Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 33494-MK

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT FOR A PROPOSED FIRST PROGRAMMATIC DEVELOPMENT POLICY LOAN

IN THE AMOUNT OF EURO 24.4 MILLION (US$30 MILLION EQUIVALENT)

TO

THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA

September 28,2005

Poverty Reduction and Economic Management Unit Europe and Central Asia Region

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

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CAS CFAA

CSA CSL ECA EU

FDI

FESAL 2

FSAP

FYR

GDP H C I HIL

HIF

HIPC

IBRD

IFC I L O IMF

GOVERNMENT FISCAL YEAR (JANUARY 1 -DECEMBER 31)

CURRENCY EQUIVALENTS (Exchange Rate Effective as o f (June 8,2005))

Currency Unit US$ l .oo 50.03 Denar Euro1 .OO 61.41 Denar

WEIGHTS AND MEASURES Metr ic System

ABBREVIATION AND ACRONYMS

Country Assistance Strategy Country Financial Accountability Assessment Agency for Civ i l Servants Civ i l Service Law Europe and Central Asia European Union

Foreign Direct Investment

Second Financial and Enterprise Sector Adjustment Loan Financial Sector Assessment Program Former Yugoslav Republic o f Macedonia Gross Domestic Product Health Care Institution Health Insurance Law

Health Insurance Fund

Heavily Indebted Poor Countries

International Bank for Reconstruction and Development Intemational Finance Corporation International Labor Organization International Monetary Fund

M O E M O F

NBRM PSAL MOH PSMAC

PSMAL

PDPL

ROSC

SA0

SBA SDP SFRY

SME

USAID

VAT

Ministry o f Education Ministry o f Finance

National Bank o f Macedonia Programmatic Adjustment Loans Ministry o f Health Public Sector Management Adjustment Credit Public Sector Management Adjustment Loan Programmatic Development Policy Loan Report on the Observance o f Standards and Codes State Audit Office

Stand-By Arrangement Supervisory Development Plan Socialist Federal Republic o f Yugoslavia Small and Medium-Sized Enterprises U S Agency for International Development Value Added Tax

Vice President: Shigeo Katsu

Sector Director Cheryl Gray Sector Manager: Bemard Funck

Task Team Leader: Bruce Courtnev

Country Director: Orsalia Kalantzopoulos

I.

11.

111.

IV.

V.

VI.

This document has a restricted distr ibution and may be used b y recipients only in the performance o f their official duties. I t s contents may no t be otherwise disclosed without W o r l d Bank authorization. -

FOR OFFICIAL USE ONLY THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA

FIRST PROGRAMMATIC DEVELOPMENT POLICY LOAN TABLE OF CONTENTS

INTRODUCTION ........................................................................................................................... 1

COUNTRY CONTEXT .................................................................................................................. 1

RECENT ECONOMIC DEVELOPMENTS IN FYR MACEDONIA...... ........................... 1 MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ................................ 3

THE GOVERNMENT PROGRAM ............................................................................................. 4

BANK SUPPORT TO THE GOVERNMENT STRATEGY ..................................................... 5

LINK TO CAS. ......................................................................................................................... 5

ANALYTICAL UNDERPINNINGS ...................................................................................... 7

THE PROPOSED PDPL REFORM PROGRAM ....................................................................... 7

COLLABORATION WITH THE IMF AND OTHER DONORS ....................................... 6

OPERATION IMPLEMENTATION ........................................................................................ 22

POVERTY AND SOCIAL IMPACTS ................................................................................. 22 FIDUCIARY ASPECTS ................................................................................................... .....23 DISBURSEMENT AND AUDITING ................................................................................... 25 ENVIRONMENTAL ASPECTS .......................................................................................... 2 6 LESSONS LEARNED FROM PRIOR OPERATIONS ...................................................... 26 MONITORING AND EVALUATION ........................................................................... ......26 RISKS AND R I S K MITIGATION ....................................................................................... 27

TABLES

Table 1: Table 2:

ANNEXES

Annex 1: Annex 2: Annex 3: Annex 4: Annex 5: Annex 6: Annex 7 : Annex 8 : Annex 9 : Annex 10 : Annex 11: Annex 12:

FYR Macedonia Key Economic Indicators Summary o f the Proposed PDPL Program

Letter o f Development Policy PDPL Policy Matrix FYR Macedonia - At a Glance Social Indicators Key Economic Indicators Key Exposure Indicators Operations Portfolio (IBRD and grants) Statement o f IFC’s Committed and Outstanding Portfolio Selected Indicators o f Bank Portfolio Performance and Management IFC and MIGA Program Summary o f Non-Lending Services Fund Press Release

LOAN AND PROGRAM SUMMARY

THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA FIRST PROGRAMMATIC DEVELOPMENT POLICY LOAN

I Borrower Amount +

I Tranching Description r

Former Yugoslav Republic o f Macedonia

€24.4 mi l l ion (US$ 30 mi l l ion equivalent)

Payable in 17 years, including 5 years o f grace and level principal repayment, at 6-month LIBOR for Euro plus variable spread for Variable-Rate Single Currency Loans

1 .OO% o n the principal amount, capitalized less any waiver

0.75% on undisbursed loan balances, beginning 60 days after signing, less any waiver

Single tranche

The loan would be the f i rs t in a series o f three proposed Programmatic Development Policy Loans (PDPLs) designed to support the Government’s economic reform program over a three to four year period. The program aims to promote economic growth and job creation through reforms to improve the investment climate and reforms to strengthen the governance and efficiency o f the public sector.

Pil lar 1 : Improving the investment climate 0 Judicial reform

Labor market reform 0

0 Improving the business environment Strengthening financial sector regulation and supervision

Pi l lar 2: Strengthening public sector governance 0 Public administration reform

Health sector reform 0 Decentralization

The PDPL will help the Government implement a medium-term reform program aimed at promoting growth and j o b creation through improvements in the investment climate. The program also aims at improving the governance and efficiency o f the public sector. The reform program would be consistent with the Government’s aspiration for eventual EU membership

Capacity weakness could impede full implementation o f some proposed reforms. The current capacity o f some public sector institutions to

.. .. 11

I Proiect ID Number I Map

implement an ambitious reform agenda remains relatively weak. However, the risk i s mitigated through the continued use o f donor financed technical assistance and f i o m ongoing and proposed Bank investment projects in health, social protection, judiciary, and business environment.

There are also some political risks. Whi le the threat o f renewed ethnic violence i s modest, the continued uncertainty over the status o f neighboring Kosovo i s pending. Also, the ambitious reform agenda that the PDPL proposes to support could test the Government’s commitment to reform as the elections in Autumn 2006 approach. The domestic polit ical r isks are mitigated by the broad consensus across the political and ethnic spectrum for integration with European structures. The continued implementation o f both economic reforms and o f the Ohrid agreement are widely recognized as essential steps o n the path to EU membership.

FYR Macedonia also faces macroeconomic r isks. Whi le FYR Macedonia has an impressive track record o f macroeconomic stability and prudent macroeconomic policies which have n o w been bolstered by a 3 year IMF Stand-By Arrangement, the projected reduction in external current account imbalances could prove diff icult to achieve if exports growth i s not sustained. The risk would be mitigated to the extent that PDPL supported reforms would stimulate growth in productivity over time and/or generate an increase in savings. In addition, to the extent that the improved investment climate attracts higher flows o f foreign direct investment, a higher current account deficit could be financed without incurring additional external debt.

PE-PO90303 IBRD No.33438

The First Programmatic Development Policy Loan was prepared by a Bank team consisting o f Bruce Courtney (Task Team Leader), Sarbani Chakraborty, Rajna Cemerska, Arvo Kuddo, (ECSHD); David Bemstein, Borko Handziski, Evgenij Najdov, Gary Re id (ECSPE); Gerhard Botha, Silvia Minotti, Jasminka Vamalieva, Robert Gourley (ECSPF); and Andy Macdonald (consultant).

The peer Reviewers were: Simeon Djankov (CICMA), Randi Susan Ryterman (PRMPS), and Loraine Hawkins (EASHD).

... 111

IBRD PROGRAM DOCUMENT FOR A PROPOSED FIRST PROGRAMMATIC DEVELOPMENT POLICY LOAN

TO THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA

I. INTRODUCTION

1. This Program Document presents the f irst in a series o f three proposed Programmatic Development Pol icy Loans (PDPLs) to the Former Yugoslav Republic (FYR) o f Macedonia to support FYR Macedonia’s structural reform program. The current loan i s in the amount o f €24.4 mi l l ion (US$30 mi l l ion equivalent) and i s expected to be followed by two further PDPLs which would be the centerpieces o f the next C A S covering FY07- 09. The PDPLs are expected to be complemented by a number o f investment loans in selected areas and analytical and advisory services.

2. The objective o f the proposed PDPLs would be to promote economic growth and j o b creation in FYR Macedonia through improving: (i) the investment climate; and (ii) governance and efficiency o f the public sector. The proposed PDPLs will be designed to ensure consistency with the Government’s aspiration o f eventual EU accession.

3. The proposed PDPLs would fo l low up o n the reforms initiated under the recent Public Sector Management Adjustment Loan (PSMAL) and the Second Financial and Enterprise Sector Adjustment Loan (FESAL 2) as wel l as the reforms identified in the recent Financial Sector Assessment Program (FSAP).

4. The proposed reform program has been developed jo in t ly with the Government, and it has been coordinated closely with other development partners, in particular with the International Monetary Fund (IMF) to ensure consistency with the Stand-By Arrangement (SBA) approved o n August 3 1,2005.

11. COUNTRY CONTEXT

RECENT ECONOMIC DEVELOPMENTS IN FYR MACEDONIA

5. FYR Macedonia was among the least developed republics o f SFRY. By the time o f independence in 1991, FYR Macedonia’s economy had been contracting for more than six years. This contraction accelerated during the f i rs t years o f independence. Between 1991 and 1994, GDP declined by about 20 percent. The recession was accompanied by hyper-inflation and budget deficits that reached 13 percent o f GDP. The Government launched an impressive stabilization program in 1994, centered on a sharp fiscal adjustment and de facto pegged exchange rate, which succeeded in bringing inflation down to single digits by 1996 and reducing the budget deficit to moderate levels. The decline in economic activity leveled out in 1994 and modest economic growth resumed in 1996.

6. During the period o f 1996-2000, the Government maintained macroeconomic stability and undertook a number o f modest structural reforms. Inflation averaged about 2.5 percent per annum during this period and the budget was balanced. However, the current account deficit remained high at about 7.5 percent o f GDP until the Kosovo crisis in 1999.’ Market pressures forced a 15.5 percent devaluation o f

’ During the Kosovo crisis both imports and exports fel l abruptly. However, the swift resolution o f the crisis, return o f refugees and reconstruction in Kosovo led to a late year boom in Macedonian exports which carried over into

the denar in mid-1997, but otherwise the de facto peg was maintained. A majority o f socially-owned enterprises were privatized in this period, albeit largely into the hands o f insiders. Thus, post-privatization restructuring was l imi ted and corporate govemance remained a concem. Financial sector reforms were also initiated especially in the latter part o f this period following the collapse o f a significant pyramid scheme in 1997. The largest bank in FYR Macedonia was recapitalized and privatized to a strategic foreign investor in 2000. Also, important improvements were made in the regulatory and supervisory framework o f the banking sector in this period. Despite these efforts, the enterprise sector’s access to credit remained l imi ted as the volume o f loans remained l o w while lending rates and spreads remained high. Trade reform was undertaken as tariffs were reduced and import licenses abolished and the first hesitant steps towards labor market reform were begun.

7. Despite the modest reform effort, economic growth gradually picked up, with each year in this period registering a higher growth rate than the previous year. In 1999 and 2000 real GDP growth reached 4.5 percent. However, growth remained narrowly based o n a few key industries (steel and textiles) and the investment to GDP ratio remained modest by region standards (2 1 percent in FYR Macedonia versus 28 percent in fast growing Central European countries) while the unemployment rate remained high at over 30 percent through-out this period.2

8. The c i v i l conflict in 2001 disrupted this positive economic momentum. Whi le direct conflict damage was limited, output contracted by 4.5 percent. Investment activity markedly dropped and defense- related expenditures pushed the budget and current account deficits to 7 percent o f GDP. In August 2001, an intemationally mediated cease fire, the Ohrid Agreement, l ed to an end o f hostilities. The effects of the conflict were s t i l l clearly felt in 2002 as GDP, investment and export growth remained sluggish while the budget and current account deficits remained high. .

9. The new Government that took office in November 2002 was confronted by a deteriorating current account deficit following a surge in imports concurrent with sluggish export growth. In 2002, the current account deficit reached 9.4 percent o f GDP and international reserves fel l to 3.9 months o f imports. In April 2003, a new IMF Stand-by Arrangement (SBA) was approved. The program focused on fiscal adjustment to reverse transient expenditures associated with the conflict in 2001 and the pre- election spending in 2002. The budget deficit was abruptly cut f rom 5.6 percent o f GDP in 2002 to 0.1 percent o f GDP in 2003. Since this deficit was much smaller than agreed under the IMF program, the program called for a slight relaxation o f fiscal pol icy in 2004 relative to the 2003 outcome. However, in 2004 once again the fiscal pol icy was tightened further than programmed, as the budget moved to a surplus o f 0.7 percent o f GDP.

10. Whi le the tight fiscal pol icy helped reduce the current account deficit to about 3.2 percent o f GDP in 2003 a number o f one-off factors contributed to a relapse in 2004 to about 7.7 percent o f GDP. Also l o w capital inflows led to a reduction in the import coverage o f international reserves which fel l to 3.2 months by end-2004. Given the exchange rate anchor the fall ing international reserve cover forced the National Bank o f Macedonia (NBRM) to tighten monetary pol icy even as growth slowed in 2004 and even as the official consumer price index declined, registering an average deflation o f 0.4 in 2004 and 2.0 percent at end-December.

1 1. Clearly, macroeconomic policies over the past decade have built up an impressive track record o f macroeconomic stability. Inf lat ion has been held to single digits for a decade. Unl ike many countries in

~~

2000. Also official transfers to Macedonia increased substantially in the wake o f the Kosovo crisis. The current account deficit averaged 1.5 percent o f GDP during 1999 and 2000. The official data on unemployment almost certainly overstate the actual unemployment rate by a significant

degree. See the 2003 CEM.

2

the region, external and public debt ratios have remained modest. Over the past decade, gross external debt and gross publ ic debt have slowly fallen to about 40 percent o f GDP.

12. However, economic growth and formal sector j ob creation have been disappointing. While real GDP rose to about 3 percent in 2003 and 2004, such growth rates place FYR Macedonia among the slowest growing economies in ECA in this period. Also, the recovery remains narrowly based on a few key sectors and the unemployment rate remains extremely high. Whi le official data probably overstate true unemployment, at over 30 percent, FYR Macedonia’s official unemployment rate i s one o f the highest among transition countries. High and persistent unemployment reflects l o w new job creation in the formal sector. In part this i s due to an overly restrictive labor market and high payroll taxes. In part i t i s due to the poor corporate governance which emerged following privatization. An overly burdensome business regulatory environment also hampers new business startups and j o b creation. Collectively, these forces contribute no t only to FYR Macedonia’s high unemployment rate but also encourage informality. Some estimates suggest that the informal economy in FYR Macedonia i s we l l over 40 percent o f GDP.

13. Conversely, at about 20 percent o f GDP the investment rate in FYR Macedonia has lagged significantly behind faster growing economies in the region. The f l ow o f FDI into FYR Macedonia has also been disappointing over the past decade. Apart from the spike in FDI in 2000 and 2001 when the largest bank and the telecom company were privatized, FDI has averaged 1.5 percent o f GDP, one o f the lowest rates among transition countries. Business climate surveys indicate that the most serious obstacles to private sector development include: an inefficient and opaque judic ia l system, poor access to credit, heavy regulation (especially in labor markets), polit ical risks, corruption, and pol icy unpredictability.

MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY

14. The Government has launched a comprehensive structural reform program which i s proposed to be supported by a series of PDPLs (see below). Assuming continuing improvements in regional and domestic stability and strong pol icy performance, the medium-term outlook i s positive and would be considered sustainable for the purposes o f the PDPL program. GDP growth i s expected to accelerate modestly to 3.7 percent in 2005 as the re-opening o f large steel mi l ls under new ownership has contributed to a broad increase in industrial production. The full implementation o f key reforms should reduce the structural bottlenecks that s t i l l affect investment. These reforms are l ikely to lead to a gradual increase in the investment to GDP ratio as the investment climate improves by 2008. GDP growth i s projected to continue to slowly increase to 4.5 percent during this period. Inf lat ion turned marginally positive early in 2005 and i s projected to increase to over one percent in 2005 and to about 2 percent by 2007 and 2008.

