Commission Report 2002 (Romania)

The existence of a functioning market economy

The consensus about the fundamental goals of economic policy has progressively broadened but fears of high political and social costs still deter a more resolute implementation of structural reforms. Support for macroeconomic stabilisation and structural reform has often proved to be shallow and narrow, contributing to the large gap between policy goals and achievements, and to a frequently disjointed decision-making process. There are, however, growing indications that the consensus about the essential aims of economic policy may be broadening. After lengthy debates, in March 2000 the government managed to agree on a Medium Term Economic Strategy, which was broadly endorsed by all political parties. The change of government at the end of 2000 did not lead to any fundamental modification of the ultimate goals of economic policy, which were strongly re-stated through the approval of Romania`s first Pre-Accession Economic Programme in mid-2001 and the conclusion of a new IMF arrangement in October 2001. At the same time, improved co-ordination among ministries and between the government and the central bank facilitated the adoption of a more balanced policy mix. This progress, however, has not yet led to a significant acceleration in structural reforms leading, inter alia, to delays in disbursements from the IMF.

Although the economy has contracted in real terms relative to 1997, GDP growth resumed in 2000 on the back of rising domestic demand. Recording an average period growth of oe1%, the economy has not fully recovered from the recession of 1997-1999, when real GDP contracted by a cumulative 11.7%, and investment by nearly 9%, as the economy struggled to cope with various negative shocks against a background of indecisive policy action and faltering investor confidence. After a modest rebound in 2000, however, GDP expanded by 5.3% in 2001 on account of three main factors. Private consumption boomed on the back of rising real wages and income. Stock building continued to rise, hinting at unresolved statistical problems in the estimation of GDP components or at a persistent accumulation of unsold products by enterprises with soft-budget constraints. Investment accelerated for the second year in a row, partly as a result of distortionary tax incentives offered to small and medium-sized enterprises (SMEs). Although the strengthening domestic demand led to an increasingly negative contribution by the external sector to growth, exports expanded at double-digit annual rates from mid-1999 until the last quarter of 2001, when growth slowed down sharply as the external economic situation worsened. The economic recovery, however, has remained resilient. In the first quarter of 2002, GDP increased by 3.1% as import growth came to a near halt while exports rebounded somewhat and domestic demand continued to expand, albeit at a slower pace.

The current account deficit has been high and its sustainability a frequent source of concern. Recent trends, however, point to an improved situation. The current account deficit has fluctuated around a period average of 5.3% of GDP. External financing was called into question when the deficit peaked at 7.1% of GDP in 1998 against the background of a severely misaligned exchange rate, a rising trade deficit, dwindling reserves, a bunching of debt repayments and adverse international financial conditions. To stave off a full-blown external crisis, the authorities accepted a large devaluation of the real exchange rate and tightened policies while continuing to service their foreign debt. Following two years of successful external consolidation, however, the current account deficit widened again to 5.9% of GDP in 2001, when the trade deficit rose to 7.5% of GDP on the back of the strengthening recovery and various one-off factors boosting import growth. Unlike in the past, however, the external deterioration was kept in check thanks to the timely tightening of the policy stance in the second half of 2001. In the first half of 2002, this combined with rebounding exports of goods, lower prices for energy imports and an underlying trend towards higher private transfers from abroad and lower service trade deficits to cause a significant reduction in the current account deficit. Financing the external deficit has also become less problematic thanks to a steady inflow of foreign direct investment (FDI), averaging nearly 3.5% of GDP, a positive error and omission item, rising to 2.6% of GDP in 2001, and improving borrowing conditions. In April 2002, Romania launched its first ten-year bond on the international market, reaping the benefits of various upgrades granted by rating agencies since 2000 and of its improving vulnerability indicators. The debt-to-GDP ratio remains low while its average maturity has lengthened. Reserves` import coverage has also been on a rising trend, reaching 4.4 months by June 2002.

Over most of the period, unemployment remained fairly low and relatively constant owing to the limited progress achieved in economic restructuring. The unemployment rate (ILO definition) averaged 6.2%. After rising moderately during the three-year recession, it decreased to 6.6% in 2001 on the back of the on-going recovery. In the first quarter of 2002, however, the unemployment rate rose sharply to 10%, possibly largely due to seasonality and administrative factors linked to the introduction of a minimum income guarantee scheme. Recent trends in the registered unemployment rate support this view. Unemployment is much higher among the young and of a long-term nature for more than half of job-seekers. Between 1997 and 2001, the activity rate decreased from 71.5% to 68.3%. Average employment in industry dropped by more than 15% and the workforce of public enterprises was cut by nearly a fifth. Yet, total employment decreased by less as the agricultural sector absorbed a large proportion of dismissed workers. Along with the relative stability of the unemployment rate, the resulting increase in the share of agricultural employment, reaching 44.4% in 2001, suggests the existence of large pockets of underemployment in the economy.

