The main objectives of the Romanian reform program fall into three broad categories: introducing market forces into the economy, notably by liberalizing prices, trade and the exchange system, and interest rates, and allowing these forces to guide economic decision making; transferring ownership to the private sector; and reducing the Government’s role in the economy. This section presents the specific policies and measures the authorities took to achieve each of these objectives.
Introduction of Market Forces in Economic Decision Making
Price Liberalization
Price liberalization is central to economic transformation. Under central planning, prices did not play an allocative role but instead were used mainly to control income distribution (Hinds (1990)), resulting in several distortions. In many cases, there was a gap between production costs and sales prices, which distorted resource allocation. For goods deemed to be “essential,” production costs were higher than prices, so that producers had to rely on subsidies to continue operating. These subsidies, as well as the large need for funds to finance investment from the budget, resulted in an excessive tax burden on enterprises and in complicated tax systems, which further distorted prices. At the same time, the domestic economy was sheltered from the rest of the world by pervasive quantitative restrictions and the operation of the price equalization fund, which taxed profitable exporters and importers to subsidize unprofitable ones.23 Finally, the use of prices as a tool for income distribution and the channeling of resources to the capital goods sector under central planning were at the root of the emergence of a large monetary overhang in these economies. Because production was guided by planning rather than by the price system, and resources were channeled to the capital goods sector, the insufficient quantity and poor variety of available goods created excess demand conditions in many consumer goods markets. And, because consumer prices were not allowed to adjust, these goods were effectively rationed through queuing—a familiar sight in centrally planned economies. The counterpart to this, however, was the accumulation by households of large excess money balances.
Correcting relative prices and eliminating the monetary overhang in an orderly way are prerequisites for achieving the other objectives of economic reform. The massive transfer of property to the private sector cannot be achieved in an environment of distorted relative prices, because profitability criteria cannot be applied to state enterprises that are to be privatized. On the other hand, price distortions—and the attendant need for subsidies—as well as the perpetual threat of hyperinflation inherent in the monetary overhang, make it extremely difficult for the Government to reduce its role in the economy and move to indirect methods of macroeconomic control. At the same time, however, abrupt price liberalization in such an environment poses the risk of sustained inflation if the financial policies in place are not geared toward macroeconomic stabilization.
The provisional Government took some important measures to liberalize prices in certain markets even before it had finalized its overall reform program. Prices of agricultural products that producers sold directly in peasant markets were liberalized, and newly created private firms and firms with foreign equity participation were allowed to determine the prices of their products freely.
Aside from these initial measures, the provisional Government’s general approach to price liberalization evolved over time. From the outset, the authorities’ general objective was to create a system whereby prices are determined by supply and demand. However, they intended liberalization to be careful and gradual, because the economy was marred by grave distortions, reflected in serious disequilibria in some markets and large differences between domestic and world market prices. According to the program outlined in the early reform documents, by the end of the transition period, prices of all products were to be completely market-determined, except for the prices of a category of key intermediate and final products. This category included products of the mining, fuel, and energy sectors; metallurgy; the chemical industry; forestry; basic branches of the machine-building industry; the main products of the food industry; and transportation, postal, and telecommunication services. Prices of these goods and services would continue to be set administratively even after the transition period was over and would be adjusted using world market prices as a reference whenever possible.
The prices of the remaining products were to be gradually liberalized during the transition period. These prices were divided into two groups: wholesale prices and prices of raw materials and intermediate products on the one hand and retail prices of consumer goods and services on the other. Prices in the first group were to be liberalized faster than those in the second group, in the following order: (1) prices of goods produced by more than one producer, goods of nonstandard design, goods made to order, products with local characteristics, and some services rendered between enterprises would be liberalized first; and (2) prices of goods produced by monopolies or of products for which there was a significant demand-supply disequilibrium would be subject to government-imposed ceilings until the disequilibria disappeared. During the transition period, these ceilings would be adjusted using, among other things, world market prices as a reference. Prices in the second group—consumer goods and services—would be determined during the transition period as follows: (1) prices of products “essential for the standard of living” (food products marketed through state outlets, energy, fuels, basic drugs, some articles for children, transportation, rent, and standard design housing units) would be administratively set; (2) prices of certain other products, such as fabrics, garments, footwear, furniture, durable consumer goods, cars, and hotel and tourist services, would be subject to government-imposed ceilings; (3) prices of a few “special imports” (luxury goods, cosmetics, cigarettes, and beverages) would be set administratively, with a view to controlling the total amount imported; and (4) prices of all other consumer goods and services would be freed. All retail consumer prices subject to administrative controls or ceilings during the transition period were to be adjusted to reflect changing costs resulting from changes in wholesale prices, and were to be completely liberalized in 1992.
This complicated schedule for price liberalization was never implemented. The Government realized that it needed to take more decisive steps in this direction, and in his address to Parliament on October 18, 1990, the Prime Minister announced an accelerated price liberalization scheme in two rounds, on November 1, 1990, and January 1, 1991, respectively. The new scheme reversed the order of liberalization envisaged in the early reform documents for wholesale and consumer goods: the latter were now to be liberalized faster.
