A. Rapid Growth and Growing Imbalances

6. As in many other CEE countries, Romania’s economy boomed in conjunction with its EU accession in 2007, but high growth rates were associated with the build-up of both external and internal imbalances. Large capital inflows stimulated domestic demand while labor constraints and fast rising public sector wages exacerbated wage inflation resulting in pressures on prices. The National Bank of Romania (NBR) adopted sharply tightened monetary policy to counteract price pressures, but inflation expectations remained high. Procyclical fiscal policy helped drive domestic demand to unsustainable levels (Figure 6).

7. The rapid development of the banking system came with increasing vulnerabilities to outside liquidity shocks and foreign exchange risks. Dominated by foreign banks, banking activity grew quickly. From 2003 until the crisis, private sector credit grew at an average annual rate of 50 percent. As credit expansion outpaced the growth rate of local deposits,¹ bank lending became increasingly dependent on external financing, much of which came from the parents of foreign-owned banks. The share of foreign currency lending also reached almost two-thirds of total credit. Hence, the banking sector became vulnerable to two major sources of risks: (i) liquidity risks if inflows from aboard dried up and (ii) foreign exchange risks through the banks’ exposure to the unhedged businesses and households. To contain credit growth rates, the National Bank of Romania (NBR) sharply increased reserve requirements on both RON and FX liabilities and tightened prudential regulations. However, direct lending from abroad also increased as firms sought to circumvent local market restrictions.

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Source: Romanian National Bank; Haver; Datastream.

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B. Recent Crisis and Policy Response

8. The global economic and financial crisis severely hit Romania in late 2008 and 2009. Capital inflows suddenly dried up amid the global financial crisis, Romanian exports began to plummet, and country risk indicators skyrocketed as markets perceived the country to be among the more vulnerable to the downturn. Real GDP plummeted² as domestic demand also contracted sharply, while balance of payments pressures drove a 15 percent depreciation of the leu against the Euro from October 2008 to early 2009, putting pressures on household, corporate and bank balance sheets (Figure 7). Although banks generally entered the crisis well capitalized, they faced rising non-performing loans (NPLs), a dried up interbank market liquidity and limited access to external sources of funds. The country’s large pre-crisis fiscal imbalance left it in a weak position to respond to these developments.

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Growth Rates, Output Gap and Current Account Deficit 1/

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

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9. Faced with deteriorating conditions, in early 2009 the authorities put together a comprehensive policy package supported by an IMF Stand-By Agreement (SBA) along with funds from the EU and other multilateral institutions. The program aimed at correcting fiscal and current account imbalances that built up before the crisis while avoiding excessive contraction. The policy instruments included (i) gradual fiscal consolidation accompanied by structural reforms to restore fiscal sustainability and boost market confidence, (ii) steps to further strengthen the resilience of the financial sector and to obtain commitments from foreign parent banks to maintain their Romanian subsidiaries capitalized and liquid³, and (iii) prudent monetary policy management to reduce inflation.

10. The program contributed to stabilizing the economy and alleviating financing pressures. Economic activity remained weak throughout 2009 (declining by 7.1 percent y-o-y), but exchange rate pressure eased, the country risk premium narrowed significantly, and financial sector stress eased. The sharp decline in domestic demand helped adjust the current account, while the multilateral support package and the commitment of international banks to maintain their exposures in Romania eased capital account pressures. Financial market stabilization (Figure 4) allowed the central bank to prudently ease monetary policy. The government was able to finance its fiscal deficit through disbursements from the EU and the Fund, together with improved access to the local and international bond markets as sovereign CDS spreads for Romania gradually returned to near pre-crisis levels.

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11. Romania’s external trade and current account deficit contracted sharply in 2009. The collapse in global trade and capital flows hit Romania’s economy hard. As a result of the sharp contraction in domestic demand that followed, imports fell by nearly 35 percent (y-o-y) during the first nine months of 2009, almost double the rate of decline of exports during the same period. Hence, the crisis contributed to a sharp external adjustment, with the current account deficit falling to 4½ percent of GDP in 2009 from a peak of 13½ percent in 2007. Such adjustment was one of the largest among new EU member states. Reflecting global trade patterns, Romania’s trade staged a recovery towards end-2009, with export growth again outpacing import growth.

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Source: Haver Analytics.1/ Series are seasonally adjusted. 3-month moving average of 12-month growth rate in percent.

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C. Outlook and Risks

12. The outlook for 2010 is challenging. Economic activity continued to decline in the first quarter of 2010 and, while staff projects a moderate recovery in the remainder of the year, growth is likely to be slightly negative for the year as a whole. Domestic demand will remain subdued for some time, as unemployment continues to rise and real wages adjust to the recession with a lag, while investment will pick up slowly given tight credit conditions and a low capacity utilization rate. The contribution of net exports is expected to remain positive in 2010, although less so than last year given the tepid recovery in Romania’s main trade partners and some revival in imports. While the banking sector has so far withstood the crisis well, banks face deteriorating asset quality and rising provisioning costs that are squeezing profits. NPLs increased sharply from 6.5 in December 2008 to 15.3 in December 2009 and are projected to reach about 20 percent at the end of the year.

