive growth process is an end in itself. It is also an instrument that makes sustained growth more likely, especially in a small country like FYR Macedonia. A few years of sustained growth could easily result in labor constraints. To address this, boosting education outcomes across all segments o f the population would be needed to improve the quality and employability o f the labor force and hence increase its effective size. This also translates into a need for an increase in labor force participation and employment among women and youth, and for a similar increase in some regions within FYR Macedonia; it also means an improvement in productivity. Inclusion will also be improved if a larger share of remittances were spent on education and investment, although this has to be done indirectly through improvements in the financial sector and increases in the return to education. Finally, faster growth also creates the resources to support health care, education and other social goals (see Growth Commission 2008: a summary is provided in Box 2). Investment. Faster growth will be driven by investment to a much greater extent than is currently the case. Overall investment rates need to increase by 4-6 percentage points of 11 GDP; infrastructure services and the efficiency of public investment need to improve; private and public infrastructure investments need to increase (the latter occurring through reallocation o f expenditures). Savings. Much ofthe increase in investment will needto be financed by domestic savings, in order to not increase external risks. Corporate savings can be boosted with improvements in the investment climate. Financial sector deepening based on growing confidence of the public in the financial system and increases in access to financial services, could encourage household savings, including from recipients of remittances. Box 2: The Growth Commission Report: Habits of SuccessfulEconomies The Growth Commission's report (httu://www.Prowthcommission.orq) 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 countriesthat have been less successful: e 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 improve their productivity in manifold ways. It also providesopportunitiesfor inwardtechnology transfer and foreign direct investment. e High rates of investment, perhaps 25 percent of GDP or more, predominately financed domestically and including infrastructureinvestment ofperhaps5 percent of GDP or higher. e Investment ineducation, training, and health, with private and public spending in these areas as high as 7-8 percent of GDP. e Increasinglycapable, credible, and committedgovernments 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 reasonablesocialsafety nets. e A policy environment favoring high levels of investment, job creation, competition, mobility of resources, and efficient urbanization. This environment should include a reasonable degree of macroeconomic stability. Equality of opportunity and reasonable amounts of equity and social protection, particularly in economic transitions, interms of income and access to basic services and training. 15. A policy package to encourage such a virtuous circle should focus on small firms as well as FDI. Sustainedgrowth in FYR Macedonia has to be export-led. FDIis critical for export growth, since it brings in new technology and can enable FYR Macedonia to reduce dependence on metals-based exports. FDIcan also enable efficient import-substitution. However, the benefits of FDIcannot be realized unless there are spillovers to domestic firms, which can only happen if the latter have skills and motivation to attract purchases from the foreign direct investors, and the institutional framework makes such contracts attractive and credit available to the domestic firms. 16. Small firms dominate the economy but are faced with major constraints to growth and exports. In FYR Macedonia, small firms account for 99 percent of all firms, 48 percent of value-added, 12 and 64 percent of employment. These shares of employment and value-added are much higher than neighboring EU countries, or, indeed, any EU27 country. For FYR Macedonia, this implies that while firm entry is not a concern, there are major constraints, post-entry,which keep firms small and constrain their growth (see Box 3). Also, not enough small firms are involvedin exports, which reducesthe overall dynamism of exports-research on European, Chilean and Colombian firms suggests that what matters for export growth is how many firms engage in exports; some of them grow and becomethe future stars. Thus, over half of the growth in Colombian exports over 1996-2005 came from firms that were not initially exporters. Addressing constraints faced by small firms in FYR Macedonia will therefore be critical for addressing the need for an increase in export and GDP growth, and increasingemployment and inclusion. Such measureswill also be necessary to improvethe spilloversfrom FDI. Box3: A Typical Small Firm in FYRMacedonia The environment for a typical small firm in FYR Macedoniacan include the followingnegativefactors. First, its effective labor tax is higher than that faced by large firms; second, the skills it seeks are often not readily available (also appliesto largerfirms); third, it faces problemswith landtitles andcontractenforcement(bothon its side as well as potential large firms to whom it can sell, who generally do not extend credit to it as they do elsewhere for the same reasons); fourth, it faces finance costs that are still higher than in the SEE region, even though reduced in recentyears; fifth, issues of information, contacts and transport raise costs of exporting.As a result, it is likely to stay small, even micro, and perhaps informal, facing too many hurdles in growth and it is probablethat manyworkers inthe firm couldbe classifiedas workingpoor Muchofthis hasto changeto improveoveralleconomic performanceinthe country andmakeit more inclusive. C. RAISINGINVESTMENT FORSUSTAINED, FASTER MORE ANDITS PRODUCTIVITY AND INCLUSIVE GROWTH C.l. Investmentand EconomicGrowth in FYRMacedonia 17. FYR Macedonia's overallinvestmentneedsto be higher in order to generate higher growth. FYR Macedoniagrew at an average of 2.3 percent over 1996-2005, while 7 comparator SEE economies grew at 4.2 percent over 1997- 2005. Disaggregation of the Figure2: Gross Fixed CapitalFormation(YOof GDP, 2005) growth suggests that FYR Macedonia's investment rate generated only about 0.4 percent growth per year, while in the other SEE economies it generated about 1.8 percent per year. Over 1996- 2006, FYR Macedonia invested an average of 17 percent of GDP in fixed capital (with some increase in 2006 and 2007), versus 23-24 percent of GDP by EUlO countries over the period. Figure 2 illustrates this situation more generally, with FYR Macedonia's fixed investment to GDP ratio in 2005 being in the bottom quartile of developingcountries for which such data was available. The Growth Commission (2008) points out that sustained, high growth is associated with overall investment rates of at least 25 percent of GDP, at least 20 percent higherthan Macedonian investment rates. 