Document of The World Bank FOR OFFICIAL USE ONLY Report No. 80756-MK INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED LOAN IN THE AMOUNT OF EUR 36.4 MILLION (EQUIVALENT TO US$50 MILLION) TO THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA FOR A SECOND PROGRAMMATIC COMPETITIVENESS DEVELOPMENT POLICY OPERATION February 12, 2014 Financial and Private Sector Development Unit (ECSPF) South East Europe Country Unit (ECCU4) Europe and Central Asia (ECA) This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. FORMER YUGOSLAV REPUBLIC OF MACEDONIA GOVERNMENT FISCAL YEAR January 1- December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of December 31, 2013) Currency Unit: Macedonian Denar EUR1 US$1.38 US$1.00 MKD 44.81 WEIGHTS AND MEASURES Metric System ABBREVIATION AND ACRONYMS ASAP Agriculture Strengthening and Accession Project BERIS Business Environment and Institutional Strengthening Project CAP Common Agricultural Policy CEM Country Economic Memorandum CEMT European Conference of Transport Ministers CFAA Country Financial Accountability Assessment CGAP Code of Good Agricultural Practices CIIP Competitive Industries and Innovation Program CMT Cut-make-trim CPI Consumer Price Index CPS Country Partnership Strategy DPL Development Policy Loan DSA Debt Sustainability Assessment DTIDZ Directorate of Technological Industrial Development Zones EBRD European Bank for Reconstruction and Development EC European Commission ECA Europe and Central Asia EIA Environmental Impact Assessment Process EIB European Investment Bank ELEM Macedonian Power Plants EPE Ex-Post Evaluation ESA Employment Service Agency EU European Union EUR Euro FDI Foreign Direct Investment FITD Fund for Innovation and Technological Development FVA Food & Veterinary Agency FYR Former Yugoslav Republic GAEP Good Agricultural and Environmental Practices GDP Gross Domestic Product IACS Integrated Administration and Control System IBRD International Bank for Reconstruction and Development IDEAS USAID Investment Development and Export Advancement Support Project ii IFC International Finance Corporation ILO International Labour Organization IMF International Monetary Fund IPA Instrument for Pre-Accession Assistance ISIC International Standard Industrial Classification IT Information Technology LPIS Land Parcel Identification System MAFWE Ministry of Agriculture, Forestry, and Water Economy MBDP Macedonian Bank for Development Promotion MEPSO Electricity Transmission System Operator of Macedonia MIT Massachusetts Institute of Technology MKD Macedonian Denar MOF Ministry of Finance MTFS Medium-Term Fiscal Strategy NBER National Bureau of Economic Research NBRM National Bank of the Republic of Macedonia NPDARD National Program for Development of Agriculture and Rural Development NPL Non-Performing Loan PBG Policy-Based Guarantee PDO Program Development Objective PESR Public Enterprise for State Roads PISA Programme for International Student Assessment PLL Precautionary and Liquidity Line PPM Post Program Monitoring PPP Public Private Partnership PSIA Poverty and Social Impact Assessment R&D Research & Development SEA Strategic Environmental Assessment SDR Special Drawing Right SDIS Skills Development and Innovation Support Project SME Small and Medium Enterprise SOE State Owned Enterprise SOP Standard Operating Procedures SPS Sanitary and Phytosanitary SSHI State Sanitary and Health Inspectorate SSO State Statistical Office TIDZ Technological Industrial Development Zone TQM Total Quality Management TVET Technical and Vocational Education and Training US United States USD United States Dollar USAID U.S. Agency for International Development VAT Value Added Tax VET Vocational Education and Training Vice President: Laura Tuck Country Director: Ellen A. Goldstein Sector Director: Gerardo Corrochano Sector Manager: Lalit Raina Task Team Leader: John Gabriel Goddard iii FORMER YUGOSLAV REPUBLIC OF MACEDONIA SECOND PROGRAMMATIC COMPETITIVENESS DEVELOPMENT POLICY OPERATION TABLE OF CONTENTS 1.  INTRODUCTION AND COUNTRY CONTEXT (INCLUDING POVERTY DEVELOPMENTS) ................................................................................................................... 1  2.  MACROECONOMIC POLICY FRAMEWORK ............................................................... 3  A.  RECENT ECONOMIC DEVELOPMENTS ............................................................... 3  B.  MACRO-ECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ...................... 6  3.  THE GOVERNMENT’S PROGRAM .............................................................................. 11  4.  THE PROPOSED OPERATION ...................................................................................... 12  A.  LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION ....... 12  B.  PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS ............. 14  5.  LINK TO COUNTRY PARTNERSHIP STRATEGY AND OTHER OPERATIONS .... 23  A.  CONSULTATIONS, COLLABORATION WITH DEVELOPMENT PARTNERS 23  6.  OTHER DESIGN AND APPRAISAL ISSUES ................................................................ 24  A.  POVERTY AND SOCIAL IMPACT ........................................................................ 24  B.  ENVIRONMENTAL ASPECTS ............................................................................... 25  C.  PFM, DISBURSEMENT AND AUDITING ASPECTS ........................................... 26  D.  MONITORING AND EVALUATION ..................................................................... 28  7.  SUMMARY OF RISKS AND MITIGATION .................................................................. 28  ANNEX 1: POLICY AND RESULTS MATRIX ..................................................................... 30  ANNEX 2: LETTER OF DEVELOPMENT POLICY ............................................................. 33  ANNEX 3: FUND RELATIONS ANNEX ............................................................................... 38  ANNEX 4: COMPETITIVENESS CONTEXT: SECTORAL AND CROSS-CUTTING ISSUES ..................................................................................................................................... 42  ANNEX 5: DEBT SUSTAINABILITY ASSESSMENT (DSA) ............................................. 54  The World Bank greatly appreciates the close collaboration of the Government of FYR Macedonia in the preparation of this Development Policy Operation. The operation was prepared by an IBRD team consisting of John Gabriel Goddard (Task Team Leader), Gordana Popovikj-Friedman, Aleksandar Nacev, Jean-Paul Gautier, Charles Krakoff, Simon Keith, Kristina Mitic, Deborah Davis, Christina Tippmann, Yulia Vnukova, Feyi Boroffice, Djamilya Salieva (ECSPF), Doerte Doemeland, Bojan Shimbov, Birgit Hansl, Nikola Kojucharov, Maria Davalos, Kevval Hannah,(ECSPE), Jose Guilherme Reis, Thomas Farole (PRMTR), Holger Kray, Sergiy Zorya, Ameet Morjaria, Bekim Ymeri, Liljana Sekerinska, Natasa Vetma (ECSSD), Bojana Naceva, Indhira Santos, Johannes Koettl (ECSHD), Violane Konar-Leacy, Gagik Gabrielyan, Todor Milchevski, Perica Vrboski, Manon Schupper, Colin Gazeley (CEUIC), Frank Wallace (ECSOQ), Fabiola Altimari, Julie Rieger, Rocio Malpica (LEGEM), Jose Janeiro (CTRLA), Denis Boskovski, Cveta Peruseska- Joncevska, Jasminka Sopova and Luan Aliu (ECCMK). iv SUMMARY OF PROPOSED LOAN AND PROGRAM FORMER YUGOSLAV REPUBLIC OF MACEDONIA SECOND PROGRAMMATIC COMPETITIVENESS DEVELOPMENT POLICY LOAN Borrower Former Yugoslav Republic of Macedonia Implementation Agency Ministry of Finance Financing Data IBRD Loan of EUR 36.4 million (US$50 million equivalent) Operation Type Programmatic (2nd of 2), single tranche The PDO is to strengthen the competitiveness of FYR Macedonia’s economy by incentivizing productive investment and technology upgrading in the manufacturing, agribusiness and trade logistics sectors, and Pillars of the Operation establishing enabling conditions to progressively increase labor market and Program flexibility and innovation capacity. Development Objective The pillars of the operation are: Pillar 1 – Developing high value-added (PDO) manufacturing; Pillar 2 – Facilitating the restructuring of the agribusiness sector; Pillar 3 – Improving the efficiency of trade logistics services; and Pillar 4 – Establishing enabling conditions for labor market flexibility and innovation capacity. Pillar 1: Developing high value-added manufacturing  Investments by companies located in the TIDZs increases to EUR 50 million.  Share of medium- and high-tech exports increases to 45 percent of the total.  30 new export contracts are signed as a result of the exporter support programs. Pillar 2: Facilitating the restructuring of the agribusiness sector  The first 75 state-owned agriculture properties are auctioned.  Share of agricultural land where producers adhere to GAEP environment-friendly agricultural practices increases to 15 percent. Pillar 3: Improving the efficiency of trade logistics services Result Indicators  Average waiting time at the border for transit, import and export of goods is reduced by 10 percent at major border crossings.  40 percent reduction in physical inspections and laboratory testing for low- and medium-risk products traded across borders.  Share of CEMT licenses awarded to transport vehicles with EURO 4 and EURO 5 emission standards increases to 90 percent. Pillar 4: Establishing enabling conditions for labor market flexibility and innovation capacity  Recipients of social assistance who work formally increases to 8 percent.  Time required to process visas and work permits decreases to 35 days.  The Fund for Innovation and Technological Development is operational and 50 companies have applied for financing. Overall risk rating Moderate Operation ID P130847 v IBRD PROGRAM DOCUMENT FOR A PROPOSED DEVELOPMENT POLICY LOAN TO THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA 1. INTRODUCTION AND COUNTRY CONTEXT (INCLUDING POVERTY DEVELOPMENTS) 1. The proposed Second Programmatic Competitiveness Development Policy Loan (DPL2) to the Former Yugoslav Republic of Macedonia (FYR Macedonia) supports the government’s competitiveness development agenda. It will be the second of two DPLs in FYR Macedonia aimed at strengthening key export-oriented economic sectors with strong potential for growth and employment. Building on the reforms supported by the First Programmatic Competitiveness DPL (DPL1), the proposed operation advances the competitiveness agenda and intensifies its impact on poverty reduction and shared prosperity in several important ways. It puts emphasis on reforms to incentivize greenfield investment in manufacturing, which can boost demand for both low skilled and high skilled workers. It promotes agribusiness development through improved management of state-owned agricultural land. It supports the introduction of a risk-based approach to customs inspections to significantly reduce the time and cost of international trade. It also supports labor market reforms that improve the incentives to work. Finally, it supports more new policies to stimulate growth of R&D-intensive industries. 2. FYR Macedonia has a consistent track record with regard to macroeconomic stability and improving the business climate. Macroeconomic and financial stability were preserved in the face of significant negative shocks, and public sector debt has remained at manageable levels. At the same time, reforms to registration and permitting processes, property registration procedures, investor protection, and tax collection, have further improved the business climate. In 2013, FYR Macedonia was ranked the fifth most improved country among the top 50 economies in the world, according to the Doing Business report, jumping from the 92nd position in 2006 to 25th in 2013 and outstripping peer countries in the region. 3. Poverty and unemployment, however, have not declined significantly, due to slow GDP growth relative to other Western Balkan and European Union (EU) member states. Unemployment, at 28.7 percent in the third quarter of 2013, has been trending downwards but still remains among the highest in Europe, with long-term unemployment and youth unemployment of particular concern. Concerns over data quality from 2009 onwards limit poverty and shared prosperity analysis to the period up to 2008. Over the period 2003 to 2008, absolute poverty increased slightly from 8 to 9 percent using a regional poverty line of US$2.5 a day, and from 33 to 37 percent, using a regional poverty line of US$5 a day. 4. Further, the country has faced challenges in promoting shared prosperity. Inequality, measured by the Gini coefficient, increased from 37 to 40 between 2003 and 2008. Although overall consumption grew by 1.1 percent a year over the same period, consumption for the bottom 40 percent decreased by 1.5 percent. The bottom 40 percent are limited in their ability to benefit from or contribute to economic growth, as that share of the population has poorer than average labor market outcomes and lower education levels. 1 5. To address these challenges, the country is in the process of transitioning to a higher growth economy based on advanced manufacturing capabilities and more competitive, export-oriented enterprises. Under the government’s growth agenda, exports have grown rapidly, and in 2012 accounted for 53.4 percent of GDP. Further improvement, however, depends on structural changes given that: (a) exports are still too concentrated in commodities (metals and minerals), where value added is low and prices are volatile; (b) medium and large firms do not invest sufficiently in quality or innovation; and (c) most exporting firms are small (fewer than 10 employees) and have difficulty competing in export markets because of inefficiencies and high costs related to customs, logistics, and trade infrastructure. Further, (d) the agribusiness sector, which employs 20 percent of the workforce in 2012, is constrained by several factors including the large share of state-owned land, which needs to be better managed to unleash its productive and export potential. 