This document has been translated from Romanian to English by Radu Marian

The recent data published by the Moldova’s National Bureau of Statistics displays a contradictory image over the dynamics of the Moldovan economy in the first half of 2014. On the one hand, the 4.2% y-o-y growth in the second quarter is one of the highest in the region (Russia: +0.8%, Ukraine: -4.7%, Romania: 1.5% and the EU’s economy rose by only 0.2% compared to the same period last year). On the other hand, this increase is based on temporary sources of growth, which are to be dissipated in the near future. Why is the economic growth not sustainable and what are the main risks for 2014?

The effects of currency depreciation

While the currency depreciation is usually associated with negative economic effects (higher prices and macroeconomic uncertainty, eroding consumers’ purchasing power etc.), it can also have some positive outcomes, at least in the short run. In this year’s second quarter, Moldovan Leu was on average 10.4% weaker against the US Dollar and 16.1% weaker against the Euro, compared to the same period last year. This led to cheaper domestic products compared with imported ones, boosting the competitiveness of the local producers.

As a result, the total volume of exported goods increased with 12.2% y-o-y, owing primarily to the exports of cereals, sugar, fats and oils, pharmaceuticals, clothing and accessories. At the same time, despite the increase of final consumption expenditures by 1.9%, the volume of imported goods, in fact, decreased by 1.4% y-o-y.

The declining trade deficit and a certain substitution effect of some imported products with local ones was not due to enhancing quality competitiveness, but rather to price competitiveness of the domestic producers, generated by the currency depreciation. Therefore, these positive effects on the economic growth are short termed and are expected to exhaust in the near future. Lack of growth factors of the competitiveness through quality is revealed by weak investment activity in the private sector and the lack of wage increase (which will be discussed further).

The effect of infrastructure projects financed from the national budget and supported by foreign aid

At first glance, the structure of economic growth inspires optimism: the contribution of final consumption expenditures was lower compared to the investment activity, suggesting a transition to the much-desired economic growth model based on investment and exports. Thus, the gross fixed capital formation increased with 7.6% in Q2-2014, providing about half of the GDP growth in this period. However, this increase was not due to private sector massively investing in modernizing production technology. Rather, the advance is determined by investments financed from the central and local budgets, which increased in the first half of 2014 with 41.6% and respectively 81.2% y-o-y. At the same time, investments financed by the private sector and the population increased with just 5.6%, and those financed from abroad fell by 53.9%.

Therefore, investment activity, which has boosted the economic growth in Q2:14, was mainly due to investments financed from the public budget. Those were mostly infrastructure projects, supported also from foreign grants. At the same time, investment activity of the businesses remains low, being affected by the high level of the uncertainty in the country and region, high cost of credit, unfriendly and unpredictable business climate and other domestic vulnerabilities.  

Economic growth amid stagnating households’ incomes

Further evidence that the economic growth is not sustainable lays n the fact that, in the second quarter, household incomes increased with just 5.3%, while in real terms (inflation adjusted), they have practically stagnated comparing with the same period last year. Hence, the economic increase is illusory from citizens’ perspectives, as they do not perceive its benefits.

The main cause relates to the key component of the household incomes (43% of total) – wages, which are the lowest in Central and Eastern Europe. The roots of this problem are related to poor property rights protection, weak judicial system, high level of corruption perception, macroeconomic and political instability - all the domestic institutional problems that perpetuate in the Republic of Moldova for the last two decades and which, ultimately, are damaging the investment climate and respectively the access to technologies and know-how. As a result, the level of business sophistication and technology penetration in the Moldovan economy is one of the lowest in the region (ranked 104^th out of 144 states in terms of technology adoption, according to the Global Report on Competitiveness 2014-2015). Consecutively, this affects the labor productivity within the businesses and respectively the level of salaries and generally, the population’s standards of living.

Conclusions: the economic growth risks for the near future

We conclude that the growth observed in the first semester of 2014 is not sustainable, rather being conditioned by temporary effects of the national currency’s depreciation and the infrastructure projects financed from public money and external grants. Meanwhile, the incomes of the population, in real terms have stagnated and the households’ final consumption increased with a mere 1.9% y-o-y – a fairly low value compared with previous increase levels. These tendencies can create the illusion of a change in the growth paradigm, given the downturn of the consumption growth due to a visible advance in exports and investment in fixed (physical) capital. Still, the this growth is not based on sustainable factors, but is rather determined by temporary factors. At the same time, some imminent risks are being shaped, risks that can jeopardize the economic growth in the near future:

1. A decreasing domestic demand amid the lack of alternative economic growth sources. High level of uncertainty, determined the Moldovans’ propensity to save rather than to consume. In Q2-2014, the average monthly expenditures of thedecreased in real terms by 2.6% y-o-y, while the volume of the new deposits opened in the commercial banks by individuals  increased with 20%, y-o-y. In the coming months, this behavior might get emphasized, further contributing to cooling the consumption. Meanwhile, the high level of unpredictability associated with the domestic political situation, economic environment in the region, but also the conflict in Ukraine, will prevent conversion of the households’ savings into investments, undermining economic growth.
2. The effect of trade restrictions applied by the Russian Federation will become visible starting with the second semester of the year. For example, already in July, exports’ volume was down 0.2% y-o-y, caused by a reduction of exports to CIS (former Soviet) countries with 8.7% y-o-y. Obviously, the increase of exports to the EU could mitigate the effects of these restrictions, but the reorientation process could be slowed down by the economic difficulties from the EU market.
3. High comparison base. The record-breaking 8.9% economic growth from the previous year occurred mainly in the second half of the year: in Q3:13, the Gross Domestic Product increased with 12.9%, and in Q4:13 – with 11.2% (for comparison: in Q1:13 and Q2:13, the GDP increased with just 3.5% and 6.1% respectively). Therefore, maintaining such a high growth rate in the second half of 2014 will be nearly impossible. So, due to an increased comparison base for the next two quarters, we can expect a slowdown in the GDP growth rate by the end of the year.

This list of immediate challenges to the economic growth is not necessarily comprehensive. Nevertheless, these pressures could reduce the pace of the economic growth to as low as 2.0% by the end of 2014, which is slightly more pessimistic than the government estimates.

In order to mitigate the identified risks, public policy priorities shall include:

• Reducing the impact of a declining demand due to lack of alternative sources of economic growth can be primarily achieved by removing administrative constraints on the private sector (particularly bureaucratic difficulties in obtaining the licensed documents), ensuring greater predictability of the business climate, facilitating access to credit and other sources of finance. This would allow the development of the investment and export activity, contributing to the long term replacement of the consumption as a economic growth engine.
• The effect of the trade restrictions applied by Russian Federation can be minimized through removing internal trade barriers and adopting and implementing the EU quality standards. It is also necessary to modernize the Customs Service, which should facilitate, and not restrict, commercial trades.
• The high comparison base is the result of the booming growth in agriculture in the previous year, being determined by the traditional volatility of the agricultural output, which relies more on the rainfall level than on labor productivity of the sector. In this respect, intensive farming development, increasing sector’s technology penetration and post-harvest infrastructure development are crucial priorities for immunizing the sector from the weather variations. In turn, these priorities can be achieved through fair competition and eliminating anti-competition practices, especially between intermediaries, and by efficient and transparent subsidies’ allocation and facilitating the access to finance for farmers. 

Finally, the Republic of Moldova needs now, more than ever, a strategy for strengthening its economic security, which shall be based on three pillars: (i) ensuring stability of the banking system; (ii) diversification of foreign markets and (iii) diversification of energy import sources.