INTERNATIONAL MONETARY FUND: Romania—2007 Article IV Consultation, Concluding Statement of the Mission
The original document was published on the National Bank of Romania official website: www.bnro.ro
March 7, 2007
Romania’s accession to the European Union was a significant milestone that
followed a period of important accomplishments. Output growth was strong, substantial
disinflation took place, and unemployment fell sharply. Starting from a low base, per capita
GDP measured in euro rose by 130 percent during 2000-06, the fastest among the 27 EU
countries. These achievements, which took place in a favorable external environment, reflect
sound macroeconomic management and advances in structural reforms.
The confluence of positive factors that led to the positive developments in 2006
cannot be counted on to continue. The external environment has been benign, but, as
witnessed in early-March in various prominent international markets, can quickly become
volatile and unpredictable.
Against this background, there is no room for policy complacency if Romania
wants to bridge the significant gap that still exists with EU living standards. The lasting
increases required in human and physical capital will be possible only if domestic savings
and investment increase. Although the private sector will take the lead in accelerating income
convergence, the public sector will need to provide the appropriate enabling policy setting.
The current unsettled external environment and increased risks due to the widening current
account deficit, place a higher premium on appropriate fiscal and monetary policies as an
insurance against sudden shifts in market sentiment. Moreover, postponing a policy response
to the emerging vulnerabilities would increase the need for a much more abrupt policy action
in the future. The authorities’ intention to adopt the euro by 2014 provides an added beacon
for confronting these challenges, accelerating structural reforms, and implementing policies
that lay the foundation for successful entry to the eurozone.
I. RECENT DEVELOPMENTS
Growth and inflation performance has been remarkable. Real GDP growth was
7.7 percent last year. Domestic demand grew strongly owing to a sharp increase in private
consumption and investment. CPI inflation was 4.9 percent y-o-y at end-2006, against the
NBR’s 5 percent central target. In addition to prudent monetary and fiscal (through
November 2006) policies, inflation performance benefited by slower-than-envisaged
administered-price increases, falling agricultural prices, and an appreciating currency.
However, the declining trend of core inflation has stalled.
Continued strength in credit growth, a widening current account deficit and
attendant increase in vulnerabilities raise concerns. From a low base, real domestic credit
is estimated to have grown by 66 percent in 2006—reflecting both strong leu- and foreigncurrency
denominated credit. The current account deficit widened to 10.3 percent of GDP,
compared with 8.7 percent in 2005, reflecting large excess demand pressures. FDI covered
91 percent of the current account deficit. Following the substantial real appreciation in 2005,
with slowing nominal appreciation and modest unit labor cost increases, the real effective
exchange rate appreciated moderately last year. Moreover, enterprise profitability in manufacturing appears to have improved on account of strong productivity gains that have
outpaced real wage growth.
Fiscal policy supported stabilization for most of last year, but a significant
procyclical fiscal loosening started recently. A sharp rise in government spending in
December led to an annual deficit of 1.7 percent of GDP compared with a surplus of
1.2 percent of annual GDP during January-November. Indeed, more than 40 percent of the
capital budget was spent in December alone. For the year, government expenditure rose by
20 percent in real terms. The government revised the budget four times, increasing the deficit
target from 0.5 percent of GDP to 2.5 percent.
Procyclical government wage policies exacerbated domestic-demand pressures.
The original wage allocation proved insufficient given average statutory wage increases of 9-
15 percent (in two rounds), employment increases, and increases in bonuses. Although the
authorities had committed to freeze vacant positions (except for EU-accession-related hiring)
to offset overruns, government employment increased by almost 30,000 (3? percent). Given
this increase in employment and the average statutory wage increases, the increase in the
government’s wage bill of 36 percent last year implies a sharp increase in other personnelrelated
spending, including bonuses—these developments raise significant concerns about
the transparency of the government wage policy. On a positive tone, the government
exercised prudence in the minimum wage (an increase of 6½ percent) and controlled the
SOEs’ wage bill.
The monetary authorities have focused on improving the credibility of their
inflation targeting (IT) regime, but upward pressure on the exchange rate has
prompted the NBR to reduce the policy interest rate recently. The NBR tightened
monetary conditions in 2006, by raising the official policy interest rate and the effective rate,
to a unified level of 8.75 percent. However, the strong nominal leu appreciation since
December has caused the authorities to limit the amount of excess liquidity absorbed at the
official policy rate, and was accompanied by a reduction in the policy rate to 8 percent on
February 9. The return of a gap between the effective interest rate and the official rate has
been interpreted by market participants as highlighting the NBR’s concern about the pace of
appreciation, in addition to its inflation objective.
Progress on structural reforms has been mixed. The privatization of Romania’s
largest bank (BCR) is commendable, but the privatization of CEC bank has been postponed.
Gas prices remain far below the opportunity costs and the domestic gas producer price is
only 47 percent of the international import price. Services provided by the public sector,
particularly education and health, remain subject to frequent complaints. Despite recent
amendments to the labor code, labor market rigidities remain. Finally, judicial reform has
progressed in line with Romania’s commitments toward the EU, although questions remain
about the effective implementation of recent changes in legislation.
