MACEDONIAN ECONOMY: PERIOD OF UNCERTAINTY

UNCLAS SECTION 01 OF 02 SKOPJE 000265

SIPDIS

SENSITIVE
SIPDIS

DEPT FOR EUR/SCE
TREASURY FOR W. LINDQUIST

E.O. 12958: N/A
TAGS: ECON PGOV PREL MK
SUBJECT: MACEDONIAN ECONOMY: PERIOD OF UNCERTAINTY

REF: A. SKOPJE 262

B. SKOPJE 256

Summary
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1. (SBU) Since 2001, the GOM has maintained conservative fiscal
and monetary policies. Those policies, agreed with the IMF, have
sustained a foundation of economic stability that has supported the
GOM's implementation of structural reforms. Over the past few
months, Macedonia's inflation rate has shot up, however, hitting
10.2 percent in March, and the current account deficit has widened
significantly. During a recent visit, an IMF mission indicated that
Macedonia faces macroeconomic risks over the next several months.
Some analysts also fear that a perception of heightened political
risk, following Macedonia's recent failure to receive a NATO
invitation, could hit the economy hard. We remain optimistic that
Macedonia's economy will weather these trends without major
downturns, although the GOM may have to struggle to reach its
ambitious economic growth targets. End Summary.

Worrying Trends
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2. (SBU) Over the past few years, the GOM and Macedonia's National
Bank have implemented economic policies that have maintained a
stable macroeconomic environment. The National Bank has maintained
a fixed denar/euro exchange rate, providing the economy with a solid
"anchor." Relatively high interest rates have kept credit growth at
a moderate pace. The government has kept its budget roughly
balanced and its external debt at a sustainable, and declining,
level. Although Macedonia has run a persistent trade deficit,
financial inflows have covered most of the deficit and kept the
current account deficit relatively low.


3. (SBU) This positive macroeconomic picture continued in 2007 (ref
B),but at the end of the year inflation was rising and the current
account deficit was growing. Year-on-year inflation, measured by
the consumer price index, jumped to 6.1 percent in December 2007.
The first three months of 2008 saw the inflation rate continue to
accelerate, with an inflation rate of 8.7 percent in January, 9.6
percent in February, and 10.2 percent in March. The current account
remained in surplus throughout most of 2007, before turning into a
deficit equal to three percent of GDP by December.


4. (SBU) Rapidly increasing food prices have been the greatest
contributor to the higher inflation rate. Food prices were 21
percent higher in March 2008 than in March 2007. Because incomes in
Macedonia are substantially lower than in the EU, food represents a
significantly higher percentage of consumer spending than it does in
EU countries. Therefore, the rise in global food prices has
contributed to a greater increase in the overall consumer price
index in Macedonia than in the EU (up only 3.5 percent in March),
even though the denar exchange rate has remained fixed to the euro.
In response to the higher inflation rate, the National Bank raised
interest rates on the bills it offers.

IMF Moderately Concerned
--------------

5. (SBU) An IMF mission that visited Skopje April 1-8 to review
Macedonia's progress conveyed to us several concerns about these
trends. The head of the mission, Mark Griffiths, appraised the
higher inflation rate in Macedonia as primarily the result of
international increases in food and energy prices. Assuming
international food and energy prices do not continue their rapid
rise, the inflation rate in Macedonia should begin to moderate,
according to Griffiths. He noted, however, there was a risk of
"secondary" inflationary effects if domestic spending accelerates
and workers demand higher wages in anticipation of continuing high
inflation.


6. (SBU) Griffiths welcomed the National Bank's recent interest
rate increase (to six percent) on the bills it sells to banks and
argued that the GOM should avoid an expansionary fiscal policy. In
his public statement, Griffiths warned the GOM against engaging in
additional spending, above that currently budgeted, despite higher
than anticipated tax revenue during the first three months of 2008.
Griffiths told us that he expects Macedonia's inflation rate will
decline during the rest of the year and end the year at about five
percent.


7. (SBU) Griffiths was more concerned about the potential problems
stemming from the growing current account deficit. The IMF mission
estimated that the current account deficit for 2008 will be about
ten percent of GDP, three times higher than in 2007. A growing
current account deficit could put pressure on the National Bank's
currency reserves and raise concerns about the Bank's ability to
maintain the denar's fixed exchange rate to the euro.

SKOPJE 00000265 002 OF 002



Political Risk and the Doomsday Scenario
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8. (SBU) Some local analysts have speculated that the international
price shock could combine with worries about political stability
here and lead to an economic crisis in Macedonia. In March, the
local weekly business magazine Kapital featured on its cover a
picture of a sinking and burning ship flying the Macedonian flag
under the title "political risks for Macedonian business." The
magazine article sketched a scenario that some local economic
analysts have also raised with us.


9. (SBU) Under this extreme scenario, Macedonia's failure to gain a
NATO invitation or a date for EU negotiations, and the GOM's call
for early elections (ref A),would deter potential foreign and
domestic investors and stall economic reforms. The GOM (according
to this scenario) would spend freely and make expensive promises in
the run-up to the election. This government stimulus would increase
inflationary pressures. Concerned Macedonians would convert their
denars to euros. As a result of the high domestic demand for euros
and the low level of foreign capital coming into the country, the
National Bank's reserves would become depleted, forcing the National
Bank to devalue the denar and dramatically raise interest rates. In
the end, Macedonia would be stuck in a vicious cycle of high
inflation, a devalued currency, and low investment.

Comment: Not Business Heaven Or Hell
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10. (SBU) We do not believe this economic crisis scenario is likely.
The initial economic reaction to NATO's failure to invite Macedonia
has been moderate. The Macedonian stock market index dropped over
eight percent on the day of the NATO decision, but it has since
fluctuated in a narrow range. In the past week, potential foreign
investors have continued to visit Macedonia and some new projects
have been announced. A few days before the NATO decision, the head
of Macedonia's second largest bank told us that he had seen a slight
increase in customers' demand for euros but no dramatic shift away
from denars. On April 14, Standard and Poor's announced that
political events had not changed its credit rating for Macedonia.


11. (SBU) It is likely, however, that economic growth will not hit
the GOM's six percent growth target for 2008. Inflation concerns
and political uncertainty may reduce private consumption and
investment somewhat in the short-term. Early elections, and
subsequent coalition building, will stall government capital
spending and put on hold important government tenders for a few
months. Ironically, this fiscal restraint is exactly what the IMF
prescribed and should dampen inflationary pressures. However,
economic growth, at least for the next few months, will suffer.
Important structural reforms will also slow until a new government
is in place.

Milovanovic