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Romania and the IMF
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On January 8, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Romania.1
Until recently, Romania's macroeconomic performance was weak and characterized by boom and bust cycles, driven by loose fiscal policy and weak financial discipline in state-owned enterprises (SOEs). Since mid-2001, a combination of budget restraint, ambitious energy price adjustments and prudent monetary policy moderated domestic demand and reduced the current account deficit. At the same time, export and GDP growth were among the highest in the region, reflecting the fruits of private investments in export-oriented consumer goods industries over the last few years, and the gains in competitiveness from the 1999 adjustment in the real effective exchange rate. Rising productivity, complemented by moderate economy-wide wage growth, has preserved competitiveness despite the slowing rate of depreciation and allowed Romania to expand its share in its main export markets.
The far-reaching reform of the VAT and profit tax legislation in 2002, which eliminated many distortionary incentives, has contributed to improving the business climate. Moreover, the extremely high payroll taxes, which have contributed to the growth of the informal sector of the economy and narrowed the tax base, were reduced by 3 percentage points in 2002 and will be cut by another 5 percentage points in January 2003. Monetary policy contributed to disinflation by reducing the rate of crawl while keeping interest rates high. The soundness of the banking system has improved, but the recent very rapid expansion of credit to the private sector, which supported the pick-up in investment, is of concern owing to its potential implications for the quality of the credit portfolio of commercial banks.
The successful stabilization has reflected some progress in imposing hard-budget constraints on SOEs. However, wages in state-owned enterprises have continued to outpace those in private sector. An additional risk for disinflation has been created by the sharp minimum wage increase in January 2003. Collections of the largest utilities have improved only modestly, and natural gas prices remain much below import prices. The slow progress in privatization continues to hold back Romania's economy and, as a result, the private sector has one of the lowest shares in GDP among EU accession candidates. Privatization has in general been slowed by restrictions on labor retrenchment and investment requirements.
Directors commended the authorities for Romania's progress in addressing several long-standing economic weaknesses. Macroeconomic performance had been encouraging; the budget and the broader public sector deficits, especially in the energy sector, reduced; inflation brought down; and the external position strengthened substantially. The authorities' commitment to stabilization and reform had served to boost investor confidence and investment, and had contributed to the strong pick-up in growth over the past two years.
Directors noted that continued strong performance over the medium term would require a steadfast commitment to macroeconomic stabilization and accelerated structural reforms that would include a strengthening of the efficiency of SOEs, completion of privatization, and increased efforts to improve the business environment. It would be important not to revert to the stop-and-go policies of the 1990s. Directors encouraged the authorities to continue orienting monetary and fiscal policies toward macroeconomic stabilization, with focus on a further reduction of the still high inflation rate, and containing the current account deficit; and to address vigorously the problem of losses and quasi-fiscal activities of SOEs. These efforts would also be crucial for completing Romania's transition to a fully operational market economy and for paving the way for EU accession.
Directors strongly welcomed the recent reduction in Romania's extraordinarily high social security contribution rates and the recent reforms in the area of VAT and profit taxation, which contributed to improving the business climate. They supported further cuts in the social security tax rates, but pointed to the need to broaden the tax base and improve tax administration in general. To make tax cuts affordable and avoid putting at risk the fiscal balance, Directors saw a need for the authorities to develop detailed medium-term expenditure plans. They noted that expenditures should be carefully prioritized to make room for accession-related spending on infrastructure and other investments. Most Directors recommended that the authorities aim at a somewhat tighter budget stance than envisaged in Romania's Pre-Accession Economic Program submitted to the EU in August 2002.
Directors noted that completing the task of stabilization would require rapid progress in eliminating the still substantial losses in the state-owned companies, particularly in the energy sector. While commending the ambitious increase in energy prices as a key step toward reducing losses in this sector, Directors considered that further progress in enforcing hard budget constraints would depend on stepping up the fight against the nonpayment of utility bills and tax arrears. They urged the authorities to accelerate the closure of nonviable enterprises, to implement further gradual increases in gas prices to import parity levels, and to ensure timely adjustments of electricity and heating prices in line with costs. Directors also stressed the importance of proceeding with privatization in the energy sector.
