BRIEF

Moldova Economic Update

November 1, 2018


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The economy is expected to continue to grow by 4% on average in 2018-2020, supported by remittances and real wage growth induced private consumption. With economic growth driven by consumption, deep structural reforms are needed to enable new drivers of growth.

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Recent Economic Developments 

In the first half of 2018, real GDP increased by 4.5% mainly driven by private consumption and capital formation. Underpinned by lower inflation, strong growth of remittances and wages drove private consumption growth (+3.8%, y/y). Despite robust exports (+12.5%, y/y), supported by the good harvest and foreign demand, imports increased by 10.4%, resulting in a negative contribution from net exports to growth.

Driven by new investments in machinery and equipment, including in the economic zones and the construction sector, gross fixed capital formation increased by 7.2%. The build-up in inventories added another 1.8 p.p. to overall growth. On the production side, wholesale and retail trade were the main drivers of GDP growth, contributing 1.6 p.p. overall, followed by industry (1.1 p.p.).

Consumer inflation has been below the lower target of the corridor since April. In 2018 the Leu appreciation, alongside weaker external inflationary pressures, and declines in administered prices resulted in more pronounced deflationary pressures. By end-September, consumer prices increased only by 2.4%, y/y.

The Central Bank has maintained the policy rate at 6.5% since the beginning of the year, after the large cut during 2017. Yet financial intermediation remains subdued. The latter, combined with a recovery in deposits, is contributing to persistent excess liquidity.

To address the excess liquidity, the reserve requirement ratio was raised to a record high of 42.5%. Favorable exchange rate developments allowed further accumulation of foreign reserves, which now exceed 6 months of imports. 

In the first half of 2018, the current account deficit increased to 9.8% of GDP from 5.9% in 2017 driven by stronger imports growth. On account of reinvested revenues, net foreign direct investments reached 2.5% of GDP, from 1.6% at end-2017. Remittances growth remains strong (+14.8%, y/y).

External debt remained the main source of current account deficit financing. Due to Leu appreciation and new GDP accounting, external debt decreased by 10.7 p.p. to 62.1% of GDP.

In January-September 2018, underpinned by robust growth and higher employment, government fiscal revenues registered strong nominal y/y increase (+11%). As a result, fiscal surplus registered 0.9 percent of GDP. Current expenditures in the first nine months of 2018 rose rapidly (+9.7%). The largest increases were marked in subsidies and wages.

Spending on fixed assets increased by 10%, y/y, while capital investments continue to decrease (-4%, y/y). In the first half of 2018, on account of stronger growth, public debt and guarantees decreased by 3.3 p.p. of GDP, as compared to end-2017, reaching 29.7% of GDP.

Medium Term Outlook 

In 2018 growth is expected to reach 4.8% thanks to strong domestic demand and to moderate thereafter. On the expenditure side, growth remains driven by private consumption, higher remittances and strong real wage gains, particularly in the public sector.

The revitalization of foreign inflows, and improvements in the financial sector and in the business environment are expected to support private investments and accumulation of stocks. Robust domestic demand will result in solid increase in imports, resulting in a negative contribution from net exports to growth. The 2019 parliamentary elections will also motivate higher public outlays in the short term.

By 2020 growth will moderate at 3.5% supported by improved consumer and business confidence, and a continued, albeit slow, normalization of financial conditions which should stimulate growth in private investments after the elections. The fiscal deficit is forecasted to remain below the planned 2.5% of GDP.

Strong revenue performance in 2018 is expected to offset higher public spending. Underpinned by the political cycle, in the medium term public current expenditure will continue to increase, while revenue performance will be negatively affected by recent tax cuts and fiscal amnesty. With recently adopted legislative acts, the deficit will spike to 2.7% in 2019 and will moderate after elections.

As consumption and imports strengthen, the current account deficit is expected to gradually increase, but to remain below its historical average thanks to the ongoing revitalization of foreign inflows. Subdued inflation pressures are projected to persist throughout 2018 on account of the Leu appreciation, alongside weaker external inflationary pressures, and declines in administered prices.

Inflation will gain momentum gradually in medium term, with stronger domestic demand and expected adjustments in the regulated prices in the second half of 2019. Against this background, the poverty headcount is projected to fall 2.9 p.p. to 12% in 2018 and to just below 10% by the end of 2020, supported by continuous real wage growth, remittances and public transfers.

The outlook is subject to considerable downside risks stemming from low productivity levels, lower external assistance and inefficient public spending. Political uncertainty, and ongoing political polarization may constrain foreign and domestic investments, needed to raise labor productivity and export competitiveness, thereby leaving the economy vulnerable to chronic external risks.

Extreme weather may affect agricultural output with consequences for overall growth. Weaker growth of key trade partners and potential changes in international trade and migration relations could undermine exports and remittance flows. The recently adopted fiscal legislative measures will negatively affect public revenue collection and may impact external assistance unless not addressed properly.

Government efforts to support significant improvements to the rule of law, the investment climate, business environment and the quality of human capital would help mitigate these risks and facilitate a sizeable expansion of the tradable goods in the economy. Although the World Bank's Human Capital Index for Moldova has slightly increased in recent years, the country still lags behind the average for its region.

A Special Topic to this note analyses tobacco taxation in Moldova from an angle of health outcome and increased revenue mobilization.