13 18, Private investment including FDI will need to increase significantly to achieve a higher investment rate, which can be catalyzed by improvements in the investment climate, finance and infrastructure services. A significant part of the increase in FDI and domestic private investment will depend on improvements in the investment climate (section C2). It will also depend on more efficient and eventually higher government expenditure in infrastructure (section C3), and more efficient infrastructureservices, which will in most cases need a partnership with the private sector (section D2). Also important is a second generation of financial sector reforms (sectionC4). More private investment will also depend on ensuring that the other key factor of production, labor, is available inadequate quality and quantity so that it does not constrainthe increase in investment (section D3). Note that investment and the economic framework will needto be focused more towards exports than is currently the case (for example, taking measures to reduce costs of exporting such as time taken for physical inspection, or lowering the costs of entry into exports, especially for small firms), to ensure demand for higher production. C.2. EncouragingmorePrivate Investmentand FDI,by Improving the InvestmentClimate 19. An overall investment climate approach is required when analyzing the investment decisions of firms. Attracting investment requires an overall approach that considers issues relatingto macroeconomic stability, human capital, finance, infrastructure, and so on. Bringing in these dimensions requires analysis andjudgment based on multiple sources of information.This report relies on a mix of industry/firm studies and interviewswith existing foreign investors and lost investors, both prepared for this report; as well as FIAS foreign investor surveys, the BEEPS surveys, Doing Business and analysis of relevantexperience of other countries. Table 3: FDIInflowsto 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 I26 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 5,2 13 9,082 7,000 1,432 Slovakia 2,089 1,768 4,397 1,914 2,441 1,694 3,324 *.. 3,339 SouthEast 3,946 4,746 4,477 7,409 10,678 12,124 21,048 18,500 1,636 Europe * Actual figuresbasedonNBRMdata, March2008. Source: Vienna Instituteof InternationalEconomic Studies 20. FYR Macedonia's investmentclimate has improved in many ways. The overall framework has steadily improved. For example, the government has recently reduced the time for starting a business and reduced corporate tax rates and simplified tax procedures (which have made FYR Macedoniaone of the top five reformers in the world in Doing Business 2008 (World Bank, 2007e). Also, a new law for contract enforcement was introduced in 2006, a regulatory guillotine is being applied to licensing procedures, and customs reforms are ongoing. In addition, many investors see the government as committed to economic reforms, and the EU candidacy in 2005 has helped make the future policy path more predictable. Doing Business 2009 records further progress, with FYR Macedonia's overall rank improving further, from 79 in 2008 to 71 in 2009. (Note that Doing Business focuses on one part of the business environment--that dealing with doing business on the ground.) However, much more 14 improvementsare neededoverallto improvethe flows of FDI and domestic private investment-Table 3 shows the low stock of per capita FDI in FYR Macedonia vis-h-vis the average of SEE, especially Bulgariaand Croatia. 21. Even modest improvements in growth in the past have increased some problems faced by firms, and future, sustained growth is likely to bring additional challenges. Increases in growth can exacerbate some problems and bring forth new ones, as even the moderate increase in growth between 2002 and 2005 showed. Top concerns of business changed from macro instability, regulatoryuncertainty and the functioning of thejudiciary (BEEPS 2002), to the cost of finance, anti-competitivepractices, and contract violations (BEEPS 2005). The changes in business concerns mirrored the shift in the country's overall climate, from survival in 2001/02 to more normal, growth-related concerns by 2005. This report suggests that to support faster and more sustained growth in the future, continued improvements will be needed in some areas that were important in the past (many of the problems identified, such as contract violations or anti-competitive practices, are not subject to quick fixes); and new areas, such as infrastructureand human capital, will need more attentionto prevent growth and export bottlenecks from emerging. The following paragraphs provide some policy options to address concerns of foreign and domestic firms. 22. The analysis of this report suggests that concerns relating to anti-competitive practices, contract violations, land titles and permits, and work visas continue to require attention from government; other relevant areas, such as finance, skills and infrastructure are dealt with in separate sections. Actions in the following areas could help to mitigate some of the concerns of foreign firms as well as domestic firms (who are largely small), and will also help towards the goal of meeting the "Copenhagen" criterion for EU accession (which requires a functioning market economy able to cope with competitivepressure and market forces within the Union): Reduce investor uncertainty by increasing predictability of economic policies. Policy predictability improves investor confidence significantly, and any reinforcement of such predictabilitycan be useful.Reinforcingindependenceand capacity ofjudicial and regulatory institutionscan help in this process. In addition, the data indicates that a reductionin political uncertaintywill help improve the prospects for foreign investment in particular. Improve contract enforcement. Contract violations are a major problem because they affect business expansion, trust between suppliers and buyers, and lending by banks. In FYR Macedonia, outstandingdebts and court disputes between legal entities are widespread. The government's new law on enforcement of court decision in May 2006 has shortened enforcement procedures, and ledto increasingrealizationsand value of claims enforced. This has also led to an improvement in FYR Macedonia's Doing Business ranking in this area. However, much remains to be done to improve actual results on the ground, as suggestedby case studies of firms and contractviolations-especially since the increasingsimplificationof registeringnew firms is making it easier for entities to strip assets and transfer these to new entities. Suggestionsto improveenforcement include: 9 Shortening court procedures (such as by allowing private delivery of court summons; fully implementing new procedures added to the Litigation Law in September 2008); > Introducing comprehensivecase managementsystems in the courts; 9 Empoweringjudges (through trainingl to use the tools and authority they have to better control the courtprocedures. 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-mostimportantconcern for small firms in 2005-and the issuesraisedby this concern 15 require patient, institutional solutions that take time to have an impact. 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 to be provided in FYR Macedonia; strengthening of regulatory capacity and the competition authority can help reduce perceptionof unfair regulatory forbearance. Giventhat foreign firms and small firms find it more difficult to `work the system', strengthening the institutions and competition will 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, implementationof strict product quality standards (following EUnorms) would reduce upholding firms' perceptions of unfair competition from firms that do not conform to such standards. Improve land titling and land use policies. Property records in FYR Macedonia are incomplete, especially in the larger cities, despite recent progress-many land transactions are not registered, many others are disputed (between people, or between peopleandthe state, for exampleband 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 affectedby the inability of investorsto find land with clear titles. Speeding up the government's reform program in three areas will promote FDI and credit flow: 9 Accelerating thecompletionof the landcadastre,especiallyin large cities: 9 Improving land administration services: > Developing a modern land usepolicy so that land rights are secure and land can be used for investment in the context of a transparentpolicypamework. 