EUROPEAN COMMISSION Brussels, 27.2.2019 SWD(2019) 1022 final COMMISSION STAFF WORKING DOCUMENT Country Report Romania 2019







Including an In-Depth Review on the prevention and correction of macroeconomic imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2019 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2019) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Overall findings regarding imbalances, risks and adjustment issues 4.Reform priorities 4.1.Public finances and taxation 4.2.Financial sector 4.3.Labour market, education and social policies 4.4. Competitiveness reforms and investment Annex A: Overview Table Annex B: Commission Debt Sustainability Analysis and fiscal risks Annex C: Standard Tables Annex D: Investment Guidance on Cohesion Policy Funding 2021-2027 for Romania References LIST OF Tables Table 1.1:Key economic, financial and social indicators - Romania Table 2.1:Assessment of 2018 CSR implementation

Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth LIST OF Graphs Graph 1.1: GDP growth and demand-side components Graph 1.2: GDP growth and supply-side components Graph 1.3: Contribution to potential growth Graph 1.4: Disparities across Romanian regions Graph 1.5: Gross fixed capital formation Graph 1.6: Current account breakdown and capital account Graph 1.7: Contributions to headline inflation Graph 1.8: Labour market overview Graph 1.9: General government balance and output gap Graph 1.10: 10 year government bond yield: Romania and peers Graph 1.11: Loans to households and non-financial corporations Graph 2.1: Overall multiannual implementation of 2013-2018 CSRs to date

Graph 4.1.1: Drivers of change of general government balance Graph 4.1.2: Degree of progressivity of labour income taxation in EU Member States, 2017 Graph 4.1.3: Redistributive power of the tax and benefit systems in EU Member States, 2016 Graph 4.1.4: General government debt projections (% of GDP) Graph 4.3.1: Inactive female population by reason for inactivity Graph 4.3.2: Activity and employment rates for selected groups Graph 4.3.3: Productivity and labour costs (GDP deflator) Graph 4.3.4: People at risk of poverty or social exclusion by degree of urbanisation Graph 4.3.5: Redistributive power of social transfers Graph 4.3.6: Spending on healthcare by Member State, 2016 Graph 4.4.1: Nominal unit labour costs, growth breakdown Graph 4.4.2: Evolution of unit labour costs by sector Graph 4.4.3: Evolution of public and private wages Graph 4.4.4: Export market share growth Graph 4.4.5: RON-denominated export price evolution Graph 4.4.6: Real effective exchange rate growth Graph 4.4.7: Breakdown of the trade balance Graph 4.4.8: Net international investment position Graph 4.4.9: FDI flows by investment type Graph 4.4.10: R&D intensity 2000, 2007, 2017 and 2020 target

Graph 4.4.11: Quality of public infrastructure index, Romania and regional peers LIST OF Boxes Box 2.1: EU funds and programmes contribute to addressing structural changes and to fostering growth and competitiveness in Romania Box 3.1: MIP assessment matrix (*) – Romania 2019 Box 4.2.1: Second pension pillar in Romania Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights Box 4.4.1: Investment challenges and reforms in Romania Executive summary Romania’s economic growth model, based on consumer spending, affects the country's ability to reach EU living standards in a sustainable way. The near halving of GDP growth in 2018, largely due to a slowdown in consumer spending, has revealed the limits of Romania’s economic growth model. Strong wage increases, a decreasing work force and skills shortages risk undermining the country’s ability to compete internationally. Moreover, investors’ confidence is being eroded by persistent legislative instability, unpredictable decision-making, low institutional quality and the continued weakening of the fight against corruption. Inequality and poverty remain high, with increasing regional disparities. Ensuring continuity with past reforms and shifting the growth model to investment could set the economy on a sustainable path towards convergence with EU living standards and help reduce inequality (). Despite the substantial slowdown in 2018, growth remains robust. After a 7 % advance in 2017, real GDP growth (i.e. adjusted for inflation) slowed down to an estimated 4 % in 2018. Higher inflation dented disposable income and consumer spending, which is the main driver of economic growth. Strong growth in imports of consumer goods, which outpaced exports, caused the country’s current account deficit to continue to widen. The labour market is under increasing stress. The lowest unemployment rate in a decade (3.8 %), a declining labour force and persistent skills shortages have brought Romania close to full employment, which makes recruitment difficult and drives wage growth. Employees’ earnings are low compared to the EU average but the strong growth since 2016, also driven by hikes in the minimum wage and public-sector wages, risk putting pressure on competitiveness if not accompanied by corresponding productivity increases. The public deficit has been increasing, driven mostly by spending on wages and tax cuts. Tax rates have been repeatedly cut while public wages have significantly increased since 2015 and are set to increase further. At the same time, public investment fell to a post-EU accession low in 2017 and is set to rebound only slowly. As a result, the public deficit has substantially increased since 2015 and is forecast to break the 3 % of GDP threshold required under the Stability and Growth Pact, pushed up also by increases to pensions. In June 2018 the Council launched a new significant deviation procedure addressed to Romania (). The structural deficit is projected to remain broadly stable at around 3.4 % until 2019 and to increase considerably in 2020. Financial sector stability has been put under strain. Recent parliamentary and government measures have created risks to the stability of the financial sector. These could negatively impact lending and limit the impact of monetary policy, and may reverse several years of continuous improvement. In addition, changes to the rules on privately managed pensions increased unpredictability and may have undermined their long-term viability. This in turn may curtail the development of capital markets and deprive the economy of an important source of long-term investment financing. Public and private investment in infrastructure, education, healthcare, social inclusion and innovation would improve productivity and long-term growth. Public investment has been subdued in recent years and is expected to recover only slowly while private investment could be affected by increasing uncertainty. Investments in transport, energy and environmental infrastructure would strengthen the economy’s long-term growth potential and would have a positive impact on the population’s standard of living. The education system does not sufficiently prepare people for employment and better social integration. Making sure that Romania’s work force achieves its full potential means investing also in social inclusion and healthcare. Increased public and private financing of innovation would help Romania’s economy move towards higher value added activities. Annex D identifies key priorities for support by the European Regional Development Funds, the European Social Fund Plus and the Cohesion Fund over 2021-2027, building on the analysis of investment needs and challenges outlined in this report. Romania has made limited () progress in addressing the 2018 country-specific recommendations. There has been limited progress in the following areas: ·Efforts to strengthen tax compliance and collection were limited to updating the guidance on the registration of certified cash registers and the use of risk assessment to audit taxpayers. ·On public procurement, the creation of a central purchasing body and the transition to e-procurement are welcome developments, but other reform commitments were stopped or even reversed; ·Social dialogue remains largely formalistic.

