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The following Letter of Intent and Memorandum on Economic Policies of the government of Romania describe the policies that Romania intends to implement in the context of its request for financial support from the IMF. It is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

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Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington DC 20431

July 26, 1999

Dear Mr. Camdessus:

Romania faces a very difficult economic situation, as indicated by a large external imbalance, declining output and investment, and structural weaknesses in the banking and enterprise sectors. Over the past several months, we have therefore formulated and started implementing, in cooperation with the Fund and the World Bank, a comprehensive program of stabilization and reform aimed at narrowing the external current account deficit so as to restore market confidence, lowering inflation, and setting the basis for a sustainable economic recovery. Our program for achieving this dual task of stabilization and reform is described in detail in the attached Memorandum of the Government of Romania on Economic Policies. In support of this program, we hereby request on behalf of the government of Romania a stand-by arrangement in the amount of SDR 400 million with an expiration date of March 31, 2000.

We believe that the policies and measures described in the attached memorandum are sufficient to achieve the objective of the program, but we stand ready to take additional measures and seek new understandings with the Fund, if necessary, to keep the program on track. The government of Romania will remain in close consultation with the Fund in accordance with the Fund's policies on such consultations, and will provide the Fund with all information that it requests to assess the implementation of the program. In this regard, we recognize that timely and reliable economic statistics are essential for policy analysis and monitoring performance under the program, and we will give high priority to the production of such statistics. The program will be reviewed by the Fund by September 15, 1999, December 15, 1999, and February 15, 2000. At the time of the first of these reviews, agreement will be reached on a rectified budget for 1999, while the second review will be the occasion for reaching understandings on the draft budget for 2000.

Yours sincerely,

Traian Decebel Remes
Minister of Finance
Ministry of Finance
Mugur Isarescu
National Bank of Romania

Memorandum of the Government of Romania
on Economic Policies

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I.  Introduction

1.  This memorandum sets forth the economic objectives and policies of the Government of Romania for 1999. The economic program described below is comprehensive in scope, and includes policies to address acute macroeconomic imbalances as well as structural problems in the enterprise and banking sectors.

II.  Background

2.  Romania's economic performance in the 1990s has been disappointing, as evidenced by its negative economic growth in recent years and the persistence of large external imbalances. Large fiscal deficits and unaddressed structural weaknesses in the enterprise and banking sectors lie at the root of these problems.

3.  Real GDP continued to decline in 1998--by an estimated 7.3 percent, against 6.9 percent in 1997--with industrial output registering an especially sharp decline. Nevertheless, the current account deficit widened by almost one-half to an estimated US$3.0 billion (8 percent of GDP) in 1998. This was largely the result of a dramatic worsening of external competitiveness: dollar wages and relative unit labor costs (vis-à-vis major trading partners) rose sharply in 1998 (by 26 percent and 38 percent, respectively), against the background of intensified competition from East Asian exporters. Meanwhile, Romania made good progress by reducing inflation, from 150 percent at end-1997 to 41 percent at end-1998.

4.  Market concerns about Romania's external position--as reflected in downgradings by major rating agencies and huge spreads on existing sovereign debt--contributed to sharply lower debt capital inflows. In these conditions, the National Bank of Romania (NBR) has found it increasingly difficult to resist downward pressures on the exchange rate of the leu and on its foreign reserves, even though interest rates have remained rather high.

5.  These unfavorable economic developments have been largely the consequence of an unbalanced financial policy mix and structural weaknesses in the enterprise and banking sectors. Specifically, the general government deficit, excluding privatization receipts, remained somewhat high at about 5.7 percent of GDP in 1998. Moreover, the recorded deficit excludes substantial quasi-fiscal deficits on account of losses in the state enterprise sector and associated bad loans in the portfolios of state-owned banks. Monetary policy was instrumental in lowering inflation--but at the cost of a large real appreciation of the leu. This has entailed quite high interest rates, reflecting persistent inflation expectations, distress borrowing by ailing banks, as well as the large borrowing requirements of the budget.

