MOLDOVA TRADE STUDY Note 1. Analysis of Trade Competitiveness

Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized MOLDOVA TRADE STUDY Note 1 Analysis of Trade Competitiveness The World Bank 1

Table of Contents 1. Executive Summary... 6 2. Introduction... 9 3. Part I. Export Outcomes Analysis... 10 3.1 Overall Trade Trends... 10 3.1.1 Trade growth and balance... 10 3.2 Openness to Trade... 14 3.2.1 Outcomes-based indicators of openness... 15 3.2.2 Policy-related determinants of trade openness... 17 3.2.3 Foreign direct investment... 19 3.2.4 Composition of exports... 22 3.2.5 Growth orientation in products... 24 3.2.6 Services... 25 3.2.7 Main export markets... 26 3.2.8 Growth orientation in markets... 28 3.3 Export Diversification... 29 3.3.1 Product dimension... 29 3.3.2 Market dimension... 31 3.3.3 Contribution of diversification to export growth... 33 3.4 Quality and Sophistication... 33 3.4.1 Technological classification... 34 3.4.2 Quality... 35 3.4.3 Quality in top export products... 36 3.4.4 Sophistication... 39 3.5 Survival... 41 4. Part II. Assessing Moldova s Main Competitiveness Challenges... 43 4.1 What Factors Enhance and Constrain Moldovan Firms Productivity?... 44 4.1.1 Productivity... 44 4.1.2 Firm-level determinants of productivity... 44 4.1.3 Linking productivity and quality of backbone services... 45 4.2 Linking Productivity with the Business Environment and Governance... 52 4.2.2 Business regulations: taxes, red tape, and trade and customs procedures... 52 4.2.3 Governance and institutional quality... 56 5. Policy Recommendations... 58 6. Appendix... 61 List of Figures Figure 1. Evolution of Merchandise Trade, 2000-2013... 11 Figure 2. Relationship Between Re-exports and Exports of Transportation Services... 12 Figure 3. Merchandise Exports Performance, 2000-2013... 13 Figure 4. Evolution of Services Trade, 2000-2013... 13 Figure 5. Share of Services in Total Exports... 14 Figure 6. Openness to Trade, 2000-2013... 15 2

Figure 7. Trade in Services as Percent of GDP vs. Income Levels... 16 Figure 8. Final Bound vs. MFN Applied Tariffs on Imports, 2013... 17 Figure 9. Bound vs. MFN Applied Tariffs on Imports, 2013... 18 Figure 10. FDI Inflows as Percent of GDP, 1992-2013... 19 Figure 11. Benchmarking Moldova s FDI Attraction Levels... 20 Figure 12. FDI Inward Stock, by Sector... 21 Figure 13. FDI Inward Stock by Origin, 2012... 21 Figure 14. Evolution of RCA, 2000-2013... 23 Figure 15. Growth Orientation in Products, 2003-2013... 25 Figure 16. Sectoral Composition of Services Exports... 25 Figure 17. Main Export Destinations, 2000-2013... 27 Figure 18. Export Composition by Region... 28 Figure 19. Growth Orientation in Markets... 28 Figure 20. Number of Exported Products... 30 Figure 21. HHI for Products... 30 Figure 22. Share of Top Products in Total Exports, 2000-2013... 31 Figure 23. Number of Markets, 2000-2013... 31 Figure 24. HHI for Markets, 2000-2013... 31 Figure 25. Share of Top Markets in Total Exports, 2000-2013... 32 Figure 26. Decomposition of Export Growth Along Extensive and Intensive Margins... 33 Figure 27. Technological Classification of Exports (Lall Classification, %)... 34 Figure 28. Export Quality Index, 2000-2011... 35 Figure 29. Relative Quality of Traditional Exports, 2003-2013... 36 Figure 30. Relative Quality of New Exports, 2003-2013... 37 Figure 31. EXPY for Moldova and Comparators, 2000-2013... 40 Figure 32. Export Relationships Survival Rates (2000 2013)... 42 Figure 33. Export Relationships Survival Rates by Sector, 1996 2012... 42 Figure 34. Median TFP in Moldova by Region... 44 Figure 35. Productivity Premium of Exporters, Innovators, Foreign Firms in Moldova... 45 Figure 36. Median Productivity Across Sectors in Moldova... 46 Figure 37. Perception-Based Quality of Services... 47 Figure 38. Perception-Based Quality of Services by Region... 48 Figure 39. Objective Indicators of the Quality of Services... 49 Figure 40. Objective Indicators of the Quality of Services in Moldova, by Region... 50 Figure 41. Government Regulations, Moldova and Comparators... 53 Figure 42. Trading Across Borders Indicators... 54 Figure 43. Logistics Performance Index (LPI) for Moldova and Comparators, 2014... 54 Figure 44. Percentage of Firms Perceiving Customs, Trade Regulations as Obstacles... 55 Figure 45. Which Aspect of the Business Environment Represents the Biggest Obstacle?... 56 Figure 46. Productivity Losses Associated with Corruption... 57 List of Tables Table 1. Main Destinations of Re-exports... 12 Table 2. Main Products Re-exported... 12 Table 3. Change in Moldova s Shares of Merchandise Exports... 23 3

Table 4. Top 10 Exported Products... 24 Table 5. Top 10 Destinations... 26 Table 6. Moldova s Top 20 Exports, 2003 and 2013... 34 Table 7. Financial Indicators for Moldova and Comparators... 49 Table 8. LPI (Rank), 2007-2014... 54 List of Boxes Box 1. Re-exports in Moldova... 11 Box 2: Policy Options for the Wine Sector in Moldova... 37 Box 3. Measuring Relative Quality of Exports Using Disaggregate Trade Data... 39 Box 4. Measuring Export Sophistication... 41 Box 5. Estimating the Impact of Services Inputs Quality on Firms Productivity... 51 4

