The previous program supported by the Fund, the European Union and the World Bank played a crucial role in stabilizing the Romanian economy, reversing imbalances, rebuilding confidence in international markets and setting the stage for sustainable economic growth. The new precautionary Stand-By Arrangement, approved in March 2011, aims at consolidating macroeconomic policies and financial stability, accelerating structural reforms and thus boosting economic growth.
Romania is on track with the implementation of the quantitative targets. All end-March 2011 quantitative performance criteria, indicative targets, and prior actions were observed. Moreover the preparation of strategic action plans for key state-owned enterprises has been completed.
Recent economic developments
Recent data suggest that the recovery has restarted and will gain momentum in 2011. First quarter GDP growth reached 0.7 percent (qoq) and 1.7 percent (yoy). The growth, driven by industrial output which grew by 10 percent, continued to be sustained by external demand, with net exports posting a significant positive contribution to GDP growth (exports grew by 24 percent while imports increased by 16 percent). Internal demand is still weak and construction output and services declined. GDP growth is expected to reach around 1.5 percent in 2011 and to further accelerate in 2012 reaching 3.7-4 percent. Gradually domestic demand will become the main engine of sustainable economic growth, supported by better absorption of EU funds.
The inflation rate will remain high in 2011, due to the first-round effects of last year’s increase in the VAT rate, pressures from food and energy prices and envisaged adjustment in administered prices. Inflation was 0.2 percent in May and accelerated to 8.4 percent yoy, but will gradually decrease in the second half of the year.
The external position improved significantly, and the current account deficit reached 4.1 percent of GDP in 2010, and is projected to stabilize below 5 percent of GDP in 2011 and 2012.
Financial market stress has eased further in the last months, and the CDS spread for sovereign debt narrowed, leaving it well below several other EU member countries, including countries from the euro-area periphery. The authorities succeeded in issuing the first five year euro-denominated bond in the euro Medium-Term Notes program and raised 1.5 billion euro at a yield of 5.3 percent.
Despite the progress achieved, the recovery remains vulnerable to risks of adverse developments in international markets and a weaker than expected recovery in Western Europe. Spillovers from the ongoing turbulence in the euro-area periphery could dampen exports and affect capital flows to Romania through the banking system. In these circumstances the authorities will remain vigilant, act proactively and take the necessary steps to contain these risks.
The fiscal package implemented since the beginning of the previous program in 2009 has produced the targeted adjustment and put the fiscal stance on the right path. For 2011 the authorities remain committed to a cash fiscal deficit of 4.4 percent of GDP, and the recent data show that the May fiscal deficit target has been met. For 2012, renewed economic growth combined with prudent fiscal policy should bring the fiscal deficit to below 3 percent of GDP in ESA terms. However, significant challenges remain in achieving the 3 percent of GDP deficit target in 2012. This will require compliance with the fiscal responsibility law and continued expenditure restraint, including on the wage bill and subsidies.
On the expenditure side, the authorities will keep the wage bill within the agreed limit and take additional measures to secure the 2011 deficit target, including by continuing to rationalize public employment (which has declined by another 15,000 to 1.25 million in the first quarter of 2011). At the same time, the authorities will continue efforts to improve and prioritize capital spending in order to increase the absorption of EU funds. On the health care reforms, the authorities will take measures to safeguard fiscal consolidation by reforming the government-insured benefits package, reducing excess public sector hospital beds with a view to reaching the EU average by 2013, and introducing new health cards for all participants. At the same time, measures to reduce pharmaceutical costs are under way, and a new electronic prescription module will be introduced in 2012. The government will broaden the base for health contributions improving revenue collection, and new legislation introducing modest copayments for medical services will be approved by the Chamber of Deputies.
On the revenue side, tax policies will remain largely unchanged, including the VAT rate, which will remain at 24 percent. Under the current program improving tax administration and fighting tax evasion are crucial elements to increase revenue. Recently approved legislation relating to high net wealth individuals, and the government’s decision to restructure the tax administration will allow increasing efficiency and better tax collection. The authorities will institute simplified taxation for smaller taxpayers requesting a shift in the VAT mandatory threshold from the EU Council of Ministers to EUR 50,000.
Accelerated absorption of EU funds remains a focal objective of the government. The program focuses on strengthening the administrative capacity of units managing the funds, including the efficiency of the public procurement process by developing standard bidding documents. To better coordinate EU fund absorption, the government has moved the EU structural funds coordination unit from the Finance Ministry to the Prime Minister’s office and will strengthen its authority and staffing. At the same time, the authorities will modernize and consolidate the legislative regulatory framework for public investment, including the PPP law to ensure that it conforms to EU procurement directives.
