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EUROPEAN COMMISSION DIRECTORATE GENERAL ECONOMIC AND FINANCIAL AFFAIRS Brussels, 26 May 2016 Assessment of the 2016 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 2015 ........................................................................... 5 3.2. Medium-term strategy and targets..................................................................... 5 3.3. Measures underpinning the programme ............................................................ 8 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 .............................................................................. 12 5. FISCAL SUSTAINABILITY ................................................................................... 14 6. FISCAL FRAMEWORK .......................................................................................... 16 7. CONCLUSIONS ....................................................................................................... 16 8. ANNEX ..................................................................................................................... 17 2 1. INTRODUCTION This document assesses Romania's 2016 convergence programme, which was submitted on 28 April and covers the period 2016-2019. It has been approved by the government. Romania is subject to the preventive arm of the the Stability and Growth Pact and should preserve a sound fiscal position which ensures compliance with the medium term objective. This document complements the Country Report published on 26 February 2015 and updates it with the information included in the Convergence programme. The following section presents the macroeconomic outlook underlying the convergence programme and provides an assessment based on the Commission 2016 spring forecast. Section 3 presents the recent and planned budgetary developments, according to the convergence 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 and the quality of public finances. Section 7 provides a summary. 2. MACROECONOMIC DEVELOPMENTS The convergence programme's macroeconomic scenario assumes a continuous improvement of the economic performance. The growth rate of real GDP is expected to increase steadily to 4.2% in 2016 and 4.3% in 2017. Domestic demand is set to remain the sole engine of growth. Private consumption is expected to continue growing although at a lower pace as of 2017 on the back of economic growth and increasing real household disposable incomes as wages keep growing and the labour market outlook is improving. The growth rate of gross fixed capital formation (GFCF) is forecast to increase steadily from 6.6% in 2016 to 7.5% in 2019, supported also by expected substantial inflows of EU funds. The real GDP growth forecast was revised upwards from 3.4% for 2016 and 3.7% for 2017 in the previous convergence programme due to better-than-expected growth in 2015, lower oil prices and the impact of the VAT cut for food from 1 June 2015. Potential output is projected to continue growing from 3.4% in 2016 to 4.2% in 20191. The (negative) output gap as recalculated by the Commission based on the information in the programme, following the commonly agreed methodology (in the remainder, the term "recalculated" will be used), is projected to close in 2016 and to turn positive in 20172. 1 The time horizon used by the Romanian authorities for the calculation of potential growth and the output gap is 2016-2019. According to the Convergence Programme, if the forecast horizon is restricted to 2017, potential growth slows down slightly to 3.2 % in 2016 and 3.7 % in 2017, leading to an output gap of -0.2 % in 2016 and 0.4 % in 2017. 2 There is a difference between the Commission's estimate for the output gap in 2016 (0.0%) and the (recalculated) output gap in the Convergence Programme (-0.4%). This is also the case for 2017 (output gap of 0.3% according to Commission estimations compared with 0.0% in the Convergence Programme). The differences arise mainly from the longer time horizon of the forecasts in the Convergence Programme. 