Romania: 2019 Article IV Consultation—Press Release; Staff Report; Staff Supplement; and Statement by the Executive Director for Romania
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International Monetary Fund. European Dept.
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Publication Date:
30 Aug 2019
eISBN:
9781513512341
Language:
English
Keywords:
ISCR; CR; GDP expenditure component; deficit; inflation pressure; headline inflation; current account; private sector; price index; GDP growth; Global; output gap
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2019 Article IV Consultation-Press Release; Staff Report; Staff Supplement; and Statement by the Executive Director for Romania

Abstract

2019 Article IV Consultation-Press Release; Staff Report; Staff Supplement; and Statement by the Executive Director for Romania

Context

1. Expansionary policies have accelerated real income growth but also expanded macroeconomic imbalances (Figure 1). Economic policies turned expansionary in 2016, adding procyclical stimulus to an economy that was already expanding at a brisk pace. As a result, Romania’s per capita GDP growth has been one of the fastest amongst new EU member states (NMS) since 2016, accompanied by strong employment. In parallel, the twin deficits deepened: the fiscal deficit approached 3 percent of GDP and the current account deficit reached 4.5 percent of GDP in 2018. The external deficit was propelled by strong consumption and eroding competitiveness on the import side, while the global slowdown in 2018 weighed down on exports. Deepening imbalances and vulnerability pushed up spreads, which rose by 40 bps over April 2018-June 2019. Imbalances deepened also in the composition of spending, as the shares of investment in government and aggregate spending fell to multi-decade lows, to the detriment of sustainable long-term growth.

Figure 1.
Figure 1.

Romania: Consumption-Led Growth and Imbalances

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

2. Political developments can add to vulnerability in the coming years. Back-to-back election years will likely weaken the political incentive for fiscal moderation or the structural and governance reforms that the Fund has been advocating (Annex IV).1 Already, the 2019 budget was delayed till March, coming in more expansionary than initially proposed. Since June, the results of the recent European Parliament (EP) election and the anti-corruption referendum seem to have halted the political momentum for further changes to the justice laws and criminal codes, which would reduce the tension with the EC and help improve market sentiment.2 The ensuing political realignments, however, will likely have limited impacts on economic policies, as the national election cycle is coming in sight. The busy election cycle could also add to the unpredictability of policy announcements, a key source of business and market uncertainty in recent years.

3. The focus of discussions was on actions required to curb the widening imbalances and to re-orient the economy towards investment and sustainable income convergence. Durable fiscal consolidation and a shift in the expenditure composition towards investment would help reduce the growing imbalances and improve the fiscal-monetary policy mix. Further monetary tightening is needed to address rising inflation pressures. Greater exchange rate flexibility would help preserve buffers and absorb external shocks. These policies should be complemented by further progress on structural reforms and a more predictable policy environment.

Recent Economic Developments

4. Growth remains strong. Albeit lower than the 7 percent recorded in 2017, GDP growth reached 4.1 percent in 2018 and accelerated to 5 percent year-on-year (y/y) in Q1 2019, led by consumption and inventory accumulation.3 The output gap remained substantially positive in 2018, as policy-driven strong domestic demand more than offset the decline in net exports and in gross fixed capital formation. Labor market remains tight and wage growth has been strong, with net wages rising by 16 percent y/y in January–April 2019.

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Growth Contribution

(Percent)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources Haver and IMF staff estimation.
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Unemployment Rate and Employment

(SA, percent)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

5. Inflation is rising again after a lull in late 2018. Headline inflation came within the target band (2.5 ± 1 percent) by end-2018. Since the beginning of 2019, however, elevated domestic demand and currency depreciation, combined with sectoral pricing disruptions associated with the General Emergency Ordinance 114/2018 (GEO 114, paragraph 10 and Annex I) have significantly increased inflation pressures and kept headline inflation above the target band since February. Core inflation has also edged up and exceeded 3 percent since April.

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CPI Inflation

(Year-over-year percent change)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

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Inflation and Contributions

(Percent, Y-o-Y)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Haver and IMF staff calculation.

6. The 2018 headline fiscal deficit remained below 3 percent of GDP, albeit relying on late-year measures. The headline cash deficit recorded 2.8 percent of GDP, while having further widened in cyclically-adjusted terms to 3.5 percent of GDP. The deficit was contained by low-quality or one-off measures at year-end, amounting to 0.6 percent of GDP, including utilization of EU funds to retrospectively finance domestic investment projects and extraordinary SOE dividends. The 2018 accrual-based deficit was calculated by the authorities at 3.0 percent of GDP, which is the EU’s Excessive Deficit Procedure ceiling.4 The expenditure composition further deteriorated, with a rising share of rigid spending (wages and social assistance) relative to tax revenue and a falling share of investment in government spending.

7. The current account deficit has expanded, on the back of strong import growth. The current account deficit rose to 4.5 percent of GDP in 2018, the highest ratio in the EU. The key driver was the continued deterioration of merchandise trade balance on the back of import-intensive growth and slower growth of exports of goods and services (Box 1). These reflected eroding competitiveness of Romanian producers in domestic and export markets as well as the euro area slowdown. A surge in the trade deficit for consumer goods—as opposed to capital goods or intermediate inputs—was the chief contributor, with all categories (durables, non-durables, semi-durables and food) exhibiting deteriorating balances. Reflecting the fiscal deficit and rapid wage increase in recent years, the savings-investment balance turned negative for both government and private sectors. Capital account inflows remained at around 1.2 percent of GDP in 2018, reflecting still low absorption of EU funds. Net FDI (mostly reinvested earnings) was around 2.4 percent of GDP during 2018, financing about a half of the current account deficit.

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Trade Deficit by Component

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Source: Eurostat and IMF staff calculations

8. Staff’s external sector assessment suggests that Romania’s external position in 2018 was weaker than implied by underlying fundamentals and desirable policies (Annex VI). The EBA-lite models imply a current account gap in the range of -1.5 to -3.5 percent of GDP, subject to substantial model and statistical uncertainty. The current account gap is partly attributed to identified policy gaps and partly to structural policies and distortions that are not captured by the model. Reserve coverage remains broadly adequate.

9. Growth of bank credit has strengthened but continues to lag the broader expansion in economic activity. The robust labor market and the government’s Prima Casa guarantee program helped sustain growth in household loans, supporting higher bank profitability. However, bank credit growth rates have remained below those of GDP. The stock of bank credit to the private sector, at 26 percent of GDP, remains one of the lowest in the region. House prices are growing at a more subdued rate than in comparator countries. The share of FX credit (currently at 34 percent) has been on a prolonged decline. The NPL ratio fell to 5 percent at end-2018 (relative to 22 percent in 2013) and is now close to the EU average (3.2 percent).

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House price index

(Year2015 = 100)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Source: Eurostat.Note: Area average refers to the average of countries including BGR, CZE, POL and HUN. House price index for each country has been deflated with HCPI.
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GDP, Bank Assets and Bank Credit to Private Sector

(NSA, y-o-y, % change)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Source: BNR, INSSE.

10. The surprise adoption of GEO 114 in December 2018 brought about significant economic dislocations. The ordinance contained sizable and distortionary sectoral measures and tax changes, which triggered a strong response from the affected parties and a negative market reaction, including a depreciation of the leu and a sharp correction in the stock market (Annexes I and II). The ordinance has since been revised, reducing the economic impact of some of the initial sectoral measures. Nevertheless, there remain measures that can be expected to hinder domestic financial market development and critically needed investment, ultimately limiting potential growth.

Outlook and Risks

11. Growth is projected to remain at around 4 percent in 2019 and to slow to 3 percent over the medium term. Economic activity would continue to be led by consumption, accompanied by elevated inflation and a current account deficit exceeding 5 percent of GDP in 2019–2020. Growth is projected to decline as productive investment has weakened amid regresses on structural reforms, while the fiscal impulse fades over time. Demographic trends, including emigration, weigh on long-term growth prospects as well.5 Without policy corrections, vulnerability will keep rising, with the twin deficits staying elevated and risks for a sudden correction in activity. However, the medium-term projections currently assume that fiscal stimulus will be limited after the elections in 2019–2020, while weakening growth will somewhat rein in external deficits.

Romania: Macroeconomic Outlook

(Percent)

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Sources: Eurostat; Romanian authorities; IMF staff projections.

