a. The origins of the centrally-planned economic system in Romania

During the post-war years, the economic system of Romania developed in ways similar to that of other centrally planned economies. Virtually all means of production were owned by the state, except for a small proportion of land cultivated by private farmers. Detailed planning of all economic activity was the responsibility of the State Planning Committee (SPC), which prepared the physical plan targets based on Communist Party directives. Once the plan was approved, its implementation was monitored--and economic activity was managed--directly by the Government through the branch ministries. The branch ministries, each covering a different sector of the economy, also allocated inputs and decided on product use (i.e., consumption or investment) and distribution. A three-tier planning process was used, with five-year, annual, and special sectoral plans.

Prices were strictly regulated and did not play an allocative role. They were determined in the context of the plan on a mark-up basis. Moreover, until the early 1970s, only labor and intermediate products were taken into account in the calculation of costs: no charge was made for capital, land, or natural resources. Over time, consumer prices were kept fairly stable, while producer prices were occasionally adjusted to reflect changes in costs. The only prices that were market-determined--although occasionally also subject to restrictions--were those of agricultural produce sold by private farmers in the so-called peasant markets, which were limited in size.

Wages and the allocation of labor were also tightly regulated. Wages were differentiated according to the type of employee (white- or blue-collar) and according to economic branch, hardship, and other parameters. “Base wages” (i.e., remuneration per unit of time) were established centrally for all categories of employees. In addition, “norms” (i.e., output per unit of time) were also established for those categories of workers whose output was measurable. Based on the output target for each enterprise and these base wages and norms--where applicable--the plan determined the wage bill and the internal wage structure of the enterprise, and placed separate constraints on the number of blue- and white-collar employees. The management of the enterprise could not raise wages to attract more labor, and their authority to fire workers was severely limited. Labor was directed to desired industries and regions by controls on mobility.

The distribution of raw materials, capital goods and intermediate products was determined on the basis of material balances. The material balance was a planning tool for ensuring that the total sources and uses of a certain product would be in balance. It prescribed the distribution of a product among different economic uses, as well as among different administrative units, such as branch ministries and districts. Consumer goods were also distributed among districts using a similar system.

Foreign trade was managed exclusively by state-owned and controlled foreign trade organizations (FTOs) supervised by the various branch ministries. All transactions in foreign currencies were conducted through the Romanian Bank for Foreign Trade. Import decisions were taken centrally in the context of the plan, by comparing the needs of the domestic economy and the resources available to fulfill the plan, and export targets were set in order to finance the imports. Import and export targets were integrated into a detailed foreign trade plan. Domestic producer and consumer prices remained unchanged in the face of changing world prices by means of a so-called price equalization fund. This fund covered the differences between international and domestic prices of traded goods through a system of taxes and subsidies on exports and imports, resulting in a vast number of implicit exchange rates. Two exchange rates of the Romanian leu vis-á-vis convertible currencies were quoted officially, but had limited application. One was the valuta leu, reflecting the official gold price of the leu and used only for statistical purposes; the other was the noncommercial rate, used mostly for tourism. The exchange rate of the leu vis-à-vis the transferable ruble was set in the context of the arrangements with the countries of the Council of Mutual Economic Assistance (CMEA).

Financial policies were designed to ensure consistency between physical plan targets and intersectoral financial flows. Thus, the physical plan was the basis for drawing up the so-called synthetic financial plan. The financial plan was prepared at the Ministry of Finance for the economy as a whole. This plan was essentially a balance sheet for the whole economy, consolidating the relevant financial information and checking the consistency of the physical plan. The prices used were the ones prevailing at the time of the preparation of the plan. The financial plan was updated to take into account current price information, especially changing world prices and trade volumes, in order to ensure the consistency of foreign currency flows on a year-to-year basis, and was the basis for the state budget. In the context of the financial plan, there was no scope for active monetary or fiscal policies. There were no financial markets, and interest rates, although adjusted occasionally, were not meant to be an instrument for fund allocation, which was handled by the Government. The banking system consisted of a number of specialized banks and the National Bank of Romania, which served as a central bank but also had commercial functions. The banks had limited discretion regarding the size and allocation of credit. Use of bank credit for investment by state enterprises was, in any case, limited; the bulk of such investment was financed directly from the state budget.

In theory, the physical and the financial plans were meant to be fully consistent, so that the value of the sales of consumer goods at the plan prices was equal to the money income of the population (i.e., the aggregate of wages, pensions, etc.). In practice, however, as physical plan targets were often unrealistic, the shortage of consumer goods combined with the lack of different forms of financial savings caused a steady increase in money holdings of the population. These money holdings were essentially forced savings, in the sense that they reflected mainly the failure of the system to provide the desired consumer goods.

b. The Romanian economic system in the 1970s

In the late 1960s and early 1970s, while other Eastern European economies were making their first attempts at economic reform, several measures were also taken in Romania with a view to improving economic management within the centrally planned framework. These measures, however, did not go as far as in other countries, and left the way in which the system operated essentially unchanged. It is interesting to note that while Ceauşescu was considered in the west to be somewhat of a “maverick communist” in foreign policy matters, especially in the wake of his outspoken opposition to the Soviet invasion of Czechoslovakia in 1968, in economic affairs he remained an unreconstructed Stalinist throughout the period of his rule. To him, the need for state control of the economy was unquestionable and the planning mechanism sacrosanct. A good example of Ceauşescu’s thinking on this subject is found in a speech delivered in July 1974, when he said: ^1/

“To give everyone the freedom of spending society’s money on whatever, and however it might strike one’s mind--this is not possible. We have a planned economy. Nobody has the right to build or produce what is not provided for by the Plan.”

