Romania-Fall 2007 Staff Visit - Aide Mémoire
October 9, 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. Underpinned by surging capital inflows, Romania's economy has performed strongly in recent years. Once EU membership was secured and domestic policy frameworks had improved, foreign and domestic investors stepped up spending to take advantage of expected higher returns and lower risk premia. Consumers, anticipating higher incomes and facing relaxed credit constraints, also reacted by stepping up spending. These pull factors, combined with an open capital account and international financial markets in search of yield, resulted in an unexpectedly protracted surge in capital inflows, especially foreign direct investment flows. With a large pool of foreign savings becoming available and domestic financial intermediation advancing rapidly, aggregate spending on private investment and consumption has boomed. At the same time, real GDP growth has expanded at a robust pace, while disinflation has continued.
2. However, the confluence of positive factors that have contributed to Romania's favorable growth and inflation outcomes cannot be counted on to continue:
• Since July, the external environment has taken a turn to the worse. Credit tensions in mature markets have led to a downward revision in global growth prospects; the tensions have also highlighted the speed and scope at which financial markets can re-assess risks. Moreover, global energy and unprocessed food prices have continued to increase, raising concerns about global inflation trends.
• The widening gap between Romania's spending and income has been mirrored by a ballooning external deficit. Large external imbalances of this size have to be corrected eventually, otherwise the country's future external net financial liabilities and payment obligations could increase to unsustainable levels.
• And Romania's protracted spending boom increasingly puts strains on productive capacities, particularly in labor markets. These strains have been aggravated by procyclical fiscal and incomes policies, while political gridlock has impeded structural reforms needed to alleviate capacity constraints.
Recent Macroeconomic Developments and Prospects
3. As regards the economy's external situation, the already large current account deficit has continued to widen, and rising real unit labor costs are scrimping Romania's competitive edge. In 2007, real domestic spending growth will again outpace real GDP growth by a large margin, and the mission now projects the current account deficit to reach about 14 percent of GDP, with a similarly high level projected for 2008. As a matter of concern, capital flows are increasingly shifting away from foreign direct investment, adding to external net debt. However, Romania's present net external liabilities remain moderate compared with those of many of its new EU member peers. With loose public sector wage policies increasingly spilling over to private sector wage settlements, external labor cost competitiveness needs to be watched. At this point, export volume growth performance remains robust, and the shift toward higher value-added export goods, reflected in significant terms of trade gains, has continued.
4. As for the economy's internal balance, recent indicators point to a moderation in growth but inflation remaining high for the remainder of the year. Mostly on account of drought effects in agriculture, staff now expects real GDP growth to moderate to 6 percent in 2007, in line with the National Commission of Economic Forecasting's views. As the economy's spending boom is likely to slow only gradually, GDP growth should remain at about 6 percent in 2008. Disinflation until July was helped by an appreciating currency, the postponement of administered price increases, and falling agricultural prices. Comforted by these favorable inflation outcomes, the National Bank of Romania (NBR) cut interest rates in four steps by a cumulative 175 basis points, bringing its policy rate to 7 percent in June. However, with the drought-related sharp increase in food prices in August, disinflation stopped abruptly, and both headline and core rates have picked up. On current trends, the mission projects headline inflation to stay close to the NBR's upper 5 percent limit through end-2007; whether inflation in 2008 will revert safely back into the target band depends sensitively on assumed fiscal, incomes, and monetary policies.
5. Turning to the financial sector, negative spillovers from credit tensions in mature markets have—so far—been limited, and booming credit growth has continued. Reflecting a reversal of volatile capital flows, the leu's value vis-à-vis the euro is roughly back to the level at the beginning of the year. Apart from a small correction in the stock market, the recent financial turmoil has had little impact on Romania. However, global credit tensions have raised analysts' concerns about Romania's external vulnerabilities, concerns exacerbated by a fragile political environment. Domestic credit has continued to boom, expanding by 46 percent in real terms in the year to July. As noted in the NBR's 2007 Financial Stability Report, the banking sector appears well-positioned to absorb adverse shocks, but short-term external borrowing and households' unhedged foreign-exchange positions are growing concerns.
6. On fiscal policy, implementation of the 2007 budget has been appropriately tight so far, but we also see Romania's underlying fiscal position as more fragile than commonly perceived. Notwithstanding the continued practice of ratcheting up spending obligations through successive supplementary budgets, the general government recorded a small cash surplus during the first eight months of 2007, largely on account of slow execution of the capital budget. However, while the level of public debt is relatively low, the underlying (structural) fiscal position may be significantly weaker than suggested by actual fiscal deficit figures. In particular, the economy's protracted spending boom has resulted in temporary revenue windfalls, and, when the large external imbalance reverses to a more sustainable level, the fiscal position will automatically weaken as the gap between spending and income narrows. Our conservative calculations suggest that the underlying fiscal position might be at least one percentage point of GDP weaker than indicated by the actual fiscal deficit. Thus, to the extent that temporary revenue windfalls have been used to finance permanent spending increases or tax cuts, future restrictive fiscal measures will be needed to shore up the public finances at a time when the economy may be weakening.
7. We see the following broad policy requirements:
• Consistent with a stability- and growth-oriented fiscal policy framework, the government's budgetary and incomes policies during 2007-08 should avoid to add procyclical pressures.
