Statement by Mr. Menno Snel, Executive Director for Romania and Mr. Mihai Tanasescu, Senior Advisor to the Executive Director, December 19, 2011

This paper discusses key findings of the Third Review of Romania’s economic performance under a program supported by a 24-month Stand-By Arrangement (SBA). The authorities are on track to achieve their 2011–12 deficit targets, but stepped-up efforts are needed on key structural reforms. Inflation has dropped sharply, reflecting food prices deflation and the removal of the VAT base effect. All end-September quantitative performance criteria and indicative targets were met, and inflation returned to the inner band of the inflation consultation mechanism.


This paper discusses key findings of the Third Review of Romania’s economic performance under a program supported by a 24-month Stand-By Arrangement (SBA). The authorities are on track to achieve their 2011–12 deficit targets, but stepped-up efforts are needed on key structural reforms. Inflation has dropped sharply, reflecting food prices deflation and the removal of the VAT base effect. All end-September quantitative performance criteria and indicative targets were met, and inflation returned to the inner band of the inflation consultation mechanism.

The economic program supported by the Fund, the European Commission and the World Bank played an important role in stabilizing the Romanian economy, generating concrete results in boosting growth and maintaining fiscal and financial stability. The current precautionary Stand-By Arrangement approved in March 2011, aims at strengthening macroeconomic policies, accelerating structural reforms, and consolidating economic development. The track record under the program to date is strong. All performance criteria and all quantitative targets for the third review were met, and the authorities continue their efforts on a large structural agenda.

Recent economic developments

Economic growth has resumed. Romania posted the fourth consecutive quarter of growth in the third quarter, when growth accelerated to 4.4 percent due to a favorable agriculture harvest, a recovery in construction, and renewed industrial growth. The recovery in domestic demand, however, remained weak while export growth has stabilized. As a whole, real GDP growth is estimated to reach around 2 percent at end-2011 (up from 1.5 percent previously forecast), and is expected to continue on a positive path in 2012. However, 2012 economic growth is likely to be less robust than previously foreseen, reflecting mainly the deteriorating external environment and spillover effects into domestic demand via the banking system. Amid signs of a gradually improving labor market and the anticipated absorption of EU funds, 2012 growth is expected to be mainly driven by domestic demand, reaching around 1.8–2.2 percent.

The inflation rate has dropped sharply in recent months to 3.4 percent in November, reflecting a large decline in food prices and the elimination of the first-round effect of the 2010 VAT increase from the 12-month index. We expect inflation to continue to decline, and the latest developments indicate that the NBR’s 2011 inflation target will be met by a comfortable margin. In 2012 inflation will continue its downward path and is likely to be within the NBR’s target band.

The external position improved significantly. The current account deficit is projected to stabilize at around 4.2 percent in 2011 and 2012. The recent growth in exports (+17.3 percent in October 2011/October 2010) improved the trade balance. Net exports in 2012 are expected to remain broadly stable as import demand slows in line with lower export growth.

Due to the recent turbulence in international markets, CDS spreads have risen apace with other economies in the region, and consumer confidence has fallen. Risk aversion on the external markets has led the leu to depreciate by 4 percent since July, and yields on domestic treasuries have been rising. The authorities have also postponed a dollar-denominated bond issue planned for November due to market uncertainties. On a positive note, international reserves remained comfortable at 36 billion Euros, covering more than 100 percent of the short-term debt residual maturity.

Despite the progress achieved, the recovery remains vulnerable to adverse developments in international markets and weaker than expected growth in Western Europe. Spillovers from the ongoing turbulence in the Euro area could further dampen exports and affect capital flows to Romania through the banking system. The authorities will remain vigilant, act proactively, and take the necessary steps to contain these risks.

Fiscal policy

The fiscal package implemented since the beginning of the previous program in 2009 has produced the targeted adjustment and put the fiscal stance on the right path. For 2011, the authorities are on track to meet the cash fiscal deficit target of 4.4 percent of GDP. Since the prospects for 2012 have worsened, the authorities have taken a conservative approach to the fiscal planning. The 2012 budget is based on a cash deficit of 1.9 percent of GDP, well below 3 percent of GDP on ESA terms. The authorities felt that a prudent approach is warranted to withstand pre-election spending pressures and contain deficit financing costs in the increasingly uncertain external environment. To achieve this goal, the authorities decided to freeze the public wages and pensions and to continue reductions in public employment.

On the expenditure side, the proposed decision to freeze the wages and pensions, together with the cuts in district heating, and reduction in co-financing of EU funded projects will provide an additional fiscal adjustment of 2.1 percentage points of GDP. The authorities will continue efforts to improve and prioritize capital spending in order to increase the absorption of EU funds. In this context, the authorities approved a list of 100 EU-funded priority projects whose implementation will be strictly monitored. The recent decision to create the Ministry of European Affairs will also accelerate this process. On health care reform, the authorities will implement a comprehensive package of measures to address the structural deficits of the health care system. They already approved new legislation introducing copayments for medical services, and a claw-back tax on pharmaceuticals. In the long term, the authorities plan to phase in a fundamental restructuring of the system to address not only spending inefficiencies but also the underfunding of the health care system.