·Access to quality education is very unequal and the acquisition of basic and digital skills is limited; ·In the healthcare system, the roll-out of community care centres suffered further delays, limiting prospects for shifting to outpatient care; ·Limited progress was made on public investment project preparation and prioritisation, while the take-up of EU funds is slow. There has been no progress in the following areas: ·Fiscal policy, including the adoption of the annual budget, continues to depart from the requirements under the national fiscal framework, ·The minimum wage continues to be set by the government in an ad hoc manner, while the law setting a minimum inclusion income is not yet in force; ·The decision-making process remains highly unpredictable, with complex and sometimes controversial legislation being adopted through emergency decrees, without impact assessment or stakeholder consultation; ·The corporate governance of state-owned enterprises is at risk of being weakened. Regarding progress towards its national targets under the Europe 2020 strategy, Romania is performing well on employment rates, national greenhouse gas emissions, renewable energy, energy efficiency and tertiary education. R&D investment and early school leaving remain some distance away from their respective targets. Romania performs poorly on most of the indicators of the Social Scoreboard supporting the European Pillar of Social Rights. The high economic growth has translated into better job prospects and increased household disposable incomes. However, Romania still has a high number of early school leavers and, although decreasing, a high number of young people not in education, employment or training. This raises concerns about equal opportunities and access to employment. Romania has not yet achieved a mature social dialogue, and its Social Scoreboard performance indicates a critical situation on reducing poverty. The main findings of the in-depth review in this report and the related policy challenges are as follows. ·Romania’s current account deficit has been widening and its composition raises concerns. From a nearly balanced position in 2014, the current account deficit increased to 3.2 % of GDP in 2017 and is forecast to deteriorate further. Imports of consumer goods have increased much faster than those of capital and intermediate goods. This means that the deterioration in the current account is driven more by consumption than investment, which will not support long-term economic growth. ·Rising labour costs may hurt Romania’s ability to compete internationally. The cost of labour per unit of goods and services produced has increased strongly since 2016, as wage increases have outpaced productivity growth, albeit less so in industrial sectors open to international trade. Coupled with the gradual depreciation of the national currency, the impact on Romania’s cost competitiveness has so far been limited and has allowed it to gain export market shares. Nevertheless, the pressure on private-sector wages due to high levels of employment, minimum wage hikes and spillovers from public wage increases may make Romania’s economy less competitive in the future. In addition, trade tensions may weaken demand for Romania’s exports. ·Risks to the financial sector have substantially increased. The functioning and stability of the financial sector and the long-term financing of the economy may be harmed by recent legislative initiatives including a retroactive cap on mortgage interest rates and a tax on banks’ assets linked to the interbank interest rate. Moreover, new rules targeting privately managed pensions may hinder the development of what is still a very small capital market in Romania. ·The business environment and investment decisions are being hurt by unpredictable policymaking. Consultation of relevant stakeholders is limited and impact assessments are lacking or are of low quality. Recent legislation on the financial sector, privately managed pensions and the energy and telecommunication sectors could hinder future investment opportunities and increase uncertainty, making the economy less attractive to national and international investors. Other key structural issues analysed in this report, which point to particular challenges for Romania’s economy, are the following. ·Labour and skills supply are not keeping up with the fast-changing needs of the economy. The limited availability of skilled labour, population ageing, weak internal mobility and continued emigration are limiting economic growth. Despite labour shortages, certain social groups, including the Roma, have difficulties entering the labour market. Schemes to help people into work provide little focus on comprehensive solutions, including upskilling and reskilling. Minimum wage levels continue to be set without a comprehensive predictable mechanism and the number of collective wage bargaining agreements is low, especially at sector level. ·Despite recent improvements, poverty and income inequality remain high, and regional disparities are deepening. One in three Romanians is still at risk of poverty and social exclusion, with particular groups such as children, the Roma, people with disabilities and the elderly being more affected. Income inequality is one of the highest in the EU, reflecting in part the low redistributive capacity of the tax and benefit system. Inequality of opportunity is also high. Social services have insufficient quality and coverage, and uneven territorial distribution. The limited integration of employment, education, health and social services does not allow for a sustainable inclusion of diverse disadvantaged groups enter employment and escape social exclusion. After repeated delays, the law which will increase the adequacy of the minimum inclusion income is expected to enter into force in April 2019. ·The insufficient capacity of the public administration limits development opportunities. Red tape and the lack of quality public services continue to harm investment, but the reform of the public administration is progressing only slowly. The public procurement system requires enhanced transparency, monitoring and supervision. Scattered resources, fragmented responsibilities between different services and levels of the public administration lead to ineffective delivery of public services. Funding of public services is uneven across regions, counties and smaller administrative units, while local authorities’ revenues lack stability and predictability. ·The weak performance of the education and training system is not helping Romania to catch up with the EU. Spending on education remains one of the lowest in the EU. Low participation in early childhood education hampers the development of cognitive and social skills. Early school leaving remains high, and attainment levels in basic skills are low and not improving. Rural-urban disparities persist and vulnerable groups, including the Roma, continue to have limited access to quality inclusive mainstream education. The quality and labour market relevance of higher education and vocational education and training face challenges, while access to adult learning is limited.

