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Current account sustainability and implications for fiscal policy in Romania Presentation by Lorena IONITA and Stefaan PAUWELS, European Commission, DG Economic and Financial Affairs Iasi, 25-26 September 2008 1 Contents • Part I: assessment of current account sustainability – – – – – • Current account developments: brief recap Financing of the current account deficit The domestic use of foreign savings Selected indicators of competitiveness Balance of risks and outlook Part II: implications for fiscal policy – What role for fiscal policy? – Fiscal policy in Romania • Part III : EU policy framework - the Stability and Growth Pact (SGP) – The SGP: background – Romania and the SGP • Conclusions European Commission 2 Part I Current account sustainability assessment 3 Current account developments • Romania’s domestic demand boom has come along widening external imbalances • The supply of foreign savings was accelerated by a boom in financial intermediation. Current account deficit % GDP 25% 2002 2007 20% 15% EU12 average in 2007 10% 5% 0% -5% PL HU SI MT SK CZ CY LT RO EE BG LV Source: Commission services 4 Financing the CA deficit (1/2) • Moderate, but increasing vulnerabilities - Declining relative importance of FDI; non-privatization related FDI flows resilient so far; - Increasing reliance on debt financing; - Coverage rate of short term debt rapidly declining. Composition external debt stock 70% %GDP 60% 17% 50% 13% 8% 40% 30% 2% 20% 3% 2% 4% 5% 30% 33% 33% 34% 35% 2000 2001 2002 2003 2004 39% 42% 2005 2006 49% 10% 0% medium and long-term external debt 2007 short-term external debt Source: Commission services 5 Financing the CA deficit (2/2) Coverage rate of short-term debt by forex reserves 600% 500% 400% 300% 200% 100% 0% 2000 2001 2002 2003 2004 2005 2006 2007 Source: Commission services 6 The domestic use of foreign savings Current account deficit in 2006 (% GDP) • Mixed picture: predominance of non-tradable sectors amongst FDI and domestic credit recipients, feeding the domestic demand boom; yet, continued foreign investor interest in the manufacturing sector strengthens Romania’s export base. 0% PL -5% CZ HU SK -10% RO LT EE -15% BG -20% LV -25% 0% 10% 20% 30% 40% 50% 60% Share of net inw ard FDI inflow s to tradable sectors in 2000-2005(%) Source: Commission services 7 Export competitiveness (1/2) • Exports have been low, but recent signs of recovery 35% • Signs of healthy export potential • Rising market shares • Export composition improved • High profitability in export sector yoy growth Export profitability (index 2001=100) 30% 200 25% 20% 150 15% 10% 100 5% Goods exports (fob) Source: Commission services Mar-08 Nov-07 Jul-07 Mar-07 Nov-06 Jul-06 Mar-06 Nov-05 Jul-05 Mar-05 Nov-04 Jul-04 Mar-04 0% Goods imports (fob) 50 ULC manufacturing Export deflator 0 2001 2002 2003 2004 2005 2006 2007 Source: Commission services 8 Export competitiveness (2/2) • Following the RON depreciation since August 2007, the real effective exchange rate dropped, stimulating exports • Equilibrium exchange rate estimations show no evidence of significant exchange rate misalignments 9 External sustainability: balance of risks and outlook + - Drivers of the current account deficit - Recent surge in exports, strong competitiveness - Moderation of domestic demand pressure on imports following monetary policy tightening and stricter prudential rules on domestic credit - Significant margin for improving absorption of (non-debt creating) EU transfers - Risk of a further slowdown euro area, dampening demand for exports - Further loosening of fiscal policy, adding to domestic demand pressures - Rapid wage increases, driving demand for imports - Lower transfers of remittances following slowdown euro area Financing of the deficit Non-privatisation FDI seems to hold up well -Increasing short-term debt roll-over risk - Higher financing cost 10 To sum up: • Risks to sustainability are moderate, but increasing • Healthy export potential • But: urgent need to cool down of domestic demand pressures • Although part of the risks are external, a stronger domestic policy response, especially from fiscal policy, will be key in securing investor confidence 11 Part II Implications for fiscal policy 12 What role for fiscal policy? • Prudence in good economic times - counterbalance strong private sector expansion - not only avoid procyclicality, but use good times for fiscal consolidation - recognise that potential growth and revenue buoyancy are easily overestimated during economic booms, notably credit and asset price booms • Provide cushion when growth slows down - avoid double retrenchement in case of sudden economic slowdown, i.e. a reduction of domestic demand compunded by a contraction of public spending • Contribute to growth by favouring growth-enhancing investments • Foster stable expectations through strong fiscal institutions, e.g. a credible medium-term fiscal framework, which helps protect growth-supporting spending priorities 13 Fiscal policy in Romania (1/4) • Fiscal policy has been pro-cyclical, adding to domestic demand pressure Romania fiscal stance and output gap Fiscal stance (Changes in CAPB) 1.0 Pro-cyclical fiscal tightening Counter-cyclical fiscal tightening 0.0 2005 2007 2008 2009 Procyclical fiscal loosening 2003 -1.0 2004 -2.0 Countercyclical fiscal loosening -6.0 -5.0 -4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 2006 3.0 4.0 5.0 6.0 Cyclical conditions (Output gap) Source: Commission services’ spring 2008 forecast 14 Fiscal policy in Romania (2/4) • High current spending, notably social benefits and public sector wages (for its level of economic development) leaves less room for productive investments Composition of e xpe nditure (% of total e xpe nditure ) 70.0 Romania 60.0 Euro area 50.0 40.0 30.0 20.0 10.0 0.0 Social benefits Compensation of employees Subsidies Interest GFCF Source: Commission services 15 Fiscal policy in Romania (3/4) • Public sector wage policy has been loose; in addition it added to private sector wage pressures Gross wage Romania: Public sector wage developments (2003=100) 220 Economy wide 200 Public administration Education 180 Health 160 140 120 100 2005 2006 2007 Source: IMF 16 Fiscal policy in Romania (4/4) • Lack of predictability and weak budgetary planning and execution: - Frequent in-year rectifications - Large end-year spending - Under-spending of capital expenditure and shifting to current spending - Slippages in current spending, notably wages and social benefits 17 Part III The EU policy framework: the Stability and Growth Pact (SGP) 18 The SGP: background • Legally-based fiscal rules • ‘Preventive arm’: - Stability and convergence programmes: medium-term budgetary objectives; Council opinion - Legal instruments: policy advice; early warning. •‘Corrective arm’: - Legal instrument: excessive deficit procedure 3% of GDP deficit threshold; graduated enforcement mechanism; possibility of sanctions. 19 Romania and the SGP (2/2) • 12 June 2008 Commission policy advice on economic and budgetary policy in Romania recommended the country to: - tighten fiscal policy so as to ensure the deficit does not breach 3% of GDP reference value and help containing external imbalances - implement a binding medium-term fiscal framework - accelerate structural reforms (labour market, education, business environment) aiming at increasing growth potential and external competitiveness. 20 Conclusions • A stronger response from fiscal policy is needed in line with the recommendations of the June 2008 Commission policy advice: – Control the deficit level – Improve the expenditure composition – Enhance predictability of budgetary policy • Responsible domestic policy response also needed to preserve investor confidence, notably in the current international economic context 21