6.  In the area of structural policies, progress with restructuring and privatization of banks and enterprises has been limited since the beginning of the reform-- notwithstanding an intensified effort in late 1998. Besides resource misallocation and stifled economic activity, this has fostered financial indiscipline through weak corporate governance, as indicated by excessive wage growth against the background of labor productivity losses. These developments were led by the public sector: wages in the régies autonomes (RAs) and national companies rose significantly faster than in the whole economy.

7.  Romania's economic situation has been aggravated by the recent conflict in the Federal Republic of Yugoslavia, owing primarily to disruptions in trade with its neighbors as well as transportation linkages in the region. Preliminary estimates point to a negative impact on the balance of payments of the order of at least US$200 million in 1999.

III.  Macroeconomic and Financial Policies

A.  Basic Strategy and Objectives

8.  Without a major strengthening of economic policies, the outlook for the remainder of 1999 and beyond would be precarious. The current account deficit would remain large and, in conjunction with the peak in amortization payments made in May and June and the resulting decline in foreign reserves, could intensify pressures in the foreign exchange market. Moreover, a sustainable economic recovery would remain elusive as long as monetary policy continues to be burdened by large fiscal and quasi-fiscal deficits and excessive wage increases, and the inefficiencies of the enterprise and banking sectors are not decisively addressed.

9.  Our economic program for 1999 therefore aims to narrow the current account deficit, lower inflation further, and establish conditions for sustainable growth, on the basis of a comprehensive set of macroeconomic and structural policies. Early progress in achieving these objectives will help strengthen confidence in policies and restore Romania's access to the international financial markets. The macroeconomic policies will focus on fiscal consolidation and wage restraint in order to contain domestic demand and improve competitiveness, and also to unburden monetary policy. In parallel, we will aim at realizing a decisive reduction of public enterprise losses, which have undermined past stabilization efforts and hindered growth, through the accelerated restructuring and privatization of state banks and enterprises.

10. Specifically, the program targets a reduction in the current account deficit by US$0.8 billion, to US$2.2 billion (7½ percent of GDP) in 1999 and a buildup of NBR foreign reserves by US$0.5 billion. Notwithstanding the accelerated depreciation of the leu since late 1998, we expect to reduce 12-month CPI inflation further, to around 38 percent by end-1999. Real GDP is projected to decline by another 3½ percent in 1999, as the effects of shedding inefficient capacity and the temporary loss of key export markets in the region are expected to be partly offset by expenditure switching--because of the improved cost competitiveness of Romanian exports and import substitutes. However, output is expected to bottom out in 1999, followed by a resumption of positive growth next year, as a result of the improved policy mix.

11.  To achieve these objectives, the program will aim to: (a) reduce significantly the general government deficit in 1999; (b) contain nominal wage growth in the state sector to well below the rate of inflation and leu depreciation; (c) maintain tight overall credit conditions, consistent with further deceleration in inflation and broad exchange rate stability after the corrective accelerated depreciation of the last few months; and (d) cut public enterprise losses and increase the role of the private sector in the economy, mainly through accelerated privatization and restructuring of the enterprise and banking sectors.

B.  Fiscal Policy

12.  Our fiscal program targets a reduction of the general government deficit (net of privatization receipts and grants) to 3.9 percent of GDP in 1999 from 5.7 percent of GDP in 1998. In conjunction with increased external financing, this would permit domestic debt repayments of 1.1 percent of GDP in 1999 compared with domestic borrowing of 3.0 percent of GDP in the previous year. We will monitor this target on the basis of ceilings on the net credit of the banking system to the consolidated government (see Annex B-III). The targeted fiscal adjustment will help narrow the current account deficit and reduce the need for inflationary financing, taking into account the low degree of monetization of the Romanian economy and the need to refinance the outstanding treasury bills, equivalent to 5 percent of GDP. The program assumes that privatization proceeds, equivalent to 1.1 percent of GDP in 1999, can be treated as budget revenue; any additional privatization receipts will be used to retire domestic debt.

