Report No.26681-MK FYR Macedonia Country Economic Memorandum Tackling Unemployment September 2003 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CURRENCY AND EQUIVALENTS Currency Unit US$l =Macedonian Denar 52.4 (as of September 11,2003) Fiscal Year January 1-December 31 ACRONYMSAND ABBREVIATIONS BEEPS Business Environment and Enterprise Performance Survey CEE Central and Eastern Europe CIS Commonwealthof Independent States EBRD European Bank for Reconstructionand Development EU European Union FIAS Foreign Investment Advisory Service FYR Macedonia Former YugoslavRepublic of Macedonia GDP GrossDomestic Product HBS HouseholdBudget Survey ILO International Labor Organization LFS Labor Force Survey MAEWS Business EnvironmentMonitoring, Analyses, and Early Warning System NGO Non-Governmental Organization OECD Organizationfor Economic Cooperation and Development SAA Stabilizationand Association Agreement SFR Yugoslavia Socialist Federal Republic of Yugoslavia SME Small and Medium Enterprise TFP Total Factor Productivity WTO World Trade Organization Vice President: ShigeoKatsu (ECAVP) CountryDirector: Orsalia Kalantzopoulos (ECCU4) SectorDirector: Cheryl W. Gray (ECSPE) Sector Manager: Bernard Funck (ECSPE) Task Manager: Erika Jorgensen (OPCCE) ACKNOWLEDGEMENTS This report was prepared by a team led by Erika Jorgensen and comprising Paul Holden, Alexandre Kolev, Evgenij Najdov, Robert Pavosevic, and Milan Vodopivic. Nancy Davies-Cole and Kathryn Rivera provided assistance with production o f the report. The report also benefited from inputs from the peer reviewers, Philip O'Keefe and Michelle Riboud, and comments, suggestions, and contributions from Hormoz Aghdaey, Rajna Cemerska, Jackie Coolidge, Peter Darvas, Robert Gourley, Loraine Hawkins, Jasminka Varnalieva, and Ruslan Yemtsov. Sector managers Kyle Peters and, subsequently, Bernard Funck provided guidance to the report at various stages. The work was carried out under the general direction o f Christiaan Poortman, Country Director for FYRMacedonia andsubsequentlyunder that of OrsaliaKalantzopoulos. The team would like to thank the Government o f the Republic o f Macedonia, especially officials from the State Statistical Office, for their assistance and cooperation. The team also wishes to thank the many academics, representatives from business, representatives o f other international donors, and NGO members for sharing their information and data and providing discussions and suggestions. This report was prepared in conjunction with a series o f background papers. These papers are available upon request. CONTENTS EXECUTIVES ~ M A R....................................................................................................... Y i 1 . UNEMPLOYMENT AND GROWTH .................................................................... 1 A.INTRODUCTION ........................................................................................................... 1 B.GROWTH AND JOBCREATIONDURINGTRANSITION .................................................... 2 Fast Privatization but Low Restructuring Has Retarded Private Sector Expansion., 4 Export Growth Has Been theMain Source ofJob Creation ...................................... 5 c.Investment Has Been Low........................................................................................... 5 A STRATEGYFORLONG-TERMPRO-EMPLOYMENT GROWTH ..................................... 5 TotalFactor Productivity Drove the Modest Growth ofthe 1990s............................ 7 Low Foreign Direct Investment is Reducing the Potentialfor Job Creation .............9 D.More POLICY CONCLUSIONS.............................................................................................. Successful SME Development WouldHelp Spur Demandfor Labor..............11 12 2. MACROECONOMIC PERFORMANCE AND MEDIUM-TERM PROSPECTS ................................................................................................................... 13 A.INTRODUCTION ......................................................................................................... 13 B.MACROECONOMIC DEVELOPMENTS .......................................................................... 14 TheRoad to Macroeconomic Stability...................................................................... 15 Security Crisis and Post-Conflict Recovery.............................................................. 18 C.MAINTAINING STABILITY 19 D.SPURRINGGROWTH THROUGHFISCALREFORM............................................... THROUGHTRADELIBERALIZATIONREGIONAL AND INTEGRATION ............................................................................................. 21 E.MEDIUM-TERMMACROECONOMIC ........................................................... OUTLOOK 24 External Debt Sustainability ..................................................................................... 26 F.Fiscal CONCLUSIONS............................................................................................... Sustainability.................................................................................................. 27 POLICY 28 3. THE FAILURE OFTHE LABORMARKET ..................................................... 29 A.INTRODUCTION ......................................................................................................... 29 B.LABOR MARKET OUTCOMES ..................................................................................... 30 High, Persistent. and Stagnant Unemployment........................................................ 30 Uneven Composition and Incidence of Unemployment across Demographics and Regions...................................................................................................................... 33 Low Levels of Employment and Participation.......................................................... 35 Labor Market Restructuring and Job Reallocation .................................................. 35 Modest Lay-ofs During Enterprise Restructuring ................................................... 36 WageArrears............................................................................................................ 36 Large Movement of Labor Towards Agriculture...................................................... 36 Uneven Gains in Labor Productivity and Wages ..................................................... 37 C.GrowingMARKET Wage Variation across Sectors.................................................................. 38 LABOR INSTITUTIONS ................................................................................. 39 WageSetting............................................................................................................. 39 D.Current Passive and Active Labor Market Policies ProvideMixed Results ............42 RECOMMENDATIONS-FURTHER IMPROVEMENTSTO LABORPOLICIES .................... 43 4. THE ENVIRONMENT FORJOB CREATION ................................................. 45 A.INTRODUCTION B.WHATISTHEINVESTMENTCLIMATE, WHY ISITIMPORTANT, ANDHOWCANITBE ......................................................................................................... 45 C.CHARACTERISTICSOFFYRMACEDONIA'S IMPROVED?................................................................................................ 45 ECONOMYISSUES - RELATED TO MARKET D.FYRMACEDONIA'S SIZE ........................................................................................................... 46 INVESTMENT CLIMATE: THEMAINISSUES 48 ............................... Financial Market Issues............................................................................................ 48 E.Institutions.EVALUATING INVESTMENTCLIMATE............................................... Regulation, and the Rule of Law........................................................... 51 TOOLSFOR THE 52 Informality ................................................................................................................. 55 Land .......................................................................................................................... 56 TheAgricultural Sector............................................................................................. 57 F.Other Issues .............................................................................................................. 57 RECOMMENDATIONS TOWARDS STRATEGY FOR IMPROVINGTHE INVESTMENT CLIMATE .................................................................................................... - A 59 REFERENCES ............................................................................................................. 62 Tables TABLE1.1:THETRANSITIONRECESSION ........................................................................ 3 TABLE1.2: DECOMPOSITION OF EMPLOYMENT GROWTH. 5 TABLE1.3: RESULTSOF GROWTH ACCOUNTING. 1991-2000.......................................... 1997-2002............................. TABLE1.4: PROJECTEDTFP GROWTH RATESFOR FYRMACEDONIA OTHERS AND .......79 TABLE1.5: FOREIGNDIRECT INVESTMENTTO TRANSITIONECONOMIES EUROPE OF AND TABLE1.6: WAGES FORFYRMACEDONIA OTHERS, AVERAGE 2000-2001... 11 CENTRALASIA........................................................................................... 10 AND FOR TABLE2.1: SELECTED ECONOMIC INDICATORS, 15 1991-1994.......................................... TABLE2.2: SELECTED ECONOMIC INDICATORS, 16 TABLE2.3: SELECTED ECONOMIC INDICATORS: 18 2000-2002.......................................... 1994-2000.......................................... TABLE2.4: FISCALSTRUCTUREOFECONOMIESTRANSITION, AVERAGE 1997- IN FOR 2001........................................................................................................... 21 TABLE2.5: SELECTED ECONOMIC INDICATORS: 25 TABLE2.6: MACROECONOMIC FRAMEWORK, 2000-2005 ............................................. 2002-2005.......................................... 26 TABLE2.7: INDICATORSOFPUBLICINDEBTEDNESSOFTRANSITION ECONOMIES, 1997- 2001........................................................................................................... 27 TABLE3.1: CHARACTERISTICS OFTHELABOR MARKET, ...................................... 2002 TABLE3.2: DISTRIBUTION UNEMPLOYMENTBYDURATION, 33 TABLE3.3: THEIMPACTOFEDUCATION UNEMPLOYMENT...................................... OF 1996-2002.................. 31 ON 34 TABLE3.4: EMPLOYMENT 35 TABLE3.5: EMPLOYMENT SECTOR(PERCENT OFTOTAL EMPLOYMENT) ......................... STATUS BY REGION, 2002.................................................... BY 37 TABLE3.6: INTERNATIONAL LEGISLATION. COMPARISON OF EMPLOYMENT PROTECTION EARLYAND LATE 1990S*(ON A SCALE OF 0.6. WHERE 6 I S MOST RESTRICTIVE) ............................................................................................. 41 TABLE4.1:REGIONALCOMPARISONSOFCREDITTO THE PRIVATE SECTOR(% OF GDP) ................................................................................................................... 50 Figures FIGURE1.1: OUTPUTAND EMPLOYMENT. 3 STOOL. REVISED ................................................ 1990-2002..................................................... FIGURE1.2: SOLOW'S THREE-LEGGED 6 FIGURE1.3 SOCIAL CONTRIBUTIONS IN EUROPE CENTRALASIA.......................... FIGURE2.1 VALUEADDEDBY SECTORS. 1990-2002................................................... AND 12 17 FIGURE2.2: EXPORTS. IMPORTSAND GDP. 1990-2002 ................................................ FIGURE2.3: SHARESOFTOP THREEPRODUCTSINTOTALEXPORTS. 23 FIGURE2.4: DIRECTION EXPORTS. AND 2002.................................................. 1990-2002..........22 OF 1992 23 FIGURE3.1 :REGISTERED UNEMPLOYMENTINSOUTH EASTERN RATES EUROPE. 1989- 2000........................................................................................................... FIGURE3.2: DECOMPOSITION OFUNEMPLOYMENT AND LABOR FORCE STATUS ...........30 FIGURE3.3 :LABOR PRODUCTIVITY AND WAGE GROWTH SECTOR. 1996-2002 BY .......32 38 FIGURE3.4: DISTRIBUTION WAGES. 1996-2002....................................................... OF 38 FIGURE3.5: EMPLOYMENT PROTECTION LEGISLATION INTHEBALKANS. LATE 1990s.42 FIGURE4.1: COMPARATIVEDOMESTIC CREDIT TO THE PRIVATE SECTOR(% OF GDP) 49 FIGURE4.2: COMPARATIVE INTERESTRATESPREADS (LENDING RATE)........................................................................................................ MINUSTHE DEPOSIT 49 FIGURE4.3: PERCEPTIONSOFTHEBUSINESS CLIMATE. 1999AND 2002 ....................... 59 Boxes Box 1.1:THEDISAPPOINTING PERFORMANCEOFPRIVATIZEDFIRMS............................. 4 BOX 3.1: ASSESSING ACCURACY OF THE LABOR THE FORCE SURVEY........................... BOX 4.1: THEBUSINESS ENVIRONMENT AND ENTERPRISE PERFORMANCESURVEY .....39 52 MAPIBRD28959 EXECUTIVE SUMMARY 1, Reducing the high rates o f unemployment from which the Macedonian economy suffers i s a leading priority o f the Government. The large share o f workmg age population who are inactive or occupying themselves with low productivity, occasional work represents output foregone and income lost. Moreover, the important goal o f sharing the benefits o f growth more equitably between groups and regions proves increasingly elusive when many citizens are trapped inlong-term unemployment, a state closely linkedto household poverty. It seems that the formal job market in the former Yugoslav Republic o f Macedonia (FYR Macedonia) has failed. What actions can and should the Government take to get more people into work? 2. As the authorities strive to solidify peace and stability, accelerate remaining structural reforms, and move policies and institutions towards European norms, the problem o f high unemployment cannot be ignored. Very high levels o f unemployment discourage the authorities from imposing further shocks onthe economy and may add t o the delay o f needed structural reforms. But reform o f labor market institutions and policies i s only one part o f the solution, and not the most important. The Government has limited ability to raise labor demand directly. Overall growth andjob creation by the private sector will be the only long-term solution. 3. The first chapter o f this report' sets out a preliminary strategy for long-term growth. It argues that high unemployment i s primarily an inheritance from the pre-transition era. Growth has been limited since independence by low investment levels, and to remove this constraint, the Government should be focused o n w ays t o improve education, create a supportive investment climate (especially for foreign investment and small and medium enterprises), and accelerate free trade as part o f integration into European markets. 4. The chapter finds that the modest growth achieved during transition must be augmented if unemployment rates are to come down. Such growth will depend on improved export performance on the demand side, requiring supportive government policies favoring openness and accelerated regional integration into European markets. On the supply side, idle and underused labor i s abundant, but the quality o f labor must be improved through heightened human capital (i.e., more effective and useful education and training). Investment rates 1ikely need to rise, indicating the need for the Government to improve the investment climate, with a special focus on foreign investors (who can provide necessary financing, know-how, and market access) and small and medium enterprises (which are most likely to expand quickly and employ risingnumbers o fworkers). 5. Chapter 2 summarizes macroeconomic performance since independence and provides medium-term growth projections. Fostering the sustained labor-intensive growth necessary for widespread job creation will require firm macroeconomic management to maintain stability, flexible labor market institutions and policies, and a favorable investment climate. Macroeconomic management inthis context refers not only to fiscal and monetary policy but also to pursuingpublic sector management reform and to deepening trade liberalization with a focus on integrationwith Europe. 'The World Bank's previous Country Economic Memorandum o n FYR Macedonia was completed in 1998. See World Bank (1998). 6. This second chapter lauds the achievement o f a stable exchange rate since 1997 and inflation kept below 6 percent since 1996. However, the volatility o f growth indicates that some further elements o f stability need to be assured, in particular public sector management reform, while trade liberalization and integration into Europe need to be pushed forward to increase investment flows and export demand, and, thereby, growth. There i s no immediate constraint to faster growth on the supply side: low levels o f capital utilization and the huge pool o f unemployed leave room to boost growth rates if opportunities become available. Presumably real restructuring of the corporate sector will take place as the remaining state-owned companies slated for privatization are sold or closed, as market mechanisms and institutions function properly, and as regional integration and liberalized trade progress via WTO membership and the Stabilization and Association Agreement (SAA) with the European Union. On the other hand, the reemergence o f domestic political instability or the outbreak o f another regional conflict, failure to strengthen the rule o f law and reduce corruption, and lack o f improvement in public services and institutions threaten to severely undermine business confidence and the likelihood o f output expansion, employment growth, andpoverty reduction. 7. The third chapter explores the functioning o f the 1abor market and its institutions and policies with recommendations to improve performance. After a careful analysis o f many sources o f data, the chapter concludes that unemployment, in the sense o f complete inactivity, i s rare. Further, unemployment in FYR Macedonia is not due primarily to labor restructuring during transition, but rather to decades o f insufficient labor demand. It i s predominantly long-term, and the unemployed are mainly young and less-educated. Unpaid work on family farms, petty trade, and other casual employment has cushioned the gradual disintegration o f the formal job market for many Macedonians. 8. The formal labor market has failed to provide jobs, but most Macedonians have found some income-earning activity, falling back on petty trade and casual employment in the absence of better options. Informalemployment i s as common as a formaljob inFYRMacedonia, and the incidence o f informality i s growing, likely driven by evasion o f taxes and regulation. Agriculture has served as a buffer against unemployment, mostly inthe form o f unpaid family work, with low productivity. 9. To reactivate formal labor markets, the report finds that labor institutions and policies are inneed o f further reform. The legal fi-amework for collective bargaining should be brought into line with practice on the ground and with best internationalpractice. Measures need to be taken to expedite labor legal cases, and fiscal resources should probably be shifted fi-om passive to active labor market programs. 10. The final chapter provides an initial assessment o f the investment climate and recommends a set o f actions by the authorities to improve the environment for job creation. This assessment finds that although there are some clear points o f weakness in the business environment, improvements are underway across the board, particularly in the area o f anti- corruption and the rule o f law. The chapter suggests that the main areas o f focus for government attention and urgent action should be: land titling and registration; the establishment o f formal consultation procedures with the private sector; better training o f commercial courtjudges and the establishment o f specialized commercial courts, and continuingthe fight against corruption. .. 11 1. UNEMPLOYMENTAND GROWTH A. INTRODUCTION 1.1 Former Yugoslav Republic o f Macedonia's (FYR Macedonia) main objectives for the next few years include establishing stable higher growth rates, sharing the benefits o f growth more equitably between groups and regions, and moving towards Europe. It i s hoped that implementation o f the peace agreement that ended the ethnic conflict o f 2001 will put that conflict firmly in the past while the Stabilization and Association Agreement, membership in the WTO, growing regional trade ties, and generally improved political and economic links with the rest o f the world (after years o f sanctions and closedborders with neighbors) will pull the country into closer alignment o fpolicies andperformancewith the rest o fEurope. 1.2 Completion o f structural reforms is a key task for the new government (since November 2002), but one made difficult by very high levels o f unemployment which make any government averse to imposing further shocks on the economy.2 Clearly, high unemployment creates economic and social problems that merit a broad and aggressive response by government. Certainly, further reforms o f labor market regulations and institutions to strengthen work incentives and some expansion o f active labor market programs and other interventions will likely help inthe short to mediumterm. But overall growth andjob creation will be the only long-term solution. 1.3 This chapter explores broad pattems o f economic development during transition and sets out a preliminary strategy for long-term growth. Chapter 2 summarizes the key aspects o f macroeconomic performance since independence and presents some conservative medium-term projections. Chapter 3 explores the functioning o f the labor market in detail and the nature o f labor market institutions and policies and provides recommendations for government actions to improve labor market performance. Chapter 4 provides an initial assessment o f the investment climate and recommends a set o f actions by the authorities to improve the environment for job creation. 