23. Future FDI incentives and promotion should be targeted, with explicit consideration of costs and benefits, and only as secondary to overall structural reform and provision of human and physicalinfrastructure. The potentialtechnologyspilloversfrom FDIto local firms (the greatest benefit of FDI) can only be realized if domestic firms have sufficient skills and motivation to absorb foreign technology. This means that overall structural reforms, infrastructureand 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 potentialforeign investment should be evaluated for its interactionwith the local economy, including local purchases, demand for high-skilled workers, and plans to get involved with local developments (such as interaction with universities). Also, with more general awareness of FYR Macedonia havingbeen built up recently, future FDI promotion would benefit from beingmore targeted, such as by working with emerging and existing industry clusters and showcasing their progress. Authorities could pay close attention to these issues in evaluating FDI, 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 improvementj 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); 16 9 Reducingthetimelag in awarding landandbuildingpermits; 9 Shorteningtheprocess andtimelagfor awardingforeigners aworkvisa; 9 Streamlining the internal organization of investmentpromotion within FYR Macedonia and clearly delineating responsibilities would help reduce costs and improve investor confidence. C.3. Improving Government Investmentin Infrastructure 24. The infrastructure situation may look adequateon the surface, but capacity issues began to develop even with the moderate growth between 2002 and 2005, according to business surveys. Good infrastructurereduces costs of productionand transport, increasereturns to private investment, and enhances competitiveness and growth. Although some dimensions of infrastructuredevelopment in FYR Macedonia look adequate, there are indicationsthat infrastructurehas held back exports (section D2), and the recent pick-up in growth has exposed emerging infrastructure issues-the share of firms citing infrastructureconstraints (BEEPS) roseby 70 percent between 2002 and 2005. Although only 22 percent o f firms complained, the rise in complaints suggests that FYR Macedonia was already beginning to overuse its existing stock of infrastructureeven with moderate growth. Faster growth since then, and in the future is likely to mean that infrastructurecould become a bottleneck, unless public investments in infrastructureand reforms inthe incentiveframework occur. 25. Higher governmentinfrastructure investmentwould help promote the needed faster export and overall growth and crowd in private investment. Public spending on infrastructure crowds in private investment by raising its rate of return. In fast-growingAsia, for example, public investment in infrastructure accounts for at least 5-7 percent of GDP, and has accompanied very high rates of private investment. In FYR Macedonia, on the other hand, general government capital expenditure in fixed assets averaged only 2.3 percent of GDP over 2003-08, with total investment includingcapital transfers being 3.8 percent of GDP (this figure may overstate investment). Average government investment for other CEE transitioneconomieswas 4.5 percentofGDP. 26. Inefficiency in government expenditure implies significant room for increasing impact of even the current levels of investment and creating space for additional capital spending. Public investment management suffers from inadequacies in project selection, budget execution, procurement and monitoring, leavingsignificant scope for improvingits impact. There is also under-execution of the capital budget (the execution rate has rarely exceeded 80 percent of the budget amount in recent years). Improvingthe efficiency and impact of government investment is therefore a matter of priority, since it is essential for rampingup infrastructureservices that are requiredfor faster growthto occur. Improvement in efficiency of execution will allow the budgeted expenditure to be executed. Better investment management also creates more confidence that additional resources devoted to public investment, as needed, will have the desired impact. In this context, the government can create fiscal space by reallocation from non-priority expenditures (a 2008 World Bank Public ExpenditureReview discusses how), improvedtax administrationand collections of user fees. As will be seen later, government needs to secure the additional resources committedto road maintenance and rehabilitationin its new regional and localroads initiative. 27. The required increase in infrastructure investment can be met through a combination of greater efficiency in governmentspending, reallocationfrom non-priority governmentexpenditures into investmentto accompany greater efficiency, reforms in the framework for infrastructure, and government's cooperation with the private sector. In terms of priorities, the government needs to shoulder most of the expenditure for roads, electricity transmission, and human capital formation (education and health). In other areas, such as telecommunications, air transport, and electricity 17 generation and distribution, the private sector can be expectedto be responsible for most of the operation and maintenance expenditures; it will also invest in new capacity provided the sector framework is credible, transparent and fully competitive. Such a framework for public-privatepartnerships should also ensure that government liabilities, if necessary, are minimized and defined ex-ante within a clearly defined institutional framework. Thus, an effective partnership is requiredbetweenthe public and private sectors to help ensure that FYR Macedonia's expected faster growth is not choked off by inadequacies in infrastructureservices (see section D2 for specific suggestionson improvinginfrastructure services). C.4. Finance: SupportingEmerging Growth Drivers 28. Financial sector development has already begun to relieve past constraints to growth and increased the availability of financial services and credit, while keeping risks reasonable. Financial services have improvedsignificantly, private credit has grown substantiallyand interestrates and spreads declined in recent years (Figure 3) as the financial sector has been strengthened, foreign entry has risen, and competition has increased. Continuationof these trends and further, second generation reforms will further increase private credit, which is an important factor in growth, and will lead banks to increase their services and deposit rates to mobilize more loanable funds, thereby strengthening savings. Unlike many other countries in the Central and East European region, Macedonian banks' credit growth was not fueled by overseas borrowing-the banks have a positive offshore position-and this means that FYR Macedonia's banks are now much less risky than others and far less exposed to ongoing financial sector upheavals in world markets.NBRMhas emphasizedprudence in its oversightof banks and its monetary policy, which is important for sustainable growth given FYR Macedonia's recent history. The Government has decided to tighten monetarypolicy inthe context of the current internationalturbulence, but it should also proceed with the reforms described below, which will improve the productivity of bank credit and accessto it. Figure 3: FYRMacedonia: Interest Rateson CB Bills and Denar Loansand Deposits 2002- 2008 1 1 2 12 $I CI10 10 g 8 8 n 6 6 4 4 2 2 0 0 Jun- Jun- Jun- Mar- Jun- Sep- Dec- Mar- Jun- Sep- D e - Mar- Jun- Sep Apr- Jun- 02 03 04 05 05 05 05 06 06 06 06 07 07 07 Dec- 08 08 07 Source: NBRM 18 29. To support future growth, development, and higher investment and domestic savings, a second generation of financial sector reformsis needed, mostly focusing on the bankingsystem. The banks will needto respondbetterto demands for credit and financial services from non-traditionalclients. This responsewill depend on more attentionto small firms than in the pasta5Also, the banks will need to expand services and increase the returns on householdsavings (reduce spreads on bank credit further), to encourage higher domestic savings, including savings from remittances. The discussion focuses on the banking system, which is likely to dominate finance for the next few years; the other elements of the financial system are discussed below. 