Report Thierry Warin Macedonia 2009

Thierry

Warin

Fiscal

sustainability

of the Republic

of Macedonia

December

2009

THIERRY WARIN

FISCAL SUSTAINABILITY OF THE REPUBLIC OF MACEDONIA

Page 3

I would like to express my gratitude and deepest thanks to Mr. Prime Minister Nikolai Gruevski for

his attention and consideration. I would like to extend my best wishes to the staff members of the

Public Debt Management Department and in particular to Mrs. Ana Stojkova for her hospitality and

to Mr. Dejan Despotoski at the Ministry of Finance. Eventually, my sincerest regards go to Mr.

Aleksandar Stojkov whose inner knowledge of the Republic of Macedonia was of a tremendous help.

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BIOGRAPHY

Thierry Warin is Associate Professor of Economics and Director of the International Studies Program at

Middlebury College (USA) and Associate Fellow at CIRANO (Center for interuniversity research and analysis

on organizations, CANADA). Thierry authored over 25 academic publications and 7 books.

Prior to coming to Middlebury College, Thierry has held positions in several academic institutions (Essec

Business School, HEC Paris, HEC Montreal, Ecole Polytechnique de Montreal). His research is mainly on

International Economics topics, with a particular interest on the European economic integration.

An alumnus of the Minda de Gunzburg Center for European Studies at Harvard University, Thierry

completed his Ph.D. in Economics at Essec Business School (Paris).

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1

1 The usual caveats apply. This report relies on available data from the Ministry of Finance, the Statistical Office of Macedonia, and the IMF. Its conclusions are based on the availability

PROJECT DESCRIPTION AND MANDATE

This project is of a paramount importance for the Republic of Macedonia in light of the accession to

the European Union. The lately issued “2009 progress report on the Former Yugoslav Republic of

Macedonia” from the European Commission (14th of October 2009) highlights great

accomplishments and areas of necessary improvements in the economic and financial track. In this

context, this PDPL2 project is of great relevance to both develop a rule-based model for fiscal

sustainability specific to the Republic of Macedonia’s economy and also doing it while keeping in

mind the future accession to the European Union.

The goal of this report is to allow staff members to replicate the results. Some

statistical/econometric techniques will be used, but in a way that will allow an educated reader to

replicate the results. This goal was kept in mind all along the writing of this report. Some

technicalities remain and are necessary due to the complex nature of the goal of the assignment.

When this happens, ‘boxes’ are used to provide with some essential background.

BACKGROUND INFORMATION

The Ministry of Finance is dedicated to create a set of sustainable policies. In this context, it is of a

paramount importance to put the Republic of Macedonia in a situation of both being able to service

its debt and allow the financing of structural policies.

Medium and long-term objectives must be drawn for medium and long-term fiscal sustainability.

Setting the quantitative targets for the level of the general government and total public debt, in the

Public Debt Management Strategy is not based on the quantitative support from a sustainability

analysis. Maastricht criteria include the maximum level of budget deficit and general government

debt, but these convergence criteria cannot be fully implemented in a developing country like the

Republic of Macedonia.

Given the current Government infrastructure investment program, Public Debt Management

Department is facing serious challenges in raising funds for financing various development projects.

The implementation of these projects will increase the level of public debt, as well as the future

interest expenditures. Hence the growing need for developing fiscal sustainability on the medium

and long term.

OBJECTIVE OF THE ASSIGNMENT

The project should result in developing the framework/model for measuring the sustainability of

the fiscal policy of the Republic of Macedonia, which in the future will be used for quantitative

support in assessment of important decisions made in the field of public finance.

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and quality of the data. It is possible that some mistakes can be found, although the author tried to be as careful as possible in the short time frame imposed by this assignment.

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EXECUTIVE SUMMARY

In the Republic of Macedonia, there is no autonomous monetary ‘policy’. The interest rate decided

by the Central Bank shall contract the money base to remain pegged to the euro. Theoretically, the

benefit is a lower risk premium and a lower inflation rate, the cost is a higher nominal interest rate.

In practice, since the pegged-exchange rate mechanism has been successful since 1997, revisiting the

system is not a priority in particular in light of the future accession to the EU and the EMU.

However, this choice of a pegged-exchange rate mechanism has impacts on the fiscal policy, in

particular on the servicing of the debt (through the domestic interest rate, and also through the

credibility level on the Eurobonds market for instance) as well as on the targets of the fiscal policy.

Therefore, the fiscal policy should target investments in capital (infrastructure) as a priority.

With a high structural unemployment rate and a structural current account deficit, it is important to

put forward reforms of the labor market, business law, and a deepening of the financial markets

(commercial banks regulations, minimum reserve requirements, etc.). Tackling the current account

deficit is of a high priority, by using the fiscal and structural policies altogether. An example of the

goals would be to aim at diversifying the Macedonian economy, while reinforcing its consumption

of domestic products (import substitution) and develop its labor market. Another priority is to

expand the tax base, without increasing the tax burden.

Furthermore, the road to Europe (EU and EMU) should be placed at the top priority and

completed as soon as possible, in particular in light of the global financial crisis consequences

(higher global interest rates, higher global inflation rates, higher taxes implying a reduction in global

consumption).

Now, when it comes to the specifics of the fiscal policy, the pattern, though still sustainable in 2009,

is pushing public finances towards a zone of turbulences. A first recommendation is to keep the

public deficit under control, and even to reduce it to gain some leeway to face the future challenges

of the global financial crisis. A second recommendation is to use the fiscal policy in a counter-

cyclical way. A third recommendation would be to keep building up the credibility of the Republic

of Macedonia at the international level (contingent on the strict control of public deficits) by issuing

Eurobonds. A fourth recommendation is to work at the political level to issue joint bonds with a

Western European country to help reduce the risk-premium and improve the Republic of

Macedonia’s credibility. The Republic of Macedonia would be the first country (with its partner) to

issue joint bonds in the world. The innovation would appeal to financial markets, in particular if the

issuance occurs when public finances are sound.

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13 policymix based recommendations:

1. The government must consider the sources of the inflationary pressures. Its

tools are either well targeted taxation or relevant public expenditure in areas

where the government does not generate an increase in the aggregate demand.

2. An upgrade in the finetuning operations of the monetary policy would be

necessary.

3. Based on the average wage rate, the sector represented by manufactured

goods should be expanded to integrate the unemployed youth, and rebalance

the current account.

4. The minimum reserve requirements should be lowered at a smooth pace in

preparation for the entrance into the EMU.

5. The European agenda should be a top priority for the government, and would

legitimate ex post the monetary policy of the Republic of Macedonia.

6. Integrate the business cycles into the design of the fiscal policy.

7. Fixing the procyclicality of the fiscal impulse so that the fiscal policy becomes

countercyclical would be necessary.

8. In the midst of the global financial crisis, this downward direction of the degree

of sustainability must be taken seriously in 2010, 2011 and 2012 to prevent

from entering into the negative area.

9. The tax gap is becoming positive. An expansion of the tax base (no increase in

tax rates) is advisable. A law offering a tax amnesty could be used for a year,

before enforcing the new tax regulations.

10. The fiscal policies for 2010, 2011 and 2012 (during the downward business

cycle) must be kept under control and ideally using the baseline as a very

maximum that may be crossed due to a deterioration of global macro

economic conditions but only for exceptional reasons.

11. The next five years must be expected to face a rise in global interest rates,

inflation rates, a reduction of global consumption and some pressures on the

liquidity of the international financial markets. All this will happen with

various degrees. The next five years will be of the utmost importance for the

stability of the Republic of Macedonia’s economy.

12. Public deficits should be lowered compared to the forecasts expecting a

toughening of the debtrefinancing conditions.

13. The Republic of Macedonia should seek issuing joint bonds with a Western

European country to (1) increase its international credibility, and (2) to lower

its costs of debt servicing.

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INTRODUCTION

his report addresses the question of establishing a framework to analyze the sustainability of the

Republic of Macedonia’s public finances2. Various indicators exist in the academic literature or

generated by the research teams of international organizations, central banks and governments. From

the “primary gaps” to the Golden Rule of public finance, the choice is vast.

However, as noticed by the IMF or the European Commission, even if a quantitative analysis is a wonderful

tool to set up guidelines and benchmarks, very often the quantitative analysis must be accompanied by a

qualitative analysis.

Indeed, the model specifications rest very often upon forecasts and projections that require some serious

qualitative interpretation. For instance, the future of a country’s demographics, interest rates in the medium-

term, inflation rates in the long-term or the stability of the global financial markets require some good

judgment.

This is why, before presenting in the third part of this report a framework to analyze the sustainability of the

Republic of Macedonia’s public finances, the first part will be devoted to a short macro-economic

presentation of the Republic of Macedonia. The strengths and weaknesses will be highlighted and both will

serve for the calibration and interpretation of the results presented in the third part. The second part will be

reserved to a thorough review of the literature on fiscal sustainability. This literature review will help for the

training of the middle-office people in the Ministry of Finance, or anyone interested in learning the rationales

of these financial criteria. It will also present the criteria in a scholarly way, justifying their use in the third part

for the assessment of Macedonia’s financial stance.

The criteria selected in this report are relevant not only for this assessment, but also to prepare the Republic

of Macedonia on its path to the European Union. The literature review and the framework presented in the

third part are the common language used by researchers and analysts from international organizations like the

IMF or the European Commission.

2 In what follows, we will use the constitutional name ‘Republic of Macedonia’ since this document is written for domestic use.

T

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Part I

[MACRO-ECONOMIC

CONDITIONS OF THE

REPUBLIC OF

MACEDONIA]

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INTRODUCTION

ith a little more than 2 million inhabitants, the Republic of Macedonia has had a very stable

demographic situation in the past ten years (see figure 1). The essential of the population

belongs to the age group 15-64, with a relatively steady age group 0-14, as well as 65+.

FIGURE 1. POPULATION BY AGE GROUPS. SOURCE: STATE STATISTICAL OFFICE, 2008.

When it comes to health, based on basic health data (see figure 2), the number of doctors per 1000 habitants

is well below the Western European average, but the numbers of doctors is on the rise.

0 20 40 60 80

65+

15-64

0-14

2007

2001

1997

W

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1996 2000 2006

Doctors-Total 4464 4455 5134

Specialists 2732 2892 3301

Dentists 1078 1129 1175

Pharmacists 342 311 187

Number of doctors per 1000 inhabitants 2.3 2.2 2.5

Number of dentists per 1000 inhabitants 0.5 0.6 0.6

Hospital beds 10311 10248 9343

Number of inhabitants per hospital bed 192 198 218

FIGURE 2. BASIC DATA ON HEALTH. SOURCE: STATE STATISTICAL OFFICE, 2008.

In terms of human capital now, the situation depends, not surprisingly, on the level of education (see figure

3). The number of entry generation in primary and lower secondary education decreased from year to year, as

well as the total number of students. The number of enrolled students in primary and lower secondary

education in school year 2007/2008 is smaller for 13.9% compared with 1997/1998.

With regards to upper secondary education and tertiary education, the situation is better than in primary and

lower secondary education, where the coverage of the enrolled students has been increased. In upper

secondary education, the number of enrolled students in 2007/2008, compared with 1997/1998 was higher

by 9.9%, while in tertiary education the number of enrolled students was higher by 100.5%.

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FIGURE 3. BASIC DATA ON EDUCATION. SOURCE: STATE STATISTICAL OFFICE, 2008.

The essential share of the population has either a lower secondary diploma or a higher secondary diploma

(see figure 4). An interesting break down would be to see whether this is more technical or professional

education than general education.

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FIGURE 4. POPULATION OF 15 YEARS OF AGE AND OVER, BY HIGHEST COMPLETED SCHOOL.

SOURCE: STATE STATISTICAL OFFICE, 2008.

MONETARY POLICY

In 1995, the Republic of Macedonia made a clear choice in terms of monetary policy by entering into a

pegged-exchange rate mechanism with first the ECU, and since 1999 with the Euro. Apart from one episode

of devaluation in 1997, the National Bank of Macedonia has always been successful at keeping the pegged-

exchange rate mechanism (see figure 5).