Inflation remains high but has declined steadily since mid-2000 on the back of a more coherent policy stance. Even excluding the 1997 spike caused by the belated liberalisation of the exchange rate and of energy and agricultural prices, the annual inflation rate has been high at 46.3% on average. Inflation has been the most visible symptom of the economy`s structural weaknesses and macroeconomic imbalances. Since mid-2000, however, it has been on a steadily declining path. Unlike in the past, from mid-2001 onwards disinflation has been achieved despite simultaneous high but warranted increases in energy tariffs. After totalling 45.7% in 2000, average yearly CPI inflation fell to 34.5% in 2001. The year-on-year rate has also dropped sharply, decreasing to 23.0% by July 2002.

Due to more supportive conditions, the present monetary policy framework has led to increased macroeconomic stability. Monetary and exchange rate policies were relieved of their quasi-fiscal functions in early 1997 but the central bank initially remained unable to sustain a stance geared to price stability. Other policy objectives routinely took precedence in an environment characterised by a fragile external position, a weak financial sector, widespread financial lack of discipline, and unsupportive fiscal and income policies. Progress on these fronts, however, has allowed the monetary authorities to increasingly focus on disinflation. Within the framework of the managed float regime adopted in 1999, the exchange rate is used as the main anti-inflationary instrument as long as this does not endanger the external balance. Thanks to an improved external outlook, productivity increases and more supportive wage trends, the real exchange rate could appreciate some 17% against the euro between 1999 and 2001 without imperilling the external accounts. However, new challenges are emerging with strong capital inflows forcing the central bank to engage in costly sterilisation operations. These totalled some 16% of GDP in volume over 2001 and continued at a sustained rate over the first half of 2002. Nevertheless, broad money has expanded rapidly with the real year-on-year growth rate turning positive at the beginning of 2001 and accelerating to above 16% by June 2002. In view of the faster than expected disinflation in the first half of 2002, however, the authorities recently allowed real policy interest rates to drop after letting real money market rates rise over 2001. Various measures were also taken recently in an attempt to slow down an on-going rapid expansion in foreign-currency denominated credit.

The authorities have been adopting an increasingly responsible fiscal stance. At 4% of GDP on average, the general government deficit has remained under control despite direct banking sector restructuring costs of some 4.5% of GDP over 1999 and 2000. After peaking at 4.5% of GDP in 2000, the general government deficit was cut to 3.4% of GDP in 2001 thanks to a tightening of policy in the second half of the year. This restored a moderate primary surplus and made it possible to achieve the target agreed with the IMF despite lower-than-planned revenues. After rising sharply from very low levels, the gross debt ratio was stabilised in 2000 and cut to 23.3% in 2001. Developments during 2002 have remained broadly positive. Thanks to strict expenditure control and increases in excise taxes compensating a shortfall in revenues, the 2.6% of GDP deficit target for the year remains achievable. Relative to 1997, GFS-based data indicate that, at 30.5% of GDP, revenues have increased by nearly 2 percentage points thanks to a higher rate of collection of indirect taxes. After increasing on the back of rising interest payments until 1999, and higher non-interest spending in the run up to the 2000 election, expenditure has been brought back to about 34% of GDP with cuts in public investment counterbalancing a slight increase in current expenditure.

Despite recent progress, fiscal consolidation needs to be put on a sounder footing by tackling the remaining unresolved issues. Tax arrears have typically been tolerated and regularly cancelled. Under the latest IMF arrangement, for instance, monitored enterprises` arrears to the budget rose above the agreed targets, increasing by 13% in the first four months of 2002 after a temporary fall in the second half of 2001. Further undermining tax discipline, tax codes have also changed frequently, often to offer targeted incentives to specific economic groups. Some progress, however, has been achieved with the recent approval of more transparent procedures for the cancellation of tax arrears and, most notably, with the enactment of new VAT and profit tax laws that constitutes a significant effort towards the elimination of tax exemptions and distortionary tax incentives. The establishment of a new minimum income guarantee scheme in late 2001 was an important step towards the creation of a better-targeted social safety net. Measures are also being taken to improve the institutional framework for budgetary policy and tax administration. The 2002 budget was the first to be approved within the mandated time limits and a new improved public finance law was recently approved. The number of extra-budgetary funds has been reduced. Procedural and administrative changes are being carried out to address the systemic weaknesses affecting tax administration. However, significant medium-term challenges still need to be faced, including the reform of the increasingly unbalanced public pension system, the orderly implementation of on-going fiscal decentralisation and the need to support transition by providing an effective social safety net and adopting a more growth-enhancing structure of revenue and expenditure.

