Moldova - Public expenditure review

Report No. 15532-MD Moldova Public Expenditure Review October 9, 1996 Country Department IV Country Operations Division II Europe and Central Asia Region u Document of the World Bank  CURRENCY EQUIVALENTS (June 1996) US$1.00 = Lei 4.6 Acknowledgements: This Public Expenditure Review was prepared at the request of the Government of Moldova and in particular the Minister of Finance, Mr. Valeriu Chitan. The work program was agreed with the Minister, who guided the work of the Bank team and whose staff provided excellent support. The PER team is grateful to them and to staff of the Ministries of Economy, Agriculture, Labor and Social Protection, the Department of Energy, and the National Bank of Moldova. The PER is largely based on the work of a mission led by Helen Sutch in February 1996 consisting of Peter Dean, (budget process and institutions), Branko Greganovic (macroeconomic framework, on-lending and guarantees), Vladimir Kreacic (budget flows to and from enterprises), and Misha Belkindas (statistics). There was a further mission in April 1996 consisting of Helen Sutch and Ivan Kupchenko (external debt). Work was done in parallel by Deborah Mabbett (macroeconomic analysis, social benefits and pensions) and Monika Huppi (health, education, and central/local fiscal relations). Alexander Palii provided research assistance in Chisinau and Louis Biely, Sergiu Panaghiu and Marina Prodan provided computing and support services, assisted by Carole Bondarev, Jim Lynch and Una Raymond. The report as a whole benefited from review by Deborah Mabbett and Hafez Ghanem. The peer reviewers were Mike Stevens (PSP, World Bank) and Mike Casella (U.S. Treasury). The Director of the Department is Basil Kavalsky and the Division Chief, Wafik Grais. The principal author of the Public Expenditure Review is Helen Sutch. The main report draws on more extensive work embodied in the following Policy Notes and Working Papers (WP): Policy Note: Issues in Social Benefit and Pension Reform Deborah Mabbett Policy Note: Fiscal and Quasi-Fiscal Subsidies and Transfers Helen Sutch WP: Budget Processes and Institutions Peter Dean WP: Public Sector Management Rino Schiavo-Campo Note on Reform of Statistics Misha Belkindas  MOLDOVA: PUBLIC EXPENDITURE REVIEW TABLE OF CONTENTS EXECUTIVE SUMMARY ........................................................... 1. INTRODUCTION ..........................................................1 2. MACROECONOMIC SUSTAINABILITY ................................................3 A. SHORT-TERM PRESSURES ..............................................3 Arrears ......................3 Other Pressures On The Fiscal Stance ............................................ 6 Bias Towards Non-Cash Expenditures ....11..................................... 11 B. SUSTAINABILITY ISSUES .............................................. 12 Energy Debt .1.................... 3 How Is The Deficit Financed :. ........................................... 16 C. MEDIUM-TERM PERSPECTIVE: TWO SCENARIOS .............................................. 20 3. THE NEW ROLE OF GOVERNMENT.@e@@@S@@@@@@@@@alB8ssz||e@|@@***@esBBosooXe**ee@24 A. OVERVIEW ............................................. 24 Recent Developments ............................................2 6 Planned V1ersus Actual ............................................ 97 Shifts In The Structure Of Expenditure: The Way Ahead ............................................ . . B. EXPENDITURE ON ENERGY ............................................. 28 C. EXPENDITURE ON AGRICULTURE ............................................. 32 D. PUBLIC INVESTMENT .............................................. 34 The Existing Public Investment Program ............................................ 36 Future Public Investment Programming ............................................ 36 4. SOCIAL EXPENDITURES ............................................. 37 A. OVERVIEW ................................................ B. EXPENDITURE ON HEALTH ............................................. 37 C. EXPENDITURE ON EDUCATION ............................................. 39 D. EXPENDITURE ON SOCIAL BENEFITS AND SUBSIDIES ............................................. 41 Moving From General Subsidies To Targeted Assistance: Mixed Results .......................................... ................ 41 Next Steps .............................................42 Household Utilities Debts ............................................ 42 The Pension System ............................................ 43 Reform Of The Pension System: Key Issues ............................................ 44 Medium-Term Objectives And Pension Reform ............................................ 46 5. IMPROVING BUDGET PROCESSES AND INSTITUTIONS ............................................. 50 A. APPROPRIATIONS AND ACCOUNTABILITY ............................................. 50 B. EXPENDITURE MANAGEMENT ............................................. 5 1 Establishing The Macroeconomic Context Of The Budget ............................................ 