• As regards monetary policy, the NBR's inflation targeting framework calls for keeping inflationary expectations firmly anchored.
• Safeguarding financial stability requires continued close monitoring of growing exposures and the banking sector's capacity to absorb adverse shocks.
There is also a continued need to address long-standing and well-known structural reform bottlenecks, including in the energy and labor markets. In this context, we note the importance of developing a clearer and more credible medium-term fiscal and structural reform strategy. Such a strategy could help to prioritize and discipline policy making, raise the public sector's lagging efficiency, and provide the increasingly dynamic private sector with more stable and predictable policy perspectives.
8. The mission considers the following fiscal framework benchmarks as consistent with fostering Romania's growth, stability, and euro-adoption ambitions:
• Medium-term fiscal balance target: A fiscal deficit target of about 1 percent of GDP would be appropriate when the economy is at internal and external balance. Under the EU's fiscal rules, such a medium-term target would seem broadly in line with Romania's low public debt and relatively high expected growth.
• Medium-term fiscal space for spending: Permanently strengthened budget revenues are necessary to meet key development needs and support real convergence, including in the areas of public infrastructure, health, and education. While raising the revenue-to-GDP ratio will become easier as the economy restructures away from agriculture over time, tax bases should be broadened by removing exemptions and revenue administration reforms be implemented.
• Stabilization role of fiscal policy: A medium-term fiscal framework would help avoid a procyclical policy bias during booms while allowing automatic stabilizers to operate in a weakening economy. In Romania's present setting with signs of overheating and a large external imbalance, this benchmark would suggest that the actual fiscal deficit should be lower than the medium-term target.
• Public financial management: The institutional setting of fiscal policy needs to be strengthened by: establishing mechanisms to ensure the efficient allocation of resources and absorption of EU inflows; avoiding the present practice of multiple intra-year budget revisions; taking a more proactive role in developing a domestic government securities market; and, most importantly, developing a credible medium-term framework with well-elaborated policies and objectives.
9. Keeping these framework benchmarks in mind, the mission sees a need for continued tight implementation of the 2007 budget. With the general government reporting a ¼ percent of GDP cash surplus during January-August, achieving the 2¾ percent annual deficit target would be equivalent to imparting a large fiscal impulse to the economy during the rest of the year. This would exacerbate inflationary pressures and further widen the current account deficit. Thus, the authorities should maintain fiscal prudence and aim for an annual deficit below 2 percent of GDP.
10. Reflecting political uncertainties plans for the 2008 budget, particularly as regards specific spending and revenue items, could remain in flux. Our preliminary assessment of present 2008 budget plans is as follows:
• Fiscal deficit target: The envisaged deficit target of 2¾ percent of GDP would likely imply a procyclical fiscal loosening, particularly if the 2007 budget is implemented in a fiscally prudent manner. A looser fiscal policy next year would also increase the need for monetary policy tightening to keep inflation in check. Thus, the mission considers a lower fiscal deficit target—consistent with a significant tightening relative to the eventual 2007 deficit outcome—as essential.
• Revenue projections: Although the improved revenue collection so far in the second half of this year is encouraging, projected revenues in 2008 seem quite optimistic. For example, social contributions are envisaged to increase by 1½ percentage points of GDP, despite a significant cut in the contribution rate and the introduction of the second pension pillar. Furthermore, the projection may also need to take into account the potential adverse effects on compliance and labor supply of two measures intended to increase social contributions: (i) the elimination of the cap on labor income subject to contributions; and (ii) the envisaged broadening of the taxable base for contributions.
• Public wage bill: The envisaged decline in the wage bill as a share of GDP is not backed by well-elaborated policies, and, in fact, the draft budget presented to us seems not to include a sufficient allocation for statutory wage increases. Moreover, if the contemplated single average 11 percent wage increase takes effect on January 1, this will imply average increases of up to 28 percent in various budget sectors owing to carry-over effects from the October 1, 2007 wage hike. Thus, the mission advocates mitigating the impact on the budget and potential inflationary pressures by postponing a single moderate wage increase until at least mid-2008.
• Pensions: Although the already approved significant increase for 2008 might be justifiable given Romania's low pension replacement rates, the also approved almost doubling of pensions over the next two years seems unsustainable. These largely ad hoc pension measures underscore the need for a more coherent pension reform strategy that takes into account the deteriorating demographic outlook and further significant labor migration outflows.
• Capital spending: The mission has doubts about the government's ability to spend the allocated massive increases in capital expenditures efficiently. Related to this, there is a danger that, as in the past, during the course of the year, underspending on capital could be reallocated to current spending.
11. The NBR should focus on containing inflation in line with its policy framework. As noted by its Board after the most recent policy meeting, inflationary prospects for 2008 are worrying, particularly if fiscal and incomes policies would be loose. Given the ongoing strength of domestic spending, pending increases of administered prices to bring them closer to cost recovery levels, and the lags with which policy tightening typically affects the economy, the NBR needs to be vigilant and monitor economic and policy developments closely. The authorities have to act in a timely manner, if needed, to keep inflation on target.
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We would like to thank the authorities for the high level of cooperation with the mission, the constructive discussions, and the usual warm hospitality.