Romania has a mixed track record of policy-making geared towards economic stability. Although the policy mix has become more balanced of late, some concerns remain. By often failing to adopt the most appropriate macroeconomic policy mix and repeatedly holding back from advancing the structural reforms needed to support successive stabilisation programmes, the authorities have directly contributed to the boom-and-bust nature of Romania`s economic performance. Signs of more responsible behaviour, however, have begun to emerge, most notably with the tightening of the inappropriately loose policy stance adopted in the run up to the general elections at the end of 2000 and at the beginning of the new administration. The adoption of a more coherent mix in the context of a new IMF stand-by arrangement was instrumental in halting the deterioration of the current account and supporting disinflation in the face of necessary increases in energy tariffs. So far, however, the authorities have failed, yet again, to put the process of macroeconomic stabilisation on a sounder basis, making insufficient advances in enterprise reforms and allowing the wage bill and the arrears stock of public enterprises to rise above the levels agreed with the IMF. Finally, in June 2002, the government signed an agreement with two trade unions providing for a 50% increase in the minimum wage and a reduction in the minimum income tax in 2003 that could endanger the future pace of disinflation. Safeguarding measures, including a tightening of the fiscal stance in 2003, were agreed only later with the IMF and will need to be strictly implemented to sustain stabilisation. In this regard, the sharp growth in money and credit observed since late 2001 also requires continued monitoring.

Most prices are liberalised. Despite diminished direct intervention by the authorities, poor payment discipline continues to affect the workings of the price mechanism. Currently, price regulations apply to eighteen goods, ten of which are included in the consumption basket accounting for a share of 20.4%. The responsibility for price administration is entrusted to the Competition Office and the energy regulators. Although formally independent, the energy regulators have not been immune from political pressure and administered prices have often lagged behind inflation. Recently, however, regulated prices have been adjusted over and above inflation. Most notably, since mid-2001 the prices for electricity, heating and natural gas have been brought progressively closer to international and cost recovery levels. To protect this achievement, electricity and heating tariffs were tied to the US dollar in July 2002. However, this important relative price adjustment has not fully fed through the economy because of a worsening in the collection rates of energy enterprises over 2001. Recent positive efforts to address this problem include the establishment of escrow accounts for intra-sectoral payments, some disconnection of delinquent users, and rescheduling agreements conditional on the payment of current obligations. However, without more fundamental reforms, particularly with regard to the privatisation or liquidation of large loss-making public enterprises, poor payment discipline will continue to affect the functioning of the price system. Progress towards this goal will also require the authorities to continue refraining from the ad hoc protective trade measures used in the past.

The private sector has continued to grow but the weight of large loss-making public enterprises remains high. Averaging 63.7% over the period, the share of the private sector in GDP has steadily increased, climbing some 6.5 percentage points to 67.1% in 2001. By end-2000, private-majority establishments accounted for roughly three-quarters of all employment, turnover and export. However, public companies still accounted for more than 40% of enterprise investment and 75% of all tangible assets. With the weight of private ownership expanding in all sectors, the continuing influence of public ownership largely rested upon its dominant role within the energy sector, which accounts for 30% of total industrial turnover. In the agricultural sector, nearly all land is privately owned but the development of an effective land market is still at an early stage. Despite some progress, property titles are not yet fully clarified. This and the limited progress in the privatisation of agricultural companies hold back the consolidation of fragmented holdings.

Amid procedural changes, repeated delays and frequently untransparent procedures, privatisation has made some progress . The sluggish pace of privatisation recorded so far reflects the limited attractiveness of many enterprises on offer but is ultimately due to the authorities` failure to overcome the political and social obstacles to faster divestiture. Rather than accelerating the process, numerous changes in privatisation methods, conditions, and administrative responsibilities have contributed to its slow pace and facilitated the proliferation of opaque procedures that deter investors` interest. Progress has nevertheless been achieved since the Opinion, particularly with respect to small and medium-sized enterprises. Some success has also been achieved with respect to larger companies, most notably with the sale of Banca Agricola and SIDEX. In agriculture, 207 companies have been sold and 256 are undergoing privatisation out of a total of 739 entities. Preparations for the privatisation of various energy companies have also started to make progress, albeit slowly. On the whole, however, the divestiture of large enterprises has been protracted despite international assistance. As a result of the enduring difficulties encountered in privatisation, the authorities missed the privatisation targets agreed with the IMF and the World Bank for the first half of 2002. A recent flurry of new offers and the approval of yet another law aiming at accelerating privatisation will need to be judged on results.