30. Broadly speaking, the following measureswould help improvethe bankingsystem's contribution to development by providing incentives for good borrowers, reducing the cost of credit to them, and expanding the size ofthe bankingsystem's privatecreditand deposits: Improve the credit information system. FYR Macedonia's current credit informationsystem, as with most central bank systems, was designed mainly to support bank supervision. It ranked lower than most EU countries, Serbia, and Bosnia and Herzegovina; the system also did not support growth of access to credit by small firms and households, given low (see Doing Business 2009) albeit growing coverage of the adult population in the database, and the provisionof only limited informationon borrowers, often with a lag. At the end of 2008, NBRM upgraded its credit registry and now provides more detailed and more timely (monthly instead of quarterly) informationon a larger number of borrowers(thresholds were considerably reduced). The Bankers' Association is in the process of setting up a credit informationsystem but that, or any other system will needvarioustypes of support to achieve the goal of widening access to sound credit. The suggested improvements include: timelier data (including penalties for slow provisionof data) and a unique identificationof borrowers (which is now complicated by the ease of forming a new firm). Inclusion of positive and negative credit historieswould not only help fonvard-lookingsupervisionbut increase access and encourage borrowersto repay, in order that they develop a non-physicalasset-a credit record of prompt repayment. Inclusion of other data-savings bank loans and payments of public utility and phone bills will improve access to first-time and other small borrowers. Such changes will also increase competition for sound borrowers and lower costs of credit. The benefitswill be more access to credit, lower cost credit to borrowerswho have a history of repayment, and better repayment by borrowersin general. Continue to reduce weaknesses in contract enforcement. This has been discussed above. Continuedimprovementinthe framework of contract enforcement and executionof contracts will make banks more confident about micro lending, and, in time, could help to bring down spreads. Improve titling of land and make it easier to register and use collateral. In addition to completingthe cadastre and ensuring clear titles and the ability to pledge land and buildings, issues include improving timeliness of registering title changes and the ease of use of the collateral registry. Again the issue of unique identification of owners is important. These improvements would help reduce disincentives of financing the agricultural sector, which remains a key challenge for the financial system. The changeswould also increase the impact of the new law allowing foreign investors to buy land. Examine how the system of collateral execution is working since the passage of the modern 2003 Law on Collateral Pledge and correct any remaining deficiencies. By allowing 5 The needs of the rural sector and small firms will need to be addressed by the measures suggested below. Programsto provide government subsidiesor directed credit have usuallynot beensuccessful. 19 creditors to take possession of collateral directly, in the case of uncontested claims, the law was intended to remedy slow, costly executionof collateralthrough the legal system that had increased the cost of credit and gave little incentive for borrowers to service debts. While there have been improvements, particularly in cases of uncontested claims, in practice some issues are reported to remain: The service of summons by notaries is reported to be sometimes slow, in part because identification of debtors is weak and citizens move frequently. Moreover, it appears that debtors can challenge the takeover of collateral in courts, and do so because of the benefitthey receive from delay. Inthe event of a successful challenge, the case reverts to the courts, where cases may take one to three years for resolutionand further delays may result from difficulties inenforcement. Improve access to non-credit Jnancial services. This will involve further expansion of the bank branch and ATM system, as most banks have indicated they are planning to do for competitive purposes. Mobile banking may be considered as an option. It may also involve participation of the mutual savings institutions in the payments system, which will allow them to intermediateremittancesmore easily.The NBRMmay also wish to encourage further consolidationof ATMs into networks, to reducethe costs of such activities. 31. The pensionsystemandthe equity market are small relativeto the bankingsystem and unlikely to provide large amounts of investment funds in the near future. FYR Macedonia's fully-funded pension system hasjust begun and experience elsewhere suggests that it can contribute to higher saving rates and provide sound retirement incomes, particularly when the range of sound investments is expanded to internationalmarkets. Requiredcommissionlevels and costs relative to services providedmay be factors that could reduce the benefits of the system and, in the extreme, be considered by workers as a tax on labor. Internationalexperience suggeststhe equity market is likely to remainsmall and a limited source of investment funds, reflecting the small potential capital size of its firms and the corresponding low liquidity ofthe market. 32. Finally, giventhe ongoing global financial crisis, the NBRMwill also need to maintainits strong regulatory and supervisory stance, not only with regard to domestic banks but also with the new foreign banks that may present more challenging issues of supervision. Also, monetary policy will have to be responsive to cope, on the one hand, with a decline in external financing prospects, and a fall in the growth of global demand, on the other. Whatever the new stance of monetary policy, the government and the NBRM should simultaneously undertake the measures to improvethe framework for credit discussed above-they will support much sounder provisionof credit to its most productiveusers. D. ENHANCING PROSPECTS EXPORT-LED FOR GROWTH IMPROVE To EFFICIENCY AND ENSURE DEMAND FORHIGHER PRODUCTION D.l. The Role of Trade Policyand LogisticsinExports 33. Higher productionin FYR Macedoniacan only be sustained if it is exported. After a point, the projectedhigher output (arising from the higher investmentexpectedto resultfrom investment climate and other economic reforms) can only efficiently be directed towards exports. In other words, exports are the only source for sustained economic growth in FYR Macedonia, like other small countries. Unfortunately, being land-locked, its products are likely to face higher transaction costs to reach external customers, and it therefore has to work harder to drive exports. On the other hand, it does have an otherwise favorable location, beingright next to the EU, the largest market inthe 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 may be positive or negative, depending on how FYR Macedonia handlesthem. 