Romania
Recent Economic Developments and Selected Background Studies
Author: International Monetary Fund
Publication Date:
07 Feb 1996
eISBN:
9781451832679
Language:
English
Keywords:
ISCR; CR; state-owned enterprise; exchange rate; private sector; banking system; interbank market
Download PDF (6.2 MB)

This Recent Economic Developments and Selected Background Studies paper on Romania provides an overview of key monetary and real sector developments in 1995, including the impact of agricultural credit on monetary control, the factors behind the growth in foreign currency credit, and the link between the current account deterioration and real sector developments. The paper examines fiscal policy and performance in the context of the tax reforms and improvements in expenditure management during the transition period, including progress in bringing implicit and “off-balance sheet” subsidies within the scope of budgetary policy.

Abstract

This Recent Economic Developments and Selected Background Studies paper on Romania provides an overview of key monetary and real sector developments in 1995, including the impact of agricultural credit on monetary control, the factors behind the growth in foreign currency credit, and the link between the current account deterioration and real sector developments. The paper examines fiscal policy and performance in the context of the tax reforms and improvements in expenditure management during the transition period, including progress in bringing implicit and “off-balance sheet” subsidies within the scope of budgetary policy.

I. Introduction

In late 1993, after three years of high inflation and declining output, the Romanian authorities initiated a forceful stabilization program, based on a sharp tightening of fiscal and monetary policy. These policies, together with a liberalization of the foreign exchange market effected in April 1994, were supported by a stand-by arrangement approved by the Fund in May 1994. During 1994, fiscal policy was kept tight, with the general government deficit on a cash basis being held to 1.0 percent of GDP. Monetary policy--including the introduction of interest rates that were positive in real terms--was used effectively from late 1993 to cut 12-month consumer price inflation from 295 percent in 1993 to 62 percent in 1994 and some 25–30 percent by late 1995. Furthermore, economic growth accelerated to some 4 percent in 1994 and is expected to reach 5 percent in 1995.

The main domestic economic indicators for the first ten months of 1995 showed a continuing improvement over performance in 1993 and 1994 (Chart 1): CPI inflation was reduced to 1.7 percent per month; industrial output increased by some 10 percent compared to the same period in 1994; and unemployment was on a downward trend, despite widespread labor shedding in industry. However, this success was jeopardized by a rapid deterioration in the balance of payments from early 1995. As imports surged, the current account deficit widened sharply, and is projected to reach some 4 1/2 to 5 percent of GDP in 1995 (compared with 1.8 percent of GDP in 1994). Concurrently, the net international reserves of the banking system declined by some US$370 million, while net domestic assets increased by 58 percent between end-December 1994 and end-October 1995. In addition, the domestic payments arrears of the core “problem” enterprises in the state-owned sector, which appeared to come under control during 1994, began to expand rapidly in the first half of 1995.

CHART 1
CHART 1

ROMANIA: ECONOMIC INDICATORS

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Source: Data provided by the Romanian authorities.1/ Monthly average wage deflated by the consumer and producer price indices.

The threat to the stabilization program can be traced to a number of factors: slow progress in enterprise and financial sector reforms--areas in which policy problems undermined the previous stabilization programs; the failure of the exchange rate to clear the market for much of 1995; the accommodation of pressure for directed credit to agriculture; the rapid expansion of credit, particularly in foreign currency; and the strong recovery of the economy. All of these factors, together with other significant economic developments, are examined in the following sections.

Section II provides an overview of key monetary and real sector developments so far in 1995, including the impact of agricultural credit on monetary control, the factors behind the growth in foreign currency credit, and the link between the current account deterioration and real sector developments. Section III examines fiscal policy and performance in the context of the tax reforms and improvements in expenditure management during the transition period, including progress in bringing implicit and “off balance sheet” subsidies within the scope of budgetary policy; this section also provides a discussion of social safety net issues. Section IV gives an account of structural issues including private sector development, enterprise and financial sector reform, estimated developments in the quasi-fiscal deficit in the enterprise sector, and privatization. Section V reviews external sector liberalization, including the foreign exchange market reforms, external borrowing, and foreign direct investment in Romania. Finally, Appendix I examines external sector performance, exchange rate policy, and competitiveness. A Statistical Appendix is being circulated concurrently.

II. Recent Economic Developments

1. Introduction

Monetary policy has been used effectively since late 1993 to reduce inflation. Although underlying inflation may be higher than the CPI headline figure (see section II.2), it is still well below the average monthly rate during 1993 and 1994 (Chart 1). With declining inflation, interest rates have been significantly positive in terms of contemporaneous inflation (Chart 2). However, monetary control has been jeopardized by a sharp increase in central bank directed credit, especially to agriculture, and a rapid rise in domestic bank credit, particularly credit denominated in foreign currency. These two factors are examined in detail in section II.3 below. In view of these difficulties in the conduct of monetary policy, indicators of confidence in domestic currency are examined in section II.4.

CHART 2
CHART 2

Romania: Exchange Rates, Interest Rates and Reserve Money

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Sources: Data provided by the Romanian authorities and staff estimates.

With regard to key real sector issues, given the current account deterioration, the rise in enterprise arrears, and the rapid growth of the economy, it is important to examine key economic variables in the potential problem sectors. Section II.5 examines detailed sectoral data on production and stocks in order to analyze the link between the current account deterioration and output growth, while section II.6 provides an overview of sectoral patterns of productivity, employment and wages in order to determine the degree of adjustment in each sector.

