In 2021, over the previous annual cycle of surveillance under the Macroeconomic Imbalances Procedure (MIP), the Commission identified “macroeconomic imbalances” in Romania. () These imbalances were related to a persistent sizeable current account deficit in a context of large government deficits, while previous overheating pressures were receding. The 2022 Alert Mechanism Report published in November 2021 concluded that a new in-depth review (IDR) should be undertaken for Romania with a view to assess the persistence of imbalances or their unwinding. ()

Romania is experiencing imbalances. Vulnerabilities relate to external accounts, linked to large fiscal deficits, and to competitiveness issues that are re-emerging. The high current account deficit further worsened in 2021 and is not forecast to improve this year or next. Large fiscal deficits pre-date the COVID-19 crisis and have driven up the current account deficit which poses risks to external debt sustainability. Sovereign borrowing costs have increased since early 2021. The expected acceleration in wages could weigh further on cost competitiveness. Nominal depreciation could mitigate competitiveness losses but add to inflationary pressures and increase the burden of serving debts in foreign currencies, which are significant for the government and the private sector. The negative net international investment position is expected to remain below its pre-pandemic levels. The external position is expected to benefit from significant RRF funds but external financing can otherwise become more challenging amid tighter global financial conditions. Recent policy initiatives, including the successful implementation of Romania’s RRP, can address some vulnerabilities, still further action is needed to improve competitiveness and potential growth.

In 2021, GDP rebounded strongly, after the COVID-19 related shock. () GDP grew by 5.9% in real terms in 2021, largely driven by private consumption and gross fixed capital formation. Despite headwinds caused by external demand shocks and supply chain disruptions, exports continued growing, not as fast as imports though. The trade deficit contributed to a further increase in the current account deficit. The real GDP growth outlook remains positive, albeit more muted than previously anticipated. Given the slowdown in late 2021 and early 2022, the economy is set to expand by 2.6% in 2022 and 3.6% in 2023, supported by major investments and reforms included in the recovery and resilience plan (RRP) and other EU funded projects, notably under Cohesion Policy Funds. Russia’s invasion of Ukraine has placed a further drag on the economy, due to the continuous disruption in supply chains and the surge in energy prices. Nominal GDP in 2023 is forecast to exceed its 2019 level by 36.3%. HICP increased at 4.1% annually in 2021 and is forecast to increase to8.9% in 2022 mainly due to rising energy, commodities and food prices. By the end of 2021, the labour market had not fully recovered from the pandemic-induced recession, with the unemployment rate at 5.6%. The unemployment rate is projected to stay roughly the same, but wage growth is set to slightly rebound, pushed by inflation, amid more muted productivity gains. The general government deficit remained high at 7.1% of GDP in 2021, adding significantly to the large net external borrowing needs of the Romanian economy. The 2022 budget and the accompanying medium-term fiscal strategy confirm the headline EDP target, but apart from a freeze on the majority of public sector wages in 2022, do not spell out the underlying measures to achieve the target. Current projections remain highly uncertain, in particular due to the war in Ukraine and rising inflation.

This in-depth review presents the main findings of the assessment of imbalances. The assessment is backed by a thematic section on the external position. Spill-overs and systemic cross-border implications of imbalances are also taken into account. In addition, assessments of structural issues made in previous IDRs and in the context of fiscal assessments are also considered if relevant. The MIP assessment matrix is published in the 2022 Country Report for Romania. ()

2. Assessment of macroeconomic imbalances

Assessment of gravity, evolution and prospects of macroeconomic imbalances

Despite the positive export dynamics, the current account deficit widened to 7.0% of GDP in 2021, marking its sixth year of deterioration, largely reflecting the still high government deficit. Since its position of being close to balance in 2015, the Romanian current account deficit has expanded each year, also pushed by the general government net borrowing that added significantly to the external borrowing needs of the economy. The increase in energy prices, also associated to the Russian military aggression against Ukraine, may adversely affect the current account balance, although dependence on imported energy remains below the EU average (see box 2.1). The current account balance is set to stay at around the same level in 2022 and 2023, which is well beyond what fundamentals would suggest. Against this backdrop, the net international investment position (NIIP) of Romania remains negative. Moreover, the steady and continuous improvements of the NIIP-to-GDP ratio over the past decade, which were mostly due to denominator effects rather than improvements in the savings-investment balance, stopped in 2020, and the prospects are for some deterioration this year and next (see Graph 3.1(f)). A more detailed analysis of the external sector dynamics is presented in the thematic section.

Until 2019, the current account deficit was financed mainly through net direct investments. The economic downturn in 2020 triggered a shift in the financing of the current account deficit away from more stable direct investments towards portfolio investments, in particular debt securities. Nevertheless, with the improvement in the economic situation in 2021 there was a reduction of financing by debt securities by half and a marked expansion of direct investments net inflows.

