1. While convergence to the EU continues and confidence in Romania’s prospects remains high, economic developments during the past year have raised concerns. Growth has slowed, disinflation has slowed considerably, and the current account deficit has widened. The direct tax cut and substantial credit growth, together with increases in public sector wages, exacerbated excess demand pressures. To prevent further pressure on the exchange rate, interest rates were lowered. Although the authorities’ successful privatizations and energy sector reforms are commendable, there have been delays in other areas of structural reform.
2. In the mission’s view, the current juncture offers a unique opportunity to strengthen policies that would reduce macroeconomic imbalances and set the stage for sustainable growth. With EU accession approaching, Romania needs a clear and coherent set of policies aimed at realizing its full potential and raising living standards. The mission believes that, from a macroeconomic and structural perspective, the following requirements stand out: achieving significant disinflation, permanently strengthening the fiscal position through revenue-raising measures, narrowing the current account deficit, improving the business environment, increasing incentives for job creation, and ensuring the capacity for the effective utilization of EU funds.
I. RECENT DEVELOPMENTS
3. Macroeconomic imbalances continue to widen. Specifically:
• Economic growth has slowed. Real GDP growth is estimated at 4 percent in 2005. In addition to a sharp decline in agriculture due to the floods, industrial production growth slowed substantially, partly on account of the abolition of global textile quotas. Domestic demand grew strongly owing to a sharp increase in consumption.
• Inflation remains stubbornly high. CPI inflation stood at 8.6 percent y-o-y at end-2005, against the National Bank of Romania’s (NBR) end-2005 target of 7.5 percent (with a ±1 percent band). Reflecting increased capital inflows in anticipation of the opening up of the capital account in April 2005, the NBR allowed greater exchange rate flexibility from mid-October 2004, which also mitigated the impact of domestic demand on inflation. The currency has appreciated by 10½ percent against the euro from September 2004 to December 2005.
• Credit growth remains strong. While foreign-currency denominated credit growth has slowed recently, leu credit growth has picked up. This shift is attributed to a number of measures introduced during the past year to contain foreign currencydenominated credit growth, and to the recent easing of interest rates.
• The current account deficit has widened and is estimated at 9.4 percent of GDP in 2005. Import growth continues to outpace export growth. However, rising FDI and EU transfers covered about 90 percent of the deficit, with private capital inflows financing the rest and supporting substantial reserve accumulation.
• Romania’s external competitive advantage has narrowed. The gains achieved by the 1999 correction in the exchange rate were preserved until end-2004 in an environment of low capital inflows. However, the recent leu appreciation, in tandem with strong wage growth and declining productivity gains, are beginning to hurt profitability and competitiveness in some sectors, making the speeding up of structural reforms necessary.
4. The government consolidated its fiscal position, although procyclical public sector policies exacerbated domestic demand pressures.
• The reduction in the fiscal deficit to 0.8 percent of GDP in 2005 from 1.1 percent of GDP in 2004 was aided by higher-than-budgeted indirect tax collections, along with cuts in capital expenditure that offset the sharp increase in public consumption.
• The flat tax fueled consumption and led to about 1 percent of GDP revenue loss in personal income and profit tax collections, compared with the 2004 outturn. However, compared to the baseline of no tax cut, this loss was about 1½ percent of GDP.
• Higher-than-budgeted VAT collections due to the strong demand for goods and services (domestic and imported) offset the loss of revenue from the flat tax, thus keeping the overall government revenue constant in terms of GDP.
• From October 2004 to October 2005, public sector wages rose by up to 50 percent. Increases in the average public sector wages were in the range of 16-34 percent in 2005 compared with the average of 2004, thus contributing to an increase in the wage bill by 0.6 percentage points of GDP in 2005.
• A significant relaxation of fiscal policy took place at end-December, swinging from a budget surplus of 1 percent of annual GDP during January-November to a deficit of 0.8 percent of GDP for the year.
