Romania 'BBB-/A-3' Ratings Affirmed; Outlook Stable

  • We believe that the Romanian government will solicit input from key domestic stakeholders and revisit key parts of the emergency ordinance 114.
  • In our view, this will likely contain imminent negative effects on monetary policy effectiveness and help recover confidence in the economy's medium-term growth outlook.
  • We are affirming our 'BBB-/A-3' sovereign credit ratings on Romania.
  • The outlook remains stable.
RATING ACTION
On March 15, 2019, S&P Global Ratings affirmed its 'BBB-/A-3' long- and 
short-term foreign and local currency sovereign credit ratings on Romania. The 
outlook remains stable.

As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 [EU CRA 
Regulation]), the rating on Romania is subject to certain publication 
restrictions set out in Art 8a of the EU CRA Regulation, including publication 
in accordance with a pre-established calendar (see "Calendar Of 2019 EMEA 
Sovereign, Regional, And Local Government Rating Publication Dates," published 
Dec. 21, 2018, on RatingsDirect). Under the EU CRA Regulation, deviations from 
the announced calendar are allowed only in limited circumstances and must be 
accompanied by a detailed explanation of the reasons for the deviation. In 
this case, the deviation is because we have resolved the appeal on the outlook 
on Romania. The outlook was placed under appeal on March 1, 2019.


OUTLOOK
The stable outlook reflects our expectation that Romania's fiscal and external 
buffers will be able to withstand the prospects of moderating economic growth 
and the potential risks emanating from the recently enacted policy package, 
emergency ordinance 114. 

We could lower the rating in the coming 12-24 months if the expected policy 
reversal was insufficient to avoid a pronounced economic slowdown, which would 
in turn feed into lower tax revenues, rising debt to GDP, and a materially 
higher interest bill. Should Romania's monetary policy flexibility weaken, for 
example, as a result of the new tax on the financial-sector balance sheet, 
downside pressure on the rating would also build.

We could raise the rating if Romania's institutional environment stabilized 
and the government made more sustained headway with budgetary consolidation, 
put net general government debt firmly on a downward trajectory, and 
strengthened its governance framework, translating into more predictable and 
stable macroeconomic growth and government finances.

RATIONALE
The affirmation of the ratings and the stable outlook reflect our expectation 
that the Romanian government will likely take steps to unwind and re-calibrate 
parts of its package of emergency policies that it introduced on Jan. 1, 2019, 
as demonstrated by ongoing dialogue among domestic stakeholders to amend the 
construction of the financial asset tax, including plans to delink it from the 
interbank rate. If unaltered, we believe that the initial policy proposals 
could have unintended negative effects on Romania's growth, competitiveness, 
and public finances, as well as on the central bank's monetary policy 
effectiveness. 

Its moderate external private and public debt levels and still strong growth 
prospects continue to support our rating on Romania. In our opinion, the 
country's institutional effectiveness remains weak, however, which constrains 
the rating. Even though we forecast that widening fiscal and external deficits 
will eat into its buffers and make the Romanian economy increasingly 
vulnerable to slowing growth momentum, we nevertheless expect the solid fiscal 
and external stock positions will withstand the worsening in fiscal and 
external flows. 
 
 
Institutional and Economic Profile: The government plans to revise its recent 
policy package, alleviating immediate risks to growth, but challenges remain 
 
  • We understand the government is set to comprehensively revise its recent policy package, which we think will alleviate short-term economic and financial risks.
  • Interventionist government policies are making economic policymaking increasingly unpredictable and, if continued, could unsettle foreign investors and weaken the growth outlook.
  • Attempts to implement legislative changes and diminish checks and balances between institutions could reverse progress made on countering corruption and diminish the independence of the judiciary.
 
We believe that Romania's already prevailing institutional and policy 
uncertainty has been accentuated by the comprehensive emergency policy 
initiatives the government announced in December 2018 and which took effect on 
Jan. 1, 2019. The measures included in these policies imply in particular a 
series of untested sectoral taxes intended to offset the effects of recent 
years' generous public wage and pension hikes, because they are beginning to 
take a toll on the fiscal position. However, the announced measures, if 
unaltered, would in our view likely bear negative consequences for the real 
economy, public finances, and the monetary policy effectiveness. 

That said, we observe an ongoing and increasingly constructive dialogue 
between the government and domestic stakeholders about the consequences of the 
emergency policies, and we expect that parts of the policies will be revised. 

