2012 Article IV Consultation with Romania- Concluding Statement of the Mission
August 14, 2012
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.
Progress has been made in reducing inflation as well as government and external deficits, but much remains to be done to increase still weak growth. The recent political turmoil is taking a toll on the economy and has dented confidence. Moreover, Romania is vulnerable to contagion from the euro area crisis. Therefore, it is important for the authorities to focus on macroeconomic policy priorities, notably achieving sound public finances, promoting low inflation with a flexible exchange rate, containing financial sector risks, and pushing ahead with reforms to boost growth and job creation.
The Challenge of Securing Economic Stability and Reaching a Higher Growth Path
The overlapping of heightened political uncertainty with increased market stress stemming from the euro area crisis poses risks for macroeconomic stabilization. Increased risk perception has led to a sharp rise in the sovereign CDS spread since end-April, and yields on treasury bills are also climbing. Capital outflows in recent months have precipitated exchange rate depreciation of more than 5 percent so far this year (compared to 2 percent during 2010-11). The weakening exchange rate is putting upward pressure on prices and on the high level of nonperforming bank loans, thereby hampering banks’ poor profitability and credit growth, and hence the expansion of economic activity.
Economic activity is expected to remain subdued in the near term due to diminished confidence, the recession in Europe, low EU-financed investment, and the impact of the drought on agriculture. The economy is projected to gradually recover from early 2013, with trend growth reaching about 3 percent over the medium term and unemployment slowly declining. Annual headline inflation would pick up in coming months to about 3½ percent by year-end due to rising food prices and pass-through from the depreciation. Given the sizable output gap, inflation would moderate from 2013. The external current account deficit is expected to narrow to below 4 percent of GDP in 2012 and, in light of the sluggish recovery, to widen only slightly over the medium term.
Risks to the outlook are mostly on the downside. A prolonged political crisis could hamper effective economic policy making, increase risk premiums and financing costs, further depreciate the exchange rate, and depress investment. A deeper recession or financial crisis in the euro area, given strong trade and financial linkages, would decrease Romanian exports, tighten bank credit, and drag down confidence and domestic demand. On the upside, a speedy normalization of the political situation and acceleration of reforms or a stronger global recovery could boost market sentiment and activity.
It is crucial to implement a comprehensive strategy aimed at ensuring financial stability and boosting Romania’s medium-term growth potential. In order to regain credibility in economic policy making, the authorities should focus on decisive implementation of their economic program supported by the International Monetary Fund, European Union, and World Bank. In particular:
- Strong fiscal discipline should be maintained to ensure the targeted deficit reduction for 2012-13, reduce payments arrears, and achieve fiscal sustainability by 2014. Higher EU funds absorption is critical for growth and a financially viable health care reform is important to deal with rising aging costs over the longer term.
- The monetary policy stance should remain prudent in light of risks to inflation, potential capital outflows, and exchange rate pressures.
- In the financial sector, it is important to continue to ensure that banks have sufficient capital and liquidity while contingency plans should be further developed to contain contagion from abroad and steps should be taken to mitigate the rise in nonperforming loans.
- Reviving growth and job creation requires a more welcoming business environment, far-reaching reforms in the energy and transport sectors, re-invigorating public enterprise reform, and continuing implementation of the recent labor market reform.
Achieving Fiscal Sustainability
The fiscal adjustment planned for 2012 is appropriate. Building on the efforts undertaken through mid-2012, the overall deficit (in ESA terms) is targeted to narrow to 3 percent of GDP from 5.2 percent in 2011. The adjustment weighs on growth but is critical to bolster market confidence and exit the EU Excessive Deficit Procedure. To achieve the deficit target, strong spending restraint is required. Significant progress has been made in containing the public sector wage bill. The mission welcomes the decision to discontinue low-priority spending on goods and services as well as on non-performing capital projects, and to firmly resist pressures to relax fiscal discipline ahead of the parliamentary elections in the fall.
Reducing government and healthcare sector arrears remains a key challenge. The implementation of a commitment control and reporting system for the central government is a priority and budget rules for local governments should be strictly enforced. To reduce hospital arrears, cost-containment actions should be stepped up, including by more frequent audits, regularly revising and applying the negative lists for services and pharmaceuticals, improving procurement, and streamlining the number of hospital beds.
In view of the considerable downside risks to the outlook, it is important to maintain adequate fiscal buffers. Recent treasury auctions at rising yields have been below planned levels and fiscal buffers have declined. Given the ongoing financial turbulence in the euro area and possible spillovers, fiscal buffers of four months of gross financing needs should be rebuilt. To limit debt service costs and reduce rollover risks, the debt management strategy should seek to diversify the investor base and continue to develop the yield curve.
In the event of a significant downturn, the automatic stabilizers should be allowed to operate. Under the current outlook, it is crucial to adhere to the planned consolidation path. However, if a significant worsening of the euro area crisis was to occur and result in a sharp contraction of economic activity in Romania, the government should let the automatic stabilizers act freely. Under such extreme circumstances, it will be important to specify a credible multi-year consolidation strategy to be implemented once the economy recovers.
