Report No. 29123-RO Romania Restructuring for EU Integration--The Policy Agenda Country Economic Memorandum (In Two Volumes) Volume I: Summary Report June 2004 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CONTENTS ACKNOWLEDGMENTS ............................................................................................................. i EXECUTIVESUMMARY .............................. .......................................................................... i1 SUMMARY REPORT .................................................................................................................. 1 RESTRUCTURINGFOREUINTEGRATION:THE POLICYAGENDA ........................... 1 1.STRENGTHENING STABILITY. GROWTH. AND INTEGRATIONWITH THE EU ........................... 1 1.1.Economic Performance: An Ovewiew................................................................................. 2 1.2. TheBroad Reform Agenda................................................................................................... 3 2 BUILDINGON TRADE . 1.3.Romania's Performance in a Regional Perspective ............................................................ 5 INTEGRATION ........................................................................................ 10 2.1. TradePolicy ....................................................................................................................... 10 2.2. TradePerformance ............................................................................................................ 11 14 3 RESTRUCTURINGTHE ENTERPRISE .2.3. Building on TradeIntegration: A Reform Agenda............................................................. SECTOR ........................................................................... 17 3.1. Privatization and Economic Restructuring........................................................................ 17 3.2. Modes of Privatization and Their effects on Outcomes.................................................... -18 3.3. Hard Budgets, Productivity, and Macroeconomic Stability .............................................. 19 Table 8 TaxArrears, 2001-02 (percent oftotal assets) ........................................................... 22 3.4. Domestic Competition........................................................................................................ 22 3.5. Licensing Regirnes.............................................................................................................. 23 3.6.Enforcement of Contracts .................................................................................................. 24 3.7.Labor Regulations .............................................................................................................. 24 4 IMPLEMENTING .3.8.RestructuringAGRICULTURAL the Enterprise Sector: A Reform Agenda.................................................... 25 TRANSFORMATION ............................................................. 26 4.1. Policy Framework ...................................................................................... ,....................... 26 4.2. Policy Outcomes................................................................................................................. 28 5 ENHANCING .4.3.Agricultural Transformation: A Reform Agenda............................................................... 29 5.1.Employment, Output, and WageDynamics: Romania in a Regional Perspective.............30 LABOR MARKET ADJUSTMENT ........................................................................... 31 5.2.Inter-Sectoral Labor Market Adjustment and Sectoral Employment Imbalances.............32 5.3. Quantifiing Labor Market Adjustment: Job Destruction and Creation in Romania in a Regional Perspective ......................................................................................................... 33 5.4. Education, Skills, and Employment.................................................................................... 4 34 35 6 RISKSAND VULNERABILITIES .5.5. Enhancing Labor Market Adjustment: A Reform Agenda ................................................. .................................................................................................. 38 6.1. Quasi-Fiscal,Risks: Nonpayment and Arrears Accumulation ........................................... 38 39 7 THEQUASI-FISCAL .6.2. Fiscal Risks: The Vulnerabilities of Budgetary Stability ................................................... CHALLENGE: ENERGY SECTOR REFORM ............................................... 40 7.1. TheEnergy Sector and State Support ................................................................................ 40 8 FROM . 7.2. TheEnergy Sector: A Reform Agenda ............................................................................... QUASI-FISCAL FINANCING EFFICIENTFINANCIALINTERMEDIATION TO ...................4342 8.1. Structure of the Financial Sector....................................................................................... 44 8.2. Role of theBankingSector................................................................................................. 45 8.3. Soundnessofthe Banking Sector ....................................................................................... 47 8.4. Basic Financial Infrastructure: Regulatory and Supervisory Framework ........................ 49 50 9 CONTAININGTHE COSTS OFUPGRADINGENVIRONMENTAL .8.5.Developing EfJicient Financial Intermediation: A Reform Agenda................................... STANDARDS ............................. 52 9.1. Environment: Romania in a Regional Perspective............................................................ 52 53 10 CONCLUSIONS .9.2.Containing the Costs of Upgradingthe Environment: A Reform Agenda......................... ......................................................................................................................... 54 ACKNOWLEDGMENTS This report was prepared, under the general direction o f Bernard Funck, by a core team comprising Rosalinda Quintanilla (Task Team Leader), Juan Carlos Ginarte, Stella Ilieva, Catalin Pauna, and Ronald Hood based on the chapters prepared by Juan Carlos Ginarte (Macroeconomic Stability and Growth); Bartelomiej Kaminski and Francis Ng (Trade Integration), for which Manuela Unguru contributed to the analysis o f FDI and trade; Simeon Djankov and Caralee Mcliesh (Private Sector Development); Csaba Csaki and his team (Agricultural Transformation), for which Henry Gordon contributed to the analysis o f rural sector development; Catalin Pauna (Labor Market Policies); David Kennedy (Energy Sector Reform); Stella Ilieva (Financial Sector Development); and h i 1 Markandya (Environmental Policies). Juan Carlos Ginarte prepared the analyses on quasi-fiscal finances included in the chapters on private sector development and energy sector reform. Stella Ilieva prepared the analysis o f total factor productivity and fiscal sustainability. Comelia Boranescu prepared the Statistical Annex. Mismake Galatis, Erlinda Inglis, Kathryn Rivera, and Amanda Carqani prepared the desktop publishing o f the document. Ms. Emily Evershed edited both volumes. Alexandra Onofrei and Raluca Banioti provided logistical support to several missions. The team also drew upon the work o f Arabela Negulescu (Privatization), Doina Visa (Energy Sector), Ana Maria Sandi (Education), and Radrigo Chavez (Financial Sector Assessment Program). The team has benefited from comments and guidance from Kyle Peters, Helena Tang, and Pedro Alba as World Bank peer reviewers, and from Johannes Linn, visiting scholar at the Brookings Institution, the external peer reviewer o f this study. Ali Mansoor, Owaise Saadat, and Harry Broadman provided very useful comments. The team gratefully acknowledges its indebtedness to the analytical work o f the IMF, the European Commission, the EBRD, and the OECD. The team i s also grateful to Pradeep Mitra, Cheryl Gray, h a n d Seth, Owaise Saadat, Albert Martinez, Myla Taylor Williams, Andrew Vorkink, Van Roy Southworth, Ziad AIahdad for their support and advice. This report was produced inclose collaboration with the Romanian authorities. The team benefited from the generous amount o f time and support o f senior government officials. The Ministry of Finance has coordinated on behalf o f the authorities. Ms. Daniela Gheorghe Marinescu, Secretary o f State o f the Ministry o f Finance, is the contact point. Discussions and collaboration with the following officials is gratefully acknowledged: Ms. Marinescu, Mioara Ionescu, Dorin Mantescu, and their colleagues at the Ministry o f Finance, Mr. Cristian Popa, Vice Governor o f the National Bank o f Romania, Mr.Valentin Lazea, Chief Economist of the National Bank o f Romania, Mr. Iulian Iancu, Secretary o f State o f the Ministry o f Industry and Mineral Resources, officials from line ministries, the National Statistical Institute, and the National Employment Agency. The team also benefited from consultations with trade union leaders (BNS and ALFA), the Foreign Investors Council, and the Business Association o f Romania, and from collaboration with Romanianresearchers. The report i s presented intwo volumes: Volume 1comprises the summary report; and Volume 2 comprises the main report with annexes. * . 11 EXECUTIVESUMMARY 1. Romania is pursuing a broad reform program, includinginstitutional, governance and economic restructuringreforms,which are anchoredin its process for accessionto the EuropeanUnion (EU). Indeed, recent progress indicates that reforms are beginning to reach a critical mass and that the economy may be turning a corner. In contrast to the 1990s, inthe last four years Romania has made good progress instabilization, growth, and poverty reduction. This progress is due, inlarge part, to its solid performance intrade integrationwith the EUand global markets. However, this performance is limited to a few activities, since large segments o f the economy remain largely unrestructured and inefficient. 2. The challenge is to expand integrationwith the EU more broadly throughout the economy by relying on market driven mechanisms in a predictable rules-based policy environmentwith the state sharply focused on the provisionof essentialpublic goods. The reform agenda o f EUaccession-led restructuring remains large. Implementingthe institutionalreformagenda. This is the first priority ic the EU accession-led reform agenda. These reforms are being defined in the context o f the negotiations and implementation o f the various chapters o f the acquis communautaire. While Romania has taken important initial steps in judiciary, governance, and public administration reforms, particularly as regards regulatory changes, much o f the reform agenda remains to be implemented and many significant challenges remain. Followingthe recent constitutional referendum, a new overarching legislative framework i s being established for the judiciary and the court system and this needs to be expressed inthe regulatory framework. Above all, steps need to be taken to ensure effective implementation. Similarly, recent regulatory changes intended to improve transparency and governance need to be implemented, and in some instances laws such as the Law on Declaration o f Assets and the Law o f Conflict o f Interest need to be revised to improve their comprehensiveness and clarity. In the area o f public administration, a more systematic approach to policy formulation needs to be established and embodied in institutional structures and processes, and the Civil Service Law needs to be refined and implemented. The government's reform program i s being supported by the European Commission, EBRD, the World Bank, the IMF, and other development partners. Complementing these efforts, this study focuses on selected policies o f the real sector as Romania integrates with the EUand the world markets. 0 Building on trade integration (Section 2 in the Summary Report). Trade performance has been robust over the last decade and trade integration has accelerated in the last four years. During this period, Romania had the largest increase in its share o f EU external imports among the Central Eastern European Countries (CEECs). Key drivers o f this growth are unskilled labor-intensive products, clothing, and footwear in particular. However, other manufactures, particularly electrical and machinery products, also show a strong performance. This ... 111 trade diversification provides a robust foundation for trade expansion. Romania's foreign direct investment (FDI) flows, although among the lowest in the CEECs relative to GDP, are having a large pull effect on trade expansion since they are dispersed among a large number o f small firms (predominantly Italian and German) inlowtechnology, unskilled labor-intensive production. T o deepen trade integration, Romania would need to broaden its trade performance throughout the economy. Without further expansion o fprivate sector activity in the economy, agricultural transformation, and enhanced labor market flexibility, Romania would appear to be losing its potential comparative advantage in high tech and skilled labor-intensive production as well as in natural resource- intensive production, as its resources are pulled toward low technology and unskilled labor-intensive activities or remain in large unrestructured segments of the economy. Without relying on market-driven mechanisms for reallocating resources, including labor, from low to high productivity activities and larger FDI flows to upgrade technology, Romania is unlikely to move to higher technology and potentially competitive activities. Similarly, without increasing labor market adjustment and without addressing the challenges o f investment ineducation and the quality o f education, and upgrading the skills o f Romania's labor force, the competitiveness o f Romanian firms will continue to depend on the availability o f low-wage unskilled labor. As a result, competing with suppliers from other developing economies will become increasingly difficult as the EUends quantitative restrictions on textiles and clothing under the World Trade Organization (WTO) agreement on January 1, 2005, and as large developing countries participate more fully inthe global markets. 0 Restructuring the enterprise sector (Section 3). Inno other area has the legacy o f the socialist years weighed on Romania so heavily as in enterprise reform. The slow and inefficient enterprise reform o f the past has left Romania with a larger number o f enterprises to be privatized or liquidated than inall o f the other CEECs combined. Public enterprises are the core o f the unrestructured part o f the economy. While there are dynamic private businesses which are leading Romania's solid trade performance in the EU and world markets, the expansion o f these internationally competitive private firms is hampered by the sizable number o f unrestructured public enterprises and the soft budget constraints prevailing between the state and the enterprise sector that keep unviable enterprises from exiting the economy. This recent momentum in enterprise reform needs to be accelerated and hard budget constraint discipline needs to be extended to the transaction interface between the state and enterprises. Privatizing to outside strategic investors rather than employing the failed privatization methods of the past, eliminating the practice o f nonpayment and arrears build-up in the transaction interface between the state and enterprises, and improving the business climate are all actions that are fundamental to the sustainability o f growth and competitiveness. iv 0 Implementing agricultural transformation (Section 4). The potential competitiveness o f agriculture that is associated with Romania's moderate climate and the availability o f land remains largely untapped. The legacy o f Romania's agricultural subsidization strategy, the persistence o f state holdings o f large loss- making state farms and land, and the slow economic restructuring elsewhere in the economy have taken a heavy toll on the country's agriculture and food sector. As a result, agricultural productivity i s low and it is stagnant, despite increases in farm inputs: the sector includes 40 percent o f the labor force whose share in GDP is only 14percent. Clearly, for Romania to realize its economic potential and to integrate with the EU, agricultural policies and transformation need to be driven by competitiveness. Measures to achieve this end include the following: completing the privatization o f state f m s and state-owned land; consolidating the small-scale farming sector, so that it can rely on market-driven mechanisms in determining investment and production in the sector; shifting to policies that target efficiency gains rather than relying on the failed price support and export subsidies; and separating instruments that target efficiency gains in agriculture from those aimed at poverty reduction inthe rural areas. 0 Enhancing labor market adjustment (Section 5). Businesses report that rigid employment laws are a significant obstacle to their efficient performance. In cross- country comparisons, Romania has some o f the most rigid conditions o f employment, with tight restrictions on hours worked and on night and holiday work, and with a relatively high minimum wage. Several details in the labor regulations create perverse incentives for workers: for example, in managing absenteeism, and ingrantingperiodic automatic increases inwages based on years worked andnot on productivity. Limited economic restructuring and limited labor mobility characterize labor market dynamics inRomania across sectors inthe economy. Inaddition, labor market participation is low and the high and long-term unemployment rates among new graduates and low-level educated youth reflect a significant mismatch between the skills that the education system generates and the labor market demand. Inmany areas the new Labor Code is more restrictive than the original one and represents a step backwards. Increased labor market flexibility is needed to improve sectoral employment imbalances and competitiveness, and hence to reduce the risks to the sustainability of growth, as competing in the EU and global markets becomes increasingly more difficult. The reform agenda includes the following aims: increasing the flexibility in entry/exit from employment by relying on economic rationale and performance to justify and estimate the costs o f dismissals; and eliminating disincentives for those who wish to work beyond retirement age or under more flexible arrangements, including temporary and part-time employment. The Labor Code needs to be changed along these lines if the benefits from solid growth are to be more broadly shared on the basis o f performance and productivity. Furthermore, reforms are needed to address the skills mismatch gap reflected inthe V high and long-term unemployment rates among new graduates and low-level educated youth. 3. Notwithstanding recent progress, there are risks and vulnerabilities to the macroeconomic stabilization and reform achievements to date (Section 6). First, there are quasi-fiscal risks due to nonpayment and arrears accumulation. And second, there are fiscal risks due to financial weaknesses in the social security system (particularly the pension system deficits) and to the costs o f upgrading environmental standards consistent with the concept o f a single market o f the EU. 4. There is the challenge of eliminating the persistently large quasi-fiscal deficits resulting from nonpayment and arrears in the transaction interface between the state and enterprises. The energy sector in Romania has been a main source o f persistently large quasi- fiscal deficits-more so than inmany other transition economies. Hidden subsidies and losses in the energy sector were as high as 6.5 percent o f GDP in 2001, and while these declined to 2.5 percent in2002, they increased to above 3 percent in 2003. Inaddition, total tax arrears (net end o f period stock) were estimated at 10.8 percent o f GDP in2001 and 12.6 percent in 2002. More than two-thirds o f implicit subsidies are due to the energy sector. Hence, energy sector reform is an essential first step. 0 Completing energy sector reform (Section 7). Energy subsidization has been used to support loss-making enterprises and to provide an implicit subsidy to consumers. Subsidization has been provided through tolerance, and therefore encouragement, o f low bill collection rates and energy pricing below full cost recovery tariff rates. These losses have resulted in a significant deterioration in basic energy infrastructure and have reduced the primary production o f oil, coal, and gas. Because energy is a critical component o f production, energy subsidies have distorted relative prices and have reduced efficiency throughout the economy. Furthermore, since energy company losses are often financed with tax arrears and unpaid loans, they have added to a rising stock o f public debt. Inthe last four years there has been important progress intariff and collection rates. However, soft budget constraints prevail in the transaction interface between the state and energy enterprises. The challenge is to implement hard budget constraints between the state and energy enterprises and complete the restructuring of the energy sector of Romania's road map for EU accession. While good progress has been made in power and gas tariff reform, further price adjustment (larger increases ingas to reach import parity) and the further restructuring o f companies will be required as investments are undertaken. These measures include moving to import parity in the medium term, improving collection to achieve sustainable financial viability and imposing hard budget constraints on the transaction interface between the state and enterprises. Regarding industry restructuring, the challenges include the need for the commercialization o f generation subsidiaries and the introduction o f the private sector in the unbundled gas structure. However, the dangers o f vertical integration vi should not be underestimated given the weight that global industry players have in the sector. 5. Quasi-fiscal financing should be eliminated and replaced by efficient financial intermediation(Section 8). Quasi-fiscal subsidization is crowding out financial intermediation. This explains, to a large extent, the low level o f financial intermediation inRomania compared to other CEECs. Banking credit represents only 8 percent o f the total financing o f the corporate sector while arrears represent 36 percent. Neither loss-making nor profitable companies are excluded from relying on nonpayment and arrears to finance their operations. However, the degree o f use o f tax arrears is inversely related to profitability. Clearly, quasi-fiscal financing channels resources to non-viable firms. In contrast, an efficient financial intermediation mobilizes and directs resources to the most profitable investment opportunities. Hence, developing efficient financial intermediation is a highpriority inthe reform agenda. Developing efficient financial intermediation. (Section 8). Romania has made progress in consolidating the financial sector since 1999, when bank restructuring took hold. The regulatory and supervisory environment has improved and progress has been made inbuildinga more solid foundation for financial sector development. However, the continuing strong presence o f state-owned banks, which represent 40 percent o f bank assets and 32 percent o f loans, places Romania at a disadvantage compared to its peers. Similarly, the basic financial infrastructure needs to be strengthened inseveral areas. Without the proper valuation o f capital, supervision on a consolidated basis, improvements inaccess and coverage o f the credit registry, and a stronger capacity to assess and manage risk, the financial sector cannot intermediate resources efficiently. Reform priorities include the completion of bank restructuring and the strengthening of the regulatory and supervisory infrastructure. Measures that are needed to develop a further basic financial infrastructure include the following: (i)implementingfully supervisiononaconsolidatedbasis; (ii) strengthening risk assessment and management; (iii) completing the adoption and full implementation o f international accounting and auditing standards and practices; and (iv) improving the coverage o f and access to the credit risk information system. Abolishing the Emergency Ordinance 61, which came into force in 2003 and permitted the authorities to seize any collateral pledged to a bank inorder to collect tax arrears, is an important step forward. There is a need, however, to abolish the legal framework that allows compensation without cash o f the bilateral obligations stipulated in the Government Ordinance No. 77/1999. Romania should rely on revenue collection and administration reform as a more appropriate and effective approach to eliminating nonpayment o f taxes. 