Banca Naţională a României

INTERNATIONAL MONETARY FUND

Romania. October 2006 Staff Visit

Aide Memoire, October 10, 2006

1. Romania's successful transition, accompanied by strong growth and considerable disinflation, is expected to culminate in EU membership on January 1, 2007. This performance reflects responsible macroeconomic management and advances in structural reforms. At the same time, confidence in the country's long-term prospects is high, as evidenced by large inflows of foreign direct investment and international ratings upgrades. The authorities recognize the need to continue with macroeconomic stabilization and structural reform. This represents a welcome agenda to prepare the economy for successful EU membership, and to help realize Romania.s full potential and raise living standards.
2. The authorities' intentions need to be backed by the continuation of appropriate policies. The risks of overheating and a widening current account deficit threaten macroeconomic stability and growth prospects. Following various discussions, the mission believes that policies to address emerging risks have not been formulated or elaborated systematically. The current juncture calls for decisive action (namely, tight fiscal, incomes, and monetary policies) to minimize external and financial-system vulnerabilities, and maximize the benefits from EU accession. Structural reforms should continue to focus on further improving the business environment, increasing incentives for job creation, and developing the capacity for the effective utilization of EU funds.



I. MACROECONOMIC BACKGROUND



3. Strong growth continues and headline inflation is on a downward path. These positive outcomes are the result of tight fiscal policy (a significant budget surplus until August), moderate wage policy (particularly in the monitored state-owned enterprises (SOEs) and the minimum wage), and tight monetary policy. The National Bank of Romania (NBR) refrained from intervening in the foreign exchange market, and acted decisively to tighten monetary conditions, increasing the policy interest rate in two steps to the current level of 8.75 percent, and increasing reserve requirements on both foreignexchange and lei-denominated liabilities.
   • Real GDP growth accelerated to 7.4 percent y/y in the first half of 2006, driven by strong growth in construction, industrial output, and services, and the mission projects real GDP growth of over 7 percent for the year. Domestic demand was driven by a sharp increase in private consumption and investment, supported by robust wage and credit growth. Import growth remains strong and continues to outpace exports.
   • Disinflation continues with CPI inflation at 6 percent y/y in August - helped significantly by the postponement of administered price increases, falling agricultural prices, and an appreciating currency in the first half of the year. The mission projects an inflation outturn of 5.7 percent for end-2006 (within the central bank's target range).
4. Nonetheless, core inflationary pressures are building and the current account deficit is widening. Driven by the ongoing strength of aggregate demand, core inflation's (excluding administered prices, food, and fuel) declining trend has stalled. Strong credit growth (48 percent in real terms in the year to July) has paralleled a widening current account deficit, suggesting that excess demand pressures continue. On current trends, the mission projects a current account deficit of 10½ percent of GDP in 2006. And although non-debt creating inflows are covering a substantial part of the deficit and international reserves provide a substantial cushion, the tapering-off of privatization receipts and the widening deficit will increase Romania's vulnerability.
5. Fiscal performance has been strong so far, but the envisaged pro-cyclical fiscal loosening for the remainder of the year is worrisome. Higher-than-budgeted tax collections (on account of above-potential growth and improved revenue administration) and slow execution of the capital budget have led to a surplus of 1.6 percent of annual GDP in the first eight months of 2006. However, pressures on current spending during the course of the year (reflecting insufficient allocations for wages, transfers, and other goods and services in the original budget) have led to an increase in the deficit target from 0.5 percent of GDP to 0.9 percent (in April) and to 2.5 percent (in July). If the government's spending plans materialize and last December's sharp increase in spending is repeated, this would represent a significant fiscal relaxation. Moreover, given an already-stretched capacity to absorb funds earmarked for infrastructure, this loosening threatens to spill into current spending, rather than capital expenditure.
6. Although increases in the minimum wage and the SOEs. wage bill were moderate, pro-cyclical budget-sector wage (and employment) policies have exacerbated excess demand pressures. On a positive note, the minimum wage was increased moderately in 2006 (from RON 310 to RON 330) and the wage bill of the monitored SOEs has remained under control (an increase of about 5 percent). Although wage increases in the budget sector were lower than in 2005, they have outpaced the ones of the private sector. The original 2006 budget included a 5.5 percent of GDP allocation for wages, which was insufficient given the authorities' original wage policy - this called for average statutory budget-sector wage increases of 12-15 percent in two rounds. Moreover, significant increases in general government employment have accentuated pressures on the government's wage bill, which, on current trends, is projected to increase by 32 percent in 2006. This year's wage bill will be equivalent to 6 percent of GDP, compared with 5.4 percent in 2005 and 4.8 percent in 2004.
   
   

   I. MACROECONOMIC OUTLOOK AND POLICY RECOMMENDATIONS

   
   Economic outlook and the policy mix
   
   
7. The envisaged policies for next year will make meeting the authorities' key macroeconomic goals difficult. With the economy already overheating, the fiscal loosening coupled with a loose wage policy will exacerbate domestic demand, and contribute to a wider current account deficit and greater inflationary pressures. On the basis of the authorities' current fiscal plans for 2007 (a deficit of 2½ percent of GDP) and a loose wage policy, the mission's baseline scenario projects continued strong GDP growth in 2007, a widening in the current account deficit to 12½ percent of GDP, and an inflation outcome of 6.4 percent at end-2007. Such macro outcomes increase the risk of a loss in market confidence and sudden capital outflows.
   