20 Table 4: Indicators of Trade Performancein FYRMacedonia and Selected Countries GNFS Export Goods Export Share (%) in Share (%) in Deficit in Deficit in Growth 96-06 Growth 96-06 World Goods World Goods GNFS GNFS (percent) (percent) Imports 1996 Imports 2006 (YoGDP, 1996) (%GDP, 2006) Albania 22.0 15.3 0.0060 0.0064 22.9 24.1 Bosnia and Herz. 15.3 19.6 0.0081 0.0276 60.3 _ _ Croatia 10.2 8.8 0.0672 0.073 1 9.5 8.9 FYR Macedonia 7.5 5.9 0.0233 0.0201 10.3 18.7 Montenegro 32.9 Serbia 12.5Ia 0.0328h 0.0480h 7.4 19.7 SEE-5 12.3 13.5 0.1374 0.1536 15.6 16.1 EU-8 13.2 14.8 1.5859 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/ Refersto 1997-2006; b/ Serbia and Montenegro. Growthrates are least squares. A minus sign inthe deficit figure indicatesa surplus Source: Annexes 3.1, 3.2 and 3.3 and WDI database 34. FYR Macedonia's export performance so far, with one or two Table 5: Market Shares in EU27 Apparel Imports (percent) exceptions for specific products, has 1990 1996 2000 2006 lagged that of neighboring countries Asia 38.9 45.1 47.1 59.6 Balkans 8.4 2.5 2.3 1.9 and been unable to provide an FYRMacedonia _- abiding stimulus to growth until 0.54 0.55 0.57 source: C O M T ~ D E recently. FYR Macedonia's exports have picked up pace since 2004, and started recovering world market share lost after 1996. However, other Western Balkancountries' exports have grown faster over 1996-2006, and even over 2000-06 (table 4). Moreover, FYR Macedonia's below-average export growth has been too dependent on metals and apparel (accounting for 70 percent of dollar export growth over 2002-06); both have grown fast but are also vulnerable-metals to ongoing energy re-pricing in FYR Macedonia and to downturns in global metal prices (as has already started happening), and apparel to increasing competition from Asian countries (table 5). Indeed, given the recent acceleration in wage growth and the potential for further increases (see section D2), much of the export basket as awhole is vulnerableto Asian competition, since only 32 percent of FYR Macedonia's exports rely heavily on skilled labor and capital, the rest being intensive in natural resources or unskilled labor. All this reflects a lack of competitiveness in exporting either a broader range of products, or in exporting existingproducts (other than say metals and garments) in larger volumes. 35. These emerging weaknesses in exports would require urgent remedial measures. These include addressing a number of factors that directly currently impinge on price competitiveness, such as high labor taxes (see section D2). They also include elements of trade policy such as tariffs, whose structure allows some scope for trade diversion in favor of EUand CEFTA countriesat the expense ofthe rest of the world. Customs and physical inspection procedures also have significant room for improvement.Moreover, Macedonianfirms in general seem to be less inclinedto exports, and not enough firms get started into exports each year. In addition, exporting firms are very concerned about contract violations, cost of financing, electricity and telecommunications,which are dealt with in other sections of this Overview and Report.Also, adequacy of skills is a looming issue, already evident in the IT sector, but also a concern for overall exports given the need to enhance their skill content and thereby improve 21 prospects for sustained export growth. Trade policy and logistics issues that could help export performanceinclude: e Move towards the establishment of a single CEFTA-wide market with at least onepeedom- that for movement of goods. The objective would be to reduce transaction costs, reduce protection and so improve prospects for exports, attract FDI, and lower prices. In turn, this would entail: 9 Adopting the EU Common External Tariy to replace the current MFN tariffs, and reducingindustrialimport tariffs under the Stabilizationand Association Agreement with the EU to zero, to reduce tariff dispersion and trade diversion, and improve export competitiveness.This will also create a `shadow customs union' with the EU. Ideally, all countries of CEFTA 2006 should also adopt these policies. 9 Pushingfor afree trade regime in agriculture, at least within the countries that are part of CEFTA, along with mutual recognition of sanitary and phyto-sanitary standards and certification procedures(through synchronized harmonizationwith CEFTA countries and Turkey of the acquis communautaire),to improve input access for agro-processingfirms and improvemarketaccess for exports andreducetransaction costs. 9 Lowering barriers to entry into exports, since the `superstars ofthe future' oftentend to emerge from a new set of firms. This includes action to lower the cost of entry into exports, particularly for potential exporters, such as a careful, target-oriented pilot program on export promotion, located within Invest FYR Macedonia; and action to improvestandards, ruralexport-orientedinfrastructureand agricultureextension services. Improve non-customs and customs clearance times. This would help to reduce the implicit tax on exports, minimize the costs of trading and encourage entry into exports, and enable faster growth of logistics outsourcing.This would entail: 9 Introducingproper risk managementsystemsfor allforeign trade- related inspections; 9 Supporting wider usage of simplified customsprocedures, which allow shipments to go directly to eligible companies (who are tax compliant) that applyfor such certification; 9 Reducing remaining delays in customs clearances, particularly for small volumes of exports; 9 Reducing delays in phyto-sanitary inspections, veterinary inspections, and market inspections which rely on one hundred percent checking of all goods, and take a minimum of one dayfor clearances.Solution should also include reviewing the necessity for such inspections whengoods are importedfrom the EU,for example. Allow a single guaranteefor all logisticsJirnctions (customs-related, public warehousing and cargo consolidation), to encourage efficiency and reduce costs of outsourcing, and promote consolidationof the logistics industry. Help the logistics industry firms that provide services such as customs clearances, warehousingand cargo consolidation) 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: 9 Introducing a clear regulatorypamework that stipulatesthe roles and responsibilities of buyers and sellers of logistics services, to tackle issues relating to liabilities of carriers; 9 Helping the industry to constantlymonitor andbenchmarkitsperformance. 22 Takehrther action on other issues that are relevantfor exports, dealt with in other parts of this Overview andreferredto above, includinginfrastructureservices, labortaxes, investment climate, and adequacy of skills. 36. The above agenda is critical for growth, employment and poverty reduction. Addressing these issues should help raise the growth of exports and, in time, allow diversificationtowards 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 improve the prospects for a secular improvement in the terms of trade. Inthe short-term, of course, garments and iron and steel will continue to dominate exports, and policies outlined above, especially those that can be implemented over the next year or so, such as reducing labor taxes and improving customs clearances, can help to prevent erosion in their competitiveness. Given the importance of exports for FYR Macedonia's growth, addressing export constraints, includingthe constraints faced by small firms, should help reduce unemploymentas well as the number of working poor (by providing an avenue for improved productivity, complemented by skill upgradation) and so help to reduce poverty. Finally, 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. D.2. ImprovingInfrastructureServices for Exports 37. Infrastructure services may have constrained exports somewhat in the past, as indicatedby the 2005 BEEPS. Inthe 2005 BEEPSsurvey, 52-57 percent of exportingfirms cited telecommunications and electricity as obstacles, compared with only 19-20 percent for domestically-orientedfirms, suggesting that exports, which have grown slower than FYR Macedonia's needs and neighboring countries, have been constrained by infrastructure. In addition, as noted earlier, more firms complained about infrastructurein 2005 than in2002, evenwith the modest improvementin growth. 