The Republic of Moldova: An Assessment of Macroeconomic Policies 1998-2001 and Recommendations Report Prepared for Public Policy 556: Macroeconomics Professor Kathryn Dominguez Prepared by Shannon Hill, Liana Mesropyan, and Chad West December 5, 2005
Background/Introduction The Republic of Moldova, once a member state of the Soviet Union, declared independence from the USSR in August 1991. While retaining economic ties to Russia and the Commonwealth of Independent States (CIS) since then, it has increasingly oriented itself politically and economically toward the west and has made progress in the transition from a planned to a market economy. Following independence, Moldova struggled to combat high inflation and negative growth rates and to improve upon the per capita GDP figures which garnered it the dubious distinction of the poorest country in Europe. Moldova pursued an initial course of contractionary monetary and fiscal policy. In 1999 Moldova started to pursue expansionary monetary policy, and later combined it with expansionary fiscal policy. In 2000 Moldova finally began to see real positive growth and increases in real per capita GDP. Over the course of the 1990 s, Moldova faced several challenges which affected its macroeconomic policy-making options. First, the unsettled political resolution to the breakaway region of Transnistria was of particular concern: industrial production capacity is concentrated in this region; Moldova s western border with Ukraine is unmonitored, thus decreasing capture of customs revenue; finally, farmers have recently been denied access to agricultural property in the region. As Moldova s primary sources of income are agricultural products and agroprocessing, resolution of this political dilemma is important for Moldova s long-run economic well-being and growth. A second challenge concerns Moldova s relationship with Russia. As the largest importer of Moldova goods and the largest source of imported energy to Moldova, the 1998 financial crisis in Russia had a substantial effect on the Moldova currency, the Lei and subsequent inflation. Finally, Moldova faces one of the challenges common to developing countries worldwide: the loss of labor force through brain-drain and the inflow of their earnings in the form of remittances. In response to political and economic conditions, as of 2002 it was estimated that 25% of working age Moldovans were employed abroad 1 ; remittances fuel consumption but are not taxed, thus not contributing to government revenue or savings. Performance Measures GDP and Components Moldova has experienced a recovery in total output since 2000. Since the Russian financial crisis of that year, GDP declined from 17.475 billion Lei to 16.020 billion Lei in 2000. The economy has since shown signs of recovery, reaching a total output figure of 17.321 billion Lei from 2000-2001. The crisis had similar effects on GDP per capita over the same time period. Per capita income dropped from roughly 4,064 Lei in 1998 to 3,763 Lei in 2000. From 2000-2001, the per capita estimate rose to 4,065 Lei putting it just above the pre-crisis level. 1 CIA World Factbook, Moldova, Accessed online 7 November, 2005. http://www.cia.gov/cia/publications/factbook/geos/md.html#econ 2
GDP growth rates also show an initial decline in the first two years of the period of analysis. GDP growth falls by 6.5% in 1998 and 3.4% in 1999 over their previous years. This was followed by a considerable increase in the growth rate to 6.1% for 2001. Per capita GDP growth also declined in a similar pattern. From 1998 to 2000, per capita GDP growth fell by 7.4%, but was then followed by an 8% increase in the growth rate from 2000-2001. Consumption: Household consumption showed a predictable trend from 1998-2001. It follows similar patterns of total and per capita GDP. Consumption was roughly 13.172 billion Lei in the beginning year, and predictably dropped off immediately after in 1999 to 11.990 billion Lei. The steep decline from 1998 to 1999 is likely due to the loss of public employment and a reduced export market immediately following the Russian financial crisis. The data are consistent with the previously reported account of total GDP. We would expect to see a reduction in consumption with the loss of public sector jobs (see section on Inflation and Unemployment). Consumption then increased to 15.516 billion Lei in 2001 to exceed the crisis year level showing a pattern similar to per capita GDP estimates. The impressive gains in consumption are predominantly responsible for the improvements in GDP from 2000 to 2001 because most of the other GDP components move in the opposite direction over the time period, as discussed in the following subsections. Government Expenditure and Revenue: Total government expenditure decreased substantially from 4.458 billion Lei in 1998 to 2.561 billion Lei in 2001. This was caused by significant reductions in government revenues over the period of analysis from 5.38 billion Lei to 3.71 billion Lei, making the reductions in public spending necessary (Reference Table 2). Government share of GDP fell from 35% to 29% from 1998 to 1999. These data are somewhat inconsistent with the predicted effects of a reduction in government