6. While Romania has made progress in fiscal adjustment and consolidation, fiscal risks remain. The monetary financing of quasi-fiscal expenditures from the National Bank o f Romania was halted in 2000. Fiscal deficits have been cut in half compared to 1997, and budgetary consolidation has remained broadly on track. This progress has contributed to reducing the rate o f expansion o f public indebtedness. Estimates o f fiscal sustainability included vii in this report indicate that, under generally favorable assumptions, a debt-stabilizing primary fiscal balance o f 0.4 to 1percent o f GDP seems to be sustainable provided quasi-fiscal deficits are eliminated and the macroeconomic adjustment mechanism becomes monetary dominant so that monetary policy becomes functionally independent o f fiscal needs. However, two key areas of reform are needed to address fiscal risks (i) deepening the reforms o f the social security system to address its financial weaknesses; and (ii)containing the costs o f upgrading environmental standards. 0 Deepening the reforms of the social security system. The social security system is a key long-term source o f fiscal risk. Despite recent reforms, including a two-year increase in the statutory retirement age and a widening o f the contribution base to include the self-employed, farmers and the unemployed, the pension system remains unsustainable. Without further reform the system imbalances will continue to grow and to pose a serious threat to macroeconomic sustainability, particularly if the economy grows slowly. The urgency for reform is increasing owing to the demographic challenge o f an aging population. Policy issues and reforms in the social security system are presented in the World Bank's recent Public Expenditure and Institutional Review o f Romania, andthus are not covered inthis study. 0 Containing the costs of upgrading environmental standards (Section 9). In relation to countries which joined the EU this year, Romania is starting out with a lower level o f environmental capital and a poorer state o f the environment. The estimated cost o f the environmental investments needed to reach EU standards i s therefore comparatively large (around 29.7 billion during the period 2004-2015- the highest among CEECs). About 75 percent o f this cost i s to be financed by the central and local governments and the private sector. A two-pronged approach is needed to contain the costs o f upgrading environmental standards. First, estimates o f the total costs and benefits for each o f the environmental directives should guide the sequencing o f the investments and their implementation, and those investments that generate the greatest benefits should be selected first. The estimates show that Romania will derive the greatest benefits from air pollution reduction, followed by water and waste management. The second reform is needed to enhance the role o f the private sector, which is critical if targets are to be met, and fiscal risks are to be reduced. 7. Ultimately, Romania's success in integrating with the EU depends on its implementing the policy reforms outlined inthis report, and achieving its goal o f EU accession is predicated on its implementing the institutional, administrative and governance reform agenda. SUMMARYREPORT RESTRUCTURINGFOREUINTEGRATION: THE POLICYAGENDA 1. STRENGTHENINGSTABILITY, GROWTH, INTEGRATIONWITHTHE EU AND 1. Romania i s pursuing a broad reform program, including institutional, governance, and economic restructuring reforms which are anchored in its process toward EU accession. The institutional and governance reforms are being made in the context o f negotiations and implementation o f the various chapters o f the acguis communautaire and are being supported by the World Bank's Programmatic Adjustment Loan, currently being developed, and by programs o f other development partners. To complement these efforts, this study focuses on selected policies o f the real sector as Romania integrates with the EU and the world markets. Indeed, recent progress indicates that reforms have tumed the comer-the challenge is to make consistent and sustained progress in the institutional, governance, and economic restructuring reform agendas. 2. Policies that underpin stability, economic restructuring, and integration with the EU and the global markets anchor Romania's progress toward EU accession. Restructuring for EU integration requires that the reallocation o f resources should rely on market driven mechanisms inapredictablerules-based policyenvironment withthe state sharply focused onthe provisionof essential public goods.' While progress has been made in policy reforms in the last few years, the reform agenda of EUaccession-led restructuring remains large.2 3. To extend this integration effort more broadly throughout the economy and to safeguard the sustainability o f trade performance and growth (Section 2), three areas o f reform are central: restructuring the enterprise sector (Section 3), transforming the agriculture and food sector (Section 4), and increasing labor market adjustment (Section 5). Quasi-fiscal and fiscal risks, however, need to be addressed decisively (Section 6). To address the quasi-fiscal challenge: (i) hard budget constraints need to be implemented to eliminate quasi-fiscal financing o f enterprises and instead enterprises need to rely on efficient financial intermediation (Section 8); and (ii) energy sector reform needs to be completed (Section 7). Further fiscal consolidation is needed and will require addressing financial weaknesses in the social security system, and also containing the costs o f upgrading environmental standards (Section 9). 4. Romania has been implementing reforms toward stabilization, economic restructuring, and integration with the EU and the world markets, and recently the country has taken initial ' Essential public goods include governance and the rule o f law, basic infrastructure, health and education, and a well-targeted fiscally sustainable social safety net. See Chapter 1 inVolume 2 o f this report for a more detailed discussion o f policy issues on stability, growth, and integration with the EUand world markets. 2 steps have been taken on the institutional and governance reform agenda. This section first provides an overview of recent economic developments. It then outlines the broader reform agenda, which includes judiciary, governance, and public administration reforms. This section ends with an assessment o f Romania's performance ina regional perspective. 1.1. Economic Performance: An Overview 5. The legacy o f the socialist years has weighed heavily on Romania during the transition years. Policies during the 1990s were dominated by entrenched interest groups, which were embedded in state-owned enterprises (SOEs), and exhibited a pervasive lack o f discipline in relations with the financial sector and were characterized by poor public administration that resulted in unsustainable macroeconomic policies. As a result, structural reforms and institutional changes were delayed. Table 1Selected Economic Indicators, 1992-2003 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003p GNI per capita (Atlas method, USS) 1,240 1,190 1,270 1,470 1,590 1,520 1,520 1,580 1,680 1,710 1,850 (Percent) Total Povertyrate (headcount) 25.4 20.1 30.3 30.8 33.2 35.9 30.6 28.9 Extreme Povertyrate (headcount) ..9.4 6.3 11.2 11.3 12.5 13.8 11.4 10.9 Unemploymentrate 8.9 10.4 11.8 10.5 8.6 8.1 7.8 Real GDP growth -8.8 1.5 3.9 7.1 3.9 -6.1 -4.8 -1.2 2.1 5.7 4.9 4.7 CPI inflation (p.a.) 210.4 256.1 136.7 32.3 38.8 154.8 59.1 45.8 45.7 34.5 22.5 15.1 (Percent ofGDP) Investment 31.4 28.9 24.8 24.3 25.9 20.6 17.7 16.1 19.5 22.6 23.1 ForeignDirect Investment 0.3 0.3 1.1 1.2 0.7 3.5 4.8 2.9 2.8 3.0 2.5 2.7 Gross DomesticSavings 20.8 24.0 22.5 18.6 17.6 13.5 9.7 11.4 14.5 13.9 15.0 Total revenuesand grants 38.7 34.0 32.0 31.4 29.6 28.9 29.9 31.9 31.4 30.5 29.7 30.9 Total expenditure andnet lending 43.7 34.4 34.7 34.8 33.9 34.2 35.3 35.5 35.4 33.7 32.4 33.6 Overall fiscal balance -4.6 -0.4 -2.2 -3.4 -4.8 -5.3 -5.4 -3.6 -4.0 -3.3 -2.6 -2.4 Currentaccountbalance -8.0 -4.5 -1.4 -5.3 -7.4 -6.1 -8.4 -4.0 -3.9 -6.0 -3.4 -6.2 Externaldebt 18.5 18.2 23.5 27.2 23.8 25.9 27.8 29.6 33.7 30.2 Public and publicly-gtd.Debt 1/ .. 11.8 12.9 19.4 22.9 21.1 24.2 23.6 24.6 25.5 Interest payment 3.8 4.7 5.3 4.8 3.8 3.0 2.9 Official reserves(mo. of imports) 0.2 0.1 1.1 0.4 0.6 2.5 2.4 2.1 2.5 3.2 3.5 Broadmoney/GDP(percent) 30.8 22.3 21.4 25.3 27.9 24.6 24.8 24.6 23.0 23.2 24.7 Source: World BankandIMFdatabases; RomaniaPublic Expenditures Review (2002) andPovertyAssessment (2003) The World Bank.. 6. Inthe 1990s,macroeconomic instability exacerbated the decline inthe standard of living. Duringthis period, Romania experienced two major economic crises one in 1991-93 and another in 1997-98 (see Table 1). Inthe 1991-93 crisis, the annualinflation ratereached 256 percent, the debt to Gross Domestic Product (GDP) ratio increased from 3 percent in 1990 to 16 percent in 1993, and the accumulated GDP contraction was about 30 percent. In the 1997-99 crisis, inflation reached above 150 percent per year from a level o f about 35 percent per year in 1995- 96, the debt to GDP ratio reached 40 percent, and the accumulated GDP contraction was about 15 percent. These events exacerbated the effects o f the collapse o f output on broad segments o f 3 the population, and total poverty rate reached a peak o f close to 36 percent and extreme poverty reached 14percent in2000. 7. In the last four years, however, there has been a turnaround in terms of both the magnitude and quality o f macroeconomic adjustment and growth (see Table 1). Recent improvements in macroeconomic performance and growth have contributed to reductions in poverty levels, which by 2002 had declined to 28.9 percent in the case o f total poverty and to under 11percent in the case o f extreme poverty. GDP growth has been reestablished at around 5 percent per year, ledprimarilyby investment and exports rather than consumption. Occasionally, though, aggregate consumption surfaces as a key driver o f growth, reflecting sporadic reflationary pressures related to high wage increases in SOEs. The inflation rate has declined more rapidly than projected in the macroeconomic stabilization program and was about 15 percent per year in 2003, the lowest level since the start o f transition. The fiscal deficits o f the consolidated general government have been cut to about half the 1997 levels, but the external current account gap, estimated at 5.8 percent o f GDP in 2003, is high. However, official reserves have been increasing and reached a record level o f over US$8 billion, or about 3.5 months o f imports, in2003-an impressive increase by US$4.5 billion since 2000. The bankingsector i s on firmer footing and direct lending by the central bank has been eliminated. International market sentiment towards Romania has continued to improve-Standard & Poor's upgraded Romania's sovereign currency risk from B+to BB-inFebruary 2003. 8. These results reflect initial progress made in a broad institutional agenda, including judiciary, governance, and public administration reforms. As discussed in the following section, while significant challenges remain and much o f the agenda remains to be implemented, important initial steps have beentaken. 1.2. The BroadReformAgenda 9. Romania is pursuing a broad reform agenda that is motivated in large part by its desire for EU accession. The authorities have successfully concluded negotiations on 22 o f the 30 chapters o f the acquis communautaire. However, many significant challenges remain. Among these challenges are Romania's ability to meet the criteria for entry into the EUand to implement the acquis inthe field o fjustice and home affairs, to improve governance and reduce corruption, to implement key reforms inpublic administration, and to ensure human rights and the rights o f minorities. Interms o f the economic criteria for accession, the authorities need to establish a functioning market economy by vigorously implementing the privatization program, improving the business environment, and introducing labor and capital market reforms. 10. Judicialreform. Significant initial steps have been taken, including the September 2003 adoption o f a comprehensive Judicial Reform Strategy for 2003-2007. The objectives o f this strategy were to enhance the rule o f law in the country, to strengthen the institutional independence o f the judiciary, to increase the efficiency o f the courts and the professional level o f both judges and court personnel, to improve the quality o f judgments and o f legal predictability in dispute resolution, and to achieve compliance with the EU standards and regulations. In October 2003, through a national referendum, constitutional amendments were adopted which would: (i) establish the principle o f the independence o f the judiciary and ensure the right to a fair trial within a reasonable time; (ii)transform the Supreme Court o f Justice into a 4 High Court o f Cassation and Justice, responsible for ensuring the consistent interpretation and implementation o f laws throughout Romania; and (iii) revise the composition andmandate o f the Superior Council o f the Magistracy, which would strengthen its role as an institutional guarantor o f judicial independence. This establishes an overarching legal framework for judicial reform that now needs to be fleshed out inlegal detail and implemented. 11. Governance reform. Efforts have been made to curb corruption, including the adoption o f the National Program for the Prevention o f Corruption and the National Action Plan against Corruption in 2001. Freedom o f information legislation has been adopted and a National Anticorruption Prosecutor's office has been established. In March 2003 further legislative advances were made with the establishment o f basic regulations for public asset declarations by public officials, andwith new legislation on conflicts o f interest. 12. Public administration reform. Several actions have been directed at improving public administration. The Civil Service Law was recently overhauled as part o f the government's package of anti-corruption measures. The proper direction for the reform o f the policy formulation process, long subject to excessive reliance on emergency ordinances, has been taken with the passing o f the Law on Decisional Transparency in early 2003, and with the constitutional changes later that year limitingthe scope of emergency ordinances. 13. Many challenges,however, remainin the institutionalreformagenda.Inthe areas o f judiciary, governance, and public administration, the reforms going forward include: refining the newly introduced legislation, developing the necessary secondary legislation and norms, and building effective implementation and monitoring systems. This is being carried out with a strong program o f support from the EUand the IFIs, including a Programmatic Adjustment Loan (PAL) program currently being developed with the World Bank and a program with the IMF currently under discussion. The main features o f the PAL program supporting Romania's qualification for the political criteria for EU accession include: amending the Law on the Superior Council o f the Magistracy; eliminating extraordinary appeals in criminal cases and further strengthening the institutional independence o f the judiciary through the enhancement o f the role o f the Superior Council o f the Magistracy; increasing the accountability o f judges and the court system for the timeliness and quality o f their work; providing a more efficient organization o f the court system; and improving the system o f court financing. The Law on Declaration o f Assets and the Law on Conflict o f Interest will be made more comprehensive, and better provisions will be made for the publication and indexation o f results. The Civil Service Law will be amended and comprehensive Civil Service management monitoring indicators will be collected. A Civil Service law on salary setting will be adopted and new systems o f pay grading and employment management put in place. A new public financial management reform system will be launched, and specific measures will be taken for the improvement o f education finance, the reform o fpension finances and the rationalization o f the hospital system. 14. The governmentprogramincludesstructuralreformsthat are going forward. These reforms are being supported by the EuropeanCommission, the EBRD, the World Bank, the IMF, and several bilateral programs. Under these programs, the privatization program will be completed with the full disposition o f the APAPS portfolio, and the privatization the BCR and CEC banks as well as major public enterprises inthe energy sector. Gas prices will be advanced 5 towards economic levels. District heating systems will be overhauled, with the introduction o f new tariff rates and heat metering and control systems, and programs for the restructuring o f the miningindustryando fTarom will be completed. Improvementsinthe business environment will be sought through the following measures: the revision o f the Companies and Securities Laws, the enhancement and extension o f the Silent Approvals Law procedures, the refinement o f the bankruptcy law and procedures, and the implementation o f accounting and auditing practices. The Labor Code will be amended to improve market flexibility, and a set o f reforms will be introduced to enhance the functioning o f the capital markets: this will include the introduction o f a consolidated law on the regulation o f private equity funds, which will also apply to the Financial Investment Companies (SIFs). 15. The urgency o f this agenda is greater than it may appear, if Romania is to catch up with the CEECs. As discussed in the following section, notwithstanding the progress made to date, Romania needs to build on the recent progress and extend integration more broadly throughout the economy if it i s to succeed in catching up with the economic performance o f other CEECS.~ Insome instances, countries inthe regionhave acceleratedthe pace ofreforms, as their timetable for EU accession is fast approaching. With one o f the lowest per capita incomes in the region, Romania also needs to accelerate growth and strengthen stabilization efforts to set its economy on a sustainable convergence path. 1.3. Romania's Performance in a Regional Perspective 16. In the last four years Romania's economic performance has shown a remarkable improvement compared to the 1990s. Nevertheless, the country's economic performance relative to the CEECs i s mixed (Table 2). Romania's growth o f 4.3 percent per year in 2000-2002 reached the average growth in the CEECs (excluding R ~ m a n i a )The relatively good growth . ~ performance o f the last few years is, however, temperedby the fact that Romania has the lowest GDP per capita at PPP and improvement in its social indicators is slow (Box 1). Improvements incompetitiveness are limited to a few activities, while large segments o f the economy remain unrestructured (see Section 3). The slow and inefficient enterprise reform o f the past has left Romania with a large number o f enterprises (a total o f 1,900 firms) fully or partially in state hands, (1,300 SOEs and 600 in state hands). The inefficiencies and losses inthe enterprise sector are large-the total tax arrears o f the enterprise sector (eop stock) are estimated at close to 13 percent o f GDP in2002 (see Section 3). Agriculture includes 40 percent o f the labor force whose share inGDP is only 14 percent, and the rural areas include 45 percent o f the population, and 67 percent o f Romania's poor. The agriculture and food sector, however, remains unrestructured, and heavily subsidized, and productivity is low despite increases in inputs. As a result, Romania's potential competitiveness associated with its moderate climate and the availability o f land remains largely untapped (see Section 4). 17. Solid performers in the region have leveraged economic restructuring, financing needs, and the resulting net job creation through FDI and expansion o f the private sector in the economy. Initially, a large share o f FDIwas related to privatization, and as the policy framework Central Eastern European Countries (CEEC) are defined here to include Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Lithuania, Latvia, Poland, Romania, the Slovak Republic and Slovenia. Calculations o f CEEC averages exclude Romania. 6 improved green field FDIincreased inimportance. Intum, the private sector undertook the risks o f investments needed for economic restructuring, improved technology and managerial skills, thereby increasing competitiveness, and deepened integration with the EU and the world markets. These changes also allowed most CEECs to put their fiscal house in order by eliminating implicit subsidization, and to set their economies on a sustainable convergence path by increasingtheir reliance onmarket mechanisms to allocate resources across sectors. Table 2 Romania and the CEECs: Selected Economic Indicators, 2000-2002 a/ Interest Overall Private GDPper capita in GDp CPI Rates, Fiscal External Sector FDI, Growth,. Inflation, 2000-2002 Balance, CAB, Money Broad Output, 1995-2002 2o02, ppp 2000-2002 2000-2002 (avg. long 2000-2002 2000-2002 2002 (us$) (avg. (avg. YOof YO) (avg. %) term, (avg, %of (% of GDP) (% Of GDP (% of GDP) bl GDP GDP) Bulgaria 6,909 4.8 7.8 11.2 -0.9 -5.4 43.3 75 4.3 Croatia 9,967 4.0 3.9 11.5 -6.2 -4.9 66.0 60 4.5 Czech Rep. 15,148 2.8 3.5 4.9 -3.7 -5.8 75.5 80 7.4 Estonia 11,712 6.6 4.4 8.8 0.0 -8.0 42.6 80 5.1 Hungary 13,129 4.2 8.2 8.0 -5.4 -4.6 47.2 80 4.2 Latvia 8,965 6.9 2.4 3.5 -2.6 -8.1 36.5 70 5.5 Lithuania 10,015 5.8 0.9 9.5 -2.0 -5.4 29.3 75 4.0 Poland 10,187 2.1 5.8 18.6 -4.7 -3.9 64.6 75 2.9 Romania 6,326 4.3 34.2 27.7 -3.3 -4.2 23.6 65 2.7 Slovak Rep. 12,426 3.3 7.6 8.1 -4.4 -1.2 65.3 80 5.4 Slovenia 17,748 2.9 8.3 9.7 -1.8 -0.0 55.5 65 1.9 Notes: ai Dataare an average of 2000-2002 unlessotherwise specified.b/ Rates pertainto the following: Bulgaria, commercial bank lending (weighted average); Croatia, prime lending, Czech Republic, one-year interbank lending; Estonia, commercial lending; Hungary, 10-year govemment bond auction; Latvia, prime lending- refinancing; Lithuania, prime lending; Poland, refinancing; Romania, interbanklending; Slovakia, one-year interbanklending; andSlovenia, discountrate. Sources: IntemationalFinancialStatistics, IMF; World Bank database SIMA, andDatastream. 18. The risks and vulnerabilities involved in Romania's recent achievements cannot be underestimated. While the overall fiscal deficit compares favorably with other CEECs, the relatively modest fiscal deficit o fthe consolidated general government does not reflect the size o f nonpayment and arrears. The inflation rate in Romania declined from 45.8 percent in 1999 to 22.5 and 15.1 percent in 2002 and 2003, respectively. However, current inflation rates greatly exceed those o f other countries inthe region, which have been in the single digit levels since the late 1990s. Further fiscal adjustment and a stricter incomes policy are neededto sustain a gradual but sustained reduction o finflation. 19. The economy is exposed to external risks. In 2000-2002, the average external current account deficit o f around 4 percent o f GDP was below the average o f 5 percent observed in the CEECs. However, the deficit increased to nearly 6 percent o f GDP in2003 and it is increasingly financed by relatively mobile portfolio capital flows and less by FDI. This exposes the economy to the risk o f sudden capital flow reversals, which could ultimately hurt growth. 