Monetary and financial sector policies
The monetary authorities responded well to the contraction in economic activity, and the Central Bank has taken important measures to bring down inflation levels. However, inflation in recent months was boosted by first-round effects of last July’s VAT rate increase, and continued food and fuel price pressures. Moreover, further expected hikes in administered prices will make it difficult to meet the Central Bank’s 2011 inflation target. We expect inflation to peak at 8.5 percent in mid-year, before gradually declining to slightly above 5 percent by the end of the year. The authorities will shift monetary policy to a tightening bias and take action as needed to ensure the 2012 inflation target is met. The Central Bank will continue to improve liquidity management, and will remain alert to potential risks of a return of significant capital inflows as the economy recovers.
The Romanian financial system so far has weathered well the impact of the economic downturn of the past two years. However, non-performing loans continued to rise, and lending to the private sector declined, as did deposits. On the positive side, the banking sector returned to profitability during the first quarter and remains well-capitalized, with an average solvency ratio of 14.7 percent, and with all banks posting a solvency ratio above 11 percent. A key role for keeping the financial sector in good health has been played by the European Bank Coordination Initiative which enabled the parent banks of the nine largest foreign-owned banks operating in Romania to keep their long-term capital exposure commitments to the country. At end-March 2011, the aggregate exposure of these banks stood at 97 percent of the level when the Initiative started. All subsidiaries of euro zone periphery banks, including the Greek banks, are better capitalized than the system average, their liquidity position is still strong, and there have been no indications of adverse movements in deposits. However, the Central Bank is still alert to the risks that could develop from the euro area periphery, and is prepared for the potential impact of any banking sector turbulence.
Progress continues to be made on the regulatory front, and the central bank agreed to retain key aspects of the current prudent and simple approach to provisioning under International Financial reporting Standards, which are to be introduced in 2012, and is developing new regulations to discourage un-hedged consumer borrowing in foreign currency. The authorities took significant measures to strengthen the financial safety net, and will develop operating procedures and contingency plans for deploying the new resolution tools, and will ensure that the Deposit Guarantee Fund (DGF) has ready access to liquidity to meet any potential shortfalls in funding and prepare joint procedures for deploying DGF funds in a bank resolution.
Under the previous program, the authorities have made significant progress on the structural side. However, sustainable economic growth will require further structural reforms in key economic sectors, and the authorities, under the new program, committed to deep-rooted reform of the state-owned enterprises (SOEs), especially in the energy and transport sectors. Implementing a comprehensive strategy addressing the viability of key firms in these sectors and reforming their governance will be vital for further growth in Romania. In this context, the authorities finalized action plans for 18 firms, and are advancing in finalizing the action plans for the remaining state firms. They also approved that all SOEs subordinated to local governments submit quarterly key financial and operational indicators to the Ministry of Public Finance.
To improve the governance of SOEs the authorities decided to improve legislation requiring all SOEs to have regular independent external audits, to report and publish financial data quarterly, and to move the financial control of SOEs from line ministries to the Ministry of Public Finance. For the largest firms, the legislation will specify that all key management positions be filled only after an open international search process conducted by internationally recognized human resources firms. This management search will begin by end-August and private management teams will be selected by the end of the year to take office as soon as legally possible thereafter.
In the transport sector, both the railway and road companies will be restructured in line with their restructuring plans. These plans aim at better cost recovery, competitive tendering for public services and infrastructure maintenance, and a decrease in losses and arrears. In the railways system, the authorities have begun to extend the policy of standard costs, and developed a multi-annual plan for public procurement and investments. They also started the restructuring process at the railway Cargo Company by reducing staffing by some 3,000 workers, and a 20 percent stake will be offered by IPO or a strategic investor. In the railway Passenger Company, operating losses will be reduced by 25 percent by end-2011 through territorial restructuring, reducing staffing by 1,000 employees and reducing the number of trains where revenues are low. The authorities will pass legislation to establish a new metropolitan transit authority that will oversee the metro together with the above-ground public transport system in Bucharest, and will move further with tariff adjustments. On the air transport sector, the authorities will appoint a legal advisor to assist with the privatization of 20 percent of the Romanian air transport company (TAROM) via the stock exchange or to a strategic investor.
In the energy sector, the authorities will take the necessary steps to restore the energy regulator’s operational and financial autonomy in accordance with EU legislation. New legislation will be approved to separate prices between households and non-residential customers to allow the regulator to have full autonomy in adjusting the price for non-residential customers. The regulator will also start to adjust prices for gas and electricity in June/July for non-residential customers and later in 2012 for households, thereby developing a new mechanism to protect the most vulnerable consumers. Much needed capital and managerial know-how will be brought to the energy sector through minority and/or strategic private investors into key energy firms, including Petrom, Transelectrica, Romgaz. In order to generate sizable additional investment in the energy strategy, the authorities will begin the process of offering minority stakes in the Hydropower Company and Nuclear power plant. The coal companies will continue to be downsized by forming separate legal entities and splitting viable and non-viable assets. The viable assets will later be privatized and non-viable assets will be liquidated in line with EU rules.
In conclusion, my authorities concur that the current precautionary Stand-By Arrangement will maintain the reform momentum, provide additional security against unforeseen shocks and build on the considerable progress achieved over the past two years, thereby setting the stage for strong and sustainable economic development while maintaining external and internal stability.