S&P Global Ratings: Romania 'BBB-/A-3' Ratings Affirmed; Outlook Stable

Overview Preelection spending will push Romania's fiscal deficit to beyond 7% of GDP this year; the fiscal outlook beyond this year's general election remains uncertain. Real GDP growth this year will fall short of our previous expectation as domestic demand has largely been channeled into rising import growth. We therefore expect Romania's real GDP to expand by only 1.6% of GDP this year. However, we anticipate gradual fiscal consolidation and stronger growth over the next three years on the back of EU funding. We affirmed our 'BBB-/A-3' ratings on Romania. The outlook remains stable.   Rating Action   On Oct. 11, 2024, S&P Global Ratings affirmed its 'BBB-/A-3' long- and short-term foreign and local currency sovereign credit ratings on Romania. The outlook is stable. Outlook   The stable outlook balances our view of the country's high twin deficits against the buffers provided by its still-moderate stock of external and government debt and a stronger growth outlook from 2025. We anticipate that Romania's commitments under the EU's Recovery and Resilience Facility (RRF) and the Excessive Deficit Procedure (EDP) will anchor the authorities' commitment to fiscal consolidation over the next seven years.   Downside scenario   We could lower the ratings if government deficits exceed our current projections over the medium term, which would result in rising debt levels. We could also downgrade Romania if other existing imbalances persisted, such as high inflation or substantial current account deficits (CADs), which could result in a macroeconomic correction with lower growth.   Upside scenario   We could raise the rating if Romania's fiscal deficits narrowed substantially and government debt levels declined. This could improve the government's debt profile and reduce its financing costs. We could also raise the ratings if external deficits narrowed more than we anticipate. Rationale   Expansive fiscal policy amid this year's heavy election calendar--Romania has a total of four scheduled elections in 2024--will increase its already-large twin deficits. We now believe preelection spending will push the fiscal deficit to 7.3% of GDP in 2024.   Fiscal policy from 2025 remains uncertain and we assume deficits will narrow only gradually over the next years, converging on 5% of GDP by 2027, in line with the minimum fiscal correction required by the EU's EDP. Consequently, we project net government debt will steadily rise, exceeding 54% of GDP by 2027.   While fiscal policy has kept domestic demand afloat, much of this is channeled into imports. As a result, the CAD will likely exceed 8% of GDP this year with little sign of correction thereafter. Partially mitigating those external imbalances, non-debt-creating inflows in the form of EU funds and net foreign direct investments (FDIs) will continue to fund a significant share of Romania's external deficit (around 50% on average).   We expect that due to high import growth, real GDP will increase by only 1.6% this year, despite private consumption rising on the back of strong real wage growth and ongoing (partially) EU-funded investments. Inflation in Romania is now the highest in Central and Eastern Europe (CEE), at over 5%, due to high domestic demand on the back of fiscal expansion. We forecast it will remain elevated and continue to pose a challenge for the National Bank of Romania (NBR). We classify the exchange-rate regime as a managed float. The Romanian leu (RON) has remained broadly stable vis-à-vis the euro over the past two years.   Romania's EU membership constitutes a key policy anchor for the country's institutional framework. It remains a backstop to progress on structural reforms, which are required to receive EU funds (most notably in the context of the Recovery and Resilience Plan [RRP]), and can serve as a control to ensure the long-term sustainability of public finances as required by the reformed fiscal rules under the EU's Stability and Growth Pact.   Institutional and economic profile: Growth will fall short of our previous expectations, despite pro-cyclical fiscal policy   Romania is holding presidential and parliamentary elections toward the end of the year. Despite expanding domestic demand, particularly in the form of private consumption, we have adjusted downward our real growth projections for this year to 1.6% due to rising imports. EU funds and related reforms will continue to represent a policy anchor and substantial backstop to growth over the next few years. Real economic growth in the first half of the year has been more sluggish than we anticipated and we have substantially decreased our real growth forecast to 1.6% this year from about 3% previously. Consumption continues to expand strongly because Romania has experienced one of the largest increases in real disposable income growth dynamics globally over the past 12 months--including a 20% wage increase in the public sector over the past year, several raises of the minimum wage, and a substantial pension hike.   Despite this, the labor market has been robust, with stable employment levels and unemployment remaining near all-time lows. Skill mismatches inhibit further expansion of the employment base. Projects co-financed by the EU continue to spur public sector investment, including in the transportation sector. Still, export growth remains weak, mainly because of the economic sluggishness of Germany, Romania's main trading partner.   The current economic slump in Germany has hampered Romania's manufacturing sector and contributed to a fall in productivity in the first half of the year. In addition, Romania has been reporting the highest wage growth in Europe for some time now and this highlights looming competitiveness issues.   In addition to continued strong consumption, EU-funded investment will underpin average growth of slightly below 3% between 2025 and 2027. EU funds of close to €60 billion, slightly below 17% of estimated 2024 GDP, are still available to Romania under the current 2021-2027 Multiannual Financial Framework and under the RRF.   This roughly corresponds to annual EU fund inflows of close to 3% of GDP on average over the next few years. We expect Romania to receive the lion's share of the third tranche of the RRF funds--potentially up to €1.8 billion--in 2024, which will enable more investment in energy transition, transportation, and health care.   Romania's economy continues to face several structural challenges, which will persist after 2027, including adverse demographic trends. The declining working-age population could increasingly drag on growth, absent reform efforts to address skill mismatches or improve the business environment, and ultimately to slow net emigration. Over the past decade, Romania's working-age population has decreased by about 1.1% per year and we expect this decline to reduce only marginally over the next few years.   EU transfers under the RRF are contingent on fiscal and political reforms under Romania's Recovery and Resilience Strategy. We therefore consider the RRF an important policy anchor that incentivizes the government to reform the country's institutional framework. Romania has some of the lowest governance indicators within the EU; corruption and government effectiveness specifically are weak points.   