In the first round of price liberalization that took place on November 1, 1990, accompanied by a devaluation of the leu from lei 20 to lei 35 per U.S. dollar, a large number of prices were decontrolled. In general, prices of all goods and services produced by three or more producers were freed, except for those of (1) a group of 77 basic domestic and imported raw materials and intermediate goods, whose prices were generally increased to reflect world market prices at the new exchange rate (except for 20 mineral products, whose prices were not increased); and (2) 40 basic consumer goods and services, whose prices were left unchanged, including household energy, local transportation, and food items. Prices of goods produced by only one or two producers were to be set in negotiations between producers and the Ministry of Finance. In all, about half of the prices in the economy were freed, although if weighed by the volume of transactions, probably far fewer than 50 percent of all transactions were to take place at market-determined prices. The Government also introduced a system of partial indexation for wage earners and pensioners to compensate them in part for the price increases.
The second round of price liberalization was postponed until April 1, 1991, and was also accompanied by a new devaluation of the official rate of the leu from lei 35 to lei 60 per U.S. dollar. An interbank foreign exchange auction market, however, had already started operating in February 1991, where the rate was fluctuating around lei 180-200 per U.S. dollar. In the second round, the prices of controlled domestic and imported raw materials (with the exception of the same limited list of minerals as before) were increased again broadly in line with the devaluation; the prices of household energy products were kept under control but were increased; and the controls on basic food items were abolished. Indicative ceilings were announced for only 12 food products (including meat, butter, milk, bread, cheese, eggs, sugar, and edible oils). These indicative ceilings were set at the level of prices that obtained for the same products in the free peasant markets, implying increases of 100-150 percent vis-à-vis the former prices, and applied only to products of standard quality sold through state stores. Prices of products of different quality were freed, while prices of the same products sold in peasant markets had already been liberalized in early 1990. The ceilings were indicative in the sense that producers could challenge them, and the Ministry of Finance could allow prices to exceed the ceilings if cost conditions warranted it, on a case-by-case basis.
At the same time, the system of price controls on goods produced by fewer than three producers, introduced in the first round of price liberalization to protect consumers from monopolies exercising their monopoly power, had become increasingly cumbersome to operate. Because of continuous price adjustments throughout the economy, the prices of these products, set jointly by the Ministry of Finance and the producers, became irrelevant only weeks after the negotiations were concluded. Further, domestic producers considered the system to be unfair because it did not apply to joint ventures. Most important, the system put pressure on the Government to offer subsidies, as loss-making enterprises blamed their financial difficulties on the price controls. In light of these developments, the authorities quietly abandoned this system of controls. The effect of this action, combined with the second round of price liberalization, was that by mid-1991 about 80 percent of prices in Romania were free. Finally, in July 1991, the authorities completed the final stage of price liberalization, which resulted in controls being applied to only 14 categories of products that are critical for the consumption of the population (that is, 5 basic food items and 9 other categories, including home heating fuels, local transportation, and rents). It is noteworthy that in only eight months, Romania went from a system of complete price controls to one that compares favorably with many market economies.
Trade Liberalization and Reform of the Exchange System
Convertibility of the domestic currency through the reform of the trade and exchange systems is considered to be a key component of the overall reform strategy.24 Generally speaking, trade liberalization has been advocated for two main reasons.25 First, it helps to raise economic growth and generate employment by improving resource allocation and economy-wide efficiency. This argument is based on the well-known principle of comparative advantage and the benefits of exploiting economies of scale and specialization. The connection with growth rests on the notion that a liberal trade regime, in addition to improving static efficiency, will also tend to increase the efficiency of investment, thereby stimulating growth. The second main benefit of trade liberalization is that it helps to improve the balance of payments by strengthening the competitiveness of the external sector and by expanding exports and efficient import substitutes. Because import protection increases the costs and reduces the availability of inputs used in the production of exports, thus driving up the (real) exchange rate, it creates a bias against exporting activities and promotes inefficient import substitution.
Overall, the evidence available from countries that have engaged in trade reform programs suggests that trade policy and other structural reforms have contributed to the growth of output and exports (Thomas et al. (1990)). Furthermore, when the real exchange rate has depreciated during the process of liberalization, the evidence also suggests that import liberalization is associated with improvements in the external current account position.
Crucial in the process of trade liberalization is the issue of sequencing, that is, which measures should be adopted first. It is generally accepted that nontariff barriers, such as quotas and import licenses, should be removed first. Because quantitative restrictions depend on discretionary decisions by the authorities, they make the system of protection less transparent and predictable and encourage lobbying, corruption, and rent-seeking activities. Even with little or no decrease in protection, a reduction in nontariff barriers can have major salutary effects. For example, a switch from quotas to tariffs that provide roughly equivalent protection establishes the link between domestic and international prices—ensuring that they move in the same direction and do not diverge by more than the amount of the tariff—and provides revenue to the Government.