13.  Achieving such an ambitious fiscal adjustment--while allowing for higher restructuring costs and protecting critical sectors of the economy--will be difficult owing to the contracting economy and measures taken last year to reduce direct taxation. Revenue measures recently adopted include: the suspension of tax incentives for investors (previously promulgated); an increase in social security contributions; introduction of licensing fees related to sales of alcohol, tobacco, and other products; higher presumptive valuation levels for the property tax; and a 70 percent hike in the excise tax on petroleum products. However, delays in the adoption of some of these fiscal measures, together with amendments to the 1999 budget as approved by parliament, effectively raised the fiscal deficit beyond the program target. Specifically, the budgetary allocation for reform expenditures was largely assigned to non-reform purposes--a subsidy for the passenger railway company, as well as other subsidies to agriculture, small and medium-sized enterprises, and funds for the recapitalization of Eximbank--equivalent to 1.3 percent of GDP. As a result, the cost of bank restructuring (in particular for Bancorex), estimated at about 2 percent of GDP in 1999, was not provided for in the budget.

14.  Since parliament's approval of the budget in mid-February, we have strengthened fiscal policy to ensure that the program objectives are achieved. On the revenue side, we will continue and reinvigorate our drive to collect all taxes due. Moreover, we have decided to further cut exemptions affecting the profit tax, value-added tax (VAT), excises, and custom duties. Apart from the beneficial revenue impact of 0.5 percent of GDP, this is another step toward making our tax system more equitable and efficient. In particular, on the basis of an ordinance, which was adopted by the cabinet on June 24, 1999, as a prior action for consideration of this program by the Fund Executive Board, we have suspended the provision for accelerated amortization; canceled profit tax exemptions and reductions for insurance, construction, and sponsoring activities, as well as for commercial activities of nonprofit organizations; levied the standard VAT rate on tourism services; removed the excise reduction for Romanian-produced tobacco products; removed all temporary import tariff exemptions; and eliminated the customs exemption on motor vehicle imports by nonprofit organizations. Excises on nonfuel products were also raised by 25 percent. Realizing the continuing bad payment record of large public enterprises, the government has now decided to apply a forced execution scheme on the tax arrears of CONEL, ROMGAZ, and PETROM. Thus, their tax arrears to the consolidated general government will be reduced by lei 2 trillion by end-1999 (see Annex B-VIII). The government will not implement any tax cuts except after consulting with the Fund and provided that measures to cover the resulting budgetary revenue shortfall have been implemented. In particular, we will refrain from considering recent proposals to cut wage taxes and VAT before the first review of the program.

15.  On the expenditure side, given the difficulties encountered in containing wage allocations during the first four months of 1999, the government adopted, in early June, an ordinance that limits the monthly wage allocations in the state budgetary sector to a level consistent with the achievement of an annual allocation of lei 21.4 trillion. Also, the subsidy allocations of lei 2.7 trillion for agriculture, industry, and small and medium-sized enterprises, and the recapitalization of the Eximbank were sequestered, and lei 400 billion were cut from the railway subsidy, in order for the budget to absorb the high priority cost of bank restructuring. The government has also decided to lower the budgetary allocations for materials and capital expenditure by lei 1 trillion and lei 400 billion, respectively. Moreover, the government will adhere strictly to nominal budgeted expenditure allocations envisaged in the program, even in the face of higher than initially envisaged inflation, except for a few areas where some overruns will be unavoidable as described below. Finally, the government will abstain from using State Ownership Fund (SOF) deposits as collateral for commercial bank loans to public enterprises (see Annex B-IV).

16.  Social protection considerations, in connection with the deteriorating economic environment, are likely to result in expenditure overruns for pensions, severance payments, and wages. Pension spending is now envisaged to increase by 6.2 percent in real terms compared with 1998, in line with our intention to decompress the pension structure and a 3.5 percent increase in the number of pensioners. In addition, spending related to unemployment (unemployment benefits plus severance payments classified as reform expenditure) is now envisaged to increase to 1.5 percent of GDP, reflecting the unexpectedly high unemployment rate, as well as additional spending on severance packages, which we hope to finance mainly through a grant from the EU. Reflecting in part the large increase in social security contributions (by 11 percentage points), we have also decided to provide additional wage allocations of 12 percent. Expenditure related to economic reform is now expected to amount to 2.6 percent of GDP, for bank restructuring, severance payments, and closure of mines. Finally, interest expenditure on government debt is now conservatively estimated to amount to 6.6 percent of GDP, in line with only a gradual return of confidence, which could prevent interest rates from falling rapidly in line with inflation.