5. Monetary policy seems overburdened by conflicting objectives, undermining the NBR’s ability to meet its inflation goals. With liberalization of the capital account and the recent adoption of inflation targeting, the monetary authorities face a difficult dilemma— tackling inflation through higher interest rates risks putting excessive pressure on the exchange rate. In the event, the NBR offset upward pressure on the currency by cutting the policy interest rate dramatically over 2005, and by pushing the effective interest rate even lower in September by opting not to sterilize fully at the policy rate. These measures appear to have been successful in dampening pressure on the exchange rate, allowing the NBR to cease intervention in the foreign exchange market and to gradually raise the effective rate since October. However, the policy and effective interest rates are still negative in real terms, and the continuing policy compromise has sent inconsistent signals to the public, jeopardizing the credibility of the new monetary framework. In this context, the NBR’s failure to meet the end-2005 inflation target—only four months after the target was adjusted upward—was unfortunate, reflecting both the effects of adverse shocks and policy easing in September/October.
6. Progress on structural reforms has been mixed. Bright spots include the privatization of BCR, liberalization of the electricity and gas markets, an increase in the national reference price for heating, and the introduction of a new two-part heating tariff. Moreover, some progress has been made in the reform of the judicial system. However, gas prices have not been adjusted in line with opportunity costs, and the domestic gas producer price is only 37 percent of the international import price. Following lengthy consultations, parliament approved amendments to the Labor Code, including on the use of short-term contracts, the extension of the probation period, more flexible working hours, and the introduction of the employer’s right to retrench labor for economic reasons. However, these amendments fall short of eliminating some of the main sources of labor market rigidity.
II. MACROECONOMIC OUTLOOK AND POLICY RECOMMENDATIONS
Policy Mix and Outlook
7. Sustainable growth requires macroeconomic stabilization and renewed structural reform efforts. A tightening of macroeconomic policies is needed to resume Romania’s disinflation path. And tighter fiscal and incomes policies will allow monetary policy to fight inflation without excessive pressure on the exchange rate. In this context, the mission supports the authorities’ commitment to take further steps to establish credibility of the new monetary regime.
8. With appropriate policies, staff sees sustainable economic growth at 5-6 percent.
Convergence to EU living standards will require increased investment and a focus on employment creation—which will require a more flexible labor market and a reduction in payroll taxes. An increase in investment, aided by EU transfers, will increase capital’s contribution to output growth, while privatization and industry restructuring will help sustain strong productivity gains. Staff estimates that a more ambitious program of structural and institutional reform could substantially boost the sustainable growth rate. A mixed or delayed reform effort, on the other hand, will prevent the economy from taking full advantage of the opportunities offered by EU accession and would dampen growth prospects.
Fiscal and Incomes Policies
9. Tight fiscal policy should remain the centerpiece of Romania’s macroeconomic strategy, especially given the likelihood of continued capital inflows and strong private sector growth. It should aim at stemming excess demand and putting public finances on a sustainable medium-term path. To this end, the mission advocates targeting a balanced budget in 2006 and small surpluses over the medium-term, while providing ample room for capital spending. Given the current expenditure envelope, a permanent strengthening of the revenue base is needed. The following menu of options could be considered: an increase in the VAT, revisiting the rate of the flat tax, broadening the tax base, increasing administrative fees, increasing property taxes, and improving revenue administration.
10. Strengthening revenue is imperative. First, compression of expenditure is unsustainable. Second, to enhance employment, competitiveness and economic growth, the social contributions tax needs to decline. This revenue loss has to be offset by other taxes through a comprehensive revamping of the tax system, thus avoiding the frequent changes that have been disruptive for the business environment in the past. Third, additional revenue will be needed to provide resources for Romania’s contribution to the EU budget as well as the co-financing of EU projects. Overall revenue in Romania is far below the minimum EU level of 35 percent of GDP attained in all EU members except Lithuania. Romania will benefit from EU transfers, but its net position vis-à-vis the EU will depend on its ability to absorb such funds. Finally, to ensure real convergence to EU income levels, Romania faces substantial infrastructure needs.