2. Inflation performance

Chart 1 and Table 1 provide monthly CPI and PPI inflation figures. Although CPI inflation during the first three quarters of 1995 was only 18.4 percent, underlying inflation was higher for a number of reasons. First, the interbank exchange rate was at a more appreciated level than justified by the stance of monetary policy (Chart 2), resulting in an artificial restraint of import prices. Second, the retail prices of a number of key agricultural and dairy products were kept artificially low by the imposition of profit margin controls. 1/ Third, the prices of services have been rising faster than the CPI average (by 30 percent to end-October 1995, see Table 1); the CPI weights, meanwhile, have not been revised for some time and services have a weight of only 16 percent in the CPI basket: given the growth of the services sector, this is likely to be an under-estimate and, hence, CPI inflation maybe under-recorded on this account. 1/ Finally, the above points are somewhat reinforced by the fact that the PPI increased by more than the CPI: 22 percent (versus 18.4 percent) in the first nine months of 1995. These elements suggest that underlying inflation may be higher than the headline figure, but it remains clear that monetary policy has achieved a major success in reducing inflation from the levels of 200–300 percent experienced in 1991–93.

Table 1.

Romania: Monthly Inflation, 1994–95

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Source: National Commision for Statistics.

January-September 1995.

September 1994-September 1995.

3. Monetary policy

At present, the National Bank of Romania (NBR) allocates its refinancing credit primarily through two channels: directed lines of credit at the official reference rate (referred to as “structural credit” by the NBR) and a weekly refinancing auction. In addition, refinancing is provided through three other channels, which have generally been quantitatively less significant: (i) “special” lines of credit provided to banks under exceptional circumstances, such as when they are under the direct supervision of the central bank; (ii) overdraft credit when banks fail to meet reserve requirements (referred to as “Lombard credit” by the NBR); and (iii) preferential credit extended at very low interest rates--the volume of which has been kept to a very modest level since 1993.

The NBR reference rate is regarded as the floor for market determined interest rates in Romania; NBR lines of credit are extended at this rate. With regard to the weekly auction, the NBR announces the maximum volume and the minimum interest rate a day ahead of the auction. The interest rate on overdraft credit is usually substantially higher than the reference or auction rates. Interest rates on preferential credit are at a much lower level than the reference rate. In addition, a large proportion of credit lines and auction credit obtained by the banks from the NBR at the reference or auction rates is on-lent to the agricultural sector at much lower interest rates. Until recently, the interest subsidy was paid to a significant degree by the NBR, but interest subsidies have been shifted fully to the budget since 1995. 1/

a. Credit to agriculture

Chart 3 provides an indication of the significance of directed credit in the NBR’s refinancing activities. At the end of 1994, over two-thirds of the NBR’s refinancing credit had been earmarked for specific sectors, i.e., agriculture, energy, and exports, through lines of credit. By far the largest share of directed credits was allocated to agriculture. In addition to this, a large part of the credit allocated through the auction is, in essence, for agriculture, as Banca Agricola (BA) has consistently received the largest share of auction credits. Since most of the agricultural lines of credit are also extended to Banca Agricola, a good estimate of the share of agriculture in total refinancing credits is the amount of NBR refinancing received by Banca Agricola (Chart 3).

CHART 3
CHART 3

ROMANIA: NBR Refinancing Credits

(Billions of lei)

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Source: Staff estimates.

At end-1994, 72 percent of the NBR refinancing credits was extended to Banca Agricola. Between end-December and end-July 1994, there was a concerted effort to reduce the ratio of NBR refinancing going to Banca Agricola. This ratio had declined to 59 percent by end-July 1995. However, financing for the large autumn harvest led to a sharp rise in credit to agriculture and by end-November 1995, 69 percent of NBR refinancing was extended to Banca Agricola, and directed lines of credit accounted for 52 percent of total NBR refinancing.

b. Money and credit

Monetary developments in the first ten months of 1995 were in sharp contrast to those in 1994. In 1994, the increase in broad money was accompanied by a large rise in NIR; however, by end-October 1995, with the NIR falling, the increase in NDA was larger than the rise in broad money, and the government recorded a deficit (Table 2). Indeed net domestic credit increased by 50 percent in the first ten months of 1995, with the bulk of this credit going to the nongovernment sector. Given the rigidity of the exchange rate, there was a very high leakage of this credit to the balance of payments, while the money supply (and in the short run, inflation) remained broadly on track.

Table 2.

Romania: Monetary Developments, 1992–95

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Source: National Bank of Romania and staff estimates.

Monthly GDP (annualized) divided by the end-of-period stock of money.

Currency holdings of non-bank public divided by annualized monthly GDP.

A striking feature of the rise in NDA during the first ten months of 1995 was the sharp increase in foreign currency denominated domestic credit: measured in domestic currency terms, this doubled (while leu-denominated domestic credit rose by 51 percent), and it accounted for about 40 percent of the increase in credit to nongovernment. 1/ 2/ It is important to explore the possible factors behind the rise in foreign currency lending, as it has the potential to jeopardize monetary control; moreover, a shift toward-foreign currency denomination in domestic financial transactions is frequently associated with a loss of confidence in the domestic currency. The following points emerged from interviews with the key banks and an analysis of the data:

(i) The malfunctioning of the exchange market was indeed one factor behind the rise in foreign currency lending. During the first half of 1995, and again in October-November 1995, when the exchange rate was not at a market clearing level, many banks were unable to obtain exchange at the going rate and, consequently, transactions between banks dropped to insignificant levels (Chart 4, middle panel, and Chart 5). Concurrently, each bank rationed the available foreign exchange among its own clients (state owned companies were obliged to hold their accounts at only one bank). Faced with difficulty in obtaining exchange from the interbank market, firms may have turned to borrowing in foreign currency to finance imports of goods and services. (To that extent, however, the rise in foreign currency-denominated lending basically substituted for a drawdown of domestic currency deposits and for an increase in domestic currency lending.)

