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EUROPEAN COMMISSION DIRECTORATE GENERAL ECONOMIC AND FINANCIAL AFFAIRS Brussels, 23 May 2018 Assessment of the 2018 Convergence Programme for Romania (Note prepared by DG ECFIN staff) 1  CONTENTS 1. INTRODUCTION ....................................................................................................... 3 2. MACROECONOMIC DEVELOPMENTS ................................................................ 3 3. RECENT AND PLANNED BUDGETARY DEVELOPMENTS.............................. 5 3.1. DEFICIT DEVELOPMENTS IN 2017 AND 2018 .................................................... 5 3.2. MEDIUM-TERM STRATEGY AND TARGETS ..................................................... 5 3.3. MEASURES UNDERPINNING THE PROGRAMME ............................................. 7 3.4. DEBT DEVELOPMENTS .......................................................................................... 9 3.5. RISK ASSESSMENT ............................................................................................... 11 4. COMPLIANCE WITH THE PROVISIONS OF THE STABILITY AND GROWTH PACT ...................................................................................................... 12 4.1. Compliance with the deficit criterion .............................................................. 12 4.2. Compliance with the MTO or the required adjustment path towards the MTO ................................................................................................................ 12 5. FISCAL SUSTAINABILITY ................................................................................... 15 6. FISCAL FRAMEWORK .......................................................................................... 18 7. SUMMARY .............................................................................................................. 19 8. ANNEXES ................................................................................................................ 20 2 1. INTRODUCTION On 14 May 2018, Romania submitted its 2018 Convergence Programme (hereafter called the Programme), covering the period 2018-2021. The government approved the programme on 11 May 2018. 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. In spring 2017, a significant deviation procedure (SDP) was opened for Romania due to the observed significant deviation in 2016. On 5 December 2017, the Council found that Romania had not taken effective action in response to the Council recommendation of 16 June 2017 and issued a revised SDP recommendation for a fiscal adjustment in 2018. On 23 May 2018, the Commission recommended a decision to the Council, which finds that Romania had not taken effective action in response to the revised Council recommendation of 5 December 2017. 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 2017 and recommended the Council to adopt a new SDP recommendation. This document complements the Country Report published on 7 March 2018 and updates it with the information included in the Programme. Detailed information concerning the latest steps within the significant deviation procedure can be found in the Comission Staff Working Document accompanying the legal documents adopted on 23 May 2018. Section 2 presents the macroeconomic outlook underlying the Programme and provides an assessment based on the Commission 2018 spring forecast. The following section presents the recent and planned budgetary developments, according to the Programme. In particular, it includes an overview on the medium term budgetary plans, an assessment of the measures underpinning the Convergence 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 Romania's economy will continue to grow at very robust rates. After reaching a post crisis high of 6.9% in 2017, real GDP growth is projected to decelerate gradually to 6.1% in 2018, 5.7% in 2019 and 2020, and 5% in 2021. Private consumption, which expanded by 10.1% in real terms in 2017, is expected to slow down to an average annual real growth rate of 5.8% over the 2018-2021 horizon but is nevertheless forecast to remain the main driver of growth. Investment growth is projected to further accelerate between 2018 and 2020, before slightly moderating in 2021. Imports are forecast to continue outpacing exports over the forecast horizon and net exports are