After growing by 6.9% in 2017, the economy is estimated to have slowed down. Private consumption continued to be the major contributor to growth in 2017 and 2018, as consumers’ purchasing power increased on the back of VAT and income tax cuts as well as public sector wage hikes. Investment has had a modest contribution to growth, driven principally by growing disbursement of EU funds and an improvement in industrial confidence over the past three years.
Source: National Accounts, National Bank of Romania
Net exports continued to make a negative contribution to growth. Rising consumption has boosted imports, while export growth fell behind, despite favourable demand conditions in the EU during most of the past two years. With 75% of its exports destined for EU countries, Romania remains highly dependent on European export demand.
Source: National Bank of Romania
Driven by the tightening labour market and rising household consumption, inflation peaked at a 5-year high of 5.4% in June 2018, well above the central bank’s upper target of 3.5%. Consequently, the central bank has started to tighten its monetary policy, raising its main policy rate three times in 2018 from 1.75% to 2.50%. As a result, inflation has gradually receded to 3.3% in December 2018.
Following a significant decline since mid-2012, Romania’s country risk premium, as measured by credit default swaps (CDS) has been stable at just over 100bps since 2015. While increasing slightly since early 2018 as a result of tightening global liquidity, Romania’s CDS have remained stable and comparable to regional peers. At the same time, the declining country risk premium helped support the ongoing stability of the currency.
Source: Bloomberg
The equity market has been performing well since 2012, outperforming Romania’s regional peers. The Romanian index partly benefited from historically low interest rates, and also from the additional cash in European markets due to the European Central Bank’s stimulus package. However, the Bucharest Stock Exchange fell by around 15% in December, following the government’s announcement of controversial policy measures including taxation of bank assets and changes to the private pension system.
External imbalances are rising but remain modest. The deterioration of the trade balance has led the current account deficit to increase above 4% of GDP at the end of 2018. External debt has stabilised at around 60% of GDP over the past two years, ending its downward trajectory since 2012.
Source: National Bank of Romania
As a result of the deteriorating external position, the current account deficit is no longer fully covered by Foreign Direct Investment (FDI) inflows, as was the case prior to mid-2017. While FDI inflows have been robust over the past two years, funding of the current account deficit has become more reliant on portfolio flows, which are usually more volatile than FDI and prone to shifts in global market sentiment.
The banking sector remained well capitalised, with a capital adequacy ratio of around 19.7% as at December 2018. Since 2008 banks have progressively increased their funding from local deposits, and reduced their reliance on external debt . The loan to deposit ratio declined from above 120 per cent in 2012 to 74% in the last quarter of 2018. Asset quality also improved, as banks continued to address non-performing loans (NPLs). The combination of NPL sales and strong credit growth has pushed the NPL ratio down to 5% in December 2018, from a peak of 22.0% at the end of 2013.
Romania was successful in correcting imbalances arising following the start of the global recession in 2008, bringing the fiscal deficit down to below 2% of GDP in 2015. Nevertheless, fiscal policies have loosened considerably since 2016, when the government undertook a series of tax cuts and wage increases. VAT was cut in steps from 24% to 19%, while income tax and social security contribution rates for individuals have been reduced. Meanwhile, public sector wages have risen substantially since the adoption of a unitary public sector wage bill in 2017. These measures have increased the fiscal deficit to almost 3% of GDP over the past three years, bringing the government close to breaching the EU’s budget ceiling.
Source: IMF, Ministry of Public Finance
Source: IMF
Public debt remains moderate by regional standards, standing at around 35% of GDP at end 2017. Despite improvements over the past few years, around half of debt is still exposed to foreign currency risk. However, the maturity structure of government debt has improved recently, partly as a consequence of favourable global liquidity conditions, with around 84% of total debt stock having a maturity in excess of one year.
Having last lowered its policy rate to a historical low of 1.75% in May 2015, the National Bank of Romania (NBR) has tightened monetary policy as a response to rising inflation in 2018, raising its interest rate to 2.50%. The policy rate hike was preceded by a rise in market rates, with the ROBOR 3m rising by over 2% between mid-2017 and end-2018. Further increases are likely given the continued inflationary pressure and monetary tightening in the US.
The FIC expects GDP growth to moderate in the following period. Growth is expected to be 3.2% in 2019, due to weakening policy stimulus and tighter monetary policy, although growth will continue to be supported by investment linked to EU funds. Downside risks, including the exacerbation of the current labour shortages, prolonged weakness in the eurozone, changes in global investor sentiment and domestic political and reform uncertainty, may hamper growth in the near term.
In the longer term, the diversified economy, large market size and scope for convergence within the EU (GDP per capita, PPP-adjusted, is 60% of the EU average) should allow growth rates of around 4% to be sustained, provided further structural reforms are undertaken.
To achieve this, Romania needs to further improve its business environment and make it more attractive for investors. While Romania’s investment environment is better than regional peers, challenges remain. In the World Bank’s Doing Business 2019 report, Romania ranked 52nd out of 190 countries, a deterioration of seven places over the previous year. The slide in performance is in part due to the introduction of new value added tax regulations making starting a business more difficult. Other areas that are particularly challenging include obtaining construction permits and getting electricity. However, Romania performs best among the countries surveyed in trading across borders.
According to the European Commission’s Cooperation and Verification Mechanism (CVM) report published in November 2018, judicial reforms over the past year have been uneven despite some positive steps in implementing the EC’s recommendations. Pressure on the National Anticorruption Directorate and amendments to several justice laws on judicial appointments and dismissals in particular have raised the concern of the European Commission.
There are a number of reform priorities needed for the enhancement of the business environment:
The quality of the transport infrastructure remains insufficient by EU standards. Extending a high-quality road and rail network to more distant parts of the country remain amongst the major priorities to encourage regional growth and attract FDI into the regions. Funding and capacity impediments restrict the development of large-scale infrastructure investments, meaning that EU funds are under-absorbed. While some public-private partnership (PPP) contracts have been attempted for road projects, there appears to be limited capacity to identify, carry out, and monitor PPP concessions in line with good industry practices.
Growing labour shortages need to be addressed. Population aging, together with emigration of the labour force and skills mismatches make it increasingly challenging for employers to meet their labour demands. At the same time, participation in the labour market remains problematic for women, older people, young people or people from rural areas. Active labour market policies would help address low labour participation and improve the access of businesses to labour, while expanding training opportunities and improving the education system would ensure a better match between the skills offered by the labour force and those required by firms.
Privatisation of state-owned enterprises (SOEs) needs to be prioritised. SOEs remain dominant players in the energy and transportation sectors, weighing on public finances. Plans to privatise state-owned enterprises remain stalled. Uncertainty surrounding the establishment of a sovereign wealth fund to hold the state’s participation in profitable SOEs means that prospects for privatisation of these entities remain unclear. However, privatisation through initial public offerings (IPOs) would attract investors and increase market capitalisation, thereby helping to upgrade Romania from frontier market to emerging market status.