POLITICAL OUTLOOK
Political stability
Romania faces increasing political uncertainty as relations between the prime minister, Victor Ponta, and the president, Klaus Iohannis, appear to have broken down. The breakdown of relations follows Mr Ponta’s second appearance, on July 13th, before the Anti-Corruption Directorate (DNA) to face charges of forgery of private documents and of being an accessory to tax evasion and money-laundering. Prosecutors ordered a freeze on Mr Ponta’s assets up to the value of the alleged damages, and his status in the case was changed from that of a suspect to a defendant. In further signs of the growing tension between the president and the prime minister, Mr Iohannis refused to approve Mr Ponta’s first nomination for transport minister and also rejected the government’s proposed fiscal code, returning it to parliament for re-examination. Mr Iohannis has requested Mr Ponta’s resignation as prime minister.
So far, the ruling Social Democratic Party (SDP), the government and parliament have resisted pressure from the president to remove Mr Ponta. On June 9th the Chamber of Deputies (the lower house of parliament) rejected, by 231 votes to 120, a DNA request to remove Mr Ponta’s parliamentary immunity to permit a criminal investigation into him. At the same time, a vote of no confidence in the government, called by the president’s National Liberal Party (NLP), gained only 194 votes of the 278 required to be successful. Mr Ponta’s ability to survive politically until the next election, scheduled for late 2016, will depend on his capacity to retain the support of his party and his coalition partners. He has faced criticism for his decision to ‘step down’ temporarily from the presidency of the SDP to contest the charges against him and there are signs that the support of the junior governing party, the National Union for the Progress of Romania (UNPR, a party in an electoral alliance with the SDP, which sits as a single party in both parliamentary chambers) cannot be taken for granted.
Currently, the SDP and the UNPR control 260 of the 588 seats in the two chambers; they are supported by the Alliance of Liberals and Democrats (ALDE), comprising the Liberal Reformist Party and the Conservative Party, with 37 members in the two chambers. The ALDE was formed on June 19th under the leadership of Calin Popescu Tariceanu, the leader of the Senate (the upper house of parliament), who served as prime minister in 2004-08. The opposition NLP holds 177 seats, the Hungarian Union of Democrats in Romania (HUDR) has 25, the populist Democratic and Popular Group controls 11; and there are 27 independents and 17 representatives of national minorities. Mr Iohannis secured 258 votes in favour of his nomination of former prime minister Mihai-Razvan Ungureanu (NLP) as head of the Foreign Intelligence Service on June 30th. The appointment was opposed by the SDP, but some members of the UNPR may have voted for Mr Ungureanu. Mr Ponta said that he would consider resigning if the president gave a firm commitment to appoint a prime minister from the governing coalition and said that, if he were to resign, he would support the candidacy of Mr Tariceanu. However, Mr Tariceanu opposed the president’s defence proposals and is unlikely to prove acceptable to him.
Election watch
The next general election is scheduled for late 2016, and a presidential election will take place in 2019. Mr Iohannis won the November 2014 presidential election in a second-round run-off by a comfortable margin, with 6.3 million votes (54.4%) to Mr Ponta’s 5.3 million (45.6%). The election of Mr Iohannis reflected widespread disillusionment with the political elite, and the governing SDP in particular. The mobilisation behind him of large numbers of customarily abstaining voters in addition to the usual centre-right constituency suggests that the SDP will face a challenge at the 2016 general election. Mr Iohannis was the candidate of the Liberal Christian Alliance (LCA), comprising the NLP and the Democratic Liberal Party (DLP). The two parties have now merged, retaining the NLP name. If Mr Iohannis can rally the centre-right parties, they may have a chance of unseating the SDP. However, recent history suggests that they will find it hard to unite and present a coherent programme. Mr Ponta will count on his party benefiting from a ‘feelgood factor’ by the time of the election, stemming from rising household consumption and real GDP growth in 2015-16.
International relations
The European Commission monitors Romania’s progress under the co-operation and verification mechanism, with the focus on reforming the judiciary and tackling corruption. Parliament voted in February to allow the DNA to pursue the prosecution of Elena Udrea, a former minister for tourism and protégé of the previous president, Traian Basescu, on charges relating to three separate cases of alleged graft. However, in June parliament voted to protect the immunity of the prime minister after his indictment on corruption charges. The two votes suggest that the anti-corruption campaign is politically charged, with the potential to taint both sides of the political spectrum and to erode popular confidence in Romania’s institutions.
ECONOMIC POLICY OUTLOOK
Policy trends
Macroeconomic policy since the global economic crisis of 2008-09 has largely corrected internal and external imbalances, but spending pressures are building again and further fiscal structural reforms are being demanded by the European Commission and the IMF. The two institutions want the government to improve the absorption of EU funds to modernise public infrastructure, tackle long delayed reform of the state-owned enterprise sector and address weaknesses in the financial sector.