1.4 This chapter describes the general behavior of growth during transition, noting that although employment growth has been minimal, highunemployment i s primarily an inheritance from the pre-transition era. Part o f the explanation i s that privatized firms have not restructured and are not particularly profitable, so they are not hiring. The modest growth that has been achieved has, not surprisingly, depended heavily on export demand, but has been limited on the supply side by low investment levels. For higher Highunemployment is frequently cited as the primary factor undercutting commitment to reform by the public and the Government (particularly restructuring o f state enterprises and civil service reform, both o f which would contribute further to the ranks o f the unemployed). growth rates into the future, FYR Macedonia should 1ook t o b0thfactor accumulation over the shorter term (given the large numbers o f inactive or unemployed persons, low investment inrecent years, and a still growing population o f working age) as well as total factor productivity over the long term. The Government should be thinking now about ways to improve education, create a supportive investment climate (especially for foreign investment and small and medium enterprises), and accelerate free trade as part o f integration into European markets. B. GROWTH JOBCREATION DURINGTRANSITION AND 1.5 High unemployment is not a novel phenomenon inFYR Macedonia, yet it is one o f the country's most pressing social problems. Almost 20 percent o f the labor force were already registered as unemployed in 1970.By 1991, as FYR Macedonia embarked on independence and transition, and while open unemployment was virtually absent elsewhere in the region, about 24 percent o f the labor force were registered as unemployed. Since then, the situation in the labor market has deteriorated. In the early 2000s, and despite the fact that further enterprise restructuring is yet to come, unemployment inFYRMacedonia was among the highest inCentral and Eastern Europe. This naturally poses questions about the reasons for such high and persistent unemployment. 1.6 The pattern o f real gross domestic product in FYR Macedonia during transition has more or less matched that observed inthe other countries o f Central and Southeastern Europe and the Baltics (see Table 1.1). Output declined for five consecutive years with a cumulative decline o f 21 percent. Real GDP in2000 stood at 91 percent o f 1990 ~utput.~ In addition, FYR Macedonia performed well on initial structural reforms during transition, as measured in EBRD Transition Reports: price liberalization, trade and foreign exchange system liberalization, and small-scale privatization. It scores less well, though, o n second phase reforms, particularly governance and enterprise restructuring, and competition p01icy.~Nevertheless, its comparative progress at structural reforms seems somewhat at odds with the country's record so far o f littlejob creation, worsening income distribution (although distribution remains relatively egalitarian by international standards), stagnant trade patterns, little small and medium enterprise (SME) development, and low foreign investment. 2002 real GDP had fallen to 87 percent o f 1990 output because o f the 2001 domestic conflict and its after effects. See, for example, EBRD (2002), Transition Report 2002: Agriculture and Rural Transition. 2 Table 1.1: The Transition Recession Countries Consecutive years Cumulative output Real GDP, 2000 of output decline decline (percent) (1990 = 100) FYRMacedonia 5 21.2 91.2 Central and SoutheasternEurope andthe Baltics 3.8 22.6 106.5 ofwhich: Albania 3 33 110 Bulgaria 4 16 81 Croatia 4 36 87 Romania 3 21 144 Slovenia 3 14 105 CIS countries 6.5 50.5 62.7 Source: World Bank (2002), "Transition"; Bank staff calculations. 1.7 Employment levels in2002 remain below those of 1990.This poor performance of the labor market since independence seems stark evidence o f the insufficient level and poor quality of economic growth. From Figure 1.1, it can be seen that output dropped more sharply than employment in the first half o f the 199Os, as enterprises resisted shedding labor, thereby depressinglabor productivity. This pattem is also observed inthe Czech Republic, Romania, and many CIS countries. But this avoidance o f painful restructuring early on has dampened any subsequent expansion o f labor demand. The modest but volatile growth achieved since 1996 has generated a cumulative rise in employment o f only 6 percent through 2002 and reduced unemployment only slightly. Figure 1.1: Output and Employment, 1990-2002 100 80 70 , , 1990 1992 1994 1996 1998 2000 2002 Notes: The employment series was constructed from data from the central payments bureau, LFS, enterprise reports, and the NationalAccounts. 2002 is an estimate. Source: Bank staff calculations from various data, State Statistical Office. 3 Fast Privatization but Low Restructuring Has Retarded Private Sector Expansion 1.8 Low employment growth necessarily means insufficient labor demand, in particular from the private sector. For FYR Macedonia, it seems that relatively speedy privatization o f state enterprises has failed to spur recovery o f labor demand. A rapid and far-reaching privatization program started in 1993 and accelerated in 1995 and 1996.By end-1995, privatization was completed for almost half o f the 1,200 or so designated enterprises, with another quarter o f enterprises underway, together accounting for more than 9 0 percent o f the workers inenterprises s lotted for privatization. As a result, the public sector share invalue-added dropped sharply, to about 25 percent of GDP in 2001. Inthe industrial sector, publicly-owned enterprises produce less than 10percent ofvalue- added (andthat is mostly because o f the state-owned electricity company). 1.9 To date, however, the impact o f privatization has been rather disappointing. Despite the shift of employment to private entities, there has been little labor restructuring (discussed further in Chapter 3) and few privatized enterprises became profitable as a result o fthe change intheir ownership structure, most likely because o f the dominance o f insider buy-outs5but also because improper procedures and substantial corruption during the process, discouraging new owners from investing in their new acquisitions because o f uncertainty about property rights. However, firms that are now fully private are performingsomewhat better inrecent years (see Box 1.1). Box 1.1: The Disappointing Performance of Privatized Firms Enterprises showed somewhat improved performance inthe late 1990s but driven by the stronger results o f new private firms. Analysis of the financial accounts o f a sample o f manufacturing fmfindsthatsurvivingfirms(thathavebeeninexistencesince1994)haveundergonelimited restructuring, and their labor productivity in 2000 remained below 1994 levels. The weak record o fthese finw may be attributed at least partly to the predominance o f insider privatization. Gross losses o f the corporate sector have declined (to 5.9 percent o f GDP in 2000) and gross profits improved (to 6.5 percent o f GDP), but they remain l o w by international standards. High entry and exit accounts for part o f this improvement, and this high turnover rate suggests growing efficiency (two-thirds o f the firms operating in 2000 did not exist in 1994). Also, the concentration o f losses in the economy has fallen, indicating some success in dealing with large loss-making enterprises. The recent improvements in performance are due to newly-created firms, rather than surviving older firms. Of surviving firms, those with purely private ownership have outperformed those with mixed, social, or state ownership, and the importance o f private ownership for profitability has grown over time. Source: Zalduendo, IMF (2003). While the privatization law did initially encourage outsider purchase o f enterprise shares, inpractice, most o f the privatized enterprises were sold through preferential share sales to former managers and workers. This kmdof approach to privatization has not worked well elsewhere. For example, Slovenia's experience `internally privatized' enterprises, lacking strategic investors, is that they contribute little to growth. World Bank (2002e), "Transition"). 4 ExportGrowthHas Been the Main Source ofJob Creation 1.10 Not surprisingly for a small economy, foreign demand has a large impact on macroeconomic outcomes. A decomposition of sources o f employment growth from the demand side6 shows that during 1997-2000 (when growth was accelerating), growth in exports (which expanded during the period at a 16 percent annual rate in constant Denar terms) contributed most to the small amount o f job creation that occurred, followed by increases in domestic consumption. These were offset somewhat by rising imports and falling labor productivity, driven at least partly by low levels o f investment. Table 1.2: Decomposition of Employment Growth, 1997-2002 InYO 1997 1998 1999 2000 2001 2002 Average1997-2000 Employment growth -4.7 5.4 1.0 0.8 9.0 -6.3 0.6 of which: Exports 10.7 3.1 2.8 8.1 -5.5 -1.3 6.2 Imports -12.6 -3.8 -0.1 -14.1 6.3 -4.4 -7.7 Consumption 1.9 3.0 3.5 7.6 1.2 4.5 4.0 Investment 1.7 1.2 -1.9 2.7 -5.1 1.9 0.9 Productivity -6.4 1.9 -3.3 -3.5 12.1 -7.0 ' -2.8 Source : Bank staff estimates. InvestmentHas BeenLow 1.11 Growth must be supported by sufficient investment levels, and in FYR Macedonia, investment rates have been moderate overall during transition, averaging around 20 percent of GDP through the 1990s.This rate is well below that o f the most successful transition economies such as the Czech Republic, the Slovak Republic, Hungary, and, more recently, Slovenia, which have hadinvestment ratios o f around 25 to 30 percent of GDP. Further, FYR Macedonia started on transition with a capital stock weakened by a period o f collapsing investment duringthe 1980s. After some recovery in 1995-98, the shocks o f the Kosovo crisis in 1999 and the domestic security crisis in2001 undercut business prospects and investment activity. Chronically low domestic savings, of around 13 percent o f GDP in recent years, makes clear that a substantial portion of investment financingwill likely need to come from abroad. C. A STRATEGYFORLONG-TERMPRO-EMPLOYMENTGROWTH 1.12 Starting with Robert Solow's famous work in the 1 9 5 0 ~growth has been ~ attributed to accumulation o f labor and capital, whose combined impact is augmented by These relationships are capturedby the following decomposition ofthe rate of employment growth: where r denotes the growth rate of employment (E), consumption (C), investments (I), exports (3,imports (M),andproductivity (P),while Qrepresents total output. 5 total factor productivity (TFP).7 Theoretical advances inthe 1980s and 1990s focused on the quality o f labor and capital and interpreted TFP as advances in technology and management. Although increases in physical investment and labor supply certainly will strengthen output growth, and improvements to quality o f both o f these factors will further increase their impact, yet it i s factor accumulation accompanied by rising TFP growth that is seen as creating the largest, most sustainable benefits. 1.13 Government policy has been put forward as an important influence on productivity through effects on innovation, factor returns, and factor quality. The provision o f education can increase the humancapital stock (that is, the effective size o f the labor force is increased by additional education), and basic education i s generally accepted as the first priority for government action. Similarly, government actions to improve the investment climate can stimulate investment. An updated diagram o f economic growth which provides a concise summary o f current thinking on the growth process is Figure 1.2. Figure 1.2: Solow's Three-Legged Stool, Revised J Innovation Tertiary Climate ! " ^ Education I / . L Source: World Bank (2001), "Brazil," p. 4 1.14 Transition countries face the additional challenges o f adjusting existing production structures and allocations o f capital and labor to radically changed relative prices and incentives. The imposition o f market discipline and the encouragement o f new enterprises have proved to be central aspects o f successful transition strategies and a return to growth, by accelerating the necessary reallocation o f factors.' One difficulty in trying to understand growth in transition economies is the need to separate the effect o f Total factor productivity i s that part o f growththat cannot be attributed to increases incapital or labor inputs. 8World Bank (2001); also, Boeri and Terrell (2002), "Institutional Determinants o f Labor Reallocation in Transition," Journal of Economic Perspectives, 1612. 6 reallocation from accumulation andt echnological progress, since the two are 1ikely t o occur simultaneously. Total Factor Productivity Drove the Modest Growth of the 1990s 1.15 Growth accounting exercises for transition countries argue that it is productivity, not factor accumulation, that drove growth in the 1990s. In general, TFP rates fell even more than factor accumulation rates, especially at the beginning o f transition, and then recovered rapidly. Further decomposition reveals that sectoral shifts were the driving source of productivity im rovements-that is, reallocation o f factors from lower to higher productivity sectors. r 1.16 Using a standard growth accounting framework decomposing GDP growth into growth o f factor inputs and a residual, total factor productivity, reveals that in FYR Macedonia, as elsewhere during transition, total factor productivity hadthe largest impact on overall growth, but a slowly shrinking capital stock undermined those gains. During the recessionary years o f 1991-96, total factor productivity fell sharply, by an average 1.7 percent each year. The recovery period, 1997-2000, witnessed a strong reversal, as TFP growth contributed 2.4 percentage points to GDP growth. Employment also recovered to some extent, but investment rates remained too low to sustain the capital stock. At a sectoral level, as would be expected, productivity growth i s concentrated in tradable sectors (particularly manufacturing, construction, and transport) as well as sectors undergoingrapid development such as banking. Table 1.3: Resultsof GrowthAccounting, 1991-2000 Average growthrates Impact on growth InYO 1991-96 1997-2000 1991-96 1997-2000 GDP -3.6 3.4 Capital Stock -1.6 -1.1 -0.6 -0.4 HumanCapital -2.1 2.4 -1.3 1.5 Total Factor Productivitv -1.7 2.4 -1.7 2.4 Notes: Following the techniques suggested in Doyle (2001) and Ghosh and Kraay (2000), and after sensitivity analysis of the results, these calculationsassume that the capital-outputratio was 2 in 1990, depreciationis 9 percent, and the share of capital inproductionis 0.4. Source : Bank staff calculations. 1.17 Looking beyond transition, that is, as the gains from reallocation dissipate, long term growth will need to be generated from the "three-legged stool" o f Figure 1.2. The average rate o f TFP growth estimated above for FYR Macedonia during 1997-2000 exceeds what i s generally considered to be the sustainable long-term rate, based on international experience, o f about 1.2 to 1.3 percent per year. However, for transition and developing countries, productivity growth may well remain well above those rates as income converges to the level o f richer economies. This presumed stimulus o f income Campos and Coricelli (2002), "Growth in Transition: What We Know, What We Don't, and What We Should," Journal of Economic Literature, September. 7 convergence to total factor productivity as an economy approaches a steady state has beenused to predict long-term growthfor a number o f transition countries. 1.18 The predicted dominance o f factor accumulation or total factor productivity in growth is based on historical evidence from Europe and Asia during 1950-75. For Westem Europe and Japan, total factor productivitydominated, while increased factor inputs drove East Asian growth. The dominance o f productivity in growth performance appears to be related to: higher initial income levels (which limit the role for factor accumulation), flatter demographic trends (which set limits for expansion of the labor force); higher initial quality o f the labor force (as measured by average years o f education); and stronger market institutions rather than the state in the economy." On these aspects, FYRMacedonia likely stands to gain from both sources o f growth. 1.19 The gains from total factor productivity growth could be dramatic. Estimates o f potential growth rates for TFP, using a methodology developed by Benhabib and Spiegel (1994) and applied to some transition economies by Doyle, et. al. (2001), can set an upper bound for overall growth projections for FYR Macedonia. Empirical research has identified the role o f the income gap and the level o f education (as an indicator o f human capital) in the process o f income convergence. This approach yields very optimistic potential TFP growth for FYR Macedonia over the next decade o f 3.5 percent. When combined with predicted growth o f the labor force approaching 2 percent, per capita income could grow by as much as 7.5 percent (or more than 8 percent GDP growth). But these results assume that the c apital t o output ratio will be held steady, which for the scenario below, would require investment rates to rise to 30 percent o f GDP, a challengingprospect that maynot be attainable. 1.20 Inaddition to very high investment demands, the scenario above does not factor in the especially poor quality of education in FYR Macedonia." Dramatic gains in productivity and growth rates will demand better quality education for the work force. FYR Macedonia needs to build a system o f education that lays the foundations for lifelong leaming and that develops the capacity for innovative thinking, focusing on general competencies and skills that will improve employability and the ability to adjust to shifting labor market demand. Inparticular, the quality o f primary education needs to be improved for all, not only for the urban population and for the more prosperous regions. Moreover, secondary education should especially provide skills and tools for lifelong leaming to a larger group o f the population. Within the curriculum, focus on general knowledge areas needs to be strengthened, and occupation-based vocational training should be delayed to post-secondary level. Inthe meantime, post-secondary and 10 ''See Doyle, et. al. (2001). International assessments show that the quality o fprimary education inFYR Macedonia has declined during the recent decade to one o f the worst inEurope, especially due to increasing variance between the worst and best performing schools and regions. These results come from two assessments undertakenby the International Association for the Evaluation o f Educational Achievement: (i) 1999 Trends in the International Mathematics and Science Study (undertaken every 4 years since 1995 - the 1999 study assessed 8th grade students' math and science knowledge in38 countries), and (ii) Progress in the International Reading Literacy Study (runfor the first time in2001, assessing 4th grade students' reading achievement in35 countries). 8 tertiary education needs to be diversified interms o f the lengtho f studies, programs, and providers. 1.21 A more likely scenario, considering human capital limitations as described above and investment constraints, suggests growth rates o f 4 to 5 percent, and this i s the scenario used for the mediumterm projections o f Chapter 2. Using a more conservative model o f medium-term growth prospects, also based on income convergence theory but adjusting for the presence of supportive economic policies, the range of growth rates possible for FYR Macedonia are a more modest 4 to 5 percent, and these depend on maintaining investment at 24 percent of GDP.12 Such growth will also require regional political stability. Table 1.4: Projected TFP Growth Rates for FYRMacedonia and Others Average Projected Projected labor years of Income gap TFP growth force growth schooling with U S (in%) (in%) FYR Macedonia 7 5.6 3.5 1.8 Lithuania 12 4.6 4.2 0.2 Latvia 12 4.6 4.5 -0.4 Estonia 13 3.2 3.4 -0.2 Poland 9.5 3.8 3.O 0.2 Czech Republic 9.1 2.5 1.9 -0.4 HwwY 8.9 2.9 2.2 -0.6 Slovak Republic 9.1 3.2 2.5 0.4 Slovenia 9.2 2.1 1.7 -0.1 Source:FYR Macedonia from Bank staff calculations; Lithuania, Latvia, Estonia from World Bank (2002), "Lithuania: CEM", Poland, Czech Republic, Hungary, Slovak Republic, and Slovenia from Doyle (2001). 1.22 For FYR Macedonia to aspire towards these potentially high rates o f growth of total factor productivity and the accompanying highrates o f investment, the country will need to focus fully on improving the climate for inve~tment,'~especially foreign investment. As discussed below, foreign direct investment is generally accepted as a crucial engine for job creation, providing access to technical, managerial, and organizational know-how, and thereby contributing to economic development beyond the capital infusion it represents. Low Foreign DirectInvestment is Reducingthe Potential for Job Creation 1.23 Experience in other transition economies and in the developing world points to the importance o f foreign direct investment in energizing growth rates. Not surprisingly, foreign investment flows into FYR Macedonia have been modest through 2002, with a cumulativeper c apita t otal o f USS4 51s ince 1990. This 1eve1is c lose t o the regional average for South Eastem Europe (see Table 1.5) but only a fraction o f the levels achieved by the more successful transition economies of Central Europe. A large privatization in 2001 i s responsible for almost doubling the per capita inflow l2IMF(2003). l3 issueisdealt This withmore fully inChapter 4. 