1. Macedonia Business and economic outlook Quarterly update – July 2013 Final analysis by Nenad Pacek

2. Contents Executive summary Important facts Economic fundamentals Corporate sales and profit trends Growth prospects Growth prospects Inflation and interest rate Currency and the current account Currency and the current account Other economic and business issues Forecast table

3. Executive summary I Macedonia ended up in a recession and contracted by 0.3% last year (down from 3.0% growth in 2011 and 1.5% growth in 2010) The economy rebounded in the first quarter of this year (up 2.9% y-o-y), driven largely by surging state investment (mostly construction) Household consumption and foreign trade underperformed (as expected) Growth should reach 1.4% in 2013, driven mostly by public investment Private investment, credit growth, household consumption and foreign trade (important growth engine) will remain rather weak 2014 ought to be just a slightly better year for business (GDP should reach 2.3%) Major downside risks to our scenario are the EU outlook, lower foreign demand for the country’s exports, lower remittances and lower foreign investment According to our June 2013 survey, corporate expectations for this year are almost identical to corporate results registered in 2012

4. Executive summary II However, as compared to the Dec 2012 survey, corporate expectations for this year have deteriorated for the majority of companies Companies are a bit more optimistic about 2014 Inflation accelerated slightly in the last few months, but we expect it to ease throughout the rest of 2013 This year inflation will be 3.2% and will fall to 2.7% in 2014 Due to expansionary fiscal policy in the first half of the year, some moderation in public spending can be expected in the second half of 2013 and in 2014 (however, it remains to be seen how this will be implemented since 2015 is an election year) Political tensions have calmed down so far, but political stability remains very fragile amidst ethnic tensions, delays in EU accession talks, and high unemployment Growth will continue to improve from 2014 onwards, but will remain below potential averaging 2-3% over the mid-term in a base case scenario (not enough to generate more jobs and reduce the high unemployment rate)

5. Important facts I Population of 2m (growing by 0.2% annually, mostly ethnic Albanians) GDP per capita (PPP) is $10,700 Total GDP: $10.5bn The economy is dominated by services, which account for 63% of GDP and employ almost 60% of the total labour force Industry accounts for 27% of GDP, while agriculture accounts for 10% of GDP The grey economy is estimated to be between 25-45% of GDP There are large inflows of remittances from a huge expatriate workforce The country’s main trading partner is the EU Exports are highly dependent on economic growth in the EU and western Balkans (90% of all exports are directly or indirectly linked with the EU) Major export products are food, beverages, tobacco, textiles, miscellaneous manufacturing products, iron and steel

6. Important facts II The nominal net monthly wage is about €338 Official unemployment rate is over 31% The official poverty rate is 30% Macedonia is waiting to start accession talks with the EU Macedonia achieved candidate status in 2005, but delays in full accession are linked to the long-standing country name dispute with Greece In April 2013, the European Commission report was positive and Macedonia obtained one more recommendation to start EU membership negotiations, but it still remains questionable if the talks will be opened due to the name dispute with Greece Politically fragile; ethnic riots between Slavs and Albanians occur sporadically

7. Economic fundamentals Economic fundamentals are mixed Public debt is relatively low at 28.6% of GDP (might increase in the future due to expansionary fiscal policy, but there is certainly enough room for more fiscal spending) Foreign debt is high at 68.6% of GDP and some deleveraging of the households and companies will keep growth below potential in the coming few years Foreign exchange reserves (€2.2bn) cover four months of imports (sufficient) The domestic currency (denar) is pegged to the euro One of the underlying problems is that Macedonia largely exports commodity- related products such as iron, steel products, oil derivatives, clothing items and ferrous-nickel products – its global competitiveness is low and will be for years to come despite massive and globally noticed improvement in its Ease of Doing Business rankings