expenditure within the IS-LM model. As reported previously, total output decreased from 1998 to 1999, which partially can be explained by the contraction in the public sector. However, government share of GDP continues to fall to a low of 22.8% in 2001 while total GDP improved over the same period (Reference Tables 1 & 3). The growth in GDP may, therefore, be attributed to expansionary monetary policy which outweighed the effects of contractionary fiscal policy. Investment: Investment also declined substantially from 4.523 billion Lei to 3.475 billion Lei. These figures are also inconsistent with the IS-LM model in that interest rates have also fallen over the same period from 30.9% to 5.1%. In theory, a drop in the interest rate of this magnitude should have substantially increased total investment. Therefore, the decline is likely due to low investor confidence, which may still be heavily affected by the economic downturn after the Russian financial crisis of 1998 and high annual inflation rates (Reference Tables 4 &5). Net Exports and Exchange Rate: Moldova consistently has been dependent upon imports. Net exports are negative over the entire time period of analysis, as well as all previous years back to the establishment of an independent state in 1991. However, net exports have improved from their previous mark of -4.676 Billion Lei in 1998 to -4.231 billion Lei in 2001. This was likely caused by the depreciation of the Lei over the same time period. The exchange rate fell against major 3
currencies including the Euro and the dollar (from 8.3 to 13.1), making Moldovan exports cheaper against foreign goods in domestic and foreign markets. Inflation and Unemployment Much of the economic stagnation in Moldova can be attributed to the country s continual problem of high inflation. The inflation rate hit a dizzying height of nearly 46% in 1999, and only decreased to 31.2% the following year. Since 2000, inflation rates have decreased substantially but still remain comparatively high. The inflation rate in 2001 was roughly 9.8%, and in more recent years has remained in low double digits. The unemployment rate has been relatively stable since the recovery from the Russian financial crisis in 1998. Before the crisis, the unemployment rate was 1.9% and spiked in1999 to 11.2%. It has since fallen off but remains substantially higher than its 1998 level (2001 figures place it at 7.4%). The Phillips Curve suggests a trade-off between unemployment and inflation, and the extremely low levels of unemployment before 1998 were likely contributing to the high rates of inflation witnessed prior to the period of analysis. The unemployment rate has never dropped to its pre-crisis levels, which can partially explain the lower post-crisis inflation rates. Monetary Policy Moldova pursued a contractionary monetary policy from 1998 to 1999. This was likely in response to the overall high inflation rates the country had been experiencing and to the particular shock of the Russian financial crisis. Starting in 1999, monetary policy became expansionary. The steadily falling interest rate from 1999 to 2001 can be explained by the combination of expansionary monetary policy and contractionary fiscal policy. Over this period, inflation has been positive, but the growth rate of inflation has decreased markedly as the interest rate has fallen. The money supply has grown at increasing rates (from 4.2% in 1999-2000 to 12.5% in 2000-2001) which are higher than GDP growth rates. The velocity theory of money, which would predict inflation based on this relationship, holds in this case, but does not explain why the inflation rate is falling (Reference Table 6). Policy Options Policy Option 1: Reduce Inflation It is important that the Republic of Moldova reduce the inflation rate and promote investment. The government should return to a contractionary monetary policy. The IS-LM Model shows that restricting the money supply will help reduce the annual inflation rates which have been consistently high since the Russian financial crisis in 1998. Persistently high inflation rates have contributed to a loss of confidence in the Lei as a store of value among Moldova s citizens, causing them to rely on other currencies such as the dollar and the Euro for financial transactions. More stable prices will contribute to increased investor confidence and lowered expected inflation rates. Lower inflation rates will also be associated with higher rates of unemployment, but the current unemployment figures for Moldova are not unsustainably high, particularly for a developing economy. Higher unemployment will have to be tolerated until annual inflation rates can be reduced. This option is also politically difficult. A reduction in output and an increase in unemployment would be very unpopular with Moldovan citizens, and the central bank could face intense opposition from elected officials to avoid a contraction in the money supply. 4
