Romania: Concluding Statement of the 2015 Article IV Mission
February 9, 2015
IMF Press release:
Following the global crisis, the Romanian economy has largely corrected internal and external imbalances with a mix of sound macroeconomic policies. However, convergence has stalled and weak public infrastructure has emerged as a key bottleneck for a higher growth trajectory. At the same time, Romania remains vulnerable to external shocks and the repair of balance sheets is not yet complete. Going forward sustainable macroeconomic policies need to be combined with measures that boost the efficiency of public spending—in particular an acceleration of EU-funds absorption to upgrade public infrastructure—, re-invigorate delayed state-owned enterprise reforms, and resolve crisis legacies in the financial sector.
Economic outlook and risks
1. GDP recovered in 2014 to its pre-crisis level and the growth momentum is becoming more entrenched. Strong private consumption and exports supported the economic rebound last year, while investment remained subdued. Staff expects real GDP to grow by 2.7 percent in 2015 and 2.9 percent in 2016. Firming private consumption—against the backdrop of strong real wage growth, low oil prices and record low interest rates—is projected to be the main driver. As domestic demand strengthens, the current account deficit is forecast to widen somewhat this year. Imported low inflation and a persistent negative output gap will likely keep inflation substantially below its target during most of 2015.
2. Risks to the outlook are titled to the downside. Renewed volatility in the global financial market or the euro area as well as a protracted period of slow growth and low inflation in the euro area could put strains on the Romanian economy. Due to relatively limited trade and financial linkages to Russia and Ukraine, direct effects from geopolitical developments should be manageable, however. Domestically, in the absence of needed reforms, continued underperformance of EU funds absorption would delay a much needed infrastructure upgrade.
3. Potential growth is currently projected at around 3 percent in the medium term. The mission estimates that ratcheting up EU funds absorption substantially, leading to a greater density and higher quality of infrastructure, could boost this growth by about ½ percentage point annually over the medium term.
Fiscal policy: budgeting and building institutions for the future
4. Romania has continued to reduce fiscal vulnerabilities. Over the past six years it relied primarily on expenditure cuts to bring the fiscal deficit to 1.9 percent of GDP in 2014, a 7 percentage point reduction in structural terms. The deficit target for 2015 of 1.8 percent of GDP will help to put public debt on a gradual downward path and strengthen resilience of public finances. Going forward, fiscal policy will be anchored by the medium-term budgetary objective (MTO).
5. However, spending pressures are building. More effective public investment, driven by greater EU funds absorption, is needed to address a rising infrastructure gap. Despite a history of capital spending above the average in peer countries, Romania’s infrastructure density is relatively low and quality is perceived to be the worst in the EU, reflecting wasteful spending and weak medium-term planning, despite some efforts made to improve investment project prioritization. Moreover, the authorities plan to permanently raise defense spending in coming years, and face age-related social spending pressures as well as contingent fiscal liabilities related to court cases on restitution and other payments.
6. Thus, fiscal structural reforms will be key to consolidating the fiscal adjustment. In particular, revenue mobilization is still far below potential despite some efforts to improve tax administration. On the spending side, stronger public expenditure management and planning and better project management are needed to improve efficiency and support a shift in budget resources toward EU funded projects. At the same time, further reforms of the health sector could address the projected expansion of health-related spending. Until such reforms deliver results, there is no room to lower tax rates unless fully offset by other fiscal measures.
Monetary policy: anchoring expectations in uncharted waters
7. The mission supports further easing steps amid declining inflation expectations, sharply lower oil prices, a persistent negative output gap, and ECB monetary easing. The mission also recommends a gradual transition of the conduct of monetary policy to a more full-fledged inflation targeting regime by reducing the role of the exchange rate in the policy framework and continuing to narrow the interest rate corridor. This could help strengthen the clarity of monetary policy signals and the transmission channel.
8. The exchange rate is currently broadly in line with medium-term fundamentals. Moreover, reserve coverage is generally adequate according to most reserve adequacy metrics. Going forward, the mission recommends limiting interventions in the foreign exchange market to smoothing excessive volatility and maintaining a prudent stance with moderate reserve accumulation in light of continued downside external risks.
