Romania: Macroeconomic Policy Challenges

1. Romania: Macroeconomic Policy Challenges National Bank of Romania Dorina Antohi, Deputy Director Monetary Policy and Macroeconomic Modelling Department The Global Financial Crisis and SEE: Lessons for macroeconomic policy and financial stability 1st Workshop on Economies of the Eastern European and Mediterranean Countries, 14th May 2010, Athens, Greece

2. Romania – basic info • Location: Central & Eastern Europe • European Union member since 1 January 2007 • Population: 21.5 million inhabitants as of 1 January 2009 • Currency: Romanian leu • Small open economy • GDP per capita: 12000 (pps, 2008) • 25100 EU 27 National Bank of Romania

3. Main structural and institutional characteristics of the economy • Degree of openness: 73.9% (2008) • Share of private sector in GDP: 70.8% (2008) • Structure of GDP by sectors (2008) • Banking system: majority foreign owned (88.3 % of total assets, 2008) • Monetary policy strategy and exchange rate regime: since August 2005, inflation targeting and managed float exchange rate regime National Bank of Romania

4. Main macroeconomic developments during pre-crisis period • Romania exhibited high annual economic growth between 2001-2008: catching-up, increased capital inflows due to improved risk perception (EU accession, NATO membership), favourable external context, speeded-up pace of economic and financial integration, increased productivity, substantial credit flows, consumption smoothing • After 2005-6: increasing signs of overheating, emergence and subsequent aggravation of macroeconomic imbalances (persistent excess of aggregate demand, widening external deficits), also on account of increased pro-cyclicality of fiscal and income policies National Bank of Romania

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9. Source: NBR National Bank of Romania

10. Source: NBR National Bank of Romania

11. Source: NBR, NIS National Bank of Romania

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14. ... together with: Up to mid-2007: • continued nominal appreciation of the RON, with the exchange rate reaching an unsustainable level (in the first part of 2007); increased risk to monetary and financial stability (given the large share of foreign-currency-denominated loans and liabilities in banks’ balance sheets), induced by a potential relatively sharp subsequent correction of the exchange rate • ongoing disinflation process initiated in 2000 Since second half of 2007 (following the onset of global financial market turbulences): • starting and steepening of RON corrective depreciation • pick-up in inflation, also owing to the occurrence of both domestic and external shocks (the decline of agricultural output following the severe drought, the surge of agri-food and oil prices on external markets) • worsening of inflationary expectations, due to the prospects of a fiscal policy easing and a continued lax income policy in 2008, a period with a busy election schedule National Bank of Romania

15. Source: NBR, NIS National Bank of Romania

16. Complicated context of monetary policy implementation • Implementation of IT focused on ensuring compliance with sustainable progress of disinflation along medium-term path described by announced annual inflation targets, while remaining mindful of not exacerbating existing macroeconomic vulnerabilities or creating financial stability problems whose effects might compromise durability of secured disinflation gains • Continuous focus on slowing down speed of growth of both leu and foreign-exchange credit (for macro as well as financial stability reasons), using all available policy tools (interest rate policy, management of liquidity conditions in the money market, reserve requirements mechanism, LTV, loan-to-income limits for households, fx exposure limits to unhedged borrowers, higher coefficients in stress tests for exposures to non-euro credit) • Permanent message on need for maintaining consistency of the macroeconomic policy mix (particularly avoiding pro-cyclicality of fiscal and wage policies) National Bank of Romania

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19. Source: NBR National Bank of Romania

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21. Source: NBR National Bank of Romania

22. Radical change of domestic economic developments in the aftermath of Lehman collapse • Built-up macroeconomic imbalances made the Romanian economy extremely vulnerable in the face of global financial and economic crisis • Main propagation channels of the global financial and economic crisis to the domestic economy: • financial channel and, implicitly, exchange rate and wealth- and balance-sheet- effects channel • confidence channel • foreign trade channel • Significant importance of the financial channel, stemming from banks’ reliance upon external financing, high debt service; strong impact on lending and exchange rate National Bank of Romania

23. Main manifestations of the impact of the global crisis • Effects – which had started to be felt during the last quarter of 2008 – amplified materially in 2009: (i) severe economic contraction against the background of a steep decline in domestic demand; (ii) relative rapid increase of unemployment rate; (iii) significant decrease of unit labour cost in industry; (iv) stronger-than-expected adjustment of the current account deficit (mainly via adjustment of the private sector), due to imports having declined much faster than exports; (v) marked weakening of lending activity • Some effects faded out during the first part of the year, while other adjustments have been continuing, being incomplete/asymmetrical until presently: (i) halt of the leu depreciation and subsequent quasi-stabilisation of the exchange rate; (ii) consolidation of disinflation with a certain lag – given the pace of increase and amplitude of aggregate demand deficit - also on the back of supply-side shocks; (iii) asymmetric adjustments of labour market conditions; (iv) gradual increase in the share of non-performing loans National Bank of Romania

