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EUROPEAN COMMISSION Directorate-General Economic and Financial Affairs Brussels, 27 May 2015 Assessment of the 2015 Convergence Programme for ROMANIA (Note prepared by DG ECFIN staff)  CONTENTS 1. INTRODUCTION ....................................................................................................... 3 2. MACROECONOMIC OUTLOOK............................................................................. 3 3. RECENT AND PLANNED BUDGETARY DEVELOPMENTS.............................. 5 3.1. Deficit developments in 2014............................................................................ 5 3.2. Target for 2015 and medium-term strategy....................................................... 6 3.3. Debt developments .......................................................................................... 10 3.4. Risk assessment ............................................................................................... 12 4. COMPLIANCE WITH THE PROVISIONS OF THE STABILITY AND GROWTH PACT ...................................................................................................... 14 4.1. Compliance with the deficit criterion .............................................................. 14 4.2. Compliance with the MTO or the required adjustment path towards the MTO ................................................................................................................ 14 5. LONG-TERM SUSTAINABILITY ......................................................................... 17 6. FISCAL FRAMEWORK AND QUALITY OF PUBLIC FINANCES .................... 19 6.1. Fiscal framework ............................................................................................. 19 6.2. Quality of public finances ............................................................................... 19 7. CONCLUSIONS ....................................................................................................... 20 ANNEX ............................................................................................................................. 21 2 1. INTRODUCTION This document assesses Romania's April 2015 Convergence Programme (hereafter called Convergence Programme), which was submitted to the Commission on 30 April1 and covers the period 2014-18. It was approved by the government. The 2015 Convergence Programme contains a main scenario, which does not incorporate the new draft fiscal code, comprising significant tax cuts, inter alia in the standard VAT rate. Tables and annexes in the Convergence Programme are based on this main scenario, which serves as a basis for the Commission's assessment. The Convergence Programme also includes an alternative scenario, with an assessment of the measures embedded in the new draft fiscal code, as approved by the senate on 27 April. The fact that a key element of current fiscal policies is not included in the main scenario is not in line with the Code of Conduct2. Also, other major policy initiatives, like adjusting public sector wages, which was publicly announced, and providing sufficient means for the envisaged public investments, as planned according to the draft transport master plan, are not included in the Convergence Programme. Therefore, the Convergence Programme does not include a comprehensive reflection of policy priorities on the expenditure and revenue side in the medium term. The Commission's 2015 spring forecast incorporates all relevant information at the cut-off date (21 April), in line with the no-policy-change assumption. This includes the fiscal code, as approved by the government on 25 March. Romania is currently 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. Romania also benefits from a precautionary balance-of-payments programme, due to expire in September 2015. This document complements the Country Report published on 26 February 2015 and updates it with the information included in the Convergence Programme. Section 2 presents the macroeconomic outlook underlying the Convergence Programme and provides an assessment based on the Commission 2015 spring forecast. The following section 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 Stability and Growth Pact, 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 summarises the main conclusions. 2. MACROECONOMIC OUTLOOK Romania's economy grew by 2.8% in 2014 and the country continued to correct key macroeconomic imbalances, progressively closing the output gap and significantly reducing the current account deficit. Private consumption was the main driver of growth. Employment grew by 1% and the unemployment rate dropped to 6.8%. 1 The English version of the Convergence Programme was submitted to the Commission on 08 May 2015. 