Explanatory Memorandum to COM(2023)74 - Providing macro-financial assistance to North Macedonia - Main contents
Please note
This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2023)74 - Providing macro-financial assistance to North Macedonia. |
|---|---|
| source | COM(2023)74  |
| date | 06-02-2023 |
1. CONTEXT OF THE PROPOSAL
• Reasons for and objectives of the proposal
Given the strong dependence of North Macedonia on imported energy, soaring gas and electricity prices led to a significant deterioration of the external balances in 2022. Underpinned by sound economic and monetary policy and committed reform implementation, the economy was on track to recover from the COVID-19 induced setback. However, the steep rise in global food and energy prices began to take its toll on domestic demand and the country’s external balance. A significant widening of the country’s trade and current account deficit has emerged since the beginning of 2022 despite strong inflows of remittances from abroad. Foreign reserves declined in the early months of 2022, mainly in response to rising import prices and external debt repayments, but have stabilised since the summer. Year-on-year GDP growth still averaged 2.6% in the first half of 2022 but slowed to 2% in the third quarter. High uncertainty over the economic fallout from Russia’s war of aggression against Ukraine, rising inflation and tighter financing conditions are set to curtail domestic demand further. Exports are impacted by weaker external demand and by ongoing supply chain disruptions, particularly those affecting the production of automotive components, one of the country’s main export sectors.
Against the backdrop of tighter global financial conditions, higher energy prices and higher-than-expected losses by the domestic state-owned electricity producer, the government of North Macedonia renewed its request for macro-financial assistance (MFA) on 18 October 2022. The Commission had put the government’s initial request for MFA, submitted on 19 April 2022, on hold, mainly because the economy was still relatively resilient and because there were some other options to meet external financing needs in 2022. In April, the government had already secured Staff Approval from the International Monetary Fund (IMF) for a 24-month precautionary and liquidity line (PLL) of up to EUR 530 million, which was officially approved by the IMF Executive Board on 22 November 2022. The IMF estimates that the country’s external financing needs in 2023 will amount to some EUR 1.5 billion, reflecting a large current account deficit and high repayments on external government debt (including a Eurobond that will mature in July 2023). Given significant uncertainties regarding the availability and costs of external market financing (which is assumed to cover over half of the country’s 2023 external financing needs), the Commission is now submitting a proposal to the European Parliament and the Council to provide an MFA loan of up to EUR 100 million to North Macedonia. The proposed legal basis will be Article 212 of the Treaty on the Functioning of the European Union.
The proposed MFA would help North Macedonia to cover part of the country’s residual external financing needs in 2023, which are estimated at EUR 800 million under the IMF’s baseline scenario. The operation would reduce the economy’s short-term balance of payments and fiscal vulnerabilities and demonstrate the EU’s support for the country when addressing this challenging situation. Its design and implementation would take account of the policy guidance agreed in the Joint Conclusions of the Economic and Financial Dialogue between the EU and the Western Balkans and Türkiye of 24 May 2022 1 , as well as the programme North Macedonia has agreed with the IMF 2 .
The disbursement would take place in two instalments. The release of each instalment would be conditional on progress being made with the implementation of a number of policy measures to be agreed between the Commission and the authorities and listed in a Memorandum of Understanding (MoU) as well as on a satisfactory track record implementing the IMF programme. The MoU is likely to focus on policy reforms addressing fiscal governance, tax policy, the management of public investment, public-private partnerships, business environment, transparency in state aid, energy efficiency, judiciary reform, and the fight against corruption. The policy measures will aim to address some of the most important weaknesses of the economy of North Macedonia and its economic governance system.
As further detailed in the Commission Staff Working Document accompanying this proposal, the Commission considers, based also on its assessment of the political situation, that the political and economic pre-conditions for the proposed MFA operation have been satisfied.