13. Risks to the outlook are tilted towards the downside and uncertainty is particularly high. With domestic demand still weak, the expected recovery rests on hope of an upturn in demand in Western Europe. Financing constraints, banking sector vulnerabilities, skittish investors, as well as potential spillovers from regional developments and volatile international markets may slow down the incipient recovery. In particular, recent regional developments have generated renewed downward pressure on the exchange rate and have stalled the fall in CDS spreads experienced in Romania since the program was agreed in March 2009. Persistent uncertainties of this nature would adversely affect credit supply and the health of the banking system and could produce a double dip recession. On the upside, a potential reversal of the inventory cycle may prop up growth and the easing of monetary policy may begin to stimulate credit growth to fuel a rebound in consumption and investment.

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Romania: Real GDP Growth: Risks to the Forecast

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

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14. Beyond 2010, GDP should recover, with growth forecast to rise by around 3½ percent in 2011 and rising to the range of 4–4½ percent per year in 2012–15. Staff envisages some lasting effects of the crisis on potential output growth in the medium-term due to the lower capital stock and lasting effects on financial intermediation. Potential output growth is expected to average 3–3½ percent in the medium-term, well below the average growth rates experienced in 2003–2008 (Box 1).

15. The current account deficit is expected to stabilize at a sustainable level in the medium run, financed mainly by FDI inflows. Staff baseline projections are for the current account deficit to increase to about 5 percent of GDP in 2010, and stabilize at around that level over the medium term. This stabilization is projected on the basis of the expected economic recovery in Romania’s trading partners, sluggish recovery in domestic demand reflecting the real exchange rate depreciation that has taken place since mid-2008, as well as limited scope for private credit growth as banks continue to deleverage. FDI inflows are projected to amount to about 4½ percent of GDP over the medium term, and thus expected to finance most of the projected current account deficit. As a result, external debt is projected to decline gradually to about 45 percent of GDP in 2014, from 65 percent in 2009.

Box 1:

The Crisis Impact on Potential Growth

Historically, economic growth has been largely driven by investment. The accumulation of capital explains most of output increases up to the crisis year. During the latest strong-growth period, labor input also provided additional growth stimulus but the contribution of Total Factor Productivity (TFP) was slightly negative. In 2009, the contribution of capital fell substantially but remained positive. The strikingly negative contribution of total factor productivity appears to reflect the crisis situation, implying a severe reorganization of the economy. Near-term economic growth is expected to follow the same historical pattern with capital accumulation being the main source of growth.

Contribution to GDP Growth

Source: IMF staff estimates. Figures in italics refer to potential growth.

Contribution to GDP Growth

	Real GDP growth (%)	Growth contributions (pps.)
		Capital stock	Labor	TFP
Average 1993 – 99	0.6	2.3	-1.2	-0.5
Average 2000 – 04	5.5	2.5	-0.2	3.2
Average 2005 – 08	6.4	6.1	0.4	-0.3
2009	-7.1	2.9	-0.9	-9.5
Average 2010–15	2.9	3.4	-0.1	-0.4

Source: IMF staff estimates. Figures in italics refer to potential growth.

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Contribution to GDP Growth

	Real GDP growth (%)	Growth contributions (pps.)
		Capital stock	Labor	TFP
Average 1993 – 99	0.6	2.3	-1.2	-0.5
Average 2000 – 04	5.5	2.5	-0.2	3.2
Average 2005 – 08	6.4	6.1	0.4	-0.3
2009	-7.1	2.9	-0.9	-9.5
Average 2010–15	2.9	3.4	-0.1	-0.4

Source: IMF staff estimates. Figures in italics refer to potential growth.

The global crisis and the economic recession will take their toll on Romania’s growth capacity. The global economic crisis and the sudden stop in capital flow triggered not only the steep recession in 2009 but also a more permanent slowdown in potential output growth as the financial crisis affected investment and productivity.¹ In addition, a large part of the recent increase in unemployment could be transferred into higher structural unemployment, as a result of hysteresis effects. All these factors are likely to have a lasting negative long-term impact on potential output. Potential growth is estimated at around 3% until 2015, down compared with 4 to 5% in recent years.² Projections also indicate that the output gap could close around 2015.

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Potential Growth and Output Gap Estimates

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

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1/

Reduced financing will affect capital accumulation through lower investment rates, and total factor productivity through the credit crunch and lower investment in research and development (R&D).

2/

Results are quite similar using a Hodrick-Prescott filter or a production function approach.