15. On August 31, 2005 a new three year S B A was approved by the IMF Board. The program envisages budget deficits of 0.8 percent o f GDP in 2005 and 0.6 percent o f GDP in 2006-2008. Such a fiscal stance would continue the gradual reduction in the public debt t o GDP ratio o f recent years f rom about 40 percent o f GDP to below 35 percent by the end o f the program. Debt sustainability analysis conducted by the JMF for the new S B A suggests that public debt sustainability i s robust under al l shocks except an implausibly large GDP shock.

16. The current account deficit in 2005 is, projected to fa l l t o 6.5 percent o f GDP following the reversal o f the one-off factors o f 2004 noted above (see paragraph 108 o n macroeconomic risks). Prospects for export growth with reforms are expected to slowly improve as structural reforms improve the competitiveness o f FYR Macedonian companies. At the same time, tight fiscal pol icy should contain demand for imports. Under this reform scenario, the current account deficit i s projected to gradually decline below 5 percent o f GDP. The privatization o f the electricity company expected in early 2006 and other planned privatizations will help boost the international reserve cover to about 4 months o f imports. The evolution o f external debt would be benign under this scenario. Gross external debt i s projected to

3

remain below 40 percent o f GDP and the debt service ratio i s projected to remain below 10 percent with the exception o f 2006 when a large repayment o f Brady bonds falls due. Debt sustainability analysis conducted by the IMF for the new S B A suggests that extemal debt sustainability underscores the need for structural reforms. Bound tests point to temporary vulnerabilities before debt ratios retum to a declining path. But a scenario based on key variables reverting to historical levels (slow growth, l o w foreign direct investment, and wide current account deficits) indicates that debt sustainability could become unsustainable. This highlights the disappointing economic performance o f the past decade and stresses the need to reduce the current account deficit, attract foreign direct investment, and accelerate growth.

Table 1: FYR Ma

National Accounts GDP (US$ mill ion) Real GDP growth rate Investments (percentage o f GDP) Gross National Savings (percentage o f GDP)

Fiscal Accounts (percentage o f GDP) Expenditures Revenues, including grants Deficit, including grants

External Accounts (Percentage o f GDP) Exports o f Goods and Services Imports o f Goods and Services Current Account balance, including transfers External debt Gross reserves (months o f imports)

Inflation

Sources: Ministry o f Finance; National Bank o f tt projections.

Consumer Prices (period average)

!donia Key Economic Indicators 2003 2004 2005 2006 2007 2008

Actual Estimate Projected

4,666 2.8 19.8 16.6

38.2 38.1 -0.1

37.6 54.4 -3.2 40.2 4.1

1 9

5,355 2.9

21.6 13.9

35.9 36.6 0.7

40.1 60.6 -7.7 37.5 3.2

5,609 5,937 3.7 4.0

21.7 21.9 15.2 16.2

38.8 35.3 38.0 34.8 -0.8 -0.6

44.1 44.9 63.7 63.3 -6.5 -5.7 38.2 37.1 3.6 4.1

6,329 4.5 22.3 17.3

33.9 33.3 -0.6

45.5 62.8 -5.0 35.7 4.2

6,756 4.5 22.8 18.3

33.1 32.5 -0.6

46.0 62.3 -4.5 34.5 4.3

1 .L -0.4 1.2 1.8 2.0 2.0 Republic o f Macedonia; State Statistics Office; and World Bank staff

17. Gross extemal financing requirements are expected to increase in 2006 to about $800 mi l l ion largely due to the expected build up o f international reserves and the Brady bond repayment. Depending on market conditions and markets perceptions o f FYR Macedonia’s improved creditworthiness, the Govemment i s considering i ts f i rst issuance o f a Eurobond in late 2005. Gross external financing requirements are then expected to fa l l back towards $600 m i l l i on in 2007 and 2008. The IMF program i s expected to move to a precautionary mode fol lowing an in i t ia l purchase o f SDR 10.5 mill ion.

111. THE GOVERNMENT PROGRAM

18. In M a y 2005 the Govemment adopted an economic program which builds on the policy agenda implemented during the f i rs t two years o f the Government’s tenure. The policy agenda focuses o n improving living standards, ensuring polit ical and social stability, supporting j o b creation, and reducing corruption. This program i s broadly consistent with the Government’s commitments under the Stabilization and Association Agreement (SAA) with the EU. In fact, the broad consensus across the political spectrum for European integration has emboldened the Government to accelerate structural reforms and to implement the Ohnd Agreement. FYR Macedonia was the f i rst country to s i g n an S A A

4

with the EU (April 2001). The S A A requires the gradual alignment o f laws, institutions and policies to the acquis communautaire. FYR Macedonia formally submitted an application to the EU in April 2004.

19. The Government implemented a reform program supported by the Public Sector Management Adjustment Loan (PSMAL) the final tranche o f which was released in June 2005. These reforms include: (i) budget formulation, aimed at increasing the usefulness o f the budget as a strategic policy instrument and ensuring that the Government i s capable o f formulating a budget within macroeconomic constraints; (ii) budget execution, aimed at strengthening the Treasury’s control over spending commitments and extrabudgetary funds; (iii) audit, aimed at establishing an internal audit department in the Ministry o f Finance (MoF) and in other key Government agencies, and also aimed at strengthening the external audit capacities o f the State Audit Office; (iv) improving procurement, through the adoption o f a new procurement l a w and the creation o f a specialized procurement bureau within the MoF; (v) civil service, aimed at improving mechanisms for merit-based hiring and introducing a uniform, decompressed salary structure for the c i v i l service; (vi) health sector reform, aimed at improving the intemal control system in the Health Insurance Fund (HiF) as wel l as in the procurement o f drugs; and (vii) social protection reform, aimed at improving the administration and targeting o f social transfers.

20. The Govemment also has focused o n implementing the Ohrid Agreement which sets out specific reforms aimed at ensuring the rights o f minority communities. The agreement commits the Govemment to ensuring “equitable representation” o f minorities in FYR Macedonia’s public administration. Significant progress has been made in this respect despite the challenges posed by cuts in public sector employment, an overall freeze in the public sector wage bill and Government efforts at c i v i l service reform which aims at a merit-based recruitment strategy for the c i v i l service. Another major element o f the Ohrid Agreement i s a commitment to decentralize a substantial number o f Government functions to local governments. The Government has made progress in implementing the decentralization components of the Ohrid agreement. In July, 2004, Parliament approved a new law o n local finance. The most controversial step to date has been the enactment o f the l aw on territorial reorganization in August, 2004 which, having withstood the referendum in November 2004, n o w completes the basic legal framework for decentralization.

21. The M a y 2005 reform agenda focuses on maintaining a stable macroeconomic framework, reforms to improve the business environment, financial sector reform, labor market reform, and decentralization. This reform agenda also complements the Judicial Reform Strategy adopted in December 2004.

IV. BANK SUPPORT TO THE GOVERNMENT STRATEGY

LINK TO CAS

22. The CAS was discussed at the Board o n September 9, 2003 (Document No.R2003-0158). I t identifies three main objectives for Bank intervention: (i) to promote the efficient management o f public resources and tackle corruption; (ii) to promote reconciliation, build human capital and protect the most vulnerable; (iii) to promote j o b creation through private-sector-driven growth. The proposed PDPL would focus primarily on the f i rst and third o f these objectives. Technical assistance to implement the proposed reforms would be financed through the ongoing Dutch Trust Fund as wel l as the complementary Health Sector Reform Project, the Social Protection Implementation Project, and the Cadastre Project. The proposed Judicial Reform Project and the recently approved Business Environment and Institutional Strengthening Project would also support the implementation o f PDPL-supported reforms and have been designed in close collaboration with the design o f the proposed PDPL.

5

23, The C A S indicates the triggers for moving to the high case scenario, each o f which has been met.

0 Satisfactory macroeconomic performance as demonstrated by successful implementation o f a government program supported by the IMF.

0 Implement control over commitments to improve budget execution.

0 Amend the l a w o n public procurement and issue implementing regulations o n accountability and transparency.

0 Complete external audit o f the HIF’s systems o f control and develop and action plan to implement the recommendations.

0 Progress towards achieving CAS Outcome benchmarks.

i. Integrate extra-budgetary funds (EBFs) into budget preparation and reporting systems. Status: fully accomplished.

ii. Extend annual extemal audit coverage o f budget users f rom 10 to 25 percent. Status: good progress (see paragraph 97 below).

iii. Reduce average loan spreads from 9 percent t o 6-7 percent. Status: fully accomplished, loan spreads fel l to 5 percent by end 2004.

iv. Increase private sector participation in infrastructure. Status: good progress.

v. Increase access to agreed poverty monitoring datasets. Status good progress.

0 Maintain a maximum o f one problem project in the portfolio.

24. The high case scenario o f the CAS envisaged a program o f $165 mi l l ion including three adjustment loans: a Public Sector Management Adjustment Loan (PSMAL) o f $30 mi l l ion and two Programmatic Adjustment Loans (PSALs) o f $15 mi l l ion each in FY 2005 and FY 2006. The P S M A L was approved by the Board in FY 2004 as envisaged. The final tranche conditions o f the P S M A L have al l been met and the second tranche was released in June 2005. The PSALs have evolved into the proposed f irst PDPL presented in this Program Document. Given the Government’s strong pol icy performance and high financing requirements, the f i rst PDPL i s proposed to be in the amount o f $30 mi l l ion which i s the upper amount envisaged in the C A S for adjustment lending. The amount o f the proposed second and third PDPLs would be determined in the course o f the preparation o f the next CAS.

COLLABORATION WITH THE IMP AND OTHER DONORS

25. The new IMF program has a heavy structural component reinforcing a number o f reforms to be supported under the proposed PDPL. The Bank and Fund teams have coordinated intensively to ensure that: the two institutions give consistent pol icy advice and that areas o f overlap are l imi ted to supporting polit ically challenging and important reforms where the weight o f both institutions would be needed. Coordination has included participation in each other’s preparation missions and extensive intra-mission meetings between the two teams. This cooperation builds o n the close coordination under the current P S M A L and former Stand-by Arrangement as wel l as the jo in t Financial Sector Assessment Program (FSAP) report prepared in 2003. Also, Bank staff contributed to the recent Ex Post Assessment.

6

26. The PDPL team has worked closely with other donors active in FYR Macedonia. At the end o f each mission the team summarized their findings at a donor coordination meeting. Team members also visited the European Commission to exchange views o n the reform agenda ahead. The potential components o f the program have been proposed following close consultation with donors involved in each o f these areas. The other active donors include the Dutch Government, the European Agency for Reconstruction, the European Commission, USAID, and UK DFID.

ANALYTICAL UNDERPINNINGS

27. The proposed PDPL i s heavily based o n a series o f recent economic and sector work. The Country Economic Memorandum o f September 2003 focused on reforms needed to tackle unemployment and stressed the need for the simultaneous implementation o f labor market reforms and reforms to improve the investment climate. The FSAF' focused o n issues o f corporate and financial sector governance, bank regulation and supervision, the legal and judicial framework. In 2003, the C F A A and CPAR built o n the analysis o f the 2000 PER which together formed the basis for P S M A L supported reforms in public expenditure management including internal and external auditing, public procurement, and budget formulation and execution.

28. The Bank completed a Judicial Reform Assessment in June 2005. The work o n this assessment has come in time to in form the preparation o f the f irst proposed PDPL. A number o f important analytical studies began in M a y 2005 are yielding recommendations which will be incorporated into the second and third proposed PDPLs. These include a ROSC on corporate governance being carried out in conjunction with a study o n financial sector governance and a diagnostic o n financial sector supervision.

V. THE PROPOSED PDPL REFORM PROGRAM 29. A number o f factors discourage growth and j o b creation in FYR Macedonia. The exchange rate regime has not been sufficiently supported by key structural reforms and has thus required tight macroeconomic policies in an overly rigid economy. The results have been depressed growth and, more recently, deflation. Crit ical rigidities include the following. An inefficient and opaque judicial system obstructs creditor, contract and property rights and hampers the effectiveness o f key government agencies and supervisory bodies f rom enforcing administrative sanctions such as fines, penalties and actions to revoke licenses. Inflexible product and labor markets, high payroll taxes, a burdensome regulatory environment, and poor corporate and financial sector governance impede j o b and new business creation. A poorly functioning bankruptcy regime hinders firm exit and the secondary transformation o f ownership. These flaws in the investment climate are compounded by weak public sector governance which further undermines investor sentiment.

30. A series o f PDPLs i s proposed to support the Government's development policies across a number o f interconnected reform areas. The Government has recognized that comprehensive judicial reform i s urgently needed to firmly establish the rule o f l a w including creditor, contract and property rights. After engaging in a crit ical dialogue with social partners regarding an overhaul o f the labor l aw and institutions to introduce more flexibil i ty into FYR Macedonian labor markets, a new Labor L a w was enacted in July 2005. The Government also recognizes the importance o f increasing competition in the economy and the need to establish an environment that facilitates efficient entry and exit o f f i r m s as wel l as a regulatory environment which i s conducive to dynamic private sector activity. A corporate governance ROSC and a banking sector governance assessment were begun in M a y 2005. A diagnostic on financial sector supervision was conducted in July and August 2005. These assessments are yielding key recommendations which will be integrated into the second and third PDPLs. Finally, the Government remains committed to continuing reforms initiated under the P S M A C and P S M A L to build a meritocratic,

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rules-based, transparent public sector through the continuation o f public administration reforms, health care reforms, and decentralization as envisaged under the Ohrid agreement.

31. Sustained improvements in the investment climate would also require a reduction in perceived polit ical and geopolitical risk. The continued implementation o f the Ohrid Agreement, continued progress toward eventual EU membership, and the successful implementation o f a final status arrangement in neighboring Kosovo ultimately could prove as important to the investment climate in FYR Macedonia as the proposed PDPL reform program.

32. The objective o f the proposed PDPLs would be to promote economic growth and formal sector j o b creation in FYR Macedonia through improving: (i) the investment climate, and (ii) governance and efficiency o f the public sector. The proposed PDPL will also support the Government’s efforts to carry out intensive structural and institutional reforms required for EU accession.

Table 2 Summary of the Proposed PDPL Program Pillar Objective Reform Area Issues/actions

Improving the [nvestment Climate

Judicial Reform Reduce backlog and delays in court proceedings

Strengthening Public Sector Governance

Labor Market Reform

Strengthening Financial Sector Regulation and Supervision

Improving the Business Environment

Public Administration Reform

Improving Governance and Transparency o f the Health Sector

Decentralization

Improve enforcement o f court judgments

Improve regulatory and implementation framework for bankruptcy cases

Increase transparency and fairness o f administrative agency decisions

Increase institutional capacity to implement and monitor reforms

Enhance labor market flexibility

Strengthen banking supervision and regulation

Strengthen compliance o f banks with AML and CTF requirements

Strengthen corporate governance o f the enterprise sector

Adopt a quality-oriented approach to regulatory reforms

Implement a business-friendly system for business registration

Enhance the quality o f corporate financial reporting

Improve institutional arrangements for effective strategic prioritization

Develop a professional, politically neutral c iv i l service, managed on the basis o f merit, rather than political loyalty

Revise salary structures public administration to ensure consistently competitive yet fiscally sustainable remuneration across required types o f human capital

Strengthen HIF Governance and the health pol icy making environment

Improve budget planning and control, financial management and procurement in HIF, MOH and HCIs

Transfer distribution formula

Municipal arrears workout

Financing teachers’ salaries

Decentralization strategy

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33. Table 2 summarizes the reform areas and issues/actions proposed to be covered under each pillar. The attached Pol icy Matr ix spells this out in more detail across the proposed 3 year program. The investment climate pi l lar i s proposed to include judicial reform, labor market reform, financial sector reform, and business regulatory reform. The public sector governance pil lar i s proposed to include public administration reform, health care reform, and decentralization.

Pillar 1: Improving the Investment Climate

34. Judicial Reform: The efficient, effective and fair enforcement o f creditor, contract and property rights are key ingredients in a business climate that promotes investment and growth. The EU has also made the proper, efficient functioning o f independent judicial institutions a key criterion in i t s analysis and assessment o f progress in FYR Macedonia’s application for accession. In December 2004, the Government adopted a comprehensive Strategy on the Reform o f the Judicial Sector (Reform Strategy). The development and adoption o f this Reform Strategy have been critical f i r s t steps in the process o f modernizing FYR Macedonia’s judic ia l institutions.