Romania’s stand-by arrangement with the IMF, which runs to September 2015, has effectively lapsed. The IMF, together with the European Commission, criticised proposals by the Chamber of Deputies to cut the basic rate of valueadded tax (VAT) from 24% to 19% by January 1st 2016. The Commission referred the proposals to its Economic and Financial Affairs Council (Ecofin) on July 14th. The tax changes are likely to result in a budget deficit in excess of 3% of GDP in 2016, breaching EU fiscal rules. The government cut the rate of VAT on foodstuffs (excluding alcoholic beverages and tobacco) from 24% to 9% from June 1st, and on draught beer to 9% on June 10th). As the 2016 general election nears, the government is likely to make further changes to tax rates in an attempt to win over voters.
Fiscal policy
Parliament approved a consolidated budget for 2015, after tough negotiations between the Romanian authorities and the IMF, the EU and the World Bank as part of the third review of the IMF stand-by arrangement (SBA). This allows for a deficit of 1.83% of GDP on a cash basis, equivalent to a deficit of 1.5% of GDP according to ESA 2010 ‘accruals’ methodology. The government plans to reduce the annual consolidated budget deficit to 1.1% of GDP in 2016-17 and 0.9% of GDP in 2018, in line with commitments under the EU’s fiscal compact to maintain a structural deficit of about 1% of GDP. The government argues that improvements in revenue collection and stricter expenditure control have created leeway for tax cuts to boost consumption and growth. However, planned tax cuts will have a negative impact on revenue generation in 2015-16, jeopardising official deficit targets.
- Consolidated budget revenue rose by 10.8% year on year in the first five months of 2015, to Lei 93.2 billion (US$23.4 billion), while expenditure increased by 1.4% to Lei 86.8 billion, resulting in a budget surplus of Lei 6.3 billion, equivalent to 0.9% of projected annual GDP.
- VAT receipts grew by 17.5% year on year in the first five months, to Lei 25.9 billion, equivalent to 3.4% of projected annual GDP, and accounted for 52% of the increase in revenue in the first five months.
- The Economist Intelligence Unit believes that VAT revenue would have risen to about 8.2% of GDP in 2015 without the cut in VAT on foodstuffs, which will reduce VAT receipts to around 7.7% of GDP in the full year.
- We forecast that the reduced rate of VAT on foodstuffs will result in a reduction in budget revenue of just below 1% of GDP in a full year (or 0.5% of GDP in 2015), assuming no significant reduction in tax evasion resulting from the lower rate.
- We forecast that, from 2016, the cut in the basic VAT rate from 24% to 19% on non-foodstuffs will result in a reduction in budget revenue equivalent to 1.2% of GDP in a full year, although improved tax collection may partly offset this.
- We forecast that the changes in all VAT rates will reduce budget revenue by just above 2% of GDP in 2016.
- Cuts in social security contributions could also reduce budget revenue by a further 0.6% of GDP in 2017.
On this basis, we forecast that the proposed VAT cuts will lead to a consolidated budget deficit of 2.3% of GDP in 2015 (cash basis) and a deficit of more than 3% of GDP in 2016. Over the medium term, we expect fiscal consolidation to be broadly maintained, but we do not expect the authorities to meet the deficit target of 1% of GDP.
Monetary policy
The National Bank of Romania (NBR, the central bank) operates an inflation-targeting regime with a multi-year target of 2.5% (±1 percentage point). The NBR began policy of monetary easing in July 2013, cutting its monetary policy rate by a cumulative 325 basis points between July 2013 and May 2015, in response to a progressive reduction in inflation, weak domestic demand, negative credit growth and a persistent negative output gap. The NBR announced a surprise cut in its monetary policy rate of 25 basis points, from 2% to 1.75%, at its board meeting on May 6th. The NBR also narrowed the corridor around the monetary policy rate, from ±1.75 percentage points to ±1.5 percentage points, reducing its lending rate from 3.75% to 3.25%, but leaving the deposit rate unaltered at 0.25%. It reduced its minimum reserve requirements on liabilities of credit institutions denominated in lei from 10% to 8%, but left the requirements on liabilities denominated in foreign currencies unchanged at 14%. The reduction of minimum reserve requirements is part of a gradual lowering towards European Central Bank (ECB) levels. By leaving unchanged the requirement on liabilities denominated in foreign currencies, the central bank aims to encourage lending denominated in lei.
We expect the NBR to hold the rate at 1.75% for the rest of 2015, amid growing concerns about currency fluctuations and the fear of contagion from the situation in Greece, and also because of a faster than expected narrowing of the output gap. Romania’s monetary policy rate remains one of the highest in the EU, and compares with a rate of 0.05% in the euro zone and 1.5% in Poland.
The government targets January 1st 2019 as the formal date for euro adoption. NBR governor Mugur Isarescu argues that Romania will not be ready to join the European exchange-rate mechanism (ERM II) in January 2016, which he considers essential for euro adoption by the target date. We assume that Romania will postpone euro adoption until after 2019, and perhaps indefinitely.
