Romania -- 2007 Article IV Consultation, Concluding Statement of the Mission
March 13, 2007
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. Romania's accession to the European Union was a significant milestone that followed a period of important accomplishments. Output growth was strong, substantial disinflation took place, and unemployment fell sharply. Starting from a low base, per capita GDP measured in Euro rose by 130 percent during 2000-06, the fastest among the 27 EU countries. These achievements, which took place in a favorable external environment, reflect sound macroeconomic management and advances in structural reforms.
2. The confluence of positive factors that led to the positive developments in 2006 cannot be counted on to continue. The external environment has been benign, but, as witnessed in early-March in various prominent international markets, can quickly become volatile and unpredictable.
3. Against this background, there is no room for policy complacency if Romania wants to bridge the significant gap that still exists with EU living standards. The lasting increases required in human and physical capital will be possible only if domestic savings and investment increase. Although the private sector will take the lead in accelerating income convergence, the public sector will need to provide the appropriate enabling policy setting. The current unsettled external environment and increased risks due to the widening current account deficit, place a higher premium on appropriate fiscal and monetary policies as an insurance against sudden shifts in market sentiment. Moreover, postponing a policy response to the emerging vulnerabilities would increase the need for a much more abrupt policy action in the future. The authorities' intention to adopt the euro by 2014 provides an added beacon for confronting these challenges, accelerating structural reforms, and implementing policies that lay the foundation for successful entry to the eurozone.
4. Growth and inflation performance has been remarkable. Real GDP growth was 7.7 percent last year. Domestic demand grew strongly owing to a sharp increase in private consumption and investment. CPI inflation was 4.9 percent y-o-y at end-2006, against the NBR's 5 percent central target. In addition to prudent monetary and fiscal (through November 2006) policies, inflation performance benefited by slower-than-envisaged administered-price increases, falling agricultural prices, and an appreciating currency. However, the declining trend of core inflation has stalled.
5. Continued strength in credit growth, a widening current account deficit and attendant increase in vulnerabilities raise concerns. From a low base, real domestic credit is estimated to have grown by 66 percent in 2006—reflecting both strong leu- and foreign-currency denominated credit. The current account deficit widened to 10.3 percent of GDP, compared with 8.7 percent in 2005, reflecting large excess demand pressures. FDI covered 91 percent of the current account deficit. Following the substantial real appreciation in 2005, with slowing nominal appreciation and modest unit labor cost increases, the real effective exchange rate appreciated moderately last year. Moreover, enterprise profitability in manufacturing appears to have improved on account of strong productivity gains that have outpaced real wage growth.
6. Fiscal policy supported stabilization for most of last year, but a significant procyclical fiscal loosening started recently. A sharp rise in government spending in December led to an annual deficit of 1.7 percent of GDP compared with a surplus of 1.2 percent of annual GDP during January-November. Indeed, more than 40 percent of the capital budget was spent in December alone. For the year, government expenditure rose by 20 percent in real terms. The government revised the budget four times, increasing the deficit target from 0.5 percent of GDP to 2.5 percent.
7. Procyclical government wage policies exacerbated domestic-demand pressures. The original wage allocation proved insufficient given average statutory wage increases of 9-15 percent (in two rounds), employment increases, and increases in bonuses. Although the authorities had committed to freeze vacant positions (except for EU-accession-related hiring) to offset overruns, government employment increased by almost 30,000 (3⅓ percent). Given this increase in employment and the average statutory wage increases, the increase in the government's wage bill of 36 percent last year implies a sharp increase in other personnel- related spending, including bonuses—these developments raise significant concerns about the transparency of the government wage policy. On a positive tone, the government exercised prudence in the minimum wage (an increase of 6½ percent) and controlled the SOEs' wage bill.
8. The monetary authorities have focused on improving the credibility of their inflation targeting (IT) regime, but upward pressure on the exchange rate has prompted the NBR to reduce the policy interest rate recently. The NBR tightened monetary conditions in 2006, by raising the official policy interest rate and the effective rate, to a unified level of 8.75 percent. However, the strong nominal leu appreciation since December has caused the authorities to limit the amount of excess liquidity absorbed at the official policy rate, and was accompanied by a reduction in the policy rate to 8 percent on February 9. The return of a gap between the effective interest rate and the official rate has been interpreted by market participants as highlighting the NBR's concern about the pace of appreciation, in addition to its inflation objective.
9. Progress on structural reforms has been mixed. The privatization of Romania's largest bank (BCR) is commendable, but the privatization of CEC bank has been postponed. Gas prices remain far below the opportunity costs and the domestic gas producer price is only 47 percent of the international import price. Services provided by the public sector, particularly education and health, remain subject to frequent complaints. Despite recent amendments to the labor code, labor market rigidities remain. Finally, judicial reform has progressed in line with Romania's commitments toward the EU, although questions remain about the effective implementation of recent changes in legislation.
