Problems and Prospects for Economic Growth in Moldova: A Critical View on Institutions

Hochschule für Technik und Wirtschaft Berlin University of Applied Sciences

Master’s thesis in International and Development Economics

Problems and Prospects for Economic Growth in Moldova: A Critical View on Institutions

Presented by

Viorel Girbu

Supervisor: Prof. Dr. Ulrich Wurzel

Prof. Dr. Sebastian Dullien

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I herewith formally declare that I have written the submitted dissertation independently. I did not use any outside support except for the quoted literature and other sources mentioned in the paper.

I clearly marked and separately listed all of the literature and all of the other sources which I employed when producing this academic work, either literally or in content.

I am aware that the violation of this regulation will lead to failure of the thesis.

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Contents:

Introduction 4

1. What are institutions and what is their role for in economic development? 5

a. What are institutions? 5

b. Institutions and economic growth, theoretical considerations 7

c. Growth enhancing institutions 8

2. Institutions in Moldova 10

a. The Moldavian economy since the 1990s 10

b. Social institutions as determinants of economic performance 11

i. Property rights protection and cost of contract enforcement 12

ii. Educational system 14

c. Economic institutions 15

i. South East Asian recipes 15

ii. Economic growth strategy 16

iii. Business environment 18

iv. Tax performance 20

v. Subsidies 21

vi. Foreign trade policy 21

vii. Fiscal policy 22

viii. Monetary policy and financial sector 24

3. Problems and prospect for growth in Moldova 25

a. Market failures 25

b. Alternative policies of economic growth 26

c. Policy recommendations 28

4. Conclusions 29

Annexes 31

References 34

Introduction

A way to diagnose the economic structure of a nation is to look at its institutions. Following Douglass North, a Nobel laureate in economics, “institutions determine the performance of economies” (North, 1990, p.137).

Although Moldova has struggled to achieve similar economic performance to the European continent for about twenty years, the results are still mediocre. The level of the country’s economic development, expressed as GDP per capita, is less than it was in 1990, at the beginning of the process.

The goal of this paper is to conduct an exploration of the main causes that hinder economic growth in Moldova and of the possibilities to gain a fair level of economic development in Moldova in the near future.

“ Whatever generalizations we are prepared to accept, however, there has to be a next stage: after history made it plain that secure property rights and market are better for growth than mere hierarchical rent-extraction, what do you do for an encore? The devil is in the details.”

Robert M. Solow

1. What are institutions and what is their role in economic development?

Institutions viewed as the constituent elements of society ultimately determine its economic and social performance. Following Gagliardy, (The Journal of Socio-Economics, 37, 2008, pp.416-443), three broad approaches to the study of institutional issues can be identified. The first approach, “the historical perspective” is linked to North’s theory on institutions (North, 1990). Aoki (2001) provides the second approach of “comparative institutional analysis” and the third approach is represented by the “imperfect information theory” of Bardhan (2000).

The aim of this paper is to analyze the long-term prospects and problems for economic growth in Moldova from the perspective of its institutional framework. In this respect, the first approach of the institutional assessment seems to be most relevant.

a. What are institutions?

What are institutions? From “the historical perspective” the answer to this question is contained in D. North’s work on institutions, institutional change and economic performance (North 1990). This work can be regarded as a pivotal theory on the economic institutions that has inspired much research in this field.

North’s theory is based on an analysis of human behavior and transaction costs (North 1990, p.27). In fact, transaction costs play a central role in North’s theory of institutions. Referring to a previously made study of the US economy, North states, “… it is costly to transact” and “… when it is costly to transact, institutions matter” (North 1990, p.12). From the perspective of human behavior, the role of institutions, as viewed by North, is to reduce uncertainties in human interaction.

The definition of the institutions proposed by North is fairly straight. He views institutions as “rules of the game in a society”, or expressed in another way, “humanly devised constraints that shape human interaction” (North 1990, p.3). Institutions are a major determinant of the present well being of a society as they make the connection between the past and the future.

North divides institutions into two major categories: formal and informal. The formal category is made of norms and rules specifically created by human beings. It is exhibited in the form of laws or regulations, while the latter category comprises attitudes and behaviors of a particular social group, commonly referred to as culture. Informal constrains, according to North, play an important role in any society and can be changed by imposing formal rules, although not immediately. The level of

economic development determines the relative importance of formal and informal institutions in a society. Informal institutions play a bigger role at the incipient level of development (North 1990, pp. 36-54).

In his theory, North made a separation between institutions and organizations. Organizations, following North, are “groups of individuals bound by some common purpose to achieve objectives” (North 1990, p.5). Included in the category of organizations are entities like political parties, firms, churches, schools etc.

Institutions change with time. Fundamental changes in the relative prices modify the incentives of individuals in the process of human interaction. In this way organizations created by individuals to take advantage of the opportunities provided in the society by the institutional framework, evolve and diversify. This continuous transformation determines an alteration of formal rules and the subsequent creation of new, informal constrains that produce increasing returns through an “… interdependent web of an institutional matrix” (North 1990, p.95). The reverse situation is equally possible if institutions evolve under the influence of the organizations that favor disincentives to productive activity. The ultimate result that will shape the institutions in any particular society “… will be determined by the relative bargaining power of the participants” (North 1990, p. 101).

O. Williamson has advanced a distinctive approach to the analysis of the institutions (Williamson 2000). In his view, social institutions can be grouped into four distinctive hierarchical groups, where a higher level imposes constrains on the level immediately below and also receives feedback from it.

On top of the structure Williamson allocates a so called “social embeddedness level” (Williamson 2000, p.596). This level comprises tradition, customs, social norms, and codes of conduct, referred to also as a culture that is perceived as given in a society and that has high resistance to changes. This level corresponds to the informal institutions in the North’s categorization (North 1990, pp. 36-46).

The second level, an “institutional environment” as Williamson calls it, is formed from formal rules, like constitution, laws, etc. which are products of a coordinated, evolutionary process. At this level, according to Williamson’s approach, bureaucratic functions of the government, divided into the commonly known branches of executive, legislative, and judicial powers, are found. Also the distribution of power between different levels of government is considered here. Property rights represent main category to be observed at this level (Williamson 2000, p.598).

At the third level Williamson includes the governmental institutions. The distinctive aspect that needs to be observed at this level is how the system for defining contract laws and enforcing contract is working or, in other words, “the governance of contractual relations becomes the focus of analysis.” (Williamson 2000, p.599).

The second and third levels of institutions in Williamson’s classification represent what North calls formal institutions or rules. The principle of “get institutions right” in developmental economics is applied at these levels (Williamson 2000, pp.598-599).

The fourth level comprises firms. On this level resource allocation and employment takes place, and prices, output and incentives are major control elements. To continue the parallels made with the above-mentioned North classification, it may be concluded that the last level in Williamson’s classification comprises the organizations from North’s theory on institutions (Williamson 2000, p.600).

In this way the novelty brought by Williamson consists of a deeper understanding of the formal institutions, manifested as legislative framework and governmental entities.

b. Institutions and economic growth, theoretical considerations

What is the relation between institutions and economic growth? The role of the institutions in the economic activity is predominant and in North’s view, quality of the institutional framework is directly correlated with the level of economic development. Institutions determine profitability of economic activity as they “… provide the structure for exchange that determines the cost of transacting and the cost of transformation” (North 1990, p.34). These elements cumulated, form total cost of production. In this respect North argues, “The success stories of the economic history describe the institutional innovations that have lowered the costs of transacting and permitted capturing more of the gains from trade and hence permitted the expansion of the markets” (North 1990, p.108).

An essential economic attribute of the institutions perceived by North as “rules of the game” is related to the costs associated with rules enforcement and subsequent severity of punishments (North 1990, pp.54-61). The importance of these elements in North’s view is overwhelmingly “… the inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World” (North 1990, p.54).

A major conclusion of North’s theory on institutions is that different institutional frameworks lead to different developmental patterns. According to North: “… an overwhelming feature of the last ten millennia is that we have evolved into radically different religious, ethnic, cultural, political, and economic societies, and the gap between rich and poor nations, between developed and underdeveloped nations, is as wide today as it ever was and perhaps a great deal wider than ever” (North 1990, p.6). But this observation contradicts standard neoclassical and trade theories that predict elimination of the disparities between different countries.