20. This vulnerability is magnified by the inefficiency and small size o f the financial sector. At 24 percent o f GDP, the level o f monetization o f the Romanian economy is about half the 7 average level o f other countries inthe region (Table 2). The low level o f financial intermediation reflects weaknesses inbasic financial infrastructure, the still dominant role o f state owned banks, and the heavy reliance on nonpayment and accumulation o f arrears which i s crowding out bank lending as the most important source o f financing (Section 8).5 The banking sector dominates the financial sector, holding about 90percent o f the total assets in the system. As a result o f important reforms in the banking sector since the banking crisis, today the liquidity o f banks is high and the sector seems to be well capitalized and profitable.6 However, incontrast to other countries in the region, where the banking sector i s mostly private-the median o f state owned banking is 4.6 percent o f total assets-state-owned banks in Romania hold nearly 40 percent o f bank assets and a similar share in all deposits, and 31 percent o f loans. While the state share i s concentrated in only two state banks, both earmarked for privatization, the challenge now i s to proceed with the actual transfer o f ownership. Box 1Trends in Selected Social Indicators, CEECs Based on GDP per capita at PPP, Romania is the poorest country with the second largest population among the CEECs. Inaddition to making progress inpoverty reduction-poverty rates have declined from a peak level o f 13.8 in2000 to 10.9 in2002-Romania's social indicators have also been improving. Adult illiteracy, infant mortality as well as the mortality o f children under 5 years o f age, school enrollment and life expectancy at birthhave improved since the start o f tracs-tion (Chapter 1). These improvements are remarkable taking into account the fact that Romania, besides being one o f the poorest countries inthe region, started the transition ina more precarious condition interms of social indicators. However, direct comparisons o f social indicators, irrespective o f differences inper capita incomes, show that Romania on the whole was and remains worse off than other CEECs. Improvements insocial indicators over time have been slower inRomaniathan inother CEECs. I Selected Social Indicators, CEECs GDPper School enrollment, Mortality Mortality Life expectancy capita, Adult secondary rate, infant rate, under-5 at birth,total ppp(US$) Illiteracy (YO) (YONet) (per 1,000) (per 1,000) (years) 2002 1990 2002 1990 2000 1990 2001 1990 2001 1990 2002 Bulgaria 6909 2.8 1.4 63.3 87.6 14.8 14 18.7 16.0 71.4 71.8 Croatia 9967 3.1 1.5 63.2 79.0lb 10.7 7.0 12.5 8.0 72.2 73.8 Czech Republic 15148 86.1 la 87.1 /a1 10.8 4.0 12.4 5.0 71.7 75.0 Hungary 13129 0.9 0.6 74.8 87.21~ 14.8 8.0 16.8 9.0 69.3 71.8 Latvia 8965 0.2 0.2 76.8ld 74.4 13.7 17.0 18.1 21.0 69.3 70.4 Lithuania 10015 0.7 0.4 80.5 l e 88.6 10.3 8.0 13.5 9.0 71.3 72.7 Poland 10187 0.4 0.3 75.8 90.9 19.3 8.0 21.9 9.0 70.9 73.8 Romania 6326 2.9 1.7 72.8lf 79.6 26.9 19.0 35.7 21.0 69.7 70.0 Slovak Republic 12426 .. 74.9 11.96 8.0 14.1 9.0 70.9 73.3 Slovenia 17748 0.4 0.3 88.6 Ig .. 8.4 4.0 10.2 5.0 73.3 75.9 Estonia 11712 0.2 0.2 82.3lh 82.8 12.4 11 17.2 12 69.5 70.6 Source: World Bankdatabase (SIMA). Notesla data 1993 andla1 1995;/b 1997;Ic 1999; Id 1993;/e 1994;If 1993;/g 1997; 21. The pace o f recent reform efforts needs to be accelerated if Romania is to catch up with CEECs. Selected indicators o f the progress o f structural reforms between 1999 and 2003 are See Chapter 6 o f Volume 2 o f this report. There are, however, issues on the assessment o f the capital o f the banks (see Chapter 6 inVolume 2 o f this report). 8 shown inFigure 1. The figure distinguishes between two types o f reforms. The first relates to the changes inbasic economic liberalization typical o f the early stages o f transition, and the second to the deeper more complex reforms that involve the privatization o f large scale enterprises, financial sector development, and changes in institutions and govemance structures. There are two clear observations. One is that Romania's progress in the first stage o f reforms has stalled compared to that o f other countries inthe region. The other is that, relative to its regional peers, Romania lags significantly inimplementing the second phase o f reforms. Figure 1Selected Indicators of Progress of Reforms: CEECs Initial Phase of Reforms Second Phase of Reforms EBRD Index EBRD Index Slovak Rep Hungary Poland Estonia Lithuania CzechRep Latvia Poland Hungary Lithuania CzechRep Latvia Slovenia Slovak Rep Estonia Croatia Slovenia dulgaria Croatia Romania - Bulgaria 1 Romania 3 00 3 50 4 00 4 5- ______ 100 150 200 250 300 350 40( Source: EBRD Transition Indicators; Indicators for the initial phase o f reforms are calculated as unweighted averages o f indicators for: small-scale privatization; price liberalization; trade and foreign exchange system. Indicators for the second phase o f reforms are calculated as unweighted averages o f indicators for: large-scale privatization; govemance, and enterprise restructuring; competition policy; banking reform and interest rate liberalization; securities markets and nonbank financial institutions; infrastructure reform. 22. While stability and growth performance have improved, these achievements must be complemented by consistent progress in the structural and govemance reform agendas. Romania's rating in the initial phase o f reforms is good but it has remained unchanged in 2003 compared to 1999, while other CEECs have continued to advance. While Romania had a better rating inthe initial phase o f reforms than Bulgaria in 1999, by 2003 Bulgaria's rating surpassed that o fRomania. Romania made some progress inthe second phase o f reforms between 1999 and 2003. However, it is in the second phase o f reforms that Romania has shown the greatest lag behindother CEECs. Romania's rating inthe second phase o f reforms in2003 is close to that o f Bulgaria, Latvia, and Lithuania in 1999 inthe second phase o f reforms. IfRomania is to catch up with the other CEECs in second phase reforms, then reforms in enterprise restructuring and large-scale privatizationwould need to be implemented decisively. 23. The political economy o f reforms in Romania i s beyond the scope o f this study. Clearly, the slow pace o f reforms in the 1990s has been costly to Romania. These costs could not have been maintained without the means to finance them. Nonpayment and arrears have been pervasive inmaintaining otherwise unviable activities. The low levels o f public debt inthe early 1990s provided headroom to finance them-public and publicly guaranteed debt more than doubled between 1994 and 1999. A better understanding o f the drivers o f change o f the political 9 economy o f reforms inRomania (who wins, who loses, and how decisions are being made) could be useful inaccelerating the pace o f reforms. 24. Trade integration is progressing more rapidly than the other dimensions o f economic integration discussed above (Table 3). The share o f imports in total imports and the share o f exports in total exports frondto the EU and sub-regional markets are at the higher end o f those observed in the other CEECs. This indicates that trade integration with the EU plays an important role in economic restructuring and hence inproductivity gains inthe tradable sectors- mainly in unskilled labor-intensive activities such as clothing and footwear (see Section 2). Romania is establishing economic links to this highly competitive market. While FDIlevels are low, there i s evidence that these flows are having a strong pull effect on Romania's trade performance, given the strong links o f these flows to small and medium enterprises (see Section 2). Limited domestic financing to small and medium enterprises (SMEs) does not seem to be holding back these companies from carrying out the needed investments and achieving the productivity and quality levels required to compete in EU markets. This shows that the policies that affect FDI flows, including financing, and incorporating local producers into global production networks are far more important and have more impact in terms o f economic restructuring and productivity gains than do other policies, such as those aimed at addressing limited domestic financing to SMEs. However, the total trade relative to GDP is low compared to that o f other CEECs, which reflects the fact that improvements in competitiveness have a limitedscope inthe economy. Table 3 Romania and the CEECs: Selected Indicators of Trade Integration, 2002 Imports plus Imports Imports from Exports to Exports to FDIfrom Exports to from EU CEEC-10 EU CEEC-10 EU GDP(%) (YOof Total imarts) (YOof total (YOof total (YOof total (YOof imports) exports) exports) total FDI) Bu1garia 83.4 54.3 5.2 55.5 10.5 69.1 Croatia 113.9 56.9 50.6 71.2 Czech Rep. 68.1 57.4 2.4 65.4 1.3 84.1 Estonia 125.2 65.5 2.3 69.4 6.4 Hungary 108.9 56.2 9.8 72.6 10.0 80.2 Latvia 78.5 51.2 3.1 52.5 21.5 Lithuania 96.9 42.6 0.3 43.9 0.7 Romania 69.3 61.6 5.1 65.7 11.3 61.1 Slovenia 96.3 67.6 9.3 57.7 5.8 85.6 Note: FDIshares are for 2001; all other indicators are 2002 data. Source: World Bank database SIMA; UNCOMTRADE, and Datastream. 25. Romania's reform efforts to date have had their rewards interms o f stability, growth, and integration with the EU and global markets. This progress is being driven, in large part, by the country's remarkably rapid pace o f trade integration with the EU and global markets. This is a promising trend as regards Romania's aspirations to join the EU. However, as is shown in the next section, the large segments o fRomania's economy which remain unrestructured represent a considerable risk to the sustaining o f solid trade performance and to growth. Romania needs to make consistent progress in its structural and governance reform agendas to move up technologically, to improve competitiveness more broadly across its economy, and to safeguard the sustainability o f growth. 10 2. BUILDINGON TRADE INTEGRATION 26. Romania has had a solid performance in trade integration with the EU and global markets. However, trade integration i s limited to a few activities in the economy, working around large unrestructured segments o f the economy dominated by public enterprises. Extending this performance more broadly across the economy, however, i s central to the sustainability o f this trade integration performance and growth. This section first provides an overview o f Romania's trade policy framework. It then assesses its trade performance and indicates key features o f its solid performance. The section ends with a reform agenda for addressing the risks and emerging challenges to trade integration. 7 2.1. Trade Policy 27. The recent progress in Romania's economic performance is due, to a large extent, to its prospects for EU accession. Thanks to the European Association Agreement and the EUEastern Enlargement project, Romanian foreign trade policy has facilitated its integration into the global economy. The benefits to Romania are broadly outlined inthis section. The EU associate status has encouraged bilateral trade liberalization not only with the EU but also with other countries enjoying preferential status intheir relations with the EU. Romania has become a member o f the Central European Free Trade Agreement (CEFTA), and an associate member o f the European Free Trade Association (EFTA), and it has a Free Trade Arrangement (FTA) with Israel and Turkey. Together with these countries (excluding Israel), Romania is a party to the Pan- European Cumulation Agreement, which led to the establishment o f a free market for industrial products in 2003. This has created broad opportunities for moving segments o f the production processes across borders without losing duty-free access. More recently, under commitments made inthe Balkan Stability Act, Romania has concluded negotiations and signed bilateral FTAs with Albania, Bosnia and Herzegovina, the FYR o f Macedonia, and SerbidMontenegro. Romanian producers have duty-free access to most o f these trading partners' markets but, in return, they also have to face competition from their imports being subject to mostly zero-tariff rates. However, Romania has not made similar progress inmultilateral trade liberalization. 28. Romania has, on average, the highest MFN applied tariff rates, not only among CEEC- 1O8 countries but also among Stabilization and Association countries, which results in a large scope for reverse discrimination.' Romania's simple average MFN applied tariff rate on industrial products is 16 percent and its weighted average tariff rate is 4.4 percent. However, nearly 86 percent o f all 8-digit industrial custom lines face an applied tariff rate above 5 percent, and 42 percent o f these custom lines face a tariff rate above 15 percent. The rationale for such 7See Chapter 2 inVolume 2 o f this report. The CEEC-10 includes: Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic and Slovenia. Reverse discrimination occurs when differences between MFNtariff rates in the home country and in the trading partners' domestic market, ceteris paribus, result in placing producers in the home country at a disadvantage compared to producers in the preferential trading partners' domestic markets. The result i s similar to providing an import subsidy on the final product importedby the home country since the MFNtariff rate o n the imported input in the home country is substantially larger than the MFN tariff rate o n the same imported input faced by producers in the preferential trading partners' domestic markets. Hence, these differences place producers of the final product in the home country at a disadvantage compared to their peers inthe trading partners' domestic markets. 11 large MFNtariff rates, however, is questionable. For most products manufactured in Romania, producers face competition from firms from the EU and other FTA partners. Tariffs do not protect them from competition from imports. For some products, where there are only a few producers that are competitive worldwide, MFN tariff protection only leads to reverse discrimination and higher prices paid by Romanian users. For others, importers seek exemptions from duties-redundancy intariffratesgenerating opportunities for corruption. 2.2. Trade Performance 29. Trade performance appears to be based on solid ground and may be sustainable provided the pace o f structural and governance reforms i s accelerated. Indeed, as discussed inthe sections below, the sustainability o f Romania's solid trade performance hinges on expanding integration more broadly throughout the economy and eliminating large inefficiencies in the enterprise sector and the agriculture and food sector, and increasing labor market adjustment. Romania's trade performance shows the following characteristics. Figure 2 Foreign Trade in Goods and Services, 1992-2002 (millions o f U S dollars) 0Ratioof 18,000 100% exports to 16,000 80% imports 14,000 12,000 60% - Exportsof 10,000 40% goodsand 8,000 services 6,000 - 20% 4,000 lmportsof 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 A-+ 0% goodsand services Source World Bank staff estimatesbased on dataof the NationalBank of Romaniareportedin OECDEconomic Assessment Romania, June 2002. 30. Trade expansion continued well beyond the initial reorientation of trade associated with the end of the CMEA (Figure 2). While the expansion following the collapse o f central planning could be attributable to the unavoidable realignment o f trade patterns once the CMEA disappeared and economic considerations began to shape trade, the reorientation cannot have driven export growth for more than three or four years. However, in Romania the expansion continued, indicating progress in industrial restructuring that has led to the emergence o f new exporters that are competitive in international markets-these appear to be linked to FDI and de novo companies, particularly SMEs. 31. Romania 's share in EU external imports increased every year during 1993-2002, accompanied by a strong expansion of Romania 's imports. Among the CEEC-9," Romania's export performance in EUmarkets matches that o f the relatively large and industrially advanced economy o f the Czech Republic. Only Estonia (30 percent) and the Slovak Republic (22 percent) had average export growth rates (measured in terms o f change in the share o f exports in EU loThe CEEC-9 includes: Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic and Slovenia. 12 external imports) over 1993-2002 that were higher than Romania's (20 percent), and these two countries had a quite small base level o f exports. This performance was accompanied by an equally strong expansiono f imports. 32. Romania's most rapid trade expansion in EU markets occurred in 2000-2002 despite adverse external market conditions and slow growth in E U economies (Figure 3). Romanian producers appear to be core rather than marginal suppliers and are therefore not excessively vulnerable to swings in import demand in highly developed markets. The dramatic increase in the Romanian presence in EU markets occurred in 2000-2002 against the background o f the falling import demand inthe EU. This suggests that Romanian exporters have firmly established a commercial presence inEUmarkets. Figure 3 Exports to the EU and Other Preferential and MFNMarkets, 1993-2002 (millions o fU S dollars) -Other FTA ' I exports - 4 - E U I I M FN exports ____________ 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source: World Bank estimatesbasedon the UNCOMTRADEdatabaseas reportedby Romania. 33. In 2000-02, Romania also maintained a strong export growth in other markets during the marked acceleration in EU-oriented exports (Figure 3). While the share o f Romania in EU imports increased 64 percent, from 0.64 percent to 1.05 percent, between 1999 and 2002, the share o f markets other thanthose o f the EUinRomania's total exports fell only slightly, from 34 percent to 33 percent, indicating an equally strong export performance elsewhere. Considering the weak import demand in the EU and other highly developed countries, this has been a remarkable performance. 34. Romania is not a single product exporter and its import base is also broad. Although garments tower over other products inRomania's exports, their dominance i s not as pervasive as in other countries (Figure 4). Although clothing remains the most important single sector determining overall export performance in EU markets, its relative weight has been on the decline without negatively affecting overall exports. In fact in the recent past it is capital equipment that has accounted for most o f the export expansion, not only to the EU but also to other markets. The combination o f product and the geographical diversification o f exports and imports seems to augur well for the sustainability o f exports. 35. The drivers of Romania's trade expansion seem well anchored in strong production chains in the EU. Over the broader period o f transition to competitive markets, clothing and to a lesser extent footwear have been the engines o f trade expansion for Romania. Empiricalevidence 13 inthis study shows the following: (i) sectors appear to be firmly entrenched inEUclothing both and footwear value chains; (ii) Romania is no longer solely an assembly shop for EU firms that are taking advantage o f low cost, largely female, labor (many clothing producers have moved from simple cut-make-trim operations, where buyers supply fabrics, to FOB operations, with the clothing firm responsible for obtaining fabrics); and (iii)backward linkages have been developing with much input for both sectors' export activities being supplied locally. This suggests the increased sophisticationo f domestic producers o f footwear parts and textiles. Figure 4 Exports, 1993-2002 (millions o fU S dollars andpercent) 7,000 machinety intotal 6,000 30 exports - 5,000 25 Shareof clothingan( I footwear in total exports 4,000 20 I ElectncalMachinery 3,000 l5 I 2,000 10 +Clothingfootwearand 1,000 5 -Other manufactures 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 ___ Source: World Bank staff calculations based on UNCOMTRADE statistics as reported by Romania. Table 4 FDIInflows in ComDarative PersDective. 1991-96.1997-2002 a/ Average FDI(in millions Average FDIper capita Cumulative FDI Over 1990-02 of US dollars) (inUS dollars) Total per 2001 1991-96 1997-02 2002 1991-96 1997-02 2002 (mln. capita in GNP ofus$) US$ (percent) Bulgaria 85 782 647 10 79 48 4,927 587 27 Estonia 135 422 296 90 249 197 3,05 1 2,034 55 CzechRepublic 1,089 6,242 9,886 106 520 1,059 39,227 3,808 54 Hungary 2,156 1,890 908 211 179 106 24,484 2,400 40 Latvia 159 323 349 64 142 140 2,926 1,170 38 Lithuania 56 596 744 15 149 201 3,587 969 30 Poland 2,119 6,127 4,371 55 148 113 46,483 1,204 28 Romania 207 1,334 1,324 9 60 61 9,249 413 20 Slovak Republic 175 1,834 4,260 32 325 1,078 10,322 1,911 42 Slovenia 111 612 1,950 55 282 989 4,017 2,009 22 TotaVaverage 6,254 20,152 241621 59 175 257 1481096 11406 34 Note: ai 2002 is a preliminary estimate. Source: Various issues ofEconomic Surveyfor Europe (UNEconomic Commission for Europe), World Development Indicators 2003 (World Bank, 2003) and IMFBalance o f Payments database. 36. Development in trade in parts and networks indicates the growing specialization and competitiveness of Romania in some of the most dynamic niches of world trade. These are usually lucrative activities that provide stability to commercial relations and create opportunities 14 for supplying several different single producers o f a final product. This adds the opportunity o f diversification, beyond the simple benefit o f the stability associated with being part o f a well- established supply chain o f single large firm. 37. Although Romania has been the least successful among the CEEC-IO in attracting FDI inflows (Table 4) it appears that FDIflows have boosted trade performance more than is the case elsewhere. The reasons for this include the large number o f relatively small foreign-owned firms, mainly Italian and German, operating in low tech, unskilled labor-intensive sectors. Knowledge and technological spillovers from these firms appear to have been significantly stronger than in most transition economies. The associated influx o f management skills and technology i s providing a positive impact on the modernization o f the country's industrial capacities. 2.3. Buildingon Trade Integration:A ReformAgenda 38. The present trends intrade performance, may not be sustained without the accelerationof the pace o f the economic restructuring reforms, particularly the restructuring o f the enterprise sector, the transforming o f agriculture, the increasing o f labor market flexibility, and the strengthening o f the macroeconomic framework. These reforms are all the more urgent if the emerging challenges to Romania's trade performance are to be addressed. These challenges are the following: 39. Thecontinued domination of unskilled labor-intensiveproducts in EU-oriented exports is troubling (Table 5). Slow progress in structural reforms is keeping Romania from reallocating resources from sectors with low productivity to more productive and potentially competitive sectors. Without further expansion o f private sector activity in the economy, increased labor market flexibility, and a predictable policy environment, Romania seems to be losing its potential comparative advantage in high tech and skilled labor-intensive production as large amounts o f resources are mired in the unrestructured part o f the economy. Without economic restructuring, and without market-driven mechanisms to reallocate resources, including labor, from low to higher productivity activities and FDI flows to upgrade technology, Romania's economic potential remains untapped. Similarly, without improvements to education and the upgrading o f the skills o f its the labor force, the competitiveness o f Romanian firms will continue to depend on the availability o f low-wage unskilled labor. As a result, competing with suppliers from developing economies will become increasingly more difficult. 40. The end of E U quantitative restrictions on textiles and clothing imports under the W O Agreement on Textiles and Clothing of January I, 2005,presents a signijicant challenge to the sustainability of export performance. While it is difficult to predict the potential impact o f a new import regime, Romania has some advantages compared to other exporters from non-European developing countries. These advantages include geographical proximity and a large presence o f foreign owned firms with, thus far, solid commercial links to EU producers and distributors. However, the operations of value chains are particularly vulnerable to potential delays and disruptions in various stages o f the supply chain. Without a predictable and stable policy environment, and without sustained structural reforms, as well as improvement to the overall business climate and efforts to keep increases in wages in line with productivity growth at the 15 firm level, and without the application o f trade and transport facilitating measures, Romanian firms are vulnerable to a rapid loss o f their comparative advantage relative to Asian or African competitors insome production lines. Table 5 Factor Intensity of Romania's Trade with the European Union, 1993-2002 Factor Intensity Product 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 est. Romania's Exports to EU: ($ million) Natural Resource Based 338 641 986 837 985 1,004 1,154 1,278 1,428 1,330 Unskilled Labor 1,295 1,670 2,194 2,476 2,824 3,352 3,630 3,887 4,762 6,497 Capital Intensive 200 366 578 644 650 767 842 1,307 1,429 1,534 Skilled Labor 214 406 686 680 685 763 611 653 807 981 All aboveproducts 2,045 3,082 4,443 4,637 5,143 5,885 6,238 7,125 8,425 10,343 Composition of Romania's Exports to EU: (percent) NaturalResource Based 17 21 22 18 19 17 19 18 17 13 Unskilled Labor 63 54 49 53 55 57 58 55 57 63 Capital Intensive 10 12 13 14 13 13 14 18 17 15 SkilledLabor 10 13 15 15 13 13 10 9 10 9 Romania's Export Specialization Index in EU Natural Resource Based 0.51 0.65 0.70 0.57 0.62 0.64 0.71 0.61 0.58 0.50 UnskilledLabor 3.71 3.31 3.18 3.40 3.44 3.57 3.71 3.81 3.79 3.94 Capital Intensive 0.29 0.34 0.36 0.38 0.34 0.33 0.33 0.46 0.43 0.37 Skilled Labor 0.63 0.79 0.93 0.90 0.81 0.73 0.55 0.57 0.57 0.53 Share in EU'sExternal Imports: (percent) NaturalResource Based 0.16 0.28 0.37 0.31 0.36 0.41 0.47 0.42 0.48 0.55 Unskilled Labor 1.19 1.45 1.70 1.82 2.02 2.28 2.44 2.58 3.10 4.34 Capital Intensive 0.09 0.15 0.19 0.20 0.20 0.21 0.22 0.31 0.35 0.41 SkilledLabor 0.20 0.35 0.50 0.48 0.48 0.47 0.36 0.38 0.47 0.58 All aboveproducts 0.32 0.44 0.53 0.54 0.59 0.64 0.66 0.68 0.82 1.10 Romania's Net Exports to EU: ($ million) NaturalResourceBased -362 61 7 -311 -59 -103 96 71 -90 -457 Unskilled Labor 654 826 943 1,076 1,215 1,425 1,657 1,717 2,238 3,191 Capital Intensive -745 -843 -1,118 -1,415 -1,376 -1,742 -1,587 -1,792 -1,777 -2,267 SkilledLabor -283 -66 -77 -211 -147 -455 -423 -671 -1,037 -1,515 All aboveproducts -735 -23 -245 -860 -367 -875 -257 -675 -665 -1,048 Source: WorldBank staff estimates based on EU as reportedfrom UNCOMTRADEstatistics. 