17.  This fiscal position is still subject to considerable uncertainty and risk, which may require additional measures to ensure that the fiscal program remains on track. Continued economic contraction may undermine tax yields; the cost of bank restructuring could well exceed the 2 percent of GDP envisaged in the program; unemployment could increase even more, requiring the payment of additional unemployment benefits; and interest rates may not register even the very modest decline presently projected, triggering larger interest payments. Also, the compression of expenditures in real terms is likely to come under attack from a number of fronts. To facilitate rapid preventive steps, a comprehensive budgetary monitoring system has been implemented as described in a technical memorandum. Indeed, the government has already identified a list of contingency measures that it stands ready to take should the fiscal situation worsen. These include additional cuts in capital outlays--which are facilitated by the self-financing nature of investment funds, currently experiencing revenue shortfalls--and vigorous collection of outstanding debt. In addition, the government will resist pressures for an early rectification of the budgetary spending allocations to accommodate higher inflation. Agreement on a rectified budget will be the subject of the first review under the stand-by arrangement.

18.  Turning our sights to the year 2000, we will target a further improvement in the underlying overall balance of the consolidated government so as not to jeopardize the economic recovery and the credibility of policies. Given the need for continued expenditure on economic reform over the medium term, it will be essential to consolidate revenue collection through a general strengthening of the tax regime. This would imply broadening the tax base so as to improve the distribution of the tax burden. In this vein, we have begun--with assistance from the Fund and the World Bank--to reform the existing distortionary and inequitable system of direct taxation by introducing a global income tax and reforming the company profit tax. This will permit the government to justify the removal of the multitude of ad hoc incentives--as entailed in Laws 92 and 241--and to properly address the issue of generalized incentives to encourage investment without undue erosion of the tax base. With this endeavor under way, we have adopted a moratorium on licensing investors under the recent ordinance on strategic investments until a joint World Bank-Fund mission can provide us with alternative recommendations on improving the environment for investment. Understandings on a revised incentive framework for investors will be reached during the second review of the stand-by arrangement. An effective limitation of tax base erosion by means of this moratorium was a prior action for consideration of this program by the Fund Board and was implemented on June 3, 1999.

19.  In light of budgetary constraints, characterized by the limited resources available and the growing claims on them, greater selectivity in expenditure projects will need to be exercised in the years ahead. To guide decisions in this area, we will commence, by September 1999, work on a review and rationalization of public expenditure, with assistance from the World Bank and the Fund. Expenditure allocations will need to reflect Romania's priorities, especially in key social sectors and infrastructure. In this regard, the government will resist pressures to broaden the lunch tickets program. Moreover, big-ticket expenditure projects, such as for military hardware and housing construction, will be carefully scrutinized to ensure that such schemes do not compromise the objectives of the stabilization effort.

C.  Monetary and Exchange Rate Policy

20. Key objectives of monetary policy will be to reduce inflation so as to preserve the gains in competitiveness brought about by the recent depreciation, and gradually to stabilize the exchange rate of the leu, owing to its importance as a nominal anchor. Given an unfavorable environment--characterized by persistent inflation expectations, a fragile banking system, uncertainty stemming from large debt-service payments and downward pressure on official foreign reserves--achievement of these objectives will require a determined effort by the NBR.

21.  The NBR will maintain tight monetary conditions, especially in the coming months, and proceed carefully with bank restructuring so as to contain adverse systemic and macroeconomic effects. There should be some scope for achieving a gradual and sustained reduction in interest rates in the second half of the year, as the uncertainty about the external sector is resolved and market confidence in policies improves. The program sets quarterly floors on the net foreign assets of the NBR and ceilings on its net domestic assets, designated as performance criteria under the stand-by arrangement (Annexes B-I and B-II). In the event that the increase in reserve money is larger than programmed, owing to external overperformance, the NBR would consult the Fund staff and reexamine these targets, taking into account developments in the underlying external position and progress in reducing inflation. Should, on the other hand, depreciation pressures emerge, the NBR would raise interest rates further, and we would safeguard foreign reserves by a general tightening of all financial policies.

