IMF Staff Concludes Visit to Romania

Last year’s fiscal package was a step in the right direction and creates additional revenue. Nonetheless, we project fiscal deficits above 6 percent of GDP in the next few years, given the fiscal costs of the new pension law. New measures will be needed to reduce the deficit to sustainable levels.   Inflation is decelerating but remains well above the target. Monetary policy should remain tight until there is firmer evidence that inflation will converge to the tolerance band of the National Bank of Romania in a timely manner.      An International Monetary Fund (IMF) mission, led by Jan Kees Martijn, visited Bucharest from January 29 to February 1 as part of its regular engagement with the Romanian authorities and other stakeholders.   At the conclusion of the visit, Mr. Martijn issued the following statement:   Macroeconomic developments. Growth slowed in 2023, primarily due to weaker consumption. Core and headline inflation declined to single digits during the second half of 2023, while the policy interest rate was prudently kept on hold. Although the current account deficit remains large, it has fallen to around 7 percent of GDP, owing to slower domestic demand and lower prices of commodity imports. Outlook. In 2024, the economy is projected to recover, with growth close to 3 percent, as consumption—driven by rising real wages—and external demand are strengthening. Headline inflation is expected to return gradually to the target band by end-2025. However, ongoing double-digit wage increases, among other factors, can obstruct the normalization of inflation. Budget. The 2023 fiscal deficit is estimated around 5¾ percent of GDP, which is well above the originally budgeted level (4.4 percent of GDP). The newly enacted pension reform makes the pension system fairer and reduces spending in the long run, but is expected to create large additional fiscal costs of about 1½ percent of GDP in the coming years. Risks. Large current account and fiscal deficits are constraining Romania’s capacity to withstand adverse shocks. That said, some buffers remain, including adequate international reserves, which have risen due to large inflows of EU funds. Policy Priorities Effective fiscal consolidation is needed to restore the soundness of government finances. Fiscal deficits—projected at 6 percent or more—will need to fall below 3 percent of GDP over the medium term to stabilize public debt, secure affordable market financing, and support ongoing disbursement of EU funds. Last year’s fiscal package was a step in the right direction, but more is needed. While efforts to contain non-pension spending and improve government and tax administration efficiency are welcome, their potential to contribute to fiscal adjustment is limited, especially over the short run. Romania’s tax revenue is well below the level in peer countries, and too low to support public services at EU standards. Therefore, there is no realistic way forward without substantial tax policy reform. Key options include: (i) Income tax reform: Elimination of remaining loopholes and exemptions, including by lowering the threshold for micro enterprises, and possibly making the PIT progressive. (ii) VAT reform: Increasing VAT revenue, including by taxing more items at the standard rate. (iii) Green taxes: Introducing a carbon tax in the transport and building sectors or additional excises on fossil fuels. (iv) Property taxes: Increasing property taxation, if possible by implementing the reforms already prepared. (v) Pension reform impact: Developing a mechanism to effectively stretch out the fiscal burden resulting from the pension reform.   In designing and implementing tax policy changes, predictability is critical. Early discussion and communication of plans for tax reforms would facilitate planning by firms and households and improve the investment climate. Tight monetary policy is warranted.In light of upside risks to inflation from strong wage growth and a positive fiscal impulse in 2024, the policy rate should not be lowered until headline and core inflation are on a firm downward path and on track to reaching the tolerance band of the National Bank of Romania’s target of 2.5 percent in a timely manner. The banking system maintains strong capital, liquidity, and profitability positions. Nonetheless, emerging financial sector risks—including the increased level of corporate FX borrowing—should be monitored closely.