12. Risks are tilted to the downside and sizable. The key domestic risk is a further increase in vulnerability caused by policy shocks (Annexes II and III). Given the electoral cycle over the next two years, there are risks of further fiscal stimulus or backtracking on structural policies that could further reduce Romania’s competitiveness. Currently, the new pension law poses a significant (medium-term) risk to fiscal sustainability (paragraph 17 and Annex V). The key external downside risk is a sharper-than-expected external slowdown, which would further deteriorate an already large current account deficit and magnify financing pressures. A sharp tightening in global financial conditions could lead to capital outflows and higher borrowing costs in Romania, especially if matched with domestic policy shocks. Romania’s reserves and moderate government debt could provide a temporary cushion, but these buffers could prove insufficient under an adverse event as the imbalances continue to grow.

Authorities’ Views

13. The authorities had a more optimistic outlook. They project GDP growth to be stronger this year at 5.5 percent and exceed 5 percent in the medium term, consistent with Romania’s history of high growth and their higher estimates of potential growth. They highlighted the measures implemented under GEO 114 that aimed to alleviate construction workforce shortages (Annex I) and thus stimulate the construction sector, which in the past had been a bottleneck to raising fixed investment. While concurring that rebuilding buffers was useful, the authorities expected a mild impact of an external downturn on the economy, including from the eurozone. Romania’s exports had a niche in value-driven product segments notably in automotive, IT services and agribusiness sectors. The authorities reaffirmed commitment to the EU fiscal framework and to ensuring the consistency between their policy objectives and sound public finances. They pointed to several revisions of the GEO 114 that reflected business concerns. On the external sector assessment, the authorities expressed reservations about the EBA-lite model’s fit, noting that the EBA-lite CA model likely underestimated the contribution of cyclical and structural factors to the current account deficit in 2018. Moreover, central bank’s analysis suggested that the leu was broadly in line with fundamentals.

Policy Discussions

Rising vulnerability calls for a balanced macroeconomic policy mix built on durable fiscal consolidation. High-quality fiscal consolidation would reduce the burden on monetary policy for macroeconomic stabilization, mitigate external pressure by containing the current account deterioration, and bolster growth potential by improving the balance between consumption and investment (CR/18/148 Box 3). Greater exchange rate flexibility combined with a tighter monetary policy stance is also critical for absorbing shocks amid the weak external outlook, while reining in inflation pressure. Structural and governance reforms should be resumed in order to boost Romania’s growth potential.

A. Lower Fiscal Deficit, Better Budget Composition, and Quality Measures

14. The 2019 budget targets a deficit of 2.8 percent of GDP, but staff projects the outturn at 3.7 percent of GDP without additional measures. Continuing the trend since 2016, the 2019 budget increases public wages and pensions significantly, matched with strong revenue growth for value-added tax and social security contributions. The budget also includes tax exemptions to the construction sector, partly offset by revenues from new taxes on the energy and telecom sectors (Annex I). Staff views revenues overestimated by about 0.9 percent of GDP, due to optimistic assumptions on improvement in tax collection and growth in the private sector wage bill. Relative to the 2018 outcome (deficit of 2.8 percent of GDP), staff’s baseline for 2019 projects an increase in fiscal deficit by 0.9 percent of GDP, which would amount to a significant positive fiscal impulse for an economy operating above potential.

15. Given the cyclical strength and rising vulnerabilities, durable fiscal consolidation supported by quality measures is necessary. Achieving the authorities’ target deficit of 2.8 percent of GDP in 2019 would be a start, entailing a marginally negative fiscal impulse relative to 2018, which would help curb the twin deficits and improve the macroeconomic policy mix. This should be combined with a credible commitment to reduce the deficit further to 1.5 percent of GDP by 2022, transitioning toward Romania’s medium-term objective (MTO) of 1 percent of GDP. By staff estimate (paragraph 14), quality measures equivalent to about 1 percent of GDP are needed to achieve the 2019 deficit target. Drawing on a list of quality measures, the consolidation in 2019 and the future should aim at protecting the revenue envelope while shielding the poor and vulnerable groups and improving the budget structure by moderating growth in wages and pensions (see the table on targets and measures). The consolidation would strengthen confidence in the budget framework and help build fiscal buffers.

16. Re-energizing fiscal reforms would help facilitate and sustain fiscal consolidation over the medium term. There is significant scope to strengthen both revenue and expenditure efficiency.

  • Revenues. Tax efficiency in Romania is among the lowest in the EU, with sizable potential revenue gains from closing efficiency gaps relative to regional peers (estimated at 2½ percent of GDP, CR/18/149). Strengthening the revenue administration (ANAF) is urgent, including by modernizing the IT infrastructure, adopting modern compliance risk management systems and improving the administration of large tax payer office. ANAF should move towards a more transparent and service-oriented model of revenue administration and improve its organizational structure to facilitate the implementation of recommended reforms. Envisaged restructuring plans, including reorganization and the split of customs and tax administration, should guard against disrupting revenue collections. Given numerous changes in the tax code in recent years, a comprehensive review of the tax system to identify distortions and areas for revenue gains is also recommended.

  • Expenditures. Bolstering expenditure efficiency and transparency (CR/18/148) will help manage spending better and reduce corruption vulnerability. Rebalancing the budget structure to reduce the share of rigid spending—the wage bill and pensions—would increase the flexibility while making room for investment. Improvements can also be achieved by strengthening expenditure reviews and the procurement process.

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Fiscal Outlook and Staff Recommendation

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

17. The new pension law calls for a reassessment. The parliament passed in June 2019 a new pension law, which entails doubling pillar I pension benefits by 2022. Implemented as is (with no offsetting measures), the new law would increase pension spending in several steps and add 3.2 percent of GDP to the total government expenditure in 2022 (text table). Debt sustainability analysis (DSA) shows that this could increase public debt in the medium term by 20 percentage points of GDP and nearly double gross financing needs to 14.4 percent of GDP by 2024 (Annex V and Box 2). Higher pension spending would further worsen the budget structure and constrain resources available for public investment and other social spending. It is critical to reconsider the pace of implementation of the law (in accordance with the clause subjecting the benefit increases to fiscal space) and conduct a comprehensive review of the pension system, which had the last major reform in 2010. Such a review should reflect available fiscal space and reassess the balance among social needs, equitable distribution and competing budgetary priorities (including the spending on youth, current workers, and future productive investment). Based on the staff’s baseline scenario, Romania is assessed to have fiscal space at risk6, while demographic challenges add to the need to build long-term fiscal buffers.

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18. Greater medium-term orientation of policies would increase predictability and generate positive dividends for the economy. Regarding fiscal policies, the credibility of Romania’s medium-term objectives would be enhanced by greater predictability. In recent years, the fiscal deficit target has been met by deploying ad-hoc measures that undermined the predictability of fiscal policy. Initiatives for tax amnesty and tax debt restructuring can damage taxpayers’ discipline. They should only be considered as part of a comprehensive and carefully calibrated strategy to strengthen enforcement. Going beyond fiscal issues, adequate impact assessment, prior consultations with stakeholders and a more measured implementation would strengthen the predictability and effectiveness of economic policies.

Authorities’ Views

19. The authorities emphasized their commitment to the 2.8 percent-of-GDP fiscal deficit target set in the 2019 budget law. While acknowledging slightly underperforming fiscal outturns for the first trimester of 2019, they attributed it to temporary factors and expressed confidence in stronger revenue collections for the rest of 2019. Available buffers will be used according to the public finance law, if fiscal outturns continue to underperform. Agreeing on the urgency of improving revenue collection, the authorities noted that the newly appointed ANAF head would implement sweeping ANAF reforms, which could include IMF TA. Acknowledging that the new pension law poses risks to public finances, they stated that its implementation should go hand in hand with strong fiscal-structural reforms to stay within available fiscal space.

B. Tighter Monetary Stance and More Flexible Exchange Rate

20. Monetary policy needs further tightening. Inflation pressure is expected to remain elevated, in light of the still sizable positive output gap, strong wage increases, fiscal stimulus, and nominal exchange rate depreciation thus far. Staff projects inflation to stay above the NBR’s inflation target band by end-2019 and return to the target band in 2020, assuming significant monetary tightening (involving policy rate hikes) in the near term. Fiscal consolidation would reduce the size of needed tightening (CR/18/148 Box 3). Tight liquidity management, which complemented policy rate hikes in 2018, would continue to help monetary management and mitigate FX pressures. In light of the weakening external position, greater exchange rate flexibility and limited interventions to smooth excessive volatility of the leu would help preserve buffers and absorb shocks.