   Fiscal and incomes policies
   
   
8. The mission views the envisaged fiscal policy stance for the remainder of 2006 as problematic. Beginning from a very strong position of a 1.6 percent of GDP surplus at end-August, it is the mission's understanding that a significant increase in expenditure is planned for the remainder of the year. Such a policy would exacerbate inflationary pressures and widen the current account deficit. Thus, the mission strongly urges the authorities to maintain fiscal prudence during the remainder of this year and aim for an annual general government deficit of below 1 percent of GDP.
9. In addition, the budget discussed by government for 2007 would further accentuate macroeconomic imbalances. The mission has the following concerns:
   • With the economy growing above potential, a deficit target of 2½ percent of GDP implies a significant procyclical fiscal loosening. This lack of coordination with monetary policy cannot credibly bring about lower inflation and interest rates.
   • Expenditures on wages have been underestimated again, as the budget does not include any allocation for statutory wage increases next year.
   • Two wage rounds are contemplated, despite targeting low single digit inflation.
   • Although current revenue performance is encouraging, projections for next year are optimistic.
   • With expenditure projected to increase by ¼ in 2006 and 2007, there is a risk that the efficiency and quality of public spending will deteriorate.
   • The mission has doubts about the ability of the government to spend the allocated amount on capital expenditures (6.6 percent of GDP compared with an outturn of 2.6 percent in 2005 and a budgeted 4.1 percent in 2006).
   • Related to the above, there is a danger that during the course of next year, underspending on capital could be reallocated to current spending.
10. Thus, the mission urges the authorities to approve a 2007 budget consistent with a reduction of macroeconomic imbalances. Such a budget should aim at fiscal consolidation based on strengthening the revenue base, while being fully transparent regarding the policy intentions in the various expenditure areas (e.g., wages). A nearbalanced budget in 2007 will help contain inflation and the current account deficit, while relieving some of the burden on monetary policy and safeguarding growth prospects.
11. There is a need to permanently strengthen budget revenue and improve fiscal management. Regarding the former, additional resources are needed to meet infrastructure needs, finance cuts in the (high) social contributions tax, and cover contributions to the EU budget and co-financing of EU projects. As for fiscal management, the mission urges the authorities to strengthen management of capital spending, improve the capacity to absorb EU funds, avoid frequent budget rectifications, and develop a medium-term fiscal framework.
12. A prudent wage policy is essential for disinflation. Following the recent wage bill overruns, a tightening of public-sector wage policy is needed, which will give the signal for prudent private-sector settlements. The mission urges the authorities to gear their wage policy to the needs of a low inflation European economy by adhering to their commitment to a single (moderate) wage increase next year, which should be incorporated in the budget. Moreover, following the recent substantial increases in employment in the general government, a careful review of any additional hirings is needed. The mission finds the proposed minimum wage of RON 390 (an increase of 18 percent from the current RON 330) inconsistent with the objective of disinflation. Thus, it urges the authorities to approve a moderate increase in the minimum wage and in the wage bill of the monitored SOEs, as was the case in 2006.
    
    Monetary Policy
    
    
13. The NBR should continue to focus on inflation. On the basis of recent developments, including positive shocks to agricultural prices and the impact of an ongoing trend appreciation, the mission believes that CPI inflation will likely fall within the official target range for end-2006. However, inflationary prospects for 2007 are more worrying, particularly in light of the authorities. fiscal and incomes policy intentions. Given the ongoing strength of excess demand, and the pending increase of administered prices, and in light of the fact that monetary policy typically operates with a significant lag, inflation will likely exceed the upper band of the 2007 target range unless the authorities act firmly and quickly to tighten monetary policy further. Moreover, the mission would stress that meeting the 2007 target will require substantial support from fiscal and incomes policies. The authorities' inflation objectives are laudable and feasible. However, if the government proceeds with the envisaged fiscal loosening, the central bank will face an extremely challenging task - one in which further disinflation will necessarily entail a steeply aggressive hike in interest rates, and perhaps an unduly rapid pace of appreciation with possible further consequences for the current account deficit.
14. Credit developments are still a concern. Although the authorities' measures have helped reduce foreign-currency denominated lending over the past year, foreign-currency loans to households are starting to grow once again, while local-currency credit is expanding dramatically. The mission notes that real convergence with other EU members will naturally require an expanding financial sector. However, in terms of prudential risk, overly rapid credit growth can magnify existing distortions and raise medium-term vulnerabilities, so the authorities are urged to maintain continued vigilance. Still, in the view of the mission, the ongoing strength of credit demand parallels the continuing strength of excess aggregate demand. And in this context, the mission cautions that prudential-style policy tools are generally ill-suited to addressing a macroeconomic stabilization problem.as a first best response to growing demand, the focus of monetary policy should be on higher interest rates.

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We commend the authorities for implementing policies that have led to the successful transformation of the Romanian economy and to EU accession. But full integration is not yet complete and we urge the authorities to continue implementing prudent policies that, combined with the gains from EU membership, will put a rapid improvement in living standards within reach. We thank the authorities for their close cooperation with the mission, their generous hospitality, and for the constructive discussions.