This paper reviews economic developments in Romania during 1990–97. Reforms have been relatively slow since the beginning of the transition process. Except for a brief and inconsequential interlude in 1993, comprehensive programs for privatization and for restructuring or liquidation of loss-making enterprises were not launched until 1995. These programs have done little to improve governance so far. As of end-1996, the economy was still largely characterized by state ownership and control; by fixed prices and quantitative constraints; and by ailing enterprises and subsidization of losses.
This paper reviews economic developments in Romania during 1990–97. Reforms have been relatively slow since the beginning of the transition process. Except for a brief and inconsequential interlude in 1993, comprehensive programs for privatization and for restructuring or liquidation of loss-making enterprises were not launched until 1995. These programs have done little to improve governance so far. As of end-1996, the economy was still largely characterized by state ownership and control; by fixed prices and quantitative constraints; and by ailing enterprises and subsidization of losses.
1. Romania’s economic performance since the collapse of the communist system in 1989 has been disappointing. Living standards have dropped sharply from levels that were already extremely low under communism, and attempts at stabilizing the economy have been unsuccessful. Persistent financial imbalances, high rates of inflation and balance of payments crises have originated from the lack of progress in structural reforms, which has left the economy largely characterized by state ownership and control, administered prices, and quantitative constraints. The authorities are now determined to launch an economic reform program based on an acceleration of structural reforms in the agricultural and industrial sectors, intended to support the simultaneous implementation of stabilization policies. In this regard, the present section provides an analysis of previous experience with structural reform and stabilization attempts, demonstrating the key lessons that lay behind the new program.
A. The Legacy of Communism
2. Romania emerged from communism with an economy that was suffering from considerably more deep-seated structural problems than most former communist countries in the region. Unlike Hungary, Poland and Yugoslavia, Romania had not attempted serious economic reform under communism, and central control of economic decisions was among the tightest and most pervasive in the region. Prices, wages and interest rates were strictly regulated and did not play any allocative role; raw materials, intermediate products, capital, labor and credit were centrally allocated; foreign trade took place only through state trade organizations, in accordance with plan-targets for imports and exports; and all foreign currency transactions were conducted through a specialized bank at multiple exchange rates. Attempts at reform under a Fund-supported program between 1981 and 1984 produced no effective easing of central control over the economy. The misallocation of resources created particularly serious structural problems in two sectors.
3. First, governments had, since the 1950s, promoted self-sufficient industrialization by investing heavily in energy-intensive industries that could take advantage of the significant endowment of domestic hydrocarbon resources. Energy prices played no role in the allocation of resources. These sectors accounted for half of industrial output and had the highest gross-energy-intensity in eastern Europe. Many of them would have had a significant negative value added if energy prices had been set at world market levels.
4. Second, a parallel drive for self-sufficiency in the agricultural sector was reflected in the creation of large, highly inefficient collective state farms, in particular in the livestock sector. There was no private farming of importance, unlike in some other eastern European countries. Farm output was delivered to large and equally inefficient intermediaries and agro-processing centers in exchange for bundled supply of all inputs and services (like seed, fertilizers, harvesting, and storage), with the implicit prices having no role in the allocation of resources.
5. These two structural problems were exacerbated during the second half of the 1980s as a result of the drive to repay the entire medium- and long-term foreign debt through a policy of import compression and export promotion. A massive reallocation of resources to the export sector involved further subsidization of energy inputs to industries that were already characterized by excessive energy-intensity. Moreover, the effort to reduce imports intensified the emphasis placed on self-sufficiency in the agricultural sector, prompting a further concentration of resources in large, inefficient entities.
B. Structural Reform
6. Reforms have been relatively slow since the beginning of the transition process. Except for a brief and inconsequential interlude in 1993, comprehensive programs for privatization and for restructuring or liquidation of loss-making enterprises were not launched until 1995. These programs have done little to improve governance so far. As of end-1996, the economy was still largely characterized by state-ownership and control; by fixed prices and quantitative constraints; and by ailing enterprises and subsidization of losses. The private sector share in GDP remained among the lowest in eastern Europe.
The privatization and enterprise restructuring programs
7. Excluding the agricultural sector (see below), the privatization process began in earnest only in 1993. It initially involved management and employee buy-outs of small enterprises on generous terms, excluding medium and large enterprises, which accounted for most of the losses. The privatization program was, however, effectively terminated in 1994, and 85 percent of industrial output was still accounted for by state enterprises by end-1995. A new voucher-based program was launched in late 1995, but it was in effect limited to formally transferring minority ownership to the population while leaving existing managers and state agencies in control (see Section III). The State Ownership Fund (SOF), the agency that holds the remaining 70 percent of shares and is supposed to sell them at auctions to strategic investors or to managers and employees, had offered only a limited number of enterprises for privatization by end-1996. Dividends from profitable enterprises have often been used by the SOF to cross-subsidize the loss-making ones.
8. A special program for liquidation or restructuring of a selected group of about 150 enterprises was introduced in 1995.1 This program, however, failed to improve governance and total losses and arrears of the enterprises have increased significantly since its adoption. As of end-1996, only six of the enterprises had been privatized, none had been liquidated, and only three had achieved a positive cash flow for more than two consecutive quarters. During the first half of 1996, the losses of the enterprises concerned were already twice as high as during all of 1995. Inclusion in the program de facto entailed a softening of budget constraints as enterprises benefitted from conciliation of debt and arrears owed to banks and energy providers; access to special financial assistance from the SOF and the state budget; and support from the Financial Recovery Fund to pay off workers and energy suppliers.
Deficits in the agriculture and energy-intensive sectors
9. The failure to advance enterprise restructuring, liquidation and privatization left the economy burdened by massive enterprise deficits, mainly originating in the agricultural and energy-intensive sectors. Deficits in these two sectors have been financed mainly through fiscal and quasi-fiscal subsidies. Such subsidies have been a major source of macroeconomic instability since the beginning of the transition.
10. As a result of spontaneous privatization in 1989-90—in the wake of the collapse of the Ceausescu regime—private farmers hold more than 80 percent of arable land and account for most of the grain and vegetable production. However, the state has retained control over all other parts of the grain and vegetable sector, including suppliers of seeds and fertilizers and providers of equipment, storage, processing and marketing. It has used this control, reinforced by export bans, to maintain low producer prices. The low prices, along with state restrictions on land use and transfer, have been the main reasons for the limited output response to the privatization of primary production of grain. The state has also retained control over livestock farming, which remained highly inefficient. A particularly egregious example is that of the huge pig and poultry farms.
11. The agricultural sector benefited from substantial fiscal and quasi-fiscal support. Fiscal support consisted of a wide variety of subsidies, including direct payments to farmers, subsidies for irrigation and production of fertilizer, interest subsidies and payment of farmers’ social security contributions. Quasi-fiscal support has come almost entirely from the NBR, in die form of large directed credits, at highly subsidized interest rates. These directed credits to the agricultural sector, which were largely tantamount to an unrequited transfer, have accounted for about 50 percent of total NBR credits in recent years. Total quasi-fiscal support of the NBR to the agricultural sector amounted to 2.1 percent of GDP in 1996. The state-owned intermediaries and pig and poultry farms, which make large losses, have been the main beneficiaries of the fiscal and quasi-fiscal subsidies at the expense of both private farmers and consumers. State intermediaries have been the primary recipients of subsidized NBR credits.
12. Little has been done to restructure the highly energy-intensive sectors, especially the refinery, chemical, machine-building, metallurgical and synthetic textile sectors. These sectors, accounting for about SO percent of gross industrial output, still have the highest energy-intensity in eastern Europe and three times the average for European OECD countries. Many of them incur huge losses at world market energy prices. Domestic energy prices have therefore been kept well below world levels over prolonged periods. Attempts have been made to increase energy prices through a formula linking domestic prices to the exchange rate and border prices in U.S. dollars. Pressures from energy-intensive sectors for low energy prices have, however, soon caused this formula to be abandoned. The low energy prices have been financed in two ways:
13. First, at world market energy prices, the energy-intensive enterprises soon started to accumulate arrears to energy suppliers. The utilities have generally not cut off supplies to delinquent customers, and have financed the resulting losses by incurring arrears and through bank lending. Low energy prices and arrears have forced the energy producing sector to cut investments and maintenance to the extent that energy production has been seriously disrupted. The electricity company cannot meet domestic peak demand despite sufficient installed excess capacity, and the petroleum sector has been unable to acquire the technology needed to maintain domestic crude oil production, which has fallen by almost half since 1989. Energy imports, to make up the shortfall, accounted for virtually the entire trade deficit in 1995. Second, as arrears to the utilities have continued to increase, pressures have mounted to reduce the price of energy by maintaining the currency at an overvalued level, eventually causing the flexible exchang rate policy to be abandoned. The energy sectors’ losses have in effect been financed through an implicit tax on exports.
14. Régies autonomes (RAs), a group of enterprises that includes many of the largest loss-makers, have been excluded from the privatization program and partly from the special restructuring program. They include enterprises in the mining, energy and transportation sectors. In 1995, half of all state enterprise losses were accounted for by nine RAs, including loss-making companies for mining of coal, lead, zinc, lignite and copper. Only five of these nine largest loss-making RAs were included in the aforementioned special restructuring program.
15. The problem of the RAs has two main aspects. First, the main problem for public utilities (like the electricity company and the railways) has been that tariffs have been kept low and fixed for prolonged periods, as a subsidy primarily to the industrial sector. Second, a number of enterprises which engage in commercial activities have nonetheless been included in the RAs because of their strategic importance (e.g., coal and copper mines). Output prices for some raw materials producers in this group have also been kept artificially low as a subsidy to industrial processors. The losses of both kinds of RAs have been compounded because of inefficient operations, substantial overstating, and high wages.
C. Macroeconomic Policies, 1991-96
The quasi-fiscal objectives of monetary and exchange rate policies
16. The high and variable rates of inflation and the frequent balance of payments crises since 1991 have mainly resulted from monetary and exchange rate policies being geared toward covering large losses in the agricultural and energy-intensive enterprises, losses that had their origin in the failure to advance reform of these sectors. The flexible exchange rate policy and monetary targets of past stabilization programs have consistently given way to demands for an overvalued currency to keep energy prices low and for agricultural credits.
17. A flexible, market-determined exchange rate policy has been adopted at the onset of all stabilization attempts since 1991, only to be abandoned shortly thereafter, as explained above. A case of stop-and-go policies has ensued, with prolonged periods of significant overvaluation of the leu, persistent excess demand, and external payments delays—followed by real depreciation in the face of dwindling reserves. In effect, exchange rate policy has given priority to the objective of providing quasi-fiscal support to ailing enterprises, at the expense of external equilibrium.
18. Similarly, conflicting objectives have led to a stop-and-go monetary policy. The NBR has assumed substantial quasi-fiscal functions by providing large subsidized credits, in particular to the agricultural sector. As a result, monetary policy has been inherently accommodating of any deterioration of the financial situation in these sectors, including through three rounds of clearing outstanding inter-enterprise arrears by increasing NBR credits. The priority accorded by the NBR to such quasi-fiscal objectives has given way only when acute balance of payments constraints have forced a tightening of policies.
19. The inherently accommodating nature of monetary and exchange rate policies has meant that shocks to the economy have exacerbated pressures on prices and external reserves. However, such pressures were contained until 1994 because of three factors: (i) the extremely low foreign indebtedness, and the large inflows from official creditors (averaging US$1 billion annually during 1991-94) permitted comparatively large current account deficits; (ii) the very low monetization that had resulted from the near-hyperinflation in 1991-92 was followed by a significant decline in velocity as money demand gradually recovered; and (iii) the quasi-fiscal functions of monetary and exchange rate policies allowed relatively low fiscal deficits.
20. Adverse developments in each of these three areas combined to produce major inflationary and balance of payments pressures in 1995-96: (i) external debt service payments mounted and support from official creditors dropped sharply to an annual average of US$50 million; (ii) the pace of remonetization slowed; and (iii) fiscal policy was gradually relaxed in the run-up to the 1996 elections.
The relaxation of policies in 1995-96
21. The general government deficit increased from 1.9 percent of GDP in 1994 to 2.6 percent of GDP in 1995 and 5.7 percent of GDP in 1996. This relaxation reflected significant increases in agricultural subsidies, wages and pensions, in combination with an increased tolerance of tax arrears as a means of supporting ailing state enterprises (see Section IV).
22. The deficits in the state enterprises have also increased continuously. Data for enterprises monitored under the aforementioned special restructuring program show that their losses have been increasing since monitoring began in early 1995. Moreover, during the first half of 1996, losses of these enterprises were already twice as high as during all of 1995.
23. The increase in losses has been mainly due to excessive wage increases, reflecting the lack of an effective incomes policy. Real wages increased by 30 percent between mid-1994 and mid-1996, and generally exceeded changes in labor productivity in the traditional sectors, while wage increases have been in line with productivity improvements in new emerging sectors. The large wage increases in the traditional sectors supported the consumption-led recovery of GDP growth in 1994-96 (see Section II).
24. As in previous years, the increase in losses initially involved rising domestic payments arrears, in particular to the energy sector, followed by increasing overvaluation of the currency and accelerating growth in NBR credits. Increases in agricultural credits alone made the planned monetary framework unattainable in both 1995 and 1996. In addition, the NBR provided large-scale credits to finance banks’ purchases of treasury bills. Finally, acting as a lender of last resort, the NBR provided considerable emergency credits to overcome liquidity problems in two ailing private banks. Inflation reached 10 percent per month by December, notwithstanding delayed adjustments in administered prices and a significant overvaluation of the currency (see Section V).
25. The balance of payments deteriorated sharply in 1995-96. The current account deficit increased from 1.7 percent of GDP in 1994 to 4.9 percent of GDP in 1995 and 6.6 percent of GDP in 1996. The deterioration was exacerbated by an inflexible exchange rate policy due mainly to pressures for low energy prices. The premium in the parallel market had reached 30-40 percent by end-1996.
26. As external assistance from official creditors dropped off sharply, reserves were rapidly depleted. They stood at the equivalent of just two weeks of imports by December 1995. In 1996, the NBR borrowed about US$1.5 billion from international capital markets, taking advantage of the non-investment grade credit ratings. While this borrowing enabled the NBR to arrest the decline in reserves, it was on a relatively short term and debt-service payments are now set to surge temporarily in 1999-2001. The sharp increase in external debt (from 2.9 percent of GDP in 1990 to 24 percent of GDP in 1996) and in the debt-servicing ratio (from zero in 1990 to 14 percent of exports in 1996) shows that Romania has been rapidly losing the advantage of low indebtedness with which it began the transition process (see Section VI).
II. real sector developments
27. The Romanian economy started to grow earlier and faster than most other transition economies. In 1996 real GDP grew for the fourth consecutive year, at a rate of 4.1 percent (Chart 1, Tables 1 and 2). Cumulative real GDP growth amounted to 17.6 percent between 1993 and 1996. This consumption-led growth was, however, clearly unsustainable, as evidenced by the severe balance of payments problems. Moreover, a Fund staff analysis of sectoral output and export performance suggests that the early recovery in output has, to a considerable extent, been driven by substantial direct and indirect subsidies to ailing state-owned enterprises.
B. Income and Expenditure
28. On the demand side, the recovery of GDP was initially led by exports, especially in 1993 and 1994. The strong export performance was accounted for mainly by state-owned industries. In 1995 and 1996 net exports declined sharply, and real GDP growth was driven by domestic demand, especially consumption. By 1996, the cumulative growth in private consumption since 1993 amounted to 31 percent. It was fueled by rising real wages (see section II.D) and budgetary transfers (see section IV.C).