Acronyms ATP BEEPS CIS DCFTA ECA EU FDI FTA HHI MFN MIEPO NZW RCA TFP WTO Autonomous Trade Preferences Business Environment and Enterprise Performance Survey Commonwealth of Independent States Deep and Comprehensive Free Trade Agreement Europe and Central Asia European Union Foreign direct investment Free trade agreements Hirschman-Herfindahl Index Most Favored Nation Moldova Investment and Export Promotion Organization New Zealand Winegrowers Revealed comparative advantage Total factor productivity World Trade Organization 5

1. Executive Summary As a small economy, Moldova s growth and development prospects are closely related to its performance in international and regional markets. With a strong reliance on remittances and the exports of a few commodities, Moldova remains one of the poorest and most vulnerable countries in the region. Despite strong economic growth over the last decade, Moldova s export performance has been unremarkable. In recent years, Moldova s economic performance has been crucially affected by developments in the Russian Federation and geopolitical tensions between the latter and the European Union (EU). The possibility of increasing economic linkages with the EU through a Deep and Comprehensive Free Trade Agreement (DCFTA) calls for a thorough assessment of trade performance. In this report we have looked at the export performance and competitiveness of the Moldovan economy. Specifically, we addressed two complementary issues: First, we assessed how exporters perform in the global marketplace by looking at four dimensions of competitiveness: growth, diversification, quality upgrading, and survival. We benchmarked Moldova s performance against that of comparator or aspirational countries. Second, we investigated constraints on Moldova s competitiveness focusing specifically on a series of supply-side factors, such as the role of backbone services, access to finance, the business environment (particularly government regulations affecting trade and governance), and institutional quality. Using firm-level data from the World Bank/EBRD Business Environment and Enterprise Performance Survey (BEEPS), we assessed Moldova s performance in these areas and then investigated their effect on firm productivity and performance. Moldova is highly integrated into the global market place, mainly as a consequence of high import penetration. The country s trade to gross domestic product (GDP) ratio of 125 percent is substantially higher than that of its regional comparators. In contrast to its peers, however, Moldova has failed to deepen its relative trade openness over the last decade. This is because, despite the sum of exports plus imports having expanded substantially, from US$1,250 million in 2000 to US$7,800 million in 2013, income per capita grew even more. Indeed, GDP per capita, which was US$370 in 2000, reached US$2,470 in 2013. Even when measured in real terms, income per capita growth was impressive, at an average rate of 5.8 percent. The recent expansion of merchandise trade in Moldova has been primarily driven by imports. Imports experienced a six-fold increase between 2000 and 2013, growing at an average annual rate of 16 percent. In comparison, exports have been less dynamic, growing at a slower average annual rate of 13 percent and experiencing a 20 percent decrease in 2009. Although export growth has recovered over the last year, the trade balance has remained negative during the 2000-2013 period. The sizeable trade deficit has been financed mainly by inflows of remittances, and to a lesser extent, by foreign direct investment (FDI). Moldova s export performance compares poorly with regional peers. 6

Trade in services has achieved greater dynamism than trade in goods. Indeed, during the last decade, exports of services have grown faster than imports. While the services export growth averaged 16.5 percent per year, imports grew at an annual average 13.9 percent. FDI Inflows to Moldova increased tenfold between 2002 and 2007, reaching 12 percent of GDP in 2007, Although FDI inflows were hit by the 2009 financial crisis, the share of FDI in GDP in 2013 (3.11 percent) was above the level expected given its income per capita. The composition of Moldova s main export basket has shifted in the past decade, with exports of machinery and vegetables increasing in importance at the expense of foodstuffs and textiles. Wine, the top export product in 2003, fell to the fourth place in 2013, in part due to trade restrictions imposed by Moldova s main wine importer, Russia, and in part due to the dynamism of other export products. While wine exports accounted for 21 percent of total exports in 2003, they represented less than 9 percent in 2013. Indeed, in 2013, the main export product was co-axial cables and other electric conductors, mainly explained by the production of a handful of foreign firms that transformed the production structure of the country. Moldova has diversified its export product base, although less than comparator countries in the region, with the number of varieties exported growing from 274 in 2000 to 393 in 2013. Export revenues remain concentrated in a few products. The top five products account for onethird of total exports, making the country significantly vulnerable to external shocks. Moldova has achieved greater diversification along the market dimension, with the count of export destinations reached by exporters growing from 63 to 103 from 2003 13. Moldova significantly decreased its reliance on markets in the Commonwealth of Independent States (CIS), shifting toward European countries. The share of Moldovan exports going to Russia decreased from 39.5 percent in 2003 to 14 percent in 2013. In recent years, new markets, such as China, Egypt, and Turkey, have gained salience among top export destinations. However, there is still significant scope for further diversification and for expanding trade ties with more distant markets. While most of Moldova s export growth is explained by the expansion of sales of the same products to the same markets, diversification in markets has been a growing driver of export growth. The increase in market destinations explains more than half of the export growth observed in recent years. In addition, the new products introduced accounted for a sizeable 9 percent export growth in recent years. Moldova s export basket has experienced a quality upgrade between 2003 and 2013 but remains limited when considering regional peers. However, the sophistication of Moldova s exports has not changed substantially in the last 10 years. Indeed, the country s export sophistication has lagged behind the country s growth during the last decade. It is also low when compared with other countries in the region. Moldova s export survival rates are significantly below those of comparators. The probability of a Moldovan export relationship surviving past the first year is less than 40 percent. Our findings show that the chances of survival of export relationships vary according to destination and export product. Exports to preferential trade partners Russia, Kazakhstan and Belarus have the highest 7