11. A strict wage policy is essential for successful disinflation. To anchor inflation expectations in single digits, public sector wages should increase once a year and be incorporated in the budget process. Moreover, wages need to better reflect skill needs, otherwise a ballooning wage bill will only undermine the aim of establishing a modern civil service and the ability to absorb EU funds. Following substantial wage increases, the government’s wage policy needs to be recalibrated to the needs of a low inflation economy.
The average public sector wage increases in 2006 of 12-15 percent compared with the 2005 average are incompatible with the NBR’s inflation objective of 5 percent. By contrast, the increases in the minimum wage to RON 330 and in the wage bill of the public enterprises of 3.5 percent are prudent, although excessive settlements should be avoided. Given recent sizeable wage increases, a tightening of wage policy is urgently required. Measures could include: a single wage round, canceling non-wage payments, approving a maximum number of positions other than those filled by EU accession-related hiring, and eliminating the remaining vacancies.
12. Additional measures will be needed to balance the 2006 budget and make it consistent with achieving macroeconomic stability. The envisaged sharp reduction in the allocation for goods and services is not sustainable and will lead to the accumulation of new arrears. This consideration, combined with pressures stemming from recent wage increases, points to an underlying deficit of over 1 percent of GDP. The mission welcomes the government’s decision to freeze all vacant positions in the general government (with the exception of EU accession-related hiring), which is expected to offset wage overruns. However, in the absence of further measures, meeting the deficit target of 0.5 percent of GDP may result in a squeeze in capital expenditure. Finally, to balance the budget and provide for a permanent increase in revenue, strong revenue action will be needed as outlined above.
13. An ambitious and transparent medium-term budget framework is needed. Such a framework would include setting of a realistic fiscal trajectory, fully incorporating postaccession EU receipts and expenditures into the budget process, as well as the impact of structural fiscal reforms in a number of areas (e.g., civil service, health, education, and pension systems). Transparency and candid communication based on realistic targets will help avoid destabilizing surprises, while simultaneously improving budgetary controls.
Moreover, public spending management needs to be improved to ensure a uniform spending pattern over the year. The authorities need to assess the macroeconomic impact of the expected large privatization proceeds and EU funds. Finally, mechanisms need to be put in place for the oversight of all resources to ensure their efficient use and to ensure a high absorption rate for EU funds to increase growth prospects and accelerate convergence.
Monetary Policy
14. The immediate challenge for the NBR is to strengthen public confidence in its commitment to inflation targeting. Bringing inflation down to the NBR’s target of 5 percent by end-2006 is unlikely to be feasible, given the impact on inflationary expectations of the recent miss, together with the delayed impact of monetary easing and higher wages over the second half of 2005. In addition, planned increases in administered prices are likely to add 2½-3 percentage points to the headline inflation rate this year.
Without immediate policy actions, an end-2006 inflation outcome considerably above target is likely, and is already included in market expectations.
15. In this context, an immediate tightening of monetary policy is necessary—both to bring the 2006 target closer within reach and to ensure that inflation can feasibly arrive at the center of the target range for 2007. To signal clearly the primacy of inflation over other considerations, this should be effected principally through increased interest rates, requiring a significant increase of both the policy and the effective interest rates. In the mission’s view, there is room for further appreciation of the currency to be accommodated, unless it leads to the likelihood of an undershooting of the inflation target range. Further, any intervention should be fully sterilized and focused on reducing excess volatility in the foreign exchange market, rather than on controlling the longer-term trend.
16. The authorities’ prudential restrictions on credit flows have had a significant effect over the short run, particularly on the mix between foreign-currency and localcurrency lending. It should be noted, however, that the shifting composition of lending has been assisted in large part by a marked narrowing of the gap between local– and foreigncurrency interest rates.