9 (the monopoly telecommunications company was sold), but nevertheless, overall Macedonian performance in attracting foreign direct investment remains poor. These modest flows, driven by large scale privatization in a few sectors like banking, are unlikely to provide much in the way o f enhancing competitiveness by transferring technology and skills. Table 1.5: Foreign Direct Investment to Transition Economies of Europe and Central Asia Cumulative FDIinflows Cumulative FDIinflows per 1990-2002 capita 1990-2002 FYR Macedonia 919 451 South Eastern Europe 25,407 464 Central Europe and the Baltics 127,830 1,737 Commonwealth o f Independent 43,999 157 States All Europe and CentralAsia 198,155 483 Source: ECA regionaltables, World Bank. 1.24 FDI in other transition economies has come largely from richer neighboring countries. However, FYR Macedonia's relations with its most developed neighbor, Greece, were blocked until 1995 due to a political dispute over the name o f the country. As a result, the share o f foreign-controlled companies i s limited, accounting for only 10 percent o f worker^.'^ to 15 percent o f total value-added in the economy in 2001 and employing less than 5 1.25 The scope for attracting more FDIinFYR Macedonia i s not negligible, however. Real effective exchange rates have slowed down since the 1997 devaluation and wage labor costs are actually in line or lower than in other countries in the region (Table 1.6) (although productivity is, o f course, another crucial dimension). All these indicators indicate that the external competitiveness o f the Macedonian economy is adequate, and this shouldbe apositive sign for foreign investors. 14Foreign ownership i s important in the telecommunications services as a result of the sale o f the mobile and fixed line operators. It i s also present insubstantial amount in the financial sector, with 44 percent ownership overall o f the banking sector. 10 Table 1.6: Wages for FYR Macedonia and Others, Average for 2000-2001 Monthly Gross Wages (inUS$) Former SR Yugoslavia Bosnia andHerzegovina 303 Croatia 684 FYR Macedonia 268 Serbia and Montenegro 156 Slovenia 986 Other transition economies Bulgaria 144 Czech Republic 483 Hungary 445 Poland 554 Romania 187 Slovakia 336 Average 413 Source:IMF. More SuccessfulSME DevelopmentWould HelpSpur Demandfor Labor 1.26 Competitiveness and productivity are also spurred in transition economies by small and medium sized enterprises, which tend to be new enterprises. These firms have been central to the successful return to growth in countries such as the Czech Republic, Hungary, and Poland as well as the reduction o f unemployment levels. SMEs in FYR Macedonia were founded in substantial numbers early in the transition, but by the mid- 1990s, the country lagged behind its neighbors in numbers, with only 9.1 SMEs per thousand inhabitants" compared with 45 per 1000 people inthe EU and between 20 and 24 per 1000 people in other transition countries such as Poland, Hungary, or the Czech Republic. Most S MEs inFYRMacedonia have remained small, single proprietorships employing less than 50 persons, and most remain self-financed. 1.27 The creation o f a favorable environment for SMEs is one o f the most important aspects o f a pro-employment growth strategy. High payroll taxes and social security contributions, which increase the cost o f labor, are often a particularly acute problem for SMEs, which may choose to remain informal instead, thereby limiting their potential for growth. These t axes are 1ower in FYRMacedonia than other countries inEurope and Central Asia, with social contributions set at 32 percent o f gross wage. (See Figure 1.3.) Further, a recent survey o f SMEs found that employment legislation was among the most important problems for small entrepreneurs (see Chapter 4). l5According to Acevska, et. al. (2001). 11 Figure1.3 Social ContributionsinEurope and CentralAsia Belarus Tajikistan Armenia FYR Macedonia Estonia Lithuania Poland Russia Kazakhstan Uzbekistan 0 K Y W Z Latvia 80 0 Slovenia Moldova 83910 Croatia > 1 3 9 2 Lkraine I 140 0 Turkmenistan I 140 0 Georgia t ill0 BosniaBulgaria )_L Rep Sr i l112 l 2 7 Bosnia Fed BIH I 1450 Albania c i45 9 Czech Republic j i17 5 Hungar) j j 1150 8 5 Slobakia 0 Romania 1_ 160 0 0 5 10 15 20 25 30 35 40 45 50 5 5 60 65 YOof gross \\age Note: Year i s 2000 for Czech Republic, Hungary, Estonia, and Slovenia; mid-1990s for Belarus, Georgia, Latvia, Moldova, Turkmenistan, and Uzbekistan. D.POLICYCONCLUSIONS 1.28 The modest growth achieved during transition must be augmented if unemployment rates are t o c ome down. Such growth w illdependonimproved export performance on the demand side, requiring supportive government policies favoring openness and accelerated regional integration into European markets. On the supply side, idle and underusedlabor i s abundant, but the quality o f labor must be improved through heightened human capital (ie., more effective and useful education and training). Investmentrates likely need to rise, indicating the need for the Government to improve the investment climate, with a special focus on foreign investors (who can provide necessary financing, know-how, and market access) and small and medium enterprises (which are most likely to expand quickly and employ risingnumbers o f workers). 12 2. MACROECONOMIC PERFORMANCEAND MEDIUM-TERMPROSPECTS A. INTRODUCTION 2.1 Sustained labor-intensive growth will be the key to job creation and the resolution o f the unemployment problem over the medium-term. Such growth will require firm macroeconomic management to maintain stability, flexible labor market institutions and policies, and a favorable investment climate. Macroeconomic management inthis context refers not only to containing inflation through appropriate fiscal and monetary policy but also to pursuing public sector management reform that will relieve eventually fiscal pressures and improve government performance, and t o deepening trade 1iberalization, broadly defined, with a focus on integrationwith Europe. Further, since the exchange rate has been pegged to the Euro, a successful strategy to contain inflation, flexibility o f the economy to preserve competitiveness inthe fact o f shocks must come primarily fiom the flexibility o f labor markets (a topic taken up by Chapter 3). 2.2 A cursory examination o f the main macroeconomic aggregates and social indicators in FYR Macedonia a decade after the start o f transition reveals a broadly disappointing pattem o f development. Output remains below the level o f the early 1 9 9 0 ' ~ ~ the unemployment rate i s apparently among the highest in Europe, and poverty i s on the rise. But a closer consideration o f the country's weak starting point and the number o f shocks-external and domestic-that the country has weathered could lead one to the contrasting conclusion that the Macedonian economy is surprisingly resilient. Inthe early 1990s, during the last days while still a part o f the Socialist Federal Republic o f Yugoslavia (SFRYugoslavia), the economy was heading towards collapse. After gaining independence, the country and its already battered economy were challenged numerous times by closed borders, regional unrest, and domestic conflict as well as droughts and the vagaries o f foreign demand.I6 2.3 The key challenge to the authorities inthe near future will be to secure peace and stability, the centerpiece o f which i s the implementation o f the Peace Framework Agreement that ended the 2001 civil conflict. Progress has been made on a number o f aspects o f strengthening minority rights - the main focus o f the Agreement, and the intemational community continues to provide encouragement and support. It i s important that the Agreement be implemented as soon as practical, so that the authorities can tum their attentiontowards the longer term project o f integration into Europeanmarkets. The Stabilization and Association Process that was launched in 2001 between FYR l6 FYR Macedonia faces particularly volatile demand because its two main exports are iron and steel (vulnerable to foreign anti-dumping actions) and textiles (contracts for processing tend to come in waves), both o f which are strongly affected by developments inworld markets. 13 Macedonia and the European Union, along with membership in the WTO (as o f April 2003), promise to bring the country improved access to markets and capital, heightened competitive pressures at home, and growing involvement in regional, European, and international institutions and structures. 2.4 This chapter discusses macroeconomic developments and the quality o f macroeconomic management in FYR Macedonia so far during transition, with an emphasis on improving fiscal and trade policies; and then, in light o f the requirements o f fiscal and debt sustainability, the chapter presents medium-termprojections o f achievable growth (following onfrom the discussions o f growthpotential inChapter 1) that w ill underpinthe expansionofemployment over the next few years. B. MACROECONOMIC DEVELOPMENTS 2.5 Initial conditions. FYR Macedonia was the least developed o f the republics o f SFR Yugoslavia, accounting for roughly 5 percent o f output and 7 percent o f total population. The Macedonian economy was well integrated with those o f the other republics and depended heavily on the overall performance o f the Yugoslav economy which had fallen into deep recession in the mid-l980s, including high rates o f unemployment. Among the republics and provinces, only Kosovo recorded a higher unemployment rate than FYRMacedonia, and, inthe absence o f new investmentsandjob creation, the unemployment problem was partly alleviated through encouragement o f temporary foreign work and immigration. At independence, the Macedonian economy had been contracting for more than six years and unemployment stood at about 24 percent. 2.6 Early transition. Extreme macroeconomic instability reduced output by about 19 percent between 1991 and 1993. Depressed economic activity together with price liberali~ation'~ to record levels of inflation, averaging about 820 percent per annum. led A rapid depreciation (of around 6,000 percent) accompanied the introduction o f the Macedonian denar (the newly established domestic currency which replaced the Yugoslav dinar in April 1992). The monetary authorities tried to control inflation by fixing the exchange rate to a basket o f seven currencies. However, pressure on reserves pushedthe authorities towards a floating exchange rate (although it is run as a managed peg), introduced in May 1993. During 1991-1993, the local currency had depreciated by more than 38,000 percent. 2.7 The loss o f most o f its domestic market and its trade links to traditional foreign buyers, the international embargo against its major trading partner, Serbia and Montenegro, and the inability to secure new markets for Macedonian products resulted in deteriorating exports. Unlike more successful transition economies that saw massive inflows o f investment and capital from developed neighbor countries, FYR Macedonia's relations with its only high income neighbor, Greece, were blocked until 1995 over a political dispute regarding the country's name. Overall regional instability, and other administrative and political barriers deterred foreigners as well as locals from investingin " Most prices were set freely by 1993, except those for energy, basic necessities, and transport, communications and public utilities. 14 the country. With its northern and southern transport routes blocked for formal economic transactions, finding alternative routes created additional costs, thus discouraging trade and investment. 2.8 Fiscal outcomes deteriorated quickly as 1ower e conomic activity translated into lower budget revenues in an economy that had traditionally relied heavily on state transfers and subsidies. The inherited tax system, despite implementation o f measures to improve collection, was unable to ensure the collection o f the needed revenues. At the same time, the inflexible composition o f the expenditure side o f the budget led to a surge in expenditures. During 1991-93, revenues increased only slightly, while surging expenditures pushedthe fiscal deficit above 13 percent o f GDP in 1993 (see Table 2.1). Table 2.1: Selected Economic Indicators, 1991-1994 1991 1992 1993 1994 (in%) Gross Domestic Product -6.2 -6.6 -7.5 -1.8 Inflation 115 1,691 350 122 (in%ofGDP) Fiscal Balance ... -9.8 -13.4 -2.7 Revenues ... 39.3 40.2 43.1 Expenditures ... 49.1 53.6 45.8 Current Account ... ... -3.2 -7.8 Foreign Direct Investment 0.0 0.0 0.0 0.7 Gross Domestic Investment 17.2 15.6 17.9 15.5 Source: National Bank o f Macedonia, State Statistical Office, and Ministryof Finance. 2.9 The unemployment rate, already among the highest in Europe, continued to drift upwards in the early transition years as it had for the previous few decades. But in contrast to the rapid restructuring o f enterprises that occurred in the most successful transition economies, FYR Macedonia did not begin privatization until late 1993." The existing management structures, comprised o f workers councils and government appointees, were not interested in 'restructuring' which usuallymeant labor-shedding. T h e R o a d to Macroeconomic Stability 2.10 Stabilization. In 1994, the authorities embarked upon a stabilization program, bringinginflation down to single digit levels by 1996, and squeezing the fiscal deficit to about 1percent of GDP through sharp cuts intransfers and subsidies and rescheduling o f external debt. Relative st ability inthe region and improvedrelations with its southern neighbor, Greece, eased access to markets and facilitated the first entries o f foreign investment. Privatization and other structural reforms accelerated, and, in 1996, two years '*Previous attempts to privatize enterprises inSFR Yugoslavia, the so-called "Markovich Law" from 1989 was abolished by the Macedonian Government in 1992. 15 after the initiation o f the stabilization program, the country registered its first modest but positive growth rate since 1986 (see Table 2.2). Table 2.2: Selected Economic Indicators, 1994-2000 1994 1995 1996 1997 1998 1999 2000 (in%) Gross Domestic Product -1.8 -1.1 1.2 1.4 3.4 4.3 4.5 Inflation 122 16 3 4 1 -1 6 (inYOofGDP) Fiscal Balance -2.7 -0.7 -1.4 -0.4 -1.7 0.0 2.5 Revenues 43.1 38.3 35.7 34.8 33.3 35.4 36.6 Expenditures 45.8 39.0 37.1 35.1 35.0 35.4 34.1 Current Account -7.8 -6.7 -7.7 -7.7 -7.5 -0.9 -2.1 Foreign Direct Investment 0.7 0.2 0.3 0.4 3.3 0.9 4.9 Gross Domestic Investment 15.5 20.8 20.1 21.0 22.3 19.7 21.4 Source: National Bank of Macedonia, State Statistical Office, and Ministry o f Finance. 2.1 1 The pace of economic growth picked up over the next couple o f years, price stability was preserved, and close to fiscal balance was achieved in 1997. Growing pressures on the balance o f payments were countered by a 16 percent devaluation of the denar in July 1997. Real appreciation o f the de-facto fixed exchange rate had driven the current account deficit to near 8 percent o f GDP, and the depreciation was needed to spur imports (which jumped by 8 and 7 percent indollar terms in 1997 and 1998 respectively). But the overall supply response was weak: the lack o f restructuring by enterprises, since privatization was mainly through employee and management buy-outs, set limits to recovery. 2.12 Crisis. In early 1999, an influx o f 300,000 ethnic Albanian refugees from neighboring Kosovo (the equivalent o f 15 percent o f the population o f FYR Macedonia) strainedthe scarce financial and administrative resources o fthe authorities and threatened to undermine the extremely fragile ethnic balance o f the country. Economic activity fell sharply, with double-digit rates o f decline o f industrial production, and severe deterioration of the fiscal balance because o f depressed revenues and surging security and refugee-related expenditures. 2.13 However, the swift resolution o f the crisis and the return of most o f the refugees soon afterwards, provideda strong stimulus for the Macedonian economy. Higher exports and consumption resulted ina 4.3 percent growth rate for the economy. Donor aid helped close the fiscal gap, allowing for a balanced budget with both revenues and expenditures equaling 35.4 percent o f GDP. The current account deficit fell to just below 1percent of GDP as official and private transfers surged. The factors buoying growth in 1999 were temporary innature (e.g., goods and services to support reconstruction in Kosovo) while the negative impacts on investment and exports could be expected to linger. Most o f the planned foreign investment for 1999 did not materialize, while overall investment fell markedly. 16 2.14 Return to growth. The positive developments in the second half o f 1999 continued into 2000. Exports recoveredto their 1998 level, investment bounced back, and the economy registered the highest growth rate since independence (4.5 percent). Macroeconomic stability was preserved with low inflation, a stable exchange rate, and a substantial fiscal surplus. Large private transfers in 2000 moderated the current account deficit, despite a one time import spike prior to the introduction o f the VAT. Inaddition, the authorities returnedto their program o f structural reforms that hadbeenstalled during the crisis. 2.15 Overall, in the 1995-2000 period, the economy grew by 16 percent, with the industrial sector taking the lead with a 27 percent growth, driven by revival o f the iron and s tee1industry and t extiles, which underwent deep restructuring. S ervices followed with a 14 percent growth rate (mostly under the influence of the developing telecommunication and transport sector) while output in agriculture grew by 6 percent (see Figure2.1). Figure 2.1: Value Added by Sectors, 1990-2002 90 , 1 ..Agriculture -Industry -- "Private" Services - - - ."Public" Services Notes: "Private" services includes transportation, trade, dwellings, banking, personal services, and catering and tourism. "public" services includes public administration, health, and education. Source: National Accounts, State Statistical Office. 2.16 Despite the improved economic performance, new jobs were not created. The unemployment rate" increased sharply in 1997 to 36 percent before gradually declining to slightly above 32 percent in 2000. At the same time, despite rapid privatization, the transformed enterprise sector continued to generate losses, while the newly emerging private sector was too small and fragmented to take the lead. Investments remained inadequate as domestic savingsremained low and foreign capital rare. In 1996, a Labor Force Survey was conducted for the first time. Previous data on employment and unemployment are based on administrative sources (registered unemployed, annual accounts of enterprises) with deteriorating coverage as transitionhas progressed. 17 Security Crisis and Post-Conflict Recovery 2.17 The strong performance o f the country in 2000 left it well placed for 2001, with expected growth o f 5-6 percent per annum over the medium term. This scenario was disrupted by the ethnic Albanian insurgency in2001. Direct damages o f the conflict have been estimated at around 2 percent o f GDP; but the economic impact o f the six-month conflict was much greater - instead o f GDP growth o f 6 percent, output contracted by 4.5 percent. Investment activity dropped by around 15 percent, and private consumption fell by close to 9 percent. Inaddition, the fiscal and external deficits widened significantly as security related expenditures surged and exports and transfers plummeted due to uncertainty and cancellationo f contracts (see Table 2.3). Table 2.3: Selected Economic Indicators: 2000-2002 2000 2001 2002 (in YO) Gross Domestic Product 4.5 -4.5 0.7 Inflation 6 6 2 (in % of GDP) FiscalBalance 2.5 -6.3 -5.7 Revenues 36.6 34.4 36.1 Expenditures 34.1 40.8 41.8 CurrentAccount -2.1 -6.8 -8.7 ForeignDirectInvestment 4.9 12.9 2.1 Gross Domestic Investment 21.4 18.3 21.9 Source: National Bank of Macedonia, State Statistical OfficeandMinistry ofFinance. 2.18 Unemployment, measured by the Labor Force Survey, fell to 30.5 percent but mostly due to seasonal effects2' and temporary hiring o f military reservists. Employment data from the national accounts show a reduction in employment of around 2 percent in 2001. 2.19 The recovery o f the economy was slower than expected in 2002. Investments remained sluggish (increasing by only 1.1 percent), while higher private consumption was offset by depressed exports and surgingimports. The economy expanded by only 0.7 percent, reflecting to some extent the ongoing impact o f the 2001 conflict on investment and exports. The fiscal deficit remained exceptionally high (5.6 percent o f GDP), partly because o f ongoing security needs but mostly because o f a spending spree in the run-up to the September 2002 Parliamentary elections. The failure o f exports to recover drove a worsening current account deficit, moving from -6.8 percent o f GDP in 2001 to -8.7 percent in2002. *'In 2001, the LFS was conducted in September rather than in April. Agricultural harvesting activities biasedthe results, which showed a highjump inemployment inagriculture. 