The Law on the Organization and Functions of the SPC of 1968 gave the SPC more responsibilities than before in overseeing plan fulfillment and making adjustments to the targets if necessary. At the same time, it attempted to decentralize the planning process by giving enterprises a greater role in preparing the plans. The preparation of the draft plan was now supposed to commence at the enterprise level, and the SPC would combine the proposals in the final draft. Moreover, with the establishment of the Department of Technical-Material Supply within the SPC in 1969, the Committee was given a central role in allocating inputs. Prior to this, allocation of inputs was primarily the responsibility of the Council of Ministers, which in 1967, for example, allocated centrally over 200 raw materials and intermediate products. An additional 1,300 inputs were allocated the same year by the branch ministries (Spigler, 1973).

A further reform was the addition in 1969 of a new administrative layer between the branch ministry and the enterprise: the centrala, which combined all enterprises with similar activities in a certain geographical area. Between 1969 and 1972 some 200 centrale were created, covering all the enterprises in industry, mining, and construction. The average centrala had a total of about 8,000 employees in its enterprises, although a few had as many as 100,000 employees (Granick, 1975).

The centrala had an important role in the planning process. Once the plan was voted into law by the National Assembly, the production targets were “nominalized”; in other words, specific quantitative indicators and constraints were placed on branch ministries. They, in turn, distributed these targets among their centrale. as well as “nominalized” some additional ones. The same process, in turn, took place between the centrale and the enterprises. The centrala had wide discretion for specifying different types and qualities of products to be produced by its enterprises, for “nominalizing” additional targets in addition to those set by the branch ministries, and for revising enterprise plan targets if necessary.

The price system was revised with the promulgation of the Law on Prices and Tariffs of 1971, which was amended in 1977. Although the mark-up rule remained in place, a more comprehensive accounting of costs in the formation of prices was stipulated by the Law. Most producer and consumer prices, which had remained unchanged since 1963, were re-evaluated in 1973-76 based on this revised framework (Tsantis and Pepper, 1979). The Law also introduced restrictions on prices in peasant markets in the form of price guidelines (“mercurial” prices), around which peasant market prices were supposed to fluctuate. Enforcement of these guidelines, however, was weak, especially in the countryside.

Since wages could not be used to affect the allocation of labor among industries or regions, during the 1970s direct controls on labor mobility increased, mainly through the stricter use of the “employment card” and the introduction of the system of “closed cities”. The former was the practice, usual among enterprises, not to hire any applicant who did not have his employment card certified by his previous employer. In this way, although the right to quit was in theory unrestricted, in practice each enterprise could pressure the worker to stay, or to postpone his departure, by delaying the certification of the employment card. For the same reason, there was virtually no mobility between small private farms and the state sector. In addition, in order to move out of an agricultural cooperative, a worker needed the permission of the manager.

The system of closed cities began in 1976, when legislation restricting migration to 14 large cities was promulgated. Only those who had a resident spouse or relatives, or had some predetermined “necessary skills”, could obtain permanent residence permits for these cities. By the late 1970s, virtually all cities with more than 100,000 population were closed. Nonresidents were not allowed to move or work there. Temporary residence permits were granted by the municipality, usually for less than one year, with possibility of renewal. In this way, labor could be directed to those enterprises and cities that would otherwise suffer from labor shortage.

In order to improve the management of foreign trade transactions, in 1973 the Government established a commercial exchange rate (also known as the internal conversion coefficient) set at lei 20 per U.S. dollar, to be used for comparing foreign with domestic goods prices. Although all foreign trade transactions continued to be conducted at the implicit rates resulting from the operation of the price equalization fund, the commercial rate was supposed to represent an efficiency indicator for these transactions.

As regards capital flows, Romania was one of the first centrally planned economies to introduce legislation in 1971 permitting the establishment of joint ventures involving foreign equity participation. Although this legislation was rather liberal compared to that in other Eastern European countries at the time, it placed quite restrictive conditions on foreign investment: the foreign share could not exceed 49 percent; profits could be repatriated in foreign currency only after the deduction of foreign currency imports; and the tax rate on profits was initially set at 30 percent, with an additional 10 percent charge on profits transferred abroad.

Finally, with the Financial Law of 1972, which standardized bank lending practices, there was an attempt to increase the use of bank credit for financing of enterprise investment and, at the same time, reduce the budgetary burden. However, the amount and allocation of credit were under central control and banks had no discretion in their lending activities.