29. Both gross fixed capital formation and inventories grew at a diminishing rate from 1992 to 1996. Industry accounted on average for more than 40 percent of total investment in the economy (Table 3). Trade, including the hotel and restaurant sector, overtook agriculture in 1995 as the sector with the second largest share of investments. Housing investments soared in 1996, approaching trade investments in value. In 1996 the value of stocks of finished goods in industry still amounted to a quarter of the total value of industrial production, with only a few branches accounting for the bulk of total inventories (see section II.C).
30. Total investment was financed mainly through domestic savings until 1994, but starting in 1995 investment was increasingly financed by recourse to foreign savings (Table 4). The public sector’s savings-investment deficit narrowed from 19 percent of GDP in 1992 to 7.6 percent of GDP in 1995, but widened again to 10.5 percent in 1996. The private sector’s savings-investment surplus fell from 11.2 percent of GDP in 1992 to 3.9 percent in 1996. Foreign financing as a percentage of GDP increased by nearly a factor of five between 1994 and 1996.
C. Developments in Output—Sectoral Analysis
31. The great potential of Romanian agriculture remained underutilized due to the lack of structural reform (see Appendix I). Although the private sector dominated agricultural employment, production and land ownership (Tables 5, 6, and 7), the absence of free markets for land, inputs, and agricultural products prevented further intensive and extensive growth of agriculture. Furthermore, the state directly controlled the producer and consumer prices of key agricultural products (wheat and bread, milk, pork, poultry and related products).
32. Agricultural employment rose to some 40 percent of the total labor force, up by 10 percentage points since 1990. Private farms employed 85 percent of the total agricultural labor force and accounted for 86 percent of total agricultural production. The bulk of vegetable products came from private farms, while livestock production was dominated by state-owned farms. As of end-1996, agricultural production had grown by a cumulative 25.1 percent since 1992. The GDP share of agriculture remained fairly stable at just below 20 percent (Chart 2, Table 1). After a steady increase in the production volumes of grains (wheat, rye, maize) since 1992, the drop in 1996 amounted to some 30 percent, bringing the per capita production back to the level of 1992 (Table 8). The export share of all vegetable products rose nevertheless from around 1 percent in 1992 to 5.2 percent in 1996. Livestock production remained stable at the level of 1992, with meat, milk, eggs, wool, and honey as the main items. The export share of live animals and animal products fell from 4.2 percent in 1992 to 1.7 percent in 1996.
33. Industrial production increased steadily between mid-1992 and end-1996 (Chart 3, Table 9), and grew by 9.8 percent in 1996, bringing the cumulative growth since mid-1992 to 40 percent. This, however, was just sufficient to restore industrial production to the 1991 level.5 The GDP share of industrial production remained around a third, and industry continued to employ more than 40 percent of the labor force in 1996 (Tables 1 and 10).
34. A detailed Fund staff analysis of output, exports, inventory building, and unit labor costs of 27 sub-groups of industrial enterprises shows that the strong output and export performance since 1993 have come from two distinct sources. The main role has been played by large, state-owned traditional sectors. These are generally also the sectors that have seen a deterioration in their financial situation as a result of weakening wage discipline (see Section II.D). This finding suggests that the strong output and export growth by these traditional sectors has to a large extent been sustained by fiscal and quasi-fiscal subsidies.6 An increasingly important role, however, has been played by dynamic emerging sectors. The successful performance of these enterprises appears to be due mainly to their ability to contain real wage growth below productivity growth. The industrial sector is thus characterized by a sharp dichotomy between traditional and emerging sectors.
35. The traditional sectors are characterized by large, energy-intensive state-owned industries. Their production has not been responsive to demand, and much of their output has accumulated in inventory rather than being sold. The six branches that are defined to comprise the traditional sector are: food, metallurgy, electricity production, petroleum processing, chemicals, and machines and equipment (Table 11). These branches include many loss-making state-owned enterprises that have been kept open by large fiscal and quasi-fiscal subsidies, including direct fiscal transfers, transfers from the state ownership fund, tax arrears, arrears to other enterprises (especially the utility companies), and arrears to banks. The importance of arrears as a means of financing for majority state-owned enterprises can be seen in Tables 12 and 13. This is in sharp contrast to the private sector, where the accumulation of arrears as a share of GDP has dropped sharply during the transition.
36. The six traditional branches accounted for 61 percent of total industrial production on average during 1993-96, and employed 39 percent of the industrial labor force (Box 1 and Table 11). They exported just 20 percent of their production, but this accounted for 60 percent of total industrial exports during the period. At the same time, these six branches accounted for 63 percent of total industrial stocks of finished goods; the average value of stocks in these six branches equaled 24 percent of the value of their production. These traditional branches accounted for more than 60 percent of the total increase in industrial output during 1994-95.
The emerging sectors are characterized by small, dynamic private enterprises with low energy-intensity. This sector is defined to include: communication equipment; publishing; electric machines; fabrics, furs and leather; and furniture. These five fast-growing branches at least doubled their production between 1993 and 1996. The two fastest-growing branches—communications equipment and publishing—were also the smallest and domestic-market-oriented. The other three were labor-intensive and export-oriented, employing 14 percent of the total industrial labor force. The latter three branches exported on average 38 percent of their production, although they still accounted for less than 15 percent of total industrial exports. The high export growth rates in these three branches, roughly equaling the growth rates of output, were made possible by the considerable excess of labor productivity growth over real wage growth (see section II.D). These five branches together contributed about 40 percent of the total increase in industrial output in 1994-95.
Comparison of the Traditional and Emerging Industrial Sectors
Source: National Statistics Commission and Fund staff estimates.
Share of industrial output
Share of industrial employment
Share of industrial exports
Share of the increase in
Share of industrial output
Share of industrial employment
Share of industrial exports
Share of the increase in
Source: National Statistics Commission and Fund staff estimates.
Share of industrial output
Share of industrial employment
Share of industrial exports
Share of the increase in
Share of industrial output
Share of industrial employment
Share of industrial exports
Share of the increase in
Source: National Statistics Commission and Fund staff estimates.
37. A dramatic shift in the relative contributions to industrial growth took place in 1996. The contribution of the traditional sectors to industrial output growth dropped sharply from 60 percent in 1994-95 to just 7 percent in 1996. They were overtaken by the emerging sectors, which accounted for nearly three-quarters of the growth in industrial output in 1996. In fact, given the poor performance of agriculture in 1996, these emerging sectors were the main engine behind GDP growth in 1996. This augurs well for sustainable rapid medium-term growth as subsidies are withdrawn and the traditional sectors are restructured or closed.
D. Wages, Employment, and the Labor Market
38. At the aggregate level, real wages evolved by and large in line with labor productivity, except in 1995 and 1996, when real wage growth exceeded labor productivity growth by 3.6 and 3.3 percentage points, respectively. The roughly parallel growth of real wages and labor productivity at the aggregate level masks a sharp dichotomy between traditional and emerging sectors. (Tables 14, 15 and 16). In traditional sectors, real wage growth significantly exceeded labor productivity growth, especially in 1995 and 1996. In the four largest brandies, accounting for 47 percent of industrial production, real wage growth from 1994 to mid-1996 was double the growth in labor productivity—the most egregious cases were state-owned régies autonomes and commercial companies, where real wages grew at almost double the rate of the economy-wide average. The growth rate of real wages in the food sector exceeded the growth rate of labor productivity by a double-digit factor. In the petroleum processing and chemical industry sectors, wages grew at double the rate of productivity. In emerging, fast-growing sectors, labor productivity growth significantly exceeded real wage growth. Productivity grew by at least double the rate of wages in publishing; electric machines; communications equipment; fabrics, furs and leather; and furniture.
39. Owing to the slow pace of structural reform, the public sector still employed 77 percent of the labor force in 1995 (Table 10). Having peaked at 9.5 percent in 1993 and 1994, the unemployment rate was on a downward trend thereafter, declining to 6.1 percent in 1996 (Chart 3, Table 17).
E. Price Developments
40. Inflation fell steadily from mid-1993 to mid-1995 (Chart 3, Table 18), in line with the onsiderable decline in velocity during this period (see Section VI.E). However, the continuous deterioration of policies since late 1994 lead to an increase in inflation from mid-1995, with a sharp acceleration in 1996. For 1996 as a whole, consumer prices increased by 38.8 percent on average, while the increase from December 1995 to December 1996 amounted to 56.9 percent. Underlying inflation in 1996, especially during the latter part of the year, was even higher, due to the failure to adjust administered prices and the overvaluation of the exchange rate. Consistent with the pattern of the past five years, the prices of food items, non-food items, and services in the CPI basket increased broadly at the same pace in 1996 (Table 18). In 1996, the CPI was still calculated using 1992 weights; non-food products dominated with a share of 44 percent, followed by food products (40 percent), and services (16 percent).
41. In 1996, industrial producer prices increased by 49.9 percent on average, while the rise from December 1995 to December 1996 was 60.7 percent. Producer price increases were fairly evenly distributed throughout the year, except for a peak in July (Chart 3), caused by increases in administered energy prices. Over the last five years, producer prices in extractive and processing industries as well as in energy production increased at roughly the same pace (Table 19).
III. ownership structure and privatization
A. Ownership Structure
42. Although the private sector contribution to GDP doubled between 1992 and 1995, the private sector still accounted for a smaller share of GDP than in other central and eastern European transition economies (Chart 4, Table 20). Of the 45 percent of GDP that the private sector accounted for, agriculture accounted for 17 percent, trade for 14 percent, industry for 10 percent and construction for 4 percent.
43. The share of private ownership varied significantly between the sectors of the economy (Table 21). In agriculture, the share of private ownership increased slightly to 90 percent in 1995, from around 80 percent in 1992. The share of private ownership reached 60 percent in both construction and services. The private share remained below 30 percent in industry, however, owing to the slow pace of enterprise reform and privatization (see below).
44. Privately-owned enterprises accounted for 99 percent of the total number of enterprises but employed only 23 percent of all employees in 1995 (Tables 10 and 22). The number of private companies and family businesses more than doubled in the same period. In industry and trade the share of workers in privately-owned units increased from a fourth in 1993 to a third in 1995, while it fell from a fourth to a sixth in construction.
45. The first step toward reforming the enterprise sector was the commercialization of most state enterprises. Some 6,300 state enterprises were turned into joint-stock commercial companies during 1990-91. Seventy percent of the capital of each commercial company was distributed to the SOF, which was created to exercise the state’s ownership rights until the commercial companies are privatized. Its by-laws require that it sell its share of all commercial companies by 1999. The remaining 30 percent of the capital of each commercial company was distributed to one of five Private Ownership Funds (POFs). These were established by the state, although they are formally owned by all Romanian citizens who have stakes in them as a result of two Mass Privatization Programs (MPP) (see below). In the meantime, the directors of enterprises are appointed by parliament from a list proposed by the government.
46. Some 400 enterprises that were deemed natural monopolies of public interest, or essential for national defense and security, are not intended to be privatized. These enterprises were converted into régies autonomes, of which 44 are owned by the state and the remainder provided local service. Portions of these RAs have been spun off as commercial companies and have consequently become eligible for privatization.
47. The Privatization Law passed by parliament in August 1991 is the cornerstone of the privatization process in Romania. Under this law, all commercial companies were deemed open to privatization. It envisioned the use of a wide array of market privatization methods, including trade sales, open auctions, open and limited tenders, initial public offerings (IPO), and management-employee buy-outs (MEBO). The law also provided for the distribution of 15 million certificates of ownership to all Romanian adults free of charge. These certificates of ownership were the counterpart of the 30 percent of commercial company shares held by the five POFs; they could be freely traded among individuals and could be: (i) converted into shares of commercial companies belonging to the POFs; (ii) retained as ownerships interests in the POFs; or (iii) converted at a later stage into shares of the successor investment funds of the POFs.
Sale of enterprises
48. Following passage of the Privatization Law, the government adopted a privatization strategy aimed at transferring most of the state-owned enterprises to private ownership within seven years. This strategy was based on the SOF selling the 70 percent of shares in commercial companies (for cash only) that it held on behalf of the state, but this approach was hampered by organizational problems at the SOF and by the legal requirement to conduct cumbersome evaluations of the enterprises’ worth. For the sale of large commercial companies (capital of more than lei 18 billion—then about US$235 million—and more than 3,000 employees) and medium commercial companies (capital of between lei 2.5 and 18 billion—then about US$33 to US$235 million—and 500 to 3,000 employees), the SOF relied mostly on direct trade sales to strategic investors. In fact, this approach resulted in the sale of only 13 percent of the medium-size and large enterprises by end-1995.
49. The most successful privatization record so far has been for small enterprises (capital of less than lei 2.5 billion—about US$33 million in 1991—and less than 500 employees), for which the SOF adopted a “fast track” approach based on MEBOs. Under this procedure, the shares held by the POFs could be exchanged for certificates of ownership held by employees, giving them a 30 percent stake in the enterprise. An additional 15-20 percent share could be bought from the SOF for cash, with the balance payable in installments over two to six years.7 This approach resulted in 57 percent of small commercial companies being privatized by October 1996. The pace of privatization for medium-size and large commercial companies also picked up some in 1995-96 after a law was adopted extending to them the use of MEBO (Table 23). About 80 percent of the privatizations by October 1996 were through MEBO.
50. The distribution of certificates of ownership (described above) launched the first attempt at mass privatization in Romania. But this initial mass privatization program (MPP) ended in failure due to organization problems, conflicting incentives, and political resistance. The certificates of ownership were distributed to the population before the SOF and POFs even existed. Moreover, there were inherent conflicts of interest: the POFs were unwilling to exchange shares in their best companies against these worthless vouchers. Meanwhile, the SOF was not interested in selling the good enterprises in its portfolio since it used their profits to subsidize loss-making enterprises.
51. In practice, certificates of ownership could only readily be exchanged against shares for MEBO privatization of small commercial companies. Consequently, an unknown (but allegedly large) portion was traded at a price far below their initial par value of lei 25,000 (some US$325 in 1991). Many of these certificates of ownership were purchased by a limited number of wealthy Romanian investors, who eventually would have been in a position to acquire large stakes in commercial companies with these discounted certificates of ownership. This was, however, politically unacceptable and by mid-1994 it was decided to revalue the assets—and hence the asking price for shares in companies—by an average factor of four to five. As in other east European countries the book values were already very high relative to the true worth of the enterprises; the revaluation increased the share prices of commercial companies further and the privatization effort ground to a halt.
52. A second full-scale MPP was launched in mid-1995. Based on the Law for Acceleration of Privatization, new free vouchers were issued to all adult Romanians who had not used up their certificates of ownership in buying shared at previous privatizations. Each new voucher was given a face value of lei 975,000 (then about US$475) while certificates of ownership still outstanding retained their face value of lei 25,000 (by then only about US$12).