3  Table 1: Comparison of macroeconomic developments and forecasts 2015 2016 2017 2018 2019 COM CP COM CP COM CP CP CP Real GDP (% change) 3.8 3.8 4.2 4.2 3.7 4.3 4.5 4.7 Private consumption (% change) 6.1 6.1 6.9 6.3 5.0 5.3 5.1 4.9 Gross fixed capital formation (% change) 8.8 8.8 5.5 6.6 6.1 6.9 7.3 7.5 Exports of goods and services (% change) 5.5 5.5 4.5 4.5 4.8 5.6 6.3 6.6 Imports of goods and services (% change) 9.1 9.1 9.8 8.7 7.6 7.8 7.9 7.8 Contributions to real GDP growth: - Final domestic demand 6.1 6.1 6.4 6.0 5.0 5.3 5.3 5.3 - Change in inventories -0.8 -0.8 0.0 0.0 0.0 0.0 0.0 0.0 - Net exports -1.5 -1.5 -2.2 -1.8 -1.3 -1.0 -0.8 -0.6 Output gap1 -1.1 -1.2 0.0 -0.4 0.3 0.0 0.4 0.9 Employment (% change) -0.9 -0.9 0.0 0.2 -0.1 0.6 0.9 1.0 Unemployment rate (%) 6.8 6.8 6.8 6.7 6.7 6.6 6.5 6.4 Labour productivity (% change) 4.7 4.7 4.2 4.0 3.8 3.7 3.5 3.6 HICP inflation (%) -0.4 -0.4 -0.6 -0.5 2.5 2.3 2.5 2.3 GDP deflator (% change) 2.9 2.9 2.0 2.0 2.4 2.1 2.2 2.0 Comp. of employees (per head, % change) 3.2 3.2 6.9 5.6 6.2 5.2 5.1 5.1 Net lending/borrowing vis-à-vis the rest of 1.5 1.2 0.1 0.7 -0.7 0.5 0.5 0.5 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 2016 spring forecast (COM); Convergence Programme (CP). The real GDP growth included in the programme is identical with the Commission projection for 2016, but 0.5 pps. higher in 2017 due to favourable assumptions for the growth rates of GFCF and exports. The expected growth rates for private consumption are plausible both for 2016 and 2017. The GFCF growth rates in the convergence programme for 2016 and 2017 are favourable compared with the projections of the Commission. On the external side, the assumptions for export growth rates are plausible for 2016 and favourable for 2017. The assumptions for the growth rate of imports are cautious for 2016 and plausible for 2017. The growth estimates do not include any impact from structural reforms as the measures presented in the national reform programme are not quantified. The projections for the growth rates of compensation of employees are cautious for both 2016 and 2017 compared with the Commission's forecast, due to differences in the employment growth projections and in the assumptions on public wage increases. The inflation projections of the convergence programme are in line with Commission estimates. Overall, the economic growth assumptions in the convergence programme are plausible for 2016 and slightly favourable for 2017. Downside risks to the macroeconomic outlook mainly stem from the uncertainty caused by the adoption of a law on debt discharge (see section 3.3 below). 4 3. RECENT AND PLANNED BUDGETARY DEVELOPMENTS 3.1. Deficit developments in 2015 The 2015 budget deficit amounted to 0.7% of GDP in headline terms and 0.6% of GDP in structural terms. Romania' structural deficit thus remained below its MTO of 1% of GDP. The 2015 convergence programme targeted a higher budget deficit of 1.3% of GDP for 2015. The better-than-expected outturn is mainly due to better-than-expected tax revenues by 2.2% of GDP, both from indirect and from direct taxes. Strong economic growth and enhanced tax compliance more than offset the adopted tax cuts (in particular, a cut in social security contributions implemented in the end of 2014, a cut in VAT rate for food in force since mid 2015) and the higher expenditure (by 1.7% of GDP). Real GDP growth outturn in 2015 – at 3.8% – was better than the 3.2% assumed in the previous convergence programme, with a positive impact on the general government outturn in 2015. 3.2. Medium-term strategy and targets The programme plans a significant deterioration of the headline deficit from 0.7% of GDP in 2015 to 2.9% in 2016 and 2017 and a gradual decrease of the deficit thereafter, to 2.3% of GDP in 2018 and 1.6% of GDP in 2019. The programme does not change the MTO chosen in the previous programmes of a deficit of 1% of GDP in structural terms. This MTO is more stringent than what the Pact requires and also aims at taking into account the requirements of the Treaty on the Stability, Coordination and Governance in the Economic and Monetary Union. Romania reached the MTO in 2014 and 2015. The programme