Statement by Mr. Menno Snel, Executive Director for Romania, and Mr. Serban Matei, Senior Advisor to the Executive Director, September 28, 2012

Significant progress has been made in macroeconomic stabilization under two successive SBAs but the economic recovery remains fragile. Growth is expected to remain subdued in the near term and to only gradually recover over the medium term, with risks to the outlook mostly on the downside. With strong trade and financial sector linkages, Romania is exposed to the euro area crisis. Fiscal and external reserves provide a buffer and the banking sector remains well-capitalized. At the same time, the political situation has become more unsettling with three governments in 2012, uneasy cohabitation between the President and the governing coalition that has sought to remove him, and parliamentary elections to be held in the fall. The political uncertainty has contributed to accelerated exchange rate depreciation and higher financing costs, and has dented confidence.

Abstract

Significant progress has been made in macroeconomic stabilization under two successive SBAs but the economic recovery remains fragile. Growth is expected to remain subdued in the near term and to only gradually recover over the medium term, with risks to the outlook mostly on the downside. With strong trade and financial sector linkages, Romania is exposed to the euro area crisis. Fiscal and external reserves provide a buffer and the banking sector remains well-capitalized. At the same time, the political situation has become more unsettling with three governments in 2012, uneasy cohabitation between the President and the governing coalition that has sought to remove him, and parliamentary elections to be held in the fall. The political uncertainty has contributed to accelerated exchange rate depreciation and higher financing costs, and has dented confidence.

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. Romania’s performance under the current program continues to be strong, and all performance criteria for the sixth review were met, except for the one on accumulation of central government arrears, which was missed by a small margin. The authorities continue their efforts on accomplishing the goals of a broad structural agenda, with a focus on reforming the healthcare sector and state-owned enterprises.

Recent economic developments

Romania’s economic recovery continues. Real GDP grew by 2.5 percent in 2011 on the back of a very good harvest and thanks to a front-loaded pick-up in exports, which however faded during the year. There was also some recovery in private demand, but it declined by 0.2 percent in the fourth quarter (q/q) and by 0.1 percent in the first quarter of 2012. In the second quarter of 2012, GDP expanded 0.5% (q/q/) and accelerated to 1.2% (y/y) in real terms with industry turning positive and constructions gathering pace, rebounding from a seasonal dip. Economic growth is likely to be less robust than foreseen, reflecting mainly the deteriorating external environment in the euro area and spillover effects from financial market turbulence. Overall, growth in 2012 is expected to reach around 1 percent, with downside risks.

The inflation rate reached record lows of 1.8 - 2.0 percent in the period April through June. It increased to 3.9 percent in August, mainly driven by an expected reversal of favorable base effects as a result of developments in food prices in the previous year. These effects are amplified by exchange rate fluctuations, the impact of drought on domestic agricultural output and an increase in international agricultural commodity prices. We expect inflation to climb further in the second half of the year, notwithstanding the persistent negative output gap. Due to the stronger upside risks for the inflation outlook, the NBR has pro-actively stopped interest rate cuts since May and maintained the policy rate at 5.25 percent, while adjusting liquidity conditions.

The external position has been consolidated. The current account deficit is expected to be around 4 percent of GDP for 2012, lower than the levels registered in 2009-11, and is seen as stabilizing at around 4.5-5 percent of GDP from 2013 onwards. In 2012, net exports are expected to remain broadly stable, and official transfers are projected to begin recovering.

Public debt issuance has been positive so far this year. The authorities successfully tapped the external markets by issuing USD and EUR denominated bonds, extending the maturities at competitive rates. Meanwhile, consolidation of the local currency yield curve has been continued. The efforts to consolidate the fiscal buffers were continued and in June the World Bank has approved a Development Policy Loan of EUR 1 billion.

Despite the progress achieved, the recovery remains vulnerable to adverse developments in international markets, weaker-than-expected growth in Western Europe, and possibly more rapid and less orderly bank deleveraging. Spillovers from the ongoing turbulence in the euro area could dampen exports and affect capital flows to Romania. The authorities will remain vigilant, act proactively, and take the necessary steps to contain these risks.

Fiscal policy

Since the first program started, Romania significantly improved its fiscal position and the authorities remain committed to continue this process in 2013.

Under the new fiscal strategy, implementing further structural adjustments, the deficit target in 2013 is set at 2.2 percent in ESA terms. Moreover, to achieve this goal the authorities are committed to continue restraining expenditures and prioritizing investment projects with a focus on EU-funded initiatives. They will also improve tax collection by implementing measures to simplify the tax code and strengthen the tax audit and enforcement efforts, based on the technical assistance recommendations from the Fund and the Bank.