survival rates. Exports of foodstuffs and vegetables and other low-technology products have the highest survival rates. Moldova s competitiveness remains hindered by a series of supply-side obstacles, including poor access to finance, weak infrastructure and backbone services, and an inefficient business environment. Almost 25 percent of surveyed firms viewed access to finance as a severe obstacle to their performance. These perceptions reflect objective conditions. Moldovan firms confront significantly high cost and limited access to external funds. Indeed, almost 70 percent of all investments in fixed assets are financed with internal funds. High reliance on internal funds and high collateral requirements are associated with lower total factor productivity levels. There is negative premium or bribe tax associated with corruption. Corruption has an adverse effect on firm performance and productivity. Moldovan firms that allegedly used informal payments and gifts to deal with customs procedures and with the courts had lower productivity levels than their counterparts. Specifically, firms that relied on bribes were between 6 and 7 percent less productive than their counterparts. 8

2. Introduction As a small economy, Moldova s growth and development prospects are closely related to its performance in international and regional markets. With a strong reliance on remittances and the exports of a few commodities, Moldova remains one of the poorest and most vulnerable countries in the region. Although the country grew at an annual average of 5.6 percent between 2001 and 2008, it was severely hit by the global economic crisis, experiencing a 6-percent contraction in 2009. After recovering in 2010, the economy contracted again in 2012 as the economy was hit by a drought-induced contraction in agriculture and weaker external demand due to the Eurozone crisis. In response, the government has launched the Moldova 2020 national development strategy, which aims to move from a remittance- and consumption-driven model of growth to an export-driven model in order to reduce the economy s vulnerabilities and spur job creation. 1 The expansion of exports of goods and services, at the center of the new development model, will require attracting foreign investment to facilitate participation in regional value chains, and encouraging productivity upgrading and innovation to enhance efficiency and competitiveness. This report provides an overview of Moldova s trade competitiveness. Its objectives are twofold: (i) to present a comprehensive analysis of Moldova s recent trade performance and (ii) to identify policy measures and interventions that can enhance the competitiveness of Moldova s export firms and the value added of their exports. Specifically, we address the following questions: How has Moldova s trade in goods and services evolved in the last decade? How does this performance compare to that of peer countries and groups? What are the potential opportunities for trade expansion? What policies are needed to increase trade and investment integration and to gain from it? The framework of analysis of this report draws upon the World Bank s Trade Competitiveness Diagnostics (Reis and Farole, 2012). The report is divided into two main parts. Part I contains an exports outcome analysis. It assesses export performance along four dimensions that contribute to form a comprehensive picture of the sustainable competitiveness of the export sector, including (i) the level, growth, and market share performance of existing exports (the intensive margin ), (ii) diversification of products and markets (the extensive margin ), (iii) the quality and sophistication of exports (the quality margin), and (iv) the survival of export flows (the sustainability margin ). Part II investigates constraints on Moldova s competitiveness, focusing specifically on a series of supply-side factors, such as the role of backbone and input services and utilities, and access to finance; and the business environment, particularly government regulations affecting trade and governance and institutional quality. Using firm-level data from the World Bank/EBRD Business Environment and Enterprise Performance Survey (BEEPS), we assess Moldova s performance in these areas and then investigate their effect on firm productivity and performance. 1 World Bank, 2014, Republic of Moldova: Policy Priorities for a Private Sector Development, p. 1. 9

The rest of the report is structured as follows: Section 2 examines overall trends in trade flows, including the growth of exports and imports, the degree of trade openness, and the recent evolution in foreign direct investment flows. In Section 3, we concentrate on export outcomes, analyzing the sectoral composition, the growth orientation, and degree of diversification of Moldovan exports. We also analyze the evolution in the quality and sophistication of exports and the survival of export relationships in different markets and sectors. In the second part of the report, we look at productivity dynamics of Moldovan firms in comparative perspective, and then investigate the impact of access to finance, backbone services, trade and customs regulations, and corruption on firm productivity. 3. Part I. Export Outcomes Analysis 3.1 Overall Trade Trends 3.1.1 Trade growth and balance Trade in goods has expanded dramatically over the last decade, with imports being substantially more dynamic than exports. The remarkable growth in trade has been driven primarily by imports, resulting in a progressively deteriorating trade balance. Indeed, since 2000, exports expanded at an average rate of 13 percent per year, while import growth averaged 16 percent per year. Exports contracted slightly in 2006, as a result of trade sanctions imposed by one of its main partners, Russia, and more markedly in 2009, following the onset of the global financial crisis, and the decline in demand from its other main partner, the EU (Figure 1a). The underwhelming performance of exports in recent years, when compared to the more dynamic imports, have led to a progressive deepening of the trade deficit, which in 2013 was 10 times larger than in 2000 (Figure 1b). Exports decreased slightly, from US$1,619 million to US$1,529 million, between 2013 and 2014. 2 Re-exports have been increasing in importance since 2005. They accounted for 33 percent of total exports in 2013. There are different definitions for the concept of re-exports. In this report, re-exports measure the exports of previously imported goods without any transformation. In Moldova, this category grew by almost 150 percent between 2004 and 2005, increasing their share of total exports from 1.8 to 20 percent. Re-exports represented almost 40 percent of the value of exports in 2008, as Moldova took advantage of EU special preferences not enjoyed by other CIS members. While representing an expanding external inflow, re-exports are typically associated with little job creation value addition, relative to direct exports (see Box 1). 2 According to both Comtrade and UNCTAD, exports increased by 12.3 percent in 2013 and fell by 3 percent in 2014. 10

