Document o f The World Bank

FOR OFFICIAL USE ONLY

Report No. 50883-MK

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT FOR A PROPOSED FIRST PROGRAMMATIC DEVELOPMENT POLICY LOAN

IN THE AMOUNT OF EUR 20.5 MILLION (US$30 MILLION EQUIVALENT)

TO

THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA

November 13,2009

Poverty Reduction and Economic Management (ECSP2) South East Europe Country Unit (ECCU4) Europe and Central Asia (ECA)

This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. I t s contents may not otherwise be disclosed without World Bank authorization.

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

BBP CB CCT CEM CFAA

CFAA

CPAR CPS DIF DPL DRG EBF EBRD

ECA ECB EIB ESW FDI FSAP GDP GNP GoRM

H B S HCI HIF IBRD

IFC

GOVERNMENT FISCAL YEAR

CURRENCY EQUIVALENTS (Exchange Rate Effective as of November 10,2009)

January, 1 - December, 3 1

Currency Unit Macedonian Denar (MKD) U S $ l .OO 4 1.065

Weights and Measures: Metric System

ABBREVIATIONS AND ACRONYMS

Basic Benefits Package Cash Benefits Conditional Cash Transfers Country Economic Memorandum Country Financial Accountability Assessment Country Financial Accountability Assessment Country Procurement Assessment Report Country Partnership Strategy Deposit Insurance Fund Development Policy Loan Diagnosis-Related Group Extra Budgetary Fund European Bank for Reconstruction and Development Europe and Central Asia Region European Central Bank European Investment Bank Economic and Sector Work Foreign Direct Investment Financial Sector Assessment Program Gross Domestic Product Gross National Product Government o f the Republic o f Macedonia Household Budget Survey Health Care Institution Health Insurance Fund International Bank for Reconstruction and Development International Finance Corporation

IMF IPA ISA LDP LFS LPP MLSP MOF MOH MoU NATO NBRM

NPL NTR OECD

PDIF PDO PER PIT PRO SA0 SIC SP SRA swc TSA VAT WTO

International Monetary Fund Instrument for Pre-Accession Insurance Supervision Agency Letter o f Development Policy Labor Force Survey Law on Public Procurement Ministry o f Labor and Social Policy Ministry o f Finance Ministry o f Health Memorandum of Understanding North Atlantic Treaty Organization National Bank of the Republic o f Macedonia Non-Performing Loan Non-Tax Revenues Organization for Economic Cooperation and Development Pension and Disability Insurance Fund Program Development Objective Public Expenditure Review Personal Income Tax Public Revenues Office State Audit Office Social Insurance Contribution Rate Social Protection Special Revenue Accounts Social Welfare Center Treasury Single Account Value Added Tax World Trade Organization

Vice President: Country Director: Jane Armitage, ECCU4

Sector Director: Luca Barbone, ECSPE Sector Manager: Bernard Funck, ECSP2

Philippe H. L e Houerou, ECAVP

Task Team Leader: Evgenij Najdov/Marina Wes, ECSP2

.. 11

THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA FIRST PROGRAMMATIC DEVELOPMENT POLICY LOAN

I . I1 *

I11 .

Iv .

V .

V I .

TABLE OF CONTENTS

INTRODUCTION ................................................................................................................ - 1 COUNTRY CONTEXT ........................................................................................................ 2 POLITICAL CONTEXT ..................................................................................................................... 2 RECENT ECONOMIC DEVELOPMENTS ...................................................................................... 2 MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY .............................................. 6 THE GOVERNMENT’S PROGRAM AND PARTICIPATORY PROCESSES ................. 10 PUBLIC SECTOR EXPENDITURE REFORMS .............................................................................. 12 STRENGTHENING SOCIAL SAFETY NETS ................................................................................ -19 PRESERVING FINANCIAL SECTOR STABILITY ........................................................................ 22 BANK SUPPORT TO THE GOVERNMENT’S PROGRAM ............................................. 24 LINK TO CAS .................................................................................................................................... 24 COLLABORATION WITH THE IMF AND OTHER DONORS ...................................................... 25 RELATIONSHIP TO OTHER BANK OPERATIONS ...................................................................... 25 LESSONS LEARNED ........................................................................................................................ 26 ANALYTICAL UNDERPINNINGS .................................................................................................. 26 THE PROPOSED FIRST PROGRAMMATIC DEVELOPMENT POLICY LOAN (DPL1) 28 OPERATION DESCRIPTION ........................................................................................................... 28 PILLAR I: IMPROVING PUBLIC EXPENDITURE OUTCOMES .................................................. 28 PILLAR 11: STRENGTHENING SOCIAL ASSISTANCE ................................................................ 29 PILLAR 111: STRENGTHENING RESILIENCE OF THE FINANCIAL SECTOR .......................... 30 OPERATION IMPLEMENTATION .................................................................................... 31 POVERTY AND SOCIAL IMPACTS ............................................................................................... 31 ENVIRONMENTAL ASPECTS ........................................................................................................ 33 CONSULTATIONS ............................................................................................................................ 34 IMPLEMENTATION, MONITORING AND EVALUATION ......................................................... 35 FIDUCIARY ASPECTS ..................................................................................................................... 35 DISBURSEMENT AND AUDITNG ................................................................................................ 37 RISKS AND RISK MITIGATION ..................................................................................................... 37

ANNEXES

Annex 1: Letter of Development Policy ............................................................................................. 39 Annex 2: DPL Policy Matrix .............................................................................................................. 44 Annex 3: Fund Relations Note ........................................................................................................... 47 Annex 4: Country At-a-Glance ........................................................................................................... 5 1 Annex 5: Government Definitions ..................................................................................................... 54

Map IBRD 33438

TABLES

Table 1: Recent Economic Developments ............................................................................................... 3 Table 2: Medium-term Projections for Key Economic Indicators .......................................................... 7 Table 3: Projected Fiscal Accounts and Deficit Financing ..................................................................... 8 Table 4: External Financing Requirements and Sources ......................................................................... 9 Table 5: Structure o f Central Government expenditures, 2005-2009 .................................................... 13 Table 6: Labor Tax Wedge for Various Income and Family Situations (Including Mandatory Fringe Benefits), Western Balkan Countries, 2007 .......................................................................................... 15 Table 7: Pension System At-a-Glance ................................................................................................... 17

... 111

Table 8: Adequacy, Coverage, and Targeting'Efficiency o f Social Assistance Programs .................... 20 Table 9: Selected Financial Sector Soundness Indicators ..................................................................... 23 Table 10: Bank Analytical Work by Area and Links to Proposed Operation ....................................... 27

BOXES

Box 1: The October Supplementary Budget for 2009 ............................................................................. 5 Box 2: Government Measures to Mitigate the Impact o f the Crisis ...................................................... 11 Box 3: Key Features o f Public Financial Management Practices in FYR Macedonia .......................... 14 Box 4: Good Practice Principles for Conditionality .............................................................................. 3 1

The First Programmatic Development Policy Loan was prepared by an IBRD team consisting o f Marina Wes and Evgenij Najdov (Task Team Leaders) Mismake Galatis (ECSP2), Sarosh Sattar (ECSP3), Rajna Cemerska (ECSH3), Sarbani Chakraborty (EASHH), Martin Melecky (ECSF2), Aurora Fenari (ECSF l), Carl-Johan Lindgren (Consultant), Snjezana Plevko (ECSH3), Bojana Naceva (ECSHZ), Lewis Hawke (ECSC3), Erika A. Jorgensen and Roumeen Islam (ECSPE), Nikolai Soubbotin (LEGEM), Nicholay Chistyakov (CTRFC), and Jasminka Sopova (ECCMK).

iv

LOAN AND PROGRAM SUMMARY THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA

FIRST PROGRAMMATIC DEVELOPMENT POLICY LOAN

Borrower

Implementing Agency

Financing Data

Operation Type

Main Policy Areas

Key Outcome Indicators

Program Development Objective(s) and Contribution to CAS

Former Yugoslav Republic of Macedonia

Ministry of Finance

[BRD Loan of US$30 million equivalent

Programmatic (1" of 2), single-tranche.

Public financial management, social protection, financial sector

1. General Government debt maintained at below 29 percent of GDP. 2. Increase in the number of formal workers with paid pension

contributions from 418,958 in 2008. 3. Replacement rate in the pensions system i s reduced from a baseline of

55 percent in 2008. 4. Arrears in the public health sector (HIF and Health Care Institutions)

do not exceed 0.3 percent o f GDP. 5. Pension spending i s maintained at less than 9 percent of GDP in 2009

and in 2010. 6. Reduced out-of-pocket payments for health services among vulnerable

population (defined as those in the two poorest income quintile). 7. Wage bill contained at about 10.5 percent of GDP in 2009 and 2010. 8. Percentage of cash benefits going to the poorest quintile i s increased

from 43 percent in 2008. 9. Processing time for Social Financial Assistance application reduced

from a baseline of 30 days. 10. Financial stability indicators regularly published and National Bank

takes corrective actions if necessary 1 1. Coordinating Supervisory Committee meets on a regular basis

The proposed First Programmatic Development Policy Loan (DPL 1) i s the first in a series o f two programmatic Development Policy Loans designed to be disbursed during fiscal years 20 10 and 20 1 1.

The three main Program Development Objectives are: (i) to manage the impact o f the global crisis by maintaining a sound macroeconomic and fiscal framework; (ii) to cushion the impact on the poor and vulnerable by enhancing social protection systems; and (iii) to strengthen the resilience of the financial sector by addressing potential vulnerabilities. The ultimate objective i s to support the Government to emerge from the crisis on a stronger footing and to resume sustained high growth and convergence in living standards with the rest of Europe.

These DPOs will contribute to the following CPS outcomes: (i) labor market: increasing flexibility of labor market outcomes and decreasing the tax wedge; (ii) health: improve the efficiency and transparency of Health Insurance Fund operations; and (iii) social protection: improve administration and targeting of :ash benefits and strengthen the pension system.

V

Risks and Risk Mitigation

Operation ID

The envisaged reform program would also be consistent with the Government’s aspiration for eventual membership of the European Union (EU). The proposed operation should have a positive impact on the functioning of the labor market and public administration, which have been identified as critical benchmarks to begin membership negotiations.

The proposed DPL series has moderate risks. The country went into the financial crisis with a sound fiscal position. Following a fiscal stimulus in late 2008 and early 2009, two budget revisions and tightening of monetary policy have been critical in keeping macroeconomic balances at sustainable levels. Specific risks include:

0 Uncertainty of global economic outlook. Shocks relating to the external environment could continue to affect the economy negatively, e.g. slower than expected recovery in the EU will suppress demand for exports and capital inflows. The main macroeconomic risk i s that the balance of payment shortfalls will put renewed pressure on reserves. The capacity of some public sector institutions to design and implement ambitious reforms, while much improved over the past few years, remains relatively weak. Political risks appear moderate. The government has a stable majority in all levels of Government and the next elections are a few years away. However, a dispute over the name of the country could potentially trigger some political instability. Last year’s veto over NATO membership does not appear to have undermined commitment to reforms. However, one more veto (this time on the start of negotiations for EU membership) could trigger a reform fatigue and remove a big reform anchor.

In terms of risk mitigation, economic risks are somewhat mitigated by recent signs of stabilization. Moreover, the authorities have indicated that they may approach the N F in 2010 should the economy deteriorate. The N F currently broadly endorses the country’s fiscal stance which should ease the process of reaching an agreement in case the authorities request it. Going forward, progress towards EU accession should also support capital inflows, and thus the current account; while setbacks to EU membership are a downside risk.

P116984

v i

IBRD PROGRAM DOCUMENT FOR A PROPOSED FIRST PROGRAMMATIC DEVELOPMENT POLICY LOAN

TO FORMER YUGOSLAV REPUBLIC OF MACEDONIA

I. INTRODUCTION

1 . The ongoing international economic crisis has brought to a halt the acceleration of economic activity of the last few years in the Former Yugoslav Republic of Macedonia (FYR Macedonia). Following growth rates of close to 6 percent in 2007 and the first three quarters of 2008, economic activity has slowed down considerably since. Industrial production has been declining, business confidence has reached low levels, financing conditions have become tighter and labor market performance has deteriorated. Exports have dropped sharply. Negative effects have also spilled over into the fiscal accounts, and tax revenues in particular have disappointed relative to expectations - although two budget revisions in May and October 2009 have introduced sharp expenditure cuts, and hence the fiscal deficit i s still forecast to be a manageable 2.8 percent of GDP.

2. The authorities have proactively managed the crisis to create grounds for a sustainable and robust recovery. Anti-crisis measures were announced in late 2008 and early 2009 (see Section 111). Following an initial fiscal stimulus, the two supplementary budgets adopted in 2009 have not only helped to contain public spending but also to improve its allocation. Non-priority expenditures were eliminated while funds for the social safety nets were protected. In addition, comprehensive payroll reform has been introduced to boost competitiveness o f the economy. Significant improvements to the business environment were undertaken and measures to strengthen the resilience o f the financial sector are underway.

3. Building on this, the proposed First Programmatic Development Policy Loan (DPL1) supports a program of government reforms in fiscal management, social protection and the financial sector. Given the fixed exchange rate regime, fiscal policy has been the main tool for mitigating the consequences o f the global economic crisis and preserving macroeconomic stability. In this context, the 2010 budget, which was approved by Government in November 2009, provides further assurances that fiscal policy will stay supportive of macroeconomic stability. The DPL also supports an on-going reform program in social protection, to cushion the impact of the crisis on the poor and vulnerable. Finally, it proposes to support continued financial sector stability, including by strengthening contingency planning.

4. The three main Program Development Objectives are:

a. to manage the impact o f the global crisis by maintaining a sound macroeconomic and fiscal framework;

b. to cushion the impact o f the crisis on the poor and vulnerable by enhancing social protection systems; and

c. to strengthen the resilience of the financial sector by addressing potential vulnerabilities.

5 . The proposed US$30 million First Programmatic Development Policy Loan @PL1) to FYR Macedonia i s the first in a planned series of two operations. This operation and the follow-on DPL 2 operation are designed to be disbursed during calendar years 2009 and 20 10.

6. The March 2009 Country Partnership Strategy Progress Report (CPSPR) maintains flexibility to respond promptly and adequately to the evolving economic situation and includes the possibility for a DPL to support an endorsable policy response to the global economic crisis.’

11. COUNTRY CONTEXT

POLITICAL CONTEXT

7. The political scene has stabilized, although some challenges remain. The early parliamentary elections in 2008 and the regular 2009 local and presidential elections further concentrated power in the hands of VMRO-DPMNE and the party (and the new coalition partner DUI, the biggest ethnic Albanian party) now commands an absolute majority in the Parliament, holds the Presidency of the country and controls the majority of local governments. The European Commission (EC) recently recommended to i ts member states the introduction of a visa-free travel regime for FYR Macedonia and proposed to start negotiations on full European Union (EU) membership. Whi le progress has been made in meeting the benchmarks set by the EC as conditions for starting negotiations, Greece may decide to block the start of negotiations due to a dispute over the name of the country. Pressures to reach a compromise on the name issue have intensified recently and i t s resolution will open the way for immediate NATO membership (vetoed by Greece in 2008) as well as potentially faster EU integration.

RECENT ECONOMIC DEVELOPMENTS

Pre-crisis

8. The performance of the economy improved considerably over the last few years. A laggard in the region in terms of GDP growth rate until recently, output expanded more vigorously during 2007 and the first three quarters of 2008 bringing the country’s growth rate closer to regional averages. Real GDP growth averaged 6 percent until the final quarter o f 2008, up from around 4 percent in 2003-2006. Growth benefited from strong external demand and prices for the country’s exports, and later on from strong domestic demand. Investment increased from 20.8 percent of GDP in 2005 to 27.7 percent in 2008, in parallel with improvements in the investment climate. Fees and charges of various agencies were reduced, procedures eliminated, labor relations overhauled, and reforms in the judiciary and cadastre strengthened property and creditor rights. At the same time, stronger competition in the banking sector increased the availability of credit and reduced the cost of finance. Modest employment and real wage growth as well as better access to credit fueled private consumption.

9. Fiscal policies were largely supportive of macroeconomic stability and accelerated economic activity. At around 35 percent of GDP, the size of the budget i s relatively small by regional standards. Furthermore, tax policy reforms (introduction of a flat tax) further reduced the fiscal burden on economic activity. Historically, the budget has been largely balanced which contributed to keeping aggregate demand at manageable levels and avoided crowding out of financing for the private sector. As a result of the low deficits in recent years, the public debt level i s moderate, amounting to 21.3 percent of GDP in end-2008. Price stability was largely maintained with inflation picking up somewhat in late 2007 and early 2008 as a result of the surge in world prices of food and energy.

10. Relatively slow credit expansion and limited cross-border borrowing further mitigated economic risks. The role of credit expansion in fueling growth was less pronounced than in other countries in Central and Eastern Europe. Credit growth intensified much later in FYR Macedonia (around

(Document No. R2009-0054; IFC/R2009-0050).

2

2006) and i t s peak (at 44 percent y-0-y in April 2008) was lower than in other countries. In nominal terms, credit expansion financed by domestic banks was roughly equally distributed between household and enterprises. More than half o f al l loans at the end of 2008 were either extended in foreign currency or indexed to a foreign currency. Private sector external indebtedness i s also modest, although it almost doubled in nominal USD terms between 2006 and 2008 reaching around 36 percent of GDP (25 percent if trade credits are excluded). Most of the increase i s due to long-term loans and mother-daughter firm transactions related to foreign direct investments (FDI), while exposure to the commercial banking sector i s limited. According to Bank of International Settlements (BIS) data, foreign banks claims on the FYR Macedonian non-bank private sector were 4.1 percent o f GDP, one of the lowest in the region.

Table 1: Recent Economic Developments

National Accounts GDP (US$ millions) Real GDP growth (%) Gross domestic investment (% of GDP) Gross domestic savings (% o f GDP)

Fiscal Accounts (as % o f GDP) Expenditures Revenue Balance Public debt as % GDP

External Accounts, (millions o f US$) Exports of goods and services Imports of goods and services Current account balance, after grants Current account balance, as % o f GDP Official reserves (in months o f M of GS)

Indebtedness (external debt) TDO/GDP TDSMGS

Prices

2005 2006 2007 2008 2009 actual est. proj.

5,815 4.1 20.8 3.5

35.0 35.2 0.2

39.5

2,556 3,653 -103 -1.8 4.4

51.1 9.9

6,373 4.0 21.9 3.3

33.9 33.3 -0.5 32.9

2,997 4,254 -34 -0.5 5.3

51.5 18.6

7,927 5.9

24.2 5.4

33.1 33.7 0.6 24.7

4,168 5,762 -346 -4.4 4.7

52.5 16.6

9,521 5.0

27.7 1.7

35.1 34.2 -1.0 21.3

4,982 7,532 -1,191 - 12.5 3.4

49.1 9.3

9,313

24.8 1.4

-1.3

34.7 31.9 -2.8 23.9

4,218 6,405 -878 -9.4 4.0

55.2 9.3

0.5 3.2 2.3 8.3 -0.5 Retail price inflation (period average)

1 1. The current account deficit increased from 1.8 percent in 2005 to 12.5 percent in 2008. This deterioration reflects the pick-up in import-intensive investments, a terms o f trade shock (oil price increase) as well as reduced net private transfers (including unrecorded exports of goods and services). Stronger FDI inflows as well as a draw down in commercial banks’ deposits abroad largely financed the current account deficit. FDI averaged around 6 percent of GDP over 2006-2008, a considerable increase from the average of 3.7 percent o f GDP in the decade before.