18 C.MAINTAINING STABILITY THROUGH FISCALREFORM*^ 2.20 Duringthe mid-l990s, the country achieved remarkable fiscal improvement, but the quality o f fiscal adjustment was low. The country managed to reduce the general govemment22deficit from over 13 percent o f GDP in 1992 to near balance in 1997. Most o f the fiscal adjustment o f the mid-1990s was accomplishedthrough cuts inexpenditures. From 1994-97, reductions in subsidies, capital expenditures, and pension payments accounted for over half of the total expenditure cuts. Lower interest payments after the restructuring o f external debt in 1995 and 1996 also contributed significantly. The quality o f expenditures had become an important issue by the late 1990s. Although acceptable aggregate targets were being achieved, the budget's economic composition remained ill- suited for promoting economic growth and fiscal pressures accumulated. The discretionary component fell to around 15 percent of the Budget. Essentially, short-term fixes were chosen over comprehensive reforms in social protection, health, education, and civil service management. 2.21 The inflexibility o f the budgetwas revealed during the 1999 Kosovo crisis, when the authorities found themselves unable to shift priorities in spending. The outcome was an 8 percent increase in expenditures, threatening fiscal sustainability. Thanks to better- than expected economic performance in the second half o f 1999 and in 2000 as well as inflows o f foreign assistance ( 1.3 percent of GDP in 1999 and 1.4 percent o f GDP in 2000), the 1999 budget remained balanced while a substantial surplus o f 2.5 percent of GDPwas registered in2000. 2.22 Despite the experience o f budget adjustment from 1999, the fiscal balance was seriously threatened again in 2001. Security related expenditures surged (reaching above 10 percent o f GDP) while the 4.5 percent drop in output considerably reduced revenues. Instead of shifting resources from lower priority activities, the 18 percent increase in expenditures was countered by an increase inthe tax burden(through the introduction o f a tax on all financial tran~action).~~Despite the extra revenue, the fiscal deficit ballooned to -6.3 percent o f GDP which was coveredby spendingofprivatization receipts. 2.23 Developments in2002 as parliamentary elections approached highlighted the lack o f transparency and accountability inthe Budget execution process. Contrary to planned consolidation o f the budget, irresponsible government policies (including misconduct in public procurement, and implementation o f various economically unsound policies) kept the deficit at 5.7 percent o f GDP. Actual spending in2002 exceeded that projected at the 21This sectiondraws onthe findings ofthe 2002 World Bank Public Expenditure andInstitutional Survey. 22 The General Government in the country consists o f three levels: (i) government; (ii) central local government and (iii) extra-budgetary finds. Inthe early 199O's, inits efforts to consolidate the fiscal stance, the Government shifted from a relatively decentralized to a highly centralized structure with the local government accounting for around 1.5 percent of total general government revenues and expenditures. However, this change will need to be reversed as decentralization i s one o f the main components o f the 2001 PFA. 23Introduced on July 1, 2001, the Tax on Financial Transactions was levied o n all transaction between legal entities that were carried out through the payment system. The tax was set at 0.5 percent o f the value of the transactions and raised around 2 percent o f GDP in revenues in 2001. However, it also increased the volume of unregistered transactions, as enterprises and individuals tried to evade payment. 19 start o f the year by 14 percent. The extent o f overspending was not discovered until after elections, at which point the Parliament had little choice but to approve a supplementary budget. The 2003 Budget projects a reduction inthe deficit to around -2.0 o f GDP to be achieved primarily by expenditure cuts and slight modification to the taxation framework (abolishing the financial transaction tax and amending the V A T rates). The budget balance i s expected to returnto the stabilizing levels o f -0.5 percent o f GDP by 2005. 2.24 The reduction o f formal sector employment during the 1990's significantly worsened the revenues side o f the extra-budgetary funds (the Employment Fund which provides unemployment insurance, the Pension Fund, the Health Insurance Fund, and the Road Fund) because the primary method o f financing o f t hese institutions (except the Road Fund) has been payroll contributions. At the same time, rising unemployment, the generous social security net and early retirement and lay-offs due to implementation o f structural reforms resulted in a surge in expenditures. Despite measures to improve the financial viability o f the funds (by increasingthe contribution rate, reducing coverage and indexation, and other measures.), the funds continued to post losses that had to be coveredby growing transfers from the Central G~vernment.~~ 2.25 FYRMacedonia's fiscal burden(general govemment expenditure as a share of GDP) is lower than those o f other countries in transition, equaling around 35 percent of GDP on average during the last five years. Its structure is broadly in line with that o f other transition economies, with sales taxes (VAT and excises) comprising the major source o f revenue. At below 17 percent o f GDP, taxes and contributions on employment as a share o f GDP are below levels elsewhere, and they have been declining although this i s mostly because o f shrinking formal sector employment rather than lower labor costs. On the other hand, import duties comprise a much larger source o f revenues, reflecting the highdegree o f openness o fthe country to international trade. 2.26 Even though expenditures overall are lower compared to other economies in transition, the Macedonian Government spends more on personnel and less on investment. Overall government consumption is below average, but expenditures for personnel are relatively high, reflecting 1arge public s ector employment. This problem may get worse because personnel expenditures are facing increased pressures from the 2001 Peace Framework Agreement which requires hiringo f minorities into the public administration. At the same time, capital expenditures are only half the level o f other transition economies and likely insufficient to replace the gradually deteriorating public infrastructure. Subsidies and transfers, including social transfers, are considerably lower compared to other transition economies as they, together with capital expenditures, took the primaryburdeno fthe fiscal adjustmentinthe mid 1990s (see Table 2.4). 24 For example, unless the current system o f providing free health insurance to the registered unemployed without sufficient mechanisms for monitoring and control is amended, to enable better enforcement o f work testing and collection o f contributions from the informal sector, the transfers from the Budget to the Employment Fundto pay for health insurance contributions for the registered unemployed will tend to rise as employment inthe formal sector declines. 20 Table 2.4: FiscalStructureof EconomiesinTransition, Average for 1997-2001 FYRMacedonia Bulgaria Czech R. Estonia Hungary Latvia Lithuania Poland Romania Slovak R. SloveniaAverage (in %ofGDP) Total Revenue & Grants 34.9 38.3 39.5 38.2 44.7 37.9 32.0 41.5 31.4 38.4 43.0 38.2 Total Revenue 34.4 37.5 39.4 37.9 44.6 38.3 31.9 41.7 32.4 38.4 43.0 38.1 Tax revenue 32.0 29.2 36.4 33.7 37.5 32.5 30.0 35.0 28.3 33.3 40.1 33.5 ---- domestic taxes on income & profit: 5.5 8.1 8.8 9.7 9.1 8.2 8.8 8.8 6.9 8.0 7.7 8.1 social security taxes 11.2 7.6 14.8 10.6 11.8 10.2 7.7 11.8 9.7 12.7 13.8 11.1 taxes on g & s 11.3 11.2 11.6 12.9 14.1 12.6 12.4 12.0 9.2 10.8 15.0 12.1 taxes on intl trade 3.3 1.3 0.7 0.0 1.3 0.5 0.5 1.0 1.3 1.3 1.3 1.1 - other taxes 0.8 1.0 0.6 0.5 1.3 1.1 0.6 1.5 1.2 0.6 2.3 1.0 Nontax revenue 2.2 7.8 2.6 3.4 6.0 5.1 1.8 6.0 3.5 4.4 2.6 4.1 Capital Revenue 0.1 0.5 0.5 0.9 1.1 0.7 0.1 0.6 0.6 0.7 0.2 0.5 Grants 0.6 0.8 0.0 0.3 0.1 -0.5 0.1 -0.2 -1.0 0.0 0.1 0.0 Total Exuenditures 36.1 36.6 41.3 37.3 48.5 39.7 34.3 43.3 34.5 42.1 44.0 39.8 Current Expenditure 33.5 34.3 37.3 34.8 43.3 35.3 31.4 41.5 31.3 36.8 39.5 36.3 Wages & salaries 8.0 6.1 3.8 6.8 9.1 8.2 8.9 8.3 5.5 6.4 9.8 7.4 Goods & services 4.3 9.8 4.8 12.6 7.4 8.4 10.0 9.0 7.2 5.0 8.4 7.9 Interestpayments 1.8 4.8 1.1 0.4 7.2 1.0 1.4 3.1 3.9 2.8 1.4 2.6 Subsidies & curr transfers 14.6 13.5 27.6 14.9 19.6 17.7 11.1 21.1 13.7 22.6 20.0 17.9 Capital Expenditure 2.3 3.9 5.5 4.0 6.7 3.9 3.5 3.3 4.1 5.4 4.6 4.3 Overall Deficit /Surdus -1.2 1.7 -1.8 0.9 -3.8 -1.8 -2.3 -1.8 -3.1 -3.7 -1.0 -1.6 Source: ECA Regional Govemment Finance Database, World Bank. 2.27 Fiscal management will not get any easier unless public sector management reform i s pursued. This agenda must address the following key issues. Budgetpreparation and execution processes are disjointed and provide a weak link between policy commitments and available resources. Capacity at the center, although improving, remains weak. The central agencies that play a key role in coordinating policies and proposals lack strategic focus and coordination. Severe under-staffing in critical central agencies and over-employment in others has only recently begunto be addressed. Policy volatility undermines the credibility o f the Government, hampers growth and slashes confidence in public institutions. Absence o f performance measurement and evaluation mechanisms, combined with a large degree o f politicization, produce chronic organizational instability and persistent personal insecurity among employees. In addition, the issues o f transparency and accountability were barely addressed until recently. Internal Audit remains underdeveloped, while the State Audit Office does not have the capacity to regularly and effectively audit the entire public sector. D.SPURRINGGROWTH THROUGH TRADELIBERALIZATION REGIONAL AND INTEGRATION 2.28 With the signing o f a S A A with the EU in 2001, FYR Macedonia has started moving down the path o f integration into the single European market. While FYR Macedonia has benefited from broad and generous trade access to the EU since 1997,25 25 The EU has allowed market access without quantitative restrictions or tariffs for most Macedonian products since 1997. Then in1ate 2 000, the EUestablished the Autonomous Preference scheme, which provides duty and quota free access for practically all exports o f South Eastern European countries to EU markets, except wine and some beef and fishproducts. 21 the SAA has started the creation o f a regional free trade area as well as setting an overall legal framework that will guide the future economic and political relationship with the EU. While some o f the greatest short term impact may be felt through the liberalization o f trade with the EU and the creation of a regional free trade area in South Eastern Europe through multiple bilateral free trade agreements, commitments under the SAA extend to investment, competition, the environment, and standards. Eventually, the SAA will bring the institutions, legislation, and regulations of FYR Macedonia into line with those inthe EU, facilitating its eventual integrationinto the community. Figure 2.2: Exports, Imports and GDP, 1990-2002 130 - 120 1 110 - 0 0I/ 100 - m - 0 m 90 - 80 - 60 4 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 -Exports Imports GDP Notes: Changes in exports and imports are based on US$values; change in GDP is basedon constant MKDvalue. Source: State Statistical Office. 2.29 Tradingpatterns. As a small economy, FYR Macedonia is heavily dependent on international trade. Output growth has been driven primarily by export activities (see Chapter l), inparticular of three subsectors: clothing, beverages and tobacco, and iron and steel. The elasticity o f import demand remains at a very high level o f about 4 in recent years.26Especially because it i s a landlocked country, dependent on neighbors for transit o f goods, the economy i s extremely vulnerable to external shocks and regional political events such as sanctions, wars, and disputes, and, as discussed above, the 1990s provided a regular supply o f these. Nevertheless, in spite o f this volatile environment, FYR Macedonia's trading patterns have shifted significantly in the last 10 years, as exports o f iron and steel were replaced by clothing. But exports overall have only recovered in2002 to 86 percent o f their 1990 level (see Figures 2.2 and 2.3). 26This means that imports need to increase by 4 percent to allow an additional 1percent of GDP growth. By comparison, the income elasticity of import demand inthe U.S. is about 2. 22 Figure 2.3: Shares of Top Three Products in Total Exports, 1990-2002 100% -___l__l_l~ -____I___I_ 80% 2 38 & 60% 40% s 20% 0% 1990 1992 1994 1996 1998 2000 2002 Ironand steel 0 Clothing &I andtobacco Beverages Source:State StatisticalOffice. 2.30 Inaddition, FYR Macedonia's maintrading partners have shifted from CEE and CIS countries to members of the European Union. Trade with the CIS countries (especially the RussianFederation and Ukraine), which constituted about one-quarter o f both imports and exports, has diminished to very low levels. Serbia and Montenegro (including Kosovo) has emerged as a growing buyer of Macedonian goods, purchasing 22 percent o f all Macedonian exports in2002 (see Figure 2.4). Figure 2.4: Direction of Exports, 1992 and 2002 Other Other countries 1992 CIS- countries 2002 1w- 11% 1," CEE and other SEE I 6% CEE and Ai other SEE 17% l EU 45% A Other forme Yugoslav Other form republics 7 Yugoslav 29% - republics 15% Source: State Statistical Office. 23 2.3 1 Tradepolicy. FYRMacedonia became a full WTO member inApril 2003 after 10 years o f negotiations, an achievement which, despite the delay, sent a positive signal to investors and improved prospects for growth. Although economic theory does not offer a clear answer, WTO membership and other regional trade agreements are expected to yield far more benefits than costs for the Macedonian economy. However, slow growth and dampened prices inthe world's major economies over the next few years could well undercut the more immediate benefits, possibly creating firther pressures on Macedonian unemployment and incomes through heightenedcompetition. 2.32 The shorter term impact o f regional integration could well be mixed. The experience o f Mexico in NAFTA suggest positive impacts on the Macedonian economy as a result o f tariff reductions with its EU trading partners, but overall, regional integration has been found to have an ambiguous impact on welfare and is too complex and case-specific to permit universal operational rules.27A partial equilibrium framework o f pure trade diversion and trade creation, however, suggests that FYR Macedonia may well suffer losses during the transitional period.28 However, findings o f dynamic frameworks tend to elicit positive trade effects from regional integration inthe long run. 2.33 More importantly, the broader impact o f regional free trade will be felt through greater flows o f foreign direct investment and domestic investment, as the free trade agreements within the region accelerate the alignment o f policies, legislation, and institutions with the EU. More than market access to the EU, the importance of the SAA is that it draws FYR Macedonia into the emerging pan-European free-trade area, within which both goods and capital will freely flow. It is these effects that are likely to boost sustainable growth for FYRMacedonia over the long-run. E.MEDIUM-TERMMACROECONOMIC OUTLOOK 2.34 With the security situation stabilizing, economic growth is expected to gradually increase, retuming to pre-conflict levels by 2005. Growth should be supported by a recovery ininvestments which are expected to rise to around 25 percent o f GDP by 2005 and an average growth rate o f exports of around 6 percent. This level of investment i s necessary to support growth o f 4 to 5 percent (see the discussion in Chapter 1). The authorities are planning to pursue a relatively tight fiscal stance, so investment growth should be fieled by the private sector as business confidence gradually recovers and monetary and credit policies react to the improved budget position. Already in 2003, tighter fiscal policy has allowed interest rates to decline. The low (although improving) level o f official domestic savings29 will need to increase firther and efficiency o f financial intermediation will need to improve to finance needed investment levels. But ''Schiff, Maurice, and L. Alan Winters (2003), Regional Integration and Development (World Bank, Oxford University Press). 28 Green, Michael (1999), "Trade Creation and Diversion Model o f Macedonia" European Commission, processed. 29Despite the relatively low level of private savings inthe financial sector, evidence suggests that there are large sums o f foreign currency outside o f the banking sector. Foreign currency deposits inthe commercial banks increased by around US$ 250 million at the time o f the Euro change over (or around 7 percent o f GDP) inlate 2001. 24 there i s sufficient scope for improvement. Confidence inthe banking sector i s rising, and there i s likely a large pool o f savings currently beingheld outside o f the banking system. Over the next few years, higher private savings is likely to flow into the banks (see Table 2.5). Table 2.5: Selected Economic Indicators: 2002-2005 Projected 2002 2003 2004 2005 (inYo) Gross Domestic Product 0.7 3.0 4.0 4.5 Inflation 2 3 2 3 (inYoofGDP) Fiscal Balance -5.7 -1.9 -1.4 -0.8 Revenues 36.1 32.9 33.2 32.8 Expenditures 41.8 34.8 34.5 33.6 Current Account -8.7 -6.8 -6.9 -6.5 Foreign Direct Investment 2.1 2.4 2.7 2.8 Gross Domestic Investment 21.9 23.0 23.5 24.4 Source: 2002: National Bank o f Macedonia, State Statistical Office and Ministry o f Finance. Projection: World Bank staff estimates. 2.35 Tight domestic demand policies should keep the growth rates o f imports at around 2-3 percent per annum, helping to close the current account gap, reduce the reliance on foreign savings, and preserve reserves at a comfortable level o f around four months o f imports o f goods and services. This will be crucial because the country cannot dependon substantial foreign financing, since it has now graduated from most concessional borrowing, since its low creditworthine~s~~on international private capital markets cannot be expected to change in the near future, and since large flows o f foreign direct investment may not be forthcoming (except perhaps proceeds from the possible privatization o fparts of the electrical utility). 2.36 Continuing the current policy o f pegging the exchange rate to the Euro and reducing the government deficit to a sustainable level o f around 0.5 percent by 2005 will help keep inflation at around 3 percent per annum. At the same time, continuation o f reforms in the public, financial and corporate sector should strengthen the ability o f the private sector to generate growth and create jobs (see Table 2.6 for more details on the projected macroeconomic fkamework). 30The country does not have an official credit rating yet but expects to have one by end-2003. . 25 Table 2.6: Macroeconomic Framework, 2000-2005 2000 2001 2002 2003 2004 2005 Actual Actual Estimated Projected Projected Projected (% change) Gross Domestic Product 4.5 -4.5 0.7 3.0 4.0 4.5 Total Consumption 6.6 -2.8 6.9 -1.5 3.5 2.9 Private Consumption 8.9 -10.0 8.3 2.1 4.9 4.7 Gross Domestic Investment 14.5 -17.9 7.7 12.1 5.3 7.5 (in%ofGDP) Gross Domestic Investment 21.4 18.3 21.9 23.0 23.5 24.4 Gross National Saving 23.O 14.0 13.0 16.1 16.6 17.9 Current Account Balance -2.1 -6.8 -8.7 -6.8 -6.9 -6.5 (YOchange) Exports of GNFS 19.0 -15.7 -4.4 5.3 8.5 5.9 Merchandise 15.3 -9.1 -4.0 4.5 9.0 5.5 Imports of GNFS 24.2 15.3 10.7 -0.4 6.7 3.9 Merchandise 10.7 -39.6 3.3 -1.8 6.8 3.3 (in% of GDP) Current Fiscal Revenues 36.4 34.2 35.9 32.6 33.1 32.8 Current Fiscal Expenditures 30.6 36.7 37.2 31.8 31.6 30.6 Current Fiscal Balance 5.8 -2.5 -1.3 0.8 1.5 2.1 Capital Expenditure 3.5 4.1 4.6 3.1 2.9 2.9 Source; World Bank staffprojections. ExternalDebt Sustainability 2.37 With proper management, external debt should not create sustainability problems inthe medium-tenn. With the current level of external debt, around 39 percent of GDP, the country ranks in the group o f moderately-indebted countries. Although this ratio increased rapidly in the period up to 1998 it has stabilized at around 40 percent o f GDP since. The structure o f external debt is relatively favorable, with liabilities based on concessional lending accounting for around one-quarter o f total debt outstanding. Liabilities towards private and commercial creditors accounting for just over one-quarter o f total external debt, and short-term debt is less than 6 percent o f the total. Close to 86 percent o f the total debt outstanding is public and publicly-guaranteed, with the majority beingobligations o fthe central govemment. 2.38 FYRMacedonia's debt situation also appears favorable incomparisonto other countries. The ratio of debt to exports o f goods and services is below the average for the region and for groups o f countries with similar levels of development. The country ranks among the strongest as indicatedby the ratio o f reserves to GDP, while interest payments and average interest rate are among the lowest. However, it should be noted that due to 26 the extremely weak performance o f exports in the last two years, these indicators have slightly deteriorated, approaching the averages for the region. 