22.  Maintaining a tight monetary stance will be complicated by the need to undertake bank restructuring operations, which could involve large liquidity injections that might be difficult to sterilize in an environment of low confidence in the leu and the banking system. This is especially true since the NBR currently relies mainly on deposit-taking operations to withdraw liquidity. These operations have proved to be a relatively inefficient instrument under current market conditions because they leave the NBR in the position of being a net debtor to the banking system, forced to react passively to banks' offers of deposits. Moreover, our ability to conduct open market operations is somewhat constrained by the term structure of the securities in the NBR's portfolio. Thus, with some reluctance, the NBR raised the reserve requirements to 20 percent from 15 percent, as of July 15, 1999, on a temporary basis, so as to facilitate sterilization operations. With respect to foreign currency deposits, the measure has the added benefit of reducing, to some extent, the banking system's net exposure. To alleviate the distortionary effects of such a measure, the NBR simultaneously raised the remuneration of the required reserves closer to the level of the average commercial bank deposit rates. The rise in the required reserve ratio may create a need by banks for access to a Lombard facility at the NBR. Based on conditions in the money market and the individual banks, the NBR stands ready to accommodate such requests at interest rates above those prevailing in the interbank market. Finally, we intend to institutionalize a secondary market for government securities as a means of enhancing the efficiency of monetary policy.

D.  Incomes Policy and Financial Discipline

23.  Incomes policy will play a key role in containing domestic demand and improving enterprise profitability and external competitiveness. To this end, we intend to strictly enforce ceilings on nominal wage bills in the state budgetary sector, RAs and national companies, and 24 of the largest commercial companies, jointly accounting for about 30 percent of total registered employment in the economy. Specifically:

  • In line with the revised fiscal program for 1999, the growth in the nominal gross wage bill in the state budgetary sector will be limited to 28 percent, implying a 9 percent decline in real terms on the basis of the projected rise in consumer prices.

  • In line with the Budget Law (Article 29), the annual gross wage bills in RAs and the national companies will be limited to the equivalent of four times their level in 1998 Q4; this implies a 16 percent increase in the nominal wage bills of these companies, representing an 18 percent decline in real terms; the budgets of these entities were approved by the cabinet in May 1999.

  • On the basis of an emergency ordinance, adopted on April 8, the nominal gross wage bills in the 24 largest loss-making commercial companies in 1999 have been limited to four times their level in 1998 Q4.

We expect that the above-described policy will restrain wage developments in the general economy at large, beyond the sectors directly affected by it. In this regard, it should be noted that the SOF has issued instructions to its representatives in the general assemblees of shareholders of all commercial companies in its portfolio to contain wage bills in line with the Budget Law. We have established quarterly cumulative ceilings on the gross wage bill in the budgetary sector, RAs, national companies, and 24 of the largest commercial companies. These ceilings will constitute performance criteria under the stand-by arrangement (see Annex B-IX).

24.  Toward greater enterprise discipline we will also forcefully and consistently implement the policy of cutting energy supplies by CONEL and ROMGAZ and crude oil supplies by PETROM to enterprises that are delinquent in paying their bills. The combined outstanding arrears to these three entities amounted to lei 10.6 trillion at the end of February 1999, which constitutes a ceiling for the value of such arrears throughout the balance of 1999. This ceiling also represents a performance criterion under the stand-by arrangement.

E.  Balance of Payments and External Debt Management

25.  From a level of US$3.0 billion, the current account deficit is projected to decline to about US$2.2 billion (7½ percent of GDP) in 1999, underpinned by the reduction in the fiscal deficit and a large improvement in external competitiveness. Given this current account deficit, the projected capital account balance, and the targeted increase in the NFA, the financing gap for 1999 is projected at US$1.0 billion, which can be covered by exceptional balance of payments support from official creditors (World Bank, EU, and the Fund).

