Explanatory Memorandum to COM(2022)4 - Providing macro-financial assistance to Moldova

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dossier COM(2022)4 - Providing macro-financial assistance to Moldova.
source COM(2022)4 EN
date 04-01-2022


1. CONTEXT OF THE PROPOSAL

• Reasons for and objectives of the proposal

In recent years, the Republic of Moldova has faced many difficulties including on the economic and political front. In 2020, the COVID-19 pandemic, as well as a drought in the summer, had a sizeable negative effect on growth, with GDP contracting by 7%, the strongest recession since the global financial crisis. The economic downturn was exacerbated by a protracted political crisis that followed the presidential elections in November 2020, finally resolved by the parliamentary elections in July 2021. Since August, when the new, reform-oriented government took office, all political forces in Moldova (including the President, the Government and the Parliament) are aligned, supporting a common ambitious reform agenda, with the focus on key policy areas such as the justice sector reforms, good governance and fight against corruption.

However, notwithstanding the renewed political momentum and strong commitment to implementing reforms, Moldova continues to face significant challenges, including governance, corruption, limited administrative capacity, and a recent energy crisis, which further weakened Moldova’s economic stability and put the country through a challenging negotiation process with Gazprom (a new gas supply agreement was signed on 29 October).

In this context and given Moldova’s continued sizeable financing needs, with the external financing gap estimated at 1.2% of GDP in 2022, the Moldovan government requested a new MFA from the EU on 19 November 2021, following an IMF staff level agreement (announced on 21 October 2021) on a three-year Extended Credit Facility/Extended Fund Facility of USD 564 million.

Against the backdrop of renewed political stability and after an in-depth assessment of the political and economic situation in Moldova, the Commission is submitting to the European Parliament and the Council a proposal to provide a new MFA of EUR 150 million to the benefit of the Republic of Moldova, of which EUR 120 million would be in the form of loans and EUR 30 million in the form of grants.

The proposed MFA would help Moldova cover part of its residual external financing needs, which are estimated at USD 480 million, in the context of the new IMF programme over the period of 2021-2025.

The disbursement would take place in three tranches, with the release of each tranche, including the first one, strictly linked to good progress with the implementation of both the IMF programme and a number of additional policy measures to be agreed between the Commission and the authorities and listed in a Memorandum of Understanding (MoU). The MoU is likely to focus on policy reforms addressing asset recovery linked to the 2014 bank fraud, continued Public Finance Management (PFM) reforms, the justice sector reform , the energy sector as well as the business environment in general. The implementation of the proposed operation is expected to go hand-in-hand with the support under budgetary operations financed by the Neighbourhood, Development and International Cooperation Instrument (NDICI).

As further elaborated in the Commission Staff Working Document accompanying this proposal, the Commission considers, based also on the assessment of the political situation made by the European External Action Service, that the political and economic pre-conditions for the proposed MFA operation are satisfied.

• General context

Despite a notable recovery following the severe 2020 recession, Moldova’s macroeconomic outlook remains vulnerable. This is partly due to the on-going difficult pandemic situation (with the number of COVID-19 cases rising and a relatively low vaccination rate below 30% by early December 2021), as well as the recent gas crisis that put Moldova under additional financial strains. This is on top of significant structural weaknesses, notably limited administrative capacity, further need to improve governance as well as the ongoing fight against corruption.

Following a steep decline in 2020, caused by the pandemic, the economy marked a considerable recovery in the first half of 2021 with GDP up by 11.5%, however, much of it due to the low base. Growth is projected to slow down in the second half of the year, with higher inflation and weakened household consumption. Against this backdrop, the IMF and World Bank assume an overall recovery of about 7% for this year as a whole, and a decline next year to 4.5% GDP.

After significant disinflation last year, inflation as measured by the Consumer Price Index (CPI) picked up strongly in 2021, up to 8.8% in October, significantly exceeding the target rate set by the National Bank of Moldova (NBM) at 5% +/- 1.5 pps. Most of it can be accounted for by the rise in food prices as well as higher energy tariffs. In response to the high inflationary pressure, the central bank raised its policy rate several times this year, standing at 5.5% in October. The NBM projects a double-digit inflation in the first half of 2022, up to 15%, some of which is assumed to be of transitory nature, but may also lead to further monetary tightening.

On the back of the improved growth perspective and higher tax revenues, in September, the government amended the State Budget Law, projecting a lower than initially assumed deficit, at 5.1% of GDP compared to 6.7% of GDP at the start of 2021. However, given the ongoing energy crisis and with the authorities planning to introduce new compensation measures to protect the most vulnerable consumers, Moldova’s fiscal position is forecast to deteriorate next year. According to the State Budget 2022, presented to the Parliament on 25 November, the budget deficit will increase to 6% of GDP next year, high compared to Moldova’s historical averages, hovering below 2% of GDP in 2015-2019. Expenditures are projected to rise by 7.6 billion lei, compared to a rise in revenues by 4.2 billion lei, supported by higher VAT collection.