• General context
Following a partial recovery from the pandemic-induced recession, North Macedonia has been severely hit by the fallout from Russia’s war of aggression against Ukraine. GDP dropped by 4.7% in 2020 but rebounded by 3.9% in 2021, driven by domestic demand. Remittances from abroad returned to pre-crisis levels and bolstered household’s disposable income. COVID-19 containment measures were gradually lifted. Growth slowed towards the end of 2021 as external demand weakened, disruptions in global supply chains grew and global food and energy prices started to rise rapidly (fuelled further by the fallout from Russia’s war of agression against Ukraine in 2022). North Macedonia has limited direct exposure to Russia or Ukraine, but its economy is vulnerable to rising commodity prices. Government efforts to mitigate the impact on households and small business have caused fiscal spending to increase well above the initial budget. Sharply rising food and energy prices pushed inflation to almost 20% in the autumn of 2022. GDP grew by 2.6% in the first half of 2022, thanks in part to a rise in investment, but this rise was largely due to increases in companies’ stocks. Annual growth slowed to 2% in the third quarter of 2022.
The external position started to deteriorate in late 2021 as import prices rose sharply. The current account deficit stood at 3.5% of GDP in 2021 (the same as in 2020). This was above the 2017-2019 average of 1.5%. However, the goods trade balance has deteriorated steadily since the last quarter of 2021, largely on account of rising energy prices and reflecting the country’s high dependence on energy imports. The economy imports over 30% of its domestic energy needs and fully relies on imports for gas and oil. Driven by the sharply deteriorating energy balance, the four-quarter moving average current account deficit rose to 7.3% of GDP in the third quarter of 2022, compared to 1% in the third quarter of 2021. This was despite a marked increase in private transfers (remittances) and the services surplus, which was helped by a rebound in tourism. The external debt ratio had decreased each year between 2016 and 2019 but jumped by 7.3 percentage points (pps.) in 2020 to 80.3% of GDP and rose further to 81.4% in 2021, mainly as a result of continued foreign financing for crisis-induced needs.
Foreign reserves dropped heavily in the first half of 2022, mainly due to higher energy imports and external debt repayments. Foreign exchange reserves declined by over 14% in the first half of 2022 due to the increased conversion of domestic denar-denominated savings into euro; a surge in energy imports; external debt payments; and decreasing valuations of securities holdings. In early 2022, during a period of high energy imports, the central bank intervened in the foreign exchange market to support the de facto exchange rate peg to the euro. Forex markets stabilised somewhat over the summer due to seasonally high inflows of foreign currency that exceeded central bank expectations and supported by a EUR 250 million private placement of government securities in Germany in September. Foreign exchange reserves increased each month between July and December to reach 100% of the IMF’s reserve adequacy metric and now correspond to 3.9 months of imports. However, reserves are expected to decline again as the heating season progresses and energy imports increase further.
The central bank has been tightening monetary policy to counter rising inflation expectations and protect the de facto exchange rate peg. Headline inflation rose to 19.8% in October 2022, reflecting the high pass-through of the global energy and food price shock, but abated somewhat in November and December. Since April 2022, the policy rate has been raised by 350 basis points in eight consecutive hikes to 4.75%, thereby increasing the spread to the European Central Bank (ECB). The central bank also adjusted reserve requirement rates in June and September to dis-incentivise the shift into euro deposits that was a significant factor behind the fall in reserves in early 2022. These actions have reduced inflation expectations and pressures on the exchange rate.
The authorities have responded to the external shocks with significant fiscal support. In addition to ongoing expenditures to support the energy sector and maintain subsidised electricity prices for households, the authorities of North Macedonia adopted a EUR 400 million package of measures in March 2022, and another one in October, worth EUR 350 million, to protect households from rising food and energy prices, and to help firms maintain liquidity. Largely on account of under-implementation of the capital expenditure budget, the fiscal deficit for the full year of 2022, at 4.3% of government-projected GDP, remained below the revised target (5.3%) and in line with the government’s initial target. The government intends to continue supporting the loss-making domestic electricity producer and end customers also in 2023, yet in a more targeted fashion. The level of general government debt and public debt (including the debt of state-owned enterprises) remained moderate but rose markedly in 2020 and 2021, reflecting high fiscal deficits and, in 2020, the fall in GDP.