CHART 4
CHART 4

ROMANIA: Interbank Exchange Market

(In millions of dollars)

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Source: Data provided by the Romanian authorities.
CHART 5
CHART 5

ROMANIA: Interbank Exchange Market and Exchange Rate

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Source: Data provided by the Romanian authorities.

(ii) Another factor behind the rise in lending denominated in foreign currency rather than in leu was the very high level of domestic currency interest rates. Leu lending rates (at 50–85 percent per annum (Chart 6)), have been considerably higher than, say, dollar interest rates (at 5-10 percent per annum). Given this wide margin, those borrowing in foreign currency were either prepared to take on the depreciation risk in return for the availability of credit, or were hedged through export receipts. The fact that the exchange rate was, de facto, depreciating at a relatively gradual and predictable rate, may have encouraged banks’ clients to take the exchange risk on foreign currency borrowing. (This would imply, however, that the financial market is very segmented; otherwise arbitrage would quickly have eliminated the perceived difference between returns on domestic and foreign currency assets and liabilities--see 11.4 below). The cost of foreign currency borrowing after allowing for actual exchange rate depreciation is shown in Chart 7. On the face of it there appears to be an inconsistency between this account of credit developments and the argument that the growth in imports reflected in part fears of devaluation. Indeed the literature on exchange market behavior suggests that such divergences of view between participants in goods and asset markets can play a significant role in explaining the adjustment process.

CHART 6
CHART 6

Romania: Interest Rates, Inflation and Bureau Premium

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Sources: National Bank of Romania, and staff estimates.
CHART 7
CHART 7

ROMANIA: Cost of borrowing, 1994–95

(In percent per annum)

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Sources: Data provided by the Romanian authorities and Fund staff estimaes.1/ Libor adjusted for the future 3 month depreciation of the leu; annualized.

(iii) Both the Romanian Commercial Bank (RCB) and the Romanian Bank for Foreign Trade (RBFT) indicated that part of the lending in foreign currency has financed the import of raw materials, especially petroleum. However, they claimed that a significant portion of such lending was based on trade-related lines of credit extended by foreign banks to finance capital goods imports for credit-worthy enterprises in exporting sectors such as furniture and textiles. This re-lending or on-lending by domestic banks would contribute to an increase in imports, but not, of course to the rise that occurred in NDA. 1/

The sustainability of current trends needs to be assessed, inter alia, in light of banks’ sources of financing for foreign exchange lending. Banks can finance such lending through (i) an increase in customers’ foreign currency deposits, (ii) reducing their foreign assets, or (iii) foreign borrowing on their own account or on account of clients. It is difficult to distinguish clearly between these cases from the available data (Chart 8). However, in the first ten months of 1995, foreign currency lending rose by US$680 million 2/ while foreign exchange deposits increased by about US$168 million. This is consistent with a US$326 million decline in commercial banks’ liquid foreign assets and broadly in line with the decline in NIR (Chart 8). In fact, until March this year, the total stock of foreign exchange deposits was higher than total lending in foreign currency by banks; since then, foreign currency lending has exceeded total foreign currency deposits by about US$300 million.

CHART 8
CHART 8

Romania: Commercial Banks’ Foreign Currency Deposits & Lending, and Banking System NIR

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Sources: National Bank of Romania.

In response to the rapid growth of foreign currency lending, the NBR substantially increased the reserve requirements for foreign currency deposits in November 1995. Foreign currency reserve requirements were more than doubled to 40 percent, if paid in foreign currency, and 20 percent, if paid in lei. The NBR also indicated that a prudential, foreign exchange liquidity ratio is to be introduced by end-1995. Finally, the sharp depreciation of the exchange rate in late 1995 presumably increased significantly uncertainty about the domestic currency cost of borrowing in foreign currencies (ending the de facto “tablita”) (Chart 7).

4. Confidence indicators

Given the delicate balance of payments situation, the difficulties in the exchange market, and the rise in foreign currency lending, the performance of indicators of confidence in the domestic currency is of particular interest:

(i) After declining sharply for several months during 1994, the velocity of circulation of broad money increased in January 1995 (Chart 9); since then it has declined modestly compared to 1994. The level of velocity in Romania, however, remains significantly higher than in the other transition economies (Table 4).

CHART 9
CHART 9

Romania: Velocity, Foreign Deposits and Household Savings

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Sources: Data provided by the Romanian authorities; and staff estimates.
Table 3.

Romania: The Increase in Foreign Currency Lending, January-October 1995

(in billions of lei)

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Source: National Bank of Romania
Table 4.

Romania: Velocity of Brood Money, 1990–1994

(M2 Excluding Foreign Currency Deposits)

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End of period.

(ii) The ratio of foreign currency deposits to money has been fairly flat since the beginning of 1995 after declining significantly during 1994 (Chart 9, middle panel). However, real leu denominated household deposits rose continuously during the first eight months of 1995 (Chart 9, bottom panel) before declining during September and October. It seems somewhat puzzling that in spite of very high real interest rates (Chart 6), which have attracted household leu deposits, the ratio of foreign currency deposits in total money has not declined further in 1995; and more generally, as noted above, that there was not greater arbitrage between foreign and domestic currency-denominated assets and liabilities of residents. Chart 10 sheds some light on this matter. First, until recently, household leu deposits grew much faster than non-household leu deposits 1/, and the stock of household leu deposits now exceeds the stock of non-household leu deposits (Chart 10). 2/ Meanwhile, 80 percent of the stock of foreign currency deposits belongs to non-households: movements in the total value of foreign currency deposits are thus much more sensitive to enterprise, rather than household, behavior. These data thus suggest that enterprises were concerned to maintain high levels of foreign exchange deposits.

CHART 10
CHART 10

Romania: Domestic and Foreign Currency Deposits

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Sources: National Bank of Romania.

