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EUROPEAN COMMISSION DIRECTORATE GENERAL ECONOMIC AND FINANCIAL AFFAIRS Brussels, 5 June 2019 Assessment of the 2019 Convergence Programme for Romania (Note prepared by DG ECFIN staff) Disclaimer This is not an official Commission document and the views expressed therein do not necessarily represent the views of the European Commission. 1  CONTENTS EXECUTIVE SUMMARY ................................................................................................. 3 1. INTRODUCTION ....................................................................................................... 3 2. MACROECONOMIC DEVELOPMENTS ................................................................ 4 3. RECENT AND PLANNED BUDGETARY DEVELOPMENTS.............................. 5 3.1. DEFICIT DEVELOPMENTS IN 2018 AND 2019 .................................................... 5 3.2. MEDIUM-TERM STRATEGY AND TARGETS ..................................................... 6 3.3. MEASURES UNDERPINNING THE PROGRAMME ............................................. 9 3.4. DEBT DEVELOPMENTS ........................................................................................ 11 3.5. RISK ASSESSMENT ............................................................................................... 12 4. COMPLIANCE WITH THE PROVISIONS OF THE STABILITY AND GROWTH PACT ...................................................................................................... 13 4.1. Compliance with the deficit criterion .............................................................. 13 4.2. Compliance with the MTO or the required adjustment path towards the MTO ................................................................................................................ 14 5. FISCAL SUSTAINABILITY ................................................................................... 16 6. FISCAL FRAMEWORK .......................................................................................... 19 7. CONCLUSIONS ....................................................................................................... 20 8. ANNEXES ................................................................................................................ 21 2 EXECUTIVE SUMMARY Romania is subject to the preventive arm of the Stability and Growth Pact. Romania's economic boom started to cool down in 2018. Real GDP grew by 4.1%, compared to 7% in 2017. In its spring 2019 forecast, the Commission projects the relative slowdown to continue in 2019 and 2020, with real GDP growing at 3.3% and 3.1%, respectively. Private consumption is forecast to remain strong in 2019 and to decelerate somewhat in 2020. Investment growth is expected to return to positive territory, following negative growth in 2018. According to the Commission’s spring forecast, Romania’s positive output gap started to narrow in 2018 and is set to close progressively on the back of decreasing labour and productivity contributions. The real GDP growth projected in the 2019 Convergence Programme (hereafter called the programme) is significantly higher than the Commission forecast mostly due to more optimistic assumptions regarding the growth rates of private consumption and investment. The general government deficit increased to 3.0% of GDP in 2018. The programme plans a modest decrease of the deficit to 2.8 % of GDP in 2019 and 2.7 % in 2020. The programme does not envisage reaching the medium-term budgetary objective (MTO) of a structural deficit of 1% of GDP over the programme horizon. The structural balance – recalculated by the Commission according to the commonly agreed methodology – is projected to decrease from 3.0% of GDP in 2018 to 2.7% of GDP in 2019 and increase to 2.9% of GDP in 2020. Downward risks to achieving the planned budgetary targets mostly stem from the favourable macroeconomic projections underpinning the programme, an overly optimistic revenue projection and a possible underestimation of current spending. Moreover, the fiscal consolidation from 2020 onwards is based on measures that are not specified in the programme. As a consequence of observed significant deviation from the recommended adjustment path towards the MTO in 2018, the Commission recommended to the Council to open a new Significant Deviation Procedure concerning Romania. Both in 2019 and in 2020, there is a risk of deviation from the recommended structural adjustment, both based on the programme and based on the Commission 2019 spring forecast. Moreover, although the programme projects the headline deficit to remain below the 3% of GDP reference value, according to the Commission 2019 spring forecast, based on a no-policy change assumption, Romania's headline deficit is projected to exceed the reference value in 2019 and in 2020. 