In the framework of North’s theory the explanation of this fact is given by the ability of the political and economic markets to alter institutions. This alteration is done by organizations and can advance in both directions: deficient or productive. On top of that, even the quality of the established institutions differ (North 1990, pp.73-107). As North mentions “… institutions were – and are – always a mixed bag of those that induce productivity increase and those that reduce productivity. Institutional change, likewise, almost always creates opportunities for both types of activity” (North 1990, p.9). In this respect North states “Institutions are not necessarily or even usually created to be socially efficient; rather they, or at least the formal rules, are created to

serve the interests of those with the bargaining power to devise new rules” (North 1990, p.16).

North describes correlation that exists between political and economic rules as being both-way causality, although in general terms “political rules in place lead to economical rules” (North 1990, p.48).

The correlations between social institutions and their influence over the economic development are analyzed in detail in a framework proposed by Acemoglu, Johnson and Roberts (Aghion & Durlauf 2005, pp.389-396). This framework is built on 6 arguments that are as follow:

1. Economic institutions shape the incentives in the society and determine economic growth and distribution of resources;

2. Economic institutions are endogenous and determined by political power; 3. Political power is used in the best interest of those that possess it, although

resulting economic institutions might not maximize the aggregate growth of the whole society;

4. Distribution of political power is endogenous. Two types of political power can be distinguished: de jure political power and de facto political power;

5. De facto political power plays an important role in a society that can offset de jure political power;

6. The hierarchy of institutions is as follows: political institutions influence economic institutions. Through them economic outcomes are determined.

c. Growth enhancing institutions

Having stated all of this, the next question that arises is what are those specific institutions that favor economic development and which can be easily identified in any national specific institutional framework? The answer to this question is not so easy to be found given high diversity of the specific institutional setups throughout the world. Even in the group of the most developed countries, institutions present a great deal of disparity, as they are a result of an individual developmental path.

Nevertheless, it makes sense initially to clarify what are “good institutions”. Acemoglu et al. define good institutions as “… those that provide security of property rights and relatively equal access to economic resources to a broad cross-section of society” (Aghion & Durlauf 2005, p.395). In this way they argue “Of primary importance to economic outcomes are the economic institutions in society such as the structure of property rights and the presence and perfection of the markets” (Aghion & Durlauf 2005, p.389).

In North’s theory, institutions determine the transformation and transaction costs and subsequently the viability of economic entities (North 1990, pp.61-73). However, any given country’s specific transformation and transaction costs represent a characteristic of the institutional quality, not a particular institution in itself.

What generic types of institutions can be identified? North points out two important institutions: respect of property rights and smooth contract enforcement (North 1990, pp.64-67). Although there are no such institutions that would fit exactly into the

mentioned categories, it is possible to substitute them with easier quantifiable indicators of rule of law and governance quality.

What else can be added to this setup? The Aghion-Howitt model of endogenous growth with quality improving innovations (quality-ladder model) explores the interconnections between growth and the process of institutional change (Aghion & Durlauf 2005, pp. 69-107). Specified model links the productivity growth rate, or long-run economic growth rate, with total amount of resources spent for innovations and thus quality improvements.

The authors drew few conclusions from the model, that are: “Countries that invest more in higher education will achieve a higher productivity of research activities and also reduce the opportunity cost of R&D”, “… growth increases with the size of innovation” and “… growth is decreasing with the degree of product market competition and/or with the degree of imitation” (Aghion & Durlauf 2005, p.75).

The last conclusion contradicts the commonly accepted perception of positive relationship between growth and competition, but the authors argue that the factor that makes the difference is the distance from the technological frontier. In this respect Aghion and Howitt state that “… competition should be most growth-enhancing in sectors in which incumbent firms are close to the technological frontier and/ or compete “neck-and-neck” with one another” (Aghion & Durlauf 2005, p.90).

The Quality-ladder model does not give any specific policy recommendation for economic growth, although Aghion and Howitt state that “… countries like Japan and Korea managed to achieve very high growth rates between 1945 up until the 1990s with institutional arrangements involving long-term relationships between firms and banks, the predominance of large conglomerates, and strong government interventions through export promotion and subsidized loans to the enterprise sector” (Aghion & Durlauf 2005, p.99).

The quality-ladder model added new candidates relevant for this research: favorable investment climate, efficient educational system, low interest rates for loans, interventionist state, efficient economic growth strategy, oligopolistic economic environment and large and stable banking sector.

It is also notable that any country wanting to initiate an economic development strategy based on quality-improving innovation, may take conclusions advanced by its developers in respect of the distance from the technological frontier into consideration. Namely countries that are considerably below the technological frontier could opt for investment based institutions or policies that would provide long term bank finance, subsidized credit and a mix between primary, secondary and higher education. Once a country moves closer to the technological frontier innovation based institutions or policies began to play a bigger role. Market finance, speculative monitoring, trade liberalization, more flexible labor market and highly educated labor force are the elements to observe and to be managed by the Government (Aghion & Durlauf 2005. p.101).

2. Institutions in Moldova

Core institutions than determine economic outcomes, identified in first chapter, are: rule of low, good governance, efficient and well correlated with an economy educational system, favorable business climate, macroeconomic stability and efficient economic growth strategy.

In order to give a coherent approach in the second chapter, the above-mentioned institutions are split in two groups. The institutions that are not specifically designed to deal with economic issues, but have an indirect impact on the economic activity, form the first group. The importance of these institutions lies in the fact that they create the social environment where economic activities take place. The second group comprises core economic institutions with a direct, straightforward impact on the economy.

As the institutions change with time and their present performance is the reflection of a continuous historical process, a brief economic outlook of the country since the 1990s will commence the assessment of the institutions in Moldova.

a. The Moldavian economy since the 1990s

Moldova gained independence from the former Soviet Union (USSR) in the year 1991. During the USSR, Moldova had a highly open and trade dependent economy that was organized on the principles of planned economy. The range of goods produced by the country in the late years of the USSR was mainly comprised of agricultural and agro-processed products, consumer durables and hi-tech defense systems. Almost all industrial inputs, energy sources and most consumer goods were imported (WB, 1994).

The rapid disintegration of the USSR and subsequent collapse of the economic production and trade systems halved the country’s GDP in 1993. At the same time prices rose substantially, mainly as a result of a rapid increase in the value of imported goods; particularly energy sources, which are entirely imported in Moldova. Estimated terms of trade loss due to the surge of the energy prices accounted for more than 20 percent of GDP in the years 1991 and 1992 (WB, 1994).

Soon after independence, in response to the continuously aggravating economic situation, the Moldavian government began rapid liberalization of external trade, accompanied by the introduction in 1993 of the national currency with a floating exchange rate (WB, 1994).

Starting in 1993 Moldova adopted a comprehensive financial stabilization program that emphasized liberalization of prices, finances and trade, and privatization of state assets (IMF, 1998).

The following four years did not bring any improvements. In 1993, real GDP contracted by 1.2 percentage points, but in the year that followed GDP lost a third of its value. GDP contraction slowed to a moderate 1.4 percentage points in 1995, but increased sharply again in the year that followed to 7.8 percentage points. Sharp contraction of GDP in the years 1994 and 1996 are attributed to droughts that hit

Moldova (IMF, 1998). However, at that time the fragile state of the Moldavian economy that made it highly dependant on the harvest cannot be left unobserved.

In 1997 the Moldavian economy grew by 1.6 percentage points for the first time after the independence (IMF, 2004). However, the Asian financial crisis that hit the Russian Federation’s economy in 1998 influenced the Moldavian economy as well, as the Russian Federation at that time was a major export market for Moldova. In the next two years, the Moldavian economy continued to shrink. By 1999 Moldova’s GDP accounted for only 34% of what it was ten years before (IMF, 2004). In 1998/1999 foreign trade squeezed in volume by half, mainly as a consequence of the straightened Moldavian real exchange rate in respect to Russian Federation’s currency that experienced a dramatic loss of value in that period.

Beginning in 2000 the economy of Moldova, altogether with other regional economies, entered a period of upturn that lasted till 2008. During this period Moldova’s GDP grew with an average annual rate of 6 percent, but GDP growth was driven mainly by the increase of the household’s consumption that climbed up to the 96% of GDP in the year 2006.