51 Improving The A llocative Mechanism ............................................ 52 Achieving Greater Efficiency ............................................ 53 C. A MEDIUM-TERM EXPENDITURE FRAMEWORK ............................................. 55  TABLES Table 1: Arrears from Budget-Covered Organizations ........................................................................4 Table 2: Budget Lending to the Economy: 1994-1995, through January 1996 ...........................................................8 Table 3: Growth of Uncovered Energy Debt ....................................................................... 13 Table 4: Key Indicators for High Case ....................................................................... 20 Table 5: Low Case Sustainability Scenario ........................................................................ 21 Table 6: Sustainability Indicators: Low Case ....................................................................... 21 Table 7: Sustainability Indicators: High Case ....................................................................... 22 Table 8: Share of Expenditures in Total Budget ........................................................................ 26 Table 9: Economic Composition of Expenditures ....................................................................... 29 Table 10: Relative Importance and Evolution of Public Spending on Health: 1993-96 . . 38 Table I 1: Relative Importance and Evolution of Public Spending on Education: 1993-96 . . 40 Table 12: Spending on Subsidies, Compensations and Benefits ........................................................................ 42 FIGURES Figure 1: Domestic Guarantees ....................................................................... 10 Figure 2: External Debt Outstanding and Disbursed by Creditor ....................................................................... 13 Figure 3: A Decreasing Reliance on Money Creation and Foreign Borrowing ........................................................ 16 Figure 4: Office Supply Share of Total Expenditure ....................................................................... 30 Figure 5: Budget Organizations' Energy Debt as of Ist Quarter 1996 ..................................................................... 30 Figure 6: Arrears from Budget-covered Organizations for Electricity and Heat for Ist Quarter 1996 ..................... 31 Figure 7: Options for Restructuring Pensions ........................................................................ 34 BOXES Box 1: Enterprise Adjustment .........................................................................5 Box 2: Briceni Arrears ....................................................................... 32 Box 3: Medium-Term Expenditure Framework ........................................................................ 56 STATISTICAL ANNEX BUDGE 1. Consolidated Budget Expenditures for 1993-1995 and Ql 1996 2. Consolidated Budget, Revised Plan and Actual Expenditures, Quarterly for 1995 3. 1996 State Budget 4. Ministry of Agriculture Budget 1993-1995 and Plan for 1996 5. Explicit Subsidies from the Budget 1993-1996 6. Tax Arrears to the Budget for 1995 as of January 1, 1996 7. Tax Arrears to the Budget for 1994 as of January 1, 1996 8. Tax Arrears by Locality and Type of Tax 9. Tax Arrears by Sector and Ministry and Type of Tax 10. Deficit Financing 1993-1995 11. Budget-Covered Organizations: Numbers Employed 12. Budget-Covered Organizations: Pay Structure Guarantees and Budget Lendin" 1. Domestic Guarantees: 1-10 2. External Guarantees by Borrower and Creditor as of Dec. 31, 1995  Social Fun 1. State Social Fund Budget for 1996 2. State Social Fund Budget for 1995 3. Pension Distribution by Coefficient, 1995 Labor Market 1. Average Wage, Employment, and Arrears, Totals 1994-1995 2. People on Forced Leave by Sector 1994-1995 3. Average Wage, Employment, and Arrears by Sector, Summary 1994-1995 4. Average Wage, Employment, and Arrears by Sector, Quarterly 1994-1995 Population 1. Population Distribution by Age and Sex at January 1994 and January 1995 2. Population Distribution by Municipalities and Districts by Age and Sex at January 1993   MOLDOVA: PUBLIC EXPENDITURE REVIEW EXECUTIVE SUMMARY Achievements 1. Moldova achieved a dramatic reduction of the fiscal deficit from 23.4 percent of GDP in 1992 to 5 percent in 1995. This allowed a tightening of monetary policy, the introduction of a new currency, and a decline in inflation from a monthly rate of around 37 percent in January of 1995 to under 1 percent in mid-1996. Fiscal adjustment implied a reduction in expenditures from 43.6 percent of GDP in 1992 to under 28 percent in 1995. This was achieved mainly through massive reductions in net lending to enterprises through the budget and the almost complete elimination of quasi-fiscal subsidies through bank credit directed to specific sectors and borrowers, and through loans at concessional interest rates. There has also been a recovery in revenues from 16 percent of GDP in 1992 to around 22 percent in 1995. Safeguarding and building on these achievements will be crucial to the maintenance of stabilization and to economic recovery. 