0 200000 400000 600000

Still in the process of primary and

lower secondary education

No education

Incomplete primary and lower

secondary education

Primary and lower secondary school

Upper secondary school

higher school

Faculty, academy

Master's degree

Doctorate

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FIGURE 5. AVERAGE ANNUAL EXCHANGE RATES. SOURCE: STATE STATISTICAL OFFICE, 2008.

Under a pegged-exchange rate mechanism, a country deliberately decides to abandon its monetary policy. The

fiscal policy and the structural policy are the ultimate devices to develop and support the economic activity. A

pegged-exchange rate mechanism has benefits and costs. One benefit is to import the credibility of the

monetary policy to which the Macedonian monetary policy is pegged. The results in terms of inflation are

relevant. Between 2003 and 2007 for instance (see figure 6), M2 increased from 76 billion Denars to 164

billion Denars without generating too high an inflation rate.

0

10

20

30

40

50

60

70

80

90

100

2003 2004 2005 2006 2007

CHF GBR USD EUR 100 JPY

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FIGURE 6. MONEY SUPPLY (MILLION DENARS). SOURCE: STATE STATISTICAL OFFICE, 2008.

With better credibility, the hope is also to reduce the risk premium international markets put on a country-its

treasury bonds or its central bank bills-when the country is trying to raise money on international markets.

But in open macro-economics, we know that the risk premium may not be as low as the risk premium from

the pegged currency, and even worse, it can actually deteriorate if financial markets do not believe in the

pegged exchange rate. In the context of the Republic of Macedonia, although the risk always exists, evidence

is that since 1997 the pegged exchange rate mechanism has been effectively managed.

Due to a lower risk premium than under a floating exchange rate mechanism, this earned credibility may lead

to a lower interest rate overall. This conclusion holds true if the policy-mix with the fiscal policy and the

structural policy is efficient. In effect, the coordination with the fiscal policy and the structural policy is of the

utmost importance in this specific context.

Indeed, the central bank is contracting the monetary policy year after year to remain pegged to the euro. The

hope is to control the inflation rate. But since the secondary objective is inflation, the government must

implement policies considering this secondary objective as well. Inflationary pressure will come from the

current account, the capital account, the fiscal policy, and the structural policy. The fiscal policy as well as the

structural policy must be decided in light of their impacts on the national economy while considering the

inflation rate. If not, the gains in productivity will lead in the short-term to inflationary pressures. Under a

pegged exchange rate mechanism, these inflationary pressures will translate into pressures on the current

0

20000

40000

60000

80000

100000

120000

140000

160000

180000

2003 2004 2005 2006 2007

Money supply (M1)

Money supply (M2)

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account, and hence pressures on the amount of reserves. In this context, the central bank will need to issue

central bank bills (a reverse repo) to be able to accumulate the reserves necessary to sustain the pegged-

exchange rate mechanism. Domestic interest rates will go up as a matter of facts, and will backlash on the

fiscal policy.

To leave this locked-in scenario, the government must consider the sources of the inflationary pressures. Its

tools are either well targeted taxation or relevant public expenditure in areas where the government does not

generate an increase in the aggregate demand. To help decide, one needs to know the distribution of

household expenditures (see figure 7).

FIGURE 7. DISTRIBUTION OF HOUSEHOLD EXPENDITURES. SOURCE: STATE STATISTICAL OFFICE,

2008.

Interestingly, a little more than 60% of household income goes to food, clothing and housing. Housing is

very stable, though dwellings are increasing at a higher pace every year (see figure 8).

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FIGURE 8. BUILT DWELLINGS IN TOTAL. SOURCE: STATE STATISTICAL OFFICE, 2008.

0 500 1000 1500 2000 2500

1 room

2 rooms

3 rooms

4 rooms

5 and more rooms

2007

2001

1999

Recommendation 1:

To leave the lockedin scenario, the

government must consider the

sources of the inflationary

pressures. Its tools are either well

targeted taxation or relevant public

expenditure in areas where the

government does not generate an

increase in the aggregate demand.

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And apart from passenger car, “luxury goods” as defined by the income elasticity are on the rise in

households (see figure 9).

FIGURE 9. SUPPLY OF DURABLES IN HOUSEHOLDS (%). SOURCE: STATE STATISTICAL OFFICE, 2008.

Housing is what contributes most to the consumer price index (see figure 10), though prices seem to be kept

relatively stable likely as a result of the new dwellings (see figure 8).

0 20 40 60 80 100

mobile phone

Passenger car

CD Player/recorder

HiFi sound equipment

Personal computer

Air conditioner

2007

2001

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FIGURE 10. CONSUMER PRICE INDEX. SOURCE: STATE STATISTICAL OFFICE, 2008.

The inflation rate was on the rise before the global financial crisis (see figure 11). This is likely a result of the

fiscal expansion as well as the Balassa-Samuelson effect capturing a rise in productivity.

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FIGURE 11. INFLATION. 1999=100. SOURCE: STATE STATISTICAL OFFICE, 2008.

As shown on figure 11, although is stays under

control on a yearly average basis, inflation on a

monthly basis displays a great deal of volatility. This

may be explained by the one-month tender

procedure. A better fine tuning of the monetary

policy could help (weekly tenders for instance, as is

the case for the ECB).

FISCAL POLICY

It seems relevant to look at the Republic of Macedonia’s fiscal situation based on past examples of similar

countries. Llorca & Redzepagic (2008) perform an econometric study of eight new member states of the

6.0

4.0

2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

I V IX I V IX I V IX I V IX I V IX I V IX I V IX I V IX I V IX I V IX I V IX

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Recommendation 2:

Improve the finetuning

of the monetary policy.

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European Union. They look at these member states in light of the SGP requirements (government budget

deficit, and gross public debt). They show that there are considerable differences across the CEECs, offering

a heterogeneous picture of fiscal policy in the new EU members. They identified two distinct groups of

countries that are following different fiscal strategies with sharp differences in the behavior of their budget

deficits and debts:

1. A group with a prudent and sound fiscal policy: the Baltic States (Estonia, Latvia, Lithuania) and

Slovenia;

2. The Visegrad group (the Czech Republic, Hungary, Poland and the Slovak Republic) with high and

growing budget deficits.

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The chronic character of fiscal imbalances in the Visegrad group seems to have emerged in the earlier stages

of their post-communist transitions (Dabrowski & Rostowski, 2001). More precisely, the Visegrad group’s

fiscal troubles have their roots in high public expenditure, particularly related to social commitments

(redistributive objectives). Indeed, this group is characterized by a high proportion of so-called mandatory

social expenditure, for example on pensions and social benefits. According to EBRD 2001, it appears that the

persistently high relative levels of public expenditure and revenue in the Visegrad group may be seen as part

of the command economy legacy from the omnipotent role of the state, as well as the cushion against the

high social cost of systemic transformation. Only Slovakia has managed to move from a big to a small

government (Schneider & Zapal, 2005): its expenditure fell from 47% of GDP in 1995 to 35% in 2008.

About the debt, in the Czech Republic, Slovakia and Slovenia for instance – which started from a position of

little or no debt – the growth of the public debt has been rapid and substantial. Indeed, the growth of public

debt in the Slovak Republic has been phenomenal because of the large bank restructuring costs. In the Czech

Republic, poor management of contingent liabilities and over-generous privatization schemes left the

government with massive increases in debt levels. Slovenia is a borderline case because it already had some

debt and fiscal management capacity before independence, due to the much greater decentralization of

economic policy making in the former Yugoslavia.

The new member states have relatively small and illiquid domestic debt markets. In the early 1990s, domestic

government debt markets were non-existent or shallow; and, during the transition process, because of the

unstable macroeconomic conditions, the domestic debt market in these transitional market economies did not

develop much. Interestingly enough for the Republic of Macedonia, since the mid-1990s the ratio of foreign

debt to GDP in CEECs has been steadily falling while the share of the domestic debt has increased. Public

FISCAL SUSTAINABILIT

decisions taken in 1992-1993 by Polish official and private creditors (Pa

40% of the country’s external debt inherited from the command economy

Finally, according to the empirical findings

such a strategy was ruled out under a currency board as in Estonia and Bulgaria since mid

of Macedonia entered in a pegged exchange rate mechanism with the Ecu in 1995.

FIGURE

12).

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1993 by Polish official and private creditors (Pa

40% of the country’s external debt inherited from the command economy

irical findings, inflation was being used to reduce debt rat

such a strategy was ruled out under a currency board as in Estonia and Bulgaria since mid-

pegged exchange rate mechanism with the Ecu in 1995.

FIGURE 12. FISCAL DEFICITS. SOURCE: IMF, 2009.

debt reduction was facilitated by some generous debt underwriting. This was the case in Poland with the

ris and London clubs) to forgive up to

(Rapacki & Prochniak, 2009).

ios in may larger

CEECs (Poland and Hungary), and once inflation slowed, debt ratios began to rise more sharply. However,

1997. The Republic

When compared to its neighbors, the Republic of Macedonia seems in a reasonable fiscal position (see figure

Moldova

1.0

8.0

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FIGURE 13. GOVERNMENT DEBTS IN 2008 AND 2009 (% GDP). SOURCE: IMF, 2009.

The Republic of Macedonia’s gross debt in 2009 is among the lowest debts in the region, apart for EU

member Bulgaria (see figure 13), and it compares positively with Croatia’s debt, which is interesting since

Croatia is a candidate country to the European Union as well.

0.0 20.0 40.0 60.0 80.0

2008

2009

Albania

Croatia

Montenegro, Rep. of

Bosnia & Herzegovina

Serbia, Republic of

Moldova

Romania

Macedonia, FYR

Bulgaria

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FIGURE 14. FISCAL POLICY DURING 2005-2008 (% GDP). SOURCE: IMF, 2009.

Bulgaria and Croatia between 2005 and 2008 have a similar pattern in terms of revenue and expenditure

growth (see figure 14). Macedonia is following a different pattern this time, which may explain the pressure

on inflation in 2007-2008.

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FIGURE 15. FISCAL POLICY DURING 2009. SOURCE: IMF, 2009.

As a consequence of the global financial crisis, real revenue growth is negative in Macedonia like in most

countries, and real expenditure growth is slightly positive (see figure 15). In light of the deflationary pressures

of the late 2009, the fiscal adjustment could have been used even a little more.

However, over time, the Republic of Macedonia raises less money and spends more (see figure 14). And

although this seems to be a little better than most of the neighbors, this can still be worrisome in light of the

aftermath of the global financial crisis: higher inflation, higher interest rates, and higher taxes.

10.0

8.0

6.0

4.0

2.0

0.0

2.0

4.0

2008

2009

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STRUCTURAL POLICY

When studying the structural policy, many items can be considered. Here we will focus on the labor market

and innovation.

LABOR MARKET

FIGURE 16. LABOR FORCE. SOURCE: STATE STATISTICAL OFFIE, 2008.

Female participation is lower than male participation (see figure 16), which highlights another issue of the

labor market: the unemployment rate is incredibly and rigid at 34.9% in 2007.

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FIGURE 17. ACTIVITY RATE AND UNEMPLOYMENT IN AN INTERNATIONAL PERSPECTIVE. SOURCE:

STATE STATISTICAL OFFICE, 2008.

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This high unemployment rate is an anomaly compared to the European Union or some neighbors (see figure

17). Interestingly enough, the activity rate is similar to many European countries but the structure of the

economy does not seem to be able to integrate the unemployed.

FIGURE 18.UNEMPLOYED PERSONS BY DURATION OF UNEMPLOYMENT. SOURCE: STATE

STATISTICAL OFFICE, 2008.

This is confirmed when one looks at the duration of unemployment (see figure 18), and two thirds of the

unemployed are unemployed for 4 years or more in 2007. The situation worsened compared to 1997. This

unemployment rate is mostly a structural unemployment rate with strong hysteresis phenomena. This is

another priority for the government.

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FIGURE 19. UNEMPLOYED BY AGE GROUPS, 2007. SOURCE: STATE STATISTICAL OFFICE, 2008.