Millions USD Millions USD Figure 1. Evolution of Merchandise Trade, 2000-2013 a. Imports, exports, and trade balance b. Imports, exports, and re-exports 3,000 2,000 1,000 0-1,000-2,000-3,000-4,000-5,000 6,000 5,000 4,000 3,000 2,000 1,000 0-6,000 Exports Imports Trade Balance Exports Re-exports Imports Note: The value of exports in panel (a) includes re-exports. Source: Authors calculations based on data from UN Comtrade. Box 1. Re-exports in Moldova 11

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Re-exports, in Million USD Exports of Transportation Services, in Million USD Re-exports have become increasingly important in Moldova. Since 2000, they have been growing at a cumulative rate of 35 percent per year. Because they imply no domestic transformation of merchandise, it has been argued that re-exports have little impact on jobs or domestic value creation. Anecdotal evidence suggests, however, that the surge in this type of low is explained by firms that prefer to rely on Moldovan transport companies know-how in certain markets mainly in Russia, rather than relying on their own. Under that hypothesis, the value addition associated with these flows happens in the services sector rather than in manufacturing. Figure 2. Relationship Between Re-exports and Exports of Transportation Services 1200 1000 800 600 400 200 0 450 400 350 300 250 200 150 100 50 0 Re-exports and exports of transportation services are correlated. Figure 2 shows the evolution of exports of transportation services and of re-exports, broken down into those to Russia (blue) and those to the rest (red). The series show co-movement. For example, in levels, the correlation between re-exports to Russia and exports of transportation services is 86 percent, while when measured in growth rates, it is still a sizable 30 percent. Re-exports to other countries Re-exports to Russia Exports of Transportation Services Source: Authors calculations based on UN Comtrade and UNCTAD. Russia accounts for almost half of re-exports of Moldova. Table 1 reports the top five destinations of re-exports for 2013. It reveals that although Russia accounted for half of them expressed in values, other destinations play an important role, including Romania and Italy. In terms of the main products being re-exported, the picture is more diversified, with the top five products accounting for only 22 percent of total re-exports (Table 2). Table 1. Main Destinations of Re-exports Top 5 Market Value in destinations of reexports USD Mln Share of re-exports in 2013 Russian Federation 399.7 49.4 Romania 99.7 12.3 Italy 71.3 8.8 United Kingdom 37.4 4.6 Unspecified 31.1 3.8 Source: Authors calculations based on UN Comtrade. Table 2. Main Products Re-exported Top 5 products reexported in 2013 Value in USD Mln Share of re-exports in 2013 Other Medicaments 90.81 11.23 Ignition wiring sets 36.42 4.50 Other mountings 24.83 3.07 Shampoos 17.60 2.18 Petroleum oils 15.32 1.89 Source: Authors calculations based on UN Comtrade. Moldova s merchandise export growth has lagged behind regional comparators. Moldovan merchandise exports increased 3.5 times their dollar-value between 2000 and 2013. As Figure 3 reveals, this performance pales in comparison with the dynamism exhibited by other countries in Eastern Europe and Central Asia, such as Albania and Lithuania, which saw their exports grow 12

2000=100 almost nine times between 2006 and 2013. Yet, Moldovan exports have experienced a sustained increase since 2009, growing at an average rate of 20 percent between 2009 and 2013. Indeed, exports doubled during this 4-year period. 1000 Figure 3. Merchandise Exports Performance, 2000-2013 900 800 700 600 500 400 300 200 100 0 Moldova Ukraine Slovakia Belarus Albania Hungary Lithuania Georgia Poland Source: Authors calculations based on UN Comtrade data. On the other hand, trade in services has achieved significant dynamism in the past decade. Exports and imports of services have expanded at comparable rates (Figure 4a). Since 2000, exports in services have grown at an average rate of 16.5 percent per year. During this period, imports have also grown but at a slower pace (average 13.9 percent per year). Indeed, Moldova s trade balance in services has been slightly negative during the period under analysis. Figure 4b shows that although Moldova s service trade balance is negative, it has grown over the last 10 years. As a consequence of their dynamism, services exports have increased importance as a share in total exports, accounting for one-third of total exports since 2008. The share of services in the total goods and services export basket reached 34 percent in 2008, and despite declining marginally after the global financial crisis, it recovered in 2012 (Figure 5a). The relative weight of services in total exports is larger for Moldova than for all of its comparators, except for Albania and Georgia (Figure 5b). Moldova s export growth performance in services is also on par with that of its regional comparators. Services exports growth was only slightly below the growth rates of Albania (average 17.7 percent per year), Belarus (18 percent) and Georgia (21 percent). By contrast, Moldova outperformed other countries in the region, such as Hungary, Ukraine, the Slovak Republic, and Poland. Yet, a different picture emerges when one considers the services trade balance indicator. Figure 4. Evolution of Services Trade, 2000-2013 a. Imports, exports, and balance b. Trade balance in goods and services 13