Once nontariff measures have been sharply reduced, priority should be given to bringing about more uniformity in the tariff structure. In addition to minimizing production distortions for a given protection level for importable goods, a more uniform tariff structure is less vulnerable to lobbying from diverse interest groups. Once greater uniformity has been achieved, the final stage of the process, in which the overall level of protection is gradually reduced, should ideally begin.
The Romanian Government moved decisively to liberalize the foreign trade sector, first by abolishing the state monopoly in foreign trade. Starting in February 1990 under Decree-Law 54, private enterprises were free to engage in foreign trade transactions, and state enterprises ceased to be subject to central plan directives and were no longer required to conduct their foreign trade transactions through specified foreign trade organizations (FTOs). Following the abolition of the state monopoly in foreign trade, a large number of newly created private enterprises, including joint venture companies, registered as foreign trade operators. These enterprises, most of them quite small, coexist with about fifty large former FTOs. The FTOs are state owned, but they are expected to be opened up to private participants, in line with the Government’s privatization strategy.
From early 1990, import control was to be effected through a system of licenses issued by the Ministry of Trade and Tourism, and an import license was to be a prerequisite for opening of letters of credit by the Romanian Bank for Foreign Trade. The Government intended to introduce three categories of import licensing, based on balance of payments considerations and sectoral priorities. The first category would apply to raw materials and inputs, for which licensing would be automatic and would be required only for data-gathering purposes. The second category of licenses would apply to about 100 to 200 products, such as tools, machinery, and agricultural products, that were produced domestically. Quotas for such products would be established in consultation with the respective producers and consumers. The third category of licenses would apply to goods for which the Government did not have clear information as to the import needs or domestic production capability. For these products, the Ministry of Trade and Tourism would consult with the relevant ministries before approving the license applications.
The Government also intended to introduce three types of export licenses. The first category would cover products in excess supply domestically. The purpose of quotas in this case was to ensure that domestic consumption would not be disrupted. The second category of export licenses would apply to products for which the Government had no information as to the domestic consumption needs. For the remaining exports, licenses would be issued automatically.
This licensing system was regarded as a temporary solution to managing trade during the radical transformation of the economy, which was hampered by a complete lack of data on import needs and export availability. In the event, the Government decided that licensing of imports and exports was inconsistent with its aim of an open and transparent trading system, and in 1991 abandoned the scheme completely insofar as imports were concerned. Licenses were to be used only for statistical purposes and were to be issued automatically. For exports, licenses were maintained for only those products that received subsidies from the Government or were subject to domestic price controls.
The domestic economy was now to be protected solely through tariffs and exchange rate policy, and, starting in January 1991, the Government modified the existing tariff code to make it more compatible with the overall objectives of the reform program. First, it revoked the generalized exemptions from tariffs granted to inputs used by the public sector; only energy products were exempt from duties. Second, it abolished the distinction made for tariff purposes between imports of inputs and final products or among different uses of the same product. Third, it cut the highest tariff rates significantly so that the maximum rate was 40 percent, with the rates for some 95 percent of line items less than or equal to 30 percent. Notwithstanding these reforms, the Government regarded the existing tariff code as inadequate to meet Romania’s long-term need for a rational and transparent tariff system consistent with an outward-looking development strategy. Accordingly, it began to develop a new tariff code to be implemented in 1991. The new tariff structure is based on several general principles. First, the nomenclature of the new code has been harmonized with those of other Western European countries. Second, the rates have been determined on the grounds of efficiency considerations alone, implying that the fiscal consequences of any particular structure are not regarded as important. Third, the tariff code is to be used to create incentives in the economy for improving efficiency—products for which Romania is clearly not internationally competitive will not be protected. Thus, protection will be limited to those products that are viewed as needing to develop on a sound basis without disruptive foreign competition. Specifically, in this new system, tariff rates are grouped into three basic categories depending on the degree of protection granted. Products with low protection face tariffs of up to 10 percent, those with medium protection face rates of 10-20 percent, while the most protected items face tariffs of up to 30 percent. The assignment of products to different categories is to be based on several considerations, including the domestic and international prices of the product, domestic production and consumption, import requirements, and sectoral development strategies. The new tariff system was submitted to Parliament in mid-1991 and is awaiting enactment.
The liberalization of trade was accompanied by a policy of allowing agents greater access to foreign exchange. Before January 1990, although residents and nonresidents could legally hold foreign currency accounts, their ability to open or effect transactions through these accounts was severely restricted. Interest was paid in domestic currency at an appreciated exchange rate. In January 1990, the provisions governing foreign currency accounts were substantially liberalized. Residents could legally hold foreign exchange outside the banking system, although the requirement to effect all foreign exchange transactions only through authorized agents remained in force until August 1991.