In terms of age groups, most of the unemployed are young (see figure 19). This may seem like a very negative

situation, but in a transitory economy like Macedonia, it may be a chance since the youth is more incline to

adjust easily to the new technologies (see figure 20).

FIGURE 20. EMPLOYED BY AGE GROUPS, 2007. SOURCE: STATE STATISTICAL OFFICE, 2008.

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FIGURE 21. INDICES OF NOMINAL AND REAL WAGES. 1995=100. SOURCE: STATE STATISTICAL

OFFICE, 2008.

The real wage is regularly increasing since 2001 by approximately 30% in 6 years, which may also explain why

in the short-term the unemployment rate did not change (see figure 21).

0

20

40

60

80

100

120

140

160

180

1996 1997 1998 1999 200020012002 2003 2004 200520062007

Nominal

Real

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PRODUCTION

FIGURE 22. AGRICULTURE, PRODUCTION OF MAIN CROPS. SOURCE: STATE STATISTICAL OFFICE,

2008.

In terms of structure of the production, agriculture is slightly going down (see figure 22). Metal-based

production is on the converse on the rise (see figure 23).

0

50000

100000

150000

200000

250000

300000

350000

Wheat Grape Apple Tomato Barley Tobacco

1997

2001

2007

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FIGURE 23. INDUSTRIAL PRODUCTION. SOURCE: STATE STATISTICAL OFFICE, 2008.

This situation seems to illustrate the fact that Macedonia exports metals and imports more final products,

which does not help fix the current account deficit (see figure 23).

Energy dependency

Net energy imports / Gross inland consumption 45.20%

Energy efficiency

final energy consumption / Gross inland consumption 58.20%

Efficiency of thermal power stations 35.1%

FIGURE 24. ENERGY. SOURCE: STATE STATISTICAL OFFICE, 2008.

In terms of energy, most of the energy is imported, which again does not help the current account deficit in

particular in times when energy prices are highly volatile (see figure 25).

In terms of productivity and medium-term, gross capital formation is increasing steadily in the three sectors:

agriculture, industry, and service. (see figure 26).

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NACE sector Purpose of investment 2002 2003 2004 2005 2006

Total 40448 42110 47286 48868 56485

A+B Agriculture, hunting and

forestry+fishing 1237 1379 1730 1603 2030

C+D+E+F Industry including energy and

construction 20754 23391 26881 27823 32985

G to O Services 18457 17340 18675 19442 21470

FIGURE 25. GROSS FIXED CAPITAL FORMATION BY PURPOSE OF INVESTMENT (IN MILLION

DENARS). SOURCE: STATE STATISTICAL OFFICE, 2008.

FIGURE 26. GROSS FIXED CAPITAL FORMATION BY INSTITUTIONAL SECTORS. SOURCE: STATE


0

10

20

30

40

50

60

Nonfinancial

corporations

Nonprofit

institutions

Financial

corporations

State Households

2005

2006

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INNOVATION

In terms of innovation, we are just using the Internet use as a proxy. One third of the population has access

to Internet (see figure 27) compared to more than 50% in the European Union.

2007 2008

Population with Internet access 468198 661653

Had Internet access at:

home 190958 409928

work 103108 137820

place of education 88664 118701

Internet café and other public places 227954 241213

FIGURE 27. INTERNET USE BY POPULATION AGED 15-74. SOURCE: STATE STATISTICAL OFFICE, 2008.

Significant improvements have been accomplished in terms of having access to the Internet at home (see

figure 28).

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FIGURE 28. HOUSEHOLDS WITH INTERNET ACCESS AT HOME (%). SOURCE: STATE STATISTICAL

OFFICE, 2008.

The Internet has made an incredible penetration at home and is on the rise. Needless to say that access to

Internet is not the only proxy for innovation: total investments in research and development (R&D), persons

employed in R&D, number of patents, etc. are other proxies to measure the dynamism of an economy.3

INTERNATIONAL STANCE

In terms of international trade, The Republic of Macedonia has a structural current account deficit (see figure

29).

3 We did not have access to these data at the time of this study.

0

5

10

15

20

25

30

35

2007 2008

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FIGURE 29. DISTRIBUTION OF THE COMPONENTS OF GROSS DOMESTIC PRODUCT BY

EXPENDITURE METHOD (% GDP). SOURCE: STATE STATISTICAL OFFICE, 2008.

In the short-run, the Republic of Macedonia should improve its trade relationships with wealthy countries like

Germany and Italy. This would help the balance of trade in terms of value and diversification. In 2007, the

first trading partner was Serbia, followed by Germany, Greece, Italy and Russia (see figure 30).

40

20

0

20

40

60

80

100

2002 2003 2004 2005 2006

Households final

consumption including

NPISHs

General government final

consumption

Gross fixed capital

formation

Changes in inventories

Balance of exports and

imports

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FIGURE 30. EXPORTS AND IMPORTS BY COUNTRIES, 2007 (% GDP). SOURCE: STATE STATISTICAL

OFFICE, 2008.

Interestingly enough, the Republic of

Macedonia does not sustain itself in terms

of food products (see figure 31). And in

2007, one fifth of the imports are mineral

fuels. Also, based on the average wage rate,

the sector represented by manufactured

goods should be expanded to integrate the

unemployed youth, and re-balance the

current account (see figure 32).

0

2

4

6

8

10

12

14

16

18

20

Serbia Germany Greece Italy Russia

Exports

Imports

Recommendation 3:

Based on the average wage

rate, the sector represented

by manufactured goods

should be expanded to

integrate the unemployed

youth, and rebalance the

current account.

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FIGURE 31. FOREIGN TRADE ACCORDING TO THE SITC SECTORS (IN THOUSANDS $US). SOURCE:

STATE STATISTICAL OFFICE, 2008.

This priority is reinforced by the numbers from the foreign direct investments showing that manufacturing is

of special interest to foreign investors (see figure 32).

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FIGURE 32. FOREIGN DIRECT INVESTMENT BY ACTIVITY (IN THOUSANDS $US). SOURCE: STATE


Based on the previous analyzes in terms of monetary, fiscal and structural policies, we have a better

understanding of the expectations and the challenges the Republic of Macedonia is facing. One tremendous

help-direct through the form of the Copenhagen criteria and indirect through the form of lower risk premia

(may and will be the path towards the European Union and later) though as soon as possible-the Economic

and Monetary Union.

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THE ROAD TO EUROPE

The road to Europe consists of two ways: (1) entering into the European Union, and then (2) entering into

the Economic and Monetary Union. By entering into the European Union, the Republic of Macedonia will

have to abide by the Stability and Growth Pact, and by entering into the Economic and Monetary Union, the

Republic of Macedonia will have to abide by the new exchange rate mechanism (ERM-II).

THE STABILITY AND GROWTH PACT EXPLAINED

Formally, the SGP consists of three elements: a political commitment, a preventive element, and a dissuasive

element.

THE POLITICAL COMMITMENT

Peer support and peer pressure are an integral part of the Stability and Growth Pact: the Council and the

Commission are expected to motivate countries to adhere to the pact, and make public their positions and

decisions at all appropriate stages of SGP procedure. The idea is to make the SGP more transparent. Member

States may also establish a committee of experts to advise them on the main macroeconomic projections, a

notion that has roots in the economic literature (Wyplosz, 2005). With this aim, Council Regulation 1466/97

reinforces the multilateral examination of budget positions and the coordination of economic policies.

The SGP foresees the submission of all Member States to stability and convergence programmes. Stability

and convergence programmes must present information on the adjustment path and the expected path of the

general government debt ratio, as well as the main assumptions made about expected economic development.

New to SGP II and in line with the recommendations of the literature, structural reforms are encouraged by

the possibility of taking them into account on the path towards adjustment.

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THE PREVENTIVE ARM OF THE SGP

The preventive arm of the Pact was, for the first time, given real substance with the implementation of the

Medium Term budgetary Objective (MTO). In the 1997 version of the SGP, the MTO was the same for

every country: a close-to-balance or surplus budget. Since 2005 the MTO has been given a new definition and

is part of a broader new addition to the SGP: the code of conduct. Member States have to define a specific

MTO in cyclically adjusted terms. Thus, cycles are now taken into consideration. As recommended by the

literature, country specificities must be taken into account. This new device means that surpluses from

periods of economic growth are required to be used for debt and deficit reduction.

The goals of the MTO are threefold. The first is to provide a margin with respect to the three per cent of

GDP deficit ceiling. This margin is calculated by taking into account the past output volatility and budgetary

sensitivity to output fluctuations of each Member State. The second goal is fiscal sustainability, for instance,

taking into account the economic and budgetary impact of aging populations. Influenced by the economic

literature (Buti, Eijffinger, & Franco, 2003; Fatas, 2005), the third goal is to take into account the need for

public investment and represents the structural side of the SGP. The MTOs are revised every four years or

whenever a major reform is implemented.

The Council also has the leeway to issue an ‘early warning’ to Member States before an excessive deficit has

occurred. Articles 6(2) and 10(2) of Council Regulation 1466/97 state that:

“In the event that the Council identifies significant divergence of the budgetary position from the medium-

term budgetary objective, or the adjustment path towards it, it shall, with a view to giving early warning in

order to prevent the occurrence of an excessive deficit, address, in accordance with Article 103 (4) a

recommendation to the Member State concerned to take the necessary adjustment measures.”

THE DISSUASIVE ELEMENT

If a country breaches the three per cent value for three consecutive years, it is considered to be in violation of

the SGP. In order to dissuade countries from excessive deficits, Council Regulation 1467/97 establishes the

Excessive Deficit Procedure (EDP). When the council decides that an excessive deficit exists, it makes

recommendations to the Member State and establishes a deadline of six months (raised from four) for

corrective policies to be implemented. If a Member State fails to implement the policies based on the

Council’s decisions, the Council imposes sanctions (deposits, and then fines), which are levied within ten

months of the first report of an excessive deficit. A country cannot avoid the deposits, and ultimately the fine,

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unless the Council decides to abrogate some or all of the sanctions. Abrogation depends on the significance

of the progress made by the participating Member State concerned in correcting the excessive deficit, if the

breach has resulted from an unusual event or a major economic decline (that is, an annual decline in real

GDP of at least two per cent), or if the country’s deficit is due to ‘relevant factors’. Any fines already imposed

are not reimbursable. Interest on the deposits lodged with the Commission, and the yield from fines, are

distributed among Member States without an excessive deficit, in proportion to their share in the total GNP

of eligible Member States (Warin, 2009).

MONETARY POLICY

The entrance into the EMU will take at least two years after the entry into the EU. To qualify for the

Economic and Monetary Union, the Republic of Macedonia will have to follow a set of criteria for two years

in a row: an interest rate benchmark, the Stability and Growth Pact, an inflation benchmark, and the ERM-II.

Since the Republic of Macedonia has a pegged-exchange rate mechanism, it is already in great shape to

qualify. However, a particular

point will need to be adjusted

and may create some

distortions of the monetary

policy: the minimum reserve

requirements. It is currently at

10% for bank accounts in

Denars. This will need to be

adjusted to 2%. Obviously, the

adjustment cannot be done

overnight, and will take some time at a rate of 2% every 6 months on average, the minimum time to contract

the minimum reserve requirements to 2% will be 2 years. Of course, it is advisable to start as soon as

possible, and to do it as smoothly as possible.

Lowering the minimum reserve requirements will change the capacity of the central bank to hold foreign

reserves and ensure its credibility. It is really difficult to think of a highly probable scenario, since it will

Recommendation 4:

The minimum reserve requirements

should be lowered at a smooth pace

in preparation for the entrance into

the EMU.

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depend on when the Republic of Macedonia will enter into the EMU, when the global financial crisis will be

over, and what will be the thinking of foreign investors.

It is likely that the declared candidacy to the EMU will actually reassure the foreign investors, and will hence

prevent speculative attacks. In this scenario, the National Bank will be able to lower the minimum reserve

requirements without needing as many foreign reserves as in the alternative scenario of speculative attacks.

Therefore, we should not expect a rise (or too high a rise) on the central bank bills’ interest rates. If this holds

true, then the Macedonian economy will enjoy a higher liquidity, pressures downward on the interest rates,

higher investments.

