October 15, 2003

I would like to convey to the management and staff of the Fund the appreciation of the Romanian authorities for their continuing support, frankness in discussion and constructive policy advice. The staff report presents a well balanced assessment of recent economic and policy developments.

Over the past two years, Romania has achieved considerable progress on macroeconomic stabilization and has made important steps forward in the area of structural reform. In the enterprise restructuring process during the period covered by the present SBA, the government implemented a program of layoffs totaling more than 57,000 employees, almost 50 percent more than required by the conditionality of the program. This reflects the determined implementation by the authorities.

All prior actions for the fourth review under the SBA and additional measures for correcting slippages on some structural areas were observed. Out of seven structural performance criteria, only that referring to the signing of the contract for the sale of 25 percent of the BCR capital to the EBRD and IFC by July 2003 was not observed, but it was subsequently converted to a prior action for the review and met. The quantitative performance criterion on the collection rate of the main thermo-power producer was missed; nevertheless a substantial improvement in the collection rate was achieved. This is a difficult area in Romania as well as in other transition economies, which my authorities are now addressing, inter alia, by providing larger amounts of heating support to vulnerable households.

Since the last review in April, macroeconomic developments have continued to be favorable and broadly in line with program targets. Two intermediate quantitative performance criteria on the NFA and NDA of the National Bank of Romania were not observed in June owing to a temporary reversal in capital inflows that created difficulties for monetary policy, but now they are back on track.

At the same time, Romania made further progress towards its goal of EU accession. The economic strategy should be seen in the context of the aim to assume the obligations of EU membership by 2007, as envisaged at the Copenhagen summit last December. In this respect, the negotiations on all chapters of the acquis communautaire have been opened, and 19 of them provisionally closed.

Despite the encouraging macroeconomic achievements, the Romanian authorities are fully aware that further structural reforms and a balanced development of domestic demand are of utmost importance. In the area of structural reform, the challenging agenda covers mainly enterprise restructuring, financial discipline and privatization in the energy sector. Therefore, the Romanian authorities wish to restate their determination to continue with implementation of the economic policies aimed at ensuring long-term sustainable growth.

Economic Developments

The Romanian economy grew at moderate rates in the first two quarters (4.4 and 4.2 percent as compared to the same period of last year, respectively). Recent data indicate that domestic demand also picked up, fueled by net real wages and credit to the private sector. Inflation declined faster than targeted, from 30 percent at end-2001 to 18 percent at end-2002, and 14 percent in August 2003.

Weaker external demand and exports and more brisk domestic demand resulted in a widening of the current account deficit by ¼ percent of GDP above projection. In response, the authorities developed and implemented corrective measures (presented in the SMEFP-3). Thus, fiscal adjustment, monetary tightening and strengthened control over wages in the public sector have helped to consolidate Romania’s fiscal sustainability and prevent further deterioration of the external account. As outlined in the current staff report and the 2003 Article IV staff report, the current account deficit is expected to range within sustainable limits.

After their stronger than anticipated increase in 2002, official reserves declined by 0.5 percent of GDP in the first half of 2003 owing to delays in disbursing some public and private loans. However, in July reserves resumed growth, reaching a comfortable level of about 3.7 months of prospective imports of goods and services as of end-August 2003. Total public and publicly guaranteed debt has remained under 27 percent of GDP, while domestic public debt was reduced to 6 percent of GDP at the end of 2002.

Access to the international market has been consolidated. After a temporary slowdown of their downward trajectory, following the issuance of euro 700 million eurobond this year, spreads continued to narrow to around 220 bps, Romania’s impressive macroeconomic performance has been recognized by the recent credit rating upgrade to BB by Standard &Poor’s, who also confirmed their positive outlook. Moreover, Romania’s success in macroeconomic stabilization and economic restructuring in the past few years led to the US’s recognition of the country as a functioning market economy.

Fiscal Policy

Fiscal consolidation has been at the center of Romania’s adjustment policies. With a deficit of 0.3 percent below the program target in the first semester of 2003, fiscal policy continued to support disinflation and current account sustainability. Despite weaker-than-projected revenues and substantial additional expenditure, the authorities decided in late-August to reprioritize on the expenditure side so as to reduce the general government deficit for the current year to 2.7 percent of GDP and thus protect Romania’s current account.

The authorities have been paying special attention to improving revenue performance. The new VAT and profit tax laws have limited the number of tax exemptions and tax incentives, thus creating room for higher budget revenues and better resource allocation. A comprehensive reform of the tax administration is under way. The authorities have already decided to transform the tax administration department under the Ministry of Finance into a semi-autonomous agency by January 1, 2004. During 2004, this agency will gradually integrate the audit, collection and enforcement of social security contributions. On the expenditure side, the authorities have made efforts to create more scope for capital expenditure, repayment of health institution arrears accumulated in 2002 and improvement of the social safety net.