2 The code of conduct states that "The Programmes should describe the budgetary and other economic policy measures being taken, envisaged or assumed" 3 The Convergence Programme's baseline macroeconomic scenario, i.e. that without including the draft fiscal code, assumes a continuous improvement of the economic performance. The growth rate of real GDP is forecast to increase steadily to 3.2% in 2015 and 3.4% in 2016. Domestic demand is set to remain the main engine of growth. Private consumption is expected to grow continuously as a result of increasing real household disposable income as wages grow, the labour market outlook is improving and inflation remains low. The growth rate of gross fixed capital formation (GFCF) is forecast to increase steadily, supported also by substantial inflows of EU funds. On the supply side, all sectors of the economy are expected to grow, in particular the export-related industries and the construction sector3. The real GDP growth forecast was revised upwards from 2.6% for 2015 and 3.0% for 2016 in the previous Convergence Programme due to better-than-expected growth in 2014, lower oil prices and the impact of the announced VAT cut for food as of 1 June 2015. Potential output is projected to continue growing from 2.5% in 2015 to 2.9% in 2016. The (negative) output gap as recalculated by the Commission based on the information in the Convergence Programme, following the commonly agreed methodology (in the remainder, the term "recalculated" will be used), is gradually narrowing and is forecast to turn positive in 20184. In contrast to the macroeconomic scenario in the Convergence Programme, the Commission's 2015 spring forecast includes the draft fiscal code. Even without the impact of the fiscal code, the projections for the growth rate of real GDP in the Convergence Programme exceed those of the Commission. The expected growth rates for private consumption are plausible for 2015 and favourable for 2016. The GFCF growth rates in the Convergence Programme for 2015 and 2016 are markedly favourable compared to the projections of the Commission. On the external side, the assumptions for export and import growth rates are plausible for both 2015 and 2016. The growth estimates do not include any impact from structural reforms as the measures presented in this national reform programme are not quantified. The projections for the growth rates of compensation of employees are markedly favourable compared to the Commission's forecast due to differences in GDP growth rate projections and in the impact assessment of the cut in social security contributions from October 2014. There are downside risks to the inflation projections of the Convergence Programme for 2016 mainly due to the additional VAT cuts planned in the fiscal code as of 1 January 2016. In sum, the economic growth assumptions in the Convergence Programme are markedly favourable for both 2015 and 2016. 3 The external outlook underpinning the Convergence Programme's macroeconomic scenario is based on the Commission's 2015 winter forecast and the IMF's Economic Outlook for April 2015. The numbers in the Commission's 2015 spring forecast were revised slightly upwards for 2015, but the main expectations still hold. 4 There is a difference between the Commission's estimate for the output gap in 2016 (-0.3%) and the (recalculated) output gap in the Convergence Programme (-0.8%), which arises mainly from the longer time horizon of the forecasts included in the Convergence Programme. 4  Table 1: Comparison of macroeconomic developments and forecasts 2014 2015 2016 2017 2018 COM CP COM CP COM CP CP CP Real GDP (% change) 2.8 2.8 2.8 3.2 3.3 3.4 3.7 4.0 Private consumption (% change) 4.5 4.5 3.5 3.5 3.8 3.6 3.9 4.1 Gross fixed capital formation (% change) -3.5 -3.5 3.2 4.5 4.2 5.5 6.3 6.8 Exports of goods and services (% change) 8.1 8.1 6.0 6.1 5.9 5.8 6.2 6.3 Imports of goods and services (% change) 7.7 7.7 6.5 6.5 6.8 6.8 7.2 7.2 Contributions to real GDP growth: - Final domestic demand 2.7 2.7 3.0 3.4 3.7 3.8 4.1 4.4 - Change in inventories 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 - Net exports 0.1 0.1 -0.2 -0.2 -0.4 -0.4 -0.4 -0.4 Output gap1 -1.3 -1.6 -0.9 -1.1 -0.3 -0.8 -0.3 0.4 Employment (% change) 1.0 1.0 1.2 1.1 1.4 1.1 1.2 1.2 Unemployment rate (%) 6.8 6.8 6.6 6.7 6.4 6.6 6.5 6.4 Labour productivity (% change) 1.7 1.7 1.6 2.0 1.8 2.2 2.4 2.7 HICP inflation (%) 1.4 1.4 0.2 0.2 0.9 2.0 2.7 2.5 GDP deflator (% change) 1.8 1.8 1.3 1.8 1.7 2.3 2.3 2.2 Comp. of employees (per head, % 2.0 2.0 2.5 3.7 2.8 3.7 4.0 4.2 change) Net lending/borrowing vis-à-vis the rest of 1.9 2.1 1.6 1.2 1.4 1.0 0.8 0.8 the world (% of GDP) Note: 1 In percent 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 2015 spring forecast (COM); Convergence Programme (CP). 