2.39 The debt to GDP ratio should come down further inthe medium-term. Intensified economic growth, reaching 5 percent per annum by 2006 and 2007, together with an improving current account balance and foreign direct investment rates o f around 2.6 to 2.8 percent o f GDP should reduce the external debt burden to around 35 percent o f GDP by the end o f the period. However, taking into account that the country is no longer eligible for concessional lending, significant threats to external debt sustainability might arise ifthe economy and exports fail to perform as projected. Fiscal Sustainability 2.40 The total debt o f the Government increased inthe second half o f the 1990s, from 48 percent o f GDP in 1996 to above 57 percent of GDP in 1999, because o f the devaluation o f the exchange rate in 1997, higherborrowing from abroad, andthe issuance o f government bonds to take over liabilities during the sale o f state-owned companies. Less new debt and the maturing o f existing debt has reduced the public debt to GDP ratio since 1999 to just above 50 percent today. External debt accounts for roughly two-thirds of total public debt, while domestic bonds issues to compensate depositors who lost foreign currency deposits at independence and bonds issued to take over privatizing companies' liabilities constitute most o f the remaining obligations. Commercial banks' credit to government bodies and institutions i s relatively low. 2.41 With a public debt to GDP ratio of slightly above 50 percent,31the country's fiscal position i s stable despite being above the average for the region (see Table 2.7). However, because most debt is denominated in foreign currency, it i s extremely vulnerable to exchange rate fluctuations. The projected deficits o f the general government of 1.3 percent o f GDP in2004 and 0.5 percent of GDP in2005 are expected to reduce the public debt to GDP ratio to the debt-stabilizing ratio of around 40 percent.32 Table 2.7: Indicatorsof PublicIndebtednessof TransitionEconomies, 1997-2001 FYRMacedonia Czech R. Estonia Hungary Latvia Lithuania Poland Slovak R. Slovenia Average Average for 1997- 2001 (in% ofGDP) Total debt 54.0 15.7 5.9 60.2 13.1 20.5 43.5 32.4 25.1 30.0 Domestic debt 20.6 12.1 2.4 49.9 5.1 7.9 21.7 20.7 14.1 17.2 Foreign debt 33.4 1.8 3.6 10.3 8.0 12.6 21.8 11.7 11.0 12.7 For 2001 Total debt 51.6 19.1 4.8 53.7 15.0 24.0 42.0 43.5 27.5 31.2 Domestic debt 17.9 17.7 2.1 38.6 5.4 8.4 25.8 30.4 14.5 17.9 Foreigndebt 33.7 1.4 2.7 15.1 9.6 15.6 16.2 13.0 13.0 13.4 Source: ECA Regional Govemment Finance Database, World Bank. 31Due to the recording system inthe country this number most probably does not include all arrears or non- registered commitments. 32See IMF (2003- Staff Report). 27 F.POLICY CONCLUSIONS 2.42 FYR Macedonia has maintained a stable exchange rate since 1997 and inflation below 6 percent since 1996. However, growth has been volatile, driven by large variations inexports and investment. Clearly some further elements o f stability need to be assured. As discussed above, public sector management reform has the potential to improve fiscal management over the long-term. Trade liberalization and integration into Europe will be the surest route to higher and more stable investment flows and export demand. 2.43 There are both significant opportunities to outperform as well as challenges to achieve the growth s cenario 1aid out above, and much depends o n the c onfidence and expectations o f various economic agents (banks, entrepreneurs, foreign investors). There i s no immediate constraint to faster growth on the supply side: Low levels o f capital utilization and the huge pool o f unemployed can give a boost to higher growth rates if opportunities become available. Presumablyreal restructuring o f the corporate sector will take place as the remaining state-owned companies slated for privatization are sold or closed, as market mechanisms and institutions function properly, and as regional integration and liberalized trade progress via WTO membership and the Stabilization and Association Agreement with the EuropeanUnion. Onthe other hand, the re-emergence o f domestic political instability or the outbreak o f another regional conflict, failure to strengthen the rule o f law and reduce corruption, and lack o f improvement in public services and institutions threaten to severely undermine business confidence and the likelihood o f output expansion, employment growth, andpoverty reduction. 28 3. THE FAILURE OFTHE LABORMARKET A. INTRODUCTION 3.1 Politicians and the press in FYR Macedonia tend to quote the latest registered unemployment numberswhich indicate that 374,000 people were out o f work in2002, or as much as 50 percent o f the labor force.33This is generally accepted as an exaggeration o f the true situation. Still, unemployment as measured inthe Labor Force Surveys (LFS) comes in at over 30 percent o f the labor force. This rate i s surprisingly high, compared with other relatively positive economic outcomes inFYR Macedonia and compared with the experience o f other transition economies. Has the labor market failed so completely duringthe 1990s?What has beenthe role o flabor institutions and employment policies in the performance o f the job market? What actions on labor market policies should the Government undertake to tackle the problem o f highand persistent ~ n e m p l o y m e n t ? ~ ~ 3.2 As is discussed in the first section o f this chapter, in trying to understand the dimensions o funemployment and the functioning o f the labor market inFYRMacedonia, one faces the challenge o f conflicting sources o f data. Despite some concerns about the accuracy o f the Labor Force Surveys conducted since 1996, LFS data remains the richest source for insights into the workings o f the labor market, supplemented as appropriate by other available sources.35 The analysis that follows finds that unemployment in FYR Macedonia i s not due primarily to labor restructuring during transition, but rather to decades o f insuffcient 1abor demand. Unemployment is predominantly 1ong-term, and the unemployed are mainly young and less-educated. Unpaid work on family farms, petty trade, and other casual employment has cushioned the gradual disintegration o f the formal job market for many Macedonians. Yet, further labor restructuring i s likely imminent, since the contribution o f lay-offs to unemployment so far has beenmodest. 3.3 The second section o f this chapter notes that sustained economic growth is the best hope for more robust labor demand and job creation and that it has been lacking. Nevertheless, labor institutions and policies have a role to play in improving flexibility 33 This calculation uses employment data from enterprise reports to the State Statistical Office to create the most conservative estimate o f the size o f the labor force. 34 See UNDP (2001) for an important complementary study o n the labor market. 35,The Employment Bureau has data o n the registered unemployed (but there is weak enforcement of eligibility criteria). The Pension and Disability Fund has data o n the contributing employed and their employment history (but records are incomplete). The Health Insurance Fundhas data o n the contributing employed but s ome households are insured more than once. Untilits disbandment in2 001, the Central Payments Registry (`ZPP `) had extensive and accurate records o n all financial transactions by legal entities, including payments o f wages and taxes, and also annual reports on employment. The State Statistical Office collects enterprise report data, through monthly and semiannual reports o f businesses, but without coverage o f the agriculture sector and with deteriorating coverage o f the private sector. The Household Budget Surveys provide some limited labor-related information, but the sample i s small. 29 and dynamism of the labor market. Some further action i s merited to bring the legal framework for collective bargaining into line with practice on the ground in FYR Macedonia and with best international practice. Measures need to be taken to expedite labor legal cases, perhaps by reestablishing separate labor courts. Lastly, resources should be shifted from passive to active labor market programs. B. LABOR MARKET OUTCOMES High, Persistent,and StagnantUnemployment 3.4 Registered unemployment in FYR Macedonia has been rising since the early 1 9 6 0 ~surpassing 20 percent in the early 1970s, and standing at around 24 percent at , ~ ~ the time o f independence in 1991. Registeredunemployment has continued to rise during transition and has accelerated since the mid-l990s, leaving FYR Macedonia an apparent outlier in the region. Part o f these cross-country differences reflect changes in national rules and incentives to register. In FYR Macedonia, registration rates are raised because eligibility criteria are not enforced and many o f the registered unemployed are working informally and register to receive free health insurance.37 Figure 3.1:Registered Unemployment Rates in South Eastern Europe, 1989-2000 60 - 50 - 40 30 20 10 0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 +Slovenia -Croatia +FYR Macedonia --~t Bosnia-Herzegovina +FR Yugoslavia +Albania +Bulgaria -Romania Note: Only comparable data across countries are represented. Source: UNICEF(2002). 3.5 A better measure o f unemployment is available since 1996 from the Labor Force Surveys. Unemployment using a n I L O definition w as 32 percent o f the 1abor force in 2002, still almost double the rate elsewhere inthe region.38A summary o f the hnctioning of the labor market in2002 i s presented in Table 3.2. Information from the LFS allows a 36The system of worker self-management in the Socialist Federal Republic of Yugoslavia allowed open unemployment. 37Cashbenefits are paid only to about 10percent of the registered unemployed. 38For comparison, the unemployment rate obtained fiom Labor Force Surveys inother Balkan countries in the late 1990s were 16.9 percent in Bulgaria, 7.7 percent in Romania, 15.1 percent in Croatia, and 12.6 percent inSerbia and Montenegro. See Vodopivec (2002). 30 decomposition o f registered unemployment, revealing that in 2002, about 40 percent o f those registered as unemployed were actually working informally or were out o f the labor force (see Figure3.2 below). Table 3.1: Characteristics of the Labor Market. 2002 2002 Unemployment rate (in%) 31.9 Males 31.7 Females 32.3 Under age 25 58.4 Ethnic Macedonians 28.2 Ethnic Albanians 49.1 Ethnic Roma 73.1 Long-term unemployment 84.5 (as share of total unemployed) Labor force participation rate 52.6 (in%) Males 63.1 Females 41.5 Notes: Long-term unemployment i s for more than 1year. Ethnicity is for 2000. Working age population, employment, and unemployment use the Macedoniandefinition of ages 15-80. Source: Labor Force Surveys, State Statistical Office. 31 Figure3.2: Decomposition of Unemploymentand Labor Force Status I " (19,843) (24,383) Source: 2002 Labour Force Survey, State Statistical Office. 3.6 Further, a look at the flows of unemployment in 2002 reveals very little movement by individuals between labor force categories: only 8 percent o f those working in2002 were not working in2001, while 90 percent ofthose unemployedin2002 were in the same status a year earlier. Yet another worrying feature o f Macedonian unemployment i s its stagnant nature - nearly two-thirds o f the unemployed have been without ajob for 4 years or more3' (see Table 3.2 below). Evidence aroundthe world has shown a strong negative correlation between the probability o f finding a job and time spent in unemployment, indicating that the long-term unemployed are at a higher risk o f permanent labor market exclusion and poverty. Addressing the problem o f the very low mobility out o f unemployment should, thus, be a major concern for the Government o f FYRMacedonia. 39This is much higher than in neighboring Bulgaria and Romania, where long-term unemployment measuredinthe LFS stood at 59 and 48 percent respectively in2000. See Vodopivec (2002). 32 Table3.2: Distributionof UnemploymentbyDuration, 1996-2002 1996 1997 1998 1999 2000 2001 2002 <1 year 19.3 16.9 17.1 16.2 16.7 13.1 15.5 1-4years 36.2 39.5 27.5 24.5 23.0 22.0 21.8 4+ years 44.5 43.6 55.4 59.3 60.4 64.8 62.8 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: Labor Force Surveys, State Statistical Office. 3.7 Despite the widespread beliefinFYRMacedonia that today's highunemployment is due primarily to restructuring during transition, the increase in unemployment in the 1990s has been well within the range experienced in other transition economies. Very roughly, transition has contributed as little as 8 percentage points to overall ~nemployment.~'The larger part of unemployment in FYR Macedonia reflects persistence, which, simply put, i s that the longer an individual i s unemployed, the more difficult it is to change status.41 UnevenCompositionandIncidenceof Unemploymentacross Demographicsand Regions 3.8 Almost 30 percent o f the unemployedinFYR Macedonia are young (age 15-24), two-thirds1ive inurbanareas, and about 5 7 percent are men. While two-thirds o f the unemployed are ethnic Macedonian, rates o f unemployment are twice as high for minorities (see Table 3.2). Compared with 1996, the share among the unemployed o f prime-age and older individuals, individuals with secondary and higher e ducation, and ethnic Macedonians has increased, reflecting the restructuring that has accompanied privatization since the mid-1990s. The positive side o f this development i s that unemployment rates have declined among youth and young adults below 30, yet still more than half o f those unemployed for 4 years or more are aged below 35. That is, very long-term unemployment in FYR Macedonia i s primarily of young individuals rather than older workers. 3.9 Education reduces the probability o f being unemployed (see Table 3.3), but those with the lowest levels of education have a lower unemployment rate than those with primary education. Individuals with complete primary or secondary education usually have more expectations that those with no education and are, thus, more reluctant to accept low-qualified jobs (a result driven by relatively low unemployment rates for uneducated rural workers, who have subsistence agriculture as a fallback). This has been a problem for many years in FYR Macedonia. An earlier study o f the Yugoslav labor market inthe 1 9 8 0 noted ~ ~ ~that an important challenge facing the country was to provide 40 This calculation simply subtracts the 24 percent registered unemployment in 1991 from 2002's 32 percent unemployment rate as measured by the LFS. 41 Economic theory indicates that hysteresis effects in unemployment can arise because o f union membership effects (Blanchard and Summers, 1986), because o f loss o f skills and discouraged-worker effects, and because o f depreciation of human capital during recession that does not fully recover subsequently or takes a long time doing so (Rowthorn, 1995). 42 See World Bank (1983). 33 jobs outside agriculture for young people leaving the educational system and who were reluctant to enter agricultural occupations once they c ompleted their formal education. The growing inability o f the secondary and higher education systemto provide adequate skills further exacerbated the problem, translating to a rising risk o f becoming unemployed for those with secondary or higher education.43Inother words, the mismatch between the capacity o f the economy to provide qualified jobs and the expectations o f a formally educated youth cohort remains a key contributor to FYR Macedonia's unemployment problem. Table 3.3: The Impact of Education on Unemployment,1996 and 2002 Shareammgallthe Lmrploy?d Unenploymrate 1996 2002 19% 2 m Nitidaverage 100 100 31.9 31.9 EdLKation Lessthanprinruy 11.5 6.6 33.6 26.8 prinaryeducation 36.5 36.4 40.6 41.8 secondary 45.0 49.7 30.4 32.0 Higher 7.0 7.4 15.2 16.0 3.10 Unemployment inFYR Macedonia also has an strong regional dimension, despite the country's small size (see Table 3.4). Skopje i s the largest region and has an unemployment rate and rate o f participation close to the national averages. The extremes are in the Tetovo region (the farthest western part o f the country) which has the highest unemployment rate (51 percent), and the lowest participation rate, and the Strumica region (in the southeast) with the lowest unemployment rate (16 percent) and the highest participation rate. 43The education system remains rigid and unresponsive to labor market needs. Vocational programs still dominate secondary education, and shorter, non-university programs are mostly absent at the tertiary level. 34 Table 3.4: Employment Status by Region, 2002 Unemployment Employment Population Region rate rate share Skopje 31 32 28 Bitola 27 43 12 Kumanovo 45 29 8 Ohrid 43 28 11 Stip 24 44 10 Strumica 16 57 9 Tetovo 51 21 14 Veles 32 37 7 FYR Macedonia 32 36 100 Notes: ropulation i s Irom the 1YY4 census and it i s total, not working age, population. Unemployment and employment data are from the 2002 Labor Force Survey. The unemployment rate i s number of unemployed as a share of the active population. The employment and participation rates are shares of working age population. Source: 2002 Labor Force Survey data; 1994 Census o f the Population, State Statistical Office. Low Levels of EmploymentandParticipation 3.11 The number o f employed out o f the working age population is low. In2002, there were about 550,000 employed individuals in FYR Macedonia, according to the LFS, or only 40 percent of the working age p ~ p u l a t i o n This . ~ ~ i s significantly below the EU average o f 61 percent and the Organization for Economic Cooperation and Development (OECD) average of 65 percent. Employment o f women i s particularly low. Only 32 percent of the working age population o f women were employed in FYR Macedonia in 2001, compared with 51 percent for women in the EU and 54 for women in the OECD. The rate of labor force participation, at 60 percent in2002, is comparable to countries in the region, although low by European standards.45 LaborMarket RestructuringandJob Reallocation 3.12 The behavior o f the Macedonian labor market during transition contrasts with the changes observed in the more advanced transition countries. Some part o f the Macedonian market's apparent failure to generate jobs, especially for youth, may be due to biases inthe LFS data itself. Some preliminary evidence about the accuracy o f the LFS i s in Box 3.1. Nevertheless, it seems that the pattem of labor market adjustment in FYR Macedonia differs greatly from that in, for example, Hungary and Poland, where employment fell and unemployment increased dramatically. Restructuring implied a 44 These numbershave been adjusted to match the international definition of working age population (ages 15-65). The Macedonian definition includes population ages 15-80. 45 These numbers are also adjusted to exclude those over age 65. In2002, labor force participation inFYR Macedonia was well above Bosnia and Herzegovina (49 percent), Bulgaria (49 percent) and Croatia (50 percent), and comparable to Romania (63 percent) and Serbia and Montenegro (58 percent). See Vodopivec (2002). 35 process o f job destruction, which was instantaneous, while the process o f job creation, accompanying the slower process o f economic recovery, took time. In these countries, the existence o f labor compensation schemes were instrumental to help the temporarily unemployed to quit non-profitable enterprises and look for new jobs, or to become self- employed, although outflows from unemployment to employment turned out to be more limitedthan initially expected (Boeri, 2000). Job reallocation took place mostly fromjob to job, and from the state sector to the private sector. There was a shift from traditional industrial sectors to new activities in services and trade. The development o f SMEs, which have been identified as fundamental to rising productivity and growth inthe more successful transition countries,46was strongly supported by the building-upo f a favorable institutional environment and business c limate, particularly inPoland. What, then, has happened in FYR Macedonia? Most specifically: (i) H o w much restructuring has taken place? (ii) Has the apparent stability in the labor market hidden important differences taking place between and within sectors? ModestLay-offsDuringEnterpriseRestructuring 3.13 The slow pace o f enterprise restructuring in FYR Macedonia i s visible in administrative data on the work history o f registered unemployed. Since the early 1980s, the vast bulk o f the registered unemployed-between 73 and 84 percent-were young people leaving the education system with no work experience. And although there has been some increase inrecent years inthe share o f unemployed with longjob tenure (10 or more years o fjob experience), this increase was limited compared with other countries in the region. Contrary to several countries in the region, there were no massive lay-offs in FYR Macedonia. Instead, firms have tended to resist shedding labor until they go bankrupt, pushing the burden o f adjustment to smaller labor demand fully onto new entrants to the workforce. WageArrears 3.14 An alternative method to reduce labor costs, other than firing workers, has been non-payment o f wages. Based on the limited available data on wage arrears, in 2002 about 8 percent o f those employed outside o f agriculture did not receive a wage payment inMarch (based on the April 2002 Labor Force Survey results). Alternatively, enterprise reports (which tend to represent a subset of larger and older firms) show that over 25 percent o f employees did not get paid in March, a proportion that has risen steadily over the last few years. Large Movementof LaborTowardsAgriculture 3.15 Growth in FYR Macedonia since 1996 has been concentrated in the industry, construction and services sectors, balancing stagnation in agriculture. Employment growth has been uneven as well. In agriculture, despite the overall fall in output (of 1.2 percent inreal terms between 1996 and 2002), employment rose by 34 percent according to LFS data. In contrast, employment fell in construction, industry, and services despite 46See World Bank (2002e), "Transition" 36 strong output growth (of 10 percent in industry and 16 percent in services). Within the services sector, the largest increase took place inpublic administration. 