Political stability and the quality of governance have been undermined in recent years by unstable coalitions and minority governments.
Political stability outlook
In the December 2012 parliamentary election the Social Liberal Union (USL) — the political alliance of the Centre-Left Alliance of the Social Democratic Party (SDP) and the National Union for the Progress of Romania (UNPR), and the Centre-Right Alliance of the National Liberal Party (NLP) and the Conservative Party (CP) — won a resounding victory, winning a two-thirds majority in both chambers.
However, the alliance was always at risk of fraying given the inherent policy and personal differences between the two main parties.
These came to a head in February 2014 as the two parties fell out over ministerial appointments and accused each other of pursuing independent election strategies. On February 10th the prime minister and SDP leader Victor Ponta announced the formation of the Union of Social Democracy (USD), comprising the SDP, the CP and the UNPR, to contest the European Parliament elections in May 2014 on a separate ticket from the NLP.
The government lost its parliamentary majority on February 26th, when the NLP formally left the USL and NLP ministers tendered their resignations.
The newly formed USD retained 48% of the seats in the combined chambers, but would have been unstable without the formal support of another party. Parliament approved an interim government nominated by Mr Ponta on March 4th and the new ministers were sworn in at the presidential palace on March 5th, despite earlier speculation that Mr Basescu would refuse to accept the new cabinet. Dubbed ‘Ponta 3’, the government includes members of the Hungarian Union of Democrats in Romania (HUDR) and independents with no parliamentary affiliation. Hunor Kelemen, the leader of the HUDR, was nominated as minister for culture and as deputy prime minister, and Attila Korodi (HUDR), a former minister of the environment in two governments, was nominated as minister for the environment and climate change. The SDP holds 16 ministries (including two previously held by the UNPR). The head of the CP, Daniel Constantin, became deputy prime minister as well as minister for agriculture. Seven independents, largely comprising young professionals in their 30s, were nominated as government ministers. The Economist Intelligence Unit assumes that the SDP will be able to continue in office with the support of the HUDR at least in the short term, if not until the next scheduled election in 2016.
Economic policy outlook
POLICY TRENDS .The IMF and European Commission teams that visited Romania between January 21st and February 4th concluded the first and second reviews of the stand-by agreement (SBA), despite their concerns over a failure to reduce arrears and delays to planned increases in excise duties. The failure to meet the target for the reduction of arrears of state- owned enterprises (SOEs) in the final quarter of 2013 was the main criticism made by the mission, in what was a broadly favourable assessment.
However, progress in reducing SOE arrears has stalled, and Andrea Schaechter, the head of the IMF mission to Romania, hinted that approval by the IMF board in late April might not be given in the absence of further progress in reducing arrears. Ms Schaechter pointed out that the transport sector, particularly rail-freight and rail- passenger companies, accounted for more than 50% of SOE arrears and required urgent restructuring.
The SBA was approved by the IMF board in September 2013 for an amount equivalent to SDR 1.75bn (EUR 1.98bn; USD 2.59bn). The Romanian authorities, who intend to treat the agreement as precautionary, also requested precautionary support of EUR 2bn from the EU. The new programme aims to build on the achievements of recent years by supporting fiscal policy continuity and encouraging further structural reform. It will also provide a reserve buffer, given that the economy is subject to volatile capital flows and remains vulnerable to external shocks.
FISCAL POLICY. In 2014 the government plans to reduce the budget deficit to the equivalent of 2.2% of GDP, from 2.5% in 2013, in keeping with its medium-term plans to achieve a structural deficit (on ESA 95 methodology) of 1% by 2015. However, the deficit rose by 26.4% year on year in nominal terms in the first two months of 2014, to RON 3.1bn (USD 939mn), equivalent to 0.46% of projected annual GDP compared with 0.39% in the year-earlier period, as budget expenditure grew faster than revenue. The indications are that current expenditure, particularly on goods and services, subsidies and transfers, is rising at the expense of capital expenditure, which fell by 10.1% year on year.
