Moldova in 1995 - 1999: Macroeconomic and Monetary Consequences of Fiscal Imbalances

After stabilization in 1993 Moldova maintained an unsustainable macroeconomic policy mix. The key problem was a lack of a fiscal adjustment, which resulted in large budget deficits. At the same time, the National Bank of Moldova (NBM) attempted to conduct a tight monetary policy. As a result, the exchange rate was appreciating, domestic absorption increasingly exceeded income and the country has been running large Current Account deficits. Moldova had an access to international financial markets and its indebtedness vs. the rest of the world was growing year by year at an alarming rate. Finally, in late 1998 Moldova suffered a balance of payments crisis, directly triggered by developments in Russia. Moldovan leu was devalued by about 70% and the current account improved. The paper concentrates on the empirical dimension of the Moldovan financial crisis. It provides a case study of a) detecting and interpreting macroeconomic anomalies and b) identification of early warning signals of policy unsustainability and imminent change of financial market sentiment. The first part of the paper discusses domestic macroeconomic developments, which correspond with the current account evolution. It examines determinants of a steady growth of the share of consumption in GDP, and of developments in government and non-government disposable incomes. The turnaround of foreign balance had its counterpart in a significant reduction of the share of consumption and investments in GDP, although, given the economic outlook of Moldova, investments still remained surprisingly high. Macroeconomic anomalies in Moldova have their roots in both the fiscal disequilibrium and a too slow progress in enterprise restructuring. The second part of the paper identifies monetary phenomena generated by macroeconomic imbalances. Initially, the tight monetary policy of the NBM, the resulting stable exchange rate and low inflation contributed to a gradual growth of demand for money and remonetization. However, growing imbalances in the Moldovan economy put sustainability of the exchange rate and price level under question. As a result, demand for lei started to shrink and remonetization reversed itself. Interest rates increased and the NBM foreign reserves started to fall. Because of the uncertainty about the future stability of the leu, people converted much of their deposits into dollars and the dollarization of deposits reached more than 50%. The case of Moldova illustrates dangers faced by a country, which conducts a loose fiscal policy and relies on foreign capital inflows. Prior to the crisis, many macroeconomic indicators, especially in the monetary sphere, had been judged as appropriate. However, a hard monetary stance only postponed manifestation of problems caused by the fiscal imbalance and lack of structural reforms.