From September 1990, exporters were no longer compelled to surrender all foreign exchange earnings to the Government. Instead, they became eligible for a minimum uniform retention of 50 percent of their gross export earnings. They could use retained foreign exchange without restrictions on payments and transfers for current account transactions, and could import goods for their own use or for resale. Joint venture firms were exempt from the surrender requirements and were free to use foreign exchange as they wished.26
In February 1991, the Government instituted an interbank exchange market open to all enterprises through participating banks acting as brokers. The supply of foreign exchange to this market comes primarily from the 50 percent retained earnings of exporters and from the Government. Foreign exchange is made freely available for all bona fide current account transactions, with the exception of limits on profit remittances by nonresidents. Starting in August 1991, individuals were permitted to conduct small-scale transactions in foreign exchange through exchange houses. The access of these exchange houses to the interbank market is to be intermediated through the participating banks.
The dual exchange rate system, combining a fixed exchange rate for a limited set of transactions with a freely floating interbank rate, is considered to be a temporary arrangement. The Government is committed to—and announced this intention in July 1991—an early unification of the two markets. The regime to be chosen after unification, namely fixed or floating, will depend on a number of factors, in particular, balance of payments and inflation developments and prospects, as well as on the level of international reserves.
Interest Rate Policies
The liberalization of credit markets, in particular allowing interest rates to reflect market conditions and determine the allocation of credit, generally accompanies the liberalization of prices and exchange rates in reforming economies. Interest rate deregulation is necessary to prevent higher prices from distorting saving and investment decisions, with adverse consequences for efficiency and growth.27
The experience of several Latin American countries in financial sector reform, however, has indicated that there may be risks involved in liberalizing interest rates. If the liberalization occurs before the economy is stabilized, the profitability of enterprises improved, and the system of prudential regulations over the banking system strengthened, there could be an immediate run-up of real interest rates on deposits and loans and increased uncertainty about the future cost of funds. As a consequence, interest rates lose their value as a signaling device, and long-term investment and growth can suffer. Economic stability and effective bank supervision are thus fundamental prerequisites to successful liberalization of interest rates in a short time. If these preconditions are met, there is merit to moving rapidly to a system of free interest rates that the government can influence only indirectly to achieve monetary policy objectives.
Until late 1989, interest rates in Romania were very low and their structure complicated. Household deposit rates at the Savings and Loan Bank (SLB) averaged 2.5 percent in 1989, whereas the SLB received 3.0 percent on its deposits at the National Bank of Romania (NBR). Other banks paid between 1.5 percent and 1.8 percent for credit they obtained from the NBR in 1989. Enterprise deposits were remunerated at 1.5-1.8 percent in 1989.
On April 1, 1990, the provisional Government simplified the structure of interest rates and increased their level. Households began to receive 3.5 percent on all types of savings deposits at the SLB, which, in turn, received 3.6 percent on its deposits with the NBR. Interest rates on all enterprise deposits were raised to a uniform 3.0 percent, as were rates on credit from the NBR to the specialized banks.
Although the increases in deposit rates in 1990 may have reduced somewhat excess demand pressures and the existing monetary overhang, they were clearly insufficient to eliminate the increase in excess demand and inflationary expectations that had been created since the beginning of the year. Partly for this reason, and partly to be consistent with its exchange rate policy, the Government decided in early 1991 to liberalize interest rates. As of April 1, 1991, the NBR permitted deposit and lending rates to be freely determined between banks and their customers. This policy was designed to complement the flexible exchange rate policy. While interest rates are expected to exhibit some rigidity in the short run because banks will adapt slowly to the new environment or may even collude in setting rates, over time they will become solely market-determined. The interest rate policy was set in the context of a strong adjustment program, and bank supervision is a priority with the Government. To prevent interest rates from rising excessively, the NBR intends to monitor the spread between lending and deposit rates and has retained the option of intervening if it believes this spread is too large or likely to become so.
Transfer of Ownership to the Private Sector
Basic to the transformation of the formerly centrally planned economies in Eastern Europe is the transfer of state-owned enterprises to private ownership. Privatization is generally viewed as essential if producers are to respond to market signals in making production and investment decisions, because private ownership provides incentives for producers to minimize costs (by maximizing profits) and to allow output to respond to market indicators rather than to the dictates of the central plan.28 Private ownership also facilitates the monitoring and evaluation of, and control over, the performance of those managing and operating enterprises, thereby minimizing the impact of political considerations. In addition, private ownership makes it easier to subject enterprises to the threat of bankruptcy and to foster a competitive business environment by eliminating the Government’s interest in protecting state-owned enterprises. Finally, and perhaps most important, privatization is believed to render the transformation to a market-based economic system irreversible. For these reasons, every reform program in Eastern Europe has included measures to facilitate the rapid transfer of state enterprises to private ownership. Most programs have also included measures to privatize state-owned housing and agricultural landholdings.