Economic growth
Romania’s recovery from recession in 2009-10 has been modest, with real GDP growth having averaged 1.7% per year in 2011-13, but growth came in at 2.8% in 2014 and has gained momentum in the first half of 2015. We forecast a pick-up in euro zone growth to 1.5% in 2015, which should allow Romania’s economy to continue to expand in the coming months. Meanwhile, consumer and business confidence indicators, together with recent high-frequency data, point to a pronounced pick-up in domestic demand.
Romania recorded one of the fastest growth rates in the EU, in both year-on-year and quarter-on-quarter terms, in the first quarter of 2015. Real GDP grew by 4.3% year on year on a gross basis and by 4.2% when adjusted for the number of working days; quarter-on-quarter output (adjusted for seasonality and the number of working days) grew by 1.6%. Significant growth in real wages boosted domestic consumption. Meanwhile, the growth of services appears to have been a major factor driving sectoral growth. We forecast real GDP growth of 4% in 2015, given the first-quarter performance and the likely further boost to domestic demand from the reduction in the VAT rate on food products and strong real wage growth. Tax cuts will boost consumption, although this will stimulate imports, while public investment in infrastructure, partly financed by improved absorption of EU funding, will also stimulate growth. Foreign direct investment inflows picked up in the first half of 2015, but the corporate sector is continuing to reduce its net credit exposure, and this may constrain domestic investment in full-year 2015.
We forecast average real GDP growth of 3.8% per year in 2016-19. Better absorption of funding from the EU would contribute to investment in infrastructure, thereby boosting export potential over the longer term. Romania obtained a potential €22 billion (US$29 billion) in structural funds from the EU budget for 2014-20, up from €20 billion in the previous programming period (2007-13). The country will also receive €17.5 billion in funds for agriculture during 2014-20 under the common agricultural policy, up from €13.8 billion in 2007-13. Romania’s absorption of EU structural funding has improved over the past year and is likely to progress further in the coming years, but administrative deficiencies (especially in local government) and the need for the government to co-finance projects will limit prospects for a significant increase in the absorption rate. The main downside risk arises from the potential for further reversals in the euro zone, especially if Greece were to leave it, as Romania would be directly and indirectly exposed.
Anaemic growth in the euro zone, heightened risk of a sovereign debt crisis and/or continued deleveraging by EU banks (which own 82% of banking assets in Romania, including 12% under Greek ownership) would have a negative impact on business and consumer confidence and on economic growth.
Inflation
Annual consumer price inflation, as measured by the consumer price index, fell to 0.4% in January and February 2015, driven down by falls in world energy and food prices. Year-on-year inflation climbed back to 1.2% in May, but turned negative in June, at -1.6%, as the reduction in the VAT rate on foodstuffs, nonalcoholic drinks and beer pulled down food prices by 8.2% month on month. Average inflation is forecast to be zero or negative in the second half of the year. The cut in VAT on foodstuffs has had a major effect on inflation expectations, which have declined sharply. The residual positive effects of the 2014 bumper harvest will also hold down food prices.
In addition, the impact of increases in administered prices will be less than expected previously. We forecast an average international oil price (Brent blend) of US$60.2/barrel in 2015, compared with US$98.9/b in 2014, which will also suppress inflation this year. We forecast average inflation of -0.9% in 2015.
Once the VAT effect fades, from the second quarter of 2016, and assuming another normal harvest in that year, we expect volatile food prices to result in average inflation of -1.8% and year-end inflation of 1% in 2016. In 2017-19 we forecast average annual inflation of 2.4%.
Exchange rates
We forecast the average US dollar:euro exchange rate at US$1.07: €1 in 2015. The euro’s sharp depreciation in the early months of 2015 came in response to two major – and related – monetary policy events: the decision by the Swiss National Bank (Switzerland’s central bank) to withdraw its ceiling on the exchange rate of the Swiss franc against the euro, and the ECB’s launch of its programme of sovereign bond purchases. We expect strong US growth and market expectations of monetary tightening by the Federal Reserve (the US central bank) to support the dollar in coming months. We forecast a sharp nominal depreciation of the leu against the dollar in 2015 and a milder weakening in 2016, alongside a broadly stable exchange rate against the euro. We expect a modest real appreciation of the leu against a tradeweighted basket of currencies from 2017, in line with productivity differentials, as the economic recovery gathers pace.
External sector
The current account recorded a deficit of €312 million in January-May 2015, compared with one of €424 million in the year-earlier period, with the surplus on trade in goods and services falling from €340 million to €270 million. The deficit on merchandise trade increased only marginally, from €2 billion to €2.1 billion. The balance on primary and secondary incomes improved from a deficit of €764 million in the first five months of 2014 to one of €582 million this year.
The size of the deficit in 2015 as a whole will depend on two volatile financial flows: the level of income-taking from foreign investment, and the level of EU funding. We assume that growth in outflows of income (largely associated with deleveraging by foreign-owned banks) will inflate the current-account deficit by around €1 billion. As the economic recovery progresses and domestic demand increases, we forecast an annual deficit averaging 2.6% of GDP in 2015-19.