Firmly maintaining prudent fiscal policies over the medium term would strengthen confidence and support growth. Following the large fiscal adjustment since 2009, achieving fiscal sustainability in the coming years is now within reach. The government should follow through on its commitment to undertake a structural adjustment of ½ percent of GDP in 2013, in order to achieve a structural deficit of less than 1 percent of GDP by 2014. This will allow for keeping the public debt at sustainable levels, lower financing costs, and free resources for investment and growth.
Putting in place the institutional framework required under the EU Fiscal Compact would provide an important tool for strengthening fiscal discipline and policymaking. The mission welcomes the intention to shift the focus beyond 2012 on targeting the structural balance which allows fiscal policy to play a stabilizing role over the economic cycle. It is important to amend the legislation to incorporate a fiscal rule on the structural fiscal balance target and the related automatic correction mechanisms. In addition, the role of the independent fiscal council needs to be strengthened.
Tax base broadening and strengthening tax collection would help to achieve the fiscal targets. The narrow tax base and weak compliance weigh on revenue yields in Romania. There is room to adjust excise taxes to maintain their real value, update the base for property taxes, and broaden the tax base of the VAT, in agriculture, and among the self-employed. To improve tax collection, further efforts (based on IMF technical assistance recommendations) should be undertaken to strengthen tax audits of large taxpayers and high net-wealth individuals; close loopholes in the VAT refund process; introduce a mandatory simplified tax for small business taxpayers below the VAT threshold; and modernize IT systems.
Increasing the absorption of EU funds is a priority. A much higher use of these free resources is critical to boost infrastructure investment and economic growth, and would also help to strengthen international reserves. Although disbursements in the first half of the year picked up somewhat, possible lengthy interruptions and de-commitments risk depriving Romania of important resources going forward. A drastic improvement of the absorption capacity is thus needed. This requires strong coordination between all involved ministries to implement the EU priority action plan in this area; significant strengthening of both technical expertise and proper incentives at managing authorities and other bodies; as well as easing of administrative and procedural burdens.
Further entitlement reforms should be undertaken to deal with rising aging costs and improve service delivery in healthcare. Aging costs are expected to increase by at least one percent of GDP through 2030 and to accelerate thereafter. The 2010 pension reform is already helping to address this challenge but further action may be needed in the future to keep the pension age in line with rising life expectancy. In the health care system, the public consultation on draft legislation is a welcome first step to prepare for an overhaul of the benefits package and financing mechanisms. The draft law envisages the introduction of private insurance to supplement the mandatory basic health insurance. Before moving this process further, an impact analysis should be undertaken to ensure the financial sustainability of the planned reform. In light of the low level of public health care spending in Romania, there is a strong need to mobilize adequate financing to improve service delivery. It is equally important to better contain costs by reducing structural inefficiencies in the system.
Promoting Low Inflation with a Flexible Exchange Rate
The central bank (NBR) has appropriately refrained from further monetary policy easing in recent months. Falling inflation and better anchored inflation expectations allowed the NBR to reduce its policy rate in four steps to 5.25 percent as of April 2012. The easing stance had to be abandoned in recent months, however, in light of lower net capital inflows and exchange rate depreciation. NBR interventions to smooth the depreciation have used up some international reserves, which nevertheless continue to fully cover short-term external debt obligations. While regular repurchase operations ensure adequate liquidity in the banking system, the interbank market rate has recently increased. At the same time, the interbank market remains fragmented, largely due to high perceived counterparty risks.
A prudent monetary policy stance while maintaining exchange rate flexibility is warranted going forward. Although inflation is expected to remain within the target band, risks are tilted to the upside, including from higher-than-expected world food prices. Moreover, given that Romania has a history of high inflation, anchoring inflation expectations remains a challenge. Exchange rate flexibility and retaining adequate international reserves buffers provide an important cushion against external shocks. The NBR should avoid excessive intervention in support of the leu, allowing for some further depreciation as long as inflation is expected to remain within the target band and bank balance sheets effects (stemming from the legacy of large foreign-currency bank loans to un-hedged borrowers) remain manageable. The monetary policy stance should be tightened if exchange rate pressures persist. To help reduce interbank market fragmentation, the NBR should enable banks to engage in collateralized interbank lending.
Further progress in structural reform is needed to prepare for eventual euro adoption. An overly ambitious timetable for adopting the euro can be costly as entry into the euro area removes the exchange rate as an important adjustment tool to respond to shocks to the economy or competitiveness pressures. Given the need to boost economic flexibility and productivity, in order to be better prepared for the rigors of monetary union with countries whose economic structure and response to shocks are different, the authorities should step up their efforts to implement structural reforms and improve public sector operations.