Services exports as percent of total exports Percent Millions USD Percent of GDP 900 10 0 400-100 -10-20 -30-40 -600-50 -60-1,100 Imports Exports Balance Services Goods Source: Authors calculations based on UNCTAD data. Figure 5. Share of Services in Total Exports a. Moldova, 2000-2013 b. Moldova and comparator countries, 2000, 2007, 2013 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Goods Services Source: Authors calculations based on UNCTAD data. 70 60 50 40 30 20 10 0 ALB BLR GEO HUN LTU POL MDA SVK UKR 2000 2007 2013 Services exports growth rate 2010-13 Source: Authors calculations based on UNCTAD data. 25 20 15 10 5 0 3.2 Openness to Trade How open is the Moldovan economy to trade? There are two approaches to this question. The first focuses on outcomes. A typical indicator is the trade-to-gdp ratio. It weighs the combined importance of exports and imports of goods and services in an economy, and gives an indication 14

of trade integration in the global marketplace. The problem with this indicator is that some countries may trade more than others for reasons related to their geography (landlocked countries like Moldova, or islands typically present a handicap to trade) or their economic size (firms in large economies tend to trade internationally less than small economies because they have more scope to trade among themselves). For these reasons, outcome-based indicators of openness are typically complemented with policy-based indicators. The second approach then focuses on policies one example is the tariff barriers that the country imposes on imports of goods or services, and the tariffs faced abroad for the products it exports. We follow both approaches to describe Moldova s openness below. 3.2.1 Outcomes-based indicators of openness Empirically, there tends to be a concave relationship between trade openness and per capita income: trade increases with income per capita, at a decreasing rate. Figure 5 shows the location of each country in the world along these two dimensions for the periods 2000 03 and 2010 13. Moldova is highly integrated into the global marketplace, exceeding the levels of openness of other countries at comparable income per capita. Figure 6a and 6b show that Moldova is well above the predicted line, revealing that the country is more open and more integrated into the global economy than expected, given its development level. Indeed, with a trade-to-gdp ratio of 125 percent, Moldova s trade openness surpasses that of regional peers of comparable small size, such as Georgia, Albania, and Ukraine. However, the comparison between the two panels suggests that Moldova has not considerably deepened its trade integration over the last decade. The tradeto-gdp ratio increased between 2000 and 2007, reaching a peak of 145 percent, but was negatively affected by the global financial crisis in 2008 09. Figure 6. Openness to Trade, 2000-2013 a. 2000-2003 b. 2010-2013 Note: The panels plot the relationship between trade openness and GDP per capita for all countries. Relevant comparators are labeled. The curve shows the expected trade openness for a given per capita income. The white band represents the 95 percent confidence interval. Countries above (below) the confidence interval are said to be more (less) open to international trade than what their economic development implies. Source: Authors calculations using data from WDI and UN Comtrade. 15

By contrast, some of Moldova s comparators, most notably Georgia, and an aspirational country such as the Slovak Republic (also a member of the EU), have experienced important growth in their trade-to-gdp ratio and have moved further away from the average given their levels of development. Although Poland and Albania continue to trade less with the world than their income level would predict, the two countries have improved their positions. Only Ukraine, understandably given the political turmoil in recent years, has seen its trade openness and integration levels slip between the earlier and more recent periods. Moldova s high openness to trade is mainly driven by imports. The faster pace at which imports grew when compared to exports is evident when considering the exports-to-gdp and imports-to-gdp ratios separately. As Figure A 1 in the Appendix shows, exports as a share of GDP have fallen between 2000-03 and 2010-13. Export growth has lagged behind the expansion in income per capita during the last decade. Still, Moldova remains more open in terms of exports than the average country with its level of development. The opposite trend is evident in imports. Imports as a share of GDP increased during the period under investigation. Moldova has moved further away from the line of prediction, as both its imports and its income per capita grew (see Figure A 2). Despite the dynamism of Moldovan services exports, the services trade-to-gdp ratio has slightly deteriorated in the past decade. Figure 7 benchmarks Moldova s trade (exports plus imports) in services-to-gdp ratio against other countries in the world for 2005-07 and 2010-13. The comparison of the two panels shows that while Moldova is still above the predicted line, its position has shifted downward (toward the line of prediction) in the more recent period. Although Moldova still trades more in services than countries at the same level of development, its trade-to- GDP ratio in services has not expanded as fast as its income per capita over the last decade. This slight decrease has been driven by the reduction in imports of services, which have not expanded as fast as GDP (See Figure A 3 in the Appendix). Figure 7. Trade in Services as Percent of GDP vs. Income Levels a. 2005-2007 b. 2010-2013 Source: Authors calculations using data from WDI. 16

3.2.2 Policy-related determinants of trade openness Openness to trade is influenced by a variety of policy choices, in particular, decisions over a country s trade regime. A country s tariff profile crucially affects the efficiency and competitiveness of domestic producers and exporters, particularly as production processes are increasingly fragmented and firms participate in global value chains in which they need to import inputs to process domestically and export to the rest of the world. Tariff profiles also influence market access prospects for a country s own export products. Moldova maintains a liberal tariff regime. The simple average most favored nation applied tariff rate is amongst the world s lowest. According to the World Trade Organization, the simple average MFN applied tariff was 4.6 percent in 2013, with average non-agricultural tariff of 3.7 percent and agricultural tariff of 10.6 percent. Moldova s final bound tariff level for 2013 was higher: 7 percent average (14 percent for agricultural goods and 5.9 for non-agricultural products). Moreover, Moldova has free trade agreements (FTAs) with more than 40 countries, including the EU-28 member states (DCFTA), CIS states, Eastern European countries, and Turkey. In addition, Moldova has signed a number of preferential trade agreements with other advanced industrial economies, including the United States, Canada, and Japan. There are different levels of protection across sectors. Animal products and foodstuffs enjoy relatively higher levels of protection. 1. Figure 8 compares the MFN applied and final bound tariffs for different products in 2013, showing that sugars and confectionary products exhibit the highest bound tariff level (56 percent). No MFN applied tariffs surpass 25 percent. Moldova s average tariff level is below that of the EU as well as that of some of its benchmark countries. With an average MFN applied tariff of 4.7 percent, Moldova is more open than its Western European trading partners. Its tariff structure is also more liberal than that of Belarus, Macedonia, and Ukraine (Figure 9). Moldova has lower bound tariffs than Albania and Armenia, but it has relatively higher applied tariffs than those countries. Interestingly, despite the overall liberal tariff schedule, Moldova maintains a relatively high tariff on glass containers a crucial input into the production of one of its main export products: wine. Figure 8. Final Bound vs. MFN Applied Tariffs on Imports, 2013 17