6. The proposed operation will address these challenges by supporting reforms that incentivize investment and technology upgrading in the manufacturing, agribusiness, and trade logistics sectors. Specific actions will be aimed at removing bottlenecks to growth in these sectors, and create an enabling environment for agricultural modernization, private sector entry and technology transfer from Foreign Direct Investments (FDI). The importance of these sectors and their dense linkages with the rest of the economy will ensure that the reforms have an economy-wide impact on poverty and unemployment. Annex 4 provides a summary of the challenges and opportunities in each of these sectors, as well as crosscutting issues. 7. The crosscutting policy actions under DPL2 will lay the groundwork for increased labor market flexibility and innovation capacity in the key productive sectors. Improving the efficiency of the labor market is essential to the competitiveness of FYR Macedonia’s economy, and is necessary to resolve the problem of long-term unemployment. The reforms will strengthen incentives for workers to participate in the formal labor market, which is characterized by a low participation rate by regional and European standards; and will also make it easier for employers to recruit seasonal workers. The DPL2 will also support comprehensive reforms in the innovation support framework to stimulate private R&D and technology transfer. 8. The proposed operation is in line with the Country Partnership Strategy (CPS 2010- 2014) objective of achieving faster, greener and more inclusive growth. Specifically, the DPL2 will support key goals within each pillar:  the Competitiveness pillar goals of (a) increasing financing and investment in sectors where FYR Macedonia could become competitive; (b) establishing the legal framework for land privatization; and (c) lowering transport and freight costs by improving customs procedures and border crossing facilities.  the Inclusive Growth pillar goal of improving employability by reducing impediments to hiring; and,  the Green Growth pillar goal of aligning agriculture sector and agricultural exports with EU requirements. 2 9. This operation will also contribute to deepening competitiveness reforms, a strategic priority in the 2012 Europe and Central Asia (ECA) Regional Strategy of the World Bank. 10. Political and operation-specific risks are moderate. The program of structural reforms to be supported by the proposed DPL2 has strong ownership within the government, as demonstrated by the recent adoption of laws, strategies, methodologies, and action plans that map out concrete steps to be taken through 2015, as recommended under DPL1. However, implementation of the proposed operation will strain the capacity of some public sector institutions. Targeted capacity building and technical support is being provided by the World Bank, the EU, EBRD, USAID and other donors. Given the medium-term nature of some of the actions, increased and prolonged attention to communicating with the government about the progress of the reform agenda will be warranted. 2. MACROECONOMIC POLICY FRAMEWORK A. RECENT ECONOMIC DEVELOPMENTS 11. FYR Macedonia is a small, open middle-income country in South East Europe with a solid track record of macro-economic stability. FYR Macedonia has been able to preserve macroeconomic and financial stability, even in the presence of significant shocks. Its exchange rate peg to the Euro, introduced in 1995, has successfully supported price stability, with inflation averaging 2.5 percent over the last 10 years. The National Bank of the Republic of Macedonia (NBRM) has responded quickly and decisively to any possible threats to the peg. Central government debt, which reached 34.1 percent of GDP by the end of 2012, remains one of the lowest in the region (Table 1). The government has also implemented important structural reforms in recent years to attract FDI and keep the current account manageable. 12. Lackluster external demand has weighed on growth in recent years. In the wake of the global financial crisis, FYR Macedonia’s economy contracted by 0.9 percent in 2009, as exports plummeted and private capital inflows declined. Although the subsequent rebound was rather quick, with real GDP growth recovering to 2.9 percent in 2010 and 2.8 percent in 2011, the economy fell back into a mild recession in 2012 (contracting by 0.4 percent) amidst the re- intensification of the euro crisis and the associated slump in import demand. Momentum began to turn in the latter half of the year, however, and real GDP growth through the first three quarters of 2013 reached 3.2 percent, primarily on the back of a surge in construction activity. For 2013 as a whole, real GDP growth is projected to be 2.5 percent. 3 Table 1: Key Macro-economic Indicators Projections 2010 2011 2012 2013 2014 2015 2016 Real economy Annual  percentage  change, unless otherwise  indicated Nominal  GDP (MKD billion) 434.1 459.8 458.6 481.6 513.7 548.9 584.9 Per capita GDP (USD, Atlas method) 4543 5047 4634 4869 5129 5495 5802 Real  GDP 2.9 2.8 ‐0.4 2.5 3.0 3.5 3.7 Contributions to growth (percentage  points): Consumption 1.2 2.3 ‐1.5 2.5 1.1 2.4 2.2 Investment ‐1.7 2.2 3.9 ‐3.0 3.0 2.4 2.2 Net exports 3.0 ‐1.8 ‐2.8 3.0 ‐1.2 ‐1.3 ‐0.7 Real  imports 7.3 27.3 ‐5.5 ‐1.5 8.2 8.0 6.8 Real  exports 18.7 31.6 ‐9.1 3.5 9.0 8.5 8.0 Unemployment rate  (percent, end‐of‐period) 32.0 31.4 31.0 28.7 ─ ─ ─ Prices GDP deflator 2.8 3.1 0.1 2.5 3.5 3.3 2.8 CPI (end‐of‐period) 3.1 2.8 4.7 1.5 2.5 2.3 2.1 CPI (average) 1.7 3.9 3.3 2.8 2.6 2.4 2.2 Fiscal accounts Percent of GDP, unless otherwise  indicated Revenues 30.4 29.8 30.1 29.4 29.7 30.3 30.4 Expenditures 32.9 32.3 34.0 33.4 33.2 33.5 32.9 Central  government balance ‐2.4 ‐2.5 ‐3.9 ‐4.0 ‐3.5 ‐3.2 ‐2.6 Gross central  government debt 24.2 27.9 34.1 35.6 34.0 35.0 35.4 Gross public sector debt 1/ 27.8 32.1 39.5 43.2 44.3 47.2 49.0 Selected Monetary Accounts Annual  percentage  change, unless otherwise  indicated Base  Money 12.2 9.7 4.4 5.8 12.5 9.6 8.6 Credit to private  sector 7.3 7.7 5.2 6.3 3.8 3.3 2.9 Balance of Payments Percent of GDP, unless otherwise  indicated Current account balance ‐2.1 ‐2.5 ‐3.1 ‐3.1 ‐4.5 ‐5.7 ‐5.2 Trade  balance ‐20.0 ‐20.7 ‐23.7 ‐21.0 ‐21.4 ‐21.6 ‐21.3 Imports (BOP basis) 65.4 74.5 76.3 73.4 76.2 78.0 79.2 Exports (BOP basis) 45.4 53.7 52.7 52.5 54.8 56.5 57.9 Foreign direct investment (FDI) 2.2 4.5 1.0 2.5 3.5 3.8 4.3 Gross international  reserves (US$ mn, eop) 2277.8 2677.8 2892.9 2858.7 3162.0 3353.6 3681.5 in months of next year's imports 3.4 4.2 4.5 4.4 4.4 4.3 4.4 in percent of short‐term external  debt 130.6 152.7 139.6 128.9 139.5 144.7 155.5 External  debt 2/ 58.3 57.4 69.0 66.8 66.6 65.4 64.4 Exchange  rate  (MKD/USD, average) 46.45 44.26 47.89 47.89 48.47 48.66 48.78 Memo items: Nominal  GDP (US$ million) 9346 10388 9576 10061 10598 11281 11990 1/ Incudes  the debt of municipalities  and publick enterprices, but not the debt of the central  bank (NBRM) 2/ Excludes  central  bank repo arrangements Source: Macedonia  State Statistical  Office, Ministry of Finance, National  Bank of Macedonia, World Bank staff estimates. 4 13. Notwithstanding its high export share in GDP, FYR Macedonia has been incurring persistent current account deficits, mainly because of oil and electricity imports and a high import content of exports. The current deficit widened from 2.1 percent in 2010 to 3.1 percent in 2012, as the trade deficit worsened from 20.0 percent in 2010 to 23.7 percent of GDP in 2012. In 2011, higher fuel prices weakened the trade balance and in 2012, exports plummeted as a result of weak import demand from Germany and Italy, which are among FYR Macedonia’s key export destinations. The persistent trade deficits have been financed by private transfers, which increased from 18.9 percent in 2010 to 21.8 percent in 2012. FDI, though low in terms of GDP compared to other South East European countries, has been critical for supporting export growth and diversification. In 2008, only six products contributed to around 70 percent of total exports. By 2012, this number had increased to fifteen. Export growth has been driven by an increase in FDI-related exports, which by end 2012 accounted for more than 55 of percent of all exports. 14. FYR Macedonia has maintained price stability and solid reserve coverage throughout the decade, with inflation averaging 2.2 percent between 2002 and 2012. In 2011 and 2012, Consumer Price Index (CPI) inflation reached 3.9 percent and 3.3 percent, respectively, driven by rising food and fuel prices as well as regulated price hikes in the energy sector, but has come down to 2.8 percent in 2013. FYR Macedonia’s reserve coverage has been stable since 2002. Even during the depths of the crisis in 2008 and 2009, gross international reserves were sustained at 3.7 and 4.8 months of imports, after strong policy interventions, and have remained at around 4 months of imports since. Moreover, as of end 2012, international reserves covered over 1.5 times the stock of FYR Macedonia’s short-term external debt1. The real exchange rate has been stable and is, by standard metrics, aligned with economic fundamentals. 15. The banking sector is stable, but non-performing loans are high and credit growth remains weak. FYR Macedonia’s banking sector is dominated by three large banks, which control 69.2 percent of banking assets. Two of these banks are owned by parent banks in Greece and Slovenia that are facing difficulties at the parent bank level which may affect operations of their local subsidiaries2. Still, all foreign-owned banks in FYR Macedonia operate as standalone subsidiaries under domestic regulation and supervision and with their own balance sheets. Moreover, the Central Bank maintains a prudent supervisory policy, including semi-annual stress tests. Private banks are highly liquid, but there is an insufficient quality of bankable projects, and non-performing loans reached 12.1 percent in July 2013, but subsided slightly to 11.2 by December 2013. Loan-loss provisions cover the stock of non-performing loans, but bank profitability has been declining since the beginning of 2013. In this environment, credit growth to the private sector has been weak throughout most of 2013 and has only picked up in the last quarter, reaching 6.3 percent (year-on-year) for 2013. 16. Expansionary fiscal policy in the aftermath of the crisis led to a widening of the fiscal deficit and a build-up in arrears. Revenues fell by over 3 percent of GDP between 2008 1 The IMF (2013) assesses that the country’s current level of reserves provides a sufficient buffer against shocks. 2 The National Bank of Greece has reported that it will withdraw from Southeastern Europe (including Albania, FYR Macedonia and Serbia), following an agreement with the European Commission’s competition authorities. And Slovenia’s NLB bank recently arranged a restructuring plan with the European Commission that aims at downsizing its portfolio, raising the risk of divestment from the region. 5 and 2011, reflecting not only weakening economic activity, but also a policy decision to reduce the tax burden (mainly the profit tax and the personal income tax) and social security contributions in order to boost competitiveness. The government offset this to some extent by cutting expenditures (from 34.1 percent of GDP in 2009 to 32.3 percent in 2011), but the fiscal deficit still widened from 0.9 percent of GDP in 2008 to 2.5 percent in 2011. Further deterioration of the deficit was contained at the expense of an accumulation of budgetary arrears on VAT refunds and payments on goods and services. The government started to clear these arrears in September 2012. By the end of February 2013, the government had cleared all outstanding payment obligations with the exception of payment obligations in the health sector3. The government has since taken steps to strengthen commitment controls and medium-term fiscal planning (indicated in paragraphs 75-76 below). 17. At the same time, the government has elected to shift some capital expenditure off- budget, complicating fiscal management and weakening transparency. In January 2013, the government moved a large part of road infrastructure projects off-budget by transforming the former Road Fund into the Public Enterprise for State Roads (PESR), a non-profit entity which can borrow on its own behalf but is backed by a sovereign guarantee. At inception, the PESR carried EUR 82 million in debt (1.1 percent of GDP), but this is set to rise rapidly in the near term as the PESR executes what is fundamentally a central government investment agenda. Going forward, the PESR’s spending and borrowing operations are therefore inherently linked to assessments of the government’s fiscal risks and debt sustainability. 18. While increased public investment has supported growth, it has also contributed to a rapid build-up of FYR Macedonia’s debt, although from a relatively low level. Gross central government debt as a share of GDP climbed from 20.7 percent in 2008 to 34.1 percent by the end of 2012. However, the burden of supporting domestic demand has increasingly fallen on the broader public sector, through large investment projects by non-financial SOEs and financing for SMEs through the Macedonian Bank for Development Promotion. By end-2012, total public sector debt (which includes the liabilities of these and other SOEs, as well as municipalities) stood at 39.2 percent of GDP, 5.1 percentage points higher than central government debt. B. MACRO-ECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 19. Growth is expected to accelerate in the medium term, benefiting from the increase in public investments and sustained export growth. Under the baseline projection, real GDP growth is expected to reach 2.5 percent in 2013 and accelerate to 3.0 and 3.5 percent in 2014 and 2015. Exports are projected to grow at 9.0 percent and 8.5 percent in 2014 and 2015, driven by past and future FDI4 and supported by strengthening external demand. Externally financed public 3 There remain some central government arrears in the health sector, which are estimated to be around 0.5 percent of GDP as of end 2013. The government has taken several steps to reduce these arrears and prevent the accumulation of future arrears by increasing transfers to the health sector, and establishing a reference price for medicines. Moreover, the health insurance fund is strengthening financial controls. The Ministry of Health has also started to implement centralized procurement for specific goods and services. 