12. M o r e rapid growth did not improve living conditions for the poor in spite of improvements in labor market outcomes. Unemployment (measured by the Labor Force Survey) fe l l to 32.0 percent

3

by the second quarter of 20092. Employment increased faster, but was also accompanied by an increase in labor force participation which dampened the fal l in the unemployment rate. The country's poverty rates have (so far) not been responsive to the improved performance of the economy; regional experience suggests that poverty does respond to growth but only with a lag. Poverty rates may also have been stagnant because jobs were generated in low-paid sectors or for unpaid family work while wage growth occurred for households already above the poverty line. During 2007-2008, when employment growth was higher, poverty was also impacted by the surge in world energy and food prices. Characteristics of the poor include low educational attainment, household size, ethnicity, number o f children, unemployment (though there are growing numbers of employed poor).

Impact of the crisis

13. Economic activity has slowed considerably since the final quarter of 2008, though there are early signs of stabilization. GDP growth in the last quarter of 2008 declined to 2.0 percent (y-0-y) as compared to an average growth rate of 6 percent in the previous three quarters. This was followed by a contraction of 1.2 percent in the first half of 2009; this i s one of the smaller contractions registered in the region, and i s mostly attributable to a s t i l l relatively healthy financial sector and expansionary fiscal policy in late 2008 and early 2009. Signs that the crisis i s moderating appeared in the third quarter of the year, as shown by data on industrial production, electricity consumption, and tax revenues. Output i s forecast to decline by 1.3 percent in 2009, one of the milder contractions in the region reflecting also the broadly appropriate economic fundamentals at the onset of the crisis.

14. The crisis resulted in a collapse in export demand for FYR Macedonian products and reduced private capital flows. The country's exports are concentrated in a few low value added sectors (mining, metals and garments) and these saw the demand for and prices of their products plummet. Furthermore, excessive reliance on net private transfers and more recently FDI to finance domestic demand has made the country vulnerable to sudden stops in these flows. In the f i rst half of 2009, FDI levels fel l by 60 percent compared to levels during the same period in 2008.

15. As in other countries in the region, budget revenues suffered significantly from the international economic crisis and two supplementary budgets were approved in 2009. Budget revenues in the first nine months of 2009 were 6.9 percent lower than in the same period the previous year. Budget expenditures, on the other hand increased' by 11.0 percent, which contributed to the relatively slow adjustment in domestic demand and a relatively milder GDP contraction. In spring the first Supplementary Budget was adopted which provided a fiscal adjustment of around 2.5 percent of GDP, reflecting lower import-intensive capital expenditures and lower goods and services spending and a freeze on public sector wages and employment. As it became clear that further adjustments were needed, a second Supplementary Budget was prepared, which was approved by Parliament in October 2009. The second Supplementary Budget maintains the deficit target of 2.8 percent of GDP, and reduces expenditures to match the lowered projection for revenues by 3.2 percent (see Box 1). The authorities are committed to the deficit target and will further adjust expenditures if required. Most of the 2009 deficit i s being financed by the proceeds of a Euro 175 million Eurobond (see Box 2).

16. The current account deficit i s projected to fall from 12.5 percent of GDP in 2008 to about 9.4 percent in 2009, due largely to a smaller trade deficit and a recent rebound in private transfers. Private transfers, the main source of financing the deficit, improved since the second quarter of the year

* I t i s widely acknowledged that the reported unemployment rate i s probably overestimated. Alternative measures o f the unemployment rate (either through using stricter filters in the LFS or using the HBS) suggest that the unemployment rate i s most likely lower, but still high, at around 25 percent.

4

as speculations about potential devaluation which triggered conversion from Denar into forex assets subsided. The current account deficit i s expected to be close to balance in the third quarter o f 2009.

Box 1: The October Supplementary Budget for 2009

The second Supplement Budget for 2009 was enacted in October. The Supplementary Budget maintains the deficit target of 2.8 percent o f GDP, and reduces expenditures by around 3.2 percent compared to the May Budget revision (9.2 percent compared to the original 2009 Budget) to match the lowered projection for revenues. Financing for the 2009 deficit was secured as the authorities plan to finance this by running down deposits (replenished in July 2009 as a result o f the Eurobond issuance) and domestic debt issuance.

The revenue assumptions in the Supplementary Budget are ambitious. Still, the risk o f breaching the deficit target i s low. Namely, considerable part o f the over-estimation on the revenues side i s on Special Revenue Accounts (SRAs) and grants which are largely non-deficit creating items (Le. revenues must be realized in order to undertake expenditures). Also, the traditional inability to execute expenditures further mitigates some of the risks from the ambitious revenue projections. This i s especially the case for capital expenditures. Finally, the commitment of the authorities to the deficit target i s strong; they already cut expenditures twice and have announced further cuts if needed to meet the target. The deficit for the first three quarters o f 2009 was around 1.7 percent o f (annual) GDP and there are no indications that the deficit target for the year will be breached.

17. The Central Bank has responded to the crisis and a loss of foreign currency reserves in late 2008 and early 2009 by raising interest rates and tightening liquidity and reserve requirements. In this regard, FYR Macedonia stands out compared to other countries in the region. The country’s response likely reflects factors including the currency peg, low (and until recently declining) reserves, and a relatively robust banking sector. Official reserves, after reaching a low o f euro 1.2 billion in May 2009 have risen to above euro 1.5 billion as o f late October 2009.

18. The banking system has weathered the external shocks so far. The quality o f banking supervision and regulation, as well prudent macroeconomic policies contributed to the stability o f the banking sector. Nevertheless, at 60 percent o f all loans, the large share o f foreign exchange (FX) or FX- indexed loans in the portfolios o f banks i s a cause o f concern, and NPLs are increasing. However, the risks have been tempered somewhat by the banking system’s relatively sound liquidity, low external roll- over needs (claims o f non-resident were only 10.5 percent o f total liabilities excluding capital in June 2009, and mostly long-term) and capital buffers (Capital Adequacy Ratio o f 16 percent in June 2009). Still, tightening monetary policy and competing demand from the public sector, has resulted in lower amounts and more expensive credit being available to the private sector. Annual growth o f credit to private sector fel l to 6 percent in September 2009, a considerable slowdown from the 34 percent registered at end-2008. The Denar lending rate increased to 10.3 percent in September 2009, up from 9.6 percent at the end o f the third quarter o f 20093.

19. The growth slowdown i s expected to worsen living conditions. The performance o f the labor market improved over the last few years. Even with output contracting recently, unemployment (measured by the LFS) fell to 32.0 percent by the second quarter o f 2009. However, most o f the jobs created were low paid jobs and did not contribute to poverty reduction (see para. 12). With economic growth projected to contract by 2 percent in 2009 from a 5 percent growth rate in 2008, poverty depth, as well as the number o f poor i s expected to increase. Slower improvement in labor markets w i l l result in

The actual increase i s probably higher than what i s suggested by the weighted interest rates reflecting the “flight to quality” by banks. As they reduce overall credit exposure, banks first cut their lending to more risky clients with higher interest rates thus having an effect o f lowering the weighted interest rate in the economy.

5

reduced employment and earnings in a country which already has a lot o f working poor. So far, the impact appears to be relatively minor but could intensify as employment i s typically a lagging indicator (administrative and LFS data do not point to a deterioration in labor market performance, while national accounts data suggest a relative modest contraction in private consumption). Reduced access to credit because of the global credit crunch i s further impacting consumption. The slow recovery in EU-countries may also reduce remittances although private transfers appear to have performed well so far.

20. FYR Macedonia’s most recent IMF supported program expired in August 2008. The country remains on the regular Article N consultation process with the IMF. The last Article N consultation took place in October 2009. According to the Letter of Assessment from this round o f Article IV Consultation accompanying this PD (Annex 3), the economic and financial conditions have improved in recent months and the risks o f instability have decreased. The country has thus far weathered the global crisis better than most o f the countries in the region with macroeconomic policies helping to achieve this outcome. At the same time, risks remain, stemming in particular from the still large current account deficit and from remaining uncertainties about the health and prospects o f the global economy and world financial markets. Against this background, policies should remain geared towards reducing risks: the proposed reduction in the fiscal deficit to 2.5 percent o f GDP for 2010 i s appropriate, monetary policy should remain cautious while structural reforms need to continue. While the authorities have not requested an arrangement with the IMF, they have indicated that they keep this option open should the financial situation deteriorate.

MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY

21. Under the baseline scenario, growth i s expected to turn positive in 2010, and to gradually accelerate over the medium-term. In line with the latest IMF projections, the authorities are projecting a GDP growth o f 2 percent in 2010, accelerating to about 4.5 percent over the medium-term, driven by both capital accumulation (higher investments) as well as total factor productivity gains due to the ongoing reforms (including on payroll reform, see section below). This will be accompanied by a gradual narrowing of the fiscal and external balances. There are early indications that some foreign investments - delayed as a result of the crisis - will be resumed while the improvements in the business environment, including lower labor costs, and an eventual start of negotiations with the EU should bolster investor confidence. Inflation will remain stable and low, anchored by the strong commitment of the authorities to the exchange rate peg.

22. The general government budget deficit i s expected to decline gradually over the medium- term to around 1.5-2.0 percent of GDP which should support macroeconomic stability but will still continue to provide stimulus to the economy. Despite a reduction in direct taxes (payroll reform and generous corporate income taxation exemptions), total revenues are projected to rebound slightly in 20 10 due to recovering domestic demand. Pressures over revenues as a result of reforms to lower the tax burden are expected to be off-set over the medium-term, including by larger inflows of EU pre-accession funding. Expenditure adjustments are expected on the wage and salaries component as policies to control employment and wages are extended. The authorities are committed to identify additional savings in non- priority expenditures, while trying to protect spending on productive expenditures. The fiscal deficit i s expected to recede to around 2.5 percent o f GDP in 2010 and further down to 2 percent over the medium- term. Around one quarter of the deficit i s from foreign financed projects, and financing for the remaining 1.5-1.8 percent will need to be identified. Given the relatively shallow domestic capital market, financing from this source will be limited over the medium term, and a considerable part of the financing will need to be secured externally.

6

Table 2: Medium-term Projections for Key Economic

National Accounts GDP (US$ millions) Real GDP growth (%) Gross domestic investment (% o f GDP) Gross domestic savings (% o f GDP)

Fiscal Accounts (as % o f GDP) Expenditures Revenue Balance Public debt as % GDP

External Accounts, (millions of US$) Exports o f goods and services Imports o f goods and services Current account balance, after grants Current account balance, as % o f GDP Official reserves (in months o f M o f GS)

Indebtedness (external debt) TDO/GDP TDSKGS

Prices

Source: World Bank staf f estimates Retail price inflation (period average)

ndicators 2009 2010 2011 2012

projected

9,3 13

24.8 1.4

-1.3

34.7 31.9 -2.8 23.9

4,2 18 6,405 -878 -9.4 4.0

55.2 9.3

9,689 2.0

24.8 2.0

35.1 32.6

25.5 -2.5

4,453 6,662 -800 -8.3 3.8

56.1 9.5

10,298 4.0

25.1 3.1

34.7 32.4 -2.3 26.3

4,815 7,081 -747 -7.3 3.8

55.4 9.2

1 1,020 4.5

25.3 4.9

34.5 32.6 -2.0 26.5

5,265 7,5 18 -686 -6.2 3.8

53.3 9.5

-0.5 2.2 2.0 2.1

23. The pegged exchange rate regime puts an even greater emphasis on the need for prudent policies and sustained reforms. While the fixed exchange rate peg i s critical to macroeconomic stability, i t also constraints government policies and can undermine competitiveness relative to other countries in the region which have allowed their currencies to depreciate. The authorities are responding to this by reducing social insurance contributions and taking steps to improve the business environment in order to reduce costs for businesses. Standard measures do not show significant exchange rate misalignment, while the reductions in the labor tax wedge and improvements in property rights and in the overall business climate should enhance competitiveness.

7

Table 3: Projected Fiscal Accounts and DI

Revenues Direct taxes Indirect taxes Non-tax and capital revenues Foreign grants

Expenditure Current expenditures Capital expenditures

Deficit

Financing Domestic Deposits Foreign

World Bank Other

Public Debt Domestic Foreign

Source: World Bank staff estimates

icit Financing 2009 2010 201 1 2012

projected 3 1.9% 13 .o% 14.1% 4.5% 0.3%

34.7% 30.9%

3.8%

-2.8%

2.8% 0.1% 0.6% 2.1% 0.3% 1.8%

23.9% 8.0%

32.6% 12.6% 14.7% 4.6% 0.7%

35.1% 3 1 .O% 4.1%

-2.5%

2.5% 0.5% 0.3% 1.7% 1 .O% 0.7%

25.5% 8.5%

32.4% 12.2% 14.8% 4.4% 1.0%

34.7% 30.7%

3 -9%

-2.3%

2.3% 0.5% 0.0% 1.8% 0.7% 1.2%

26.3% 8.4%

32.6% 12.2% 14.8% 4.4% 1.2%

34.5% 30.5% 4.0%

-2.0%

2.0% 0.5% 0.0% 1.4% 0.6% 0.8%

26.5% 8.4%

16.0% 17.0% 17.9% 18.1%

24. The external balance i s also projected to adjust. Stronger nominal GDP growth combined with a recovery in exports and private transfers as well as gradual fiscal adjustment i s expected to lower the current account deficit to around 6 percent o f GDP by 2012. Export growth (nominal) i s projected at 5.6 percent in 2010 accelerating to 9.3 percent by 2012 as exports return to their pre-crisis levels over the medium term. The projections for the growth rate of exports o f goods and services reflect assumptions of a gradual recovery in foreign markets (growth in advanced economy o f 0.3 percent in 2010 accelerating to 1.7 percent by 2012 as projected in latest World Economic Outlook), some improvement in prices as well as higher exports resulting from the recent FDI inflows. Private transfers are expected to rebound somewhat in 2010 reflecting largely a low base effect from early 2009. The pick-up in growth in developed countries in 2010 i s expected to increase private transfers by around 5 percent in 201 1, in line with forecasts for the region in the latest Migration and Development Brie+. Afterwards, the growth rate of private transfers i s expected to moderate to around 2-3 percent annually over the medium term.

Migration and Development Brief 11, Development Prospects Group, The World Bank.- November 3,2009. 4

8

Financing requirements Current account deficit Amortizations Reserve changes

2009 2010 2011 2012 projected

925.9 1,031.4 1,076.0 1,055.6

Financing sources FDI Portfolio investments

Eurobond Disbursements Other capital

Gross External Debt as % o f GDP

877.8 800.1 747.2 685.6 226.9 221.8 2 12.7 250.3

-178.8 9.6 116.1 119.8

925.9 1,031.4 1,076.0 1,055.6 250.0 360.0 432.5 473.9 155.0 170.0 170.0 170.0 225.0 100.0 100.0 100.0 460.9 421.4 383.5 311.8

60.0 80.0 90.0 100.0

5,137.3 5,437.0 5,707.8 5,869.3 5 5.2% 56.1% 55.4% 53.3%

25. Gradual improvement is expected on the financing side as well, with foreign direct and portfolio investments gradually returning to the pre-crisis levels by 2012. The recovery o f FDI in 2010 and 201 1 should be substantial based on a global recovery’ of private capital flows and the resumption o f a number o f delayed investments (including the concession o f the airports, investments in the free trade zone and some real estate investments). Loosening financial market conditions should also allow for cheaper and easier access to international capital markets. Credit default spreads have already declined from the highs registered earlier this year6 and with the recent stabilization and upgrade in the outlook o f the credit rating (S&P recently reinstated the “stable” outlook for the BB+ credit rating o f the country, after downgrading it to “negative” earlier this year), the spreads should decline further. The baseline scenario assumes that the authorities will secure financing by issuing Eurobonds, however, the authorities have also indicated that they could enter into an arrangement with the IMF. Reserves are largely expected to remain stable over the medium-term in terms of coverage of imports, while increasing in absolute amounts. In the outer years, privatization could further bolster reserves and reduce state involvement in the economy.

26. Still, considerable risks remain and the authorities need to remain committed to prudent macroeconomic policies. Slower recovery o f exports (sluggish growth in main trading partners andor low metal prices) and capital flows (FDI and portfolio investments) could renew pressures on the pegged exchange rate. At the same time, affordable external financing may not be available. Under such a scenario, macroeconomic policies will have to be adjusted with a greater focus given on stabilization rather than countercyclical policies. Monetary policy will need to remain tight and the authorities are committed to larger fiscal consolidation (most likely further expenditure restructuring) if needed in order to reduce aggregate demand. Under this scenario, the external adjustment will be faster, though at a higher cost to growth. An IMF-arrangement will be one o f the few alternatives to avoid an unnecessarily

According to the Institute for International Finance, net Direct Investments in Europe in 2010 are expected to increase by 48 percent compared to 2009.

As o f early-November 2009, the credit default spread o f the 2005 Eurobond issue over a corresponding Bundes Bond was 520 bps (compared to 1,152 bps in December 2008); the spread for the 2009 Eurobond issue was 529 bps (compared to 749 bps in July 2009).

9

sharp economic adjustment and as outlined in the IMF’s Letter o f Assessment, the authorities have signaled that they are prepared to request IMF support if needed in the future.

27. Under the baseline scenario of gradual recovery, public and external debt remain sustainable. Despite some narrowing o f the current account deficit in 2009, external debt i s projected to increase to around 55 percent of GDP as non-debt creating flows remain suppressed (FDI and portfolio investments). External debt i s envisaged to increase further to 56 percent of GDP in 2010 before resuming a declining path. At the same time, fiscal deficits over the medium-term will increase general government debt to slightly below 27 percent o f GDP by 2012, a relatively moderate (to low) level compared internationally. Though solvency indicators on public and external debt do not point to significant risk o f unsustainable debt under the base case scenario, liquidity indicators give reason for policymakers to be cautious.

28. However, debt sustainability can potentially be tested if some of the assumptions of the base case scenario do not materialize. Public debt remains sustainable under the standard alternative scenarios imposed in sustainability analysis (key variables at historic levels and no policy change scenario), and it appears resilient to the shocks imposed. Public debt becomes unsustainable if growth remains sluggish or if there i s a larger fiscal expansion over the medium term. Additional budget financing and further adjustment measures would be needed under this scenario. Similar conclusions apply to external debt sustainability. Moreover, swings in unexplained private transfers or volatility in non-debt creating inflows may impact the sustainability of external balances.

29. Despite the considerable uncertainty, the macroeconomic environment i s considered adequate for the purposes of the proposed Development Policy Loan. The set o f macroeconomic policies implemented prior to the global crisis and during the last year has helped limit the GDP decline in 2009. Going forward, the announced policies appear to be supportive o f gradual recovery o f economic activity and narrowing of the external and fiscal imbalances. Still, policy-makers need to remain vigilant and adequate measures need to be undertaken in case o f a slower than expected recovery.