A. Performance Under the Program

16. Most first quarter program targets were met, but mounting expenditure pressures and weaker-than-expected revenue collection caused fiscal targets to be missed and jeopardize compliance with end-of year 2010 targets. The government missed the end-March fiscal deficit target by a small margin, and once again missed the target on domestic payments arrears (for which they request waivers). Revenues fell far short of programmed levels, forcing the authorities to slash discretionary outlays in March in an attempt to reach the target. All other quantitative performance criteria were met by ample margins, as were the indicative targets on general government current expenditure and operating losses of SOEs (LOI ¶2).

17. All structural benchmarks for the review have been met (Table 2). On the financial side, banking legislation was modified to increase the authority of the special administrator to implement promptly a broad range of measures in bank resolution, including purchase and assumption, sales of assets, and transfer of deposits while taking into account the provisions of EU company law. The NBR’s decision-making power with respect to the proceedings to deal with an insolvent credit institution was strengthened and the Deposit Guarantee Fund claims were provided with the same seniority as claims of depositors. On the fiscal side, the Fiscal Responsibility Law was approved by Parliament, legislation on SOEs to improve their accountability has been enacted, and the first stage of the tax administration reforms has also been approved.

B. Fiscal Consolidation

18. The first quarter fiscal performance was disappointing. Cumulative tax receipts in the first quarter of 2010 were not only lower than anticipated (by 0.4 percent of GDP), but also lower compared to the same period in 2009. The revenue shortfall, stemming mainly from lower VAT revenues and social security contributions, was partly due to weaker-than-expected economic activity and still rising unemployment, but also to lower yields as tax evasion, especially in excises, appears to have increased substantially. While cash expenditures were held to well below program in an attempt to meet the Q1 target, underlying expenditure pressures accumulated. Pension and other social outlays were significantly higher than anticipated, and promised cuts in goods and services spending did not materialize, due in part to significant overruns in the health care system. The increase in arrears also reflected accumulated expenditure pressure, despite the authorities’ commitment to remedial measures.

19. Reaching the original end-year targets proved unrealistic. The downward revision in economic conditions, falling revenue yields, and the sharply higher projected expenditures in goods and services, pensions and social transfer payments, combined to move the program’s deficit target of 5.9 percent of GDP well out of reach. In the absence of compensatory measures, staff estimated the deficit would have climbed to 9.1 percent of GDP. Of this deterioration, roughly 0.8 percent of GDP is due to lower economic growth and a statistical revision in the size of GDP, 1.3 percent of GDP is due to expected expenditure overruns (including paying down arrears), and 1 percent of GDP due to falling revenue yields. Staff and the authorities agreed to adjust the target to 6.8 percent of GDP to accommodate for the cyclical deterioration of the economy and the statistical revision of GDP without endangering the medium term credibility of the consolidation path.

20. Attaining even the adjusted deficit target required measures totaling 2.3 percent of GDP in 2010. Staff and the authorities discussed a number of different possible revenue and expenditure packages to close the gap, with staff advocating a greater reliance on revenue measures. However, the authorities opted for a package focused almost entirely on radical expenditure cuts to meet the revised program target. Their adjustment measures consist of expenditure cuts of roughly 2 percent of GDP, including a 25 percent cut in public sector wages and 15 percent reduction in pensions and transfer payments (LOI ¶7).⁴ Public staffing will continue to be streamlined. Moreover, structural reforms in the health system, pensions, education, and local government finance will generate further savings and assist in consolidation efforts going forward (LOI ¶12, 17–20). In addition, revenue-boosting measures of 0.3 percent of GDP will include widening the tax base, improving tax enforcement and introducing a turnover tax on medical suppliers (see text table). The authorities recognized that the heavy emphasis on expenditure cuts posed political and implementation risks. Political opposition could scuttle the measures in parliament, and likely court challenges could delay or derail implementation. For this reason, they agreed that enactment of the measures would be a prior action for conclusion of the review and committed to implementing revenue measures if their expenditure cuts are not applied or fall short (LOI ¶7).

Fiscal program

(in percent of GDP)

Fiscal program

(in percent of GDP)

		2010
Overall deficit - revised macroframework, no new measures		9.1
Overall deficit - revised program		6.8
Required adjustment effort, of which:		2.3
	Reduction in personnel spending (25% compensation cut)	1.0
	Reduction in social assistance (15% cut)	1.0
	Other cuts in spending (transfers, subsidies)	0.4
	Lost taxes due to wage and social transfers cuts	-0.3
	Broadening of the tax base	0.1
	Net lending repayment	0.2
	Turnover tax on medical distributors	0.0

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Fiscal program

(in percent of GDP)

		2010
Overall deficit - revised macroframework, no new measures		9.1
Overall deficit - revised program		6.8
Required adjustment effort, of which:		2.3
	Reduction in personnel spending (25% compensation cut)	1.0
	Reduction in social assistance (15% cut)	1.0
	Other cuts in spending (transfers, subsidies)	0.4
	Lost taxes due to wage and social transfers cuts	-0.3
	Broadening of the tax base	0.1
	Net lending repayment	0.2
	Turnover tax on medical distributors	0.0

21. The authorities took some steps to mitigate the impact on the most vulnerable. The minimum pension will remain unchanged and no pensions will be cut below that level. There will also be no reduction in the minimum wage and workers near that threshold will be protected from falling below it. To mitigate the social consequences of cutting social transfers, less efficient social assistance programs will be cut by more so as to allow for lesser reductions in better targeted programs. Social assistance programs will also be reformed to better target the poor and most vulnerable as agreed with the World Bank.