8. Corporate sales and profit trends for 2012-2014 In 2012, close to 40% of surveyed firms did not manage any top-line growth, around 5% had a decline in sales and the rest mostly grew in single digits Profit movements were similar; less than 10% had a decline in profits, more than 35% recorded flat profits, while the rest registered some growth, mostly in the single-digit zone According to our June 2013 survey, corporate expectations for this year are almost identical to corporate results registered in 2012, but less optimistic than expectations reported in Dec 2012 Corporate expectations for 2014 are slightly stronger, with some 70% of firms expecting sales growth and around 65% expecting profit growth

9. Corporate sales and profit trends as expected in Dec 2012 and June 2013

10. Consumer goods sales and profit trends June 2013 survey In 2012, consumer goods companies had a mixed performance; all found profit growth (40% grew in double digits), while sales were less successful (around 20% stagnated) Consumer goods firms are the most optimistic as far as sales growth in 2013 is concerned and all of expect to find sales growth -- 15% expect to grow in the range of 20-30% On the other hand, 15% expect a decline in profits, while the majority are aiming for mainly single-digit profit growth Expectations for 2014 are good in terms of revenue growth; all companies remain optimistic and expect top line growth, with almost 30% expecting a double-digit sales increase The majority of consumer goods firms expect some profit growth in 2014, but still, some 15% forecast a double-digit decline in profits

11. Food and beverages sales and profit trends June 2013 survey Last year was a successful year for food and beverages firms; more than 70% of all food and beverages firms registered sales and profit growth in 2012 (mostly in single digits) Around 75% expect their sales to grow in single digits this year, while more than 60% forecast an increase in profits No company expects a decline in sales or profits Expectations for 2014 are similar in terms of sales growth (70% expect predominantly single-digit sales growth), but profit expectations are much stronger than those for 2013 Almost 85% of surveyed food and beverage firms expect single-digit profit growth in 2014

12. Industrial B2B sales and profit trends June 2013 survey 2012 was weak for the majority of industrial B2B firms Around 30% of industrial B2B companies increased their revenues in low single digits, 15% faced a decline in sales of more than 10%, and the rest registered zero growth Industrial B2B companies faced either zero profit growth or a decline of more than 10% In 2013, industrial B2B companies expect either a stagnation (70%) or low single-digit sales growth (30%); around 10% expect a decline in profits, while some 60% expect profits to stay flat Only 30% of industrial B2B firms expect profit growth in 2013 (low single-digit) 2014 should be just slightly better; more than half expect flat sales and profits, while the rest plan to grow, but solely in single digits

13. Pharma/health care firms June 2013 survey 2012 was good for pharma/healthcare firms; 70% of firms increased their sales and profits, mostly in single digits This year, almost 70% of surveyed pharma/healthcare companies expect their sales to grow in single digits, while 80% forecast some (weak) profit growth None of the companies expect a decline either in sales or profits Expectations for 2014 are much stronger All pharma/healthcare firms expect single-digit revenue growth Profit expectations are not as good; 40% expect zero profit growth, while the rest expect predominantly a single digit profit increase

14. IT sales and profit trends June 2013 survey IT firms broadly saw business stagnate last year Expectations for this year are much better than the results registered in 2012, but also much better than the expectations presented in the Dec 2012 survey 40% of IT companies expect a low single-digit revenue increase in 2013 (better than in our Dec 2012 survey, when all IT companies expected flat sales), while 50% expect a single-digit profit increase The remaining companies expect to stay flat in 2013 In 2014, some 35% of IT firms expect to increase their sales in the upper single-digit space, while the rest forecast a stagnation Profit expectations for 2014 are stronger Around 75% of IT firms expect to increase their profits in the single-digit zone

15. Corporate sales and profit trends in 2013 based on June 2013 survey

16. Corporate sales and profit expectations for 2014 based on June 2013 survey

17. Growth prospects I Real GDP growth reached only 1.5% in 2010 after a mild recession in 2009, and then accelerated to 3.0% in 2011 (driven by the construction, industry and trade sectors) In 2012 Macedonia ended up in a recession and contracted by 0.3% Industry and trade fell by 7.4% and 0.2% respectively Agriculture and construction expanded and prevented a deeper recession Household consumption shrank by 1.2%, while public consumption grew by 1.2% The economy rebounded in the first quarter of this year (up 2.9% y-o-y), with surging state investment as the major growth engine The construction sector made the strongest contribution to GDP, expanding by almost 37% y-o-y, making up for sluggish external and domestic demand Both private investment and credit growth remained rather weak