One reason why enterprises may have preferred to hold foreign currency rather than leu may lie in the malfunctioning of the exchange market. When the exchange market was operating as intended, between March and November 1994, both velocity and the foreign deposits ratio fell sharply (Chart 9). Subsequently, importing enterprises holding deposits may have believed that the exchange rate was over-valued (but presumably not those enterprises borrowing in foreign exchange--see above). However, prudential considerations may also have played a role. First, difficulties in accessing foreign exchange: holding deposits in foreign currency assured immediate access to foreign exchange in the event of shortages. Second: to the extent foreign exchange deposits are held not directly by enterprises but by their subsidiary/associate trading companies, then--if an enterprise has tax, interest or other arrears--its foreign exchange holdings are safe while its leu deposits may be vulnerable to seizure by domestic creditors.

(iii) Other relevant factors affecting confidence are inflationary expectations and perceptions of risk. During the first nine months of 1995, three to six month leu deposit rates declined from about 70 percent to some 40 percent, whereas dollar deposit rates ranged from 4 to 6 percent. Therefore, there were either large inflationary expectations, or a substantial risk premium associated with leu holdings, or both. While annualized monthly inflation declined to as low as 15 percent during the first ten months of 1995, year-on-year inflation declined from about 50 percent at the beginning of the year to about 25 percent by end-October. It could well be that people form expectations on the basis of past rather than current inflation; therefore, inflationary expectations may be higher than contemporaneous inflation.

One way of ascertaining inflationary expectations is to look at the yield curve over time (Table 5 and Chart 11). Given the imperfections in the financial system, the shape of the yield curve varies from bank to bank even for the same period; however, these curves have converged in recent months (Chart 11). For every bank, the yield curve shifted down between mid-1994 and September 1995, suggesting that inflationary expectations improved. By November 1995, as the current account continued to deteriorate and inflation picked up somewhat, yield curves started to move up at some banks. However, for most banks the shape of the yield curve continues to be fairly flat, indicating that inflation was not expected to fall from current levels--no doubt in part because inflationary expectations are slow to adjust.

Table 5.

Romania: Commercial Bank Deposit Rates, 1994 -95

(In percent per annum)

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Source: National Bank of Romania and staff calculations.
CHART 11
CHART 11

Romania: Commercial Banks’ Yield Curves

(In percent per annum)

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Sources: National Bank of Romania.

5. Current account deficit and output growth

Table 6 illustrates that imports of all commodities rose sharply in the first half of 1995. However, the increases in imported raw materials, intermediate inputs, and petroleum were particularly marked. Most of the increase in the value of oil imports was due to a 44 percent increase in the volume of oil imported during what turned out to be a mild winter (see Chapter III). Three types of commodity groups: mineral products (half of which is petroleum), chemicals, and basic metals--which are primary or intermediary inputs--accounted for 40 percent of the total value of imports (the value of petroleum by itself accounted for 15 percent of the total value of imports). Another major category of imports was machinery and electrical equipment; accounting for 19 percent of the total value of imports. 1/ It is also interesting to note that imports far exceeded exports in only two of the above categories: mineral products, and machinery and electrical equipment.

Table 6.

Romania: Exports and Imports by Commodity Group, January-June 1995

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Sources: Romanian authorities; and Fund staff estimates.

In millions of U.S. dollars.

Relative to a corresponding period of the previous year.

It is difficult, through the available data, to trace directly the imports of the above commodities in the production chain and determine whether they are demand led or speculative, or if they go to viable or problem enterprises. However, a number of indicators may shed some light on these matters, albeit, indirectly. For example, if output in a sector is growing and stocks are rising it may indicate problems. On the other hand, if the rise in output is associated with declining stocks then we would have a simple demand led output growth with an associated rise in imports. Other useful indicators are ratios of stocks to output, exports to output, and stocks to exports. Developments in sectors such as chemicals, metallurgy, metallic construction, petroleum processing, power, and machines and equipment should be of particular interest since they would be key users of the major imported commodity groups mentioned above, and they include many problem enterprises.

Tables 7–13 provide an overview of output growth and sectoral developments during the first three quarters of 1995. Although industrial output increased by some 10 percent (compared to 1994:Q1-Q3), there were wide sectoral variations (Table 7). In communication equipment, paper, computers, fabrics, precision instruments, and furniture (none of which can be regarded as a problem sector), output was well above average, whereas in petroleum and gas extraction sector output actually fell. The problem arises when looking at a group of sectors such as metallic construction, machines and equipment, metallurgy and chemicals. Output in these sectors (which contain “problem” state-owned enterprises and are users of the major imported commodity groups), increased by more than the average rate.

Table 7.

Romania: Indices of Industrial Production by Branch, January-September 1995

(January-September 1994=100)

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Source: National Commission for Statistics.

Table 8 provides the change in stocks, the ratio of stocks to output, and the ratio of stocks to exports for each industrial sector. The data provide a snap-shot view of each sector and their quality cannot be assured, therefore they should be treated with caution. Nonetheless, the following points emerge:

(i) The increase in the average rate of stock-building appears rather high especially since the ratio of stocks to output is high in most sectors. The increase in stocks is partly seasonal judging by the past aggregate data (Chart 12).

(ii) With regard to the problem sectors, stocks in the chemical sector increased by an alarming 63 percent and the ratio of stocks to output is rather high. In machines and equipment sector stocks increased by 56 percent and the ratio of stocks to output and stocks to exports are high. In the metallic construction sector, stocks rose by about the average rate; however, the ratios of stocks to output and of stocks to exports are rather high. In metallurgy, stocks rose by less than the average rate and the ratio of stocks to output, though high in absolute terms, is not high relative to the other sectors.