53. The new MPP transferred wealth to the population but did not include any provisions to facilitate the operation of market forces or effective transfer of ownership. The new vouchers could not be transferred or sold. They could be exchanged at par for shares in the 3,900 commercial companies which were offered, but there was no bidding for shares (each share was valued at a flat lei 25,000). The law also failed to authorize voucher investment funds to participate in the MPP. Thus citizens had only three alternatives: (i) personally exchange their voucher and certificates of ownership against shares in an enterprise on the MPP list; (ii) entrust their voucher and certificates of ownership to one of the (state-owned) POFs, which were the only organizations permitted to participate in the MPP, and bid for blocks of shares on the citizens’ behalf; or (iii) acquire under limited circumstances8 shares in enterprises outside the MPP list. Up to 60 percent of individual enterprises were eligible to be exchanged against vouchers and certificates of ownership, depending on demand, but in aggregate only 30 percent of enterprise shares were offered through the MPP.
54. Distribution of the vouchers was completed in September 1995, and the exchange against shares began in October. But citizens had little information upon which to base their decisions, as no information was provided on the performance history, present financial health, or future potential of any of the enterprises. This gave insiders an advantage and fostered widespread public suspicion of the program. As the initial deadline of December 31, 1995 for surrendering vouchers and certificates of ownership approached, only 26 percent of shares had been used. The deadline was subsequently extended several times due to low participation. Following a publicity campaign by the government encouraging people to use their vouchers and certificates of ownership, 93 percent were ultimately used by the final deadline of May 1, 1996 of which 86 percent were exchanged directly for shares in enterprises and 14 percent were exchanged for shares in the POFs. The distribution of share certificates began in June 1996 and was completed in October 1996. Cases of over-subscription were resolved by a pro rata distribution of shares.
55. The POFs were supposed to be legally converted into fully private closed-end investment funds by March 31, 1996, owned by those people who had entrusted their vouchers and certificates of ownership to the POFs. The POFs legally became investment funds on November 1, 1996. Shares in the new funds will eventually be traded on the over-the-counter (OTC) market.
56. Given the wide dispersion of share ownership resulting from the MPP and the fact that only 30 percent of shares were offered, it has not produced any effective transfer of control from the SOF or the current managers and employees. Whether, and how quickly, there will be a concentration of private ownership will depend on the speed with which secondary trading of these shares develops on the new OTC market and the Bucharest Stock Exchange.
Disposition of the shares remaining in state ownership
57. The shares of commercial companies remaining in the ownership of the SOF are being offered for cash sale, a process which began concurrently with the MPP. For a limited group of 312 enterprises deemed of special interest to strategic investors, up to 51 percent may be offered for cash. The remainder are being offered through all available methods, including auctions, MEBO, trade sales, and initial public offerings. An important element of the special restructuring program was to encourage cash sales to provide fair access to all potential domestic and foreign buyers, although this had previously been ineffective given the unrealistically high book value of enterprises. Deferred payment facilities to buyers in an effort to make the enterprises more attractive, allowed for payment by installments over a period of up to ten years, with a down payment of 20 to 35 percent and a maximum interest rate of 10 percent per annum. Effective prices to the buyer were also reduced by the fact that the SOF was required to plough back into the privatized enterprises up to 60 percent of the proceeds of cash sales of shares. If no buyers can be found, the value of the commercial companies are reassessed and the price of the shares may be discounted. Despite delays in the launching the cash auctions, 711 enterprises were offered for sale this way in the first nine months of 1996, of which 391 were sold.
IV. the public sector
A. Structure of the Public Sector
58. The general government in Romania is characterized by an intricate and fragmented structure: numerous extrabudgetary funds were established in the early 1990s with a view to earmarking resources for specific expenditures, and other off-budget activities emerged, such as those carried out by fiscal accounts administered by the Treasury. These developments had a detrimental impact on fiscal transparency, and required the adoption of a broad definition of public sector in order to obtain a sufficiently accurate picture of fiscal developments.9 The state budget, which covers the operations of all the individual ministries and provides transfers to local governments and other public institutions, accounted for 64 percent of general government expenditures in 1996. Local governments accounted for 13 percent of expenditures of the general government, while the three main social security funds accounted for 21 percent.
59. In addition to the extrabudgetary funds, Romania has been characterized by a complex system of quasi-fiscal operations, as detailed in Section I. First, the NBR provided directed credits at below-market interest rates to the agricultural and industrial sectors. Second, the inflexible exchange rate policy acted in effect as an implicit tax on exporters to provide support to energy-intensive enterprises. Third, tolerance of enterprise arrears to the utility companies financed the energy-intensive sector at the expense of the energy-producing sector. Arrears to other enterprises and to banks have also been important sources of financing for loss-making state-owned enterprises. Fourth, the SOF effected off-budget transfers of resources from profitable to ailing state-owned enterprises.
60. The quasi-fiscal operations were of a significant magnitude, and contributed de facto to determining the overall fiscal stance. With the exception of those carried out by the NBR (see Section VI), however, such quasi-fiscal operations are extremely difficult to quantify. The present section focuses mainly on the operations of the general government.
61. After a surplus in 1990 and 1991, the balance of the consolidated general government turned to a deficit of 4.6 percent of GDP in 1992, reflecting a sharp decline in revenues and a simultaneous marked increase in expenditures. While the decline in revenues continued, a major curtailment of expenditures took place in 1993, which contained the deficit to less than ½ percent of GDP. A sustained relaxation of fiscal policy subsequently caused the deficit to widen again, from 1.9 percent of GDP in 1994 to 5.7 percent in 1996, on an accruals basis.
B. Revenue Developments and Tax Reform
62. Like most transition economies, Romania has experienced a marked decline in revenues during the transition. Total revenues of the general government fell from 39.8 percent of GDP in 1990 to 32.1 percent in 1994, with a further decline to 29.6 percent taking place in 1996 (Tables 24 and 25).
Structure of revenues
63. The initial phase of the transition (1990-93) was characterized by the elimination of several taxes of the pre-reform period—such as the turnover tax—and the creation of a more modern tax system, including a value added tax (VAT) and an inflation-indexed profits tax.
64. The previous confiscatory profits transfer tax on enterprises was abolished in 1990 and replaced with a profit tax that was reformed in 1991 and then again in 1994. The 1994 revision was mainly aimed at correcting the excessively generous provisions for investment tax allowances and tax holidays, originally aimed at attracting investment, but which had caused a significant decline in revenues. The 1994 reform managed to arrest the decline, but its impact was mitigated by difficulties in administration and decreasing collection from state-owned enterprises and banks, partly as a consequence of the financial restructuring program for state-owned enterprises. Currently, the standard rate is 38 percent.10 Revenues from the profit tax amounted to 3.2 percent of GDP in 1996, compared to 5.1 percent in 1991.
65. An individual wage tax was introduced in 1991, to replace the former wage tax based on the economy-wide gross average wage. The wage tax, however, still suffers from important shortcomings, in particular the complex rate schedule (14 tax brackets, with rates ranging from 5 percent to 40 percent) and the fact that the tax only covers wages and salaries, while other income sources (e.g., self-employment and rent) are subject to different tax rate schedules. Current marginal tax rates are quite high by international standards, and, together with social security contributions levied on the same base (3 percent for the pension fund and 1 percent for the unemployment fund) create a high tax burden on labor income. The tax base encompasses all wage payments, including bonuses and premia, and the tax is withheld at source and levied and collected on a monthly basis. The brackets are adjusted on a discretionary basis to avoid “bracket creep,” usually in conjunction with wage indexation decisions. Revenue from wages and salaries declined from 7½ percent in 1991-92 to 6½ percent in 1995.
66. The VAT was introduced in 1993 to replace the inefficient turnover tax. Initially, the tax had a single rate of 18 percent; in 1994 a rate of 9 percent was introduced for certain food items and medicines, which were previously exempt. An excessive number of exemptions has, however, remained, and revenues from the VAT have hovered around a rather disappointing 5 percent of GDP.
67. Customs duties have taken on a more significant role during the transition, and yielded revenues of 1½ percent of GDP on average over the last five years. Customs duties have also suffered from an excessive number of exemptions, mostly granted on an ad hoc, temporary basis—29 such exemptions were extended in 1996. Rates vary from 0 to 40 percent. Customs duties are due upon import, and the customs offices also collect any VAT and excise taxes on the imported goods—this gives rise to some classification problems, with revenue data being subsequently adjusted to reflect a proper distribution of the revenue collected at the border across the relevant revenue categories.
68. Excise taxes yielded revenues between 1½ and 2½ percent of GDP over the last four years. Excises are levied on such products as alcoholic beverages, tobacco products, cars, some electronic equipment, certain luxury items, and domestically produced crude oil and natural gas.
Developments in 1996 and priorities for tax reforms
69. Revenue collection dropped significantly in 1996, falling well below 30 percent of GDP compared to 32 percent in 1994 and 1995. The decline was concentrated in social security contributions (minus 0.7 percent of GDP compared to 1995), profit taxes (minus 0.7 percent of GDP) and excises (minus 0.6 percent of GDP). To a large extent, the weakening of revenue collection was the result of increased tolerance of tax arrears. In a simultaneous effort to induce some enterprises to clear pre-existing tax arrears, the government issued an ordinance waving the penalties for overdue tax liabilities carried over from 1995, provided that they be repaid by December 31, 1996. This measure, however, proved ineffective, due both to the tight financial situation of enterprises in arrears and to the moral hazard problem created by the ordinance itself, which generated the expectation of a future renewal of the waiver.
70. The weak performance of revenues in 1996 points to the pressing need for a strengthening of tax administration and for further changes to the tax system, to consolidate the major overhaul of the system enacted during the first phase of the transition. Priorities should include (i) establishing a global personal income tax, based on all sources of personal income; (ii) broadening the tax base by substantially reducing the number of exemptions (especially for the VAT and customs duties); (iii) strengthening the tax administration unit, especially through intensified training of tax auditors; (iv) improving the coordination between the central government and local authorities; (v) computerizing the tax system; and (vi) simplifying administrative procedures.
C. Expenditure Policies and Management
71. Several important institutional changes have been implemented since the beginning of the transition process. Of key importance was the establishment of a Treasury Directorate and a Public Debt Directorate within the Ministry of Finance. The establishment of the Treasury Directorate was soon followed by the creation of local treasury offices, and the treasury system quickly improved the flow of information from the localities to the central government. The Public Debt Directorate took charge of coordinating the domestic and external financing strategy of the state budget, as well as the government loan guarantee program.
72. The first few years of transition were characterized by the increased routing of expenditures through newly established extrabudgetary funds and accounts—which in turn required a progressively broader definition of the fiscal deficit. Since 1993, these special extrabudgetary funds have been incorporated into the annual Budget Law, thereby improving transparency and accountability.
Structure of expenditures
73. Expenditures of the consolidated general government increased markedly in 1992, an election year, to 42 percent of GDP from less than 39 percent in 1990 and 1991. Expenditures then plummeted in 1993 to just over 34 percent of GDP, and remained broadly constant in 1994 and 1995.
74. The reduction in outlays in 1993 reflected a major effort to control public expenditures and to change their composition, with mixed results. Subsidies were cut dramatically, by over 6 percent of GDP. Transfers remained at the same level, but they were to some extent redirected from the agricultural and mining sectors to the transportation and construction sectors, and to social programs. Government spending on goods and services was substantially reduced in real terms; since the scope of government activities was not reduced correspondingly, though, this cut led to a marked deterioration in the level of services provided. Real wage payments also declined significantly, with no reduction in the level of employment in the government sector, leading to a marked fall in the average compensation in the public sector, which would eventually lead to problems in attracting and retaining qualified staff. Capital outlays were also scaled down, consolidating the effort toward reducing and rationalizing public investment after the massive expenditures on showcase projects carried out in the years preceding the transition (capital expenditures averaged about 17 percent of GDP over the 1985-90 period.)
75. The effort to improve the composition of expenditures continued into 1994. Capital expenditures recovered and a new agency (the Council for Reform) was put in charge of assessing and coordinating the public investment strategy. There was a further reduction in subsidies, especially to agriculture, while more resources were allocated to strengthen the social safety net, to cushion the impact of the reforms underway. Expenditures increased somewhat in 1995, although toward the end of the year they had to be held below the budgetary allocations, due to a shortfall in revenues compared to the original projections.
76. Social expenditures, including pension payments, unemployment benefits, active labor market measures and social protection expenditures, have consistently attracted the biggest share of public spending, averaging well over 9 percent of GDP between 1990 and 1996 (Table 26). Resources allocated to education ranged between 3 and 3½ percent of GDP over the same period, and accounted for 10.5 percent of total expenditures in 1996. Over 60 percent of expenditures in this sector went to cover wages and salaries; almost 50 percent of the outlays were directed at pre-primary and primary education, 24 percent to secondary education, 16 percent to tertiary education and about 10 percent to special education for handicapped and homeless children. Budgetary allocations to health fell from 3.3 percent of GDP in 1991-92 to 2.8 percent in 1996, when they accounted for 8.2 percent of total expenditures; in 1996, wages and salaries accounted for an estimated 43 percent of expenditures in the sector, down from 47 percent in 1995; drugs and medical supplies accounted for 21 percent (18 percent in 1995); other goods and services for 23 percent (24 percent in 1995); and capital expenditures for 11 percent (8 percent in 1995). Expenditures on defense, which stood at over 3 percent of GDP during 1990-92, had fallen to 1.9 percent in 1996 (5.6 percent of total expenditures), down from 2.1 percent in 1995 (6.1 percent of total expenditures).
Developments in 1996 and the focus of expenditure reform
77. Total expenditures of the consolidated general government in 1996, on a cash basis, fell by 1 percent of GDP compared to 1995. This, however, was largely achieved by postponing payments on already committed outlays—arrears amounted to 1.8 percent of GDP, mostly on subsidies to the agricultural sector. On an accruals basis, subsidies increased by 1.4 percent of GDP over the previous year, and transfers by 0.4 percent. Capital expenditures remained unchanged at 5.2 percent of GDP.
78. Overall, the evolution of expenditures has highlighted several weaknesses in the budgetary process, especially in the Ministry of Finance’s ability to forecast and monitor macroeconomic variables in the course of the budget preparation and revision. Under the current system, the budget preparation originates at the level of line ministries, which submit allocation requests to the Ministry of Finance. The Ministry of Finance then consolidates the requests and, on the basis of macroeconomic forecasts provided by the National Statistics Commission, elaborates projections for revenues and for outlays under entitlement programs. The Ministry of Finance then determines the allocations to be granted to the line ministries. The budget is periodically revised, to take into account deviations of macroeconomic variables from the original projections or new policy decisions. In principle, the budget should only be reviewed at mid-year, but in practice these revisions can be more frequent—during 1996, three rectified budgets were approved by parliament.
79. Between 1993 and 1995, expenditure control relied crucially on the mechanism of expenditure blocking, or sequestration, whereby a certain amount of expenditures in the budget was made contingent on the availability of sufficient resources, and could therefore be discretionally reduced in case of shortfalls in domestic revenues or external financing. The blocking of certain expenditure allocations was mandated in the Budget Law, and from the blocking were excluded allocations for wages, pensions, child allowances and interest payments. This mechanism, although effective in keeping expenditures under control, proved detrimental to the efficiency of public spending, and contributed in an important way to the deterioration in the level and quality of public services. The mechanism was abandoned as of 1996.
80. Technical assistance is currently being provided by the U.S. Treasury, aimed at (i) improving the budgetary process, strengthening the forecasting capabilities of the Ministry of Finance and improving the coordination between the Ministry of Finance and the line ministries; and (ii) strengthening the debt management and planning, on the basis of a new Public Debt Law, to diversify the range of public debt instruments issued and to guarantee a more flexible financing, moving towards longer maturities and lower costs.