3.16 The large employment growth in agriculture has also translated into a visible increase in the share o f agriculture intotal employment, which accounted for 24 percent o f total employment in 2002, compared with 19 percent in 1996 (Table 3.5). Incontrast, the relative weight o f all other sectors declined. Evenin services, the rise in employment -largelyduetoariseinpublicadministrationjobs - was not enoughto maintain its share in total employment, which declined slightly from 45 percent in 1996 to 43 percent in 2002. Table3.5: Employmentby Sector (percent oftotalemployment) 1996 1997 1998 1999 2000 2001 2002 Agriculture and Forestry 18.6 18.5 19.9 21.2 21.8 24.8 23.9 Miningand Industry 29.4 27.8 28.7 28.2 27.5 26.8 27.5 Construction 6.6 6.3 6.6 5.7 6.5 5.6 5.8 Services 45.4 47.4 44.8 44.9 44.2 42.8 42.8 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: Labor Force Survey. UnevenGainsin Labor ProductivityandWages 3.17 The aggregate changes in labor productivity and wages in FYR Macedonia also mask large differences across industries. Over the period 1996-2002, labor productivity collapsed in agriculture, reflecting the rush of labor into the sector, mostly into subsistence ag r i c u l t ~ r eT. ~he~ gain in1abor productivity inc onstruction w as drivenby labor restructuring, and, as inthe s ervices sector, productivity improvements outpaced wage increases. However, in mining and industry, employment remained steady, output rose, but wages rose by even more than productivity, suggesting greater bargaining power among industrialworkers.48 47Inagriculture, wages remained unchanged despite the large drop inproductivity. However, ths is likely because administrative data o n wages does not include data o n self-employment, which is particularly important in agriculture. 48 Absolute levels o f labor productivity and wages across industries show that, in general, sectors with higher labor productivity pay higher wages. In 2002, wages and labor productivity were the highest in services, and the lowest in agriculture. However, in construction, labor productivity was higher than in industry,but wages were lower, again suggesting greater bargaining power among industrial workers. 37 Figure 3.3: Labor Productivity and Wage Growth by Sector, 1996-2002 30 1 17.2 17.5 -30 -26.4 -40 - Agriculture Miningand Industry Construction Services Labor productivity 0 Realwages Note: Wages are from enterprise reportsto the State Statistical Office. Source: Bank staff estimates basedon data from Labor Force Surveys, National Accounts, and administrative data, State Statistical Office. Growing Wage Variation across Sectors 3.18 The past six years in FYR Macedonia have also seen a growing dispersion of wages.49As shown inFigure 3.4, the distribution of real wages has flattened since 1996. This is a positive sign, as it indicates enhanced wage flexibility, partly arising from low enforcement and more liberal options introduced for collective agreements at branch and enterprise level for wage setting. Figure 3.4: Distribution of Wages, 1996-2002 2oo,ooo 1 150.000 B -6 P I ---- L 100,000 1998 I. a -__- 1999 z s 2000 50,000 -2001 -2002 0 1,000 10,000 100,000 N e t monthly wage in 1996 MKD (logscale) Source: Labor Force Survey Data. 49Data on wages from enterprise reports also shows growing sectoral wage dispersion. Between 1996 and 2001, the variance of the log of average net wages across 11 sectors doubled from .030 to .070. This sectoral net wage data reflects mostly larger and older firms, so the improved wage distribution is a particularly positive sign. 38 3.19 Some part o f the Macedonian market's apparent failure to generate jobs, especially for youth, may be due to biases in the LFS data itself. Some preliminary evidence about the accuracy o f the LFS is in Box 3.1 using information from the household budget surveys. These alternative calculations find that the unemploymentrate was no higher than 23 percent in2002 and likely was lower. I Box 3.1: Assessing the Accuracy of the Labor Force Survey Even though the Labor Force Surveys meet international standards for design and conduct, they seem to suffer to some degree from `fictitious reporting' that exaggerates unemployment and downplays the size o f the informal sector. Some indication o f the magnitude o f this problem comes from a look at household budget survey data, from which a much lower unemployment rate can be constructed. Unemployment based on self-reporting in the Household Budget Survey (HBS) is significantly below the LFS calculation, with a rate o f 23 percent for 2000. This rate is comparable to rates similarly derived from household budget survey data for other countries o f the former SFR Yugoslavia. Labor Market Statistics from Different Sources, 1997-2000 Source 1997 1998 1999 2000 Unemplovment rate Labor Force Survey 36.0 34.5 32.4 32.2 Household Budget Survey 20 25 22 23 Employment rate Labor Force Survey 34.4 35.9 35.9 35.8 Household Budget Survey 45 41 43 45 Notes; Data is for ages 15 to 80. Source:World Bank staff calculations basedon LFS and HBS data, State Statistical Office. Adjustments to the 2000 HBS calculations to capture work on family farms, unpaid work in family businesses, and unreported self-employment reduces the estimated unemployment rate dramatically, to 10 percent. This result indicates that people are engaging in some kind o f economic activities despite the lack o f jobs in the formal market. These are mostly coping strategies, and further analysis o f the H B S data is needed to assess the impact on family incomes o f such `employment'. C.LABOR MARKET INSTITUTIONS Wage Setting 3.20 Although a process o f collective bargaining at the national, branch and enterprise level i s defined in law, in practice, wage determination seems to be increasingly decentralized. Inthe public sector and in large privatized enterprises, union coverage and union power remain important, and wages tend to be determined mostly through collective bargaining. Inthe private sector, however, trade unions are almost nonexistent, and wage levels are mostly determined at the enterprise level, reflectingthe firm's ability 39 to pay and worker bargaining power.50Although a minimumwage is supposed to be in place, it was set for the first time in 2002 and at such a low level that it i s unlikely to discourage much e m p l ~ y m e n t . ~ ~ 3.21 Despite the modest and declining impact o f collective bargaining in practice, the Government should consider legal changes to shift wage setting to enterprises or to improve bargaining at the national and branch level through better representation o f employers (who currently lack effective organizations) and o f workers (because unions needto be involved constructively at the firm level so that higher wages are balancedby greater cooperation with management and easier dispute re~olution).~~ Employment Protection Legislation 3.22 An initial assessment of FYR Macedonia's employment protection legislation is inTable 3.6. This assessment uses a methodology developedby the OECD that provides a systematic treatment o f labor codes, covering numerous aspects o f regular and fixed- term contracts and collective dismissal procedures. As shown below, employment protection scores for FYR Macedonia have come down during the 1990s and then again in 2003 because of recent amendments to legislation -- but they are still quite high, certainly above the average for transition countries as well as above the scores o f its neighbors (see Table 3.6). The scores for regular contracts have been reduced substantially, but fixed-term contracts, which are an important source o f flexibility, do not score as well because temporary employment agencies do not have a clear legal framework. Also, collective dismissals have a rather prolonged process compared to individual dismissals. A further source o f inflexibility i s the disincentive against use o f part-time employees created by the floor set for social contributions, which i s based on 65 percent o f the average sectoral wage for full-time work, thereby increasing the effective payroll tax for part-timers. 50 See h a m and Rutkowski (1998) . 5 1The use of a minimumwage is stipulated inthe labor laws, but it was defined for the first time in June 2002, only for the public sector, and at a low level of about 45 percent o f the monthly average wage. By way o f comparison, the ratio o f minimum to average wages ranges from 71 percent in Italy to over 60 percent inAustria and Norway, and to below 45 percent in Spain, UK, Canada and the United States (from Nickel1and Layard, 1999). 52 Aidt and Tzannatos (2003). Evidence from the 1970s and 1980s seems to argue that inperiods o f larger economic shocks, the level o f bargaining coordination may be more influential, and semi-coordinated bargaining may elicit the worst outcomes. In such conditions, centralized bargaining should allow a coordinated and fast response to changing economic conditions, but only if the right conditions for coordinated bargaining hold, i.e., strong employer coordination. 40 Table 3.6: InternationalComparisonof Employment ProtectionLegislation,Early and Late 1990s*(on a scale of 0-6, where 6 is most restrictive) Regular Temporary Collective Combined score employment employment dismissals (regular and temporary employment) Early Late Early Late Early Late Early Late 1990s 1990s 1990s 1990s 1990s 1990s 1990s 1990s FYR Macedonia* 3.9 2.1 5 4.4 4.2 4.0 4.4 3.2 Transition economies** 2.4 2.2 3.5 3.4 2.5 3.4 3.O 2.8 OECD countries* ** 2.2 2.0 2.1 Notes: Using a scale o f 0-6, where a higher score indicates more restrictive legislation. Following the OECD (1999) methodology, the above summary scores reflect the following aspects o f employment protection legislation: (a) regular contracts: difficulties in procedures for layoff, delay to start a notice, the length o f notice period, the value o f severance pay; definition o f unfair dismissal; trial period, compensation for unfair dismissal, and the frequency o f reinstatement; (b) fixed-term contracts: valid cases other than the usual "objective," maximum number o f successive contracts, maximum cumulated duration, and temporary work agency: type o f work for which such work is legal, restrictions on number of renewals, and maximum cumulated duration; and (c) collective dismissals: definition o f collective dismissal, additional notification requirements, additional delays involved, and other specific costs to employers. *The latest score refers to 2003. **Average for Bosnia and Herzegovina, Bulgaria, Czech Republic, Estonia, Hungary, Kosovo, Poland, Romania, Russia, Slovakia, Slovenia, and Ukraine. ***Average for Australia, Austria, Belgium, Canada, Switzerland, Germany, Denmark, Spain, Finland, France, UK,Greece, Ireland, Italy, Japan, Netherlands, Norway, NewZealand, Portugal, Sweden, andUSA. Source: Haltiwanger et a1(2003), World Bank (2002), Bank staff computations for FYR Macedonia. 41 Figure 3.5: EmploymentProtectionLegislationin the Balkans, Late 1990s 0Regular I ' 0Fixed-term 0Collectivedis. Source: Table 3.6. Current Passive and Active Labor Market Policies Provide Mixed Results 3.23 Unemployment insurance. Unemployment benefits are not excessive, especially with the recent reduction in maximum duration.53However, in addition to regular cash benefit, for which only about 2 percent o f the registered unemployed are eligible, some older workers are eligible for a cash benefit until retirement (about 8 percent o f the unemployed), and pension contributions are paid for all those receiving cash benefit. In addition, health insurance i s paid for all who choose to register as unemployed. Together, these benefits cost about 2.5 percent o f GDP, about double the OECD average, and most i s financed out o f the budget. But the amount spent on regular unemployment benefits is only 15 percent o f the total (or 0.3 percent o f GDP), while almost 60 percent finances what i s essentially an early retirement scheme (a long-term unemployment benefit) and about 30 percent pays for health insurance for those not eligible for cash benefit (many o f whom are working i n f ~ r m a l l y ) . ~ ~ 3.24 These multiple programs confuse the role o f unemployment insurance and place large administrative burdens on the Employment Bureau offices. Very few people leave to take a job before their benefits expire, and so long-term benefits especially discourage people from looking for work. Moreover, both to clarify the financial situation o f the PensionFundand to improve the design o f unemployment benefits, pension contributions should no longer be paid for unemployment cash beneficiarie~.~~ As a principle, unemployment should not be counted into work history. 53 Since April 2003, the maximumbenefit i s 50 percent of the last wage for the first 12monthsandthen 40 percent for the next2 months. 54 To receivehealthinsurance, the registeredunemployedhave to declarethat they have no other way of beinginsured, e.g., throughanother family memberwho is working. 55 Sucha change would have no fiscal impact-the Governmentwouldreducetransfers to the Employment Fundand increase them to the PensionFund.But despite the tax neutralityof sucha change, it would make 42 3.25 Active labor marketprograms. There have been a number of active labor market programs in FYR Macedonia, most supported by donors and focused on job counseling, training, public works, and measures that encourage the start up of businesses. Funding has been extremely low relative to OECD countries. Between 1996 and 2002, only about U S $ 10 millions were spent on active measures, or less than 0.05 percent o f GDP, compared with 0.7 percent in OECD countries.56 Cost effectiveness seems to be best in training and counselingprograms and least inpublic works programs. Carefully designed and targeted programs that focus on the integration into unsubsidized employment o f vulnerable groups (either minorities, or communities especially hard hit by unemployment) could be worth financing. The most desirable solution to the employment problems o f teenagers i s to help these young people remain in school, reenter the education system, or pursue more training as quickly as possible. For young adults in their 20s, it is more important to help them acquire work experience and to raise their skills inorder to avoid the traps o funemployment and social exclusion. D.RECOMMENDATIONS-FURTHER IMPROVEMENTS TO LABOR POLICIES 3.26 Although labor market institutions and employment policies have already undergone much reform in FYR Macedonia, including reductions to severance and unemployment benefits in April 2003, firther action could contribute to flexibility and dynamism o f the job market. However, as discussed in Chapter 1, job creation will be spurred primarily by vibrant private sector growth. The recommendations here can only serve to support the translation o f growth into labor demand. a The framework for collective bargainingagreements should be altered to improve the representation o f employers (and o f workers), and separate labor courts, or some other method to expedite labor legal cases, shouldbe (re)established. e A preliminary assessment finds that employment protection legislation remain more restrictive than in transition countries on average or in neighboring countries, despite improvements during the 1990s and again in 2003. The legal framework for flexible labor contracts needs clarification, in particular for temporary employment agencies, and the process for collective dismissals needs to be streamlined. The method for calculating payroll taxes for part-time employees should be revised to reduce the effective tax rate. a The provision o f free health insurance to all those registered as unemployed encourages registration by many who may be working in the informal sector, working part time or on short-term contracts, or living on income from abroad. This inflates the unemployment numbers that are more clear the large current deficit in the Pension Fund, which, despite significant reforms to restrict benefits and increase contributions, continues to suffer the impact o f the sharp drop incontributors early in transition. (The number of workers making c ontributions t o the P ension Funddropped 28 percent from 1990-97as formal sector employment fell. ) 56Simple average computed for 22 OECD countries for which data were available (OECD, 2002). 43 most often quoted and burdens the employment offices with the administrative task o f providing health insurance documentation to the unemployed. Greater enforcement o f eligibility to register as unemployed, combined with legal and administrative measures to enable collection of contributions from part time and short-term contractors, the self-employed and farmers would help to reduce numbers o f registered unemployed. This, together with simplification or transfer o f health insurance administration for the unemployedwould begin to free resources for active labor market services. e Although recent tightening o f unemployment benefits and reduction in severance payments bring Macedonian policy into line with international norms, the payment o f pension contributions for the unemployed should be stopped. e Active labor market programs should be expanded ,especially for youth and for high-unemployment communities, perhaps by shifting resources away from passive programs such as long-term unemploymentbenefits. 44 4. THE ENVIRONMENT FORJOB CREATION A. INTRODUCTION 4.1 Inthe wake of the turmoil and upheaval of the last decade-recession, political embargo and border closures, disruptions from the Kosovo conflict, two severe winters and a drought, and internal conflicts in 2001-it is not surprising that FYR Macedonia has struggled to stimulate economic growth and create jobs. The insecurity created by these events together with the uncertainty generated by conhsing and conflicting domestic policies has added to the difficulty o f doing business inthe country and has had a strong negative impact on business. However, the new govemment that came to power inNovember 2002 has made a strong commitment to improving the investment climate. community has been positive. These are welcome steps - sustainable economic growth Several new initiatives have been launched and the initial reaction from the business can only come from the private sector and issues related to the business environment, (investment climate), are central to putting the country on the road to long term prosperity. 4.2 This chapter examines the factors that affect business activity andjob creation in FYR Macedonia and identifies some o f the key constraints to businesses. It suggests areas that require further investigation and makes some recommendations that could help improve the investment climate. B. WHAT IS THEINVESTMENTCLIMATE, WHY ISITIMPORTANT, ANDHOW CANITBE IMPROVED? 4.3 The investment climate, or business environment, describes the conditions in which the private sector o f a country operates. It determines the costs o f doing business and includes such factors as financial markets, infrastructure, and the legal, regulatory, and institutional framework o f a country. It influences how contracts are written, the time horizon for investment decisions, the type o f activities in which the private sector engages and the size o f the informal sector. Evaluating the investment climate identifies the incentives and constraints faced by the private sector that affect its ability to perform efficiently and grow. 4.4 A dynamic private sector is a feature o f all countries that have registered sustained economic growth. Besides promoting general prosperity, rising GDP is the most effective means o f reducing poverty. An investment climate that supports the private sector, therefore, i s central to efforts to improving the lives o f all, but particularly poor Macedonians. 45 4.5 create growth - entrepreneurs and companies create growth. If higher productivity, the It is important to remember that reforms, projects, and other interventions do not growth o f new activities, the restructuring o f existing companies, and the formation o f new firms are not the result o f reforms, they have not been effective in promoting economic growth and poverty reduction. Any policies or interventions should bejudged against this central criterion. 4.6 The premise o f this chapter i s that there are two elements that are critical for an investment climate that promotes a vibrant private sector: 0 Low transactions costs. The cost o f doing business, or the cost o f transacting determines the way economic activity i s organized. If transactions costs are too high, business activity will either cease or adapt (generally perversely) to avoid those costs. By examining these costs, it i s possible to obtain insights into the constraints being imposed upon businesses and derive the implications for public sector policies and the ways inwhich the FYR Macedonian government can promote a dynamic investment climate for private sector growth. 