IMF Executive Board Concludes 2006 Article IV Consultation with Romania

Public Information Notice (PIN) No. 06/49
May 4, 2006

On April 26, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Romania.¹

Background

Romania has registered substantial accomplishments since 2000. Macroeconomic conditions improved owing to fiscal adjustment, the enhanced financial performance of state-owned enterprises, and privatization. The National Bank of Romania (NBR) achieved substantial disinflation while slowing the rate of depreciation of the exchange rate. This stabilization, and improved prospects for EU accession, have created a positive supply response.

Macroeconomic results were not as strong in 2005 compared with 2004 on account of both internal and external factors. Growth slowed to 4.1 percent in 2005, with agricultural output falling as a result of floods and industrial output growth slowing due in part to the abolition of global textile quotas. Domestic demand, on the other hand, grew strongly reflecting a sharp increase in private consumption—supported by significantly lower direct taxes, higher wages, and faster credit growth. The credit expansion has contributed to a widening in the current account deficit to 8.7 percent of GDP in 2005, and also led to inflationary pressures. As a result, and despite the significant appreciation of the leu, disinflation slowed considerably: CPI inflation was 8.4 percent year-on-year in March 2006.

Fiscal consolidation continued last year: the general government deficit declined to 0.8 percent of GDP in 2005 from 1 percent of GDP in 2004. However, some procyclical fiscal policies exacerbated domestic demand. The introduction of the 16-percent flat tax on personal income and profits led to a loss in collections of about 1 percent of GDP. This loss was offset by higher-than-budgeted indirect tax collections due to strong demand for goods and services, thus keeping the revenue-to-GDP ratio broadly constant. On the expenditure side, there were large overruns in the wage bill as a result of substantial increases in public sector wages (16-34 percent compared with the 2004 average), and significant cuts in capital expenditure (compared to the budget). Moreover, the recalculation of pensions for those retired before 2001 also increased government spending. Finally, there was a significant relaxation of fiscal policy in December 2005, as the government cleared arrears, paid for flood-related repairs and other goods and services, and injected capital into Exim Bank.

Having brought inflation down into single digits, the NBR succeeded in maintaining inflation on its downward trend in 2005 even though it slightly missed its inflation target for 2005. In a major regime change, the NBR announced its shift to inflation targeting in August 2005. However, facing sustained upward pressure on the exchange rate, it reduced its sterilization efforts in September 2005—by not absorbing the full amount of excess liquidity in the banking system, and so driving its effective interest rate (the average rate at which it accepts bank deposits) significantly below its policy rate. The drop in the effective rate was largely successful in arresting short-term pressure on the exchange rate, but represented a significant procyclical easing of policy. Since November 2005, the NBR has not intervened in the foreign exchange market, and has taken steps to gradually increase the volume of sterilization. In February 2006, the NBR redoubled its disinflation efforts by increasing its policy rate from 7.5 to 8.5 percent, and by stepping up sterilization operations to bring the effective rate in line with the policy rate. This has generated renewed pressure on the currency, which appreciated by about 4¼ percent against the euro from end-2005 to end-March 2006.

Mixed progress has been made on structural reforms. Large-scale privatization has been successful (including Romania's largest bank (BCR)), the liberalization of the electricity and gas markets has continued, the national reference price for heating has increased, and significant progress has been made in the implementation of the mining strategy. However, gas prices have not been adjusted in line with opportunity costs, and the domestic producer price is only 38 percent of the international import price. The Labor Code has been revised with the objective of increasing labor market flexibility, although a number of important rigidities remain. Finally, judicial reform has progressed, including the recent establishment of the National Anticorruption Prosecutor's Office.

Executive Board Assessment

Executive Directors commended the Romanian authorities on their economic policy achievements since 2000, including continued fiscal consolidation, disinflation, enhanced financial performance of state-owned enterprises, and privatization. These accomplishments, which resulted in a substantial improvement in macroeconomic conditions, pave the way for eventual accession into the EU.