Persistent high fiscal deficits weigh on the government’s debt level as well as on the external financing needs of the country as a whole. Even before the outbreak of the COVID-19 crisis, the fiscal stance was expansionary despite robust economic growth, leading to large government deficits. These increased further during the pandemic to finance measures to support the economy. The budget deficit is projected to gradually narrow from 7.1% in 2021 to 6.3% of GDP in 2023, after increasing to 7.5% of GDP in 2022, while the Romanian government aims to reduce it below 3% of GDP by 2024, in line with the EDP recommendations. Romania’s fiscal deficits have been increasingly financed from abroad and raised the total government debt ratio from 35.3% of GDP in 2019 to 48.8% of GDP in 2021. The share of general government external debt reached 50.9% in 2020, up from 46.3% a year before and the share of debt denominated in foreign currency remained somewhat over 51% in 2020 and 2021. However, the share of short-term debt (i.e. maturity of less than one year) stayed low and the gross financing needs of the government are moderated. Romanian sovereign debt has been rated with the lowest investment grade by the main rating agencies. Long-term yields on government debt kept on rising since February 2021, reaching more than 6% in the first quarter of 2022 and are among the highest in the region. The Commission’s fiscal sustainability assessment () shows that Romania faces high fiscal sustainability risks over the medium–term, and medium risks over the long-term.

Cost competitiveness pressures eased during the pandemic but are expected to increase again. Before the COVID-19 crisis, over the years 2016-2019, nominal unit labour costs (ULCs) grew on average by over 8% per year, mainly due to wages (nominal compensation per employee) growing on average by 13.5% per year over that period. The pandemic led to a moderation in wage growth, but already in 2021 wage growth rebounded strongly to 5.7%, from 2.6% in 2020. As public wages were frozen in 2021, private and industry wages grew more than those of the public sector for the first time in five years. Still, public wages grew on average 50% more than private services (33% more than industry) (). Possible wage-growth spillovers from the public to the private sector risk denting the competitiveness of exports (). The deceleration of ULCs growth between 2019 and 2021 enabled more moderate appreciations of the real effective exchange rate than in past years. Nominal unit labour costs are forecast to increase by 6.4% in 2022 and 4.1% in 2023, which, while well below pre-crisis rates, is higher than for several trading partners. This will be on the back of stronger nominal wage growth of 8.3% and 7% in 2022 and 2023 respectively, and as productivity growth moderates to an average of 2.3%. The effects on future export and investment performance remains to be seen, as the economy recovers from the pandemic.

Non-cost factors limit Romania’s competitiveness. An insufficient transport infrastructure hinders businesses’ ability to ship merchandise both within and outside the country, and jeopardises spatial cohesion. A shrinking labour force, skills shortages, limited capacity of the public employment services, a weak training and education system and low innovative capacity negatively affect the business environment. Significant red tape coupled with an inefficient public administration, and a rather unpredictable legislative framework (), further undermine competitiveness and investment inflows and overall country attractiveness as an investment destination.

The financial sector weathered the COVID-19 shock well, but the sovereign-bank nexus remains significant. The banking sector remained well capitalised and liquid, with the aggregate Common Equity Tier 1 ratio slightly increasing from 19.6% in 2020Q3 to 20.4% in 2021Q3. Bank profitability as measured by the return-on-equity increased from 8.2% in 2020Q3 to 10.3% in 2021Q3. The gross non-performing loans (NPLs) ratio declined to 3.7% in 2021Q3. Consolidated private sector debt is low at around 50% of GDP, but part of it is denominated in foreign currency 16.7% of the domestic loans for households and 37.2% of the domestic loans for non-financial corporations), which exposes debt service to exchange rate risk. The sovereign-bank nexus, however, has remained significant. With government debt holdings by the local banks at around 24% of their total assets in August 2021, the own-sovereign exposure of banks in Romania is among the highest in the EU. Risks related to the phase-out of state-support measures and to potential second-round effects on economic growth from Russia’s unprovoked invasion of Ukraine could lead to further vulnerabilities associated to private sector debt.

Assessment of MIP relevant policies

In November 2021, the Council approved Romania’s Recovery and Resilience Plan (RRP), which contains several measures that contribute to addressing Romania’s macroeconomic imbalances. The successful implementation of the RRP should improve fiscal sustainability and the business environment in the long run, compensating short-run effects such as the boost of imports due to the high import content of investments. In particular, the tax and pension reform component covers measures aimed at modernising the fiscal administration, revenue collection, improving the budgetary programming by making it more transparent and predictable, as well as adopting a new law on public pensions system to cap its total gross expenditure at 9.4% of GDP, thus safeguarding its sustainability. The RRP foresees a number of measures that aim at making the legislative process more predictable, transparent and less burdensome for business. For example, legislative initiatives with a significant impact on the business environment will go through regulatory screening and any newly introduced burdens will be offset by removing equivalent burdens. A Single Industrial Licence should moreover minimise excessive red tape for companies.