4 The government of FYR Macedonia is pursuing an active strategy to attract FDI. Net FDI reached 6.1 percent in 2008 and declined somewhat between 2009 and 2011. In 2012, FYR Macedonia was able to attract important second-generation investments of already established companies. While FDI has contributed significantly to export 6 investment is projected to accelerate, supporting growth but leading to a widening of the current account deficit over the medium term. Domestic private demand will remain somewhat muted in the near term amidst still-high unemployment and anemic credit growth to the private sector, but its contribution to growth is assumed to increase in the medium term as continued structural reforms to improve competitiveness and productivity begin to pay dividends. Inflation is projected to decline gradually over the medium term to around 2 percent. 20. The fiscal deficit is projected to fall below 3 percent by 2016, in line with the government’s new medium-term fiscal strategy (MTFS). Securing the reduction in central government deficit from an expected 4.0 percent of GDP in 2013 to 2.6 percent in 2016 will require a sizeable consolidation effort. On the expenditure side, the government is committed to contain the public wage bill as well as expenditures on goods and services5. Central government capital spending is expected to remain constant as a share of GDP as the PESR scales up its investment. Revenues are also projected to increase due to increases in excises and improved revenue collection (Table 2)6. The financing of this deficit has increasingly relied on domestic sources as of late, as the government has capitalized on high liquidity in the banking sector to ramp up domestic bond issuance and lengthen the maturity of its bond portfolio. Financing is expected to shift increasingly to external sources, with the government also tapping into its sizeable pool of accumulated cash reserves in 2014 to reduce market financing needs (Table 3). 21. Assuming medium-term fiscal targets are achieved, gross central government debt is projected to stabilize at around 35.4 percent of GDP by 2016 (Annex 5). The gross debt ratio is set to decline slightly in 2014 as the government draws on its large deposit buffer to meet its financing needs.7 Failure to implement the planned fiscal consolidation would push gross debt to 46.5 percent of GDP by 2018, while partial implementation (half of all required measures) would still un-anchor debt from its stable baseline path and push it to 40.9 percent in 2018. Even if the fiscal effort remains on track, a negative shock that permanently reduces GDP growth by 1.2 percentage points (half a standard deviation from its 10-year average) throughout the projection period would still put debt on an upward trajectory to 42.8 percent of GDP in 2018. growth, backward linkages have been weak. This is expected to change as new foreign operations in 2013 and 2014 establish stronger links with the local economy. Future FDI is expected to be related to automotive components, mining and services. 5 The government has announced increases in public salaries by 5 percent starting from November 2014 onward as well as a tight control on public employment. Pensions will also increase by 5 percent – about 1.5 percent above the legal indexation - from March 2014 onward. 6 The Excise Law stipulates an increase in the excise on tobacco and alcoholic products starting from 1 July 2013. Parliament has also approved a Tax Procedure Law aimed at increasing revenue collection. 7 Net central government debt, which excludes the government’s cash reserves, gives a clearer picture of the projected underlying debt path since it abstracts from transitory shifts in deposits. 7 Table 2: Key Fiscal Indicators and Projections (Central Government) Projections % of  GDP 2010 2011 2012 2013 2014 2015 2016 Overall balance ‐2.4 ‐2.5 ‐ 3.9 ‐4.0 ‐3.5 ‐ 3.2 ‐ 2.6 Primary balance ‐1.7 ‐1.7 ‐ 3.0 ‐3.1 ‐2.5 ‐ 2.1 ‐ 1.3 Total Revenues (and grants) 30.4 29.8 30.1 29.4 29.7 30.3 30.4 Tax  revenues 25.9 25.8 25.6 25.2 25.7 26.3 26.4 Taxes on goods and services 12.1 12.6 12.0 11.6 12.1 12.5 12.6 Direct Taxes 2.9 2.9 2.9 3.1 3.1 3.1 3.1 Social  insurance  contributions 8.9 8.7 8.9 8.7 8.7 8.9 8.9 Taxes on international  trade 1.1 0.8 0.9 0.9 0.9 0.9 0.9 Other taxes 0.9 0.9 0.9 0.9 0.9 0.9 0.9 Non‐ tax  revenues 3.2 2.8 2.7 2.5 2.5 2.5 2.5 Grants 0.3 0.2 0.7 0.9 0.8 0.8 0.8 Other revenues 1.0 0.9 1.1 0.8 0.8 0.8 0.8 Expenditures 32.9 32.3 34.0 33.4 33.2 33.5 32.9 Current expenditures 29.3 28.5 29.9 29.8 29.1 29.4 29.1 Wages and compensation 5.2 5.0 5.0 4.7 4.7 4.8 4.8 Goods and services 3.4 3.0 3.2 3.1 3.1 3.1 3.0 Interest payments 0.7 0.8 0.9 0.9 1.0 1.1 1.3 Current transfers 20.0 19.7 20.8 21.2 20.3 20.3 20.0 Pensions 8.7 8.5 8.9 9.4 9.5 9.5 9.5 Other transfers 11.3 11.1 11.9 11.8 10.8 10.9 10.5 Capital  expenditures 3.5 3.9 4.1 3.6 4.1 4.1 3.8 Capital  investments 2.6 3.1 3.5 3.6 4.1 4.1 3.8 Capital  transfers 1.0 0.8 0.6 0.0 0.0 0.0 0.0 Financing 2.4 2.5 3.9 4.0 3.5 3.2 2.6 External  (net) 1.1 4.5 0.9 1.3 ‐0.4 2.6 1.8 Domestic (net) 0.4 ‐0.4 5.6 3.0 1.0 0.6 0.8 of  which: privatization 0.0 0.1 0.0 0.1 0.0 0.0 0.0 Deposits 0.9 ‐1.6 ‐ 2.6 ‐0.3 2.9 0.0 0.0 1/ Cumulative amount of measures. Note: Central  government refers  to the core government plus  consolidated extra ‐budgetary funds. It excludes   municipalities  and the newly‐formed Public  Enterprise for  State Roads  (PESR). Source: Ministry of Finance, World Bank staff estimates. 8 Table 3: Central Government Financing Needs and Sources Projections Projections 2012 2013 2014 2015 2016 2012 2013 2014 2015 2016 GROSS FINANCING NEEDS 712.4 1211.2 1161.4 1306.9 1106.9 9.6 15.5 13.9 14.6 11.6 Primary Deficit ( ‐ is surplus) 220.6 244.1 209.9 185.1 123.8 3.0 3.1 2.5 2.1 1.3 Interest Payments 68.6 71.4 84.4 97.2 119.4 0.9 0.9 1.0 1.1 1.3 Debt amortization 423.3 895.8 867.0 1024.6 863.7 5.7 11.4 10.4 11.5 9.1 Domestic 366.7 656.3 722.1 698.6 641.0 4.9 8.4 8.6 7.8 6.7 Short‐ term debt (t‐bills) 335.4 626.1 695.0 600.0 550.0 4.5 8.0 8.3 6.7 5.8 Medium & long‐ term bonds 31.2 30.2 27.1 98.6 91.0 0.4 0.4 0.3 1.1 1.0 External 56.6 239.5 144.9 326.0 222.7 0.8 3.1 1.7 3.7 2.3 Private creditors 16.8 184.4 0.0 150.0 130.3 0.2 2.4 0.0 1.7 1.4 Official  creditors 39.8 55.1 144.9 176.0 92.4 0.5 0.7 1.7 2.0 1.0 GROSS FINANCING SOURCES 712.4 1211.2 1161.4 1306.9 1106.9 9.6 15.5 13.9 14.6 11.6 Privatization receipts 1.9 8.5 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.0 Use  of  government deposits ‐ 195.2 ‐23.1 243.1 0.0 0.0 ‐ 2.6 ‐ 0.3 2.9 0.0 0.0 Domestic market access 782.1 883.1 804.0 752.4 716.2 10.5 11.3 9.6 8.4 7.5 Short‐term debt (t‐bills) 626.1 695.0 600.0 550.0 500.0 8.4 8.9 7.2 6.2 5.3 Medium & long‐term bonds 156.1 188.1 204.0 202.4 216.2 2.1 2.4 2.4 2.3 2.3 External  financing 1/ 123.5 342.7 114.3 554.5 390.7 1.7 4.4 1.4 6.2 4.1 Private  creditors 105.9 256.3 4.9 483.6 303.4 1.4 3.3 0.1 5.4 3.2 Official  creditors 17.6 86.4 109.4 70.9 87.3 0.2 1.1 1.3 0.8 0.9 Memo items: Government cash balance  (end‐ of ‐y 320.0 343.1 100.0 100.0 100.0 4.3 4.4 1.2 1.1 1.1 Overall  fiscal  balance  2/ ‐ 289.2 ‐ 315.5 ‐294.4 ‐282.3 ‐243.2 ‐ 3.9 ‐ 4.0 ‐ 3.5 ‐ 3.2 ‐ 2.6 Gross central  government debt 2541.8 2789.6 2840.8 3123.1 3366.3 34.1 35.6 34.0 35.0 35.4 Net central  government debt 3/ 2221.8 2446.5 2740.8 3023.1 3266.3 29.8 31.2 32.8 33.9 34.3 Nominal  GDP 7457.3 7834.8 8352.3 8925.5 9510.3 ─ ─ ─ ─ ─ 1/ Incl udes  s tructural   bonds   and   Treas ury s ecuri ti es . 2/ Incl udes  projected   di s burs ements  of commi tted  project funds . 3/ Net of cash reserves. Note: Central  government refers  to the core government plus  consolidated extra ‐budgetary funds. It excludes  municipalities  and the newly‐formed PESR. Source:  Mi ni s try of Fi nance, Worl d  Bank   s ta ff  es ti ma tes 22. Total public sector debt is set to rise rapidly in comparison, as SOEs take over much of the investment spending. On the basis of planned borrowings by the PESR and other SOEs to finance an ambitious agenda of infrastructure and other investment projects, public enterprise debt is projected to rise from 4.9 percent of GDP at end-2012 to 15.4 percent by 2018, bringing total public sector debt in 2018 to 51 percent. The debt of municipalities is projected to remain stable at a negligible 0.1 percent of GDP on the assumption that these entities continue to run a broadly balanced budget. Around 7 percentage points of this estimated increase in public debt is attributable to the PESR, which is expected to receive nearly EUR 800 million in external financing through 2018 to invest in roads projects aimed at strengthening FYR Macedonia's trade linkages with its neighbors. The financing will come both from multilateral institutions (IBRD and EBRD) and from the Chinese government (EUR 575 million).8 23. External financing needs are expected to rise in the medium term, but reserve adequacy should remain robust and external debt is projected to decline (Table 4). The current account is expected to widen further in 2014 and 2015 as imports related to the upswing 8 These loans have predominantly fixed interest rates and maturities ranging from 15 to 20 years with grace periods from 3 to 5 years. 9 in public investment and FDI-financed activity gather steam and private transfers are forecast to decline slightly to an average of 19 percent of GDP. After 2015, the current account deficit is projected to decline steadily as growth of FDI-related exports accelerates and the decline in private transfers is offset by falling import demand. Capacity to service existing external obligations is set to remain strong, with gross international reserves projected to average around 4.5 months of imports and cover roughly 150 percent of short-term external debt. Strengthening FDI inflows and a favorable growth-interest rate differential on external borrowing are expected to place external debt on a gradual downward path from its peak of 69.0 percent of GDP at end- 2012 to 62.4 percent by 2018 under the baseline. Table 4. External Financing Requirements and Sources (US$ million) Projections USD million 2012 2013 2014 2015 2016 Financing requirements 2532.6 3296.4 3244.4 3616.0 3523.4 Current account deficit 300.4 311.5 477.5 639.3 624.2 Short‐term debt amortization 1/ 1753.6 2072.9 2217.4 2267.4 2317.4 Long‐ term debt amortization 2/ 478.6 912.0 549.5 709.3 581.8 Other short‐ term capital  outflows 0.0 0.0 0.0 0.0 0.0 Financing sources 2532.6 3296.4 3244.4 3616.0 3523.4 FDI and portfolio investments (net) 3/ 80.9 223.1 434.5 496.4 587.5 Capital  grants 25.8 20.0 15.0 15.0 15.0 Short‐term debt disbursements 2072.9 2217.4 2267.4 2317.4 2367.4 Long‐ term debt disbursements 637.4 1094.9 944.3 1130.2 919.2 of  which: general  government 163.0 442.0 145.9 700.8 492.6 of  which: public enterprises 132.6 277.6 426.7 390.9 348.7 Other 4/ ‐99.8 ‐293.2 0.0 0.0 0.0 Change  in reserves (‐ : increase) ‐184.7 34.2 ‐416.8 ‐ 343.0 ‐365.7 Memo items: External  debt (percent of GDP) 69.0 66.8 66.6 65.4 64.4 External  financing requirements (% of GDP) 27.2 30.2 27.9 29.1 26.6 Gross international  reserves (USD million) 2892.9 2858.7 3162.0 3353.6 3681.5  as months of  imports 4.5 4.4 4.4 4.3 4.4 as percent of short‐term external  debt 139.6 128.9 139.5 144.7 155.5 1/ Excludes  central  bank repo arrangements. 2/ Excludes  the amortization of M< intercompany loans, which is  included in net FDI. 3/ Excludes  Eurobond financing, which is  included long‐term debt disbursements. 4/ Includes  currency and deposits, other  liabilities  and net errors  and omissions. Source: National  Bank of Macedonia, World Bank staff estimates. 24. Overall, the macroeconomic framework is adequate. The current macroeconomic policy mix is geared toward supporting economic growth and ensuring macroeconomic and fiscal stability. Financial sector risks appear manageable. While the economy remains vulnerable to significant shocks, particularly in the context of a still-fragile EU growth recovery, external buffers remain adequate and financing prospects favorable, especially in light of the sizeable 10 external funds already committed for various public sector projects. Increasing FDI, enhancing backward linkages between foreign firms and domestic suppliers, reducing energy imports, and strengthening the country’s competitiveness will be critical for reducing FYR Macedonia’s reliance on private transfers and its exposure to external risks. The proposed DPL2 would provide an additional source of financing, and support reforms to boost the competitiveness of FYR Macedonia’s economy and enhance medium-term growth prospects. 3. THE GOVERNMENT’S PROGRAM 25. The government program to increase competitiveness of the economy, accelerate exports, and increase inclusive growth centers on actions to attract FDI, incentivize productive investment and R&D, develop a more dynamic land market, increase employment and the flexibility of the labor force, improve trade logistics, and strengthen the export promotion and innovation capacity of public and private sector entities. 26. In the manufacturing sector, the government is focused on acquiring advanced manufacturing capabilities and creating jobs through the attraction of large multinational corporations; and on upgrading industries with high export potential. To attract manufacturing FDI to its Technology and Industrial Development Zones (TIDZs), the government is providing a package of incentives for qualified investors, including land, tax exemptions, and staff training grants. A system for approving and monitoring investment incentives has been put in place to ensure these incentives continue to be aligned with EU and national state aid rules. InvestMacedonia is introducing new programs for export-oriented companies which generate leads for export orders through trade fairs, trade missions, contact lists, and identification of high-level opportunities. 