Although the need for privatization has been recognized, issues have arisen regarding the content of privatization programs, and despite broad agreement as to the desirability of selling smaller enterprises directly to potential owners, the direct sale of large enterprises remains somewhat controversial. Some observers contend that such sales, if made early in the transition period, may result in substantial undervaluation of the disposed properties, providing windfall gains to the purchasers. Questions have also arisen as to the appropriateness of “inside sales” of enterprises to workers and managers, which may transfer valuable assets to well-placed individuals, including those in the previous Communist hierarchy, the so-called nomenklatura. To ensure widespread private ownership of the enterprises, many privatization plans in Eastern European countries have called for the free distribution of shares in large enterprises to all citizens, with each citizen obtaining a voucher for an equal number of shares.29 This approach has been criticized, however, as providing inadequate supervision over enterprise management, because no individual would hold enough shares in any one company to control its officers or directors effectively. To remedy this problem, several economists have proposed creating several large holding companies in each country, each of which would hold shares in a number of enterprises.30 Large blocks of shares in the privatized enterprises would be allocated among the various holding companies, and the shares of these holding companies would, in turn, be distributed broadly among the country’s citizens.
Because privatization may lead to increased tensions between workers and management, several plans would encourage workers to support productivity-improving measures by allowing them to buy a portion of their enterprise’s shares at preferential prices. Furthermore, to encourage direct investment from abroad to finance modernization and improve the competitiveness of domestic enterprises, reforming countries have been advised to liberalize their investment laws, so that foreign as well as domestic companies and individuals can acquire shares in privatized enterprises, either on their own or in joint ventures with domestic partners. In addition, countries have been urged to liberalize at least some of their restrictions on external capital transfers, so that nonresidents can freely repatriate investment capital, retained earnings, and salaries, pensions, and other compensation from employment in domestic firms.
To facilitate the allocation of savings to newly privatized firms, the transforming economies have been urged to establish stock markets in which shares of enterprises and holding companies can be traded. However, how soon citizens should be allowed to sell or trade their initial allocations of enterprise or holding company shares is an open question. On the one hand, it can be argued that these shares should be nonnegotiable for a limited time, to prevent well-financed traders from acquiring large blocks of shares at low prices early in the adjustment period, when reductions in real incomes may be particularly severe. On the other hand, such restrictions would prevent individuals and firms from acquiring sufficient blocks of shares to exercise effective supervision over enterprise managers.
As part of its reform program, the Government of Romania has taken significant steps to facilitate privatization. Since November 1990, many small enterprises have been sold to domestic owners and to joint ventures between domestic and foreign partners. In addition, the Government has vigorously promoted leasing of state-owned assets, including equipment and structures. For large enterprises, a two-stage process was developed in the context of Law 15 of August 1990. With the exception of strategic sectors, such as defense, mining, and telecommunications, in which enterprises became state-owned autonomous entities (regies autonomes), most enterprises were converted into commercial companies that will eventually be privately owned and operated. Commercial companies were then required to inventory and value their assets and then transfer shares equal to 30 percent of their value to the National Agency for Privatization (NAP), a government agency created under the same law, which would then arrange for the eventual free distribution of these shares to all eligible citizens. Another 10 percent of the shares of commercial enterprises was to be made available for sale to the enterprise’s employees at preferential prices, with the remaining 60 percent to be retained by the Government for eventual sale to private parties, either domestic or foreign.
Law 15 had several shortcomings, which the authorities quickly realized. As a result, a new privatization law was drafted with extensive foreign assistance and was enacted by Parliament in July 1991. This new law will create five holding companies—Private Operating Funds (POFs)—to serve as the immediate holders of shares equivalent to 30 percent of the share capital of each commercial company. The board of governors of each POF will initially be chosen by the Government and approved by Parliament. The actual certificates in the POFs will be distributed to Romanian citizens in bearer form and will be tradable between Romanian citizens after 12 months. These certificates cannot be transferred to foreigners for 5 years. They will initially carry no voting rights, but, within 5 years, the board of each POF must determine a procedure for the owners to elect a new board. Income and other proceeds received by the POFs may be deposited in interest-bearing accounts, paid out in dividends, or used in other commercial activities.
The Government’s share of commercial companies, initially equivalent to 70 percent of capital, will be held by the State Ownership Fund (SOF), whose board of directors will be appointed by Parliament. The SOF is obliged to reduce over time its ownership share of commercial enterprises and to report to the Government and Parliament on its activities. It can deposit the income and other proceeds it receives into interest-bearing accounts, or use them to make equity investments, to extend credit to purchasers of state-owned assets (including employees of state firms), and for expenditures related to the privatization process.
Consistent with Law 15, the new privatization law provides for the preferential distribution to employees and managers of up to 10 percent of a commercial company’s shares. In general, these shares will be sold at a discount of 10 percent of the price paid by third parties.
The new law establishes simplified regulations for the creation and sale of small-scale operations, such as retail trade establishments. Part of the draft law on privatization allows for the sale of government assets, which will allow the NAP to start privatizing small businesses without waiting for the entire privatization infrastructure to be developed. Under Government Decision 1228, which permits leasing activity, the administration of many small-scale entities has already passed into private hands. As of mid-1991, out of a total of 25,400 commercial units existing in Romania, 12,193 units have been transferred to private administration by franchise contracts. In tourism, from a total of 2,384 units owned by 135 companies, 1,049 units have passed to private administration. Leases are given for up to two years, after which the new owners of the property take control. Together with newly created private firms, as of April 1991, there were 134,143 authorized private entities operating in Romania.