Wage policy

To prevent the spillover effect from the minimum wage increase in January from disrupting macroeconomic stabilization or slowing down disinflation, the wage policy has been strengthened from the beginning of 2003. The 2003 budgets of the monitored SOEs were approved timely in December 2002. The authorities have notified monitored SOEs that the wage bills would have to be adjusted in case of outsourcing of employees, and imposed a partial hiring freeze. Thus, wage discipline has become more credible and the wage bill targets in Ql and Q2 were observed. However, wage dynamics in mid-2003 had made it necessary for the government to intervene with additional measures to secure the September and December wage bill targets. These measures are expected to generate wage bill savings in an amount sufficient to ensure compliance with the annual wage bill target. The authorities are aware that prudent policy will continue to be crucial for reducing SOE losses and containing domestic demand within sustainable limits and are determined to strengthen wage control measures developed under this SBA.

Monetary policy

As mentioned in the SMEFP-3, the NBR will continue to pursue gradual disinflation without putting external competitiveness at risk. The NBR considers this policy to remain appropriate for the near future, until conditions for introducing inflation targeting are strongly settled. Following this policy, the NBR has limited its interventions on the market during the first semester of 2003 when demand has been outstripping the increasing supply on the domestic foreign exchange market. Under the recently re-emerging excess supply on the foreign exchange market, to achieve the targeted international reserve accumulation, the NBR committed to sizable purchases in the remainder of 2003 and to adequate liquidity sterilization.

To moderate booming credit and to fight off second round effects form energy price increases, the NBR raised the policy interest rates twice by one percentage point each time, on August 6 and October 6. The Bank also expressed its willingness to raise rates further or take other appropriate measures should this prove necessary to ensure the inflation target. The Romanian central bank considers that high credit growth was inevitable and is desirable in the context of a degree of bank intermediation of only 11.9 percent¹ (as of 2002) and financial deepening of only 24.7 percent of GDP². However, the Bank considers that credit increase should be within sustainable limits and carefully watched. In addition to increased interest rates, the NBR advised banks to be more selective in choosing their clients, continued with on-site inspections to the most active lenders and with bank-by-bank stress assessments, as recommended by the FSAP mission. It also helps that the banking legislation is now at a high degree of alignment with international standards. The authorities consider Romania’s participation in FSAP, which started in March 2003, a useful experience, both with regard to the general assessment of the financial system, and with the opportunity to define areas of concern.

Structural reforms

Structural reforms remain a key challenge for Romania. Progress is being made as regards this area, but the authorities are fully aware that further effort is needed, in order to sustain macroeconomic stabilization gains and to ensure the fully functioning market, able to cope with EU pressures. Therefore, a decisive approach to strengthening financial discipline, private sector development and improvement of the business climate has been taken this year.

To improve financial discipline and to reduce losses in the energy sector, the authorities adjusted administered prices as of September 1 and continued to implement disconnections to the larger non-payers. The authorities are committed to implementing further measures to reform the pricing scheme in the gas sector to avoid having producer prices determined as a residual after import, distribution and storage costs. In line with their commitment to gradually adjust gas prices every quarter, they have decided to implement another adjustment of 4 percent in lei prices of gas on November 1, 2003. The schedule of future adjustments in gas prices aimed at reaching import parity in 2007 will be announced by end-2003. In the authorities’ view this is essential for new exploration, as recommended in a recent World Bank study, and for facilitating the privatization of Petrom, the largest oil company in Romania.

Notable progress has been made in privatizing companies under the Authority for Privatization. The agency implemented a program of layoffs for more than 22,000 employees, thus overperforming on the end-June structural PC. Moreover, the Agency signed contracts for the sale of seven large companies in the second quarter, compared with the structural benchmark of six. Steps for privatization of oil company Petrom are within the target, with the tender for expression of interest issued on August 26, after finalizing discussion with the World Bank on the privatization strategy. The sale contract for Petrom is expected to be signed before end-March 2004. However, privatization in the energy sector has been slow, with the ongoing negotiations for the privatization of the two electricity distribution companies clouded by uncertainties about future tariffs and the deadline for privatization of gas companies postponed by 6 months, to June 2004. The negotiations on the EBRD’s and the IFC’s participation in the largest bank BCR were successfully concluded on September 19 and approved by the government on September 25.

Given the importance for Romania and the broad and sustained policy efforts that have been made, the authorities look forward to the successful completion of this review and thus of the Program.