27. In the agribusiness sector, a transformational program to auction state-owned agricultural land will incentivize agri-firms to invest in productivity improvements, complemented by improvements in public sector capacity to deliver support programs. The new Law for the Sale of Agricultural Land in State Ownership provides a legal basis for land divestiture. A new valuation methodology based on land market prices and land yields will set floor prices for the land sales. Private ownership of the parcels by producers will facilitate the acceptance of agricultural land as collateral for credit for investment. Efficiency of agriculture expenditures has been strengthened through the upgrading of the EU-modeled Integrated Administration and Control System (IACS) which will simplify IT-based administrative procedures, better inform public expenditure planning, and increase the public sector’s capacity to detect fraud subsidy claims. 28. In the trade logistics sector, the government is modernizing the transport infrastructure to speed the flow of passenger and cargo traffic, while simultaneously introducing trade facilitation measures. The largest airports were recently upgraded through a concession with a private operator from Turkey, and the government has initiated investments to upgrade Corridor X, its main road and rail corridor to the European Union markets and ports. Investment plans to upgrade Corridor VIII and local roads are also underway. Trade facilitation measures include simplified customs procedures; introduction of a single-window system for processing export/import and transport licenses; introduction of an Integrated System for Risk 11 Assessment to improve the inspection process; and systematizing professional standards and internal controls to prevent corruption among customs officers. 29. To increase the flexibility of the labor market, and improve work incentives, the government is simplifying its labor regulations and facilitating temporary employment. Legal amendments supported by DPL1 have made it easier for companies to apply for visas and work permits on behalf of their foreign employees. The priority today is introducing second- generation reforms to tackle disincentives to work, especially for low-wage earners. The government is working closely with the EU, the International Labor Organization (ILO) and the World Bank to develop more effective employment strategies. Medium and long-term reforms to improve the quality and relevance of technical vocational education and training are being designed, with support from the World Bank Skills Development and Innovation Project. 30. Increasing innovation capacity is a priority for the government, and a central part of the strategy to accelerate productivity growth and export diversification. The government has taken important steps towards strengthening the innovation policy framework by adopting an Innovation Strategy in October 2012 and enacting a Law on Innovation Activity in May 2013. The Law enabled the establishment of a Fund for Innovation and Technological Development that will introduce competitive financial instruments to stimulate commercial R&D, support new start-ups and spin-offs, and scale-up technology commercialization and transfer activities, thus connecting the research sector to private sector and market needs. 4. THE PROPOSED OPERATION A. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION 31. The proposed operation will accelerate the government’s Competitiveness Agenda by strengthening policies and institutions aimed at (a) attracting FDI to foster innovation in export-oriented industries; (b) promoting technological upgrading and productive investment in the agribusiness sector; (c) improving trade logistics processes and services; (d) fostering a more dynamic labor market that can alleviate long-term unemployment; and (e) increasing access to market-relevant skills and innovation capacity. 32. The Project Development Objective of the proposed DPL2 is to strengthen the competitiveness of FYR Macedonia’s economy by incentivizing productive investment and technology upgrading in the manufacturing, agribusiness and trade logistics sectors, and establishing enabling conditions to progressively increase labor market flexibility and innovation capacity. The policy actions are expected to have positive poverty and social impacts by increasing both high and low-skill employment, and in some cases increasing the returns to employment. 33. Under Pillar 1, aimed at developing high value-added manufacturing, the operation supports actions that will increase the sustainability and impact of the government’s Technological Industrial Development Zones (TIDZ) program, which offers industrial parks and incentives to attract FDI in value-adding, export-oriented manufacturing. The operation includes advisory support, through a US$1.6 million grant from the Competitive Industries and 12 Innovation Program (CIIP) Multi Donor Trust Fund, to strengthen the governance system for the TIDZs, and to put in place a monitoring system for the investment incentives. 34. Under Pillar 2, aimed at facilitating restructuring of the agribusiness sector, DPL2 supports the enactment of the legal framework in 2013 and initial program for the sale of state- owned agricultural land. An improved land valuation methodology will be used to set base prices for auctions of that land to agribusiness firms and individual agricultural entrepreneurs. The land auctions are expected to incentivize investment by agribusiness firms, in turn stimulating employment and agricultural exports. DPL2 is also supporting measures to improve the targeting, administration and efficiency of agricultural support, as a follow-up to the reforms in DPL1. 35. Under Pillar 3, aimed at improving the efficiency of trade logistics, the operation will continue to support measures that improve the efficiency of customs controls and inspections at border crossings; and incentivize upgrading of the vehicle fleet to meet EU emission standards. The operation will support comprehensive improvements in the risk-based approach to customs controls and technical inspections, including improvement of risk profiling for technical inspections, improved data collection and information systems, training of inspectors, and adoption of regulations in line with EU best practices. The Bank is supporting these activities by providing technical assistance under the CIIP in cooperation with IFC’s Western Balkans Trade Logistics Project. 36. Under Pillar 4, establishing enabling conditions for labor market flexibility and innovation capacity, the operation will improve incentives for formal work through reforms that redefine unemployment, allow part-time workers to stay on social assistance registry, and facilitate seasonal employment; address skills bottlenecks by easing the hiring of foreign personnel; and strengthen the innovation system and innovative activity of firms in FYR Macedonia through legal reforms and establishment of a Fund for Innovation and Technological Development. 37. The World Bank has been actively using Development Policy Operations as the principal tool to assist the Macedonian authorities with the design and implementation of structural reforms. Over the past 15 years, the authorities have successfully implemented reforms supported by DPLs in the financial and social sectors, public administration, and the areas of business environment and investment climate. The operations have introduced a number of reforms which have had an important development impact on the country. This DPL program is the first to have a sector-specific operational design. The program builds on the following lessons learned:  Country ownership of the proposed policies and actions is essential for success. Close involvement of all stakeholders in program design increases the Bank’s ability to respond quickly and adequately to government demands. As a consequence, the proposed DPL2 is firmly geared towards supporting the objectives of the 2011-2015 Government Work Program and Competitiveness Action Plan.  Bank assistance in aligning government policies with EU requirements has been largely successful. Supporting policies aimed at harmonizing national systems with EU norms and practices considerably strengthens the ownership of the program. Reforms in 13 the agriculture sector and in logistics services supported by the proposed DPL2 aim to bring the country in closer compliance with prevailing practices in EU member countries.  Coupling technical assistance with policy dialogue and targeted just-in-time technical assistance can significantly improve results. In the case of FYR Macedonia, technical assistance is being provided through the CIIP Program to help with the design and implementation of the reforms that are underway. B. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS Pillar 1 – Developing high value-added manufacturing 38. Pillar 1 of the proposed DPL2 is supporting the development of high value-added manufacturing through measures that: (a) maximize the impact of government interventions to stimulate investment in advanced manufacturing plants; and (b) enhance support to exporters so that local firms can become more closely connected to global firms and global markets. At the same time, the measures will establish stronger regulatory and governance frameworks to improve the allocation and effective use of fiscal resources deployed to attract and monitor investment. The measures supported under DPL1, and related initiatives, resulted in continued FDI inflows into medium- and high-tech manufacturing industries. These investments jumped to EUR 78 million in 2013, accounting for net exports of EUR 87 million in 2013 and are expected to be up to EUR 190 million in 2014, with total exports of EUR 1.2 billion. The companies employed around 5,000 workers in 2013, and this is expected to increase to 9,000 by end 2014. Objective 1.1. Attracting greenfield investment Prior action #1: DTIDZ’s Managing Board has adopted a Three-year Investment Program for 2013-2015 that is aligned with investor demand for each TIDZ and regional development priorities. Prior action #2: InvestMacedonia has adopted a Guideline for Control, Assessment and Monitoring of State Aid on September 30, 2013, to, inter alia, verify continued compliance with the conditions under which aid is granted to legal entities. 39. Following implementation of reforms under DPL1 which enhanced governance of the TIDZ Directorate (DTIDZ) by strengthening its Managing Board with representatives of the private sector, the DPL2 supports better targeting of investment resources for the pipeline of TIDZs, assessing and aligning investments with market demand and regional development priorities. This will be achieved through the strengthening of diagnostic tools, resulting in the development of an investment program for 2013-2015 adopted by the Managing Board that is grounded in market demand and follows good practice of investment demand forecasting. 40. Concentrating the DTIDZ budget on the zones with the largest investment pipeline will help to develop more integrated manufacturing clusters and increase their sustainability. The DPL2 will support the establishment of TIDZs with the potential to become world-class zones, and provide them with the infrastructure and support services needed to attract top-quality companies. New models are being introduced to develop the TIDZ, including Public Private Partnership (PPP) arrangements that can attract private management and 14 investment, and the transfer of industrial zones to municipal governments. An example is the TIDZ in Tetovo, which was tendered out in 2013 to a consortium of private investors. 41. DPL2 is supporting additional measures to strengthen the accountability framework for state aid, as provided in the Law on TIDZs, to ensure a predictable environment for investors and more effective monitoring of associated fiscal costs. As the number of enterprises receiving incentives increases, it is critical to step up the control function by establishing a system to monitor and audit the state aid awarded under both the TIDZ Law and the Law on State Aid. The State Audit Office conducted a regular annual audit and issued recommendations for development of an internal audit unit, function and guideline for control, monitoring and assessment of state aide at InvestMacedonia. In addition to ensuring that incentives continue to be aligned with European Union and national State Aid rules, a rigorous auditing system will help the government to revise and streamline the overly complex incentive framework and ascertain the effectiveness of the incentives in achieving economic goals. Objective 1.2. Scaling up export promotion Prior action #3: InvestMacedonia’s Export Promotion Unit has implemented exporter support programs, including: (i) leads generation; (ii) participation in international trade fairs; and (iii) the establishment of an online marketplace that serves at least 300 companies. 42. While DPL1 supported the adoption of the Strategy for Export Promotion and the establishment of an export promotion unit in InvestMacedonia, DPL2 will support implementation of the first generation of exporter support programs. The strategy aims to ensure that appropriate institutional mechanisms are operating at the ministerial and agency levels, and that programs with high potential impact are put in place. The exporter support programs help build the capabilities of those exporters aiming to increase the quality of their products or reach new markets, which could progressively increase FYR Macedonia’s share of medium and high-tech exports. As an example, a total of EUR 350,000 was made available in 2013 for the participation of export-oriented companies in international trade and tourism fairs. InvestMacedonia’s total budget for 2014 was increased by 35.5 percent in comparison to 2013, to a total of EUR 9.2 million (equivalent). 43. Improving the capabilities of domestic suppliers can enable backward linkages from FDI and increase local competitiveness. The DPL2, together with advisory services provided through the CIIP program, will support the establishment of a Supplier Network Development Program. This program will stimulate new partnerships among manufacturing companies that located in FYR Macedonia in recent years, local SMEs and sources of finance (banks, innovation fund, equity investors). The program will provide assistance to upgrade product quality, quantity and reliability through technical skills, managerial competence, business planning and improved access to capital. The increased technological and business sophistication of local suppliers will, in turn, facilitate backward linkages with new greenfield projects and stimulate exports. 