·The healthcare system faces many challenges. Low funding and an inefficient use of public resources limit the effectiveness of the health system. Continued migration has resulted in a sizeable shortage of doctors and nurses. Health infrastructure and the prevalence of informal payments remain sources of concern. Access to healthcare services for those living in rural areas and for vulnerable groups is limited. These in turn have a negative impact on the population’s health status. ·Despite significant public investment after EU accession, physical infrastructure remains underdeveloped. The general condition and reliability of the road and rail networks are very poor. In addition, energy, waste, water and waste water infrastructure continue to show deficiencies. Substantial challenges remain over climate change adaptation, risk prevention, disaster resilience and air pollution. ·Romania’s modest performance in research and innovation limits growth prospects. The country lacks a coherent strategy to help firms move towards higher value added activities. Public and private spending on research and development is one of the lowest in the EU, resulting in a low quality of the public science base and a low innovative capacity. Links between science and business are underdeveloped, while technology imports are not being substituted by home-grown innovation. ·The corporate governance of state-owned enterprises is only loosely applied. The legislation in this field could be weakened through forthcoming legislative amendments before Parliament. Appointments of interim boards are a recurrent practice, departing from the spirit of the corporate governance laws. ·Progress in the fight against corruption has suffered significant setbacks. The independence of judges and prosecutors has been weakened by recent amendments to the justice laws. The key anti-corruption institutions have come under increased pressure, raising concerns about their ability to continue the fight against corruption. The ongoing amendments to the Criminal Code and Code of Criminal Procedure could further weaken the fight against corruption and other serious crimes, undermining progress achieved over the past 10 years. 1. Economic situation and outlook GDP and potential growth Economic growth has slowed down but remains robust. Real GDP is estimated to have grown 4 % in 2018, down from a peak of 7 % in 2017 (Graph 1.1). The slowdown has been driven mainly by a deceleration in private consumption due to high inflation, fuelled by energy prices, and the fading of the effects of public policies aimed at increasing disposable income. However, private consumption continued to be the main driver of growth. Investment remained broadly stable and net exports became more negative as exports continue to decelerate faster than imports, affected by price hikes and the slow-down of external demand. Graph 1.1:GDP growth and demand-side components Source: European Commission Growth is expected to remain broadly stable in the medium run. Real GDP is projected to remain below 4 % in 2019 and 2020 (Graph 1.1). Private consumption is set to continue being the main driver of economic activity, although slower increases in wages and a tighter credit environment could restrain its evolution. The contribution of the external sector to growth is forecast to remain negative but to improve as the growth of exports remains broadly stable while import growth is projected to decrease, following the slowdown in consumption. Investment is expected to increase somewhat more than in 2018. On the supply side, the economic deceleration was more evenly distributed across sectors. For the first three quarters of the year, business services accounted for a stable 38 % of GDP. Industry and trade represented 24 % and 18 %, respectively. In terms of contribution to growth, business services are estimated to have accounted for 1.3 pps, followed by industry with 1 pp. and trade with 0.6 pps (Graph 1.2). The slowdown in exports registered in 2018 is taking a particular toll on the performance of trade and industry. Graph 1.2:GDP growth and supply-side components Source: European Commission Potential growth has been driven mainly by total factor productivity. Potential GDP growth has strengthened in recent years, to reach 4.5% in 2017. (Graph 1.3). It is estimated to have remained strong in 2018, but is forecast to decrease progressively. Total factor productivity has been the main contributor to potential growth, despite a slight slow down in 2018. Labour made a modest but positive contribution in 2018 due to lower structural unemployment and a higher labour participation rate. After 2018 however, total factor productivity is expected to slow down and labour’s contribution to potential growth to worsen due to slower growth of the working age population. Graph 1.3:Contribution to potential growth Source: European Commission Regional disparities Despite convergence towards the EU average, disparities within the country are still significant. Romania's GDP per capita has increased from slightly more than 40 % at EU accession, in 2007, to more than 60 % of the EU average in 2017. Differences across regions are substantial. In 2016, the Bucuresti-Ilfov region recorded a GDP per capita in Purchasing Power Standards of EUR 40 400, 1.4 times the EU average and almost 4 times that of the Nord-Est region, the country’s poorest region. Excluding the capital region, GDP per capita is half the EU average. Bucuresti-Ilfov also registers twice the EU average in terms of investment as a percentage of GDP and 1.5 times the national average (Graph 1.4 and Section 4.4.4). When considering all EU regions, Romanian regions with initially lower levels of GDP per capita have experienced comparatively higher growth rates since the country's accession. Disparities are also felt in the labour market. In 2016, labour productivity divergence across regions was one of the highest in the EU. Bucuresti-Ilfov registered the highest productivity (22 % above the EU average), while productivity in the Nord-Est region is only one-third of the EU average (Graph 1.4). Average productivity for all regions excluding the capital is only half the EU average. The regional unemployment rate in 2017 varied significantly, from 2.9 % in Nord-Est to 7.7 % in Sud-Vest Oltenia, despite a reduction in the gap across regions from 6.9 pps in 2016 to 4.8 pps in 2017. Regional socio-economic indicators show a major divide between a growing capital that mainly attracts skilled labour in higher value-added sectors and the rest of the country where employment is concentrated in lower value added sectors in a context of outward migration.