41. Substantialprogress to be made in economic restructuring, particularly theprivatization or liquidation of large SOEs and the institution of reforms to improve the business environment and labor market flexibility, remains as a core challenge. The divergence between Romania's export basket and its relative endowments is an indication that government policies have prevented the emergence o f competitive markets that would reallocate resources from sectors with low productivity to industrial sectors with a potential comparative advantage. While inother CEEC-10 economies FDIinflows have closed the gap between endowments in skilled labor and the dominance of unskilled labor-intensive products in their exports to EU markets, this has not happened in Romania as yet. The factor intensity o f the EU-oriented export basket, after a significant change in 1994-95, reverted to its original composition in 1993, except that the share o f capital-intensive products increased at the expense o f natural resource-intensive products. 16 42. Even though the line between capital and skilled labor-intensive products is not sharply defined, the continued dominance o f unskilled labor-intensive products i s insharp contrast to the experience o f most other CEEC-9 countries. In most o f them, the initial gap between an endowment featuring a relatively highly skilled labor force and a highvolume o f unskilled labor- intensive exports has been closed relatively quickly. This process was aided by FDIflows which were initially related to privatization sales to strategic investors and, as the policy framework improved, were associated with green field investments. While competitive production cost structures and the proximity to important markets are necessary conditions for attracting FDI, they are not sufficient to attract MNCs that establish outside production blocs. An unpredictable policy environment, burdensome tax administration and customs procedures, transportation delays, telecommunications problems and other logistics issues usually prevent the emergence o f border-spanning production networks. 43. I n contrast to exports, where improved market access to regional partners has been signijicantly offset by much lower MFN rates than in Romania and competition from EU producers, the scope for reverse discrimination in Romanian markets has been several times higher. As shown in the previous section, Romania has on average the highest MFN applied tariff rates not only among CEEC-10 countries but also among Stabilization and Association countries, and the economic rationale o f these rates is questionable, since the scope o f reverse discrimination is large. It is therefore recommended that Romania start moving its MFNtariffs toward the Common External Tariff o f the EU. 44. Structural reforms supportive of enterprise restructuring, agricultural transformation and labor market flexibility are needed to improve the prospects for Romania's trade performance. Romania's moderate climate and the availability o f land point to potential competitiveness in agriculture, provided that investment and production decisions in the sector are drivenby market mechanisms. The availability o f an inexpensive skilled labor force suggests a comparative advantage in skilled labor-intensive products. On both counts, export performance has not borne out these expectations, as agricultural net exports have remained stagnant and there has been no perceptible shift toward skilled labor-intensive exports. High protection and the subsidization o f this sector have resulted in major allocative distortions and low productivity, despite preferential agreements, and constitute a major barrier to the development o f competitive agro-food production lines. 45. Insum, Romania's potential insectors other than unskilled labor-intensive tradables and inthe agriculture and food sector remains largely untapped. IfRomania improves its policy and governance frameworks so as to attract FDIflows at levels similar to other CEECs, the evidence suggests substantial benefits for the future competitiveness o f Romanian products. The role o f FDI and de novo industries in economic restructuring, competitiveness, and the generation o f meaningful net job creation in transition economies i s well documented. Furthermore, the alignment o f applied MFNtariffs on industrial products to those o f the EUCET would represent a significant improvement. It would expose both local producers and exporters from Romania's preferential partners to conditions similar to those that the latter face inEUmarkets. Without the restructuring o f the enterprise sector, the expansion o f the private sector in the economy, and a heavier reliance on market driven mechanisms to reallocate resources from low to high 17 productivity activities across the economy, including agriculture, the risks to Romania's trade performance and integration are large. 3. RESTRUCTURINGTHE ENTERPRISE SECTOR 46. Inno other areahas the legacyofthe socialist years inRomaniaweighed as heavily as in enterprise reform. The slow and inefficient enterprise reform o f the past has left Romania with a larger number o f enterprises to be privatized or liquidated than that in all o f the other CEECs combined. Public enterprises are the core of the unrestructured part o f the economy. As discussed in the previous sections, there are dynamic private businesses that are leading Romania's solid trade performance in the EU and world markets. Their scope o f action, however, is limited to a few activities operating around the unrestructured enterprise sector. Furthermore, the expansion o f these internationally competitive private firms is hamperedby the sizable unrestructured public enterprises and the soft budget constraints that keep unviable enterprises from exiting. Inthe last few years the share o f new firms, weighted by employment, i s high and compares well with other CEECs and thus many new firms have started operations. Incontrast, the share of exits, weighted by employment, is very low compared to new entries. This unstable business environment reflects the dominant role o f unrestructured public enterprises over a competitive fringe o f private businesses and represents a significant risk to extending integration with the EUand the world markets more broadly across the economy." 47. Recently, however, Romania has carried out privatization to strategic investors. The government has reduced the number o f large loss-making enterprises by completing important privatizations, including Siderurgica Hunedoara, Tractorul and Roman Brasov and ARO Campulung. Indeed, the momentum for enterprise restructuring seems to be picking up. The challenge is to accelerate the pace o f these reforms and to avoid the failed privatization modes used in the past. This section first takes stock o f the remaining privatization agenda. It then examines the links between hard budgets, productivity, and stability, and discusses the role o f domestic competition and productivity gains. This is followed by a discussion on policies affecting the business climate, including licensing regimes, contract enforcement, and labor regulations. The section ends with a reform agenda for accelerating private sector development. 3.1. Privatization and Economic Restructuring 48. Only recently has Romania carried out privatization to strategic investors. As discussed above, Romania has a legacy o f a large number o f enterprises that are still fully or partially in state hands. By end-2003, Romania had privatized only about 40 percent o f its large enterprises and about two-thirds o f its medium enterprises (Table 6). There are 1,300 SOEs and another 600 enterprises that are effectively under state control. No other country in the CEECs has such a large remaining privatization agenda (with more such enterprises than the rest o f the CEECs combined). See Chapter 3 inVolume 2 o f this report. 18 49. In 2002, the private sector Table6PrivatizationinRomania, 1993-2002 generated about 65 percent o f GDP, Companies for Companies privatized compared with a regional average o f privatization Number Share of total (%) 76 percent. Furthermore, only 19 Large 708 288 40 percent had strategic investors, since Medium 2549 1582 62 33 percent o f Romania's enterprise Total 3257 1870 57 sector was still in state hands, 24 Source: Romanian Authority for Privatization and Management of State percent was insider-controlled, and Ownership. 13 percent was controlled by shares o f mass-privatization.'* In contrast, in the Czech Republic by 1998 about 85 percent of the companies had a strategic owner following the privatization o f 1992-94, and by end-2003, 33 percent o f its enterprise sector had significant foreign ownership. Since 1999 the Slovak Republic has been a preferred destination for foreign investment in the region and about 40 percent o f its GDPproduced is by foreign-owned companies. 3.2. Modes of Privatization and Their effects on Outcomes 50. Romania's choice o f privatization modes, in the past, caused delays and thwarted the necessary restructuring. Romania's isolation program, supported by Romanian "Structural Funds," was aimed at bringing companies back to a sound financial condition. But managers remained in place and, since they were either elected by the workers or approved by the union, they did not take the necessary steps to improve the financial viability o f these companies. Instead, they focused their efforts on accessing the Structural Funds and findingways to continue to accumulate arrears. Little restructuring took place, and the funds were used for employment preservation. At the close o f the program in early 1997, only four firms graduated into profitability, two were privatized, and two were liquidated out o f 147 companies that participated inthe program. Hadthe StructuralFunds been usedto offer separationpackages to workers, the resources used in the isolation program could have offered an average o f 30 monthly wages to every employee. 51. In contrast to the mass privatization in many CEECs, Romania's approach limited commitment to long-term restructuring and investment. Mass privatization in many CEECs, including Bulgaria, the Czech Republic, Poland, and the Slovak Republic, where the privatization funds were privately owned and operated, resulted in majority owners and hence a commitment to long-term restructuring and investment. Incontrast, in Romania the funds were state-managed, with boards o f directors appointed by the government and approved by the Parliament. The nominal owners, 18 million Romanian citizens, exercised no effective control. As a result, majority owners did not emerge in Romania, and without majority owners, a commitment to long term restructuring did not emerge. Restructuring under managed employee buyouts (MEBO) was equally disappointing. 52. Since 1998, privatization for cash has gained momentum in most CEECs, and recently Romania has started to privatize to strategic investors. This shift in policy strategy i s crucial to Romania's economy, given the large size o f the privation agenda that is going forward. And the '*The remainder was inthe hands ofprivatization fimds and dispersed owners. 19 potential productivity gains are large, provided that the privatization mode is to strategic investors and carried out ina transparent manner (Figure 5). Figure5 The Benefitsof OutsiderOwnershipinCentralandEasternEurope (average annual productivity growth, percent) I Note: Insiders does not simply add the analyses for employees and managers as some studies do not distinguish among the two groups. Similarly, Outsiders does not simply add the various groups of outsider investors. In some cases, these are reported and analyzed together. The two categories-Insiders and Outsiders-should only be comparedto each other. Source: Djankov, S. and Peter Murrell, 2002, "Enterprise Restructuring in Transition: A Quantitative Survey," Joumal o f Economic Literature. 3.3. HardBudgets,Productivity, andMacroeconomicStability 53. Incontrast to most CEECs, applying hard budget constraints remains a major challenge in Romania. The evidence from other transition economies shows that hard budgets are the second most important determinant o f enterprise restructuring and productivity gains (Figure 6). Most CEECs have had to deal with loss-making financially unviable enterprises. However, in most cases distressed assets were isolated under state fund management and sold o f f or liquidated. Unlike the situation in most other CEECs, nonpayment and arrears in the state/enterprise transactions is common in Romania. Both financially unviable and financially viable companies rely on nonpayment to finance their operations. In contrast, this practice i s nearly absent in private-to-private transactions in Romania. The challenge is to extend this practice to the state-private transactions inthe economy. 54. Strengthening the financial discipline o f the enterprise sector inRomania is fundamental not only to growth and productivity but also to macroeconomic stability. To the extent that much o f the public enterprise sector i s unprofitable and unrestructured, however, companies depend on budgetary assistance and quasi-fiscal subsidies to continue operating. Furthermore, unrestructured public enterprises remain a source o f inflationary pressure and low competitiveness: historically they have been a source of rapid wage increases unrelated to productivity gains. Rapid real wage growth was partly responsible for the strong real appreciation and consequent sharp exchange rate devaluation o f 1998 and 1999 that was needed to restore current account sustainability. 20 Figure 6 HardenedBudgets Increase Productivity Growth in Transition Economies (average annual productivity growth, percent) o u t s i d e privatization h a r d b u d g e t s d o m estic c o m petition I m p o r t c o m petltlon I Source: Djankov, S and Peter Murrell, 2002, "Enterprise RestructuringTransition: A Quantitative Survey" Journal of Economic Literature. 55. Budgetary subsidization involves sizable implicit subsidies including nonpayment o f taxes and accumulation o f tax arrears, budgetary credits, transfers from off-budget funds and government payment o f guaranteed loans. Table 7 presents estimates o f the amount o f budgetary subsidization o f the enterprise sector. Direct subsidies declined from 2.6 percent o f GDP in2001 to 2.2 percent in2OO2.I3 However, explicit budgetary subsidies are not the only public resources transferred to enterprises. In Romania, a variety o f implicit subsidies i s provided to both state- owned and private companies. The transfers include budgetary credits, nonpayment o f taxes and accumulation o f tax arrears, transfers from off-budget funds, and government payment o f guaranteed loans. Intotal, these implicit non-energy subsidies increased from 4.1 percent o f GDP in 2001 to 5.5 percent in 2002. In addition, there are significant implicit subsidies from the energy sector to non-energy producers and households, o f which about two-thirds accrue to firms.I4 In2002 these subsidies were 2.5 percent o f GDP, and they increased to an estimated 3.2 percent in2003. l3 thelate 1990s,state-owned enterprisesinRomaniadependedheavily ondirectedbankcreditsto finance Until losses and inter-enterprise arrears, which often were driven by rapid wage increases. As the loans were seldom repaid, the financial imbalances were effectively monetized. As a result, monetary policy could not be reconciled with the strategy o f using the exchange rate as a nominal anchor to control inflation. After 1997, soft-budget constraints were no longer financed by the centralbank. Firmsalso began to impose hard-budget constraints on each other. Today, because the enterprises remain largely unrestructured, continuing losses have been financed with direct budgetsubsidies, tax arrears, unserviceable foreign loans that are ultimately repaid by the government, and subsidized sources o f energy. l4 Energy sector subsidies have been estimated by the IMF. See the September 2003 Staff Report for the Fourth Review Under the Stand-By Arrangement and Request for Waivers o f Perfonnance Criteria. These estimates exclude the district heating companies that were not spun away from Termoelectrica. The estimate o f the allocation o f subsidies between households and producers i s based on the 2003 IMF Policy Discussion Paper (PDP/03/02) by Stephane Cosse. 21 Table 7 Subsidization of the Enterprise Sector, 2001-02 2001 2002 2001 2002 (billions oflei) (%of GDP) Direct Subsidies 1/ 30,923 32,772 2.6 2.2 Energy 9,633 12,372 0.8 0.8 O/w local govemment 3,841 4,564 0.3 0.3 Transportation 7,765 8,620 0.7 0.6 O/w local govemment 2,808 2,875 0.2 0.2 Agriculture l / 6,280 2,581 0.5 0.2 Other 7,245 9,199 0.6 0.6 Implicit Subsidies 47,476 83,864 4.1 5.5 Budgetarycredits, net 978 1,165 0.1 0.1 Tax debt 35,417 65,033 3.0 4.3 Change in end ofyear stocks 26,901 63,423 2.3 4.2 Cancelledinterest and penalties 8,5 16 1,610 0.7 0.1 Energyfund 3,068 4,175 0.3 0.3 Loanguarantees paid 8,013 13,492 0.7 0.9 O/w energy sector 7,435 6,050 0.6 0.4 Quasi-FiscalEnergySubsidies2/ 39,027 25,554 3.3 1.7 Low tariffs 31,763 22,304 2.7 1.5 Non-payments 7,264 3,250 0.6 0.2 Memorandum: Total tax arrears (eop stock) 126,587 190,010 10.8 12.6 Oiw arrearsof 76 large loss-makers 46,944 68,274 4.0 4.5 rescheduledarrears 6,259 5,019 0.5 0.3 Notes: I/Includesitems classifiedin the state budget as transfers to mining and agriculture. 2/1 Basedon IMF estimatesof the allocationof subsidiesbetweenhouseholds and firms in2001. Source: Ministry of Finance; Ministry o f Industry andResources; World Bank staffestimates. 56. Indeed, in Romania subsidization through nonpayment, accumulation o f arrears, and periodic barter settlement i s widespread. Both public and private enterprises use tax arrears to finance themselves (Table 8). Neither loss-making nor profitable companies are excluded, although the degree o f the use o f tax arrears is inversely related to profitability -- thus it is far higher inSOEs. Majority andminority state-owned companies have had the largest tax debts as a percentage of total assets during the last two years, averaging 30percent and 7 percent, respectively. Of these companies, which had losses inboth 2001 and 2002, the arrears averaged, respectively, 37 and 11percent of assets. For private companies, persistent loss-makers averaged more 30 percent o f assets in tax debt, while profitable entities owed the equivalent o f 2 percent of assets. Furthermore, the distribution by type o f arrears tends to be about the same irrespective of the level o f profitability, with debts to the state budget, social insurance funds, and local and special funds on average accounting for, respectively, 51 percent, 37 percent, and 12 percent o f the total amount owed. Insum, nonpayment and arrears accumulation are pervasive inthe public enterprise transaction interface. These practices undermine both economic restructuring and ~tabi1ity.I~ See Chapter 1 inVolume 2 of this report. 22 Table 8 Tax Arrears, 2001-02 (percent o ftotal assets) Large Losses inboth 2001 Losses in at Profitable in Least One and 2002 Year both years Total 2001 2002 2001 2002 2001 2002 2001 2002 Regie Autonomes ,. 3.7 3.6 1.1 1.1 1.8 1.8 State-owned 69.4 74.6 30.7 6.1 1.1 1.3 6.4 4.3 Majority state 32.6 40.7 25.1 28.8 14.4 17.6 26.7 33.1 Minority state 11.7 10.5 10.3 11.4 1.6 1.0 7.3 7.1 Private 31.1 36.1 7.9 10.4 2.3 2.1 5.7 6.3 Cooperative 44.5 76.9 18.9 18.7 5.7 4.6 9.2 8.8 Total 27.9 32.4 9.5 10.7 2.4 2.2 7.1 7.4 olw state budget 13.7 14.7 5.2 6.1 1.1 1.o 3.6 3.8 social security 11.2 14.2 3.0 2.7 1.0 0.9 2.6 2.6 local gov. & spec. funds 3.1 3.5 1.3 1.9 0.2 0.2 0.9 1.0 Source: Julian Fennema and Mark Schaffer, "Financial and Economic Performance of Romanian Firms 2001- 2002" the World Bank. 57. In contrast, this practice is much less extensive in private-to-private enterprise transactions. Firms largely impose hard budget constraints on each other. Empirical evidence shows that the scale o f overdue trade credit among enterprises in Romania is not outside the range found in developed Western market economies.I6 Late payment to suppliers i s common, but persistent non-payment is not.l7 Extending this hard budget discipline to government transactions is key to Romania's improving productivity dynamics-hard budget discipline enhances competition among firms for markets, financing, and labor, resulting in higher productivity and hence competitiveness. 3.4. DomesticCompetition 58. Figure 6 shows that improving domestic competition is the third most important determinant o f enterprise restructuring. As is illustrated in Figure 7, below, the conditions for starting a new company in Romania have ample scope for improvement. In particular, the commercial registry is one o f the least efficient in the region, taking on average three weeks to issue a company identification number. Furthermore, exit rarely takes place and by the time it does, assets are often obsolete. Romania's bankruptcy law has the weakest protection for creditors o f any transition economy. Once a company i s in distress, its management dictates the terms o f the insolvency process. This together with the common use o f nonpayment and arrears, results in a strong bias on the part o f creditors to avoid using formal insolvency and contributes to the low level o f financial intermediation observed in Romania. Assets remained unused for years, and this inflicts large costs on the economy andon employment. l6See Julian Fennema and Mark Schaffer, "Financial and Economic Performance o f Romanian Firms 2001- 2002,'' a 2003 background report prepared for the Romania Country Economic Memorandum on the basis o f the financial reporting o f approximately 49,000 companies. 17Of course, timeliness o f payment tends to vary inversely with profitability, and the payment discipline of state- owned firms has been relatively weaker compared to other firms. Also, it is clear that energy companies have been more tolerant of late payment. 23 Figure7 Roomfor ImprovementinEntryRegulation,2003 (number o f days to legally start operations o f a new business) 35 i 30 25 20 15 10 5 France Turkey Latvia Slovakia Romania Bulgaria Source: DoingBusinesswebsite, www.worldbank.or~/Doin~business. 3.5. LicensingRegimes 59. Recently, Romania has made important progress in this area. In mid-2003, the government introduced the silent consent rule, which had an immediate impact on 480 licenses. The new rule allows companies to undertake activities if the relevant government authority has not responded within 30 days. In addition, new legislation i s to be accompanied by a regulatory impact assessment, in line with OECD standards. Finally, statutory limits on the processing o f licensing requests have been mandated. As illustrated inFigure 8, the pace o f reform inthis area needs to be sustained-25 percent o f businesses in Romania report licensing as a moderate to major obstacle to doing business. Figure 8. A Quarter of Businesses Identify Licenses as a Major Problem (percentage o f businesses that say business licensing is a moderate to major obstacle) 30 I 25 ~ ' 20 15 5 Source: BEEPS 2002 survey. 