35. The Reform Strategy has been devised to address many o f the inefficiencies and obstacles to the effective functioning o f the judic ia l system. I t notes that change in the judicial sector must be comprehensive and should be guided by two priorities: (i) strengthening the independence o f the judiciary; and (ii) reorganizing the court system to better address complex civil, commercial and criminal cases, while reorganizing the courts’ jurisdiction to address the many administrative and misdemeanor cases. The PDPL program focuses on a,subset o f this strategy which addresses obstacles to the enforcement o f contract, creditor and property rights.

36. Issues: The Wor ld Bank’s Doing Business Report 2004 indicates that the time and cost o f enforcing contracts and conducting bankruptcies i s considerably higher than most neighboring European and Central Asian countries. In addition, weak judicial recognition and enforcement o f real property or land registration rights (“security o f title”) have hindered the efficient sale, transfer and commercial use o f real property. Procedural deficiencies and abuses have caused some o f these enforcement problems. The recently enacted L a w o n Civil Procedure will address many o f the deficiencies. The bottleneck caused by misdemeanor cases has contributed to the significant backlog o f cases facing the court system. Under the Constitution misdemeanor and administrative disputes require court action for enforcement. The Government has reached a preliminary agreement with the opposition and the Parliament on i t s plan to prepare critical amendments to the Constitution to increase the independence of the judiciary and the efficiency of court proceedings. The Reform Strategy then calls for the enactment o f a number o f new laws to further reduce backlogs and delays in court proceedings including: the Misdemeanor Law, L a w on Courts, L a w on Administrative Disputes and L a w o n Republic Judicial C o ~ n c i l . ~ In addition new legislation will create a judic ia l training academy.

37. At the end o f 2003, the enforcement of judgments in approximately 175,000 general cases and 35,000 commercial cases was pending due to a poor legal framework and lack o f sufficient capacity within the courts. The Reform Strategy recognizes the need to revamp the enforcement o f court judgments and the recently adopted L a w o n Enforcement will move FYR Macedonia towards a system o f regulated and licensed enforcement agents outside o f the courts. However, the development o f implementing regulations and the creation o f a competent, professional group o f enforcement agents will require time and great care in order to improve the efficiency o f enforcement whi le protecting citizens’ rights.

The enactment o f many o f these laws await proposed changes to the Constitution expected in late 2005or early 2006.

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38. FYR Macedonia’s bankruptcy proceedings have been open to delay and abuse. While improvements are being drafted in the bankruptcy law, the major shortcoming i s the inefficient implementation o f the law. Implementation i s hindered by a lack o f understanding o f the role and purpose o f bankruptcy in a market economy, both within and outside the judiciary, as wel l as lack o f a professional cadre o f bankruptcy trustees.

39. Under the current Constitution, Govemment agencies and supervisory bodies such as the National Bank, Public Revenue Office, the Telecommunications Regulator, the Energy Regulator, the Competition Agency, and Labor Inspector, lack adequate authority and power to issue and enforce administrative sanctions such as fines, penalties or actions to revoke a license. Another proposed change to the Constitution would remove the requirement for court action for the enforcement o f administrative disputes. The Parliament recently enacted a new L a w on General Administrative Procedures. T h e Govemment wil l draft a new L a w o n Administrative Disputes which will need to be accompanied with changes in administrative policy, procedure and practices in order to ensure that supervisory bodies apply their sanction powers in a transparent and fair manner.

40. The Reform Strategy lays out a comprehensive reform but needs to ensure sufficient institutional mechanisms for the supervision and coordination o f the implementation process. For instance, a robust assessment o f the fiscal impact o f the Reform Strategy was not included in the strategy and i s only now being carried out with assistance f rom USAID. The Judicial Reform Council currently lacks sufficient human and financial resources to monitor, coordinate, and revise the implementation o f the Reform Strategy. In addition, the Court Budget Office (located in the Supreme Court) lacks the staff and other resources needed to conduct the functional analysis o f court operations and provide analytical reports necessary for improved court management and administration.

41. the following:

Reform Strategy: Under the PDPL the proposed key policies to support the judicial reform are

Reduce backlog and delays in court proceedings: Under the PDPL program, a transparent and consultative legislative and regulatory drafting procedure will be used to develop critical pieces o f legislation and regulation, including the Civil Procedure (Litigation) L a w (PDPL l), L a w o n Misdemeanors (PDPL 2), L a w o n Courts (PDPL 2), and the L a w o n Administrative Disputes (PDPL 2) to increase the independence o f the judiciary and the pace and efficiency o f the court system.

Improve enforcement of court judgments: Fol lowing the passage o f the L a w on Enforcement (PDPL 1) and in order to establish a competent and effective enforcement agent service, the PDPL i s proposed to support the adoption o f necessary by-laws, creation o f a supervision capacity in the Ministry o f Justice (PDPL2) and creation o f self- regulating enforcement agent agency (PDPL 2).

Improve regulatory and implementation framework for bankruptcy cases: The PDPL i s proposed to support strengthening o f the bankruptcy l a w (PDPL 2) and the institutional development o f a profession o f bankruptcy trustees, including the creation o f a monitoring and disciplining mechanism for trustees (PDPLs 2 and 3).

Increase speed, transparency and fairness of administrative decisions: PDPL i s proposed to support: (i) the development and passage o f the L a w on General Administrative Procedure (PDPL 1); and, fo l lowing the adoption o f the planned constitutional amendment removing the requirement o f a judic ia l order for administrative sanctions, (ii) a new L a w on Administrative Disputes (PDPL 2); and (iii) measures to

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assist govemment supervisory bodies with the fair exercise o f administrative sanction responsibility (PDPLs 2 and 3).

Increase institutional capacity to implement and monitor reforms Strategy: Under the PDPL program the Government will adequately finance and staff the Judicial Reform Council and the Court Budget Office to monitor implementation o f the Reform Strategy and to monitor and report on capital and continuing court expenses and provide ongoing functional analyses o f judicial operations, respectively.

42. Expected Results: Over the course o f the PDPL program period, FYR Macedonia expects to be on a path to a more efficient and effective enforcement o f contract, creditor and property rights by courts and enforcement institutions and achieve the following:

0 EU assessment o f judicial sector showing annual progress in adapting to EU standards and best practices;

0 A 15% reduction in the mean time to dispose o f a commercial case from 223 to 189 days as measured by Closed Case Surveys by July 3 1,2007

43. Labor Market Reform. Throughout the past decade FYR Macedonia has had one o f the highest unemployment rates among the transition c o u n t r i e ~ . ~ High unemployment and l o w employment rates are mainly due to lack of demand for labor. This, in turn, stems from a business environment which i s not conducive to investment and j o b creation as wel l as the impact o f high payroll taxes’ and current labor regulations which hinder private sector activity and encourage informality. In undertaking labor re fom, the Government intends to fo l low EU Directives, ILO Conventions and intemational best practices in drafting the new Labor Law.6

44. . Issues: M a n y components o f the legal framework for labor in FYR Macedonia have been amongst the most rigid o f a l l transition economies. T h i s has contributed to a stagnant formal sector labor market, with high unemployment, l imi ted opportunities for new entrants, and a large informal sector. Labor regulations and minimum standards were set in both the Labor L a w approved in 1993 (as amended) and two General Collective Agreements f rom 1994 (as amended) - one for the private sector, and another for the public sector.

45. The institutional framework for individual labor contracts needs significant strengthening. Labor contracts are often not respected and enforced in FYR Macedonia. T h i s reduces confidence in other labor and non-labor contracts and contributes to an environment characterized by wide-spread wage arrears and

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According to the 2004 labor force survey 309,300 individuals out o f an 832,300 economically active population were unemployed (a rate o f 37.2 percent). More than 85 percent o f the unemployed were out o f a job for more than one year. Again, the unemployment data likely overstate by a significant degree, the true leve l o f unemployment. One indication o f this i s the relative l ow level o f poverty. ’ The Government has launched with technical assistance from the IMF a multi-year strategy to consolidate the collection o f personal income taxes and social security contributions. The Government will consider possible gayroll tax rate reductions as t h i s reform progresses.

The European Council Decision o f 23 July 2003 on i t s guidelines for the employment policies o f the Member States (2003/578/EC) suggests that Member States must: (i) encourage job creation by supporting entrepreneurship and a favorable business environment for enterprises, (ii) simplify and reduce the bureaucracy, regulations and administration governing: starting business, hiring staff and accessing start-up capital, (iii) reform overly restrictive employment legislation that affect labor market dynamics, (iv) promote flexible and diverse forms o f labor agreements and working arrangements, (v) improve access to training and re-training for employees; (vi) remove disincentives to work (e.g. simplify regulations, provide incentives) and develop actions to eliminate undeclared employment.

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other violations and an enormous employment in the informal sector, estimated at about one third o f the labor force.

46. Employers, especially in the S M E sector, would benefit f rom increased flexibil i ty in working hours. Although the Labor L a w allows part time employment, the effective payroll tax for part-timers has been prohibitive since the floor set for social contributions i s based on 65 percent o f the average monthly sectoral wage for full-time work.

47. In an environment which increasingly demands flexibility, dismissal costs have been excessive. Employment could be terminated through notice due to economic, technological, structural or similar transformations, but the process was unnecessarily cumbersome and costly to employers. Under these circumstances f i r m s were not able to easily adjust to market changes. Furthermore, mandatory minimum severance payments were capped at 8 months’ salaries, a very high level even by regional standards.

48. Finally, bargaining o n terms and conditions o f employment should become more market driven in order to overcome rigidities o f the current labor market. Also, labor dispute settlement mechanisms were narrow and not suited to the demand o f a market economy.

49. following:

Reform Strategy: Under the PDPL the proposed key policies to support labor reform are the

Enhancing labor market flexibility through signifcant changes in the legislative framework A new labor l aw was enacted in July 2005 (PDPL 1). The law: (i) promotes more diversified employment contracts, by ending restrictions o n the use o f fixed-term, temporary and part-time employment contracts while allowing for a provision whereby the cumulative duration o f fixed-term contracts cannot exceed 4 years; (ii) relaxes pre- conditions for val id dismissal and limit severance pay to a maximum o f 6 individual monthly salaries; (iii) increases the scope for overtime work by increasing the yearly limit o n overtime to 190 hours annually, with lower levels for minors; (iv) ensures that collective bargaining i s done o n a voluntary basis so that collective agreements are binding only to parties who are signatories to such agreements, in line with ILO Convention N o 144 and Recommendations N o 113 and 152 o n tripartite consultations; and (v) establishes methods for labor dispute resolution as an alternatives to strikes and litigation to limit the social and economic costs o f industrial disputes.

e Subsequent PDPLs will support the further implementation o f this legislative framework. Alternative labor dispute resolution institutions will be established (PDPL 2). Also, nationally representative social partners will renegotiate the General Collective Agreements consistent with the revised Labor L a w (PDPL 3). T h i s would be followed by renegotiation o f branch collective agreements and collective agreements at firm level, as necessary. All collective agreements will be effective for a f ixed term. Negotiations will be carried out in a tripartite manner with representative participation of each party.

50. Expected Results: Over the course o f the program period, FYR Macedonia expects that labor reform wil l have a positive impact o n the labor market by creating a more conducive environment for creation o f productive employment opportunities and enhancement o f social dialogue.

e Short-term monitoring indicators would include: an increase in the share o f workforce with formal labor contracts, the share o f workers with part-time and f ixed term contracts, and an increase in the number o f contributors to payroll taxes.

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In the longer-term increased flexibility in the labor market combined with other improvements in the investment climate should result in higher labor participation rates, employment to population ratios, youth unemployment rates and share o f women and youth in total labor contracts as wel l as reduced shares o f long-term unemployed to total unemployed.

5 1. Strengthening Financial Sector Regulation and Supervision. Over the past years, FYR Macedonia has taken several important steps to build a sound and stable financial sector. The privatization, restructuring, and liquidation o f the banking and enterprise sectors i s largely completed; the legal, regulatory and supervisory framework for the banking sector has been strengthened; the National Bank o f the Republic o f Macedonia (NBRM) has successfully adopted a compliance-based approach to banking supervision and a new audit l aw - which i s drafted to be largely in line with EU requirements - has been submitted to Parliament.

52. Issues: However, much needs to be done to improve the role o f the financial sector in providing access to credit and financial services, including full implementation o f recently enacted legislation. In fact, the enterprise sector’s access to finance i s poor, restricted to relatively basic banking products and constrained by weak banking competition. The 2003 Financial Sector Assessment Program (FSAP) highlights poor transparency o f the ownership and control structure o f the banking sector, l imited presence o f well-regarded foreign strategic investors in the capital o f banks, poor financial reporting in the enterprise and financial sectors, and weak enforcement o f contracts, and o f creditor and property rights as major constraints to the sound development o f the financial and enterprise sectors.

53. The privatization o f the banking sector has reduced state ownership to a very l imited level and resulted in a significant share o f foreign investors in the equity o f banks. However, the privatization has not favored strategic investors and has led to the large presence o f non-financial corporate investors (both foreign and domestic) in the banking sector. Some banks continue to have a very opaque ownership and control structures that results in: (i) difficulties in conducting effective supervision; (ii) high risk o f connected lending and money laundering; and (iii) difficulties in attracting investment f rom reputable foreign banks. Also, despite the significant results achieved over the past few years, additional efforts are needed to further strengthen the supervisory capacity o f the NBRM and move towards a more risk-based approach to supervision.

54. financial sector regulation and supervision are the following:

Reform Strategy: Under the PDPL the proposed key policies to support the strengthening o f

Strengthen banking supervision and regulation. Under the PDPL program a supervisory development plan (SDP) for bank supervision will be implemented by the NBRM (PDPLs 2 and 3). This SDP will represent a shift towards a more risk-based supervision and will promote stronger governance o f the banking sector. A banlung sector governance assessment begun in M a y 2005 i s also l ike ly to propose key recommendations to strengthen the governance o f banks and could be incorporated in the PDPL 2 and 3 programs.

Strengthening compliance of banks with Anti-Money Laundering (AML) and Counter Terrorism Financing (CTF) requirements. Under the PDPL program a review o f the N B R M ’ s manual o n assessing banks’ compliance with AML requirements wi l l be conducted (PDPL 2) and fit and proper screening procedures for applicants for banking licenses will be strengthened (PDPL3).

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55. following:

Expected results: Over the course o f the PDPL, FYR Macedonia expects to achieve the

0 Strengthened supervisory capacity o f the banking sector with migration toward increased transparency, disclosure, and a r isk based supervisory approach leading to improved compliance with regulation and concrete corrective actions with specific banks.

56. Improving the Business Environment. FYR Macedonia’s business environment suffers f rom weak corporate governance and a burdensome stock o f regulatory and administrative constraints which hamper business entry, operations and ex i t7 The lack o f reliable financial information on business operations due to weak accounting and auditing standards also constrain financial intermediation and new investment.

57. Issues: The lack o f a level playing field appears to be a major issue in FYR Macedonia’s business environment. Opaque ownership structures and a weak disclosure framework obscure the picture, but anecdotal evidence suggests that a few business groups dominate the economy.

58. The business environment also suffers f rom burdensome regulations affecting business entry and operations. Regulation lacks a clear strategic vision with litt le inter-ministerial coordination. Weak institutional capacity and poor consultation mechanisms with the business community have also contributed to the current burdensome regulatory environment. The F IAS 2003 Administrative Barriers Review and Administrative and Regulatory Cost Survey (ARCS) highlight a lack o f clarity in the existing regulations (72 percent), instability o f laws and regulations (60 percent), and corruption in the public sector (87 percent) as major weaknesses in FYR Macedonia’s business environment. Most F IAS recommendations have not been implemented and the Government has made litt le progress in removing regulatory and administrative barriers to foreign direct investment. As a result, the business sector continues to operate under burdensome regulations which also hamper the entry o f new f i rms.

59. However, the Government has recently begun to address these issues. I t has committed to establish an institutional framework and processes for implementation o f regulatory reforms. A unit has been established in the General Secretariat responsible for improving the quality o f existing and new regulations through the adoption o f methodologies such as the guillotine and the regulatory impact assessment (RIA).’

60. The Government recently decided to remove business registration f rom the courts and establish a “one-stop-shop system”. A working group has been established to draft a separate l a w o n registration and the “one-stop-shop system” which envisages business registration being transferred to the Central Registry and ensuring procedures will be short, transparent and inexpensive.