Environmental policy and expenditures
81. Expenditures for the environment stood at 0.2 percent of GDP in 1996, unchanged from 1995. Expenditures related to environmental protection are carried out by the Ministries of Environment, Agriculture, and Industry. Romania is burdened with serious environmental problems, a legacy of past policies which undervalued natural resources and encouraged heavy, environmentally-damaging industry with old, polluting technologies. The Ministry of the Environment elaborated during 1996 a detailed environment protection strategy. At its core is a six point plan covering: (i) reducing pollution, thereby protecting the population’s health; (ii) managing the exploitation of the country’s national resources; (iii) encouraging the use of less polluting technologies; (iv) preserving the nation’s bio-diversity; (v) maintaining cultural and historical assets; (vi) establishing and enforcing the “polluter pays” principle. The government is also committed to improve environmental standards to the levels prevailing in the European Union (EU), as part of its approach to EU accession. It has outlined some 21 steps, including improved environmental legislation and better waste management operations, in its strategy to be advanced through 1997 and beyond. Some of Romania’s environmental problems could be attenuated by increasing the prices of crude oil and petroleum products, as well as by closing loss-making energy-intensive enterprises characterized by obsolete and inefficient technology.
D. Social Funds and the Social Safety Net
82. Poverty in Romania has risen dramatically during the first stage of the transition—the number of individuals below the poverty line has increased from 1 million, or 4 percent of the population, in 1989 to about 5 million, or 22 percent of the population, in 1994.11 Besides affecting a large proportion of the population, poverty is very deep, as the poor have an average income which is 25 percent of the poverty line. Poverty is strongly correlated with low levels of education and low health status—Romania ranks near the bottom among eastern European countries in most health indicators.
83. The dramatic increase in the poverty level—average household income dropped by 21 percent between 1989 and 1993, and average household consumption by 29 percent—has been accompanied by a widening of income inequalities across geographical areas and professional categories. The most affected groups are the unemployed, salaried workers, farmers and certain categories of pensioners; poverty is more acutely felt in rural than in urban areas, and is particularly concentrated in the northeast, which has been affected the most by restructuring and layoffs in the industrial sector.
84. This deterioration in the living standards has been exacerbated by policy failures. Social spending declined in real terms and became progressively less targeted, with some of the discretionary cash assistance programs and in-kind benefits becoming actually regressive. In order to correct this problem, in June, 1995 the authorities introduced a new means tested social assistance program, discontinued in-kind benefits, and began phasing out other discretionary cash benefits.
85. The social safety net in Romania currently has three main components: (i) a social security system, administered mainly through extrabudgetary funds; (ii) an unemployment compensation system, administered through the Unemployment Fund; and (iii) a system of social protection measures, comprising both cash and in-kind benefits, administered by the central government and the local governments.
86. The financial position of the social funds has up to now been generally sound, but signs of weakening have emerged during 1995-96. The Unemployment Fund has always been in surplus, but its outlays may have to increase significantly to allow for an acceleration of enterprise reform. The balance of the State Social Security Fund has worsened significantly between 1994 and 1996, and the deterioration is set to accelerate over the medium term, in the absence of a comprehensive reform. Outlays on social protection programs have so far been limited, but allocations in the 1997 budget have been significantly increased, notably for child allowances. Improved targeting of the social safety net remains a priority.
The social security system
87. The main pillar of the Romanian social security system is the State Social Security Fund, under the authority of the Ministry of Labor and Social Protection. The system also comprises two other extrabudgetary funds, the Supplementary Pension Fund and the Agricultural Pension Fund; some pensions are paid directly by the state budget, e.g. pensions to military personnel.
88. The system is on a pay-as-you-go basis, with contribution rates of 23.5 percent for the employer (earmarked for the State Social Security Fund) and 3 percent for the employee (earmarked for the Supplementary Pension Fund). Contributions to both the State Social Security Fund and the Supplementary Pension Fund are mandatory for all workers in the non-agricultural sectors. The retirement age is 62 years for men and 57 for women. Early retirement is possible for employees working under particularly hard or hazardous conditions: workers in the mining and metallurgical sectors can retire ten years before the statutory age, and workers in the chemical and construction sectors can retire five years before the statutory retirement age. Moreover, according to a law passed in 1995, unemployed individuals who have completed the period of eligibility for unemployment benefits and are within five years of retirement are allowed to retire immediately. Pension benefits are calculated as a percentage (54-58 percent) of the average wage over the best five out of the last ten years of employment. Pension benefits are currently being paid to about 3.8 million beneficiaries, financed by about 5.8 million contributors.
89. As in other transition countries, the Romanian pension system had to take on an additional burden in connection with the first attempts at restructuring the industrial system. In 1990 early retirement was introduced in order to facilitate the labor shedding process in state-owned enterprises while containing the increase in unemployment: upon completion of a minimum service period, workers were given the possibility to retire five years before the minimum statutory retirement age. As a consequence, the number of old age pensioners increased from 1.7 millions to 2.6 millions between 1990 and 1996, while over the same period the number of recipients of disability pensions increased from 200,000 to 500,000. In order to finance the corresponding increase in outlays, employer contribution rates were increased from less than 15 percent in 1990 to the current 23.5 percent, after a peak of 27.5 percent in 1992.
90. In 1995 the State Social Security Fund registered its first deficit since 1990, albeit limited to only 0.2 percent of GDP (Table 27). In 1996, however, the State Social Security Fund suffered a dramatic increase in arrears on social security contributions—arrears stood at lei 1.2 trillion at year-end—and an extraordinary transfer of 0.3 percent of GDP from the state budget was necessary to contain the deficit at 0.2 percent of GDP.
91. The Agricultural Pension Fund has been financed almost entirely through transfers from the state budget, since contributions from industries in the sector (2-4 percent of revenues) were suspended by government decree in 1995 and 1996. Individual contributions from employees in the sector are voluntary; as of 1996, only about 70,000 were paying contributions, compared to about 1.6 million beneficiaries. Most pensioners in the agricultural sector receive close to the minimum pension, and they have been identified as one of the most vulnerable sectors of the population.
92. So far, the social security system has benefitted from the favorable age structure of the Romanian population. Over the medium- to long-term, however, the financial position of the system is slated to deteriorate as demographic developments will cause a worsening of the contributors-to-beneficiaries ratio. Moreover, the pension system could again be adversely affected by the planned acceleration of the structural reform process. In order to limit the impact of projected demographic developments on the finances of the fund, a reform of the pension system is a high priority. Preliminary assessments have already been carried out; a white paper on social insurance and pension reform was issued by the government at the end of 1993, and draft legislation was submitted to parliament but never approved. Reform of the system should, in any case, be based on a comprehensive medium- and long-term study of the sustainability of the system and its fiscal implications.
93. The unemployment compensation system in Romania is administered through the Unemployment Fund, established in 1990. The fund’s main source of revenues is contributions, established at a rate of 5 percent for the employer and 1 percent for the employee. Unemployment benefits are paid for the first nine months of unemployment in an amount equivalent to a certain percentage (60-70 percent) of the average wage in the last three months of activity. If the individual remains unemployed beyond nine months, an additional allowance equivalent to 60 percent of the minimum wage can be paid for a maximum additional 18 months, provided the recipient does not have other sources of income yielding more than 40 percent of the minimum wage. The Unemployment Fund also sponsors retraining programs to allow laid-off workers to acquire new skills and hence help them find a new occupation. In order to stimulate enterprises to hire new entrants into the labor force, the fund pays an “allowance for professional integration” equivalent to 60 percent of the minimum wage for graduates of professional and secondary schools, and 70 percent of the minimum wage for college graduates. Outlays under these two programs amounted to 8 percent of total outlays of the fund in 1996.
94. Since its creation in 1990, the Unemployment Fund has been in surplus. The surplus at the end of 1996 was 0.7 percent of GDP, down from 1 percent of GDP in 1995. The main reason behind the sound financial position of the Unemployment Fund is the relatively low number of beneficiaries, which, after escalating rapidly from just over 600,000 in 1991 to about 1.1 million in 1994, fell to 500,000 by 1996. The low number of beneficiaries is in part a reflection of the increased burden assumed by the pension system. While the number of recipients of unemployment compensation was only 500,000 in 1996, total recorded unemployment stood at 800,000. The fact that only 60 percent of recorded unemployed receive unemployment benefits seems to reflect a high number of long-term unemployed as well as a high incidence of unemployment among new entrants in the labor market.
Social protection programs
95. Together with minimum pensions, unemployment benefits and active labor market programs, the main pillars of the Romanian social safety net are social protection programs providing both cash and in-kind benefits: (i) the child allowances program; (ii) the minimum income guarantee program; and (iii) the social canteens program.
96. Child allowances constitute the most important rash transfer program in Romania. Until 1993, child allowances were delivered exclusively through state enterprises, and were therefore available only to state employees. In 1993, the program was modified into a system with universal coverage, providing an identical lump sum payment per child for all children aged 16 and under, irrespective of family income.12 The delivery of the benefits is administered through the school system and eligibility is conditional upon enrollment and attendance, so as to provide an incentive for poor families to send their children to school. The universal coverage was aimed at avoiding the difficulties and costs of means-testing, and the inverse correlation between household size and household income was supposed to guarantee that the benefit would accrue disproportionately to poorer households, thereby compensating for the lack of targeting. The amount of the allowance, however, was allowed to quickly erode in real terms: total outlays on the child allowances program declined from 2.7 percent of GDP in 1990 to 0.6 percent of GDP in 1996, when the benefit per child stood at a mere lei 10,000. To partially reverse this trend, the 1997 budget provides for an increase in child allowances by 1.2 percent of GDP.
97. As mentioned above, a means-tested minimum income guarantee program was instituted in 1995, as the government recognized that existing social assistance programs were ineffective in reaching the poorest groups of the population. The minimum income guarantee program, administered through the local governments, has a very limited scope—total outlays declined from 0.23 percent of GDP in 1995 to 0.16 percent of GDP in 1996. No comprehensive evaluation of the program has been carried out so far, and the limited evidence available points to significant inclusion and exclusion errors. In-kind benefits are provided through the social canteens program, aimed at providing minimum nutritional support to the poorest people. This program also has a very limited scope, with outlays constant at 0.1 percent of GDP in 1995 and 1996.
V. the financial sector
98. Romania had only a few banking institutions and effectively operated a monobank system until December 1990 when a traditional two-tier banking structure was introduced. The basic legislation governing activities of the NBR and commercial banks was adopted in April 1991. Development of non-bank financial markets has so far been limited. Government securities only began to be issued in large volume in 1996, and no secondary market has yet developed. The stock exchange opened in late 1995 and an over-the-counter market in late 1996.
99. The banking system has expanded greatly since the two-tier system was established in 1991, but it remains heavily segmented and dominated by the state-owned banks. None of the state-owned banks had been privatized by end-1996. An appropriate legislative and prudential framework has largely been put in place, but the banking system remains fragile.
100. Monetary policy has been overburdened, and monetary and inflation targets have consistently given way to demands for the NBR to provide large directed credits and quasi-fiscal subsidies. The generally accommodating monetary policy, in particular large-scale directed credit to ailing sectors, has prevented many of the underlying financial weaknesses of the enterprise sector from directly showing up as major problems in the financial accounts of the banks. The true quality of banks’ portfolios is thus uncertain since prudential supervision is in its infancy and there are no recognized accounting standards for enterprises or banks.
B. The National Bank of Romania
101. Monetary policy has been geared toward supporting specific sectors of the economy, at the expense of inflation control. This made monetary policy inherently accommodating and led to high and variable inflation. Monetary policy was further burdened during 1996 by the need to support troubled banks and by the government’s large-scale recourse to borrowing from the domestic banking system.
102. Nominally monetary policy has been guided by reserve money targets, but these have generally been subordinated to the liquidity demands of influential sectors, in particular, the agricultural sector. To the extent possible, the NBR has sought to offset excess directed credits and credits to troubled banks by reducing the volume of otter credits, crowding out more dynamic sectors. The large element of direct credit control has, in effect, helped to preserve the dominant role of the state-owned banks. While the NBR has relied on reserve money management, the conduct of monetary policy has been hampered by the paucity of instruments available to the central bank. The NBR has not conducted open market operations, and has had no instruments for absorbing liquidity.
103. The main instruments of monetary control are credits to banks and reserve requirements:
104. NBR credits. The NBR advances credit to the banking system through four windows Total credit to banks on the NBR’s balance sheet over time are shown in Table 28, and the shares of this credit extended through each window are shown in Table 29.
Directed credits. The discount window was initially created as a facility available to banks in need of liquidity. However, it quickly became the main facility through which the NBR advanced directed credits at heavily subsidized interest rates. Interest rates are set by the NBR Board, and have generally been far below both the average bank lending rates and the NBR auction rate (Table 30). At the end of 1996, for example, the average NBR rate on directed credits was 51 percent at a time when inflation was almost 60 percent and the average bank lending rate was 71 percent. In addition to the credits channeled through the discount window, directed credits include preferential credits, and special agricultural credits created in 1996. These credits have been channeled almost exclusively through state-owned banks to state enterprises. Despite repeated attempts to curb these facilities, directed credits have remained the dominant source of financing from the NBR, generally accounting for some 70 to 90 percent of total NBR credit during the past few years13 (Chart 5). The main beneficiary of these credits has been the agricultural sector.14 The other main uses of directed credits have been energy imports and export promotion.
Auction credits. The auction is open to any private or state-owned bank that is in a position to provide adequate collateral.15 The auctions are held weekly, and all credits carry a one-week maturity. The NBR announces the volume to be offered and a minimum interest rate. In practice, however, interest rates on central bank auction credits have been determined by informal agreement among the participants rather than by the market, and even the auction credits have continued to go mainly to the state-owned banks. The auction has often been another vehicle for providing directed credits, in particular to the agriculture sector. At times, the auction rates have been higher than the interbank market, and continued borrowing by state banks at the auction has reflected the preference of private banks not to lend to them in the interbank market.
Lombard (overdraft) credits. The Lombard facility provides last resort liquidity at a penalty interest rate, winch was 90 percent compared with an auction rate of 68 percent at end-1996 (Table 30).16 Credit is automatically advanced to banks under this facility if they have insufficient funds on deposit at the NBR to meet payment obligations through the payments system. Lombard credits have an overnight maturity, and banks are not permitted to roll them over for more than three days. During 1995, two insolvent private banks took substantial recourse to this funding before being moved by the NBR to the special credits facility and then sued for bankruptcy in mid-1996 (see below). Based on the experience with these two banks, an access limit of 75 percent of a bank’s own funds was introduced, and the credits must be fully collateralized.
Special credits. The special credit facility is used for banks in distress or with special needs. Banks needing recourse to the Lombard facility for more than three days have been moved to this window. It has also been used as an extension of the discount facility for providing directed credits. The interest rate is set at the discretion of the NBR executive management, usually somewhere between the discount and Lombard rates. These credits are supposed to be fully collateralized, but exceptions are permitted.
105. Reserve requirements. As of end-1996, the reserve requirement was 7.5 percent for required reserves held in lei against lei deposits. Banks have had a choice since 1994 between holding reserve requirements against foreign exchange deposits in lei or in foreign currency; presently the distribution is about half-and-half. Banks are remunerated for required reserves; as of end-1996, the rates were 12.7 percent for lei deposits and 3 percent for foreign exchange deposits.