3. RECENT AND PLANNED BUDGETARY DEVELOPMENTS 3.1. Deficit developments in 2014 The 2014 budget deficit came out at 1.5% of GDP in headline terms and 1.0% of GDP in structural terms. Romania thus reached its MTO. The 2014 Convergence Programme targeted a higher headline budget deficit of 2.2% of GDP for 2014, which included an EU funds adjustor of 0.2% of GDP to cater for accelerated EU funds absorption. This adjustor was granted under the precautionary EU/IMF 2013-15 balance-of-payments programme in conjunction with the investment clause.5 As EU funds absorption remained below target and the adjustor was thus not used, the deficit target excluding the adjuster was 2.0% of GDP. Revenue measured as a share of GDP increased in 2014, as a hike in fuel excise rates and the introduction of a special constructions tax outweighed the 5 pps. cut in social security contributions introduced in late 2014 and the tax exemption on reinvested profits. However, the main driver of the over-performance compared to the 2014 Convergence Programme target was an under-execution of capital expenditure, which came out 0.5 pp. of GDP below 5 Additional resources under the "adjustor" were only to be used for national co-financing EU Funds and not for other type of spending. In the event of a slower implementation of EU-funded projects and therefore of a smaller need for co-financing, the deficit target was to be adjusted downwards accordingly. 5 the estimate in the 2014 Convergence Programme. This includes sluggish EU funds related spending, such that the EU funds adjustor granted in 2014 was not used. Personnel expenditure was below expectations. 3.2. Target for 2015 and medium-term strategy The target for 2015 The Convergence Programme targets a deficit of 1.45% of GDP in 2015, broadly stable compared to 2014 outturn. The revenue projection includes the full-year impact of the cut in social security contributions, the reduction in the special construction tax rate and the tax exemption for re-invested profits. The Convergence Programme also includes the impact of the cut in the VAT rate for food and related services as of June 2015, as adopted via Government Emergency Ordinance (GEO 6/2015). According to the Convergence Programme, the cut in VAT for food is assumed to be more than offset by improved tax collection, related to reforms at the tax administration agency (ANAF), and second round effects. The public wage bill is set to remain contained due to a partial wage freeze. In recalculated structural terms, the Convergence Programme projects a structural deficit of 1.1% of GDP (at face value: 1.25% of GDP), moving somewhat away from the MTO. The Commission's 2015 spring forecast includes a moderately higher headline deficit of 1.6% of GDP, which is estimated to correspond to a structural deficit of 1.3% of GDP. Revenues, mostly from indirect taxation and social security contributions, are lower in the Commission's spring forecast. The forecast also assumes moderately lower capital expenditure than the Convergence Programme. The 2014 Convergence Programme targeted a headline deficit of 1.4% of GDP for 2015, in line with the April 2015 Convergence Programme, which was estimated to correspond to a recalculated structural deficit of 1.0% of GDP. National legislation, in particular the Fiscal Responsibility Law (amended: Law 377/2013), defines the budget balance rule and the conditions under which the rule is deemed to be respected. The targeted deficit for 2015 appears compatible with the fulfilment of this national fiscal rule. The medium-term strategy The Convergence Programme's aim is to continue fiscal consolidation and reduce the headline deficit to 1.2% of GDP in 2016, which according to the authorities would bring the structural deficit to its MTO. The Convergence Programme envisages Romania to remain at the MTO thereafter. The MTO chosen by Romania is a deficit of 1% of GDP in structural terms. This is the same as in the previous Convergence Programme, and it reflects the objectives of the Pact. Romania also applied for the structural reform clause and for the pension reform clause in the Convergence Programme. Related policies are not included in the main parts of the Convergence Programme and in the tables. The targets do not incorporate the requested clause and accompanying deviation. As detailed in 4.2, Romania is not found eligible for the two clauses. The 2016 headline deficit is estimated at 1.2% of GDP. The recalculated structural deficit is projected at 0.9% of GDP, in line with the MTO. The Convergence Programme projects tax policy into the future as currently in force. It includes the full-year impact of the VAT cut for food and constant revenues from natural resources taxation as the current regime, which is bound to expire at end-2015, is assumed to be replaced by a new one to yield comparable revenue. Revenues from current taxes on income and wealth are expected to increase by 0.4 6 pp. of GDP, whereas related measures are not specified. Tax collection is projected to further improve and a number of measures are described, but their impact is not specified. On the expenditure side, the Convergence Programme assumes a partial public wage freeze, which is not legislated at this point. Both revenue and expenditure ratios measured as a percentage of GDP are forecast to decrease significantly, which seemingly also relates to an assumed decrease in EU funds absorption following a peak in 2015. From 2017 onwards, the reduction in the headline deficit stems mostly from reduced "other expenditure", but measures are not specified. Table 2: Composition of the budgetary adjustment Change: 2014 2015 2016 2017 2018