61. Financial intermediation and investment also suffer f rom the lack o f reliable financial information on businesses. Fol lowing the recommendations made by the 2003 Report o n Observance and Codes (ROSC) o n Accounting and Auditing, and after some delays, a new audit l aw has been submitted to Parliament which will improve the quality o f financial reporting. Implementation and enforcement o f this framework will be a challenge.

Weaknesses in the bankruptcy framework are discussed above in the judicial reform component o f the proposed rogram.

‘The Guillotine approach, used by countries such as Sweden, Hungary and Mexico, i s based on a quick and automatic review and reform o f regulatory measures with the automatic elimination o f unjustified ones.

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62. business environment are the following:

Reform Strategy: Under the PDPL the proposed key policies to support improvements in the

a Strengthening the governance of the enterprise sector. Under the first PDPL the Government has undertaken corporate governance assessment (ROSC) regarding OECD corporate governance principles as wel l as a banking governance assessment. Subsequent PDPLs are proposed to support the implementation o f key recommendations o f the ROSC o n Corporate Governance. T h i s may include Parliament approval o f amendments to the company and securities laws.

a Adopt a quality-oriented approach to regulatory reforms to improve the quality of existing and new regulations affecting business activity. The second PDPL i s proposed to support the enactment and implementation o f legislation establishing a permanent body in the General Secretariat which will implement the regulatory impact assessment system and institutionalize mandatory consultation mechanisms with the business community.

a Implement a business-friendly system for business registration. The second PDPL i s proposed to support the enactment and implementation o f a business registration law and corresponding regulations.

Enhance the quality of corporate financial reporting. Fol lowing the recommendations o f the ROSC o n Accounting and Auditing, under the f i rs t PDPL a new audit l aw will be enacted. Subsequent PDPLs are proposed to support the implementation o f this legislation including: the establishment and operations o f the Institute o f Certified Auditors (PDPL 2); (iii) implementation o f International Financial Reporting Standards (IFRS) and International Standards for Auditing (ISA) in the business sector (banking and corporate) and I S A in public interest entities (PDPL 3) ; and (iv) the adoption o f a Code o f Professional Ethics for Accountants as promulgated by the International Federation o f Accountants (IFAC), (PDPL 3).

63. following :

Expected Results: Over the course o f the PDPL program, FYR Macedonia expects to achieve the

Improved perception o f foreign and domestic investors o f the investment climate and reduced administrative and regulatory barriers to investment (FIAS 2007 Administrative and Regulatory Costs Survey, ARCS).

Pillar 2: Strengthening Public Sector Governance

64. Strategic Management. The Government has improved i ts capacity to make tough policy choices. Supported by the PSMAL, the Government has implemented a series o f budget formulation process improvements. A medium term fiscal strategy for 2004-2006 was approved by the Government in 2004. Hard budget ceilings for each o f the f i rst l ine budget entities were approved by the Government in June 2004and provided to the entities as part o f their budget instructions. These were ultimately reflected in the 2005 Budget approved by Parliament.

65. During the same period, the General Secretariat and Ministry o f Finance prepared strategic plans designed to ensure that their organizations would be equipped to deliver o n the stronger pol icy and fiscal management role envisioned by new legislation. A milestone was achieved with the issuance, in

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September 2003, o f a Government Decision on the Adoption of the Methodology for Strategic Planning and Preparation of an Annual Work Program of the Government of FYR Macedonia.

66. Issues: The strategic planning effort i s not yet fully effective. Ministries and other budget users generally fa i l to use i t as a tool for serious business process redesign. Whi le a few good examples o f effective use o f that process do exist (e.g., Ministry o f Defense, General Secretariat), the Government needs to find a strategy to ensure that l ine ministries and other budget entities will use the process more effectively. Importantly, the process needs to be employed to address key human resource management challenges; in particular, reconfiguring staffing composition within individual budget entities so as to ensure the s k i l l sets required for meeting priority objectives, while simultaneously ensuring that wage bill targets are respected. In fact, some o f the reforms which could be supported by the proposed PDPL require a number o f budget users to strategically and quickly undertake such a staffing reconfiguration.

67. Over the next three years, the Government should continue implementation o f the strategic planning methodology. This effort should be closely l inked with the budget formulation process improvements introduced during 2003-04, as wel l as the Acts o f Systematization process, in order to ensure that staff redeployment challenges are effectively addressed. The Government should also improve monitoring o f the costs and impacts o f key programs and policies and ensure that such information i s widely and publicly available, so as to foster debate about their effectiveness.

68. the following:

Reform strategy: Under the PDPL the proposed key policies to support strategic management are

0 Develop institutional arrangements and capacities that permit more effective strategic prioritization The PDPL i s proposed to support the implementation o f a strategic prioritization and planning process reform which will be integrated into the annual budget preparation process. The Government will also establish a mechanism for monitoring and publicizing systematic evidence on intermediate impacts o f c i v i l service and public expenditure management reforms (PDPL 1).

69. achieve the following:

Expected results: Over the course o f the PDPL program period, FYR Macedonia expects to

0 Programmatic summary o f budget allocations shows increases (or, at least, n o net reductions) in shares o f total General Government budget allocated to policy priorities enunciated in the Government Program, as reflected in (a) programmatic ceilings established in the annual Budget Circular, and (b) f inal budget allocations approved by Parliament.

0 Percentage difference between budget ceilings established in annual Budget Circular (BC) and Budget User’s (BU’s) init ial proposed budgets (BU-specific and average in absolute value terms across BU’s). Target: Tendency to fa l l over time.

0 Average deviation o f budget units’ actual expenditures fkom budgeted. Target: Tendency to fa l l over time.

0 Number o f days between end o f fiscal year and the publication o f the final report by the certified state auditor o n state budget execution for that year. Target: <300 days and declining over time.

70. Human Resource Management. The 2000 L a w o n Civil Servants provided the legislative framework for a meritocratically managed c i v i l service system. The L a w provided for a uniform, rule-

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based and less compressed salary structure; uniform definitions o f the types o f positions encompassed by the c iv i l service; and the establishment o f an independent agency, the Agency for Civil Servants (CSA), responsible for establishing and enforcing c iv i l service management policies and procedures. The proposed salary decompression was repeatedly postponed, and despite the provisions o f the law, sectoral ministries had, until recently, been able to bypass the CSA, recruiting staff for c i v i l service positions without competitive exams or review by the CSA. Both problems have now been addressed. A phased decompression o f salaries has begun, and i s being implemented over a 24-month period. A payroll based enforcement mechanism i s n o w in place to ensure that c iv i l service recruitment provisions are followed.

7 1, Issues: An important next step i s to extend certain aspects o f the c iv i l service reforms to the 90 percent o f public employees who are not c iv i l servants. In March 2003, the Economic and Social Council established a working group to devise a uni form position classification and salary structure throughout the public sector. This i s not the f i r s t time such an effort has been launched in FYR Macedonia. Previous efforts have not yielded an agreement, in n o small part because the wide variety o f functions undertaken by FYR Macedonia’s public administration call for an enormous variety o f j o b sk i l l s and responsibilities. T o begin this process, a salary survey working group, under the leadership o f the CSA, has begun a review o f remuneration structures throughout FYR Macedonia’s public administration and relative to domestic private sector comparators. The survey o f salaries should be followed by analysis o f the data and options for enhancing transparency and competitiveness o f public administration remuneration packages. In the longer term, considerable work will need to be done to modi fy existing pay-setting rules and practices, so as to create institutional arrangements that can ensure a more competitive, while affordable, public administration salary structure.

72. Instituting public employment reforms will be particularly complicated in the light o f two major constraints. The f i rst i s the Government’s commitment under the Ohrid Agreement to ensure the “equitable representation” o f minorities in FYR Macedonia’s public administration. The second i s the tight fiscal constraints under which the country must operate. The Government hopes to satisfy these competing objectives by rely ing on attrition to open up positions to which individuals f rom “under- represented communities” could be recruited. This may not prove sufficient, in view o f the Government’s efforts to reconfigure staffing to better address key priorities. Moreover, it i s critical that, as the Ohrid Agreement states, efforts to address “equitable representation” also respect “the rules governing competence and integrity that govern public administration”.

73. resource management in the public sector are the following:

Reform strategy: Under the PDPL the proposed key policies to support reform o f human

0 Develop a professional, politically neutral civil service, managed on the basis of merit, rather than political loyalty. Under the PDPL program an amendment to the Organic Budget L a w will establish a mechanism for controlling compliance with both the recruitment and selection requirements and the position classification requirements. The CSA wil l conduct a consultative review o f the Civil Service L a w (PDPL 2) and devise an action plan for addressing challenges identified including possible revisions to the legislation (PDPL 2).

0 Revise salary structures within FYR Macedonia’s public administration to ensure consistently competitive yet fiscally sustainable remuneration across required types of human capital. Under the PDPL program, the Government will continue implementation o f wage decompression in the c iv i l service begun under the P S M A L supported program. Also a public/private sector salary survey will be initiated and subsequently incorporated within the State Statistical Off ice annual work program. Finally, a legal framework governing salaries o f public sector employees (ensuring fiscal sustainability and

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consistency o f competitiveness o f total remuneration across positions) will be adopted and implemented.

74. achieve the following:

Expected results: Over the course o f the PDPL program period, FYR Macedonia expects to

Average quarterly gross turnover rates within the c iv i l service coupled with information indicating timing o f major changes in political leadership, such as a change o f Government or significant reshuffling o f Ministers. Target: Spikes following changes in polit ical leadership are small, particularly relative to identical series on political appointees.

Fraction o f c iv i l servants for which annual performance appraisals were reported to the CSA. Target: Fraction tends to approach 100% over time.

a Fraction o f overall performance ratings falling within each rating category. Target: Ratings are not concentrated in one or two categories.

a Average number o f qualified (long-listed) candidates per advertised CS opening. ,Target: Tends to increase over time.

a Ratio o f average highest ranlung c iv i l servant t it le total remuneration to average lowest ranking c i v i l servant t it le total remuneration. Target: Approaches 4.3 by PDPL3.

a Actual central budget wage bill including allowances as a percentage o f GDP. Target: Does not exceed 8.4%.

75. Improving the Governance, Transparency and Management o f the Health Sector. A series o f analytical work in FYR Macedoniag have identified significant public financial management risks associated with the Health Insurance Fund (HIF). For example, the 2004 Wor ld Bank Country Financial Accountability Assessment (CFAA) identified many weaknesses in the HIF’s management o f health expenditures contributing to the chronic build-up o f arrears among health care institutions (HCIs) and suppliers. The C F A A noted that deficits in the HIF raise concerns o f fiscal sustainability. Opaque financial management within HIF and inadequate oversight o f HIF by the Ministries o f Health (MOH) and Finance (MOF) leave significant scope for corruption.

76. The fiscal and corruption r i sks exacerbate concerns with the quality and accessibility o f health services in FYR Macedonia. Public opinion polls have consistently rated health services as “poor or very poor.” Household budget surveys show that out-of-pocket payments for health care are large and pose financial access barriers for poor households. Informal payments are rampant. Combined public and private health spending in FYR Macedonia i s almost 10 percent o f GDP, one o f the highest in the E C A Region and close to the levels o f EU15 countries.”

See for instance: (i) World Bank. 2003, Public Expenditure and Institutional Review: FYR Macedonia; (ii) World Bank. 2004. Country Financial Accountability Assessment (CFAA): FYR Macedonia; (iii) Burchfield K. 2004. Improving HIF Governance: Report prepared under PHRD for Macedonia: Health Sector Management Project (HSMP); (iv) Emst and Young. 2005. Audit o f the Health Insurance Fund (HIF) o f Macedonia. Emst and Young, Luxembourg. lo Since the 1990s, FYR Macedonia has implemented a series o f changes in the health sector, with the objectives o f improving performance. The Health Insurance Law o f 2000 consolidated health financing under a single public entity, the Health Insurance Fund (HIF), which accounts for 90 percent o f total public spending on health in Macedonia. The health insurance system i s based on principles o f universality and solidarity, and al l citizens are

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77. Issues: Despite the health reforms supported by the P S M A C and P S M A L there i s significant unfinished business with reducing the fiscal r isks posed by the HIF. The budget planning, financial management and procurement in the health sector remain inadequate and the pol icy making environment remains weak. The range o f institutional weaknesses in the health sector include: (i) the absence o f essential budgetary functions and spending controls, resulting in the inabil ity o f HIF to plan and subsequently control Health Care Institution (HCI) budgets and the delivery o f health services; (ii) contracting practices do no t generate hard budget constraints for HCIs, and provide n o reliable information on the performance o f health providers;" (iii) a weak HIF governance framework marked by l o w involvement and oversight o f the MOH; (iv) a benefits package that i s not evaluated on the basis o f effectiveness and the available resource envelope for the health sector; and (v) a weak health policy environment and regulatory framework which do not provide a fiamework for HIF operations, with respect to the mix o f publidprivate provision o f health services, contracting with health providers and performance monitoring.

78. Also, the governance and accountability o f the HIF remain weak. The HIF Board has played a passive role in managing the affairs o f HIF. Most Board members do not have financial management ski l ls . T h e large number o f doctors and health providers on the Board represents a potential conflict o f interest. The MOH has also not played an active oversight role with respect to the HIF. The MOH does not have a recent health sector pol icy to underpin the activities o f the HIF. In the absence o f clear policy guidelines o n publidprivate mix in the provision o f health services, HIF i s contracting with the public and private sectors for the same services. This increases the financial burden o f the HIF and undermines fiscal sustainability. I t also contributes to problems such as moonlighting among public providers, reinforces under-performance in public HCIs and enhances the tendency o f public providers to refer patients to private clinics. Other crit ical areas o f concern for health pol icy formulation include the scope o f the benefits package, policies o n payment mechanisms for health providers, and policies to increase the accountability and performance o f HCIs.

79. Reform Strategy: The PDPL proposes to continue to support Government efforts to build-upon and deepen the reforms initiated under PSMAC and P S M A L programs. Importantly, the PDPL i s proposed to support the implementation o f the recently adopted HIF Act ion Plan. The broad areas o f focus for the reforms include:

0 Improving HIF governance and the health policy making environment. Under the PDPL program HIF governance would be strengthened by improving accountability and structure o f the HIF Board. The PDPL program would include the adoption o f amendments to the Health Insurance L a w (PDPL 2) which a im to: (i) reduce the number o f HIF Board members f rom 13 to 7; (ii) change to the criteria for selection o f Board members; and (iii) require a stricter conflict o f interest clause. Veto power would be granted to the MOF and MOH representatives o n the Board. Transparency o f the HIF Board would be enhanced through the regular and timely publication o f the minutes o f Board meetings. The PDPL program would also support improvements in the health pol icy environment for health sector resource allocation decisions including: (i), review

expected to contribute according to their ability to pay, and receive basic health services according to need. Health care institutions (HCIs) operate as autonomous State-owned enterprises, although the Ministry o f Health (MOH) i s supporting privatization o f pharmacies, dental practices and primary care. A by-law allowing the privatization o f these entities was passed in 2004. While health insurance coverage i s fairly high, health outcomes such as l i f e expectancy at birth and infant and under-five mortality lag behind the SEE and EU25 averages. l1 The hospital contracting process i s not transparent and does not define the basis for formulation o f the global budget nor the rules and regulations that would govern budget execution. Also, reporting requirements remain unclear. The contracting process contains far too many performance indicators and hospitals do not have the necessary t e c h c a l skil ls to deliver on these indicators. Finally, there was no val id baseline, making it difficult for HIF to use these indicators to strengthen H C I accountability to HIF.

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and revise the positive l i s t s o f drugs and the negative l i s t in the context o f an evaluation o f the Benefits Package (PDPL 2); and (ii) analyze the relationship between medical needs and service delivery capacity, in the form o f a Medical M a p to improve the basis for planning and resource allocation decisions. The results f rom the medical map exercise will provide the analytical basis for the distribution o f resources throughout the country, for guiding investment decisions, HIF selective contracting with Health Care Institutions (HCIs) and strengthening the licensing o f HCIs (PDPL 3).

0 Improving budget planning and control, financial management and procurement in HIF, MOH and HCIs: Under the PDPL program the Government will implement the f i rs t phase o f the HIF Act ion Plan to strengthen the financial management and intemal controls within the HIF, including the development o f HIF and H C I staff competencies in business planning and budget formulation, execution, monitoring and control. Hard budget ceilings will be imposed o n HCIs and measures will be undertaken to strengthen performance orientation among HCIS.’’ By 2007, 10 percent o f the budget o f HCIs will be l inked to performance.