Graph 1.4:Disparities across Romanian regions Source: European Commission Investment Romania continues to have one of the highest investment ratios in the EU. In 2017, total investment accounted for 22.6 % of GDP, above the EU and neighbouring countries' averages of 20.1 % and 20.2 % respectively. Private investment, which reached 20 % of GDP in 2017, is estimated to have increased somewhat despite concerns about fiscal and legislative instability and unpredictability (see Section 4.4.2). Public investment, by contrast, remains subdued, partly due to the slow uptake of projects under the EU financing period (see Section 4.4.2). In 2017, public investment fell to a post-EU accession low of 2.6 % of GDP, just at the EU average but below neighbouring countries (Graph 1.5). However, it is estimated to have slightly recovered in 2018 and forecast to progressively recover in coming years. Graph 1.5:Gross fixed capital formation Source: European Commission Investment could be hit by increasing uncertainty. Levels of investment could be heavily affected by the susceptibility of private investment to more challenging financial conditions and the government’s under-execution of initially budgeted projects. The persistent unpredictability of policymaking creates a climate of instability which could hinder business confidence and investment decisions (see Sections 3 and 4.4). Moreover, the recent emergency ordinance () introducing a set of far-reaching fiscal measures (see Section 3) may affect private investment in energy and communication and the financial sector's capacity to finance the economy. External position The current account deficit widened further in 2018. The deficit is estimated to have worsened to 4.3 % of GDP due mainly to the deteriorating trade balance (Graph 1.6). As a result, the current account balance is increasingly diverging from the economy’s fundamentals (), which for Romania imply a balanced current account. The export market share is estimated to have remained on a gentle upward path in 2018. This evolution is felt in the net lending/borrowing, which became negative already in 2017 when the current account deficit started to widen markedly and the capital account balance almost halved. By sector, the net borrowing needs come mainly from households and, to a much lesser extent, the government. Corporations are net lenders. Graph 1.6:Current account breakdown and capital account Source: European Commission The net international investment position is still improving. Strong nominal GDP growth facilitated a further improvement in the net international investment position to an estimated -47.8% of GDP in 2017 and -44.8 % in Q3-2018. However, progress has slowed down as a result of the widening current account deficit and some deceleration in nominal GDP growth (see Section 4.4). Inflation and monetary policy Inflation reached a post-crisis peak in 2018. Inflation as measured by the harmonised index of consumer prices turned positive in 2017 and continued to increase throughout 2018, to reach an annual average of 4.1 %. This is the result of both internal and external factors. Internally, inflation accelerated at the beginning of 2018 as the effect of the January 2017 tax cuts faded away. Increases in the excise tax on energy products in autumn 2017 further added to the increasing trend. Internationally, the hike in food prices and, to a larger extent, of energy prices, further spurred headline inflation (Graph 1.7). In 2018, Romania had the highest inflation rate in the EU, well above the euro area average. Headline inflation is expected to moderate to 3.3 % and 3.1 % in 2019 and 2020, respectively, on account of weakening domestic demand. Core inflation has remained more stable, at an average of 2.7 % for the whole of 2018. Graph 1.7:Contributions to headline inflation Source: European Commission In 2018 the National Bank of Romania tightened its accommodative monetary policy. As inflation increased, the key monetary policy rate was raised three times by a total of 0.75 pps in the first months of 2018, to 2.5 %. These were the first hikes in 10 years. Since May 2018, however, the National Bank of Romania has kept the rates constant, anticipating the return of the annual inflation rate, as measured by the consumer price index, to within the Bank's target of 2.5 %±1 pp, reaching 3.3 % in December 2018. The conduct of monetary policy is increasingly constrained by fiscal policy measures. The recent introduction of a tax on banks’ assets linked to the interbank rate (ROBOR) is likely to limit the room for manoeuvre of the monetary policy. It may also introduce a conflict between the objective of maintaining price stability and that of safeguarding financial stability (see Section 4.2). Labour market, poverty and social exclusion Labour market conditions continued to improve, supported by robust economic growth. The activity rate increased to 72.3% in 2017, exceeding the pre-crisis level of 68.7 %. The unemployment rate in December 2018 (3.8 %) is at its lowest level in a decade (Graph 1.8). However, the shrinking workforce in the context of unfavourable demographics represents an obstacle for companies in filling job vacancies and finding the relevant skills on the labour market. As such, it could limit potential GDP growth. The labour market continues to be characterised by weak social dialogue, with a very limited involvement of social partners in policy-making. Graph 1.8:Labour market overview Source: European Commission Wages and unit labour costs continued to increase at a rapid pace in 2018. The record low unemployment rate, structural labour supply shortages and public policies increasing public and minimum wages () are forcing a correction in the labour market. Overall, wages are estimated to have increased further in 2018, also due to the impact of the 2017 change in the structure of social contributions, which shifted the burden almost entirely to the employees. As a result, unit labour costs have grown on average 8.1 % annually since 2016. These developments imply the risk of a competitiveness loss given that productivity developments can no longer compensate for such wage increases (see Section 4.4.1). Despite the growing labour shortages, some groups are not fully integrated in the labour market. Participation rates remain particularly low for people with low education attainment, and among women and people with disabilities. The share of young people not in education, employment or training, while on a decreasing path since 2015, remained relatively high in 2017 at 15.2 %. A large part of the long term unemployed either remain unemployed (73.2 %) or fall into inactivity (13.2 %). The active labour market measures in place do not sufficiently address upskilling and integrated service delivery (see Section 4.3.1). High poverty and inequality rates hamper Romania's ability to achieve inclusive growth. Although decreasing, poverty and inequality rates remain very high. Income inequality has declined over the past 2 years but remains one of the highest in the EU, reflecting in part the weak redistributive capacity of the tax and benefit system. More than 1.5 million people earn under EUR 3 per day (Friedrich-Ebert-Stiftung, 2018) and 3.9 million people suffer from severe material deprivation. Opportunities are unequal, in many respects. High poverty levels are associated with unemployment, low education attainment, high intergenerational transmission of poverty and regional disparities. The share of children living in poverty or social exclusion (4 out of 10) is one of the highest in the EU. Socioeconomic status greatly affects students' performance, deterring sustainable growth in the long-run (see Section 4.3.3). The education and care systems are not conductive to sufficiently independent living and to the employability of people with disabilities (see Section 4.3.2).