These measures did not change the basic way in which the Romanian economy operated, and in some instances led to tighter central control. Central planning remained the mechanism through which production, input allocation, distribution, investment, and pricing decisions were taken for the economy as a whole. Although the preparation of the plan in theory commenced at the enterprise level, in practice the SPC continued to prepare the draft plan based on Party directives, as in the past. Even the attempt to decentralize the planning process with the introduction of the centrala did not enhance enterprise autonomy, because as the centrala took over many enterprise functions, enterprises were actually left with less power to make decisions. Moreover, although the price measures led to a revision of most producer and consumer prices, they did not enhance their allocative role, nor did they increase their flexibility. The single commercial exchange rate introduced in 1973 had simply an indicative value, as the policy of keeping domestic prices stable and the operation of the price equalization fund kept it from becoming an important policy instrument. Controls on labor allocation increased during the 1970s. Finally, the law on foreign ventures did not have the intended effect: only six joint ventures were established in the early 1970s, while the restrictive nature of the legislation and the economic difficulties facing Romania in the late 1970s and early 1980s deterred new investment (Granick, 1975).

c. The New Economic and Financial Mechanism of 1979 and the development of the economic system in the 1980s

The main revision in Romania’s system of economic management was the introduction in 1979 of the “New Economic and Financial Mechanism” (NEFM). The objectives of the NEFM were to improve economic efficiency in the context of the planning system, to promote enterprise autonomy, and to increase enterprise participation in the planning process. The NEFM was a general framework for reform, in the context of which additional systemic measures were taken throughout the 1980s. ^1/ Also, a three-year stand-by arrangement was negotiated with the IMF in 1981, which lasted until 1984.

In the area of planning and enterprise management, important changes were the replacement of the physical output targets with targets for net production (a concept akin to value added); the introduction of additional quantitative indicators; the imposition for the first time of quality standards and control; and an emphasis on forward contracting by enterprises for inputs and outputs. In spite of these changes, however, the nature of planning and economic management remained the same as in the pre-NEFM years. The state retained its firm control on economic activity. The SPC, apart from determining the plan targets, continued to monitor closely plan implementation by receiving quarterly production reports for some 300 products, as well as monthly, weekly, and daily reports for a smaller number of products. The number of targets and indicators included in the plan increased substantially during the 1980s. At the level of the SPC alone, by 1989 the complete annual plan included material balances for 400 products, and up to 452 targets and indicators for each one of an additional 2,000 products. Additional material balances and indicators were elaborated at the level of branch ministries and centrale.

To discourage production without sufficient regard for the needs of final users and, at the same time, to stop the practice by enterprises of overstating production by overstating stockbuilding of finished products, the NEFM introduced a system of forward contracting among enterprises for inputs and outputs as a basis for formulating production plans at the enterprise level. Enterprises were henceforth permitted to produce only on the basis of negotiated contracts with buyers, except in the case of production for exports. The forward contracting system was soon rendered ineffective, however, because of the distortions of the planning system. Underlying the forward contracting system was the assumption that enterprises would fulfill their plan targets. As these targets were increasingly unrealistic, the system could not function properly. Moreover, the forward contracting system provided the incentive for overstating the stockbuilding of exportable goods, since this had become the only way for enterprises to overstate production.

In an effort to reduce enterprise reliance on the budget for investment financing, the NEFM placed much greater emphasis on enterprise self-financing and the budgetary outlays for investment were correspondingly reduced in the period 1980-83. In addition, interest rates on investment credit to enterprises were substantially raised in 1983, in an attempt to increase the efficiency of resource use and to make enterprises more cost-conscious. The same year, a capital charge was imposed on funds advanced from the budget for investment.

The success of these measures was limited. Although enterprises were made responsible for financing a larger part of their investment, their own resources were limited due to the overstatement of their profits and the excessive tax burden on enterprises during the 1980s. In addition, they were not able to invest their own funds as they wished; investment projects had to be approved by the SPC. Consequently, the allocation of investment funds probably did not become more efficient. Similarly, as increased interest costs were taken into account in the plan and were reflected in lower planned profits and remittances from profits to the budget, the use of investment funds probably did not lead to greater efficiency. In any event, the role of the budget in investment financing, after declining in the period 1980-83, started growing rapidly again. Finally, in 1984, after the program with the IMF lapsed, the authorities lowered interest rates, restoring them to their earlier levels.

The policy of maintaining price stability in the face of changing world prices in the late 1970s caused large discrepancies to arise between domestic and world prices expressed in lei at the commercial exchange rate. To offset this effect, the authorities introduced gradually over the 1970s additional “commercial” exchange rates, each applying to a different category of trade transactions. To correct these distortions a number of measures were introduced in the early 1980s in the context of the NEFM and the stand-by arrangement with the IMF. All commercial exchange rates were unified and depreciated against the U.S. dollar in the period 1981-83; major domestic price adjustments took place in the same period; and the price equalization mechanism was modified.

As regards the price equalization mechanism, whereas in the past both exporters and importers were completely insulated from world price movements by means of the price equalization fund, starting in 1981 exporters were exposed more to world prices. The foreign trade plan began to include explicit export price targets in foreign currency terms. If the target export price was indeed realized but, when converted to lei at the commercial exchange rate, was still below the domestic price, the price equalization fund paid a subsidy to the exporter. If, however, the target export price was not realized, the shortfall was covered by the exporter’s profits. Conversely, if the world price converted at the commercial rate was higher than the domestic price, the difference accrued to the exporter if it was due to a realized export price higher than targeted, and to the price equalization fund otherwise. This system was intended to create incentives for exporters to achieve high export prices through better quality control and more careful marketing. The system of price equalization applying to imports, however, remained essentially unchanged.