80. achieve the following:

Expected Results: Over the course o f the PDPL program period, FYR Macedonia expects to

0 N o HIF arrears to f ive largest HCIs in 2006

0 No HIF debts to suppliers in 2006

0 Access and quality o f care improved in Health Care Institutions (HCIs) implementing budget ceiling (10 percent decrease in hospital admission rate, 15 percent decline in average length o f hospital stay, 30 percent reduction in the number o f re-admissions for the same condition during a 3 month period, reduction in the number o f referrals to outpatient specialists and hospitals by lo%, improved patient satisfaction).

8 1. Decentralization. The Govemment has made very substantial progress in enacting the legislative framework for decentralization, as specified in the Ohrid agreement. In January 2002, a new L a w o n Local Self-government was approved. In July, 2004, Parliament approved a new L a w o n Local Government Finance. The most controversial step to date was the enactment o f the L a w o n Territorial Reorganization (August 2004) which withstood a national referendum in November 2004. The basic legal framework for decentralization i s n o w completed. Nevertheless, much remains to be done in terms o f implementation. The Government’s p lan o f action i s specified in i t s Draft Plan of Activities for the Transfer of the Competencies from the State to the Municipalities (Apr i l I, 2005- October 31, 2005).

82. Issues: Functions. The new L a w o n Local Self-government spells out in considerable detail the functions that municipalities may eventually undertake. The law reiterates the existing municipal responsibilities for communal services (including drinking water supply, sewerage, and district heating), regulation o f public transport, construction and maintenance o f local roads and maintenance o f parks and sports facilities. In the social sphere, local responsibilities would expand. Under the law, municipalities would be responsible for chi ld care centers and homes for the elderly. They would be responsible for establishing, financing, and administering primary and secondary schools (in cooperation with the central government) and organizing student transport and housing. Municipal responsibilities in the health sector would be more limited. Whi le they would be represented o n the boards o f public health organizations,

These actions w i l l be supported by establishing and further strengthening o f the health management information system (HMIS). HIF and H C I financial reports will be published on the HIF website on a quarterly basis. The H C I financial reports will also include information on the performance indicators.

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they would have no direct ro le in managing health care facilities. They would however, be responsible for certain aspects o f public (preventive) health.

83. Finances. The new L a w o n Local Government Finance provides the fiamework for financing these services. I t maintains the three existing local taxes (property, inheritance, transfer o f real estate) and allows municipalities to retain three percent o f the personal income taxes (PIT) collected within their jurisdictions. I t also establishes a revenue sharing system in which three percent o f Government VAT collections will be distributed among municipalities on a formula basis. T o finance municipalities’ increased role in the social sectors, the l a w provides for a system o f b lock grants. These wil l be distributed according to formulas devised by the relevant Government l ine ministries and would be fixed by Government ordinance after approval by the Ministry o f Finance and a special-purpose monitoring committee.

84. Phase I Reforms. The decentralization o f functions and finances i s designed to occur in two phases. Under Phase 1, which began o n July 1,2005, municipalities would assume responsibility for chi ld care and homes for the elderly. They would also substantially increase their role in primary education. Municipalities will assume ownership o f school buildings and will be responsible for their operation (e.g., heating and lighting) and maintenance. Mayors will acquire the power to appoint school directors (nominated by school boards). Teachers will become municipal employee^.'^ T o finance these additional functions, the new revenue arrangements governing three percent o f the personal income tax and the VAT would be put in place.

85. Before the f i rst phase o f decentralization can go into effect, the L a w o n Local Government Finance requires two major issues to be resolved. First, the Government must decide o n a formula for distributing the VAT. The l a w specifies that ha l f will be distributed on a per capita basis. The remainder i s to be distributed on the basis o f a formula to be adopted by Government o n the recommendation o f the MOF. The MOF, in turn, i s to be advised by a nine-member commission, consisting o f five representatives f rom the Association o f Municipalities (ZELS) and four representatives o f the Government. The Committee i s only n o w reconstituting itself after the end-March municipal elections.

86. The second precondition for Phase 1 i s the implementation o f a p lan (adopted in July 2005) to resolve the status o f existing municipal arrears. The total stock o f municipal arrears i s n o w estimated at MKD 2.7 b i l l ion (1 percent o f GDP). The p lan requires the municipalities to fully repay the expropriation debt and the outstanding principal o n arrears to suppliers and contractors. The M o F wil l organize and facilitate negotiations between municipalities and their creditors, whi le avoiding any large scale Government-financed debt rel ief that might encourage municipalities and creditors to engage in excessive debt-financing in the future..

87. Phase 2 Reforms. In Phase 2 o f decentralization municipalities will obtain direct responsibility for paying the teachers’ salaries. The L a w o n Local Government Finance provides minimal guidance as to how this will be accomplished. I t specifies that costs will be financed through b lock grants, distributed according to a formula devised by the Ministry o f Education and guarantees only that the amount will be ‘not less than the same amount used for the same purpose in that area in the previous year.’ This leaves several unanswered questions. Should municipalities have the authority t o determine the number o f authorized teaching positions in each school? Should they have the authority t o set teachers’ salaries? And if so, should the Ministry o f Education be obligated to finance the resulting wage biIl?l4

~~

l3 The Ministry o f Education, however, will continue to determine the number o f authorized teaching positions in each municipality, set wages, and pay teachers’ salaries. l4 Some o f these issues are already being addressed through recent legislation (including the Law on Primary and Secondary Education) and current Ministry o f Education proposals. One such proposal, for example, would allocate

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88. The L a w o n Local Govemment Finance also specifies that Phase 2 will be implemented on a case by case basis. Any municipality that ‘possesses an adequate staff capacity for financial management, shows good financial results for at least 24 months, and has n o arrears to suppliers or any other creditors exceeding those ordinary terms o f payments’ will be eligible. In effect the l a w treats Phase 2 as a reward for good financial performance rather than as an element o f a larger sectoral strategy. This raises the prospect o f two parallel systems o f education in FYR Macedonia-- one financed directly by the Govemment in municipalities not deemed ready for Phase 2; the other by the municipalities that qualify for Phase 2.

89. following:

Reform Strategy: Under the PDPL the proposed areas to support decentralization are the

0 Transfer distribution formula. Under PDPL 1 the Govemment has adopted an acceptable formula for distributing the municipal share o f the VAT.

0 Municipal debt workout. Under PDPL 1 the Government has adopted a formal policy on the resolution o f the arrears. Under PDPL 2 and 3 the Govemment will provide technical assistance to individual municipalities in the renegotiation o f their debt and will closely monitor the implementation o f the resolution o f arrears.

0 Financing teachers’ salaries. Under PDPL 2 or 3 and before responsibility for paying teachers’ salaries devolves to municipalities, the Govemment wil l adopt an action plan specifying the required financing and management arrangements

0 Decentralization Strategy. Under PDPL program, the Govemment will review the overall strategy for decentralization and replaces the case-by-case approach for moving to Phase 2 with an approach that applies sectoral reforms uni formly to a l l municipalities.

90. achieve the following::

Expected Results. Over the course o f the PDPL program period, FYR Macedonia expects to

0 Revenue structure o f local govemments i s stable and transparent.

0 Municipal liabilities are reduced to sustainable levels.

VI. OPERATION IMPLEMENTATION

POVERTY AND SOCIAL IMPACTS

91. Some o f the pol icy measures that would be supported by the PDPL could potentially have distributional impacts. Labor market reform, in conjunction with other improvements in the investment climate, should help alleviate poverty in the medium-term as employment in the formal sector improves. As contract based labor participation increases and informal jobs are formalized, social protection coverage should also increase. On the other hand, insiders would have less j o b security and would receive lower redundancy payments. The second phase o f decentralization, expected to occur after the PDPL program, poses risks for the equitable delivery o f social services if no t we l l designed. Thus the PDPL program includes measures to ensure that the design o f the second phase o f decentralization will

funding for teachers’ salaries on the basis o f enrollment, while allowing local school directors to determine their own staffing requirements. Salary levels would continue to be set by the Ministry o f Education and Science. Local school boards would set the education budgets o f each municipality, which would be approved by the municipal government.

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safeguard equal access to quality education, an adequate supply o f qualified teachers and non-teaching staff for ethnic minorities, and appropriate language o f instruction.

92. Our knowledge o f poverty in FYR Macedonia has recently been updated. The f i rst in a series of three programmatic Poverty Assessments in FYR Macedonia was carried out in 2005 covering the years 2002 and 2003. The programmatic approach to this Poverty Assessment will allow for a close monitoring o f the impact o f PDPL supported reforms on poverty and may be supplemented by specific poverty and social impact analyses. The team preparing the programmatic Poverty Assessments seeks to strengthen poverty monitoring capacity in FYR Macedonia and provide analytical input to the development o f the next CAS. The draft finds that the modest rate o f economic growth in this period did not lead to a decline in poverty or even an improvement in general living standards for the bottom 80 percent o f the population. The strongest determinants o f poverty in FYR Macedonia are household size and number o f employed persons in household. L o w education o f head o f household and living in secondary urban areas are other important determinants of poverty. In 2002 and 2003 about 22 percent o f the population in FYR Macedonia l ived on less than US$4.30 (measured at purchasing power parity). The “cost o f basic needs” methodology also suggests the same 22 percent rate o f poverty but indicates that about 5.5 percent o f the population i s affected by extreme poverty. With a poverty gap o f about 7 percent, poverty seems to be deep. Social transfers account for roughly ha l f o f Govemment spending and nearly ha l f o f the population receives some sort of social assistance. The alleviation o f poverty would require improvements in targeting o f social benefits, sustained and increased economic growth and j o b creation, as wel l as sustained improvements in productivity which could support sustained increases in real wages.

FIDUCIARY ASPECTS

93. The Country Financial Accountability Assessment (CFAA) was finalized in March 2004 while the Country Procurement Assessment Report (CPAR) was finalized in June 2002. The Govemment has addressed a number of major weaknesses identified in those fiduciary assessments o f the public financial management and procurement framework and i s continuing to progress o n others.

94. The IMF conducted a safeguard’s assessment o f the NBRM in 2003 and found n o systematic vulnerabilities in the safeguards. The NBRM had completed a l l the principal recommendations o f the 2000 assessment, and safeguards had been considerably strengthened. Assessed risk declined in al l areas from the 2000 assessment. Vulnerabilities remained only in the financial reporting framework and intemal controls.

95. The CFAA reported that the Govemment had a well-functioning treasury operation, exercising good control over the spending o f budget entities. The NBRM efficiently administered the Treasury Single Account (TSA) o n behalf o f the Govemment and had implemented controls over foreign currency accounts o f donors and others. The budget formulation process had been steadily improving including the introduction o f a multi year framework. The S A 0 performed audits but the Government did not respond thoroughly to the SAO’s significant recommendations. At the time o f the in i t ia l CFAA mission and draft report, there was n o intemal audit function in the govemment, EBFs were outside o f the T S A and generally not wel l monitored and the CFAA reported major deficiencies in financial controls in the Health Insurance Fund.

96. Since then, the govemment has made good progress o n a number o f these issues: the EBFs are now using the TSA; the MOF records and controls commitments; a L a w o n Internal Audit has been passed that requires the establishment o f modem intemal audit units across al l significant budget entities; a number o f intemal audit units have already been established; basic and advanced auditor training i s being provided through the MOF internal audit unit; and implementation o f intemal audit i s continuing. Over time, these uni ts will develop and will provide an independent source o f management information on ministry budget execution and procurement activities.

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97. The supreme audit institution, the SAO, has considerably increased i t s number o f staff to 76 (expected end o f 2005), although this i s s t i l l wel l below the target o f 125 staff. Their audit processes and practices have been improved as part o f a two-year project financed through the Dutch Trust Fund supporting the PSMAL. The SA0 i s conducting 10 performance audits for the f i rst time in 2005. An ongoing negotiation between S A 0 and the government i s concretely addressing the current back-log. Legislative amendments to the S A 0 l a w were passed in 2004. They provided: a formal follow-up process by the S A 0 on al l outstanding recommendations contained in the S A 0 audit reports; the requirement for the S A 0 to make public i t s annual audit reports and i t s audit o f the government’s final accounts; requiring the S A 0 to summarize in i t s annual report the key systemic weaknesses identified through i t s audits; and enabling the S A 0 to conduct media information sessions as deemed appropriate. ‘All o f these requirements have been implemented in 2005. The S A 0 was audited for the f i rs t t ime for 2004. The further development o f the S A 0 has been secured through a three year twinning arrangement with the Dutch Supreme Audit Institution starting in September 2005. Finally, S A 0 i s working o n a new amendment to the law o n State Audit to further enhance their independence, including financial independence, ensuring access to a l l relevant information, as wel l the implementation o f a risk based approach in the planning o f entities to be audited. This will decrease the number o f compulsory audits and will focus o n those entities o f greatest r isk.

98. Over the course o f the P S M A L program al l extra-budgetary funds (EBFs) were brought into the T S A and their budgets are n o w being tabled in Parliament together with the government’s budget proposal. An internal control study o f the HIF was conducted in 2004 and an action p lan to implement i t s recommendations for improvement was approved by the government in M a y 2005. Implementation i s now underway as part o f the PDPL process.

99. Based o n the l aw on internal audit approved in September 2004 intemal audit units are now being established in al l budget entities with expenditures exceeding 500 m i l l i on Denars. T o date, 15 entities now have such units; an additional 17 entities and 42 municipalities will establish internal audit units this year, In almost al l cases, these are very small un i ts o f 1-2 staff that will have to grow over the next 2-3 years to reach a critical mass o f at least 6 auditors. The current staffing freeze will make this a diff icult challenge. The smaller budget entities will be covered by the internal audit unit in MOF. An intensive learning and certification program has been undertaken, supported by the PSMAL. A recently launched 12 month project financed by EAR will assist with the ambitious roll-out o f the internal audit and enhancing the use o f international standards in the audit work, but using a practical approach. EAR i s also assisting with the improvement o f the internal financial control through the establishment o f a Public Internal Financial Control (PIFC) framework in FYR Macedonia.

100. Several improvements have taken place o f the procurement since the CPAR. A new L a w on Public Procurement in l ine with international standards and best practices was enacted in March 2004 as part o f the P S M A L program. Government has adopted a comprehensive implementing regulation, promulgated standard procurement documents and forms o f contract, and established a state administrative body for public procurement within the Ministry o f Finance made fully operational with staff, resources and terms o f reference. The Public Procurement Bureau i s working with an EC financed consultant on MOF website for the Register of Performed Public Procurement. All these P S M A L second tranche conditions were met in M a y 2005.

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S A 0 staffing

Measures undertaken based o n S A 0 recommendations

Intemal audit staff across govemment

Number o f institutions with internal audit

I I I

End of 2003 End of 2004 Expected end of 2005

59 68 76

13% in 2002 18% in 2003 22% in 2004

11 29 58

2 15 74 (some to start in 2006)

DISBURSEMENT AND AUDITING

102. The proposed Loan will fo l low the Bank’s disbursement procedures for development policy loans. The untied budget support will be disbursed in compliance with the agreed pr ior actions and will not be tied to specific purchases. No procurement requirements wil l be needed. Upon approval o f the Loan and notification by the Bank o f Loan effectiveness, the Government will submit a withdrawal application. At the request o f the Government, the Bank wil l disburse the Loan, less the amount o f the front-end fee amounting to 0.25% o f the Loan amount, 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. During negotiations it was decided that the net Loan proceeds would not be converted into local currency; however, for accounting and budgeting purposes, the Borrower wil l also record the net proceeds o f the Loan in local currency fol lowing established procedures The Borrower shall ensure that upon deposit o f the net proceeds o f the Loan into said account, an equivalent amount will be credited in the Borrower’s budget management system, in a manner acceptable to the Bank. The Borrower will report to the Bank o n the amounts deposited in the foreign currency account and credited to the budget management system. If, after the proceeds are deposited in the NBRM account, the proceeds o f the Loan are used for ineligible purposes as defined in the Loan Agreement, the Bank will require the Borrower to promptly, upon notice f rom the Bank, refund an amount equal t o the amount o f said payment to the Bank. Amounts refunded to the Bank upon such request shall be cancelled. The administration o f the Loan will be the responsibility o f the MOF.

103. The MOF will maintain accounts and records, showing that disbursements were in accordance with provision o f the Loan Agreement. Such accounts and records will be maintained in a form acceptable to the Bank.

104. Considering the Bank’s knowledge o f the public finance management systems, the ongoing improvements o f these systems and considering the assessment o f the NBRM made by IMF, n o audit will be necessary o f the deposit account. The auditors issued unqualified opinions o n the Statement o f Sources and Uses o f Funds and Statement of Expenditures Withdrawal Schedule for previous adjustment lending.