Public finances The public deficit is projected to widen, mostly due to increases in current spending. In its 2018 Autumn Forecast, the Commission projected the headline deficit to increase from 2.9 % of GDP in 2017 to 3.3 % of GDP in 2018, mostly driven by public wage increases. The headline deficit was projected to increase slightly further in 2019, to 3.4 %, and then to jump to 4.7 % in 2020 due to significant increases to old-age pensions. The pension point, i.e. the main parameter used for pension indexation, is set to increase by 15 % in September 2019 and by 40 % in September 2020. The structural deficit () is projected to remain broadly stable at around 3.3 % to 3.4 % of potential GDP until 2019 and to increase to 4.5 % in 2020 (Graph 1.9). In June 2018 the Council launched a new significant deviation procedure addressed to Romania. Graph 1.9:General government balance and output gap Source: Eurostat, European Commission 2018 Autumn Economic Forecast The tax cuts and expenditure increases are being financed with public debt. Because of the widening of the public deficit, the general government debt is projected to increase from 35.1 % of GDP in 2018 to 38.2 % of GDP in 2020. Assuming no policy change, public debt is projected to increase to above 60 % of GDP in 2029 (see Section 4.1.4). The financing cost of public debt has been steadily increasing since mid-2017 to levels well above those observed for peer countries (Graph 1.10). Graph 1.10:10 year government bond yield: Romania and peers Source: European Commission Financial sector Consumer credit accelerated in 2018. The stock of loans denominated in Romanian lei (RON) continued to increase for both households and corporations. The domestic currency increased its share of the loans' stock to 65.9 % in November 2018, up from a low of 35.6 % in May 2012. Credit to non-financial corporations, albeit still increasing, has somewhat decelerated in 2018 compared to 2017 (Graph 1.11). Meanwhile, household lending has picked up on the back of an increase in the growth of consumer credit and mortgage lending, although the latter registered a slight slowdown. As of January 2019, a new macro prudential regulation limits the level of households’ indebtedness (see Section 4.2). Graph 1.11:Loans to households and non-financial corporations Source: National Bank of Romania Banking sector stability is threatened by recent legislative changes. Capital adequacy at system level continued to increase and stood at almost 20 % at the end of September 2018. As banks increased locally collected deposits and reduced dependency on parent funding, the loan-to-deposit ratio declined to around 76 % at end-September 2018. The share of non-performing loans in total loans fell below 6 %, but sales of impaired assets declined significantly as of March 2018 following changes to the Fiscal Code. Moreover, in December 2018, Parliament adopted several laws, not yet enacted (including retroactively capping interest rates in loan contracts), which are expected to hamper the disposal of non-performing loans and negatively impact the already very low level of financial intermediation in Romania. More worryingly, the newly introduced tax on banks’ assets could have a long- lasting damaging effect on banks’ ability to finance the economy, on the conduct of monetary policy and ultimately on economic growth (see Section 4.2). The second pension pillar was further weakened. In December 2018, the government significantly increased the minimum capital requirements for second pillar pension funds’ management companies operating in Romania, while substantially reducing the allowed level of the administration fees. Moreover, participants with at least 5 years of contributions are now allowed to opt out of the second pillar. These changes, following a 2018 reduction in the proportion of the contributions accruing to the second pension pillar, significantly weaken the second pension pillar, with negative consequences for future pension adequacy, the development of the local capital market and the long-term financing of the economy (see Section 4.2). Housing market The growth rate of house prices is slowing down, but developments vary at sub-national level. Housing demand has been adversely affected by higher lending costs and overall higher prices. House prices increased by 5.7 % in Q3-2018, less than the same period of the previous year (6.2 %). The deceleration continued in the first quarters of 2018 on the back of volatile demand, especially in the residential segment, due to the tightening of both public (the Prima Casă programme) and private credit conditions. Substantial regional differences persist. House prices advanced by less than 6 % in Bucharest in Q3-2018, but some counties saw double-digit increases. Table 1.1:Key economic, financial and social indicators - Romania (3) The tax-to-GDP indicator includes imputed social contributions and hence differs from the tax-to-GDP indicator used in the section on taxation. Source: Eurostat and ECB as of 31-1-2019, where available; European Commission for forecast figures (Winter forecast 2019 for real GDP and HICP, Autumn forecast 2018 otherwise) 2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 59 % of all country-specific recommendations addressed to Romania have recorded at least ‘some progress”. 41 % of country-specific recommendations recorded 'limited' or 'no progress' (Graph 2.1). Overall, Romania has advanced in implementing its country-specific recommendations since 2013, and some reforms have been pursued even during economically challenging times. However, the reform momentum appears to have waned over the past few years. In several policy areas subject to country-specific recommendations action has slowed down or even been reversed and significant efforts are still needed to achieve tangible results on implementing reforms. Graph 2.1:Overall multiannual implementation of 2013-2018 CSRs to date Source: European Commission On fiscal adjustment, past progress has been gradually undone. Since 2009, Romania has pursued a significant fiscal consolidation which led to achieving its medium-term objective in 2014 and 2015. However, since 2016 the authorities have been pursuing an expansionary fiscal policy that led to a substantial departure from that objective. Progress on labour market and social assistance reforms has stalled since 2016. The minimum wage continues to be set by the government in an ad-hoc manner, without applying a set of objective criteria. Social dialogue remains ineffective, while the role of certain important institutions has been recently weakened. The implementation of the minimum inclusion income law, adopted in 2016, stalled in 2017 and is now expected to be enforced only as of April 2019. Active labour market policies are not comprehensively looking to individual needs and are insufficiently focused on upskilling.