plans to significantly depart from the MTO in 2016 and to return to an adjustment path toward it from 2018 onwards. The programme does not envisage reaching the MTO over the programme horizon (until 2019). The deficit targets in the current programme are significantly higher than the ones in the 2015 programme (headline deficit targets of 1% of GDP in 2016 and 0.8% of GDP in 2017). This is mainly due to the significant fiscal loosening measures adopted since the last programme, notably the amendment to the Fiscal Code which introduced significant tax cuts as well as public wage increases. For details on the adopted measures see section 3.3 below. 5  Table 2: Composition of the budgetary adjustment Change: 2015 2016 2017 2018 2019 (% of GDP) 2015-2019 COM COM CP COM CP CP CP CP Revenue 34.8 31.8 32.5 31.5 31.7 31.9 31.8 -3.0 of which: - Taxes on production and imports 13.2 11.9 12.0 11.2 11.2 11.2 11.1 -2.1 - Current taxes on income, wealth, etc. 6.7 6.4 6.5 6.5 6.6 6.7 6.7 0.0 - Social contributions 8.1 8.2 8.1 8.1 8.1 8.1 8.2 0.1 - Other (residual) 6.7 5.3 5.9 5.8 5.8 5.9 5.8 -0.9 Expenditure 35.5 34.6 35.4 34.9 34.6 34.1 33.4 -2.1 of which: - Primary expenditure 33.9 32.9 33.8 33.1 33.0 32.5 32.0 -1.9 of which: Compensation of employees 7.6 8.3 8.1 8.4 7.9 7.8 7.7 0.1 Intermediate consumption 5.6 5.6 5.6 5.6 5.5 5.5 5.4 -0.2 Social payments 11.5 11.4 11.4 11.2 11.2 11.0 10.7 -0.8 Subsidies 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.0 Gross fixed capital formation 5.1 3.8 4.6 4.1 4.5 4.5 4.5 -0.6 Other (residual) 3.6 3.4 3.6 3.3 3.4 3.4 3.3 -0.3 - Interest expenditure 1.6 1.7 1.6 1.7 1.6 1.6 1.4 -0.2 General government balance (GGB) -0.7 -2.8 -2.9 -3.4 -2.9 -2.3 -1.6 -0.9 Primary balance 0.9 -1.1 -1.3 -1.6 -1.2 -0.7 -0.2 -1.1 One-off and other temporary 0.3 0.1 0.0 0.0 0.0 0.0 0.0 -0.3 GGB excl. one-offs -1.0 -2.8 -2.9 -3.4 -2.9 -2.3 -1.6 -0.6 Output gap1 -1.1 0.0 -0.4 0.3 0.0 0.4 0.9 2.0 1 Cyclically-adjusted balance -0.4 -2.8 -2.7 -3.4 -2.9 -2.4 -1.9 -1.5 2 Structural balance -0.6 -2.8 -2.7 -3.4 -2.9 -2.4 -1.9 -1.3 2 Structural primary balance 1.0 -1.1 -1.1 -1.7 -1.3 -0.8 -0.5 -1.5 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 2016 spring forecasts (COM); Commission calculations. In 2016, the programme envisages a significant deterioration of the headline balance to -2.9% of GDP, while the structural balance (recalculated by the Commission on the basis of the information in the programme according to the commonly agreed methodology) is set to decrease to -2.7% of GDP. The deterioration is driven by the revenue side. Significant tax cuts enacted in 2015 are set to have a negative impact on revenues. The expenditure-to-GDP ratio is projected to be broadly stable, with the significant increases of public wages offset by a fall in gross fixed capital formation. The 2016 deficit projection in the programme is similar to the one from the Commission' spring 2016 forecast. In 2017, the programme envisages an unchanged headline deficit at 2.9% of GDP, and a (recalculated) structural deficit at the same level. A decrease of the revenue-to-GDP ratio, driven by further, already enacted tax cuts, is planned to be offset by moderation on the 6 expenditure side. The 2017 projection in the programme is more optimistic than the Commission's (3.4% of GDP). The difference is due to more optimistic macro scenario in the programme (2017 real GDP growth of 4.3% in the programme compared to 3.7% of GDP in the spring forecast) and to consolidation measures on the expenditure side which are not specified in detail. The planned improvement of the headline balance in 2018 (-2.3% of GDP) and 2019 (-1.6% of GDP) relies on a steady fall of expenditures as a share of GDP, while the revenues are projected to remain broadly stable. The envisaged consolidation relies on unspecified measures, as the programme does not explain in detail the measures supporting the planned consolidation targets. The headline balance targets for 2016-2017 are much lower – by around 2 percentage points of GDP – compared to previous convergence programmes (Figure 1) due to the significant fiscal easing measures (in