Moldova at historic crossroads

By bne IntelliNews September 28, 2009

Ben Aris in Chisinau -

The sun was shining down on Stefan cel Mare in the last week of September, the main drag through the sleepy capital of Moldova, and the locals were enjoying the end of the summer, drinking beer in the park or hanging out at McDonalds. But just a few steps away in the parliament building a bitter fight over the future of the country that began with people storming the building in April was coming to an end.

Those popular protests brought to an end the eight-year rule of President Vladimir Voronin, the last communist-led government in the Commonwealth of Independent States (CIS). And in the second week of September, a new liberal coalition took control, sacked the old president and installed a new prime minister, who has promised to reform and throw the country open to foreign investors.

Moldova is a small country - it is the first thing everyone tells you in the capital of Chisinau - but stability in the tiny republic is important. Since the Russo-Georgian war last August ended with the de facto independence of South Ossetia and Abkhazia, Moldova's breakaway republic of Transdniestria remains the last disputed border left following the break-up of the former Soviet Union and a potential flash point.

Moldova is at an historic crossroads. The new government is saying all the right things about building a democratically run market economy, but unfortunately it is only the end of the first battle. Moldova is still in for a difficult few years.

Not doing so badly

The international economic crisis hasn't entirely passed the country by, but Moldova is doing pretty well compared to most of its peers in the neighbourhood.

McDonalds (there are several outlets in Chisinau) is one of several foreign investors that have set out their stalls in Moldova. On the road to the airport is a brand new Metro, the German retail chain, and the Russian Aroma trading house bought the local Vismo cognac and wine plant that exports across the CIS a few years ago. However, these foreign investors came to Moldova under their own steam, as part of their parents' regional expansion plans rather than anything the government did to attract them. Indeed, the rampant corruption and the iron control over business that the "communists" wielded (especially the son of President Voronin) actively dissuaded investors. A cherry coloured Rolls Royce and the bright red Ferrari that stand outside the fashionable cafés on Chisinau's main drag stand in stark contrast to the horse-drawn carts most of the farmers drive just 20 minutes outside the city limits. "You think the problem with corruption in Romania is bad? Come to Chisinau," says Christoph Lindinger, managing partner of Schoenherr, a leading Austrian law firm that works in the region. "Starts are always painful, but this country has fantastic potential over the medium term, as they are clearly committed to making a difference and getting their house in order. Political commitment to change is half the battle, even if the process is long and difficult."

Moldova's economy was lifted on the rising tide of regional economic prosperity in the recent boom years. Economic growth has been running at 10% for half a decade, but total GDP in 2008 had still only reached a modest $6.1bn in 2008, with average salaries of some €190 per month. Even these low numbers are suspect, as most local experts say these numbers are probably a communist overstatement.

The economy crashed at the end of last year, contracting by 6.9% over the first quarter of this year, according to the National Bank of Moldova (NBM). The central bank's deputy governor, Marin Molosag, is reluctant to given an estimate for the whole of 2009, saying that everything depends on how fast the economies of the big surrounding countries fare. Dmitru Ursa, head of the local banking association, says most people are forecasting a 7% economic contraction for the whole year, but everyone is also expecting the country to bounce back strongly in 2010. "The smaller the country, the faster the turnaround, as the simpler the problems are," says Ursa.

Making the problems worse is that Moldova is doubly dependent on its neighbours - partly as its main trading partners, but more importantly as most Moldavians work elsewhere.

The director of the Vismo cognac factory, Constantin Olaru, says that he sells only 5-8% of the 6m bottles of cognac the firm produces locally, with the rest being exported to other CIS countries. Production this year has tanked to only 2m bottles, mostly due to a ban on Moldovan cognac by Russia following a row between Chisinau and Moscow over the fate of the Transdniestria region. Most other local businesses have seen sales fall, but none by as much as in Vismo's case.