Moldova promoted active foreign economic relations. Following its independence, it has signed free trade agreements with most of the member countries of the Commonwealth of Independent States (CIS) and adhered to WTO in 2001. In 2007 Moldova joined CEFTA1 and in 2008 EU granted Moldova Autonomous Trade Preferences.

b. Social institutions as determinants of the economic performance

Because of the imminent difficulties to give a relevant assessment of the institutions included in this category, proxy indicators and surveys undertaken by specialized organizations will be used. Main sources of information are the data offered by the International Country Risk Guide (ICRG) computed by Political Risk Services Group, an organization focused on political and country risk analysis, by Polity IV Project, specializing in research on the authority characteristics of states for purposes of comparative, quantitative analysis, and relevant assessments made by World Bank (WB).

A time series analysis of Moldova’s achievements, with respect to each of the discussed indicators below, can offer an explanation of the country’s economic performance. The other possibility is to analyze Moldova’s present performance from a regional perspective. Given limited access to data, the second alternative is preferable. In this way the quality of the economic institutions in Moldova will be assessed in a static way, by making reference to other regional economies.

Trade agreement between non-EU countries in Central and South-Eastern Europe

i. Property rights protection and costs of contract enforcement

In order to assess the degree of the property right protection and the costs of contract enforcement in Moldova, multiple proxy indicators are used with relevance to Rule of Law and Quality of the Governance in Moldova.

The straights, impartiality and observance by the population of the legal system in Moldova, measured by ICRG’s indicator Law and Order, is marked for July 2009 by 4.5 points from a total of 6, where 0 means very high risk and subsequently 6 meaning minimum risk. In comparison with other regional countries, Moldova’s performance in this field is better than in the Russian Federation, Ukraine or Romania and is equal to Slovakia and Poland.

The WB’s survey in the framework of the Worldwide Governance Indicators project for the year 2008 assesses rule of law as the “… extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence” (Kaufmann et al, p.6). It places Moldova in position 41 out of a total of 212 countries. From a regional perspective Moldova performed better than the Russian Federation and Ukraine but worse than Romania, Poland and Slovakia.

According to the Polity IV assessment for the year 2009, Moldova is located in the group of countries with moderate state fragility and welfare (Marshall & Cole, 2009). It tied with the Russian Federation for the worst position on the European continent. Moldova has a high fragility index for the Political Legitimacy and Economical Effectiveness. This situation is liable to ongoing territorial dispute with the Russian Federation that restricts the exercise of the state’s legal attributes on the whole territory of Moldova. Also, Moldova has the lowest GDP per capita in Europe, which is incorporated in this index as well. Nevertheless, what has greater relevance to the present paper from the Polity IV analysis is the assessment of the political effectiveness in Moldova, which is regarded to have low fragility.

The ICRG covers the issue of Good Governance in few dimensions: Government stability, Corruption, Democratic accountability and Bureaucracy Quality. Government stability in Moldova is evaluated with 6.5 risk points from a total of 12, similar to Romania and above the score of Ukraine, but substantially below Slovakia, Poland and the Russian Federation. Moldova, with 1.5 risk points from a total 6 points at corruption benchmark has the weakest performance from the group of examined countries. Democratic accountability is evaluated in Moldova with 4 points from a total of 6, above the Russian Federation, but below Ukraine, Slovakia, Romania and Poland. The last indicator evaluated by ICRG in respect of Good Governance is the Bureaucracy quality. Here, Moldova gets 1 risk point from a total of 4, similarly with Romania, the Russian Federation and Ukraine, but below Poland and Slovakia.

For 2008, Governance’s quality is assessed by the WB’s Governance Matters VIII survey in 4 major areas. With regard to voice and accountability, Moldova, similarly to the ICRG assessment, is located in front of the Russian Federation but below Ukraine, Romania, Slovakia and Poland. Governance effectiveness in Moldova is assessed by WB more critically than in the ICRG survey; here Moldova holds the

weaker, 24th position, followed by Ukraine, Russian Federation, Romania, Poland and Slovakia. Also, disparities with the previously presented survey are found concerning corruption, where Moldova is ranked in 31st position, above the Russian Federation and Ukraine but below Romania, Poland and Slovakia. Regarding regulatory quality Moldova is ranked 48th, followed by the Russian Federation and Ukraine, but below Romania, Poland and Slovakia.

Table.1: Rule of law and governance quality

INDEX Moldova Ukraine Russian Federation

Romania Slovakia Poland

Law and order (max 6 points)1 4.5 4 4 4 4.5 4.5 Rule of law (212 countries, top-down)2 41 31 20 54 65 67 State fragility and welfare (from extreme to little, 6 cat.)3

moderate

low moderate low little little

Political effectiveness fragility (from extreme to no, 5 cat.) 3

low low low no no no

Government stability (max 12 points no risk)1 6.5 6 10.5 6.5 8 9 Corruption (max 6 points no risk)1 1.5 2 2 2.5 2.5 2.5 Democratic accountability (max 6 points no risk)1

4 5.5 2.5 6 6 6

Bureaucracy quality (max 4 points no risk)1 1 1 1 1 3 3 Voice and accountability (212 countries, top-down)4

39 47 22 59 75 73

Governance effectiveness (212 countries, top-down)4

24 33 45 50 77 68

Corruption (212 countries, top-down)4 31 28 15 57 69 68 Regulatory quality (212 countries, top-down)4 48 39 31 68 85 74

Source: 1 International Country Risk Guide, 2009; 2 Worldwide Governance Indicators 2008; 3 Polity IV 2009; 4 Governance Matters VIII 2008

The evaluation of laws designed to expand access to credit is made, in the framework of WB’s Cost of Doing Business Survey, by straights of legal rights index. According to the estimations for the year 2010, Moldova scores better than the average for Eastern Europe and Central Asia and OECD, with 8 from a total 10 points.

Ease of enforcing commercial contracts is measured by the above-mentioned WB’s survey as time, cost, and number of procedures involved from the moment the plaintiff files the lawsuit until actual payment. In respect of time in Moldova a number of 365 days are normally required. It is below the OECD and Eastern Europe and Central Asia region requirements. The cost related to the contract enforcement expressed as share from the claim reach 20.9% in Moldova, which is below Eastern Europe and Central Asia but above OECD. Finally, referring to the number of procedures, Moldova’s regulations entail a number of 31 procedures. It is above OECD but well below the value for Eastern Europe and the Central Asian region.

Table.2: Straights of legal rights and commercial contract enforcement

INDEX Moldova Eastern Europe and Central

Asia

OECD

Straights of legal rights (max 10 points) 8 6.6 6.8 Commercial contract enforcement: - Time (days) 365 450.9 462.4 - Costs (share from the claim) 20.9% 25.6% 19.2% - Number of procedures 31 37.1 30.6

Source: WB cost of doing business survey 2010

To conclude, Moldova is performing well in respect of the costs of contract enforcement, with an above average level for the Eastern Europe and Central Asian regions, and comparable to the average values for OECD countries. The state of property rights protection, assessed from the perspective of the rule of law, good governance and state fragility, is not as well settled in Moldova as it should be, compared to the other regional countries. The main factors in at-risk property rights protection in Moldova are related to high state fragility, corruption, and low government effectiveness.

ii. Educational system

Economic growth is impossible to achieve without a properly educated work force.

Moldova is placed 117th out of 182 countries in the year 2009, according to the Human Development Index computed by the United Nations Development Program. Referring to the Education Index that reflects adult literacy and the combined gross enrollment ration for primary, secondary and tertiary schools, Moldova is ranked 59th, below Ukraine, which has the best performance in the region, Poland, the Russian Federation, Slovakia and Romania. Specifically, combined gross enrolment rates that measure the number of students enrolled in primary, secondary and tertiary levels of education in Moldova register only 71.6%, compared to 90% in Ukraine. The share of state expenditures on education in total government expenditures in Moldova reaches 19.8 %; above Ukraine, the Russian Federation, Poland, Slovakia and Romania.

For the present state of economic development in Moldova the enrollment rate in primary and secondary educational levels is important. The enrollment rate in compulsory educational levels decreased in Moldova to 90.9% in 2008, down from 93.8% in 2000 (National Bureau of Statistics of Moldova (NBS), 2009). The rural areas of Moldova are most affected by the decline.