111. THE GOVERNMENT’S PROGRAM AND PARTICIPATORY PROCESSES

30. The overarching goal of the country i s EU integration, improved economic performance and reduction of unemployment and poverty. While FYR Macedonia does not have a single national development strategy statement, key documents include the Stabilization and Association Agreement with the EU and Accession Partnership with the EU, as well as the closely-linked National Plan on Adoption o f the Acquis and the Pre-accession Economic Program (serving a macro-fiscal strategic document) and other sector strategies. The Ohrid Framework Agreement, which concluded the six months o f hostilities in 2001, regulates the relationship with minority communities in the country.

3 1. The current Government was elected on the basis o f an ambitious economic reform agenda in July 2006. The government i s led by VMRO-DPMNE (Democratic Party for Macedonian National Unity). After the early Parliamentary elections in 2008, which saw further strengthening o f the positions of VMRO-DPMNE, the Democratic Union for Integration (DUI), the largest party o f ethnic-Albanians replaced the smaller Democratic Party o f Albanians (DPA) as a coalition partner in the Government. The new Government has absolute as well as the so-called “Badinter” majority (some regulations require that majority o f representatives of ethnic communities support it in addition to the regular majority). At the local and presidential elections held in 2009, VMRO-DPMNE also won most o f the mayoral positions at the local level, while their candidate was elected into the presidential position. The Government’s program i s based on an election manifesto entitled “Rebirth in 100 Steps”.

10

Box 2: Government Measures to Mitigate the Impact of the Crisis

First set of measures (late 2008): 1. Moratorium on liabilities towards the HIF and their elimination after 4 years in case firms regularly service current liabilities; 2. Cancelation of penalty interest on late liabilities based on non-payment o f personal income tax, corporate income tax, VAT, property tax and pension contribution if firms pay the original outstanding amount; 3. Re-programming o f tax liabilities; 4. Continuation o f the suspension o f the provisions of the Law on Payments which would have closed all firms with blocked accounts; 5. Conversion of Government claims on 4 large loss-makers into equity; 6. Amendments to the Corporate Income Tax allowing profit tax exemption for al l profits not allocated to dividends; 7. Reduction in customs duties; 8. Continuation of the non-taxation o f interest income on time deposits; 9. Lowering the tax burden for farmers; 10. Reduction of “representation expenses” of budget users.

Second set of measures (early 2009): Prior to elections, the government announced a massive multi-year infrastructure program estimated to be worth around EUR 8 billion, or 120 percent of GDP to be implemented over a 7 year period. The program includes major rehabilitation of the road and energy infrastructure in the country and i s expected to mitigate the consequences o f the crisis as well as improve the overall competitiveness o f the economy. The program has been described as over-ambitious, and implementation will be at best delayed.

Third set of measures (May 2009): 1. In May, 2009, the government adopted a first Supplementary Budget keeping the 2.8 percent of GDP deficit but based on a revised macroeconomic framework. 2. EUR 100 million loan from the EIB to support access to finance for SMEs. 3. Set of 50 measures for trade facilitation.

Fourth set of measures (October 2009): 1. Adoption of a second Supplementary Budget (see Box 1)

32. Given the weakening external environment, anti-crisis plans were announced in late 2008 and early 2009 and two supplementary budgets were adopted in 2009. The anti-crisis plans (see Box 2 ) largely benefited f i rms facing liquidity problems due to liabilities towards the public sector, but also included some trade facilitation measures and additional tax exemptions. The first Supplementary Budget included employment freezes (with the exception o f employment on the grounds o f the Ohrid Framework Agreement), postponement o f wage increases as well as cuts in current and capital spending, totaling around 2.5 percent o f GDP. The second revision to the 2009 Budget projects a 2.8 percent o f GDP deficit based on more realistic projections for economic developments and if carefully managed should be consistent with medium-term sustainability o f fiscal accounts.

3 3 . The authorities also remain committed to reforms that create grounds for a sustainable and robust recovery including through a strong focus on improving the investment climate. A better business environment w i l l reduce costs and improve competitiveness o f businesses. Also, the global crisis represents an opportunity to attract investors as investors may be in search o f lower cost opportunities once the recovery materializes. At the same time, the authorities appear committed to investments to improve the stock o f human and physical capital.

11

34. The improvements in the business environment over the last few years have improved the country’s ranking on the Ease of Doing Business Indicator from 92 in 2006 to 32 in 2009. FYR Macedonia now ranks among the top ten countries on the Starting a Business indicator. Over the last few years, the authorities embarked upon a comprehensive reform o f tax policy and administration. According to the BEEPS 2008, labor i s a considerably smaller obstacle to doing business compared to 2005 - linked to the 2005 Labor Law and i t s 2008 amendments. Efforts were also undertaken to promote competition in a number o f sectors (banking, telecommunications etc.) and to strengthen property, creditor and contract rights (reforms in the judiciary, cadastre etc.). However, further efforts are needed, including to ensure the implementation o f recently adopted legislation. Continuing the reform o f social security contributions i s also particularly important in helping to maintain wage competitiveness, especially given FYR Macedonia’s fixed exchange rate.

35. As discussed in further detail below, the government’s reform program focuses on three areas:

a. to manage the impact of the global crisis by maintaining a sound macroeconomic and fiscal framework;

b. to cushion the impact on the poor and vulnerable by enhancing social protection systems; and

c. to strengthen the resilience of the financial sector by addressing potential vulnerabilities.

PUBLIC SECTOR EXPENDITURE REFORMS

36. The government sector in FYR Macedonia i s not excessively large. Central Government revenues averaged around 34 percent o f GDP over the 2006-2008 period, placing FYR Macedonia among the ECA countries with moderate government size. Fiscal revenues had been on a declining trend up to 2006, when a comprehensive tax policy and administration reform was launched resulting in considerable improvement in tax collection and an increase in government revenues as a percent o f GDP. The overall tax burden i s similar to Romania and Slovakia, with only Albania having considerably lower government revenues as a percent of GDP. Compared internationally, government expenditures are s t i l l slightly below the median for central and east European countries.

37. The planning and budgeting process has been strengthened in recent years with revisions to the Budget Law in 2005,2007 and 2008. Key features o f the budget management framework in FYR Macedonia are summarized in Box 3. While the legislation adopted i s generally in line with good international practice, implementation could be improved further.

38. However, the structure o f spending i s unfavorable with wages and other current spending dominating. Although the fiscal accounts suggest declining wages and salaries as a percent o f GDP during the last few years, this excludes a considerable part o f the government wage bill’. A broader (and more realistic) definition of the wage bill would probably reach about 10 percent o f GDP, which i s large (although not as large as in some other countries in the region). Pensions are the second largest spending category accounting for around 8-9 percent of GDP, while at around 2 percent o f GDP the remaining social transfers are not excessive. Government capital expenditures averaged around 4 percent of GDP over 2006-2008, slightly higher compared to the earlier period but still below pre-crisis levels in most countries in the region.

’ The second phase o f decentralization transferred responsibility for payment o f wages in some sectors (primary and secondary education, culture, social protection etc.) to the municipal level and these are now captured under transfers in the Central Government accounts. The health sector wage bil l i s also classified under transfers. Finally, government agencies widely use consultancy contracts (captured under goods and services) to avoid relatively rigid conditions for new employment.

12

Economic Classification (as ‘YO of GDP)

Total expenditures Total expenditures, including transitional costs

Current expenditures Wages and salaries Goods and services Transfers

Pensions Unemployment benefits Social benefits Health care Transfers to Local Governments Other transfers

Interest Capital expenditures

Fixed investments Capital transfers

39. The 2008 Public Expenditure Review noted the scope to improve the efficiency of public spending in a number of sectors. While there has been progress in tackling inefficiencies in some sectors, considerable inefficiencies remain and some new measures introduce further limitations to policy effectiveness. The two 10 percent across-the-board increases in public sector wages in late 2007 and late 2008; the more generous indexation o f pensions; the Personal Computer for every student program; and the additional support to former employees o f “bankrupt” companies are examples of policies which are likely to have fiscal implications and restrict flexibility o f government expenditures over the medium and long-term.

2005 2006 2007 2008 2009 Actual Budget

35.0 33.4 32.6 34.5 37.5

35.0 33.9 33.1 35.1 38.2 31.4 30.5 28.7 29.5 32.5

8.0 7.5 6.7 5.2 6.0 4.5 4.2 4.2 4.7 4.9

18.0 17.8 17.1 18.9 21.0 8.7 8.2 7.4 7.7 8.7 1 .o 0.7 0.5 0.4 0.6 1.4 1.3 1.1 1 .o 1.1 5.2 5.1 4.5 4.8 4.8 0.3 0.7 1 .o 2.6 3.3 1.4 1.9 2.5 2.4 2.6 0.9 1 .o 0.8 0.7 0.6 3.6 2.8 3.9 5.0 5.0 2.0 2.0 2.5 3.4 3.9 1.6 0.8 1.3 1.6 1.1

Overall fiscal framework and the composition of spending

40. The onset of the global crisis necessitated a shift in spending patterns in FYR Macedonia. I t required an adjustment to the fiscal framework to preserve fiscal and external sustainability. In terms o f composition, the adjustment needed to be directed towards eliminating non-priority spending while protecting expenditures that help mitigate the impact of the crisis on the most vulnerable groups, as well as expenditures that provide most stimulus to the economy.

4 1. The two Supplementary Budgets adopted in 2009 proposed a number of improvements in public spending. In spring the first Supplementary Budget was adopted which provided a fiscal adjustment of around 2.5 percent o f GDP, reflecting lower import-intensive capital expenditures and lower goods and service spending, and a freeze on public sector wages and employment. The second Supplementary Budget further reduces non-priority and high-import content expenditures, while at the same time maintaining the allocation for the well performing social transfers. Wage and salaries and goods and services were cut to a level that should still ensure normal functioning o f the public administration and non-accumulation of arrears. There were further expenditure cuts on capital expenditures, reflecting the elimination o f a number o f less productive capital investments.

13

Box 3: Key Features of Public Financial Management Practices in FYR Macedonia

1. The fiscal framework i s defined as part o f a medium-term macroeconomic and public debt framework; 2. Strategic priorities are included in the medium term budget plans required for budget users; 3. An explicit annual budget calendar with key dates i s specified in the Budget Law; 4. The Budget Circular sets three year budget ceilings for each budget user; 5. The multi-year development projects planning process i s incorporated into the budget process and

harmonized with strategic plans and general budget preparation requirements; 6. Budget plans are specified in terms o f programs and sub-programs for each budget user and performance

indicators are required for each ministry’s programs; 7. Explicit limits are in place on in-year virement within appropriations, including maximum adjustments

for salaries, rents and allowances, and there i s Parliamentary control over virement between budget users; 8. A Centralized Treasury Single Account and centralized payment control i s in place; 9. Mandatory quarterly financial plans are prepared by budget users on the utilization o f appropriated

budgets and they are submitted to the treasury. Budget users also submit monthly financial plans, by budget classification, to the Treasury for approval before the beginning o f each quarter;

10. Financial commitments are registered in advance o f payment through a central commitments ledger; 11. Monthly financial reports on budget execution are published on the Ministry o f Finance website and

12. Final accounts are submitted to the Assembly within six months o f the end o f the financial year and

Despite this relatively elaborate framework for PFM, there are still some weaknesses in the budget process. Some o f the features outlined above are still evolving. Namely, while expenditure controls are rather sound, budget preparation could further improve and monitoring and evaluation also need to be strengthened. Furthermore, PFM capacity and practices also vary considerably among various parts o f the Government.

Strengthened governance and transparency has been a major source o f improved PFM practices in the HIF. Similar reforms, focusing on improved governance and disclosure arrangements were introduced in other key agencies (Customs, PRO, Cadastre) resulting in improved performance. There are early signs that the reforms in the judiciary (promoting greater accountability and transparency) are also beginning to show results. However, a number o f public sector agencies still remain unreformed and accountability mechanisms need to be strengthened. Recent reforms in this area include the introduction of the “silence i s consent” principle in the public administration; the implementation o f the Law on free access to information as well as the broader regulatory reform.

Reform efforts in Public Financial Management have strong ownership by the Government and have been actively supported by the Donor community. The Budget reform process was initially supported by the World Bank, through the PSMAC and PSMAL, and later on by USAID. The Bank also took the lead on reforms in the health sector, internal and external audit, leveraging assistance from the Dutch Government. The IMF has taken the lead on reforms in the Public Revenue Office. With the EU policies on procurement being relatively extensive, the initial World Bank lead on public procurement issues has been recently taken over by the EU. UNDP and USAID have provided support for improved PFM arrangements at the local level.

Semi-annual reports on budget execution are also published;

independently audited by the State Audit Office.

42. The 2010 Budget entails a further change in the structure of expenditures. The 2010 Budget was adopted by Government on November 5, 2009 and envisages a fiscal deficit o f 2.5 percent o f GDP. Wage spending i s expected to decline as a result o f the government intention to freeze (net) wages and employment in the public sector. Spending on goods and services i s also going to be controlled by further reducing non-priority spending. Social spending i s expected to increase slightly to reflect indexation o f pensions, higher transition costs o f the pension system and increased spending for the vulnerable. Subsidies and transfers are expected to increase mostly due to higher subsidies in the agriculture sector and greater support to businesses. Capital expenditures are projected to increase significantly, to an ambitious 5.4 percent of GDP in 2010. Financing of the 2010 Budget i s largely planned to come from foreign sources.

14

Public Wage Bill

% o f average wage FYR Macedonia (2008) Serbia Montenegro Federation BiH (2006) Republic Srpska BiH Albania (2006)

43. Control over the wage bill has reemerged as a priority of the government. The Government adjourned the planned 10 percent increase in public sector salaries for 2009 (the third and last increase in a 3-year plan to increase wages by 10 percent annually). Moreover, al l new employment has been frozen with the exception of new employments on the grounds o f the Ohrid Framework Agreement. In 20 10, the authorities plan to use the planned reduction in social contribution rates due to the payroll reform (see discussion below) to reduce outlays on wages and salaries by reducing the gross wage in the public sector (rather than allowing for net wage increases). These measures, while expedient in the light of the fiscal crisis, are not sustainable in the medium-term. A long term freeze on salaries will make it difficult to attract and retain competent staff. Hiring freezes, by the same token, run the risk o f generating skill gaps, as key staff retire and are not replaced.

Single person Couple 50 67 100 167 100+0 100+33 100+67

39.1% 33.7% 32.2% 35.0% 32.2% 37.2% 32.8% 37.6% 38.4% 39.2% 39.7% 39.1% 39.8% 38.8% 36.3% 38.6% 40.9% 42.8% 40.9% 38.5% 39.9% 30.6% 29.3% 32.3% 35.3% 32.3% 30.2% 31.0% 31.7% 31.6% 32.5% 33.2% 31.7% 31.0% 31.7% 34.1% 27.9% 28.9% 29.8% 28.9% ... 28.2%

44. Renewed efforts in public administration reform would be supported by the proposed DPL2. The Central Government maintains relatively strict controls over employment by requiring MOF approval o f al l new employments. Financial controls exercised by Central level institutions also appear effective in containing employment at other levels of government. The implementation of the Civil Servants Law, including the decompression efforts, represents further progress. However, more remains to be done, including extending the system to the rest of the public administration. The authorities recently established an Inter-ministerial Committee on Public Administration reforms chaired by the Prime Minister which should lead the efforts in this area. Some o f the priorities of this body will include regulating the status o f employees across the entire public administration as well as their remuneration. This would help to ensure that the system o f pay i s transparent and promotes accountability, and that salary levels are comparable to and competitive with those in the wider labor market. In addition to modernizing pay policy and preparing a new Public Sector Wages Law, further efforts are also needed to improve the quality o f data about pay and jobs for public administration employees outside the central government.

Reforming payroll taxes in a fiscally sustainable manner

Reducing social contributions

45. Crisis management in FYR Macedonia has taken place against the background of an ambitious payroll reform, which was started in 2009. Like in other parts of former Yugoslavia, overall labor taxation remains high because o f the social contributions, which until recently were as high as 32.5 percent of gross wages for the average wage earner. The labor tax wedge i s especially high for low-wage labor, largely because o f the minimum social contribution and therefore has important distributional impacts, in addition to offering a disincentive for formal employment (especially of low-wage labor).

15

46. A major pillar o f the reforms i s the gradual reduction of Social Insurance Contributions rates (SICs) until 2011. As of January, 2009, the total SICs were reduced from 32.5 percent of the gross salary to 28.4 percent. Going ahead, in 2010, the SIC will be further reduced to 27 percent of the gross salary. At the end of the reform, the SICs will be 22.5 percent in 201 1, however, the exact schedule of reduction may be adjusted to reflect the expectations for the fiscal outcomes in 2010 and 201 1, Additional elements of the reforms included reducing the tax wedge for lower-wage workers, broadening the tax base by including fringe benefits, harmonizing income bases for social security, and moving from a net wage to a gross wage basis for calculating contributions. These reforms should have positive effects on the labor market in general, and for unskilled and young workers, in particular. However, the across- the-board cut in social contributions by 10 percentage points over the next three years raises the issue of the fiscal costs of these measures.

47. The payroll reform will be critical in laying the conditions for a more sustainable recovery in FYR Macedonia over the medium term, but it also raises particular challenges to the sustainability of the pensions and health systems. The on-going cuts in social contribution rates are reducing the labor tax wedge and streamlining wage contracting and payment, and are thus an important instrument for improving wage competitiveness, especially given FYR Macedonia’s fixed exchange rate regime. At the same time, the reform will put pressure on revenues over the medium term, increasing the urgency of further measures to improve the efficiency of spending. This i s particularly the case for the health and pensions sectors, which are affected mostly directly by the reductions in contributions, and are thus the focus of attention in the dialogue.

48. I n the context of the payroll reform, a number of further measures to strengthen the fiscal position are being introduced. For instance, as part of the payroll reforms, the definition of wage was expanded to include some important fringe benefits paid to employees (i.e. the food and transport allowances). With pensions partially indexed to wages, amendments to the Pension and Disability Insurance Law have been adopted earlier in 2009 to temporarily reduce the indexation coefficients in order to limit the fiscal impact of the recently introduced expansion of the wage definition’. As a result, pension expenditures will increase by less than 5 percent in 2009, compared to an increase of around 12.5 percent had the amendments not been adopted.

49. Efforts to increase the contribution base can help to offset the negative fiscal impact of the payroll reforms. One important distortion has been caused by the provision of free health insurance by the Employment Agency to those registering as unemployed (with relatively limited checks on the accuracy of the information provided). As a result, people working informally or being inactive registered as unemployed, thus inflating the number of unemployed. According to the Employment Agency, around 68,000 of the 34 1,000 registered unemployed in July 2009 were registering only for the purpose of receiving free health insurance. The recently adopted amendments to the Health Insurance Law moved the responsibility for the provision of free health insurance from the Employment Agency to the Health Insurance Fund. While there i s no requirement to be registered as unemployed any more, anyone who applies for free health insurance but i s not registered as unemployed needs to submit a

Net reported wages increased by around 20 percent on in the first half o f 2009 compared to the second half o f 2008, most o f which (around 70 percent) due to the inclusion o f transport and meal allowances as wages. The “corrected” wage increase over this period was probably around 3 percent. Using the officially reported wage statistics in the indexation formula would have meant a significant additional increase in pensions. Namely, pension indexation in Macedonia takes place twice a year and takes into account wages and inflation with equal weights 50:50 (this decision was introduced in 2008 replacing the 80:20 CPI: wages indexation). The 50 percent weight given to wages would have resulted in a pension increase o f around 10 percent, compared to an increase o f around 1.5 percent in case the “genuine” wage increase was used.