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Interbank Offered Rates

(3 month, percent)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Haver: Eurostat,’National Bank of Romania: and IMF staff calculations.1/ Computed using the underlying inflation rate, adjusted for VAT changes.
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Illustrative Macroeconomic Scenario with Recommended Fiscal Consolidation

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: IMF staff calculation.

21. The independence and credibility of the central bank is an important asset for policy makers. Monetary policy credibility, through well-anchored inflation expectations, provides a valuable buffer for emerging markets, increases resilience to external shocks, and reduces exchange rate pass-through to domestic prices (Fall 2018 WEO). The Consumer Credit Reference Index (IRCC), the new benchmark reference rate based on interbank transactions that was introduced in March (GEO 19), has several shortcomings that can weaken monetary policy transmission and its suitability for pricing household loans. These include its backward-looking calculation, high volatility (driven by liquidity), and potential confusion arising from the parallel use of IRCC for new loans and ROBOR for existing loans.

Authorities’ Views

22. The authorities agreed on the desirable direction of policy adjustments. The NBR stressed its commitment to rein in inflation and continue strict liquidity management. They shared concerns about the growing external imbalance, including limited prospects for FDI needed to finance it. They agreed with the need for a somewhat greater exchange rate flexibility and underscored the need to balance the trade-off between greater exchange rate flexibility and financial sector stability. The IRCC, noted the NBR, will likely complicate the conduct of monetary policy, although it is too early to assess the full consequence. They likened the introduction of IRCC to the international efforts to replace LIBOR-based mechanisms to address their flaws.

C. More Resilient Financial Sector

23. Banking sector performance is strong, while facing the new bank tax. After several profitable years, banks have strong capital and liquidity positions, and non-performing loans have approached the EU average level. The banking system is overall stable, but the tax on bank assets (Annex I) creates some uncertainty. The tax could negatively affect the cost of bank credit to the private sector, and linking the tax to performance targets could lead to distortions in the allocation of credit and resources. The policy uncertainty surrounding implementation of the tax as well as the recently introduced IRCC could hinder financial sector development.

24. Good progress has been made to improve resilience, consistent with the 2018 FSAP recommendations. A majority of FSAP recommendations, including debt-service-to-income ratios and currency-differentiated liquidity requirements, have been fully or partially implemented (Annex VII). Areas that lack progress include the scaling back of the Prima Casa program, for which an expansion was recently announced.

25. Additional progress in some areas, in line with FSAP recommendations, would further support financial stability. One such area is the introduction of a carefully calibrated systemic risk buffer, which would increase the banking sector’s resilience under a high sovereign exposure. While the exposure of banks to the Romanian state approached 20 percent of assets in 2018, one of the highest in the EU, the exemption of government bond holdings from the new bank tax could incentivize banks to further increase the exposure. The authorities are also encouraged to continue strengthening the AML/CFT framework in compliance with the FATF standards (e.g., comprehensive assessment of ML/TF risks, customer due diligence requirements for politically exposed persons, enhancing entity transparency) and the asset declaration framework for senior officials.

Authorities’ Views

26. The authorities broadly agreed with the staff’s financial sector assessment. The NBR stressed the good progress made on many FSAP recommendations (Annex VII). They shared staffs concerns over the sovereign-bank nexus and have been discussing internally an introduction of a systemic risk buffer. The authorities are strengthening the AML/CFT framework and have enacted a new law in July 2019.

D. Reforms to Stimulate Investment and Growth

27. Progress with the structural reform agenda has stalled or been reversed in some cases. Consequently, gaps in Romania’s structural performance indicators relative to regional peers appear to have stopped narrowing since 2015 or so, particularly in the quality of infrastructure and control of corruption. The decline in the share of public investment in government spending over the recent years has been a contributing factor to the lack of progress in narrowing infrastructure gaps (relative to peers, especially in transport and utilities sectors). These structural gaps negatively affect Romania’s competitiveness, FDI and growth potential.

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Progress with Structural Reforms (Relative to CEE peers)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: WEF, WGI and IMF staff calcualtions.Note: CEE peers include Bulgaria, Hungary, Poland, Czech Rep. and Slovak Rep.All reported indicates, except the financial development index, are perception-based and should be interpreted with care, as they are based on opinion survevys and expert assessment.Interpretation of the reported results should also take into account that there is uncertainty surrounding each point estimate.

28. Structural reform initiatives require a re-start. The aim should be to remove the most binding constraints to investment and long-term growth prospects.

  • Infrastructure. With the quality of Romania’s infrastructure remaining below its regional peers, strengthening the public investment management institutions is a priority. Effective absorption of EU funds will improve infrastructure quality with growth dividends (CR/17/134). Private-public partnerships (PPPs) should be accompanied by careful value-for-money analysis and strengthened administrative capacity for evaluating fiscal risks. Moreover, the desirability of PPPs should be assessed relative to other funding arrangements, such as EU funds. There should be a renewed focus on strengthening the governance of SOEs to raise the quality of public goods and services, which would benefit Romania’s competitiveness.

  • Governance and anti-corruption. Effective and sound institutions are critical for inclusive and sustained growth. Reducing corruption would help improve government revenue, enhance spending efficiency, and strengthen competitiveness. Strong governance has also been found to help reduce emigration, especially of the high-skilled (SDN/16/07). Whereas Romania’s past progress in the fight against corruption was recognized internationally, recent amendments to the justice laws and initiatives to amend the criminal codes have been criticized as potentially weakening Romania’s capacity to fight corruption. Unabated anti-corruption efforts need to resume.

  • Minimum wages and labor market. Continued wage growth exceeding productivity bodes ill for competitiveness, and minimum wage hikes could decrease labor market flexibility. The minimum wage in Romania has tripled over the last 7 years to more than 40 percent of the average wage. It should be set by a transparent and objective mechanism that reflects gains in labor productivity (SM/16/94).

Authorities’ Views

29. The authorities and staff agreed on the eventual goals. The authorities agreed that improving Romania’s infrastructure remains a key priority and acknowledged bottlenecks in implementation, including the capacity of the construction sector. They argued that the construction activity was stimulated by GEO 114 and that PPPs provided an alternative funding means for bridging the infrastructure gaps. The authorities noted that the minimum wage determination, as guided by the governing program, takes productivity into account in a discretionary manner, and did not commit to a more systematic mechanism for linking the minimum wage to productivity developments. The sovereign wealth fund was no longer being pursued, eliminating a source of uncertainty on the governance of SOEs. The authorities indicated that the government will not pursue further initiatives related to the judicial system and will continue efforts to exit the EU’s Cooperation and Verification Mechanism.

Staff Appraisal

30. Romania is among the fastest growing countries in the EU, but imbalances have widened. Strong growth performance in recent years has supported convergence toward average EU income levels. However, its sustainability is increasingly at risk, as the twin deficits (current account and fiscal deficits) and inflationary pressures grow and room for macroeconomic policy maneuver is being eroded. Romania’s external position in 2018 was assessed to be weaker than implied by underlying fundamentals and desirable policies. The consumption-led boom, fueled by rapidly increasing wages, continued in the first quarter of 2019 and was accompanied by a further deterioration in the trade balance.

31. A correction in the course of policies is needed to sustain convergence and reduce the likelihood of a setback. A durable fiscal consolidation—toward the authorities’ medium-term objectives—would help improve the fiscal-monetary policy mix by alleviating domestic inflation pressures and reducing the extent of required monetary tightening. While consolidating the deficit, there is still room with revenue and other reforms to improve the fiscal space to meet social and public investment needs. The fiscal consolidation should be accompanied by monetary tightening to rein in inflation, greater exchange rate flexibility as a shock absorber, and renewed structural reforms to facilitate investment. Across a broad spectrum of policies, adequate impact assessment, prior consultations with stakeholders and a more measured implementation would strengthen the policy predictability and effectiveness. In unison, these policies will reduce macroeconomic imbalances, strengthen buffers, and sustain inclusive convergence.

32. Fiscal consolidation should start with meeting this year’s deficit target with quality measures. Staff has estimated that additional revenue and expenditure measures of almost 1 percent of GDP would be needed to bring this year’s fiscal deficit to the budget law’s target. Such measures should aim to shift fiscal expenditures away from rigid spending (e.g. the surging wage bill). Supported with suitable revenue measures, the recent trend of declining public investment should also be reversed.