The degree of relevance of the educational system on the needs of economy in Moldova can be observed based on the student’s preferences in the type of education following compulsory levels. Although Moldova has the lowest GDP per capita on the European continent and subsequently has a less sophisticated economic structure, the preference for higher education in Moldova is obvious. For the academic year 2009/2010 the number of students enrolled in vocational education institutions was 22,161 (NBS, 2009), while those enrolled in universities reached a number of 109,892 students (NBS, 2009).

In conclusion, it can be stated that although Moldova spends more in relative terms on education, it nevertheless registers the lowest performance of adult literacy and combined growth enrollment ratio for the primary, secondary and tertiary schools. This situation is mainly due to the lowest for the European continent GDP per capita in Moldova.

Another issue with a potential negative impact on the economic development of the country was manifested during the last decade: a decrease in the enrollment rate for the compulsory educational levels. This tendency can be partially attributed to the increased emigration of the labor force from Moldova, which displaced many families

with children at the compulsory educational level and are therefore no longer covered by Moldova’s statistics.

The last aspect, which needs to be mentioned, is related to the prominent preference of the youth in Moldova for a high level education. This aspect suggests that the educational system in Moldova registers very limited success in meeting the demands of economy, which are the reason for youth to opt for highest opportunities offered by the educational system in Moldova. This is especially true for vocational education, which does not provide large opportunities for the potential beneficiaries, making it less popular that it supposedly should be.

c. Economic institutions

Labor force equipped with capital generates material prosperity. Taking the quantity of the labor force as given for any particular country, how to attract more capital to increase the prosperity?

A common way to increase the stocks of capital is represented by investment. Investment is financed from savings. While the savings rate in an open society can be regarded as a cultural issue, there are factors that can influence it. The institutional quality of the banking sector, viewed as the operational efficiency of any separate banking institution, but also as countrywide penetration, is an important aspect that determines the national savings rate. At macro level the size of GDP per capita; macroeconomic environment; fiscal and exchange rate policies are relevant.

Poor economies that are in great need of investments, beside low-income levels, also register serious flaws in relation to the other mentioned factors. A myriad of problems faced by the emerging economies takes the form of market failures, hindering the process of resource mobilization and allocation. What can break this vicious circle of self-sustaining poverty? East Asian economies that recently registered big successes in the field of economic development encompass answers to this question.

i. South East Asian recipes

In order to encourage capital accumulation, authorities in China, Hong-Kong and Taiwan (Aoki et al, 1995, pp.44-45) resorted to specific solutions that comprised:

- The lack of confidence in the banking sector in China and Taiwan is ruled out by deposit insurance, fully eliminating the default risk of savings accounts;

- Hong-Kong and Taiwan achieved macroeconomic stability by making use of a conservative fiscal policy with budgetary surpluses;

- Monetary policy in Taiwan is targeting a positive real interest rate, while in China the real interest rate on bank loans is negative, though positive for the saving accounts;

- All East Asian economies have repressed real wages and kept weak labor unions; - In order to attract foreign savings a stable exchange rate is maintained in Hong-

Kong and Taiwan; - Settling tax incentives and Special Economic Zones encourages investment; - Fixed investments are financed by the state founded Development Banks or by

the commercial banks that for instance in China, almost all government owned.

Economic growth is determined not just by the quantity of the accumulated capital but also by the efficient usage of it. Here, the economic policy of the government that guides and shapes the quality of capital accumulation process can play a role. Lau states “…export orientation and more general participation in the world market through international trade provide the competitive pressure for the exporting enterprises in China, Hong Kong and Taiwan to be efficient” (Aoki et al, 1995, p.51).

All the above-mentioned solutions, designed to overcome specific to emerging economies market failures, have active government involvement in common. Yoon Je Cho, regarding the South Korean experience, brings an even more convincing argument that supports active role of the government in the process of economic development, at least in its initial stages. He argues, “Korea is a country where government intervention in the market, especially in the financial market, was extensive, and where substantial economic rent was created and allocated in the course of economic development.” (Aoki et al, 1995, p.208).

In South Korea state control over the financial sector was a powerful tool of the industrial policy that promoted economic growth as the government “… had a comprehensive development strategy in which credit policies were well coordinated with other economic policies” (Aoki et al, 1995, p.209). But is there anything similar in Moldova?

ii. Economic growth strategy

The state is an expression of the political will of a community. Government manages the State and builds the framework where interactions of the members of the community take place. Besides dealing with current issues, governments in developing countries also struggle to manage the strenuous process of economic alignment to the standards imposed by the leading economies. Usually, the major steps to be taken in the field of economic development are specified in plans or strategies. In the case of Moldova, medium term developmental objectives of the country for the period 2008-2011 are specified by a document called the National Strategy for Development (NDS), approved by the Law No. 295-XIV from December 21, 2007.

The major goal of the strategy is to increase the quality of life in Moldova by the means of robust, sustainable and inclusive economic growth. Authorities of Moldova envisage achieving this goal by alignment of the national regulations to EU’s standards, encompassed in Copenhagen criteria.

According to NDS in Moldova, economic development is favored by: stable macroeconomic conditions; a relatively well developed banking sector; a cheap and well qualified labor force; national consensus over the EU vector of development and partially free access to EU markets; free trade arrangements with CEFTA member

states and with most of CIS countries; favorable investment climate; and access to maritime trade corridors through Giurgiulesti port2.

On the other side, factors that can hinder economic growth, following NDS, derive from the contorted production sector of Moldova that delivers a narrowed variety of low quality output; high costs of capital, as the interest rates for bank loans are high; massive labor force migration; outdated capital stock; undeveloped, poorly managed and weak infrastructure; weak public administration’s capabilities; corruption and inefficient judicial system; administrative barriers for businesses and investment; inefficient social system; negative demographic tendencies; and high intraregional discrepancies in the level of economic development.

Critical to the success of strategy are maintenance of macroeconomic stability and consolidation of the public administration’s capacities.

Strategy is developed in five priority areas. Further enforcement of the democratic principles grounded in rule of law and respect of human rights is the first priority of the NDS. In order to achieve this, government will consolidate democratic institutions of human rights protection, will modernize the judicial system, fight corruption and improve border control.

Resolution of Transnistrian conflict3 is the second issue approached by NDS. Reintegration of the country is to be achieved, according to NDS, by democratization and development of the civil society in the Transnistrian region, demilitarization and socio-economic assimilation of the region.

The third priority of NDS is to increase the national economy’s competitiveness. Regulatory and fiscal reforms with the aim to improve business climate and decrease fiscal pressure over the real economy are emphasized in this respect. This will be done by: improvement of Metrology, Standardizing, Testing and Quality regulatory framework to promote exports with a special view on EU markets; increase access to finance for Small and Medium Enterprises; improve entrepreneurial culture and develop dedicated consulting services and enhancing the quality of the public property’s management. Development of the social overhead capital is emphasized by NDS as well.

Development of human resources, increase of the employment rate and social inclusion is the fourth priority of the strategy. In this part, improvement of the educational system with its further alignment to the economy’s needs and ameliorated social inclusion of the population are pointed up.

Giurgiulesti International Free Port's is an economic free zone in Moldova comprised from a petroleum terminal, a cargo port and an industrial free zone. It is located on the Lower Danube and is capable of receiving both inland and sea going vessels. 3 Breakaway territory in Moldova located mostly on the left bank of the river Nistru. Transnistria declared its independence from Moldova in 1990, followed soon by an armed conflict between Moldova and Russian Federation that lasted from 2 March to 21 July 1992. Officially Transnistria is not recognized by any UN member states.

Last in the list of the NDS priorities is regional development. In this field the strategy is focused on the balanced economic development for the whole country. Special attention is paid to economic development in the small cities and improvement of the productivity in the agricultural sector.

This short overview of the Moldavian development strategy leads to a few observations. The most important is that Moldavian authorities rely on well functioning democratic institutions and macroeconomic stability to achieve economic development. A major element of the macroeconomic stability is the inflation rate. Nevertheless, it may be argued that democratic institutions function well only after certain level of economic development is achieved. Also, concomitant low inflation rate and rapid economic growth could be burdensome to be reached. In this respect a choice that best fits the current needs of Moldova should be made.