CONCLUSION

The road to Europe will be of an incredible help for the Republic of Macedonia in terms of economic

transformation. Not only the

European Union provides the

guidelines for sound economic

development, but also reassures

the international markets,

allowing new members to

benefit from improved financial

conditions. The European

agenda should be a top priority

for the government, and would

legitimate ex post the monetary

policy of the Republic of

Macedonia.

Recommendation 5:

The European agenda should be a

top priority for the government,

and would legitimate ex post the

monetary policy of the Republic of

Macedonia.

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[INSTRUMENTS TO

MEASURE FISCAL

SUSTAINABILITY]

Part II

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INTRODUCTION

here are two distinctive reform choices discussed in the literature about the quality of public

finances: first, expenditure target analyzed through the “gaps” indicators; and second, the golden

rule of deficit financing. The first choice focuses on how expenditure rules can link the annual

budgetary process to a multi-annual policy framework (Buti, Eijffinger, & Franco, 2003). For

instance, Brunila (2002) argue for expenditure targets for central governments, and balanced budget

requirements for local governments. In contrast, the golden rule allows for the spreading of capital projects

over several different generations of taxpayers. This golden rule provides an answer to the criticisms of

maintaining close to balance or surplus budget positions, because capital expenditures would not necessarily

have to come out of the current revenues (Buti, Eijffinger, & Franco, 2003; Fatas, 2005).

Fiscal sustainability is an important question in recent economic policy debates. Numerous empirical studies

focus on the developed countries (the United States, the European Union, Japan or Canada) (Ehrart &

Llorca, 2007), but very few address the question of public finances sustainability in the Central and Eastern

European countries. The first empirical studies emerged of course right after the transition from communism

to capitalism (Dabrowski, 1996; Budina & van Wijnbergen, 1997; Ambrus-Lakatos & Schaffer, 1997).

Another batch of papers appeared notably due to the official start of the negotiations for membership to the

European Union in 1999 (Green, Holmes, & Kowalski, 2001; Radulescu, 2003).

Public finances scrutiny and in particular the question of fiscal sustainability has become a central issue for

the CEECs since the EU enlargement in May 2004 and for any country on the road towards the Eurozone

(Buiter, 2004). The new member states have at some point to abide by two principles: (1) they are expected to

comply with the Stability and Growth Pact rules for government budget deficit and debt rules (3% and 60%

of GDP, respectively), and (2) the fiscal situation has to be judged as sustainable in the medium term.

As for a case study, the three new member states with the best fiscal and macroeconomic performance

entered the ERM-II in June 2004 (Estonia, Lithuania, and Slovenia). However, even these best cases can

exhibit serious fiscal imbalances. As a result, they were put under the “excessive deficit procedure” by a

decision of the Council of Ministers on July 5, 2004 taken under Article 104(6) of the Treaty on the European

Union and the SGP. They were all given at least four years to undertake the adjustment, within a rather loose

T

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framework (Llorca & Redzepagic, 2008). No sanctions were imposed, although they could be prohibited from

drawing financial resources from EU cohesion Funds (see European Commission 2004, pp.69-72 for further

details).

Why is fiscal sustainability of the utmost importance for policy-makers in particular in a country such as the

Republic of Macedonia with a pegged-exchange rate mechanism? The answer is easy and extremely relevant:

large fiscal deficits and growing debt ratios will lead sooner of later to adjustment. Under a pegged-exchange

rate mechanism, the adjustment will be only twofold: from the fiscal policy, and from the structural policy.

The effects of the adjustment from the fiscal policy will depend on the tools chosen to tackle the imbalance:

more taxes or cuts in public expenditure. This relies obviously on the capacity of the country to raise new

taxes or cut expenditure without too big social costs (rising poverty, inequalities and political unrest). On the

structural side, this is conditional to the country’s ability to pass new labor regulations, reform the public

sector, reinforce the judicial system in particular the business law component, and accompany the private

sector in its development.

As we can understand, the costs of the adjustment will depend on whether the adjustment is preventive, in

other words initiated by the government soon enough before the markets question the sustainability of the

country, or on whether the financial markets force the hesitant government to bring in measures that can be

unpopular. The latter is obviously more costly since it results in a loss of credibility of the country leading to

higher risk premia as well as the necessity to implement policies (fiscal or structural) that are by definition

costly adjustments. The rise in risk premia is the main reason why one should detect any unsustainable

policies with a sufficient lead so that policy-makers have time to act and to mitigate the costs ensuing from

the fiscal correction.

The high costs of adjustments explain why economists have spent so much time trying to define fiscal

sustainability and to develop various sustainability indicators.

The aim of this part is to describe the notion of fiscal sustainability that is currently accepted by the

mainstream literature. Indicators of fiscal sustainability will be presented and the extent to which they draw

upon the theoretical definition will be assessed.

A thorough review of the literature on fiscal sustainability was made by Balassone & Franco (2000). The

theory has proposed different conditions for sustainability—from a non ever-rising tax rate to an inter-

temporal discounted budget constraint. The requirement that the tax rate should not rise forever is one of the

first definitions of sustainable fiscal policy and is based on Domar’s model.

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In line with Buiter (1985), Blanchard (2000), chief economist at the IMF, explains that sustainability is about

whether, based on current fiscal policy, a government is headed towards excessive debt accumulation. To

make this rather general statement operational, Blanchard defines sustainable fiscal policy as a policy that

ensure that the ratio of debt to GDP converges back towards its initial level. Blanchard was well aware of the

complexities involved in measuring the asset/liability position of the government, but in his definition he paid

attention to debt dynamics rather than to the precise content of the word debt.

The major problem with defining sustainable policy as a policy under which the debt-to-GDP ratio converges

back towards the initial level is the apparent arbitrariness of such a definition. The definition is arbitrary in at

least two ways. Firstly, there is no theoretical reason why the debt ratio should be required to return to its

initial level and not to any other stable level, be it lower or higher. Secondly, one can easily conceive of a

policy under which the debt ratio initially rises to levels that are likely to be perceived as excessive by market

participants and it is only later when the debt comes down and returns to “safe” levels.

The former strand of criticisms was resolved by making the definition of sustainability more general. The

requirement of convergence of the debt ratio towards its initial level is only a special case of a more general

definition which states that fiscal policy is sustainable if the present value of future primary surpluses is equal

to the current level of debt. This definition is derived from the inter-temporal budget constraint.

The latter strand of criticisms led some authors to distinguish between solvency and sustainability. The

government is said to be solvent if it is capable, over an infinite time horizon, of paying its debt via future

primary surpluses. In other words, the government is solvent if the inter-temporal budget constraint is

fulfilled. This rule prevents the Ponzi scheme, which is when a government borrows to service its debt.

From this general statement, we will explain the indicators highlighted in the economic literature in the next

section. We will start with the more general indicators to narrow down to a different and specific approach.

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BACKGROUND

What is a good indicator of fiscal sustainability? A good indicator must be one that signals when current

policy appears to be leading to a rapidly growing debt-to-GDP ratio. Moreover, it should not only signal the

need for readjustment, but also indicate the magnitude of the needed adjustment.

The most widely used indicators of sustainability are six fold:

(1) Net debt, net worth indicators

(2) The inter-temporal primary gap, which measures the change in the primary balance required to

equate the present discounted value of future primary balances to the current level of debt. This

measure thus indicates the adjustment required to stabilize the debt at a level that is permanently

sustainable (not just attained in a certain year, as is the case with the first indicator);

(3) the tax gap;

(4) the debt-target primary gap, which measures the difference between the current primary fiscal

balance (that is, revenue less non-interest expenditure) and the primary fiscal balance required to

reach a target level of gross public debt-to-GDP ratio in a certain year;

(5) the current threshold balance;

(6) and the Golden Rule.

The construction of the primary gaps (inter-temporal or debt-target) and the tax gap is based on the same

approach. Firstly, the sustainable level of the fiscal variable at hand is calculated, most of the time using a

Hodrick-Prescott filter. Secondly, the gap is defined as the difference between the sustainable and the current

level of the primary deficit or the tax ratio. The sustainable level of the fiscal variable is such that it ensures

convergence of the debt ratio towards a finite value.

Let’s formalize first the inter-temporal gap since it serves as the starting point for derivation of other

indicators of fiscal sustainability.

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NET DEBT, NET WORTH AND INDICATIVE NET LIABILITIES

What to put on a public sector balance sheet is actually straightforward: sum up all financial and nonfinancial

assets accumulated over the years on the credit side, and all debt and other liabilities on the debit side. The

net worth will be the difference between the credit and the debit. In doing so, analysts can assess the impact

of fiscal policies on net worth and determine trends in net worth over time. This exercise will serve to

evaluate the sustainability of fiscal policies.

The difficulty however is to determine which assets have been acquired over the years, which ones do they

owe? It is particularly true in transitioning economies. Prices at which these assets and liabilities should be

marked are also difficult to decide in practical terms. In the case of the Republic of Macedonia, it is still too

early to have an idea of the net worth. This is why this first indicator will not be used in the third part of this

report.

THE INTER-TEMPORAL PRIMARY GAP

In what follows, we will use the mathematical presentation used by Krejdl (2006). The inter-temporal primary

gap analyzes the change in the primary balance—calculated as the present value of the future primary

balances—compared to the current level of debt. It concludes that the present value of future primary

surpluses must be equal to the initial value of debt. The latter is the sustainable level of debt. Closing the

inter-temporal gap guarantees that the debt ratio stabilizes at a permanently sustainable level (considering for

instance age-related expenditure in countries facing demographics issues). According to the IMF, a

sustainable level of debt for developing countries would be around 25% of GDP. If the Republic of

Macedonia were to follow the inter-temporal primary gap, 25% would thus serve as the benchmark.

GENERAL APPROACH

By definition, the public debt (B) at time t is the sum of the debt in the previous periods (t-1) and the public

deficit at time t. Also by definition, the deficit can be broken down into the primary deficit (PD) and

interest payments (IP) on the debt. Interest payments are a function of the interest rate and the previous

period debt level:

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�� (1)

�� 1 � � �� (2)

All the variables are expressed in real terms. r is an implicit real interest rate. The primary deficit (or surplus)

is indicated by a positive (or negative) value. As economies grow over time and consequently governments’

capacity to repay their debt increases, it is appropriate to re-write the latter equation in terms of GDP ratios:

��

��

1 � 1 � ��

�� (3)

where y stands for the real GDP growth rate, and �1 � /�1 � � is defined as the growth-adjusted

interest rate.

Simplifying the notation, we obtain:

�� 1 � 1 � �� (4)

The latter equation is the public debt as a percentage of GDP. In order to write this equation in an inter-

temporal way to measure sustainability, it can be solved backwards to an initial period 0. Hence the public

debt as a percentage of GDP at time T (bt) can be written as the sum of the present value of the initial debt

and the present value of all past primary deficits:

�� 1 � 1 � �� 1 � 1 � ��

��

��(5)

In order to find our condition for sustainability with the inter-temporal primary gap, let’s re-write the latter

equation in this format:

�� 1 � 1 � �� 1 � 1 � ��

��

��(6)

To identify a condition for sustainability that is not too complicated to compute, we need to make two related

assumptions: (1) the first one is an infinite time horizon (� → ∞); and the second one (2) is a present value of

the public debt as a percentage of GDP is equal to zero. Based on the first assumption, we obtain:

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lim�→∞�� 1 �1 �

�� lim�→∞�� 1 �1 �

��

�� (7)

Based on the second assumption, we obtain:

lim�→∞�� 1 �1 �

�� 0 (8)

Therefore:

�� lim�→∞�� 1 �1 �

��

�� (9)

This is our condition for sustainability. It says that the present value of future primary surpluses must be

equal to the initial value of debt.

Condition for sustainability for the inter-temporal primary gap indicator:

The present value of future primary surpluses must be equal to the initial value of

debt.