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26. Asymmetrical adjustment of labour market conditions National Bank of Romania

27. Source: NBR National Bank of Romania

28. Source: NBR National Bank of Romania

29. Monetary policy response since end-2008 • Monetary policy has been geared towards anchoring inflation expectations and ensuring sustainability of disinflation • Monetary policy aimed to ensure prudent broad monetary conditions at all times with regard to evolving economic environment • Monetary policy decisions had in view: • during the first part of the interval: considerations related to the necessity of an orderly adjustment of the external deficit and preservation of financial stability • during the second part of the interval: the need to create favourable conditions for a sustainable recovery of lending activity within the Romanian economy National Bank of Romania

30. Main monetary policy decisions • Policy rate has been lowered gradually in 2009 and 2010 from 10.25% to 6.25% (in 9 steps) on background of (i) the outlook for consolidation of disinflation in the medium term, in line with the expected magnitude and duration of the negative output gap, (ii) gradual decline of risk premium and of (iii) relative persistence of core inflation over short-run: inflation reacting with a lag to substantial economic contraction • Minimum reserve requirements ratios has been cut in several stages: from 20% to 15% for domestic currency liabilities, from 40% to 25% for foreign-exchange-denominated liabilities (both w. residual maturities of up to two years), from 40% to 0 (zero)% for foreign-exchange-denominated liabilities with a residual maturity of over to years as of the end of observance period and which are not subject to contractual clauses • The central bank has pursued an adequate management of liquidity conditions in the money market National Bank of Romania

31. Source: NBR National Bank of Romania

32. Other policy responses since end-2008 • Despite significant economic contraction, lack of degrees of freedom in easing fiscal, wage policies: need for a relative tightening of fiscal policy in 2009 and for a firm fiscal consolidation starting with 2010 (pro-cyclical fiscal policy) • Enhanced supervision & permanent dialogue w. banks on regulatory issues; maintaining adequate solvency levels (10% minimum) • Multilateral financing agreement w. EU, IMF, World Bank, other IFIs (besides reserve build-up): restoring confidence, functioning as “crisis management program”, enhancing stability of foreign bank exposure to Romania & maintaining capital adequacy National Bank of Romania

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34. Economic outlook over short and medium term • Economic recovery will be delayed and slower than previously anticipated • The negative outuput gap will remain significant into 2010 and persist over the entire forecast horizon (8 quarters) • Annual inflation rate will converge towards the central point of inflation targets set for end-2010 and 2011 (3.5 %±1 percentage points and 3%±1 percentage points respectively) • Current account will remain at sustainable levels National Bank of Romania

35. Source: NIS, NBR calculation National Bank of Romania

36. Challenges for macroeconomic policy Lasting policies adjustments are needed to prevent a re-emergence of macroeconomic imbalances in the future and to restore/ensure the credibility of the overall policy framework • The overall challenge over the relatively near term horizon: maintaining the macroeconomic policy mix in line with the coordinates agreed under the multilateral external financing arrangement with the EU, the IMF and other international financial institutions, as well as observing the commitments assumed under the most recent Convergence Programme • The general challenge over the longer term: attaining a high degree of sustainability of economic convergence and adopting the euro National Bank of Romania

37. Monetary policy challenges (I) • The most important challenges for monetary policy are to effectively anchor inflation expectations and to ensure the continuation of the disinflation process at the pace implied by the medium-term inflation targets, and subsequently to achieve and maintain price stability and the fulfilment of the related Maastricht inflation criterion In the short term: these challenges arise foremost from the anticipated administered price adjustments and likely increases in certain volatile prices, as well as from the continued relative persistence of core inflation, though this is clearly declining Over the medium term: the main challenge is to firmly anchor inflation expectations and to ensure sustainable disinflation (and subsequently to ensure and maintain price stability) while simultaneously creating favourable conditions for the revival of a healthy lending activity and implicitly for a sustainable economic recovery National Bank of Romania