(iii) It is also interesting to note that, in spite of low production, stocks in both petroleum and gas extraction, and the petroleum processing sectors increased sharply in the first nine months of 1995 (by 72 and 63 percent respectively). So, despite the large imports of petroleum, it appears that the demand for oil was not particularly high relative to the same period last year. This confirms the view that the petroleum imports were either speculative because of the level of the exchange rate or whey were simply for building strategic stocks and were not demand-driven.

Table 8.

Romania: Achieved and Invoiced Industrial Output by Branch, September 1995

(In millions of lei. producer prices)

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CHART 12
CHART 12

ROMANIA: Inventories

(End of period)

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Source: Data provided by the Romanian authorities.

Tables 9 and 10 provide output and stock-building data by product. Again, it is difficult to draw precise conclusions; however, the following points are worth noting:

(i) Stocks of a number of products (steel sheets, fertilizers) from problem sectors increased substantially with a commensurately high increase in output. This would be problematic unless the cause were seasonal (fertilizers may be seasonal but not steel sheets). 1/

(ii) Again, stocks of petrol and fuel oil increased substantially while production of these items increased modestly.

(iii) Stocks of a number of products fell (dairy products, synthetic rubber, synthetic fibers) while their output increased substantially, indicating strong demand.

Table 9.

Romania: Output of Main Industrial Products, January-September 1995

(January-September 1994=100)

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Table 10.

Romania: Stocks at Producers for Main Industrial Products, January-September 1995

(Product units)

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Source: National Commission for Statistics.

In summary, it is exceedingly difficult to trace the rise in imports through the production chain; however, the following conclusions emerge from the above analysis: (i) the imports of oil were clearly not demand driven; (ii) the output rise in a number of problem sectors which are potential importers of raw materials, such as metallic construction, chemicals, and machines and equipment, has been associated with rising stocks. If this pattern is not seasonal, then any imports by these sectors were either speculative or else their output increase is not entirely demand driven (the arrears of a number of steel companies increased sharply in the first nine months of 1995); and (iii) in a number of sectors--many of which do not include problem enterprises--the increase in output, and any associated rise in imports, appears to be demand driven.

6. Productivity, employment and wages

Tables 11-13 provide data on sectoral productivity, employment and wages in order to ascertain the degree of adjustment in each sector. Industrial employment fell by 129,000 (5.4 percent) between September 1994 and September 1995 (Table 11). There was significant labor shedding in some of the large problem sectors. For example, employment fell by 8,100 (6.7 percent) in the chemicals sector, 4,300 (6.1 percent) in metallic construction, and 9,000 (5.3 percent) in metallurgy. Consequently, productivity in these sectors improved (Table 12). Employment reduction was lower in some of the other sensitive problem sectors. In iron ore mining, employment fell by 2,200 (4 percent), and in other extraction activities employment declined by 700 (3.9 percent). Productivity in these sectors increased by less than the industrial average (Table 12).

Table 11.

Romania: Employment in Industry by Branch, 1994–95

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Source: National Commission for Statistics.
Table 12.

Romania: Indices of Hourly Labor Productivity in Industry by Branch, January-September 1995

(January-September 1994=1001)

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Source: National Commission for Statistics.
Table 13.

Romania: Monthly Average Wages, September 1995

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Source: National Commission for Statistics.

Average net-wages increased by some 50 percent between September 1994 and September 1995 (Table 13). CPI and PPI increased by about 25–30 percent during this period; therefore, there has been an increase in the real wage of some 20–25 percent. The recent increases may have been due to a catch-up effect as by October 1995 real consumption wages were at the same level as in 1992. In addition, unit labor cost competitiveness does not seem to have deteriorated (Chart 13).

CHART 13
CHART 13

Romania: Real Exchange Rate Measures 1/

(January 1991=100)

Citation: IMF Staff Country Reports 1996, 009; 10.5089/9781451832679.002.A001

Sources: Data provided by the Romanian authorities and staff estimates.1/ An Increase in an index Indicates real appreciation.2/ January 1992=60.3/ The observation for November 1995 is based on the actual exchange rate and estimated inflation.

The highest wage increases were in the financial and public sectors. However, the latter reflects a one-off payment to public employees whose wages had fallen behind other groups and whose wage level remains one of the lowest in the economy. Wages in industry increased by about 50 percent in nominal terms (some 20–25 percent in real terms) during the September 94-September 95 period. The industrial distribution of wage increases is interesting: wages in both the mining and power sectors increased by much less than average, which is surprising given the strength of the labor unions in these sectors. Wages in metallurgy increased by more than average (59 percent in nominal terms). However, wage levels in mining, engineering, metallurgy and chemicals continued to be the highest in the public sector, well above those in public administration and education.

In short, there has been important adjustment in terms of labor shedding in the industrial sector. However, not surprisingly, the adjustment in some of the sensitive problem sectors, such as mining, has been slow. One potential problem is the rate of increase in wages. So far, this has not damaged competitiveness or led to higher inflation but it needs to be monitored closely in the coming months.

III. Fiscal Policy in Transition

Fiscal policy in Romania has undergone major changes since the initiation of economic liberalization and market reform. Revenues have declined as the tax base was eroded, and the taxation system had to be adapted to the needs of a decentralized economy; expenditure policies had to be reoriented towards new priorities, and budget management systems had to be improved; finally, the social safety net had be adapted in response to new challenges such as unemployment and inflation. This section discusses major trends in revenue and expenditure policies, reforms of the tax and expenditure management systems, and the evolution of the social safety net during the transition period.