33. Sustained revenue and expenditure reforms are needed to achieve consolidation over the medium term. With tax collection efficiency among the lowest in the EU, revenue administration should be modernized, by upgrading IT systems and improving compliance risk management. Expenditure efficiency and transparency should also be improved, to better manage spending and reduce corruption vulnerabilities, by strengthening expenditure reviews and the procurement process. The new pension law, if implemented as is, would undermine medium-term fiscal sustainability. It should be subjected to a comprehensive review, balancing social and equity needs and fiscal costs.

34. Monetary policy should be tightened further, given sizable inflation pressures. Inflation for 2019 is projected to stay above the target band, driven by the cyclical strength of the economy and fiscal stimulus. Tight liquidity management alone is not sufficient to rein in inflation, and further monetary tightening to anchor inflation in the medium-term is warranted. Such actions will also bolster the credibility and independence of the central bank.

35. Banking sector performance is strong, while progress with financial regulation should continue. The financial sector is stable, mainly reflecting several years of strong bank performance. Good progress has been made on implementing 2018 FSAP recommendations, improving the sector’s resilience. Bank exposure to the Romanian state remains a concern and requires continued monitoring and appropriate regulatory responses. The new AML/CFT legislation should be followed by a robust implementation.

36. Improving medium-term growth prospects requires a re-energized structural reform agenda. The public investment rate should be increased from the current multi-decade low by focusing on public infrastructure and achieving a more efficient absorption of EU funds. SOE reforms require a re-start, to improve the quality of public goods and services. Minimum wage hikes should be moderated and linked to a set of objective criteria that reflect productivity developments. Romania’s fight against corruption should be renewed. These reforms would alleviate constraints on growth, enhance Romania’s competitiveness and facilitate investment.

37. It is recommended to hold the next Article IV consultation on the standard 12-month cycle.

The Current Account Deterioration

The current account balance in Romania has deteriorated significantly in recent years. From almost a balanced position in 2014, Romania’s current account deficit has widened in recent years and reached 4.5 percent of GDP in 2018. The deterioration is expected to continue, as staff projects the deficit to increase by 1.0 percent of GDP in 2019. This Box examines the current account from the perspectives of consumer goods imports (which has been the main driver of the deterioration) and of Romania’s internal saving-investment balance.

The rise in the trade deficit for consumer goods has been broad-based and driven mostly by imports, reflecting strong domestic demand. Consistent with Romania’s cyclical strength, imports of consumer goods—as a share of GDP—have increased in all sub-categories since 2014, partly reflecting the eroding competitiveness of domestic producers in the face of wage-driven cost pressures. While the share of Romania’s exports in world exports has continued to rise despite cost pressures (Annex VI), the share of exports in (Romania’s) GDP declined and contributed to the rising trade deficit—this was due to Romania’s strong GDP growth that exceeded the GDP growth in main trading partners (including EU). Geographically, the trade deficit has increased vis-à-vis both EU and non-EU trade partners, also indicating the domestic origin of the imbalance. The relatively larger increase in the trade deficit vis-à-vis EU trade partners reflects the increasing regional integration of trade.

uA01fig12

Trade in Consumption Goods: 2009–18 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Source: Eurostat and IMF staff calculations.1/ Consumption goods: raw and processed foods and beverages for household consumption and consumer goods.

Saving-investment balances also look consistent with the strong imports of consumer goods. Both private and public sectors have contributed to the imbalance. This is in contrast to the previous external imbalance episode prior to 2007, when the private sector was the sole driver. Booming economic activity coincided with declining rates of both investment and savings, in a clear indication of the role of consumption in the current expansion. Savings declined faster than investment and widened the current account deficit, in another contrast with the pre-2007 episode, when investment increased faster than savings and widened the current account deficit.

Changes in Current Account by Components

(in percent of GDP)

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Source: Eurostat and IMF staff calculations Note: ΔCA denotes respectively CA2018-CA2014 and CA2007-CA2004. The same notation applies to ΔS and ΔI.

Potential Consequences of the New Pension Law

If implemented as is without offsetting policy measures, the new law could double Romania’s already sizable fiscal deficit, substantially increase current account deficits and raise external financing needs to excessive levels.

The government has enacted a new law that will double the pillar I pension benefits by 2022, without yet spelling out the budgetary implication of its implementation. As discussed in paragraph 17, pensions will rise in several stages, bringing about the additional fiscal expenditures of 3.2 percent of GDP by 2022 (compared to those that would have taken place under the previous law). As a result, the replacement ratio1 is estimated to increase substantially from 42 percent in 2018 to 64 percent by 2022. This should help narrow the poverty risk gap2 for elderly population in Romania, which is the highest in the EU (based on estimates for 2017), but will have no effect on the even higher poverty risk gap for population aged 18–64. The government has yet to explain how the budget will accommodate the additional expenditures, despite a clause in the law that emphasizes the importance of fiscal space.

An illustrative scenario fleshes out the possible implications of the new law for the fiscal and external accounts. This illustrative medium-term scenario elaborates on an alternative DSA scenario (Annex V) and assumes that no offsetting policy measures are adopted (while some would likely be announced in the 2020 budget law). The added pension expenditures would provide a boost to aggregate demand, but would also worsen the economic sentiment, as Romania’s macroeconomic imbalances deteriorate. Worsening sentiment and rapidly increasing external financing needs are assumed to increase financing costs by 300 basis points. There are two important caveats. First, this scenario does not incorporate any restraint on the deficits that the EU’s Excessive Deficit Procedure would impose, were the fiscal deficit to exceed 3 percent of GDP. Second, while tracing out the first round of macroeconomic consequences of the legislated additional fiscal expenditures, the scenario does not consider the possibility of more adverse market reactions (possibly induced by sovereign credit rating downgrade) and deeper economic dislocations that could follow.

The scenario reveals potentially devastating medium-term consequences. Romania’s fiscal and current account deficits would both reach 8 percent of GDP by 2022. Public debt would increase by 20 percentage points of GDP (Annex V). External debt would also increase significantly, as the sizable additional expenditures would predominantly need to be financed in external markets (given already high domestic bank exposures; Annex II), tripling public sector’s external financing needs by 2022. The rising financing needs could bring out more adverse market reactions than the 300 basis-point increase in the financing costs. Increasing reliance on external financing would raise the foreign currency share of public debt and heighten the exposure to the exchange rate risk.

uA01fig13

Fiscal and current account deficits (percent of GDP)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Source:IMF staff calculations

The authorities need to reassess the implementation of the new pension law to ensure fiscal and external sustainability. Without additional fiscal measures, the new law endangers medium-term fiscal sustainability and prolongs policy uncertainty with adverse effects on economic activity and investment. The implementation of the new law can be paced to limit its negative impact on medium-term fiscal and external imbalances. Turning to the overall budget, redoubling fiscal reform efforts along the lines of staff recommendations would help provide fiscal space. In particular, a comprehensive reform of revenue administration and a review of the tax system could significantly raise fiscal revenues over the medium term (CR/18/149). More targeted social policies could help to alleviate poverty risks for the elderly and the rest of the population.

1 Defined as the ratio between the net average pension and net average wage, as reported by the National Institute of Statistics. 2 Defined as the difference between the median equivalised total net income of persons below the at-risk-of-poverty threshold and the at-risk-of-poverty threshold.
Figure 2.
Figure 2.

Romania: Real Sector, 2007–19

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Haver Analytics; and IMF staff calculations.
Figure 3.
Figure 3.

Romania: External Sector, 2007–19

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Haver Analytics; National Bank of Romania, IMF Information Notice System (INS); and IMF staff calculations.1/ Reserves coverage is based on end-of-year data.
Figure 4.
Figure 4.

Romania: Labor Market, 2007–19 1/

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Eurostat, Haver Analytics; and IMF staff calculations.1/ Year 2018 reflects the upward adjustment of gross wages, including gross minimum wages, due to the implementation of the shift in social security contributions from employers to employees, which kept net wages and costs to employers unaffected.
Figure 5.
Figure 5.

Romania: Monetary Sector, 2007–19

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Haver Analytics; National Bank of Romania; Eurostat; Consensus Forecast; and IMF staff estimates.
Figure 6.
Figure 6.

Romania: Fiscal Operations, 2008–20

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Romanian authorities; and IMF staff estimates and projections.
Figure 7.
Figure 7.

Romania: Financial Sector, 2007–18

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Dxtime; and National Bank of Romania.1/ Excludes credit to central government.2/ In December 2015, the NBR moved from a national definition to an EBA methodology-based definition of NPL’s.
Figure 8.
Figure 8.