For 2012, the authorities remain fully committed to bringing the fiscal deficit below 3 percent of GDP in ESA terms, in compliance with the EU Excessive Deficit Procedure. For 2013, the structural deficit will be reduced by at least 0.5 percent of GDP. To ensure meeting this goal, the cash deficit target will be limited to 2.2 percent of GDP in 2012 and will require continued expenditure restraint and strengthened tax collection. Personnel spending will remain at 6.7 percent of GDP in 2012, unchanged from 2011, reflecting the continued strong decline in public employment.

After a year of declining arrears and unpaid bills in the general government, arrears slightly increased in the second quarter 2012, being concentrated mostly in local governments. To strengthen enforcement, the authorities conducted a thorough audit and will undertake a comprehensive analysis of local government arrears to determine their causes. A government ordinance has been issued to ensure that tax-sharing resources available to local governments can be used for paying arrears and to allow the central government to directly pay off arrears of local governments. The arrears in the SOE’s in the first half of 2012 stood below the indicative target for that period, and the authorities anticipate that they will be further reduced in the second half of 2012. In the health sector, arrears in registered bills with the Health Insurance Fund have now been eliminated.

Monetary policy

The monetary authorities responded appropriately to economic developments, and the central bank has gradually and prudently reduced its policy rate amid abating inflationary pressures in the first half of the current year. Since November 2011, the central bank eased the rate by a cumulative 100 basis points while maintaining the reserve requirements on local and FX currencies. Due to external uncertainties and a heightened upside risk balance for the inflation outlook, the central bank decided in its May, June and August policy meetings to keep the interest rate unchanged. It has also been managing liquidity in the system through weekly repo auctions with banks. Lending and deposit rates for non-bank clients, as well as interbank rates, have generally reflected the cumulative reduction in the NBR policy rate.

Headline inflation was 3.9 percent in August as favorable food prices receded. Core inflation continued to decline, reaching a low of 2 percent in March, but it has recently increased somewhat due to expectations fueled by relatively more volatile exchange rate dynamics, as well as by the impact of the expected increase of processed food prices from last year’s lows. However, upside risks remain, including from additional adjustments of administered prices and a stronger than previously estimated rebound of domestic food prices. Nonetheless, inflation is expected to stay within the target band for 2013, after the current volatile food price-related increase dissipates. 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 are committed to taking action as needed to ensure the achievement of the medium-term inflation targets.

Financial sector

The Romanian financial sector so far has weathered well the impact of the economic challenges. The banking system remains well capitalized, with an average capital adequacy ratio of 14.7 percent at end-June 2012. Private sector credit has grown in annual real terms by 4.1 percent through July. At the same time, non-government client bank deposits grew annually in real terms by 6.7 percent through July. However, the NPL ratio rose to 16.8 percent in end-June. Total prudential provisions at end-June were sufficient to cover 98 percent of NPLs. In light of the current uncertain external environment, the central bank remains vigilant to vulnerabilities in the banking system and stands ready to provide liquidity, as necessary, to mitigate segmentation in the interbank market. It has also broadened its range of contingency measures to be deployed - if necessary - to preserve depositor confidence and consolidate financial stability.

Structural reforms

Under the current program the authorities are committed to reforming the state-owned enterprises, especially in the transport and energy sectors, to enable sustainable economic growth and better competitiveness. The authorities have made progress in the reform agenda, but challenges remain.

In the transport sector, the authorities are continuing the implementation of the general transport master plan, which will balance increasing demand and available fiscal means, ensure complementarities between different transport modes and define priorities for the medium and long-term investment.

In the energy sector, the authorities have taken a number of actions to establish a framework to improve the sector’s efficiency. Electricity and gas legislation, in line with EU energy directives, was adopted. The law on the energy regulator (ANRE) is expected to be promulgated by mid-October 2012. Following the earlier approval of a roadmap to deregulate electricity prices, a similar step has been taken for gas prices. This envisages complete liberalization of gas prices for non-residential consumers by January 1, 2015, and for households by October 1, 2018. Regulated electricity prices were also increased by five percent at end-June.

An extraordinary step was placing the hydro-electric power producer, Hidroelectrica, into insolvency in June, in view of its deteriorating financial position. The judicial administrator has cancelled or renegotiated in market terms contracts at below-market prices with the energy traders. Hidroelectrica will sell the electricity being released from the cancelled contracts on the electricity trading platform (OPCOM).

To better align the currently regulated end-user prices of gas with the actual cost of supply and distribution, the authorities have increased tariff rates for non-residential consumers by ten percent and for households by five percent.

The authorities will continue the privatization agenda and accelerate implementation of the SOE corporate governance Law. The process has already been started to appoint professional boards and management for key SOEs that remain under majority government ownership.

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