The second transmission route of the crisis is the collapse in remittances from Moldavian expats living and working abroad (mostly in Russia and Italy). Moldova's total population is 4m, of which 500,000 live abroad, and they sent back $1.8bn in 2008, equivalent to a quarter of annual GDP. Remittances are by far the biggest contributor to the economy, four-times larger than foreign direct investment (FDI), but were down by a third to $500m home in the first six months of this year, which more than any other factor has put the brakes on growth. "As a percentage of GDP, Moldova has one of the highest rates of remittances in the world, which is much higher than FDI," says Molosag. "Moldova attracted a total of $200m of FDI in the first eight months of 2008, but this has fallen as well to $62m over the same period this year."

The silver lining to these two black clouds is that most of the other macroeconomic problems have improved because of the crisis. Inflation was running at over 10% a year, but this has now reversed and the country experienced deflation of 3.4% over the first eight months of this year. Likewise, imports have fallen faster than exports, down 36% and 21% respectively, which has cut the current account deficit in half. Even the currency is holding up well: the Moldovan leu had lost some 16% of its value by the start of September year on year, but thanks to deflation, the real effective exchange rate (REER) is actually the same as it was before the crisis. "It means that Moldova has lost none of its competitiveness in the current crisis, while the current account deficit has been cut in half," says Molosag.

Poison pill

The picture would be quite rosy if it were not for one thing - the budget deficit.

The outgoing regime has left the liberals with a fiscal poison pill. Import duties make up most of the state's tax revenue, so the evaporation of inbound trade has knocked a $500m hole in the budget, equivalent to about 10% of GDP.

As it went into April's key elections, the previous administration spent heavily on populist measures, hiking public sector wages and borrowing heavily on the local market. Now the new government finds itself in a public financing hole. The International Monetary Fund (IMF) refused to sign a stand-by agreement with the outgoing government - although it did give the government a $140m emergency facility to tide it over the transition period - and the local market is tapped out. "We are obliged to pay salaries and pensions, but to be honest with you, I don't know how we are going to finance it now," says Alexandru Tanase, prime vice president of the Liberal Democratic Party of Moldova, who took office the same day as he made this comment to bne.

Keeping Moldova Inc in business in the short term marks the first of many challenges that the new administration faces. An IMF deal will probably follow the installation of the new pro-Western government, but the biggest problem will be how to implement any of the promises that transition countries have to make to get this money. The problem is that the four-party coalition won enough seats to take control of the parliament, but they didn't win enough seats to take the presidency, without which the new government can't wield power effectively.

The communists are still the biggest party in Moldova after winning 48 seats in the house of 101 seats in the recent elections. The Liberal Democratic Party came second and, together with its partners, has formed a four-party coalition of 53 seats. The PM is chosen by a simple majority of the parliament, but the constitution stipulates that two-thirds, or 61 seats, are needed to appoint the president, leaving the liberals eight seats short. If a new president can't be chosen, fresh elections must be held within a year (and, as the constitution also precludes holding two elections in any one year, the earliest elections could be held are in January). The Moldovan president has real power, so pushing through tough reforms without control of the presidency will be tough - assuming the liberals win the next election as well.

While Tanase says the government intends to fight corruption and break the economic stranglehold the former president (and especially his son) have had on the economy "in accordance with the law," the primary challenge for the new government is to win those new elections that must be held by December 2010 at the very latest.

Asked how his party intends to overcome the president problem, Tanase talked about nixing the job of president completely, but that is even harder than appointing a new one: a change to the constitution requires a supermajority of at least 76 seats.

A deal with the communists isn't impossible. In September, Moldova's ex-president and head of the communist party, Voronin, said his party would participate in a presidential poll if the liberals met two conditions: salaries, pensions and other social benefits must be indexed; and "the Transdniestrian region must be granted the status of a "republic within the Republic of Moldova" by the government.

A deal is unlikely. More likely is that the new government will use the next year to bolster their political position in the country by making use of "administrative resources," so it can clear the various constitutional hurdles when a fresh election is called next year rather than pushing through badly needed reform. Still, transformation is always hard. "We followed our Romanian clients to Moldova and I was not sure it was a good idea to open an office," says Schoenherr's Lindinger. "But we were surprised: there is work and the office is profitable. But we never expected the recent changes and suddenly the prospects for change have improved enormously."

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