II. Macroeconomic Outlook and Policy Recommendations
Policy Mix and Outlook
10. Although short-term macroeconomic risks remain modest, sustaining strong growth and minimizing vulnerabilities will be difficult on current policies. With the economy already overheating, the fiscal loosening that began at end-2006 and the envisaged fiscal and incomes policies this year will exacerbate demand pressures, and contribute to a further widening of the current account deficit and inflationary pressures. The mission's baseline scenario for 2007 projects continued strong growth, a widening in the current account deficit to 12 percent of GDP, and an inflation outcome outside the target band at end-2007. Such an outcome, combined with a delay in strengthening macroeconomic policies, increases the risk of a change in market sentiment and sudden capital outflows, which would lead to pressures on the exchange rate. A slowdown in growth combined with a possible depreciation would adversely affect the debt-servicing capacity of private-sector borrowers, thus putting the banking system under strain. In any event, meeting the Maastricht criteria will require a strengthening of policies and a delayed policy action would increase the need for a much-more abrupt policy response in the future.
11. The current juncture, thus, calls for a clear and coherent set of policies to minimize external and financial-system vulnerabilities, to retain positive foreign investor sentiment and to maximize the benefits from EU accession. In a setting of strong private sector expansion and large capital inflows, fiscal and incomes policies are key for assuring macroeconomic stability. A tightening of policies will relieve some of the burden on monetary policy to achieve further disinflation without relying as much on the exchange rate, thus safeguarding the current margin of competitiveness. With appropriate policies in place, staff sees a containment of the external current account deficit and meeting the NBR's inflation target. Convergence to EU living standards requires increased investment, including efficient government spending, and a focus on employment creation. An increase in investment, aided by EU transfers, will increase capital's contribution to output growth, while industry restructuring will help sustain strong productivity gains. A mixed or delayed reform effort, on the other hand, would prevent the economy from taking full advantage of the opportunities offered by EU accession and would dampen growth prospects.
Fiscal and Incomes Policies
12. The current fiscal plans are inconsistent with maintaining macroeconomic stability. The approved budget targets a deficit of 2.8 percent of GDP, which represents a significant expansion in the cyclically-adjusted deficit. In the mission's view, budget revenue projections are optimistic. This view is confirmed by revenue performance so far this year. On the expenditure side, the wage allocation does not fully incorporate the impact of salary increases agreed following the budget's approval by parliament. The mission projects that, on current policies, the underlying budget deficit is about 3.7 percent of GDP. The recognition of additional claims related to the Property Fund and the possible use of resources from the National Development Fund would add yet further to the deficit.
13. To support the macroeconomic objectives and relieve some of the pressure off monetary policy, the mission strongly urges the authorities to tighten fiscal policy. Although fiscal sustainability is not an immediate concern and may lead the authorities to postpone difficult decisions, fiscal restraint is needed to quell excess demand. The mission thus favors a withdrawal of fiscal stimulus by aiming for a general government deficit of below 1 percent of GDP this year, and a smooth path for medium-term fiscal consolidation. Recognizing the need for stability in the tax legislation, the scope for revenue measures this year is limited, and therefore the majority of the adjustment will have to fall on the expenditure side. In addition to the need to control the wage bill (see below), savings compared to budget could be realized in spending on capital (on account of last December's sharp increase), goods and services, and transfers.
14. A strict public-sector wage policy is needed for maintaining low inflation. The approved government wage increases of 14-19 percent on average in three rounds, the minimum wage increase of 18 percent, and the easing in the monitoring of the SOEs' wage bill are all incompatible with the NBR's inflation objective (unless sizeable appreciation takes place and administered-price increases are delayed, which in the mission's view would be undesirable). To contain this year's wage bill, the mission suggests reducing the envisaged wage increases, imposing strict control on bonuses, and closely monitoring additional hirings. A tightening of public sector wage policy will give a signal for prudent private-sector settlements. To anchor inflation expectations in single digits, public sector wages should increase once a year and be incorporated in the budget. Moreover, in the context of an urgently-needed public sector reform, 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.
15. A permanent strengthening of revenue and expenditure reforms are key. The flat tax has led to a lower tax burden and the mission urges the government to resist calls for further tax reduction (except the social contributions tax) and distortionary exemptions (e.g., a reduced VAT rate or exemption of reinvested profits). Romania's revenue ratio is considerably below levels in EU countries, and pressing spending needs clearly argue for increasing revenue. Tax administration improvements could complement that strategy. Much-needed structural expenditure reforms should be given priority; e.g., civil service, health, education, pensions, and infrastructure.