38. Notwithstanding recent improvements, more is required to be done to ensure that infrastructure does not become a bottleneck to faster export and GDP growth. FYR Macedonia may have to do better than countries connected to the seas. FYR Macedonia's landlocked status meansthat it may need an extraedge in infrastructuresuch as transportand communicationsto enable the faster export growth that is needed for higher growth. Given the long-gestationlag between investment and delivery of infrastructureservices, anticipating possible future bottlenecks(such as airport capacity) and improving other lagging sectors are essential to improving FYR Macedonia's competitiveness in exports and import-substitutes,and allowing all economic participants (including small firms and farms) cost-efficient access to the nationaland internationalmarkets. Also, since FYR Macedoniais landlocked, its infrastructureservices have to probably surpass its competitors in order for its export sector to be on an equal footingwith them. Information and Communications Technology(ICT) 39. In the telecommunications sector, telecom tariffs, especially mobile rates, have declined dramatically with increased competition in the last five years, and especially since 2006. The Government continues to make significant progress in ICT sector reforms. Nominal mobile monthly fees fell by 30 percent and the unit rates dropped by some 50 percent over 2003-07. This owes to the introduction of a competitivemarket following EU-consistentprinciples,with the end of monopoly in the mobile and fixed markets and the establishment of a regulatory entity. Mobile phone competition began in 2003, and stronger direct fixed-line competition in 2008. Mobile teledensitystarted taking off in 2002. Internet subscription is picking up but remains low (Figure 4), reflecting insufficient access to local loops until recently and historically high dependency on dial-up internet connections, rather than broadband 23 access. Alternative technologies may have been underdeveloped in FYR Macedonia, particularly cable lines and WiMax, at least until recently. The Government is currently preparingthe Broadband Strategy. Figure 4: Mobile Phoneand Internet Density 1995-2006. I -1 I 160 70 - t -8-Estonia -e- Estonia I40 Lithuania Lithuania 6-Slovak Revublic +Slovak Rep Romania s60 1 BulRana Romania 1 Bulnana 0$0 +Macedonia a +Macedonia Bosniaand Herzegovina v s40 Bosniaand Herzegoiina 20 0 O 0 0 0 0 0 0 0 - N O - - 1 0 0 0 0 0 0 0 0 N N N N N N N 1 Sources: WDI; Transition Report; and Cullen International (2007). 40. Interconnection regulation is the single most important (and most challenging) policy issue to strengthen market competition and facilitate , private-sector led development in telecommunicationsand other ICT. Recently realized price reductions and penetration growth clearly demonstrate the importance o f effective competition not only among competing operators within each market, but also among alternative technologies. In FYR Macedonia, international calls remain relatively expensive, and VoIP (e.g., Skype) rates terminating in FYR Macedonia are among the highest in the Central and East European region. To ensure cost-based, transparent, and non-discriminatory interconnection rates without hidden cross-subsidies, the regulatory capability to assess market performance and pricing, and resolve disputes quickly, is essential. The current dispute resolution mechanism is slow, and the Agency for Electronic Communications (AEC) lacks sufficient human capital. Legal enforceability o f contracts, which could help enhance post-paid subscription and bring about additional average tariff reductions, is another problem for telecom operators. Also, a clear vision may be needed for the next level o f development in the sector, with more advanced wireless services in the 3G format, including WiMax, as one way forward. Some o f the measures that will help in this regard include: 0 Strengthen the regulatory capacity of AEC, especially in terms of overall stafJing quality. 0 Implement effective interconnection regulation to maintain fair competition between the incumbent and new entrants. 0 Review functioning of recently introduced number portability to ensure it is fast and reasonably priced. 0 Strengthen contract enforcement to reduce nonpayment andfacilitate a move@om pre-paid topost-paid contracts (see also section C2). 0 Strengthen the supply of skills in order to encouragejrms to adopt ICT Air Transport 41. In the air transport sector, air travel costs have declined sharply since 2004, owing to intensified competition in the sector (figure 5). Several foreign airlines have entered the market recently, raising the total number o f airlines up to 14. The country ratified the European Common 24 Aviation Area (ECAA) agreement in 2007 and is proceeding with its implementation and preparing to join the Joint Aviation Authority, to establish an aviation framework consistent with the EU aviation acguis. The Civil Aviation Agency has been separated from the airport operator (Public Enterprise Airport Services). The Government has also selected a private operator for the lease and operation o f Skopje and Ohrid airports and the construction and operation o f a new airport at Stip. These are all expected to stimulate competition and lower prices further, which will lower air travel costs for business and Macedonian and may stimulate tourism in the country. Reduced air Figure 5: Airfare Reductionfrom 2004 to 2007 freight costs, which are expected to decline with passenger costs, can help stimulate exports o f time-sensitive products and those 8-10 that have high value to weight ratios. 42. However, despite improvements, Macedonian air transport and passenger traffic are still severely -50 constrained by poor international connections and high passenger fares (see table 6). Proceeding with the scheduled liberalization agenda is critical especially in To Vienna Zunch Frankfurt London New York the next two to three years. This agenda FromSkopje represents a very good opportunity for FYR Source: HRGFYR MacedoniaNewsletter. Macedonia, especially as a landlocked country, to realize better all-year-around air connections to major EU cities and reduce prices, which would greatly improve business travel and hence competitiveness o f the economy. It will be particularly important to monitor the performance o f the airports after the concessioning, with close attention to possible cost overruns or other adverse effects from new investments. Some o f the key measures towards further market liberalization are: Table 6: Air Transport Costs (U.S. dollars) Destination Origin Frankfurt LondonNew York Tokyo Ensure effective implementation of the Ireland (Dublin) (-56192 1,076 1) (-66174 6) (-59460 7) (-70 6) concession contract for the airports and Estonia(Tallinn) 1,144 prompt upgrading of the airport (-16364 7) (-27377 6) (-38706 1) (-68 7) Hungary (Budapest) 313 283 619 895 injPastructureto absorb increasing traffic. (-28 4) (-45 7) (-45 7) (-75 5) Latvia 371 364 654 1,670 (-15 1) (-30 I) (-42 7) (-54 4) 9 Complete the separation of the Civil Croatia (Zagreg) 170 372 834 1,314 Aviation AgencyjPom the airport operator. (-61 1) (-28 6) (-26 9) (-64 1) Llthuan,a 372 414 717 2,020 (-14 9) (-20 5) (-37 2) (-44 8) 9 Remove the exclusivity rights of the FYR siovak(Bratlsiava) 398 471 872 3,221 MacedoniaAir Transport. (-8 9) (-96) (-23 6) (-12 0) Romania(Bucharest) 367 348 799 1,286 (-16 0) (-33 2) (-30 0) (-64 9) 9 Become afull member of the Joint Aviation Bulgarla(Sofia) 346 472 839 1,377 Authority. (-20 8) (-94) (-26 5) (-62 4) Albania (Tirana) 435 445 981 1,578 (-0 5) (-14 6) (-14 0) (-56 9) Ground Transport FYR Macedonia (Skojpe) 437 521 1,141 3,660 Note PercentagedifferencesFrom the airfaresfor 43. Goods and rail traffic have both grown in FYR Macedonia is shown inparentheses recent times, but sustaining this will require better & ~ ~ r c Staffinvestigatlons. e maintenance, as well as continued investment in some roads, as articulated in the Government's National Transport Strategy. FYR Macedonia recently experienced considerable increase in transit transport on Corridor X, connecting Western Europe and Greece, some o f which seems to have shifted away from the alternative Corridor IV (Thessaloniki-Sofia-Hungary). On the railways side, Macedonian Railway (MZ) is running a cash surplus due to increased demand. Overall, goods transported by road 25 grew by an annual average of over 32 percent over 2002-06, and goods transported by rail grew by over 16 percent. 