Romania: Financial Developments, 2013–19

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Bloomberg; and Haver Analytics.
Table 1.

Romania: Selected Economic and Social Indicators, 2013–20

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Sources: Romanian authorities; IMF staff estimates and projections; World Development Indicators database, Eurostat.

Staff’s inflation projections assume monetary tightening.

Including potential statistical uncertainty related to large inventory contribution in 2018.

Year 2018 reflects the upward adjustment of gross wages due to the implementation of the shift in social security contributions from employers to employees, which kept net wages and costs to employers unaffected (see Box 1 in the 2018 Article IV staff report).

General government finances refer to cash data.

Fiscal balance (cash basis) adjusted for the automatic effects of the business cycle and one-off effects.

Table 2.

Romania: Medium-Term Macroeconomic Framework, Current Policies, 2015–24

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Sources: Romanian authorities: and IMF staff estimates and oroiections.

Based on gross value added data from the National Institute of Statistics (NIS) in Romania. Note that there is a small discrepancy between the supply side GDP data from the NIS and the demand side data from Eurostat

Domestic demand components potentially distorted by statistical issues related to large inventory contribution (about 3 percent of GDP} in 2018, which from past experience are subsequently revised to reallocate to consumption and investment components.

Staffs inflation projections assume monetary tightening.

Actual fiscal balance adjusted for the automatic effects related to the business cycle and one-off effects.

Table 3.

Romania: Balance of Payments, 2015–24

(In billions of euros, unless otherwise indicated)

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Sources: Romanian authorities; and IMF staff estimates and projections.
Table 4.

Romania: Gross External Financing Requirements, 2015–20

(In billions of euros, unless otherwise indicated)

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Sources: Romanian authorities; and IM F staff estimates and projections.

The sharp increase in financing requirements in 2016 is partly due to the changes in the methodology of collecting data for short term debt for corporates.

Includes portfolio equity, financial derivatives and other investments.

SDR interest rate as well as exchange rate of SDR/USS and US$/€ of January 15, 2015.

Operational definition.

Table 5a.

Romania: General Government Operations, 2015–2024 1/

(In percent of GDP, unless otherwise indicated)

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Unless otherwise noted, the table is on a cash basis following GFSM 86. The general government is com posed of the central government, local governments, social security fur and the road fund company.

For data comparability, does not include the EU agricultural subsidies reflected in authorities’ budget reports starting 2016.

Includes EU-financed capital projects. Fordata comparability, does not include the EU agricultural subsidies reflected in authorities’ budget reports starting 2016.

Does not include all capital spending.

Total consolidated general-government debt, including state government debt, local government debt, and guarantees.

Percentage deviation of actual from potential GDP,

Expressed in percentage of potential GDP.

Includes guarantees and intra-governmental debt.

Table 5b.

Romania: General Government Operations, 2015–2024

(In millions of lei)

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For data comparability, does not include the ELI agricultural subsidies reflected in authorities’ budget reports starting 2016.

Includes EU-financed capital projects. For data comparability, does not include the EU agricultural subsidies reflected in authorities’ budget reports starting 2016.

Does not include all capital spending.

Total consolidated general-government debt, including state government debt, local government debt, and guarantees.

Includes guarantees and intra-governmental debt.

Table 5c.

Romania: Consolidated General Government Balance Sheet, 2012–2017

(In millions of lei, unless otherwise indicated)

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Sources: Romanian authorities; Eurostat; and IMF staff calculations.
Table 6.

Romania: Monetary Survey, 2014–20

(In millions of lei, unless otherwise indicated; end of period)

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Sources: National Bank of Romania; and IMF staff estimates and projections.

Rates for new local currency denominated transactions.

Table 7.

Romania: Financial Soundness Indicators, 2010–18

(In percent)

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Source: National Bank of Romania.

For 2010, market and operational risk are not used in compiling risk weighted assets.

In December 2015, the NBR moved from a national definition to an EBA methodology-based definition of NPL’s.

Return on equity is calculated as net profit/loss to average own capital.

Liquid assets = balance sheet assets and off balance sheets items with residual maturity of up to 3 months.

Short term liabilities = balance sheet liabilities and off balance sheet items with residual maturity of up to 3 months.

Tier 1 capital to average assets.

Annex I. Summary and Evolution of December 2018 GEO 114 Policy Measures

In December 2018, the government announced policy measures under emergency ordinance (GEO 114/2018) and caught the market by surprise due to several drastic clauses contained in the original announcement and the uncertainty on the final format to be implemented. The announced measures were modified upon adoption, with extensive additional modifications in March 2019 (GEO 19/2019) and again in May 2019. Further modifications look possible.

While the package can generate some additional fiscal revenue, it is likely to have significant negative impact, especially when the broader impact of the surprise announcement on the predictability of business environment and legislative stability are considered. The package still contains many measures that distort markets, including through differentiated sectoral treatments without a clear economic rationale. Some of them potentially violate EU competition rules.

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Annex II. Potential Macroeconomic Vulnerabilities

The relatively narrow financing base and higher vulnerabilities accumulated due to procyclical policies since 2015 raise risks of a hard landing in the event of an adverse external financing shock. Market developments in the months after December 2018 were a short-lived stress episode.

A. Indicators for Vulnerability in a Romanian Context

1. At first glance, and relative to other EU countries, Romania’s indicators do not appear concerning (table)• Public debt ratios are relatively low, current account and fiscal deficits higher but not extraordinarily large for a fast-growing emerging market economy, reserve coverage comfortable by most Fund metrics for floating regimes, and banking liquidity ample. Buffers also exist on several other fronts.1 The indicators are better on the whole than the levels in 2008 just before the last major crisis, although showing some deterioration compared to 2015.

Romania: Selected Indicators, 2018 vs. 2015 and 2008

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Since 2011, includes fiscal buffer in FX built up towards four months of financing needs.

Partly reflects methodological changes that increased short-term corporate external debt beginning 2016.

Earliest reported share for December 31, 2009.

2. However, a detailed analysis of indicators reveals potential sources of concern. The concern will be heightened in the event of a large adverse shock, especially amidst a weakening outlook for the eurozone that dominates Romania’s external trade and financial exposures:

  • Romania’s relatively low public debt ratio hides some potential vulnerabilities. Before the GFC shock, the public debt ratio was significantly lower than its current value.2 While public debt maturity profile has been lengthened over recent years, the absolute size (nominal value) of market borrowing, both in domestic currency bonds and Eurobonds, has increased markedly (see table). Furthermore, despite the low public debt ratio, Romania’s sovereign credit rating has

  • In contrast to its EU new member state peers, the current account deficit widened rapidly from being close to balance in 2014 and exceeded 4 percent of GDP in 2018, which is the indicative EU’s macroeconomic imbalance procedure threshold. This deficit has mostly been financed with FDI and EU funds, which have in recent years together amounted to about 4 percent of GDP. A deficit above the 4 percent level would likely require additional market financing, increasing Romania’s sensitivity to global financial market conditions.

  • After having reached its Medium Term Objective (a fiscal deficit of 1 percent of GDP) in 2015, the structural fiscal deficit (cyclically adjusted, excluding one-off measures) has substantially deteriorated in recent years, reaching 3.6 percent of GDP in 2018.

  • Reserve coverage is declining as imports have surged in recent years, while external public debt service requirements are sizable (Table 4: Gross External Financing Requirements).

  • As a broad indicator of available banking liquidity, headline loan-to-deposit ratios appear comfortable. However, in a small financial sector with a high domestic sovereign exposure (at 20 percent of bank assets, the highest in EU as noted in the 2018 FSAP), there may be limited room to further increase exposure to the sovereign.

uA01fig14

Long-term Sovereign Credit Rating Since Romania’s EU Accession

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Moody’s. Standard & Poor’s. Fitch; IMF staff calculation.Note: The yearly rating is calculated by assigning equal weights to rating from each agency (S&P. Moody’s. Fitch), not risen above the borderline-investment grade in a decade after the EU accession.
uA01fig15

Romania vs New Member States: Twin Deficits

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: IMF Staff calculations.

B. Market Developments Following GEO 114

3. Following the launch of the fiscal policy package (GEO 114, Annex I) in mid-December 2018, market pressures surged in January 2019 (panel figure). The initial design of the policy package (revised subsequently) appeared to potentially affect Romania’s external and fiscal financing bases, having been aimed at banks and pillar II pension managers (together holding about 65 percent of the government’s lei securities). It also appeared to be targeted at important FDI sectors (energy and telecoms).