In its initial form, the proposed tax on the banking sector assets is linked 
to ROBOR (Romanian interbank offered rate) and exempts no assets from the 
taxable base. We note that this disposition would constrain monetary policy 
effectiveness, as well as the Romanian National Bank's ability to keep 
inflation under control while maintaining financial sector stability. In 
addition, we note that legislation to notably increase the capital 
requirements of pension funds and to make contributions to the second pillar 
voluntary could place increasing pressure on the pension system. 

To date, we view the policies of the incumbent government as predominantly 
short term in nature, focusing the available fiscal space on public sector 
wage and pension increases. Structural reform initiatives are lacking, 
meanwhile, to the detriment of the ailing infrastructure network and 
underperforming education system. Romania has a long history of operating 
pro-cyclical income policies, which, by crowding out public investment, have 
often interrupted or reversed previous periods of improving competitiveness. 

In addition, Romania continues to suffer from corruption, although the 
anti-corruption agency National Anticorruption Directorate has made gradual 
improvements in recent years. That said, controversial legal reforms to weaken 
corruption charges and political interference in independent institutions risk 
weakening the rule of law and diminishing checks and balances. 

In 2018, we estimate that real GDP growth moderated to 4.1% from the very high 
7.0% growth rate in 2017 when fiscal stimulus and a favorable external 
environment combined for an economic boom in Romania. Wage growth of close to 
15% (in double digits for the third consecutive year) and tax cuts continued 
to lift disposable incomes in 2018 while net external demand, on the other 
hand, subtracted from growth as domestic demand pushed up imports.

In 2019, we believe that growth will slow further to 3.5% due to softer 
external demand and weaker private investments. In combination with rising 
trade tensions that could lead to a sharper slowdown in the eurozone, we 
consider that risks to Romania's growth outlook are tilted toward the 
downside. As such, while Romania's average per capita growth currently exceeds 
peers', we expect average growth to moderate to a more sustainable 3.0% 
annually in 2020-2022. That said, the future growth trajectory will depend on 
progress in institutional reforms and the degree to which Romania is 
successful in boosting domestic investment levels via, for example, increased 
absorption of EU funds. 

Should the policy reversal not be forthcoming or be insufficient, we believe 
the newly introduced sectoral taxes could cause delays in previously planned 
foreign investments, particularly in the energy sector. This could slow 
convergence of incomes in Romania toward the higher levels in Central and 
Western Europe. Today Romanian per capita income remains 50% of that in the 
Czech Republic and 60% of that in Slovakia, for example. In our view, most of 
the difference represents lower absolute levels of productivity in Romania. 

Over the past three years, Romania's business environment has deteriorated, as 
indicated by the World Bank's Ease Of Doing Business Survey and in particular 
in the World Economic Forum's Global Competitiveness Ranking, in which Romania 
has dropped by about 15 places since 2015. In this vein, we observe an 
apparent emigration trend in the young, educated work force related to 
discontent with current trends in institutions, as well as a perception of 
bleak prospects for improvements in general living conditions. The Romanian 
authorities will struggle to counter this and secure a more robust growth 
trajectory, as well as sustainably manage the dynamics of a rapidly aging 
population, unless they act to win back the sizable diaspora and reverse brain 
drain.
 
 
Flexibility and Performance Profile: The widening twin deficits are starting 
to eat into the fiscal and external buffers
 
  • Pressure on the fiscal position is building and will persist in the absence of corrective measures.
  • Current account deficits (CADs) will likely widen to about 5% of GDP.
  • The credibility of the National Bank of Romania remains high and the expected amendments to the new bank tax will likely assure policy effectiveness.
 
The general government budget deficit remained below 3% in 2018, thanks to 
solid revenue performance, supported by high nominal GDP growth and another 
year of underspending of the capital budget. However, accelerated wage 
increases in the public sector have tilted the structure of government 
spending further toward inflexible social- and wage-related spending and away 
from investment. We consider the prioritization of consumption expenditure 
over investment expenditure as negative for Romania's long-term 
competitiveness and growth. Wages and social security contributions represent 
a rigid and inflexible portion of the government's expenditure, at around 60% 
of the total. We believe this disposition leaves the government little 
headroom to undertake capital expenditure, which the government forecasts will 
increase meaningfully in the 2019 budget. Romania's large fiscal deficit, amid 
very rapid economic expansion, highlights the country's vulnerability to 
potential external shocks and a pronounced slowdown in growth. The 
government's pro-cyclical fiscal policy is eroding fiscal gains hard won 
during the post-crisis years.

