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Outlook for 2016-20

Macroeconomic policy since the 2008-09 global economic crisis has largely corrected internal and external imbalances, but spending pressures are building again, as fiscal policy has been relaxed and structural reforms have been delayed.

POLITICAL OUTLOOK

 

Political stability

Following mass protests and the resignation in November 2015 of the government led by Victor Ponta's Social Democratic Party (SDP), a technocratic government led by Dacian Ciolos is in charge until the parliamentary election in November 2016. The president, Klaus Iohannis, elected in November 2014, effectively imposed a presidential system of government after the public lost confidence in the ruling parties. Mr Ciolos's inexperienced government, dependent on the support of SDP deputies, can do little other than implement policies agreed by the previous government. It is essentially a holding operation until the election.

 

After 26 years of post-communist democratic transition, popular dissatisfaction with the political class runs deep. The fire on October 30th 2015 at the Colectiv nightclub in the capital, Bucharest, which resulted in 64 deaths, appears to have been a turning-point in Romania's post-1989 history. The tragedy ignited public anger about pervasive corruption and unaccountable politicians, and led to large demonstrations in Bucharest and other towns and cities. The appointment of a technocratic government was an acknowledgement of the extent of popular distrust of the political system.


A poll conducted in early 2016 by the Romanian Institute for Evaluation and Strategy (IRES) found that 90% of Romanians have little or no confidence in political parties. Tainted by corruption and led by discredited politicians, the main political parties have little appeal for the electorate. This was confirmed by the low turnout of just above 50% in the mayoral, country and local elections held on June 5th (turnout in Bucharest was only 33%, and just 24% of the electorate voted for either of the two major parties), well down on the 64% recorded in the second round of the presidential election in 2014.


Traditionally, the countrywide local election results have been a good guide to the probable outcome of the parliamentary election that is held later in the same year. The results of the June 2016 local elections point to the return in November 2016 of a government headed by the SDP in alliance with its allies in the National Union for the Progress of Romania (UNPR) and the Association of Liberals and Democrats (ALDE). In the November election Romania will revert to the parliamentary electoral system that was in place before 2008, which is effectively proportional representation at the county level.

 

Election watch

The parliamentary election in November 2016 will have new rules, following changes to electoral law in 2015.


• The election will be organised as a list-based system, last utilised in 2004.


• The amended electoral law stipulates a representation norm of 73,000 citizens per deputy (elected to the Chamber of Deputies—the lower house of parliament) and of 168,000 citizens per senator (elected to the Senate—the upper house). 


• This will decrease the number of members of parliament from the 588 elected in 2012 to 466 in 2016. There will be 308 deputies, plus 18 deputies representing minorities, and 134 senators. 


• An additional four deputies and two senators will be elected by the diaspora. These two senators will be elected by postal vote.


The SDP and its allies won an emphatic victory in the mayoral elections, beating the centre-right National Liberal Party (NLP) by 17 percentage points (51% to 34%). The margin was closer in terms of the popular vote, with the SDP and its allies leading the NLP by about 6 percentage points, at 39% to 33%. The share of the vote for the SDP was in line with opinion polls conducted in May, but that for the NLP was down by 5-6 percentage points. The poor performance of the NLP, which was supported by roughly 16% of the electorate, indicates either weariness with the anti-corruption campaign waged by Mr Iohannis or simply popular distrust of NLP politicians. Relations between the president and the NLP have cooled noticeably since the elections. With only 4% of the Bucharest electorate voting for the NLP candidate, Catalin Predoiu, who was widely expected to be Mr Iohannis’s nominee for an NLP premiership, the president may be tempted to establish a new party and try to mobilise behind it the support of the 6.2m voters who supported him in the 2014 presidential election. 


At 20% of the electorate, support for the SDP and the UNPR in the local polls was not particularly strong. However, the SDP may have benefited politically from the strong growth of household disposable incomes, stimulated by tax cuts and wage increases that the outgoing government (which was SDP-led) announced in 2015 and which the technocratic government subsequently implemented. The disaffected public mood and the lack of party loyalties among the electorate (outside of the patronage-dispensing local party machines that dominated the mayoral contests) make it very difficult to predict election outcomes with any degree of confidence. 

 

 

 

International relations
The European Commission monitors Romania’s progress under the co-operation and verification mechanism, with a focus on reforming the judiciary and tackling corruption. In 2015 corruption became a politically charged affair, when the then prime minister, Mr Ponta, was indicted on corruption charges. In its January 2016 report, the Commission praised the headway made by the National Anti-Corruption Directorate (DNA) in securing the convictions of prominent politicians and other public figures charged with corruption. The DNA indicted 1,250 defendants. However, the Commission criticised parliament for its lack of respect for the judiciary and judicial decisions, and for voting to maintain parliamentary immunity from prosecution in cases of alleged corruption. At a meeting in March 2016 EU foreign and European affairs ministers decided to keep the co-operation and verification mechanism in place for both Romania and Bulgaria. 