26.  The year 1999 has witnessed a surge in external debt-service payments, owing partly to the US$0.8 billion debt-service obligations for the NBR bonds. The debt-service ratio is projected to increase from 22 percent in 1998 to 29 percent in 1999 and stabilize at slightly more than 20 percent over the medium term. In the interest of burden-sharing between official and private creditors, we are exploring with private creditors how to secure new financing of US$0.6 billion, equivalent to 80 percent of the maturing NBR bonds. This refinancing will be implemented in two steps: we will secure US$350 million of new money from the private creditors as a prior action before the IMF Executive Board consideration of the stand-by arrangement in early August 1999, and the remaining new money, US$250 million, from the private creditors before the first program review in September 1999. We will contract both loans from the private creditors at a maturity structure of at least two years and both would bear pure Romanian risk (that is, they will not be collateralized).

27.  In order to avoid exacerbating the debt-service payments over the medium term, we will limit medium- and long-term nonconcessional borrowing at US$3.1 billion in 1999, with a subceiling of US$0.8 billion for maturities between one and three years (see Annexes B-V and B-VI). The ceilings would cover all (including defense-related) borrowing by the government, the NBR, and state-owned banks and enterprises. External borrowing by subnational public entities will be strictly controlled and will require explicit approval of the Ministry of Finance. As a performance criterion under the arrangement, we will ensure that there is no accumulation of external payments arrears to official creditors throughout the program period.

28.  During the last quarter of 1998, we experienced attempts by investors in Romania to exercise a put option (or call an early repayment) on bonds/loans contracted by one RA (RENEL/CONEL) and one state bank (Bancorex). Accordingly, as a matter of principle and in order to avoid unplanned debt-servicing payments, we will limit contracting sovereign debt instruments that have put options embodied in them.

29.  During the period of the stand-by arrangement, we will not introduce new or intensify existing exchange restrictions, allow multiple currency practices, or impose or intensify import restrictions for balance of payments/fiscal purposes. In this connection, we are committed to eliminate the import surcharge by end-1999, after having reduced it to 4 percent on January 1, 1999. The elimination of the surcharge will be a subject of the second review. Moreover, no new bilateral payments agreements inconsistent with Article VIII will be concluded. We have made progress in the ongoing negotiations with Sweden on the settlement of disputed external arrears and we will pursue these discussions in order to resolve this matter in a manner consistent with the objectives of our program.

IV.  Structural Reform and Social Policy

30. We have reached agreement with the World Bank on a structural reform program focused on bank restructuring, privatization, and loss reduction in the public sector; the program will be supported by a US$300 million Private Sector Adjustment Loan (PSAL), which was recently approved by the World Bank Board.

A.  Public Enterprise Loss Reduction and Privatization

31.  We expect to reduce significantly public sector losses in the economy through privatizations, closures, and restructurings, initiated under the World Bank program. In part, this will be accomplished through the liquidation of 40 companies accounting for 5 percent of state sector losses and through privatization of enterprises accounting for 7.7 percent of state sector losses. While this reduction in losses will not be realized during 1999, we expect to see significant benefits even in the short term, notably enhanced financial discipline. In addition, we have undertaken to reduce operational losses in the coal and metallurgical mining sector--which account for almost one-third of losses in the state sector--by 25 percent in real terms by end-1999. This loss reduction will be accomplished by closing operations in 46 mines, reducing the labor force by 8,000, and cutting subsidies by 40 percent in dollar terms. More generally, the new Privatization Law (which came into effect 30 days after its publication in the Official Gazette of Romania on May 27, 1999) and the norms governing it allow for more expeditious and efficient implementation of actual enterprise closures, and should contribute significantly to a reduction in losses through the closure of certain unprivatizable large enterprises.