These measures did not change the role played by prices in the Romanian economy, and the allocation of resources continued to be determined by the plan. Rather, these changes were supposed to increase incentives provided to exporters and to correct the large misalignments between domestic and world prices. Even these limited objectives, however, were not achieved. The pervasiveness of planning, as well as the increasingly unrealistic character of the export targets included in the foreign trade plan in the 1980s, did little to improve export performance. Moreover, most of the price adjustments of 1981-83 were reversed in 1984 and the exchange rate was appreciated. Finally, the enforcement of guidelines for prices in peasant markets was stepped up sharply starting in 1984.

In the context of the NEFM, the system of remuneration of labor was revised in 1983 and 1985 in an effort to link labor incomes more closely with plan fulfillment. A system of incentives was put in place (the system of “global contracts”), specifying the performance targets and the corresponding levels of salaries of each work unit within the firm. In the event of plan over/under-fulfillment by a certain unit, its members’ salaries could be increased or cut accordingly. Similar incentives, based on a number of performance indicators, were established for white-collar workers and managers. Furthermore, a system of distribution of a fixed share of profits to managers and workers was introduced to provide additional incentives to enterprises for profit maximization. Planned profits were allocated in varying proportions--determined centrally--to loan repayments, various enterprise funds (for development, working capital, employee benefits, and employee profit-sharing), and remittances to the budget. If actual profits were below the plan, payments to the budget and to the enterprise development fund had priority, in that order. If actual profits were above the plan, payments to workers and managers were higher.

The enhanced incentives that the system of global contracts and profit distribution created were plagued by severe problems. First, the incentives were more penalty- than reward-oriented. Second, inputs other than labor continued to be determined centrally through the plan. Finally, the different indicators, criteria, and conditions were complex and occasionally contradictory. For example, exports and efficient use of inputs often had different weights in the contract for the management of an enterprise and in the system of allocating above-plan profits.

The controls on labor mobility pre-dating the NEFM, notably the practice of the “employment card” and the system of “closed cities”, remained in place in the 1980s. In addition, in the late 1980s, the Ceauşescu Government introduced the program of “systematization of localities”. This program was intended to compel the reallocation of labor from small agriculture to state farms and industry by eliminating a large number of villages and moving the inhabitants to large agro-industrial centers. As implementation started relatively late in the decade, this program did not have a significant effect on the allocation of labor. ^1/

Despite the changes introduced with the NEFM, and the brief association with the IMF in the context of a stand-by arrangement, the nature of the planning process and the economic management system in the 1980s not only remained essentially unchanged, but the state’s firm control on economic activity and the strict central planning framework increased. The emphasis on self-financing, the various bonuses and incentives for plan fulfillment, and the forward contracting system did not succeed in effectively increasing the autonomy of state enterprises and encouraging competition between them because the Government continued to absorb the bulk of profits, to determine the use of investment funds and bank credit, and to limit contact with foreign suppliers. Similarly, the changes in the price and exchange system, as well as the wage system, did not enhance the allocative role of prices and wages in the Romanian economy. The plan continued to allocate resources and determine exports, imports, and domestic sales of enterprises. Finally, the pervasiveness of the foreign trade plan and the unrealistic character of many of the targets meant that the modification of the price equalization mechanism for exporters failed to achieve its objectives.

In summary, the Romanian economic system at the end of the 1980s was one of the most tightly controlled and centralized in Eastern Europe. The Ceauşescu regime deprived the country of the experience of any significant economic reform, leaving the administration, the managers, and the institutions tied to a Stalinist model that had by that time been abandoned by almost all other countries in the region. In addition, the economic policies of the regime resulted, inter alia, in distorting further the economic system. As plan targets became more and more unrealistic, policies gradually lost touch with reality, misreporting of plan fulfillment grew, forced savings in the hands of the population increased, and the economic system fulfilled its function less and less. ^2/ This led to a vicious circle of tightening of controls, greater disorganization, and further tightening of controls which, by the end of the decade, had eroded the credibility and effectiveness of the economic management system and had driven the country into an economic and institutional crisis.

a. The conditions at the beginning of 1990

The provisional Government that came to power in the last days of 1989 after the violent overthrow of Ceauşescu faced, as discussed in the previous Section, an economic and institutional crisis. ^2/ On the one hand, years of economic mismanagement and the self-imposed isolation of the country in the latter part of the 1980s had undermined the productive capacity and led to an erosion of the standard of living. On the other hand, the institutional framework was probably one of the most antiquated in Eastern Europe, and the country’s administrative and managerial apparatus had no experience with even limited economic reform. At the same time, as tight controls on emigration were in place throughout the 1970s and 1980s, Romania--unlike other Eastern European countries--did not have a large expatriate community that could act as a channel of foreign expertise and advice.

In addition to this crisis, the provisional Government was also faced with social turmoil following the December events that led to the overthrow of Ceauşescu, which aggravated the disorganization of the economy. The turmoil was manifested in various ways. Perhaps the most disruptive for the economy were worker absenteeism and lack of discipline and a breakdown of law and order. ^3/ Also, in many enterprises workers decided to eject their managers, whom they associated with the old regime, and hold new elections to replace them. These elections were often disorganized and had to be repeated until, in early February, the provisional Government decided to put an end to this practice. ^4/ These factors disrupted further the already problematic supply network of state enterprises.