II. MACROECONOMIC OUTLOOK AND POLICY RECOMMENDATIONS
Policy Mix and Outlook
Although short-term macroeconomic risks remain modest, sustaining strong
growth and minimizing vulnerabilities will be difficult on current policies. With the
economy already overheating, the fiscal loosening that began at end-2006 and the envisaged
fiscal and incomes policies this year will exacerbate demand pressures, and contribute to a
further widening of the current account deficit and inflationary pressures. The mission’s
baseline scenario for 2007 projects continued strong growth, a widening in the current
account deficit to 12 percent of GDP, and an inflation outcome outside the target band at
end-2007. Such an outcome, combined with a delay in strengthening macroeconomic
policies, increases the risk of a change in market sentiment and sudden capital outflows,
which would lead to pressures on the exchange rate. A slowdown in growth combined with a
possible depreciation would adversely affect the debt-servicing capacity of private-sector
borrowers, thus putting the banking system under strain. In any event, meeting the Maastricht
criteria will require a strengthening of policies and a delayed policy action would increase the
need for a much-more abrupt policy response in the future.
The current juncture, thus, calls for a clear and coherent set of policies to
minimize external and financial-system vulnerabilities, to retain positive foreign
investor sentiment and to maximize the benefits from EU accession. In a setting of strong
private sector expansion and large capital inflows, fiscal and incomes policies are key for
assuring macroeconomic stability. A tightening of policies will relieve some of the burden on
monetary policy to achieve further disinflation without relying as much on the exchange rate,
thus safeguarding the current margin of competitiveness. With appropriate policies in place,
staff sees a containment of the external current account deficit and meeting the NBR’s
inflation target. Convergence to EU living standards requires increased investment, including
efficient government spending, and a focus on employment creation. An increase in
investment, aided by EU transfers, will increase capital’s contribution to output growth,
while industry restructuring will help sustain strong productivity gains. A mixed or delayed
reform effort, on the other hand, would prevent the economy from taking full advantage of
the opportunities offered by EU accession and would dampen growth prospects.
Fiscal and Incomes Policies
The current fiscal plans are inconsistent with maintaining macroeconomic
stability. The approved budget targets a deficit of 2.8 percent of GDP, which represents a
significant expansion in the cyclically-adjusted deficit. In the mission’s view, budget revenue
projections are optimistic. This view is confirmed by revenue performance so far this year.
On the expenditure side, the wage allocation does not fully incorporate the impact of salary
increases agreed following the budget’s approval by parliament. The mission projects that, on
current policies, the underlying budget deficit is about 3.7 percent of GDP. The recognition
of additional claims related to the Property Fund and the possible use of resources from the
National Development Fund would add yet further to the deficit.
To support the macroeconomic objectives and relieve some of the pressure off
monetary policy, the mission strongly urges the authorities to tighten fiscal policy.
Although fiscal sustainability is not an immediate concern and may lead the authorities to
postpone difficult decisions, fiscal restraint is needed to quell excess demand. The mission
thus favors a withdrawal of fiscal stimulus by aiming for a general government deficit of
below 1 percent of GDP this year, and a smooth path for medium-term fiscal consolidation.
Recognizing the need for stability in the tax legislation, the scope for revenue measures this
year is limited, and therefore the majority of the adjustment will have to fall on the
expenditure side. In addition to the need to control the wage bill (see below), savings
compared to budget could be realized in spending on capital (on account of last December’s
sharp increase), goods and services, and transfers.
A strict public-sector wage policy is needed for maintaining low inflation. The
approved government wage increases of 14-19 percent on average in three rounds, the
minimum wage increase of 18 percent, and the easing in the monitoring of the SOEs’ wage
bill are all incompatible with the NBR’s inflation objective (unless sizeable appreciation
takes place and administered-price increases are delayed, which in the mission’s view would
be undesirable). To contain this year’s wage bill, the mission suggests reducing the envisaged
wage increases, imposing strict control on bonuses, and closely monitoring additional
hirings. A tightening of public sector wage policy will give a signal for prudent private-sector
settlements. To anchor inflation expectations in single digits, public sector wages should
increase once a year and be incorporated in the budget. Moreover, in the context of an
urgently-needed public sector reform, wages need to better reflect skill needs, otherwise a
ballooning wage bill will only undermine the aim of establishing a modern civil service and
the ability to absorb EU funds.
A permanent strengthening of revenue and expenditure reforms are key. The flat
tax has led to a lower tax burden and the mission urges the government to resist calls for
further tax reduction (except the social contributions tax) and distortionary exemptions
(e.g., a reduced VAT rate or exemption of reinvested profits). Romania’s revenue ratio is
considerably below levels in EU countries, and pressing spending needs clearly argue for
increasing revenue. Tax administration improvements could complement that strategy.
Much-needed structural expenditure reforms should be given priority; e.g., civil service,
health, education, pensions, and infrastructure.
Improved transparency, enhanced monitoring, and a credible medium-term
fiscal framework would strengthen the institutional setting of fiscal policy. It is
important to put in place mechanisms to ensure the efficient allocation of resources and
absorption of EU inflows. The experience of the central European accession countries
suggests that strong efforts are needed to improve the efficiency of absorbing EU funds.