44. I t is of particular importance for FYR Macedonia to maintain the competitiveness of Corridor X, because of high concentration of its ground traffic in this corridor. Toll collections, largely from Corridor X, are importantnot only to maintainCorridor X (road) per se but also to invest in other corridors and local road networks (since they help reduce fiscal spending on roads). Currently, toll collections, declining for the last 3 years, have started to increase in 2008, following stern measures to improve collections at pay-tolls, and this trend needs to be maintained.Also, regional connections with Albania and Bulgariathrough Corridor VI11couldbe developed further to support the regional integration inthis east-west direction. 45. Although much attention has been paid to Corridor X, regional and local roads are also essential to maintain the linkages of farmers and small firms with the national and international economies. About 70 percent of FYR Macedonia's local roads are estimatedto be in very poor condition, owing to inadequate maintenance, which means there is a major backlog of maintenance. To overcome constraints posed by these inadequacies, the Government has initiated a large program of investment in regionaland local roads, with the support of the internationalcommunity, includingthe World Bank.This would also improve access to public services such as health and education. To augment exports and competitiveness, and internalconnectivity, priorities for FYR Macedonia's ground transport development could be in the following areas: Maintain and upgrade Corridor X as scheduled. Further improve toll collections on Corridor X Accelerate other domestic road network development,especially of local roads, and improve governance capacity in road-related institutions. This has been recently initiated by the Government, and 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 46. FYR Macedonia needs to unwind its electricity subsidies (a process it has initiated), followingthe Athens Treaty. FYR Macedonia is among the most electricity-intensive economies in the Central and East European region (Figure 6), reflecting, at least in part, its subsidized prices for electricity. Sector pricing results in government subsidies, as well as cross-subsidies that are borne by the state-owned companies. Under the Athens Treaty, countries in the SEE region agreed to liberalize their electricity retail market by 2015. As of January 2008, FYR Macedonia increased power tariffs for large companies, requiring them to purchase all of their electricity in the market (consumers and other companies have been given more time to adjust). While this move will reduce government subsidies, and improve the overall viability of the sector, it will also pose a challenge to energy-intensiveusers in the economy. 47. The critical challenge in the energy sector is to adjust energy prices to full cost-recovery levels while minimizing the impact on companies and households. The adjustment process of electricity tariffs in FYR Macedoniahas been sluggish compared with neighboringcountries (Figure 7). To comply with the obligations of the Athens Treaty, FYR Macedoniawill face greater adjustment in the short-run than its neighbors. It is importantto ensure that tariff adjustment schedule be adhered to-the alternative is a sector where investments will not be viable, and so will harm the long-termdevelopment 26 of the Macedonian economy. On the demand side, the immediate challenge will be to deal with the possibility of reduced competitiveness of the electricity-intensivemetal-producing firms, who, together with cement, consumeabout 30 percent of electricityanddominate FYRMacedonia's exports. Inaddition to any support from government (such as by reducing labor taxes, see below), these firms will need to implement major efficiency measures to reduce the cost impact of energy re-pricing. Also, as market- based electricity pricing spreads to the entire economy, the government will also need to mitigate the impact ofthe price increaseson poor households. Policyactions on these lines could include: 0 Gradually adjust the corporate and residential tariffs tofull cost- recovery levels (taking into account the needfor future investment). 0 Undertake measures to ease the negative effects of the price adjustment on electricity- intensive producers by reducing cost pressuresfrom other production inputs, especially the non-wage cost of labor (see section D3). Ensure that the poor are not hurt by energy tariff adjustments through efficient and targeted transfers (theproposed reform of the social safety netprogram is in the right direction). Figure 6: Electricitv Intensitv of the Economv Figure 7: ResidentialElectricitv Tariff go50 2f Residential electricity tariffs (U.S cents per kWh) 045 0 2 4 6 8 I O 12 14 16 18 4 040 5E Estonia 035 Latvia 030 g o 2 5 Croatia $020 Lithuania 2E 015 SlovakRep. ,010 Romania e 005 Bulgaria P o 0 0r -T I I Macedonia Albania Ireland Source: WDI. Sources: World Bank (2006); EurostatandEBRDTransition Report. D.3. Improving Labor Market Outcomes for Exports and PovertyReduction 48. Increasing employment and improving related labor market outcomes remain the critical challenge for FYR Macedonia. As mentioned in section A, employment outcomes are critical for the inclusion agenda and explaining continued high poverty-including low employment, low productivity and unequal participation in employment. Also, education affects employment prospects significantly (figure 8). 27 Ggure 8: EmploymentRates by Age Group and EducationalAttainment,2004-2006 Age group 15-34 Age group 35-64 020% 02005 12006 02004 Q2005 12006 90 0 90 0 770 770 70 0 700 u Q) 0 2 600 * * 2 600 u 500 E 5 0 0 -E$ 4 0 0 -54 0 0 2 3 0 0 E 3 0 0 W 20 0 W 20 0 100 100 0 0 0 0 Primarforless SeCOndarf Secondary Higheror Primaryorlera Secondary Secondary Higher or Vocational General University Vocahonal Genera University Source: Angel-Urdinolaand Macias (2008), basedon LFS data 49. The competitiveness of the labor force--both skills and wages--is a matter of concern for exports, growth and poverty reduction. Skill shortages, while not a general issue, are beginningto appear in dynamic sectors such as ICT. Even garment manufacturers that have done well so far are reporting problems of finding the right skills for upgrading their production, according to firm studies undertaken for this Report. The most recent survey of employers carriedout by the EmploymentServices Agency (2007) showed that 20 percent of firms reporteddifficulties in filling vacancies. The analysis of BEEPS 2005 showed that firms that saw faster growth in exports and output and invested in research and development reported relatively more problems in finding the right skills. Moreover, the experience of EUlO countries suggests that skills will become a more important concern as reform proceeds. Population aging will further increase supply-side pressures. The current system of education and skill formation suffers from weaknesses at all levels-in primary and secondary education, tertiary education and training. Disparate outcomes of different groups in the education system exacerbate these weaknesses, since they effectively exclude the marginalized groups from more effective participation in the labor market. Emerging skill concerns are reflected in, and amplified by, faster growth of wages in recent years, especially in some sectors. A key issue inwages is the structure of social contributions, with tax wedges the highest for low-wage labor--creating disincentives for young and unskilled workers to find formaljobs. 50. Action is therefore needed to strengthen export competitiveness, complement higher investment and improve inclusion. An improved investment climate can improve returns to education and so create incentives for people to learn more. But it needs to be accompanied by other action to improve the supply side of education, improve labor competitiveness, and use foreign workers and migrantsto address potentialshort-runsupply shortages. 