Access to quality and inclusive education is highly insufficient. Early school leaving remains problematic and the acquisition of basic and digital skills faces substantial challenges. Ensuring equal opportunities for students from poor households and the Roma community remains a challenge. The limited availability of nurseries and their uneven distribution does not support children’s early cognitive and social development and women’s return to the labour market. The labour market relevance of education is limited. Forecasting and anticipation of skills needs remains unused, hampering the adaptation of the education system to labour market needs. The healthcare system is faced with multiple challenges. Progress of reforms in key areas such as the development of integrated community care centres and the building of regional hospitals has been delayed, while in other priority areas the measures taken by the authorities appear insufficient. The administrative capacity of the Ministry of Health continues to be very limited, while poor investment planning and lack of political commitment further hamper the progress of reforms. The shift to outpatient care remains at an early stage, with most efforts concentrated on hospital care. The conduct of public policy continues to be highly unpredictable. Important and sometimes complex legislative changes are still adopted without proper consultation of stakeholders, while impact assessments are often lacking. This often results in additional legislative changes being necessary to correct the unintended effects of emergency ordinances adopted on very short notice. Contradictory public statements about the future of important reforms also contribute to the overall climate of unpredictability of policy making, negatively affecting the business environment. Table 2.1:Assessment of 2018 CSR implementation Source: European Commission Overall, Romania made limited progress () in addressing the 2018 country-specific recommendations. There was limited progress on tax compliance and collection, upskilling and education, social dialogue, outpatient care, public investment prioritisation and public procurement. No progress was made on the fiscal framework, minimum wage setting, minimum inclusion income, predictability of decision-making and the corporate governance of state-owned enterprises. Box 2.1: EU funds and programmes contribute to addressing structural changes and to fostering growth and competitiveness in Romania Romania is a large beneficiary of EU solidarity. EU funds allocated to Romania amount to EUR 30.8 billion for the 2014-2020 programming period, potentially representing around 2.4 % of GDP annually. As of the end of 2018, around EUR 20.8 billion was allocated to selected projects. EUR 7.9 billion of the total allocation was paid to Romania. In addition, EUR 1.2 billion was allocated to specific projects on strategic transport networks through the Connecting Europe Facility. Furthermore, Romanian research institutions, innovative firms and individual researchers benefited from other EU funding instruments, notably Horizon 2020. EU funds can help address policy challenges identified in the 2018 country-specific recommendations. Actions financed include investments in transport, energy, water and waste management infrastructure, education, employment and social policies, strengthening healthcare, extending broadband access and developing public administration and inter-operable e-government services. As a result, 315 km of TEN-T railway lines and 378 km of TEN-T roads are under construction; almost 140 000 additional households will have access to broadband of at least 30 Mbps; around 750 000 additional people could benefit from improved water supply and more than 2.5 million people are set to be served by improved wastewater treatment. In addition, 1 793 micro-enterprises and 688 SMEs have received direct support to strengthen their competitiveness. The SME Initiative has generated EUR 361 million of loans supporting 1 344 SMEs. Moreover, the European Social Fund is currently supporting ongoing active labour market measures for about EUR 473 million, while other EU funds will also enable the hiring of 174 new researchers. Despite some progress, implementation is still delayed in several sectors including for smart, sustainable, social and connectivity investments. The reform of the public administration, a precondition for EU funding support, is progressing at a slow pace. In addition, the implementation of some key country specific recommendations and related reforms is severely delayed (see Section 2). In addition, the Commission can provide tailor-made technical support upon a Member State's request via the Structural Reform Support Programme to help Member States implement growth-sustaining reforms to address challenges identified in the European Semester process or other national reforms. Romania, for example, is receiving support for the establishment of a national promotional bank. The Commission is also assisting the authorities in their efforts to develop an economically and environmentally sustainable water and waste water sector, to modernise the health service delivery model and to reinforce the administrative capacity of the National Agency for Fiscal Administration to improve tax compliance and revenue collection. In addition, in 2018, work has started on assisting the National Institute of Administration in introducing modern methods of training of public administration, on conducting the first evaluation of state aid schemes to assess market outcomes and optimise their design in the future, and on creating a mechanism of early detection/warming and intervention for identifying children at risk of repeated school drop-out. EU funding can contribute to the mobilisation of private investment. Out of the total European Regional Development Fund financing, EUR 350 million is to be delivered via financial instruments and is expected to leverage additional private investment of around EUR 1 billion. European Social Fund financial instruments should support in particular the creation of new jobs and investments in the social economy. However, implementation has not started. Romania is advancing in the take up of the European Fund for Strategic Investments, with total financing amounting to EUR 652 million and expected to trigger EUR 2.7 billion in additional private and public investments ( I ). A Romanian project backed by the European Fund for Strategic Investments is "Agricover Loan for Small and Medium-sized Enterprises", for which the European Investment Bank provides a EUR 15 million loan to Agricover Credit IFN to finance small projects in the agricultural sector. EU actions are intended to strengthen national, regional and local authorities and civil society. Around EUR 1 billion has been allocated to strengthen the capacity of the public administration at different levels and encourage cooperation with relevant stakeholders. The Coal Regions in Transition Initiative seeks to improve socio-economic and technological transformation processes in the Jiu Valley mining region. https://cohesiondata.ec.europa.eu/countries/RO# 3. Overall findings regarding imbalances, risks and adjustment issues Introduction The 2019 Alert Mechanism Report concluded that a new in-depth review should be undertaken for Romania to examine the possible existence of imbalances (European Commission, 2018i). An in-depth review was not prepared for Romania in 2018 and no imbalances have been identified. This chapter summarises the findings of the analyses in the context of the Macroeconomic Imbalances Procedure (MIP) in-depth review that is contained in various sections in this report (). 