1. Revenue developments and tax reform

During the first four years of economic liberalization, Romania experienced an extensive decline in revenues, which began to be reversed only in 1995. This experience was shared by most transition economies, and is in part related to the decline in output associated with the reallocation of resources following the end of the state-trading system among centrally-planned economies. In Romania, important progress has now been made in establishing a modern tax system, through a succession of tax reforms beginning in December 1989--the most recent of which have proved quite effective. These reforms have gradually transformed the former tax structure into a modern system, which includes a value-added tax (VAT) and an inflation-indexed profits tax. Two stages have marked tax reform efforts over the last five years.

a. Developments in 1989–93

During these years a number of taxes of the pre-reform period were eliminated while new taxes were introduced, in part in an ad hoc manner. At the same time, total revenue declined substantially--from 39.8 percent of GDP in 1990 to 33.8 percent of GDP in 1993 (Statistical Appendix tables 34 and 35).

Initially, several anachronistic turnover taxes were canceled, including, in particular, the turnover tax at the wholesale level. The rules regarding profitability, destination of goods, margins applied to consumer goods delivered to rural areas, and labor contributions to production were rescinded. By end-1990, the turnover tax was retained only at the retail level--a first step toward the ultimate replacement of turnover taxes with a VAT in 1993. 1/

In addition, in mid-1990, the confiscatory profits transfer tax was abolished, so as to reduce the tax burden on enterprises. In the first instance, it was replaced (retroactively to early 1990) with an entity-specific, progressive enterprise tax, which contained six brackets with rates ranging up to 58 percent. Subsequently, in early 1991, another profits tax was promulgated. In this second round of the reform of the profits tax, the archaic profits tax on state enterprises was abolished together with the agricultural profits tax on farming cooperatives. A new, multiple rate profits tax was adopted as a tax for all enterprises. 1/ An unfortunate feature of the new tax was the explicit promotion of tax incentives as instruments to attract investments. The new profits tax offered generous investment tax allowances and tax holidays for selective activities, which, in the event, acted like a sieve through which revenue would slip. Collection of profits tax fell from 7.2 percent of GDP in 1990 to 3.8 percent in 1993.

In early 1991, an individual wage tax was introduced, based on wage payments at the enterprise level, replacing the former wage tax based on an average gross wage at the economy level. Furthermore, to support the tax-based income policy that would be a major element in the government’s effort to control wage-induced inflation during the transition period, a supplementary wage tax was introduced. Enterprises which continued to pay wages that exceeded an established limit, differentiated by industry, would be heavily penalized.

b. Developments since 1993

By early 1993, it became clear that previous ad hoc measures to reform the wage tax and profits tax were producing poor results in terms of revenue, and that stronger measures were needed to prevent a further collapse of tax revenue collection. A major effort in tax reform was launched by the new government, with two major tax laws--among other changes--contributing to a halt in the decline of tax revenues: the VAT and, finally, an effective reform of the profits tax.

The most important reform was the introduction of a 18 percent VAT in July 1993 to replace the inefficient turnover tax. While removing the cascading effect of the turnover tax, the VAT, being a tax on consumption, would also provide a better balance between the taxation of income and consumption in Romania. This would reduce the growing imbalance that had emerged in recent years. 1/ In late 1994, a new rate of 9 percent was introduced for certain goods, primarily foodstuff and medicine, which were previously exempt. Revenues collected from the VAT increased rapidly, and are expected to reach 5.5 percent of GDP in 1995, compared to 4.6 percent of GDP in the preceding year. Nevertheless, this level of collection remains low by international standards and also compared with other Eastern European countries.

The second major reform was the introduction of a new Profits Tax Law, issued as an Ordinance in end-August 1994. The new tax eliminated the structural weaknesses embodied in the old tax through the combined use of inflation adjustments, appropriate depreciation allowances, and with a severe reduction in the use of tax holidays. However, the new profit tax did not lead to the expected large surge in revenues, due to difficulties in the administration of the new tax; lower than expected effects from the elimination of tax holidays; and increasing difficulties in profit tax’ collection from state owned enterprises--again an experience shared with other transition economies. Moreover, the financial restructuring program among large state-owned enterprises sharply reduced banks’ profits in the first half of 1995, resulting in commensurately lower profit tax revenues (revenue losses from this source will exceed 0.4 percent of GDP in 1995). Nevertheless, revenues from the profit tax are projected to reach 4.3 percent of GDP in 1995--the first increase in five years, albeit still almost 2 percent of GDP short of the initial budget projections.

Additional reforms were introduced in the agricultural income tax, local taxation and wage taxes. The wage tax was amended to reduce the tax burden on second employment income by 70 percent, the maximum penal rate of the supplementary wage tax on excess wages was raised to 500 percent on enterprises which pay wages exceeding an industry-based reference wage. Finally, plans are being developed to broaden the tax base further through the introduction of a global income tax.

The most important challenge for the near future will be to consolidate the gains from tax reform by strengthening tax administration. While the tax base for some taxes (VAT) can be broadened and others (excise taxes) streamlined, the strengthening of tax administration is needed urgently in order to stem the increasing difficulties in tax collection. High priorities at the present time include: simplifying administrative procedures, improving coordination between the central government and judets on tax-related matters, computerizing the tax system, providing more manpower to the tax administration unit, and intensifying the training of tax auditors.

2. Expenditure policies and management

In the first two years following economic liberalization, few major decisions appear to have been taken to formulate a public expenditure strategy: total expenditure remained around 39 percent of (the much reduced) GDP. In 1992, an election year, expenditure rose to some 42 percent of GDP. Throughout this period, there was a need to broaden the definition of the fiscal deficit substantially, as expenditures were routed through extra-budgetary accounts. (Thus, for the 1994 stand-by arrangement with the Fund, a broad definition of the consolidated general governments has been used--see discussion of public expenditure management, below). As a result of these developments, the fiscal balance deteriorated sharply from a surplus in 1990–91 to a deficit of 4.6 percent in 1992. This contributed to a serious deterioration in macroeconomic performance.