0 Appropriate and effective institutions. The institutions that support private sector activity determine the way in which business is organized. Indeveloped economies these consist of secure property rights for b0th fixed and movable property, legal systems that allow for transparent long term contracting, court systems that enforce these contracts and resolve business disputes, and "light" and transparent regulation that govern business activity. 4.7 Ultimately, transactions costs and institutions are determinants o f Business Dynamism. Identifying factors that encourage firm formation and dynamism i s central to formulating effective policies or programs to promote the investment climate, and thereby a vibrant private sector that creates employment. Growth and new firm innovation are synonymous with large numbers o f firms being created as well as failing. It is this process o f"creative destruction" that leads to a dynamic private sector. C. CHARACTERISTICSOFN R MACEDONIA'S ECONOMYISSUES- RELATEDTO MARKET SIZE 4.8 FYR Macedonia's economy shares many o f the features o f small economies throughout the world. Among the most important are: 0 Small population and limited domestic market. FYR Macedonia's small population means that by default there i s a relatively limited local market and supply o f appropriately skilled labor.57 Economies o f scale are 57Educated and trained workers may be available but they might not have the skills that are necessary for the changing demand for labor. For example, a worker trained for heavy industrial work may not have the skills to switch to the services industry. 46 difficult to achieve, which raises costs and makes investing in new skills and technologies less attractive. As a result, firms are generally small. 0 Higher cost of Government. The per capita cost o f providing government services is higher for a small nation because there is a smaller population over which to spread the costs. The small state needs the same institutions as larger states but it cannot capture the economies o f scale in operating public services, formulating policy, undertaking regulatory activities, justice, and foreign affairs. Thus, the per capita cost o f the apparatus o f state is higher for FYR Macedonia, implying that taxes must be a higher proportion of income than in countries where economies o f size are captured. 0 Largepresence of the State. It i s often assumed that given small size, the state has a large role to play, both interms o f regulating the economy and in terms of ownership, for perceived disadvantages arising out of its "unique situation". FYR Macedonia is no exception-the State still has a substantial ownership o f resources, (especially of infrastructure and land5*) as w ell as residual direct ownership o f in d u s t r i e ~T. ~he ~ country has undergone significant privatization. However, many o f the newly privatized companies are unprofitable. Their losses are often financed by runningarrears intax payments, utilitypayments, andpaymentsto smaller suppliers. This "twilight zone" status will have to be confronted in the foreseeable future. 0 Residual ownership of SOEs. For far too long, the state continued to own a number o f companies that appeared unsellable, some o f which eventually entered into bankruptcy proceedings. The government recently initiated a massive sale o f about 200 companies, o f which 100 have been sold. 0 There is substantial regulation, especially in the labor market (see Chapter 3). State involvement in the economy creates inefficiencies by increasing costs to the private sector and hampering growth. The state does have a role to play in the economy but this role should be limited to restricting taxation, developing favorable land policy, ensuring consistency o f government decisions, reducing transactions costs for business, and ensuringthe security and enforceability o fprivate contracts. 0 Problematic environment for foreign investors. Foreign investors face a particular challenge inFYR Macedonia. Complicated local regulation and processes, small firms that are generally unattractive business partners, 58As of 1999, the state still owned, in one form or another, 21 percent of cultivable land. World Bank Report, 2002c, FYRMacedonia: Agriculture Sector Review" ,p.6. 59Although observers claim that there is no direct influence o f the state in the managing of these companies. 47 haphazard enforcement o f contracts, and an uncertain geo-political environment combine to make foreign investment risky. In addition, the nascent nature o f capitalism in FYR Macedonia makes many in government unfamiliar with its concepts, further compounding the problems o f local and foreign investors alike. 0 Geo-political issues. Small states, and FYR Macedonia is no exception, are particularly impacted by geopolitical issues. The impact o f the Kosovo crisis, the border closures by Greece, and the internal conflict o f 2001 all served to raise uncertainty by adding substantial political risk to business risks that were already considerable. It has been difficult or impossible for business owners to plan for the long term future. Investments without very high intemal rates o f return are unattractive. However, the corollary o f very highrates o f return is very highrisks o f failure. e Limited entrepreneurial skills. Participants in the private sector in FYR Macedonia often lack entrepreneurial skills because o f the heritage o f the Yugoslavian socialist system. FYR Macedonian entrepreneurs, therefore, are still struggling to develop the skills to compete with imports and penetrate export markets, particularly small enterprises.60Furthermore, the contracting, and customer service - so potential investment opportunities country i s adjusting to the realities o f the market - selling campaigns, are often overlooked.61 D. FYRMACEDONIA'S INVESTMENTISSUES CLIMATE:THEMAIN Financial MarketIssues 4.9 Inall economies, the financial sector plays a pivotal role infinancing investment by the private sector. A well functioning financial sector determines which investment demands are legitimate and should be funded and which should not. In mature financial markets, financial intermediaries are able to identifymore effectively those entrepreneurs with the best chances of successfully initiating new products and production processes. With the most promising firms and managers getting funds, improved capital allocation efficiency fosters faster growth. 60Phare ACE (2001). "A Comparative Analysis." p. 14. 61Phare ACE (2001) "Macedonia Country Study" p. 11. 48 Figure 4.1: ComparativeDomesticCredit to the Private Sector (% of GDP) 140 120 1M) 80 60 40 20 0 1987 1998 1999 m zoo1 0 "Joria, N R 0 Low i l c m Some, M i d D m / c f " t lndcatcrS 0 Laver niddeircon-e Mddeircm 0 Ippe nidleh c m IKQhircm 4.10 In terms of the availability of credit, financial markets in FYR Macedonia are underdeveloped relative to low andmiddle income developing countries (see Figure 4.l), although not especially so by the standards o f other transition economies (see table below). Inspite o f very low inflation, both lending and deposit rates are high (see Figure 4.2). The latter is a reflection of the loss o f confidence inthe banking system engendered by the freezing o f foreign currency deposit accounts during the break-up o f SFR Yugoslavia and the ongoing weak financial condition of many banks. The overall profitability o f the financial system i s very weak, with profit ratios that are among the lowest in the region. The share o f non- performing loans is around 16 percent o f the portfolio o f the bankingsystem. Figure4.2: ComparativeInterest rate Spreads(Lending minusthe DepositRate) 25 r--- 2 0 - D n 49 4.1 There are differing Table 4.1: Regional Comparisons of Credit to the Private Sector opinions among observers (% of GDP) regarding the impact o f the low level o f financial development on the toprivatesector D~mesticCredit 1997 1998 1999 2000 2001 investment climate. Yo of GDP claim that the problem i s not Some FkMacedokia 27.3 17.7 20.9 17.8 17.7 one o f limited access to credit, but rather that there are Albania 3.8 3.2 3.6 4.5 5.9 a limited number of Armenia 6 8.6 9.2 10.6 8.3 "bankable projects". Bulgaria 5.6 8 10.4 11.9 14.3 According to this view, firms Croatia 37.3 41.2 37.1 36.2 41.5 inFYRMacedonia have little Czech Republic 75.7 66.6 61 54 44.4 Estonia 26.5 25.3 26 25.5 27.3 experience in preparing Georgia 4.6 6.1 7.4 8.8 7.6 business plans and the banks KyrgyzRepublic 3,5 5.3 5.1 4.2 3.8 have limited experience in Latvia 10.5 14.9 15.7 18.6 23.2 granting and supervising Lithuania 10.9 11.3 13 11.5 11.5 commercial credits. In Moldova 7 13.9 11.8 12.7 14.8 addition, the large informal ~~~~i~ 8.4 11.6 8.1 7.2 7.8 sector, which operates Slovenia 28.6 32.8 36 38.1 40 the ambit o f the financial in cash' is Outside Source: World DevelopmentIndicatorsDatabase. sector. 4.12 Whatever the reason for the low volume o f commercial lending, experience in other countries indicates that limited access to credit makes it difficult for firms to take advantage o f investment and trading opportunities. Given the lack o f access to credit, businesses have to rely on their own sources o f capital - either personal or borrowed from friends and family.62 In FYR Macedonia, the lack o f credit combined with the uncertainty created by the geo-political environment and large costs o f being formal provides strong incentives to remain informal, small, and short-term in focus. In the opinion o f this report, it i s hard to avoid the conclusion that the financial sector is underperforming inits role o f financing the private sector. 4.13 Although FYRMacedonia has a system inplace for pledging movable property as the banks do not seem to be using it, although bankers have told visiting missions that the framework is satisfactory. Observers disagree as to why this is the case. Some believe that it i s a lack o f training o f bank officials in the new way of operating. Others see it as an extension o f the lack o f good investment opportunities, while others believe that it i s a problem with the courts. 62 This observation is confirmed by the 2002 BEEPS surveythat indicates that the share o f working capital for formal firms i s mostly comprised o f internal funds (47.71 percent) or loans from family/friends (17.65 percent.) Borrowing from any banks only comprised a total o f 7.04 percent. World Bank. 2002. BEEPS surveyresults, Table 6. Sources ofFinance. 63 Completed as part o f the World Bank FESAL 2000 program. 50 4.14 Experience inother countries, however, indicates that when a secured transactions reform fails to bringthe expected results, it is more likely that there are problems at some point in the four stages o f creating a secured tran~action.~~Alternatively, there are many examples o f good secured transactions laws that have been passed without amending other legislationthat govems lending thereby making the law ineffective. 4.15 Without further analysis, identifying the reasons for high interest rates and spreads i s not possible. However, a partial explanation i s undoubtedly the low level o f confidence inthe banking system. As long as the banks gradually improve the quality of their portfolios, confidence will return. Furthermore, the damage caused by directed credits, often at below market interest rates in other countries should discourage the Government and donors from attempting to short circuit the process inFYRMacedonia. Institutions,Regulation,andthe Ruleof Law 4.16 In addition to those related to the privatization program, FYR Macedonia has passed many laws that affect businesses. There have been attempts to reform laws and regulations related to property and tenancy rights, trade, the financial system, bankruptcy proceedings, movable collateral, creditor rights, and property registries. The aim o f much o f the legislation has been to improve the business environment. While some of the new laws embody rules for modembusiness practices, inmanyways the raft o f legislation has had a perverse effect and made doing business more difficult. The sheer volume o f lawmaking has engendered confusion regarding which rules actually apply.65Combined with the inability o f the courts to resolve disputes effectively,66the legislation has led to uncertainty and confusion and provided a fertile ground for petty corruption and favoritism - two factors that the private sector perceives as significant barriers to doing business in FYR Ma~edonia.~'The Government has recognized the damage that corruption i s causing the economy and has begun to implement measures to reduce it. These issues are discussed inmore detail inthe following paragraphs. 64 The four stages, which comprise a secured transactions framework, are: creation - establishment of the security interest; priority - establishment of the order in which claims are executed; publicity - disclosure o f the established priority; and enforcement -ability of the creditor to enforce the secured interest. 65 The Administrative and Regulatory Costs Survey determined that 68.2 percent o f respondents considered the "instability of changes in laws and regulations" as an issue. FIAS. 2003. p. 6. In the 2002 BEEPS survey, 37.34 percent o f respondents indicated that "Regulatory Policy Uncertainty" was a "major" problem and 61.39 percent o f respondents indicated that it was a "moderate" to "major" problem. See Tables 4a and 4b. The 1999 BEEPS survey found that 47.1 percent o f respondents considered changes in "Rules, Law, and Regulations" "Fairly Unpredictable," 9.6 percent thought they were "Highly Unpredictable" and 15.4 percent thought they were "Completely Unpredictable." 66 "Dealing through the court i s expensive and excessively time consuming, respondents do not think that their problems are big enough to go to Court (this may be a function o f cost and time), and that respondents do not necessary believe inthe court system in general." FIAS. 2003. p. 26 OECD, EBRD and Ministryo f Economy FYROM.2001. p. 30. 67 FIAS. 2003. p.18. 51 E.TOOLS FOR EVALUATING THE INVESTMENT CLIMATE Box 4.1: The BusinessEnvironment and EnterprisePerformanceSurvey TheLegal Framework The Business Environment and Enterprise Performance Survey (BEEPS) was developed and conducted by the World Bank and European Bank for Reconstruction and 4.17 Providing an effective legal Development (EBRD). The survey was undertaken in 22 framework for contracting and transition countries including FYR Macedonia. Two in- resolving disputes i s a central and person surveys were undertaken, one in 1999 and a second in2002.The survey inFYR Macedoniahadasamplesize of critical role o f the state. Such a approximately 160 firms in 2002 and 130 in 1999. The aim framework does not appear to exist in of the surveys was to examine interactions between firms FYR Macedonia in spite o f many and the state and gauge firm opinion regarding the current state of the investment climate in the country. The survey changes in the law. While an accurate queries respondents about areas such as corruption, diagnosis i s not possible without a government and regulation, public service provision and detailed investigation o f the laws and infrastructurequality that canthen be relatedto specific firm characteristics and firm performance. (Please note that the regulations, the situation suggests that 2002 BEEPS survey was undertaken just prior to the there are overlapping and September 2002 elections at a time when the country was contradictory laws and regulations as experiencinga great deal of uncertainty both interms of the government and internal unrest in the country. The geo- well as significant problems o f delays political situationhas since improved.But the survey results and enforcement in the courts. The must be viewedinthis light. timing and sequencing o f legal reform FIAS Administrative Barriers Survey The FIAS Administrative Procedures Survey was initiatives appears to have occurred undertaken by FIAS at the bequest of the government to haphazardly, which has resulted in assess the administrative barriers to doing business in FYR substantial opacity, particularly Macedonia. Through identifying barriers to conducting business, the government of FYR Macedonia intends to because there are reports from undertake a reform program (including dialogue with the business people that information on business community) that will hopefully improve laws and regulations i s difficult to investmentin the country. The survey was undertaken using two t ools - a detailed business survey (the Administrative obtain. Unfortunately, this situation andRegulatoryCosts Survey) and templates for government encourages corruption by giving agencies to complete. (One of the intents of the templates is "discretion" to officials, as business to establish "procedure descriptions" that can then be made available to the public.) The sample size for the business people are not armed with the survey was 500 private companies with the sample being information they need on the laws. representative of the composition of the FYR Macedonian Despite the legislative changes business environment. The business survey and templates were completed in 2002. (The government reviewed the undertaken by the Government, the data in January 2003 as well.) The data are useful as a expected improvement in areas related diagnostic tool but will also provide baseline information to to private sector activity-land, investors, provide the basis for future policy and regulatory reform, establish the basis for a dialogue with business, financial markets, the informal develop an action plan for the removal o f barriers to sector-have not been observed. The business. most probable reasons are a combination o f complicated overlapping legislation and inadequate enforcement mechanisms. Clarification is urgently needed, both to increase the transparency o f government and as a critical step inthe reform o f the legal foundation for business. 4.18 The laws that govern commercial transactions are a central determinant o f the way that firms structure their organization and conduct business. Business dealings rely largely on trust, the perception of mutual self-interest, and repeat transactions that lead to satisfactory outcomes. It is clear that in FYR Macedonia, trust in the legal system does not exist. Businesses avoid the courts and many deals are limited to a handshake, which makes entry by newcomers difficult, and leads to degradation o f the investment climate 52 through the loss o f potential business opportunities, and reduced business dynamism.68 The courts in FYR Macedonia are generally characterized as being corrupt, overly politically influenced, having little impact, and generally i n e f f i ~ i e n tApart from the . ~ ~ extra-judicial provisions o f the movable pledges law, out-of-court arbitration and conciliation are ineffe~tive.~'This situation increases the burden o f dispute resolution on the already overburdened and ineffective court system and exacerbates the time and cost o f obtaining justice. Delays and costs in the legal enforcement o f contracts are an impediment to the expansion o f contracting. FYR Macedonia's situation is so extreme that companies have been observed as saying that business i s done rarely by signing contract^.^^ This i a concerning sign for the investment climate. s TheImpact of Policy Inconsistency on Investment 4.19 Many observers o f economic policy in FYR Macedonia have commented on the inconsistent and complex nature o f policy.72This situation has at least partly been the result o f political instability but i s one that has had a dampening impact on investment and added to the incentives for many o f the most enterprising Macedonians to leave the country. Firms' ability to undertake long term planning has been significantly impacted, and compounded by burdensome regulation that has raised transactions costs associated with complying with the complexity o f the regulatory environment. A complaint o f the business community i s that the Government fails to consult with them or even inform them o f forthcoming changes in regulations, laws, and taxes that affect busine~ses.~~ More consultation with the private sector and signaling o f changes in laws and regulations affecting business is essential if this s ituation is t o improve. However, the private sector i s also at fault for failing to make better efforts at organizing itselfto lobby the Government. Corruption, Government Credibility, and the Rule of Law 4.20 Ultimately, the state o f the legal system and the policy environment are both indicators o f the potential for corruption. Unfortunately, inFYR Macedonia the endemic nature o f corruption i s o f great concern to busine~ses.~~ When corruption is considered 68 Both the 2002 BEEPS survey results indicate these problems-27 percent of respondents indicated the legal system and conflict resolution as a major problem and 50 percent o f respondents indicated that it was a moderate to major problem-and the SEE8 case studies with firms uncovered general distrust o f the legal system. 69SEE8 Case Studies. World Bank (forthcoming.). 70SEE8 Case Studies. World Bank (forthcoming.). 71 SEE8 Case Studies. World Bank (forthcoming.). 72 FIAS. 2003. OECD, EBRD, and Ministryo f Economy FYROM. 