2. At the same time, the Government is significantly improving budget management with the implementation of a new Budget Process Law. Work is in progress on a new system of Treasury management, a new methodology for classifying expenditures, a draft Law on State Debt and Guarantees, and a new tax code. Critical Challenges To Overcome 3. Moldova is facing three specific challenges which have the potential to make or break a successful transition. 4. First is the continuing crisis in Moldova's energy sector and the unremitting growth in external energy-related debt - now 22.5 percent of Right Bank GDP. Moldova has the highest energy debt per unit of GDP of any former Soviet Union country. This threatens the sustainability of the reform program and the creditworthiness of the country. In addition, indirect subsidies for energy use by agriculture, industry and households undermine deficit gains and the efficient allocation of resources throughout the economy. 5. Second is the reliance on financing by means of payment arrears, which pervades the economy including the Government budget. Arrears from the budget undermine the credibility of the hard budget constraint. They also represent a distortionary method of funding the deficit because they are not neutral between different types of expenditure. Elimination of financing by arrears is crucial to economic recovery, to efficient expenditure allocation, and to social protection. 6. Third is the new role of Government in a market economy. The Government needs to redouble its efforts to move away from a role in which it controls and finances production towards a regulatory and facilitating role. It will need to focus on the effective provision of information, public infrastructure and social protection. The roles and function of Ministries will have to change. Government guarantees, on-lending to  enterprises, and other hidden subsidies to agriculture and industry from the budget will have to go. Why is public expenditure significant? * A small and declining fiscal deficit is the best defence against inflation. Given that public revenues can increase only gradually, the level of public expenditures determines the size of the fiscal deficit; . At 28 percent of GDP in 1995, public expenditure represents over one quarter of the whole economy; . Public expenditure is the main channel for social protection: education, health and social benefits; . The allocation of public expenditure plays a crucial role in the transition to a market economy: will it be a help or a hindrance? Energy 7. The immediate reasons for the apparently uncontrolled growth of energy debts are poor collection rates (falling as low as 15 percent last winter); tariffs that do not match cost recovery levels; and high energy charges, reflecting energy waste, theft, and lack of meters and effective controls on amounts used. Without fast actions to resolve the problems of the energy sector, the Government budget will continue to pay indirectly for energy use by agriculture, industry and households and external debt will grow unsustainably. This crisis demands radical changes both inside and outside the public sector in past methods of using, distributing and accounting for energy. Much of Government's attention will need to be given to ways to save energy and ways to pay for it. Arrears, budget loans and guarantees 8. Budget arrears--particularly on wages, social sector expenditures, and pensions-- were cut back to 197 million lei by end 1995, or 8.3 percent of expenditures, but tax arrears increased by 414 million lei (25 percent of total revenues) during that year. Because arrears to the budget exceed arrears from the budget, the fiscal position may appear sounder than it actually is. But only a small percentage of tax arrears is likely to be collected. Repayment of arrears will also be overtaken by the introduction of international- accounting standards, which will invalidate earlier tax assessments. In the future, expenditure planning should be based on realistic revenue estimates so as to avoid further increases in arrears from the budget--that have difficult social consequences and affect the credibility of reforms--and allow for a reduction in the stock of existing arrears. ii  Table 1: Tax Arrears, Guarantees and On-lending Are a Large Portion of Government Spending 1995 million lei % of Government % of GDP Expenditure Increase in tax arrears 414 17.4 5.4 Payments on called guarantees 131 5.5 1.7 On-lending 180 7.6 2.4 9. The productive sectors, especially energy and agriculture, have also obtained financing from the budget through nonpayment of budget loans and from called guarantees which are charged to the government account. More than US$450 million equivalent has been lent from the budget to around 230 borrowers in the last three years and the Government has issued guarantees worth over 523 million lei, making over half of $1 billion in total for guaranteed loans and direct lending. Payments on loan defaults were 9 percent of central Government expenditure