  • Heightened policy uncertainty surrounding the implementation of these measures initially led to the largest one-day stock market drop (over 15 percent) since the GFC, followed by some recovery once the revision of the measures was indicated.3

  • With signs of some financial outflows and sharply higher trade deficit in January 2019, the lei-euro exchange rate depreciated by about 2 percent in January. Romania’s exchange rate and financial flow movement contrasted with the backdrop of a broadly favorable “risk-on” environment of portfolio inflows into emerging markets since Q4 2018.

  • The EMBI spreads for Romania have widened relative to CEE peers since 2017, with an additional widening since December 2018. A major credit rating agency in March 2019 had signaled a possible downgrade to sovereign rating outlook, conditional on corrective actions for GEO 114, but subsequently kept the outlook after changes were made by end-March.

Annex Figure 1.
Annex Figure 1.

Romania: Recent Market Developments

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Haver, NBR and IMF staff calculations.

C. Results of the Growth-at-Risk Model

4. Findings of the Fund’s Growth-At-Risk (GaR) model. To illustrate the consequence of potential vulnerabilities in the event that significant tail risks from the IMF’s Global Risk Assessment Matrix materialize (see Annex-RAM), we use a partial-least-squares version of the Fund’s Growth-At-Risk model (WP/19/36) that was customized and calibrated with Romania’s data.

5. Model summary and caveats. The GaR estimates the distribution for GDP growth rates conditional on macro-financial variables, which are combined in partitions. For Romania, the main regressors for the four partitions are:

  • (i) Domestic financial conditions (one-week and 3-month ROBOR, interest rate volatility and inflation)

  • (ii) Main trading partners’ macro conditions (Germany’s GDP growth and share of exports relative to its GDP, Romania import shares for Germany, France and Italy)

  • (iii) Euro area (EA) financial conditions (EA VIX, 1-week Euribor, EA inflation)

  • (iv) World financial conditions (VIX, CEE bond flows, oil prices and its implied volatility)

Because of data limitations, the model is estimated for Romania starting from year 2000 (or in a few cases from 2008 onwards). The short sample period limits the statistical accuracy and applicability of the results for Romania. The modelling also does not factor in the availability of buffers which exist in the case of Romania (e.g. FX reserves and fiscal financing buffer). Such buffers may be utilized in response to adverse shocks, assuming the shock is temporary.

6. Results. The GaR analysis shows that external financial conditions have by far the largest adverse growth impact in the downside tails of the distribution, especially under an external volatility shock, such as occurred during the GFC and the European crisis. Domestic financial conditions have a relatively small influence, reflecting low domestic financial intermediation. Trade partner growth has been a steady contributing factor to Romania’s growth since year 2000, reflecting Romania’s rising export market share especially in autos (Dacia and Ford FDI). The historical distribution and 1-year ahead projected distribution of GDP growth suggest that Romania has a relatively high trend growth (close to 3.3 percent) which could continue conditional on recent factors. However, there is a non-negligible probability of a sharp growth deceleration in the event of an external financing shock.

uA01fig17

GaR for Romania: Projected GDP Growth 1-year Ahead

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

To illustrate the sensitivity of growth to adverse external financing shocks, the VIX was shocked by ½ standard deviation, as a key external financial volatility factor. The resulting values of the VIX are similar to the levels that prevailed in 2010 and briefly in 2015. This would shift the distribution to one with a mode of virtually recessionary levels (orange distribution below, relative to the original distribution).

uA01fig18

GaR for Romania: Baseline GDP Growth Distribution vs. Scenario of External Financial Shock

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Annex III. Risk Assessment Matrix (RAM) 1/

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The RAM shows events that could materially alter the baseline path. (The scenario most likely to materialize in the view of IMF staff.) The relative likelihood of risks is staff’s subjective assessment of risks surrounding the baseline. Non-mutually exclusive risks may interact and materialize jointly.

Annex IV. Implementation of the 2018 Article IV Key Recommendations

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Annex V. Debt Sustainability Analysis

Public debt in Romania is expected to remain relatively low but rise gradually over the medium term. Under the baseline scenario, the public debt-to-GDP ratio is projected to reach 43.1 percent by 2024 from the current level of 36.7 percent. Gross public financing needs (7.5 percent of GDP in 2018) are expected to increase to 8.4 percent in 2019 and remain above 8 percent by 2024. While the DSA suggests that public debt is sustainable under various shocks, in the recession scenario debt reaches around 52 percent by 2024.1 The combined macro-fiscal shock shifts the debt trajectory most significantly, pushing debt to 57 percent by 2024. Exposure to international capital outflows continue to present a notable risk, with the associated debt profile vulnerability indicator exceeding the upper early warning benchmarks.

A. Comparison with the Previous Assessment

1. The baseline debt trajectory has increased relative to last year’s DSA. The debt outturn for 2018 was marginally lower-than expected, because the fiscal balance remained contained below 3 percent (outturn of 2.96 compared to 3.6 percent of GDP in 2018 DSA). Notwithstanding the lower debt base in 2018, the medium-term trajectory for debt is higher due to: (i) higher projected deficits for 2019–2024 compared to 2018 DSA, and (ii) lower projected growth for 2020–23 compared to 2018 DSA. Under the baseline scenario, the budget deficit is expected to exceed 3.5 percent over the period 2019–2023—without additional measures—thus violating the 3 percent rule under the Stability and Growth Pact. The budget deficit is expected to peak in 2022 at 3.7 percent of GDP due to increasing pension expenditures and the peak of the EU financing cycle, and gradually decline thereafter.

B. Baseline and Realism of Projections

2. Debt level. Under the baseline scenario, gross debt level (including guarantees) is projected to rise gradually over the medium term, reaching 43.1 percent in 2024. Gross financing needs are projected to increase to 8.3 percent of GDP by 2022—from 7.5 percent in 2018—and stabilize thereafter.

3. Fiscal balance and adjustment. In the baseline projection, the budget deficit peaks in 2022 at 3.7 percent of GDP and declines to 3.3 percent of GDP in 2024. The deterioration in the budget deficit in 2019 is mainly driven by the continued wage and pension increases. Over the medium term, revenue and expenditure projections are driven by the macroeconomic projections for key variables2 and the assumption that absorption of EU funds will gradually improve over the medium term.3 Taking into account the distribution of fiscal adjustment episodes provided in the DSA template (Figure 2), the projected 3-year adjustment in the cyclically-adjusted primary balance (CAPB) of 0.5 percent of GDP indicates that there may be room for a greater adjustment in Romania. Similarly, the 3-year average level of the CAPB places Romania in lower end of the distribution.

Figure 1.
Figure 1.

Romania: Public DSA Risk Assessment

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Source: IMF staff.1/ The cell is highlighted in green if debt burden benchmark of 70% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.2/ The cell is highlighted in green if gross financing needs benchmark of 15% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are: 200 and 600 basis points for bond spreads; 5 and 15 percent of GDP for external financing requirement; 0.5 and 1 percent for change in the share of short-term debt; 15 and 45 percent for the public debt held by non-residents; and 20 and 60 percent for the share of foreign-currency denominated debt.4/ EMBIG, an average over the last 3 months, 21-Dec-18 through 21-Mar-19.5/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external debt at the end of previous period.
Figure 2.
Figure 2.
Figure 2.

Romania: Public DSA – Realism of Baseline Assumptions

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Source : IMF staff.1/ Plotted distribution includes all countries, percentile rank refers to all countries2/ Projections made in the spring WEO vintage of the preceding year3/ Not applicable for Romania, as it meets neither the positive output gap criterion nor the private credit growth criterion.4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.

4. Growth. Considering the high sensitivity of Romania’s debt dynamics to surprises in GDP growth, there seems to be no systematic projection bias in the baseline assumption for growth that could undermine the DSA assessment (Figure 2). The current real GDP growth projection of 4.0 percent for 2019 is significantly lower than the authorities’ forecast of 5.5 percent. Reflecting the temporary nature of the fiscal impulse, as well as the slow progress in structural reforms, medium-term growth is expected to stabilize at 3.0 percent of GDP. The boom-bust analysis is not triggered because the three-year cumulative change in the credit-to-GDP ratio does not exceed 15 percent in Romania and output gap has been positive for less than three years.