15 Pillar 2 – Facilitating the restructuring of the agribusiness sector 44. Building on the reforms supported by DPL1 which strengthened the government capacity to manage state-owned agricultural land and allocate financial support to agricultural producers, Pillar 2 of the proposed DPL2 facilitates restructuring of the agribusiness sector through measures that: (a) improve agricultural land administration in FYR Macedonia, focusing on privatizing state-owned land that is leased to private sector; and (b) aims at improving the agricultural support administration and prevent leakage of public resources. It is estimated that the government will earn up to EUR 500 million from selling the state owned land in vacant possession and that which is under lease, for a total of 210,000 hectares. Objective 2.1. Improving agricultural land administration Prior action #4: The Borrower has: (a) enacted the Law on Sale of Agricultural Land in State Ownership, of June 17, 2013 (Official Gazette 87); and (b) approved the First Annual Program for Sale of State Owned Agricultural Land and started its public review. 45. Agriculture land policy dialogue under DPL1, and related sector studies prepared in the course of the preparation of the DPL program, played a pivotal role in the government’s decision to privatize its substantial agriculture land holdings. DPL1 supported improvements to the overall management of state-owned land, in particular contract enforcement for the 140,000 hectares (about a quarter of county’s agriculture land resources) under lease to the private sector. This initiative also accelerated completion of the state-owned agricultural land plots inventory, which had been neglected since socialist times and led to frequent encroachment cases. The policy dialogue provided strong arguments about the advantages of private ownership for incentivizing investment, and contributed to the government’s decision to gradually dispose of its land holdings. The Law for the Sale of State-Owned Agricultural Land was enacted in June 2013, and sales will begin in 2014. 46. The sale of state-owned agricultural land will reinvigorate the land market, addressing the sector’s major structural deficiency—the excessive division of privately owned land, which constrains production, economies of scale, and sector competitiveness. The gradual disposal of state-owned land, combined with initiatives to consolidate small private land parcels, is likely to bolster both the land sale and private rental markets, leading to better use of land resources, higher productivity, vertical integration, and market entry by new foreign and domestic firms. 47. Several regulations, including the first Annual Program for Sale of Agricultural Land in State Ownership have been developed. With these measures, the Government finalized the regulatory framework needed to pilot the land divestiture and encourage participation in the auctions, ensure transparency and mobilize fiscal revenues. The valuation methodology will set the floor price for the competitive sales of state-owned land and will facilitate the acceptance of agricultural land as collateral. The first Annual Program developed by MAFWE sets the size of the land in state ownership proposed for sale in the first year, the maximum size of land which can be sold to one natural person or legal entity and the conditions for the auction which prospective buyers have to meet. The World Bank is working closely with the government on a comprehensive land value survey which will provide a better indication of regional price differences. 16 Objective 2.2. Better targeting of incentives for agricultural producers Prior action #5: The Ministry of Agriculture, Forestry and Water Economy has: (a) established a functional Integrated Administration and Control System (IACS) for agricultural income support and rural development payments; and (b) increased the controls for direct payments based on a risk-based approach. 48. DPL1 focused on increasing the competiveness of the agriculture sector by reshaping the composition of the agriculture subsidy program and facilitating the implementation of the bylaw on Good Agriculture and Environmental Practices (GAEP)9. The National Program for Development of Agriculture and Rural Development 2013-2017 commits the government to increase investment support to 25 percent of the total agricultural subsidy envelope by 2017. Even before the program was put in place, the allocations for investment support had already increased from 10 percent of the agriculture subsidy budget in 2011 to 16 percent in 2013. Further, the newly introduced GAEP, as part of the cross-compliance concept of EU-like direct support policies, is already compulsory for the large operators (47,000 hectares or more) that receive crops subsidies. Thus the GAEP already covers 25 percent of the arable land farmed by subsidy program beneficiaries—significantly above the DPL1 intermediate target of 6 percent for 2013. 49. DPL2 aims at strengthening the efficiency of the agricultural expenditures by simplifying administrative requirements and reducing leakages. The upgrades of the EU- modeled IACS, supported by DPL2, will have multiple benefits for the public and private sectors. In addition to improving the EU Common Agricultural Policy (CAP) approximation, the upgrades will simplify IT-based administrative procedures, lower the associated costs for public sector institutions, provide for better-informed public expenditure planning, and increase the public sector’s capacity to detect fraudulent subsidy claims. Private sector benefits include simplified subsidy claim procedures, with substantially reduced requirements for supporting documentation. In the past, each claim had to be accompanied by proof of ownership of the eligible productive assets, but this information is now drawn from the Farm Registry database, which contains real-time information. 50. DPL2 is also supporting the introduction of on-the-spot inspections based on beneficiary risk assessment, which is making it possible to reduce the number and cost of inspections. The risk-based inspection approach was initiated in 2011 and so far has captured EUR 1.4 million equivalent in subsidy claim irregularities. In the same year, back-office IACS administrative controls prevented EUR 2.1 million equivalent in subsidy payment leakages. The full risk-based inspection rollout in 2012 and other IACS upgrades are expected to further improve the transparency of public expenditure in the agriculture sector. 9 The Macedonian Code of Good Agricultural Practices (CGAP) was introduced in 2009 as a general set of environmental conservation practices that farmers need to consider and implement on a voluntary basis. The 2013 Bylaw entitled Minimum Requirements for Good Agriculture and Environmental Practices (GAEP) determines the compulsory environmental conservation practices for the recipients of direct payments, i.e., subsidy claimants have to adhere to the minimum GAEP requirements to be eligible to receive financial support from the National Program for Development of Agriculture and Rural Development 2013-2017 (NPDARD). 17 Pillar 3 – Improving the efficiency of trade logistics services 51. Pillar 3 of the proposed DPL2 continues the support for upgrading the trade logistics sector through measures that: (a) facilitate trade at road border crossings by improving the efficiency of customs controls and inspections; and (b) increase the export readiness of the transport industry by incentivizing upgrading of the vehicle fleet to meet EU emission standards. Objective 3.1. Facilitating transport of goods at border crossings Prior action #6: The Food & Veterinary Agency (FVA) and the State Sanitary and Health Inspectorate (SSHI) have adopted a risk strategy, risk methodology and standard operating procedures, dated December 27, 2013 and January 14, 2014 respectively, which establish a risk- based approach for inspections in international trade. 52. DPL1 supported several measures to make border controls and inspections more efficient, as a core element of a well-functioning facilitation system. DPL1 policy actions strengthened the coordination between the Customs Administration and inspection agencies and mandated the presence of more inspectors at major border crossings, helping to reduce the waiting time for international transport of goods. In addition, the decision to regularly publish the waiting times at major border crossings is helping private transport companies to improve their planning, and is helping the government to monitor the impact of recent reforms. 53. DPL2 is supporting comprehensive improvements in the risk-based approach to customs controls and technical inspections, in line with EU best practices. The implementation of the regulatory phase of the Single Electronic System for risk-based customs control and its ultimate integration into Sanitary and Phytosanitary (SPS) inspections, requires the inspection agencies (FVA and the SSHI) to: (a) adopt a number of regulations, including a strategy and a methodology document, risk profiles for goods that are commonly traded, and new standard operating procedures (SOP) to guide decision making by inspectors; (b) improve data collection and processing as well as information exchange systems; and (c) train inspectors to effectively implement risk-based inspections. The Bank Team has provided technical assistance for these activities under the CIIP grant, in close cooperation with IFC’s Western Balkans Trade Logistics Project. 54. Better application of the risk-based approach is a critical trade facilitation improvement to address the costs and delays from unnecessary controls and inspections. For importers, the changes will lead to cost economies with respect to inspection, parking and storage fees at terminals, and facilitate the timely delivery of goods to businesses. For transporters, the changes will reduce direct losses due to idle time of vehicles and consequent costs of lost opportunities. Fewer physical examinations, and less sampling and laboratory testing, will reduce the clearance time from up to two weeks to just one day. The improvements will be particularly helpful for agribusiness, which is subject to extensive controls that can entail substantial costs given the perishable nature of fresh agricultural produce. 18 Objective 3.2. Increasing export-readiness of the transport industry 55. DPL1 supported the measure to distribute CEMT annual licenses to transport companies that meet the highest emission standards, which is strengthening the incentives of the transport industry to upgrade. Starting in 2012, the distribution of CEMT licenses has prioritized vehicles that meet higher emission standards (EURO 4 and EURO 5 standards), thereby increasing the number of transport companies that are export ready, and fostering a more environmentally friendly transport fleet. Pillar 4: Establishing enabling conditions for labor market flexibility and innovation capacity 56. Pillar 4 of the proposed DPL2 is supporting legal reforms and measures that improve incentives for formal work and stimulate innovation capacity by: (a) reforming the conditions for social assistance and facilitating seasonal employment contracting; and (b) more effective support policies that catalyze innovative activity of firms in FYR Macedonia. Objective 4.1. Improving incentives for formal work Prior action #7: The Borrower has enacted the Law on Amendments to the Law on Labor Relations, dated February 19, 2013 (Official Gazette 25) which facilitate seasonal employment contracting. Prior action #8: The Borrower has enacted the Law on Amendments to the Law on Social Protection, dated May 31, 2013 (Official Gazette 79), which allow income disregards in social assistance, enabling a limited amount of wages to be earned before workers are de-registered from the beneficiary list and benefits are reduced. Prior action #9: The Ministry of Labor and Social Policy has established a functional employment online registry and has implemented a public information campaign about the new procedures of the registry and available types of contracts, including for seasonal employment. 57. As part of the policy actions supported by DPL1, legal reforms were enacted to address rigidities in labor market regulations. Amendments to the Law on Employment and Insurance against Unemployment established a clear distinction between unemployed people and active job seekers, which is helping the Employment Service Agency (ESA) to better manage the benefits available to the unemployed and to active labor market participants. This process has been completed, and more than half of previously registered unemployed now self-report as being inactive or working. In addition, amendments to the Law on Employment and Work of Foreigners have simplified the work permit regime for foreign citizens. 58. The proposed DPL2 is supporting legislative reforms to facilitate seasonal employment. The Law on Labor Relations has been amended to make it easier for firms to hire and register seasonal workers. The government has established a working group on seasonal work to track the evolution of season contracts (concentrated in the summer during the agricultural, construction and tourism seasons), and respond to the needs in this sub-area. Reforming the labor laws governing seasonal employment can help promote dynamism as well as increase formalization of this type of work. 19 59. DPL2 is also supporting amendments to allow for income disregards in social assistance. Through amendments to the Law on Social Protection, the proposed operation will support a reform allowing for income disregards for up to 90 days of public or seasonal labor without affecting the qualification for social assistance following the seasonal work10. Improving the incentives for workers to take on at least a certain amount of work should help increase the work that is declared, reduce registered unemployment, and increase workers’ attachment to formal employment. This measure is particularly important for low-wage earners, who still face significant disincentives to work. 60. An online employment registry and a public information campaign are increasing the efficiency and awareness of new labor regulations and systems. Employers can now easily complete and register employment contracts through an online registry established at the Employment Service Agency. However, employers lack awareness about current labor regulations and procedures. DPL2 will support a campaign to communicate and clearly explain current regulations and recent changes, to help employers better utilize available flexibility and reduce labor costs. The Ministry of Labor and Social Policy plans to hold “open days” every three months to inform companies of all sizes, including foreign investors, about recent and ongoing changes in labor laws. Objective 4.2. Increasing innovation capacity Prior action #10: The Borrower has: (a) enacted the Law on Innovation Activity, dated May 31, 2013 (Official Gazette 79); and (b) adopted the Statute and Rulebooks for the financing instruments of the Fund for Innovation and Technological Development (FITD), dated November 30, 2013. 