in 1994 and 7.4 percent in 1995. Moreover, the stock of called and outstanding guarantees continues to grow. The Government is now setting aside provisions against called guarantees but the amount allocated in the 1996 Budget, at 25 million lei, was exhausted before the middle of the year. Called guarantees, non-payment of loans from the budget and tax arrears have damaging consequences: * They are equivalent to subsidies which are triggered by the recipient, contravening the determination of expenditure as approved by the Parliament. * Because they immediately pre-empt other planned expenditures at the time they occur, they result in arbitrary cuts elsewhere in the budget, making it impossible for Government sector managers to plan, finance and deliver services reliably. * They encourage budget expenditures which can be netted against these debts to the budget or promissory notes issued by the budget. These payments are largely to non- adjusting enterprises in the energy and agricultural sectors. This creates a bias in favor of the old role of Government in the economy and against expenditures which require cash - such as most social expenditures. . .  The New Role Of Government 10. A reallocation of spending is needed away from subsidies to the economy and towards the social sectors and the provision of public goods. Much progress has been made in eliminating explicit subsidies, but distorted prices, tax arrears, budget lending and called guarantees have created implicit, non-appropriated subsidies, undermining this shift and dragging Government expenditure back into the past. These practices also help to finance the lack of adjustment in the energy and agriculture sectors which in turn creates new costs for the budget. Lagging adjustment in the agricultural sector is reflected in the plethora of direct and indirect subsidies that flow from the budget, together with arrears on debt service on budget loans (especially to Cereale and Fertilitatea entities) and on payments to the energy utilities, (much of which is then picked up by the budget). Meanwhile public investment has fallen to under 2 percent of GDP in 1995 - but still covers some private sector investments - and the social sectors have suffered. 11. Over the last three years, the real fall in expenditure on education has been 18 percent, on health 26 %, and on social benefits and price compensations 30 percent. The share of social sector spending in budget expenditure overall has fallen from close to 60 percent in 1993 to 47 percent in 1995. It is likely to fall further in 1996. The Social Fund ended 1995 owing about 124m lei to pensioners or 20 percent of pensions due for the year. Pension arrears increased to over 200 million lei by mid- 1996 and, on the basis of existing arrangements, can only get worse. These arrears reflect the progressive withdrawal of budget finance for pensions and compensations and the transfer of responsibility for these payments to the Social Fund without a corresponding transfer in resources. The shortfall has been aggravated by a 20 percent increase in work pension entitlements in February 1996 - again without any increase in resources to pay them. Meanwhile, unemployment is high -- much of it is hidden -- and unemployment benefits are unduly restricted. Recommendations 12. The public/private divide: all expenditure should be reviewed to ensure that it is appropriate to Government's role in the new market economy and that there is adequate provision for public goods and social protection. Key areas of expenditure reform include the energy sector, pensions, agriculture and public investment. 13. Energy. Meters should be installed and consistently used in all budget-covered organizations, industrial and agricultural producers, and households. Gas meters are needed at the border and at all major off-take points. The household heating subsidy should be transferred explicitly to the Government budget, with abolition of the cross- subsidy through excessive tariffs for budget-covered organizations and enterprises. Assistance to vulnerable households should be targeted through a cash payment or voucher scheme in the short run; in the longer term, a lifeline tariff approach could be used for all forms of energy. Energy utilities should halt the inexorable rise of energy-related debt by upgrading financial management and distribution systems, adjusting tariffs to cost recovery levels, and improving collections policy. Supply to payers should be maintained, and non- payers disconnected. Government accounts should identify amounts of energy used, iv  payments and arrears; managers should be held responsible for cost overruns. Excessive space and poor insulation of accommodation of budget-covered organizations should be reviewed to save energy. 