16. Improved transparency, enhanced monitoring, and a credible medium-term fiscal framework would strengthen the institutional setting of fiscal policy. It is important to put in place mechanisms to ensure the efficient allocation of resources and absorption of EU inflows. The experience of the central European accession countries suggests that strong efforts are needed to improve the efficiency of absorbing EU funds. Multiple revisions of the budget should be avoided, while public-spending management needs to be improved to ensure a uniform spending pattern over the year. To strengthen the budgetary process, a credible medium-term fiscal framework—which will fully incorporate post-accession EU receipts and expenditure—is needed.
Monetary and Exchange Rate Policies
17. The NBR faces a challenging policy environment. Having recently joined the EU, the NBR's monetary policy guidelines call for entry into ERM II by 2012. This timetable is both feasible and appropriate. However, such a timetable implies that the central bank has up to six years under an inflation-targeting framework to bring nominal-convergence criteria down to Maastricht levels, while simultaneously managing a real-convergence process in which capital inflows, real incomes and international purchasing power are rising steadily. In this context, the NBR faces a difficult dilemma—meeting its inflation goals through higher interest rates may threaten to put further nominal appreciation pressure on the currency. In the staff's view, however, the only long-run solution is to lower nominal interest rates by firmly anchoring inflationary expectations. This requires a solidly-credible IT framework. The NBR needs to make clear that inflation, not the exchange rate, is its primary objective and employ interest-rate policy effectively in support of its inflation goals.
18. The NBR should focus on inflation and reunify the headline and effective policy interest rates as soon as possible. Under the current practice of partial sterilization, the effective rate is about 6-7 percent, which represents a broadly neutral monetary stance. This setting is too loose, given the current level of excess demand. The NBR should increase the effective rate, bringing it in line with the headline policy rate of 8 percent. This would not only reassert the signaling role of the official policy rate, but would also represent a moderate tightening of monetary conditions in real terms. It should be stressed, however, that there are significant upside risks to the inflationary outlook, and that if the authorities do not tighten fiscal and incomes policies, an additional hike in interest rates would most likely be needed.
19. Credit developments are still a concern. Real convergence with other EU members will naturally require an expanding financial sector. However, in terms of prudential risk, overly-rapid credit growth can magnify existing distortions and raise medium-term vulnerabilities, so the authorities are urged to maintain continued vigilance. Moreover, in the view of the mission, the ongoing strength of credit demand parallels the continuing strength of excess aggregate demand. On prudential and administrative measures, the mission cautions that administrative measures are often less and less effective over time, and are generally ill-suited to addressing a macroeconomic stabilization problem. In this context, the NBR recently relaxed a number of administrative measures on lending (mainly on the retail segment) in the context of EU membership; however, this will place a greater premium on effective supervision. On the issue of reserve requirements, although levels in Romania are significantly higher than those in other EU members, efforts to lower these requirements should proceed cautiously over time. High reserve requirements do impose an added cost on the domestic banking sector, and may contribute to disintermediation, but the authorities should take care that lowered reserve levels not add to Romania's current macroeconomic imbalances.
Financial Sector and Capital Market Issues
20. Financial soundness indicators (FSIs) suggest that the banking sector is well-positioned to absorb adverse shocks, but the authorities nonetheless need to be alert to medium-term vulnerabilities. Although competitive pressures are increasing, rates of return on equity and capital adequacy ratios are still 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, as well as to a slowdown in growth. However, in the context of rapid credit growth, indirect exposures through loan portfolios are much more difficult to assess, and need to be reflected in high capital ratios and conservative provisioning practices. The mission notes that it has been some time since the 2003 Financial Sector Assessment Program (FSAP), and that in the context of EU membership, Romanian institutions are now operating in a significantly different environment. In this light, the mission welcomes the authorities' desire to have an FSAP update this year.
21. 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 opportunity cost developments and their commitment to achieve import parity, to allow time for economic agents to adjust. Second, strong efforts are needed to improve efficiency of government spending, which should be supportive of private sector economic activity. Third, increasing labor supply will require an ambitious strategy, encompassing improving the education system, training opportunities, and enhancing the flexibility of the labor market. Fourth, the mission urges the authorities to strengthen their efforts to introduce the second pillar on January 1, 2008, while revisiting some of the parameters of the first pillar. Fifth, the momentum on privatization needs to be maintained with the privatization of companies in the energy sector and other smaller companies. Finally, the mission advocates the forceful implementation of the government's judicial reform agenda, with the objective of strengthening public administration, reducing corruption, and improving financial discipline and the business climate.
22. The authorities' emphasis on real convergence prior to euro adoption underscores the urgency of structural reforms. While we agree that the envisaged timetable for euro adoption represents a pragmatic recognition of political economy constraints, we also see a risk that it can lead to a more gradual implementation of policies needed for convergence. We therefore recommend that a balanced approach in this area also contains the right incentives for accelerated reform.