The RRP is set to address several of the factors limiting competitiveness. Investments are foreseen in road and rail infrastructure, benefitting trade and distribution chains. On education, around 12% of the plan will focus on improving the quality and access to education and its digital and overall infrastructures. Further measures will provide aid schemes for the digitalisation of SMEs and support businesses in general through the operationalisation of the National Development Bank. On innovation, reforms of the R&D&I system also aim at attracting more talent and resources to broaden the innovative capacity of research institutes and strengthen science-industry linkages. The capacity, transparency and effectiveness of the judiciary system and public administration is also set to be improved.

A minimum wage setting mechanism will prevent future ad-hoc increases as in the past, easing cost-competitiveness pressures. In early 2021, the government raised the minimum gross salary to Lei 2300 (EUR 466) and approved a subsequent increase to Lei 2550 (EUR 515) for January 2022. These increases were already taking into account several economic indicators such as inflation and productivity, as opposed to past ad-hoc increases, but an objective mechanism is still not in place. The RRP foresees for 2024, a reform establishing a new mechanism for setting the minimum wage, based on objective criteria and consistent with competitiveness and job creation in the country. Furthermore, public wages were frozen in 2021, except in the health sector, after a cumulative increase of 37.5% over the past four years, contributing to an easing of cost-competitiveness pressures.

There is scope for further action to address labour shortages and skills mismatches, overly regulated markets, weak business innovation and poor public administrative capacity. The 2022 Romania Country Report () identifies four priorities ahead, which could build up and complement ambitious reforms and investments contained in Romania’s RRP. Firstly, the supply of skills does not meet its demand, and active labour market policies have failed to narrow this gap – especially among the most vulnerable segments of the labour force. Secondly, because of overly regulated markets, certain business services can weigh significantly on companies’ books, thus undermining their competitiveness. Thirdly, knowledge transfer between science and industry is still limited: the supply of ideas is scant, companies (especially those that do not benefit from foreign direct investments) lack the capacity to absorb them, and the governance of the R&D&I system is fragmented. Finally, weak administrative capacity – with insufficient own resources and over-reliance on transfers from the central government – is one of the causes for low-quality local public services.

Conclusions

Romania is facing vulnerabilities relating to its competitiveness and particularly to its external balance developments. The large fiscal and current account deficits, which pre-dated the COVID-19 crisis, have increased further with the pandemic-induced recession. Government debt increased significantly, albeit from moderate levels, and sovereign borrowing costs kept growing. Currency exposures are significant for government and private sector debt. Cost competitiveness losses have eased somewhat in recent years due to more moderate pay rises. A volatile policy environment contributes to uncertainty and high risk premia, with detrimental effects on investment activity and the business environment. Concerns around the external position are not expected to unwind soon, amid a sizeable government deficit. The current account deficit further deteriorated in 2021 and is expected to remain elevated in the medium term, with sizeable fiscal deficits also forecast to continue. The financing of the significant external borrowing needs could become more challenging as global monetary policies normalise. The expected acceleration in wages could weigh on cost competitiveness. Nominal depreciation gave some relief to the competitiveness losses over past years but it could create further inflationary pressures and weigh on the service of government and private debts in foreign currencies. Romanian trade and financial links with both Ukraine and Russia are fairly small and are likely to affect economic vulnerabilities more via its impact on energy markets and prices (see box 2.1).

Recent policy initiatives, including the successful implementation of Romania’s recovery and resilience plan, could address some vulnerabilities, still further action is needed. After several years of expansionary fiscal policy, some fiscal consolidation albeit limited has started in 2021. The freezing of public sector wages in 2021 had a positive impact on cost competitiveness. Increases in the minimum wage appear to be contained and should, within the RRP commitments, be based on an objective mechanism. The RRP also includes measures that are conducive to improving non-cost competitiveness, such as improving infrastructure, education, the business environment and the efficiency of the public administration, the legislative process, financial management as well as the judiciary. The activation measures provided by the public employment service, including up- and re-skilling, are not sufficient and effective in view of the rapidly shrinking workforce and increasing labour shortages. The number of beneficiaries profiting from these services is increasing only slowly, with participation in activation measures still one of lowest in the EU. The quality of local public services suffers from a fragmented decentralisation framework and inadequate own fiscal capacity. Finally, research institutions’ scant supply of ideas and the poor ability of the private sector to absorb them jeopardises Romania’s innovativeness and competitiveness.

Based on the findings in this in-depth review, the Communication “European Semester – 2022 Spring Package” () sets out the Commission’s assessment as to the existence of imbalances or excessive imbalances in Romania, in line with Regulation 1176/2011.