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EXTENSION 1: THE ENHANCED CRITERION FOR THE INTER-TEMPORAL PRIMARY GAP INDICATOR USING THE PUBLIC DEBT AS A MEASURE

Sustainability defined in this way is ensured not only when the present value of the debt is equal to zero, but

also when the debt ratio diverges from its initial level. This is true so long as its growth rate is lower than the

difference between the real interest rate and the real GDP growth rate. This extension comes from the

following relationship:

lim�→∞�� 1 � � ��1 � ��1 � � �� 0⇔ 1 � � ��1 � ��1 � � � � 1 (10)

� stands for the growth rate of the debt ratio.

Public revenue, expenditure, deficit and debt have an impact on other macroeconomic variables, of which the

interest rate and the growth rate of GDP are of utmost interest for sustainability. Unfortunately, economists

have not reached any significant agreement about the theory governing the interaction between the public

budget and the economy. Thus, the common practice in assessing fiscal sustainability is to assume that the

interest rate and the growth rate of GDP are exogenous to fiscal policy and the possible interactions are only

analyzed outside the model.

From there we can build up an indicator that captures the ‘magnitude of sustainability/un-sustainability’:

100. ��1 � �1 � �� 1 � � �� (11)

Enhanced criterion 1 for the inter-temporal primary gap indicator:

Sustainability defined in this way is ensured even if the debt ratio diverges from its initial level, so long as its growth rate is lower than the difference between the real interest rate and the real GDP growth rate.

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If this indicator is positive, then public finances are sustainable.

EXTENSION 2: THE ENHANCED CRITERION FOR THE INTER-TEMPORAL PRIMARY GAP INDICATOR USING THE PRIMARY DEFICIT AS MEASURE

Here, we are looking for using the primary deficit as a benchmark--instead of the public debt in the prior

paragraph--to satisfy the condition of sustainability. The infinite geometric series of discounted primary

deficits can be summed up and the sustainable primary deficit can be expressed as follows:

��∗ � �� (12)

And the inter-temporal primary gap becomes:

��∗ �� (13)

When we calculate the primary gap, we only need to know:

1. The current primary deficit

2. The public debt

And we need to make assumptions about:

1. The long-run expected average values of the interest rate

2. The growth rate of real GDP

If the current primary deficit is greater than the sustainable one ��∗ �� 0�, the debt ratio will rise

without any limits and fiscal policy can be called unsustainable.

Enhanced criterion 2 for the inter-temporal primary gap indicator:

If the current primary deficit is greater than the sustainable one ��∗ �� 0�, the debt ratio will rise without any limits and fiscal policy can be called unsustainable.

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Why is this an interesting criterion? Well, the sustainable primary deficit (��∗) can be used directly as a target

guiding the government towards a sustainable deficit path, while considering the interests on the debt. It

helps design the fiscal policy by focusing it on the primary deficit, which is the instrumental part of the

budget. It is an interesting indicator, since it helps define a reasonable public deficit: “a reasonable public

deficit is a deficit that follows this criterion: �1 � �� <(r-y).”

This definition serves also as base for the definition of the tax gap.

THE TAX GAP

Following a budget rule based on a reasonable public deficit definition is of the utmost importance in

particular in countries like the Republic of Macedonia.

The utility of using in practical terms the inter-temporal primary gap is mainly twofold: (1) to define a

Medium-Term Objective; and (2) to serve as an early warning procedure in case of economic shocks. In the

future, public expenditure may rise (e.g. as a result of aging) and maintaining the primary deficit at the

sustainable level (��∗) will require an adjustment of public revenue or expenditure. To take into account

future economic shocks, the assumption of a constant primary deficit must be relaxed.

The primary deficit can be calculated as the difference between (1) public expenditure represented by g public

consumption (including investment) and h transfers (social transfers); and (2) tax revenue represented by

the tax ratio:

�� (14)

All variables are measured in terms of GDP ratio.

Substituting the latter equation into the inter-temporal equation, and solving for , we obtain the sustainable

tax ratio:

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�∗ � � � �1 � � �� 1 � �1 � ��

∞

�� (15)

By subtracting the current tax ratio from the sustainable level �∗, we get the so-called tax gap indicator:

��_ �� ∗ � � (16)

This indicator is easy to interpret: if the sustainable tax ratio (�∗� exceeds the current tax ratio �, i.e. the tax

gap is positive, the fiscal policy will have to be adjusted in order to avoid a path towards excessive debt

accumulation.

A positive tax gap suggests that the current tax ratio is not high enough to finance future spending and to

service the debt. In order to satisfy the inter-temporal budget constraint, it will be necessary to either reduce

public expenditure, or increase the tax revenue the latter can be done in two ways: (1) by increasing taxes, or

(2) by increasing the tax base. This is particularly true in the context of the Republic of Macedonia where the

unemployment rate is above 30% of the labor force in 2009, and where there is an important grey economy.

�� _ �� ∗ � �Tax gap indicator:

If the sustainable tax ratio (�∗� exceeds the current tax ratio �, i.e. the tax gap is positive,

fiscal policy will have to be adjusted in order to avoid excessive debt accumulation.

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THE DEBT-TARGET GAP

The debt-target primary gap measures the difference between the current primary balance (i.e. public revenue

minus non-interest expenditure) and the primary balance required to reach a target level of gross public debt-

do GDP ratio in a certain year.

Both the inter-temporal primary gap and the tax gap were derived from the condition of sustainability

proposed by Blanchard. Both indicators relied on the assumption of an infinite time horizon, which is

different from the debt-target primary gap.

Relaxing the infinite time horizon is not an issue, since of course in practical terms it is impossible to forecast

the future and one has to rely on assumptions. However, closing the debt-target gap is sufficient for achieving

for instance the Stability and Growth Pact target of 60%, but does not prevent an explosive situation of the

debt thereafter generated by issues such as age-related expenditure. In other words, none of the indicators are

ideal indicators, but one should know the limits and advantages of each method so that the conclusions

drawn are realistic.

The construction of the debt-target primary gap requires the acceptance of a debt target at the end of the

period (see equation 5). Again, the IMF recommends a level of public debt of 25% of GDP for developing

countries. This could serve as a benchmark for the Republic of Macedonia.

GENERAL APPROACH

As in equation (5), we will again calculate the sustainable primary deficit. Since we are interested in a

constant value of pd, let’s determine the following equation:

��∗ � � � �1 � � �1 � �1 � �1 � �� 1 � �1 � ��

� � �� (17)

From equation (16), we can conclude that given the initial debt level (��), pd* now stands for the value of

the primary deficit that will ensure that the debt ratio reaches the value of (� ) at time T. This indicator is

of a paramount importance when the Ministry of finance has identified the sustainable level of public

debt for the Republic of Macedonia.

Again, by definition the debt-target primary gap indicator is the difference between the sustainable and

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current level of the primary deficit ��∗ � ��. Since we are looking for the primary deficit that will stabilize the debt ratio at the initial level �� at time T, then equation (16) can be simplified as follows:

��∗ � � � �1 � � �1 � �1 � �1 � �� 1 � �1 � �1 � ��

� � � �� 1 � � (18)

From a formal point of view, the expression for the primary deficit stabilizing the debt ratio at a finite

horizon (17) does not differ from the sustainable primary deficit satisfying the inter-temporal budget

constraint (9).

Let us calculate now the sustainable tax ratio for a finite horizon:

� �1 � �1 � ��

��1 � �1 � ��

��(19)

As in the case of the infinite horizon sustainable primary deficit, equation (18) can be solved for � by

summing the finite geometric series of the discounted tax ratios, which yields:

Debt-target primary gap rules of thumb for the specifications:

The difference between the debt-target and the inter-temporal primary gap is in

the choice for r and y. When calculating the primary deficit that will stabilize the

debt ratio at the desired level within, for example 3 years, the forecasted values of

r and y for the next 3 years will be applied. One rule of thumb says that the target

period should be the longest maturity of T-bonds, here 10 years in the Republic

of Macedonia. Another rule of thumb would be to calculate a weighted average of

the maturity of the different T-bonds.

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�∗ � � � �1 � � 1 � 1 � �1 � �� 1 � �1 � ��

� �� 1 � �1 � ��

�� (20)

The indicator calculated by equation (19) requires a debt-target, which can be arbitrary (see the 25% rule

from the IMF).

EXTENSION

Now, if the debt-to-GDP ratio at time T is required to equal the initial level, (19) becomes:

�∗ � � � �1 � � �� 1 � 1 � �1 � �� 1 � �1 � ��

�� (21)

As can be seen from (20), in the real world, a forecast of future expenditure is necessary for instance on

age-related expenditure (represented by h) and on non-age related expenditure (represented by g). Also,

the target value of debt �� and the time horizon (T) must be determined by the policy-makers.

The gap indicators corresponding to the tax gap indicator (15) and (19) are easier to interpret, as they

express the adjustment needed to prevent the debt ratio from deteriorating and do not require an explicit

debt target to be set.

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Empirical specifications:

As for the choice of T, Blanchard (1990) proposes to use three indicators of fiscal

sustainability. Each of the indicators should be associated with a different time horizon,

equal to 1, 3-5 and 30-50 years.

Blanchard justifies the choice of t equal to one year by the fact that such an indicator does

require a forecast as the budget data are widely available. As a result, such an indicator can

easily be constructed from published data. On the other hand, the one-period gap may give

a distorted picture of the amount of adjustment that would reasonably be required. Firstly,

the actual primary deficit or tax ratio may be affected by transitory events (a hike in non-

interest spending or short-lived spending cuts, one-off revenues) or by cyclical factors.

Secondly, it does not take account of predictable changes in spending trends resulting from

events such as population ageing.

To diminish the influence of transitory and cyclical factors, it is appropriate to construct

medium-term indicators (T of three to five years). The application of gap indicators may,

however, be limited by data availability. But these days, three-to five- year projections are

often made by national fiscal authorities or international organizations.

Although less relevant in the case of the Republic of Macedonia, population aging may still

be an important driver of future expenditure. It is advisable to compute gap indicators for a

very long time horizon of 30 to 50 years. Calculation of long-term gaps is fairly ambitious

because very long forecasts have to be made and these are necessarily subject to wide

margins of uncertainty. Despite all the uncertainties, international organizations, mist of

national authorities of developed countries and independent researchers publish long-term

projections.

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THE CURRENT THRESHOLD BALANCE

According to Blanchard (1990), the debt will be sustainable when the value of current debt is lower than

the net present value of future primary balances. Another approach is to determine the dynamics of debt,

which evolves according to a limited number of parameters. The starting point is the fiscal budget

constraint of the government, which can be expressed, after some algebra, as:

Δ��

��

�∗�Δ��

�� 1 � � �� (22)

Where �� is the primary balance and �� is the stock of public debt at the end of time t, both expressed

as a ratio of GDP. There are two different types of debt to be considered: (1) the domestic debt, and (2)

the external debt, which have respectively a share � and �1 � � in the total stock of debt, and their real

interest rates are �� and ��∗. Δ�� is the change in the nominal exchange rate – where an increase in e

represents an exchange rate depreciation – and �� is the real growth rate.

Primary surpluses, which reflect the excess government resources over expenditure, reduce the debt

stock, which is an increasing function of the domestic and foreign real interest rates and the exchange rate

depreciation, and a negative function of growth.

From equation (21), a useful indicator of fiscal sustainability can be simply derived. By just setting Δ��

0, the threshold value for the primary balance which would render the debt stable is obtained. Above that

threshold, public debt will be sustainable. We will denote this value as the current threshold (primary)

balance �� : �� such that Δ�� 0, that is:

��

��

�∗�Δ��

�� 1 � � �� (23)

Due to the pegged-exchange rate mechanism in the Republic of Macedonia, this methodology is

eventually identical to the inter-temporal primary gap indicator.

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THE GOLDEN RULE

The definition of the Golden Rule is as follows: over the course of the economic cycle, allow the fiscal

deficit to average out at a figure no greater than the level of net public investment.

This rule allows a government to run a public deficit if it is no greater than the level of public investment

in capital as a percentage of GDP. This rule is assessed over the course of the economic cycle, which is

approximately 7 years. A Hodrick-Prescott filter can be used.

The Golden Rule allows a government to borrow if it is only to invest in capital.