Percent Percent 60 50 Bound MFN applied 40 30 20 10 0 Note: *Simple Averages. Source: WTO Tariff Profile Data Base. Figure 9. Bound vs. MFN Applied Tariffs on Imports, 2013 10 9 8 7 6 5 4 3 2 1 0 Final bound MFN applied Source: WTO Tariff Profile Data Base. Moldova s export expansion may be constrained by the relatively high tariff levels imposed by some of its main partners. The agricultural and non-agricultural tariffs imposed by some of Moldova s main export destinations suggest Moldova has much to gain from completing the DCFTA with the EU. Since 2008, Moldova has enjoyed Autonomous Trade Preferences (ATPs) with the EU, which provide unlimited and duty-free access to the EU market for almost all products originating in Moldova. However, this agreement does not include certain agricultural products. 18

Million USD Percent The most binding constraint to market access in the EU is related with standards. This is particularly relevant for exporters in agribusiness. For example, black caviar is certified to be shipped to the EU, but eggs for processing are in the process of getting certification, while eggs for consumption and meats are not yet compliant with EU standards. For apples, there are challenges associated with the varieties that are accepted in the EU, which are not the classic varieties produced in Moldova. Standards also apply to post-harvesting processes associated with sorting, calibration, packaging, and storage. Producers need to continue improving such processes (see Note 3 on Agribusiness for a thorough analysis of the challenges faced by that sector). 3.2.3 Foreign direct investment Foreign direct investment in Moldova grew strongly between 2003 and 2008, but was severely affected by the 2009 global crisis and has yet to recover to pre-crisis levels. FDI inflows grew from US$38 million in 1999 to US$711 million in 2008. Impressively, FDI increased tenfold in only five years, reaching 12 percent of GDP in 2007 and 2008 (Figure 10). Inflows plummeted in 2009 and, despite a slight recovery in 2011, fell again in 2012. In 2013, FDI as a percent of GDP (3.1 percent) was below its 1995 level (3.7 percent). The government of Moldova has used various instruments to attract FDI in the country, including investment promotion activities performed by the Moldova Investment and Export Promotion Organization (MIEPO), fiscal incentives, and special economic zones (see Note 4 on Special Economic Zones for a thorough analysis of how these operate). Figure 10. FDI Inflows as Percent of GDP, 1992-2013 800 700 600 500 400 300 200 100 0 14 12 10 8 6 4 2 0 FDI (Million USD) FDI (as percent of GDP) Source: Authors calculations based on UNCTAD data. Moldova s performance in terms of FDI attraction is poor when benchmarked against other economies in its comparative group. In 2012-13, FDI stock in Moldova was among the lowest in the group. FDI inflows to Moldova in absolute terms were significantly lower than inflows to its 19

peers, particularly between 2005-08 and 2010-13. Indeed, in 2013 FDI inflows to Hungary and Ukraine were 13 and 16 times the value of inflows to Moldova. Moldova also underperformed relative to smaller economies in the region, with average inflows falling below those of Albania, Belarus, and Lithuania in the three periods analyzed. However, Moldova outperformed several of its peers, especially Belarus and Georgia (Table A 2). Moldova s share of FDI in GDP is higher than expected given its level of development. Figure 11 benchmarks Moldova among other countries in terms of their level of openness to FDI. It shows that Moldova is considerably above the line, even after the decline in inflows triggered by the 2009 financial crisis. Moldova s FDI-to-GDP ratio (3.5 percent in 2013) compared favorably to the level of FDI openness of other new and associated EU members, including Hungary, Poland, and Slovenia. The share of FDI in GDP income fell during the past decade while income per capita expanded. Yet Moldova s performance in terms of FDI attraction is still above that of other new and potential EU entrants (see also Table A 3). Figure 11. Benchmarking Moldova s FDI Attraction Levels a. 2000-2003 b. 2010-2013 Source: Authors calculations based on WDI data. Services account for almost two-thirds of inward FDI stock. In 2012, financial intermediation dominated, accounting for 28 percent of inward FDI stock (Figure 12b). The comparison of the sectoral composition of FDI stocks in 2005 and 2012 suggests an important expansion of this sector, which doubled its share in total stocks between these two periods (Figure 12a). This expansion took place at the expense of wholesale and retail trade services, which represented 26 percent in 2005 and decreased to 17 percent in 2012. FDI into the manufacturing sector, which includes industries such as automotive parts and components, textiles, and construction materials as well as food, tobacco and beverages, remained constant at around 23 percent of total inward stock. The relative low levels of FDI into transport and communications (6.8 percent) and the power sector (8.6 percent) points to untapped opportunities. In a landlocked country such as Moldova, 20