The combination of the economic and institutional crisis and the sociopolitical circumstances prevailing in the country at the beginning of the transition period had three major implications for the Romanian reform process. First, the economic collapse it caused required an immediate policy response by the authorities without allowing for a “pre-reform” period--in the sense used by and Calvo and Frenkel (1991) and experienced in other Eastern European countries--during which the elements and priorities of the reform program are negotiated, the population is informed and educated, and a broad consensus on the strategy is reached before any structural measures are actually introduced. Several measures intended to unblock the productive structures were introduced before a coherent reform program was formulated; as a result, many of these measures had to be modified or replaced later, making the reform effort--at least in its early stages--a process of “trial-and-error”. Secondly, the release of the population’s pent-up demand for consumer goods and the dramatic decline in living standards influenced considerably the early decisions of the provisional Government. On the one hand, it made the adequate provision of basic consumer goods--especially food, heating, and electricity--a necessary condition for the population’s consent to policy changes, and made the improvement in living standards an immediate policy objective. On the other hand, it focused the Government’s attention from the outset on the importance of an adequate social safety net to shield the most vulnerable groups from the burden of the transition to a market economy over the medium term. Thirdly, the combination of the collapse in output with the policy of boosting the population’s real incomes to improve the living conditions caused a rapid deterioration of the macroeconomic situation in 1990; this forced the authorities to change somewhat the priorities of their reform program in mid-course.

b. Economic developments in 1990

The disorganization of the economic management system and the obsolete capital equipment and production techniques inherited from the previous regime, together with the further supply disruptions and the diversion of energy from industry to the population in early 1990, caused output to collapse. Production in state industry in January and February 1990 was 22 percent and 20 percent, respectively, below its level in the corresponding months of 1989, and averaged almost 20 percent below for the year as a whole. Gross Domestic Product is estimated to have fallen by almost 8 percent in real terms in 1990, on top of a 5.8 percent decline in 1989 (Chart 1).

In the face of these developments, the authorities introduced very early in 1990 a number of supply-side measures intended to contain the downward trend in economic activity. Many of these measures were of a structural nature, but were introduced in haste, without adequate preparation, and preceded the elaboration of a coherent program of reform. The most important of these measures were: the complete liberalization of peasant markets in January in order to increase the supply of food; the abolition of the State Planning Committee in January, and its replacement by a Ministry of the National Economy, with mainly coordinating functions; the abolition of certain provisions of the turnover tax that were particularly burdensome on enterprises; ^1/ the introduction in February of decree-law 42, ^2/ allowing agricultural cooperatives to distribute land to their members and to other peasants for “long-term use”, and of decree-law 54, allowing small-scale private enterprises with up to 20 employees; the introduction in March of decree-law 96, liberalizing the regime governing foreign direct investment in Romania; and the abolition of the state monopoly in foreign trade and the partial liberalization of foreign exchange regulations. All these early structural measures--although they were pointed in the right direction--turned out to be inadequate and incomplete, with the exception of the liberalization of peasant markets and the modification of the turnover tax, and had to be supplemented or replaced by improved versions later, when a more coherent reform strategy emerged. The Ministry of the National Economy was closed within a few months of its establishment, and its functions were partially taken by a new National Commission on Prognosis; decree-law 54 had to be complemented by additional legislation and regulations, including a privatization law, in order to perform its function as the major vehicle for reforming the ownership structure of the economy; and decree-laws 42 and 96 had to be replaced by a comprehensive land reform law and a new foreign investment law, respectively, in 1991.

In order to satisfy the population’s demand for basic consumer goods, notably energy and food, as well as to improve living conditions, the authorities decided to divert energy resources from industry to the population, adding to the supply disruptions in state industry. In addition, they pursued expansionary fiscal and monetary policies through most of 1990. These policies, combined with the output collapse, aggravated the domestic imbalances and caused a sharp deterioration in the balance of payments. This deterioration was further exacerbated by the reversal of the policy of import compression of the previous regime; the introduction in January 1990 of a ban on food exports in order to improve the availability of food domestically; and the deterioration of the external environment in the second part of 1990 due to the Middle East crisis. ^3/

On the fiscal side, revenues declined as a result of the simplification of the turnover tax in January 1990, as mentioned above, as well as the replacement of the system of remittances from profits--the other major factor resulting in the excessive tax burden on enterprises in the 1980s --by a profit tax later in the year. Expenditures also declined somewhat, mostly due to the sharp reduction in investment outlays, which reflected the cancellation of several of Ceauşescu’s showcase projects. Current expenditures, however, increased dramatically, mainly as a result of doubling the outlays for subsidies, pensions, and transfers. These increases were, to some degree, inevitable: under the previous regime, some benefits to which civil servants were entitled were simply not paid, ^1/ and promotions were unlawfully delayed. The bulk, however, was due to increases in employee benefits, subsidies to producers of consumer goods--notably food--and transfers for social assistance. These increases were considered by the provisional Government to be necessary in order to ensure social peace by improving the living standards, especially of the most disadvantaged groups. As a result of these fiscal measures, the general government accounts registered a surplus of less than 2 percent of GDP, down from over 8 percent in 1989. In addition, accumulated unserviceable bank debts of state enterprises and cooperatives were written off against government bank deposits resulting from fiscal surpluses of the past, all but eliminating these deposits by the end of 1990 (for more details on this operation see below and in Section IV).