Given increased spending and notwithstanding additional assistance from its international partners to mitigate the effects of the energy price increase, Moldova’s public debt is projected to widen rather considerably, exceeding 40% of GDP in the medium term, compared to some 28% of GDP in 2019, before the pandemic-induced recession and the gas crisis.

The current account deficit, after having narrowed in 2020 to 6.6% of GDP, widened in the first half of 2021 to 14% of GDP year-on-year, putting renewed pressure on Moldova’s balance of payments. According to IMF forecasts, the current account deficit will reach USD 1.5 billion by the end of this year (some 11% of GDP), an almost two-fold increase compared last year. Much of this can be accounted for by the significant rise of both imports and exports in 2021. Between January-September exports were up by 21.1% compared to the same period in 2020, but were outpaced by a 31.7% growth of imports.

Moldova’s foreign exchange reserves proved stable throughout the pandemic in 2020, and increased in 2021, remaining high relative to historical standards, at USD 4 billion as of end-September. This translates into a coverage of 8 months of imports, and largely reflects the allocation of the Special Drawing Rights (SDR) by the IMF in August of USD 236 million, which was part of the Fund’s global response to the COVID-19 crisis.

• Consistency with existing policy provisions in the policy area

Decision No 701/2020/EU on providing previous macro-financial assistance to the Republic of Moldova (as part of the MFA package to the enlargement and neighbourhood countries in the context of the COVI-19 pandemic) in the amount of EUR 100 million in loans was adopted by the European Parliament and the Council on 25 May 2020. The assistance was fully disbursed during 2020-2021.

• Consistency with other Union policies

The EU and the Republic of Moldova have developed a close political and economic relationship over the years, leading to conclusion of the Association Agreement (including the DCFTA), which was signed on 27 June 2014 and entered fully into force on 1 July 2016, and an Association Agenda sets out the list of priorities for joint work. The last Association Agenda for 2017-2019 has been extended over the period of one year (due to the pandemic last year), whilst a new document is under preparation, covering the 2021-2027 period.

Moldova's economic ties with the EU are also well developed. The EU continues to be Moldova’s largest trading partner, accounting for 52% of its total trade in 2020 (approx. 67% of total exports and 45% of Moldova’s total imports), followed by Russia (9%) and China (8%).

Countries that are covered by the European Neighbourhood Policy are eligible for MFA (if fulfilling different conditions). The EU MFA would complement the grants mobilised under the NDICI and other EU programmes and, in particular, the conditionalities envisaged under the budget support packages being implemented by the EU. By supporting the adoption, by the Moldovan authorities, of an appropriate framework for macroeconomic policy and structural reforms, the EU’s MFA would enhance the added value and effectiveness of the EU’s overall financial interventions, including through other financial instruments.

2. LEGAL BASIS, SUBSIDIARITY AND PROPORTIONALITY

• Legal basis

The legal basis for this proposal is Article 212 TFEU.

• Subsidiarity (for non-exclusive competence)

The subsidiarity principle is respected as the objectives of restoring short-term macroeconomic stability in the Republic of Moldova cannot be sufficiently achieved by the Member States alone and can be better achieved by the European Union. The main reasons are the budgetary constraints faced at the national level and the need for strong donor coordination in order to maximise the scale and effectivenes of the assistance.

• Proportionality

The proposal complies with the proportionality principle: it confines itself to the minimum required in order to achieve the objectives of short-term macroeconomic stability and does not go beyond what is necessary for that purpose.

As identified by the Commission based on the estimates of the IMF in the context of the Extended Fund Facility, the amount of the proposed new MFA corresponds to 36% of the estimated residual financing gap for the period 2021-2025. This is consistent with standard practices on burden-sharing for MFA operations (for a country with an Association Agreement, the upper limit would be 60% according to the ECOFIN Council conclusions of 8 October 2002), taking into account the assistance pledged to Moldova by other bilateral and multilateral donors.

• Choice of the instrument

Project finance or technical assistance would not be suitable or sufficient to address the macroeconomic objectives. The key value added of the MFA in comparison to other EU instruments would be to alleviate the external financial constraints and to help create a stable macroeconomic framework, including by promoting a sustainable balance of payments and budgetary situation, and an appropriate framework for structural reforms. By helping to put in place an appropriate overall policy framework, MFA can increase the effectiveness of the actions financed in Moldova under other, more narrowly-focused EU financial instruments.