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ENVIRONMENTAL ASPECTS

105. The proposed PDPL will not support specific measures which are l ikely to have an effect o n the environment, forests or other natural resources o f FYR Macedonia and n o environmental impact assessment will be required for this operation.

LESSONS LEARNED FROM PRIOR OPERATIONS

106. The preparation o f the proposed PDPL has benefited f rom important lessons learned from previous pol icy based lending. T h i s i s especially true o f the P S M A L (see paragraph 19 above) which was under implementation during the in i t ia l preparation o f PDPL 1. One key lesson f rom the P S M A L (as wel l as the PSMAC) i s that complex institutional changes involve an iterative process o f “learning while doing” and take t ime to gain momentum. Continued fol low through i s essential to ensure results. In this regard, a series o f single-tranche operations designed within a multi-year program i s l ikely to be more appropriate than a traditional multi-tranche operation due to the flexibil i ty inherent in this new instrument. With fol low through in mind, the proposed PDPL program in part reflects a continuation o f a number o f institutional reforms initiated under PSMAL. The c iv i l service reforms as outlined in the PDPL pol icy matr ix most directly incorporate this iterative nature o f institutional reform. The PDPL team has also worked closely with several government bodies in establishing institutional arrangements and capacities to monitor a r i ch array o f indicators designed to measure the impact o f the public expenditure and human resource management reforms begun under the P S M A L supported program. The evaluation o f these regular indicators wil l help determine to what extent and where alterations o f the reform program would be advisable. Reforms in the health sector proposed to be supported by the PDPLs grew directly out o f a comprehensive extemal audit and action plan which were key features o f the P S M A L program. Finally, as important as it i s to continue the public sector reforms launched under P S M A L and PSMAC, i t i s also clear that reforms to improve the investment climate are necessary to foster higher levels of growth and productivity in FYR Macedonia.

107. Another lesson learned i s that reforms supported by pol icy based lending tend to be more effectively implemented when supported by critical technical assistance and investment projects supported by the Bank and other donors. The PDPL program i s thus being supported not only by the PDPL itself but also by the Bank’s health, education, cadastre, and business environment projects. The proposed judicial reform project i s also being designed to assist in the implementation o f the judicial reform component of the PDPL program. Technical assistance provided by the EU Delegation, EAR, the Dutch, UK-DFID, and USAID also supports a number o f reforms in the PDPL program.

MONITORING AND EVALUATION

108. The Government recognizes the importance o f monitoring and evaluation in ensuring the successful implementation o f the PDPL supported program. The reform program sets out qualitative and quantitative benchmarks and targets embedded in the PDPL Policy Matr ix. Some o f these indicators are produced in regular surveys conducted by the Bank and other international organizations, while other indicators are regularly produced by the Government. The Government recognizes that the proposed PDPL 2 and PDPL 3 are subject to the approval o f the Bank’s Board o f Executive Directors and that adequate progress in reform implementation would be required. The Bank and the Government, in consultation with other stakeholders, c i v i l society, and international donors, will fully uti l ize the flexibility inherent in the PDPL instrument to determine whether or not and where adjustments might be made to the indicative pol icy actions stipulated in the Policy Matr ix during the preparation o f the proposed PDPL 2 and PDPL 3, to ensure effective implementation without compromising program outcomes.

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R I S K S AND R I S K MITIGATION

109. Implementation r i sks are fairly substantial. The institutional changes that the PDPL program seeks to overcome are a medium-term endeavor. The current capacity o f some public sector institutions to implement an ambitious reform agenda, whi le much improved over the past few years, remains relatively weak. The risk wil l be mitigated through the continued use o f ample donor-financed technical assistance as wel l as support f rom ongoing and proposed Bank projects in health, social protection, judiciary, and business environment.

110. There are also some polit ical risks. Whi le the threat o f renewed ethnic violence i s modest, the continued uncertainty over the final status o f neighboring K o s ~ v o ' ~ i s pending. Also, the Government has now entered the second ha l f o f i t s four year mandate. The ambitious reform agenda that the PDPL proposes to support could test the Governments commitment to reform as the elections scheduled in Autumn 2006 approach. The domestic polit ical r isks are mitigated by the broad consensus across the polit ical and ethnic spectrum for EU membership. The continued implementation o f both economic reforms and o f the Ohrid agreement are widely recognized as essential steps o n the path to EU membership.

11 1, FYR Macedonia also faces macroeconomic r isks. Whi le FYR Macedonia has an impressive track record o f macroeconomic stability and prudent macroeconomic policies which have n o w been bolstered by a 3 year IMF Stand-By Arrangement, the projected reduction in external current account imbalances would require that investment be increasingly financed by domestic savings. The ratio o f investment to GDP could itself increase in the medium-term as the investment climate improves, with the implementation o f PDPL supported reforms. This risk o f a rising current account deficit would be reduced to the extent that domestic savings continue to recover to their pre-2001 level. The risk would also be mitigated to the extent that reforms would stimulate growth in productivity over time. This risk bears careful monitoring in conjunction with the IMF over the PDPL program period.

l5 Kosovo i s presently under United Nations' (UN) interim administration (UNMIK), pursuant to UN Security Council Resolution 1244 (1999) o f June 10, 1999,

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Annex 1 1 o f 6

REPUBLIC OF M A C E D O N I A M I N I S T R Y OF FINANCE

To: Mr. Paul D. Wolfowitz President International Bank for Reconstruction and Development 1818 H Street, N.W. Washington DC, 20433

September 20,2005

RE: LETTER OF DEVELOPMENT POLICY

Dear Mr. Wolfowitz:

1. I am writing to request, on behalf o f the Government o f the Republic o f Macedonia, a Programmatic Development Policy Loan (PDPL) o f €24,400,000 (US$30 mi l l ion equivalent) to support our economic reform program. This Letter o f Development Policy sets out the key actions that the Government has undertaken and i s committed to undertake over the medium-term to enhance economic growth in Macedonia and make progress towards our goal o f EU accession. Attached to this Letter i s also a Policy Matr ix that summarizes the contents o f this Letter.

2. The overarching objective o f our reform program i s t o promote economic growth and job creation in Macedonia through improving: (i) the investment climate, and (ii) governance and efficiency o f the public sector. I wi l l br ief ly describe our reform plans in both o f these areas.

Improv ing Investment Climate:

3. Despite a number o f reforms camed out over the past decade, including trade liberalization, financial sector reform and privatization, and enterprise restructuring and privatization, Macedonia’s investment climate has not yet created an enabling environment for rapid growth. The reform strategy we hope the PDPL would support includes key reforms in the judiciary, labor markets, financial sector and business environment.

4. Judicial Reform: W e have demonstrated our commitment to a comprehensive reform in this area with the adoption o f the Strategy on the Reform of the Judicial Sector (Re fom Strategy) in December 2004. W e consider the development, adoption, initial implementation o f this Reform Strategy as critical first steps in the process of modemizing Macedonia’s judicial institutions. An important subset o f our Reform Strategy seeks to ensure the efficient, effective and fair enforcement o f creditor, contract and property rights. W e recognize that such r i gh ts are key ingredients in a business

28

Annex 1 2 o f 6

climate that promotes investment and growth. One important component o f the Reform Strategy aims to reduce the backlog and delays in court proceedings. We are following transparent and consultative legislative and regulatory drafting procedures to develop critical pieces o f legislation and regulation. A new Law on Civ i l Procedure (Law on Litigation) was enacted by the Parliament. We have established working groups which will draft the Law on Courts and the ]Law on Misdemeanors which Parliament will enact in 2006. Thereafter, we will ensure the effective implementation o f each o f these important laws to increase the independence o f the judiciary and the pace and efficiency o f the court system. We have recently raised the salary o f judges and will devise an improved incentive system for the judiciary b y 2007, consistent wi th the principles, rules and procedures for setting public sector salaries embodied in the legal framework governing such salaries referred to in paragraph 13 below.

5. The Parliament has enacted a new Law on Enforcement and will focus on the effective implementation o f th is law through the establishment o f an enforcement agent service. We wi l I also improve the supervisory and oversight capacity in the Ministry o f Justice, conduct a public awareness campaign and user surveys which w i l l allow us to follow up with an action plan for continued improvements in the enforcement o f court judgments.

6. We are now drafting a new Bankruptcy Law which was submitted to Parliament for first reading in July 2005. We expect the Law to be enacted later in 2005. We wil l follow through with the implementation o f th is law to ensure the institutional development o f the bankruptcy trustee profession.

7. We plan to adopt constitutional amendments in late 2005 or early 2006. Such amendments will, inter alia, remove the requirement o f a judicial order for administrative sanctions. The Parliament recently enacted a modem General Administrative Procedure Law. Following the constitutional changes the Parliament wi l l enact a new Law o n Administrative Disputes and we may enact amendments to the L a w on General Administrative Procedure, if needed. We w i l l ensure the effective implementation o f these laws by adopting measures to assist our various supervisory and administrative bodies wi th the fair exercise o f administrative sanction responsibility.

8. Finally, we are currently staffing key bodies such as the Court Administrative Office (AO), in agreement with the Judiciary, to monitor implementation o f the Reform Strategy. Capacity w i l l be established in the A0 in order to provide statistical and analytical reports necessary for improved court administration and management. The Judicial Reform Council w i l l continue to monitor and report on progress in the implementation o f the Reform Strategy.

9. Labor Market Reform: Parliament has enacted a new Labor Law in July 2005. Given the high unemployment rate and large informal sector, we consider this reform as one o f the most critical in 2005. Th is law balances the need to protect workers’ rights with the need to increase flexibility in the labor market. The law has: (i) promoted more diversified employment contracts, by limiting restrictions on the use o f fixed-term, temporary and part-time employment contracts while allowing for a provision whereby the cumulative duration o f fixed-term contracts cannot exceed 4 years; (ii) relaxed pre-conditions for valid dismissal and limit severance pay to a maximum o f 6 individual monthly salaries; (iii) increased in the scope for overtime work by increasing the yearly limit on overtime to 190 hours annually, with lower levels for minors; (iv) ensured that collective bargaining i s done on a voluntary basis so that collective agreements are binding only to parties who are signatories to such agreements, in line with ILO Convention N o 144 and Recommendations No 113 and 152 on tripartite consultations; and (v) established methods for labor dispute resolution as an alternatives to strikes and litigation to l imi t the social and economic costs o f industrial disputes. We will play an active role in

29

Annex 1 3 o f 6

encouraging the social partners to negotiate and s ign collective agreements in line with the new Law. We will also establish improved labor dispute resolution mechanisms in early 2006.

10. Banking Sector Regulation and Supervision: We are continuing reforms in the financial sector. We are committed to improving the legal framework for banking and bank supervision as well as the application of the framework and the practice therein. To this end, in cooperation with the World Bank, we launched a banking sector governance study in M a y 2005 and are preparing an evaluation o f the current banking supervisory process. Thereafter, the National Bank o f the Republic o f Macedonia (NBRM) w i l l prepare and adopt a supervisory development plan (SDP) by the end o f 2005. The SDP w i l l be implemented over the next few years and w i l l help the NBRM gradually move towards a more risk-based supervisory approach and address bank governance weaknesses. We are also committed to further strengthen the legal framework for the banking sector, including fit and proper criteria for banks. In this regard, we intend to enact new banking legislation by mid-July 2006. In concert with these efforts, in 2006, the NBRM w i l l also conduct a review o f i ts procedures for assessing banks’ compliance with anti-money laundering and counter-terrorism financing requirements with the view o f approving strengthened fit and proper screening procedures in compliance with the new banking legislation.

11. Improving the Business Environment: With the cooperation of the World Bank we launched a Report on the Observance of Standards and Codes (ROSC) on corporate governance in M a y 2005. We w i l l work wi th the Bank in ensuring that key recommendations from this assessment are implemented over the next few years. We are aware that these recommendations may require some amendments to existing legislation such as the Company L a w or the Securities Law. W e are committed to the adoption o f a quality-oriented approach to regulatory reforms to improving the quality o f existing and new regulations which affect the business sector. We will enact legislation to establish ‘an institutional framework and processes for implementation o f regulatory reforms, with a permanent body in the General Secretariat. This body will be responsible for assuring the quality o f existing and new regulations through the adoption o f methodologies such as the guillotine and the regulatory impact assessment. Through this legislative framework, we wil l also institutionalize mandatory consultation mechanisms with the business community. We will then ensure effective implementation o f this legal and institutional framework by fully staffing the new permanent body in the General Secretariat which w i l l use the new methodologies to streamline a number o f regulatory regimes. In order to further improve business environment, we wi l l ensure a better public access to business sector-related regulations. We also recognize that the process o f registering new business needs to be faster and less burdensome. In this regard, w e have decided to adopt an administrative business registration system with no court involvement. To this end, we have established a working group to draft a new business registration law and devise a “one-stop-shop” system for business registration under the Central Registry. We will adopt the necessary legislation, including amendments to relevant laws and accompanyng implementation regulations, by the end o f 2005. Finally, a new Audit Law was enacted by the Parliament. Over the next few years we will endeavor to fully implement this legislation and ensure that an Institute of Certified Auditors as well as an oversight council wi l l be established.

Strengthen Public Sector Governance:

12. We recognize that good public sector governance i s a pre-requisite for private sector growth. We have implemented many reforms in recent years in public administration and health care which were supported by the Public Sector Management Adjustment Credit (PSMAC) and the Public Sector Management Adjustment Loan (PSMAL). We improved our capacity to make tough policy choices. We have implemented a series o f budget formulation process improvements. A medium term fiscal

30

Annex 1 4 o f 6

strategy for 2005-2007 was approved by the Government in 2004 and enrolling 2006-2008 i s adopted b y the Govemment. Hard budget ceilings for each of the first line budget entities were approved by the Govemment in 2004 and provided to the entities as part o f their budget instructions. These were ultimately reflected in the 2005 Budget approved by Parliament. We have also implemented a number of reforms in the Health Sector and have launched a decentralization process. Our reform efforts in these areas continue as outlined below.

13. We are developing institutional arrangements and capacities designed to ensure more effective strategic prioritization, consistent with the Methodology for Strategic Planning issued by the Govemment in 2003, under guidelines issued by the Govemment in M a y o f this year. Our strategic prioritization and planning process reform w i l l be integrated into the annual budget preparation process. We are piloting this process this year in two ministries and w i l l deepen and expand the process in subsequent years. We have also established a mechanism for monitoring and publicizing systematic evidence on intermediate impacts o f c iv i l service and public expenditure management reforms. In human resource management we are also continuing a number o f reforms supported by PSMAL. W e have strengthened the legal framework establishing a mechanism for controlling compliance with both the recruitment and selection requirements and the position classification requirements, by including th is provision in the New Organic Budget Law, which was enacted in July 2005. We have submitted to Parliament a l imited number o f specific amendments to the Civil Service Law, designed to improve our capacities to attract, retain and motivate qualified civil servants. The C iv i l Service Agency wil l undertake a consultative review o f experience implementing the Civi l Service Law and its subsidiary legislation, and wil l develop and begin to implement a strategic plan for the Agency, consistent with the Government’s Strategic Planning guidelines, which addresses the challenges identified by that review. We w i l l make more fundamental revisions in the Civ i l Service Law, as required, based on that review. We wil l continue the decompression o f civil service salaries as agreed under the P S M A L program. We w i l l also adjust the legal framework goveming the setting o f public sector salaries, with the aim o f establishing a consistent set o f principles, rules and procedures for setting public sector salaries, including assignment o f authority and responsibilities for the various roles required for such salary setting. In so doing, that legal framework w i l l enable the setting of salary structures for well defined subsets o f the public administration (e.g., health care professionals, judges, teachers, etc.) via laws or sub-legal instruments, such as collective bargaining agreements or decrees issued by Govemment; albeit subject to clearly specified procedural constraints designed to ensure compliance with the underlying principles for salary setting. Those principles include: (i) fiscal sustainability o f the overall public sector wage bill, (ii) consistency in the competitiveness o f total remuneration across types o f human capital required by Macedonia’s public administration, and (iii) transparency and faimess in the setting o f public sector remuneration, both the overall structure and composition o f remuneration within the public administration, as well as the remuneration o f individual public servants. We w i l l conduct a p i lo t public/private sector salary survey, which w i l l then be incorporated into the State Statistical Office’s annual work program. Th is survey will help inform the design o f salary structures within the public administration, under the principles, procedures and rules established by the legal framework governing public sector remuneration.

