Press Release No. 23/427

IMF Executive Board Concludes 2023 Article IV Consultation with Romania

December 8, 2023

Washington, DC: The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with Romania, and considered and endorsed the staff appraisal without a meeting. [2]

Romania has weathered the economic shocks from the pandemic, Russia’s war in Ukraine, and the resulting surges in energy and food prices relatively well. Growth, at 4.7 percent, surprised on the upside in 2022 but slowed in the first half of 2023 to around 1.9 percent y/y as consumption weakened due to real incomes being eroded by inflation, and external demand remained subdued. Public and private investment, on the other hand, has accelerated further. CPI inflation peaked at 16.8 percent y/y in November 2022, and has since been falling steadily to 8.8 percent y/y in September, aided by base effects, price caps on energy and, more recently, receding energy and food prices, an easing of supply bottlenecks, and monetary tightening. The financial sector remains robust. Fiscal deficits remain high. While spending pressures from the pandemic and support measures to cushion increases in energy and food prices have abated, structural spending has increased since 2019 without offsetting increases in revenue, and fiscal consolidation has stalled in 2023. The current account deficit also remains large but is declining, and is largely driven by direct investment flows and rising inflows of EU funds. International reserves have increased significantly.

Despite the slowdown, growth is expected to remain robust. In 2023, growth is projected at 2¼ percent, before recovering modestly to around 2¾ percent in 2024 as stronger consumption—driven by rising real wages—and external demand are partially countered by the necessary fiscal consolidation. In the medium term, Romania’s growth trajectory is expected to return to its potential rate of around 3¾ percent as consumption and exports recover further, and investment, underpinned by RRF funds, remains strong. CPI inflation is projected to return inside the NBR’s target band in early 2025 on the back of weaker economic growth and falling prices for food and energy, which comprise almost half of the consumption basket. A fiscal package adopted by the authorities in September is a first step towards fiscal consolidation, although the deficit in 2023 is projected by staff at 6 percent of GDP. In 2024, without further fiscal measures, the deficit is forecast to fall to slightly above 5 percent of GDP. Over the medium term, owing to fiscal adjustment and—near the end of the projection horizon—declining EU capital grants, the current account deficit is projected to narrow moderately to around 6 percent of GDP.

Executive Board Assessment[3]

In concluding the 2023 Article IV consultation with Romania, Executive Directors endorsed staff’s appraisal, as follows:

Romania’s economy has performed relatively well in difficult times. Growth, while slowing, remains fairly robust, and higher than in most peers. Inflation, after peaking at lower levels than in CESEE peers, remains too high but is receding gradually. The impressive convergence to Western European income levels is continuing. At the same time, Romania’s external position in 2022 was substantially weaker than the level implied by fundamentals and desirable policies, although the assessment is subject to considerable uncertainty.

Growth is expected to recover modestly in 2024, and to return to its potential rate in the medium term, but there are substantial risks. Escalation of the war in Ukraine, a possible further weakening of activity across Europe, or an abrupt global slowdown could undermine growth and capital flows to emerging markets. Prolonged strong wage growth in Romania could delay the projected fall in core inflation. Finally, the electoral calendar could make fiscal consolidation and structural reforms in 2024 difficult to achieve.

A weak fiscal position renders Romania vulnerable. The scope to respond to adverse developments is circumscribed by a structural budget deficit well in excess of sustainable levels. Addressing this is a key priority Continued efforts to improve expenditure efficiency and tax collection are needed and welcome, but high spending pressures to address relative poverty and raise productivity imply that revenues must be increased.

The recently adopted fiscal package offers a welcome improvements in tax policy and should help reduce the fiscal deficit somewhat in 2024; but more will be needed. In particular, the reduction of some tax exemptions it is a step forward. However, some measures—notably the new turnover taxes—are not in line with good practice and should be reconsidered. Moreover, further tax reforms to raise at least 2 percent of GDP in additional revenue beyond the gains from the recent tax package are needed to put the fiscal deficit on a sustainable medium-term trajectory, while ensuring that all taxpayers pay their fair share. Streamlining VAT and personal income taxes (including the closing of loopholes and the removal of tax privileges) should be key elements of such a reform. Once this is achieved, consideration should be given to re-introduce progressive income taxation.

Tax and expenditure policies will need to become more predictable. Announcing further tax reforms well in advance will help companies and households adjust to these changes. Spending on pensions and public sector wages should be set on a sustainable formula-based trajectory, as envisaged in the NRRP. These steps should help improve medium-term budgeting, and underpin a credible path for the necessary fiscal consolidation. The new draft pension law would help reduce spending over the longer run, but generate upfront fiscal costs that could jeopardize efforts to reduce the deficit in the next few years. A gradual phase-in of these costs and prudent implementation are needed to avoid this risk.

Monetary policy should not be relaxed until core inflation is on a firm downward path as needed for returning headline inflation within the tolerance band by early 2025. Inflation is declining broadly in line with projections, but risks arise from strong wage growth. Moreover, the monetary authorities should also stand ready to tighten monetary policy if upside risks to core inflation materialize.

The recent episode of higher exchange rate volatility offers an opportunity to gradually increase two-way exchange rate flexibility over the medium term. This would reduce opportunities for destabilizing capital flows, raise monetary policy effectiveness, and enhance resilience to economic shocks. In this context, it is important to move gradually to preserve confidence gains made over the past decade. Enhanced data on inflation expectations would support the calibration of monetary policy.

While financial sector vulnerabilities are limited, emerging risks need to be monitored. Strong fundamentals of the financial sector underpin its resilience, but the recent increase in corporate FX borrowing warrants close scrutiny. The turnover tax on banks could, if maintained for an extended period, weaken banks’ financial buffers and already-low financial intermediation.

Improvements to the AML/CFT system should be swiftly implemented. Building on ongoing progress, the authorities should compile an overarching AML/CFT strategy to ensure the effective functioning of the AML/CFT system.

There is significant room to underpin real income growth and further convergence with Western Europe. This requires investment in physical infrastructure as well as people, and strengthening the efficiency of the state.

· Making the most of available EU support is critical—both to help finance much-needed investment, and to support implementation of the agreed reform agenda.

· Governance reforms are critical, including to enhance administrative capacity and transparency, fight corruption, and make SOEs more efficient. Such reforms would reinforce Romania’s attractiveness for investment and also counteract continued (though declining) net outmigration.

· Raising labor force participation is key to mitigating the effects of a falling population. Increasing opportunities for women to join the formal labor force, and improving education outcomes to enhance opportunities for all are especially important.

Advancing the green transition of Romania’s economy is vital. Reducing GHG emissions in line with EU and updated NECP targets is challenging, even though Romania’s electricity production is already dominated by low-carbon sources. In particular, the emissions by transport and housing sectors are difficult to address. This not only requires large and well-coordinated investments, but also a complementary set of policies to mitigate the social impact of the transition. Such policies should disincentivize carbon emissions (including through taxation) while shielding compensating low-income households. The scheduled closure of coal mines will require special efforts to provide compensation and new opportunities for affected households. Romania’s large potential for renewable energy offers it important opportunities to benefit from decarbonization and become more competitive in green value chains.