Also, the alignment to the Copenhagen criteria in order to achieve economic development in Moldova, emphasized by the strategy, sounds a bit superficial. Firstly, mentioned criteria are developed in order to achieve social and economic harmonization in a group of countries (most of them with much more complex economies than Moldova) where Moldova is not taking part. Secondly, Copenhagen criteria can be understood as an advanced pattern for social organization, but not necessarily as a developmental tool. Nevertheless, the countries that applied these criteria before simultaneously benefited from substantial financial support from the EU and had insured future financial assistance in the framework of EU integration process, while Moldova had not.

Previously made assessments of the social institutions in Moldova revealed that the situation in Moldova with regard to rule of law and human rights protection are not so tremendously lagging behind compared to the neighboring countries, as the level of economic development measured as GDP per capita.

In respect of the Transnistrian conflict, given high discrepancy in the economic, political and military potential that exists between Moldova and the Russian Federation, the identification of a fair resolution is virtually impossible.

In this context, the first two priorities of the NDS can be easily cut as being least relevant for the economic development of the country.

But a major deficiency of the NDS resides in the fact that it does not give any solution for a timely economic catch-up of Moldova; rather this process is entrusted to the market forces.

iii. Business environment

In order to measure the quality of the business environment in Moldova two proxy indicators are used. Index of Economic Freedom is one of them. The Heritage Foundation and the Wall Street Journal compute this index. It assesses the quality of the economic environment, and neoclassic liberal principles are benchmarks. According to the mentioned index, Moldova is placed in 125th position, from total 179 countries assessed in the year 2010. Overall, Moldova, with a score of 53.7 points, is

characterized as having predominantly mostly unfree economic environment (Miller & Holmes, 2010).

From a continental perspective Moldova is located in 40th position from a total 43 European countries. The final score of Moldova is below world and regional average.

According to this index, Moldova is performing inadequately in many fields relevant to economic activity, namely:

- Business freedom in Moldova is hindered by a burdensome licensing procedure that requires a longer processing time then the world average, while non-tariff barriers obstruct trade freedom;

- The taxation system is characterized in Moldova as being too complex and high government spending further hinders economic freedom;

- Monetary freedom is restrained by the interference of the Government into price formation for few basic utilities;

- Lack of transparency in regulatory administration, poor physical infrastructure, weak contract enforcement, excessive interference of bureaucracy into economic activities, impartial ruling of legal disputes and restrictions on land procurement by foreigners obstruct investment freedom in Moldova;

- In the financial sector, freedom is limited by the problematic long-term financing and highly concentrated banking sector, but also by the underdeveloped capital markets;

- Weaknesses of the property right system lay in the interference of the executive power into the judicial system and in the weak protection of the Intellectual Property Rights;

- Corruption is perceived as widespread in Moldova. According to the Transparency International Rankings of Corruption, Moldova is placed in 109th position from 179 countries.

- Rigid regulations hinder labor freedom.

Another modality to assess business environment is to refer to the perceptions of the entrepreneurs. The Enterprise Survey computed by the Enterprise Analysis Unit of the World Bank is a viable source of information. According to a study made during 2008-2009, three major obstacles faced by the firms in Moldova are those related to the Access to finance, inadequately educated work force and access to land. Corruption, Tax rates, Practices and Informal Sector, and Political Instability represent deficiencies of lower severity. Supply of electricity, license & permits and tax administration are perceived as being less burdensome, ending the list of top ten problems faced by businesses in Moldova (WB, 2009).

In contrast, the top three problems faced by the firms operating in the entire East European and Central Asian region, and also in countries with the same income level as Moldova, are related to the Tax rates, Access to finance and Practices – Informal Sector.

Access to finance, which is a major obstacle for the firms in Moldova, notably represents a serious problem for the large size companies, while the Inadequately Educated Work-force equally plights medium size firms. In the case of small firms a secondary major problem identified is access to land.

Although both of the examined indicators are important, in the case of Moldova the latter presents more relevance. The economic freedom, as the Index of Economic Freedom perceives it, is important in two extreme to each other cases. First, when important barriers for economic activity are imposed, like those contained by a planned economic system. Second, in the situation of free, market oriented high performing economy when even a small malfunction plays an important role for the overall success.

Licensing in Moldova takes longer compared to the known best standards. Also, the taxation system is not as smooth as it could be. Also, low quality of the bureaucracy, imperfections of the legal system and corruption impose additional burdens for the Moldavian economy, but the crucial problem faced by the firms in Moldova is limited access to long-term finance. Additionally, weak infrastructure and an inadequately educated work force need close attention in order to facilitate economic growth in Moldova.

iv. Tax performance

Two types of fiscal duties are imposed in Moldova: general state taxes and local taxes. According to Moldova’s Fiscal Code, at the national level six different taxes are collected; the most important of them are income taxes (corporate and personal income tax, contributions for social and health insurance), Value Added Tax (VAT), excise taxes, customs duties, and road tax. At the local level another 14 taxes are imposed.

Overall, incomes derived from taxing economic activities are collected at the central level, while local authorities accrue other specific duties. This distribution of the fiscal revenues renders local authorities reluctant to economic activity at the local level.

The tax system in Moldova is competitive from an international perspective, according to a tax benchmark exercise performed in 2008 by USAID (Gallagher et al, 2008). The level of taxation in Moldova is not high. Total tax revenue, including social contributions, accounts for 34% of GDP. If excluded import duties and social contributions the total tax revenue squeezes in half, to only 17% of GDP. This is not particularly high. (Gallagher et al, 2008). Moldova collects fewer direct taxes and more indirect taxes. According to the Medium Term Expenditures Framework (MTEF), in 2007, 8060 mil. lei4 in revenues came from direct taxes and 9879 mil. lei from indirect taxes while VAT accounted for 42.3% of the total fiscal proceeds.

About 22% of the labor income is subtracted by the state in the form of taxes in Moldova. That is slightly greater then the worldwide average (Gallagher et al, 2008).

Complying with taxes in Moldova is not more stressful than in other places. Administrative burdens placed on businesses by the Moldavian tax system are competitive from a regional perspective. During one year, businesses have to operate an average of 49 payments to the tax authorities and spend an average of 218 hours to

National currency of Moldova

comply with Moldavian tax regulations. For Eastern Europe and Central Asia these benchmarks are 46.3 payments and 451.5 hours, while in CIS 52.1 payments and 595.5 hours respectively (Gallagher et al, 2008).

v. Subsidies

There is not much to say about the subsidization of the economic activities in Moldova. Partly, this situation is due to the scarcity of financial resources but mainly to the fact that the government of Moldova does not apply an active and interventionist economic policy.

Although subsidies are detectable in the structure of public expenditures, the amount of allocated funds is decreasing in time. According to MTEF subsidies to the productive sector expressed as shares in GDP will be reduced from 3.3% in 2007 to 1.3% envisaged for 2011. The advent of the recent world financial crisis accelerated this tendency even further, but this issue will be touched in more details with fiscal policy of Moldova.

The agricultural sector is mainly subsidized in Moldova. Roughly 40% of the total planned for 2011 allocations in the agricultural sector will be directed to support the agricultural production. In 2009 subsidies accounted 53% from the total allocations approved for this sector.

The subsidization policy of the agricultural sector in Moldova is inward oriented and targets modernization and economic performance improvement of the agricultural producers in Moldova, in order to allow them to efficiently compete on the internal market (Government decree nr. 1305 from 29.11.2007).

An immediate conclusion regarding the subsidization policy of Moldova is that besides the fact that it is directed to a less promising sector for the economic growth, it also does not directly seeks to improve external competitiveness of Moldova that could essentially contribute to the economic growth perspectives of the country.

vi. Foreign trade policy

The foreign trade policy in Moldova is shaped by the principles of the Most Favored Nation (MFN) treatment and national treatment for all imported goods in respect to WTO members. Also, Moldova has free trade agreements with most of the CIS countries and with member states of the CEFTA accord.

In 2008 the EU assigned Moldova Autonomous Trade Preferences that secured duty free access for all products originating from Moldova to EU markets, with the exception of a limited number of agricultural products sensitive for the EU’s internal market.

During the accession negotiations to the WTO, Moldova did not manage to get any derogation from the basic rules of this organization, applicable to emerging economies (Mincu, 2007). In this way Moldova dismissed the possibility to use taxes and non-tariff measures to protect local producers from foreign competition, neither to provide subsidies in exchange for certain export targets, nor to use

subsidies to promote consumption of domestically produced goods in detriment of the imported ones.