8

16

certificate on income from the Public Revenue Office. Going forward, it would be important to fully de- link the provision of free health insurance from the employment status and to introduce a means threshold above which individuals will be required to pay contributions for health insurance.

332,728 549,492 249,421 1.33 321,105 535,246 254,262 1.26 348,212 516,269 260,075 1.34 348,500 536,335 265,152 1.31 394,882 562,938 269,681 1.46 424,338 582,605 272,386 1.56 451.491 601.883 273.281 1.65

Reaffirming the sustainability of the pension system

50. Pensions provide subsistence to a large part o f the population and are an important buffer against poverty. Around 273,000 persons receive pensions from the Pension and Disability Insurance Fund at a total cost o f around 8 percent o f GDP in 2008. After increasing fast in the 1990’s (due to low retirement age and early retirement schemes), this number has stabilized over the last decade. The average pension in 2008 was 9,541 MKD, translating into a replacement rate o f around 55 percent. The replacement rate had been on a declining trend until 2007, however, a change in the indexation and an additional ad-hoc increase in pensions resulted in some reversal in 2008, setting a replacement rate to the level above the one the system can afford.

Table 7:

200 1 2002 2003 2004 2005 2006 2007 2008

22,091 9.1 24,023 9.6 25,148 9.5 24,969 8.7 26,735 8.6 28,185 8.0 33.366 8.4

Annual pension increase

1.8% 6.6% 5.7% 1.2% 0.4% 2.7% 1.7%

21.7%

Replace- ment rate

61.7 60.2 61.4 59.3 56.9 55.5 50.5 55.0

5 1. The country has come a long way in reforming its pension system. A number o f parametric reforms to the PAYGO system, a defined benefit system typical for most economies in ECA, were introduced over the last 15 years to restore its sustainability endangered by the deteriorating performance o f the economy and labor markets and the generous entitlements provided under the previous system. These measures included the increase in the retirement age and contribution rates as well as reduction of the replacement rate. Further, a mandatory defined contribution component was added to the system with the introduction of the second pension pillar (private) on January 1, 2006, and the voluntary defined contribution component in 2009.

52. The sustainability o f the pensions system needs to be reconfirmed in light of the on-going payroll reform’. The 2008 PER extensively analyzed the long-term sustainability of the pension system and concluded that the system i s largely sustainable even under relatively conservative assumptions about GDP and employment growth. However, some measures undertaken recently could potentially test the affordability o f the system. These measures include more generous indexation of pensions (replaced the 80:20 Consumer Price Index (CP1)-wages indexation with 50:50); ad-hoc increases o f pensions (in

In addition, a considerable part o f the population i s excluded from the system. The high unemployment rate and the large informal sector have resulted in relatively low coverage o f the pension system. As a result, over the medium- to long run, a growing number of citizens will not meet the minimum requirements for receiving a pension. The authorities still have to define a long-term strategy to deal with these issues.

17

addition to the increase mandated by the indexation formula) as well as gradual reduction in pension contribution rates without a corresponding reduction in the replacement rate.

53. The authorities are devising a long-term strategy to ensure sustainability of the system. Depending on the outcome of the update of the actuarial analysis and the analysis of the impact of the planned reduction of contribution rates (to be supported by DPLl), the authorities will introduce additional measures to safeguard the system. These measures could involve a retirement age increase, further changes in indexation o f pension benefits, changes in the PAYG pension formula and adjustments of the mandatory pension system contribution rates. The Bank will support these measures within the framework of the DPL 2.

Improving the sustainability of the health sector

54. A strong reform effort over the last few years focusing on the performance of the Health Insurance Fund has considerably improved the sustainability o f the sector. The Health Insurance Law was amended to streamline the operations, decision-making and transparency o f the Board of Directors of the HIF. The competitive procurement of pharmaceuticals (an important achievement of a previous DPL series) resulted in considerable savings. Most recently, the HIF board has decided to institute reference pricing” and stronger controls over spending were institutionalized.

55. The financial results of the public health sector have improved. The financial obligations of the HIF towards suppliers were cleared by 2007, while the obligations of the entire public health sector fe l l from 1.7 percent of GDP (4.7 percent of government revenues) in 2004 to 0.4 percent of GDP (1.0 percent of government revenues) in 2008. The preparation for launching bundled pricing for acute inpatient services based on Diagnostic Related Groups (or DRGs) i s well advanced and will hrther rationalize capacity in the hospital sector. However, in order for hospitals to be prepared to function under output-based financing, financial management and service delivery arrangements (level of autonomy over budget, hiring and firing), and capacity must be enhanced. For example, currently, the majority of HCIs have very high fixed costs (over 80 percent for salaries) which leave little for purchasing other inputs for service delivery. More balanced budget allocations will require capacity rationalization, especially on human resources and use of more contracted staff.

56. Still, the long-term sustainability o f the system needs to be further strengthened, as the labor market impact o f the crisis and the announced contribution reforms reduce available health sector financing, with a potentially significant impact on the poor. Combined public and private health spending in FYR Macedonia in 2008 i s around 6.5 percent of GDP, down from close to 9 percent in 2004. Access and quality of services are an issue. Public opinion polls consistently rate health services as “poor or very poor” while household budget surveys show that out-of-pocket payments for health care are significant and pose financial access barriers for poor households.

57. I n the short term, a well functioning treasury function within the Health Insurance Fund (€€IF) can significantly enhance financial management and control in the health sector. I t provides a second line of defense against budget over-commitment or spending by the HIF and the HCIs. Because a treasury system records every transaction in the health care system, it enables a complete set of management reports on al l aspects of budget execution to be prepared on a regular or ad hoc basis. It captures all commitments and payables, assisting HCIs in better managing their own budgets throughout the year. It also can supply reports on an economic, organizational or functional basis. Finally, it would

lo Rather than procuring drugs, under reference pricing the HIF would reimburse a fixed amount covering the cost o f a generic drug. Doctors and patients could choose which drug to use.

18

enable future streamlining o f the financial processes in the health sector and improve efficiency and combat against the problem o f arrears build-up for HCIs.

58. A Treasury function in the HIF, rather than the Ministry o f Finance (MoF) allows for health-sector specific procedures and policies. Financing o f provision o f health services i s evolving away from input-based financing o f health services towards output-based financing. The recent introduction o f DRGs i s a step in this direction. Under such contract arrangements, control mechanisms need to be flexible enough to allow public HCIs autonomy in the allocation o f resources. The Treasury only acts a mechanism for ex-ante controls and ensuring that HCIs do not exceed the allocations and not a mechanism to control how HCIs spend their money.

59. While in the short-run some gains can be achieved through improved financial management (Le. the Treasury function), over the medium-term, the reform of the Basic Benefit Package will be a critical factor in achieving sustainability of health spending; and will also have an important impact on access to basic health services for the poor. Currently, the benefits package in the country provides 90 percent o f the population enrolled in the HIF with comprehensive coverage for outpatient and inpatient health services. In contrast to the EU countries, non-medical benefits including sick leave and maternity benefits are also included in the healthcare package. However, the package i s not evaluated using cost-effectiveness and allocative efficiency criteria and there i s a weak link between annually available resources for the health sector and the benefits package. While the l i s t o f services being covered by the health insurance scheme may be reduced, it should be able to guarantee easy and affordable access to these goods and services. In addition, there i s an overlap and duplication o f benefits. There i s a need for division o f typically public health and preventive services, at one hand, traditionally funded by general revenues and covering entire population, from the curative health services funded by compulsory health insurance and provided to eligible individuals in need o f health care. In addition to the coverage under the compulsory health insurance, certain categories o f citizens (children, students, pregnant women, persons suffering f rom renal failure, diabetes, cancer, cardiac diseases, etc.) are exempt from co-payment for those services on categorical or diagnosis basis instead o f their l o w income status, as required by the existent L a w on Health Insurance.

60. The reforms of the basic benefits package will be an opportune moment to tackle a number of long-standing issues in the country. Namely, the lack o f a relationship between available health sector financing and the BBP, the accountability o f the Health Insurance Fund and Health Care Institutions for delivering the B B P and opportunities for voluntary health insurance (VHI) covering services outside the BBP.

STRENGTHENING SOCIAL SAFETY NETS

61. A well functioning social safety net that provides a targeted policy response can substantially reduce the depth, length and impact of economic shocks, such as the current international crisis. However, this requires sufficient resources, both financial (fiscal resources) and institutional (existence o f country system to channel the resources to the ones needing them most). The Government program tries to strengthen the social safety net along these lines.

62. FYR Macedonia has a complex social safety net system that provides various types of support to a large part of the country's population. Currently, the country has 10 social protection programs (income-support and disability benefits) and three child protection programs. All together, the Budget spent around MKD 4 billion, or 1 percent o f GDP on the 'various programs social and child protection programs in 2008, considerably lower than the ECA average o f 1.7 percent o f GDP and the OECD average o f 2.5 percent o f GDP. The remaining 1.1 percent o f GDP refers to social insurance payments (assistance to the unemployed).Means (or income) testing i s applied only to some programs.

19

The social and child protection programs include income support programs, child allowances and disability benefits. While some o f the largest programs are means-tested, the rest of the social and child protection programs are categorical (i.e. rights-based). Furthermore, it appears that proper means testing i s only carried out for the largest program, the social financial assistance.

63. The safety net performs reasonably well, but still suffers from both leakage and exclusion. Repeated assessments indicate that, while the bulk o f social protection expenditures do end up with the poorest households, a considerable part o f the assistance i s leaked, i.e. ends up in the population in richer quintiles. While the country i s among the top five performers in the region in terms o f targeting accuracy o f total social assistance, still around 30 percent o f social assistance benefits ended up in the households in the highest three quintiles, with 7.6 percent going to households in the top quintile. While part o f this i s due to the design o f the programs (categorical rather than means tested), there i s evidence o f failure o f the means testing mechanisms to properly screen out ineligible households or individuals. At the same time, only slightly less than half o f all households in the poorest quintile receive social benefits suggesting relatively large exclusion from the system. As would be expected, the pro-poor effect of child benefits and other benefits i s much smaller.

Table 8: Adeaua

Social benefits Child benefits Other benefits

Social benefits Child benefits

Other benefits

Social benefits Child benefits Other benefits

Social benefits Child benefits

Other benefits

7, Coverage, and Targeting Efficiency of Social Assistance Programs Bottom TOP quintile 2 3 4 quintile Al l households

Social assistance in percent of total expenditures (all households) 6.4 1.6 0.6 0.4 0.2 1.8 0.2 0.1 0.1 0.0 0.0 0.1 0.1 0.1 0.0 0.0 0.1 0.1

Social assistance in percent o f total expenditures (beneficiaries only) 29.1 14.9 11.4 8.0 4.9 19.9 13.8 7.9 4.6 3.2 4.8 8.7

26.0 36.1 7.0 1 16.1 19.2 10.

Social assistance programs coverage (on percent o f households) 22.0 10.5 5.6 4.4 3.2 9.2 1.7 1 .o 1.3 0.2 0.4 0.9 0.2 0.4 0.3 0.3 0.5 0.4

Distribution o f program benefits among households 47.9 22.2 13.2 9.1 7.6 100.0 35.3 22.2 24.9 2.9 14.7 100.0

15. 5.2 25.0 7.4 1 47.4 100.0

64. Despite decent overall coverage and targeting accuracy, the social safety net faces several challenges. There are excessive number of benefits that are inconsistent in their definitions and parameters resulting in funds being dispersed to a number o f small programs which increases administration costs and limits their effectiveness. In addition, the programs are not consolidated (most are rights-based and are not taking into account if the recipient benefits from some other program). Program administration i s fragmented with the Ministry of Labor and Social Policy and i t s implementing agencies lacking sometimes the basic information systems to efficiently manage the programs. The

20

SWCs and the Employment Agency are overburdened with administrative procedures and have limited capacity to respond to the real needs of their clients.

65. Social assistance transfers have been protected from the fiscal spending cuts necessitated by the crisis. Despite cutting expenditures by 6 percent with the May 2009 Supplementary Budget and a further 3 percent with the second revision, the budgetary allocation for social protection transfers has been preserved at MKD 2.9 billion. As a result, government spending on social financial assistance increased from 1.8 percent o f Core Central Budget spending in the original 2009 Budget, to 2.0 percent in the second Supplementary Budget. Over the January-August period, allocated funds are being executed as budgeted.

66. Medium-term improvements of the functioning of the social protection systems are embedded in amendments to the Law on Social Protection approved by Parliament in June 2009. The adopted amendments streamline the procedures regulating social protection system, open up the option for potential harmonization in the future and allow for a rapid response of the system to emerging crisis..

67. An important next step will be to prepare and adopt the by-laws needed for effective implementation of the recent amendments (including the critical one on comprehensive definition o f countable income for social assistance purposes). Going ahead, the authorities should utilize the information from the unique registry to analyze the social cash benefit system and lay the groundwork for possible harmonization o f the cash benefit system.

68. Going forward, the system can be improved to better monitor the programs through relevant social protection indicators and to track the demand for social assistance. A Unique Registry o f Social Cash Beneficiaries, currently being developed, will serve this function. The establishment o f the unique registry should allow for a detailed analysis of the existing cash benefits and the preparation of a comprehensive Strategy for future development o f the social cash benefit system. The Strategy, recommending the options for the possible harmonization of the CB system, will be based on the data from the unified registry and the review o f al l benefits (including non-means tested ones).

69. There are plans to develop an energy poverty program to mitigate the impact of the planned electricity price reforms on the poor. By ratifying the Athens Energy Treaty the country joined the Energy Community and committed to gradual liberalization o f the electricity markets. The Treaty calls for the establishment o f energy market models based on competition in generation and supply that would ensure cost-recovery and a reasonable rate o f return for energy market participants. This transition will result in higher prices for consumers. Given the significant poverty impact such a move could have, the authorities have been exploring the option of introducing an energy poverty program or adjusting the existing cash benefit system to ensure protection against increased household costs of energy. A well targeted program has a considerable poverty reduction impact but also equally important it should improve collection and financial situation in the system. Considerable background work has already been undertaken under the leadership of the Ministry o f Economy and with technical assistance financed by the EBRD. The process i s currently at a stage when critical decisions need to be made about the design and implementation o f the program. This dialogue will be supported in the context o f DPL2.

70. The authorities are introducing Conditional Cash transfers (CCTs). CCTs can considerably affect human capital and reduce inter-generational transmission o f poverty by directly linking social safety net programs to incentives for investing in human capital development. The introduction of CCT will be initially piloted to the education sector and will focus on ensuring full compliance with the recently introduced mandatory secondary education. The DPL will support the Government’s reforms critical to the successful implementation o f the CCT, including the strengthening o f the capacity o f the

21

Social Works Centers as well as the institutional infrastructure (management information system) needed to implement CCT.

PRESERVING FINANCIAL SECTOR STABILITY

71, The banking system entered the period of the global crisis in a relatively healthy state. This i s in part due to the prudent regulation and supervision in the recent past as well as central bank's earlier move to increase prudential requirements". While considered prudent, the supervision has only recently moved towards risk-based supervision which i s s t i l l developing. The capital adequacy ratio for the sector has been declining in recent years (from 21.3 percent at end-2005 to 16.4 percent at the end of June 2009), mostly due to fast credit growth and weaker origination practices, but it i s s t i l l comfortable on aggregate and liquidity across the sector i s relatively high. Other financial soundness indicators do not point to major concerns, despite the current financial crisis.

72. Even though fundamentals appear appropriate, access to finance was a considerable concern even prior to the crisis. Finance has been less available in FYR Macedonia compared to other countries in the region. In addition to high interest rates, credit conditions (collateral requirements, fees, etc.) have been generally tight, excluding a considerable part of the population from access to formal sources of financing. According to the H B S datal2, consumer and investment loans accounted for only 2 percent of total available resources o f households in 2006. By 2007 this percentage increased to 3.9 percent before falling drastically to 1.2 percent in 2008 (potentially reflecting the tightening of monetary policy since 2008). Furthermore, it appears that only a small part of the population has access to traditional financing sources with the wealthiest decile accounting for 94 percent of al l consumer and investment loans. Less well-off households appear to rely more on unofficial sources of borrowing which are overall much smaller (0.1 percent of total available resources) but are more equally distributed.

73. Furthermore, although the resilience of the banking sector does not raise major immediate concerns, a number of issues, if not tackled, could undermine stability of the sector going forward. NPLs have increased and credit growth has slowed substantially since end-2008. After reaching the bottom of 6.8 percent in 2008, the NPLs have been growing and as of June 2009, stood at 8.6 percent for the system. Moreover the indirect credit risk, due to the unhedged foreign-exchange and floating-interest rate exposures of most borrowers, constitutes a substantial risk for the banks and necessitates prudent capital levels. In June 2009, the NPLs less provisions as a share of the capital have turned positive for the first time since the beginning of 2007, a development that raises concerns about the ability o f some banks to cope with the rapidly deteriorating credit portfolio quality. Despite overall satisfactory fundamentals, the possible failure of individual banks cannot be ruled out which in turn could evolve into a larger crisis. A potential crisis can be devastating for public confidence in the banking sector, which has been regained very slowly following the near collapse in the early 1990's.

The NBRM prudential measures included an increase in reserve requirements, risk weights for consumer loans, credit cards and overdrafts exposures, and in loan- loss provisioning requirements. In addition, NBRM required banks to improve matching o f assets and liabilities across currency and maturity.

These statistics should be considered as indicative only as income sources in the HBS are considerably underestimated. According to the HBS total average available resources per household was MKD 295 thousand a year compared to estimated expenditures o f MKD 40 1 thousand a year.

11

12

22

21.3% 18.3% 17.0% 16.2% 16.5% 16.4%

37.6% 37.1% 34.2% 22.5% 19.8% NIA 15.0% 11.2% 7.5% 6.8% 7.5% 8.6% 2.9% 0.7% -5.0% -6.2% -2.6% 0.4%

Table 9: Selected Fidancial Sector Soundness Indicators

Total regulatory capital to risk

Liquid assets to total assets (on

NPLs to total loans NPLs, net o f provisions / capital FX denominated and FX indexed loans

Sources: IMF IFS, except for liquid assets (NBRM)

I 2005 2006 2007 2008 Mar-09 Jun-09

weighted assets

average)

to total loans I 47.6% 56.7% 54.7% 57.0% 54.7% 56.8%

74. The main risk to the financial sector in the medium-term lies with possible pressures on the fixed exchange rate regime, especially given FYR Macedonia’s significant current account deficit and high credit euroization. Recent pressures on the peg have been successfully withstood by the NBRM with the use of FX reserves and increased interest rates. The latter, in combination with very low inflation, has resulted in high real interest rates and impaired access to finance. Given the large external imbalances, the preservation of the peg and the easing o f the credit crunch and lowering of real interest rates can best be achieved through monetary and fiscal policies that help to maintain confidence in macroeconomic stability. While the housing market does not appear to show any indications of price bubbles, the on-going credit crunch and slipping domestic demand could increase downward pressures on property prices in the near future.