22. While substantial, the cuts in personnel compensation and social transfers mostly reverse recent increases. In 2005–2008, spending on public wages and pensions nearly doubled and public wage growth has outpaced growth in private wages (see figure below). A cut of 25 percent in personnel compensation would result in compensation falling to between 2007 and 2008 levels in nominal terms and the 2006 level in percent of GDP. A 15 percent cut in pensions would put pensions back at the 2008 level. In addition, many social assistance programs are poorly targeted and have witnessed large increases as well (about 10–40 percent growth in 2008–2009 for some large programs). The authorities argued that their expenditure-based consolidation program was superior to one including tax increases because it directly addressed the expenditure boom that generated the fiscal gap, notwithstanding distributional concerns about the adjustment falling mainly on public employees and recipients of social transfer payments. Staff broadly supported public wage cuts, but expressed the view that increases in broad-based taxes would spread out the adjustment burden on a wider group than the cuts in social spending. In addition, the mission suggested that reductions in public employment and a more targeted restructuring of the social benefits and health system would yield better results. The authorities agreed in principle, but noted that such reforms take time; meanwhile, they preferred spending cuts to tax increases. In the mission’s discussions with trade unions, union leaders generally recognized the need for significant fiscal adjustment, but stressed their preference for greater reliance on revenue measures (particularly progressive taxation) with more gradual expenditure reductions.

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Romania: Pension and Public Wage Developments, 2004-10

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

Source: Haver, National Forecasting Commission, and staff estimates.

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23. The authorities are struggling with the chronic problem of domestic arrears. The stock of arrears has increased since the beginning of the year mostly due to increases in the health sector and central government, which caused them to miss the program target yet again in March, 2010.⁵ Efforts to control arrears in late 2009 and early 2010 were swamped by falling revenues at all levels of government, leaving little cash to clear arrears while covering ongoing expenditures. The authorities indicated that they will take further steps to address the arrears issues both at the central and local government levels. First, at the general government level, more spending will be allocated in the budget this year to clear health arrears and a restructuring plan is underway to contain arrears growth in the future. Line ministries will monitor their subordinated units to observe commitment ceilings and sanctions for breaching limits will be enforced. Second, at the local government level, the government plans to use swap agreements to clear mutual debts between local authorities and public enterprises.⁶ Going forward, the amendments to the local public finance law (structural benchmark end-September 2010) will preclude the accumulation of overdue payments. In addition, the authorities plan to integrate the accounting reporting system with the Treasury payment system (structural benchmark for end-March 2011) to improve monitoring commitments and assist in budget management and control (LOI ¶10). The authorities have made progress in recent months in reducing arrears in VAT refund payments to exporters.

24. The authorities made progress on fiscal structural reforms. The Fiscal Responsibility Law was approved by parliament (end-March structural benchmark). Legislation to improve the accountability of SOEs has been approved in early 2010, significantly ahead of the end-June structural benchmark. The authorities are committed to refining the Unified Wage Law (UWL) approved in 2009. They indicated that work on the implementing legislation on the UWL is progressing and that they expect to be able to meet the September program target. To further reduce pressures on the wage bill, the government has committed to reducing personnel by another 70,000 by January 2011 on top of a reduction of roughly 30,000 since late 2009; has already restructured about 100 state agencies; and a functional review of major ministries is being carried out by the World Bank. Sustained efforts to improve revenue collection and streamline tax administration operations are being continued with support of the IMF technical assistance missions in 2009-10, and the first stage of these reforms, focused on noncompliance and increasing control of largest taxpayers, has been approved as part of the end-April structural benchmark (LOI ¶13). Further reforms in tax administration will focus improving methodologies to identify and audit unreported income, especially of high-income individual taxpayers (proposed structural benchmark for end-November 2010; LOI ¶13), and on combating other forms of tax evasion. Supported by IMF technical assistance in April 2010, the government is also preparing amendments to the Local Public Finance Law to mitigate potential fiscal risks from local governments; to allow additional time for improving the draft legislation, the associate structural benchmark is proposed to be moved from end-June to end-September, 2010 (LOI ¶11–17).