According to the WTO assessment (2009), Moldova applied an average trade weighted tariff of 2.7% in 2007. The average tariff rate for agricultural products constituted 8.5%, while in the case of non-agricultural goods the rate was 2.1%. In the same year, imported goods totaled USD 3.7 billion while non-agricultural products accounted for USD 3.4 billion.

From a regional perspective, the average trade weighted tariff applied by Moldova in 2007 equated the level of the EU average trade weighted tariff. In Ukraine average trade weighted tariff accounted for 5.1%. In the Russian Federation, average trade weighted tariff constituted 11.4% in 2006.

Moldavian economy is traditionally highly dependent on foreign trade, as the small size of the country inhibits economic growth in a continuously globalizing world. Nevertheless, the commitments assumed by Moldova in the framework of WTO agreements can likewise represent a serious impediment for the development of the national companies as the free competition between firms from Moldova and of any other advanced economy is comparable with boxing competition, where no separation based on weight of the competitors is made. It may happen that Moldova cannot afford even the “headgear”.

vii. Fiscal policy

The assessment of the fiscal policy of the Moldavian authorities is mainly based on MTEF for the period 2009-2011, which is a medium term planning document in the field of public expenditures and fiscal policy. Although the initially made estimations are outdated after the occurrence of the recent world financial crisis, mentioned document sheds light on the principles of the fiscal policy applied in Moldova.

Improving fiscal equity, stability and transparence; optimization of fiscal pressure; systematization, simplification and alignment of the national fiscal regulations to the EU’s standards represent the major objectives of the fiscal policy in Moldova for the period 2009-2011.

In 2007 government outlay reached 41% of GDP, where current spending accounted 33.4% of GDP. Capital expenditures constituted the remaining 7.6%.

The predominant category of the current costs in 2007 was represented by the transfers to the population that came to 11.2% of GDP. The wage bill in the budgetary sector weighted 9.3% of GDP. Expenditures on goods and services and production subsidies are other major spending items that attracted 8.7% and 3.3% respectively of the public funds.

During 2008, when MTEF was developed, public expenditures were assumed to increase up to 41.5% of GDP in 2011, where current expenditures had to reach 34.4% of GDP and capital expenditures were to contact to 7.1% of GDP. All current expenditure’s components according to the MTEF 2009-2011 were expected to increase by 2011. For instance, personnel costs were planned to climb to 10% of

GDP, procurement of goods and services to 9.8% of GDP and transfers to the population to 12.7% of GDP. The only category planned to contract to just 1.3% of GDP is that of the production subsidies.

The social sector that comprises expenditures on social assistance, education and health is the major beneficiary of public resources. In 2009 it consumed 68.7% of total budgetary allocations. This situation is due to the fact that about 70% of the total public employees in Moldova are occupied in the educational sector. On the other side, economic expenditures in the same year account for only 10.7% from the total public spending.

In 2011, capital investment, which is part of the capital expenditures, is planned to decline by 20 percentage points to 1.8% of GDP compared to the level attained in 2005. About two thirds of the capital investments in Moldova are directed to the investment in social overhead capital.

According to the MTEF 2009-2011, public deficit has been planned to reach 1% of GDP in 2011. During the period 2006-2008 it never passed 0.5% of GDP.

About 62% of the national budget is operated at the central level and subsequently 38% is handled by local, social insurance and health insurance budgets. One third of the resources collected by the central budget are transferred to above-mentioned budgets to cover the deficits.

The emergence of the world financial crisis and subsequent economic crisis exercises a tremendous impact on the Moldavian economy and determined drastic changes in the fiscal policy of the government. Reduction of foreign and domestic demand led to a sharp decline of the economic activity. Balance of payments moved into deficit as FDI and other capital inflows fell dramatically (IMF 2010).

In 2009 the GDP of Moldova declined by 9%, which led to a 9% of GDP budgetary deficit. Authorities envisage restoring fiscal sustainability by 2012. In 2010 Moldavian government is planning to reduce budgetary deficit to 7% of GDP. 5% has to be reached in 2011 and 3% in 2012. By the year 2014 the government envisages to return the budgetary deficit to the levels registered before the crisis.

To rebuild its financial sustainability, at the beginning of the year government resorted to IMF. The program prepared under IMF arrangements, in order to achieve above-mentioned reduction of the budgetary deficit to 7% of GDP, envisages reduction in the public sector’s wage bill from an estimated 15.3% of GDP to 11.7% in 2010; reduction of the spending on goods and services by 0.7% of GDP and reduction of subsidies by 0.4% of GDP. On the revenue side, VAT applied for the imports of natural gas will be raised by one percentage point to the level of 6% and income tax will be reinstated in 20125, with a single rate of 10%.

This short incursion into fiscal policy of the Moldavian authorities reveals the fact that from a broad perspective it is difficult to argue that Moldova is following an

In 2007 Moldova introduced zero corporate income tax

economic growth policy. Specifically, the high share of government spending in GDP leaves very little space for the private sector to grow and develop. This approach can be justified somehow by a presumable infrastructure development policy, but this is not the case in Moldova as the share of the government investment in the social overhead capital is kept around 2% of GDP. Social expenditures dominate the overall public expenditures and also the government’s will, as the only solution that the government is able to bring against the continuously increasing share of the social sector in the public budget is to further increase share of the government’s outlay in the GDP and simultaneously contract items which are vital to the economic growth like subsidies and infrastructure development.

High reliance on the transfers from the central budget hinders local autonomy in Moldova. Specifically it reduces the incentives of the local authorities to implement an active economic policy at local level and subsequently inhibits intraregional competition.

viii. Monetary policy and financial sector

The National Bank of Moldova (NBM), which is an autonomous public entity (Law No.548-XIII from 21.07.1995), implements monetary and foreign exchange policy in Moldova. The primary objective of the NBM is to achieve and maintain price stability, understood as neutral to the economy deviations in the price level measured by the consumer price index computed by the National Bureau of Statistics.

In order to achieve its main objective, NBM uses an inflation-targeting regime. A desired inflation rate is established and published by the NBM on an annual basis. The current long-term objective of the NBM is to keep inflation at a single digit level.

In achieving its inflation target NBM renders intermediate targets of the monetary aggregates, which are interest and foreign exchange rates. The secondary objective of the NBM is to promote economic growth and employment, as long as it does not interfere with its fundamental objective (NBM 2009).

Conditions on the money market are influenced by NBM through the base rate. The most important monetary policy instrument used by NBM is open market operations. Other instruments like standing facilities, minimum reserve ration and interventions on foreign exchange market are used as well.

Regarding national currency, NBM is applying a free-floating exchange rate regime. Interventions on the foreign exchange market in Moldova are operated by the NBM, not only to meet certain inflation targets, but also to smooth excessive fluctuations of the national currency and to supplement the holdings of the international foreign reserves. These interventions can take the form of the direct interventions, reversible foreign exchange operations (SWAP) and/or forward transactions.

Monetary policy of the NBM is transmitted into the economy by the financial sector. The size and maturity of the financial sector determines the relative importance of the monetary policy for the economy. In Moldova, volume of expanded loans in the November 2009 constituted 36.3% of GDP, while total assets of the banking sector represented 64% of GDP (IMF 2010). At the end of the first quarter of 2010, there

were 15 active commercial banks in Moldova. Total share of foreign capital in the banking sector of Moldova reached 77.8%. About two thirds of the assets in the banking sector of Moldova belong to the five largest banks. Referring to the lending portfolio, over one half of it is in the industry and trade sector (52.96%). Agriculture and food processing industry attracted 15.9% of the loans, followed by real estate, construction and the development sector with 12.27% (NBM, 2010).

The price stability objective that governs monetary policy in Moldova favors the economic activity by reducing uncertainties; nevertheless it limits the ability of government to use monetary policy as an active tool for quick economic transformation. Rapid economic growth in many cases is incompatible with low inflation.

The depth of the financial sector in Moldova is about 5 times lower compared to the EU25 average, expressed as a share of the banking sector’s assets in GDP (IMF country report 07/243 from July 2007). In this respect, in order to manage big investment projects that can insure sustainable economic growth, a state held development bank could constitute an alternative in Moldova for the period until the private banking sector grows enough.