Budget revenue will be boosted in the rest of the year by increases in excise duties on fuel and cigarettes that took effect on April 1st. Total excise duties on cigarettes also went up by 3.17% from EUR 81.78/1,000 cigarettes to EUR 84.37/1,000 cigarettes on April 1st. The increases are still the subject of a bitter dispute between the government and the president, Mr Basescu, who has asked parliament to find alternative sources of revenue. The latest data indicate that the government may face difficulties in implementing proposed cuts of 5 percentage points in employers’ social security contributions and in reducing value-added tax (VAT) on food products without commensurate spending cuts.
MONETARY POLICY. The National Bank of Romania (NBR, the central bank) operates an inflation-targeting regime with a target of 2.5% (±1 percentage point) for 2013 and 2014. The NBR commenced a policy of monetary easing in July 2013, cutting its monetary policy rate (MPR) by a total of 130 basis points in the period up to February 2014, when the MPR was lowered to 3.5%. The cuts were a response to the progressive reduction in inflation during the second half of 2013. However, the central bank has halted for the time being its policy of progressive cuts in interest rates. Despite a slowdown in the annual inflation rate to 1.1% in February 2014, the NBR kept the monetary policy rate unchanged at 3.5% at its meeting on March 28th, following forecasts that inflation would accelerate to 3.5% by the end of 2014. The cuts in the MPR are likely to feed through, with a time lag, to lower interest rates on bank loans, as was the case with earlier reductions in the rate. Our long-standing forecast is that Romania will postpone adoption of the euro for several years, and perhaps indefinitely.
ECONOMIC GROWTH. Recovery from recession in 2009 and 2010 has been modest. Romania avoided negative growth in 2012, with real GDP expanding by 0.7%, according to revised data. The first provisional estimates for 2013 confirm initial flash estimates that real GDP grew by 3.5% year on year (unadjusted) in 2013 and by 5.2% year on year in the fourth quarter. Growth was driven by net exports, while domestic demand fell as a result of falling gross fixed capital formation and declining expenditure on government- provided goods and services.
Net exports were the main driver of growth on the demand side, contributing 4.8 percentage points to GDP growth. Value added in industry grew by 8.1% in 2013, in response to the demand for exports, contributing 2.3 percentage points to GDP growth. Value added in agriculture, forestry and fishing rose by 23.4%, but the relatively low weight of agriculture in GDP of 5.6% meant that the sector contributed just 1.1 percentage points to GDP growth.
Gross fixed capital formation fell by 5.7% year on year in 2013, making a negative contribution of 1.6 percentage points to growth, and contributing to a fall in construction output of 1.2%. The impact of shrinking gross fixed capital formation on gross capital formation was reduced by significant stockbuilding in the final quarter of 2013. Household expenditure on goods and services grew by 1.4%, to the equivalent of 60.9% of GDP, and contributed 0.7 percentage points to growth. However, this was largely offset by falls in expenditure on government-provided consumption. Government consumption (which mainly comprises public services, defence and law and order) fell by 4.1%, making a negative contribution of 0.2 percentage points to growth. Consumption of services provided by the government but consumed individually (largely health, education, culture, sport, recreation and waste collection) also fell by 4.1%, making a negative contribution of 0.4 percentage points to growth.
The surge in growth in the second half of 2013 complicates forecasts for 2014. If the third- and fourth-quarter growth rates are merely a blip, growth will be slower than expected in 2014 owing to base effects. If they represent sustained growth in exports, GDP expansion will be faster than expected. The upturn in retail trade during the fourth quarter, largely resulting from higher real incomes following falling food prices, suggests that domestic demand could maintain its recovery in the first half of 2014. Year-on-year growth rates for industry in the first two months exaggerate the annual trend increase as they compare with the relatively subdued performance of the first two months of 2013. Nevertheless, the latest data are in line with our real GDP growth forecast of 3.1% in 2014.
Even without an acceleration in export growth from the second half of 2013, year-on-year industrial growth could reach 6% in the first half of 2014, given the low year-earlier period. However, this scenario could prove optimistic given the abnormally harsh weather conditions and disruptions to transport experienced in the first six weeks of 2014. The benefits of the good harvest in 2013 will dissipate as the year proceeds and will create base effects, which will result in slower growth during the second half of the year. Rising food prices will push inflation back towards 3.5% in the second half of the year, which will result in a levelling-off of real incomes and consequently household expenditure.