2001. FIAS. 1998.World Bank. 1998. World Bank. 1999 and 2002 BEEPS Survey. 73OECD, EBRD, and Ministryo f Economy FYROM. 2001. p. 30. 74 T h o one percent of respondents to the 2002 BEEPS survey listed corruption as a major obstacle to business and 49 percent listedit as a moderate to major obstacle. Tho-five percent o f respondents inthe 1999 BEEPS survey listed corruption as a major obstacle and 17.6 percent as a moderate obstacle. In the FIAS 2003 Study, 72.6 percent o f respondents saw corruption in the public sector as a problem and 66.8 percent saw favoritisdcronyism as a problem. p. 18 Thejudiciary was also a concern to the respondents to the World Bank 2003 MAEWS focus group study and the survey of 150businesses where they complained o f "inefficient and lengthy court procedures, absence o f good contract enforcement, and lack o f appropriate 53 acceptable and i s widespread, businesses suffer because of the increased costs o f conducting business and the uncertainty it creates and the public's trust in government and institutions i s undermined. Politicization o f bureaucratic decision-making has also been a problem with favoritism towards businesses associated with the ruling party. (Corruption thrives when regulation i s widespread, when regulations and laws, or changes t o t hem, are opaque, and when information onthem is not readily available.) Government credibility is a critical component o f confidence regarding the future o f a business and thus o fprivate investment.An absence o f credibility reduces investment and the returns to capital. (FYR Macedonia scored poorly in the index o f economic freedom maintained by the Heritage Foundation for some o f the critical elements o f the investment climate -trade,75property rights, and reg~lation.~~) 4.21 Reduction o f the role o f government through deregulation, privatization, trade liberalization, and consistency in national and local laws and regulation are fundamental means o f combating corruption. Copies o f commercial rules and regulations should be widely disseminated and readily and cheaply available so that businesses can keep current and have the information available to fend off bribe seekers. In addition, the Government has to identify andpunishperpetrators of corrupt practices. 4.22 The Government o f FYR Macedonia has committed to an anti-corruption strategy77to reduce the endemic corruption that exists in the country.78 In addition, they have prosecuted highprofile government officials for c~rruption,~~ passed anti-corruption legislation and public expenditure reforms. An area o f particular success i s in customs administration where there has been a striking reduction in corruption through the adoption o f more transparent procedures. 4.23 Anti-corruption strategies (see for example Klitgaard 1989) should generally aim to: 0 Reduce the control o f t he Government over activities and s ervices. (An issue that would be helped by a rationalization of business regulation as suggested.) 0 Reduce the de facto discretion granted to government agents through the confusing rules and regulations and lack o f information available on procedures. (The aim i s achieved by decreasing actual discretion as well as legal protection." P. 2. 75 The poor rating for trade probably reflects the rampant corruption in customs during the 2001-2002 period. The FYR Macedonian Government has made s trides, however, in improving the s ituation. FYR Macedonia as a whole received a rating o f 3.25 which i s not a poor score. 76With a scale o f 1through 5 with 1being positive and 5 being negative, FYR Macedonia scored a 5.0 on trade, a 4.0 on property rights and a 4.0 o n regulation. 77h~:/iwww.sinf.~ov.mk/ActEN/Governme~i~sessions12003~0 106lses0421.htm. 78"Strategy for FightAgainst Corruption inthe Republic o f Macedonia." 79 The Government prosecuted the former director o f the Health Insurance Fund, the former Minister o f Economy, and the former director o f Customs, among others. 54 increasing available information on regulations - as suggested by the FIAS2003 report.80) e Increase the accountability o f government agents. 4.24 The new government strategy takes some o f these principles into account. However, passing laws and establishing strategies must be followed by actions - actions that inmany cases may be politically difficult to complete and therefore, face significant opposition from interest groups. But follow through i s critical to improve business expectations andthe investmentclimate. Informality 4.25 The informal sector o f the FYR Macedonia economy i s large. A variety o f indirect estimates place the size o f the shadow economy at 40 to 45 percent o f official GDP (and informal employment as high as 60 percent o f formal employment). A large informal sector often implies that the institutions underlying business are weak, that financial systems are unavailable to smaller businesses and that the cost o f paying taxes and c omplyingw ithregulation outweighthe benefits o f being formal. Inaddition, the geo-political situation (intermittently closed borders, no enforced border with Kosovo/Serbia until 2001) encouraged smugglingand illegal, informal activity. (There is also a tradition o f working outside o f FYR Macedonia, which explains the pervasiveness o f foreign banknotes.) 4.26 The benefits o f formality include expanded access to credit and the banking system, establishing a legal entity for contract enforcement, dispute settlement, limited liability, and company closure, as well as access to large formal firms and the public sector as suppliers o f inputs. InFYR Macedonia, however, it appears that these benefits are uncertain at best. InFYRMacedonia, there is: e Limitedaccessto credit providedbythe financial market. e Pervasive and confusing business regulation that imposes highcosts on formal businesses. e A tax system that "punishes" success by focusing the attention o f government inspectors on businesses that report a profit.81 4.27 In other words, the incentive for formality in FYR Macedonia is low; a fact confirmed by the data. But simply ignoring the informal sector and the incentives that lead to informality i s not a good long run policy option. Growth o f informal firms is limited by their tendency to engage in spot contracting and by their restricted access to credit. In general, the productivity o f informal firms is low, a result o f short time horizons, and a limited ability to invest ineither human or physical capital. It also erodes The templates produced as part of the FIAS survey should result inprocedure descriptions that must be made available as soon as possible. 81 The observation was confmed again in the latest World Bank MAEWS focus group study where respondents complained o f the constant "attention" o f the Government and officials particularly if a business i s successful. 55 the tax base with the result that successful firms in the formal sector become a target for tax collectors - as noted there is a large "success" tax. The restrictions placed on informal firms also imply de facto that they have limited ability to hire employees, a critical need for FYRMacedonia. Land 4.28 Despite reform efforts in the area o f land inFYR Macedonia, issues with land tenure and rights remaing2Secure ownership and the ability to exchange land are critical for the investment climate particularly for the agricultural sector, foreign investment, the local business community, and small entrepreneurs. It i s also a precondition for the healthy development o f financial markets. Countries with insecure property rights to land have less developed financial markets and much lower rates o f investment. In most developed countries, the bulk o f small businesses are started using loans that are backed by land. Indeed, the lack of formalized property rightsprevents poor people from turning their latent assets into live financial capital - one reason why the entrepreneurial spirit that is so visible invirtually the entire developing world is not translated into a more inclusive pattem o f growth. InFYR Macedonia, land plays the critical role o f providing sustenance when employment cannot. Many o f the unemployed return to and rely on the land as a means o f supporting their basic needs. Land, therefore, plays a crucial role. Rural land i s mostly privately owned but there are restrictions on use. Urban land is mostly state owned though private ownership has recently become possible through the Law on Urban Land, which passed in July o f 2001. The restrictions on use and heavy state ownership and/or control o f urban land (particularly land that i s open for construction) i s a major issue for the manufacturing and services sector.83(According to the World Bank MAEWS study "the average number o f days for acquiring necessary permits for c onstruction and 1andw as 126 days.") A rea1estate c adastre does exist in FYR Macedonia, but only 40 percent o f land in FYR Macedonia is registered and this landdoes not represent the most productive parts o f the country. It also appears from the FIAS 2003 Administrative Barriers study that the legislative framework for land ownership anduse i s still unclear.84 4.29 Creating a good land tenure system is a challenging task made more difficult by the fact that basic institutions have to be inplace before those members o f society who needthem the most feel the benefits o f changes inproperty rights. Furthermore, inFYR Macedonia, the issues are complicated and have deep historical roots, which will make resolution difficult It i s hard enough to draft a good property law, but it is even more difficult to create local land registries, local cadastre offices, and local court systems that serve all the citizens. In addition, there i s the difficulty o f finding the professional skills needed for mortgaging, conveyancing, surveying, property valuation, and other institutional services that form part o f a land management system. All these factors have '*As mentioned previously, the FI A S Administrative Barriers study determined that isues surrounding land tenure were problem one o f the largest problems inFYR Macedonia. See footnote 8 above. 83Agriculture is considered a more important priority, however, because o f the importance of the sector for the general population and development o f the private sector. 84FIAS. 2003. OECD, EBRD, and Ministry o f Economy FYROM.2001 p. 60. 56 to be inplace before a land market can be expected to play a full role inthe development o f the private sector and the economy. Inaddition, donors inmany countries have tended to recommend overly technical solutions to titling and registration programs with the result that countries end up with costly high-resolution maps but no secure titled registered land. TheAgriculturalSector 4.30 Macedonia still has a substantial agricultural sector, equivalent to nearly llpercent o f GDP as o f 2001g5 and accounting for 12 percent o f employment as o f 2000.86It is made up o f a combination o f the remainder o f the state owned or previously state-owned agricultural cooperatives, which account for about 20 percent o f the total cultivatable 1and and a 1arge number o f private holdings (79 pe r ~ e n t )The . ~ ~ 1atter are small, averaging less than three hectares scattered over 6 separate plots, many o f which support families on a subsistence basis.8g Nevertheless, encouraging examples o f agricultural production for the local market both within FYR Macedonia and from neighboring countries show that there i s significant private sector potential inthis sector. Nevertheless, agriculture suffers from the same impediments to private sector growth as the rest o fthe economy. 4.31 Although the land i s fertile, productivity i s low due to the combination o f inefficient sized lots and the lack o f investment both infertilizer and inmachinery. Banks generally will not lend against agricultural land because o f the uncertainty o f title and in spite o f the s ecured transactions 1aw, future crops are an insufficiently secure asset t o mitigate the risks that banks feel they take and, therefore, farmers are effectively left without collateral. 4.32 There are means to improve access to capital for agricultural producers in the longer term through effective titling and registration and inthe shorter term through using the secured transactions framework. Rural finance projects could have relevance for FYR Macedonia (But any project should follow the lead o f the Romanian rural finance project, which combined a far reaching and very successful reform o f the secured transactions frameworkg9 with providing market-based access to credit for activities related to agriculture.) Other Issues 4.33 The issues listed above are the primary areas that deserve attention from the Government. There are, however, other issues that do impact the investment climate that will need attention soon so the environment is not negatively effected. Those issues include: 85 World Development Indicators Database. 86 World Bank. 2002c. p.viii. "WorldBank.2002c.p.viii. 88 World Bank. 2002c. p. 7. 89 Inthe space oftwo years, over 500,000 collateral pledges have beenregistered. 57 0 State involvement in the economy. The Macedonian economy still has a highlevel of state involvement inthe economy. Privatization efforts have gone well with 95 percent" o f the companies originally listed for privatization being sold, but there remain a number o f companies that are acting as a severe drain on the government budget, diverting funds away from infrastructure improvement and the social sectors. With the expected closure o f these state-owned companies, an additional 30 thousand jobs will be lost. So, FYRMacedonia's transition period has yet to end. But the Government must undertake these steps if the country is to truly reap the benefits o f reform through an improved investment climate and economic growth. Such a step will reduce budget pressures and release resources for social spending, as well as positively effect expectations regarding the Government's commitment to improving the investmentclimate. 0 Foreign investment regulation. The Government o f FYR Macedonia requires that foreign investment must be approved by the Ministry o f Foreign Affairs - this approval or rejection now has a limitation o f 8 days at which time the investor must be notified. This change is a great improvement over the previous situation where subjective decision- making by judges as to the merit o f companies. But approval is still required. In addition, any foreigners wanting to purchase land must have the purchase approvedby the Ministry o f Justice and foreigners wanting to work in the country must apply for a visa, the requirements for which are lengthy, and the visa i s only valid for a year." The Government seems to want to vet projects to ensure they are genuine in nature. But these requirements have the effect o f discouraging legitimate investors as well as the less-legitimate ones. Experience in such countries as China, Singapore, and Brazil has illustrated that foreign direct investment (FD1)-with its transfer o f technical and organizational skills, best practices, and market access-stimulates rapid growth in incomes for all members o f society. The Government has redrafted the Trade Company Law but enforcement has been delayed. 0 Infrastructure. Reliable infrastructure i s a critical contributor to business competitiveness. Good quality highways and railroads and reliable energy and communications are central to a business being able to compete inthe global economy. Countries with unreliable infrastructure handicap their businesses compared with businesses in countries with reliable infrastructure - the poor infrastructure acts as a tax on business because o f the expenditure that is necessary to overcome the shortcomings. Different surveys yield differing opinions regarding the quality o f infrastructure in FYR Macedonia. Respondents to the FIAS Administrative Procedures 2003 survey considered infrastructure (quality and costs) to be a problem 90PrivatizationAgency o f the Republic of Macedonia. httu:/lwww.m~a.or~.mkl~rivatization.as~`?id=22 91FIAS. 2003. p. 21 and 22 58 but relative to other issues, it was not a highpriority.92On the other hand, inthe 1999 BEEPS survey, for all ofthe types ofinfrastructure except for roads - water, electricity, mail, and telephone - around 50 percent o f respondents classified the quality and efficiency o f the services to be "good.93 Currently, the Government is responsible for all infrastructure excluding telecommunications, which was privatized. The Government, as o f May 2003, has also committed to spend Euro 50 million on various infrastructure projects inthe country.94 F.RECOMMENDATIONS TOWARDSSTRATEGYFORIMPROVINGTHEINVESTMENT - A CLIMATE 4.34 The needforfurther analysis. Although there are several surveys o f the business community in FYR Macedonia that provide information on issues facing the private sector and foreign investors, there i s still a shortage o f analytical work that identifies priorities for improving the investment climate. While this chapter has attempted to provide an initial look at the issues, additional, deeper analytical work on investment climate issues should be undertakenwith the goal o f identifying a manageable number o f priorities for reform. A clear place to start is with the extensive data collected inthe two BEEPSsurveys, the overall results o fwhich are shown inFigure 4.3. Figure4.3: Perceptionsof the BusinessClimate, 1999 and 2002 Financing - - - FYRMacedonia 1999 c --- FYR Macedonia 9 T I a .. x 2002 -Worst Case Source: BEEPS, 1999 and 2002, World Bank andEBRD. 4.35 Why is the banking sector notfinancing investment? An earlier section o f this chapter hypothesized that there may still be problems with the collateral framework, in spite o f a new law that purportedly modernized the ability to pledge assets as security for loan. Given the importance o f this issue for financial market development, this report recommends that there be a thorough review o f the secured transactions law and its 92FIAS.2003 p. 80 and 81. 93BEEPS 1999 Infrastructure questions. 94http:/lwww.sinf.gov.mkiActENlGovernmentlsessions/200310106ises0513.htm. 59 enforcement procedures (including the judiciary) as well as legislation related to collateral to ensure that the mechanisms function as designed. Further, the banks have little incentive to finance long-term investment projects when relatively risk-free rates on Central Bank bills bore double-digit rates o f return untilrecently. 4.36 Land titling and registration is an urgentpriority. The agricultural sector has the potential to be a growth sector in the economy. However, uncertainty regarding ownership reduces incentives to invest in the land, makes consolidation o f small plots difficult and prevents using land as collateral. Two courses o f action are needed. First, it i s timely to commence a titling and registration program that results in genuine titling, i s not unnecessarily technical, and takes into account local customs in the land market. By rationalizing the process, the current titling procedure that started 10 years ago but has only registered 40 percent o f land, could be sped up and issues with urban landcould also be resolved during this process. However, time horizons over which reform can be reasonably expected are long - decades rather than years. Nevertheless, if the process i s well established and is seen to work, the certainty o f future titling will improve tenure rights and values. 4.37 Using the secured transactionsframework tofirzance land improvements. Inthe interim, there are ways inwhich the secured transactions framework, properly specified, can be used to facilitate taking real estate as collateral. This paper recommends strongly that this option be explored. Users o f the land do not necessarily need title in order to undertake improvements if the improvements themselves c an be pledged as c ollateral. Alternatively, a well designed secured transactions law allows for the pledging o f future rights. 4.38 Establish formal consultation procedures with the private sector. The business community in FYR Macedonia complains, apparently with justification, that they are excluded from decisions that vitally affect their interests. This paper recommends that consultation mechanisms be established. The procedures would involve regular meetings with private sector representatives in which proposed legislation could be discussed and in which the private sector could apprise the Government o f their problems. As part o f the process, the parties could undertake a joint review o f legislation and regulations that are counterproductiveto private sector activity. 4.39 Labor markets and legislation. 0ther parts o f this report have examined 1abor issues in detail. The impact o f current labor regulations on hindering private sector activity and encouraging informality should not be underestimated. A private sector perspective adds weight to the recommendations that labor market regulation be reviewed with urgency. 4.40 Specialized commercial courts. Besides being contradictory, secretive, and confusing, the operation o f courts in hearing commercial cases i s also hampered by judges who are unfamiliar with commerce and commercial law. This report therefore recommends that a system o fpublicizing commercial laws and regulations be formalized, with the assistance o f donors and that there be intensive training o fjudges incommercial law. 60 4.41 Continue with combating corruption. 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IMF Working Paper Wp/03/136, Washington, D.C. 64 MAP SECTION