3. RESULTS OF EX-POST EVALUATIONS, STAKEHOLDER CONSULTATIONS AND IMPACT ASSESSMENTS

• Stakeholder consultations

MFA is provided as an integral part of the international support for the economic stabilisation of the Republic of Moldova. In the preparation of this proposal for MFA, the Commission services have consulted with the IMF and the World Bank, which have already put in place sizeable financing programmes and are preparing new ones. The Commission consulted the Alternate Economic and Financial Committee on 25 November 2021, where an endorsement for the draft proposal was provided. The Commission has also been in regular contact with the Moldovan authorities.

• Collection and use of expertise

In line with the requirements of the Financial Regulation, in the context of the COVID-19 MFA package, the Commission services have carried out an Operational Assessment of the financial and administrative circuits of Moldova in order to ascertain that the procedures in place for the management of programme assistance, including MFA, provide adequate guarantees. The final report of the Operational Assessment, prepared by a consultancy company, was received in June 2020. The report notes clear progress in PFM systems and other financial circuits since 2015 when the last exercise was undertaken and concludes that the status of Moldova’s financial circuits and procedures is deemed favourable for a subsequent MFA operation. Developments in this area will continue to be closely monitored also through the regular progress reports on PFM reforms produced by the EU Delegation in Chisinau.

• Impact assessment

The EUs macro-financial assistance is an exceptional emergency instrument aimed at addressing severere balance-of-payment difficulties in third countries. Therefore, this MFA proposal is exempted from the requirement to carry out an Impact Assessment in accordance with the Commission's Better Regulation Guidelines (SWD(2015) 111 final) as there is a political imperative to move ahead quickly in a situation requiring a rapid response.

More generally, the Commission's MFA proposals build on lessons learned from ex-post evaluations carried out on past operations in the EU's neighbourhood. The new MFA, and the economic adjustment and reform programme attached to it, will help alleviate Moldova's short-term financing needs while supporting policy measures aimed at strengthening medium-term balance of payments and fiscal sustainability and raising sustainable growth, thus complementing the programme to be adopted by the IMF Executive Board. These policy conditions should address some of the fundamental weaknesses shown over the years by the Moldovan economy and economic governance system. Possible areas of conditionality could, in principle, include reforms to strengthen governance in the financial sector, PFM, energy sector reforms, and accompanying measures to strengthen the social safety net, improving the investment climate and supporting the implementation of the DCFTA agreement.

• Fundamental rights

Countries that are covered by the ENP are eligible for MFA. A pre-condition for granting MFA is that the eligible country respects effective democratic mechanisms, including a multi-party parliamentary system and the rule of law, and guarantees respect for human rights.

The renewed reform-commitment and strong political will by the new Moldovan authorities, following the elections in July, in the key reform areas including justice sector reforms, good governance, the rule of law and fight against corruption is a clear positive sign. The authorities are committed to conduct these reforms in a transparent manner and in line with EU standards. To that end, the political pre-condition for an MFA programme is considered to be satisfied.

4. BUDGETARY IMPLICATIONS

The proposed EUR 150 million MFA operation for Moldova is foreseen to be disbursed in three equal tranches to be released between 2022 and 2024. The financial programming over the 2022-2024 period allows for a grant component of EUR 30 million to be financed from the available budget on budget line 14 20 03 01 “Macro-financial assistance (MFA) - grants''. For the loan component of EUR 120 million, the required provisioning at a rate of 9% of the External Action Guarantee will be programmed under the Neighbourhood, Development and International Cooperation Instrument (NDICI), for a total amount of EUR 10,8 million (budget line 14 02 01 70 “NDICI – Provisioning of the Common Provisioning Fund”).

5. OTHER ELEMENTS

• Implementation plans and monitoring, evaluation and reporting arrangements

The European Union shall make the MFA available to Moldova for a total amount of EUR 150 million, provided in the form of medium- to long-term loans as well as including a grant component, which will contribute to cover Moldova’s residual financing needs in 2022-24. The assistance is planned to be disbursed in three instalments, disbursed evenly throughout the MFA’s duration, provided that the policy measures attached to each tranche have been fully implemented in a timely manner.

The assistance will be managed by the Commission. Specific provisions on the prevention of fraud and other irregularities, consistent with the Financial Regulation, are applicable.

The Commission and the Moldovan authorities would agree on a Memorandum of Understanding setting out the structural reform measures associated with the proposed MFA operation, including aspects of timing and sequencing. Moreover, as is normally the case with MFA, the disbursements would inter alia be conditional on satisfactory reviews under the IMF programme, as well as progress on the implementation of the EU Moldova Association Agreement and the DCFTA. The Commission will work closely with the authorities to monitor progress on the policy actions and the pre-conditions, as specified above.