On the revenue side, tax policies will remain largely unchanged, including the VAT rate, which will be kept at 24 percent. With the technical assistance of the Fund, the authorities will review the tax code by the end of the year to close tax loopholes and improve its efficiency. Under the current program, improving tax administration and fighting tax evasion are crucial elements to increase revenue. The authorities made progress in the areas of risk assessment, taxpayer segmentation, office network reorganization, and indirect audit methods.

To continue the fiscal consolidation path, the authorities are committed to decreasing the stock of arrears. Arrears of the general government have been declining since the beginning of the program and are almost zero today. However, challenges remain in local governments, where reducing the stock of existing arrears will require stricter enforcement of the law, and in state-owned enterprises. Additional efforts are needed to continue reducing these challenges. To this end, the authorities have prepared a series of schemes to clear state owned enterprise arrears via netting arrangements, debt swaps, recapitalization of firms, arrears securitization and government lending.

Monetary and financial sector policies

The monetary authorities responded appropriately to recent economic developments, and the Central Bank has taken important measures to bring down the inflation. In November the NBR cut its policy rate by 25 basis points to 6 percent, while maintaining the reserves requirements on local and FX currencies. This is the first policy cut since May 2010, as inflationary pressures have eased significantly after the global food and energy price shocks receded. As we expect inflation to continue to decline, the Central Bank’s 2011 inflation target will be met by a comfortable margin. In light of the gathering risks of contagion from financial disturbances in the region and possible capital outflows, the monetary authorities will remain vigilant against inflation risks and committed to take action as needed to assure achievement of its 2012 inflation target.

The Romanian financial system so far has weathered well the impact of the economic downturn of the past two years. The banking sector remains well capitalized, with an average solvency ratio of 13.4 percent and a tier one capital ratio of 12.9 percent at end-September. NPLs rose to 14 percent, but provisioning remains prudent, covering some 97 percent of NPLs. Despite an increase in corporate lending, which more than offset a slight decline in household lending, credit growth remains weak in real terms. A key role in keeping the financial system in good health has been played by the European Bank Coordination Initiative. The aggregate exposure to Romania of the nine largest foreign banks stood at 99 percent of the March 2007 level, and even though they have not agreed on a specific target exposure, these banks have affirmed their long-term commitment to Romania and continue to report exposures. In light of the current international vulnerabilities, the Central Bank remains vigilant to weaknesses in the banking system, and stands ready to provide liquidity as necessary to mitigate segmentation in the interbank market. It is also refining its full range of contingency measures to be deployed if necessary to preserve depositor confidence.

On the regulatory front, the NBR continues to make progress, and the authorities have finalized the regulatory framework and tax treatment for filters of provisioning that will preserve the current prudent approach once the International Reporting Standards are introduced for the banks at the beginning of 2012. At the same time, the NBR has tightened the regulatory treatment of banks’ foreign currency lending to households, including via differential loan-to-value limits for lending in domestic and foreign currency on a hedged and unhedged basis.

Structural reforms

Under the current program the authorities are committed to deep-rooted reform of the state-owned enterprises (SOEs), especially in the transport and energy sectors, to enable sustainable economic growth and better competitiveness. The authorities made progress in the reform agenda strengthening the database for monitoring local government state-owned enterprises. Restructuring plans for all 154 companies have been finalized, and the authorities have started to implement them. Arrears are expected to be reduced by around 1 percent of GDP. A corporate governance reform for SOEs has been approved, which requires regular independent external audits, quarterly publication of financial data, and reinforcement of OECD principles on corporate governance. Progress is also achieved in the privatization process, and despite some delays, the authorities remain committed to offering minority and majority stakes in a series of companies over the coming months.

In the energy sector, the authorities envisage major reforms, including a change in the national energy strategy with a view to attracting more private capital and allowing for more transparent, flexible, and competitive energy production and supply. To enhance the pricing and regulatory framework, the government will approve and submit legislation to Parliament ensuring a complete transposition of the 3rd Energy Package as agreed with the European Commission, including the functional and financial independence of the energy regulator. To better align the price with actual costs, the authorities approved an additional increase of the gas price by 5 percent starting January 2012.

In the transport sector, the authorities continued to implement measures to cut expenditures and raise revenues. In the rail sector they implemented standard costs for infrastructure procurement and maintenance of rolling stock. In order to bring the rail sector closer to economic viability, the authorities will continue the process of closing 1000 kilometers of rail lines. At the same time, major infrastructure projects using EU funds are advancing and revenues are increasing through tariff adjustments and enhanced toll collection.

In conclusion, my authorities concur that the current precautionary Stand-By Arrangement will maintain the reform momentum, provide additional security against unforeseen shocks, and build on the considerable progress achieved over the past two and half years, thereby setting the stage for strong and sustainable economic development while maintaining external and internal stability.

Romania: Third Review Under the Stand-By Arrangement—Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Romania.
Author: International Monetary Fund