75. A strong financial sector, properly regulated and supervised is important for maintaining macroeconomic stability as well as ensuring sufficiently competitive markets that will improve access to financing. The authorities have already implemented a number o f measure^'^ to improve the performance o f the financial sector and this operation will support measures to enhance crisis preparedness. Critical constraints identified by the 2008 FSAP mission and an IMF assessment in early 2009 include: (i) lack o f contingency planning for crisis management by agencies responsible for the financial safety net (MoF and NBRM); (ii) operational uncertainty about the lender-of-last-resort functions (LOLR processes have never been tested and relevant operations manual has not been developed); (iii) DIF resources limited and lack contingency liquidity; (vi) narrow grounds for the NBRM to appoint temporary administrators; (v) uncertainties that limit the range of available bank resolution models; and (vi) weakened NBRM’s supervisory powers (resulting from a recent constitutional court ruling).

76. A Memorandum of Understanding (MoU) among key stakeholders responsible for resolution of systemic financial crises is under preparation and will be the first step towards efficient coordination, and adequate crisis preparedness and contingency planning. The MoU will facilitate the creation of a framework for information exchange, consultations on financial stability and crisis management among the MoF and the NBRM, including agreements on crisis communication strategy, the lead crisis manager and definition and monitoring o f systemic risk, among others. The MoU will also envisage establishment o f a Committee on Financial Stability at the higher policy level which will follow procedures agreed upon in the MoU and meet regularly at all times and with necessary

The sector i s generally liberalized, credit and property rights are improving, the regulatory framework i s sound and credit information systems are improving. The public credit registry was recently upgraded while activities are underway to establish a private registry with greater coverage (including also utilities). Initial consumer protection legislation has also been implemented.

13

23

frequency in a crisis time. The committee should ensure that systemic risks are adequately monitored and dealt with.

77. While banking sector supervision i s broadly satisfactory, establishment of a Coordinating Supervisory Committee should help harmonize regulation and supervisory practices and improve information exchange and capacity building among the financial supervisors, as a first step towards consolidation of supervision in the financial sector. While safeguarding the soundness and safety o f the financial sector, the dominant banking sector must be considered as a priority in supervision. Nevertheless, increased attention must also be given to the supervision o f other financial subsectors that are likely to grow in importance, such as the leasing (Non-Bank Credit Institutions - NBCIs) sector which i s currently not prudentially supervised. The Coordinating Committee should include the supervisors o f all financial sector segments; the NBRM, SEC, MAPAS as well as the newly established ISA and the MoF which i s responsible for oversight o f the NBCI.

78. The authorities are also working to increase NBRM accountability and independence to reach EU standards. To do so, a new Central Bank Law was drafted in 2007. The Law has been subsequently revised by the NBRM and MoF based on comments from the IMF, EC and ECB, and i s at the final stage for comments with the ECB and the EC before being submitted to the Parliament. Early adoption of the new NBRM law will increase independence and accountability of the NBRM in accord with the prevailing EU standards.

IV. BANK SUPPORT TO THE GOVERNMENT’S PROGRAM

LINK TO CAS

79. The proposed DPL was envisaged in the March 2009 CPS Progress Repod4. The FY07-10 FYR Macedonia Country Partnership Strategy was discussed by the Board on March 27, 2007.15 The main pillars o f the Bank’s support to the country were defined as: (i) fostering job-creating economic growth and increasing living standards for all; and (ii) improving governance and transparency in public sector delivery to support a market economy. A CPS Progress Report was approved by the Board on March 4, 2009. It found that the two pillars o f the CPS, and its underlying theme o f supporting the country’s objective o f EU membership, remain consistent with government priorities. I t also confirmed the overall direction o f the World Bank Group program while introducing some adjustments to the evolving partnership through the remainder of the CPS period, including the possibility for provision of DPL support.

80. The proposed DPL contributes to the following CPS outcomes: (i) labor market: increasing flexibility o f labor market outcomes and decreasing the tax wedge; (ii) health: improve the efficiency and transparency o f Health Insurance Fund Operations; and (iii) social protection - improve administration and targeting o f cash benefits and strengthen the pension system.

l4 (Document No. R2009-0054; IFC/R2009-0050).

l5 (Document No. R2007-0046; IFC/R2007-0038).

24

COLLABORATION WITH THE IMF AND OTHER DONORS

81. The Bank maintains close working contacts with the IMF and other donors assisting the Government for the purposes of harmonizing policy recommendations, seeking synergies among the respective operations, and avoiding overlaps. The World Bank team remains in close coordination with the IMF resulting in largely shared views of the economic situation in the country. This operation may also leverage assistance from other donors. The Dutch Government has allocated Euro 7 million as DPL co-financing and in addition i s supporting a technical assistance trust fund which provides important assistance to key components o f the DPL agenda (health sector Treasury function, Law on public sector wages etc.).

82. The Bank has maintained a robust dialogue with the donor community on issues related to the proposed DPL. On issues related to labor taxation, the Bank benefits from regular consultations with the IMF Technical Assistance Team on improving tax administration. The policy dialogue on energy poverty i s informed by work done by USAID consultants. The Bank’s coordination and cooperation with the European Union, the most important current and future development partner of FYR Macedonia, i s increasing and deepening. In addition, the Bank i s at the forefront o f the process o f the introduction of Program-Based Approach to Donor coordination.

RELATIONSHIP TO OTHER BANK OPERATIONS

83. The World Bank’s lending program consists of fourteen lending operations and two grants, totaling US%300 million, grouped into four outcome clusters: i) the growth and competitiveness cluster; ii) business environment cluster; iii) the human development cluster and iv) the infrastructure cluster.

84. A number of Bank operations will support the proposed DPL operation. There i s an important direct link between the Conditional Cash Transfers project and the proposed DPL, and both operations are expected to reinforce each other in a number of important areas, including on the adoption of a suitable policy framework for the improved functioning of the social safety net system. Synergies are also expected between the Social Protection Implementation Loan and the proposed DPL in the area o f pensions and pension reform. The Bank i s also ready to provide technical assistance (TA) through its just-in-time ESW and analytical activities, for example on further progress in public administration reform or energy-related issues.

85. The operation builds on the successful engagement under the previous DPL series. Previous DPL series supported the competitiveness of the economy through improvements in the business environment, including by cutting costs of businesses by improving the functioning of the labor market through changes in the legal framework. This operation continues to support the competitiveness o f the economy by lowering labor costs; this time through reforms of the payroll system. Previous DPLs also supported reforms in the financial sector, including through improvements in the supervisory practices in the banking sector (the support o f the Supervisory Development Plan in the NBRM). This time, a similar objective i s being pursued by supporting the endorsement o f a Memorandum of Understanding on crisis preparedness between the MoF and the NBRM as well as establishing o f a Coordinating Supervisory Committee with the aim to improve the supervisory practices for the entire financial sectors system. Finally, the structural reforms related to the remuneration o f the public administration as well as the introduction o f the Treasury system in the public health sector support by the current DPL series can be directly linked to public sector governance activities supported by the previous DPL series (Civil Service Law, private/public sector salary survey, strengthening ex-ante controls over hospital spending).

25

LESSONS LEARNED

86. The World Bank has been actively using Development Policy Lending as the principal tool to assist the FYR Macedonian authorities with the design and implementation of important structural reforms since 2000. Over the past 15 years, the Bank and the Authorities have successfully implemented reforms supported by DPL-type o f operations in the financial and enterprise sectors, public administration as well as in the areas o f business environment and investment climate. The operations have introduced a number of reforms which have contributed greatly to the development of the country. With follow-through in mind, the proposed DPL series in part reflects a continuation o f reforms initiated under the previous (PSMAL and PDPL) series (see para 85).

87. The FYR Macedonian experience with DPLs suggests that a broader scope for the DPL could be considered if there i s strong government commitment. Despite having a relatively broad scope, earlier DPL-type operations in the country have been successful. This experience confirms the importance o f “ownership” and “criticality” as good practice principles for DPL operations. The experience o f earlier DPL programs suggests that a broader focus could be supported provided the good practice principles are met.

88. Institutional continuity, on both sides (the Bank’s and Client’s), i s important for success. An important factor in the ability o f the Government to push through a broad reform agenda i s the existence o f a strong coordinating and leading role, which in the FYR Macedonian case was provided by the Ministry of Finance. The Ministry was able to do this, in large part, due to strong internal capacity in some of i t s departments and their extensive experience in dealing with the World Bank. At the same time, the Bank’s satisfactory performance in design and preparation o f the program was, to a large degree, due to the continuity of the Bank team throughout the l i fe o f previous DPL-series.

89. A strong analytical basis i s needed to design effective operations. Analytical work can play an important role to crystallize clearly the areas to be supported under development policy lending, ensuring at the same time a strong government buy-in at the preparation stage and a strong commitment during implementation. Bank analytical work that has helped inform the dialogue with the Government and other donors, and has anchored the scope and substance o f the proposed DPL, i s summarized in Table 10.

90. Another lesson learned i s that reforms supported by policy-based lending tend to be more effectively implemented when supported by investment projects and critical technical assistance by the Bank and other donors. The proposed DPL program i s reinforced by the Bank’s social protection and conditional cash transfers projects. (see para 8 3 ) Technical assistance in areas broadly related to the DPL i s provided by the IMF (on tax and administration and payroll reforms), the EU (Central Bank Law and Customs administration) and the Dutch Government (supporting IMF and WB programs).

ANALYTICAL UNDERPINNINGS

91. In recent years, the Bank has undertaken extensive analytical work in areas covered by the proposed Operation. The recently completed Country Economic Memorandum focused on the reforms needed to improve growth performance by increasing investments and improving export performance. I t also called for greater inclusive policies (including on education and social policies) to ensure shared growth. Also, the 2009 Poverty Assessment shed light on the reasons for the relatively stagnant living conditions in the country including the functioning o f the social safety net. The 2007 Public Expenditure Review analyzed spending patterns in a number o f sectors, including education, health and social protection. The 2008 FSAP noted considerable progress in the financial sector but also provided recommendations to strengthen its resilience. In addition to the standard ESW documents, the Bank produced a number of on-demand analysis on various issues raised by the Government, including a recent

26

Policy Note on Response to the Global Crisis as well as a series o f notes on Labor Market performance and reforms. The table below presents an overview of the analytical activities over the last few years.

Table 10: Bank Analytical Work by Area and Links to Proposed Oneration AAA work Public Expenditure Review (2008)

Country Economic Memorandum (2009)

Poverty Assessment (2009)

FSAP (2008)

Policy Note (2009)

Main recommendation o Slow the pace of increase in teacher salaries; o Review and begin reforming the generous

health benefit package; o Consider shifting a part of the financing of

healthcare from payroll taxes to general revenues;

o Consider an increase in retirement age;

o Strengthen the capacity o f the HIF, MOH and the HCIs to help limit cost pressures and eliminate wasteful spending.

o Reduce labor tax wedge in a fiscally sustainable manner;

o Maintain a strong regulatory and supervisory stance over financial sector;

o Mitigate impact of electricity tariff adjustment over the poor.

o Reduce administrative cost of public sector; o Improving the social welfare system,

especially the social assistance program, can help to reduce poverty by expanding coverage of the poor while reducing leakage to the affluent.

o Further refine financial safety net arrangements;

o Strengthen NBRM independence and supervisory powers;

o Address the legal vacuum surrounding insurance supervision by either establishing the new insurance supervisory authority or unified supervision.

o Revise fiscal framework to ensure it i s in line with realistic projections and financing;

o Ensure that the announced freeze on public sector employment and wages i s respected;

o Refrain from pension increases in excess o f the legally mandated percentage;

o Reconsider non-means-tested transfers.

DPL-supported agenda o Nominal wage freeze o Revise the Basic Benefit Package

o Analyze impact of payroll reforms

o Improve sustainability of pension system reflecting findings o f analysis o f impact of payroll reforms

o Introduce a Treasury Function in public health sector

o Analyze impact of payroll reforms

o Adopt policy on sectoral supervision

o Adopt energy poverty program

o Freeze on public sector wages o Maintain adequate levels o f spending

on social programs; Amend SP legislation; Develop database on benefit recipients

o MoU on crisis preparedness outlining key responsibility and coordination mechanisms drafted

o Adopt a new Central Bank Law

o Adopt policy on sectoral supervision

o 2009 and 2010 Budgets are fiscally sustainable

o Nominal wage and employment freeze

o Improve sustainability of pension system reflecting findings o f analysis of impact of payroll reforms

o Develop Strategy for social cash benefit svstem

92. The proposed DPL also builds on the findings of the recent Policy Note on a Response to the Global Crisis. The Policy Note discusses the implication o f the crisis over the short and medium-term macro-fiscal framework and discusses issues and provides recommendations in key sectors. The Note i tse l f builds on the recently completed CEM, the Poverty Assessment, documents related to preparation of the Conditional Cash Transfers Investment Loan, the 2005 PER as well as other Bank documents.

27

V. THE PROPOSED FIRST PROGRAMMATIC DEVELOPMENT POLICY LOAN (DPL1)

OPERATION DESCRIPTION

93. The DPL 1 i s the first o f two development policy lending operations to be executed sequentially in 2009 and 2010. The DPL series will support concrete Government reforms in the following areas:

a. to manage the impact of the global crisis by maintaining a sound macroeconomic and fiscal framework;

b. to cushion the impact on the poor and vulnerable by enhancing social protection systems; and

c. to strengthen the resilience of the financial sector by addressing potential vulnerabilities.

94. The operation, although modest in size, will support critical reforms needed to mitigate the crisis. The proposed operation will cover about 10 percent of the projected fiscal deficit in 2010 respectively. The measures supported by the DPL are critical for the implementation of reforms that will protect the most vulnerable and support resumption of growth over the medium-term.

95. A policy matrix i s attached at the end of this Document. The remainder of this Section outlines policy areas supported by the proposed DPL in greater detail.

PILLAR I: IMPROVING PUBLIC EXPENDITURE OUTCOMES

96. The proposed set o f reforms focuses on fiscal policies that will support sustainable macroeconomic outcomes, with a particular focus on monitoring and mitigating the impact o f the payroll reforms. The set of macro-policies implemented by the authorities are expected to result in sustainable fiscal balances and reduced external vulnerability of the economy. The proposed deficit of 2.8 percent of GDP in 2009 and a slight reduction in 2010 should not endanger the fiscal sustainability given the size and structure of public debt. The government’s intention to secure most of the needed financing externally should also mitigate concerns regarding the sustainability o f the external balance.

97. The team will continue to carefully monitor the execution of the 2009 Budget and the preparation o f the 2010 Budget, and will maintain an active dialogue with the authorities and the IMF regarding economic developments.

The specific measures are:

0 Overall fiscal framework

o Implementation of 2009 Budget in line with deficit target stipulated in the second Supplementary Budget (DPL 1 benchmark)

o Adoption by Government of Budget for the year 2010 with a target to have a budget deficit of 2.5 percent of GDP (DPLl prior action)

o Implementation of 2010 budget as envisaged and corrective measures taken if necessary (DPL2 trigger)

28

0 Public wages

o Nominal wage and employment freeze for the employees funded from the Central Government Budget, at least throughout calendar year 2009 (DPL1 prior action)

Inter-Ministerial Committee on Public Administration established (DPL 1 benchmark)

Adoption by Government o f Law on public sector wages, regulating the status o f employees across the entire public administration and their remuneration. (DPL2 trigger)

o

o

Payroll reform

o Implement first stage of payroll tax reform by reducing social insurance contributions from 32.5 percent of gross wage in 2008 to 28.4 percent in 2009. (DPL1 prior action)

Implement second stage o f payroll tax reform by reducing social insurance contributions. (DPL2 benchmark)

o

0 Pensions

o Initiate analysis o f impact o f labor taxation reforms on the sustainability of the pension system (DPL1 benchmark)

o Amend Pension and Disability Insurance Law to improve current sustainability o f PAYG system (reduce indexation coefficients from 50:50 CP1:wages to 50:20 CP1:wages in 2009) (DPL1 benchmark)

o Improve long-term sustainability of the pension system reflecting findings o f analysis of impact of labor taxation reforms (potential measures could include further changes in indexation of benefits, changes in Pay-As-You-Go pension formula, adjustment o f the mandatory pension system contribution rates etc.) (DPL2 trigger)

0 Health

o Initiate analysis o f impact o f labor taxation reforms on the sustainability o f the health system (DPLl benchmark)

o Approval by Government o f amendments to the Law on Health Insurance in order to establish a HIF Treasury function for the public health sector (DPLl prior action)

o New Health Single Treasury Account including all public health institutions i s fully functional. (DPL2 trigger)

o Adoption by Government o f a Basic Benefits Package consistent with available financial resources for the health sector for 2010. (DPL2 trigger)

PILLAR 11: STRENGTHENING SOCIAL ASSISTANCE

98. The proposed DPL supports efforts to ensure support to vulnerable groups in the short- term, but also structural reforms that will improve effectiveness and administration of social cash benefits over the medium term.

29

The specific measures are:

Levels o f spending for social protection maintained at the level set forth by the original 2009 year Budget in all its subsequent Supplementary Budgets adopted for this year. (DPL1 prior action)

Enact the new Law on Social Protection to establish a framework to improve the regulation o f cash benefits, to streamline the procedures for the administration of social safety net programs and enable further harmonization o f said programs, and to enable a rapid response to crisis. (DPL1 prior action)

Prepare and enact the bylaws that set the regulatory framework for the implementation o f the Law on Social Protection. (DPL2 trigger)

Develop a unique database of social cash benefit recipients and establish a network between the SWCs and the MLSP, including design and implementation of all business processes for effective use o f the registry. (DPL2 benchmark)

Policy Unit fully operational and issuing regular monthly reports on SP. (DPL2 benchmark)

Government adopts a strategy for further development o f the social safety net, also addressing energy poverty linkages. (DPL2 benchmark)

PILLAR 111: STRENGTHENING RESILIENCE OF THE FINANCIAL SECTOR

99. The DPL series supports measures aimed at enhancing the resilience of the financial sector to the crisis. These include both immediate tools such as further enhancement of the crisis preparedness framework that the authorities have started developing in the past few months, as well as measures aimed at addressing medium term and structural issues such as the adoption of a central bank law, which will increase the autonomy and accountability o f the NBRM, and a policy to implement consolidated supervision including prospective integration of the existing sectoral supervisory agencies for increased effectiveness o f prudential supervision.

The specific measures are:

o MoU on crisis preparedness outlining key responsibilities and coordination mechanisms endorsed (DPL 1 benchmark)

o Establishment o f a Committee on Financial Stability (NBRM and MoF) and drafted agenda for the Committees regular meetings. (DPL2 benchmark)

o Establish a Coordinating Supervisory Committee including al l financial sector supervisors'6 and the DIF to harmonize regulation and supervisory practices, and improve formalized information exchange and capacity building among non-bank supervisors (DPL2 benchmark)

o Adoption o f the new NBRM law by Government. (DPL2 trigger)

l6 At present these would be the NBRM, MSEC, MAPAS, the newly established ISA and the MoF which i s responsible for oversight o f the NBCI. Should a new supervisors or an existing one assume the prudential supervision o f NBCIs after the Law on NBCIs i s adopted the Commissions members shall be adjusted accordingly.