3.1.Imbalances and their gravity The current account deficit has been widening markedly. From being nearly balanced in 2014, the current account registered a deficit of 3.2 % of GDP in 2017 and is estimated to have deteriorated further to 4.3 % of GDP in 2018. This evolution implies an increasing divergence from the economy's fundamentals, which point to a close to balanced current account. This is mainly the result of an increasing deficit of the trade in goods, spurred on by the private consumption boom against the backdrop of an expansionary fiscal policy in times of high GDP growth. The net international investment position, in turn, has improved to -47.8 % of GDP in 2017. The 20 pps correction since 2012 has been mainly due to the strong nominal GDP growth more than offsetting the widening current account deficit. The capital account surplus added further relief. Unit labour costs have been growing strongly. Despite significant productivity gains in recent years, which are to some extent a catching-up effect from a low starting point, wage increases have been significantly outpacing productivity growth since 2016, leading to a marked acceleration of unit labour costs. This in turn has led to an appreciation of the unit labour costs-based real effective exchange rate (see Section 4.4.1). Public and minimum wages have been increasing at a rapid pace, with potential spillovers to the private sector and negative implications for competitiveness. Public wages are on a marked upward trend. The more subdued evolution of wages in the tradeable sector in recent years, as well as relatively robust productivity developments, have allowed exports to remain competitive so far and helps explain the more limited loss in cost competitiveness in tradeables. Nevertheless, empirical evidence shows that the public sector has a leading role in wage determination in Romania. Therefore recent and future wage increases in the public sector may lead to substantially higher private sector wages, including in the tradeable sector, undermining competitiveness. Also the unilateral government-set increases in the statutory minimum wage, starting in 2015 and due to continue into 2019, have added to wage pressures and reinforce the potential negative effect on competitiveness. Recent legislative initiatives risk threatening the normal functioning of the financial sector. These include a parliamentary law retroactively capping mortgage interest rates and a government emergency ordinance imposing a tax on banks' assets linked to interbank interest. Furthermore, measures aimed at the second pension pillar, also passed into law by the emergency ordinance, may strongly hinder the development of capital markets, which are already very shallow in Romania. The new risks to the banking sector, the weakening of institutional investors and the increasing unpredictability of policy making may also dent private investment. 3.2.Evolution, prospects and policy responses The current account deficit is on a deteriorating trend, with its composition being a concern. Prospects imply a further deterioration in 2019 and 2020, to close to 5% of GDP according to the Commission’s 2018 Autumn Forecast. Romania is one of the very few Member States whose current account deficit is worsening. Changes in composition are also a concern, as growth in imports has been substantially higher for consumer goods than for intermediate or capital goods. This means that the import spree is not adding much to the potential future growth of the economy or improving living standards in a sustainable way. Recent improvements in the net international investment position may stall. GDP growth, while still robust, has slowed in 2018 and is expected to slow further in 2019 and 2020, while the current account is forecast to continue to deteriorate. That could end the substantial improvement of the net international investment position observed over the past 5 years. The composition of the net international investment position, with a small debt weight, may mitigate risks. Overall, however, recent and prospective developments on the external side expose the economy to growing risks, especially in times of a more uncertain and weakening world economy. While the export performance is still strong, fast-growing unit labour costs can hurt competitiveness and the country’s external position. Romania’s export market shares continued to increase in 2017 despite increasing RON-denominated export prices. The gradual depreciation of the national currency over the past 2 years has somewhat reduced the pressure on the price competitiveness of exports. However, private sector wages are under pressure from a very tight labour market, repeated minimum wage increases, and possible spillovers from strong public sector wage hikes. This could trigger competitiveness losses, including in the sectors more exposed to external competition. Threats to the external performance also arise from the current policy trajectory and the external environment. These could increase macroeconomic volatility, undermine the capacity to withstand adverse shocks, and eventually slow down convergence toward the standards of living in other EU countries. Uncertainty over policy and legislative decisions, including those with potential impact on investment and production decisions, contributes to the overall perception of unpredictability in public policy making. The main external risks to the economic outlook include an abrupt shift in global risk appetite against the backdrop of continued monetary policy normalisation in the EU, as well as trade tensions leading to weaker external demand. If these developments were to materialise, they would have a negative impact on investment and exports. 3.3.Overall assessment

Romania faces increasing risks in the form of a deteriorating current account deficit and accelerating unit labour costs. The current account deficit has been widening since 2014 mainly due to a growing deficit of the trade in consumer goods. Despite a good export performance and significant export market share gains since 2012, growth in imports has persistently outpaced that of exports. Repeated increases of the minimum wage and public sector wages have put unit labour costs under growing pressure. The impact of the wage policies on cost competitiveness has so far been mitigated by a number of factors: productivity gains, a slow pass-through to the tradeable sector of the rising economy-wide unit labour costs, and currency depreciation. However, the continuation of this trend entails potential competitiveness losses, leaving the country vulnerable to external shocks. Policy measures adopted so far may exacerbate the risks of imbalances. Government decisions on public and minimum wages have played a major role in increasing risks to cost competitiveness. Also, an expansionary fiscal stance limits the room to cushion potential shocks. The persistence of these trends can further harm the confidence of economic players, reduce the economy's capacity to adapt to shocks that may arise at home or spill over from abroad, and affect the economy’s growing external financing needs as measured by the high and worsening external deficit. Recent government decisions have increased risks in the financial sector and may negatively affect private investment. These decisions could lead to a lower availability of credit, fewer long-term investors, and an unstable and unpredictable policy-making environment. In light of the economy’s limited debt tolerance, strong reliance on foreign investment and past record of capital flows volatility, addressing the ongoing trends would prevent a reversal of investors’ sentiment in a context of slowing economic activity and increased uncertainty in the economic outlook. Box 3.1: MIP assessment matrix (*) – Romania 2019 4. Reform priorities 4.1.Public finances and taxation 4.1.1.Fiscal policy (*) () The authorities have been reducing taxes and increasing current spending, while cutting public investment. (Graph 1.1) Tax revenues have been dropping following cuts in consumption tax rates in 2016-2017 and a cut of the flat personal income tax rate as from 2018. On the other hand, collected social contributions significantly increased in 2018 thanks to the social security shift on the employees and to the cut to the proportion transferred to the second pension pillar (Box 4.2.1). On the expenditure side, public wages have been significantly increased in an ad-hoc manner since 2016. The unified wage law, adopted in summer 2017, increased gross wages in the public sector in 2018 and beyond. At the same time, public investment gradually fell to a post-EU accession low in 2017 and is projected to have increased only slightly in 2018. These policies have increased the public deficit and boosted private consumption (see Sections 1 and 4.4.1) to the detriment of long-term growth. Graph 4.1.1:Drivers of change of general government balance Source: Eurostat, European Commission 2018 Autumn Forecast (for 2018) 4.1.2.Taxation The tax structure is characterised by low levels of revenues, with high reliance on consumption taxes. The tax-to-GDP ratio stood at 24.9 % in 2017, the lowest value since 1996. This represents the second lowest level in the EU – well below the EU average of 39.2 %. The tax structure largely relies on consumption taxes, while the share of tax revenues from labour (including social contributions) is well below the EU-average (European Commission, 2019a). The power of