61. DPL2 is supporting reforms focusing on improving the public sector capacity and regulatory framework to nurture private sector innovation. The regulatory reforms include enactment of a Law on Innovation Activity and establishment of the Fund for Innovation and Technological Development. Upon adoption of the Statute of FITD, rulebooks of the financing instruments and appointment of the Board and Fund Manager, the FITD was legally registered on December 16, 2013 and is expected to be fully operational in early 2014. The World Bank’s Skills Development and Innovation Support (SDIS) Project is expected to provide the funding for FITD to pilot financing instruments in support of entrepreneurship, innovation commercialization and in-house business innovation at the pre-commercial and growth stages. Analytical Underpinnings 62. The DPL series is supported by extensive analytical work undertaken by the World Bank in recent years. The 2009 Country Economic Memorandum (CEM) focused on reforms needed to improve growth performance, and also called for more inclusive policies to ensure shared growth. The Business Environment and Institutional Strengthening Project (BERIS), implemented in 2005-2010, produced several assessments with recommendations for improving the business environment and strengthening the regulatory and institutional framework to attract 10 The right to receive social assistance is suspended during the 90-day period of seasonal work but the beneficiary will be eligible for social assistance immediately after the end of the seasonal work period. Previously, re- registration for social assistance was possible only after 6 months of registered income from seasonal employment. 20 FDI, protect investors, and promote exports and innovation. In addition, the following analytical work has been produced specifically for this DPL series.  The FYR Macedonia Modular Competitiveness Assessment (2012) identifies new measures to strengthen the country’s exporting and growth performance. The assessment consisted of a Trade Competitiveness Assessment and a Sectoral Competitiveness Assessment, which provided a detailed review of the performance and competitiveness potential of the export basket in general and of four major export-oriented sectors – Automotive, Apparel, Agribusiness and Logistic Services (see Annex 4).  The Public Expenditure Technical Assistance in Agriculture (2011-13) assesses the allocation of financial support to agriculture. It examines the allocation over time to different types of measures and beneficiaries, and recommends ways to incentivize competitiveness- enhancing investments in the sector and reduce distortions.  The Policy Note on Seasonal Employment (2012) analyzes the legal and institutional constraints associated with seasonal employment in FYR Macedonia, and suggests policy options based on international experience. The analysis looks at the nature and extent of seasonal employment in FYR Macedonia, reviews international good practices, and suggests ways to address existing constraints associated with seasonal employment.  The Employment and Job Creation - Labor Market Assessment (2013) assesses the main constraints to employment in FYR Macedonia and the nature of the skill mismatches. The report includes an in-depth analysis of available labor market data, including labor force surveys and administrative labor market data, and from two new surveys about the demand and supply of technical, cognitive and non-cognitive skills. The report identifies policies that could alleviate some of the constraints that particularly affect women. Table 5. Prior Actions and Their Analytical Underpinnings Prior actions Analytical Underpinnings Pillar 1: Developing high value-added manufacturing Prior action #1: DTIDZ’s Managing Board has The activities under CIIP helped to shared market adopted a Three-year Investment Program for 2013- assessment methodologies that DTIDZ officials are 2015 that is aligned with investor demand for each using to develop demand-driven TIDZ investment TIDZ and regional development priorities. program, including PPPs. Prior action #2: InvestMacedonia has adopted a Ongoing advice provided under the CIIP program. Guideline for Control, Assessment and Monitoring of State Aid on September 30, 2013, to, inter alia, verify continued compliance with the conditions under which aid is granted to legal entities. Prior action #3: InvestMacedonia’s export promotion InvestMacedonia, in collaboration with the Ministry unit has implemented exporter support programs, of Economy, other agencies, chambers of commerce including: (i) leads generation; (ii), participation in and donors, designed and implemented marketing trade fairs and (iii) the establishment of an online campaigns including a web portal, participation in marketplace that serves at least 300 companies. international trade fairs, business-to-business meetings, forums, study tours and publications (guidebook on export promotion, flyers, brochures). 21 Pillar 2: Facilitating the restructuring of the agribusiness sector Prior action #4: The Borrower has: (a) enacted the Bank experts have advised MAFWE on how to Law on Sale of Agricultural Land in State Ownership, improve the methodology that will determine the floor dated June 17, 2013 (Official Gazette 87); and (b) price in the Sale and make it consistent with approved the First Annual Program for Sale of State international standards, and provided Owned Agricultural Land and initiated its public recommendations that enhanced the design of the First review. Annual Program. Prior action #5: The Ministry of Agriculture, Forestry EU IPA and World Bank projects have provided and Water Economy has: (a) established a functional technical support for the design and development of Integrated Administration and Control System (IACS) the IACS. for agricultural income support and rural development payments; and (b) increased the controls for direct payments based on a risk-based approach. Pillar 3: Improving the efficiency of trade logistics services Prior action #6: The Food & Veterinary Agency The World Bank through the CIIP grant and in (FVA) and the State Sanitary and Health Inspectorate cooperation with the IFC Trade Logistics project (SSHI) have adopted a risk strategy, risk methodology Team extended technical assistance to the FVA and and standard operating procedures, dated December SSHI for the development of the risk strategy, risk 27, 2013 and January 14, 2014, respectively, which methodology and standard operating procedures. establish a risk-based approach for inspections in international trade. Pillar 4: Establishing enabling conditions for labor market flexibility and innovation capacity Prior action #7: The Borrower has enacted the Law on The government has established a working group on Amendments to the Law on Labor Relations, dated seasonal work to respond to the needs of employers; is February 19, 2013 (Official Gazette 25), which holding regular roundtables with firms and other facilitates seasonal employment contracting. stakeholders; and is tracking the evolution in the registration of seasonal contracts. Prior action #8: The Borrower has enacted the Law on The Policy Note on Seasonal Employment, developed Amendments to the Law on Social Protection, dated on request from the Government, significantly May 31, 2013 (Official Gazette 79), which allows facilitated the policy dialogue with the Bank Team income disregards in social assistance, enabling a and subsequent development of the legal amendments limited amount of wages to be earned before workers by the Ministry of Labor and Social Policy. are de-registered from the beneficiary list and benefits are reduced. Prior action #9: The Ministry of Labor and Social The Ministry of Labor and Social Policy has planned Policy has established a functional employment online a set of open meetings with stakeholders every three registry and has implemented a public information to four months, to discuss recent changes to the law campaign about the new procedures of the registry on seasonal employment, online registration of and available types of contracts, including for contracts, and labor inspections. seasonal employment. Prior action #10: The Borrower has: (a) enacted the A World Bank-funded Skills Development and Law on Innovation Activity, dated May 31, 2013 Innovation Support Project (approved by the Board on (Official Gazette 79) and; (b) adopted the Statute and January 28, 2014), will help with capitalization and Rulebooks for the financing instruments of the Fund technical assistance to FITD to pilot the four financing for Innovation and Technological Development instruments for innovation-driven projects of SMEs in (FITD) dated November 30, 2013. FYR Macedonia. 22 5. LINK TO COUNTRY PARTNERSHIP STRATEGY AND OTHER OPERATIONS 63. The proposed operation will support the priorities of the 2011-2014 Country Partnership Strategy (CPS), the objective of which is to provide selective and targeted financing and knowledge and advisory services in support of faster, more inclusive and greener economic growth. The proposed DPL2 contributes to the first CPS outcome of ensuring faster growth by supporting competitiveness and macroeconomic stability, further improving the business climate, continuing sound macroeconomic management, further reducing bottlenecks in the business environment and infrastructure, and stepping up investments in training. The DPL will also contribute to the CPS pillar of improving governance and transparency in public sector delivery to support a market economy. 64. This Second Programmatic Competitiveness DPL builds on the DPL of 2009, the Policy-Based Guarantee of 2011, and ongoing analytical and advisory services to strengthen fiscal and financial sector stability and the competitiveness of the economy. It also builds on the PDOs of six ongoing or recently closed investment projects, all of which were/are aligned with the CPS development goals of faster, more inclusive and greener growth. More specifically:  Manufacturing – previous work on TIDZs under the BERIS project.  Agribusiness. The Agriculture Strengthening and Accession Project (ASAP), which closed in 2012, supported improved delivery of government assistance to the agriculture sector in a manner consistent with EU pre-accession requirements, including the establishment of information systems to monitor agricultural support programs. The Real Estate Cadaster and Land Market project, approved in 2005, strengthens land markets and the use of real property as collateral for business investment by providing more secure titles.  Trade logistics. The recent Second Trade and Transport Facilitation Project has facilitated trade between the FYR Macedonia and neighboring countries in South East Europe by removing bottlenecks at selected border crossings and improving the efficiency and quality of road and rail services along the main transport corridors.  Labor market reform and innovation. The BERIS project strengthened the capacity of Macedonian institutions to improve the business climate and enhance the competitiveness of the enterprise sector. The proposed DPL2 goes further by also strengthening the regulatory environment, competitiveness policies, and innovation policy. A. CONSULTATIONS, COLLABORATION WITH DEVELOPMENT PARTNERS Consultations 65. The framework in place allows for extensive consultative process in decision- making. The government has had regular and extensive consultations with private sector and civic society regarding the various measures proposed in the matrix. Inter-governmental working groups, discussions within government and within parliament facilitate consultations across 23 political groups. There is broad based support for most of the reforms as they are primarily targeted towards supporting the private sector. However, implementing some of them (particularly in the agribusiness pillar) may be difficult. The government has established a number of bodies and channels to discuss planned policies; additional efforts are needed to build capacities among stakeholders in order to be able to constructively engage in these processes. 66. Extensive consultations have taken place concerning the supported reforms, cutting across sectors and involving key counterparts, industry groups, stakeholders and international donors. For example, during the preparation of the various labor laws consultations were conducted with the employers’ organization and trade unions. The authorities have also taken considerable efforts to discuss the reforms in the agricultural support with the farmers’ associations. The PSIA of proposed measures in the labor markets and agribusiness sector have also included extensive consultations through focus groups and interviews. The findings of the Modular Competitiveness Assessment that served as the analytical underpinning for many of the reforms in the program have been discussed with government and stakeholders. Collaboration with other Development Partners 67. The DPL2 preparation included a close dialogue with the IMF, the European Commission (EC), and relevant development partners. Regular discussions have been organized with the IMF about emerging macroeconomic and financial risks and policies that could impact the competitiveness of the private sector. The Bank and the Delegation of the EC serve as focal points for the government and donor community on a Program-Based Approach in the areas of business environment, competitiveness and innovation. There is close collaboration on export promotion with USAID, which is funding an Investment Development and Export Advancement Support (IDEAS) Project to build capacity in InvestMacedonia; and an AgBiz Project to support competitiveness of the agribusiness sector. 