Monetary policy was also expansionary, as banks were initially instructed to extend credit to enterprises to meet higher labor costs. Even later in 1990, when commercial banks had become nominally independent, the financial system was not yet market-oriented and bank supervision was imperfect. As a result, broad money in 1990 as a whole increased by over 22 percent. Moreover, wage increases granted during the early months of the year (before a wage moratorium was agreed between the Government and trade unions in July), as well as higher benefit payments, contributed to an increase of about 3 percent in the average real wage in the economy in 1990. This monetary expansion took place while output was collapsing and before prices were fully liberalized and, as a result, it added to the stock of forced savings, or monetary overhang, created as a result of the planning system, thus exacerbating inflationary pressures in the economy. Although it is extremely difficult to produce even a rough estimate of the monetary overhang due to the fundamental changes in the demand for money that take place in a situation of systemic upheaval and great uncertainty like the one in Romania in 1990, the pattern of income velocity of money can be suggestive: income velocity of broad money at end-1990 in Romania was about half its level during the late 1970s and early 1980s, indicating that perhaps up to 50 percent of the money stock was involuntarily held.

On the external side, in order to improve the domestic supply of food and energy (the latter, unlike in most other Eastern European countries, was imported mostly from the Middle East). ^1/ one of the first decisions of the provisional Government was to discontinue the policy of import compression followed by the previous regime and to ban food exports. These measures, the rapidly growing domestic imbalances, and the Middle East crisis in the second half of the year, were reflected in a swing of the convertible currency current account balance from a surplus of US$2.9 billion in 1989 to an estimated deficit of US$1.7 billion in 1990. This took place despite two devaluations of the leu in February and November 1990, which together moved the official exchange rate from lei 14 to lei 35 per U.S. dollar. As external financing--other than trade financing--was not available, mainly as a result of the self-imposed alienation of the country from the international financial markets in the late 1980s, the convertible currency current account deficit in 1990 was financed almost entirely by the country’s foreign exchange reserves, which were all but exhausted by end-year. The trade balance in transferable rubles with the countries of the CMEA also deteriorated from a deficit of TR 0.5 billion in 1989 to a deficit of almost TR 1.7 billion in 1990.

This sharp deterioration in the macroeconomic situation of the country during 1990, besides being a concern in itself, also forced the authorities to reconsider the priorities of their reform program. First, during the year there was a shift in the emphasis put on macroeconomic stability. The early reform statements simply noted the danger of inflation and the need for a stable macroeconomic environment during the transition. Gradually, however, macroeconomic stabilization became a central part of the Government’s program and a pre-requisite for further reform. This led to negotiations with the IMF for a 12-month stand-by arrangement which became operative in 1991. Second, there was a rethinking of certain elements of the reform program directly related to the macroeconomic situation, notably price reform. While initially the approach to price reform was timid, it soon became evident that such an approach would have budgetary implications incompatible with the tight fiscal policy necessitated by the worsening macroeconomic situation and, in addition, would delay all other aspects of reform; as a result, the price reform was accelerated.

The need for immediate structural measures to contain the collapse in output, the lack of a consensus-building pre-reform period, the trial-and-error approach to reform, and the partial re-ordering of priorities and the change of pace of reform in mid-course made the Romanian reform effort appear somewhat haphazard from the outside. At no point, however, was there hesitation as to the ultimate objective of the authorities’ reform program; these features reflected rather the conditions in which the program was launched and the absence of any received wisdom on how best to proceed with such a reform.

a. Price liberalization

Price liberalization is a central element in the process of economic transformation. Under central planning, prices did not play an allocative role but were used instead mainly for controlling income distribution (Hinds, 1990). As a result, several distortions arose. In many cases production costs were different than sales prices, thus distorting resource allocation. In the case of goods deemed to be “essential”, production costs were higher than prices, necessitating subsidies for the producers to continue operating. These subsidies, as well as the great need for funds to finance investment from the budget, resulted in an excessive tax burden on enterprises and 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 “price equalization funds”, which taxed profitable exporters and importers to subsidize unprofitable ones. ^1/ Finally, the use of prices as a tool for income distribution and the channelling 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. As production was guided by planning rather than the price system and resources were channeled to the capital goods sector, excess demand conditions developed in many consumer goods markets, since the quantity and mix of consumer goods available were not what the consumers desired. As consumer prices were not allowed to adjust, these goods were effectively rationed through queuing--a familiar sight in centrally planned economies. The counterpart of this, however, was the accumulation of large excess money balances by households.

Correcting relative prices and eliminating the monetary overhang in an orderly way is a prerequisite for the achievement of 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 approach of the Government of Romania to price liberalization evolved over time. In the beginning, as evidenced in the early reform documents, the Government was planning to liberalize prices gradually and differentiate between prices of capital and intermediate goods and prices of consumer goods. Some important measures to liberalize prices in certain markets, however, were already taken even before the provisional Government’s reform program was finalized. Prices of agricultural products sold directly in “peasant markets” by producers were liberalized, and newly created private firms and firms with foreign equity participation were allowed to determine the prices of their products freely.

From the outset, the general objective of the authorities was to create a system where prices are determined by supply and demand. This liberalization, however, was 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 goods and services in this category 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 rest of the 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, and in the following order: (i) 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 (ii) 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, inter alia, world market prices as a reference. Prices in the second group, that of consumer goods and services, would be determined during the transition period as follows: (i) 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; (ii) prices of certain other products, such as fabrics, garments, footwear, furniture, durable consumer goods, cars, hotel and tourist services, etc. would be subject to government-imposed ceilings; (iii) prices of a few “special imports” (luxury goods, cosmetics, cigarettes and beverages) would be set administratively, with a view, inter alia, of controlling the total amount imported; and (iv) 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 to be completely liberalized in 1992.