24 3.6. Enforcement of Contracts 60. The enforcement o f contracts inRomania faces more serious challenges than may at first appear. As described in Section 1, judiciary reform is high in the agenda in Romania's process toward EU accession. In late 2003, important initial steps were taken, including the adoption o f the Judicial Reform Strategy 2003-2007, and o f constitutional amendments overhauling the legal framework for judicial reform. Regulatory and organizational changes have to be further worked out and, more important, actions need to be taken to develop a functional, transparent, and independentjudiciary system. These changes will improve the enforcement o f contracts. There is evidence that deficiencies in the judiciary are significant. '* A recent World Bank study reports that these deficiencies have for the most part discouraged businesses from resolving disputes through litigation. l9 Only very large enterprises seem to be more litigious than medium and small businesses. In addition, the large and dominant presence of public enterprises combined with the practice o f barter settlement further reinforces these findings, since firms can resort to these alternative mechanisms to settle disputes. Therefore, the low 240 days needed to enforce a simple debt contract in Romania, compared with an average o f 252 days in the CEEC, reflects deficiencies rather than strengths, since only large companies use the courts to settle disputes and the judiciary lacks transparency (Chapter 3). Furthermore, in 2003, Emergency Ordinance 58/2003 reintroduced two levels o f appeals for all types o f commercial disputes, and hence, represents a step backward in the efficiency o f settling commercial cases. Data from January 2004 indicate that debt collection cases can now take, on average, one year to resolve. In addition, deficiencies in the enforcement o f contracts protecting property rights to land in agriculture are a major stumblingblock for agricultural transformation (discussed inSection 4).20 3.7. Labor Regulations 61. Businesses report that rigid employment laws are a significant obstacle to their performance. As illustrated in Figure 9, in cross-country comparisons Romania has some o f the most rigid conditions o f employment, with tight restrictions on hours worked, and on night and holiday work, and a relatively highminimumwage. Several details inthe labor regulations create perverse incentives for workers: for example, in managing absenteeism, and in periodic automatic increases inwages based on years worked and not on productivity. Recently, Romania revised it's the Labor Code that it inherited from the socialist years. Insome areas the new Labor Code is more restrictivethan the original one (Section 5).21 Romania: A Public Expenditure Review, 2002, the World Bank andRegular Reports onRomaniaby the EC, 2002 and2003. Building Market Institutions in South Eastern Europe: Comparative Prospects for Investment and Private Sector Development, the World Bank, forthcomingin2004. 2o See Chapter4 inVolume 2 ofthis report. 21 See Chapter 5 inVolume 2 of this report. 25 Figure9 EmploymentRegulationIndex(index varies between 0 and 100; higher values for more rigid regulation) 60 50 ' I 40 I 30 Czech Slovak Estonia Hungary Bulgaria Romania Poland Slovenia Republic Republic Source: DoingBusinessproject, www.worldbank.org/Doinebusiness. 3.8. Restructuringthe EnterpriseSector: A ReformAgenda 62. Reform priorities that are important to restructuring the enterprise sector include the following: 0 Implementing the large privatization agenda decisively and transparently to strategic investors is the highest reform priority. It i s only recently that Romania has carried out privatization to strategic investors. This recent momentum givento enterprise reform needs to be accelerated. Privatizing to outside strategic investors, rather than relying on the failed privatization modes o f the past, together with eliminating the widespread practice o f nonpayment and arrears, are fundamental to the success ofthe restructuring reforms interms o f growth, netjob creation, and competitiveness. 0 Implementing hard budget constraints in the transaction interface between the state and enterprises is necessary. Private companies largely impose hard budget constraints on each other. In contrast, soft budget constraints prevail in the transaction interface between the state and enterprises. If hard budget disciplines are not applied to government transactions, the unrestructured public enterprises will remain dominant, and unviable firms will remain active longer, which will hamperthe expansion of competitive firms that are able to integrate with the EU and the world markets. 0 Improving the business environment is necessaryfor growth and competitiveness. Progress in this area has been mixed. A more systematic approach to these reforms is necessary if growth and competitiveness prospects are to improve. The actions needed should include enhancing domestic competition by adopting more flexible labor market principles and more efficient entry and exit rules for businesses (particularly regarding bankruptcy), simplifying the licensing regime, and improvingthe efficiency andpredictability o f commercial contracts. 26 63. As in the case o f the enterprise sector, transforming the agricultural and food sector requires expanding the role o f the private sector and improving the business environment inthe sector and in the economy as a whole. The economic potential o f a large amount o f resources, human andphysical assets, and landremains largely untapped. 4. IMPLEMENTING AGRICULTURALTRANSFORMATION 64. The agricultural sector in Romania includes 45 percent o f the population living in the rural area, and 67 percent o f the poor. The 4.8 million people working in Romanian agriculture today constitute about 72 percent o f agricultural labor in all the EU-15 countries combined. The legacy o f the past agricultural policies o f heavy reliance on subsidization, the slow restructuring elsewhere in the economy, and macroeconomic instability have taken a heavy toll on Romania's agricultural and food sector. As a result, agricultural productivity is low and is not improving: the sector includes 36 percent o f the labor force, which contributes only 14 percent o f GDP. However, as discussed in Section 2, Romania's moderate climate and the availability o f land point to the country's potential competitiveness in agriculture. This potential competitiveness, however, can only be unleashed provided that investment and production decisions inthe sector are driven by market mechanisms and agricultural policies target efficiency improvements. This section first provides an overview o f Romania's agricultural policy framework, and then analyzes the results to date o f these policies. The section ends with a reform agenda for implementing agricultural transformation. 22 4.1. Policy Framework 65. Agricultural transformation in Romania has several dimensions: economic, rural, and social. Economically, while the agricultural sector is potentially competitive given Romania's moderate climate and land availability, policies have resulted in an agricultural sector with one o f the lowest productivities among CEECs, occupying 36 percent o f the labor force, and receiving large subsidies. The rural dimension is highlighted by noting that 45 percent o f the population lives in the rural area. The social challenge is clear by noting that 67 percent o f Romania's poor are in the rural areas. As Chapter 4 of Volume 2 and this section show, an important step towards agricultural transformation i s to separate policy instruments aimed at increasing productivity in agriculture, from those aimed at supporting rural development, and those aimed at reducing poverty inthe rural areas. 66. Inthe early 1990s, after the first democratic elections, Romaniaembarked onaprocess of general economic reform which included reforms in the agriculture and food sector. Progress, however, was rather modest until 1997. Since 1997 Romania has made uneven progress in implementing and maintaining the sectoral reform program. In 2000 the substance o f reform began to shift toward measures aimed at EU accession. The overall process, however, has been slower and the results are less consistent than in other CEECs in the final phases o f the EU accession process. 22See Chapter 4 inVolume 2 of this report. 27 67. The central component o f Romania's Table 9 Structureofthe Agricultural current agricultural policy framework is the costly Support Programin2003 and largely ineffective distortive agricultural ROL(mil.) Percent support program with its highlevel o f subsidization Direct Support (Table 9). The 2003 budget and subsidy program Measures 13,675.50 97 envisages a further significant increase in support PriceSupport 5,101.00 36 7,140.60 51 to agriculture. Expressed in U.S. dollars, the 2003 Input support Other Direct payments 685.00 5 program is close to $450 million, up from about Credit andInvestment $350 million in 2002. This support program Support 749.90 5 represents about 4 percent o f the total state budget Indirect 328.6 3 (down from 10 percent in 1992-93) and less than 1 Measures percent o f GDP (down from 3 percent in 1992). General supportAg. Service 103.60 1 Like other modes of intervention, the level o f ~xportSubsidies 225.00 2 overall support to agriculture has fluctuated widely Total 14,005.10 100 duringthe transition period. The level o f support as Source: Of expressed by the Producer Support Estimate (PSE)23 was relatively modest during most of the 1990s, but it definitely seems to be higher since 1998. The liberal policies introduced in 1997, when the PSE dropped to a 10-year low o f 3 percent, were short lived and support to agriculture has increased significantly since then. Thus, the average PSE during 1991-96 was 13 percent, whereas after 1998 it rose to 20-25 percent. The level o f support varies significantly by commodity. The sugar, milk and poultry sectors receive the highest levels o f support at 64, 46, and 34 percent, respectively. On the other hand, oilseeds receive hardly any support, while the pork sector is actually taxed. 68. Most policies directed to agriculture mix economic, with rural, and poverty reduction objectives into the same instrument. Judging by the results, these measures have proved to be ineffective and in some instances financially unsustainable. For example, the input voucher system, introduced in 1997, was designed to redirect subsidies away from state farms, and to increase farm output by providing better access to inputs. However, the voucher scheme was seen as social welfare program and blamed for failing to increase production output. Similarly, relying on direct and indirect payments to support income o f agricultural producers mixes economic objectives with poverty reduction. Romania's agricultural support policy explicitly targets large-scale farms, most o f them publicly owned. More recently, the government introduced pension benefits to farmers on a non-contribution basis. Clearly the mix o f policies has been ineffective and costly interms o f resources allocated to the sector. 69. The sector has been subject to frequent and ad hoc changes in trade policies. Prior to 1997, there were frequent changes to temporary exceptions and reductions benefiting particular exporters and importers. More recently the volatility takes the form o f frequent use o f safeguards and temporary interventions on behalf o f domestic producers. Other important features o f the current sectoral policies include: there is low and inconsistent taxation inthe agricultural sector; an incomplete transition inthe farming sector; the agroprocessing industry is unprepared for EU entry; commodity and factor markets are not adapted to the needs o f privatized agriculture; and the urban-rural gap reveals significant rural problems. 23PSE is estimatedby the ratio of financial state support providedto producers relative to the value of producers' output. 28 70. The other two dimensions in agricultural transformation are the policies for rural development and poverty reduction. Romania's rural population o f 10.1million reside in 13,000 villages, clustered in about 2,700 communes. Rural income is 27 percent below urban income and about 67 percent o f the poor are located inthe rural areas. With few exceptions, such as the Guaranteed Minimum Income program which targets the poorer segments o f the population, most other policies mix economic, rural, andpoverty reduction targets. 4.2. Policy Outcomes 71. As a result o f poor agricultural policies, agricultural productivity in Romania is low and i s not improving. About 36 percent o f Romania's labor force employed in agriculture contributes only about 14percent o f total GDP (2001 data). The low productivity o f land is manifested inthe generally low yields, which achieve at most 50 percent o f the corresponding EU-15 yields (Figure 10). In livestock enterprises, milk yields hover around 3,000 liters per cow per year compared with 5,800 in EU-15. Based on the aggregate value o f production, Romanian agriculture generates about 500-600 per hectare, compared with 2,000 per hectare inEU-15, and about 1,500 per worker, compared with 21,000 per worker in EU-15 (1999 data). A weighted ranking o f EU-15 and 9 countries, whichjoined the EUthis year, by the yields o f milk, cereals, and sugar puts Romania at the very bottom o fthe scale (together with Bulgaria). Figure 10Romania's Yields Relativeto EU-15 Romania's yields relativeto EU-15 Bo M 40 30 20 10 I ` 0 Cereals Swar Rape& Sunflow Milk Wine Source: EU. OECD statistics 72. The lack o f economic restructuring in other sectors o f the economy, together with macroeconomic instability and high inflation has had an impact on the agriculture and food sector. The sector has become a refuge for those struggling to complement their low incomes with subsistence food production, particularly the older and poorer segments o f the population and the unemployed. About one-fourth o f the labor force in agriculture is 60 years or older and 67 percent o f Romania's poor are in the rural areas. Indeed, this effort to complement low incomes with subsistence food production has been effective, since nutrition poverty is more prevalent among the urban poor (the incidence o f this dimension o f poverty is about 50 percent among the urban poor, whereas the rural poor have an incidence o f 28 percent).24 While this is 24 See Romania: PovertyAssessment, Volumes 1and 2, Report number 26169-R0, The World Bank, 2003. 29 difficult to ascertain, it is possible that the introduction o f defined benefit pensions to farmers without appropriate links and incentives to years o f contributions may have created the incentives for the urban unemployed to move to rural areas while still participating in informal activities as a way o fmakingends meet. 73. A shifting o f agricultural policy strategy towards efficiency and competitiveness is central if Romania i s to bridge the gap between the dire conditions and the potential competitiveness o f its agriculture and food sector. Policy instruments need to be separated from those aiming at poverty reduction, those aimed at expanding business opportunities in the rural areas, and those aimed at improving productivity and competitiveness o f the agricultural sector. 4.3. Agricultural Transformation: A ReformAgenda 74. For Romania to realize its potential as a successful competitor inagricultural markets, the first step is for agricultural policies and transformation to be driven by competitiveness. This means abandoning the failed policies o f the past, with their emphasis on increasing production, intervention in favor o f specific commodities, and the introduction o f costly distortions. These policies have resulted in low yields in both crop and livestock production and in the lowest agricultural labor productivity in the region by far. Competitiveness requires higher efficiency and productivity inagriculture. This can only be achieved by policies that facilitate the structural reorganization o f agriculture by reallocating resources from activities where productivity is low to activities where the potential productivity is higher. This implies allowing inefficient farms to close down and removing obstacles to the expansion o fnew andmore efficient farming units. Table 10 Status of State Farm Privatization (April 2003) Number of farms Percent Starting number o f state farms inSDA portfolio, Jan. 2000 739 100 Inliquidationireorganizationbankruptcy (Law 6411995) 382 51 Privatized 279 38 Remain to be privatized 78 11 75. The recommended agricultural policy framework and support system would need to focus on facilitating the required structural changes and improving competitiveness by implementing the following reforms. 0 Quickly completing the privatization of state farms and ensuring that the bulk of state-owned land is privatized by auction or expeditiously entrusted to private operators (see Table 10); allowing the creation o f functioning land markets under clear and transparent rules; imposing hard budget constraints on bankrupt state farms and enforcing bankruptcy procedures on those which have continued to report losses during the last four to five years (nearly half o f the state farms); and eliminating preferentialtreatment o f large farms. 0 Facilitating of the consolidation of the small-scale farming sector through land market development. To this end, Romania should adopt policies that simplify 30 registration and titling procedures, minimize transaction costs, and ensure property rights through effective contract enforcement. 0 Integrating the various instruments of government intervention in the sector into a more consistent and predictableframework. This would include the provision o f a reliable orientation for farmers until the CAP is introduced and a more effective use o f budgetary support to agriculture through a policy strategy shift o f support programs to target efficiency enhancement rather than price support and export subsidies. 0 Reforming the agroprocessing sector through the privatization of state-dominated subsectors such as sugar, fruits, and vegetables, preferably to outside strategic investors. Foreign capital is needed for the modemization and upgrading o fprivatized agroprocessing. And Romania needs to complete its efforts to meet the food and safety quality and standards o fthe EU. 0 Clearly separating policy instruments aimed at improving productivity and competitiveness in the agriculture andfood sectorfrom those aimed at protecting the poor in the rural areas. 5. ENHANCING LABOR MARKET ADJUSTMENT 76. As discussed in the previous three sections, productivity is low in most sectors in Romania, except in unskilled labor-intensive activities where trade performance shows that productivity has enabled producers to compete in the EU markets. However, the economic potential in skilled and natural resource intensive activities is largely untapped. Romania's development prospects and its efforts to catch up with other countries inthe region inintegrating with the EU are determined by its ability to reallocate resources from low to highproductivity activities across the economy. Success depends to a large extent on the functioning o f three factor markets: labor, capital, and land. This study addresses policy issues inthe first two. This section discusses policies needed to enhance labor market adjustment. Without labor market flexibility, it is unlikely that the economy will be able to respond to the emerging challenges discussed in Section 2. Nor will the economy be able to improve prospects for higher labor productivity andhence better labor income earnings. 77. The section starts with an overview o f Romania's employment, output, and wage dynamics in a regional perspective. It then presents an analysis o f inter-sectoral labor market adjustment and sectoral employment imbalances, followed by a discussion o f key findings injob destruction and creation ina regional perspective. A discussion o f issues on the relation between education, employment and skills mismatch follows. The section ends with a reform agenda intended to enhance labor market a d j ~ s t m e n t . ~ ~ 25See Chapter 5 inVolume 2 o f this report. 31 5.1. Employment,Output, andWage Dynamics:Romaniain a RegionalPerspective 78. Employment dynamics in Romania have closely followed the fluctuations in output and macroeconomic performance. However, incontrast to early reformers inthe region, inRomania the employment dynamics and output fluctuations were driven by the effects o f unsustainable macroeconomic policies on output rather than by economic restructuring. The sharper declines in Romania took place during the two macroeconomic crises o f 1991-93 and 1997-98 (Chapter 1). This reflected not only Romania's protracted economic restructuring but also its policy strategy o f employment preservation. Table 11Output,EmploymentandWage Adjustment(percentage change relative to initial levels) Country AGDP AEmployment AWage 1994/1989 2001/1989 1994/1989 2001/1989 1994/1989 2001/1989 Bulgaria -23 -17 -24 -31 -48 -57 Czech Republic* -10 6 -10 -12 -24 I Hungary -16 12 -26 -23 7 14 Poland -18 15 -14 -16 -18 32 Romania -21 -14 -9 -22 -37 -37 Slovak Republic -21 9 -16 -15 -34 -25 For the Czech Republic GDP changes are computed between 1994 and 1990, and, respectively, 2001 and 1990. Source: World Bank staff estimates based on. 79. Romania's strategy in 1989-1994of preserving employment shifted in 1995-2001 to one o f average wage preservation. These strategies have taken a heavy toll on the dynamics o f output, employment, and wages. Table 11 shows the unsustainability o f this strategy. The collapse of output at the start o f transition was exacerbated by unsustainable macroeconomic policies, which resulted in the crisis o f 1991-93. While Romania's economy contracted by 21 percent in 1994 relative to 1989, employment declined by only 9 percent-the smallest decline inemployment among other countries inthe region. The brunt ofthe adjustment fell on wages, which declined by 37 percent, and hours o f work.26 By 2001, the adjustment inemployment was significantly larger than that o f output: employment declined by 22 percent and output by 14 percent relative to 1989 levels. However, the decline in wages in 2001 relative to 1989, remain unchanged compared to the wage adjustment observed in 1994 relative to 1989 reflecting inpart the benefits o frecent stabilization efforts but also a policy strategy o f average wage preservation. 80. Average wage preservation masks the wide variance o f wage adjustment across the economy. The benefits o f stabilization efforts are tilted towards providingproportionately greater benefits for lower income groups, which have greater reliance on labor earnings, compared to higher income groups. However, the ljenefits o f average wage preservation have been far larger for those employed in SOEs, many of them loss making, than for those employed elsewhere in the economy. Furthermore, since the decline in employment is not matched by a corresponding 26The average annual number o f hours effectively worked in industry was 1,588.2 in 1994, down from 1,759.2 in 1990(NIS data). 32 rise inregistered unemployment, the adjustments reflect a sharp reduction in labor participation associated with retirement and early retirement programs andwith discouragement. 5.2. Inter-Sectoral Labor Market Adjustment and SectoralEmployment Imbalances 81. Inter-sectoral labor market adjustment and sectoral employment imbalances inRomania show worrisome trends (Table 12). In terms of initial conditions, in 1989 Romania had the largest share of employment in agriculture among CEECs comparable only to that of Poland. More important, in 1989 the departure index27of 31 and 33 percent, relative to EU-South and EU-North, respectively, shows that among CEECs, Romania inherited the most distorted employment structure compared to an average EU economy. Interms of overall trends in inter- sectoral labor market adjustment in 1989-2001, Romania diverges significantly from other CEECs by its large increase in the share of employment in agriculture and its limited labor reallocation opportunities elsewhere in the economy. Indeed, the lack of labor reallocation opportunities inthe non-agricultural sectors has tumed agriculture into the labor employer of last resort. Table 12 Structure of Employment by Main Sector in Selected CEEC, 1989,2001 (percent) Bulgaria Czech Republic Hungary Poland Romania Slovak Republic Sector 1989 2001 1989 2001 1989 2001 1989 2001 1989 2001 1989 2001 Agriculture 19.0 26.3 11.7 4.7 16.6 6.2 26.8 19.1 27.9 42.3 13.8 6.1 Mining 2.6 1.2 3.6 1.4 2.0 0.3 3.4 1.9 2.3 1.4 1.0 1.0 Manufacturing 34.9 20.1 34.0 27.7 28.6 24.8 24.5 19.9 33.0 18.9 32.1 26.1 Electricity, gas, water 0.8 2.0 1.4 1.9 2.6 2.1 1.1 1.9 1.2 1.9 1.6 2.5 Construction 7.8 4.3 7.3 9.1 7.0 7.1 7.8 6.7 7.0 4.0 11.6 8.0 Trade 9.2 15.3 11.5 16.1 11.3 17.9 8.9 15.9 5.9 10.1 11.1 15.4 Transportation 6.8 7.3 6.5 7.7 7.7 8.1 7.2 6.0 6.9 4.9 6.4 7.6 Finance 0.6 5.6 0.5 7.6 0.8 7.7 1.0 6.8 0.3 1.9 0.4 6.7 Community services 18.4 17.8 23.5 23.9 23.4 25.9 19.3 21.7 15.3 14.6 22.0 26.5 DI-South 24.2 22.9 17.2 11.6 16.5 8.7 23.0 15.0 31.3 37.3 18.4 11.2 DI-North 27.3 27.7 19.6 15.8 19.6 12.4 27.7 19.9 33.4 42.3 21.6 14.6 Note: The Departure Index (DI) is a coefficient of departure, defined as the overall excess employment in the sectors where employment inthe Eastem Europeancountry exceedsmean employment inthe comparator countries. Source: OECD-LaborForce Statistics (1998), ILO, countrystatistics, and World Bank staff calculations. 