1. INTRODUCTION On 8 May 2019, Romania approved and submitted its 2019 Convergence Programme, covering the period 2019-20221. The submission was made well past the deadline defined in Article 8 of Council Regulation (EC) No 1466/97, which defines that the convergence programmes shall be submitted preferably by mid April and not later than 30 April. Romania is currently subject to the preventive arm of the the Stability and Growth Pact (SGP) and should ensure sufficient progress towards its MTO. On 22 June 2018, a significant deviation procedure (SDP) was opened for Romania due to the observed significant deviation from the adjustment path towards the MTO in 2017. On 4 December 2018, the Council found 1 The English version of the programme was submitted on 15 May. 3 that Romania had not taken effective action in response to the Council recommendation of 22 June 2018 and issued a revised SDP recommendation for a fiscal adjustment in 2019. On 5 June 2019 the Commission recommended a Decision to the Council, concluding that Romania had not taken effective action in response to the revised Council recommendation of 4 December 2018. On the same day, the Commission issued a warning to Romania that a significant deviation from the adjustment path toward the medium-term budgetary objective was observed in 2018 and recommended the Council to adopt a new SDP recommendation. This document complements the Country Report published on 27 February 2019 and updates it with the information included in the programme. Detailed information concerning the latest steps within the SDP can be found in the Commission Staff Working Document accompanying the legal documents adopted on 5 June 2019. Section 2 presents the macroeconomic outlook underlying the programme and provides an assessment based on the Commission 2019 spring forecast. The following section presents the recent and planned budgetary developments, according to the programme. In particular, it includes an overview of the medium term budgetary plans, an assessment of the measures underpinning the programme and a risk analysis of the budgetary plans based on Commission forecast. Section 4 assesses compliance with the rules of the SGP, including on the basis of the Commission forecast. Section 5 provides an overview on long term sustainability risks and Section 6 on recent developments and plans regarding the fiscal framework. Section 7 provides a summary. 2. MACROECONOMIC DEVELOPMENTS The programme's macroeconomic scenario assumes that the economy will continue to grow at very robust rates. Real GDP grew 4.1% in 2018 and is projected in the Programme to accelerate to 5.5% in 2019 and 5.7% in 2020, before easing to 5% in 2020-2021. Private consumption, which expanded by 5.2% in 2018 in real terms, is expected to increase by 6.4% in 2019 and progressively moderate its growth thereafter, reaching 5.5% in 2022. After falling by 3.2% in 2018, investment is projected to recover strongly and grow by 6.9% and 7.9% in 2019 and 2020 respectively, before slightly moderating thereafter. Import growth is forecast to continue outpacing export growth over the forecast horizon but at a slower pace, thus leading to a still negative but diminishing contribution of net exports to growth over the forecast horizon. The real GDP growth forecast for 2019 was revised downwards by 0.2 percentage points compared to the 2018 Convergence Programme. This is mainly due to a slightly lower projected contribution to growth of domestic demand. The real GDP growth projected in the programme for 2019 and 2020 is higher than the Commission forecast mostly due to more optimistic assumptions regarding the growth rates of private consumption and investment. Specifically for the later, the programme’s forecast seems overly optimistic. On the external side, export growth is expected to accelerate while the Commission forecasts a clear deceleration. Imports show a more constant pattern over the forecast horizon, while here too the Commission forecasts a downward trend. This leads to a less negative contribution of net exports to real GDP growth than projected by the Commission. The projections on inflation over the coming two years are in line with the Commission's spring 2019 forecast. Finally, the deceleration in the growth rates of compensation per employee over the forecast horizon is stronger than in the Commission’s forecast. 4 The recalculated output gap as estimated by the Commission based on the information in the programme, following the commonly agreed methodology, is projected to turn slightly positive in 2019 and to continue increasing thereafter. Overall, the economic growth assumptions in the programme are favourable for 2019-2022. The main downward risks to the macroeconomic outlook stem from a possible stronger than expected slowdown of private consumption as wage growth tempers, higher inflation than expected (as was the case in the first quarter of 2019) and more muted developments in investment than forecast in the programme, due to the uncertain internal and external environment. Table 1: Comparison of macroeconomic developments and forecasts 2018 2019 2020 2021 2022 COM CP COM CP COM CP CP CP Real GDP (% change) 4.1 4.1 3.3 5.5 3.1 5.7 5.0 5.0 Private consumption (% change) 5.2 5.2 5.2 6.4 4.5 6.2 5.6 5.5 Gross fixed capital formation (% change) -3.2 -3.2 1.4 6.9 2.3 7.9 7.4 7.5 Exports of goods and services (% change) 5.4 5.4 4.4 6.9 3.6 7.1 7.0 7.0 Imports of goods and services (% change) 9.1 9.1 6.9 7.8 4.9 7.9 7.8 7.8 Contributions to real GDP growth: - Final domestic demand 2.9 2.9 4.2 6.1 3.8 6.2 5.5 5.5 - Change in inventories 2.9 2.9 0.3 0.0 0.0 0.0 0.0 0.0 - Net exports -1.7 -1.7 -1.3 -0.6 -0.7 -0.5 -0.5 -0.5 Output gap1 0.9 -0.4 0.6 0.1 0.2 0.7 0.7 0.9 Employment (% change) 0.2 0.2 0.3 1.4 0.2 1.2 1.2 1.0 Unemployment rate (%) 4.2 4.2 4.1 4.1 4.0 4.0 3.9 3.8 Labour productivity (% change) 3.9 3.9 2.9 4.1 2.9 4.4 3.7 3.9 HICP inflation (%) 4.1 4.1 3.6 3.5 3.0 2.6 2.5 2.4 GDP deflator (% change) 5.9 5.9 5.2 3.5 3.7 1.9 2.0 2.0 Comp. of employees (per head, % change) 18.4 18.4 13.5 8.1 9.0 6.1 5.5 5.4 Net lending/borrowing vis-à-vis the rest of -3.1 -3.3 -3.4 -1.7 -3.4 -0.8 -0.3 -0.1 the world (% of GDP) Note: 1 In % of potential GDP, with potential GDP growth recalculated by Commission services on the basis of the programme scenario using the commonly agreed methodology. Source : Commission 2019 spring forecast (COM); Convergence Programme (CP). 3. RECENT AND PLANNED BUDGETARY DEVELOPMENTS 3.1. DEFICIT DEVELOPMENTS IN 2018 AND 2019 In 2018, the general government deficit increased to 3.0% of GDP, from 2.7% of GDP in 2017, while the economy grew above its potential. The rise of the deficit was – similarly to previous years – mostly driven by expenditure on compensation for public employees, which increased by 1.1 percentage points of GDP. The unified wage law, enacted in summer 2017, increased gross public wages by 25% as of January 2018 and included additional wage 5 increases in the health and education sectors. The fiscal cost of these increases in gross wages was partially compensated by a shift in social security contributions from 22.75% for employers and 16.5% for employees to 2.25% and 35%, respectively. Moreover, the government partially reversed the past systemic pension reform by lowering the proportion of social contributions transferred to the second pension pillar (which is classified outside the general government) from 5.1% to 3.75% of gross wages. At the same time, the flat personal income tax (PIT) rate was cut from 16% to 10%. As a consequence, the revenue from social contributions increased by 2.1 percentage points of GDP while the revenue from direct taxes fell by 1.4 percentage points. Public investment in 2018 remained close to record low level as a share of GDP which had been reached in 2017. Thanks to the one-off effect from reimbursements of a car pollution tax, the structural deficit increased only slightly, from 2.9% of potential GDP in 2017 to 3.0% in 2018. The 2018 general government deficit outcome of 3.0% of GDP broadly fulfils2 the target in the 2018 Convergence Programme. Both revenues and expenditures were higher than planned in the 2018 Convergence Programme. On the revenue side, the targets for social contributions and other revenues were overachieved while indirect tax revenue was lower than planned. On the expenditure side, compensation of employees, intermediate consumption and social benefits were all higher than planned, while public investment was lower. In 2019, the programme targets a headline deficit of 2.8% of GDP. This target has been revised upwards compared to the 2.4% of GDP target in the 2018 Convergence Programme. Both revenues and expenditures are higher as a share of GDP than in the last year's programme. All the items on the revenue side, except direct taxes, are higher than planned in the 2018 Convergence Programme, partially reflecting a base effect from a better than expected 2018 outturn. On the expenditure side, the planned compensation of employees and intermediate consumption considerably increased. Planned public investment is also higher compared to last year's programme (by 0.5 percentage points of GDP). The 2019 headline deficit target of 2.8% of GDP is lower than the 3.5% of GDP projected by the Commission in the 2019 spring forecast. The difference is driven by the revenue side. For more information see section 3.5 below. 3.2. MEDIUM-TERM STRATEGY AND TARGETS The programme maintains the MTO of a deficit of 1% of GDP in structural terms. This MTO takes into account the requirements of the Treaty on the Stability, Coordination and Governance in the Economic and Monetary Union. It is more stringent than required by the Pact. The programme does not envisage reaching the MTO over the programme horizon (2022). The structural balance – recalculated by the Commission according to the commonly agreed methodology – is projected to decrease from 3.0% of GDP in 2018 to 2.7% of GDP in 2019, increase to 2.9% of GDP in 2020 and to gradually decrease again thereafter, to 2.3% of GDP in 2022. 2 The 2018 general government deficit outturn amounted to 3.02% of GDP, while the 2018 convergence programme targeted a deficit of 2.95% of GDP. 6  Table 2: Composition of the budgetary adjustment Change: 2018 2019 2020 2021 2022 (% of GDP) 2018-2022 COM COM CP COM CP CP CP CP Revenue 32.0 32.5 33.8 33.3 33.8 33.5 33.9 1.9 of which: - Taxes on production and imports 10.4 10.4 10.7 10.4 10.5 10.2 10.1 -0.3 - Current taxes on income, wealth, 4.9 5.1 4.9 5.1 5.0 5.0 5.1 0.2 etc. - Social contributions 11.4 11.9 12.3