30

Box 4: Good Practice Principles for Conditionality

Principle 1: Reinforce Ownership The DPL program i s in line with the Government’s reform agenda and its policy response to the global economic crisis. The main objectives o f the DPL support the near-term priority o f the Government (as articulated in the second 2009 Supplementary Budget) to “strike a balance between the need to fiscally stimulate the economy while preserving macroeconomic stability and social cohesion” as well as the longer-term strategic priorities o f the Government (as articulated in the Government’s work programs) to increase employment and improve the living conditions o f the citizens and advance EU and NATO integration. The Bank’s analytic work (the Poverty Assessment, Public Expenditure Review, FSAP, Policy Notes on Crisis Response and Labor Markets TA) has contributed substantially to the design of the Government’s program.

Principle 2: Agree up front with the Government and otherfinancialpartners on a coordinated accountability framework The DPL series i s summarized in an agreed policy matrix which outlines actions over the next two years with clear outcome goals. The Minister o f Finance coordinates the program for the Government and assigns specific responsibility for implementing and monitoring the program to various Government agencies. The Government and the Bank have also closely coordinated the reform program with other development partners. The Bank team regularly interacts with the European Commission and the Dutch Government. The Dutch Government financed technical assistance to support the design and implementation of the reforms and could potentially provide co-financing. Cooperation arrangements with the IMF are sound with regular contacts and exchanges o f views between the two teams.

Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances The reform program i s based on, and i s part o f the Government’s strategies and programs. I t reflects short-term measures to respond to the crisis as well as the more medium-term structural and institutional reforms needed across sectors for improving efficiency o f public spending and delivery o f services. During operation preparation, the Cabinet will review and endorse the reform program.

Principle 4: Choose only actions critical for achieving results as conditions for disbursement The DPL program focuses on actions that are critical in terms of achieving the set outcome goals. The DPLl program consists o f 6 prior actions and 6 benchmarks.

Principle 5: Conduct transparent progress reviews conducive to predictable and performance-basedJinancia1 support

The prior actions included in the program have largely been drawn from the extensive AAA activity o f the Bank which has been extensively discussed and agreed upon with the Government. Progress made with the implementation of reforms and achievement of outcome goals will be monitored on a regular basis: a progress matrix, which outlines the status o f reforms and outcome indicators, will be updated periodically and circulated among ministries and agencies.

VI. OPERATION IMPLEMENTATION

POVERTY AND SOCIAL IMPACTS

100. This section reviews the poverty and social impact of key reforms in the policy matrix under DPL 1. The global financial crisis has hit FYR Macedonia hard reversing years o f moderate to robust growth. Yet, even in years o f economic prosperity and prior to the onset o f the food and fuel crises, absolute poverty rates remained stagnant (see para. 12) at 19 percent o f the population. FYR Macedonia i s characterized by relatively high inequality based upon the Household Budget Survey (HBS) which may explain the lack o f progress in poverty reduction. As the government addresses the impact o f the crisis on

31

the population through a series of reforms supported by the World Bank, new social protection measures are under consideration. The aid program options to help the poor with energy costs under DPL 2 requires further poverty and social impact analysis which will be carried out.

101. The poverty and social impact o f the first two public expenditure management reforms in the policy matrix-the implementation of the 2009 budget and the adoption of the 2010 budget-is likely to be positive. The government i s pursuing countercyclical fiscal policy that may partially offset the impact of the economic contraction on the population. In 2009 and 2010, public expenditures as a share of GDP are projected to be 34.7 percent and 35.1 percent respectively compared to 35.1 percent in 2008. As seen in Table 5, in 2009 the government has protected wages, goods and services, and transfers in proportional terms as a share of GDP but also in real terms. In particular, the social safety net transfers for pensions, social benefits, and unemployment benefits increased in real terms. Moreover, as noted above, the government’s Supplementary Budget maintained the allocation for well performing social programs. Thus, at the aggregate level, the government i s taking steps to mitigate the adverse impact of the crisis on the population, in particular the elderly, the unemployed, and the poor. However, certain social groups may be by-passed such as the working poor.

102. The public sector nominal wage and employment freezes do not adversely affect the level o f poverty in FYR Macedonia. The minimum public sector net wage rate (including allowances) was an estimated MKD 8,100 per month at the end of 2008 which exceeds the World Bank estimated absolute poverty line of MKD 3,436. Though there i s a wage freeze in nominal terms, the decline in real wages i s likely to be negligible given the very low inflation rate in 2009. The recipient o f the minimum wage rate fal ls in the top 40 percent of the population based upon the average consumption expenditures per capita. But, as the household size increases to above two persons, even public sector wage earners could fall into poverty without supplemental sources of household income such as a second earner.” The relative position of public sector employees in the labor market may change, either being set back (or moving up) in case average private sector net wages increase (decrease) during this period. The employment freeze for the public sector should not adversely impact the poor, though this policy could s t i l l have an adverse impact on job seekers who may have been queuing for jobs in the public sector.

103. The reduction in the social insurance contributions on gross wages should raise the welfare o f formal private sector workers across the board but could have adverse consequences for future pensioners. Formal wages are a significant source o f income for the working population. For the population as a whole, an estimated 55 percent o f total income was from non-agriculture formal wages, while for the poor, the proportion was 45 percent.I8 A lowering of social contribution rates translates into an increase in take-home pay and should improve the welfare of formal sector workers and their dependents and potentially even raise some out of poverty. Yet, this reform could have an intergenerational impact with current workers benefiting to the detriment of future retirees (including themselves). In order to ensure sustainability of the pension system, declining per capita contributions have to be offset by more contributions over the lifetime of the worker (higher retirement age or more contributors) or lower pension payouts. Second, this de facto increase in net formal wages could lead to either a temporary or permanent widening of the income gap between formal and informal sector workers. An estimated 25 percent of the employed do not work in the formal sector nor pay into the pension

” The HBS’s labor market module does not allow for the identification o f the sector o f employment and, consequently, the poverty status o f households with a public sector wage earner.

Source: Poverty Assessment (2009) based upon the HBS 2006.

32

system. Though both poor and non-poor work in the informal sector, the 2006 H B S indicates the greater reliance o f the poorest quintile on the informal sector.”

104, Amending the Pension and Disability Insurance Law to improve the indexation coefficients i s not expected to increase poverty or worsen the situation of the poor, though in the long term it may adversely impact the relative position of the elderly. The amendment does not preclude pension adjustments but rather modifies the rate of increase to narrow the gap between pension increases and the rate of inflation. In the current low inflation environment, pensions are likely to increase marginally in real terms. Poverty rates among the 65+ year olds are about 15 percent of the age cohort; this represents the lowest incidence o f any age group. However, poverty rates among the elderly with dependents increased between 2002 and 2006 to one in five elderly, indicating that pension income i s being used to support multiple generations within the same household. An increase in unemployment may lead to higher dependence of families on the elderly’s pension income and potentially to higher poverty rates in the absence o f government programs to mitigate the crisis impact. In the longer term, the relative position of pensioners may decline over time as their pensions fail to keep up with income growth of wage earners. However, this could be offset by change in savings behavior and especially an increase in personal savings during the income earning years.

105. The Government’s policy action of ensuring that the level of spending for social protection in the October 2009 Supplementary Budget i s no lower than the original 2009 budget will help to direct resources towards mitigating the impact of the crisis on the poor. While, the Social Financial Assistance spending was preserved at the same level as in 2008, the overall government allocation to social benefits increased during 2008 - 2009 by 6.7 percent to MKD 4.3 billion thus ensuring that more resources were available for helping the poor. The recent slowdown in the economy i s likely to increase the level of poverty in comparison to 2008 and, thus, demand for social assistance from the government. Moreover, the enactment of the new Law on Social Protection which addresses the efficiency of the safety net may serve to release resources that are currently leaked to the non-poor. Though FYR Macedonia has among the best performing social assistance programs in the Europe and Central Asia region, an estimated 60 percent o f program beneficiaries were not poor in 2006. Moreover, coverage of the poor could be improved since only about 40 percent o f the extreme poor and 20 percent o f the moderately poor live in households which receive social benefit (based on 2006 data). In order to track improvements in the targeting effectiveness o f the social protection programs, the HBS will need to be strengthened to better capture changes in absolute poverty in both rural and urban areas and key characteristics such as employment status.

ENVIRONMENTAL ASPECTS

106. The specific country policies supported by the Operation are not likely to have significant effects on the country’s environment and natural resources. The measures contemplated under the loan are primarily geared towards supporting government reforms in fiscal management, social protection and the financial sector. None of the sectors included in the Operation are expected to have any direct significant links to the environment. Although the nominal wage and employment freeze in the public sector will make it difficult to attract and retain competent staff if continued for a longer period of time, the current macroeconomic environment (low inflation and limited private sector job opportunities) should limit any significant negative impact on the enforcement o f environmental regulations in 2009 and 2010.

l 9 The share o f non-agriculture income from informal sources was 15 percent o f total income o f the poorest quintile compared to 7 percent o f the population as a whole.

33

107. The legal framework for environmental management has undergone significant reforms along the lines of the EU acquis. New laws on Environment, Nature, Air Quality and Waste Management have been passed by the Parliament, in compliance with EU requirements. Further regulation, regarding the drafting o f secondary legislation in the environmental sector as a whole i s an on- going process, guided and supervised with EU technical assistance. FYR Macedonia has also signed the South Eastern European Energy Community Treaty which subjects it to key pieces of the acquis, notably the Large Combustion Plants Directive. This directive places restrictions on local pollution emissions (sulfur dioxide, nitrogen oxides and particulate matter). The country also ratified the Kyoto Protocol.

CONSULTATIONS

108. The Government’s program outlined above largely draws from the VMRO-DPMNE’s Election manifestos for the 2006 and 2008 rounds of Parliamentary elections. According to the documents, the program reflect inputs from a comprehensive consultation process with the expert community in the country and the non-government sector, including employee representatives, chambers o f commerce, civil-society organizations etc. The Program was discussed extensively during the elections and continues to provide the overall direction for the activities o f the Government. Furthermore, the overarching goals across the political spectrum are broadly similar, which provides relatively broad consensus for the reform program.

109. The program clearly identifies macroeconomic stability as a key pre-condition for sustainable and strong growth of the economy. I t calls for prudent fiscal policy and a sustainable deficit level as well as a reduction of non-priority spending and an increase in capital spending. The reduction in contribution rates i s also a major theme o f the program. The election manifesto call for reforms in social protection to improve protection o f the most vulnerable largely along the lines outlined above (i.e. reform o f the legal framework, investments in the information systems and efforts to reduce leakage and expand coverage). Also, the program calls for more effective management o f resources in the health sector (i.e. the introduction o f the Treasury function) and clearly identifies the need for revisions to the Basic Benefits Package. Whi le the program was prepared before the current global crisis it s t i l l called for actions to improve the performance of the financial sector, including in the area o f supervision o f the overall financial sector.

1 10. The authorities have a continuous relatively extensive consultation process. The payroll reform (including the reduction in payroll contributions) i s a result of continued calls by the business community to reduce the tax burden and simplify procedures and has been discussed and endorsed at the Socio-Economic Council, a tripartite body that brings together the representatives o f the Government, the Unions and the employers’ associations. The measure to reduce pension indexation in 2009 was agreed during bilateral meetings between the Ministry of Labor and Social Policy and the Association of Pensioners. The new Law on Social Protection was extensively discussed during the Parliamentary procedure for i ts adoption (between Readings and in Committee discussions), with some NGOs also providing comments, some o f which were reflected in the final text of the Law. Given the impact o f the crisis, the Unions also provided support to the expenditure cuts envisaged with the Supplementary Budgets, including the measure to freeze wages and employment.

11 1. Consultations and discussions of Bank analytical work played a catalytic role in designing policy options and mobilizing stakeholders. For instance, the findings of the 2008 Financial Sector Assessment largely informed the Government’s program in the financial sector outlined above. Furthermore, the findings of the 2007 Public Expenditure Review, served as the analytical underpinning for many of the reforms in the education, health and pensions sectors. The findings o f the recent CEM also informed the government agenda on trade facilitation. The broad consultation process in the preparation o f all Bank operations have resulted in broad consensus for the recommendations proposed.

34

112. M o r e generally, the decision making process in the country allows for significant input from the non-government sector. The parliament i s the legislative branch o f the Government which promulgates legislation. In principle, legislation requires a simple majority in order to be adopted with the exception o f systemic laws (requiring two-thirds majority) and laws referring the issues related to ethnicities (requiring so-called Badinter majority, i.e. simple majority o f all Members of Parliament (MPs) plus simple majority of MPs which are representatives o f ethnic minorities). Each MP, the government as well as at least 10,000 voters can propose legislation. Citizens or any group o f citizens can submit an initiative to adopt legislation to the entities authorized to propose legislation or provide comments on proposed legislation. The procedure to adopt legislation i s regulated by the Rulebook of the Parliament and allows for consultation during discussions in Committees or between Readings (most Laws have to pass 2 Readings before adoption). Matters related to accession to the EU are also discussed by the National Council on European Integration, which also comprises of representatives o f the non- government sector (unions, chambers, religious institutions etc.). Once submitted to Parliament, al l legislation i s posted on its web-site.

113. The framework in place allows for extensive consultative process in decision making, although it i s not entirely clear how effective these are. The Rulebook on Government operations regulates the work o f the Government and establishes the Economic Council and the Legal Council which should provide expert services to the Government. The Rulebook regulates the cooperation o f the Government with local government units, public enterprises, institutions and services, political parties, companies and associations o f citizens. The Rulebook on Creation o f Policies instructs public bodies to undertake “transparent consultations” with al l stakeholders. Also, the Rulebook on Strategic Planning stipulates that social partners, other stakeholders, NGOs etc should also be represented in the preparation o f strategic plans. The Government rulebook prescribes that al l new legislation must be accompanied by fiscal impact analysis and regulatory impact analysis. Regulatory impact assessment was only recently introduced to check the impact o f any new legislation on the business environment and also involves a process o f consultation with the business community. Finally, draft legislation i s increasingly being made available on the web-sites of the government bodies for review and comments.

IMPLEMENTATION, MONITORING AND EVALUATION

114. The M O F will be responsible for overall implementation of the proposed operation and for reporting process and coordinating actions among other concerned ministries and agencies. The Bank will monitor actions and review progress o f the implementation of the proposed operation, as well as the subsequent actions o f the Government program by using the short term and overall program outcomes outlined in the Policy Matrix.

1 15. At the same time, the overall status of the program will be monitored during supervision to determine whether the specific conditions of the proposed operation have changed. Supervision missions will not only allow the Bank to continue the policy dialogue with the institutions involved in the implementation o f the program o f reform, but will also ensure synergies with other donors to avoid conflicting advice to the Government in the policy and technical areas involved in the reforms.

FIDUCIARY ASPECTS

1 16. The 2007 CFA and the 2004 CFAA stated that the overall fiduciary risk for the P F M system (including procurement) was considered moderate to significant at the time of those reviews. The “significant” rating was related to the assessment o f procurement arrangements, while the financial management assessment for the aspects considered in the CFA was considered “moderate”. The financial management risks continue to be moderate although there has been significant improvement since the

35

2007 CFA report. improvements in the procurement system.

A recent (2009) review of the National Public Procurement System noted

117. Public procurement: Improvements have taken place after the 2002 CPAR noted several deficiencies in the Law on Public Procurement (LPP). A new LPP in line with international standards (however not harmonized with the EU acquis) was enacted in 2004 as part of the Public Sector Management Adjustment Loan (PSMAL). The Government adopted comprehensive implementing regulations, promulgated standard procurement documents and forms of contract, and established a state administrative body for public procurement within the MOF (made fully operational with staff, resources and terms o f reference). The law was amended in 2005 to introduce electronic procurement, a “one-stop- shop” system for central registration o f tenderers’ qualifications, and the requirement for publishing al l contract notices on the website o f the Public Procurement Bureau. In 2008, a new Law on Public Procurement, fully harmonized with the EU acquis was adopted and activities are underway to ensure its effective implementation. Consequently, the review of national Public Procurement System undertaken in 2009 noted considerably improvement in the legislation, some improvement in implementation and relatively limited progress in remedies.

1 18. The Government has made significant progress in improving central budgeting processes. Improvements include the implementation of a multiyear fiscal plan, the preparation of government priorities and expenditure ceilings for the coming fiscal year, and the introduction of functional budget classification coding. Extrabudgetary funds (EBFs) and agency accounts have been integrated under the Treasury single account (TSA). Improved ex-ante controls resulting from the TSA now apply to al l budget entities and EBFs. Budget reporting has improved, with MOF producing comprehensive reports for the central government using the TSA within 40 days from the end of the month.

Budgeting, accounting and reporting:

119. Internal controls and internal audit: Following the adoption o f the Law on Internal Audit in 2004, the MOF implemented internal audit units across the government and the municipalities (supported by the DPL1). The number o f trained staff increased from 57 in 2005 to 79 in 2006. Internal auditors conducted about 100 audits, about half o f which were performed by the MOF central internal audit unit. The authorities have recently (2009) adopted a new Law on Public Internal Financial Control (PIFC)

120. External audit: There has been substantial progress in strengthening the Supreme Audit Office (SAO). The SA0 i s independent from the executive branch and i t s mandate covers al l public sector activities. The government increased resources for the SA0 and amended legislation to: require an annual audit opinion on the government’s annual financial statements; require the auditor to summarize the audit findings for the year into common themes on high-risk areas for the government to address; adopt a risk-based audit approach to the annual audit planning process; report on the government’s progress in implementing current and al l outstanding audit recommendations; perform performance-based audits; and implement international auditing standards covering al l aspects o f its work.

121. Further improvements in several areas of procurement and public finance management could be necessary, including: (i) improved reporting on state-owned enterprises; (ii) improved legal framework for public procurement in line with EU requirements and establishing an effective and independent complaints review body; (iii) strengthened internal financial controls in the MOES and consolidation of progress on financial management in the HIF; and (iii) improved SA0 public reporting.

122. Anticorruption measures: Several anticorruption measures have been put in place, including the internal and external audit functions, anticorruption laws and amendments. The fight against corruption i s an important feature of the new government’s program. Institution building and improvements o f standards ir i the areas of the judiciary, police, health, and customs i s targeted as well as strengthening o f

36

controls and punishments for those who do not respect laws and regulations. The areas mentioned are also supported by the Bank, the EAR and other donors. Even if more transparency i s introduced and civil society engaged in this fight as planned by the Government, the level o f corruption will remain a challenge. The ongoing improvements in the areas o f public procurement, internal audit, and strengthening of the role o f the SA0 contribute to the fight against corruption. The 2008 BEEPS shows a marked improvement (compared to the 2005 round o f the survey) in the percentage o f firms indicating corruption as a problem of doing business.