6. OTHER DESIGN AND APPRAISAL ISSUES A. POVERTY AND SOCIAL IMPACT 68. Overall, the policies supported under the DPL series are expected to have neutral or positive poverty and social impacts, predominantly by increasing total employment and in some cases increasing the returns to employment. A detailed Poverty and Social Impact Assessment (PSIA) has been undertaken with a focus on the distributional impacts and potential risks of the policies in the agribusiness pillar. 69. The reform of agricultural support programs supported in DPL1 is expected to have neutral or positive poverty and social impacts, and the risks of negative impacts are being mitigated by actions supported under DPL2. Since the government’s new support programs were introduced recently, the distributional impacts of higher compliance are still difficult to gauge. The PSIA suggests that, relative to commercial farms, smaller and low-income farmers could face barriers to applying and qualifying for rural development support measures. Barriers could include limited access to finance (the most important perceived barrier), lack of advisory support, legal issues, long processing times and limited incentives to invest and modernize. The establishment of the IACS supported under DPL 2 will mitigate these potential barriers by 24 instituting simplified subsidy claim procedures with substantially reduced requirements for supporting documentation. 70. The reforms aimed at strengthening the land policy and invigorating the agricultural land market in FYR Macedonia are expected to have positive social impacts in the form of increased opportunities for competitive land sales, a more dynamic land market, and access to finance, investment and job creation opportunities for land owners. A number of assessments of the agriculture sector in FYR Macedonia carried out to date have identified the excessive division of privately owned land as the major structural deficiency that hampers sector competitiveness. The gradual privatization of state- owned land, combined with land consolidation initiatives, is likely to bolster market participation and underpin the privately owned land rental markets. 71. Reforms aimed at improving incentives for formal work under Pillar 4 are expected to have positive poverty and social impacts. The legislative framework that facilitates seasonal employment contracting is expected to increase demand for seasonal labor by reducing hiring costs for employers of seasonal workers, while at the same time improving conditions and benefits for seasonal workers. The introduction of income disregards for social assistance beneficiaries is also expected to have positive poverty impacts, as it will increase incentives to formal employment for low-wage earners and thus potentially also improve their benefits and work conditions. The effect of this reform is generally more pronounced for households’ “second earners”, who are usually women. 72. The gender dimension was mainstreamed into the PSIA to better articulate gender- specific policy responses and monitor the gender effectiveness of the reforms. The supported reforms directly address several of the key issues raised in the recently completed Country Gender Assessment. The reforms aimed at seasonal employment and income disregards are expected to improve employment and earnings outcomes for women. In the agriculture sector, PSIA qualitative surveys suggest that women’s traditional role in society has limited their involvement and participation in agriculture sector, and that targeted training and support for female farmers can help overcome key barriers they face (e.g., lack of education and information, property rights and minimal support structures for women with household responsibilities). B. ENVIRONMENTAL ASPECTS 73. The proposed operation has been screened against OP 8.60 Environmental, Forest and Natural Resources Aspects. As with DPL1, none of the policy reforms to be supported by DPL2 are expected to result in significant direct negative environmental impacts, and most reforms will have to have a neutral or positive environmental impact. However, for policy actions that could have an indirect impact on the environment, mitigation measures are in place:  Investments in existing TIDZs, and the development of new zones, could increase pressure on the environment. Potential impacts will be mitigated through higher environmental standards in the zones and oversight of the activities in the TIDZs by state authorities. A Strategic Environmental Assessment (SEA) for each TIDZ will be carried out to ensure a comprehensive assessment of impacts. For each individual company within the TIDZ, the 25 Ministry of Environment and Physical Planning will issue environmental conditions for a construction permit or request that an Environmental Impact Assessment (EIA) be carried out. The zones will have high quality infrastructure and services, which will facilitate compliance with SEA, EA and the permit requirements. The one-stop shop for permits to be developed under DPL2 will help facilitate compliance. The one-stop-shop will, in time and with capacity building support, also issue environmental permits for individual firms. The DTIDZ management team will be provided with training in sustainable development and management of industrial zones.  The new National Program for Agriculture and Rural Development is intended to accelerate the growth of agriculture production, which could lead to increased use of fertilizers to increase the intensity of cropping. This risk will be mitigated by promoting compliance with the GAEP, which has not yet been adopted on a large scale. Current information from the State Statistical Office suggests that smaller farms use a larger amount of pest control substances due to noncompliant and untrained owners. GAEP minimal requirements cover sustainable land use, fertilizer use, animal husbandry, manure management, plant protection, water management and water pollution. The DPL series aims to achieve at least 25 percent compliance with GAEP under the new agriculture subsidies program, which includes the provision of training and advisory services to farmers. This training could lead to full compliance with GAEP in seven years. 74. In addition to capacity building and training, potential environmental impacts will continue to be mitigated, as they were under DPL1, by the quality of the institutional and legal framework. FYR Macedonia is making sustained progress in aligning its legislation with the EU’s environmental acquis, and to effectively implement and enforce EU environment standards in the medium term. The harmonization has been assessed positively by the EU. FYR Macedonia’s current environmental and EIA legislation could serve as a good mechanism to address environmental aspects that could arise through the policy actions supported by the DPL. The country’s basic EIA competence remains high. Sector environmental analyses are done on a regular basis by the country itself as well as by the EU. These analyses are further supported by contributions from different IFIs. Areas where further efforts are needed, as reported in the 2012 EU Progress Report for FYR Macedonia, are mainly related to capacity building in SEA, water quality, and control of industrial pollution. C. PFM, DISBURSEMENT AND AUDITING ASPECTS 75. The overall fiduciary risk is moderate. There has been a significant improvement in the procurement arrangements, an area in which the risk rating was assessed as “significant” in earlier assessments (CFAA 2004 and CFAA 2007). The financial management assessment for the aspects considered in these assessments was considered “moderate”. The financial management risks continue to be moderate. The 2009 review of the National Public Procurement System noted improvements in the procurement system, and further progress has been reported in the area of external audit and internal audit and control. However, the emergence of public sector arrears recently suggests still evolving mechanisms for control and recording of commitments. 26 76. FYR Macedonia continues to have sound public financial management arrangements compared with other countries in the region. The Budget Law provides for an orderly budget process, including provision for medium term fiscal and budgetary projections. The Public Expenditure PBG supported measures to strengthen public financial management. The Organic Budget Law was amended in December 2012 to improve strategic planning of public expenditures. Amendments to the Manual of Treasury Operations included compulsory recording of multi-year liabilities. The Treasury Department is now prohibited to approve payment requests if liabilities are not properly registered. In addition, the Ministry of Finance updated the Treasury Information System in 2013 to incorporate entry and monitoring of multi- year liabilities. A medium-term fiscal strategy has also been prepared and is envisioned to become a permanent feature of the budgeting process. Parliament approved a Law on Financial Discipline in December 2013, requiring the government to pay incurred obligations within 60 days, thus limiting the scope for future run-ups in arrears.11 The country’s ranking on the Transparency International Corruption Perception Index improved from 106th position in 2006 to 62nd in 2010, before retreating to 67th in 2013. 77. Further improvements are necessary in several areas of public finance management. These include: (i) improved budget revenue estimates and adopting a conservative approach in setting expenditure ceilings; (ii) strengthened regulation on commitment accumulation and multi- year commitments; (iii) improved reporting on state-owned enterprises and public debt levels; and (iv) strengthened internal financial controls in the public sector. The government has agreed to an in-depth PFM assessment by the World Bank which will be coordinated with the EC. 78. The proposed DPL2 will follow the Bank’s disbursement procedures for development policy operations. No withdrawal shall be made unless the Bank is satisfied with the Program being carried out by the Borrower, and with the adequacy of the Borrower’s macroeconomic policy framework. The untied budget support will be disbursed in compliance with the agreed prior actions and will not be tied to specific purchases. No procurement requirements will be needed. Upon approval of the Loan and notification by the Bank of Loan effectiveness, the government will submit a withdrawal application. At the request of the government, the Bank will disburse the Loan, less the amount of the front-end fee, and the net proceeds of the Loan will be deposited in the Treasury’s Euro account in the NBRM, this account being available for budget financing. This Treasury Euro account forms part of the foreign exchange reserves of the country. The Borrower shall ensure that upon deposit of the net proceeds of the Loan into said account, an equivalent amount will be credited in the Borrower’s budget management system. If after the proceeds are deposited in the NBRM account the proceeds of the Loan are used for ineligible purposes as defined in the Loan Agreement, the Bank will require the Borrower to promptly, upon notice from the Bank, refund an amount equal to the amount of said payment to the Bank. Amounts refunded to the Bank upon such request shall be cancelled. 11 The Health Insurance Fund will be exempt from complying with this requirement for the first three years of its implementation. 27 79. Considering the Bank’s knowledge of the public finance management systems, the ongoing improvements of these systems and the assessment of the NBRM made by the IMF, no audit will be necessary of the deposit account. The latest IMF update of the safeguards assessment was completed in May 2011. The assessment found that a good governance framework is in place and the NBRM had taken steps to strengthen its safeguards framework and implemented recommendations from the 2005 assessment. The actions taken by the NBRM to safeguard funds are deemed adequate. The audit systems within FYR Macedonia continue its progress on implementing the public internal financial control framework required for EU accession. In terms of external audits, there has been progress in strengthening the State Audit Office, which is independent from the executive branch and its mandate covers all public sector activities. The State Audit Law was last revised in November 2010 to strengthen harmonization with the acquis communautaire and provide the status of civil servants for state auditors, giving them the associated protections and conditions of service. D. MONITORING AND EVALUATION 80. The Ministry of Finance will be responsible for overall implementation of the proposed operation and for coordinating actions among other concerned ministries and agencies. Other agencies involved include the Cabinet of the Deputy Prime Minister of Economic Affairs, the Ministry of Economy, the Ministry of Agriculture, Forestry and Water Economy, the Ministry of Education and Science, the Ministry of Labor and Social Policy, the Ministry of Transport and Communications, the State Inspectorates responsible for inspections at the border, InvestMacedonia the Directorate of Technological Industrial Development Zones and the Employment Service Agency. The monitoring and evaluation capacity is generally deemed insufficient, and is being reinforced through several of the DPL policy actions and from the CIIP technical assistance. 81. At the same time, the overall status of the program will be monitored during supervision to determine whether the specific conditions of the proposed operation have changed. The Bank will monitor actions and review progress of the implementation of the proposed operation, as well as the subsequent operations through frequent visits to the country and constant communication with authorities. Implementation Status Reports (ISRs) will be prepared to assess compliance of the authorities with contractual undertakings under the program and the loan agreement. An Implementation Completion Report (ICR) will be completed within six months of the closing date of the DPL series. Further, the Bank Team through the CIIP will assist with strengthening of the institutional capacity for data collection and monitoring and evaluation of the DPL series results. 