0 Implement the announced program to reduce labor taxes and reforming social contributions, while ensuringfiscal sustainability. The reform, which has begunto be implemented, 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 calculatingcontributionsa6This should help improve labor market outcomes, reduce informality, help small firms and low-wage labor (whose proportionaltax wedge is higher), See also the policy notes on employment that were done as complementarypiecesto this Report.Inparticular, see the note on `IncreasingemploymentinFYRFYRMacedonia:the roleof labor taxation (WorldBank,2008h).' 28 and improve overall competitiveness of the economy (thereby helping mitigate loss of competitiveness arising from the ongoing impact of energy re-pricing on exports). However, the plan also includes a plannedcut of 10 percentage points in social contributionsover three years, which raises the issue of fiscal sustainability and the needto find alternativesources of revenue. 0 Take action now to improve education outcomes at all levels, to address the issue of possible future skill shortages, already felt in the IT and garments sectors; complement higher investment expected to be induced by economic reforms; and enable higher labor productivity and reducevulnerabilityto low-wage competition in exports. This agenda is also critical for creatingjobs that will pay more wages and hence reduce the number of working poor. In addition to improved education outcomes, greater proficiency in English can help more firms to adopt ICT, and also create more job potential in activities like outsourcing. Actions here could include(see Chapter 7 for details): 9 Ensuringfull implementation of recent Law on Higher Education; 9 Continuing the momentum of reform implementation in general education, such as introduction of national exams, new curricula in foreign languages and information technology, and benchmarking of the education system; 9 Implementingfully the new Adult Education Law to carry out extensive restructuring of professional and adult education and training. 0 Encourage academic linkages of universities and other higher education institutions with foreign investors. This can potentially have very high payoffsfor the host economy including attracting further, high quality FDI and private investment. One way to do this is to more favorablyjudge applications for FDI incentivesfrom those firms that generate more linkages with local institutions. 0 Encourage use of remittancesfor investment and education through indirect measures such asfinancial deepening and improving returns to education. Remittances are very significant for external sustainability; they are also a significant source of income for many ethnic Albanian households, who receive about 2/31d of all remittances (2006 HBS). However, survey data shows that most of these remittances are used for consumption; and households receiving remittances have much lower participation rates than those who do not receive remittances. Since remittances can eventually decline, and non-participationin the labor force can be self-reinforcing, use of remittances for educationand investmentcan help households to increase potentialearnings and reduce their chances of being unemployed in the future. It bears repeating that the most effective measures to achieve such objectives appear to be indirect ones, such as improving the investment climate that would raise the returns to education, and increasingthe avenues for profitablesavings and investment by households. Facilitate and even actively encourage foreign workers and return migrants to find jobs in FYR Macedonia. The process for foreign workers to get a work visa is currently very time- consuming, and hurts Macedonian firms' expansion and investment plans. Reducing the delays in this,processshould be a priority for the Government.A CEFTA agreement on free movement of skilled labor could help (see Kathuria, 2008), and can be negotiated bilaterally to begin with. Returning migrants are another source of skills and business connections overseas, and can be actively encouraged to return. Examples include the GlobalScot program. 29 E. CONCLUSION 5 1. FYR Macedonia'sgrowth potentialhas not been fully tapped. The onset of political stability and economic reforms in 2002 broughtforth faster and steadier growth. FYR Macedonia's challenge is to bring this growth to a higher level and then sustain it. The experience of many of the EUlO countries, who are ahead of FYR Macedonia in reforms of institutions and policies, shows that faster growth of 6-7 percent a year can be sustained (at least once international demand and growth return to a pre-crisis trajectory). 52. A good exampleof what is possiblefor FYR Macedonia is provided by the experience of the Slovak Republic. Like FYR Macedonia, Slovakia is a small, landlockedcountry that emerged from the shadow of central planning in 1993. After lagging behind in the 1990s, its growth has steadily accelerated: from 4.8 percent in2002, to 6.6 percent in 2005 (theyear after EUaccession), to 10.7 percent in2007. It adoptedthe euro in2009. 53. A steady improvement in a range of structural policies is likely to result in significant growth payoffs for FYR Macedonia. A cross-country growth model predicts that if FYR Macedonia were to improve its structural policy indicators by 50 percent over the current levels (the relevant indicators are education, financial depth, trade openness, and public infrastructure), the annual growth rate could increase by over 2 percentage points. While a 50 percent improvementmay appear large, note that the indicators are quantitative and do not take into qualitative factors, which are as important as quantitative ones in affectinggrowth o~tcomes.~ any case, these calculations are illustrative, and more In attention should be paid to the direction of change rather than to the exact estimated impact on growth. What they do illustrate is that no single policy framework in FYR Macedoniais substantially out of line with comparators; however, various improvements taken together could make a significant difference to overall growthandpovertyreduction. 54. This report puts forward a package of measures to support steady improvements across a range of policies and institutions. The reform package enumerated in this Overview and the accompanying Main Report is not as daunting as may appear at first sight, since the government is already taking action in most of the areas. What this report tries to do is present a consistent package of reforms and suggest areas where priorities could be warranted. This package comprises a set of policies that addresses current as well as likely future constraints to growth, the latter being a critical part of planningfor growthand ensuringthat possible future bottlenecksare minimized. 55. There are no magic bullets for growth, however. As the Growth Commission (2008) states, successful growth over long periods requires, inter alia, a capable and committed government and leadership. And this leadership `...requires patience, a long planning horizon, and an unwaveringfocus on the goal of inclusive growth' (p. 3). Like other countries that have succeeded in sustaining growth over long periods, FYR Macedonia would need to stay the course and implement reforms over a long time period. It should use its advantages, especially the anchor of the EU acquis, to maintain the momentum of policy reforms, and to ensure that the positive aspects of its geography (being next to the huge EUmarket)override its landlockedstatus. The exampleof Slovakiashows that it can be done. 7 For example, the quality of education (as reflected, say, in scores on standardized tests) is very important to long- term growth; the quality of roads is as important as the length ofthe roads, etc. 30