9. To prepare for the authorities’ stated objective of euro adoption, reaching a sufficient level of real convergence would be important.
Structural reforms: rekindling momentum and focusing on infrastructure
10. Mixed progress in structural reforms is holding back Romania’s medium-term growth prospects. The dominance of inefficient state-owned enterprises (SOEs) in the transportation and energy sectors has hindered higher quality public service delivery and modernization of the infrastructure. While the SOE arrears have been reduced substantially (by around 1½ percent of GDP since end-2012) and the financial position of some of the large SOEs has recently improved, the financial weakness of others remains a burden on the state budget, either directly through transfers or indirectly through foregone revenue.
11. Better SOE corporate governance, a concept that still has to be fully embraced and suffered a setback particularly in 2014, would enhance SOE performance and public service delivery. Going forward, strict implementation of good governance principles, underpinned by a stronger legal framework and an effective enforcement mechanism, are needed to rebuild the reforms’ credibility.
12. Improving the operational efficiency of many large SOEs will require aggressive restructuring and, in some cases, liquidation. Private-sector involvement through majority or minority ownership is also a useful tool to bring in expertise and funding as well as to raise transparency. Successful initial public offerings in three large energy companies point the way for a greater role for private capital in the future. However, the transport sector needs to urgently catch up to these developments.
13. Romania should also build on the good progress made in improving the pricing in the energy sector. Gas and electricity market deregulation for non-residential consumers is a major achievement. This should be followed by restarting the gas tariff deregulation for households, while at the same time further strengthening the support for the most vulnerable consumers.
14. Boosting medium-term growth prospects also requires continued efforts to encourage higher labor participation. Focus should be on the young, low-skilled and women, among which participation in the formal labor market is far below the EU average. Recommended measures include implementing the new vocational training programs, maintaining wage competitiveness for low income earners via moderate minimum wage increases, and further lowering the labor tax wedge for low-income earners through targeted measures, preferably financed by base-broadening.
Financial sector: rejuvenating intermediation
15. The banking sector continues to maintain adequate capital, liquidity and provisioning buffers, and asset quality has improved. Following a comprehensive NBR action plan, non-performing loans were reduced in 2014 by about 8 percentage points of total loans but bank balance sheet repair is still incomplete. Banks have also closed provisioning gaps, leaving coverage at conservative levels. NBR stress tests indicate that the solvency of the banking system would generally be resilient to severe scenarios, but require additional capital in a few banks. Pressure from the Swiss franc appreciation is manageable for the banking system, given the relatively low share of Swiss franc loans. The mission encouraged voluntary bilateral loan restructurings taking into account the repayment capacity of the borrower.
16. Rejuvenating financial intermediation remains a challenge. Foreign bank deleveraging has slowed but together with other supply factors held back a rebound in credit growth. On the demand side, a scarcity of bankable loans and the relatively high indebtedness of SMEs contributed to negative credit growth since mid-2013. Enabling long-term bank funding—including by adopting a covered bonds law—, and strengthening the existing support tools for SME lending would benefit intermediation in combination with record low interest rates and the on-going recovery of the economy.
17. Romania is in the process of modernizing its insolvency regime but not all elements are yet in place to ensure its efficacy. The new Corporate Insolvency Law still needs to be tested. Before putting in place a new Personal Insolvency Law an impact assessment and stakeholder consultation should be carried out as well as appropriate institutional support created. This would help ensure that a new framework can be properly implemented and provide those with unsustainable debt a fresh start without endangering the payment culture.
18. The non-bank financial sector and its supervisor face important challenges. An important initiative is underway to remove barriers to capital market development, with the adoption of a revised capital market law still pending. Moreover, the insurance market is troubled by insolvency issues and weak business practices, which need to be tackled forcefully by the supervisor.
The IMF mission team would like to thank the Romanian authorities and other counterparts for their warm hospitality and the open and constructive discussions.