32.  We have, during the first quarter of 1999, privatized 585 enterprises, of which 35 are large. Together, these privatizations account for 5.7 percent of SOF's share capital, relative to privatization of 8 percent of SOF's capital during the whole of 1998, and another 10 percent of SOF's capital during the entire period of 1990-97. Notwithstanding this recent acceleration in the pace of privatization (we have privatized Romtelecom, the Romanian Development Bank, Bank Post, to name a few important enterprises, and a wave of small and medium-sized enterprises), however, the overall record so far is disappointing. Thus, in cooperation with the World Bank, we will experiment with several new methods of privatization. While some of these methods may not have immediate results, they should speed up the privatization process over the medium term. Thus, the program envisages, during 1999: (a) initiation of privatization for 50 enterprises acceptable to the World Bank through reliance on a "pool" method (these enterprises account for 10.7 percent of SOF's share capital); (b) initiation of privatization for nine large enterprises acceptable to the World Bank through a case-by-case method involving international tenders (these enterprises account for 7.8 percent of SOF's share capital); (c) initiation of work-out/liquidation for another five large enterprises through this method (these enterprises account for 6.4 percent of SOF's share capital); as well as (d) continued direct privatizations by the SOF (enterprises accounting for 8 percent, 11 percent, and 14 percent, cumulatively, of SOF's share capital by end-July, end-October, and end-December 1999, respectively). We are committed to surpassing the targets agreed with the World Bank, especially in light of the importance of privatization proceeds for budget and balance of payments financing. Progress in achieving our privatization targets will be assessed during the reviews of the stand-by arrangement.

B.  Banking System Reform

33.  The temporary administration of Bancorex has sharply raised our awareness of the weaknesses in the Romanian banking system and prompted the NBR to initiate a proactive review of the banking sector in Romania. Most important, the National Bank of Romania will establish the strategy and tools to restore the solvency and profitability of the banks thought to be viable, while dealing adequately and prudently with the others. This effort will be realized with technical assistance from the Fund (see paragraph 36 below). In addition, we will review the existing legislation with a view to enhancing the management powers of the special administrator, in particular with regard to preparing the banks for privatization or--in the absence of viability prospects--for closure and orderly liquidation.

34.  With respect to bank restructuring, we are currently implementing the liquidation of Bancorex, a key measure in improving the overall health of the banking system. The transfer of liabilities (a prior action under the program) is well underway, with all household and corporate deposits to the Romanian Commercial Bank (RCB) and other banks. The Ministry of Finance has issued one-year treasury bills, paying the average lending rate, thus allowing these liabilities to be serviced. We have transferred lei 5.9 trillion, about 39 percent of the impaired assets of this bank, to the Asset Recovery Agency (ARA) as of end-June 1999, where they will be managed. The transfer of the remaining assets of this bank will be completed with the technical assistance of a World Bank-appointed team by end-July 1999. Bancorex's license will be withdrawn by end-July, and until then Bancorex will refrain from engaging in any new banking activities. In addition, the sale of Bancorex's other assets has been vigorously initiated. Together with the World Bank, we have quantified the likely proceeds and intend to use them to ameliorate the costs of liquidation.

35.  With respect to Banca Agricola, we are actively cooperating with the World Bank to develop a complete financial and operational restructuring plan to prepare the bank for privatization, and this plan will be agreed on with the World Bank before Board approval. By end-August 1999, we expect to have identified and transferred at least 50 percent of Banca Agricola's nonperforming assets to the ARA. We also anticipate that by this time we will have appointed a privatization advisor for Banca Agricola.

36.  In the key area of banking supervision, we envisage measures to strengthen the NBR's supervisory and enforcement capacities and to ensure banks' compliance with prudential regulations. In this regard, we have requested technical assistance from the Fund, specifically in the form of an advisor to the Governor on matters relating to banking supervision. The advisor shall, among other things, provide assistance in the implementation of the recommendations provided by the Operational Audit Report (OAR) on the NBR's supervisory functions that has been elaborated in accordance with the terms of reference issued by EU-Phare. In line with these recommendations, the NBR has: (a) constituted a special working group, chaired by the Vice Governor in charge of banking supervision; and (b) compiled a list of the problem banks to be treated with special allocations of resources, both on-site and off-site. The NBR will take prompt and adequate measures to address the problem of substantial understaffing of the prudential supervision department, as well as the lack of appropriate information technology equipment. In addition, we will organize an external audit of RCB on the basis of International Accounting Standards (IAS), which will be completed by end-July 1999, and will communicate the results of this audit to the Fund staff.