The 2023 budget, adopted by the Parliament in December 2022, raises the fiscal deficit target (compared with original plans outlined in the May 2022 medium-term fiscal strategy) from 4.2% to 4.6% of GDP. At the same time, the government lowered the real GDP growth projection for 2023, to 2.9%. The 2023 budget provides for a small consolidation effect from the withdrawal of some fiscal stimulus measures as well as a reduction in subsidies to the state-owned electricity company. It is based on a number of fiscal consolidation measures, in particular revenue-enhancing reforms of the tax system, which the government adopted in December 2022. In line with the policy guidance of the May 2022 Joint Conclusions, crisis-related fiscal support is projected to become better targeted to vulnerable groups.
The Commission’s autumn forecast projects moderating growth and some decline in the fiscal deficit after 2022, while risks are clearly to the downside. GDP growth in 2022 and 2023 is set to slow to 2.3% and 2.5% respectively as high inflation weighs on domestic demand. The fiscal deficit is set to remain high in 2023 due to the continuing need to support the economy during the energy crisis. The government may therefore have to postpone its plans for fiscal consolidation by another year. At the same time, the government is committed to implementing its reform agenda in public financial management. The new organic budget law, adopted by the Parliament in July 2022, puts a cap on the fiscal deficit (3% of GDP in non-crisis times) and on general government debt (60% of GDP), and will, once applied, anchor fiscal policy in the medium term. The growth outlook could be challenged if geopolitical challenges lead to further energy and food price shocks, possibly in combination with a further tightening of global financial conditions and more difficult access to capital for emerging market economies. On the other hand, the EU accession process could bolster reforms, fiscal and external sustainability, including through the further strengthening of foreign direct investment inflows.
External financing needs are high in 2023 and market conditions remain volatile. The IMF has estimated the country’s external gross financing needs in 2023 at EUR 1.5 billion. This includes high debt refinancing needs, which mainly result from the government’s need to repay its 2016 Eurobond worth EUR 450 million. Overall, the IMF assumes that the government will raise EUR 800 million in external market borrowing. This may prove challenging, given current geopolitical uncertainties and a difficult financing environment. North Macedonia has a track record of steady sovereign access to international capital markets at favourable terms. Yet sovereign spreads have increased considerably over the past months, against the backdrop of the global tightening in financial conditions, and plans to issue Eurobonds have been put on hold across the Western Balkans. In this context, the proposed MFA would help North Macedonia meet its residual financing needs.
• Consistency with existing policy provisions in the policy area
The European Parliament and the Council adopted Decision (EU) 2020/701 on providing previous macro-financial assistance to enlargement and neighbourhood countries in the context of the COVID-19 pandemic on 25 May 2020. This provided North Macedonia with EUR 160 million in loans that were fully disbursed in 2020-2021.
• Consistency with other EU policies
The EU and North Macedonia concluded a stabilisation and association agreement in 2001, which entered into force in 2004. The Council granted candidate status to the country in 2005. Since October 2009, the Commission has continuously recommended to open accession negotiations with North Macedonia. In March 2020, the European Council endorsed the Council’s decision to open accession negotiations with North Macedonia 3 . On 19 July 2022, the first Intergovernmental Conference on accession negotiations took place with North Macedonia, following the approval of the Negotiating Framework by the Council. The Commission immediately launched the analytical review of the EU acquis (screening) process, which is the first step in the negotiating process.
The EU is the most important trade partner for North Macedonia. In 2021, the EU accounted for 77.3% of the total exports and for 46.2% of the total imports of North Macedonia. EU countries are also the most important investors in North Macedonia, accounting for 56% of total FDI inflows in 2021 and for 62% of total FDI stock in 2020.
EU candidate countries are eligible for MFA if they fulfil certain conditions. The EU MFA would complement and enhance the effectiveness of other financial assistance to the country, such as that offered under Instrument for Pre-Accession (IPA) operations, including budget support. This includes EUR 80 million of EU budget support under the new EUR 1 billion EU Energy Support Package for the Western Balkans.