consequently expected to remain a drag on GDP growth. The real GDP growth forecast for 2018 was revised upwards by 0.6 pps. compared to the previous convergence programme. This is due mainly to a higher expected contribution to growth from domestic demand. The real GDP growth projected in the Programme for 2018 and 2019 is higher than the Commission forecast mostly due to more optimistic assumptions regarding the growth rates of 3 private consumption despite a foreseen deceleration of gross disposable income starting in 2018. The Programme's projections of compensation per employee growth and inflation over the coming two years are in line with the Commission's spring 2018 forecast. The Programme's expectations regarding investment are also broadly in line with the Commission's latest forecast. On the external side, the assumptions of the Programme for export and import growth rates are plausible for 2018 and 2019. The recalculated output gap as estimated by the Commission based on the information in the Programme, following the commonly agreed methodology, is projected to have nearly closed in 2017, to turn positive in 2018 and to grow further in 2019. Overall, the economic growth assumptions in the Programme are favourable for 2018-2021. The main downward risk to the macroeconomic outlook stems from a stronger than expected slowdown of private consumption as wage growth tempers and inflation increasingly weighs on real disposable income. Table 1: Comparison of macroeconomic developments and forecasts 2017 2018 2019 2020 2021 COM CP COM CP COM CP CP CP Real GDP (% change) 6.9 6.9 4.5 6.1 3.9 5.7 5.7 5.0 Private consumption (% change) 10.1 10.1 4.9 6.5 4.2 6.1 5.8 5.5 Gross fixed capital formation (% change) 4.7 4.7 7.4 7.9 6.9 8.4 8.6 7.4 Exports of goods and services (% change) 9.7 9.7 7.5 7.4 6.8 6.9 7.1 6.9 Imports of goods and services (% change) 11.3 11.3 8.2 8.5 7.4 8.0 7.9 7.8 Contributions to real GDP growth: - Final domestic demand 7.5 7.5 5.0 6.7 4.4 6.2 6.1 5.5 - Change in inventories 0.2 0.2 0.0 0.0 0.0 0.0 0.0 0.0 - Net exports -0.7 -0.8 -0.5 -0.6 -0.5 -0.6 -0.5 -0.5 Output gap1 1.2 -0.1 1.4 0.8 1.1 1.2 1.6 1.8 Employment (% change) 2.6 2.6 0.9 2.4 0.1 1.8 1.2 1.0 Unemployment rate (%) 4.9 4.9 4.5 4.8 4.4 4.6 4.5 4.4 Labour productivity (% change) 4.2 4.2 3.6 3.6 3.9 3.8 4.4 4.0 HICP inflation (%) 1.1 1.1 4.2 3.8 3.4 2.8 2.6 2.5 GDP deflator (% change) 5.3 5.3 5.2 2.1 4.0 1.9 1.9 2.0 Comp. of employees (per head, % change) 16.0 16.0 8.7 8.1 6.7 7.0 7.5 7.2 Net lending/borrowing vis-à-vis the rest of -1.9 -2.2 -2.1 -1.4 -2.1 -0.9 -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 2018 spring forecast (COM); Convergence Programme (CP). 4 3. RECENT AND PLANNED BUDGETARY DEVELOPMENTS 3.1. DEFICIT DEVELOPMENTS IN 2017 AND 2018 In 2017, the general government deficit decreased slightly, to 2.9% of GDP, from 3.0% of GDP in 2016, while the economy grew significantly above its potential. This slight decrease of the headline deficit was cyclical in nature and not due to fiscal consolidation measures. Tax cuts, in particular, a 1pp. cut to the standard VAT rate, had a negative effect on tax revenues. On the expenditure side, compensation for employees increased considerably (by 0.8 % of GDP). On the other hand, public investment dropped (by 0.8 % of GDP). Given that the output gap increased significantly and turned positive, the structural deficit increased to 3.3% of GDP in 2017, from 2.1% in 2016. The 2017 general government deficit outcome of 2.9% of GDP fulfils the target in the 2017 Convergence Programme. Both the revenues and the expenditures turned out lower than planned in the 2017 Convergence Programme. On the revenue side, the target for both indirect and direct tax revenues was not achieved. On the expenditure side, public investment was significantly lower than planned. In 2018, the programme targets a slight increase of the headline deficit to 2.95% of GDP1. This target is slightly higher than the 2.9% of GDP planned in the 2017 Convergence Programme. Both revenues and expenditures are higher as a share of GDP than in the last year's programme. On the revenue side, the planned revenues from social contributions are significantly higher (by 2.2 percentage points of GDP) while the planned revenues from direct taxes are significantly lower (by 1.9 percentage points of GDP) than