38. Source: NBR calculation, NIS National Bank of Romania

39. Monetary policy challenges (II) • Setting the appropriate monetary policy stance and implementation manner from these perspectives is still, to a certain extent, complicated by the global financial and economic crisis-induced factors: (i) uncertainty about the level of potential output; (ii) limitations/distortions of the monetary transmission mechanism, which nevertheless are declining progressively in terms of both number and intensity; (iii) uncertainties related to external economic developments; (iv) volatility and episodic tensioning of global and/or regional financial markets • Such a monetary policy setting and its efficacy is nevertheless strictly conditional upon: (i) initiating and strengthening the fiscal consolidation and tightening the income policy, (ii) implementing consistent structural reform measures to ensure sufficient flexibility of product and labour markets; (iii) ensuring the appropriate correlation between wage increases and productivity growth; (iv) safeguarding the soundness of the banking system National Bank of Romania

40. Fiscal policy challenges Short term: Appropriate balance between fiscal consolidation & fiscal reform needed to meet targets agreed with EU / IMF amid slow economic recovery Medium & long term: Convergence towards Maastricht criteria (join EMU 1st of January 2015) and improvement of public finance quality and sustainability Correct the excessive deficit by 2012 • In July 2009, Council decided on the existence of an excessive deficit in Romania and issued recommendations to correct that by 2011 at the latest • In February 2010, having in view sharper than anticipated contraction of GDP in 2009 as well as effective action taken by the Romanian authorities to comply with July recommendations, Council revised the timeframe for the correction of deficit to 2012 National Bank of Romania

41. Fiscal consolidation measures Aim: reduce the deficit in 2010 to 5.9% (6.3% ESA’95) of GDP, from 7.4% (8.3% ESA’95) in 2009, mainly via expenditure driven consolidation Expenditure driven consolidation measures* for 2010: • Reduction of public sector wage bill (through a freeze on all but lowest wages; cuts in overtime and premia; reduction in employment; implementation of the new public wage law adopted in November 2009): 0.8% of GDP • Savings in social security expenditures (freeze on pensions - except the minimum social pension, better control on fraudulent disability pensions, early retirement claims, and social benefits): 0.8% of GDP • Reduction in goods and services expenditures: 0.5 % of GDP Revenues driven consolidation measures* for 2010: • Turnover tax on medical distributors: 0.1% of GDP • Rompetrol bond redemption: 0.5% of GDP • Excise increase: 0.4% of GDP 2011 and 2012 deficit trajectory according to updated CP (% in GDP): 4.4% and 3% (ESA’95) * Compared to baseline no-measures scenario National Bank of Romania

42. Fiscal reform measures Public sector wage legislation • Initial reform law (“unified wage law”) adopted in November 2009, specifying a unified and simplified pay scale across the general government, reforming and capping bonuses for civil servants, setting a clear mandate to reduce the wage bill to 7% of GDP by 2015 (from 9.5% in 2009, cash-basis); • Further steps: additional legislation - detailing the new system - to be adopted before end-September 2010, in order to ensure compliance with best practices and EU/IMF program objectives (pay grouped by type of work responsibility, pay benchmarked on private sector salaries, further reform of bonuses) Improve fiscal governance:approval of fiscal responsibility law (setting up a medium-term budgetary framework; introducing limits on in-year budget revisions; creating a Fiscal Council to assess official macroeconomic and revenue forecasts and monitor compliance with the government fiscal strategy), approve legislation to mitigate fiscal risks from local administration (development of standardised costing norms on goods and services and on personnel spending, prohibition of the movement of resources from capital to current spending, strengthening of the central governance oversight of local authorities by using e.g. ex-ante spending controls) – all of them in the first half of 2010, improving the performance of SOEs and developing better monitoring mechanisms for financial results in public enterprises Clear the stock of payment arrears:two-thirds of the end-2009 stock of outstanding arrears to be paid in 2010 and the rest by end-April 2011, a new patient participation fee system to be set up with a view to using the revenues to help clear arrears in health sector Enhance the long-term sustainability of public finance: • pension reform legislation to be approved by end-June 2010 (gradually indexing pensions to inflation; contributions to be phased-in for the excluded groups; equalizing retirement ages between men and women at 65 by 2030; reducing early retirement and improving participation rates; tightening the eligibility criterion of disability pensions etc.) • initiating work on a comprehensive reform to develop a more streamlined and transparent, means-tested social assistance system. National Bank of Romania

43. Other fiscal policy challenges • Implementing fiscal consolidation on the expenditure side while avoiding cuts in the productive items of the budget (expenditure on education and research, public investment in infrastructure), with a view to enhance long-run economic growth • Increasing the absorption of Structural Funds • Achieving the Medium Term Objective (structural deficit of 0.7% of GDP) • Coping with supplementary expenditures driven by population ageing National Bank of Romania

44. Thank you for your attention! National Bank of Romania