C. Price Developments and Monetary Policy

25. The widening output gap helped reduce core inflation but supply factors sustained headline inflation. Core inflation fell from a peak of 8.1 percent in mid-2008 to 2.1 percent in May 2010 due to weak demand and receding exchange rate pressures. The decline in headline inflation lagged, however, preventing the central bank from meeting its inflation target in 2009 for a third consecutive year. Factors boosting the headline rate included significant hikes in tobacco excises (which contributed about 2 percentage points out of 4.7 percent at end-2009), direct and indirect pass-through of the 15 percent leu depreciation early in 2009, as well as administrative price adjustments. These supply shocks accounted for the observed persistence in headline inflation over the past few years, and their second-round effect on core prices prevented a faster disinflation in response to weakening demand (see Figure 5 and Analytical Note 1).

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CPI INFLATION AND TARGET

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

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26. As inflationary and exchange rate pressures abated, the NBR was able to ease monetary policy in response to the crisis. Interest rates were cut by 400 basis points since February 2009 to 6.25 percent, reserve requirements were reduced significantly (in particular on foreign currency liabilities), and the NBR provided ample liquidity to the banking system, especially through repo operations. A more aggressive relaxation was hindered by the need to maintain inflation expectations in check given the persisting high headline inflation and by exchange rate concerns in early 2009.

27. There is room for further prudent monetary easing in the near future, provided subdued inflationary pressures and weak demand conditions persist (Figure 5). Inflation is projected to fall to about 3¾ percent by end-2010, close to the middle of the authorities’ range of 3½ percent ±1 percentage points, as the impact of the supply shocks largely dissipates. Risks to the inflation outlook are broadly balanced: cyclical factors should continue to put downward pressure on inflation, while domestic food prices will reverse their negative contribution to inflation, with further upward risks from continued increases in world energy prices and adjustments in regulated prices. Potential pressures from regional economic uncertainties and unsettled financial markets also argue for a measured approach to further easing.

Box 3.

Inflation in Romania: How Persistent?

Headline inflation in Romania has remained high relative to its EU peers over the past two years, despite the collapse in demand during 2008-09, raising the question of why it has been so persistent. In part, the high inflation can be attributed to supply shocks. During 2009, Romania’s adjustment in tobacco excise duties to EU requirements has been among the largest in the region and added some 2 percentage points (of the 4.7 percent) to the headline inflation at end-2009. The exchange rate depreciation (~15 percent), has also been among the largest in the region, further fuelling inflation. However, core inflation has also remained high relative to the peers and started to decline only in late 2009. Has inflation in Romania been intrinsically persistent, or do supply factors account fully for the high inflation in recent years?

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ALCOHOL AND TOBACCO INFLATION

(yoy percent change, December 2009)

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

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Standard measures of inflation persistence—such as the sum of autocorrelation coefficients in univariate autoregressive models—show that headline and core inflation in Romania are not more persistent in the long run than their regional peers and that inflation inertia has decreased significantly after the introduction of inflation targeting regime (see Analytical Note 1).

However, it does appear that headline inflation is relatively sticky. For example, the half-life of a shock to headline inflation in Romania—i.e. the number of periods it takes for a shock to dissipate to below half of its original magnitude—is 15 months in Romania, compared to 10⅓ months in other inflation targeters and 5.2 months in countries with fixed exchange rate regimes (chart). This suggests that the main source of the persistence in headline inflation lies in the sluggishness of “noncore” items such as tobacco and food. Indeed, inflation in these subindices of the CPI has been among the most persistent. It also suggests that while monetary policy focus on core inflation is appropriate, it should not fully accommodate supply shocks (such as food or tobacco inflation) because of their second round effects on underlying inflation. The findings imply a favorable outlook for meeting the inflation targets going forward, as the direct and second-round effects of the 2009–10 supply shocks have largely dissipated. The main upward risks are continued increases in world oil prices and administrative adjustments in domestic gas and drug prices, which will also have strong second round effects on core inflation.

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HALFLIFE OF SHOCKS TO HEADLINE INFLATION ^1/

(in months)

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

^1/ Based on VAR (2) model estimated for 2003-2010, with world commodity prices, exchange rate, output gap, wages, headline inflation and interest rates

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D. Financial Sector Challenges

28. The deep contraction in economic activity during 2009 is taking a toll on the banking sector. Non-performing loans continued to increase and rising provisions compressed banks’ profits while lending to the private sector continued to contract. The rate of increase in impairments for consumer loans slowed, suggesting NPLs in this category may have peaked. However the system is still experiencing a rapid deterioration of loan portfolio quality in the small and medium enterprise and corporate sectors as bankruptcies are rising.

29. Banks’ capital levels continue to remain adequate as the NBR has proactively requested capital increases in a number of banks and shareholders have applied a conservative earning retention policy. At the aggregate system level, the average capital adequacy ratio in the system rose to 14.03 percent at end-2009, against 13.77 percent at the end of 2008. At the level of individual banks, all banks have a capital ratio above 10 percent⁷. Moreover, while the capital ratios of some small banks did come under pressures, recent stress tests by the NBR showed that the current ratios are sufficient to withstand the expected deterioration in loan portfolios throughout 2010. In addition, for banks experiencing rapidly deteriorating asset quality, owners are expected to provide further resources in the course of the year.