14. Pensions. The main issue for pension reform is how the Social Fund can effectively carry out the dual functions of poverty alleviation and provision of an equitable and efficient insurance system within the constraint of its financing base. A reform option is to consolidate the present complex structure into an affordable pension system. The minimum pension would be 20-25 percent of the average wage, with an additional earnings-related pension delivered only to those whose work history-based entitlement exceeds this level. To complete the reform, additional components would include a Government-regulated fund for individual retirement savings accounts, and a phased increase in the age of entitlement to pension. 15. Agriculture. The Government needs to define the public services to be performed for the agriculture sector; assess the method of funding (budget funding or cost recovery); define regulatory and economic management functions; consolidate and rationalize research institutions; set up a wind-up program with a declining budget over three years for functions that will not be retained in the Ministry of Agriculture (such as foreign trade, support of agro-industry); sell off productive and service activities that will not be retained to the private sector ; remove all budget and quasi-budget support for agro-processors and other agro-enterprises, including livestock complexes, dairies, abattoirs; and those dealing with fertilizer and other input supply; convert remaining milk and other food subsidies and tax rebates into budget funding for price compensations for beneficiaries; and phase out energy subsidies for irrigation and introduce water charges that reflect actual energy consumption for irrigation. 16. Public investment. The gulf between ambitious investment programming and available resources must be narrowed and financing of private sector investment eliminated. Significant progress was made during 1994 to reduce the number of projects considered worth financing from over 2,000 to under 200 at an estimated cost of US$169 million. Since then, however, the program has almost quadrupled, exceeding available domestic and external financing. Sector coverage expanded, with 22 percent of the program destined for the manufacturing sector, another 22 percent for transport, 15 percent for energy, and 4 percent for gas, telecommunications and agro-processing. The program needs to be cut back to a realistic size; and to focus on investments with high social and economic returns that the private sector cannot fund. Commercial projects should be left to private investors. In the short run, maintenance of existing public assets is likely to be the highest priority. 17. Both current and future costs associated with public investment need to be integrated in the Government budget. This should be part of a medium-term expenditure framework covering all types of expenditure. v  Sustainability Issues Financing thefiscal deficit 18. The size of the sustainable deficit depends upon the availability of different types of financing. Three financing methods are analyzed: (i) money creation, (ii) domestic borrowing, and (iii) external borrowing. There is some scope to finance the deficit through money creation as transactions demand for money expands in line with higher levels of economic activity and as economic agents rebuild their holdings of financial assets. Sound policies could permit an increase in money demand, so that the ratio of M2/GDP would rise from its current level of around 14 percent to around 50 percent in the year 2005. Unless this financial deepening occurs, printing more money to cover the fiscal deficit would spark inflation. 19. Domestic bonds were successfully launched as a major source of deficit financing in 1995 and are being taken up increasingly by the non-bank public (who now hold 30 percent of bonds issued). But real interest rates are already high (the bond rate in April 1996 auctions was 40 percent against forecast inflation of 10 percent in 1996) and if they have to rise further in order to persuade the public to hold increasing amounts of Government bonds, private sector activity will be further discouraged. Higher interest rates will also raise the cost to government of servicing its own debt. 20. Foreign borrowing could make up for the low levels of available domestic savings. However, over-reliance on foreign borrowing to finance the deficit could lead to loss of creditworthiness and financial instability. The immediate constraint on borrowing is a fiscal one. Debt service overall is already rising steadily, from 9 percent of total public expenditure in 1994 to 16 percent in 1995, and is projected to continue to increase. Other expenditures will have to be cut to make room for it. Foreign debt service will also produce an outflow from the balance of payments--the debt service ratio has already increased from around 3.5% in 1994 to 13.5% in 1995. The continued crisis in Moldova's energy sector makes it difficult for the Government to put in place a coherent foreign borrowing strategy. External debt to energy suppliers was estimated at US$420 million at the end of 1995. This is in addition to the stock of public and publicly guaranteed debt of around US$753 million (27 percent of GDP). vi  Chart 1: A Decreasing Reliance on Money Creation and Foreign Borrowing Composition of Deficit Financing 90000 80000 70000 . 60000 X 50000 *1993 t 40000 _ _ _*1994_