106. The calculation of reserve requirements is based on a complicated lagged, overlapping formula. From a monitoring standpoint, this means that the NBR only knows on the 20th of the month what the banks’ reserve requirements for that month are, and doesn’t know until the end of the month whether they have been met. The penalty rate on any shortfall relative to reserve requirements is the Lombard (overdraft) interest rate.
107. While reserve requirements have been adjusted over time, they have not been actively used as a policy instrument in recent years, except that reserve requirements on foreign exchange deposits were raised to 40 percent in late 1995 in an effort to curb the rapid growth of domestic lending in foreign exchange (see below). The high reserve requirement failed to stem the increase, however. In July 1996, the NBR halved the reserve requirement on foreign currency to 20 percent if held in U.S. dollars, and reduced the reserve requirement to 10 percent on foreign currency deposits held in domestic currency. A prudential foreign exchange liquidity ratio was later introduced to try to curb domestic lending in foreign exchange, although it has also proved ineffective.
C. The Banking Sector
108. There were 40 banking institutions by end-1996, of which 33 had private majority ownership or were joint-venture banks.17 These private institutions accounted, however, for less than 25 percent of bank assets at end-1996. None of the state-owned banks had been privatized as of end-1996. In fact, a bank privatization law does not yet exist. The basic legislative framework for the banking system has been strengthened since 1990, and rules and regulations governing capital adequacy requirements, loan classification and provisioning, and regulatory and prudential control are generally appropriate. Prudential oversight and enforcement, however, are still at an early stage of development. A limited deposit insurance scheme was introduced in 1996.18
109. Five state-owned banks still account for three-quarters of total bank assets despite the increase in the number of privately-owned banks (Table 31). This reflects the persistence of extreme segmentation in the banking system, with state-owned enterprises in the non-financial sector banking mostly with state-owned banks. While legislative changes were introduced in 1995 to permit such enterprises to hold accounts in more than one bank, the weak and nontransparent financial situation of most state enterprises has restricted their ability to find new (especially private) banks willing to provide services that entail credit exposure. At the same time, state banks continue to provide considerable financing to their long-time state enterprise clients, based on the traditional close relationship between the state-owned banks and enterprises and on social and political considerations.1
110. The Savings Bank (CEC) holds a special position in the Romanian banking system. It is wholly owned by the state, and is governed by a special law which provides for a full state guarantee of all deposits in the bank. The trade-off is that the CEC offers lower deposit rates than other banks, which has led to a loss of market share from 96 percent of household deposits at end-1993 to 30 percent at end-1996. Traditionally CEC has been a narrow bank, investing deposits only in government securities and interbank loans. Under a 1996 law, however, it will be allowed to expand its lending operations, and has announced the intention to move aggressively in the direction of mortgage credits and other forms of direct lending to the household sector, sometimes with subsidy elements. These plans make it urgent for CEC to quickly modernize its operations and develop the expertise in credit operations required to carry out such a re-orientation successfully.
111. Private banks have tended to focus more on the private enterprise sector and short-and medium-term lending. All commercial banking institutions in Romania are fundamentally “universal banks” offering a wide range of services. However, the banking market is not fully integrated and differences exist in the supply of services. Some domestic private banks offer fewer payment services to their clients than larger institutions (for example, some do not offer credit card services). Most foreign banks have concentrated on large domestic and foreign customers—especially providing trade-related services—and do not accept personal deposit accounts in lei or foreign currency from the general public.
112. The funding of banks differs based on ownership structure. Private banks are to a large extent funded by sight and time deposits from the general public (about 20 percent of such deposits) and by interbank borrowing, but have had virtually no funding from the NBR.2 Five state banks control almost 80 percent of the non-bank client deposits in lei and almost 60 percent of foreign exchange deposits (Table 31). NBR refinancing nonetheless continues to be a key source of financing for a few state-owned banks.
Prudential regulation and supervision
113. Considerable efforts have been made to bring the regulatory framework in line with international rules and standards, and in particular, to harmonize it with those of the European Union. The Basle Accord on bank capital adequacy was implemented in 1994. The externally audited accounts for 1995 indicate that virtually all banks reported capital adequacy ratios in excess of the Basle requirements of 8 percent of risk-weighted assets, although a few did not.
114. Banking regulations and the tax code have successively been strengthened to improve prudential provisioning. In 1994, a new loan provisioning system was introduced on the basis of a revised credit classification system (Box 2). Banks are required to make a general provision which is tax deductible up to 2 percent of total outstanding loans at the end of the year, and to make specific provisions as follows: (i) 100 percent for loans classified as “Loss”; (ii) 50 percent for those classified as “Doubtful”; (iii) 20 percent for “Sub-standard”; and, (iv) 5 percent for “Watch.” Specific provisions in respect of loans in groups (i) to (iv), are now fully tax deductible.
115. Data provided by the Banking Supervision Department of the NBR for end-1995 and June-1996 suggest that a small surplus of loan-loss reserves existed with respect to general provisioning. At the same time, however, there was, according to the NBR, a deficit on specific provisions against impaired loans of about 30 percent compared to what was needed. This represented a substantial improvement from a shortfall of 72 percent at end-1994 and 90 percent at end-June 1994 (Table 32).
116. A weakness of the system for loan loss provisioning is that it is likely to exaggerate the value of guarantees and collateral, resulting in under-provisioning. Required provisions are based on the banks’ net loan portfolios, after taking into account the portion of the gross loan portfolio that the banks report as covered by either guarantees or collateral (NBR data do not distinguish between the two). Looking at the gross loan portfolios of the banking system excluding the agricultural bank, NBR data show that at the end of 1995, 35 percent of all loans were non-performing (i.e., classified as doubtful or loss). The banks reported that provisions for non-performing loans covered just 10 percent of their gross loan portfolio, and collateral or guarantees for non-performing loans covered 20 percent.1 The true value of the collateral is uncertain, but probably lower than reported given the widespread problems of collateral overvaluation and difficulties of collection observed in many transition economies. Furthermore, to the extent that these loans are guaranteed by the government, they represent a contingent fiscal cost.
Credit Classification System
The prudential loan portfolio review methodology rests on a matrix which takes into account both the actual debt servicing performance, and, the actual financial performance of the borrower.
The first component has three sub-categories classifying the debt service as:
“Good”—when installments and interest are paid with a maximum 7 days’ delay;
“Poor”—when installments and interest are paid with a delay of up to 30 days; or,
“Bad”—when payment of installments and interest is delayed by more than 30 days.
The second component has five sub-categories classifying the debtor’s financial performance as:
“A”—very good and envisaged to be maintained;
“B”—currently good but cannot be maintained at this level in the future;
“C”—now satisfactory but obviously tending to get worse;
“D”—poor financial performance with evident cycles of deterioration at short intervals; and,
“E”—bad, financial performance reveals losses and it is dear that neither installments nor interests can be paid.
Thus, a matrix can be compiled with the two components, producing five loan classification groups: “Loss”; “Doubtful”; “Sub-standard”; “Watch”; and “Pass”. The credit classification matrix is structured as follows:
Debt Service Component
Debt Service Component
117. In addition, the data suggest that a deterioration has taken place in the quality of the combined loan portfolios of the banks. The share of impaired loans reported to be non-performing increased from 23 percent in 1994 to some 35 percent at end-1995 and end-June 1996. Some of this shift may reflect a more accurate classification in response to favorable tax treatment of loans that were in reality already nonperforming. But the shift may reflect also a real deterioration given that state banks continue to be the main providers of credit to major state-owned enterprises, as described above. The true value of these loans is uncertain, since proper loan valuation procedures are not in place.
118. The legislative and regulatory framework for prudential supervision has largely been put in place, but implementation and enforcement are at an early stage of development, and have also been hampered by deficiencies in the legal framework. These limitations were highlighted during 1995-96, when the Romanian banking sector was shaken by the collapse of two privately owned banks: Dacia Felix Bank and Credit Bank. Investigations by the NBR revealed that the banks had suffered large losses and that the institutions were being intentionally de-capitalized. Instances were identified where NBR rules and regulations had been broken with fictitious reporting of prudential ratios, fraudulent classification of credits, excessively concentrated landing, insider lending, and illegal capital export. As a result, the loan portfolios of the two banks were severely impaired and loan-loss provisions were well below required levels. After about one year of considerable liquidity support, and in the absence of clear legal provisions for dealing with bank insolvency, the NBR—as the largest creditor of these banks—asked the courts to apply the provisions of the 1995 law regarding the procedure for judicial reorganization and liquidation.
119. A limited deposit insurance scheme was established by ordinance in August 1996, providing coverage effective end-November 1996 for deposits by individuals up to a maximum amount of lei 10 million (some US$3,000 at that time). The scheme covers deposits in both lei and foreign currency, although repayment is only guaranteed in lei. The financing of this scheme during 1996 was carried out through the deposit of 1 percent of the banks’ subscribed regular share capital within 90 days of the implementation of the legislation. In future years, 0.3 percent of the banks’ household deposits are to be deposited with the fund, calculated on the basis of the end-December data of the preceding year. This transaction was to be completed before end-March. Clearly, it will be some years before the insurance fund is fully funded. The scheme covers all deposits except for those at the state-owned Savings Bank, which are guaranteed by the Ministry of Finance, and deposits with Dacia Felix Bank or Credit Bank.1
120. In recent years banks have reduced their net foreign assets, in part to fund the rapid increase in domestic foreign currency lending (see below). Nonetheless, the liquid foreign assets of the commercial banks’ covered 85 percent of the foreign currency deposits held by the Romanian general public at end-1996 (Table 33).
D. Domestic Non-Bank Capital Markets
121. Short-term (3-month) government securities were introduced in 1993, but only became an important source of government financing in 1996. The public sector had positive net claims on the banking system until 1994. Between 1990 and 1994, deficits of the central government were financed by drawing down these deposits, by foreign borrowing, and by special “state loans” from the Savings Bank at below-market interest rates. While surpluses in the accounts of some of the extrabudgetary funds continue to be an important source of financing for the state budget, the size of the government deficit last year necessitated substantial issues of government securities. The stock of outstanding treasury securities consequently increased from 851 billion at end-1995 (4.7 percent of broad money) to 3,774 billion at end-1996 (12.4 percent of broad money).
122. No active market for government securities has developed, owing in large part to legal impediments. The laws governing public finance and debt have not provided for indefinite interest appropriations, so interest rates have been set by the Ministry of Finance based on available budgetary appropriations rather than on market interest rates. Moreover, treasury certificates could only be redeemed out of new debt, not out of general government revenues. The new government has made improving the legal basis a high priority in order to foster development of a competitive primary and secondary market for government securities.
The stock market and OTC
123. Stocks are traded at the Bucharest Stock Exchange and at the OTC market. The Bucharest Stock Exchange was set up in late 1995. By end-1996, the number of stocks traded was 17, of which only two companies were completely private. Applications from another 56 companies were pending. The listed companies represented a variety of sectors. No fixed income securities were traded. To ensure orderly trading, a share’s price is not allowed to fluctuate by more than +/- 10 per cent compared to its price the previous trading day. The stock market developed in 1996 in a “bearish” manner (Table 34). The downward trend in trading volume and share prices was due to a number of factors: delays in the privatization program; the temporary suspension of seven listed companies in April due to failure to disclose required financial results; and the simultaneous collapse of mutual funds after the regulatory body issued valuation rules requiring mutual funds to list share values based on the actual values of their holdings rather than projections of future earnings. The OTC market was launched in October 1996 and had 1,207 listed stocks by year-end. It functions as the first marketplace for the shares of most privatized companies as it is a lengthy process to get a bourse listing.
Informal financial markets
124. A number of pyramid schemes have been active in Romania in the past. The largest of these collapsed in 1994, with deposits reportedly equal to some US$700 million to US$1 billion. Subsequently a number of mutual funds were established in 1995 around the time of the re-opening of the Bucharest Bourse late in the year. Given the limited number of stocks available to invest in, some of these mutual funds in fact operated as informal banks, with most of their investments in property or loans. As described above, these funds collapsed in spring 1996 following a redefinition of their net values.
125. There is no evidence of insurance or leasing companies engaging in lending activities. The only non-bank “lenders” which have been mentioned as active at present are pawn shops. A law passed in October 1996 gave some 600 credit cooperatives new, broader mandates of operation. The law authorized than to acquire deposits and to extend lending beyond their original limited circles to the general public. These institutions are not licensed or regulated, nor are they under the supervision of the NBR The new government intends to quickly amend or abolish this law to keep credit cooperatives on a sound financial footing.
E. Recent Developments
Overall monetary developments 1994-96
126. The accommodation by the NBR of fiscal and enterprise deficits has led to high and variable rates of inflation (Table 18). In early 1994, interest rates were raised to positive levels” (see below) having been sharply negative for several years. A trend decline in inflation ensued as money demand began to recover from a very low level, evidenced by a decline in broad money velocity from a peak of 7.8 percent at end-1993 to 4.5 percent at end-1995 (Chart 6, Table 35). Velocity remained unusually high, however, in comparison with other east European countries.
127. The NBR lost control of money and credit growth in the run-up to elections in 1996. Inflation began to accelerate from mid-1995, and by mid-1996 deposit interest rates once again became negative in real terms since nominal interest rates were not raised in line with rising inflation. The recovery of money demand ended, and velocity at end-1996 was higher than a year earlier for the first time since 1993. Reserve money grew by 44 percent just during the fourth quarter, and by December, inflation was running at more than 10 percent per month, compared with 2 percent per month at the beginning of the year.
128. As a result of both improvements in the payment system and attractive interest rates, the public increasingly shifted from holding cash to deposits from 1994 through mid-1996. This resulted in a gradual increase in the reserve money multiplier (Table 36). The public’s desire to hold foreign currency deposits has mirrored changes in broad money demand. As confidence in the leu recovered, the share of foreign currency deposits in broad money declined from 29 percent at end-1993 to under 23 percent in 1994 and 1995. In light of preelection uncertainties and official interference with the foreign exchange market, however, the share of foreign currency deposits edged back up beginning in late 1995.
129. Romanian banks have rapidly expanded domestic lending in foreign currency to residents from 17 percent of total lending to non-government at end-1993 to 37 percent at end-1996. Initially foreign currency lending may have been driven by demand, as bank clients found the low interest rates on foreign currency loans attractive in an environment of exchange rate stability. During 1996, however, the continued growth of domestic foreign currency lending and foreign currency-denominated lending (Table 33 and 35) appears to have been motivated by the domestic banks’ refusal to sell foreign exchange during a period when the exchange rate was clearly overvalued. To the extent that such loans are held by the nontradables sector, continued regular servicing may be vulnerable to depreciation of the currency.
130. Interest rates have not played any important allocative role in the economy. As described above, interest rates on NBR credit have not been market-determined. During 1994-95, NBR interest rates became sharply positive in real terms (Table 30). They became negative again by mid-1996, however, as the weighted average NBR rate declined (Chart 7). This reflected not only the introduction of new directed credits at very low rates, but also reductions in the NBR auction rate throughout the first half of the year despite the acceleration of inflation.
131. The role of interest rates at the commercial banks has been mixed. Commercial banks are free to set their own lending and deposit rates, and the banks have competed on deposit rates mostly at 3-month maturities in the face of uncertainties about government policies and inflation. This has resulted in steepening inverted yield curves at the banks which have competed aggressively for deposits (Chart 8 and Table 37). Nonetheless, average deposit rates, which had been positive in real terms during most of 1994-95, became clearly negative by mid-1996.