This complicated schedule for price liberalization was never implemented. The Government realized that more decisive steps in this direction would be necessary, 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, all prices of goods and services produced by three or more producers were freed, except for prices of: (i) 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 (ii) 40 basic consumer goods and services, whose prices were kept 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 much less 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 partly for the price increases.

The second round of price liberalization was postponed from January 1 to April 1, 1991. It 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 180200 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 on 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 100150 percent vis-à-vis the previous 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 less 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. Continuous price adjustments throughout the economy made the prices set for these products jointly by the Ministry of Finance and the producers irrelevant only weeks after the conclusion of the negotiations. Further, the system was considered by domestic producers to be unfair, because it did not apply to joint ventures. Most importantly, the system created pressures for subsidies on the Government, as loss-making enterprises claimed that their financial difficulties were due to the price controls. In light of these developments, this system of controls was quietly abandoned. This action, combined with the second round of price liberalization, implied that about 80 percent of prices in Romania were freed by mid-1991. 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 (i.e., 5 basic food items and 9 other categories, including home heating fuels, local transportation, rents etc.). It is noteworthy that in a short space of 8 months Romania went from a system of complete price controls to one which compares favorably with many market economies.

b. 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. ^1/ Generally speaking, trade liberalization has been advocated for two main reasons. ^2/ The first is that it helps to raise economic growth and increase employment generation by improving resource allocation and economy-wide efficiency. The argument here 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 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 in favor of inefficient import substitution.

Overall, the available evidence 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.

An important issue in the process of trade liberalization relates to questions of sequencing, i.e., which measures should be adopted first. It is generally accepted that nontariff barriers, such as quotas and import licensing, 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 providing 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, as well as provides revenue to the Government.

Once nontariff measures have been sharply reduced, bringing about more uniformity in the tariff structure should be given high priority. In addition to minimizing production distortions for a given protection level for importable goods, a more uniform tariff structure also has the advantage of being less subject 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 Government of Romania moved decisively to liberalize the foreign trade sector. The first step in this direction was to abolish the state monopoly for foreign trade. Starting in February 1990 under decree-law 54, private enterprises became 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. Following the abolition of the state monopoly for 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, co-exist with about 50 large former foreign trade organizations (FTOs). The FTOs are state owned, but it is intended to open them up to private participants for up to one third their value, 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 licenses issued were to be based on balance of payments considerations and sectoral priorities. Specifically, the Government intended to introduce three categories of import licensing. The first category would be applicable to raw materials and inputs. For these products, licensing would be automatic and would be required only for data gathering purposes. The second category of licenses would apply to about 100-200 products such as tools, machinery, and agricultural products that were produced domestically. Quotas for such products would be established in consultation with producers and consumers of the respective products. The third category of licenses would be applied to goods for which the Government did not have clear information as to the import needs or domestic production capability. For these products, the license applications would be approved after consulting with the relevant ministries.

On the export side, it was also the intention to introduce three types of licenses. The first category would be for products for which there existed excess domestic supply. 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 remainder of exports licenses would be issued automatically.

This licensing system was regarded as a temporary solution to managing trade in conditions of radical transformation of the economy, particularly as there was 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 their 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 receiving subsidies from the Government or subject to domestic price controls.

Protection of the domestic economy was now to be achieved solely via tariffs and exchange rate policy, and starting January 1991 the Government undertook a number of modifications to the existing tariff code to make it more compatible with the overall objectives of the reform program. First, generalized exemptions from tariffs granted to inputs used by the public sector were revoked; only energy products were exempt from duties. Second, no distinction was to be made between imports of inputs and final products or among different uses of the same product. Third, the highest tariff rates were cut 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 was harmonized with those of other Western European countries. Second, the rates were determined on efficiency considerations alone, implying that the fiscal consequences of any particular structure were not regarded as important. Third, the tariff code would be used to create incentives in the economy for improving efficiency. This means that products for which Romania was clearly not internationally competitive would not be protected. Thus, protection would be limited to those products deemed to need the chance 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 made on the basis of several factors, including the domestic and international prices of the product, domestic production and consumption, import requirements, as well as sectoral development strategies. The new tariff system was submitted to Parliament in mid-1991, and was awaiting enactment at the time of publication of this paper.

The liberalization of trade was accompanied by a policy of allowing greater access of agents to foreign exchange. Prior to January 1990, although foreign currency accounts were legal for residents and nonresidents, the ability of residents to open or effect transactions through such 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. It also became legal to hold foreign exchange outside the banking system, though the requirement to effect all foreign exchange transactions only through authorized agents remained until August 1991.