123. The latest IMF update of the safeguards assessment was completed in February 2006. (The previous assessment was done in 2003). The update found that the NBRM had taken steps to strengthen i t s safeguards framework, and recommendations from the earlier assessment had been implemented. This progress notwithstanding, the report made recommendations in the reporting and audit areas, including: (i) review by the NBRM internal audit unit o f processes for compiling monetary data reported to the IMF under the program; and (ii) completion o f annual external audits on a timely basis as prescribed by the NBRM Law. The NBRM has acted on these recommendations.

DISBURSEMENT AND AUDITING

124. management system.

Disbursement and auditing arrangements reflect the moderate risk for the public financial

125. The proposed DPL will follow the Bank’s disbursement procedures for development policy lending. The untied budget support will be disbursed in compliance with the agreed prior actions and will not be tied to specific purchases. No procurement requirements will be needed. Upon approval o f the Loan and notification by the Bank o f Loan effectiveness, the Government wil l submit a withdrawal application. At the request of the Government, the Bank will disburse the Loan, less the amount o f the front-end fee, and the net proceeds o f the Loan will be deposited in the Treasury’s Euro account in the NBRM, this account being available for budget financing. This Treasury Euro account forms part o f the foreign exchange reserves of the country. The Borrower shall ensure that upon deposit o f the net proceeds of the Loan into said account, an equivalent amount will be credited in the Borrower’s budget management system. If after the proceeds are deposited in the NBRM account the proceeds of the Loan are used for ineligible purposes as defined in the Loan Agreement, the Bank will require the Borrower to promptly, upon notice from the Bank, refund an amount equal to the amount o f said payment to the Bank. Amounts refunded to the Bank upon such request shall be cancelled.

126. The administration and accounting of the loan will be the responsibility o f the MOF. The standard country rules will be followed by treasury for administration and accounting. The MOF will provide the Bank within 30 days with a confirmation letter stating that the DPL funds have been received and deposited into the deposit account designated by the borrower. Considering the Bank’s knowledge o f the public finance management systems, the ongoing improvements of these systems and the assessment o f the NBRM made by the MF, no audit will be necessary o f the deposit account.

RISKS AND RISK MITIGATION

127. The proposed DPL carries moderate risks. The country went into the financial crisis with a sound fiscal position. At the same time, the large current account deficit remains a critical vulnerability. In addition, institutional and political r isks also exist. Risks are also mitigated by the programmatic DPL design which i s intended to leave some flexibility as to the pace and scope of the reform program.

128. Uncertainty of global economic outlook and the size of the current account deficit. Further external shocks or a prolonged delay of the recovery will impact the economy negatively, e.g. prolonged

37

recession in EU and lower demand for exports than currently envisaged and lower private sector capital inflows. The main macroeconomic risk i s that balance o f payment shortfalls will deplete reserves (although this risk has receded in recent months). Public debt levels could increase significantly, while the financial sector stability would be undermined given its high degree o f euroization. Additional external financial support may be needed, and the Government has indicated that it will approach the IMF in 20 10 if the need arises.

129. Economic risks are somewhat mitigated by the recent signs of stabilization as well as the relatively favorable initial external and fiscal debt levels and structure. Progress towards EU accession would also help (while setbacks to EU membership are a downside risk). In addition, the government’s decent track record on prudent macroeconomic policies give some credibility to their policies and indications to approach the IMF in case the situation deteriorates further. At the moment the authorities do not see a need to approach the IMF; views of the Government and the IMF appear to have converged which should considerably ease the process of reaching an agreement in case the authorities request it.

130. Capacity o f some public sector institutions to design and implement ambitious reforms, while much improved over the past few years, remains relatively weak. Institutional capacity i s uneven across various parts o f the Government. While some parts o f the Government involved in this operation have decent capacity (NBRM on supervision, MLSP on pension policies), relatively weak institutional capacity in other sectors raises concern. Improving i t i s an important component of this Operation, but institutional change comes slowly. The Bank will try to mitigate this risk by providing TA, leveraging the support o f investment loans and active dialogue with the counterparts.

13 1. Political risks appear more moderate. The government has a stable majority in all levels o f Government and next elections are few years away. However, the name issue could potentially trigger some political instability. Last year’s veto over NATO membership does not appear to have undermined commitment for reforms. However, one more veto (this time on start of negotiations for EU membership) could trigger a reform fatigue and remove a big reform anchor.

38

Annex 1

Annex 1: Letter of Development Policy

TO:

Attn:

Subject:

The World Bank Mt8 H Street, N.W. Washington D,C, 20433

N s

Fax *+ 389 2 3117 280

LETTER OF DEVELOPMEW POUCY

Rear Mr. toellick,

,We am writhg to rquesf on behalf of We Gcwwnrnent of the Republic of Mmdonia a ~Pregmmmatec Development Policy Loan ( O R ) crt t 20.5 million (US$ 30rnillion equhlent) to supporl our program to respond to the globgl economic crJsis and bettar position the munby for a sustainable reccsvery,

'he ongoing intmt ional ecmopnic crjsii brought to a halt the acceleration of economic activily of the last few ysam in Macedonia. Prior to the crisis, the economy mpsnded pwltivsly to the Strong reforms implemented recently I# the Repubikc of Macedonia, including regulatory Morn, reforms in labar markets aod the judicisry, market Oberalkation and financlal sedos reform, reilecrted also In the mu#"$ Tog 4 and Top 3 reformer clvrtus In the 2008 and 2010 Doing Business Rspcxts, n s p s W y , E m DomesSic lnvestmer& increased 63 close tb 28% of GOP Bh 2008, up from 23% of QPP in 2005 with Fat a b picking up slgnincrntty, thus bringing the growth r i t e of the economy to dose to 6% in 2007 end most of 2008 (up from around 4% in the perlodi before), Howevsr, the global &is intempted time t M r , retgulng In a ehsrrp drop In export m a n d for MacedonIan prbducb and reduced prlvate capital ffawrs, Exports fell by 40% En nminal terms. whik FPI levels in ttre first half of 2w39 fel by &096 compared to levels m 20043

Thls Letter sf Development Policy rets out the key actions that the Gwernment is committed to undertake to mittgate the impact of the global crisia In the ohart-Wm but a b to support mdiurn- twm stntctunl reforms that will maintain macro-fiwal slrbilaty and promote economic growth and poverty reducUan. Our program emisages a fiscal stimulus that will preserve rnacrogcanomic stabiltty and the exchangs rate peg as well as rc!ims that wil irnprova wage cornpatttiveness of iha economy in a fiscally sustainable way, provide batter support of the vulnerable and minlrnizb ndts to the financial sector. The attached Policy Matrix aummasitee the contents of this Letter.

Ths proposgd program will suppwt the objectives ouNined above by implementing mfms structured around three key policy amas (I) public expenditure re fms; (ii) refming 5ociat safety nets; and (iii) ~ ~ ~ n ~ ~ e ~ i ~ msilaesrce of the firaanclal sector. BeEow we briefly deECr1bs our mfom paans En all d &Esse areas.

Plobllc Expenditure Reforms:

Our public expenditure policies o w the last few pars were supportive of macraeconomlc stability

39

Annex 1

Rapubli of Mecsclonia Mfnrrtry of ffnance l

and accelerated econornlc actrvity. We pursued prudent fmal policles resulting in o re4ativeay modest government sector and balanced fiscal accounts Our public sector, at around 35 p m n t of WP, ia nlstively smll by regional StaMlclards and recent tax policy and adminirtration reforms (introdudlm of fiat and at the sarne time reduced lrtoome taxation) fumer nduaed and simplifkd b e fiscal burden on economic actlvily, The Budge! was largely b&anced colvtrfbutlng to keeping aggregate demand et manageable levels, avobding crowding out of financing for the private sector and reduang !he general gavernment debt level from around 5096 of GDP at the etart of the decade to 21% oat f h end of MW,

In rrt&kponsc to the strong a&ne impad of ths giobal crkis, we adopted B countbrcyclical HsME policy stance b stlrtrvlrphs UPa ecmomy witltlruf endengwi~$ rnectmeconm~ sWMy. Our

a kvd thot is iinancaabte, will not edlarger PnaCTOBwnomic stability OF undermine fiaoel and external wstainabllity. We are Sully dammittgd to this deflcit target and 50 far have adopted Wo mMsfons to the Budget to r e d w expendatures in light of declimg revmu88 and are ready to take further measures i f necessary. To alleviate pssures on the dornwtk capitel mgrket and reserves, we considerably m f a d bad! OUT korro4Ning from ttro domestio 1n3rkbl and kswed a Eurobond to cover our fisranchg needo and suppod reserves. Due to UIig and other policies, the lmpact d the cfdds has ksn mre moderate In Macedoda m p w e d to countries in tha ragion with ODP declining by only 1.2% In the firs4 half of 2009.

Witn the raveions of the Budset in 2008, we introduced a number of Improvements in putrlic

@d emR!t3W7?6i?t i?? m$ , with the exception of employments required for the proce6sss of EU- integration and Ohrid Framework Agreement irnplsrnentatron. Spending M goods and ServlGgs has h n cut, but maif?t8ln~td at a level tha wu id sbli ensure normptl funchoning of fh pubh administration and non-accumulation of arrar8, We Jso had to reduce allocaHons for capital expenditures, most notably un less productive ones and iavsgtments w&h high-import content. Control of the WE@@ bill has reemerged a$ a priority. As wage fraeres are not aurtainrMe Over t b

n PubIh AdmJn /8WmW medium term, we rscebtly Q&&&&& an Interma?&&& C m W e o Reforms that is looking into reform options golng forward. Some of the priorltiss of: this M y will include regurating the &&us of srnplcyew auD%g the entire public adminlstrstion as well as thrr remumntion.

We are aware that the BEOTW~H: environment going forward will be consrderably $#ere!% f m the pad and our fiwl response wtll remain prudent, The recovsry of IRe wr~nomy will be gmdual and lsrgery dependent an devF3lopment.s in the EU, our main mmmk partner. We project a maderst growth rak of 2% In 2010, accelerating to 4-5% over the msdium-term. Fiscal pdky will support this gradual m v e r y , The deficif in 21110 WEIl tm FBdUCsd t 0 2,594 of- whRe our medium-term fiscal ~~~~~~s~~~ a gradual reductlon of the deficit to a bevel of around 1,5-20% of ODP by M12. By securing external finorncifg fot most cb pur (inciudlng thca DpaiMI for an IMF-program), we intend to remove pwsaures ern ttss markets and support macroeconomic ebbiliity. Thls wil help support the e ~ ~ ~ b r n recovery vvhlle enwring longterm wslaln&iiity 8scal md external accounts The general gorrwnrnent debt wl i Increase as a result of the f I d M s but it Is $ti envisaged to peak at a cdmfottable 28-2W d GDP by 2012 and d m a s e eRmards,

Ow managemant of the international crisis is taking against the beckground of a compnhensiw payroll reform, which we started to lmpEeme Bq The on-going cuts In social cantributiaon rates are rrKEuchg the labor tax wedge and stmamllning wage contracting and paymsnt, and are t h e an Impostant instrumant fw rmprwrng wags competitiveness.

spending by containing current anel non-prioirty spending. We introduced a @me on a lib& WE4bS

I . .

I 2

40

Annex 1

impkrnetned. the pension insurasics CQntt'ibUElOn rate will lael to 15 peroent ( d m from 27.2 pewat prior to the reform): the hearth insurance cont*ution wil! be 8 percent 6f the gross wage (down from 9 2 percent ptior to ths r e f m ) and the unmploymmt insurance contribution will be f parcent of the grass wage. Additional e1emerPts of the payroll reforms included B shift fawn net to gross wage contracting, unifying {and In some cases reducing) me minimum thWdci fw paymen! of contributions, introduction of integrated Personal l n m e Tax [PET) and 31Ca colbctian as w~llE a8 broadening of the wage dufidtion, In thds mntsxt, we plan to generate further wings in 2010 by reducing the gma wage rn the public sector rather than aFlow for net wage I m s e .

fulthsr changes in

crrveped by the State In order to ensure its financial swtainabrlky and guarantee easy end akrcktable access for the vuRereMe by improved tergeting. The actrvitks are slnady advanoea and in cooperalion with fRe World Bank we plan b endome the reform pbn by the end of 2009 and imp?ment the mfons during the first hJf of 201 0.

In the short term, wd be%eve s l g f l l ~ n l swings can be obtained by imobuclng 9 Tmsuiy function in the Health lnsuranca fund, which will allow for health-sector specific praoedumi an# pobicks. W r m t reforms hplsmsntd in th3 health sector, fiwnciingj of ptovlsbn of heafth services is ewfving away inpubbased fhancing of taeatfh services towards output-baaed financing. The m n t introduction of DiagnOscs related Groups IDRGs) ir P step in thia direction. Under such contract arrangements, control rnechaWm3 should be fiexibls enough ta allow pliMlc HCIs autonomy in the allocatbn of murces. The HIF Treasury fumtkm Will be onty B tWGhankm f w ex-ante controls and emring that HCls do not exceed ttts alhatlons, and not a mechankrn to mntral how HCls spend their money. The Treasury buncalon will preygnt budget over-comrnllment or spcmdlng by the public Health Can lnstitutims md would enable future streamlining ob ahs

h e rystm on @Cat $ask ovw the next few months and to have a fully operational Treasury function in the public health sector by rniddQ10.

3

41

Annex 1

Repubk OF Macedanla Ministry of finanor

Reforming Social $afpr$ Nets to Support the Most Vetlnrrabltr:

We are also committed to mitigate the impad of We current global crisis by CAnsrrrJng adequate support bo the mas? vrrlJNKaife, Dasprle axpenlliaure cuts during 20M, we isllaca&d sufBbeienX funds that will ~ Despte cutting expenditures by 0 p n e n t with the May Supplemntary &&et and a further 3 percent with the 2nd revision in October, we preserved ttla budgetary allocation far social protection transfers at MKD 2.9 billion, The Republic of Macecaonia 'ks among Me top five p e r f o m in the region in terms of t b twg&rkg accuracy of total sacsal assistam b e r M t s and we believe %at by prerrewlng the allocglon we will be ab4 to respond to the weds af the most winerable. Gwen prqectjons about a refatively slow recovery, we remain cmrni t td lo conllnue! to support lb most vulnerable in the fuhn by p&eenrlng social pratetion spending in the 2010 and bcreasirrg It if circumstances w a m t .

8etyond protecting Ute most vulnerable fvm the immediate impact of Ih4, Crisis, we ere mmmMed to lmpkmnt ~trudural r e f m e !hat will hprovs #re edrnikrfsriaHon end CrblbcppVSness of #?e socZal safety net. We gg&&gJ& J-W Social Pmtectmn Lrulv which estabHshe6 the brnework to etrearnline the procedures reguhttw the social protection system, opens up the ct@@n for potbnbl hamonktion of bend& in #e hrtlure md albws fw the introduction of CondMlonat Castl Transfers @XT] as we11 as B rapkf response of Ihe system to the emerging crixdaia. While @e new Law lays ?he grounds for imptoved perforrnence of the sacial assistance sy&km We are undertaking additiional measure8 to improver targeting and reduce leakege to the non-poor. The next step is the dsafkng of the bysaws that set the reguiatory framework for the implementation of h e Law on Social Protection, incloding the issue of a cmprcthenrkve daflnition of countable income foe socxal aslsiaanca putposes.

We &re atso cammiwd tu 8ttrengthanhg the institutional capacity and infrastpucturb requited for more effective adnlniatratim d the social safety net. Wgh these, efforts we seek to rnodernbc and automate benefts administration at the central {hnhistry of Labor a d Soclat Policy) and local (Social Welfare Centrrs) bvsk with a common software and irnpwd harbwaae, These Woms wllS help consalidab and coordinate p m s s s s for mdving apflieations, detemining J%libiWy, assigning benefits, and markaging the w e load. They will dso help p m ulg way for Improved monitoring and evaluation of bur policies,

We have made considembee progress with thr, development of the Unlgue Registry of Sweh Cash BenMts. Works startecl in June 2009 on the develwmeM bf the modules crltical k r &e CCT program irnplemenlstion. 7he modules for the remaining aockal cmh benefits will be bsvdoped afterwards. Also, the tendering ptocess for the d)gkaiizafkm of the SWCs' hletorlcsl data entry Is ongoing, We are also well advanced with the setting up of a network belween the SWCs and the MoLLGP. We expect to have B fully functioning Registry and a functioning m w ~ r k between the MokSP and the SWCs by mid-2010. The establishmffl of the Unique Registry wlll aflw us to M e r understand the e % c l / w m of our pollcbs and will inform w r chislorn shut the future development of the social assistance system, We plan to adopt e cornpitsbwive Strategy for !ha Mule s8euelopmnt of the social cash benefit system by rnM-20t0 that will review all bmeflb (including nonmaana teated ones) and wiil also recommend oplllocks for the posslbk hkarmonltatbn ut the cash knefrts system,

As part of OW strategy for social protection dams, we plan to introduce measures to suppor~ vufnerabk hcussholds from the impact of IRS plgnned electrity price reforms on the poor Considsfabie background work has already been unckmken and cdtical decisions n w need ta bs made a$wt the cDes$n and Irnpmentatm of the progsam.

4

42

Annex 1

RarpuMc of Mecedonia Mfnlshy of finance I

h r e n l n g FlnanClsl Sector Stability:

The financia! sector in the Republic of Macedonia, in parlicuiar the bankhg system, he8 remained largely stabc, dwng the global crisis. AB a msult of pru&nt macroeconomic policies and bound ntguEaNon and supervisian. the banking sector entered the global ctesls period io a nlstively healthy situation with rek8lively high capita4 and tiquidity buffers Capital adequacy and iiiquMlty rndicators remain sound. Non-prfming loans increased sllgMfy but stdl remain adeqeratety provisioned,

StXit, given the Iikdlhood of a dcw recovery going ahead, we are cocnrnltPed l o fuWr sfrerlgthening the nsilienoe of Bector from indlrecS e w t a of tha glsis. For that purpobe, we haw iniljated acflvltles to eentrietnce the crisis preparedness framework, We wenfly endoreed 8

which e&&lishss a h-Elmwrk for informalion exchange, consultations OR finamal stability and cride management among the Ministry of Finrnce and lhe N&ionel Bank of Republac of Macedonia {NBRM), It also envlqcs eskblumcnt of B Committee on Financial Stability at the higher pelby level whlch Will ensure that systerrric risk is adequately monkwed and dealt whth.

We alb afso drafting 8 mw Law on the National Bank of ahns Repubk of Macedonia which increases accountability and independence In fins with prevailing EU atandarch We envisage a Parliament approval ob the Law in 2010.

We urtdetstmd lhst the varying quality of supervision of different segments of the fhnancxal sector poses a rbk for the Stability of the overell sector. While safeguarding the soundness and safety of the dominant banking skctox ha8 been a priority so far, inaeased attention must also be given to &e eupswiwon of abet finanolal aubseclorrr that a n likely to grow in irnpartance @murance. pension hnds etc.), We will eetabtlrh 0 Coordinating SupwAmry Goenrnknes which should help harmonlze rsgulaitibn and supenfiswy practices and improve mfmatlon exchange and capacity bvildling ammg the financial eupenrleors. The Caordinatmg Supervisory Committee wouM inck~de hgher techntcal bved sbff fmm all finasldai superviscbnt. The Committee 8hQuld distuso, among uthsks, infroducaion of new regulations and supervisory practioes In ditbsml sectors, hamonizatlon or repodlay3 requirements and evcrtvinp Imkaps among indwlduat fimnclal sectors.