Under the new privatization law, the NAP is responsible for developing the privatization strategy with a view to promoting a more competitive industrial structure through enterprise restructuring. In addition to issues of financial restructuring, the NAP is developing a strategy for dealing with state enterprises that are heavy polluters; it intends to ensure that the responsibilities of new enterprise owners in this area are set out in detail. After the SOF and the POFs have been constituted, they will have the right to choose the management of the enterprises they own according to their respective share holdings.
As discussed earlier, to strengthen the financial position of privatized enterprises and enable them to start on a more equal footing, the Romanian Government has moved to eliminate unserviceable enterprise bank loans, which were used to cover past enterprise losses. The remaining loans are scheduled to be replaced by the end of 1991 with nonnegotiable government instruments to be held by the NBR. An enterprise restructuring fund, financed by the sale of state assets and a tax on inventory revaluations, will help service and retire these government instruments or, in some cases, eliminate outstanding unserviceable loans directly. To provide further incentive for privatized companies to operate commercially, the Government is moving to enforce existing bankruptcy provisions and to end subsidy payments to loss-making enterprises. In addition, it is considering new bankruptcy legislation.
Besides commercial companies, Romania’s privatization program covers housing and agricultural land. The Government has begun selling state-owned housing units to foster labor mobility, improve incentives for maintaining the housing stock, and help absorb the monetary overhang. As of mid-1991, it has sold some 50 percent of state housing to the public. In addition, it has approved a land reform program under which citizens with prior claims on particular plots will be entitled to acquire a minimum plot of land. This measure is designed to promote the decentralization of large and inefficient collective farms and to give unemployed workers an alternative to remaining in urban areas. The return of agricultural land to previous owners reflects the Government’s intention to make its reforms irreversible and to make ownership of state assets as widespread as possible. The Government expects that by 1992, over 80 percent of the farmland will be privately owned.
Reduction of the Role of the Government in the Economy
The third main objective of the Romanian reform program is to reduce the size and role of the Government in the economy and to develop indirect tools of macroeconomic policy. The Government took significant steps in this direction in two major areas: fiscal and financial sector reform.
Fiscal Reform
In the context of the financial planning practiced in centrally planned economies, as discussed in Section II, fiscal policy is entirely passive and subordinate to the economic plan. The main roles of the government budget and the various extrabudgetary funds are to ensure the transfer of resources between sectors called for by the plan and to achieve redistributive goals (Kopits (1991)).
Centrally planned economies in transition have focused on fiscal reform as a necessary ingredient of their transition to market economies. To this end, they have initiated large-scale tax reforms while reducing the burden of taxation to encourage greater financial autonomy for enterprises and to avoid stifling the newly emerging private sector. These changes, however, are made more difficult by the increased need for government revenue to fund the social safety nets introduced to shelter the most vulnerable groups from the costs of transition. Cuts in expenditures for investment and subsidies, as prices are liberalized in the economy and enterprises are made more financially independent, help only partly to accommodate the increased need for funds. Moreover, these countries are also constrained by the lack of experienced staff in the administration to design and implement their ambitious tax reform measures and must often rely on external technical assistance in this effort.
In Romania during the late 1980s, the share of the Government in economic activity, as measured by government revenue, grew to about 60 percent of GDP. The bulk of government revenue came from the turnover tax, the tax on the wage fund of enterprises, and a system of remittances from profits. The latter was based on planned rather than actual profits and, given the unrealistic plan targets, resulted in large after-tax losses for enterprises, while the budget was in surplus. These losses were covered by automatic extension of bank credit, which left banks with unserviceable loans on their books, as discussed in Section II.
The first tax reform measures, introduced immediately after the change of regime in late 1989, were intended to reduce the excessive tax burden on enterprises. Specifically, effective January 1, 1990, the provisional Government abolished the turnover tax levied at the producer level—known as the “Ceauşescu tax”—and the system of remittances from profits, and replaced them with a new remittance mechanism, through which any profits in excess of 10.5 percent of total costs were transferred to the Treasury.
On the expenditure side, the provisional Government decided to cancel many of the investment projects started by the previous regime, as well as to slow the rate of implementation of other investment projects, owing to energy shortages and low labor productivity. Expenditures for direct subsidies to enterprises, by contrast, increased substantially as a result of increased labor costs and higher agricultural procurement prices, for which the Government compensated agro-industrial enterprises. Finally, subsidies to the population were increased, partly to compensate for previous deprivations and partly to cushion vulnerable groups from the costs of transition and adjustment.
During 1990 and early 1991, the Government undertook a comprehensive tax reform, revising the turnover tax fundamentally with effect from November 1, 1990. First, it substantially expanded the base from domestically produced final goods intended for domestic consumption to cover all goods and services, whether domestically produced or imported, except those intended for export. Second, it simplified the rate structure, transformed the rates from specific to ad valorem, and reduced the number of rates to twenty, ranging from 1 percent to 90 percent. Finally, to reduce the negative impact of cascading, the Government set rates on intermediate goods substantially below those on final goods. It also overhauled the system of direct taxes, introducing a genuine profit tax in July 1990 to replace the profit remittance scheme and replacing the tax on the wage fund of state enterprises with a tax on wage income, extended to many previously tax-free nonwage benefits.
