My Romanian authorities would like to express thanks for the useful discussions held in Bucharest in July. The amount of work done is reflected in the staff report, which provides a well-balanced assessment of the program implementation.

Romania is on track with the implementation of its Fund-supported program, and all end-June performance criteria and indicative targets have been met, with the exception of the ceiling on general government domestic arrears, for which my authorities have requested a waiver. My authorities are committed to implementing further measures to reduce the arrears, and recently they made major repayments in the health sector, reducing considerably the stock of outstanding arrears.

Economic developments

Economic growth turned positive in the second quarter, due mainly to a turnaround in private domestic demand, exports, and a pickup in inventory investment. However, economic prospects changed after austerity measures were introduced and the government increased the VAT by 5 percentage points in July. In these circumstances, the recovery may be delayed in the second half of the year, and the growth forecast was accordingly revised downward to -1.9 percent. On the positive side, net external demand will gradually cede its place to domestic demand as the main driver of growth as incomes recover in 2011. Growth is projected to reach around 1.5 percent in 2011, and to continue a positive trend in the following years.

The inflation rate reached 7.1 percent at end-August. The recent VAT increase, further adjustments in administrated prices, and the recent depreciation of leu, will add around 3 percentage points to inflation in 2010, pushing annual inflation above the target. On the positive side, core inflation will remain within the target band, suggesting that inflationary pressures driven by demand remained low. At the same time, the wide output gap could lead to a smaller-than projected pass-through of the VAT increase.

External financing pressures have eased, and the balance of payments outlook remains unchanged from the previous review. The current account deficit has adjusted significantly from 12.5 percent in 2008 to around 5 percent this year, and is projected to remain at the same level in the years ahead.

The economic situation remains difficult, and risks to both growth and inflation are large, but balanced. My authorities are committed to continuing implementation of the needed measures to accelerate structural reforms, and to move to a secure the recovery in the years ahead by maintaining macroeconomic stability.

Fiscal policy and structural reforms

The fiscal package implemented in June has an annual yield of about 5 percent of GDP and a balanced mix of revenue and expenditure measures. This ambitious adjustment package put the fiscal policies on track to meeting the 2010 and 2011 targets. Weaker growth prospects are still expected to generate some revenue shortfall, but the authorities are committed to implementing additional adjustment measures, including cutting spending on goods and services by 10 percent on an annualized basis, to be able to meet this year’s fiscal deficit target of 6.8 percent of GDP.

The main fiscal challenges for 2011 are related to securing an extension of the wage and social transfer cuts and overhauling the social assistance scheme. In this context, the government drafted new legislation to be passed this fall. At the same time, the authorities will continue to keep pensions frozen and to eliminate the heating subsidies. The administration will be downsized by another 15,000 public servants and bonuses will be eliminated. All these measures will consolidate the fiscal stance and create a path for stable economic growth. In the long term, the fiscal outlook remains positive, and the implementation of structural reforms will create space for further investments, co-financed by EU funds. Moreover, the Fiscal Council became operational, and the new 2011-2013 fiscal strategy has already been approved by the government with clear commitments to reaching a 3 percent deficit target by 2012.

Domestic payment arrears continue to pose a challenge, but the actions recently implemented, including the repayment of about 2 billion lei (0.4 percent of GDP), have demonstrated the government’s commitment to addressing this structural problem. To prevent further buildup in arrears, the authorities have initiated a restructuring of the health sector and have enacted amendments to the public finance law that will prevent local governments from assuming new commitments until previous obligations are met.

To contain fiscal pressures over the medium term, the authorities will introduce several reforms to increase the efficiency of public institutions, including local governments. The authorities approved measures to reduce the number of public servants by 5 percent this year and have committed to a further reduction of 1.3 percent next year. Another important step is the pension reform law recently approved by Parliament. The law envisages a gradual move to inflation indexation, and an increase and unification of the retirement ages for both men and women at 65. To strengthen the private second pillar, the government will continue to increase its contribution in 2011.

With assistance from the World Bank, the authorities will implement a strong public expenditure review and will restructure the system of social benefits, to strengthen social safety nets and eliminate inefficiencies. In this context, the second pillar of the public wage reform will be approved by end-September. The legislation will link pay to job responsibility and qualification, and benchmark it to private sector wages. Further structural reforms will include steps to restructure the health sector, improve the performance of state-owned enterprises, and improve the labor market. An important step in increasing fiscal efficiency has been made by the tax authorities in combating tax evasion and, in line with recent IMF technical assistance advice, the authorities have improved the VAT registration thresholds, streamlining tax administration offices and improving information technology networks.

Monetary and financial sector policies

Monetary policy responded well to falling activity, and the Central Bank has taken crucial measures to bring down inflation levels. However, after July’s government decision to increase the VAT, the Central Bank left its key policy rate unchanged. While the one-off nature of the VAT-induced price increase does not warrant a monetary policy response, the authorities believe that increased vigilance is required to keep inflation expectations in check and stave off possible second-round inflationary effects.

The Romanian banking system has so far weathered well the impact of the economic contraction. An important role has been played by the nine largest banks as the result of their commitment to maintaining overall exposure to the country, and to increasing capital when needed. However, the banking system registered losses in the first half of the year, but capitalization ratios remain strong and reached 14.3 percent at end-June, with all institutions above 10 percent. The banking system remains resilient, despite the fact that nonperforming loans are on the rise. A further increase is expected in the second part of the year, as economic activity remains depressed, but gradually NPLs will return to normal levels, as the economic recovery accelerates in the years ahead.

Romania has made further progress towards strengthening the financial sector. The Central Bank is preparing to amend Deposit Guarantee Fund’s (DGF) law to allow for the use of resources administered by the DGF to facilitate restructuring measures regarding the transfer of deposits. At the same time the authorities will ratify legislation to strengthen the resolution framework for problem banks, aimed at boosting the Central Bank’s powers to deal with weak banks, which was already enacted by government ordinance in March, 2010.

The Central Bank has continued to improve the banking supervisory and regulatory framework, including liquidity requirements, and is committed to take steps to ensure that the regulatory and operating environment for financial institutions remains sound. The authorities have also made progress towards the adoption of the International Reporting Standards by 2012, by issuing the necessary notification to banks.

In conclusion, my authorities acknowledge the potential risks to program implementation, but they consider that despite temporary deterioration in economic activity, the present policy response under the current SBA will address the fiscal imbalances and further acceleration of structural reforms will put Romania on a path to sustained economic growth in the years ahead.