17. From the experience of other countries, however, the effectiveness of such measures will likely diminish over time. The demand for credit in Romania remains strong, so borrowers and lenders will have a continued incentive to find alternate channels for funding. Indeed, some Romanian banks have already started to adjust to the new environment. Moreover, restrictions on bank lending may have favored the less-regulated non-bank financial sector. On the latter point, the authorities have clearly identified the risk of disintermediation, and have taken steps to bring non-bank institutions within the scope of its authority. The mission welcomes the authorities’ efforts to speed up implementation of supporting legislation.
18. In order to ensure the development of a sound and efficient financial system, the authorities should be wary of viewing prudential-style measures as a substitute for more traditional stabilization instruments. International experience has shown that such measures are often associated with undesirable or unintended consequences, and should therefore be focused on addressing specific distortions.
Financial Stability and Financial Sector Development
19. Financial soundness indicators (FSIs) suggest that the banking sector is wellpositioned to absorb adverse shocks, but the authorities need to be alert to mediumterm vulnerabilities. Rates of return on equity and capital adequacy ratios are high, while non-performing loan (NPL) ratios remain at moderate levels. NBR stress tests also suggest banking-system resilience to the direct impact of interest rate and exchange rate movements. However, indirect exposures through loan portfolios are much more difficult to assess, and need to be reflected in high capital ratios and conservative provisioning practices. In addition, strong economic expansion and rapid lending growth in recent years have both helped hold down NPL ratios. As growth slows to more sustainable rates and loan portfolios mature, NPL ratios could increase significantly.
20. Substantial progress has been made in strengthening the regulatory and supervisory framework. Many recommendations made in the 2003 Financial Sector Assessment Program (FSAP) have been addressed, including the introduction of consolidated supervision, introduction of payment and settlements systems; the recent extension of supervision to cover non-bank credit institutions; improved information exchanges with foreign-banking supervisors; tighter regulation of lending exposures; particularly in foreign exchange; broadening of the risk management matrix to cover lending to households; clarification of rules on acquisitions and investment in the banking sector; and establishment of a credit bureau. The NBR has also made impressive progress in developing its capacity for assessing overall financial system stability, and the first Financial Stability Report is scheduled for release in April/May.
21. Further implementation of FSAP recommendations should continue, including improving accounting and audit practices in the corporate and financial sectors; strengthening investor and creditor rights and judicial system effectiveness; promoting increased information sharing through the credit bureau, including through closer monitoring of banks’ efforts to assess borrower indebtedness. The mission supports the NBR’s efforts to further upgrade its risk-assessment capacity, especially in preparation for introduction of Basel II. The authorities should also consider issuing financial instruments in order to establish benchmark yields, which would promote domestic capital-market activity.
Structural Reforms
22. Convergence to EU living standards will require further structural reforms. First, the authorities need to announce publicly a schedule for increased domestic producer gas prices in line with cost developments and with their EU commitment to achieve import parity over the medium term, and allow adequate time for economic agents to adjust. Second, regarding labor market rigidities, Romania stands out compared with countries in central and eastern Europe, particularly on the costs of hiring and firing workers, and on labor market participation rates. In this context, further amendments to the Labor Code should be advanced, including the elimination of regulations and of the obligatory collective wage contracts for non-signatory parties. Third, the momentum on privatization should be maintained with the privatization of CEC, power generation, and other smaller companies.
Finally, the mission advocates the forceful implementation of the government’s judicial reform agenda as well as efforts to improve the effectiveness of the court system, particularly by pushing through with bankruptcy procedures against large debtors to the budget, reducing corruption, and improving financial discipline and the business climate.
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Romania entered the last year before EU accession facing many challenges. At the same time, however, there is a unique opportunity to adopt policies that, combined with the gains from EU membership, would put a rapid improvement in living standards within reach. It is encouraging that the authorities recognize the challenges and opportunities, and it is the mission’s hope that intentions be backed by strong policy actions. We would like to thank the Romanian authorities for their cooperation and warm hospitality. The mission looks forward to continuing our close dialogue in the months ahead, including the possibility of resuming discussions for completion of the Stand-By Arrangement reviews prior to its expiration.