Ensuring the Resilience of the Banking System
The banking sector is exposed to domestic uncertainty and spillovers from the euro area. While overall bank capitalization remains strong, the liquidity situation has become more heterogeneous among banks and funding costs are increasing. Credit growth has slowed and nonperforming loans continue to rise, mainly due to the weak economic activity and the vulnerability of foreign-currency loans to un-hedged borrowers. Provisions almost fully cover non-performing loans but profitability is poor, mainly because of the need for higher provisioning, low interest-rate margins, and high overhead costs. Most of the banking system is owned by euro-area banks and deleveraging has been moderate and orderly thus far.
In light of the uncertain environment, it is important that the NBR continues its intensive bank supervision and further elaborates its crisis preparedness. The mission welcomes the pro-active and intrusive supervision practices in place. Any necessary measures should be taken to ensure that banks have sufficient capital and liquidity. It is equally important that the NBR, in coordination with other relevant authorities, stands ready to implement its crisis management framework and updates detailed contingency plans on an ongoing basis. The arrangements for activation of the acquired bank resolution powers, including the setting up of bridge banks, should be finalized soon.
Further action is needed to mitigate the rise in nonperforming loans. The mission welcomes the recent amendment to the fiscal code that ensures a neutral tax treatment of bank receivables sold to Romanian asset-recovery firms, in order to enable banks to improve their balance sheet management. Rigidities in insolvency and foreclosure procedures should be removed. In particular, the authorities should swiftly implement the forthcoming recommendations of the World Bank Report on Standards and Codes on insolvency and creditor rights. To maintain adequate provisioning of nonperforming loans, the NBR should continue to ensure that loan-loss provisioning and collateral valuations as well as the assessment of credit risk of restructured loans remain prudent and in line with good international practices.
Fostering Higher and Inclusive Growth
Decisive implementation of the structural reform agenda is crucial to accelerate convergence with other EU countries. The government has undertaken significant pension and labor market reforms as well as measures to improve the regulatory and pricing framework for the energy sector. However, important reform gaps remain and Romania has fallen behind other countries in terms of ease of doing business, perceptions of corruption, and global competitiveness, while the energy and transport sectors are still dominated by inefficient public enterprises. Making progress in these areas and further improving the functioning of the labor market is critical to fostering efficiency and investment in the Romanian economy, in order to achieve higher growth and job creation.
A stable and predictable business environment is prerequisite to attracting more investment. In order to provide potential investors a clear perspective on their future rights and obligations, ad hoc changes in the legislation should be avoided as much as possible. Thorough preparation of new laws through consultation with all stakeholders and impact analyses would help to stabilize the legal and regulatory framework, and avoid unintended consequences. Better access to impartial and timely justice is needed to guarantee that the law applies to all and to limit costly distortions. There also remains ample scope to improve the transparency of government operations, including in procurement. Reducing the turnover in key government agencies and basing their staffing exclusively on professional qualifications would allow building up experience and upgrading service provision.
Reform of the energy and transportation sectors is indispensable to help boost Romania’s long-term growth potential. The mission welcomes the price liberalization roadmaps for gas and electricity. Determined implementation of the realignment of gas and electricity end-user prices with costs is crucial to stimulate energy efficiency; unlock the large investments needed to expand domestic production and improve delivery systems; and increase government revenue available for spending on health care, education, and infrastructure. At the same time, targeted social assistance should be put in place to protect vulnerable households from the impact of the necessary price adjustments. Major efforts are also needed to reduce costs in the transportation sector and improve the efficiency of public investments in the rail and road network.
Public enterprise reform needs to be re-invigorated to remove an important obstacle to economic growth and viable job creation. Currently, many public enterprises are loss-making and thus a burden on the economy and the public purse. In order to improve their performance, it is important that the government decisively pushes ahead with its policy to improve governance, including by appointing professional management. To support a greater focus on value creation, line ministries should regularly publish comprehensive reports on the performance of the enterprises in their portfolios. The envisaged privatization of public enterprises needs to be speeded up, in order to attract capital to finance new investments and facilitate technology transfers, especially in the energy and transportation sectors. It is also important to make further progress in reducing the large stock of public-enterprise arrears.
Building on the recent reform of the labor market legislation, efforts should now turn to raising the employment rate. The new Labor Code has significantly improved the functioning of the labor market and the new Social Dialogue Law helps keeping wage increases in line with productivity. It is important to ensure that the new legislation is consistent with core ILO conventions, but efforts to undo the progress made should be firmly resisted. At the same time, labor force participation in Romania remains low and unemployment of younger and older workers is considerable. The mission welcomes the intention of the government to address these issues. Efforts to increase the employment rate could include measures to reduce the labor-tax wedge, strengthen incentives for workers to enter and remain in the labor force, encourage job search, and enhance job search assistance and training.
The IMF mission is grateful to the authorities and all its interlocutors for their hospitality and the constructive discussions.
1 An IMF staff team visited Romania from July 31 to August 14, 2012, for the evaluation of the economy as part of the regular consultations under Article IV of the Fund’s Articles of Agreement. This statement describes the preliminary staff findings.