82. The departure indexes show that the distortions inthe employment structure deteriorated in2001 compared to the distortions observed in 1989 (Table 11). Policies which have delayed economic restructuring and limited labor mobility across non-agricultural sectors are reflected in Romania's departure indexes. The departure indexes show an alarming trendof rising distortions inthe country's employment structure by 2001 relative to those prevailing in 1989. Romania's 2'The departure index measuresthe proportiono fthe workforce ina givencountry that would needto change sector to attain the same structure o f employment as that o f a comparable Western European economy in 1989. The departure index i s a stylized indicator o f employment structure that would prevail given the same factor endowments, technologies, and prices in a given country as those observed in the comparator economy. Under a neoclassical general equilibrium framework, prices, and technologies are the same across countries with trade, production, and employment patterns varying across countries owing to differences in the countries' factor endowments. Hence, the departure index is a solid approximation o f extent o f distortions at the start o f transition, allowing for differences infactor endowments. 33 departure indexes increased from 31.3 to 37.3 percent by 2001 compared to 1989 with EU-South as comparator, and from 33.4 to 42.3 percent for the same period with EU-Northas comparator. Incontrast, all other CEECs inTable 11showed an improvement intheir departure indexeswith EU-South and EU-North comparators, including Bulgaria-with the exception o f a negligible increase in its EU-North index fi-om 27.3 to 27.7 percent by 2001 compared to 1989. These trends show that EU-South and EU-North continue to adjust to changing economic conditions, and other CEECs continue to reform, and hence their departure indexes have declined. In contrast, protracted reforms in Romania resulted in a deterioration inits departure indexes rather than an improvement. Indeed, Romania's slow progress in economic restructuring and reforms, particularly in labor market flexibility, are taking a double toll on its economy-the economic and social costs of inefficiencies and limited labor reallocation opportunities, and the costs of dangerously laggingbehindother CEECs. Table 13 ChangeinEmployment,2001/1989 (millions) Bulgaria Republic Czech Hungary Poland Romania Republic South Europe Agriculture -0.040 -0.406 -0.581 -1.837 1.471 -0.214 -1.082 Mining -0.079 -0.129 -0.087 -0.304 -0.109 -0.003 -0.021 Manufacturing -0.904 -0.524 -0.452 -1.343 -1.588 -0.247 0.085 Electricity, gas, water 0.023 0.010 -0.051 0.087 0.066 0.012 0.010 Construction -0.206 0.038 -0.072 -0.363 -0.337 -0.120 0.959 Trade 0.055 0.147 0.136 0.745 0.434 0.049 1.716 Transportation -0.076 0.013 -0.069 -0.370 -0.238 0.001 0.277 Finance 0.140 0.335 0.261 0.795 0.165 0.134 1.300 Community -0.265 -0.110 -0.154 -0.205 -0.113 0.014 1.313 Total Change -1.35 -0.63 -1.07 -2.80 -0.25 -0.37 4.56 Job Creation: 0.22 0.54 0.40 1.6 2.1 0.2 5.7 % change 5.1 10.1 8.1 9.6 19.5 8.4 27.9 % oflabor force 4.0 7.5 5.7 6.0 13.6 5.3 Job Destruction: -1.57 -1.17 -1.47 -4.4 -2.4 -0.6 -1.1 % change -36.6 -21.7 -29.7 -26.0 -21.8 -23.4 -5.4 % oflabor force -28.5 -16.3 -21.0 -16.4 -15.6 -15.8 Memo items: Labor force (2001) 5.5 7.2 7.0 26.8 15.4 3.8 Population (2001) 8.0 10.2 10.1 38.6 22.3 5.4 Note: South Europe: Spain, Greece, Portugal. Source: Staffcomputationsbasedon ILO, OECD, andNIS statistics. 5.3. QuantifyingLaborMarket Adjustment: Job DestructionandCreation in Romaniain a RegionalPerspective 83. The prolonged rigidity of Romania's employment composition reflects the mechanics currently at work interms ofjob creation and destruction (Table 13). Job destruction inRomania between 1989 and 2001 as a share o f its labor force in2001 is 15.6 percent, which together with that o f the Slovak Republic is the lowest job destruction to labor force ratio among the CEECs included inTable 12, the percent change o fjob destruction inthe Slovak Republic is higher than that of Romania-23.4 percent compared to 21.8 percent. The percent change o fjob destruction in Romania during the same period is 21.8 percent, which, together with that of the Czech Republic, is the lowest, compared to other CEECs. The largestjob destruction to labor force ratio 34 andpercentage change by 2001 relative to 1989 are those o f Bulgaria with 28.5 and 36.6 percent, respectively. 84. Romania's large job creation to labor force ratio and percent change during the same period, 13.6 and 19.5 percent, respectively, are largely due to the large expansion o f employment in agriculture-the only country among other CEECs where this i s observed. Excluding the expansion o f employment in agriculture, Romania's job creation to labor force ratio together with that o f Bulgaria is the lowest among other CEECs-around 4 percent. While Romania and Bulgaria show different reform trends and have different pending reform agendas, the low job creation in both countries indicates that both countries need to implement reforms to increase labor market flexibility and to reincorporate a large percentage o f their working-age population back into the labor market. 5.4. Education,Skills, and Employment 85. Upgrading skills is essential to sustaining Table 14 Structure of Employmentby trade performance, supporting integration with EducationLevel (percent) the EU, and improving the standard o f living. The Tertiarv Secondarv Primarv fact that Romania's strong trade performance i s Bu1garia 11.6 86.3 2.1 concentrated mainly in unskilled labor-intensive CzechRepublic 12.2 87.7 0.1 activities (as discussed in Section 3) reflects the Hungary 16.4 82.7 0.9 levels o f education embedded in the structure o f Poland 14.7 67.8 17.5 employment by education level. Romania's share Romania 12.9 12.2 14.8 o f employment for those with primary education Slovak Republic 12.3 81.0 6.7 is high by regional standards (Table 14). While Source: ILO: Bulgariaandthe Czech Republicin 2001, the employment for those with tertiary education rest in 2000. compares relatively well with the other countries, the share o f employment with secondary education i s toward the low-end range among selected CEECs. Hence, as pointed out in Section 2, Romania's potential competitiveness in skilled labor-intensive activities depends on reforms that involve the upgrading o f skills, economic restructuring, and improvements inthe investment climate. 86. Reforms will need to address the challenge o f investing in human capital and improving the quality o f education. Romania's annual investment in education, at 3.4 percent o f GDP, is low compared to CEEC average o f 4.4 percent (Figure 11). This is the result o f the poor use o f public resources, rather than o f limited resources. Public resources used to finance hidden subsidies and tax arrears relative to GDP are higher than the resources allocated to education. However, additional resources allocated to education should be accompanied by reforms that will improve the quality o f education and correct the mismatch between the skills that the education system produces and the labor market demand. Based on the latest internationally comparable assessment results currently available (shown in Table 15), the academic attainment inmathematics and science of eighth grade students inRomania is below intemational averages, while many CEECs attainment levels are above intemational averages. Furthermore, the attainment levels in Romania did not improve during the second half o f the 1990s as they did in Latvia, Lithuania, and Hungary. 35 Figure 11ConsolidatedGovernment Expenditurein Education, Selected CEECs, 2000 (percent o fGDP) 7 ' I 6 - 5.9 5 - 4.8 4.4 4.1 4.2 3.9 4 3.1 Average for Bulgaria Czech Hungary Poland Romania Slovak Rep. the selected Republic ~ CEE countries Source World Bank databaseSIMA Table 15 TIMSS EighthGradeStudentAssessmentResultsfor Science and Mathematicsfor Romaniaand Selected CEECs, 1995 and 1999 Mathematics Science 1995Mean Score 1999Mean Score 1995Mean Score 1999 Mean Score Czech Republic 546 520 555 539 Slovak Republic 534 534 532 535 Slovenia 531 530 541 533 Hungary 527 532 537 552 Bulgaria 527 511 545 518 International 519 521 518 521 Average Latvia 488 505 476 503 Romania 474 472 471 472 Lithuania 472 482 464 488 Source: TIMSS1999: International Mathematics Report, Intemational Association for the Evaluation of Intemational Achievement, December, 2000, and TIMSSl999: International Science Report, Intemational Association for the Evaluationof Intemational Achievement, December2000. 87. The significant mismatch between the skills that the education system provides and the labor market demand is evident from the high and long-term unemployment rates among new graduates and low-level educated youth. More than halfo f the discouraged population is younger than 35 years old andthey report that they either do not have the skills suitable for the available jobs or that there are nojobs available. 5.5. EnhancingLabor Market Adjustment:A ReformAgenda 88. A large proportion o f labor resources in Romania are mired in activities that are low in productivity, which results in low labor income earnings. The situation resembles, to some 36 extent, a human asset paralysis. The one exception seems to be the solid performance exhibited by some unskilled labor-intensive tradables such as clothing and footwear. The challenge is to extend that perfonnance throughout the economy by enhancing labor market adjustment, upgrading labor skills and redressing the skills mismatch so as to make more efficient use o f skilled labor inpotentially competitive sectors. 89. Adopting and implementing policies to facilitate labor mobility and to reallocate labor across sectors inthe economy are vital for Romania's economic restructuring from low to higher productivity activities and its integration with the EU.Key reforms include the following. 0 Increasingflexibility in entry/exit from employment by basing thejustification and procedural costs of dismissals on economic rationale and performance. These actions need to be supported by strengthening the Unemployment insurance system in a fiscally sustainable manner (with the costs o f unemployment benefits being assumed largely by beneficiaries) and by improving the targeting of the social safety net. 0 Adoptingpoliciesfor theflexible use offixed-term contracts andfor working time flexibility 0 Strengthening the links between wages andproductivity gains at the firm level rather than at the economy or sector-wide levels, so that mechanisms are based on results, while implementing strict income policies and hard budget constraints for loss-making enterprises; e Adopting policies that support a more balancedparticipation of stakeholders in labor relations consultations-including private sector representatives, trade unions, and independently associated workers-through appropriate labor relations consultation mechanisms with corporate govemance ruled by corporate laws; 0 Eliminating the rigidities imposed by the new Labor Code. Recognizing the importance o f labor market policies for a globally competitive EU, the EU provides well defined principles and a wide scope for members and candidate countries in choosing the rules governing the labor code that best fit the country circumstances and the commitment to EUcompetitiveness in the global markets. The EUcommitment to a globally competitive EUeconomy is well illustrated by the efforts o f many EU members to modernize their respective labor market frameworks, which worked well 30 years ago but are not supportive o f EU competitiveness today. Candidate countries face the challenge o f choosing between adopting labor codes that served EU members well in the past or adopting labor codes that are likely to serve EU members well in the coming years inthe context o f increasingly competitive global markets. By introducing rigidities inthe labor market and discouraging labor mobility, the new Labor Code is not supportive o f progress in Romania's economic 37 restructuring and integration with the EU. In particular, the Code creates new impediments to enterprise restructuring and thereby adversely affects the competitiveness o f the Romanian economy (Section 2). The political economy o f these recent developments includes the role o f entrenched powerful groups that are exercising their influence to maintain their privileged position in terms o f employment and access to public resources. To a large extent, the costs are borne by Romanian workers employed outside o f SOEs via the high taxes that are needed to finance current subsidies and debt write-offs, and by young and skilled Romanians who are facing limitedemployment opportunities. Substantial changes to the Labor Code are required along the lines presented in the first item in this list o f key reforms, if benefits from solid growth are to be more broadly shared on the basis o f performance and productivity. e Increasing labor participation by bringing a largepercentage of the working-age population back into the labor market. Successful policies used inother CEECs to reincorporate discouraged workers, early retirees, unpaid family workers and the long-term unemployed into the labor market include eliminating disincentives for those who wish to continue to work beyond the retirement age, permitting temporary and part-time job creation and temporary working arrangements (TWAs), and adopting flexible rules for entry/exit from employment. e Increasing investment in human capital and addressing the skills mismatch gap. The upgrading o f skills is essential if Romania's trade performance is to be sustained, ifintegration with the EUi s to be attained, and ifthe standard o f living i s to be raised. Reforms in this area need to address the challenges o f investing in human capital, improving the quality o f education, and addressing the skills mismatch. The education reform strategy needs to shift toward adopting automatic mechanisms and feedback rules to link the education system and labor market conditions rather than relying so heavily on centralized planning mechanisms. Stronger competition among education institutions, including universities, for public resources and private sector funding is needed. This would also help to attract the best teachers and students, and would improve the academic attainment and job performance o f graduates (both o f which should be monitored and disclosed at the level o f individual institutions). The allocation o f public resources on the basis o f results and on a student capitation basis are necessary first steps; a Implementingfiscally sound reforms in the tax and benefits systems, in terms of policy and administration, so as to support further reduce labor costs. The statutory rates o f labor taxation remain high, despite the recent reductions in social assistance contributions, equivalent to around 5 percent o f the gross wage. The deficiencies inrevenue collection, combined with the nonpayment and barter settlement o f arrears, have resulted ina low effective collection o f statutory labor taxes as a percent o f GDP. The combination o f high statutory labor taxes and inflexible labor market rules contributes to a relatively large informal sector, as a 38 percent o f GDP and as a percent o f employment. Measures intended to address these challenges include: (i)the unification o f revenue collection and administration, including social assistance, health and unemployment contributions, under a single agency; and (ii)further fiscal consolidation to support additional reductions in labor taxation (significant fiscal consolidation would be neededto support the government's plans for a reduction o f 3 percent o f the social contributions which would bring the total contributions, to 49.5 percent o f the gross wage). e Accelerating the restructuring of the agriculture and food sector and strengthening the effectiveness of programs that willfacilitate the redeployment of labor releasedfrom this sector. To support agricultural transformation, Romania needs to strengthen the social safety net by ensuring its fiscally sustainability and by targeting it sharply to mitigate the costs o f adjustment for the most vulnerable segments o f the population in the sector-those in extreme poverty and the elderly. Fiscally sustainable and well-targeted income support mechanisms, such as the Minimum Income Guarantee (MIG) program introduced in 2002, are far more effective than subsidization inprotecting the poor and the elderly, including those inthe rural areas. 6. RISKS AND VULNERABILITIES 90. There are risks and vulnerabilities involved insustaining the macroeconomic stabilization and reform achievements to date, namely: (i) quasi-fiscal risks due to nonpayment and arrears accumulation; and (ii) fiscal risks due to financial weaknesses in the social security system and the costs o f upgrading environmental standards. 6.1. Quasi-FiscalRisks: NonpaymentandArrears Accumulation 91. While Romania has made considerable progress in containing fiscal deficits and improving the allocation o f public resources, spending has been controlled in part through nonpayment to suppliers o f goods and services. Despite recent improvements in budget formulation and execution, including the reduction in the number of budgetary and extra- budgetary funds to streamline control over expenditure, total budgetary arrears to the economy increased from 0.8 percent o f GDP at the end o f 2001 to 1.O percent in2002.28About 70 percent of these debts are owed by the state budget, with the local government and the Health Insurance Fund accounting for most o f the rest.29 These arrears weaken the finances o f enterprises fostering widespread use o fnonpayment, and are clearly not sustainable. ''Estimates presented may underestimate government arrears owing to information constraints, and to items and entities excluded from consolidated general government accounts. Intra-governmental arrears, such as contributions to social insurance funds, are negligible in size and are cancelled in the consolidation of the various government budgets. 29The stocks public debt presented inthis report exclude budgetary arrears. 39 6.2. Fiscal Risks: The Vulnerabilitiesof BudgetaryStability 92. While Romania has made progress in fiscal adjustment and consolidation, fiscal risks still remain. The monetary financing o f quasi-fiscal expenditures from the National Bank o f Romania was halted in 2000. Fiscal deficits have been cut by half compared to 1997 and budgetary consolidation has remained broadly on track. This progress has contributed to reducing the rate o f expansion o f public indebtedness, which increased from 26 to 34 percent o f GDP between 1999 and 2002. However, two key areas o f reform actions are needed to address fiscal risks: (i) deepening the reforms o f the social security system to address its financial weaknesses; and (ii) containing the costs o f upgrading environmental standards. 93. In the medium term the budget is exposed to considerable market risk. In particular, spending could increase substantially if there were a sharp rise in interest rates and large swings inmajor foreign exchange currencies. One way to see the interest rate sensitivity of budgetary expenditures is to note that about 2.2 percentage points o f the 2.0 percentage point reduction in current spending were a result o f interest savings. While total spending declined by 3.1 percentage points o f GDP between 1999 and 2002, primary expenditure decreased by only 0.9 percentage points duringthis period.30 Moreover, the primary surplus, a key determinant o f debt sustainability, actually declined from 1.7 percent o f GDP in 1999 to 0.4 percent in 2002 and tumed into a deficit o f 0.3 percent in 2003. Estimates o f fiscal balances in this report clearly suggest that the inability to generate debt-stabilizing primary surpluses would jeopardize fiscal sustainability. Furthermore, the fiscal dominance o f the adjustment mechanism suggests that the adoption o f inflation targeting would be premature without a shift towards securing the independence o f monetary policies from fiscal requirement^.^' Under generally favorable assumptions, a debt-stabilizing primary fiscal balance o f 0.4 to 1percent o f GDP would seem to be sustainable provided quasi-fiscal deficits are eliminated and the macroeconomic adjustment mechanism becomes monetary dominant so that monetary policy becomes functionally independent o f fiscal needs. 94. The social security system is a key source o f long-term fiscal risk.32 Pension system deficits, in particular, are likely to grow substantially without hrther reform. Since financing gaps are mainly covered by the state budget, overall government deficits and public indebtedness will tend to rise. Despite recent reforms, including a two-year increase inthe statutory retirement age and a widening o f the contribution base to include the self-employed, farmers and the unemployed, the pension system remains unsustainable. Under current arrangements, system imbalances will continue to grow, thus posing a serious threat to macroeconomic sustainability, particularly if the economy grows slowly. The urgency for reform is increasing, because o f the projected slowdown o f population growth and the steady aging o f the population, which will increase the demands on the system while contributions tend to decline. 30Primary expenditure equals total expenditure less interest payments. 3' See Chapter 1 in Volume 2 o f this report for an analysis o f fiscal sustainability and an empirical examination o f fiscal dominance and monetary dominance in Romania. L a w 101 of 1998 established the central bank's legal independence. The fhnctional independence o f monetary policies (Le., monetary dominance regime) refers to the ability to operate effectively irrespective o f fiscal requirements. 32 A comprehensive discussion o f the issues is provided the 2002 Romania Public Expenditure and Institutional Review. The fiscal section of the 2001 IMF Selected Issues report provides a summary discussion. 40 95. Inaddition, a major challenge inthe medium and longer term is for Romania to manage the costs o f upgrading to EU standards: for this purpose, containing the costs o f upgrading environmental standards i s central. According to its Pre-Accession Economic Plan (PEP), Romania expects to make average annual outlays o f 3.8 percent o f GDP through 2004 to pay for reforms and the harmonization o f institutions with the EU. Even if EU funding were to provide one-quarter o f the total financing needs as envisioned in the PEP, Romania would still need to contribute 1.2 percentage points o f GDP from central and local govemment funds. This would leave an estimated financing gap o f 1.6 percent o f GDP.33Furthermore, these investments would entail recurrent operating and maintenance spending to be met from Romania's own budgetary resources. 96. The total investment cost required for compliance with the 17 directives that address environment-related concerns amounts to approximately 29.7 billion. This figure is about 29 percent higher than originally estimated by the E C and is one o f the highest among the CEECs. EU Funds committed to help finance the investments during the period 2004 to 2015 are estimated to be about 6.9 billion in total. Hence, the remaining 22.8 billion will need to be obtained from other sources, namely, central and local government, and the private sector. The experience o f CEECs that have been successful in carrying out these reforms illustrates several o f the key ingredients o f public expenditure policy reform strategy. 34 7. THEQUASI-FISCAL CHALLENGE: ENERGY SECTORREFORM 97. As in many transition economies, the energy sector in Romania has been central in the persistently large quasi-fiscal deficits. While some progress has been made owing to reforms in the sector, these deficits remain large and are not sustainable. These losses have resulted in a significant deterioration in the basic energy infrastructure and have reduced the primary production o f oil, coal, and gas. 35 Because energy is a critical component o f production, energy subsidies have distorted relative prices and have generated costly inefficiencies throughout the economy. Furthermore, since energy company losses are often financed with tax arrears and unpaid loans, they have added to a rising stock o f public debt. This first provides an overview o f the role and instruments o f state support in the energy sector. It then discusses reforms to date, andproposes a reform agenda. 