As in other areas of the reform effort, early fiscal reform measures were the result of a trial and error process. For example, the system of taxation of profits was changed in early 1990, when the profit remittance scheme was revised; in July 1990, when a profit tax was introduced; again in January 1991, when the profit tax was simplified and revised; and further changes are planned for early 1992.
The Government took these measures in the context of a medium-term strategy to reform the tax system and bring it in line with systems in developed market economies. The turnover tax is to be replaced by a value-added tax (VAT) in early 1993, and the profit and wage taxes by a general income tax in early 1994. The design and timetable of these major tax reform measures have been elaborated with extensive foreign technical assistance. Perhaps the greatest impediment to the swift and successful introduction of these measures in Romania, however, is the lack of trained staff to enforce the new tax laws and regulations. This means that the legislative effort—as in many other areas—has perhaps moved faster than the institutional changes necessary to support it.
Financial Sector Reform
In a typical centrally planned economy, one bank—the National Bank—has a monopoly over money creation. In addition, there are specialized financial institutions that channel credit from the National Bank to particular sectors but do not have a substantial deposit base, and—in many cases—a savings bank that attracts deposits but does not engage in credit operations. This monobanking system not only ensures that the central authority has direct and complete control over the quantity of money but it also reflects the two distinct financial circuits that exist in the centrally planned economy: one serving the household sector, which receives incomes and effects payments in cash only, and one serving the enterprise sector, which receives and makes payments only through bank accounts (with the exception of wage payments). In this way, the operation of the financial sector is completely subordinated to the physical plan. The volume of enterprise credit is set at the level necessary to finance interenterprise transactions at the level of gross production targeted in the plan, and the volume of currency in the economy is set at the level necessary to finance wage payments and, at the same time, household consumption. Interest rates have no allocative role in this system (Sundararajan (1990)).
If there is to be a successful transition to a market economy, this financial sector needs to be completely overhauled. First, the National Bank has to be broken up and a genuine two-tiered banking system, made up of a central bank and commercial banks, developed. Second, the commercial banks need to be autonomous and must start operating on a profit-making basis, which involves, primarily, competing for deposits and assessing client credit risk. This, in turn, implies that interest rates must be liberalized and used as a tool for allocating funds. Third, the payments system needs to be unified and streamlined, and the capital market developed so that enterprises can raise funds directly from the population. Finally, the central bank must take on supervisory functions and develop indirect tools of monetary control.
As is evident, these reforms require not only a substantial amount of legislative work and the development of skills and institutions, but also profound changes in attitudes. An added complication is that these reforms often have to be initiated in an unstable macroeconomic environment, which, in turn, requires tight monetary policies. The development and introduction of indirect means of monetary policy may then need to be delayed to ensure that the objective of monetary control is not compromised in the short run.
Under central planning, the financial sector in Romania was similar to that in most other Eastern European countries at the time. Flows of funds were targeted according to the financial plan and were controlled centrally, as discussed in Section II. In addition to providing credit and accepting deposits, the banking system was responsible for monitoring the implementation of various aspects of the physical plan at the enterprise level. Although the clear division of responsibilities between the state-owned specialized banks was designed to make these tasks easier to fulfill, it also had the effect of eliminating competition between banks. There were no domestic financial assets other than bank deposits and currency, and no financial markets, and effective reserve requirements of 100 percent—after costs and currency needs were met—prevented secondary money creation.
The banking sector consisted of five institutions, namely the NBR and four specialized banks—the Romanian Bank for Foreign Trade (RBFT), the Investment Bank (IB), the Bank for Agriculture and Food Industry (BAFI), and the Savings and Loan Bank (SLB). The NBR fulfilled some central bank functions in that it issued currency and held accounts of the state budget, but it was also a commercial bank, taking deposits from state enterprises and extending short-term loans to them. In addition, it channeled excess deposits from the SLB directly or through the other three specialized banks into domestic credit. The RBFT served foreign trade organizations and was the main financial link to foreign countries and the primary holder of Romania’s foreign exchange assets. Funds required by the RBFT for extending domestic credit, including export credits in lei, were provided by the NBR and, to a limited extent, by demand deposits with the RBFT. The IB financed investment in all sectors of the economy, except agriculture and the food-processing industry, and supervised the design and construction of the investment projects it financed. NBR funds were the major source of financing, but the IB also held some deposits from special funds at enterprises earmarked for investment. The BAFI served the agriculture and forestry sectors and the food-processing industry. It provided short-term credit for productive activities, as well as financing for investment along the same lines as the IB, mostly with credit from the NBR. Finally, the SLB extended only a very small amount of domestic credit in the form of housing loans to the population, and deposited the remainder of its funds with the NBR. The SLB, with a substantial network of branches across the country, held most household savings deposits, as well as a smaller number of deposits of the supplementary social insurance fund.