18. Growth prospects II Household consumption continued to shrink in the first quarter however, largely due to the high unemployment rate, lower disposable income, lower remittances, and a decline in net real wages, which fell by 2.3% y-o-y Furthermore, foreign trade remained weak, with both exports and imports struggling Generally, this year’s growth will remain very subdued, largely due to the difficult external economic environment and weak foreign demand for the country’s exports, which represent one of the major engines of Macedonia’s growth Domestic demand will remain subdued as well and fail to fully compensate for the underperformance of the external sector However, the government is likely the continue with strong investments (mainly in the capital city Skopje)

19. Growth prospects III Growth should reach 1.4% in 2013 as a whole (slightly upgraded from our previous forecast) Downside risks persist and are related to weaker-than-expected growth outside of Macedonia, the EU outlook, lower remittances, and lower foreign investment Bearing the downside risks in mind, 2014 ought to be just a slightly better year for business, with GDP growth accelerating to 2.3% We forecast some tiny improvement in domestic and foreign demand, commercial lending and private investment Consumer spending will stay rather weak due to high unemployment, lower or stagnant net real wages and the fact that some workers do not receive their wages regularly Growth will continue to improve from 2014 onwards, but will remain below the country’s potential, averaging 2-3% over the mid-term in a base-case scenario (not enough to generate more jobs and reduce the unemployment rate of 31%)

20. Inflation and interest rates Inflation averaged 3.3% in 2012 (down from 3.9% in 2011) It stood at 4.2% y-o-y in June (up from 3.1% y-o-y in our last update) We expect inflation to ease throughout the rest of the year however It will average 3.2% and 2.7% in 2013 and 2014 respectively Due to weak economic conditions, slow credit growth and low inflation risks, the central bank reduced the interest rate by 25 basis points to 3.5% in December 2012 – it has been unchanged since then Lending activity is still growing at a slower pace; banks remain very prudent The non-performing loan ratio stood at 11%, high by global standards but better than some other SEE markets

21. Currency and the current account The current account deficit reached 4.0% of GDP in 2012, while gross foreign debt increased by some 8.5% by the end of 2012 Foreign debt rose by another 6.6% in the first quarter of 2013 The current account deficit narrowed by 16% in the first quarter of this year, driven largely by the lower trade deficit, which continued to narrow throughout April- May The export/import coverage ratio stood at over 60% in the same period After growing in 2011, FDI dropped by 70% last year mainly due to internal instability but also due to the impact of the on-going Eurozone crisis We expect authorities to maintain the currency peg arrangement, so there should be no exchange rate risk for business The denar is probably mildly overvalued, but the currency regime will not change

22. Other economic and business issues The budget deficit widened by some 55% and reached 3.7% of GDP in 2012 – the deficit target was set at 2.5% of GDP The budget deficit target for this year is set at 3.5% of GDP (based on GDP growth of 2.0%) However, the budget deficit for the first five months of 2013 widened strongly on the back of declining state revenues and surging state expenditures It accounted for some 70% of 2013’s full year deficit target and was about 2.5% of the projected GDP for the year Such an expansionary fiscal policy is unsustainable over the long term but will be helpful to boost short-term economic performance S&P lowered its long-term rating to BB- stable from BB in May

23. Macedonia - Forecast table Macedonia: Macro indicators and forecasts201020112012201320142015 Real GDP (% change) 1.53.0-0.31.42.33.3 Consumer prices, % (average) 2.13.93.33.22.72.5 Budget balance (% GDP) -2.7-2.5-3.7-4.2-3.7-3.7-3.5 Current account (% GDP) -2.1-3.0-4.0-4.2-4.5-5.0 denar/euro (Average) 61.6

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