On May 12th the US officially activated a land-based missile shield system at a former air base at Deveselu in southern Romania, prompting sharp recriminations from Russia, which has said that the system is a direct threat to it. Now that the system has become operational, tensions between Russia and Romania are likely to increase. 


In a referendum on June 23rd the UK voted to leave the EU. This will not have any immediate negative impact on Romania. The UK is not a major trading partner and trading relations will not be adversely affected in the short term. However, since the opening of the UK labour market to Romanians in January 2014, increasing numbers have gone to work in the UK. Tougher immigration rules may cap these numbers in future, but nothing is likely to change in the short term while the UK negotiates the terms of its departure. The political repercussions of Brexit could be more far-reaching, however, especially if it results in the evolution of a two-tier EU, with Romania being consigned to the second tier.

 

 

ECONOMIC POLICY OUTLOOK

 

Policy trends

Macroeconomic policy since the 2008-09 global economic crisis has largely corrected internal and external imbalances, but spending pressures are building again, as fiscal policy has been relaxed and structural reforms have been delayed.

 

Romania’s stand-by arrangement with the IMF, which had been stalled for one year after disagreements about the SDP-led government’s fiscal policies, expired in September 2015. An IMF mission visiting Romania in March 2016 for Article IV consultations issued a strong warning that tax cuts and wage increases threaten financial stability after 2016.


The government cut the rate of value-added tax (VAT) on foodstuffs (excluding alcoholic beverages and tobacco) from 24% to 9% in June 2015. On January 1st 2016 the standard VAT rate fell from 24% to 20% (it will be reduced to 19% in January 2017 under the present fiscal code). On October 27th 2015 the government adopted an emergency decree amending the fiscal code, bringing forward to 2016 several tax cuts planned for 2017. Among other measures, the tax on dividends was cut from 16% to 5%, and VAT on drinkable water was reduced from 20% to 9% from January 2016. From May 1st 2016 the technocratic government implemented a 19% increase in the minimum wage. Structural reforms to improve corporate governance and efficiency in public enterprises are unlikely to make much headway until a new government is formed. The Economist Intelligence Unit expects some fiscal moderation later in 2017, but this will come too late to prevent the fiscal deficit exceeding EU rules that year (on the ESA 2010 measure).

 

Fiscal policy
The consolidated budget recorded a deficit of 1.5% of GDP in 2015, but this 12 month total included a deficit of 2.4% of GDP in the last seven months of the year. The growth of VAT receipts slowed from an impressive 17.5% year on year (largely as a result of a crackdown on VAT evasion) in the first five months of 2015 to 8.8% in the last seven months. In 2016 the government targets a consolidated budget deficit equivalent to 2.8% of GDP on a cash basis (equivalent to 2.95% of GDP using the EU's ESA 2010 methodology). Budget revenue is officially projected at Lei231.1bn (US$55.4bn) in 2016, equivalent to 31.1% of GDP; expenditure is set at Lei252bn, equivalent to 33.8% of GDP.


Tax cuts will have a negative effect on revenue generation, but improvements in tax collection and absorption of EU funding in 2015, indicating a better-functioning central administration, suggest that there is a chance of meeting the target. (A recent study by an accountancy firm, PwC, estimates that Romania loses about €8.3bn—US$9.2bn—annually as a result of VAT tax evasion.) The consolidated government budget recorded a cumulative five-month deficit of almost €173m (US$192m; 0.1% of GDP) in January-May, compared with a surplus of €1.4bn (0.9% of GDP) in the year-earlier period. However, the cumulative deficit is smaller than had been expected. We forecast a deficit equivalent to 2.9% on the national measure (3% on the ESA 2010 measure) in 2016 and 3% of GDP in 2017 (3.2%, ESA 2010), putting Romania in breach of EU fiscal rules. We expect the next government to abandon or reverse some of the planned new tax cuts in 2017 and to oversee a modest fiscal tightening in 2018 to avoid a consumption-led excessive widening of the external deficit. Over the medium term we expect fiscal consolidation to be broadly maintained.

 

 

 

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 a 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 central bank has kept the rate at 1.75% since May 2015. We expect the NBR to hold the monetary policy rate at 1.75% in 2016, amid general uncertainty about the fallout from the UK's decision to leave the EU, the slow¬down in Chinese and emerging-market growth, and the relaxation of domestic fiscal policy. Romania’s monetary policy rate remains one of the highest in the EU, and compares with a rate of 0% in the euro zone and 1.5% in Poland.