36 7.1. The Energy Sector and State Support 98. The energy sector in Romania has been a main source o f persistently large quasi-fiscal deficits-more so than in many other transition economies. Cheap energy has been used simultaneously to support loss-making public enterprises and to provide an implicit subsidy to consumers. Subsidization has been provided implicitly through the tolerance o f low bill collection rates and the pricing o f electricity, gas, and district heating below their full cost- 33The gap, however, may be larger than anticipated ifthe limitedabsorptive capacity o f EUfunds persists. 34See Funck, Bernard, 2002, Expenditure Policies TowardEU Accession, World Bank Technical Paper No. 533. 35The inefficiency of electricity productioni s partly due to considerable excess capacity. 36See Chapter 7 inVolume 2 o f this report. 41 recovery tariff rates.37As late as mid-2002, natural gas prices were about one-third lower than in OECD countries and one-half o f EUaccession countries.38Electricity prices are getting closer to full cost recovery for some unitswhich operate efficiently, however there are many units which are very inefficient and as electricity tariff rates increase these units have less incentives to restructure. Although they are close to the level o f several accession countries, district heating prices have been about halfo f the average price inthe EU. Table 16 ResourceTransfers to and from the Energy Sector, 2001-02 2001 2002 2001 2002 Total subsidizationof energy 28,865 31,267 2.5 2.1 Direct subsidiesto energy 4,250 5,166 0.4 0.3 Electricity 1,052 1,344 0.1 0.1 Mining 3,198 3,822 0.3 0.3 Gas 0 0 0.0 0.0 Other resourcetransfers 371 561 0.0 0.0 Hiddensubsidies 24,244 25,540 2.1 1.7 Energy Fund(electr.) 3,068 4,175 0.3 0.3 Foreign loan guaranteespaid 7,435 6,050 0.6 0.4 Tax debt 5,186 13,856 0.4 0.9 Change inend o f year stock 11 -3,330 13,550 -0.3 0.9 olw social insurance 2,547 2,484 0.2 0.2 Cancelled interest andpenalties 8,516 306 0.7 0.0 Bank payments overdue (domestic) 951 -187 0.1 0.0 Supplier arrears 7,604 1,647 0.7 0.1 Energy sector losses21 56,165 37,220 4.8 2.5 Low tariffs 45,792 32,527 3.9 2.2 Non-payment 10,373 4,694 0.9 0.3 Net transfers to the energy sector -10,162 5,714 -2.3 -0.4 Memorandum: Rescheduled arrears 6.259 4.947 0.5 0.3 Notes: 1J Excludes accumulated penalties.2/ Comprises implicit subsidies to both households and firms. Excludes district-heating companies that were not formerly units of Termoelectrica. Source: Ministry of IndustryandResources and InternationalMonetaryFund. 99. The resulting operating losses are financed with arrears and various budget and off- budget funds (Table 16). As has been mentioned, these losses have resulted not only in deterioration inthe basic energy infrastructure but also inunder-investment inmodem machinery and equipment. This lack o f investment has left many facilities obsolete and highly inefficient, which has led to increased import dependen~y.~~ As was noted above, energy subsidies have distorted relative prices andreduced efficiency throughout the economy, And as prices have been kept artificially low, there has been over-consumption and waste o f scarce energy resources. In 37The pricing structure o f the oil sector is considered undistorted. 38A detailed discussion o f the pricing structure and financial performance o f the sector inrecent years is provided by the 2002 IMF Policy Discussion Paper "The Energy Sector Reform and Macroeconomic Adjustment in a Transition Economy: The Case o fRomania." 39See footnote 35. 42 addition, the financing o f energy company losses with tax arrears and unpaid loans have augmented a rising a stock o fpublic debt. 100. Given the state o f financial lack o f indiscipline in the enterprise sector, the increase in prices may account for much o f the growth intax arrears, and possibly also for the greater rate o f activation o f loan guarantees. In fact, the 2.1 percent o f GDP increase in tax arrears and loan payments for the economy mirrors the 2.3 percent decline in energy losses. The elimination o f losses in the energy sector, therefore, is in itself unlikely to improve the prospects for long-run macroeconomic stability without the enforcement o f tax payment di~cipline.~' Without the elimination o f nonpayment o f taxes, smaller losses in the energy sector will give way to larger losses elsewhere and to increasing public indebtedness. As discussed in the following section, despite recent progress, muchremains to be done to complete the energy reform agenda. 7.2. The Energy Sector: A Reform Agenda 101. More recently, particularly in2003, the Government of Romania has acted to reduce the energy sector subsidy, and the energy sector-related quasi-fiscal deficit has been reduced significantly. In particular, power prices are now at cost recovery levels, there have been significant gas price increases, and power collections from residential customers are close to 1% percent. 102. E'hile good progress has been made in power tariff reform, further price adjustment and restructuring will be required as investments are undertaken. In the gas sector, although there have been significant price increases, further large increases are required to meet import parity. The challenge for the government is make good on its commitment inRomania's Road Map to EUAccession, including its commitment to move to import parityinthe medium term. 103. Regarding the affordability consequences of tariff increases, these are not likely to be problematic in the power sector, where expenditure is small relative to income, and where an effective social safety net is in place. Gas price increases, on the other hand, are likely to strain affordability inthe gas and heat sectors. Targeted social safety nets for gas and heat will require additional financing if affordability risks are to be mitigated; part o f the increased financing could be unlocked through the rationalization o f the current blanket subsidy to the district heating sector. 104. Payments discipline remains something of a problem in power and gas, notwithstanding increased collections in recent years. If collections are to be increased to levels that would permit energy industry financial viability on a sustained basis, government action is required that would permit the disconnection o f large SOEs, and would develop an industrial policy for their restructuring'privatization. Improved payments discipline in district heating will require the commercialization o f this sector. 40Disinflation may put further financial stress on loss-makers, as the erosion o f the real value o f arrears will tend to slow. 43 105. As regards institutional reform (to support commercialization and hence the reduction of the energy quasi-fiscal deficit), Romania has progressed further than all of the South East Europe Regional Energy Market (SEE REM) countries except Croatia in regulatory development, andfurther than all of these countries except Bulgaria in industry restructuring. In terms o f power market development and gas industry regulation restructuring, Romania has outperformed all SEE REMcountries. 106. Among the outstanding challenges is that o f building on its track record in regulation through continuing to implement price increases as necessary in power and gas, to impose hard budget constraints inthe enterprise sector including energy, and to move toward the introduction o f tariff setting on a long-term basis. In industry restructuring, the challenges include the commercialization o f generation subsidiaries and the introduction o f the private sector in the unbundledgas structure. Inmarket design, the proposals are consistent with those for the SEE REMcountries, the challenges relate to detailed implementation issues. 107. Regarding investment, Romania's continued status as a net power exporter to SEE will require large-scale generation rehabilitation. The challenge here i s to develop a framework to secure investment that is consistent with the objective o f liberalizing the power market. Chapter 7 in Volume 2 discusses energy sector reform in more detail and argues that capacity contracts could provide a solution here, and that these would be consistent with the proposed market design inRomania. 108. In summary, if Romania is able to meet the challenges of setting appropriate energy tariffs (Le., at a level o f full cost recovery) and o f improving operating efficiency, through applying hard budget constraints, closing unviable thermal generation units, and implementing institutional reforms, together with undertaking the necessary investments, this should bring about competitively priced domestic energy and should provide export opportunities. This would yield economic benefits in a sub-regional energy market context and also, more generally, in a regional market context. 8. FROM QUASI-FISCAL FINANCING EFFICIENTFINANCIALINTERMEDIATION TO 109. Quasi-fiscal subsidization is crowding out financial intermediation inRomania-hence it is contributing to the low level o f financial intermediation in Romania relative to other CEECs. Both loss-making and unprofitable companies rely on nonpayment and accumulation o f arrears to finance their operations. However, the degree o f use o f tax arrears i s inversely related to profitability, and thus it is far higher in SOEs. Clearly, large efficiency gains can be made through eliminating quasi-fiscal financing. Efficient financial intermediation mobilizes and directs resources to the most profitable investment opportunities. In contrast, quasi-fiscal financing channels resources to nonviable firms. This type o f subsidization i s not sustainable, nor are nonviable firms that benefit from this financing. Reforms that will develop efficient financial intermediation are needed. The 2003 Joint Bank-Fund Financial Sector Assessment Program for Romania4' includes a comprehensive analysis and policy recommendations for addressing the ~ ~~ 41Joint Bank-Fund Financial Sector Assessment Program, 2003, the World Bank and the IMF. 44 challenges o f financial sector development. The present report is based on this work andbuilds it from the perspective o f stability, growth, and integrationwith the EU. 110. Romania has made significant progress in consolidating the financial sector since 1999, when bank restructuring took hold. The regulatory and supervisory environment has improved, easing the way for progress inbuildinga more solid foundation for financial sector development. However, the completion o f bank restructuring, the further development o f the basic financial infrastructure, and the elimination o f the use o f nonpayment and arrears which is crowding out bankingintermediation, are all needed to ensure an efficient and secure financial market. Such a market would help the economy to sustain high growth rates because it would direct finance toward more productive investment alternatives. The present section first provides an overview o f the structure o f the financial sector inRomania. It then discusses the role o f the bankingsector and shows the extent to which quasi-fiscal financing is crowding out financial intermediation. The section then turns to an analysis o f the soundness o f the banking sector. This is followed by a discussion o f regulatory and supervisory issues. The section ends with a reform agenda that highlights the need to strengthen the regulatory and supervisory framework.42 8.1. Structure of the Financial Sector 111. As inother developing economies, inRomaniathe bankingsector dominates the financial system and holds about 90 percent o f the total assets in the financial system, or about 31.1 percent o f GDP (Table 17). Non-bank financial institutions are underdeveloped and consist mainly o f insurance companies and financial investment companies (SIFs). Capital market capitalization accounted for 11percent o f GDP at end-2002.43 Table 17 Structure of the Financial Svstem (as of end-2002) Assets Number o f Percent Institutions InROLBillion of GDP Commercial banks 39 469,712 31.1 Credit cooperatives 1network 2,687 0.18 Credit unions 3,895 5,079 0.34 Financial investment companies (SIFs) 5 21,969 1.45 Financial investment service companies 77 723 0.05 Investment funds 26 1,288 0.09 Of which: Open-ended investment funds 23 999 0.07 Venture capital funds 3 289 0.02 Insurance companies 11 49 22,841 1.51 Notes: I/The pension scheme authorities and Fund estimates i s a state-organized"pay as you go" system and there are no private pension funds. 42See Chapter 6 inVolume 2 of this report. 43The insurance sector is very small, despite the large number o f insurance companies. Its assets are estimated at only 1.5 percent o f GDP. There are also five financial investment companies o f a similar size. Credit unions and credit cooperatives hold, all together, assets o f about U S 2 3 0 million. 45 112. Bank restructuring hada comparatively late start inRomania andstill remainshighonthe agenda, whereas it has been largely completed inother CEECs. As seen inTable 18, the state has largely withdrawn from the banking sector in most o f the countries shown and the shares of assets inpublicly owned institutions are in single digits. State ownership inRomania, however, continues to be high-at around 40 percent. 44 Not surprisingly, foreign ownership of banks i s also substantially lower inRomania compared with more than 80 percent inthe CEECs. 113. Presently the state continues to be one o f the major players inthe banking sector-ut o f the 39 banks operating inRomania in 2002, 3 are state-owned-BCR, the Savings Bank (CEC), and the Export-Import Bank o f Romania (EXIMBANK). However, they account for nearly 40 percent o f the bank assets, a similar share o f deposits, and 31 percent o f loans. The continuing strong presence of state-owned banks places Romania at a disadvantage compared to other EU accession countries, where the benefits o f private sector ownership are already visible (including deeper financial intermediation, diversification and innovation of financial services provided, and increased competition leading to better and less costly services to support a stronger corporate sector). While these assets are concentrated in two state banks, both earmarked for privatization, the challenge i s now to proceedwith the actual and complete transfer o f ownership. Table 18 Asset Shares of State-OwnedBanks, 1996-2082 (percent) 1996 1997 1998 1999 2000 2001 2002 Lithuania 54.0 48.8 44.4 41.9 38.9 12.2 0.0 Estonia 6.6 0.0 7.8 7.9 0.0 0.0 0.0 Slovak Rep. 54.2 48.7 50.0 50.7 49.1 4.9 2.9 Latvia 6.9 6.8 8.5 2.6 2.9 3.2 4.0 Czech Rep. 16.6 17.5 18.6 23.1 28.2 3.8 4.6 Hungary 15.3 3.5 9.8 7.8 7.7 9.1 10.8 Bulgaria 82.2 66.0 56.4 50.5 19.8 19.9 14.1 Poland 69.8 51.6 48.0 24.9 23.9 24.4 26.6 Romania 75.9 73.0 71.0 46.8 46.1 41.8 40.4 Slovenia 40.7 40.1 41.3 42.2 42.5 48.9 48.6 Median (exc. Romania) 40.7 40.1 41.3 24.9 23.9 9.I 4.6 Source: EBRDTransition Report 2003, andNBR for Romanian data. 8.2. Role of the BankingSector 114. To date, the banking sector inRomaniahas not been provided with incentives to mobilize resources to finance investment and long-term growth efficiently. The adverse macroeconomic environment, the uncertain and insecure legal framework and enforcement practices, and the lack o f strong accountability mechanisms have hampered the deepening o f financial intermediation and monetization in Romania. Compared to that o f other CEECs, Romania's financial intermediation remains shallow (Figures 12 and 13) and it can be attributed to the slow pace o f economic restructuring which has permitted the persistence o f nonpayment in the economy. Firms have found it easier and less costly to accumulate arrears than to finance their activities by borrowing from the banks. At the same time, banks are reluctant to lend to firms with arrears. 44InMay2004, the governmentprivatized33 percent ofthe shares ofBCR. 46 Overall, the low payment discipline inthe economy, magnified by deficiencies in the legal and institutional environment, has been damaging to bank intermediation, in terms o f both lending and deposit taking. Figure 12BroadMoney to GDP, 2002 Figure 13 Private SectorCredit to GDP, 2002 *cent) (percent) Fig.1: Broad Money, 2002 (percent of GDP) Fg. 2 P r bate Sector Cr edt, 2002 (percent of GDP) Czech Rep 72 4 Croatia Croatia Slovenia Slovak Rep HngX Y Hungaiy Latvia Estonia Estonia Bulgaria Slovak Republic Poland CzechRepublic Latvia Bulgaia Lithuania Poland Romania Lithuania Slovenia Romania 0 20 40 60 80 Source EBRDTransitionReport,2003 0 10 20 30 40 50 Source EBRDTransitionReport, 2003 115. While some o f the impediments to iealthy financial sector development have been removed or mitigated because o f the improved macroeconomic environment, the unfinished structural reforms in the country continue to significantly constrain the development of the banking sector. The use of nonpayment as a means o f financing inthe economy i s crowding out bank lending. Nonpayment is common not only among companies that are supposedly facing hardbudget constraints but also among healthy enterprises that choose to delay tax payments -- encouraged by a long history o f tax arrears and forgiveness and the comparatively low penalties charged on outstandingtax debts. Table 19 Sources of Fundsfor 116. As shown inTable 19, bank credit represents Romanian Firms in 2o01 only 8 percent o f total financing o f the corporate (percentOf financing) sector and firms are predominantly financed by Stocks 1999 2000 2001 arrears. Banks are reluctant to lend to enterprises, Numberof Firms 1,155 932 726 either because they are perceived to be riskier or IntemalFinanCing 7.4 10 12.8 because they are unprofitable and lack growth Retained earnings 6.8 8.9 11.9 opportunities. Only a few enterprises are profitable Reserves 0.6 1.1 0.9 and liquid enough to commit an acceptable amount Extemal Financing 58.8 51.8 52.5 o f their own equity to new investment projects. Share capita1 35.6 29.2 28.3 Moreover, only a few enterprises are able to Bonds 0 0 0 establish their creditworthiness given the quality o f Bank debt 10.1 7.6 8.3 the financial statements and the lack of audited Trade credit 13.1 15.0 15.9 reports. Despite the fact that since 1999 the Arrears 33.6 38.2 34.6 corporate sector has shown improvement in its Taxes 19.2 22.6 15.2 profitability, about one-third o f firms are still Social security 6 5.7 7.2 and do not generate a cash flowto FinancialSector Assessment Program, 2003. Source: Ministry o f Finance and staff estimates, 47 service their debt. 117. The exposure o f banks to firms with accumulated arrears seems to be small. Banks are reluctant to lend to those firms that rely on nonpayment and arrears accumulation as a means o f financing. The bank credit for firms with hightax and inter-enterprise arrears is about halfo f that for firms with low arrears (Table 20). Banks are even more cautious with SOEs. Large state- owned manufacturing firms with high tax and inter-enterprise arrears have less than half o f the bank credit o f private firms with high tax arrears.45 The bank debt o f utilities with high arrears, both state and inter-enterprise arrears, accounts for only 1 percent o f the liabilities. Enterprises with low tax arrears borrow more than 40 times as much from banks. Table 20 Romania: BankDebtfor DifferentLevels ofArrears, 200146(as percentage o f liabilities) Low tax High inter- Low inter- Sector High tax arrears arrears enterprise enterprise arrears arrears Agriculture 6.18 16.22 5.53 11.91 Manufacturing 9.61 21.73 13.08 18.86 Utilities 1.27 43.43 0.40 13.33 Construction 6.33 9.15 7.18 7.94 Transport 5.41 9.39 5.97 7.99 Trade 9.64 13.53 12.27 12.40 Services 5.82 10.64 5.18 9.55 Source: Ministryof Finance andWorld Bank staffestimates. 118. The banks' ability to mitigate risks through collateral still remains limited in spite o f a well-functioning collateral registry. In part this is due to inefficiencies in the courts and difficulties in selling reclaimed assets in secondary markets. In this regard, reference must be made to Emergency Ordinance 61, introduced in 2002 and effective in 2003, permitted the authorities to seize any collateral pledged to a bank in order to collect tax arrears. The government, however, abolished this ordinance in the first half o f 2004. Further efforts are needed to simplify bankruptcy processes and provide a reliable framework for secured lending bybanks. 8.3. Soundness of the BankingSector 119. With the start o f state-owned bank restructuring, and the introduction o f stricter rules and regulations for bank supervision, the soundness o f the banking sector inRomania has improved. The closure o f Bancorex in 1999, and the transfer o f the bad assets in the system to AVAB47 improved the overall health o f the banking system (Table 21). Since then, banks have seemed to be well capitalized, liquid and profitable and they have limited market and credit exposure. Capital adequacy ratios improved from 18 percent in 1999 to 23 percent in June 2003. Non- 45See Chapter 6 inVolume 2 o fthis report and the Joint Bank-IMF FSAP o f Romania, 2003. 46Based on Ministryo fFinance data on BSE traded firms and RASDAQ traded firms with more than 50 employees. High (low) tax arrears indicate the group o f firms for which the share o f tax arrears intotal debt is above (below) the sample median. High (low) inter-enterprise arrears indicate the group o f firms for which the share o f trade credit arrears intotal debt is above (below) the sample median. 41Close to US$2.3 billion bad assets from Bancorex and Banca Agricola were transferred at that time to the asset recovery agency. 48 performing loans declined from 53 percent in 1999 to close to 2 percent in 2002 and are now on a par with those reported by other CEECs. The return on assets has more than doubled over the same period, while liquidityratios have been muchhigher than required. 120. Capital adequacy ratios show that banks in Romania are well capitalized-reported capital adequacy ratios have been constantly higher than the required 12 percent4* although they have been declining lately. The recent introduction o f International Accounting Standards needs to be filly implemented. Nearly half o f the capital is in the form o f fixed assets and full implementation o f these new principles will reduce risks o f overestimation. Until recently, there was no requirement for reporting on a consolidated basis, while a number o f banks have subsidiaries outside o f the banking sector. However, the government has introduced requirements to report on a consolidated basis which fully implemented strengthens the basic financial infrastructure. Table 21 Financial Soundness Indicators, 1996-2003 1998 1999 2000 2001 2002 2003l Capital Adequacy Ratio2 10.25 17.90 23.79 28.80 25.04 22.82 Tier 1/ Risk Weighted Assets2 na 15.82 18.90 26.21 22.93 21.15 NPLsI Gross Loans' 71.7 52.6 5.2 3.3 2.3 9.1 Returnon Average Assets 0.06 1.47 1.49 3.10 2.64 2.43 Interest margidgross income na na -0.21 5.17 7.77 9.09 LiquidAssetsITotalAssets2 na na na 77.10 78.59 70.88 Liquidity ratio (actuayrequired liquidity) 3/ 1.30 1.37 3.48 Loans I Deposits 56.93 43.92 44.57 44.69 43.91 58.22 Notes: 1. Data as of June 2003, with the exception of NPLs/Gross Loans (as o f November 2003), and liquid assetsitotal assets (as of May 2003). 2/ Foreign banks' branches are not included. 31There was a methodological change in June 2003. Source: NBR. 121. Banks prefer to keep highly liquid positions rather than becoming involved in risky lending to the large block companies that are incurring losses and that maintain high stocks o f arrears. Deficiencies incontract enforcement and bankruptcy also make bank lending riskier than would be the case with a more efficient framework. Economic rigidities in the economy, including low labor market flexibility and skills mismatch, limit growth and profitable investment opportunities in most sectors o f the economy, except in some tradables (Section 2). Moreover, the interest rates offered by the NBR on non-reserve deposits have often been a better alternative than loans. In addition, the limited inter-bank market inRomania may force banks to hold additional liquid assets in order to self-insure against higher than usual demand for liquidity. 122. The quality o f Romania's loan portfolio has improved since 1999 and compares favorably with good performing CEECs (Table 22), although there has been some worsening lately. Non-performing loans declined in Romania from more than 50 percent before 1999 to about 2-3 percent o f loan portfolio in2002. However, as a result o f the rapid growth o f lending 48The minimumcapital adequacy ratio was raised in 1999to 12percent from 8percentpreviously. 