132. It is less clear whether competition affects commercial bank lending rates, given the continued close ties of the state-owned commercial banks to their traditional customers. Anecdotal evidence suggests that the private sector uses little of the credit extended by commercial banks, both due to the high price and to lack of access. Since 1994, lending rates have been strongly positive in real terms, although they eased considerably in real terms in 1996 (Chart 7).
133. Spreads in the banking system are high, averaging almost 28 percent between the average lending and deposit rates during 1996.23 High spreads reflect the large volume of non-performing loans in banks’ portfolios and the low rate of remuneration on required reserves.
134. Reducing both interest rates and spreads over the medium term will depend on banking sector reforms to stem the accumulation of nonperforming loans, strengthen bank balance sheets24 and promote competition. A key early measure in this respect will be reducing adverse selection and improving loan servicing by imposing hard budget constraints on the state enterprises. This would in turn improve the allocation of resources, and support the sustained recovery of investment and economic activity required to expand private sector employment opportunities and raise living standards over the medium term.
VI. external sector
135. The relaxation of economic policies, in combination with an inflexible exchange rate policy, led to a substantial deterioration in the balance of payments during 1995-1996 (Table 38). There were four main features of external sector developments during the period. First, the relaxation of policies and the attendant surge in imports was associated with a sharp increase in the current account deficit, from 1.7 percent of GDP in 1994 to 4.9 percent of GDP in 1995 and 6.6 percent of GDP in 1996. Second, external debt has continued to increase sharply, and amounts now to 94 percent of export of goods and services, compared to 28 percent when Romania began the transition process in 1990. The debt-servicing ratio has increased from 0 to 14 percent during the same period. Third, foreign reserves were almost depleted in 1995 and stood only at about half a month of imports of goods and services by end-1996. Fourth, there has been a significant deterioration in the maturity profile of the external debt as a result of a switch from support from official creditors to relatively short-term borrowing from international capital markets. Financing from official creditors dropped from an average of about US$1 billion during 1991-94, to US$50 million during 1995-96. Having received non-investment grade ratings from rating agencies, the NBR proceeded to borrow about US$1.5 billion from international capital markets in 1996.
136. Romania’s export performance over the last few years has been better than that of other transition economies. Exports increased by 92 percent between 1992 and 1996, although the growth rate decelerated considerably in 1996, to 4.5 percent. The export performance has been strong across most sectors (Table 39). As detailed in Section VI.G, a sectoral analysis suggests that the strong export performance of traditional sectors has been possible because of large fiscal and quasi-fiscal subsidies to these sectors. The analysis also shows, however, that a dynamic group of non-traditional sectors has increasingly led the export growth. These emerging sectors are characterized by low energy intensity and strong wage discipline.
137. Exports have gradually been re-oriented toward developed countries. Exports to such countries increased from 43 percent in 1992 to 60 percent in 1996 (Table 40). In 1992, the former Soviet Union was Romania’s most important market, accounting for 13 percent of exports, but Germany and Italy have now become the most important trading partners, accounting for 35 percent of total exports in 1996.
138. Having experienced difficulties in securing financing for energy imports during the winter of 1995, the authorities reacted to mounting foreign exchange shortages during the first half of 1996 by establishing a foreign exchange fund for energy imports in June 1996. This fund was to be funded by surrender of foreign exchange earnings from one hundred companies exporting a broad range of products, in addition to foreign exchange obtained from commercial banks, loans in foreign currency, and foreign currency proceeds from privatization. Foreign exchange earnings used to import raw materials for the production of exportable goods, and foreign exchange used for external debt payments were exempted from the surrender requirements. However, the surrender requirements could not be effectively enforced due to the widening premium in the parallel market, and the resources raised by this fund were limited.
139. Imports have also exhibited significant growth rates across all goods, and a shift away from developing countries (Tables 40 and 41). After rising by 10 percent in 1994, imports surged in 1995, by 45 percent, only to slow to a growth rate of 9 percent in 1996 in the face of mounting foreign exchange shortages. This pattern resulted from a combination of two factors. First, the acceleration of economic growth in 1994-96, with the concomitant rise in private consumption and industrial production, triggered an increase in imports of both consumer and intermediate goods. Second, growth in non-energy imports was severely compressed by intensified official interference and quantitative constraints in the foreign exchange market in 1996. Restrictions imposed in the interbank market in mid-March 1996 (see below) were effectively aimed at reallocating foreign exchange away from non-energy and private sector imports. During the first nine months of 1996, natural gas and electricity imports increased by about 25-30 percent, while non-energy import growth decelerated to about 3 percent.
C. Currency Convertibility and Foreign Exchange Market Reforms
140. Romania liberalized the foreign exchange market during the early phases of the transition.26 The state trade monopoly and surrender requirements were eliminated in 1992; a fully-fledged direct-dealing interbank foreign exchange market was adopted in 1994; and foreign banks were allowed to obtain dealer licenses in 1995. However, faced with a sharp depreciation of the leu (Chart 9, and Tables 42 and 43), the NBR revoked the dealer licenses of all but four state-controlled banks at end-March 1996. The exchange rate was effectively fixed until end-June, 1996, when a policy of limited flexibility was introduced. As regards foreign exchange bureaus, the NBR imposed overnight cash limits of US$2,000 per office plus US$500 for the head office.
141. The inflexible exchange rate policy was associated with a virtual collapse in the volume of transactions conducted in the interbank market, which by October 1996 represented only about 6 percent of the monthly average volume in 1995 (Table 42). This policy also resulted in increased segmentation in the foreign exchange market. Significant discrepancies emerged between exchange rates quoted by those commercial banks not authorized to be dealers and rates quoted by dealer banks in the interbank market. Moreover, interbank cross-rates were broken for most of 1996, reflecting a desire to avoid a depredation of the leu vis-à-vis the U.S. dollar rate and an attendant increase in the domestic price of energy.27 Moreover, there was a sharp depreciation of the leu rate in the bureau market, and the spread between the monthly average exchange rates at the bureau and the interbank market fluctuated between 8 and 14 percent from March through October, and rose to 20-25 percent in November and December (Chart 9). This premium between the bureau and interbank markets usually differed from the one prevailing in the more important unofficial market between enterprises. The latter reached 30-40 percent by end-December, 1996.28
D. Foreign Direct Investment
142. Romania has a relatively liberal law governing foreign direct investment. It allows investment in most sectors of the economy, and grants significant incentives in the form of preferential tax treatment. In spite of these incentives, and the attractions of low wages, a well-educated labor force and a large domestic market, foreign direct investment has averaged only about 1 percent of GDP since the early 1990s, well below other countries in central and eastern Europe. During 1996, foreign direct investment actually declined by almost 50 percent to US$210 million. This poor performance has reflected macroeconomic instability and a slow reform process. By end-1996, the stock of registered foreign investment amounted to US$2.1 billion (Table 45). The countries with the largest investment in Romania between 1990 and 1996 were Korea, Germany, Italy, the Netherlands, and the United States. The main investments were in sectors such as automobile components, agricultural machines, chemicals, and the banking sector.
E. Romania’s Return to International Capital Markets
143. Romania successfully returned to international capital markets in late 1995 when the NBR tapped several markets, borrowing about US$1.5 billion at an average maturity of three years (Table 46). Medium- and long-term debt has continued to grow rapidly, amounting to US$7 billion by November 1996 (Tables 47 and 48).29
144. The successful return to capital markets was facilitated by a combination of two factors. First, Romania obtained its first non-investment grade credit rating from Moody’s, Standard and Poor’s, and the Japan Credit Rating Agency early in 1996.30 These favorable ratings were based on the perception by international investors of a considerable improvement in Romania’s creditworthiness, as a result of the resumption of economic growth, the decline in inflation and the still low indebtedness. Second, a shift by portfolio investors away from Latin American markets following the Mexican crisis in late 1994, and a sharp expansion of the international yen-bond market in 1995, increased capital flows to transition economies. In particular, the expansion of the yen-denominated market was triggered by the deregulation of the Japanese market starting in 1994.31 These factors eased considerably the NBR’s tapping of the Eurobond and especially the Samurai bond markets, and also paved the way for commercial banks and enterprises to access international capital markets.
F. Trade Policy
145. Romania’s early commitment to a rapid and comprehensive liberalization of trade contrasts sharply with a renewed intensification of restrictions for agricultural products in 1995-96. Moreover, a number of agricultural products became subject to export quotas and bans. In contrast, the trade regime on industrial products remained relatively liberal. However, the constraints imposed by an inflexible exchange rate policy increased the anti-export bias of the trade regime, discriminating in particular against imports of the non-energy sectors.
146. Romania pursued rapid liberalization of the trade regime in the early 1990s. Reforms included the elimination of the state monopoly on foreign trade and export and import licensing,32 the introduction of a simplified tariff code, and the signing of trade agreements with the EU and EFTA. These agreements have contributed to the opening of the Romanian economy. External trade equaled almost 55 percent of GDP in 1996, compared to 26 percent in 1990.
147. In 1994, Romania’s protection was moderate as trade-weighted tariffs were about 13 percent, and tariff dispersion was relatively low. However, efforts to liberalize trade in industrial products have contrasted sharply with increased protection for agricultural products. In July 1995, trade-weighted tariffs on agricultural products were raised from 25 to 75 percent following the Uruguay Round. All non-tariff barriers on agriculture were converted into tariffs and ceilings on tariff levels—for commodities not subject to tariff bindings—were established with little relation to previous levels of protection. As a consequence, Romania now has one of the highest agricultural tariff bindings of any country in the EU and central and eastern Europe.
148. Between 1993 and 1995, trade policy became more discretionary and restrictive, with increased reliance on export quotas, bans, and custom duties exemptions. The number of export products subject to quotas and bans has increased since 1993 (Tables 50 and 51), especially in agriculture (wheat, maize, wood and wood products, and animals). As to industrial products, the Ministry of Trade began a gradual liberalization by establishing an export quota for 1996 and 1997, with the expectation of fully liberalizing trade by 1998. To partially compensate for the anti-export bias of the trade regime, the authorities maintained certain export promotion policies, such as VAT refunds, duty drawbacks, free trade zones, and interest subsidies for export credits.
149. The association agreement with the European Union provides for the creation of a free trade area by 2002. In the transition period, the agreement contemplates a faster liberalization of restrictions on industrial trade by EU members than by Romania. The agreement accelerated Romania’s preferential access to the EU. It allowed for a full elimination of tariffs by January 1, 1995 for all industrial products, except steel and textiles. In the case of steel, tariffs were fully eliminated on January 1, 1996. For textiles, there is a system of tariffs and quotas on Romania’s exports, which is scheduled to be fully eliminated in January 1998. Tariffs on Romanian textile exports are already lower (by about 50 percent) than those applied to suppliers from third countries and will be eliminated in 1997. Romania still faces quotas on its exports to the EU, but these have been doubled since 1993, and 60 percent of textile exports are not subject to any quantitative restriction.
150. The concessions initially granted by the EU for Romania’s agricultural exports included the elimination of tariffs for certain products like fruits, and a preferential system of tariff-quotas for other products. The reduction in tariffs was differentiated among products, and quotas were scheduled to be increased by 10 percent annually over the following five years. In 1994, the EU extended the initial concessions by bringing forward the establishment of minimum tariffs and maximum quotas to July 1, 1995. In spite of the improvements in preferential access, Romania’s utilization of EU export quotas remains low across most agricultural categories.33
151. The United States restored Romania’s most favored nation status temporarily in 1993, after suspending it in 1988, and confirmed its permanent status in 1995. As a result, current tariffs are set at low levels in comparison to previous ones, which ranged between 75 and 95 percent. Preferential access to markets in the United States has contributed to the strength of Romania’s export growth during 1994-96; exports to the United States increased from US$1.4 billion in 1993 to an average of US$2.6 billion during 1994-96. The United States also included Romania in the list of countries benefiting from the Generalized System of Preferences. As a result, Romania has faced favorable conditions for exports of chemicals, leather, furniture, steel, and textiles. About 170 products are tariff-exempted, of which more than half are textiles.
152. Over the last few years, Romania’s external competitiveness has been affected by cycles of overvaluation and depreciation (Chart 10). Sectoral evidence shows, however, that the competitive stance of Romania’s industry differs significantly between energy-intensive sectors and other sectors in the economy.
153. Romania adopted a floating exchange rate system early in the transition, reflecting the low level of foreign exchange reserves, high and variable domestic inflation, and uncertainty about the equilibrium level of the real exchange rate. A flexible rate was also expected to facilitate adjustments in relative prices and the needed reallocation of resources in the context of structural reforms. Chart 10 shows that a sharp real depreciation took place in late 1991 which—in conjunction with exchange system reforms—improved Romania’s competitiveness considerably. The liberalization of the exchange system stalled between 1992 and mid-1994, however, and the real exchange rate appreciated throughout the period. Since economic policies were markedly tightened in 1994, this appreciation was initially not associated with a deterioration in the balance of payments.
154. The licensing of foreign banks as exchange dealers in 1995 expanded the interbank market and made the exchange rate more responsive to changes in demand and supply. The combination of increasingly lax monetary and fiscal policy, together with the seasonal pressures associated with energy imports, resulted in a 14 percent real depreciation (based on relative consumer prices) between October 1995 and March 1996. The attendant improvement in competitiveness was sharply reversed, however, during the remainder of 1996. The real effective exchange rate appreciated considerably starting in March 1996, based on relative consumer and producer prices as well as on unit labor costs. As of end-1996, all measures of the real exchange rate were again equal to their October 1995 levels.
155. The real depreciation between October 1995 and March 1996, considerably reduced Romania’s unit labor costs vis-à-vis its main trading partners, and also vis-à-vis other transition economies (Charts 11 and 12).35 A 21 percent decline during this period in unit labor costs almost fully reversed the 24 percent increase that had taken place between March 1992 and October 1995. Romania’s competitive stance again worsened vis-à-vis other transition economies after March 1996.
Sectoral analysis of exports
156. Sectoral evidence shows that large traditional energy-intensive sectors have experienced a sharp deterioration in competitiveness since 1994, while emerging non-energy-intensive sectors have shown significant improvements in competitiveness. This difference notwithstanding, both sectors have contributed considerably to the strength of exports (Table 52). Two main conclusions can be drawn from the sectoral data.
157. First, as explained in Section II.D, traditional, energy-intensive sectors experienced wage growth in excess of improvements in labor productivity. Moreover, they were generally not successful in reducing energy consumption. For example, the rubber and plastics sector experienced a decline in labor productivity of 5 percent between end-1993 and end-1995, while U.S. dollar wages increased by 39 percent and energy consumption increased by 21 percent, In the case of metallurgy, dollar-wage growth exceeded labor productivity gains by 8 percentage points, but export volume increased by about 34 percent over 1993-1995. As these traditional sectors include enterprises that have received large-scale fiscal and quasi-fiscal subsidies during the period under review, the analysis lends support to the hypothesis that exports have been partly sustained through such subsidies.
158. Second, smaller emerging sectors were more successful in containing real wage growth below the growth in labor productivity. They also successfully reduced energy consumption. Such sectors include: textiles, leather and footwear; equipment, pulp, paper, and cardboard, in addition to furniture; fabrics, fur, and leather; and electric machines, which were discussed in Section II.C. These sectors have increasingly led export growth.
159. These findings suggest that reducing subsidies and raising energy prices to world levels could entail a temporary weakening of, and possibly a decline in, exports. They also suggest, however, that there is considerable potential for export-led growth as reforms take hold.