30. The parents of the largest foreign owned banks have largely complied with their commitment of maintaining their exposure to Romania. While there are fluctuations, as a group the nine banks have broadly maintained their exposures to Romania in the 12 months to March 2010. However, as market conditions have stabilized, representatives from some banks favor a gradual easing in the exposure limits that would be consistent with internal risk-management models and credit developments while continuing to provide capital buffers to ensure strong solvency and support confidence.

31. The authorities have been preparing for the possibility of spillovers from market volatility. Existing regulations require banks to have in place contingency plans as well as plans for alternative financing. The supervision department of the NBR has been reviewing such plans and ensuring they encompass credible assumptions. NBR has also been strengthening its liquidity operations framework. It has enhanced its liquidity monitoring including through the reporting of assets and liability’s maturity breakdown by currency and has reviewed emergency lending arrangements, which are available to all banks, foreign- and domestic-owned. In addition, the NBR has taken steps to broaden the range of acceptable collateral for refinancing operations at the central bank. As other European central banks, the NBR has made contingency plans to address episodes of financial distress.

32. The authorities have been keeping close watch on the developments in Greece. They are aware of the possibility of liquidity pressures and have intensified liquidity monitoring of all banks in the system. Although some pressures have appeared, evidenced in particular by increased deposit rates, the liquidity position of the subsidiaries of Greek banks remains in line with that of the rest of the system. As for capitalization, the average capital ratio for the subsidiaries of the Greek banks’ is higher than the average of the banking system. In effect, Greek parent banks have proactively increased capital resources, while the ratio of NPLs to total loans is also lower than average. Subsidiaries of Greek banks in Romania constitute roughly 20 percent of system assets.

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Source: NBR and IMF Staff estimates

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33. To further support confidence, authorities are strengthening the Deposit Guarantee Fund. The NBR will draft amendments to the legal framework of the Deposit Guarantee Fund that will: (i) improve its governance to assure that no official of a credit institution sits on its board; and (ii) improve the funding regime with a view to enhancing confidence in the system by increasing both the actual and targeted coverage ratio and by eliminating contingent credit lines by banks (structural benchmark for end-September 2010; LOI ¶24). The process will begin with an increase in banks’ ex ante contribution rates.

34. The NBR is striving to enhance the banking supervisory framework. Technical support from the Monetary and Capital Markets Department of the IMF has been requested to further strengthen the stress test methodology in different risk areas (LOI ¶22). The prudential framework is considered adequate to address the current challenges and no amendments are currently envisaged. Under the SBA arrangement, the authorities agreed to consult Fund and European Commission staff prior to the introduction of new or revised key prudential regulations. Formally raising the minimum level of the capital adequacy ratio from 8 percent to 10 percent remains a medium-term objective (LOI ¶25) while the authorities remain committed to adopting the International Financial Reporting Standards (IFRS).

A. Medium-Term Fiscal Consolidation

35. Optimizing fiscal policy in the medium term should aim at creating conditions for stability and growth via low deficits and controls on current spending that free up resources for investment. Although Romania’s public debt level has risen only to about 30 percent of GDP at the end of 2009, high levels of deficit in future would preclude euro area accession and risk incurring higher interest costs and adversely affecting the private sector. While considerable effort has been expended in 2009–2010 to reverse the unsustainable pre-crisis fiscal policies, additional medium-term fiscal consolidation is required to avoid a return to pre-crisis overheating and external imbalances and to deal with the future spending pressures of an aging population. In addition, creating fiscal space through consolidation and reorganizing expenditures towards capital spending will help boost growth through better infrastructure and less waste of public resources. Structural reforms will help realign the public sectors’ spending obligations with its resources while improving its efficiency. Key elements in the medium-term fiscal adjustment strategy should include:

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Fiscal Balance of the Public Pension Scheme

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

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• Pension reform. The authorities should follow-through with planned reforms in pensions, including the pension reform law currently in parliament and the move to build up the pillar two private pension system. The proposed reform will in the long run save several percent of GDP per year, bringing the public system nearer to breakeven status.

• Reforms to permanently rein in the wage bill. While the authorities’ 25 percent cut in wages in 2010 will generate a major improvement in the fiscal balance, it is not a substitute for a comprehensive restructuring of public employment and pay. The already adopted unified wage law aims not only at reversing the exponential growth of the wage bill, but also to improve the simplicity, transparency, and fairness of public compensation. Approval of follow-up legislation to implement a new system will be crucial for medium-term fiscal sustainability. The increase in public employment of some 250,000 during the pre-crisis period should also be reversed over time.

• Reforms of social spending. Much of the spending pressure affecting the fiscal accounts in 2010 stems from poorly targeted and inefficient social spending, including poverty assistance, the health care system, and education. The authorities need to press ahead with their plans on reforming social assistance programs, streamlining the number of programs and improving the targeting and incentives in the remaining ones. Efforts already beginning to improve the efficiency and outcomes of the health and education systems should continue.