This rule is a little too stringent since it includes the service of the debt, which reduces by as much the

amount of money going to public investment. A variant of this rule would be to consider the primary

deficit and to allow the primary deficit to be as great as the public investment. The risk of un-

sustainability would still exist for countries that are highly indebted and would need to service their debt

each year leading to an even greater deficit.

Sustainability indicators from the International Organizations

In what follows, we will briefly describe the approaches covered in three major international

organizations of special interest to the Republic of Macedonia: The OECD, the European

Commission and the IMF.4

The OECD

The first broad report on the long-term sustainability of public finances from an international

perspective was published by the OECD in 2001. Demographics are highlighted in this report since

they are one of most important items on the OECD countries’ list of pressing issues. The report

covered most of the spending items deemed dependent on the age structure of the population, e.g.

4 See the very survery in Krejdl, (2006).

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pensions, health care, long-term care, child-related programmes and education. The results are based

on national models using a set of assumptions about macro-economic and demographic

developments.

Long-term sustainability is evaluated on the basis of the evolution of the primary balance and debt,

throughout the projection and by calculating the ‘primary balance needed to offset the impact of

ageing” (Dang, 2001). The latter is in fact the primary balance in the given initial year, observance of

which would ensure achieving a pre-determined debt ratio at the end of the year 2050. After

subtracting the initial primary balance, it essentially corresponds to the tax gap indicator. The OECD

work became an inspiration for the sustainability analysis that is now carried out by the European

Commission.

The European Commission

In a 2007 article, Hauner, Leigh, & Skaarup (2007) use two standard indicators to assess the

evolution of fiscal sustainability: (1) the first indicator is the debt-target primary gap and (2) the

second indicator is the inter-temporal primary gap. The two indicators belong to the family of the

primary gap indicators that are based on the European Commission’s (2004) approach to assessing

fiscal sustainability.

For obvious reasons, the European Commission seems to be the most active player in the field of

analyzing and evaluating the long-term fiscal sustainability of its member states. It systematically

develops, calculates and applies indicators for assessment of public finance sustainability. The

sustainability indicators make use of the information from long-term budgetary projections

calculated on the basis of commonly agreed coverage, methodology and underlying assumptions.

Starting in 2001, the EC supplemented its projections of the fiscal implications of ageing populations

with long-term indicators denoted T1, T2 and T3, later replaced by the acronyms S1, S2 and S3.

S3 has the strongest theoretical foundation since it is fully compatible the inter-temporal budget

constraint and the sustainable tax ration (equation 14). It is an infinite horizon tax gap calculated on

the basis of projected fiscal trends up to 2050 and extended beyond 2050 under the assumption of

preserving the tax and spending ratios at the levels achieved in 2050. S1 and S2 are the finite horizon

tax gaps gauging the magnitude of adjustment needed to reach the pre-defined debt level in 2050,

given the projections up to 2050. S2 assumes that the 2050 debt ratio will amount to 40% of GDP.

The arbitrariness of this target, which is used for countries with very different starting positions, has

led the EC to abandon this indicator. Construction of the S1 indicator was motivated by the

provisions of the pre-reform Stability and Growth Pact, which required the member states to

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achieve balanced budgets in the medium term. Under a balanced budget, the nominal value of debt

does not change (Bt=B0) and the target value of debt can be expressed as follows:

��

��

��

1

�1 �� 1 �

�� 24�

The SGP reform triggered changes in the assessment of public finance sustainability. The currently

used quantitative indicators comprise S1, S2 and the Required Primary Balance (RPB). The former

S2 indicator has been renamed S1 and its definition has changed. S1 currently measures the required

change in the tax ratio that guarantees a debt-to-GDP ratio of 60% in 2050. The re-definition of S1

reflects the intention to have an indicator consistent with the Maastricht targets. The current S2

indicator is the old S3 based on observance of the government inter-temporal budget constraint. To

make the indicators more understandable for policy-makers, the EC will calculate and publish the

Required Primary Balance. The RPB should facilitate transformation of the quantitative indicators

into policy prescriptions, since it indicates the required structural primary balance (in terms of GDP)

over the five-year horizon respecting the inter-temporal budget constraint. It is obtained by

subtracting the S2 indicator from the current primary deficit. Policy-makers can use the RPB directly

as a fiscal target in their medium-term fiscal frameworks.

The assessment of public finance sustainability carried out by the EC does not rest on quantitative

indicators only. The EC is well aware of the fact that the information given by the quantitative

indicators is conditional upon the results of uncertain long-term projections. The uncertainty is

partially circumvented by qualitative judgment. When pursuing sustainability analysis, the EC takes

into account information on the current level of the debt ratio, the current level of the tax burden,

the impact of structural reforms and the reliability of the projections. Sustainability analysis is not a

mere exercise. It results in concrete recommendations and guidelines for the member states.

The IMF

Assessment of fiscal (together with external) sustainability is an important part of the IMF’s analysis

carried out in the context of Article IV surveillance and Fund-supported programmes (IMF, 2002).

The IMF is pre-occupied with medium-term projections, usually not exceeding 5-10 years. Due to

the timeframe covered, the sustainability assessments abstract from the impact of the evolution of

age-related spending on sustainability. They consist in projecting revenues, expenditures and the

resulting evolution of the fiscal balance and debt under alternative macro-economic assumptions.

Apart from the baseline projections, several stress tests are usually performed in order to evaluate

the resilience of the fiscal position to adverse shocks. The debt-stabilizing primary surplus is often

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calculated and compared with the existing primary balance to show whether the current fiscal policy

is, in the medium term, consistent with a stable debt ratio.

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CONCLUSION

In retrospect, to measure the fiscal sustainability of the Republic of Macedonia in line with methods used in

international organizations of special interest for the future of Macedonia, while considering the specificities

of the country, we will develop a framework based on 3 indicators: (1) the inter-temporal primary gap, (2) a

combination of the tax gap and the debt-target gap and (3) the degree of sustainability.

The framework will consist of two stages: (1) we will analyze the cyclicality of the fiscal response (pro or

counter cyclical) to economic shocks to assess whether the fiscal policy is used according to sound economic

principles. The cyclicality will be examined using Macedonian data, and will help fit the model. (2) The second

stage will consist in a depiction of the Republic of Macedonia’s fiscal stance in light of the three indicators

aforementioned.

This framework and its application to the Republic of Macedonia will be presented in the next part of this

report. All the resources and techniques used to assess the fiscal sustainability of the Republic of Macedonia

will be presented in the appendices.

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APPENDIX 1. THE COSTS OF INACTION: MEASURING DELAYS

IN FISCAL ADJUSTMENT

Even if sustainability indicators point to a significant fiscal gap, policy-makers tend to be hesitant to adopt

corrective measures and are often tempted to postpone adjustment. However, the decision to postpone

adjustment is not costless and it is important to know the costs before such a decision is made. The costs of

delayed adjustment can be quantified as the difference between the fiscal gaps (e.g. tax gaps) prevailing at two

distinct points in time. Delaying adjustment results in a more rapid accumulation of debt, which goes hand in

hand with rising debt servicing costs and ultimately leads to lower primary spending (or higher taxes). In fact,

the broadening of the fiscal gap indicates the volume of spending that will be foregone in future in exchange

for temporarily higher spending. We will derive the costs of delay for an infinite tax gap, which is the most

comprehensive and theoretically sound indicator.

Delaying fiscal adjustment by a year is, due to higher debt servicing costs, translated into a higher sustainable

tax ratio. On the basis of equation (12), we can write:

��∗ � � � �1 � �� 1 �1 ��∞

�� (24)

Substituting for the debt ratio b1 the expression from equation (5), and expressing the primary deficit as the

difference between primary spending � �� and revenues �� yields:

��∗ � � � �1 � �� 1 �1 ��∞

�� 1 �1 � �� (25)

��∗ � �� 1 �� 1 �1 �� 1 �1 ��∞

�� 1 �1 ��

�� 1 �1 � ��∗ � � � �1 � �� (26)

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If equation (23) holds, the tax gap at any future point in time can be derived on the basis of the tax gap in the

initial period and the interest rate/growth rate differential:

��_�� ∗ � � � 1 �1 � ��_�� (27)

��_�� ∗ � �� 1 �1 ��_�� (28)

Correspondingly, the change in the tax gap takes the following form:

Δ�� ∗ � �� ∗ � �� 1 � ��_�� (29)

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Part III

[ASSESSING THE

REPUBLIC OF

MACEDONIA’S FISCAL

SUSTAINABILITY]

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INTRODUCTION

n this third part, we compute the sustainability indicators presented in the second part of this report for

the Republic of Macedonia. We start with short-term fiscal sustainability and conclude with medium-

term indicators. Due to the lack of data, we cannot assess the long-term path of public finances as we

would need to know the change in the population structure.

The short-term and medium-term indictors are based on the official forecasts of the Ministry of finance for

2010, 2011 and 2012 and on simulations (Hodrick-Prescott filter for calibration and bootstrapping).

However, making these medium-term projections requires adopting assumptions, which may not always be

realistic due to economic developments and political changes in the future. We should also note that we are

making projections and not forecasts. Projections rely on assumptions based on past data and forecasts of

endogenous variables.

For modeling purposes, the analysis in the report assumes that spending and taxation policies at the end of

the short-term forecast are continued in the future. The nature of these assumptions does not mean that the

government has made a commitment to continue current policy. Similarly, it does not mean that there will be

no changes to spending and taxation in the future.

Now, the short-term indicators are more relevant than the medium-term indicators. Based on the nature of

the data (quality and availability), the report uses techniques to circumvent some of the difficulties. For a

thorough medium-term or long-term perspective, again it should be appropriate to compile data on

demographics and ageing in particular.

I

In what follows, 6 steps are highlighted. They represent the necessary steps

for a thorough review of fiscal sustainability. They are implemented here

using the available data. The conclusions are interesting and lead to relevant

economic policy recommendations.

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CYCLICALITY OF THE FISCAL RESPONSE

Fiscal policy is expected to play an important stabilizing role over the

business cycle. When the economy is accelerating, the fiscal authorities

should be able to moderate activity by restraining the fiscal stance and,

vice versa, in downturns fiscal policy can help stimulating the

economy. Therefore, under these circumstances, fiscal policy is

expected to behave counter-cyclically.

We have used two methodologies to de-trend the actual output

(measured by the real GDP). The first one is the Hodrick-Prescott

(HP) filter. The second one is the Baxter-King (BK) filter. The

Hodrick-Prescott filter provides us with better results and we will

present only the HP filter results for clarity reasons.

CYCLE AND POTENTIAL OUTPUT USING THE HODRICK-PRESCOTT

FILTER5

In the next box, the Hodrick-Prescott filter will be explained. It is a very standard way of measuring business,

with benefits and costs. The Baxter-King filter is a little more often preferred or some other econometric

techniques. However, due to the limitations created by the data, the Hodrick-Prescott filter seems to provide

robust results.

5 Both the HodrickPrescott and the BaxterKing filters have been experimented. Due to the short timespan, the Baxter

King filter did not provide better results than the HodrickPrescott filter. The output gap can be computed by using two

different λ in the HodrickPrescott filter: λ=6.7, as recommended by Maravall & del Rio, (2007), and λ=100, which is the

usual figure and we chose in this report.

STEP 1

The first step is to

assess the counter or

procyclicality of the

fiscal policy.

Automatic stabilizers

and fiscal impulse

indicators are

therefore computed.

FISCAL SUSTAINABILIT

Box 1: The Hodrick-

The Hodrick-Prescott filter is a mathematical tool used in macroeconomics,

especially in real business cycle theory. It is used to obt

linear representation of a time series, one that is more sensitive to long

than to short-term fluctuations. The adjustment of the sensitivity of the trend

to short-term fluctuations is achieved by modifying a multiplier λ. The

Hodrick–Prescott filter affects such a break down by minimizing the following

equation:

The first term above is the sum of squared cyclical components (y is the series,

� is the cycle component) . The second term is a multiple of the sum of squares

of the trend component’s second differences. This second term penalizes

variations in the growth rate of the trend component: the larger the value of

the higher is the penal

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-Prescott filter

Prescott filter is a mathematical tool used in macroeconomics,

especially in real business cycle theory. It is used to obtain a smoothed non-

linear representation of a time series, one that is more sensitive to long-term

term fluctuations. The adjustment of the sensitivity of the trend

term fluctuations is achieved by modifying a multiplier λ. The

Prescott filter affects such a break down by minimizing the following


is the cycle component) . The second term is a multiple of the sum of squares

of the trend component’s second differences. This second term penalizes

variations in the growth rate of the trend component: the larger the value of

the higher is the penalty and hence the smoother the trend series.