5. Maturity, rollover and other risks. To manage financing risk, the authorities maintain a foreign currency financing buffer. The average maturity of government securities issued on the domestic market was 3.2 years at the end of 2018. The authorities have been addressing rollover risks under a debt management strategy which aims to issue longer-term securities as well as lengthen the yield curve. However, public debt continues to be vulnerable to exchange rate risk, with foreign currency denominated debt accounting for about half of total public debt. The new pension law presents a significant risk. An alternative scenario, incorporating the fiscal impact of the new pension law (see text table) shows public debt in 2024 reaching 59 percent of GDP—a 16 percentage point increase relative to the medium-term baseline.4 At the same time, public gross financing needs jump to 14.4 percent of GDP.

C. Stochastic Simulations

6. The fan charts illustrate the possible evolution of the debt ratio over the medium term, based on both the symmetric and asymmetric distributions of risk. Under the symmetric distribution, there is a high level of certainty that debt will remain below 60 percent of GDP (threshold under the Stability and Growth Pact) over the medium term.

D. Stress Tests

7. Real GDP growth. The debt ratio remains below 60 percent of GDP under all scenarios (Figure 5) – however, it is most sensitive to the real GDP growth shock, under which debt reaches about 52 percent of GDP and public gross financing needs surge to 11.9 percent of GDP in 2021.

Figure 3.
Figure 3.

Romania: Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(in percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Source: IMF staff.1/ Public sector is defined as general government and includes public guarantees, defined as .2/ Based on available data.3/ EMBIG.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r – π(1+g) – g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r – π (1+g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).8/ Includes changes in the stock of guarantees, asset changes, and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
Figure 4.
Figure 4.

Romania: Public DSA – Composition of Public Debt and Alternative Scenarios

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Source: IMF staff.
Figure 5.
Figure 5.

Romania: Public DSA – Stress Tests

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Source: IMF staff.

8. Combined shock. A combined shock incorporates the largest effect of individual shocks on all relevant variables (real GDP growth, inflation, primary balance, exchange rate and interest rate). Under this scenario, debt would reach 57 percent of GDP in 2024 without showing signals of a declining trajectory. Gross financing needs average at 11 percent over the 2021–2024 period.

External Debt

9. The external debt continued the downward trend in 2018. After peaking in 2012 at the 75.7 percent of GDP, the gross external debt has been gradually declining to 48 percent of GDP in 2018. Private sector deleveraging, both in banking and non-banking sector, has been the main driver of the declining debt. The short-term debt accounted for 28 percent of total external debt in 2018 and is largely covered by the intercompany lending. Public external debt at 16.4 percent of GDP, remains low by international standards.

uA01fig19

External Debt Path

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Authorities data, IMF staff calculations.

10. Going forward, the external debt is expected to plateau in the baseline scenario. Under the current policies, the external debt will only marginally decline to around 46 percent of GDP in 2025, despite strong nominal GDP growth. As a result, the debt dynamics under the baseline scenario is slightly higher than in the scenario with key variables at their historic level. The gross external financing needs are expected to gradually decline over the medium term but to stay above 20 percent of GDP. Despite the high financing needs, the roll-over risk of the non-banking sector is limited, as large portion of debt stems from inter-company lending. In addition, Romanian non-banking sector has also claims abroad that partly hedge their external liabilities.

11. Staff analysis indicates that Romania’s debt dynamics is susceptible to most shocks. The debt stays close to the 2018 level under the interest rate shock scenario, while it slightly increases in the growth-rate and current account shock scenarios. However, in a tailored combined shocks scenario (permanent ½ standard deviation shock applied to growth, current account and interest rate), the external debt reaches 55 percent of GDP in 2024. Moreover, a stress scenario with 30 percent depreciation indicates that the external debt would increase sharply to 69 percent of GDP in 2020, and hover around that level over the medium term.

Table 1.

Romania: External Debt Sustainability Framework, 2014–2024 (In percent of GDP, unless otherwise indicated)

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Derived as [r – g – r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in Euro terms, g = real GDP growth rate, e = nominal appreciation (increase in Euro value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus am ortizationon medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; Euro deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, Euro deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Figure 6.
Figure 6.

Romania: External Debt Sustainability: Bound Tests 1/, 2/

(External Debt in percent of GDP)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/ Permanent 0.5 standard deviation shocks applied to real interest rate, growth rate, and current account balance.4/ One-time real depreciation of 30 percent occurs in 2019.

Annex VI. External Sector Assessment

Romania’s external position in 2018 was weaker than implied by medium-term fundamentals and desirable policy settings. The current account deficit widened to 4.5 percent of GDP in 2018 and is expected to deteriorate further in 2019, suggesting rising external imbalances and moderate exchange rate overvaluation. Policy recommendations to address the external imbalance include durable fiscal consolidation, greater exchange rate flexibility, and structural reforms to boost productivity and competitiveness. While deteriorating relative to the previous year, reserves currently remain adequate according to most IMF metrics.

Current Account

Background

1. Romania’s current account (CA) deficit continued to deteriorate over the last 5 years. The current account deficit surged to 4.5 percent of GDP in 2018 from 3.2 percent of GDP in 2017, despite slower growth. This reflects surging consumption imports fueled by strong wage growth over the last two years. The current account balance is expected to further deteriorate in 2019, driven by slowing exports and relatively strong imports due to continued wage growth, and stay above 4 percent over the medium-term.

uA01fig20

Current Account

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Authorities data.

Assessment

2. The CA model of the EBA-lite methodology suggests that Romania’s external position at end-2018 was weaker than implied by medium-term fundamentals and desirable policy settings. The cyclically adjusted CA norm is estimated at a deficit of 1.9 percent of GDP, while the multilaterally consistent norm is estimated at a deficit of 1.4 percent of GDP. This implies a CA gap of -2.5 percent of GDP in 2018 and a real effective exchange rate (REER) overvaluation of about 8 percent, albeit subject to uncertainty around these point estimates. The current account gap is only partly explained by policy gaps and mostly by structural policies and distortions that are not captured by the model. Specifically, the domestic fiscal policy gap (2 percent of GDP in line with staff’s fiscal policy recommendations) contributes -0.86 percent of GDP to the CA GAP, but is largely offset by a similar policy gap of trading partners. Moreover, negative gaps from fiscal policy and public health expenditure are offset by positive policy gaps from change in reserves and private sector credit.

Romania: EBA-lite Current Account Model Results, 2018

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Source: IMF staff estimates.

Real Exchange Rate

Background

3. The real exchange rate (CPI-based) appreciated by 2.8 percent during the 2018, largely due to higher inflation than in trading partners. The leu real appreciation is in the mid-range of real exchange rate movements of comparator countries. The GDP-deflator based real exchange rate appreciated by about 4.4 percent. Moreover, the unit labor cost increased about 4 percent, as wage growth outpaced productivity growth, and the ULC-based REER appreciated about 5 percent.

4. The REER appreciation trend suggested a decline in Romania competitiveness. Despite the REER appreciation, Romania’s export share increased over the last few years from 0.35 in 2014 to 0.39 percent of total world’s export in 2017. This increase in export share is largely due to exports of FDI enterprises that are integrated in the global value chains and does not necessarily imply that cost competitiveness in exports has improved. However, the increase in imports, as a share of GDP (Box 1), suggests a decline in competitiveness in the domestic market, due to continued wage-driven cost pressures on domestic producers.

uA01fig21

Real Effective Exchange Rate

(Index, 2000=100)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Haver, European Commission and IMF staff calculations.
uA01fig22

Real Effective Exchange Rate

(Percent Change, 2017 2018)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: INS.
uA01fig23

Unit Labor Cost

(Index, 2000=100)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: European Commission and Haver.1/ Based on quarterly data.
uA01fig24

Export Share

(In percent of total world exports)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: Eurostat.

Assessment

5. Based on the Index of Real Effective Exchange Rate (IREER) model of the EBA-lite approach, the estimated REER gap implies an overvaluation of about 10 percent, which is broadly consistent with the CA-model based assessment.

Romania: EBA-Lite IREER Model Results, 2018

article image
Source: IMF staff estimates.

Capital and Financial Flows

Background

6. Based on preliminary data, the capital account recorded inflows of 1.2 percent of GDP, somewhat below the 5-yeard trend of 2 percent of GDP. This largely reflects slow absorption of EU funds. As in the previous years, the net FDI inflows (2.4 percent of GDP) were the main contributor to financing the CA deficit, covering about one half of it. A majority of the FDI inflows are reinvested earnings, and they are expected to continue to play an important role in financing the CA deficits over the medium-term. Portfolio flows at 1 percent of GDP slightly declined in 2018, due to lower sovereign bond issuance. There are no restrictions on the capital and financial account.