2. LEGAL BASIS, SUBSIDIARITY AND PROPORTIONALITY
• Legal basis
The legal basis for this proposal is Article 212 of the Treaty on the Functioning of the European Union (TFEU)
• Subsidiarity (for non-exclusive competence)
The proposal complies with the subsidiarity principle because the objective of stabilising the external position of North Macedonia 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 because it is limited 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 , on the basis of IMF estimates in the context of the PLL, the amount of the proposed new MFA corresponds to about 12.5% of the govenrment’s external financing needs in 2023. Given the precautionary nature of the IMF programme (which is due to disburse support in 2023 and only ‘if needed’ in 2024), this is consistent with other MFA operations’ burden-sharing practices.
• Choice of 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 with 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 North Macedonia 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 North Macedonia. The Commission services have consulted with the IMF and the World Bank when preparing this proposal. The Commission has also been in regular contact with the authorities of North Macedonia.
• Collection and use of expertise
In line with the requirements of the Financial Regulation, the Commission services carried out, in June 2020 and in the context of the COVID-19 MFA operation, an operational assessment of the financial and administrative processes of North Macedonia, in order to ascertain that the procedures in place for the management of programme assistance, including MFA, provide adequate guarantees. The assessment was based on established methodology and drew on existing documentation from the Commission’s budget support programmes with North Macedonia and its technical assistance for improving the public finance management (PFM) system. It found that North Macedonia meets the eligibility requirement to have a sufficiently credible and relevant programme to improve public finance management for budget support from the EU. The compliance of the country’s PFM system with basic budget support requirements was confirmed by the latest PEFA report of May 2022. The Risk Management Framework 2021 evaluated the PFM risk of North Macedonia as moderate.
• Impact assessment
The EU’s MFA is an exceptional emergency instrument aimed at addressing severe balance-of-payment difficulties in non-EU countries. This MFA proposal is exempted from the requirement to carry out an impact assessment in accordance with the Commission's better regulation guidelines 4 because there is a political imperative to move ahead quickly in a situation that requires a rapid response.
More generally, the Commission's MFA proposals build on lessons learned from ex post evaluations carried out on past operations in EU candidate countries. The new MFA and the associated economic adjustment and reform programme will help alleviate the short-term financing needs of North Macedonia and support policy measures to strengthen the medium-term balance of payments, fiscal sustainability and sustainable growth, thus complementing the PLL programme adopted by the IMF’s Executive Board in November 2022. The policy conditions should address some of the most important weaknesses of the country’s economy and economic governance system. Possible areas of conditionality could in principle include reforms to strengthen fiscal governance, tax policy, the management of public investment, public-private partnerships, the business environment, transparency in state aid, energy efficiency, reform of the judiciary and the fight against corruption.
• Fundamental rights
EU candidate countries 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.
As noted in the 2022 Commission Communication on EU Enlargement Policy 5 , the launch of the EU accession negotiations process with North Macedonia in 2022 was a major breakthrough and marked the beginning of a new phase in relations between the EU and North Macedonia. As also noted in the Communication, the legal framework on the protection of fundamental rights in North Macedonia is largely in line with EU standards, but implementation needs to be improved.
4. BUDGETARY IMPLICATIONS
The proposed MFA operation of up to EUR 100 million for North Macedonia is planned to be disbursed in two equal tranches to be released between 2023 and 2024. The required provisioning of the loan of EUR 100 million at a rate of 9% of the External Action Guarantee will be programmed under the IPA for a total amount of EUR 9 million (budget line 15.020203 IPA III – Provisioning of the Common Provisioning Fund (External Action Guarantee – MFA).).
5. OTHER ELEMENTS
• Implementation plans and monitoring, evaluation and reporting arrangements
The European Union will make the MFA available to North Macedonia for a total amount of up to EUR 100 million, which will be provided in the form of medium- to long-term loans and will help cover North Macedonia’s residual financing needs in 2023-2024. The assistance is planned to be disbursed in two tranches at regular intervals during the MFA’s duration, provided that the policy measures attached to each tranche have been fully implemented.
The Commission will manage the MFA. Specific provisions on the prevention of fraud and other irregularities that are consistent with the Financial Regulation are applicable.
The Commission and the authorities of North Macedonia will agree on an MoU 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 be conditional on a number of points including satisfactory reviews under the IMF programme. The Commission will work closely with the authorities of North Macedonia to monitor progress on the policy actions and the preconditions that have been specified above.