planned in the 2017 Convergence Programme, reflecting a reform to the fiscal code and a decrease of the share of social contributions transferred to the second pension pillar, both adopted in autumn 2017. On the expenditure side, the planned compensation for employees considerably increased (by 2.0 percentage points of GDP), reflecting the Unified Wage Law adopted in summer 2017. On the other hand, planned public investment dropped significantly compared to last year's programme (by 1.1 percentage points of GDP). The planned 2018 headline deficit is lower than the 3.4% of GDP projected by the Commision in the spring 2018 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 mantains the MTO of a deficit of 1% of GDP in structural terms. This MTO is more stringent than required by the Pact and aims at taking into account the requirements of the Treaty on the Stability, Coordination and Governance in the Economic and Monetary Union. The Programme plans to deviate from the adjustment path towards the MTO in 2018 and to start to adjust toward the MTO from 2019 onwards. The Programme does not envisage reaching the MTO over the programme horizon (2021). The structural balance - recalculated by the Commission according to the commonly agreed methodology – is projected to increase from 2.9% of GDP in 2017 to 3.3% of GDP in 2018 and to gradually decrease thereafter, to 2.1% of GDP in 2021. 1 In their report on action taken in response to Council recommendation of 5 December 2017, submitted on 20 April 2018, the Romanian authorities mention a headline deficit target of 2.95% of GDP in 2018. The slight difference of the target is due to the revised underling macroeconomic projection. 5  Table 2: Composition of the budgetary adjustment 2017 2018 2018 2019 2019 2020 2021 Change: 2017 2018 2019 2020 2021 (% of GDP) 2017-2021 COM COM CP COM CP CP CP CP Revenue 30.5 30.9 31.3 31.1 31.5 31.8 32.0 1.5 of which: - Taxes on production and imports 10.3 10.4 10.8 10.5 10.3 10.4 10.3 0.0 - Current taxes on income, wealth, etc. 6.1 4.7 4.9 4.8 5.0 5.1 5.2 -0.9 - Social contributions 9.3 10.7 10.9 10.6 11.5 11.8 12.2 2.9 - Other (residual) 4.8 5.0 4.7 5.2 4.7 4.5 4.3 -0.5 Expenditure 33.4 34.3 34.3 34.9 33.9 33.6 33.4 0.0 of which: - Primary expenditure 32.0 32.9 32.9 33.4 32.6 32.2 32.0 -0.1 of which: Compensation of employees 9.7 10.4 10.3 10.3 9.9 9.7 9.4 -0.3 Intermediate consumption 4.9 4.9 4.7 4.9 4.5 4.2 4.2 -0.7 Social payments 11.6 11.6 11.4 11.8 11.8 11.6 11.4 -0.2 Subsidies 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.0 Gross fixed capital formation 2.8 2.9 2.9 3.1 3.0 3.5 4.0 1.2 Other (residual) 2.6 2.8 3.1 2.9 2.9 2.8 2.7 0.1 - Interest expenditure 1.3 1.4 1.4 1.4 1.3 1.4 1.4 0.1 General government balance (GGB) -2.9 -3.4 -3.0 -3.8 -2.4 -1.8 -1.5 1.4 Primary balance -1.6 -2.0 -1.5 -2.4 -1.0 -0.5 -0.1 1.5 One-off and other temporary 0.0 -0.1 0.0 0.0 0.0 0.0 0.0 0.0 GGB excl. one-offs -2.9 -3.3 -3.0 -3.8 -2.4 -1.8 -1.5 1.4 1 Output gap 1.2 1.4 0.8 1.1 1.2 1.6 1.8 1.9 1 Cyclically-adjusted balance -3.3 -3.9 -3.3 -4.2 -2.8 -2.4 -2.1 0.8 2 Structural balance -3.3 -3.8 -3.3 -4.2 -2.8 -2.4 -2.1 0.8 2 Structural primary balance -2.0 -2.3 -1.9 -2.7 -1.5 -1.0 -0.7 0.8 Notes: 1 Output gap (in % of potential GDP) and cyclically-adjusted balance according to the programme as recalculated by Commission on the basis of the programme scenario using the commonly agreed methodology. 2 Structural (primary) balance = cyclically-adjusted (primary) balance excluding one-off and other temporary measures. Source : Convergence Programme (CP); Commission 2018 spring forecasts (COM); Commission calculations. The Programme plans a gradual improvement of the headline balance over 2019-2021. The planned fiscal consolidaton is based on both the revenue and expenditure side a a share of GDP. On the revenue side, the improvement is due to planned increases of collected direct taxes and social contributions, while on the expenditure side it relies on a moderation of expenditures on public wages, social benefits and spending on goods and services. Public investment relative to GDP is planned to increase. The Programme does not specify the measures which would support the planned 2019-2021 consolidation targets. The deficit targets for 2019-2021 in the current Programme are somewhat lower than the targets from the previous conve