Policy Option 2: Encourage Foreign Investment An alternative policy for encouraging increased investment is to look outside the country for sources of capital. Interest rates have fallen steadily since 1998, but Moldova has not seen an increase in domestic investment. To attract foreign capital, Moldova would have to boost its interest rate by pursuing a contractionary monetary policy, with no effort to offset this effect by using fiscal policy tools. The higher interest rate should attract foreign capital because it will give foreign investors incentive to invest in a country that is perceived to be a risk (likely due to inflation and other forms of instability). The increased investment should lead to a higher level of output. The Moldovan government should be cautious in pursuing this policy as well. They are very limited in their ability to maintain an interest rate higher than the world interest rate for a long period of time. The inflow of capital will also yield a higher demand for the Lei causing it to appreciate, which will reduce net exports. Policy Option 3: Improve the Investment Atmosphere Keeping inflation and interest rates low is a first step toward attracting new investment into Moldova. Many of the other measures which the government should take do not fall directly into the realm of fiscal or monetary policy, but rather concern ongoing efforts to pursue democratic reforms and bring Moldova in line with practices of liberal, market economies. The government should also support reform in secondary and higher education which help meet the demand for specialists in areas not previously important to the Moldovan economy. 1. In order to capture customs revenues, the Moldovan government should continue to participate in the recently-created joint EU Border Assistance Mission. 2 Resolution of the political stalemate with Transnistria will also improve collection of customs revenues. 2. In order to smooth the process of investment, registering a business must be made easier. Measures to do so include reducing the number and length of transactions required and curbing corruption. Corruption has the added negative effect of contributing to the erosion of confidence in the government and consequent rising inflation expectations. In order to curb it, the government should continue to support the implementation of a strong legal framework. The government should also institute a system of regular, impartial audits, and make the results publicly available. 3 3. Encourage public schools and universities to offer courses and degrees in vocational and technical subjects such as accounting and business management as well as commonly-spoken languages in the region, such as English and German. This will assist older workers in retraining and students in gaining skills relevant to a modern 2 Commissioner Ferrero-Waldner to launch Border Assistance Mission in Moldova 6-7 October, Brussels, 4 October, 2005, http://europa.eu.int/comm/external_relations/moldova/intor/ip05_1221.htm, Accessed Nov. 13, 2005. 3 World Bank Country Brief. Accessed Online 7 November 2005. [http://www.worldbank.org.md/wbsite/external/countries/ecaext/moldovaextn/0,,menupk:30 2260~pagePK:141132~piPK:141107~theSitePK:302251,00.html]. 5
Conclusions economy, supporting the diversification of the economy away from a reliance on agriculture and industry. Changes to the Moldovan economy observed in the period 1998-2001 would not, on the whole, have been predicted by standard macroeconomic models. As such, it is particularly challenging to propose changes to macroeconomic policies and assume that the desired changes will occur based on these same models. In Moldova, as in other low-income, developing countries, many of the improvements which need to be made to increase investment and prompt growth lie out of the sphere of economic policy-making alone. Instead, commitment to a combination of political and economic policies which fuel investment-based growth (rather than remittance-funded consumption-based growth) is critical to overall improvement of the standard of living in Moldova. While investment has not grown over this period, Moldova has been able to manage its debts, thereby signaling to international loan agencies and the European Union its desire to make structural changes, and has likely secured their future assistance and support should it continue on this path. Ideally, together with macroeconomic policies designed to attract them, investors will gain and express their confidence in the Moldovan economy as well. 6
Appendix Table 1. Trend of Real and Nominal GDP in Lei 25000 20000 GDP 15000 10000 Nominal GDP Real GDP 5000 0 1998 1999 2000 2001 2002 Years Table 2. Government Expenditures and Revenues in Lei 7000.0 6000.0 5000.0 4000.0 3000.0 Gov. Rev Gov Exp 2000.0 1000.0 0.0 1998 1999 2000 2001 2002 7
Table 3. Government expenditures as a share of GDP 35 30 Gov exp. as % of G 25 20 15 10 5 0 1998 1999 2000 2001 2002 Years Table 4. Investments 4500.0 4000.0 3500.0 3000.0 Investment 2500.0 2000.0 1500.0 1000.0 500.0 0.0 1998 1999 2000 2001 2002 Years 8
Table 5. Investments and Interest Rates 35.0 30.0 25.0 1999 1998 % rate 20.0 15.0 10.0 5.0 2000 2001 2002 0.0 0.0 500.0 1000.0 1500.0 2000.0 2500.0 3000.0 3500.0 4000.0 4500.0 Investments Table 6. Monetary Policy Inflation (% over previous year) GDP (% growth over previous year) Year Money Supply in Lei Interest Rate 1998 2,041,111,111 30.9-6.5 1999 1,942,047,244 32.6 45.9-3.4 2000 2,023,220,000 20.8 31.2 2.1 2001 2,276,867,031 11 9.8 6.1 9