Prescott filter is a mathematical tool used in macroeconomics,

-

term

term fluctuations. The adjustment of the sensitivity of the trend

Prescott filter affects such a break down by minimizing the following


is the cycle component) . The second term is a multiple of the sum of squares

variations in the growth rate of the trend component: the larger the value of �,

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FIGURE 33. BUSINESS CYCLE (HP) (MILLIONS OF DENARS). SOURCE: OWN COMPUTATIONS.

The Hodrick-Prescott filter provides us with the cycle of the series, here the business cycle. The Republic of

Macedonia enters into a downward cycle in 2010,

2011 and 2012 before returning to an upward

cycle. This information is of a paramount

importance for calibration of forecasts. Indeed,

this cycle is related to past data and does not

integrate too much information from the global

financial crisis. When we consider the effects of

the global financial crisis, we may assume that this

downward phase will be magnified by the global

financial crisis as well as the length of the phase.

Moreover, it is important to remember that the global financial crisis will linger for a couple of years as the

bubble is still there, having changed from a monetary policy-fueled bubble to a fiscal-policy fueled bubble.

Recommendation 6:

Integrate the business

cycles into the design of

the fiscal policy.

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FIGURE 34. POTENTIAL OUTPUT (HP). SOURCE: OWN COMPUTATIONS.

By definition, the difference between the potential output and the actual output is the output gap. A positive

difference highlights inflationary pressures, due to a rise in the aggregate demand outpacing the rise in the

aggregate supply.

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FIGURE 35. OUTPUT AND ABSORPTION GAPS (% OF POTENTIAL OUTPUT). SOURCE: OWN

COMPUTATIONS.

CYCLICAL BEHAVIORS OF FISCAL BALANCES

Automatic stabilizers work as a tool to dampen fluctuations in real GDP without any explicit policy action by

the government. It is a government program that changes automatically depending on GDP and a person’s

income and acts as a negative feedback loop on GDP. The size of the government deficit tends to increase as

a country enters recession, which helps keep national income high through the multiplier.

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FIGURE 36. AUTOMATIC STABILIZERS AND GROWTH. SOURCE: OWN COMPUTATIONS.

A positive (negative) automatic stabilizer represents a cyclically-adjusted contraction (expansion). As seen on

figure 36, when GDP growth rates are stable in 2004 and 2005. In 2006, there is a small contraction of

automatic stabilizers related to a small decrease in the GDP growth rate. In 2007, the rise in GDP growth is

accompanied by a contraction of the automatic stabilizers, easing the pressures on the fiscal policy. There are

two other years of contraction in 2008 and 2009, although GDP growth rates decline a bit in 2008 and remain

stable in 2009. In 2010, a forecasted expansion of the automatic stabilizers will accompany a negative GDP

growth rate, putting pressure on the fiscal stance.

2

1

0

1

2

3

4

5

6

7

2004 2005 2006 2007 2008 2009 2010 2011

Automatic Stabilizers, year on year change (% potential output) GDP growth rate

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FIGURE 37. CYCLICAL BEHAVIOR OF FISCAL BALANCES. SOURCE: OWN COMPUTATIONS.

A positive (negative) fiscal impulse represents a cyclically-adjusted contraction (expansion). As seen on figure

37, there has been some fiscal impulses from 2006 to

2009 greater than the contraction in automatic

stabilizers when the economy was growing. This pro-

cyclical fiscal policy led to a deterioration of the

cyclically-adjusted primary balance. However, in 2010,

although the GDP growth rate will be negative (the

economy will be in recession), the automatic stabilizers

will be in expansion, but no fiscal impulse will come

from the public budget, reinforcing the pro-cyclicality

of the fiscal policy. This rule of sound fiscal policy is

obviously a little too harsh for a country like the

Republic of Macedonia, since there is a trade-off

7

6

5

4

3

2

1

0

1

2

3

2004 2005 2006 2007 2008 2009 2010 2011

Fiscal impulse (not including interest payments), year on year (% potential

output)

Automatic Stabilizers, year on year change (% potential output)

Cyclically adjusted primary balance

Recommendation 7:

Fix the procyclicality

of the fiscal impulse

so that the fiscal

policy becomes

countercyclical.

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between fiscal sustainability and economic development. It may not seem unreasonable to use the fiscal

policy even in good times to invest in capital for instance. The question is to know whether this pro-cyclical

fiscal policy has been well exploited. Later, we will see where the Republic of Macedonia stands vis-à-vis the

golden rule of public finance.

The cost of a pro-cyclical fiscal policy is to incapacitate the government from using a fiscal impulse in hard

times. Indeed, when the government uses a pro-cyclical fiscal policy, it increases the primary deficit or

reduces the primary surplus, and cannot use more leeway in hard times otherwise risking to put the public

finances on an unsustainable path.

The next section will now be devoted to the study of whether the public finances are on a sustainable path or

not.

SHORT-TERM INDICATORS

In this section, we will first analyze some of the accounts of the

public expenditure line. We will also use the inter-temporal primary

gap indicator to assess the sustainability of public finances. We will

also check the robustness of the conclusions drawn on the inter-

temporal primary gap by using a version of the tax gap indicator.

STEP 2

Proceed to the

analysis of primary

public expenditure,

public revenue and

primary balance.

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ANALYSIS OF PRIMARY PUBLIC EXPENDITURE, PUBLIC REVENUE AND

PRIMARY BALANCE

FIGURE 38. PRIMARY PUBLIC EXPENDITURE (% GDP). SOURCE: MINISTRY OF FINANCE, 2009.

Education spending is projected to remain stable and even to represent a lightly lower share of GDP. State

pension spending is projected to slightly decrease as a share of GDP. And health spending is also projected to

decrease as a share of GDP (see figure 38).

As a result of the projected spending and revenue trends, the general government primary balance is expected

to remain in deficit in the short-term.

0

1

2

3

4

5

6

7

8

9

2009 2010 2011 2012

Education State pensions Health

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FIGURE 39. PRIMARY BALANCE (% GDP). SOURCE: MINISTRY OF FINANCE, 2009.

Figure 39 shows a structural primary deficit due to projected gradual increases in public expenditure.

PROJECTIONS FOR THE INTEREST OF THE DEBT

The interest of the debt is an interesting criterion to study (see figure

40).

2.5

2

1.5

1

0.5

0

0.5

1

1.5

2

2005 2006 2007 2008 2009 2010 2011 2012

STEP 3

Analysis of the

interest of the debt

and its projections.

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FIGURE 40. INTEREST OF THE DEBT (% GDP). SOURCE: MINISTRY OF FINANCE, 2009.

As we can see on figure 41, the interest of the debt was declining until 2009, but is from 2009-on expected to

rise.

When one looks at the interest of the debt, one should also consider three other factors: (1) the GDP growth

rate, (2) the change in public revenue to capture how much of the growth generates revenue and (3) the

change in the primary balance to see how much of this revenue is captured by the public expenditure and is

not destined to pay the debt back.

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FIGURE 41. INTEREST OF THE DEBT AND OTHER INDICATORS. SOURCE: MINISTRY OF FINANCE,

2009.

As we can see on figure 41, the interest on the debt is expected to rise in 2010 to then remain stable.

However, figure 11 shows that the GDP growth rate is declining, leading to a smaller growth of public

revenue. In the mean time, the primary balance is deteriorating, meaning that the rise in public expenditure is

greater than the rise in public revenue.

In retrospect, until 2009, GDP growth was stable and has generated higher public revenue in 2007, 2008 and

2009. However, this growth in public revenue has been largely offset in 2008 and 2009 by higher public

expenditure leading to a deterioration of the primary balance. In the future, this deterioration will lead to a

higher debt with as a result a higher interest of the debt. As we can see on figure 42, the Ministry of finance

expects to stabilize the interest of the debt starting in 2011. However, in times when the GDP growth will

degrade and tax revenue will degrade too to remain almost constant, the goal of stabilizing the interest of the

debt relies on two assumptions: (1) a reduction in primary public expenditure to a level that balances the

primary balance and (2) stable conditions on the servicing of the debt. Due to the global financial crisis, the

latter seems optimistic.

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THE INTER-TEMPORAL PRIMARY GAP

The inter-temporal primary gap analyses the change in the primary

balance compared to the current level of debt. It concluded that the

present value of future primary surpluses must be equal to the initial

level of debt.

The methodology used here to calculate the inter-temporal primary

gap will be the one relying on equation 10 and consists in the

‘enhanced criterion for the inter-temporal primary gap indicator

using the public debt as a measure’.

To calculate the inter-temporal gap, we first need the primary deficit (see figure 42).

FIGURE 42. PRIMARY BALANCE (SURPLUS/DEFICIT). SOURCE: MINISTRY OF FINANCE.

STEP 4

The calculation of the

intertemporal

primary gap.

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The Republic of Macedonia has entered in 2008 into a zone of primary deficits. Although not high, these

deficits by definition do not include the yearly interest of the debt.

Then we will use two ways of calculating the ‘growth-adjusted interest rate’. (1) The first way will divide the

real interest rate, as measured by the Central Bank bills adjusted for inflation (CPI), by the GDP growth rate.

However, when one does that, the decrease in the public debt ratio does not correspond to the definition

provided by equation 4. This is certainly due to allocations from the public revenue to the reimbursement of

the debt (to be verified). Hence, (2) we decided to approximate the ‘growth-adjusted interest rate’ by using

equation 4 and isolating (1+r)/(1+y). This is our second way to calculate the inter-temporal primary gap, and

check for the sustainability of public finances.

FIGURE 43. GROWTH-ADJUSTED INTEREST RATE AND % CHANGE IN PUBLIC DEBT. SOURCE: OWN

COMPUTATIONS.

A one percentage point increase in the initial debt stock increase the inter-temporal primary gap indicator by a

factor related to the growth-adjusted interest rate.

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FIGURE 44. MEASURE OF PUBLIC FINANCES’ SUSTAINABILITY/UN-SUSTAINABILITY. SOURCE: OWN

COMPUTATIONS.

Figure 44 shows the degree of sustainability/un-

sustainability. It is calculated by subtracting (1+b) to the

growth adjusted interest rate. When positive (negative),

it indicates the sustainability (un-sustainability) of public

finances.

It looks like the Republic of Macedonia has made great

efforts in the past to curb down the observed rise in the

public debt, but is a little too close to the border with

un-sustainability and would need to work on getting

some leeway to better adjust to unforeseen

macroeconomic changes such as for instance the future

impacts of the global financial crisis in the years to come

(higher global interest rates, higher global inflation rates,

higher global tax rates leading to a reduction in global

consumption).

Recommendation 8:

In the midst of the

global financial crisis,

this downward

direction of the

degree of

sustainability must be

taken seriously in

2010, 2011 and 2012

to prevent from

entering into the

negative region.

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Indeed, the trend is negative and is pointing into the direction giving the first warning of an un-sustainable

pattern. Moreover, when we look at the projected rise in public expenditure and as a matter of fact the rise of

public deficits for 2010, 2011 and 2012, we can conclude that the government should be aware and adjust to

this first warning.

AN ADJUSTED TAX GAP INDICATOR

In what follows, we will use an ‘adjusted’ tax gap indicator. We will rely

on equation 46, but the initial level of debt will be replaced by the

assumption of a no change in debt compared to the previous period. This

will lead to a version of the debt-target indicator with the debt target

being the previous debt level. This indicator is useful to check the

robustness of the conclusions drawn by using the inter-temporal primary

gap indicator.

Let us first present the public balance in the following figure.