160. Developments during the first half of 1996 were in line with the trend observed between 1993 and 1995. The real exchange rate depreciation through March contributed to narrowing the gap between real wage and labor productivity growth in several sectors. However, large traditional energy intensive export sectors, mainly chemicals, textiles, and metallurgy, were still experiencing a significant gap by June-1996.
APPENDIX I ROMANIA: THE AGRICULTURE SECTOR
161. Romania has considerable agricultural potential due to a favorable natural resource endowment. Since the 1950s, successive communist governments sought to capitalize on this potential to establish self-sufficiency in agricultural production. This drive led to the creation of huge, highly inefficient collective state farms, especially in the livestock sector. There was no private farming of importance, unlike for instance in Poland and Yugoslavia. Farm output was delivered to large and equally inefficient intermediaries and agro-processing centers in exchange for bundled supply of all inputs and services, with all transactions based on quantitative targets and prices having no role in the allocation of resources.
162. As a result of spontaneous privatization following the collapse of the Ceausescu regime, private farmers hold most of the arable land and account for the majority of production. The state, however, has retained control over much of the agricultural sector through the state-owned intermediaries. It has also dominated the livestock sector and barred development of a land market. The state-owned forms and intermediaries have undergone little restructuring and remain large and inefficient; they have been kept operating by a complex web of direct and indirect support. The sector as a whole has made large losses.
163. The magnitude of the imbalances in the agricultural sector is so large that lack of reform in the sector has undermined successive attempts at macroeconomic stabilization. Large directed credits to the agricultural sector have been the main reason that NBR credits have regularly and significantly exceeded annual targets. Moreover, large direct subsidies and transfers have also distorted fiscal policy. Fund staff estimates suggest that the fiscal and quasi-fiscal subsidies and transfers to this sector have amounted to some 5 percent annually during the last three years.
II. employment, ownership and output
164. The agriculture sector accounted for almost 20 percent of GDP in 1996 (Table 1), and provided employment for 40 percent of the labor force (Table 5), the largest relative shares in central and eastern Europe with the exception of Albania.1 Romania has great agricultural potential, based on geographic location, topology, soil types and access to water resources. Romania was known as the “breadbasket of Europe” during the 1930s, and agricultural goods remained an important source of export earnings during the communist era (23 percent in the early 1980s)2. But output declined by 13.5 percent between 1985 and 1989, as the policy of compressing both imports and domestic investment during the drive to repay all external debt led to shortages of imported inputs (e.g. protein feed for livestock) and to a deterioration of irrigation systems and agricultural machinery.
165. Shortly after the overthrow of Ceaucescu in December 1989, farm workers began to spontaneously dismantle the collective farms, repossessing land and distributing livestock and materials among themselves. Faced with a fait accompli, the government codified this land privatization with Law 18 in 1991, which returned land to the original owners and their heirs up to a limit of 10 hectares per household. The average holding of 2.5-3 hectares (compared with an average of 2100 hectares in the former cooperatives) is spread across 3 to 5 parcels. Out of the 87 percent of arable land that was collectivized after 1948, 70 percent was returned to private ownership by end-1991 (Table 7). At the same time, however, the government retained almost 20 percent of the most productive farm land in large state farms.
166. Gross output declined a further 15.2 percent during 1990-92 (Table 53) owing to four main factors: (i) the efficiency of the sector was initially reduced by the division of farm land into small parcels; (ii) there was some reduction in the area under cultivation as questions about land ownership were being resolved; (iii) there were shortages of inputs such as fertilizers and pesticides due to import shortages and dislocations in the distribution systems that accompanied the breakdown of the collective farm system; and, (iv) the country experienced a serious drought in 1992. During the output contraction, exports declined and Romania became a net importer of food. Total output has largely recovered from the early contraction, growing 15 percent during 1993-95.3 Production has shifted increasingly to the private sector, and from animal to vegetable production (Table 53).
167. Despite the recovery of output in recent years, the potential of the agriculture sector following privatization has not been fully realized due to institutional obstacles and government policies, which have to a large extent offset the positive effects of land privatization. First, land consolidation is fundamental to establishing an efficient private agriculture sector, but development of a land market has been slow. The sale of agricultural land is still prohibited, while leasing has been hampered by an unfavorable legal framework and by the lack of clear title to the private land; only some 55 percent of the new owners have received titles (Table 7). Second, the lack of clear title prevents the use of agricultural land as collateral to secure credit. Large amounts of credit have been directed to the agriculture sector, but this credit has largely supported inefficient state-owned farms and other state-owned agricultural entities rather than private farmers (see below). Third, and most important, while primary production has been largely privatized, most intermediate stages remain controlled by highly inefficient state-owned companies.4
III. the macroeconomic cost of support
168. The principal mechanisms for state support of agriculture were established by Law 83 in December 1993. These include allowances and interest subsidies for production credits and investment; production premia and compensations; fiscal advantages; credit guarantees; guaranteed procurement prices for products of national importance; and provision of technical assistance and other facilities (e.g., infrastructure investment). In addition to the support mechanisms envisioned in the law, the government has used extensively several other instruments, the most important of which has been large low-interest directed credits. Other mechanisms have included direct transfers from the SOF5; toleration of large inter-enterprise arrears, and arrears to banks and to the state budget and the social insurance funds. In addition, the external trade regime for agricultural products has been highly distorted, with substantial barriers to both import and export of agricultural products. Agricultural tariffs were the highest in central or eastern Europe at an average of 75 percent, with higher protection the higher the degree of processing. Moreover there has been recurrent resort to reference prices, export licenses and temporary bans to control and discourage exports (see Section VI for more detail).
169. Estimating the cost of government interventions in agriculture is subject to great uncertainty, but it has clearly been very high over time. One proxy of the cost of support to the agriculture sector is the sum of the explicit subsidies and transfers (from the budget, the NBR, and the SOF) and the implicit subsidies and transfers (increase in directed credits and arrears of agricultural enterprises). As illustrated in Table 54, this approach suggests that the cost of support to agriculture has averaged 5 percent of GDP per year during 1993-96. The cost of support was even higher when compared to gross value added in agriculture at 26 percent per year on average during the same period. This support has had a substantial fiscal cost, accounting for 2.5 percent of GDP in 1996 and 7.5 percent of total fiscal expenditures (Table 55).
170. The provision of subsidized directed credits has frequently derailed monetary policy, as the NBR has repeatedly provided such credits in quantities far in excess of what could be accommodated within annual monetary and inflation targets. A large share of these credits is non-performing, suggesting that the annual net increase in such credits has been tantamount to an unrequited transfer. Moreover, these credits have distorted credit allocation in the economy, diverting resources away from dynamic new sectors.
171. Finally, the government’s tolerance of arrears as a source of enterprise support has frustrated efforts to reduce quasi-fiscal deficits in the economy. In particular, allowing enterprises to build up arrears to the banks has contributed to the rapid growth of non-performing loans.
172. These very large subsidies and transfers do not benefit all branches of agriculture equally. On average during 1993-96, state farms and intermediaries received 80 percent of directed credits, debt conciliation and SOF transfers. The same pattern emerges with respect to indirect subsidies in the form of producer and consumer price controls. Comparing the domestic prices of agricultural commodities with world prices—adjusted for transport, marketing and processing costs—the World Bank has found that farmers who grow cereal crops are implicitly taxed, while those who raise potatoes, swine and poultry are implicitly subsidized.
173. These findings confirm that the large transfers to the sector are benefitting primarily inefficient state livestock producers, as well as the large state-owned cereal and vegetable farms and state-owned cereal intermediaries—at the expense of private farmers and consumers. Keeping the price of staple foods to consumers low has been cited as a main goal of the subsidies and transfers to agriculture, but a recent study found that the entire subsidy transfer to consumers never exceeded 4 percent of consumer expenditures. The state agriculture sector has represented a powerful vested interest group, even though it accounts for a small share of the labor force judging from the number of employees of state-owned farms and agroprocessing firms (Table 5).
IV. the role of price controls and subsidies
174. At the farmgate level, price controls have applied to four commodities declared to be of “national importance”—wheat, pork, chicken, and milk—if they were sold to state-mandated storage agents or processors. While the producer price controls were not mandatory, they were widely effective since private farmers had to agree to sell their output to the state-owned agricultural intermediaries at these official procurement prices in order to gain access to bundled services.6 By law, procurement prices were supposed to be related to the previous year’s world market prices; however, for sensitive products (such as wheat), there have been large deviations below world prices over time, especially during periods of rapid exchange rate depreciation. During most of 1996, for example, the world price for wheat was $180 per ton compared to a domestic procurement price of $100 per ton.
175. The dependence of farmers on these state-owned intermediaries has been reinforced by the fact that subsidized credit has been extended to these official intermediaries rather than to private farmers. The intermediaries then provided inputs to the former and collected repayment in output, keeping the prices of both inputs and credit to the private farmers nontransparent. According to the Ministry of Agriculture, the effective input prices paid by farmers have risen much more rapidly in the recent years than procurement prices.
176. In an effort to encourage greater production, the government also paid premia to private and state farms for the four key products, which were essentially producer subsidies above and beyond the procurement price. However, the premia were often announced late in the production cycle; were subject to change; and typically paid with a lag of at least one to three months, and sometimes were not paid at all.
177. The combination of low procurement prices and unreliable premia payments has led to a decline in marketed output since 1989. There is some evidence that the production pattern which has emerged in the new private agriculture sector is one of widespread small scale subsistence farming, supplemented by partial planting of cash crops under contract with the state intermediaries.7 This pattern appears to be confirmed by an increase in the share of total agricultural output which goes to self-consumption, from 22 percent in 1989 to 39 percent in 1994. A further 18 percent of output was sold directly at farmers’ markets, where prices are freely set. For the four key products in 1995, only 65 percent of total wheat production was marketed, 87 percent of which was sold through the state-controlled channels; 65 percent of pork was marketed, of which 65 percent through state channels; 40 percent of chicken was marketed, of which 95 percent through state channels; and only 35 percent of total milk production was marketed, half of that through state channels.
178. Finally, the government maintained direct wholesale and retail price controls in the form of price ceilings on a number of sensitive food items: milk and dairy products; wheat and (low-quality) bread; pork, poultry, and processed products; sugar; and sunflower oil. These direct controls carried a weight of 28 percent in the household consumption basket, and affected some 55 percent of the food component of the household basket. As noted above, however, consumers derived little benefit from these price controls.
179. This complex web of direct and indirect subsidies has supported the state-owned intermediaries, state farms,8 and state agroprocessing industry, which have undergone little restructuring. They are as a group large, inefficient loss-makers which would likely not have been viable even if they had not been subject to formal and informal price and margin controls. A recent study of the state-owned enterprise sector found that operational losses were concentrated in the agricultural sector, based on financial results for a sample of 6,702 firms tracked during 1993-94. The 1,421 agricultural enterprises accounted for only 10 percent of employment among the sample firms and 11 percent of revenues, but their operational losses were equal to 3 percent of GDP (losses for the whole sample amounted to 7 percent of GDP), and to 39 percent of revenues (compared with 4 percent of revenues for the sample as a whole) (Table 56).
180. Owing to their large losses, state swine and poultry farms were included in the group of enterprises to be restructured under the 1995 special restructuring program. They accounted for 74 of about 150 enterprises monitored and for 6.4 percent of total employment among these firms. Financial discipline among these farms has not improved, and the operating losses of the monitored farms have remained high, at 444 billion lei in 1995 and an annualized rate of 626 billion in the first half of 1996 (0.6 percent of GDP at an annual rate). In fact, these farms were the second largest source of operating losses within the group of monitored enterprises.9 The losses of state farms and some intermediaries are also known to be large, but no data are available to quantify them.
V. the strategy for reform
181. Past efforts to simultaneously ensure domestic food security, protect state agroindustry and keep consumer food prices low have set in motion a vicious cycle. Keeping procurement prices to farmers low and intermediate processing in state hands has forestalled the strong output response to privatization and liberalized prices which could make food products more widely available to consumers at lower prices. In addition, ending the costly distortions and support of the sector would yield both substantial budgetary savings and more efficient credit allocation. Price and trade liberalization could also contribute significantly to raising domestic incomes. The new government has realized that sweeping reform of the sector is essential to realize the potential of the sector as a major source of both growth and exports. Its strategy is based on liberalizing prices and trade; privatizing or liquidating state farms and intermediaries; improving the legal framework for agriculture; and making state support for the sector transparent.
182. Liberalizing prices and trade. Producer and retail prices for all food products have been liberalized. This has been accompanied by substantial liberalization of the trade regime, including a sharp reduction in import tariffs on agricultural products and elimination of export bans and quotas.10 These measures should help to encourage agricultural production and redirect resources to the most productive uses.
183. Privatizing or liquidating state farms and intermediaries. At the production level, the large and inefficient state-owned pig and poultry farms are to be quickly privatized or liquidated. The other state-owned farms, producing primarily cereals and vegetable oil, will be divided into smaller units and then privatized. Intermediate services will also be demonopolized, and the existing intermediaries privatized or liquidated. The intermediaries providing mechanized and other services have been divided into sub-units to be privatized at the village level, which will enhance the effective transfer of control to the new owners. The national distribution and storage companies, as well as seed monopolies, will also be privatized, in some cases through share sales and in many cases after the assets are divided into smaller units. These measures will free up resources, transfer assets to the private sector and remove unfair competition, all of which should allow private farms and especially private intermediaries to flourish.
184. Improving the legal framework. The government is working on legislation to permit land sales and to improve the deficient land leasing law. At the same time, they are trying to accelerate the distribution of titles for privatized farm land, since otherwise improving the legal framework would yield little practical benefit.
185. Making state support transparent. Direct subsidies to agriculture from the budget and from the NBR have already been reduced. Moreover, the government has taken the important decision that all remaining state support for the agricultural sector, including that required to support the reform process and any new financing which might be required, will be through the budget. This would include a temporary bread subsidy for low-income groups, incentives to encourage private lending to agriculture, and expenditures for restructuring—including, for example, redundancy payments to state farm workers, and any others which might be required. Over time, such support would be phased out, and any remaining budgetary assistance would be shifted toward providing general support, e.g. investment in rehabilitating irrigation systems.
APPENDIX II ROMANIA: THE ENERGY SECTOR
186. Romania has a significant endowment of domestic hydrocarbon resources. It was the third largest petroleum producer in the world a century ago. Communist governments began building on those resources in the early 1950s as part of a drive for self-sufficient industrialization. The country invested heavily in export-oriented industries, including refining and downstream chemical plants (to process petroleum from domestic sources, as well as from the FSU and the middle east), metallurgy, textiles, and a very large machine-building industry. Since prices played no role in resource allocation, there was little incentive for efficient energy use, resulting in a highly energy intensive industrial sector.
187. The energy sector has so far not undergone significant restructuring, and remains inefficient and over staffed. The government’s pricing policies have protected consumers from facing the true cost of energy consumption, resulting in retail prices which are far lower than in neighboring countries and which—for some products—have declined in dollar terms during the transition. Keeping the cost of energy low has been part of the general effort to cushion household consumption from the effects of transition. Low energy prices have been an even more important source of indirect subsidies to heavy industry, which remains very energy intensive and extremely energy wasteful. Energy-intensive enterprises account for about half of industrial production. As of 1994, gross industrial energy intensity was among the highest in eastern Europe, and about three times that of the OECD Europe average. Losses in transformation, transmission and distribution, which amounted to about 25 percent of primary energy supply in 1989, were 3 to 5 times higher than in OECD countries.