We forecast that Romania's headline general government fiscal deficits will 
widen to 3.3% and 3.5% of GDP in 2019 and 2020. These will be a result of the 
weakening growth momentum and the government's spending measures as it 
prepares for the upcoming elections--presidential in 2019 and parliamentary in 
2020. We consider as ambitious the government's aim to drastically reduce the 
gap between owed value-added tax (VAT) and collected VAT, the widest in the EU 
according to European Commission data. At the same time, cutting capital 
spending again could prove challenging, given Romania's acute infrastructure 
needs.

Risks to the longer-term budgetary position are also tilted to the downside, 
due to uncertainty over some recent policy proposals. For example, a draft 
pension law has been contemplated, but the proposal in its current form was 
not long ago dismissed by the constitutional court and sent back to parliament 
for re-examination. We do not exclude that this or another version of the 
proposal would re-emerge, however, and if it is pursued in line with the 
government's initial intentions, it would likely result in a notable increase 
in the pension bill in 2020 and thereafter. Such reform initiatives would 
suggest that short-term political gains could continue to influence fiscal 
strategy and direct allocations from the capital side to the current spending 
side of the budget. Moreover, within its 2018 emergency policies, the 
government made contributions to the second pension pillar optional, which has 
unlocked flows to the tune of 0.8% of GDP into the budget, while partly 
diluting the long-term sustainability of the pension system. We believe the 
pressures on Romania's budget will persist over our forecast horizon through 
2022.

At the same time, we observe Romania's membership in the EU as an important 
policy anchor. We note the authorities' strong commitment to the general 
government deficit remaining below the Maastricht Treaty's deficit ceiling of 
3% of GDP, partly because a breach could jeopardize Romania's access to EU 
structural funds. 

Romania's public debt burden remains modest in an EU comparison. In line with 
our deficit forecast, we expect Romania's general government debt will 
gradually increase to a still moderate level of slightly below 40% of GDP by 
2021. At the same time, the debt profile remains constrained by a relatively 
high share of foreign currency-denominated debt, as well as the domestic 
banking sector's high exposure to the government. 

We anticipate that pressures on the current account will continue to build 
through 2022 as government consumption and overall domestic demand keep 
driving imports. Together with slowing exports, this will widen the deficit. 
We forecast the CAD will remain around 4.5% of GDP on average through 2022. 
Positively, we observe that the funding of the CAD stems to a large extent 
from stable, non-debt-creating inflows. For this reason, Romania's external 
debt net of liquid external assets, our preferred measure, will remain 
relatively low at around 30% of current account receipts (CARs). While we 
assume that net foreign direct investment will still cover a significant part 
of the external deficit in the next few years as existing foreign investors 
keep re-investing earnings, we note a lack of foreign greenfield investments, 
suggesting that investors might be increasingly concerned about the rapid wage 
growth, lack of infrastructure development, and persisting political and 
policy uncertainties. 

Romania's predominantly foreign-owned banking sector remains sound, in our 
view. The system's loan-to-deposit ratio had declined to about 80% at year-end 
2018 from its peak of 137% in 2008. Lending growth has remained positive for 
the past two years, with loans to households and loans denominated in Romanian 
leu increasing strongly. Credit growth was meaningfully supported by mortgage 
loans that benefit from the government's Prima Casa program, designed to 
support first-time homebuyers through a 50% guarantee by the government. 
Nonperforming loans have shown an impressive decline, reducing more than 
threefold to less than 5% of total loans by Dec. 31, 2018, from over 21% at 
midyear 2014. Liquidity and solvency ratios remain strong. Banks have 
maintained their profitability despite low interest rates. 

Romania continues to operate a managed float of the leu under an 
inflation-targeting regime, with a target for inflation at 2.5% with a 
variation band of +/-1%. Surging inflation since the fourth quarter of 2017 
prompted the National Bank of Romania to take assertive action, hiking rates 
three times in 2018 by a total of 75 basis points. These actions appear to 
have curbed inflation after it hit a 5.4% year-on-year peak in May. We expect 
inflation to average 3.5% over 2019, not least thanks to lower global energy 
prices. 

Over 2018, the central bank's rate hikes and its firmer control over the 
liquidity in the banking system sustained the leu exchange rate, which, in 
contrast to regional peer currencies remained largely stable and avoided 
depreciation. We observe that some foreign currency reserve outflows probably 
helped the leu in 2018. 
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