increasing competition in the transport and communications sectors, and improving the quality of services provided is crucial to stimulate firms competitiveness. FDI in these sectors can be a vehicle to achieve that. Figure 12. FDI Inward Stock, by Sector a. 2005 Manufacturing industry 24% Hotels & restaurants 2% Other 2% Financial intermediation 10% Wholesale & retail trade 26% Transport & communications 7% Electricity, gas & water supply 23% Real estate & business services 6% Manufacturing industry 23% Financial intermediation 28% Other 3% b. 2012 Agriculture, hunting, & forestry 1% Transport & communications Electricity, gas & 7% water supply 9% Real estate & business services 10% Wholesale & retail trade 17% Healthcare & social assistance 2% Source: Authors calculations based on data from the National Bank of Moldova. Russia was the largest investor in Moldova in 2012, accounting for 9 percent of total inward FDI stock. It was followed by Italy and Germany, each representing about 8 percent of total FDI (Figure 13). German firms, for example Dra xlmaier, have invested in the establishment of plants to produce cables and car parts to supply factories in the EU, while Italian investment has concentrated in the textile and clothing industries. Romania is the fourth main source of FDI in Moldova. The investments are most likely carried out by affiliates of foreign companies operating in Romania, which may enjoy greater knowledge of the Moldovan market than parent companies (UNCTAD, 2013). Other important sources of inward FDI include the United States, Switzerland, and Turkey. 3 Figure 13. FDI Inward Stock by Origin, 2012 3 The fact that the Netherlands and Cyprus are among the top five investors in Moldova may reflect the fact that Moldova has a favorable double taxation treaty with them and hence offers advantages to firms based there, regardless of the ownership of the parent company s capital (UNCTAD, 2013). 21

Source: Authors calculations based on data from the National Bank of Moldova. 3.2.4 Composition of exports Goods Moldova s four main export industries are vegetables, prepared foodstuffs and beverages, machinery and electronic equipment, and textiles. The relative weight of these industries in the Moldovan export basket has changed in the past decade. In the last decade, Moldova s exports of vegetables and machinery increased, primarily at the expense of two sectors, namely, foodstuffs and textiles. Table 3 presents the evolution of export values by sector, their share in total exports, and the indicators of revealed comparative advantage (RCA), for two sub-periods: 2000-02 and 2011-13. 4 Exports in vegetables increased at a compound annual growth rate of 17.6, reaching one-third of total exports in 2011-13. Indeed, driven by the expansion of sales in oil seeds, fruits and nuts, and cereals, the share of vegetables in total exports doubled between 2000-02 and 2010-13. Machinery and electronic equipment (medical or surgical instruments, vehicle/transport equipment, etc.) also experienced a dramatic expansion, almost tripling its share within the export basket. Moldova deepened its comparative advantage in both of these sectors, particularly in vegetables (Figure 14). Although losing considerable ground in recent years, foodstuffs remain Moldova s second main export. The prepared foodstuffs and beverages industry accounted for almost half of the economy s exports in 2000-02. As a result of a process of gradual diversification, its share in the export basket fell to 26.4 percent in 2011-13. While the RCA declined during these two periods, the sector continues to enjoy a relatively high comparative advantage, given the abundance of raw materials, such as fruits, vegetables, and cereals. Yet, exports of one of the top products in the sector, wine, were severely hit by the imposition of trade sanctions by main partner Russia in 2006. Wine exports, which reached US$556 million in 2005, were less than US$300 million in 2013. Moreover, the sector s overall growth rate during this period has been unimpressive (Figure 14). 4 The RCA index is the ratio of a country s export share in a specific sector to the world share of that sector in total world exports. An RCA index above 1 indicates that the country s share of exports in a sector exceeds the global export share of that product, and is thus a measure of its competitiveness. 22

RCA Percent Sector Table 3. Change in Moldova s Shares of Merchandise Exports Average 2000-2002 Average 2011-2013 Exports Share Exports Share RCA (1000 USD) (%) (1000 USD) (%) RCA CAGR (%) 01-05 Animal 18,772 3.6 1.7 37,643 2.7 1.5 7.2 06-15 Vegetable 90,416 16.5 6.0 459,344 33.0 10.5 17.6 16-24 Foodstuffs 238,391 44.0 14.9 369,669 26.4 8.5 4.5 25-27 Minerals 6,891 1.2 0.1 20,304 1.5 0.1 11.4 28-38 Chemicals 7,449 1.4 0.2 20,563 1.5 0.2 10.7 39-40 Plastic / Rubber 2,173 0.4 0.1 18,666 1.4 0.3 24.0 41-43 Hides, Skins 15,723 2.9 3.4 25,529 1.9 3.1 5.0 44-49 Wood 4,264 0.8 0.2 13,977 1.0 0.4 12.6 50-63 Textiles, Clothing 95,989 17.7 3.0 95,579 6.6 1.7 0.0 64-67 Footwear 6,382 1.1 1.2 11,616 0.8 1.0 6.2 68-71 Stone / Glass 14,157 2.7 0.9 44,665 3.2 0.9 12.2 72-83 Metals 5,963 1.2 0.2 63,202 4.6 0.6 26.6 84-85 Mach/Elec. 21,699 4.0 0.1 152,466 10.4 0.4 21.5 86-89 Transportation 5,363 1.0 0.1 12,138 0.9 0.1 8.5 90-97 Miscellaneous 8,913 1.6 0.3 62,695 4.3 0.8 21.5 Note: CAGR= compound annual growth rate. Source: Authors calculations using data from UN Comtrade. Textiles and apparel declined from the second to the fourth position. The sector s RCA almost halved between 2000 02 and 2012 13. The erosion in the country s comparative advantage in textiles, despite the availability of a skilled labor force, reflects in part the failure of domestic companies to convert acquired production knowledge into higher-value services. Indeed, Moldovan manufacturers tend to subcontract higher value-added services, such as brand development and marketing, concentrating on the lowest value-added activities. Figure 14. Evolution of RCA, 2000-2013 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 RCA 2000/02 RCA 2011/13 CAGR 30 25 20 15 10 5 0-5 Source: Authors calculations using data from UN Comtrade. 23