Public Administration Reform

14, Health Reform: We are undertaking a number o f measures to strengthen the transparency, govemance and management o f the Health Insurance Fund. We have adopted and submitted to Parliament amendments to the Health Insurance Law (HIL) to improve the accountability and structure o f the HIF Board. We have proposed to Parliament that the number o f HIF Board members be reduced from 13 to 7; the criteria for selection o f Board members be changed; and a stricter conflict o f interest clause be applied. Veto power would b e granted to the Ministry o f Finance and Ministry o f Health

31

Annex 1 5 o f 6

representatives on the Board. The HIF Board w i l l regularly publish the minutes o f Board meetings, including on the results of voting. We w i l l also pass regulations to implement the amendments in the HIL (contracting, s ick leave and HIF Board). We are also endeavoring to strengthen the health policies that form the basis for health sector resource allocation decisions. In the context o f evaluation o f the Benefits Package, we w i l l review and revise the positive l ists o f drugs and the negative list. To improve the basis for planning and resource allocation decisions, we will analyze the relationship between medical needs and service delivery capacity, in the form o f a Medical Map. The results from the medical map exercise wi l l provide the analytical basis for the distribution o f resources throughout the country, for guiding investment decisions, HIF selective contracting with Health Care Institutions (HCIs) and strengthening the licensing o f HCIs.

15. We will implement the first phase o f the HIF Action Plan (supported by the PSMAL) to strengthen the financial management and internal controls within the HIF including the staffing of a senior financial executive to implement the HIF Action Plan, the development o f HIE: and Health Care Institutions (HCI) s ta f f competencies in budget formulation, execution, monitoring and control. Hard budget ceilings w i l l be imposed o n HCIs and measures will be undertaken to strengthen performance orientation among HCIs. By 2007, 10 percent o f the budget o f HCIs will be l inked to performance and all HCIs will have contracts based o n hard budget ceilings and key performance indicators. We wi l l conduct international competitive bidding in accordance with the HIF Act ion Plan for selected categories o f outpatient drugs o n the positive lists, and for all drugs o n the hospital l ist. We will also introduce an internal reference price mechanism in 2006 for selected outpatient drugs on the positive lists. In 2007, we will adopt a reference price mechanism for all drugs on the positive lists.

16.. W e are now beginning the functional and fiscal components o f our decentralization program. T h i s wi l l occur in two phases. Under Phase 1, which began on July 1,2005, municipalities substantially increased their role in education, culture, social protection (landergartens and homes for elderly) and fire-protection. Municipalities assumed ownership o f the buildings in which these functions are performed, and responsibility for their operation. Salaries, however, continue to be paid directly to schools, cultural institutions, kindergartens, homes for elderly and fire departments by the line ministries until Phase 2. To finance the operating costs o f schools, cultural institutions, kindergartens and homes for elderly the l ine ministries will transfer an amount no less than the amount i t spent on these costs in each jurisdiction in 2004 (adjusted for seasonal variations in education).

Decentralization:

17. Other functions, including urban planning, financial management, and revenue collection were also decentralized effective July 1, 2005. To finance these functions and to provide additional discretionary resources to the municipalities, Parliament has enacted a Municipal Finance Law which requires the Government to transfer three percent o f the revenues from the personal income tax and the value added tax (VAT) to the municipalities. The municipal share o f the personal income tax i s now distributed on the basis of origin (wi th certain adjustments for the City of Skopje.) The VAT i s now distributed on the basis o f a recently adopted formula. We will establish a stable formula for distributing VAT by mid-2006.

18. To address the problem o f municipal arrears, the Ministry i s organizing and will facilitate negotiations between municipalities and their creditors, while avoiding any large scale Government- financed debt relief that might encourage municipalities and creditors to engage in excessive debt- financing in the future.

19. Under Phase 2, municipalities wi l l become directly responsibility for paying salaries for employees in schools, cultural institutions, kindergartens, fire-protection departments and homes for

32

Annex 1 6 of 6

the elderly. Prior to implementing Phase 2, we w i l l devise an acceptable formula for financing these costs, We wil l also review the overall strategy for functional decentralization in Phase 2 prior to i ts implementation.

Conclusion :

20. We are aware that our ambitious goals will require a concerted effort. At the same time we are confident that this letter outlines a coherent and comprehensive program o f reforms and i s focused on critical policy priorities. W e are convinced that these reforms are essential to achieving sustained growth. In closing, we would l ike to reiterate that the continued support o f the World Bank and the international community wi l l be essential for achieving these ambitious goals. I trust that this request for World Bank support for the implementation o f this reform program wil l receive your endorsement.

Yours sincerely,

Niko la Popovski, MA

33

- 4

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a 8

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a

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s a2 Y 0 9 3 4

Annex 3 1 o f 2

1984-94 1994-04 2003 2004 (average annual growth) Agriculture .. -0.2 4.8 4.4 Industry .. 2.2 6.5 -0.1

Manufacturing .. 0.4 0.5 -3.7 Services .. 2.0 0.8 4.5

Household final consumption expenditure .. 2.4 0.6 1.4 General gov't final consumption expenditure .. 2.8 -6.0 1.5 Gross capital formation .. 2.9 -0.4 f3.8 Imports of goods and sewices .. 5.2 -5.2 10.6

Macedonia, FYR at a glance 9/22f05

Growth of exports and Imports (%)

20

10

30

0

-lo

-20

2

-Exports +Imports

POVERTY and SOCIAL Macedonia.

2004 Population, mid-year (millions) GNI per capita (Atlas method, US$) GNI (Atlas method, US$ billions)

Average annual growth, 199844

Population (%) Labor force (%)

Moot recent estimate (latest year available, 1998-04)

Poverty (% of population below national poverfy line) Urban population (% offotal population) Life expectancy at birth (years) Infant mortality (per 7,000 live births) Chiid malnutrition (% of children under 5) Access to an improved water source (% ofpopulation) Literacy (% ofpopulation age 75+) Gross primary enrollment (% of schod-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1984

GDP (US$ billions) Gross capital formatiotVGDP Exports of goods and sewicedGDP Gross domestic savings/GDP Gross national savingdGDP

Current account balance/GDP Interest payments/GDP Total debvGDP Total debt serviceiexports Present value of debffGDP Present value of debvexports

1984-94 199444 (average annual growth) GDP .. 1.7 GDP per capita 1.1 Exports of goods and services .. 3.6

FYR

2.1 2,390

4.9

0.4 -1.6

22 60 74 11 6

96 96 99 98 99

1994

3.4 15.5 38.2 5.3 7.5

-7.8 1 .o

32.6 12.2

2003

2.8 2.3 2.2

Europe 8 Central

Asia

472 3,290 1,553

-0.1 0.5

84 68 29

91 97

101 103 101

2003

4.7 19.8 37.6 3.0

18.2

-3.2 1 .I

40.2 12.8 25.1 61.7

2004

2.9 2.2

11.7

Lower- middle- Income

2,430 1,580 3,847

1 .o 0.7

49 70 33 11 81 90

114 115 113

2004

5.4 21.6 40.1

1 .o 15.1

-7.7 1.1

37.5 11.8 24.6 56.6

200448

4.2 3.8 7.3

I Development diamond'

Life expectancy

T Gross

primary capita enrollment

I

Access to improved water source

I -Macedonia, FYR - Lower-middle-income grow

Economic ratios.

Trade T

Indebtedness

-Macedonia, FYR - Lower-middle-income group

STRUCTURE of the ECONOMY 1984 I994 2003 2004

.. 13.3 13.7 13.2 (% of GDP) Agriculture lndustly .. 30.4 30.4 27.8

Manufacturing .. 23.7 18.5 15.6 Services .. 56.3 55.9 58.9

Household final consumption expenditure .. 75.7 76.5 79.1 General gov't final consumption expenditure .. 19.0 20.5 19.9 Imports of goods and services .. 48.4 54.4 60.6

Note: 2004 data are preliminary estimates. The diamonds show four key indicators in the country (in bold) compared with its incomegroup average. If data are missing, the diamond will be incomplete.

45

Annex 3 2 o f 2

Macedonia, FYR

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices implicit GDP deflator

Government ffnance (% of GDP, includes curent grants) Current revenue Current budget balance Overall surplus/deficit

TRADE

(US$ millions) Total exports (fob)

Raw materials Food Manufactures

Total imports (cif) Food Fuel and energy Capital goods

Export price index (2000=100) Import price index (2000=100) Terms of trade (2000=100)

BALANCE of PAYMENTS

(US$ millions) Exports of goods and services imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gold (US$ millions) Conversion rate (DEC, local/US$)

EXTERNAL DEBT and RESOURCE FLOWS

(US$ millions) Total debt outstanding and disbursed

iBRD IDA

Total debt service IBRD IDA

Composition of net resource flows Official grants Official creditors Private creditors Foreign direct investment (net inflows) Portfolio equity (net inflows)

Wodd Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

1984

1984

1984

1984

0

0 0

1994

121.8 151.9

43.1 0.6

-2.7

1994

1,086 77

110 835

1,484 282 161 292

133 114 116

1994

1.258 1,598 -340

-47 124

-263

305 -42

172 43.3

1994

1,104 93 42

156 136

0

74 -1 8 -1 5 24 0

80 80

104 -24 32

-56

2003

1.2 1 .o

37.8 3.8

-0.1

2003

1,367 40 92

1,023 2,306

271 323 434

113 113 100

2003

1,689 2,548 -858

-32 74 1

-149

200 -51

903 54.3

2003

1.876 175 356

243 15 2

104 56 -5 96

3

20 59 8

51 9

42

~

2004

-0.4 1.5

36.4 3.6 0.7

2004

1,673 44

126 1,297 2,903

337 377 546

123 126 96

2004

2,080 3,247

-1,166

-39 791

-415

434 -1 9

902 49.4

2004

2,007 21 8 387

275 22 3

70 38 2

156 15

55 35 15 20 10 10

lnflatlon (%)

" T I

-GDP deflator -CPI I

I Export and import levels (US0 mill.)

" I 88 98 W 01 02 03

Exports Imports

Current account baiance to GDP 6 0 1 2 3 4 5 4 7 8 9

10

~~

Composltlon of 2004 debt (US0 mill.)

I

~ A - I B R D E - Bilateral 6 - IDA D - Other multilateral F - Private C-IMF G - Short-term

~ ~ ~~

Development Economics 9/22/05

46

Annex 4

Macedonia, FYR Social Indicators

POPULATION Total population. mid-year (millions)

Urban population (X of population) Total fertility rate (births per woman)

POVERTY (% of population) National headcount index

Urban headcount Index Rural headcount index

Gmwih rate (% annual average for period)

INCOME GNI per capita (US$) Consumer price index (1995=100) Food price index(1995=100)

INCOMElCONSUMPTlON DISTRIBUTION Share of Income or consumption Gini index Lowest quintile (96 of income or consumption) Highest quintile (OA of income or consumption) SOCIAL INDICATORS Public expenditure

Health (%of GDP) Education (% of GNI) Social security and welfare (% of GDP)

Net primary school enrollment rate (% of age group)

Male Female

Access to an improved water source (% ofpopulation)

Urban Rural

Total

Total

Immunizatlon rate (% of children ages f2-23 months)

Measles OPT

Child malnulrition (% under 5 years) Life expectancy at birth Wears)

Total Male Female

Mortallty Infant (per 1,000 live births) Under5 (per 1.oOa) Adult (15-59)

Male (per 1 . W population)

197540

1.9 1.5

53.5 2.6

53 69

Female (per 1.000 population) Maternal (per 100,000 live birlhs)

198540

1.9 -0.7 57.8 2.1

0

94 95 94

72 70 74

32 33

147 100

Latest single year Same region/lncome group

Births attended by skilled health staff (%) 98 86 0812205

- - -

1998.04

2.1 0.4

59.6 1.8

21.7

22.3

2,390 123

0.4 6.0

36.7

5.7

92 92 93

96 96 6

74 71 76

11 11

160 89 23

Europe (I Central

&la

472.1 -0.1 63.6

1.6

3,290

4.2 4.4

89 89 88

91 98 80

92 90

68 64 73

29 36

317 136 61

Lower- m I d d I e. Income

2,430.3 1 .o

48.6 2.1

1,580

2.5 3.5

81 93 70

86 88 11

70 68 72

33 42

192 123 ill

47

Annex 5 1 o f 2

Macedonia, FYR - K e y Economic Indicators

Actual Estimate Projected Indicator 2001 2002 2003 2004 2005 2006 2007 2008 2009

National accounts (as YO of GDP) Gross domestic product'

Agriculture Industry Services

Total Consumption Gross domestic f ixed investment

Govemment investment Private investment

100 100 100 100 100 100 100 100 100 12 12 14 13 11 10 10 9 9 32 30 30 28 35 34 34 33 33 56 57 56 59 54 55 56 57 58

95 100 97 99 98 97 95 93 93 15 17 17 18 18 19 19 20 20 3 4 4 3 5 4 4 3 3

11 13 13 15 14 ' 15 16 16 17

~ x p o r t s (GNFS)~ 43 38 38 Imports (GNFS) 57 58 54

Gross domestic savings 5 0 3 Gross national savingsC 14 13 18

Memorandum items Gross domestic product 3437 3791 4666 (US$ mil l ion at current prices) GNI per capita (US$, Atlas method) 1690 1710 1970

Real annual growth rates (%, calculated from 1995 prices) Gross domestic product at market prices -4.5 0.9 2.8 Gross Domestic Income -4.1 1.0 2.1

Gross domestic product at market prices -4.9 0.7 2.3 Real annual per capita growth rates (%, calculated from 1995 prices)

Total consumption -3.8 5.8 -1.3 Private consumption -10.9 10.0 0.1

Balance of Payments (US% millions) , ~ x p o r t s (GNFS)~ 1400 1365 1689

Merchandise FOB 1155 1112 1363 Imports (GNFS)~ 1946 2192 2548

Merchandise FOB 1682 1916 2211

Net current transfers 343 498 741 Resource balance -546 -826 -858

Current account balance -244 -358 -149

Net private foreign direct investment 44 1 78 96

Official -26 36 56 Private -56 -33 -3

Other capital (net, incl. errors & ommissions) -38 147 51 Change in reservesd -77 131 -51

Long-term loans (net) -82 2 53

Memorandum items

Real annual growth rates ( YR95 prices) Resource balance (% o f GDP) -15.9 -21.8 -18.4

Merchandise exports (FOB) -8.5 -1.8 2.2 Primary 3.1 11.2 -11.5 Manufactures -12.6 -4.7 -1.2

Merchandise imports (CIF) -15.4 21.8 -5.2

40 61

1 15

44 64

2 15

45 63

3 16

46 63

5 17

46 62

7 18

46 62

7 18

5355 5609 5937 6329 6756

3160

7255

2390 2660 2830, 2980

2.9 0.7

3.7 2.1

4.0 4.0

4.5 4.5

4.5 4.5

5.0 5.2

2.2 0.8 0.8

3.8 0.9

-0.8

4.0 2.3 2.9

3.5 1.9 4.5

4.0 2.4 2.2

4.5 4.2 4.4

2080 1672 3247 2785

79 1

156 49 38 11

230 -19

-1 166

-415

247 1 2000 3574 3080

-1 IO3 808

-3 64

162 247

60 187 89

-133

2665 2146 3758 3226

-1093 817

-339

487 -27 24

-50 93

-214

2881 2314 3972 3406

-1091 854

-315

305 64 40 24 87

-141

3110 2500 4207 3612

890 -1097

-304

3333 2681 4484 3858

-1 152 917

-337

266 56 47

9 96

-80

270 59 44 15 84

-109

-21.8

11.7 -1.1 18.9 10.6

-19.7

16.1 11.0 17.6

3 .O

-18.4

4.4 4.0 4.5 1.9

-17.2

5.8 5.0 6.0 3.6

-16.2 -15.9

7.0 5 .O 7.5 5.0

6.2 5.0 6.5 6.2

48

Annex 5 2 o f 2

Macedonia, FYR - Key Economic Indicators (Continued)

Actual Estimate Projected Indicator 2001 2002 2003 2004 2005 2006 2007 2008 2009

Publ ic finance (as % o f GDP a t marke t prices)' Current revenues 33.8 Current expenditures 36.9 Current account surplus (+) or deficit (-) -3.1 Capital expenditure 3.5 Foreign financing -1.8

Monetary indicators M2 lGDP 34.9 Growth o f M2 ("h) 56.0 Private sector credit growth / -18.6 total credit growth ("h)

Price indices( yR95 =loo) Merchandise export price index 64.1 Merchandise import price index 77.2 Merchandise terms o f trade index 83.1 Real exchange rate (US$/LCu)' 87.3

Real interest rates 5.5

GDP deflator (% change) 3.6 Consumer price index (% change)

34.7 36.9 -2.2 3.6 0.7

29.5

15.4 -11.8

63.0 74.7 84.3 87.0

1.8 3.4

37.8 34.1

3.8 4.1 0.6

32.2 13.5 80.5

75.5 91.0 82.9 87.4

1.2 1 .o

36.4 37.8 34.5 33.1 32.7 33.5 30.9 29.8

3.6 4.3 3.6 3.3 3.1 5.3 4.4 4.1 0.2 4.5 -0.9 0.6

35.9 40.2 44.9 50.0 16.5 17.1 18.5 18.6

103.4 103.0 100.0 100.0

82.8 85.2 87.6 89.2 103.6 106.7 109.7 111.8 79.9 79.8 79.8 79.8 86.8 87.9 85.4 85.4

-0.4 1.2 1.8 2.0 1.5 1.0 1.8 2.0

32.3 32.0 29.3 28.9

3.0 3.1 3.8 3.6 0.5 0.4

55.6 60.6 18.6 17.1

100.0 100.0

90.1 91.0 112.9 113.6 79.8 80.1 85.4 85.4

2.0 2.0 2.2 2.3

a. GDP at factor cost b. "GNFS" denotes "goods and nonfactor services." c. Includes net unrequited transfers excluding official capital grants. d. Includes use o f IMF resources. e. Consolidated central government. f. "LCU" denotes "local currency units." An increase in US$/LCU denotes appreciation.