3. Problems and prospects for growth in Moldova

a. Market failures

Neoclassical economic theory is constructed on the assumptions of perfect competition. It emphasizes the supremacy of effectively functioning market mechanisms to ensure economic growth.

Deviations from the assumptions of the neoclassical theory lead to market failures. Emerging economies are more open to such inefficiencies. Azariadis and Stachurski discuss two types of market failures. These failures are: increasing returns to scale and failures on credit and insurance markets (Aghion & Durlauf, 2005, pp.298-301).

Increasing returns to scale are important, as development is synonymous with industrialization and adoption of new techniques that increase total output. But however, lower unit costs determined by rise in output, following the authors, can likewise reinforce the poverty, not just propel development (Aghion & Durlauf, 2005, pp.298-299).

Referring to the credit and insurance markets, the lack of good quality collaterals to take advantage of the economic opportunities is to be observed. The lack of good collaterals obstructs access to the insurance markets, which makes businesses in emerging economies resort to less risky but also less profitable projects comparing to the worldwide average. In the long run the preference for less risky projects widens poverty (Aghion & Durlauf 2005).

Closely related to the second type of market failure is mentioned by Azariadis and Stachurski the ‘Rosenstein-Rodan’ observation on the inability of poor countries to attract modern industrial technologies due to their high costs. They argue that a possible solution to this problem is the simultaneous whole economy industrialization that will extend the market and subsequently reduce the costs of imported technologies (Aghion & Durlauf 2005, p.340).

The experience of South Asian countries is an example. In South Korea, the government led rapid industrialization through direct control of the financial sector. During the 19th century Western Europe also achieved a quick industrialization without government involvement. However, it benefited from a large enough and mature banking sector (Aghion, Durlauf 2005, p.340).

Moldova does not benefit from a well-developed financial sector and the relative size of the leading financial institutions in Moldova is too small to afford implementation of large-scale industrial projects. Also, the possibility of bank cartelization is burdensome for Moldova, as it is for any emerging economy.

Limited access to finance constitutes a form of market failure in Moldova. Unavailability of a dedicated investment bank that could deal with this issue seriously obstructs economic perspectives of the country. Despite this, the need to institute a development bank cannot be found in any strategic economic document in Moldova.

b. Alternative policies of economic growth

Current development policies of the international financial institutions (IFI) that are influenced by the neoclassical economic school are built on principles of prudent macroeconomic stance and market liberalization (Aghion & Durlauf 2005).

A reflection on this approach can be found in Reinert, who argues that “Even the most convinced neo-classical economists will not tell his or her children that it does not matter what profession they choose – picking tomatoes or becoming a lawyer – because factor-price equalization, when wages and interest rates will be equal across the planet, is around the corner. However, when pontificating on children in the Third World, the same economists recommend that nations specialize according to their comparative advantage, which will normally mean specializing in providing cheap labor” (Reinert 2004, p.12).

Perhaps the major question derived from the second chapter of the present paper is: what constitutes the crucial priority for Moldova?

The primary goal of NDS in Moldova is to improve living standards in the country. At the same time, it is also specified in bold letters that the spirit and vision of the strategy is to align Moldova to the EU’s social benchmarks. The decisive matter is the prioritization of these two objectives. In a dynamic perspective, until a certain level of wellness is achieved, they may be incompatible. The EU’s high social norms are a consequence of high living standards and of a strong economy. By merely coping the EU’s norms, laws or regulations living standards in Moldova will not change too much.

Moldova has to decide what development strategy to follow. Is it an ordinary economic growth strategy followed likewise by societies that are now at the economic development frontier where the future economic setup is still obscure? Or it has to be a catch-up strategy where the tools and technologies used by advanced economies, not only regulations, are known and just an efficient approach to transfer them to Moldova has to be found?

The economic policy based on principles of neoclassical theory better fits advanced economies where the derogations from its basic assumptions are of lower amplitude. The relevance of neoclassic theory for the emerging economies in an environment characterized by high disparities in the economic development between different countries is contestable. In this way, governments in the emerging economies have to find a way to compensate the disappearances imposed by many market failures associated with weak economic development.

In a reference to the East Asian countries that performed consistently well since the early 1960s, Rodrik argues, “South Korean’s and Taiwan’s growth policies (…) exhibit significant departures from the Washington Consensus. Neither country undertook significant deregulation or liberalization of their trade and financial systems well into the 1980s. (…) both countries deployed an extensive set of industrial policies that took the form of directed credit, trade protection, export subsidization, tax incentives, and other non-uniform interventions.” (Aghion & Durlauf 2005, p.975).

Following Reinert and Daastol, the typical attributes of an economic policy that brought economic development in Germany, the United States and Japan, but which are neglected by the modern economic mainstream theories nowadays, were those of “…immaterial foundations of wealth (knowledge and human ‘wit and will’), the superiority of manufacturing over the agriculture and raw materials, the crucial role of infrastructure, the systemic nature of economic growth (…) and free trade among nations at the same level of development.” (Reinert 2004, p.32). In this way core determinants of economic development are knowledge, innovation and infrastructure. Given the concentrated costs of the investment in these fields and widely dispersed benefits of it, the necessity of a coordinator becomes essential. In the USA, for instance, the role of coordinator was played by the state, which under the umbrella of a defense spending directed investment in these public goods (Reinert 2004).

Referring to free trade Reinert and Daastol argue that “’symmetrical’ international trade – between nations at the same level of development – is beneficial to both nations, whereas ‘asymmetrical trade’ is beneficial only to the more advanced of the trading partners.” (Reinert 2004, p.59).

An approach that viewed industrialization as a tool to increase the value of a country’s natural resources stood at the basis of economic policies in countries like Canada, Australia and New Zealand (Reinert 2004). In this respect Reinert and Daastol state, “A manufacturing sector (even though it was not competitive with England’s) was needed to transform the natural resources of a nation into national wealth” (Reinert 2004, p.34).

Protectionism is a necessary tool that promotes production and increase wages and consumption. It increases the tax base and advances the production of public goods that further continuously favors production. But, nowadays the catch-up policies once used by today’s leading industrial nations have been forgotten, although the USA, for example, resurrected many times to protectionist policies in order to build and shield its economy (Reinert 2004).

To quote Reinert, “Patents and their rights, creating artificial rents in order to promote new knowledge, are heralded as an indispensable ingredient of world growth, while protection, creating manufacturing rents in order to spread this production into new geographical areas, is considered the greatest of all evils.” (Reinert 2004, p.9)

c. Policy recommendations

Following Azariadis and Stachurski, “The poor are not condemned to poverty by a set of unfavorable exogenous factors, or even a lack of resources. Temporary policy shocks will have large and permanent effect if one-off interventions can cause the formation of new and better equilibria.” (Aghion & Howitt 2005, p. 374).

Based on the findings of the second chapter, the one-off interventions that can improve the perspectives for economic development in Moldova could be:

1. At the strategic level Moldova has to develop an efficient economic catch-up strategy with a clear vision on how to import best performing technologies and practices, and how to create a favorable environment in order to implement these technologies at the national level and continuously improve them. The issue of the state owned development bank has to be seriously taken in consideration.

2. Recent experiences by the East Asian region proved that an outward oriented structure of the economy is an efficient tool for growth and development. The obstacles that hinder the implementation of this approach nowadays will be touched on in the conclusions part.

3. The educational system in Moldova requires cardinal adjustments in order to meet the needs of the real economy and to support the implementation of a catch-up strategy.

4. Massive long-term investment policy into social overhead capital is essential to ensure a timely economic catch-up of Moldova.

5. Develop an efficient subsidization policy of the manufacturing sector using the export targets as the selection criteria.

6. Improve local financial autonomy and intraregional competition by transferring revenues from income tax to the local authorities. A differentiated approach that would treat Chisinau6 separately, as a major pole of economic activity in Moldova, and rural regions could be considered.

7. Change the ‘price stability’ objective of the NBM into ‘economic growth’ objective.

Capital city of the Republic of Moldova

4. Conclusions

The economic performance of any society is directly correlated with the quality of the institutions that govern that society. In a broad sense, institutions are rules of the game and can take any form. This fact makes it difficult to measure and effectively observe institutions at the national level. For the convenience of this paper, in order to identify the problems faced by Moldova in its economic development and to discuss the possibilities to overcome them, many institutions identified in the socio-political context of Moldova have been analyzed. Some of them, called social institutions, are: property rights protection, cost of contract enforcement and educational system. The second group is formed from economic institutions, namely: economic growth strategy; business environment; tax performance; subsidies; foreign trade policy; fiscal policy; monetary policy and the financial sector.