STEP 5

The calculation of the

adjusted tax gap

indicator.

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FIGURE 45. PUBLIC BALANCE (% GDP). SOURCE: MINISTRY OF FINANCE, 2009.

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FIGURE 46. PUBLIC DEBT (% GDP). SOURCE: MINISTRY OF FINANCE, 2009.

As shown on figures 45 and 46, the Republic of Macedonia has improved its public debt situation and

consolidated the public balance from 2004 to 2008. The public deficit is expected to rise again in 2009 on.

This situation is too high to ensure a non-increasing debt ratio.

0

10

20

30

40

50

60

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Public debt

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FIGURE 47. PUBLIC REVENUE AND PUBLIC EXPENDITURE (% GDP). SOURCE: MINISTRY OF

FINANCE, 2009.

As seen on figure 47, the rise in 2009 expenditure is partially offset by a rise in the revenue, though not at the

same pace. This will have an impact

on the tax gap measure. Very likely,

the tax gap indicator will tell us that

fiscal adjustments are needed in

terms either (1) of a reduction of

public expenditure, (2) of an increase

in the tax rate or (3) an increase in

the tax base.

The question thus arises of what

adjustment to current policy would

be needed in order to prevent the

government debt from rising. To

answer this question, we calculate

the sustainable tax ratio according to

equation 14 for one year.

0

5

10

15

20

25

30

35

40

45

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Public revenue Public expenditure

Recommendation 9:

The tax gap is becoming positive.

An expansion of the tax base (no

increase in tax rates) is advisable.

A law offering a tax amnesty

could be used for a year, before

enforcing the new tax

regulations.

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As a reminder, the tax gap is defined as the difference between the computed ‘sustainable public revenue’6

and the actual public revenue (as a percentage of GDP):

��_�� ∗ � � (30)

When the tax gap is positive, it means that the public revenue that would be necessary to sustain the debt is

higher than the current level of public revenue. In other words, it would call for adjustments: (1) a lowering of

public expenditure,(2) a rise in taxes, or (3) an expansion of the tax base.

FIGURE 48. SUSTAINABLE PUBLIC REVENUE, PUBLIC EXPENDITURE AND TAX GAP. SOURCE: OWN

COMPUTATIONS.

As figure 48 shows, public expenditure is on the rise, and hence the sustainable public revenue. The tax gap is

slightly positive in 2009, and signals a need to constrain the fiscal policy.

6 It is usually defined as the sustainable tax ratio, but we prefer the current appellation ‘sustainable public revenue’ since

it matches with the nature of data available at the time of this report.

10

0

10

20

30

40

50

2005 2006 2007 2008 2009

Sustainable public revenue (tax ratio)

Tax_gap

Public expenditure

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MEDIUM-TERM

In what follows, we are not ‘forecasting’ the future of the Republic of

Macedonia’s economy. We are in fact making projections on the next

decade. We determine a baseline using filtering and bootstrapping

techniques (see box 2). The data shown here are in no way indication of

what the government should do, it just serves as a baseline in case the

conditions assumed here realize. Therefore, the government may take all

decisions pertaining to adjusting to the macro-economic environment,

hence changing the assumptions presented here.

For each projection, we will consider three scenarios:

1. The baseline: this scenario captures the behavior of the variable from the past and assumes the

government will act and react as it did in the past. It also captures the years 2008 and 2009 with the

global financial crisis. It may not be enough since the global crisis will have replications in the next 5

years at least. Let us conclude then that this baseline is realistic, though a little on the optimistic side.

2. The worst case scenario: each standard deviation figure is calculated from the bootstrapped data for

until 2020. Then we sum up (when appropriate, and subtract otherwise, for instance for the GDP

growth rate) this standard-deviation figure to the baseline figure. This scenario is definitely

pessimistic since it assumes the worst every year.

3. The best case scenario: following the same methodology as for the worst-case scenario, we construct

the best scenario for each year considered. This is a very optimistic scenario, that tends to assume the

global financial crisis is going to be over very soon.

STEP 6

Projections for the

general government

primary balances

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MACRO-ECONOMIC CONDITIONS

Here, we study the three scenarios in light of three important macro-economic indicators: the real interest

rate (CB Bills rate deflated), the inflation rate and the GDP growth rate.

�� ,� � �� ,�

��

3 �� !!�" �#��$%� $&�,�

Box 2: Time-series filtering and bootstrapping

We use a combination of techniques and assumptions to be able to make projections

(not forecasts). Due to the small number of observations through time for each

variable considered, we decide to use a Hodrick-Prescott filter on each variable of

interest. For instance, the public revenue is de-trended. We obtain the cycle:

From there, we calculate the average of the cycle. So for each variable, we have one

average for the series. Then we use the bootstrapping technique to generate samples

(calibrated to 50 to have enough observations to project until 2020) and calculate the

average of each sample. Each cycle average is then added at the end of the original

series up to 2050 following this formula using a moving average:

The moving average serves as a method to obtain the trend (the Hodrick-Prescott

cannot be used here). Adding the average of bootstrapped cycle of time t to the

moving average re-creates an observation for the series considered at time t.

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FIGURE 49. REAL INTEREST RATE SCENARIOS. SOURCE: OWN COMPUTATIONS.

4

2

0

2

4

6

8

10

12

14

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

real interest rate (CB Bills) baseline

real interest rate (CB Bills) worst case scenario

real interest rate (CB Bills) best case scenario

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FIGURE 50. INFLATION RATE SCENARIOS. SOURCE: OWN COMPUTATIONS.

FIGURE 51. GDP GROWTH RATE SCENARIOS. SOURCE: OWN COMPUTATIONS.

2

1

0

1

2

3

4

5

6

7

8

9

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

GDP growth rate baseline GDP growth rate worst case scenario

GDP growth rate best case scenario

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Although in these simulations the macro-economic variables are essentially exogenous to the model, there are

indirectly captured by the cycles generated by the Hodrick-Prescott filter. For a more thorough perspective, a

general equilibrium model would be best, but this would require a high quality and availability of data at the

national and a local level for calibration purposes.

PUBLIC FINANCES

Based on the three scenarios, we are going to present now the impacts on both public balances and public

debts. The next two graphs are related since when the public balance deteriorates, it negatively impact the

public debt, and conversely.

FIGURE 52. PUBLIC BALANCE SCENARIOS. SOURCE: OWN COMPUTATIONS.

As we mentioned earlier, the best case scenario is very optimistic and tends to under-represent the effects of

the global financial crisis. On the other hand, the baseline is a little optimistic. Based on these projections, the

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government should aim at targeting therefore better public deficits than the ones represented by the blue

bars.

FIGURE 53. PUBLIC DEBT SCENARIOS. SOURCE: OWN COMPUTATIONS.

Noticeably, the worst case

scenario is alarming. Interestingly

enough, it shows how fast public

finances can degrade after a

regime of public deficits that

were high on a yearly basis (see

figure 24), but that may not be

striking year after year. In this

scenario, it would be extremely

difficult for the Republic of

Macedonia to finance its yearly

deficits, and service its debt. The

baseline scenario is a little more

Recommendation 10:

The fiscal policies for 2010, 2011

and 2012 (during the downward

business cycle) must be kept under

control and ideally using the

baseline as a very maximum that

may be crossed due to a

deterioration of global macro

economic conditions but only for

exceptional reasons.

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realistic, and projects a public debt ranging between 34% and 37% in the next decade. The optimistic scenario

again tends to under-represent the effects of the global financial crisis, and projects a debt between 27% and

30% during the next decade.

CONCLUSION

In this report, we intended to achieve various goals.

The first one is to help the Ministry of Finance of the

Republic of Macedonia identify indicators to measure

public finance sustainability. Beyond the identification,

it is also to be able to do the analyses and

recommendations before the budget is approved and

implemented. The hope is that the staff members will

be able to replicate the analyses drawn upon these

indicators.

Another goal was to create an example of how a report

to an international organization is presented. Part III of

this report will be of a particular importance in this

context.

To be able to draw conclusions on public finance

sustainability, the policy-mix must be considered.

Policy-mix should even be defined in a broad way. It

should concern the fiscal policy with regards to the

monetary policy but also vis-à-vis the structural policy.

This is why this report starts with a first part dealing

with the economic aggregates available at the time of

this study to document the three categories of policies.

In retrospect, when it comes to the public finances, the

Recommendation 11:

The next five years

must be expected to

face a rise in global

interest rates,

inflation rates, a

reduction of global

consumption and

some pressures on the

liquidity of the

international financial

markets. All this will

happen with various

degrees.. The next five

years will be of the

utmost importance for

the stability of the

Republic of

Macedonia’s economy.

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conclusions of the analyses presented in part III are threefold:

1. Public finances were well managed until 2009.

2. Leaving the changes induced by the global

financial crisis, the Republic of Macedonia is

entering into a downward business cycle for the

next three years. Therefore, the forecasts for

public expenditure should be adjusted to take

into consideration not only an expected smaller

growth but also a rise in the automatic stabilizers.

3. Including now the global financial crisis, the next

five years must be expected to face a rise in

global interest rates, inflation rates, a reduction

of global consumption and some pressures on

the liquidity of the international financial

markets. All this will happen with various

degrees.. The next five years will be of the utmost importance for the stability of the Republic of

Macedonia’s economy.

The Republic of Macedonia should seek

issuing joint bonds with a Western

European country to (1) increase its

international credibility, and (2) to lower

its servicing of the debt by lowering its

risk premium.

Recommendation 12:

Public deficits should

be lowered compared

to the forecasts

expecting a

toughening of the

debt refinancing

conditions.

Recommendation 13:

The Republic of Macedonia

should seek issuing joint bonds

with a Western European

country to (1) increase its

international credibility, and

(2) to lower its costs of debt

servicing.

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LEXICON

Absorption: Absorption is the total demand for all final marketed goods and services by all economic agents

resident in an economy, regardless of the origin of the goods and services themselves. As the absorption is

equal to the sum of all domestically-produced goods consumed locally and all imports, it is equal to national

income minus the balance of trade.

Absorption gap: it is the difference between the potential absorption and the actual absorption.

Automatic stabilizers: it is the year-on-year change of the variable named ‘adjustments from the gaps’ or

‘cyclical primary balance’.

Balassa-Samuelson effect: gains in productivity will lead to rises in prices for non-traded goods, pushing

the inflation rate to higher numbers.

Baxter-King Filter: it is a time-series based technique to filter a series of observations in order to obtain a

trend and a cycle.

Bootstrapping: statistical technique used to generate new samples from an initial sample of a population

based on the statistical properties of the original sample.

Degree of sustainability/un-sustainability: it is the difference between the ‘growth-adjusted interest rate’

(corrected for inflation) and the percentage change in public debt.

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Eurobond: A Eurobond is an international bond that is denominated in a currency not native to the country

where it is issued. It can be categorized according to the currency in which it is issued.

Fiscal impulse: it represents the year-on-year change of the cyclically adjusted primary balance.

GDP deflator: the GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all

new, domestically produced, final goods and services in an economy.

Hodrick-Prescott filter: it is a time-series based technique to filter a series of observations in order to obtain

a trend and a cycle.

Hysteresis: Hysteresis is a hypothesized property of unemployment rates: that there is a ratchet effect, so a

short-term rise in unemployment rates tends to persist.

Inter-temporal primary gap: the inter-temporal primary gap analyses the change in the primary balance

compared to the current level of debt. It concluded that the present value of future primary surpluses must be

equal to the initial level of debt.

Output gap: the output gap is the difference between potential GDP and actual GDP or actual output. The

calculation for the output gap is Y-Y* where Y is actual output and Y* is potential output. If this calculation

yields a positive number it is called an inflationary gap and indicates the growth of aggregate demand is out

pacing the growth of aggregate supply

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Primary deficit: the primary deficit is the pure deficit which is derived after deducting the interest payments

component from the total deficit of any budget. In other words the total of primary deficit and interest

payments makes the fiscal deficit.

Tax gap: A positive tax gap suggests that the current tax ratio is not high enough to finance future spending

and to service the debt.

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Documents

Report Thierry Warin Macedonia 2009