188. Energy sector policies have been at odds with macroeconomic targets in the areas of exchange rate policy and fiscal policy, and they have frustrated efforts to reduce both the current account deficit and losses in industry. Low domestic energy prices have provided a quasi-fiscal subsidy to the energy consumers and have contributed to a weak financial position for the energy producing sector, leaving it unable to finance needed investment and maintenance. Maintaining the currency overvalued in order to keep the price of imported energy low has imposed a tax on the export sector, and worsened the balance of payments position. Meanwhile, declining domestic production of oil and gas—combined with continued high domestic consumption—has necessitated large and growing energy imports, the financing of which has put further pressure on the foreign exchange market. In addition, the energy producing sector’s weak financial position has made it a key contributor to recurrent buildups of enterprise losses and arrears. Fund staff estimates suggest that the magnitude of indirect subsidies to energy consumers may have amounted to 2 to 3 percent of GDP per year during 1993-96.
189. The new government has announced an ambitious agenda of reforms to end the widespread waste of domestic energy resources and foreign exchange which have resulted from the past subsidies to energy-intensive industry, and to attract the private domestic and foreign investment needed to realize the potential of the energy-producing sector.
II. the problem of energy prices
190. Retail energy prices in Romania have been very low by international standards, and even compared to other East European countries. Prices have ranged from as low as 10 percent of an East European average for natural gas to households to 50 percent for diesel fuel (Charts 13 to 16). Moreover, energy prices have declined in dollar terms over prolonged periods (Chart 17 and Tables 57 and 58) owing to delays in adjusting domestic prices to reflect exchange rate changes.
191. The energy sector remains mostly under state ownership, although it was reorganized in 1990 in a largely failed attempt to instill a more commercial orientation. Departments of ministries responsible for various aspects of the energy sector (e.g., petroleum exploration, refining, distribution, and electricity generation) were turned into either régie autonomes (RAs) or commercial companies.1 While operational responsibility now lies with the RAs and commercial companies, the Ministry of Industry formulates policy and strategy. The ministry’s pricing policies have favored energy-intensive industrial energy users at the expense of the energy producers.
192. A key element of plans for restructuring both the electric power and the petroleum sectors has been the pricing of energy at the equivalent of reference border prices in U.S. dollars. Originally the government decided in 1993 that energy prices would be adjusted monthly to reflect changes in the exchange rate. In 1995, the formula was changed to adjust prices twice-yearly so that price increases could be avoided during the politically sensitive winter months. The new formula required that domestic energy prices be adjusted to reflect deviations from the U.S. dollar reference price by more than 10 percent due to movements in either the exchange rate or world prices. But neither formula worked.
193. Periods of exchange rate flexibility, combined with increases in domestic prices to world market levels, have only been able to temporarily shift the losses back to the energy-intensive sectors where they originate. These enterprises have soon started to accumulate arrears to suppliers. Because of the importance of the heavy industrial sector, there has been no political willingness to cut off energy supplies in the event of arrears. The energy sector, in turn, has financed the attendant losses by incurring arrears and through bank lending. Eventually, the authorities have always succumbed to pressures to alleviate the situation of the energy sector by again interfering in the foreign exchange market to maintain the leu at an overvalued level and postponing domestic price increases.
III. macroeconomic implications of the energy sector
194. The imbalances in the energy sector due to lack of reform are sufficiently large to have repeatedly undermined macroeconomic stabilization. The most obvious macro linkage has been exchange rate policy, where the government’s efforts to avoid price increases have repeatedly led to official intervention in the flexible exchange rate regime, as described above. This has levied an implicit tax on exporters for the benefit of energy consumers.
195. Low retail prices for energy products have reduced fiscal revenues from the petroleum sector. Meanwhile the weak financial position of the electricity company which has resulted from postponement of price increases and large arrears has meant that government guarantees have been required for borrowing by the electricity company, resulting in contingent fiscal liabilities of at least 1.5 percent of GDP from just the external financing for the nuclear program.2
196. Declining domestic production of oil and gas—combined with high domestic consumption—has put direct pressure on the trade balance. In 1995, energy imports totaled $2.2 billion, or 23 percent of total imports (Table 59 and 60). Net energy imports were $1.6 billion, equal to the entire trade deficit for the year (Table 38). Moreover, the energy sector has indirectly contributed to worsening the trade and current account deficits due to overvaluation of the exchange rate for extended periods, discouraging exports and encouraging imports.
197. Finally, the large losses of the energy consuming sector are key to the persistence of large quasi-fiscal deficits. Low retail prices have provided a large but non-transparent indirect subsidy to energy intensive industries, especially in the metallurgy, chemicals and textiles branches, allowing them to postpone needed restructuring and shifting their losses to the energy-producing sector. As described above, the electricity company, Renel, has been a major generator of inter-enterprise arrears when it becomes unable to pay its suppliers during the extended periods when domestic retail energy prices have not been adjusted, even as the company’s costs increase due to exchange rate changes. At the same time, the energy producing companies have been used to directly subsidize other companies and municipalities, as they have continued to deliver power to clients with large arrears. An estimate of all these transfers can be derived from the financial situation of the energy producing sector during the first half of 1996, when energy price adjustment was postponed. The losses of the energy-producing sector amounted to almost 2 percent of GDP on an annual basis (Table 61). The energy-intensive industries received further quasi-fiscal subsidies in the form of net new directed credits and interest subsidies equal to ½ percent of GDP. While the value of the subsidy from overvaluation of the exchange rate is difficult to estimate, it may have been ½-1 percent of GDP during 1996 based on the premium in the exchange rate bureau market over the official exchange rate.
IV. the energy-producing sector
A. The Petroleum Sector
198. Annual production of crude oil peaked in 1976 at about 14.7 million tons, but had declined to 9.2 million tons by 1989 owing to outmoded technology and the lack of both maintenance and new technology during Ceausescu’s drive during the 1980s to repay all external debt. The annual production rate has continued to decline during the transition to 6.4 million tons in 1995 (Tables 62 and 63).
199. Rapidly growing demand in the 1970s combined with declining production resulted in Romania becoming a net importer of oil after 1976. Oil imports peaked in 1989 at 9.8 million tons, or about 48 percent of domestic consumption. Despite lower total consumption of oil since the beginning of transition, domestic production has fallen even more rapidly, resulting in rising oil imports—which in 1995 were 8.7 million tons (Table 63). In 1995, net imports accounted for almost 50 percent of domestic consumption and net imports of crude oil and oil products accounted for almost 70 percent of the trade deficit.
200. The petroleum sector is troubled at all stages of production and sale. While the country could no longer economically be self-sufficient in oil production, the domestic production decline has been accelerated by the use of obsolete equipment and technology. The oil production company Petrom has not registered large losses, but it has been decapitalized by the low producer-price policy. It has been left with virtually no resources for maintenance, much less urgently needed new investment.
201. Despite declining domestic output and increased import needs, retail prices have been held, for the most part, well below border prices, as described above, as a subsidy to consumers and industry. At the same time, the cost of producing petroleum products is far higher than in other western or eastern european countries, largely due to huge excess refinery capacity (only 14-15 out of the 34 million metric tons of installed capacity is used), overstaffing by a factor of more than 10 compared to western european refineries (Table 64), and inefficiency both of the existing plants and the way they are operated.
202. In the past the inefficient refining sector was subsidized by keeping the price of domestically-produced crude oil very low. Under a restructuring project adopted in early 1994, however, the price of crude oil produced domestically is supposed to be kept at the price of similar crude in the Mediterranean region. This wholesale pricing rule for crude oil has led to even larger losses by the refineries than previously—at least when the domestic price has been increased according to the formula. The two refineries (out of 10 total) included in the group of about 150 enterprises subject to a special restructuring program recorded losses of 279 billion (13 percent of the losses of all ISO enterprises) just in the first half of 1996 (Table 61), despite postponement of the scheduled increase in the domestic producer price. A recent study of the sector concluded that the economic losses of the refineries amount to almost $1 million per day based cm international prices.3 This study adjusted the reported “operating profits” of the 10 refineries in 1995 for the large internal subsidies they have received in the form of domestic oil purchased at below market prices (30 percent below the import price in 1995, yielding a subsidy worth $269 million); and the sale of refined products at above market ex-refinery prices (12 percent on average above international prices in 1995, yielding a subsidy worth $230 million).
203. The combination of high production costs and low retail prices has squeezed and distorted distribution margins (Chart 18), which has resulted in large losses by the monopoly distributor.4 The distribution company’s losses are made worse by the fact that it has much higher costs than comparable private companies abroad. The artificially low retail prices, low margins, and requirement that all petroleum products be purchased from the monopoly distributor have been key factors in discouraging foreign investment in the sector.
204. Natural gas has been the single largest energy source in the Romanian economy since the mid-1960s, and Romania is one of the largest users of natural gas in Eastern Europe both relative to GDP and in absolute terms. Gas production peaked at 39.6 billion cubic meters (BCM) per year in 1986, then declined to 25.3 BCM in 1989 due to the lack of modern technology for increasing exploration and production and fell further during the transition to 12.8 BCM in 1995 (Table 62). As with petroleum, rapid growth of demand resulted in Romania becoming a net importer of natural gas after 1980. The need to import gas led to dependence on the FSU for imports. Import dependence is less than for crude oil, however, as domestic production (including associated gas) still accounts for 85 percent of domestic consumption.
205. The natural gas sector is plagued by problems similar to those in the petroleum industry, except that the price distortions are worse. Domestic prices had fallen to about one-third of the international reference price by May 1996, and were not fully increased in line with the border reference price in July. The low producer price policy has decapitalized the production company Romgaz, and its financial situation has been further weakened by payments arrears from many of its largest clients. Foreign investment has likewise been discouraged by policies that have used low prices and arrears to Romgaz to subsidize energy users.
B. The Electric Power Sector
206. Romania’s installed electric power generating capacity is substantial, and through the mid-1970s Romania was a net exporter of electricity. In the electricity sector, a single public utility, Renel, serves the entire country. The public utility accounts for 93 percent of total generating capacity, out of which 28 percent is hydropower capacity, 42 percent is lignite and coal-fired, and about 30 percent is oil and gas-fired. Installed capacity is more than double peak demand, yet Renel is unable to meet domestic demand at peak due to technical operating problems (including deficiencies in plant design and construction; inadequate maintenance; use of low-grade fuels; and improper operations and management practices), and has had to resort to imports of electricity at times (Tables 65 and 66).
207. Lack of both investment and maintenance over the past decade in generation and transmission have resulted in a decline in output capacity, and a rise in technical losses and pollution. Inadequate metering, billing and collection practices have contributed to nontechnical losses. These problems are compounded by overstaffing and inefficient operations.5 Its financial position has been further undermined by pricing policies as described above,6 and by the toleration of large arrears to Renel as a means to subsidize other state-owned enterprises (these arrears amounted to about 1 percent of GDP at end-1996).
208. Renel did attempt to enforce financial discipline by cutting off power to some of the worst offenders during the 1995/96 winter, but this effort was not supported and Renel was eventually forced to resume deliveries to these companies as the general energy shortage associated with an unusually cold winter abated. Renel has also been a contributor to financial indiscipline, as it has built up arrears to its suppliers during the extended periods when prices have been held fixed. During the first half of 1996, for example, when energy price adjustments were postponed, Renel had losses of about 1 percent of GDP on an annual basis; this was mostly financed through arrears to its suppliers (Table 61).
209. Additional problems are posed by the Cernavoda nuclear power project, which was originally started in the mid-1970’s. Construction began on 5 units in 1980, but was slowed by lack of funding and technical expertise after foreign contracts were terminated in 1985 as part of efforts to repay all foreign debt. The project was resumed in 1990 with external assistance, as some $1.2 billion was needed to complete the first unit. Initially the government had intended to finance the entire project, including debt service, from the state budget. However, owing to budgetary constraints, financing responsibility has been transferred to Renel and other state agencies. Unit 1 began delivering electricity to the national grid in early 1996.7 Operation of the nuclear plant should eliminate the need to import electricity, but this is a relatively minor benefit as electricity imports accounted for only 4 percent of total electricity usage in 1995. The energy sector accounted for almost all industrial sector investment in 1992-94 due to the nuclear power development program, and the completion of Unit 1 has already resulted in sizable current external repayment obligations. It would cost at least US$850 million to finish one of the remaining 4 units.
V. strategy for reform
210. After 1989, the government initiated price increases for energy toward import parity levels as part of the general reform of price policy. Significant real increases followed in 1990-92, except for natural gas and household fuels. Further progress was initiated in June 1992, as policies were adopted which included maintenance of international prices for petroleum products and lignite, coal, electricity and thermal energy; a gradual increase to border pricing for natural gas to non-household consumers; and the gradual elimination of energy subsidies to households. As described above, however, there have been recurrent, extended periods of slippage in the required price adjustments.
211. The strategy for the energy sector has been geared to promoting fundamental reforms to support its rehabilitation, improve its efficiency, and eventually attract private investment to the sector. Sectoral efforts so far have focused on upgrading the upstream petroleum sector, electricity generation and the electricity transmission network, while improving efficiency and reducing operating costs and environmental pollution. The government that took office in December 1996 has moved quickly to accelerate reform of the economy. Its strategy for the energy sector hinges on a combination of price, structural and regulatory reform.
212. Energy pricing. In January and February 1997 the new government instituted large catch-up price increases for wholesale and retail energy prices to bring them back in line with the U.S. dollar reference prices. Moreover, these prices will henceforth be adjusted automatically on a monthly basis for changes in the exchange rate and/or world oil price. These pricing changes should help to stem the losses of the primary energy producing sector and curb the rapid growth of energy imports.
213. Structural reform. In the past, energy price increases have given rise to insurmountable pressures from the energy-intensive industrial sector for operating subsidies through arrears to the energy producers and through an overvalued exchange rate. To reduce such pressures, the government has adopted an ambitious structural reform program which aims to quickly privatize or liquidate the energy-intensive industrial enterprises with the largest losses and privatize the great majority of other state-owned commercial companies. To encourage rapid restructuring, the authorities have taken a number of measures to strengthen the electricity and gas companies’ ability to cut off supplies to delinquent clients.
214. Structural reform will also include the energy-producing sector, with the quick introduction of restructuring plans to rationalize operations and improve efficiency, including through cutting excess staff. Early actions will include cutting the excess capacity of the refining sector by closing or privatizing two of the ten refineries. This will also have a positive environmental impact given the high level of wastage and leakage at the refineries.
215. Regulatory reform. Private investment—especially foreign direct investment—could make a substantial contribution in both downstream and upstream petroleum operations, from increasing the amount of domestically-produced oil and gas (reducing import needs) to enhancing efficiency and reducing costs of refining, distribution and retail sales. There is substantial foreign interest in the sector, but it has so far made little contribution owing to legal and regulatory barriers.
216. The new government has already taken steps to give foreign investors equal access to the privatization process, and has introduced legislation to permit foreign ownership of land. The decisions to regularly adjust energy prices to remain at border prices, and to allow energy companies to stop delivery in the event of nonpayment, are also crucial to attracting private participation in the sector. Another vital measure is to convert the distribution companies into common carriers and liberalize access to them. Additional steps in the petroleum sector include further rationalization of the refinery sector, reducing ex-refinery prices to international levels, and liberalizing retail pricing for petroleum. The most important remaining step in the electricity sector is to demonopolize power generation quickly as part of restructuring the sector in accordance with EU directives.