Multiple revisions of the budget should be avoided, while public-spending management
needs to be improved to ensure a uniform spending pattern over the year. To strengthen the
budgetary process, a credible medium-term fiscal framework—which will fully incorporate
post-accession EU receipts and expenditure—is needed.
Monetary and Exchange Rate Policies
The NBR faces a challenging policy environment. Having recently joined the EU,
the NBR’s monetary policy guidelines call for entry into ERM II by 2012. This timetable is
both feasible and appropriate. However, such a timetable implies that the central bank has up
to six years under an inflation-targeting framework to bring nominal-convergence criteria
down to Maastricht levels, while simultaneously managing a real-convergence process in
which capital inflows, real incomes and international purchasing power are rising steadily. In
this context, the NBR faces a difficult dilemma—meeting its inflation goals through higher
interest rates may threaten to put further nominal appreciation pressure on the currency. In
the staff’s view, however, the only long-run solution is to lower nominal interest rates by
firmly anchoring inflationary expectations. This requires a solidly-credible IT framework.
The NBR needs to make clear that inflation, not the exchange rate, is its primary objective
and employ interest-rate policy effectively in support of its inflation goals.
The NBR should focus on inflation and reunify the headline and effective policy
interest rates as soon as possible. Under the current practice of partial sterilization, the
effective rate is about 6-7 percent, which represents a broadly neutral monetary stance. This
setting is too loose, given the current level of excess demand. The NBR should increase the
effective rate, bringing it in line with the headline policy rate of 8 percent. This would not
only reassert the signaling role of the official policy rate, but would also represent a moderate
tightening of monetary conditions in real terms. It should be stressed, however, that there are
significant upside risks to the inflationary outlook, and that if the authorities do not tighten
fiscal and incomes policies, an additional hike in interest rates would most likely be needed.
Credit developments are still a concern. Real convergence with other EU members
will naturally require an expanding financial sector. However, in terms of prudential risk,
overly-rapid credit growth can magnify existing distortions and raise medium-term
vulnerabilities, so the authorities are urged to maintain continued vigilance. Moreover, in the
view of the mission, the ongoing strength of credit demand parallels the continuing strength
of excess aggregate demand. On prudential and administrative measures, the mission
cautions that administrative measures are often less and less effective over time, and are
generally ill-suited to addressing a macroeconomic stabilization problem. In this context, the
NBR recently relaxed a number of administrative measures on lending (mainly on the retail
segment) in the context of EU membership; however, this will place a greater premium on
effective supervision. On the issue of reserve requirements, although levels in Romania are
significantly higher than those in other EU members, efforts to lower these requirements
should proceed cautiously over time. High reserve requirements do impose an added cost on
the domestic banking sector, and may contribute to disintermediation, but the authorities
should take care that lowered reserve levels not add to Romania’s current macroeconomic
Financial Sector and Capital Market Issues
Financial soundness indicators (FSIs) suggest that the banking sector is wellpositioned
to absorb adverse shocks, but the authorities nonetheless need to be alert to
medium-term vulnerabilities. Although competitive pressures are increasing, rates of return
on equity and capital adequacy ratios are still high, while non-performing loan (NPL) ratios
remain at moderate levels. NBR stress tests also suggest banking-system resilience to the
direct impact of interest rate and exchange rate movements, as well as to a slowdown in
growth. However, in the context of rapid credit growth, indirect exposures through loan
portfolios are much more difficult to assess, and need to be reflected in high capital ratios
and conservative provisioning practices. The mission notes that it has been some time since
the 2003 Financial Sector Assessment Program (FSAP), and that in the context of EU
membership, Romanian institutions are now operating in a significantly different
environment. In this light, the mission welcomes the authorities’ desire to have an FSAP
update this year.
Convergence to EU living standards will require further structural reforms.
First, the authorities need to announce publicly a schedule for increased domestic producer
gas prices in line with opportunity cost developments and their commitment to achieve
import parity, to allow time for economic agents to adjust. Second, strong efforts are needed
to improve efficiency of government spending, which should be supportive of private sector
economic activity. Third, increasing labor supply will require an ambitious strategy,
encompassing improving the education system, training opportunities, and enhancing the
flexibility of the labor market. Fourth, the mission urges the authorities to strengthen their
efforts to introduce the second pillar on January 1, 2008, while revisiting some of the
parameters of the first pillar. Fifth, the momentum on privatization needs to be maintained
with the privatization of companies in the energy sector and other smaller companies.
Finally, the mission advocates the forceful implementation of the government’s judicial
reform agenda, with the objective of strengthening public administration, reducing
corruption, and improving financial discipline and the business climate.
The authorities’ emphasis on real convergence prior to euro adoption
underscores the urgency of structural reforms. While we agree that the envisaged
timetable for euro adoption represents a pragmatic recognition of political economy
constraints, we also see a risk that it can lead to a more gradual implementation of policies
needed for convergence. We therefore recommend that a balanced approach in this area also
contains the right incentives for accelerated reform.
Termeni juridici, grupare tematica