While many political reforms under the Recovery and Resilience Strategy will be largely uncontentious, we think that those concerning the pension system, state-owned enterprises, and anti-corruption measures will be harder to implement. In addition, Romania has been under the European Commission's EDP since 2020. We believe that a perceived lack of improvement in Romania's fiscal position, along the lines of the common European fiscal rules, could delay some RRF funds.   Flexibility and performance profile: High fiscal deficits aggravate existing macroeconomic imbalances, such as high inflation and rising external deficits Pre-election spending will push the general government deficit to about 7.3% of GDP this year, and we do not expect deficits to dip below 5% of GDP until 2027. A pro-cyclical fiscal policy has widened the CAD, which will remain elevated at slightly below 8% of GDP on average between 2024-2027; however, significant EU fund inflows will somewhat moderate the increase in external debt over the same period. Fiscal policy has partly pushed inflation to the highest level in CEE; it will likely remain above the NBR's target of 2.5% over the next few years.   Rising fiscal spending ahead of four elections this year will deteriorate public finances more substantially than we expected, with deficits now estimated at 7.3% of GDP. This is despite strong revenue growth of currently close to 15% year-on-year, which has benefited from rising consumption and wages.   However, headline expenditure growth will likely come close to 20% year-on-year. Expenditure overruns are largely due to a wage increase in the public sector by 20%, costing about RON14 billion (almost 1% of GDP); a pension hike from September this year, still costing an equivalent of 0.6% of GDP; military spending rising to close to 2.5% of GDP this year; and high public investment of about 7% of GDP, only partially covered by EU funds. Our deficit projections of 7.3% of GDP exceed the government's current deficit target of 6.9% for several reasons. The underlying macroeconomic projections of the government for this year (around 3% of real growth) differ from our own; the current deficit target includes the effects of a recent consolidation package worth RON10 billion, some of which we think are less certain; and further discretionary preelection spending is still possible.   The current and projected deficits greatly exceed the thresholds stipulated by the EU's Stability and Growth Pact rules. Consequently, Romania remains under the EDP, which it entered in 2020. Generally speaking, EU countries under the EDP are required to reduce public deficits to 3% of GDP over an adjustment period of, at most, seven years. In Romania's case, this would imply a fiscal adjustment of about 0.7%-0.9% of GDP each year over this maximum adjustment period. Fiscal policy after the presidential and parliamentary elections in December remains uncertain.   Although Romania's government aims to increase the effectiveness of its tax administration, we believe consolidation efforts will only come to fruition over the medium term. The EDP and the RRP also require Romania to make further progress on structural fiscal reforms, among other things, on strengthening its tax administration, specific changes in the tax regime, and legislative changes to the overall budgetary process and spending reviews.   Romania's high public deficits imply that government debt, net of liquid government assets, will continually rise over the next three years, reaching about 54% of GDP by 2027, despite high nominal GDP growth. We believe the country will have to increase its reliance on international markets. Romania has built a good track record in issuing foreign currency bonds in recent years. Further external financing sources are available in the form of the loan component in the RRF and from pan-European financial institutions.   Over 50% of Romania's government debt is denominated in foreign currency, predominantly in euros. In addition, Romania will continue to tap its domestic market, including by selling retail bonds and notwithstanding the domestic banking sector's already-substantial exposure to the government, at over 20% of its assets. Against the higher financing requirements, we forecast interest expenditure will exceed 7% of government revenue on average between 2025 and 2027.   The expansionary fiscal policy will also contribute to high external imbalances, and we expect the CAD will expand to beyond 8% of GDP this year, and average 7.6% of GDP between 2025 and 2027. We expect the goods' trade deficit to remain at close to 10% of GDP over the next few years, reflecting high domestic demand and some underlying competitiveness issues. At the same time, we expect the external financing mix will continue to include a significant share (around 50% on average) of inflow of EU investment grants and FDI. This will also support the NBR's strong reserve position.   We estimate reserves will remain at close to four months of current account payments over the next three years. The higher external deficits will also result in a rise of the country's narrow net external debt to about 47% of current account receipts until 2027. Similarly, gross external financing needs will remain above 100% of current account receipts and NBR usable reserves.   Pro-cyclical fiscal policy and high wage growth have also added to inflation, which remained at 5.3% year-on-year in August despite decreasing energy prices. Although this represents a reduction from the peak of 14.6% reported in November 2022, it is still the highest level across CEE countries and has only gradually reduced over the past few months. Core inflation remains above headline inflation, which raises the risk of inflation remaining persistent over the next several months, in our view.   Notable upside risks to our current forecast stem from energy prices, food prices (due to adverse weather conditions), and changes to taxes and excises. We therefore expect inflation to remain above the NBR's target of 2.5% (plus or minus 1 percentage point) through 2027, further exacerbated by a pro-cyclical fiscal policy and persistently high wage growth. This inflation outlook poses a challenge for the central bank, which cut its main policy rates by 25bps in July and again in August, from its peak of 7.0% to currently 6.5%.   Romania's banking sector is predominantly foreign owned and largely deposit funded, and we see it as a limited contingency risk for the government. Nonperforming loans remain in the European Banking Authority-defined low-risk bucket, despite a marginal increase. Profitability slightly decreased from its peak in 2023, and capital and liquidity ratios remain healthy and slightly above the average for CEE countries. Still, loans to the private sector remain at 24% of GDP, reflecting low financial intermediation. The banking sector's elevated exposure to construction and real estate lending, alongside firms' rising level of indebtedness and a considerable share of foreign currency loans, could challenge financial stability if the related risks were to materialize. (Source:https://disclosure.spglobal.com/)