An improvement in expenditure restraint in 1993–94 played a major role in supporting the authorities’ stabilization effort. However, in 1995, it proved necessary to cut back spending plans at a relatively late stage in the year in response to a serious worsening in the external situation. This experience underscores, among other issues, that there remains scope to strengthen substantially the Ministry of Finance’s capacity to assess and monitor key economic variables during the annual budget preparation and when assessing the mid-year budget.

a. Expenditure policy since 1993

A major attempt to control and redirect public expenditure was initiated in 1993. As a consequence of these policies, total government expenditure was reduced by almost eight percentage points of recorded GDP. (Such comparisons need, of course, to be treated with a degree of caution, given the substantial uncertainties attaching to the national income accounts during the transition period.)

The most drastic cuts were effected on subsidies, which fell by about 6 percent of GDP. Transfers to less productive activities in the agriculture and mining sectors were scaled backed in favor of more productive activities in the transportation and construction sectors, and to free resources for welfare programs for the poor. A reduction in government spending on goods and services was decreed which led to a real cut in expenditures on these items of some 30 percent. This squeeze was not accompanied by a major cut in the number of services provided, and caused public sector productivity to decline as the general ability of the government to provide its services was markedly reduced.

The wage policy adopted in 1993 resulted in a reduction of some 25 percent of real wage payments over 1992, while there was no major reduction in the number of government employees. Sharp cuts in capital expenditure, in 1993, lead to a long overdue rationalization of the public sector investment program. The new investment approach sought to divert resources from investments with a low social rate of return (e.g., Casa Republici) in favor of investments with high a social rate of return (e.g. irrigation projects, schools, and civil infrastructure). 1/

In 1994, a significant effort was made to redirect expenditure policies toward underpinning sustainable economic growth. More resources were allocated for capital spending, social safety net expenditures, and general goods and services while consumer subsidies were cut by a further 3 percent of GDP. Capital expenditure rose by 1.2 percent of GDP, and in order to increase the efficiency of public investments the Council of Reform was instituted to coordinate and evaluate all sectoral public investment proposals.

More resources were also allocated for social safety net expenditures in 1994. As the adjustment process got underway, the combined impact of job losses and rising prices caused an increasing number of people to seek social assistance. In response, increased resources were needed to assist the aged, the poor, and the unemployed. Benefiting from an established welfare delivery network, resources allocated to child allowances, heating allowances, job training and retraining, pensions, and unemployment benefits rose by some 1.1 percent of GDP to 10.8 percent of GDP. Measures were introduced to reform the wage policy and a small scale civil service reform, was initiated. 2/ However, all remaining government employees also received an unprogrammed average salary increase of some 23 percent in the last quarter of 1994.

In 1995, the initial budget envisaged a reversal of the expenditure compression experienced in the previous years. Public expenditure was projected to increase by more than 4 percent of GDP over the level of 1994, thus bringing total expenditures to 38.8 percent of GDP, back to the levels of 1990–91. Higher expenditures were planned for wages and salaries, other goods and services and transfer payments and capital expenditures. Subsidies were slightly lowered reflecting a continued effort to reduce subsidies, especially to the mining and agricultural sectors. This budget was approved by parliament in March 1995. At this same time the allocations for capital expenditures and other goods and services and subsidies were increased. Subsequently, a number of revisions were made to the 1995 budget at the mid-year stage.

Developments in subsidies however, need to be interpreted in light of efforts to cut implicit subsidies and bring them within the budget. First, a main feature of mid-year changes in the 1995 budget was the incorporation of enterprise restructuring expenditures (see also the discussion of revenue losses from bank provisioning, above). The enterprise restructuring plans presupposed additional fiscal expenditure on employee severance payments amounting to 0.2 percent of GDP. Second, in addition to these narrowly-defined restructuring expenses, as part of an effort to cut and bring within the budget various implicit subsidies in the economy, expenditures in 1995 included a conditional transfer (amounting to 0.4 percent of GDP) to selected loss-making enterprises that were heavy energy consumers--the stipulation being that these amounts would only be paid if certain adjustment actions were carried out. Third, in the same spirit, the 1995 budget incorporated from the outset agricultural interest subsidies amounting to 0.2 percent of GDP that were formally provided by the NBR; thus all agricultural now are explicitly included within the budget.

As 1995 progressed, it became clear that the levels of revenue initially projected by the government would not be realized--and also that balance of payments developments were more strongly adverse than anticipated earlier. In light of these developments, it was determined in late 1995 that spending should be held below the original budgetary allocations (without reducing restructuring expenditures). Nevertheless, compared with the level of the previous year, overall expenditures of the consolidated government in 1995 are expected to increase by about 2.4 percent of GDP.

b. Expenditure composition

Expenditure priorities, and with them the functional composition of expenditures, changed markedly over the past three years (Statistical Appendix table 36). As noted above, expenditure policy afforded the highest priority for social expenditures--pension payments, unemployment benefits, and child allowances have consistently received the largest budget allocation throughout 1992–94 (about 9 percent of GDP). By contrast, as programs of income support to the mining sector were adopted, total spending on their sector fell from second place in 1992 (7.1 percent of GDP) to fifth in 1994 (2.6 percent).

Resources allocated for education and health--which held, respectively, fourth and fifth places in 1992 (3.6 and 3.3 percent of GDP)--moved up to become the second and third most important in 1994. Defense spending declined from 3.2 percent of GDP in 1992 to 2.4 percent of GDP in 1994, but remained among the six largest categories. Higher shares of resources were allocated for public order (e.g., reform courts) over the period while expenditure shares for community housing and recreational and cultural affairs have remained more or less constant. The expenditure composition in 1995 is expected to remain similar to the pattern observed in 1994, however, somewhat higher shares may be allocated to agriculture, education and pensions.