7. SUMMARY OF RISKS AND MITIGATION 82. The overall risk rating level of the proposed DPL2 is moderate. 83. Political risks are moderate. The program of structural reforms to be supported by the proposed DPL2 has strong ownership within the government, as demonstrated by the recent adoption of laws, strategies, methodologies and action plans that map out concrete steps to be taken until 2015. In regards to the broader political environment, following the December 2012 incidents in the Macedonian parliament, the government and the opposition signed the Report of 28 the special Commission formed to investigate, although the Commission is not yet fully operational. Furthermore, steps have been taken to improve relations with Bulgaria and Greece. 84. Governance risks are moderate. As the initiative to establish special economic zones (Technology Industrial Development Zones, TIDZ) matures, good corporate governance will become more important, The inclusion of private sector representation on the Managing Board has created checks and balances in how the zones are administered A stronger monitoring framework is needed to ensure that recipients of aid incentives remain in compliance with national legislation, which establishes ceilings for aid intensity that are aligned with the EU State Aid rules. The DPL actions and results indicators will serve as mitigating measures for these governance risks. 85. Macroeconomic risks are moderate. While growth is expected to recover in the medium term, downside risks remain significant. The uncertain external environment in the Eurozone affected FYR Macedonia’s exports and weighed heavily on the business environment. Real GDP growth is expected to be 2.5 percent in 2013 but is forecast to accelerate to 3 and 3.5 percent in 2014 and 2015, supported by a public investment program and strong export growth. Based on the 2014 budget and the government’s medium-term fiscal framework, the fiscal deficit is projected to decline gradually as the economy recovers and the government implements measures of fiscal consolidation. Upcoming elections in 2014 and 2015 could lead to fiscal slippages and a continued increase in central government debt. In the past, the government has, however, adjusted capital spending to meet fiscal targets. Debt burden indicators will significantly improve if key economic variables assume their historical values; but will significantly deteriorate in the event of further shocks. External economic risks are somewhat mitigated by buffers currently in place, including a solid reserve coverage. The IMF continues to endorse the government’s macroeconomic policies. The proposed Competitiveness DPL is supporting structural reforms to boost competitiveness and sustain FDI inflows, which will support the medium-term outlook. 86. Operational design, implementation and sustainability risks vary from low to substantial depending on the prior action. Implementation of the proposed DPL2 will strain the capacity of some public sector institutions. The major capacity risk lies with the Ministry of Agriculture, Forestry and Water Economy, which needs to implement the multi-annual Program for Development of Agriculture and Rural Development adopted in 2012, and also to initiate the privatization program for state-owned agricultural land. The implementation risks are mitigated by technical assistance provided through the Bank’s CIIP Support Program and through high- level policy dialogue with key Ministers. 87. Environmental and social risks are low. The proposed operation has been screened against OP 8.60, Environmental, Forest and Natural Resources Aspects. No direct negative impacts are expected. However, some policy actions could have indirect impacts, for which mitigation measures are in place. Continued high unemployment may directly affect the social balance in the country, provoke social tensions, and undermine support for the reform program. The proposed program is focused on strengthening the labor market, and supports interventions in social protection and skills development with the aim of translating economic growth and the recent increases in labor participation into more and better jobs for all Macedonians. 29 ANNEX 1: POLICY AND RESULTS MATRIX Objectives Prior Actions for the First DPL Prior Actions for the Second DPL Indicators Baseline Expected results PROGRAM DEVELOPMENT OBJECTIVE: To strengthen the competitiveness of FYR Macedonia’s economy by incentivizing productive investment and technology upgrading in the manufacturing, agribusiness and trade logistics sectors, and establishing enabling conditions to progressively increase labor market flexibility and skills development. PILLAR 1: DEVELOPING HIGH VALUE-ADDED MANUFACTURING 1.1. ATTRACTING - The Borrower has enacted the Law on - DTIDZ’s Managing Board has Investments per year by 2011: €10 mn 2014: €50 mn GREENFIELD Amendments to the Law on Technological adopted a Three-year Investment companies located in the INVESTMENT Industrial Development Zones (TIDZ), of Program for 2013-2015that is aligned TIDZs. October 15, 2012 (Official Gazette 127) that with investor demand in each TIDZ gives DTIDZ the authority to (i) issue and regional development priorities. construction permits and use permits for the - InvestMacedonia has adopted a companies established in the TIDZ, (ii) Share of medium- and 2011: 40.7% 2014: 50% Guideline for Control, Assessment and provide aftercare services for companies in high-tech exports in Monitoring of State Aid on September TIDZ, and (iii) appoint three members to the total exports. 30, 2013, to, inter alia, verify Steering Board of the DTIDZ that will continued compliance with the represent the private sector. conditions under which aid is granted to legal entities. 1.2. SCALING-UP - The Borrower has: (a) adopted on - InvestMacedonia’s export promotion Number of new 2011: 0 2014: 30 EXPORT November 26, 2011 a Strategy for Export unit has implemented exporter support contracts as a result of PROMOTION Promotion containing an action plan for programs, including: (i) leads the exporter support implementing support programs for generation; (ii) participation in program. exporters; and (b) established an export international trade fairs; and (iii) promotion unit within the Borrower’s participation in an online marketplace Agency for Foreign Investment and Export that serves at least 300 companies. Promotion ‘InvestMacedonia’. PILLAR 2: FACILITATING THE RESTRUCTURING OF THE AGRIBUSINESS SECTOR 2.1. IMPROVING - The Ministry of Agriculture, Forestry and - The Borrower has: (a) enacted the Number of state-owned 2011: 0 2014: 75 AGRICULTURAL Water Economy has established a functional Law on Sale of Agricultural Land in agriculture properties LAND electronic land management system that State Ownership, dated June 17, auctioned. ADMINISTRATION includes all lease contracts for state-owned 2013 (Official Gazette 87); and (b) agricultural land. approved the First Annual Program Share of agricultural 2011: 0 2014: 15% for Sale of State Owned Agricultural land where producers Land and initiated its public review. adhere to GAEP 30 Objectives Prior Actions for the First DPL Prior Actions for the Second DPL Indicators Baseline Expected results 2.2. BETTER - The Borrower has adopted the multiannual - The Ministry of Agriculture, Forestry environment-friendly TARGETING OF National Program for Development of and Water Economy has: (a) agricultural practices. INCENTIVES FOR Agriculture and Rural Development 2013- established a functional Integrated AGRICULTURE 2017 (NPDARD) of October 24, 2012 that: Administration and Control System PRODUCERS (i) makes at least 25 percent of resources (IACS) for agricultural income support budgeted under the NPDARD conditional on and rural development payments; and adherence of beneficiaries to the Borrower’s (b) increased the controls for direct Code of Good Agricultural Practices payments based on a risk-based (CGAP); and (ii) increases the resources approach. allocated to structural and investment measures to 25 percent of the total resources allocated under the NPDARD. PILLAR 3: IMPROVING THE EFFICIENCY OF TRADE LOGISTICS SERVICES 3.1. FACILITATING - The Borrower has adopted a resolution on - The Food & Veterinary Agency Average waiting time at MOVEMENT OF March 23, 2012 providing its Customs (FVA) and the State Sanitary and the border from arrival GOODS ACROSS Authority with responsibility to coordinate Health Inspectorate (SSHI) have to release of goods: 2011: 2014: BORDERS inspections of relevant inspection authorities adopted a risk strategy, risk Transit 60mins 10% reduction in at key border crossings. methodology and standard operating Import 1hr 57 mins each indicator - The Customs Administration has, from procedures, dated December 27, 2013 Export 35 mins October 19, 2012, commenced quarterly and January 14, 2014, respectively, publication of the data about the waiting which establish a risk-based approach Sampling rate for 2012: 2014 time for customs clearances and inspections for inspections in international trade. physical inspections and FVA: 21.8% 40% reduction at key border crossings. laboratory testing for SSHI : 57.2% 3.2. INCREASING - The Ministry of Transport and low- and medium-risk EXPORT- Communications has commenced products traded across READINESS OF THE distribution of annual European Conference borders. TRANSPORT of Transport Ministers (CEMT) licenses INDUSTRY through a system that gives priority to Share of CEMT licenses 2011: 78% 2014: 90% vehicles with EURO 4 and EURO 5 awarded to transport emission standards. vehicles with EURO 4 and EURO 5 emission standards. PILLAR 4: ESTABLISHING ENABLING CONDITIONS FOR LABOR MARKET FLEXIBILITY AND INNOVATION CAPACITY 4.1 IMPROVING - The Borrower has enacted the Law on - The Borrower has enacted the Law Recipients of social 2011: 0.2% 2014: 8% INCENTIVES FOR Amendments to the Law on Employment on Amendments to the Law on Labor assistance who work FORMAL WORK and Insurance in Case of Unemployment of Relations, dated February 19, 2013 formally. September 14, 2012 (Official Gazette No. (Official Gazette 25), which facilitates 114) to add the criterion of active job search seasonal employment contracting. to the definition of ‘unemployed’, and to establish the rules on what qualifies as an 31 Objectives Prior Actions for the First DPL Prior Actions for the Second DPL Indicators Baseline Expected results active job search. - The Borrower has enacted the Law Time required to 2011: 45 days 2014: 35 days on Amendments to the Law on Social process visa and work Protection, dated May 31, 2013 permits. (Official Gazette 79), which allows income disregards in social assistance, enabling a limited amount of wages to be earned before workers are de- registered from the beneficiary list and benefits are reduced. - The Ministry of Labor and Social Policy has established a functional employment online registry and has implemented a public information campaign about the new procedures of the registry and available types of contracts, including for seasonal employment. 4.2. BOOSTING - The Borrower has enacted the Law on The Borrower has: (a) enacted the Law FITD is operational and 2011: Fund has 2014: The FITD INNOVATIVE Amendments to the Law on Employment of on Innovation Activity, dated May 31, has launched the first not been is operational CAPACITY Foreign Citizens of July 4, 2012 (Official 2013 (Official Gazette 79) and; (b) calls for proposals established. (structure, staff, Gazette No. 84) and the Law on adopted the Statute and Rulebooks for and financial Amendments to the Law on Foreigners of the financing instruments of the Fund management July 4, 2012 (Official Gazette No. 84) to for Innovation and Technological capacity are in streamline the procedures for issuing visa Development (FITD), dated November place) and 50 and work permits to foreign personnel. 30, 2013. companies have applied for financing. 32 ANNEX 2: LETTER OF DEVELOPMENT POLICY 01 • Republic of Macedonia ··~ Ministry of finance TO: The World Bank No./~1- {_}_ _; / / Z 1818 H Street, N.W. '--~,$(,opjc Republi' of Macedonia Washington D .C. 20433, Ministry of Finance U.S.A Dame Gru<-v 14 lOOOSko pje Re public of Macedonia 1\tln: Or. jim Kim, President Tel: ·H 389 2 3117 288 Fax: ++ 389 2 3117 280 E-mail: finan(C(i>,) financc.gov.mk Subject: Letter of Development Policy Website: finance.gov.mk Dea r Or. Kim, On behalf of the Government of the Republic of Macedonia, l am wri Ling to you to request a Programmatic Development Policy Loan (DPL) of US$50 million to support our program aimed at strengthening competitiveness of the economy by incentivizi ng productive investments and technological upgrading in the manufacturing, agribusiness and trade logistics sectors, and by establish ing an enabling conditions to progressively increase labor market flexibility and innovation capacity. The 2009 internationa l economic cris is a nd the sovereign debt crisis in the F::urozone have interrupted the accelt' ration of economic activity in Macedonia. However, the cou ntry has maintained a solid track record of macro-economic stability and has implemented a major reform program. At the end of 2012, centra l government debt, as a share of GOP, s tood at 34.1%and public and publically guaranteed debt accounted for 39.2%. The exchange rate peg to the EUR has successfully preserved p rice stability. Financial sector risks have been manageable. Recent structural reforms have led to a significant improvement in the bus iness climate, as measured by international rankings. Accorcting to the Doing Business 2104 Report, Macedonia is one of the 10 top reformers, among 189 countries in the world. Once again, Macedonia was the fifth most improved country among the top 50 economies in the world, advan cing from the 92"d pos ition in 2006 to the 25th in 2013, taking the leading place in the region and being ahead of most EU Member States. Key reform