There has also been substantial churning at the product level when comparing the top 10 export products in 2003 and 2013. As Table 4 shows, wine in bottles, the top product in 2003, accounting for 21 percent of total exports, fell to the fourth place in 2013. Wine sold in bottles or containers holding less than 2 liters and in larger amounts, now jointly account for less than 9 percent of total exports. The main export in 2013 was coaxial cables and other electric conductors, reflecting the dramatic growth of the machinery industry in the last 10 years. While traditional agricultural exports such as seeds and apples continue occupying a top position in the external basket, bovine hides and skins have dropped from the top 10 ranking. Product Table 4. Top 10 Exported Products 2003 2013 Exports Share (Millions USD) (%) Product Exports (Millions USD) Wine (in containers of< 2 liters) 162.7 21 Coaxial cable & other electric parts 150.6 9.30 Other grapes 34.3 4.45 Sunflower seeds 136.1 8.40 Spirits 25.02 3.23 Shelled walnuts 85.9 5.31 Apples 22.2 2.86 Wine (in containers of< 2 liters) 81.01 5.00 Shelled walnuts 21.6 2.78 Wheat seed, white, other 64.9 4.01 Bovine hides & skins (whole) 17.2 2.24 Other wine 62.0 3.83 Apple juice 16.98 2.19 Spirits 58.6 3.62 Other bovine hides & skins 16.84 2.17 Parts of seats 55.7 3.44 Sunflower seeds/safflower oil 16.4 2.11 Apple juice 48.8 3.01 Boneless bovine meat 13.5 1.73 Apples 47.01 2.9 Total Exports 775.9 100 Total Exports 1,619.8 100 Source: Authors calculations using data from UN Comtrade. Share (%) 3.2.5 Growth orientation in products Moldova has gained international market share in some of its top industrial exports, particularly cables and other electric parts. Figure 15 plots the annualized growth rate of Moldova s top exports between 2003 and 2013 against the world s growth rate of exports of the same products during the same period. Products above the 45-degree line indicate that Moldova has gained market share in this product, as its exports have grown faster than everybody else s. As Panel (a) shows, Moldova has clearly gained market share in coaxial cables and parts of seats. Yet, Panel (a) also highlights that demand for traditional export products from Moldova, such as sunflower seeds, other types of seeds, wines (in bulk), and apple juice, have also grown faster than world exports of these products. Moldova has been losing market share for some of its main export products, including wine (in bottles), apples, spirits, walnuts, and sunflower oil. The fall in demand for these products, in particular wine, reflects the imposition of trade sanctions by Russia in 2006 and the difficulties of the sector in reorienting exports to other markets. The restoration of a range of trade barriers to 24

Moldovan food and beverage products in 2014 will most likely deepen their relative position in international markets. Figure 15. Growth Orientation in Products, 2003-2013 a. All products b. Without coaxial cables & parts of seats Source: Authors calculations using data from UN Comtrade. 3.2.6 Services While Moldova s services exports have been dominated by the transport and travel subsectors, ICT services have experienced a considerable expansion over the last decade. Transport services, including carriage of passengers and movement of goods, accounted for half of all services exports in 2000, followed by travel (24 percent) and communications services (10 percent). The share of transportation services has significantly declined since then, reaching 40 percent in 2013 ( Figure 16a). While the relevance of travel services has remained stable during this period, communication services as a percent of total exports have experienced a small increase (peaking at 17 percent in 2010 and staying at 13 percent in 2013). By contrast, information and computer services have expanded rapidly, with total exports growing tenfold between 2004 and 2008, and more than doubling between 2009 and 2013. Moreover, the subsector s participation in the services export basket grew from less than 1 percent in 2005 to 6 percent in 2013. Building on this impressive export performance, the ICT services sector has also expanded its contribution to Moldova s GDP, reaching 0.9 percent in 2013. Figure 16. Sectoral Composition of Services Exports a. Moldova, 2000-2013 b. Moldova and comparators, 2013 25

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% ALB BLR GEO HUN LTU POL MDA SVK UKR Transport Communications Insurance Computer and information Other business Other Transport Travel Travel Construction Communications Construction Financial Insurance Financial Royalties Computer and information Royalties Personal/cultural Other business Personal/cultural Other Source: Authors calculations using data from UNCTAD. The structure of Moldova s services exports is relatively diversified when compared with regional peers. Figure 16b shows that other countries in the region, particularly Albania and Georgia, are strongly reliant on exports of travel services. Similarly, Lithuania and Belarus exhibit a pronounced concentration in transportation services. The communications sector, in turn, appears to be larger in Moldova than in comparators. Moreover, while several countries in this group have witnessed the dramatic expansion of ICT services, in none of these countries did the subsector grow at such a rapid pace as in Moldova (average 60 percent per year between 2002 and 2013). 3.2.7 Main export markets In recent years, Moldova has progressively decreased its traditional export dependence on the Russian market. The share of Moldovan exports going to Russia decreased from 39.5 percent in 2003 to 14 percent in 2013 (Table 5). Russia is now the second main destination after Romania, which in 2013 received 19 percent of Moldovan exports. Indeed, exports to Romania tripled between 2010 and 2013. The third and fourth partners, Ukraine and Italy, did not substantially change their importance as markets for Moldovan products. In 2013, Moldovan exports to Turkey expanded significantly. In fact, Turkey received more than 6 percent of exports, becoming the fifth most important market (Figure 17b). Table 5. Top 10 Destinations 2003 2008 2013 Market Share (%) Market Share (%) Market Share (%) 26