From September 1990 exporters were no longer compelled to surrender all foreign exchange earnings to the Government. Instead, all exporters became eligible for a minimum uniform retention of 50 percent of their gross export earnings. The use of retained foreign exchange was free from restrictions on payments and transfers for current account transactions, and thus could be used for imports of 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. ^1/

In February 1991, the Government also instituted an interbank exchange market open through participating banks--acting as brokers--to all enterprises. The supply of foreign exchange to this market comes primarily from the 50 percent retained earnings of exporters and the Government. Foreign exchange is made available freely for all bona fide current account transactions, with the exception of limits on profit remittances by nonresidents. Starting August 1991, small-scale transactions in foreign exchange by individuals via exchange houses were also permitted. 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.

c. 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. ^1/

In the light of the experience of several Latin American countries in financial sector reform, however, it is now acknowledged 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 signalling 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 over a short time interval. Provided 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 was complicated. Household deposit rates at the Savings and Loan Bank (SLB) averaged 2.5 percent in 1989, while the SLB received 3.0 percent on its deposits at the National Bank of Romania (NBR). Other banks paid between 1.5-1.8 percent for credit obtained from the NBR in 1989. Enterprise deposits were remunerated at 1.5 percent to 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 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 the setting of rates, over time interest rates 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 to an excessively high level, 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.

a. Fiscal reform

In the context of financial planning as 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 extra-budgetary 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. Thus, large-scale tax reforms have been initiated, while the burden of taxation has been reduced 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 in order to cover expenditures for 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. An additional constraint most of these countries are facing is the lack of experienced staff in the administration to design and implement the ambitious tax reform measures. For this reason, external technical assistance is often solicited in this area.

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 the 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 enterprises realizing large after-tax losses while the budget was in surplus. These losses were covered by automatic extension of bank credit, which left banks with unserviceable loans in 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, the turnover tax levied at the producer level--known as the “Ceauşescu tax”--and the system of remittances from profits were abolished effective January 1, 1990. The provisional Government replaced them with a new remittance mechanism, intended to transfer to the treasury any profits in excess of 10.5 percent of total costs.

On the expenditure side, the provisional Government decided to cancel many of the investment projects started by the previous regime, as well as slow the rate of implementation of other investment projects, due 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 for the population were increased partly to compensate for previous deprivations, and partly to cushion the vulnerable groups from the costs of transition and adjustment.

In the course of 1990 and early 1991, the Government engaged in a comprehensive tax reform. The turnover tax was fundamentally revised on November 1, 1990. First, the base was substantially expanded from domestically produced final goods intended for domestic consumption to all goods and services, whether domestically produced or imported, except those intended for exports. Second, the rate structure was simplified, the rates were transformed from specific to ad valorem, and the number of rates was reduced to a total of 20, ranging from 1 to 90 percent. Finally, to reduce the negative impact of cascading, rates on intermediate goods were set substantially below those on final goods. The system of direct taxes was also overhauled. A proper profit tax was introduced in July 1990 to replace the profit remittance scheme, and the tax on the wage fund of state enterprises was replaced by 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. A case in point, 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 profits 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 those 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 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.

b. Financial sector reform

In a typical centrally planned economy, there is one bank--the National Bank--that has 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 of the population but does not engage in credit operations. This mono-banking system ensures direct and complete control of the quantity of money by the central authority, and 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 inter-enterprise 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).

In the context of the 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-tier banking system, made up by a central bank and commercial banks, developed. Second, the commercial banks need to be given autonomy and start operating on a profit-making basis, which requires primarily competing for deposits and assessing client credit risk. This, in turn, implies that interest rates have to be liberalized and become tools 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 skill- and institution-building, but also profound changes in attitudes. An additional complication is that in many cases these reforms have to be initiated in an unstable macroeconomic environment, which in turn requires tight monetary policies. In such cases, the development and introduction of indirect means of monetary policy may need to be delayed in order 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 in the context of the financial plan, as discussed in Section II. Control over these flows was exercised centrally. In addition to providing credit and accepting deposits, the banking system had the responsibility of monitoring the implementation of various aspects of the physical plan at the enterprise level. The clear division of responsibilities between the state-owned specialized banks was designed to facilitate the fulfillment of these tasks, but also resulted in an absence of bank competition. 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 National Bank of Romania (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 as it was the issuer of 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 sector 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 almost the entirety of household savings deposits, as well as a smaller amount 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 off-shore banks also conducted limited amounts of business in foreign currency and held deposits with the RBFT. Finally, there existed about 800 credit cooperatives with deposit accounts at BAFI, and some 6,000 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, quarterly credit plans were prepared by the Ministry of Finance with the help of ministries and banks. The banks, together with the economic units they served, determined the level of credit needs based on expected production and investment, while the NBR supervised this process. The resulting credit plans were approved by the Government, and available credit was subsequently divided up by banks. 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 given the freedom to negotiate financing contracts with economic units for the implementation of 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, under decree-law 54 on private initiative issued in early 1990 to encourage development of small private firms in general, private banks were also allowed 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 the central banking functions, and a new bank (the Romanian Commercial Bank--RCB) was created and took over NBR’s commercial operations. From that point on, the Romanian financial sector had the two-tier 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, which were 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 to 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. In addition, the NBR is made solely responsible for the conduct of exchange rate policy, including the issuance and implementation of foreign exchange regulations and the management of official foreign exchange reserves and gold. The NBR is given authority to license and supervise commercial banks. The law also places limits on the amount of credit the NBR can extend to the state budget.

Most importantly, perhaps, the central banking law makes the NBR independent in the performance of its duties. The Governor and the Board of Directors are appointed by the Parliament on the recommendation of the Prime Minister for renewable eight-year terms, 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 hold positions in business.

In order 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 the structure of the financial sector, however, is severely limited by the absence of experience with a modern market-based financial system, the lack of expertise and trained staff, the material constraints (e.g., 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.