49

Annex 6

Macedonia, FYR - Key Exposure Indicators

Actual Estimate Projected Indicator 2001 2002 2003 2004 2005 2006 2007 2008 2009

Total debt outstanding and 1469 1670 1876 2007 2144 2202 2257 2328 2408 disbursed (TDO) (US$m)a

Net disbursements (US$m)a .. 248 -34 56 70 80

Total debt service (TDS) .. 264 383 310 325 383 (US$m)a

Debt and debt service indicators

(%I TDOKGS~ TDO/GDP TDWXGS Concessional/TDO

IBRD exposure indicators ("h) IBRD DS/public DS Preferred creditor DS/public DS (%)' IBRD DSKGS IBRD TDO (US$m)d

O f which present value of guarantees (US$m)

Share o f IBRD portfolio (%) IDA TDO (US$mld

IFC (US$m) Loans Equity and quasi-equity /c

MIGA

96.6 110.6 98.9 86.3 78.5 74.8 71.0 68.0 65.7 42.7 44.1 40.2 37.5 38.2 37.1 35.7 34.5 33.2

.. 9.7 13.0 9.8 9.5 10.5 22.9 24.7 26.9 27.9

1.9 8.2 9.7 12.6 13.2 12.2 11.8 12.8 13.7 53.6 42.4 46.4 44.2 43.2 43.0 39.8 38.4 37.7

0.8 0.9 0.8 0.9 0.8 0.9 0.9 0.9 1.0 117 138 175 218 232 263 301 338 369

0 0 0 0 0 0 0 0 0 254 293 356 387 357 356 355 352 348

a. Includes public and publicly guaranteed debt, private nonguaranteed, use o f I M F credits and net short-

b. "XGS" denotes exports o f goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the

Bank for International Settlements. d. Includes present value o f guarantees. e. Includes equity and quasi-equity types o f both loan and equity instruments.

term capital.

50

I

Annex 7

FYR MACEDONIA Operations Portfolio (IBRD/IDA and Grants)

A6 Of Date 09/07/2005 CI0.ed ProJ.cl. 21

pctlv. P,Ol.CI.

!&B& Sup.wlilon Rallng -a

ProJacl ID ProJ~.sl N i m i IBRDnDA QRANT c.nu1.

PO66157 EDUC MOD S S 2004 6 PO74358 SOC PROT S S 2004 9.8 PO76712 COMM DEVT S S 2002 5 PO86670 HLT SEC MOT MS MS 2004 10 PO38399 IRRlG REHAB S S 1998 12.5 PO63577 COMM DEVT & CUL MS MS 2001 5 PO73483 CHILDNOUTH DEV S s 2001 2.5 PO83126 REG a REAL ESTA S S 2005 14 PO79552 BUSINESS ENV RE 11 0 2005 11.3 PO70089 TRADE a TRANS F S S 2000 9.3

TOTAL 84.4

wlo nl lame Iallon "2 ""& F1'c'lY*u

GEF SUSTAINABLE ENERGY 0.4 0.4

51

Annex 8

52

Annex 9

FYR MACEDONIA Selected Indicators* of Bank Portfolio Performance and Management

As Of Date 09/07/2005

Indicator * 2002 2003 2004 2005 Porifolio Assessment

Average Implementation Period (years) b/

Number of Projects Under Implementation a/ 13 8 11 10

Percent of Problem Projects by Number a’ c/ 15.0 12.5 0.0 0.0 Percent of Problem Projects by Amount a/z cl 16.0 8.0 0.0 0.0 Percent of Projects at Risk by Number d’ 23.0 25.0 0.0 0.0 Percent of Projects at Risk by Amount a’ dl 21.0 29.0 0.0 0.0

CPPR during the year (yeslno) Yes no no Yes

Disbursement Ratio (%) 16.9 22.8 41.5 35.0 Porifolio Management

Supervision Resources (total US$) Average Supervision (US$/project)

Memorandum Item Since FY E Last Five FYs Proj Eva1 by OED by Number 18 12 Proj Eva1 by OED by Amt (US$ millions) 25.0 13.0 % of OED Projects Rated U or HU by Number 16.0 16.0 % of OED Projects Rated U or HU by Amt 3.7 1.7

a. As shown in the Annual Report on Portfolio Performance (except for current FY). b. Average age of projects in the Bank‘s country portfolio. c. Percent of projects rated U or HU on development objectives (DO) and/or implementation progress (IP). d. As defined under the Portfolio Improvement Program. f. Ratio of disbursements during the year to the undisbursed balance of the Bank‘s portfolio at the

beginning of the year: Investment projects only. * All indicators are for projects active in the Portfolio, with the exception of Disbursement Ratio,

which includes all active projects as well as projects which exited during the fiscal year.

53

Annex 10

IFC and MIGA Program - FYR Macedonia, FY 2002-2006 In US$ Million as o f July 31st, 2005.

2002 2003 2004 2005 2006

IFC Original Commitments (US$m)

Sector (YO)

5.85 2.95 0 0 0

FINANCE & INSURANCE TEXTILES, APPAREL & LEATHER Total

Investment instrument(%) Loans Equity Quasi-Equity Other Total

91% 9% 100%

100% 100%

91% 9% 100%

100% 100%

0

0

0

0

0

0

MIGA guarantees (US$m)

5 4

Annex 11

Summary of Non-lending Services FY 2005 - FY 2006

Product Completion FY Cost (US$OOO) Audience a/ Objective

Recent completions CEM ROSC ACCT & AUDIT AMUCFT Assessment ROSC Accounting and Auditing FSAP Country Financial Accountability Assessment Country Procurement Assessment Report Energy Sector Strategy Legal and Judicial Diagnostic CCGPP: Macedonia Country Assessment Poverty Assessment

ROSC on Corporate Governance Governance of Financial Sector

Planned Investment Climate Report

03 03 03 03 04 04 04 4 05 05 05 05 05

06

223 GlDlB 59 GlDlB

.59 G 59 GIB 308 GIB 85 GIDIB 108 GlDlB 53 GlDlB 79 GIDIB 50 GIDIB

266 GIDIBIPD GlDlB GIDIB

GlDlB

KGlPS KGlPS KGlPS KGlPS KGlPS KGlPS KGlPS KGIPS KGlPS KGIPS

KGlPDlPS KGlPS KGlPS

KGIPS

a1 Government (G), Donor (D), Bank (B), Public Dissemination (PD). bl Knowledge Generation (KG), Public Debate (PD), Problem-Solving (PS).

55

Press Release No. 05/196 September 1,2005 Revised: September 15,2005

Annex 12 1 o f 4

International Monetary Fund 700 19th Street, NW Washington, D.C. 2043 1 USA

IMF Executive Board Approves Three-Year USft75.8 Mi l l ion Stand-By Arrangement for Macedonia

The Executive Board of the International Monetary Fund (JMF) on August 3 1 approved a three- year SDR 5 1.7 mil l ion (to about US$75.8 million) Stand-By Arrangement for the former Yugoslav Republic o f Macedonia to support the country's economic program and approved an extension to the obligations schedule o f the country's repayments to the Fund in the total amount o f SDR 5.4 mil l ion (about US$7.9 million).

The approval o f the arrangement enables FYR Macedonia to draw SDR 10.5 mill ion (about US$1 5.4 million) immediately. The authorities have indicated that, after making the initial purchase, they do not plan to draw under the arrangement and intend to treat the arrangement as precautionary.

Following the Executive Board's discussion on Macedonia, Mr. Takatoshi Kato, Deputy Managing Director and Acting Chair, stated:

"The authorities o f the former Yugoslav Republic o f Macedonia are to be commended for their sound macroeconomic policies: fiscal discipline has kept the debt ratio low, while the de facto exchange rate peg has brought inflation close to zero. However, structural impediments have led to relatively weak economic growth, persistently high unemployment, and a wide current account deficit. The authorities' strong program focuses on structural reforms aimed at increasing growth and employment and reducing the extemal imbalance, while securing the past gains in macroeconomic stabilization. The program also supports the process o f integration with the EU, and i s expected to allow for an orderly exit from long-term financial engagement with the Fund. The recent upgrading in FYR Macedonia's credit ratings i s encouraging.

"A core program element i s an ambitious labor market reform, which should bring down non- wage labor costs and allow for a more eff icient allocation o f resources. The reform should help draw employment out o f the grey market, thus ensuring that labor enjoys legal protections while also contributing to increased revenue collection. A comprehensive judicial reform to strengthen the ru le o f law and bring the court system closer to European standards will further improve the business climate. These reforms and other measures in the program should lead to higher investment, including foreign direct investment, and lay the basis for stronger growth and employment creation.

"The program's fiscal policies will sustain the adjustment already achieved, keeping the government debt ratio on a declining path, including through the planned broad-based containment o f expenditures. Structural fiscal reforms, including the consolidation and rationalization o f the collection o f payroll taxes, and measures to improve budget planning and execution, will strengthen the efficiency o f government operations over time. In the same vein, the authorities have begun to confront long-standing problems in the health sector, signaling a renewed commitment to fiscal integrity and budget management in this sector.

"Monetary policy will continue to rely on the de facto peg o f the denar to the euro to ensure stable and low inflation. The robustness o f the peg wil l be underpinned by using privatization receipts to boost international reserves and by recapitalizing the central bank in order to ensure

56

Annex 12 2 o f 4

i t s financial independence and further strengthen i t s policy credibility. Supervisory procedures and regulations have already been strengthened in order to contain balance sheet r isks that might arise f rom euroization and rapid credit growth. Further prudential measures to manage banks' balance sheet r isks are included in the program," Mr. Kat0 said.

Background

Despite the success in macroeconomic stabilization under the previous IMF-supported arrangement, which expired in August 2004, economic growth in FYR Macedonia has remained modest. Fiscal discipline has produced a modest and declining debt ratio and the de facto exchange rate peg has brought inflation close to zero, but deficiencies in the functioning o f the relevant institutions have undermined business activity and kept per capita FDI low. The resulting weak competitiveness has led to disappointing growth, high unemployment, and a persistent current account deficit.

Program Summary

The new program includes structural reforms to improve the business climate, and thus competitiveness, and sound macroeconomic policies to maintain financial stability. As the structural reforms take effect, GDP growth i s projected to accelerate f rom less than 3 percent per annum in 2003-04 to 4.5 percent in 2007 and the external current account deficit i s expected to narrow significantly.

O n the macroeconomic front, monetary pol icy will continue to be based o n the de facto peg to the euro, ensuring continued l o w inflation. The peg will be strengthened by using privatization proceeds to raise international reserve cover f rom about three months o f imports at end-2004 to about four months o f imports by end 2006. Appropriate financial policies wil l maintain reserve cover thereafter. Given recent rapid credit growth-much o f i t denominated in, or indexed to, the euro-the program aims to mitigate balance sheet r isks through strengthened prudential oversight and measures aimed at improving governance in banks.

The fiscal program i s anchored by a medium-term deficit target o f 0.6 percent o f GDP, which w i l l bring the central government debt-to-GDP ratio down to about 33 percent by 2008. The key to reaching the program's ambitious deficit target i s a broad-based containment o f expenditures, including wages, and the strengthening o f tax administration through a carefully sequenced set o f reforms. Expenditure management will be improved and reform o f the Health Insurance Fund w i l l strengthen government oversight over health expenditure. The program also aims to improve FYR Macedonia's borrowing capacity by developing the domestic debt market and establishing access to international capital markets.

The structural core o f the program i s a wide range o f reforms which should enhance competitiveness by improving conditions for investment and business activity. The new L a w on Labor Relations, which strikes a better balance between workers' rights and employers' needs, creates more favorable conditions for business activity by reducing restrictions on short-term and part-time employment contracts and overtime work. Comprehensive judic ia l reform, to be implemented over several years, will create a fairer and more predictable framework for business activity by increasing the independence and professionalism o f judges, eliminating court delays, and removing misdemeanors and administrative cases f rom the regular courts. The labor market and judicial reforms will be complemented by a number o f measures to strengthen the framework for business activity, including, notably, measures to shorten the time needed to open a business. Many o f the reforms included in the program are also supported by the Wor ld Bank and by other multilateral and bilateral donors.

57

Annex 12 3 o f 4

4.5

2.0

...

-0.6

33.2

33.8

33.4

25.0

...

...

...

...

2,043

2,958

-915

FYR Macedonia: Selected Economic Indicators, 2003-08

2003 2004 - 2005 2006 2007 2008

Prel. Proj .

Real economy

Real GDP

Consumer prices, (period average) 11

Unemployment rate (average)

Government finances

Central government balance 21

Revenues (including grants)

Expenditures

Central Government debt

Gross

Net 31

Money and credit

Broad money (M3)

Total credit to private sector

Short-term lending rate (percent)

Interbank money market rate (percent)

Balance of payments

Exports

Imports

Trade balance

2.8

1.2

36.7

-0.1

38.4

38.5

39.0

34.9

18.0

19.0

14.5

6.8

1,207

1,96 1

-754

(Percent change)

2.9 3.7 4.0 4.5

-0.3 1.2 1.8 2.0

35.6 ... ... ...

(In percent o f nominal GDP)

0.7 -0.8 -0.6 -0.6

37.5 38.9 35.4 34.1

36.8 39.7 36.1 34.7

37.6 40.9 36.6 35.8

33.3 33.5 27.3 25.6

(Percent change, end o f period)

16.1 17.7 18.4 ...

25.0 22.7 19.1 ...

11.8 ... ... ...

8.3 ... ... ...

(In mil l ions o f Euro)

1,344 1,640 1,755 1,893

2,244 2,517 2,636 2,792

-900 -877 -881 -899 I --I

58

Annex 12 4 o f 4

including grants

(in percent o f GDP)

Overall balance

Off ic ia l gross reserves

(in months o f fo l lowing year's imports o f goods and services)

External debt t o GDP ratio (percent) 41

Exchange rates

Real effective exchange rate (CPI-based)

Real effective exchange rate (ULC-based)

Current account balance

excluding grants

(in percent o f GDP) I

2003

-23 1

-5.6

-142

-3.5

20

715

3.3

42.4

2.7

-1.1

2004

Prel.

-396

-9.4

-343

-8.2

-25

717

2.9

44.8

2005 2006 2007 2008

Proj .

-345 -287 -281 -255

-7.8 -6.1 -5.6 -4.8

-288 -242 -244 -202

-6.5 -5.2 -4.9 -3.8

212 169 125 101

916 1,078 1,190 1,275

3.6 4.0 4.1 4.1

46.7 44.9 44.6 43.5

(Percent change, per iod average)

-1.8 ... ... ...

1.1 ... ... ...

Sources: Data provided by the authorities; and IMF staff projections. 1/ Recent revisions by the State Statistics Office have not been incorporated in this document. 2/ 0.4 percent o f GDP of the 2005 fiscal account deficit i s caused by the NBRM recapitalization. 3/ Gross debt minus government's deposits with the NBRM. 4/ Total external debt, including trade credit. Includes for 2005 an €150 m i l l i on Eurobond issuance.

IMF EXTERNAL RELATIONS DEPARTMENT Public Affairs: 202-623-7300 - Fax: 202-623-6278

Media Relations: 202-623-71 00 - Fax: 202-623-6772

59