37.  In addition, new or revised regulations are needed to motivate the banks to address their problems and strengthen their financial position. Accordingly, the NBR shall increase the existing minimum capital adequacy requirement and calibrate the definition of tier 1 elements on the Basle Capital Accord. The revised regulation shall authorize the NBR to reduce the available capital of banks to deal with risks that are not appropriately accounted for (for instance, excessive interest rate risk). The revised rules will be promulgated before the end of September 1999. The NBR shall also issue guidelines on internal control, internal audit, and risk management along the lines of the existing documents issued by the Basle Committee of Banking Supervision. The NBR shall also pass a regulation by September 1999, requiring banks to make 100 percent provisions monthly for: (i) interest overdue more than 90 days; (ii) any previously accrued but not received interest; and (iii) on-balance-sheet exposure on other credit institutions overdue for more than 30 days. The necessary measures will be taken before the end of September in order to allow banks to establish and present annual accounts, reflecting a fair view of their financial condition.

C.  Social Protection

38.  The continued economic decline in the Romanian economy in recent years, together with the privatization and restructuring measures adopted, will put larger segments of its population into a precarious position. Unemployment, which was recorded at 12 percent at the end of March 1999, is expected to rise significantly by the end of the year. Apart from our desire to ameliorate economic hardship and suffering, we also recognize that the economic grievances in the population must be addressed lest the political chances for our ambitious reform project become clouded. In this regard, we have intensified a dialogue with our social partners in order to obtain a broad consensus for the implementation of the program.

39.  In the first place, of course, the envisaged reductions in the economic imbalances and the restructuring of the enterprises should improve the prospects for a sustainable increase in employment and the living standard. In addition, we have aimed to target social transfers--amounting to 10.5 percent of GDP in 1999--at vulnerable groups: unemployment benefits are expected to be kept constant in real terms, severance payments of 0.7 percent of GDP have been provided for, active labor market measures centered on retraining will be introduced, the wage subsidy available only for recent university graduates so far will be made available to more beneficiaries, and the children allowances will amount to1.1 percent of GDP.

40. We have also taken initiatives to improve the wider system of social service delivery. Pensions will continue to be decompressed, thereby implying reward and incentives for not evading the social security contribution system. To improve the efficiency of health services, we have devolved the administration of health insurance to the 43 national insurance houses, emulating the subsidiarity principle adopted elsewhere.

V.  Program Monitoring

41.  The quantitative performance criteria are as follows: (i) quarterly ceilings on net domestic assets of the NBR; (ii) quarterly ceilings on credit of the banking system to the consolidated government; (iii) quarterly floors on net foreign assets of the NBR; (iv) quarterly ceilings on nominal wage bills for the state budget, régies autonomes, and loss-making commercial companies; (v) overall quarterly ceilings on the contracting or guaranteeing by the government of nonconcessional external debt, with subceilings for the one- to three-year maturity range; (vi) quarterly ceilings on the level of external debt with a maturity of up to and including one year contracted or guaranteed by the government; (vii) quarterly ceilings on the assumption of enterprises' debt to banks and guaranteeing of bank loans to enterprises by the general government; (viii) quarterly ceilings on domestic arrears to CONEL, ROMGAZ, and PETROM; and (ix) quarterly floors on the net reduction of tax arrears of CONEL, ROMGAZ, and PETROM. A continuous performance criterion of no new accumulation of external arrears to official creditors will also apply. The indicative targets are as follows: (i) quarterly ceilings on reserve money; (ii) quarterly ceilings on the stock of external payments arrears; (iii) quarterly floors on net foreign assets of the banking system; and (iv) quarterly ceilings on broad money. The monetary ceilings on the NBR will be defined as the average of the daily positions for the monthly period in question.

42.  Structural benchmarks include: (i) quarterly targets for privatization sales; (ii) the reduction of losses in the state sector; (iii) by end-August 1999, identification and transfer of at least 50 percent of Banca Agricola's nonperforming assets to the ARA and the appointment of a privatization advisor; and (iv) by end-July 1999, the transfer of any remaining assets of Bancorex to the ARA.

43.  The program will be reviewed by the Fund three times during the period of the stand-by arrangement (August 1999-March 2000): by September 15, 1999; December 15, 1999; and February 15, 2000. During the first review, we intend to reach understandings on, inter alia, any rectification of the 1999 budget, while completion of the second review will require agreement on the draft budget for 2000.

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