We expect average growth rates to accelerate in 2015 - 18, to 4.4%. Despite the pick-up in 2013, there is little prospect of a strong recovery in foreign direct investment (FDI) until later in the forecast period. Proposals for off-budget infrastructure investment in were scrapped by the previous government but could be reinstated by the current one, stimulating a recovery in construction — assuming that financing can be provided by negotiating larger budget deficits.
Improved absorption of EU funding would contribute to investment in infrastructure, which would boost export potential over the longer term. Romania has obtained EUR 22bn (USD 29bn) in structural funds from the EU budget for 2014-20, compared with EUR 20bn in the previous programming period (2007-13). The country will also receive EUR 17.5bn in funds for agriculture in 2014 - 20 under the common agricultural policy (CAP), up from EUR 13.8bn in 2007-13. Romania has absorbed only 12% of the total structural funding available to it under the 2007-13 budget. This is likely to improve in the coming years, but administrative deficiencies and the need for the government to co finance projects will limit prospects for a significant increase in the absorption rate.
INFLATION. Year-end consumer price inflation fell to 1.6% in 2013, just above the floor of the inflation target of 2.5 ±1 percentage point, and the lowest level recorded since post-communist price liberalisation. Food prices decreased by 1.8% year on year, non-food prices rose by 3.6% and prices of services were up by 3.4%. Headline inflation fell rapidly in the second half of the year, following the impact of the 2013 bumper harvest on food prices, augmented by base effects created by food price increases that followed a poor harvest in 2012. Annual inflation averaged 4% in 2013.
The effect of low food prices on the headline consumer price index (CPI) is tapering off. There will be further deregulation of energy prices in 2014 and excise duties are scheduled to increase. Uncertainty related to the euro zone sovereign debt crisis and the bond-buying programme of the Federal Reserve (Fed, the US central bank) could have a negative impact on exchange-rate developments and capital inflows, and a negative knock-on effect on inflation. However, the two-year IMF programme adopted in 2013 will help to mitigate these risks. We expect the CPI to rise towards 3% in the second half of the year as the base effects of the VAT reduction and the good harvest work through the system. We expect inflation to come down gradually, to 2.5% by end-2018.
EXCHANGE RATES. The leu appreciated on average against the euro in 2013 compared with 2012, averaging RON 4.42:EUR 1 in 2013 compared with RON 4.46:EUR 1 in 2012. However, the leu depreciated from RON 4.43:EUR 1 at the end of December 2012 to RON 4.48:EUR 1 at end-December 2013. We expect the leu to remain subject to turbulence, given the persistence of euro zone uncertainties and doubts related to the tapering of the Fed’s bond-buying programme, which may have a negative knock-on effect on emerging markets with large financing requirements, such as Romania. We forecast a modest real appreciation of the currency against a trade-weighted basket of currencies during 2014-18, in line with productivity differentials, as the economic recovery gathers pace.
EXTERNAL SECTOR. Exports grew by 10% year on year (measured in euro) over 2013 as a whole, and by 14% year on year in the second half of the year. The euro value of imports grew by 1% year on year in 2013, resulting in a reduction in the merchandise trade deficit (fob:fob) to EUR 3.4bn (2.4% of GDP), from EUR 7.4bn in 2012. This contributed to a reduction in the current-account deficit to EUR 1.5bn in 2013 (equivalent to 1.1% of GDP), from EUR 5.8bn in 2012.
The growth of outflows of income from foreign direct investors in Romania (largely associated with deleveraging by foreign owned banks) could increase the current-account deficit by at least EUR 1bn in 2014, in line with our forecast for a rise in the external deficit this year. The income deficit rose from EUR 588mn in January-February 2013 to EUR 783mn in the same period this year, as a result of an increase from EUR 266mn to EUR 537mn in income withdrawals from direct investment in Romania. We expect the deficit to remain within the range of 1-3% of GDP until the latter part of the forecast period, but it will expand in 2016-18.