Conclurlon:

We am confident that ttM letter outlines 8 coherent program of m f m s end i9 focused on critical poky prkrriales, We E K ~ c6mhc8d that thee reforms am esseavllal to mitigate the impact of the @i&al amis and support eustalnaMe recovery and p0Ver;iy reductron oyer the medum-term. In closing, we w i d Yke to reitwate that t h cwrtinued support of thg Warid Bank and h e intermationel community will be essembial for achievhg thew ambitious goals. We trust that this request for World Bank support for the impkernenlation of ulia reform program dll w i v e your endomment.

43

N

4 111

d d

N

f x

Annex 3

Annex 3: Fund Relations Note

Former 'Jiugoslnr Republic of Macedonia-&ssessment Letter for the World Bank

November 2.2009

47

Annex 3

2

48

Annex 3

3

49

Annex 3

4

50

Annex 4

Annex 4: Country At-a-Glance

Macedonia, FYR at a glance 1111 2/09

Key Development Indicators

(2008)

Pcpuldion. mid-year (minions) S t r f a x aea( tbusmd sq. km) Pcpuldion gcwth (%) Urban populdion ( % oftotai popubticn)

GNI (Atbs method, US$ billions) GNI percapita(Atiasmetbd. US$) GNI per capita(PPP,intemdiona $)

GDP growth (%) GDP per capla growth (%)

(mod mecent estimate, 2002-2008)

Pdlerty headcourt mtio d $1.25 a day (PPP, %) Pwerty headcourt mtio d $2.00a day (PPP. %) Life eqedancy at birth(years) Infant mortality (per 1 .Om live births) Chad mdnuttion(% ofchldren mder5)

A&It iterav, male (% d ages 15 and olckr) Adrlt iteracy. female (% of ages 15and older) Grcss primary enrolmert. male ( % d age gmup) Gross primary enrolmert. female (% of agegrwp)

Access to an improved water source (% d population) Access to hproved saritation facilities ( % ofpopulation)

Macedonia. FY R

2.0 26

0.0 66

6.4 4.1 40 9,050

5.0 5.0

c2 3

74 15 1

99 95 98 96

100 69

Europe & Central

Asia

446 23,972

0.2 64

2,697 6,052

11,262

6.9 6.7

4 9

70 21

99 96 98 96

95 69

Lower niddle incane

3.435 35,510

1.0 42

6.513 1,935 4.585

10.2 9.1

69 36 25

66 77

112 109

66 55

Age distribution, 2007 I Male Female

6 4 2 0 2 4 6 pwcentdtoBlpopulaion I

Under4 mortalty tate(per 1,000)

I 6o 1 50

40

30

20

10

0

I UMacedoma, FMI OBropS BCentslAola

Net Aid Flows

(US$ m'lions) Net ODA m d official a d Top Jdonors (in 2007):

European Ccmmission United States Japan

Aid (96 of GNi) Aid per capta (US$)

Long-Term Economic Trends

Consumer p k e s (annual % chmge) GDP knplict deflator (annual % ctmnge)

E~angera te(mnua1averqe. local per US$) Terms d trade index (2000 = la))

Pcpuldion, mid-year (minions) GDP (US$ maliors)

Agicukure In&stry

services

Household fnal consumption expenditure Geneml govt fmal consumplion expendilrre Gross cautal formation

Exports of gods m d services l m p r t j ofgoods and services Grcsssaviqs

Manufadurirg

1980

1 8

1990

3

3 0 0

0. I 2

114.9 93.7

0.1 134

1.9 4472

2000

251

86 37

6

7.1 125

5.6 6.2

65.9 100

2.0 3,587

I% ofGDF) 8.5 12.0

44.5 33.7 357 20.7 47.0 54.2

72.3 74.4 19.0 16.2 18.7 22.3

25.6 48.6 5 . 9 63.5 9.3 23.1

2008 =

213

76 31 20

27 105

8.3 7.2

41.9 66

20 9,521

10.9 34.0 21.7 55.1

79.3 19.0 27.7

526 76.6 16.0

Growth of GDP and GDPper capita (Oh)

8 6 4 2 0 1 4 6

4 a

95 05

1980-80 1990-2000 2000-08 (averageannud growth %)

0.6 0.5 0.2 -0.8 3.2

0.2 1.7 -2.3 2.9 -5.3 2.3 0.5 3.4

0.1 4.4 -0.4 -0.2 3.6 4.6

Note: Figures in Xaks are fcr years other thm those specified. 2008data are pdininary. .. indicates dah are not waiabk. a. Aid cBta are fcr 2037

Develcpment Ecommics, Dwebpmert Data Group (DECDG)

51

Annex 4

Ma ce do nia, FYR

Balance of Payments and Trade

(US$ millbnsj Total merchmdise eworts Ibb ) Total rnerchmdise hpo l l s (a0 Net tra& in (Pods and services

Current amwnt balance is a % ofGDP

Workers' remittances and mmpemation ofempbyees (receipts)

Reserves, imluding gold

Central Government Finance

(% of GDPj Current revenue (including grants)

Cunent expendture

overan surpluvaetcn

Hiaest marginal tax rate (56)

Tax revenue

hdiwdual Copcrab

External Debt and Resource flows

/US$ m'llbns) Total debt wtstmding and dsbursed Totaldebt service Debtreief (HPC. MDRI)

Totel debt (% of GDP) Total debt service(% of =pats)

Foreigl dired iwestrnent(net inflows) Pa-tfdb equity (net intows)

2000

1.323 2,094 -642

-79 -2.2

81

700

36.0 32.6 31 .O

2.5

1,548 245 -

43.2 13.9

197 0

2008

3.978 6,852

-2,550

-1,191 -12.5

267

2,108

32.4 28.9 30.2

-1 .u

12 12

4.678 463 -

49.1 8.4

594 -7 2

Composition of total external debt, 2008

Us6 millons

Private Sector Development

Timerequired tos ts t a business (days) Cost to start a bw i r r ss (56 of GNi per capita) Time required to ragister property (days)

Ranked as a m@or cmstraht to hrshess (Oh of mmagers surveyed who ;greed)

Access tdcost of fnanang AntiOmptitNe Or infomal pradices

Stmkrnarket captalkation(% ofGDP) Bmk caplal toasset ratio (Oh)

2000 2008

9 - 3 8 - 66

2000 2007

41 0 34 0

0 2 3 4 3

-

Governance indicators, 2000 and 2007

*---

i Voice and a ccoun 'a b my

Poli$cal ssbmy

Regulaloryqusldy

Rule o f law

Con to lo f corruption

~ 2 0 0 7 Counlry'rprcen6Ie rank(@ 100) . Swrce:KaufmanlF~say-Mastruai, Wodd Bank

hghor mluss imply b a l h r m l h g s

Technology and Infrastructure

Paved mads (% of totd) Fixed Ine m d motilephone

High teclnolcgy e x p r G subscribers (per 100 people)

(% of marufacbred exports)

Envir ~1 m ent

Agricukural land (% of land area) Forest s e a ( % oflandarea) National)y pmteded areas (Oh of land area)

Freshwater resources prcapha (cu. meters) Freshwaerwith&aml (bilbn cubic meters)

C02emissionspercapita(nt)

GDPperunit of energyuse (2005PPP$ per kgof o l equivaienl)

E W R V use DH capla (ko d oil eauivalent)

2000

63.8

31

1.2

49 35.6

2,671

5.7

5.4

1.348

2007

118

OB

49 356

7.9

2,651

5 1

5 9

1.355

(US$ null,CnSj

IBRD Total debt cutstmding and dsbursed 123 193 Dtsbuwments 13 54 Pmcpal repayments 3 134 Inkrest payments 7 11

IDA Total debt wtstmdirg and dsbursed 250 394 Dtsbursements 38 0 Totaldebt servce 2 8

IFC (fiscalpar) Total disbursed end aftsmnding portfolio 65 25

d which IFC ova acmunt 40 25 Dtsbuwmentsfor IFC ownacmunt 8 0 Paffi l io sdes, prepaymenb and

repaymentsfor IFC own acccunt 0 2

19 0 MGA

Grcss e p o s u e New warantees 19 0

Note: Figures in lalics are f a years otherthm those specified. 2008data zep rdh ina ry . 11/12/09 .. indicates dam are not avalatie. -indicales cbservatim isnot applicatle.

Develcprnent Ecomrnics, Dwebpmei i Data Group (DECDG).

52

Millennium Development G o a k

Measles immunization (%of I-year olds)

Annex 4

Macedonia, N R

ICT ndicators (per 100 people)

With selected targets to achieve between 1990 and 2015 (estirnafe cbsest b date shown +/- 2 vezs)

Goal 1: halve the ratesforextreme povertyand mahutrition Poverty headcwnt ratioat $1 25 a day (PPP, %of ppuhtion) Poverty hmdcwnt ratioat natonal povertylne (% of poptiaton) Share of ncane ormnsunpticn to the poorest qunble (Oh) Prwalence of malnutnton ( O h of children under 5)

Goal 2: ensure thatchildren areable to complete prinary schooling Primary schoolenrollment(net, %) Primary corrpletan rate (Oh of relevant agegrwp) Seccndaryschoolenrolbnent (gross, O h )

Youth literacy rate (% of pecple ages 15-24)

Goal 3: eliminate gender disparilyin education and empowerwomen Ralo ofgills to boys in pnmary and secondary educaton ( O h )

Wanen empoyed n thenonagncuiiuml sedor (% ofnonagffiuiiural employment) Prcportionof seats held women n natanal palllament(%)

Goal 4: reduce under5 mortalitv bv two-thirds Undx-5mortalRy raQ (per 1,000) hfant matality rate(Wr 1,000 live birth) Masles immmizatm (proporticn of onsyearolds immmized, %)

Goal 5: reduce maternal mortalily bythree-fourths Maternal mortalny ratio (mcdeled estmate, per 100,a)O live births) Brths attenckd by slaled heath s8ff (% of total) C o ~ r a x p l v e prevalence ( O h of women ages 1549)

Goal 6: halt and begin to revBrse the spread o f HIV/AIDS and other major diseases Prwalence of HIV(% ofpopulalicn ages 1549) hcdence of tlbercubsis (pa 100,000people) Tuberculosis case5 dekcted under DOTS ( O h )

Goal 7: halve the proportion of people without sustainable access to basic needs Access to m imFoved wzter souce (%of poptiatan) Access to improved smitaton Bclities ( O h d populatm) Forest area (%of totd land area) Nalonally protffitedareas (YO of tdal land aea) CO2 emsscns (metffi tons per capta) GDP per wi t denergyuse (constant2005 PPP $per kgof oilequualent)

Goal 8: develop a global partnership for development Telephonemaidnes (per 100 peope) Mobile pbne subsabers (per 100 people) htemet users (per la) peope) Personal mmputas(per 100 people)

Educatbn indicators ( O h )

:I 25 ~

20m 2 0 a 2m4 zm6 zoo7

-&- Rmary net enrol mnt ratlo

*I- Raboofglrls b boyslnplmry& sccnday educa6on

1930

94

99 38

38 33

54

35 6

s i 5 9

15.0 00 00

19%

97 77

99

33 3

26 23 97

48

5 4 4 5

17.9 OD OD

2000 2 9

19 1 6 7 1 9

92 99 84 99

98 42

8

16 14 97

36 54

100 08

35 6

5.7 5 4

25 2 5 8 2 5 3 6

2007 c2

19 0 5 5 1 2

92 97 84

99 40 28

17 15 94

10 98 14

0 1 29 66

100 89

35 6 7 9 5 1 5 9

22 8 95 6 27 3 36 8

100 140

120 75 100

80 60

40

20

0 0

9)

a

Note: Figures in taics are f a years otherthw those specified. .. hdicates data are not available.

Develcpment Economics, Dwebpmelt Data Group (DECDG).

11/12/09

53

Annex 5

Annex 5: Government Definitions

The Central Government consists o f the Government and i t s services, 14 Ministr ies and 1 Secretariat as wel l as a number o f Agencies, Bureaus, Directorates, Offices and other entities (referred to as “first- line” Budget users). In addition, there are entities affiliated to these (schools, institutes, courts and other entities established within ministries) typically referred to as “second-line Budget users”. Since 2005, the Central Government definition was expanded to include the four extra-budgetary Funds (Pensions and Disability Insurance Fund, the Health Insurance Fund, the Employment Agency and the State Roads Agency) which administer the Government’s social (PDIF and EA), pensions (PDIF), health (HIF), labor (EA) and road infrastructure (SRA) policies.

The General Government includes the Central Government and local municipalities. The number and size o f the local government as wel l as i t s competencies changed significantly during the transition period. The country started the transition period with a relatively small number (34) o f larger municipalities with extensive competencies in education, housing, public utilities etc. The 1995 L a w on territorial division increased the number o f municipalities to 123. However, by then, their competencies were significantly reduced and remained concentrated in public utilities. As a result, municipalities’ expenditures in 2004 accounted for only 1.8 percent o f GDP, while they employed around 0.25 percent o f total employment in the economy.

Greater decentralization was a key pillar o f the Ohrid Framework Agreement which ended the 2001 conflict. With the new 2004 L a w on territorial division the number o f municipalities was scaled back to 83 (plus Metropolitan Skopje area), while the new L a w on competencies o f Local Governments extended the municipal competencies in urbanism and spatial planning, education, l imited social services etc. The new L a w on property taxes and amendments to the Personal Income Tax and the Value Added Tax laws ensured greater financial resources for municipalities. Lacking official data, employment in municipalities is expected to have doubled as personnel f rom Central institutions have been taken over and new staf f has been employed. The expenditures o f municipalities are estimated to have increased to 4.7 percent o f GDP in 2008 (out o f which 3.4 percent o f GDP are actually transfers f rom the Central Government.

Entities owned by the Government commercially operate in number o f sectors. A number o f entities at the municipal level perform functions l ike public services and utilities (water supply and sewage, waste disposal). In addition, there are a number o f State-level public entities which provide goods and services mostly concentrated in agriculture and fisheries (“Makedonski Sum?,), energy (“ELEM, - generation and “MEPSO” - transmission o f electrical energy, “GA-MA” natural gas distributor), transport (“Macedonian Railways”, “Macedonia Airports”, “Makedonija Pat,’) etc.

Finally, the State owns minority stakes in number o f enterprises and owns M B D P (Macedonian Bank for development promotion). A massive sell-off o f shares in 2006 reduced the State’s portfolio but it s t i l l remains the owner o f 35 percent o f the shares in the Telekom, as wel l as various percentages in other legal entities. As part o f the anti-crisis measures, the Government converted into equity i ts claims on a few loss making enterprises.

54

MAP SECTION

Osogovske Mts.

Malesevske Mts.

Ni d

z e Mt n

.

Mt. Korab(2,753 m)

Sopotnica

Pelinci

Vratnica

Medzitlija

Drugovo Vraneshtica

Tetovo

Petrovec

Tearce

Gostivar

Debar MakedonskiBrod

Kavadarci

Gevgelija

Krivogashtani

Berovo

Vinica

Kratovo

Kumanovo

Prilep

Strumica

Valandovo

Ohrid

Struga

Resen

Bitola

Veles

KrivaPalanka

SvetiNikole

Demir Hisar

Arachinovo

Bogdanci

Bogovinje

Bosilovo

Brvenica

Centar Zupa

Chaska

Chucher-Sandevo

Demir KapijaDolneni

Gradsko

Ilinden

Jegunovce

Karbinci

Konche

Lipkovo

Lozovo

Makedonska Kamenica

Mogila

Negotino

Novaci

NovoSelo

OslomejZajas

Pehcevo

Plasnica

Rankovce

Sopiste

StaroNagorichane

Rosoman

Studenichani

Vasilevo

Vevcani

Vrapchishte Zelenikovo

Zheino

Zrnovci

Kicevo

Krusevo

Radovis

Stip

DelcevoProbistip

Kocani

Star Dojran(Dojran)

Obleshevo(Cheshinovo)

Belchishta(Debarca)

Rostusha(Mavrovo &Rostusha)

SKOPJE

Crna

Crni Drim

Vardar

Bregain

ica

Sopotnica

Pelinci

Vratnica

Medzitlija

Drugovo Vraneshtica

Tetovo

Petrovec

Tearce

Gostivar

Debar MakedonskiBrod

Kavadarci

Gevgelija

Krivogashtani

Berovo

Vinica

Kratovo

Kumanovo

Prilep

Strumica

Valandovo

Ohrid

Struga

Resen

Bitola

Veles

KrivaPalanka

SvetiNikole

Demir Hisar

Arachinovo

Bogdanci

Bogovinje

Bosilovo

Brvenica

Centar Zupa

Chaska

Chucher-Sandevo

Demir KapijaDolneni

Gradsko

Ilinden

Jegunovce

Karbinci

Konche

Lipkovo

Lozovo

Makedonska Kamenica

Mogila

Negotino

Novaci

NovoSelo

OslomejZajas

Pehcevo

Plasnica

Rankovce

Sopiste

StaroNagorichane

Rosoman

Studenichani

Vasilevo

Vevcani

Vrapchishte Zelenikovo

Zheino

Zrnovci

Kicevo

Krusevo

Radovis

Stip

DelcevoProbistip

Kocani

Star Dojran(Dojran)

Obleshevo(Cheshinovo)

Belchishta(Debarca)

Rostusha(Mavrovo &Rostusha)

SKOPJE

B U L G A R I A

K O S O V OS E R B I A

G R E E C E

ALB

AN

IA

LakeOhrid

LakePrespa

LakeDojranCrna

Crni Drim

Vardar

Bregain

ica

To Pristina

To Nis

To Pernik

To Blagoevgrad

To Petrich

To Thessaloniki

To Kozáni

To Elbasan

To Korçë

Osogovske Mts.

Malesevske Mts.

Ni d

z e Mt n

.

Mt. Korab(2,753 m)

42°N

41°N

42°N

41°N

22°E

22°E 23°E

23°E

21°E

AERODROM

CENTAR

BUTEL

SARAJ

SUTOORIZARI

KARPOSH

KISELAVODA

GAZIBABA

GJORCEPETROV

CHAIR

THE CITY OF SKOPJE

SKOPJESKOPJE

Skopje serves as theMunicipality Capital

for each of theseMunicipalities.

FYRMACEDONIA

FORMER YUGOSLAV REPUBLIC OFMACEDONIA

This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other informationshown on this map do not imply, on the part of The World BankGroup, any judgment on the legal status of any territory, or anyendorsement or acceptance of such boundaries.

0 10 20

0 105 15 20 Miles

30 Kilometers

IBRD 33438R2

JULY 2009

SELECTED CITIES AND TOWNS

MUNICIPALITY CAPITALS*

NATIONAL CAPITAL

THE CITY OF SKOPJE

RIVERS

MAIN ROADS

RAILROADS

MUNICIPAL BOUNDARIES

INTERNATIONAL BOUNDARIES

*In most cases, the names of the municipalitiesare identical to their capitals. Where theydiffer, the municipality is shown in green italic.