Directors welcomed the authorities' plan to offer for sale by end-2003 most of the state-owned companies outside of the energy sector. They noted with concern the government's intention to continue imposing conditions for preserving employment and committing buyers to large investments, a practice that has deterred investors and significantly contributed to the disappointingly low speed of privatization. Directors strongly encouraged the authorities to continue reducing employment in SOEs as a necessary condition for reducing losses and accelerating privatization. They noted that social hardship arising from restructuring should be addressed by further improvements in the social safety net and by stimulating private sector growth, notably by eliminating barriers for setting up small- and medium-size enterprises.
Directors emphasized that establishing wage discipline in the state-owned sector is critical to improving financial discipline and reducing losses. They were concerned about the continuously poor performance in this area, which had often undermined disinflation efforts in the past, and called for vigilance in efforts to prevent the sharp minimum wage increase scheduled for January 2003 from feeding through to the overall wage level. Moreover, they cautioned against further real increases in the minimum wage, which would adversely affect employment. Directors stressed that a convincing performance in this area and a full adherence to the related performance criteria on SOE wages, agreed under the Stand-By Arrangement, would be preconditions for completion of the delayed third review under the program.
Directors pointed out the importance of preserving flexible labor markets, which are seen as crucial to keeping the economy on a fast growth path and completing the far-reaching restructuring process in the Romanian economy. They urged the authorities to review, in close cooperation with the World Bank, provisions in the new labor code that could adversely affect this flexibility and impose a particularly heavy burden on small- and medium-size enterprises, and welcomed the fact that discussions had already begun.
Directors commended the authorities for progress in improving the business climate, but emphasized that further institutional reforms and a stepped-up fight against corruption, which they considered a key impediment, are needed for private investment to gain further strength. They strongly encouraged the authorities to complete the reform of the judiciary system with a view to improving its effectiveness and ensuring its independence, and to implement an efficient bankruptcy mechanism. Directors urged the authorities to continue with their efforts to liberalize foreign trade, with the medium-term goal of full harmonization with the EU, as well as to continue to reduce tariffs with non-EU partners.
Directors agreed that the current exchange rate regime, which, in the context of capital controls and lingering credibility issues, features a gradually declining targeted depreciation rate as a nominal anchor, had been one of the key factors for the recent success in reducing inflation while protecting external competitiveness. In the context of the persistent surplus in the foreign exchange market, several Directors saw some scope for a further gradual reduction in interest rates; several others, in light of the still high inflation rate, suggested erring on the side of caution and instead accepting some slowing in the rate of depreciation of the exchange rate. Directors noted that the current regime would remain appropriate until inflation had been brought down to single-digit levels and wage discipline in SOEs strengthened. They considered, however, that once these conditions had been met, inflation targeting would be a sustainable medium-term framework. Concomitantly, Directors encouraged the authorities to step up preparations for establishing the institutional, operational, and analytical prerequisites for its introduction, inter alia, by strengthening the National Bank of Romania's independence in line with Maastricht requirements.
Directors expressed concern about the recent rapid growth of bank credit, in particular in foreign currencies, which indicated that commercial banks might be overstretching their credit portfolio at the expense of a prudent assessment of borrowers' creditworthiness. They welcomed the authorities' measures to strengthen banking supervision and their intention to strictly enforce the new regulation on classification and provisioning with a view to ensuring that credit growth remained sound. While the overall exposure of the private sector to foreign currency risk was low, Directors recommended that additional measures be considered should the brisk pace of the growth in foreign currency loans continue. Directors supported the authorities' request to participate in the Financial Sector Assessment Program exercise.
Directors encouraged the authorities to make rapid progress in preparation for subscribing to the Special Data Dissemination Standard.
Directors commended the authorities for the passage of anti-money laundering legislation and for their actions to prevent the funding of terrorist activities.
1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.
IMF EXTERNAL RELATIONS DEPARTMENT