 
The governor of the NBR, Mugur Isarescu, has said that Romania’s target date of 2019 for joining the euro zone is no longer feasible, as the country would not be technically prepared to join the European exchange-rate mechanism (ERM II) by June 2016. The government has now abandoned the 2019 target date for euro entry and has said that a detailed plan to join the euro zone will be presented in 2017. We expect euro adoption to be postponed into the mid-2020s, and perhaps indefinitely.

 

ECONOMIC FORECAST
 

 

Economic growth 

Romania’s real GDP grew by 3.8% in 2015. The increase in consumer purchasing power following the cut in VAT on foodstuffs in June 2015, from 24% to 9%, was the main stimulus to growth in the second half of 2015. Consumer demand was boosted by rising real household disposable income, owing to increases in wages, pensions and remittances from abroad, and rapid growth of new consumer loans. Final consumption expenditure by households rose by 5.9% and contributed 5.6 percentage points to growth. The other growth stimulus came from gross fixed investment, which grew by 7.7% year on year and contributed 1.8 percentage points to growth.


Growth of 4.3% (4.2% seasonally adjusted) in the first quarter of 2016 was driven by the rapid growth of retail turnover of 19% year on year (16.9% seasonally and working-day adjusted) following the cut in standard VAT from 24% to 20% on January 1st. In January-April retail sales grew by 17.7% year on year (adjusted) and 19.1% unadjusted. Increases in public-sector wages contributed to an increase in gross nominal wages of 12.1% year on year in January-April and an even stronger rise in real terms given deflation. Seasonally adjusted industrial output growth was modest over the first four months, at 0.7% (driven by 2.5% growth in manufacturing), and consumer demand is being partly met by increasing imports. Tax cuts and wage growth will bolster household consumption growth in 2016 and 2017, when we forecast real GDP growth of 4.5% and 3.4% respectively. Strong domestic demand growth will compensate for the euro zone growth slowdown that we forecast in 2017.


Sustaining growth of this magnitude over the medium term will depend on the economy's capacity to respond to the demand stimulus, which in turn depends on more rapid progress in implementing structural reforms. Signs of capacity constraints in some sectors of industry, for example in the automotive sector, suggest the need for deeper structural reforms to boost labour productivity, and for increased expenditure on education and infrastructure rather than on consumption. The economy is facing severe labour shortages in some sectors, notably automotives, with an estimated 2.4m Romanians working abroad. This is likely to be a disincentive to foreign investment in the medium and long term. We forecast average real GDP growth of 3.4% per year in 2018-20.


Better absorption of funding from the EU would contribute to investment in infrastructure, boosting export potential over the long term. Romania has obtained a potential €22bn in structural funds from the EU budget for 2014-20, and is also to receive €17.5bn in funds for agriculture during this period, under the common agricultural policy. However, Romania’s absorption of EU structural funding is poor, despite some improvement; administrative deficiencies and the need for the government to co-finance projects will limit prospects for a significant increase in the absorption rate.

 

 

 

Inflation

A series of tax cuts in 2015-16 has driven negative annual inflation over the past 12 months. Consumer prices edged up by 0.3% month on month in May, but the annual inflation rate, as measured by the consumer price index (CPI), dropped to -3.5%, from -3.3% in April. Buoyant consumer demand will drive up inflation in the second half of 2016, when the impact of the June 2015 VAT cut is removed from the CPI. We expect average deflation of 0.9% and year-end inflation of 1.7% in 2016. In 2017 we expect average inflation of 3.2% and year-end inflation of 2.8% as the impact of the VAT cuts is removed from the CPI. We forecast annual average inflation of 2.4% in 2018-20.

 

Exchange rates

The leu depreciated in nominal terms by 16.4% on average against the dollar in 2015. It remained stable against the euro, at Lei4.4:€1, which represents a depreciation in real terms of 0.6%. The leu depreciated in real effective terms by 4% against a trade-weighted basket of currencies in 2015. We forecast a milder weakening against the dollar in 2016, continued relative stability against the euro and a modest real effective depreciation against a trade-weighted currency basket. We expect the leu to appreciate modestly in real terms over most of the forecast period, in line with productivity differentials, as the economic recovery continues. 

 

External sector

In 2015 the current-account deficit expanded to US$2bn, equivalent to 1.1% of GDP, from US$951m in 2014. In January-April 2016 the current-account deficit was €1.84bn, compared with a surplus of €282m in the year-earlier period. The deterioration in the current-account balance resulted from a widening of the primary income deficit from €780m to €2.5bn and an expansion of the merchandise trade deficit from €1.8bn to €2.5bn. As domestic demand fuels import growth, we forecast a widening of the deficit to 2.6% of GDP in 2016 and to an annual average of 3.3% of GDP in 2017-20.