In addition to these five banks, certain other institutions could be considered part of the financial system. One was the state insurance company (ADAS), which held its relatively small deposits with the NBR. Four foreign offshore banks also conducted limited amounts of business in foreign currency and held deposits with the RBFT. Finally, there were about eight hundred credit cooperatives with deposit accounts at BAFI, and some six thousand credit unions with accounts at the SLB, which were entirely self-financing. Loans granted by these institutions to individual members were fully collateralized by the member’s savings account with the institution.
The first step toward reforming the financial sector in Romania was the abolition of the financial plan in early 1990. In order to maintain some monetary control in an uncertain environment, the Ministry of Finance, with the help of ministries and banks, prepared quarterly credit plans. The banks, together with the economic units they served, determined credit needs based on expected production and investment, while the NBR supervised this process. The Government approved the resulting credit plans, and banks subsequently divided up the available credit. Credit requirements to clear domestic payments arrears and to cover losses from previous years were fully accommodated, as discussed earlier, as was financing of existing stocks. Later in the year, the credit plan mechanism was relaxed, and banks were formally permitted to negotiate financing contracts with economic units to implement investment projects. The sectoral specialization of banks was abandoned, and all banks were allowed to open deposit accounts for enterprises and individuals.
In addition to these changes, Decree-Law 54 on private initiative, issued in early 1990 to encourage development of small private firms in general, allowed private banks to be established. Two such banks were granted permission in 1990 and began operations in late 1990 and early 1991, respectively. To further reduce the reliance of banks on central bank credit and budgetary resources for lending, a process of recapitalization was also begun with the abolition of the effective 100 percent rate of remittances from profits to the budget that previously applied to banks. Finally, the monopoly on foreign exchange transactions previously held by the RBFT was eliminated.
In late 1990, the commercial and central banking functions of the NBR were separated; the NBR kept only its central banking functions, and a new bank (the Romanian Commercial Bank (RCB)) was created and took over the NBR’s commercial operations. From that point on, the Romanian financial sector had the two-tiered structure common in market economies, albeit with a much higher degree of concentration.
At the same time, the Government started drafting a new banking law and the new central bank statutes. These laws, promulgated by Parliament in April 1991, were designed to create a modern banking environment in Romania. The banking law makes banks financially responsible for their lending operations and revokes all restrictions on the creation of liabilities. It provides for the recapitalization of the banks, and the NBR is made responsible for issuing prudential regulations. The law also provides for the introduction of reserve requirements and deposit insurance, but leaves the timing and details of implementation of these measures to the NBR.
The central bank statutes confer on the NBR full authority for the conduct of monetary policy, including interest rates, and state that the NBR’s only goal is the stability of the national currency. The NBR is made solely responsible for conducting exchange rate policy, including issuing and implementing foreign exchange regulations and managing official foreign exchange reserves and gold. It is given authority to license and supervise commercial banks. The law also limits the amount of credit the NBR can extend to the state budget.
Most important, perhaps, the central banking law makes the NBR independent in the performance of its duties. The Governor and the Board of Directors are appointed for renewable eight-year terms by Parliament on the recommendation of the Prime Minister and can be removed only by Parliament at the request of the Prime Minister. They are not allowed to be members of the legislature or the judiciary or to hold positions in business.
To promote competition among banks, the Government authorized foreign banks to operate in Romania. As a first step in this direction, after the promulgation of the banking laws, the NBR allowed the foreign offshore banks in Bucharest to begin transactions in lei, subject to the same reporting requirements as domestic banks.
These fundamental reforms have opened the Romanian financial sector to the forces of competition and have laid the foundation for a modern market-oriented banking system. The pace of change in restructuring the financial sector, however, is slowed by lack of experience of a modern market-based financial system, lack of expertise and trained staff, material constraints—for example, commercial banks, with the exception of the SLB, start off with only a handful of branch offices around the country—and the slow change in attitudes and mentality of the banking and business communities.
It should be noted that being profitable in an environment of widespread price distortions is not the same as being efficient in an opportunity-cost sense.
See, for example, Genberg (1991), and Greene and Isard (1991).
For a discussion of the benefits of liberalization, see Corden (1987); more recent evidence on the subject is contained in Thomas et al. (1990).
This exemption naturally led to a sharp increase in joint venture firms formed with minimal foreign capital, allowing exporters to easily avoid the surrender requirements.
For a survey of interest rate policies in the context of financial sector reforms, see Villanueva and Mirakhor (1990).
For a survey of privatization schemes in Eastern Europe, see Borensztein and Kumar (1991). Other studies highlighting the role of privatization include Fischer and Gelb (1990), Hinds (1990), Lipton and Sachs (1990a, 1990b), and Tirole (1991).
See Borensztein and Kumar (1991) for a discussion of the pros and cons of the “giveaway” element embodied in the voucher scheme.
Lipton and Sachs (1990a) and Blanchard et al. (1991) are among the proponents of such an approach.