Assessment

7. While capital account inflows may pick up in case of a higher absorption of EU funds, the prospects for new FDIs are unclear (due to poor infrastructure, rising labor cost and still high policy uncertainty). Portfolio flows may pick up if the authorities issue more Eurobonds in the currently favorable low-interest rate environment, instead of issuing the bonds on the domestic market. But this could lead to higher spreads.

External Balance Sheet

Background

8. Romania’s net international investment position (NIIP), at -43.6 percent of GDP in 2018, improved over the last five years. The improvement came mostly from a decline in liabilities, in particular other investment (comprising currency and deposits, loans and trade credits) as banks and companies gradually deleveraged.

9. While the NIIP improved in 2018 as a share of GDP compared to the 2017, it deteriorated in nominal terms (about 1%) as accumulation of liabilities was slightly higher than accumulation of assets. By end-2018, direct investment represented about 11 percent of gross assets and 56 percent of gross liabilities while portfolio investment was about 6 percent of gross assets and about 17 percent of gross liabilities.

Assessment

10. The external balance sheet does not appear to be a major source of risk for Romania’s external sustainability. However, other investment liabilities (mostly loans to corporate sector and trade credits) at 20 percent of GDP could lead to liquidity problems in case of a sudden tightening of financial conditions.1 According to staff’s projections, the NIIP is expected to average around -46 percent of GDP over 2019–24.

Reserves

Background

11. Romania’s exchange rate regime was classified as floating in 2018. Gross international reserves stood at 18 percent of GDP and could cover about 4.4 months of prospective imports or about 42 percent of M2. However, reserves stood at 89 percent of short-term debt. Reserves declined marginally in nominal terms, about 1 percent relative to 2017.

uA01fig25

Gross international reserves vs. traditional metrics

(in billion US$)

Citation: IMF Staff Country Reports 2019, 278; 10.5089/9781513512341.002.A001

Sources: World Economic Outlook, International Financial Statistics, and Fund staff

Assessment

12. While lower than in 2017, reserves remain adequate, exceeding thresholds for most metrics. The reserves were above 150 percent of the reserve-adequacy metric developed by the Fund for emerging markets. Reserves are also above comfortable thresholds for most other metrics, except being 89 percent of the short-term debt (at remaining maturity).

Overall Assessment

13. Staff’s overall assessment is that Romania’s external position is weaker than implied by fundamentals and desirable policy settings. Specifically, staff assesses the current account gap to be -1½ to -3½ percent of GDP and REER overvaluation to be 5–10 percent, in line with the EBA model results and taking into account uncertainty around any point estimate. To reduce the external imbalance, staff advises durable fiscal consolidation, greater exchange rate flexibility, and structural reforms to boost productivity and competitiveness.

Annex VII. Implementation of FSAP 2018: Key Recommendations

article image
Agencies: ASF = Financial Services Authority; FGDB = Bank Deposit Guarantee Fund; MoPF = Ministry of Public Finance; NBR = National Bank of Romania.

Time Frame: I (immediate) = within one year; NT (near term) = 1–3 years; MT (medium term) = 3–5 years.

Refers to status or progress, as reported by the authorities.
1

Three elections are coming: in 2019, presidential (end-year); and in 2020, local government (mid-year) and parliamentary (end-year).

2

The recent overhaul of the judicial system laws and initiatives to amend the criminal codes were reflected in a cautionary Cooperation and Verification Mechanism report by the EC in November 2018. According to the report, key problematic provisions of the new judicial system laws included the establishment of a special prosecution section for investigating offences committed by magistrates, new provisions on material liability of magistrates for their decisions, and a new early retirement scheme. The report also noted that proposed amendments of the criminal codes would entail profound changes in the procedural aspects of the criminal investigations and trial, and also reduce the scope of corruption as an offense.

4

This estimate, provisionally cleared by the EC, will be finalized later in the year.

5

IMF Departmental Paper 19/12 “Demographic Headwinds in Central and Eastern Europe.”

6

The key drivers of this assessment are (i) the concern over the continued increase in public debt levels in the medium term in the staff’s baseline projection scenario and (ii) Romania’s persistently elevated sovereign interest rate spreads relative to regional peers.

1

EU structural funds should provide ample FX inflows to finance productive public investments, as long as they are efficiently absorbed. Furthermore, a fiscal FX financing buffer has been built up, which was intended to cover several months of gross fiscal financing needs.

2

Romania began a series of three programs from 2009. In a nutshell, external and fiscal financing gaps at program outset were caused by the GFC financing shock amidst severe FX and term mismatches, with the financing requirements having surged following highly procyclical fiscal policies in the run-up to the 2008 elections.

3

Romania is classified as a Frontier equity market, limiting its foreign investor base.

1

This scenario assumes a drop in real GDP growth to -0.9 percent in 2020 and 2021, with a sharp recovery thereafter.

2

Including GDP, private consumption growth, inflation, imports, the exchange rate, employment growth, and wage growth.

3

Higher absorption of EU funds leads to higher grants and lower capital spending directly funded out of the budget. Both in turn result in a slight increase in total capital spending over the medium term.

4

The scenario assumes that the widening fiscal deficits trigger a 300 bp increase in financing costs and a zero net impact on GDP growth rates, as the direct fiscal stimulus and worsening economic sentiment broadly offset.

1

They are partly offset by claims of Romanian corporate sectors toward non-residents.

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Cover IMF Staff Country Reports
Romania: 2019 Article IV Consultation-Press Release; Staff Report; Staff Supplement; and Statement by the Executive Director for Romania
Author:
International Monetary Fund. European Dept.
Volume/Issue:
Volume 2019: Issue 278
Publisher:
International Monetary Fund
ISBN:
9781513512341
ISSN:
1934-7685
Pages:
81
DOI:
https://doi.org/10.5089/9781513512341.002
Figure 1.

Romania: Consumption-Led Growth and Imbalances

Growth Contribution

(Percent)

Unemployment Rate and Employment

(SA, percent)

CPI Inflation

(Year-over-year percent change)

Inflation and Contributions

(Percent, Y-o-Y)

Trade Deficit by Component

(Percent of GDP)

House price index

(Year2015 = 100)

GDP, Bank Assets and Bank Credit to Private Sector

(NSA, y-o-y, % change)

Fiscal Outlook and Staff Recommendation

Interbank Offered Rates

(3 month, percent)

Illustrative Macroeconomic Scenario with Recommended Fiscal Consolidation

Progress with Structural Reforms (Relative to CEE peers)

Trade in Consumption Goods: 2009–18 1/

(Percent of GDP)

Fiscal and current account deficits (percent of GDP)
Figure 2.

Romania: Real Sector, 2007–19
Figure 3.

Romania: External Sector, 2007–19
Figure 4.

Romania: Labor Market, 2007–19 1/
Figure 5.

Romania: Monetary Sector, 2007–19
Figure 6.

Romania: Fiscal Operations, 2008–20
Figure 7.

Romania: Financial Sector, 2007–18
Figure 8.

Romania: Financial Developments, 2013–19

Long-term Sovereign Credit Rating Since Romania’s EU Accession

Romania vs New Member States: Twin Deficits
Annex Figure 1.

Romania: Recent Market Developments

GaR for Romania: Projected GDP Growth 1-year Ahead

GaR for Romania: Baseline GDP Growth Distribution vs. Scenario of External Financial Shock
Figure 1.

Romania: Public DSA Risk Assessment
Figure 2.

Romania: Public DSA – Realism of Baseline Assumptions
Figure 2.

Romania: Public DSA – Realism of Baseline Assumptions
Figure 3.

Romania: Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(in percent of GDP unless otherwise indicated)
Figure 4.

Romania: Public DSA – Composition of Public Debt and Alternative Scenarios
Figure 5.

Romania: Public DSA – Stress Tests

External Debt Path

(In percent of GDP)
Figure 6.

Romania: External Debt Sustainability: Bound Tests 1/, 2/

(External Debt in percent of GDP)

Current Account

(In percent of GDP)

Real Effective Exchange Rate

(Index, 2000=100)

Real Effective Exchange Rate

(Percent Change, 2017 2018)

Unit Labor Cost

(Index, 2000=100)

Export Share

(In percent of total world exports)

Gross international reserves vs. traditional metrics

(in billion US$)