A number of projects on environmental protection were initiated; however, due to the difficult budgetary conditions only limited resources were allocated to this sector (on average about 0.2 percent of GDP over the period from 1993 to 1995). Meanwhile, a comprehensive environmental strategy and a draft environmental law is currently under discussion. Key elements of the strategy include harmonizing environment policy and standards with those of the European Union, focusing attention on specified industrial polluters, implementing measures to reduce power consumption and enlarging Romania’s protected areas.

Further scope exists for expenditure reform that would support efficiency and growth objectives. To maximize social economic returns of public spending, resources would need to be redirected to increase capital spending on schools, hospitals, and transportation, reinvigorate repairs and maintenance programs, streamline various entitlement programs under the social insurance schemes, trim public sector employment, and cut further existing subsidies to agriculture and mining. Moreover, while considerable progress has been made, substantial scope still exists to strengthen procedures for reviewing the overall public expenditure program--including the capital expenditure program.

c. Expenditure management and control

A number of significant changes have been introduced to improve the financial management capabilities of the government since the economic reform process was initiated. One of the most important institutional reform measures was the setting up of a Treasury Directorate in the Ministry of Finance. Established in the early days to oversee the Treasury operations, the treasury system has since been extended rapidly to local offices throughout the country. In the process, the cash management of the Treasury has improved and the flow of information from local offices to the Ministry of Finance has increased significantly, thereby enhancing the quality of financial decision making in the Ministry of Finance and facilitating budgetary execution.

In order to strengthen further the institutional structures, a Public Debt Directorate was established. Through it, the Ministry of Finance has become more effective in mobilizing domestic resources--through the issuance of treasury bills and government bonds--and in securing external funds for the financing of the State budget deficit. In addition, the Public Debt Directorate was set up to become a coordinator of the government’s role as a “lender of last resort” for state-owned enterprises undergoing restructuring by overseeing the government loan guarantees program.

Major changes have been implemented in the organization and reporting of government expenditures. Since 1993, special extrabudgetary funds--traditionally not components of the annual Budget Law--have been made constituent parts of the Budget Law. Extrabudgetary funds are submitted for Parliamentary debate and approval, thereby, greatly improving the accountability of the government. The better coverage of the general government facilitated the assessment and monitoring of the fiscal position in Romania (Statistical Appendix table 37). In addition, to reduce the fragmentary nature of the Budget Law, efforts are under way to reduce a number of special extrabudgetary funds by consolidating earmarked resources with the State budget.

The quasi-fiscal operations of the NBR were curtailed with the passage of new profits tax law which imposes a tax of 80 percent on the National Bank profits. Furthermore, since 1994, the major quasi-fiscal activities previously undertaken by the NBR have been transferred to the State budget. This improved the transparency of government operations and made the consolidated fiscal budget deficit a better measure of the overall fiscal stance.

To improve explicit expenditure control, measures of expenditure sequestering have been adopted annually through the Budget Law since 1993. As an important component of macroeconomic stabilization, the Budget Law mandates an obligatory use of expenditure blocking against certain approved budgetary allocations--excluding wage payments, pensions, children allowances, and interest payments--in the event of a shortfall in either domestic revenue collection or external financing. Consequently, some 10 percent of allocated expenditure in the State budget was blocked for the first seven months of 1994, and expenditure sequestering was reintroduced in a revised budget in late 1994 which had allowed the Ministry of Finance to sequester up to 50 percent of blockable expenditures in November and December.

For 1995, up to 20 percent of allocated expenditure were to be blocked by this means and in August 1995 that share of blockable expenditure was raised to 27 percent. Although this system of expenditure sequestration has allowed the government to limit expenditures when revenues have fallen short of their projected levels, it may contribute to worsen expenditure composition and should be replaced by a more comprehensive budget management system.

3. Evolution of the social safety net

Social protection has undergone marked improvements in Romania since the beginning of transition to a market economy in 1989. In the pre-reform days in Romania, the key means of income support came in the form of job security for the able-bodied individual and pensions for the retiree. meanwhile, government subsidies on food, housing, and transportation had kept prices artificially low which--thus helping to compensate for low earnings and low, fixed pension income. With this philosophy, social assistance programs centered narrowly on the handicapped, orphans, and elderly needing special institutional care.

a. Social insurance

Two problems with the adequacy of the social insurance system became obvious at the outset of the transition: it was not structured to protect either the unemployed against the loss of earnings or the elderly against price increases on essential commodities.

As a first priority, therefore, the Unemployment Fund was established in 1990 to provide benefits to the increasing number of workers who were laid off as output fell and enterprises began to adjust to market signals. Through Law 1/1991, benefits payable for the first nine months of unemployment would provide up to a maximum of 85 percent of the minimum wage: 1/ A reduced benefit of 40 percent of the minimal wage would also be paid for a period of another nine months if the individual remains unemployed at the end of the first nine months. A skills-for-job program was introduced to retrain and upgrade anyone interested in acquiring new skills. This program, albeit modest, expanded steadily. In addition, to bolster employment opportunities, the government established, through the Unemployment Fund in late 1994, a special facility that would lend up to 0.2 percent of GDP to small- and medium-size enterprises for job creation. In late 1993, the Fund provided technical assistance on the social safety net in conjunction with the government’s stabilization program: a major focus of this assistance was an assessment of the possible fiscal impact of rising unemployment, and development of contingency measures to avoid a consequent worsening of the budget deficit.

Old-age and disability pensions also became partially indexed in 1990, to preserve the purchasing power of the elderly and disabled workers. Following years of ad hoc amendments, the pension system had become overcentralized, laden with bureaucracy, and fragmentary. 2/ New measures were thus quickly introduced