B. Better Infrastructure

36. Poor quality of infrastructure is one of the impediments to Romania’s competitiveness and long-run growth. Poor infrastructure is in part a result of limited fiscal space for undertaking large scale capital projects; lack of an adequate framework for capital budgeting to evaluate, prioritize and monitor public infrastructure projects, which leads to inefficiency and waste in public investment spending; significant state involvement in the energy and transportation sector; and an underdeveloped market for long-term financing which precludes private sector involvement in capital projects.

37. Improvements in infrastructure will be key to boosting Romania’s long-term growth, both through its direct impact on the capital stock and through its competitiveness-enhancing effects. This could be achieved in a number of ways:

• Creating fiscal space. Fiscal consolidation is already underway, and its focus on reductions in current spending will have to be sustained over the medium-term in order to create additional fiscal space for infrastructure investment. At the same time, large EU grants for capital projects are already available to Romania and priority should be given to increasing their absorption by: (i) enhancing technical capacity to develop qualifying proposals; (ii) strengthening submission requirements for domestically funded capital projects; and (iii) improving procurement procedures to prevent challenges in courts that stall projects.

• Using existing fiscal space efficiently through improved capital budgeting. The recently approved Fiscal Responsibility Legislation should help improve the capital budget process through focus on multiyear budgeting, but additional reforms will be needed to: (i) improve the prioritization of projects; (ii) review the existing portfolio of projects and rationalize it to focus on priority projects, with others deferred or discontinued; (iii) ensure adequate funding for priority projects; (iv) setting a database of proposed and approved capital projects ranked by economic and financial return; (v) strengthen the project appraisal and review process through the establishment of independent review teams; and (vi) improve the transparency of capital budget project selection and performance by publishing regular updates on MOF website.

• Reducing state presence in electricity and transportation sectors. Divesting state holdings in these sectors will not only reduce support to loss-making state enterprises, but will also improve efficiency by attracting private capital. The authorities have indicated their intention to reactivate the privatization program, especially in industry, energy, and transport. The government intends to wind-up the energy firm Termoelectrica, privatize the cargo rail firm, complete the privatization of additional firms via the privatization agency AVAS. The Ministry of Economy will also initiate the sale of minority stakes in several firms under its control. It envisages phasing out subsidies for coal mining by the end of this year and developing an exit strategy to be achieved within the next 5 years.

Romania needs to boost the absorption of EU funds

Romania needs to boost the absorption of EU funds

in € million	EU commitments (2007-2009)	Automatic payments by the Commission	Payments based on claims subject to Commission approval claims subject	Interim payments in % of commitments
Regional development Fund	2,616.01	807.88	93.10	3.56
Social Fund	1,084.86	331.57	0.34	0.03
Cohesion Fund (energy and transport)	1,941.87	668.00	0.73	0.04
Agriculture and rural developement Fund	2,589.56	561.58	315.22	12.17
Fishery Fund	67.44	37.29	0.00	0.00
All structural Funds	8,299.73	2,406.32	409.38	4.93

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Romania needs to boost the absorption of EU funds

in € million	EU commitments (2007-2009)	Automatic payments by the Commission	Payments based on claims subject to Commission approval claims subject	Interim payments in % of commitments
Regional development Fund	2,616.01	807.88	93.10	3.56
Social Fund	1,084.86	331.57	0.34	0.03
Cohesion Fund (energy and transport)	1,941.87	668.00	0.73	0.04
Agriculture and rural developement Fund	2,589.56	561.58	315.22	12.17
Fishery Fund	67.44	37.29	0.00	0.00
All structural Funds	8,299.73	2,406.32	409.38	4.93

C. Competitiveness Issues

38. Boosting competitiveness requires bringing inflation down and ensuring that wages are set consistently with productivity growth. Staff analysis shows a recent improvement in REER indicators. The results of three standard quantitative methods show a sharp reduction in REER overvaluation from the 2007 peak and, on balance, suggest only a modest, but manageable, overvaluation of the currency. Both the equilibrium real exchange (ERER) and macroeconomic balance (MB) methods show a sharp reduction in REER overvaluation from the 2007 peak. And while these methods indicate medium-term overvaluation between 5½ and 13½ percent, such overvaluation is not statistically significant at standard levels of confidence. The external sustainability (ES) method also suggests a moderate overvaluation if Romania were to target an NFA level of -53 percent of GDP, determined on the basis of its openness level. Romania has made rapid gains in both EU and global export markets shares, mainly due to a rapid increase in non-textile manufacturing exports, and has also increased the share of medium-and high tech exports. However, Romania’s economy-wide unit labor costs (ULCs) have increased at a much faster pace than in other new EU member states and while wages in the manufacturing sector remain among the lowest in the region, so does hourly productivity (see Analytical Note 3).

Romania: Quantitative REER Assessment

^1/Not statistically significant at 10 percent level.

^2/Level of misalignment for bringing the NFA level to -53 percent of GDP.