Moldova registers good performance in cost of contract enforcement, but has a weak educational system. The problems related to the economic and political situation in Moldova are potentially capable of endangering the state of property rights protection. The economic growth strategy, although formally approaches the major problems faced by the nation, does not offer any practical solution to solve them, being concentrated mainly on conventions. Business environment in the country is plagued by the many social diseases habitual in the impoverished nations, but the major economic problem of limited access to finance has not yet found an efficient solution. Overall, the economy in Moldova is not burdened by excessive tax pressure, but is likewise not enforced by an efficient subsidization policy or proper, well-developed infrastructure. On the contrary, it is curbed in growth by high government spending and confined foreign trade policy.

Moldova has to embrace an outward oriented economic growth strategy and to ensure smooth access to cheap, but efficiently allocated capital, in order to prosper economically.

The reality of course is not so simple. Economic progress is impossible without continuous technological progress. Inventions and innovations drive technological progress. However, capacities to innovate that are easier affordable for poor economies are today much more restricted then before. Following Ray and Bhaduri, “With the advent of the TRIPS agreement under WTO, the flexibility of designing appropriate IPR (Intellectual Property Rights) regime by member nations has been removed. This would have serious implications for countries involved in the technological catch-up process by suppressing the interdependent co-evolutionary character of their TC (Technological capability) and IPR institutions. These countries will now have to treat IPR institution as given or exogenous” (Ray & Bhaduri, 2008, p.13).

Referring to the access to finance, the Three-Year Arrangement Under the Extended Credit Facility signed between Moldova and IMF at the beginning of this year places a ceiling at USD 125 million7 for the year 2010 on contracting or guaranteeing of

Previously foreign borrowing of non-consensual funds was banned for Moldova

non-concessional external debt of the general government (IMF 2010). In this way IMF closely controls the external borrowing of Moldova. This situation limits the capabilities of government to undertake any measures different from those prescribed by IMF, to rule out the country from the poverty. The problem is that IMF ‘recommended’ measures do not work. Moldova may refuse to cooperate with IMF, but it can complicate the access to foreign funding if needed.

To make it even more clear the Agreement on Subsidies and Countervailing Measures under WTO explicitly prohibits subsidies that require recipients to meet certain export targets. In this way an easy to use and efficient tool for the subsidies allocation, applied by East Asian countries to build their economies so rapidly, is banned. This restriction dissipates the efficiency of export led growth strategy for poor economies.

To summarize, the present paper does not give any particular solution for the economic development in Moldova. The panacea from the three above-mentioned obstacles in the economic development of small economies, imposed by the present international economic environment, still has to be identified. The intention of this paper is rather to denote that in the present national, likewise international, institutional framework, there is no reason to expect any economic development in Moldova.

Annexes:

Table 1: GDP % change, constant prices

Indicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Central and eastern Europe 6 5 5 3 0 5 0 4 5 7 6 7 6 3 -4 Commonwealth of Independent States

-5 -4 1 -4 5 9 6 5 8 8 7 8 9 6 -7

Moldova -1 -6 2 -7 -3 2 6 8 7 7 7 5 3 8 -6

Source: IMF 2010 World Economic Outlook database

Table 2: Selected macroeconomic indicators

Indicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Current account balance, % GDP* -6 -11 -14 -20 -6 -8 -2 -1 -7 -2 -8 -11 -15 -16 -8 Foreign direct investment, net inflows (% of GDP)

1 1 4 5 3 10 4 5 4 3 6 7 12 12 n/a

Workers' remittances, receipts (BoP, current mil. US$)

1 3 1 1 1 53 80 102 152 221 395 603 842 1046 n/a

External debt stocks (% of GNI) 40 48 54 63 85 129 104 102 88 66 61 64 66 57 n/a Total debt service (% of GNI) 4 5 7 12 18 11 11 14 7 10 7 9 7 8 n/a

Source: World Bank databank; *IMF World Economic Outlook database

Table 3: Human development/ education

Indicator 1990 1991 1995 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Human Development Index* 0.74 n/a 0.68 n/a 0.68 n/a n/a n/a n/a 0.71 0.72 0.72 n/a School enrollment, preprimary (% gross) n/a 73 n/a 46 40 40 43 52 56 62 68 72 72 School enrollment, primary (% gross) 87 93 91 95 96 96 96 95 94 92 91 91 89 School enrollment, secondary (% gross) 81 80 80 84 83 81 82 83 84 84 85 86 83 School enrollment, tertiary (% gross) n/a 36 n/a 33 33 32 33 34 35 37 40 41 40

Source: World Bank databank; *UNDP statistics

Table 4: Share of top six economic branches in GDP

Indicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Agriculture and hunting 28 27 27 27 24 25 22 20 17 17 16 14 11 12 10 Manufacturing 34 31 29 23 23 26 28 28 30 28 27 25 23 22 22 Construction 4 4 5 5 5 4 4 4 5 7 8 10 12 12 8 Wholesale and retail trade 5 7 8 10 13 11 10 9 9 9 9 10 11 11 12 Transport and communication 6 6 7 8 9 11 12 12 14 14 14 14 14 14 14 Financial intermediation 2 3 3 4 4 3 3 3 3 3 3 3 5 5 6

Source: National Bureau of Statistics

Table 5: GDP expenditure composition

Indicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Households consumption 58 72 74 77 72 89 88 86 92 90 94 96 94 92 92 Government consumption 26 25 30 25 16 15 13 17 19 15 16 17 21 20 22 Gross fixed capital formation 27 27 23 27 22 25 24 22 23 24 29 33 39 38 26 Foreign sector -10 -24 -26 -29 -9 -28 -25 -25 -35 -29 -39 -46 -54 -49 -40

Source: National Bureau of Statistics

Table 6: Share of top five exported categories in total export

Indicator 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Vegetal products 9 11 15 14 14 17 12 12 12 13 12 13 Food, beverages 55 55 43 42 45 42 40 35 36 26 21 20 Textiles 7 10 14 18 18 17 16 17 18 22 21 20 Metals and articles made from metals

1 1 4 3 1 1 3 3 5 7 8 8

Machines and equipment 5 7 6 5 5 4 4 4 4 5 7 11

Source: National Bureau of Statistics

Table 7: Share of EU and CIS in Moldavian foreign trade

Indicator 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Exports to CIS 70 68 55 59 61 54 54 51 51 40 41 39 Exports to EU 21 26 38 35 32 36 39 41 41 51 51 52 Imports from CIS 52 43 41 33 38 39 42 43 39 38 36 35 Imports from EU 38 48 48 53 48 45 45 44 45 45 46 43

Source: National Bureau of Statistics

Table 8: National budget indicators, % of GDP

Indicator 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Total expenditures 36 32 34 33 35 37 40 42 42 46 Current expenditures 32 28 30 29 30 31 32 35 34 41 Capital expenditures 5 4 5 5 5 6 8 8 7 5 Employees compensation 8 8 10 10 8 8 9 9 9 12 Goods and services 6 6 7 6 8 8 8 9 9 10 Subsidies to productive sector 2 1 1 2 2 3 2 3 3 2 Social transfers to the population 9 8 9 9 10 11 11 11 11 14 Fiscal incomes 25 24 26 27 29 31 33 34 33 32 Direct taxes, share in total fiscal incomes 32 36 37 36 41 36 37 36 35 39 Indirect taxes, share in total fiscal incomes 41 39 41 44 43 45 45 44 46 43

Source: Ministry of Finance

Table 9: Selected monetary policy indicators

Indicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 NBM base rate, average value for the beginning and end of the period*

n/a n/a n/a n/a n/a n/a 17 11 12 14 14 14 15 15 9

Inflation, consumer prices (annual %)

30 24 12 8 39 31 10 5 12 13 12 13 12 13 n/a

Official exchange rate, LEU per US$, period average

4 5 5 5 11 12 13 14 14 12 13 13 12 10 11

Lending interest rate (%) n/a 37 33 31 36 34 29 24 19 21 19 18 19 21 n/a

Source: World Bank databank; *National Bank of Moldova

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