Directors stressed that Romania faces important issues. Although convergence towards the EU continues and confidence in the country's medium-term prospects remains high, slowing disinflation and a widening current account deficit pose challenges. Directors urged the authorities to adopt policies to address these developments, and to ensure an environment that supports the growth-enhancing use of large capital inflows. While external and public debt levels are low, and reserve coverage is comfortable, reducing the external imbalance will be crucial for removing Romania's external vulnerability.

Directors, while acknowledging that fiscal sustainability is not of immediate import, expressed concern about the government's recent decision to increase the 2006 deficit target. They emphasized that fiscal consolidation will be essential to containing domestic demand, making room for capital inflows, and ensuring sustainability over the medium term. Directors also noted that Romania needs a coherent plan for absorbing prospective large inflows to the public accounts from EU funds and for saving privatization proceeds, so as not to generate excess demand pressures. They looked forward to the finalization of a medium-term budgetary framework, and urged the authorities to put in place mechanisms to ensure the efficient allocation of resources and a high absorption rate for EU inflows.

Directors observed that Romania's government revenue ratio is considerably below levels in the EU. In light of this, they regretted the sizeable revenue loss resulting from the introduction of the flat tax. Directors also noted the need for additional resources to cover Romania's contribution to the EU budget, to co-finance EU projects, and to accommodate a boost in infrastructure spending. High social contribution taxes remain an impediment to employment, and cuts in labor taxation will have to be offset by other taxes. In this connection, Directors urged the authorities to take revenue-raising measures that will strengthen revenue permanently, broaden the tax base, modernize fiscal administration, and make room for the needed higher expenditures.

Directors stressed the importance of a prudent public sector wage policy for macroeconomic stability. They urged the authorities to recalibrate their policy to the needs of a low inflation economy. They welcomed the authorities' intentions in this regard, including to restrict wage increases to only once a year. The government's recent decision to freeze all vacant positions in the general government (with the exception of EU accession-related hiring) is commendable. Vigilance will be necessary to avoid wage overruns. Directors welcomed the authorities' prudent decisions regarding the minimum wage and the wage bill of public enterprises.

Directors urged the authorities to continue strengthening the central bank's inflation-targeting credentials. They noted the difficult environment in which it is operating, given pronounced capital inflows, non-supportive wage policies, and administered price increases. In this context, Directors welcomed the recent tightening of monetary policy, and viewed that further tightening might be necessary, in light of the envisaged fiscal loosening and higher excise rates. They noted that, while the exchange rate remains competitive, Romania's margin of competitiveness has eroded, and viewed that productivity gains and prudent wage policies will be needed to offset the impact of a strong currency. Moreover, interventions in the foreign exchange market should be fully sterilized and focused on reducing excess volatility in the foreign exchange market, rather than on controlling the longer-term trend.

Directors noted that financial soundness indicators suggest a relatively healthy and robust financial system, and that stress tests indicate that the banking system would be resilient to the direct impact of interest rate and exchange rate movements. Nevertheless, with bank credit to the private sector escalating, much of it in foreign currency and to unhedged households, Directors stressed that medium-term vulnerabilities will need to be monitored closely. They welcomed the implementation of recommendations contained in the 2003 FSAP and commended the authorities for the recent step to regulate nonbank financial institutions.

Directors noted that further ambitious structural reforms are needed to accelerate convergence to EU living standards while improving the business environment. They welcomed the recent progress on privatization and encouraged the authorities to maintain the momentum of the privatization of the Savings Bank, Romgaz, and other smaller companies. Directors also welcomed recent amendments to the Labor Code aimed at increasing labor market flexibility, but recommended further amendments to eliminate the imposition of collective wage contracts for non-signatory parties and to increase employers' representation. They urged improvements in the legal framework with a view to reduce corruption, improve financial discipline, strengthen exit mechanisms for bankrupt enterprises, and enforce creditor rights. Directors encouraged adjusting energy prices in line with opportunity costs.