Welcome initiatives to improve the institutional provisions for market entry and exit must be accompanied by a greater effort to impose market discipline throughout the economy. Since 1997, the annual increase in economic units recorded in the Trade Register has averaged 7%. The number of active enterprises, however, has declined by nearly 3%, reflecting a strong growth in the number of self-employed entrepreneurs. To facilitate market entry, administrative measures have been taken to reduce lengthy bureaucratic procedures and red tape. In particular, one-stop offices for simplified registration and authorising procedures were instituted in 2001. Important initiatives aimed at improving market exit have also been launched. In an attempt to streamline procedures, bankruptcy legislation for non-financial enterprises has been amended several times, most recently in February 2002. Implementation, however, remains weak. In the banking sector, the bankruptcy legislation introduced in 1997 also failed to provide an effective exit mechanism. In October 2001, it was modified and extended to credit co-operatives. Despite these efforts, uncertainties about property rights, frequent changes in laws and regulations, and difficult access to financing continue to hamper market entry. More fundamentally, several nonviable industrial enterprises have been allowed to survive, hindering the reallocation of resources to more productive uses.

Having established most of the legal framework for a market economy, Romania must ensure its sustained implementation. Despite some improvements and strengthened efforts, Romania has made insufficient progress towards the establishment of a positive investment climate and favourable business environment. To this end, tax regulations should be streamlined. Legal certainty should also be strengthened, eliminating remaining uncertainties about property rights, refraining from changing regulations frequently and ensuring a non-discretionary interpretation of the law by improving courts` effectiveness.

The banking sector has strengthened considerably but still cannot provide effective intermediation between savers and investors. Its continued development depends on the completion of privatisation and the sustained implementation of an improved supervisory and regulatory framework. The development of the banking sector was seriously hampered by the slow pace of reform and by the misuse of public banks as instruments for subsidisation. A creeping banking crisis forced the authorities to act between 1998 and 2000 when several problem banks were closed or cleaned up and privatised, overhauling the structure of the sector. In 1997, seven state-owned banks held nearly 80% of all loans. In March 2002, only three state-owned banks remained, accounting for 35% of the credit stock. The largest one, BCR, is in the early stages of privatisation. The share of foreign institutions has also increased with thirty-two foreign-owned banks and branches accounting for more than half of total banking sector net assets, and three-fifths of all loans by March 2002. Largely due to the clean up or closure of problem banks, vulnerability indicators have improved dramatically. The capital-adequacy ratio increased from 14.5% at end-1997 to 27.1% in June 2002. The share of non-performing loans fell from 71.7% at end-1998 to 2.8% in June 2002 and prudential reports indicate that past due and doubtful claims dropped from over 250% of commercial banks` own capital at end-1998 to some 2.8% in June 2002. Taking advantage of much strengthened supervisory powers, the National Bank of Romania will need to rigorously apply the significantly improved prudential regulations to avoid any renewed deterioration in the financial health of the banking sector, especially in view of the on-going expansion of credit and deposits. Real year-on-year growth of deposits and credit to the non-government sector resumed in 2001 and accelerated strongly from a low base. The banking sector, however, remains underdeveloped. Total assets still amount to less than 30% of GDP, deposits to some 20% and domestic credit to little more than 10%. Occasional scandals point to persisting governance problems, at least among domestic banks. A low, albeit rising, average profitability depends upon a large spread between deposits and lending rates which equalled 16.4% in June 2002.

Although strengthened supervision and other institutional developments have set the stage for the growth of non-bank financial markets, these are still underdeveloped and will be unable to mobilise significant funds for years to come. The equity markets remain small with the total aggregate capitalisation of the Bucharest Stock Market and the over-the-counter RASDAQ amounting to some 7% of projected GDP in July 2002. Privatisation has recently been completed in the insurance sector which has grown steadily but remains underdeveloped: gross insurance premiums collected in 2001 amount only to some 1% of GDP. To support the development of the non-banking financial sector, the authorities have been taking steps to strengthen the supervisory framework. In particular, regulations in the insurance sector have improved and the recently established supervisory body has begun to operate. The formation of a joint committee between the capital market regulator, the central bank and, as of April 2002, the Insurance Supervision Commission, has the potential to improve the surveillance of the local financial sector.

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