49 and the introduction o f stricter rules for loan classification 49 andprovisioning, the share o fnon- performing loans has quadrupled in a year's time and at end-November 2003 stood at 9 percent o f total loans. This raises concems about the sustainability o f rapid credit growth in a system that is still dominated by large state-owned banks, that lacks comprehensive credit information and that has inefficient debt enforcement practices. Table 22 Non-Performing Loans, 1996-2002 (percent) 1996 1997 1998 1999 2000 2001 2002 Bu1garia 15.2 13 11.8 17.5 10.9 7.9 10.4 Czech Rep. 21.8 19.9 20.3 21.5 19.3 13.7 9.4 Estonia 2 2.1 4 2.9 1.3 1.2 0.8 Hungary na 6.6 7.9 4.4 3.1 2.9 4.6 Latvia 20 10 6.8 6.8 5 3.1 2.1 Lithuania 32.2 28.3 12.5 11.9 10.8 7.4 5.8 Poland 14.7 11.5 11.8 14.5 16.8 20.1 24.6 Romania 48 56.5 58.5 35.4 3.8 3.4 2.3 Slovak Rep. 31.8 33.4 44.3 32.9 26.2 24.3 11.2 Slovenia 10.1 10 9.5 9.3 9.3 10 na Source: EBRDTransition Report, 2003. 8.4. Basic FinancialInfrastructure: Regulatory and Supervisory Framework 123. Important progress has been made in improving the regulatory and supervisory environment. A large number o f new laws and substantial amendments to the existing financial legislation have been adopted since 1998 in an effort to harmonize the legislation with international standards and EU requirements. A broad range o f measures has targeted all stages o f the prudential supervision o f banks, from licensing to exit proceedings. Appropriate licensing and sanctioning mechanisms have been set inplace, a modem early warning bank-rating system is being implemented, and the frequency and coverage o f on-site and off-site supervision has increased. At the same time, some o f the instruments necessary to support supervision have been created or streamlined-namely, the Credit Risk Bureau and the Payment Incident Bureau. 124. Nevertheless, important challenges remain in developing a more solid financial infrastructure that ensures that the right incentives for financial market participants are inplace. The financial sector, banking in particular, has the responsibility o f safeguarding deposits and savings in the economy by channeling these resources to the best possible investment opportunities. This function cannot be performed well without a solid infrastructure. Challenges to improving the basic financial infrastructure in Romania include the following: (i)assessment of bank capital; (ii) access and coverage o f the credit registry; and (iii) capacity to assess and the manage risk. 125. Assessment of bank capital. Capital adequacy regulation i s largely compliant with the Base1 Core Principle. The recent introduction o f regulations for the supervision o f banks on a consolidated basis is an important step forward which needs to be fully implemented. Similarly 49The old loan classification rules disregarded the borrower's financial condition and thus led to an underestimation of the non- performing loans inthe banks' loan portfolio. 50 fullimplementation o fIntemationalAccounting Standards is neededto bringnational accounting standards and practices on par with other countries inthe region. The centrality o f supervisionon a consolidated basis, capital figures, compliance monitoring with prudential standards and asset quality, is needed for meaningful assessment, since otherwise weak assets can easily be hidden in subsidiaries, and double gearing can take place. In addition, the capacity will need to be developed to exercise supervision on a consolidated basis, including through mechanisms for consultations with non-bank financial supervisors or supervisory bodies in other countries. In 2002, the NBR signed a Memorandum o f Understanding with the National Securities Commission and the Insurance Supervision, with a view to improving the supervision o f the financial sector as a whole. 126. Access and coverage of the credit registry. To create conditions for sound lending decisions, to increase transparency o f the financial market, and to reduce financial risk, the credit registry should be expanded and made easily available. Currently, the credit history of loan applicants is neither complete nor widely accessible. The Public Credit Information Bureau only includes financial institutions regulated by the NBR and does not take account o f small commercial loans or consumer loans. In addition, there is no available credit history o f individuals, which is generally required for lending to new and small firms. To accelerate the expansion o f the Credit Bureau, NBR may encourage a private bureau to operate and distribute credit information to banks, including additional end-user products such as credit scores and ownership links. 127. Capacity to assess and manage risk. To safeguard the health o f the banking sector, and bank supervision, a methodology needs to be developed to "stress test" banks' portfolios for various risks-credit, foreign exchange, interest rate, systemic inter-bank risk, and the combination o f shocks in these areas. Banks need to have a comprehensive risk management process to identify, measure, monitor and control all material risks and to hold capital against these risks. It is especially important that banks manage interest rate risk to mitigate risks arising from loans extended in foreign currency to non-foreign currency earners. More power should be given to off-site supervision to receive information on risk management. Currently, banks provide some o f the information only during on-site examination, while the NBR does not have the right to require this information for off-site surveillance. New draft legislation is being developed, which is expected to address the issue o f the right o f collecting information. 8.5. DevelopingEfficientFinancialIntermediation:A ReformAgenda 128. The Joint Bank-Fund Financial Sector Assessment Program for Romania includes a comprehensive analysis and policy recommendations intended to address the challenges o f financial sector development. The present study is based on this work and builds on it from the perspective o f stability, growth, and integration with the EU. Inthis context, this study highlights the following recommendations for supporting the development o f a sound banking sector. 0 To privatize state-owned banks. The completion o f the privatization o f the remaining state-owned banks will improve efficiency in the financial system and will bringRomania closer to its peers inthe region. 51 0 To improve banking regulations and supervision. Important progress has been made in improving the regulatory and supervisory environment necessary for adaptation to the demands o f Romania's economic restructuring. Key challenges going forward are: to further strengthen supervision on a consolidated basis, to focus on adopting and enforcing risk assessment and management rules, and full implementation o f recently adopted IAS. Progress in these areas is critical to deepening financial intermediation. 0 To eliminate the practices of nonpayment, arrears and barter settlement. The reliance o f firms on nonpayment as an important means o f financing is crowding out regular banking credit and contributes to the low levels o f financial intermediation inRomania. Abolishing the Emergency Ordinance 61which came into force in2003 and permitted the authorities to seize any collateral pledged to a bank in order to collect tax arrears is an important step forward. There is a need, however, to abolish the legal framework that allows compensation without cash o f the bilateral obligations stipulated in the Government Ordinance No. 77/1999. . Romania should rely on revenue administration reform as an appropriate and effective approach to eliminating the practice o f nonpayment, arrears accumulation, andbarter settlement; 0 To introduce and enforce international accounting and auditing standards and practices. The government plans to introduce international accounting standards as a key step toward improving both the level and the quality o f financial intermediation, since poor financial reporting, accounting and auditing norms and practices prevent banks from effectively allocating resources to productive investments and thus influence capital accumulation and long-term growth. The adoption o f inflation accounting principles (IAS-29) is especially important because most Romanian companies have not revalued their assets since 1994 despite the high inflation in the period. As a result most o f the current balance sheets underestimate the value o f assets. 0 To improve credit risk information by expanding the coverage of and access to the Credit Information Bureau. Despite a good start, the Credit Information Bureau at the NBRcould still be improved interms o f the coverage o f institutions and loans. Currently, it includes only financial institutions regulated by the NBR and does not take account o f small commercial loans or most consumer loans. The credit history o f entrepreneurs, which is generally used to grant loans to SMEs, is not accessible. A good and widely accessible credit registry would not only allow banks and other intermediaries to better assess potential borrowers, but it would also contribute to higher competition between lenders, and, last but not least, mighthave a disciplining effect onborrowers.50 Impediments to the Development and Efficiency of Financial Intermediation in Brazil, Beck. 52 9. CONTAININGTHE COSTSOFUPGRADINGENVIRONMENTAL STANDARDS 9.1. Environment: Romaniain a Regional Perspective 129. The experience of countries which joined the EU on May 1 of this year shows that estimates o f investment costs cover a wide range depending on the their respective initial conditions and the choice o f the type o f investments which also cover a wide range o f possibilities. Timetables also have varied across countries, with earlier reformers having more generous timetables than other countries. The experience o f acceding countries thus far, also show that there may be important differences between planned and actual investments. However, the total investment costs do not stop at the accession date, since compliance with environmental standards, while providing a range of technology choices, i s required to function in a single market. 130. Relative to other countries, Romania is starting out with a lower level o f environmental capital and a poorer state o f the environment in many dimensions, as is illustrated by indicators such as the country's low access rate to improved water sources and sanitation, and its low energy efficiency (Table 23). Table 23 Key Environmental-Related Indicators, 2001:A Regional Perspective Percentof Percentof Under 5 Population Population C02emissions Mortality with access to GDP per unit per unit of Rate per Country with access to sanitation improvedwater of energy GDP 1,000 live source (PPP$/Kgoe) Kg/PPP$GDP births Bulgaria 100 100 2.8 0.9 16 Cyprus 100 100 6.3 0.4 6 Czech Rep. 3.6 0.8 5 Estonia 2.9 1.4 12 Hungary 99 99 4.9 0.5 9 Latvia 4.6 0.4 21 Lithuania 67 67 3.9 0.5 9 Malta 100 100 6.7 0.7 5 Poland 4.0 0.9 9 Romania 58 53 3.4 0.7 21 Slovak Rep. 100 100 3.6 0.7 9 Slovenia 100 100 5.0 0.5 5 Turkey 82 90 5.3 0.5 43 Note: Countrieswithout data on sanitationand improvedwater generallyhave very high levelsofprovision. Source: World DevelopmentIndicators,2003, theWorld Bank. - ~- 131. Since it is difficult to predict with precision the total costs o f upgrading environmental standards, and since estimates cover a wide range depending on the type o f investments undertaken, the estimates used in this study are indicative. Current indicative estimates o f the investment costs for Romania are substantially higher than those estimated by the E C in 1997 and would be the highest among CEECs. To provide an idea o f the magnitude, the total investment cost required to comply with 17 directives that address environment-related concerns may amount to approximately 29.7 billion. Taking this figure as one possible estimate of total investment costs, it would be about 29 percent higher than originally estimated by the EC and this would make it one o f the highest among the EU-8 and other candidate countries. EUFunds 53 committed to help finance the investments during the period 2004 to 2015 are estimated to be about 6.9 billion intotal. Hence, the remaining 22.8 billion will need to be obtained from other sources, namely, central and local governments and the private sector. 132. Overall, Romania will need to devote more resources than other countries to upgrade its environmental standards to make them consistent with the concept o f a single market o f the EU. This highlights the critical role o f the reforms discussed in previous chapters-the need for further fiscal consolidation will require containing the costs o f upgrading environmental standards and the need for policy shifts to implement the privatization program and improve the business climate to increase FDI. This is necessary to provide the essential complementary financial resources needed to upgrade technologies and environmental standards. 9.2. Containingthe Costs of Upgradingthe Environment:A ReformAgenda 133. While estimated investment costs are only indicative, it i s reasonable to expect that the estimated investments by the central and local governments will imply a major increase relative to the present levels. An estimate has been made o f the investment needs, by year, over the period 2004-2015. It shows that the central government will have to allocate more for the environment and that local governments will have to mobilize more funds than they have at present if the schedule is to be met. With realistic expectations of what can be achieved, however, one must conclude that it is unlikely that the central and local governments will be able to raise their expected shares of the total, at least in the next five years. On a more optimistic note, the picture looks better after 2007, especially for the central government. For local governments the medium term will continue to be challenging, and an enhanced role for the private sector will be critical if the targets are to be met. Specific constraints on the environmental side for the private sector's participation in the supply o f local public services have been noted and some suggestions offered for dealing with them. 134. The private sector also has a major demand being placed on it as a result o f the acquis, and it is by no means clear that the levels o f investment required can bemet. External resources will be vital to the success o fthe programhere, andmeasuresto make this easier should continue to be pursued actively by the government. 135. The government is seeking to mobilize more funds for the environment by using economic instruments such as charges and allocating them through an Environment Fund. However, to be effective the Fund needs to adhere to principles o f sound finance, expenditure control, and financial accountability. These environmental charges serve not only to raise revenues but also to reduce (in the first place) the emissions that are the source o f the investment needs. Examples o f potential instruments that can be adopted in Romania, in addition to those already introduced, are the carbon tax and other product charges. These would need to be investigated further. 136. Environmental benefits also expected from the environmental investments are such benefits as reduced risks to health and the protection o f ecosystem. Estimates o f these benefits have been reported for Romania and other countries (Table 24). They show that Romania will derive the greatest benefits from air pollution reduction, followed by water and waste directives. 54 There is, however, great uncertainty about the magnitude o fthese benefits, and more information is needed, especially at the local level, so that the data can be used in sequencing the investments. In particular, an effort needs to be made to better understand the benefits o f the drinking water and solid waste directives, and to select those investments that generate the greatest benefits first. 137. Another major factor that could limit the rate at which investments are made to meet the environmental directives is the affordability o f the ensuring tariffs for the environmental services. A simple analysis for the water charges shows that the number o f people who may need some support in paying these charges will increase sharply if rates go up from their present levels. The problems naturally become less as economic growth raises incomes, but even with the projected growth, increases in charges that are feasible without raising the social protection burdenunacceptablywill remainmodest. ~~ Table 24 Total Benefits over the Period 2005-2020 ( Billion) Water Air Waste TotalBenefits Per capita Low High Low High Low High Low High EuroOOO Bulgaria 1.58 4.20 1.07 11.00 0.20 6.62 2.85 21.82 3.01 CzechRepublic 15.23 24.05 7.10 35.10 0.93 11.20 23.26 70.35 9.09 Hungary 2.72 10.49 5.74 39.92 1.12 18.50 9.58 68.91 7.77 Poland 13.59 31.96 25.80 149.90 1.60 26.30 40.99 208.16 6.44 Romania 3.96 12.15 7.59 56.95 0.83 26.30 12.38 95.40 4.79 Slovak Republic 3.00 6.61 3.40 21.90 0.29 4.28 6.69 32.79 7.31 Slovenia 1.47 3.44 0.68 4.62 0.24 2.82 2.39 10.88 6.64 Baltics Estonia 0.26 0.99 0.39 2.05 0.09 1.75 0.74 4.79 3.95 Latvia 0.38 1.34 0.49 3.12 0.05 1.07 0.92 5.53 2.69 Lithuania 1.23 2.75 1.56 7.98 0.06 2.00 2.85 12.73 4.21 Total 43.42 97.98 53.82 332.54 5.41 100.84 102.65 531.36 6.06 As percentoftotal 42.00 18.00 52.00 63.00 5.00 19.00 100.00 100.00 Note: Net present value at a 4 percent discount rate. Source: Ecotech. 2001. The Benefits of Compliance with the Environmental Acquis for the CEEC. Brussels: EuropeanCommission. 138. Finally, the successful execution o f the environmental directives does not depend solely on the availability o f funds. Another important factor is the strengthening o f the institutional capacity to implement the directives. Perhaps even more than in CEECs, there is a need in Romania to further integrate the environment into their policies. Environmental regulatory institutions must be complemented by judicial, legislative and data collection institutions. The enforcement and monitoring o f environmental regulations requires the backing o f such strong complementary bodies. 10. CONCLUSIONS 139. In the last four years, Romania has made good progress in stabilization, growth, and poverty reduction. These recent policy reforms have brought important rewards. Growth has 55 been re-established at around 4.5 to 5 percent, led primarily by investment and exports rather than con~umption.~'Inflation had declined from above 40 percent to 15 percent in 2003, the lowest level since the start o f transition. Fiscal deficits have been cut to about half the 1997 levels, but the extemal current account gap, estimated at 5.8 percent o f GDP in 2003, is high. Good macroeconomic performance has contributed to official reserves reaching a record level o f over US$8 billion in 2003-an impressive increase o f US$4.5 billion since 2000. The banking sector is on a firmer footing, and direct lending by the central bank has been eliminated. International market sentiment towards Romania has continued to improve-Standard & Poor's upgraded Romania's sovereigncurrency risk from B+ to BB- inFebruary 2003. Improvements in macroeconomic performance and growth have contributedto a reduction inpoverty to 11percent in2002. 140. This recent reform momentum has been provided, in large part, by the prospect of EU accession. As a result o f reforms to date, trade integration with the EU and global markets is progressing faster than in other C E E C S . ~This report lays out the policy agenda needed to ~ accelerate the pace o f restructuring for EUintegration. 141. Strengthening macroeconomic stability. Measures in this area include further fiscal consolidation and the implementation of a stricter incomes policy, supported by efforts to rely more heavily on fiscal adjustment to safeguard fiscal sustainability, with monetary policy more sharply focused on disinflation and containing the growth o f debt. There is also a need to extend hard budget discipline to the transactions between the state and enterprises. The sustainability o f growth depends on expanding the recent solid trade performance throughout the economy. 142. Building on trade integration. Recent progress is due, to a large extent, to Romania's solid trade performance. To deepen this integration and fully exploit the economy-wide growth and competitiveness potential, three areas o f reform are central: 0 Restructuring the enterprise sector by implementing the large privatization agenda decisively and ina transparent manner and improvingthe business climate. 0 Transforming the agricultural and food sector by expanding the role o f the private sector and increasing reliance on market driven mechanisms to determine investment andproduction inthe sector. 0 Increasing labor market flexibility by adopting entry/exit rules with justification and procedural costs based on economic rationale and performance. At the same time, these changes need to be supported by strengthening the unemployment insurance system on a fiscally sustainable basis and following sound contribution benefit principles. 5 'Although consumption occasionally resurfaces as a key dnver reflecting sporadic reflationary pressures that result from high wage increases in SOEs. 52 The share of imports in total imports and the share of exports in total exports from and to the EU and other markets are increasing at a faster pace than most CEECs. 56 143. Implementing reforms to eliminate quasi-fiscal financing. First, energy sector reform needs to move forward. The challenge is to implement the reforms on Romania's Road Map to EUAccession. These include: (i) implementing import parity inthe medium term; (ii) improving collection rates to achieve sustainable financial viability; and (iii)imposing hard budget constraints on the public enterprise payment interface. In industry restructuring, the challenges include the need for the commercialization of generation subsidiaries and the introduction o f the private sector inthe unbundled gas structure. However, the dangers o f vertical integration should not be underestimated, given the weight o f global industryplayers. 144. Developing efficient financial intermediation. The completion o f banking restructuring, further development o f the basic financial infrastructure, and the elimination o f financing through nonpayment and arrears, which has thwarted efficient financial intermediation, are all needed to develop efficient financial intermediation. Strengthening the basic financial infrastructure includes: (i)adopting and implementing supervision on a consolidated basis; (ii) strengthening risk assessment and management; (iii)improving the valuation o f capital by completing the adoption and full implementation o f international accounting and auditing standards andpractices; and (iv) improving the coverage and access o f the credit risk information system. In this context, the government is commended for having abolished Emergency Ordinance 61/2002, which permitted the authorities to seize any collateral pledged to a bank in order to collect tax arrears. There is a need, however, to abolish the legal framework that allows compensation without cash o f the bilateral obligations stipulated in the Government Ordinance No. 77/1999. Romania should rely on revenue collection and administration reform as a more appropriate and effective approach to eliminating nonpayment o f taxes. 145. Addressingfiscal risks. Two areas o f reform are needed to address the fiscal risks, which emerge from financial weaknesses in the social security system and from the costs o f upgrading environmental standards. The issues and reforms regarding social security are discussed in depth inthe recent Public Expenditureand InstitutionalReview ofRomania, 2002, bythe World Bank. On the environment, this report finds that Romania is starting out with a lower level o f environmental capital and a poorer state o f the environment, and hence it will need to invest more than other countries. The estimated costs o f environmental investment are large -- around 29.7 billion during the period 2004-2015-the highest among CEECs. Even if EU funds finance about one-quarter o f these costs, 75 percent o f these costs are to be financed by the central and local governments and the private sector. A two-pronged approach i s needed to contain the costs o f upgrading environmental standards. First, estimates o f total costs and benefits for each o f the 17 environmental directives should guide the sequencing o f the investments and the implementation. Those investments that generate the greatest benefits should be selected first. The estimates show that Romania will derive the greatest benefits from air pollution reduction, followed by water and waste management. Second, enhancing the role o f the private sector will be critical iftargets are to be met and fiscal risks are to be reduced. 146. Ultimately, Romania's success in integrating with the EU depends on its implementing the policy reforms outlined inthis report, and achieving its goal o f EUaccession is predicated on its implementingthe institutional, administrative and governance reform agenda. MAP SECTION