Romania: Quantitative REER Assessment

Approach	Magnitude of Misalignment
Equilibrium Real Exchange Rate	Overvalued: 13½ percent 1/
Macroeconomic Balance	Overvalued: 5½ percent 1/
External Sustainability	Overvalued: 5¼ percent 2/
Overall assessment	Overvaluation: 5-15 percent

^1/Not statistically significant at 10 percent level.

^2/Level of misalignment for bringing the NFA level to -53 percent of GDP.

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Romania: Quantitative REER Assessment

Approach	Magnitude of Misalignment
Equilibrium Real Exchange Rate	Overvalued: 13½ percent 1/
Macroeconomic Balance	Overvalued: 5½ percent 1/
External Sustainability	Overvalued: 5¼ percent 2/
Overall assessment	Overvaluation: 5-15 percent

^1/Not statistically significant at 10 percent level.

^2/Level of misalignment for bringing the NFA level to -53 percent of GDP.

D. Structural Reforms

Business climate-essential for boosting investment

39. Improving Romania’s business climate would boost Romania’s growth potential. Romania lags behind other EU member States in terms of quality of business environment according to indicators on perceived corruption (Transparency International), ease of doing business (World Bank) or competitiveness (World Economic Forum). The EU’s latest report on Romania’s state of business climate notes mixed results while Romania slid down by ten positions on the World Bank’s ease of doing business ranking in the past year. In particular, Romania has room for improvement in tax simplification, contract enforcement and hiring. The chart below shows the impact in terms of business-friendliness of reforms that would bring Romania to the average level of the Euro area countries in areas such as labor market, tax administration, and contract enforcement.

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Ease of Paying taxes

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

Source: World Bank; IMF Staff estimates

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Impact of reforms on the business climate

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

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Labor market reform—improving hiring conditions and raising participation

40. Raising Romania low labor force participation and employment rate would boost both current welfare and longer-term growth. Romania has one of the lowest employment rates among EU countries. Lifting the Romanian employment rate (58.6 percent of the labor force) gradually to the average level in the EU (65.9 percent) while reforming the early retirement schemes would boost potential growth by about 0.6 percentage points, help with fiscal sustainability, and pension costs. Moreover, Romania’s labor market is rigid compared to other countries in the region (see chart). Labor reforms should include helping low-skilled workers enter the job market and promoting senior labor. The authorities highlighted that Romania’s draft pension reform includes changes in the incentives structure for early retirement. They also envisage modifying the labor code in order to increase working time flexibility and to reduce hiring and firing costs. Effective vocational training could also help senior and low skilled workers rejoin the labor market.

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Employing workers

Citation: IMF Staff Country Reports 2010, 227; 10.5089/9781455203468.002.A001

Source: World Bank; IMF Staff estimates

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Source: Eurostat and World Bank

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41. The authorities envisage a comprehensive education reform. After four years of negotiations, a commission including all parties, unions and NGOs has signed the national education pact. The corresponding new education law (vote in parliament expected for end June) addresses several key challenges including a nationwide standard wage for teachers, an increase in teaching hours per teacher, a nationwide system to allocate means according to the number of pupils while at the same time all other decisions will be decentralized, including the implementation of after school activities and establishing competence centers. Education reform should contribute to fiscal consolidation while improving the productivity of the future workforce through better training.

E. The Road to Euro: The Need for Reforms to Improve Flexibility

42. While Romania is officially committed to seeking entry into the Euro area in 2014–15, there is increasing recognition within the country that this timetable may be overly ambitious. Entry into the Euro area in 2014 would require (i) joining ERM2 in 2011– 12, which in turn would require the ability to sustain reasonable exchange rate stability, and (ii) adherence to the other Maastricht criteria. An overly ambitious timetable for adopting the euro could be costly as entry into the euro area takes away important adjustment tools. While adopting the euro eliminates exchange rate risks for foreign-currency denominated loans and can help anchor inflation, it also comes at the expense of limited flexibility in response to future shocks and the danger of loss of competitiveness if domestic adjustment capacity is insufficient.

43. Successful economic performance within the Euro area will depend upon the flexibility and productivity of the Romanian economy. After adopting the Euro, Romania will need to rely on internal adjustment mechanisms rather than on monetary and exchange rate policy to deal with asymmetric shocks. Romania’s trade is Euro-oriented but the structure of the economy is different and shocks are not fully synchronized with the EU (see Analytical Note 5). If business cycles are not synchronized, the higher potential costs of joining the monetary union need to be mitigated by other adjustment mechanisms which are as yet underdeveloped. Specifically, the loss of the monetary policy tool needs to be mitigated by flexible wages and prices, financial integration and a counter-cyclical fiscal policy which is effective in stabilizing the economy. The newly adopted fiscal responsibility law is a step forward as it will help anchor the deficit target in a medium-term framework incorporating expenditure ceilings but more needs to be done to boost productivity and flexibility.