the tax system to reduce poverty and correct social disparities is limited. Income inequality remains one of the highest in the EU and a third of Romanians are at risk of poverty, the highest rates in the EU (Section 4.3.2). The relatively low level of tax revenues limits Romania's ability to tackle these problems, either via redistribution or through financing public goods and services (Section 4.3.2). In addition, the tax structure relies substantially on consumption taxes, which have no or very little redistributive impact. The design of labour taxation is among the least progressive in the EU, as measured by the difference between the relative tax burden for low- and high-income earners (Graph 4.1.2). This partly explains the limited redistributive impact of the tax and benefit system (Graph 4.1.3). The graph shows that both non-pension social benefits (the distance between the square and triangle) and taxes (the distance between the triangle and the cross) have a low impact on income inequality. Graph 4.1.2:Degree of progressivity of labour income taxation in EU Member States, 2017 Source: European Commission calculations, based on Eurostat and OECD data. Graph 4.1.3:Redistributive power of the tax and benefit systems in EU Member States, 2016 Source: European Commission calculations, based on Eurostat data The implementation of several environmental taxes has been delayed. The implementation of the landfill tax introduced in 2014 was gradually postponed until 1 January 2017. This tax proved to be short-lived as on 1 July 2017, the government decided to suspend its application until 1 January 2019. However, government emergency ordinance 74/2018 introduced a contribution for the circular economy, imposed at relatively low levels, to be collected by the sanitation/waste collection companies. The government is also planning to introduce in 2019 a pollutants-dependent car registration tax (see Section 4.4.2). Moreover, the mandatory contribution/surcharge for failure to achieve the collection targets by economic operators placing on the market electrical and electronic equipment and portable batteries and accumulators, and by collective organisations has been postponed until 2020. Tax compliance remains low, as exemplified by the high value added tax (VAT) gap. The VAT gap is defined as the difference between the VAT liability theoretically due and VAT actually collected. It thus represents lost revenue due to evasion, fraud, insolvencies, bankruptcies, administrative errors or legal tax optimisation. The VAT gap in Romania was the largest in the EU in 2016 as a share of VAT theoretically due (CASE et al. 2018). It amounted to around 36 % of VAT theoretically due, compared to the EU average of approximately 12 %. The gap increased by about 2 pps in 2016 compared to the previous year. The large shadow economy poses additional challenges in terms of tax compliance. The Romanian informal economy is estimated at 22 % of the total economy (2014 estimation based on OECD methodology), with the unregistered workforce the biggest component. The National Institute of Statistics estimates the unobserved economy at about 21 % of GDP in 2017 (). According to a recent study (PWC, 2018), 42 % of surveyed organisations reported having been subject to economic crimes (defined as fraud committed by consumers, cybercrime, business misconduct) in the last 24 months, a significant increase compared to the 2016 study (17 %). Undeclared work in Romania is high. It is estimated to account for around one fifth of labour input and a quarter of gross value added in the private sector (European Commission, 2018m). Although coercive measures were expanded, i.e. by enlarging the legal definition of undeclared work situations (), the overall number of cases detected by the labour inspectorates is still low. Coordination between the labour inspectorates and the fiscal authorities is, however, improving. Still, “envelope wages” (i.e. underreported salaries) have so far been only treated as a tax collection problem and not as a labour relations issue. The preventive measures are not showing sufficient results and could benefit from stronger cooperation with social partners. Tax evasion is facilitated by high use of cash payments. According to the National Bank of Romania, cash payments are four times larger than electronic payments. Only 77 % of total bank cards are active, in the context of a relatively low level of financial education (). Only 58 % of Romanian adults hold a bank account compared to 94 % in high-income economies and 63 % in developing countries. About a third of pensioners receive their rights in cash (World Bank, 2017b). All this facilitates the spread of the shadow economy and tax evasion. Law 19/2018, amending government emergency ordinance 193/2002 on the introduction of modern payment systems (the so-called "cashback law") now obliges companies with a minimum turnover equivalent to EUR 50 000 to operate card readers or other modern electronic payment systems. Although a positive development, its ability to reach consumers in rural areas remains to be assessed.

The tax administration has taken some steps on internal reorganisation and processes to enhance tax compliance. The tax administration moved about 24 000 mid-sized contributors/companies from the control of regional tax administrations to county-level ones as of November 2018. The tax administration has recently updated its guidelines on the registration of certified cash registers and the issuing of single identification number for cash registers. It is also in the process of operationalising the use of its risk analysis in order to identify, assess and manage the risk of tax non-compliance. As of July 2018, the Large Taxpayers Office began sending taxpayers formal questionnaires about risk indicators identified in their specific activity which may influence their risk rating. Even though the criteria for risk assessment are not made public, the questionnaires may help the tax administration identify inconsistencies in the VAT reporting obligations of the notified taxpayers (). 4.1.3.Fiscal framework The Fiscal Responsibility Law sets national numerical fiscal rules which should guide the budgetary process. It contains a structural deficit rule, which requires compliance with or convergence to the medium-term budgetary objective of a structural deficit not exceeding 1 % of GDP (). The national framework also contains several auxiliary rules concerning expenditure and revenue items. Furthermore, the government is required to prepare an update of the fiscal strategy – which sets out the macroeconomic assumptions, medium-term budget planning and expenditure ceilings that should guide the annual budget process – and send it to Parliament by 15 August of the preceding year. The Fiscal Responsibility Law also requires that the Prime Minister and the Minister of Finance sign a joint statement certifying that the draft budget and the fiscal strategy respect the fiscal rules set in the Law, and the principles of fiscal responsibility. As in previous years, the national fiscal framework has not been respected. According to the national Fiscal Council, the 2018 budget is in flagrant contradiction with the fiscal rules set up by the Fiscal Responsibility Law (Fiscal Council 2017). In particular, the 2018 budget targeted a headline deficit of close to 3 % of GDP, which is inconsistent with the structural deficit rule. The 2018 budget amendment from September broke, among others, rules prohibiting increases: (i) of the nominal headline and primary deficit ceilings during the fiscal year; and (ii) in personnel expenditure and total government expenditure excluding EU funds during the fiscal year. The second 2018 budget amendment, published in November, also broke several national fiscal rules. The draft 2019 budget, approved by the government on 8 February, again broke multiple fiscal rules, including the structural deficit rule (Fiscal Council, 2019). Moreover, as in previous years, the authorities did not send an update of the medium-term fiscal strategy to Parliament by the statutory August deadline, thereby undermining its guiding role. Also, as in previous years, the authorities derogated from the requirement to sign a statement that the 2019 budget and the fiscal strategy respect the fiscal rules and principles of fiscal responsibility. 4.1.4.Debt sustainability analysis and Fiscal Risks Over the short term, no significant risks of fiscal stress are foreseen. The value of the early-detection indicator of fiscal stress (ʻS0ʼ), which assesses risk within one year, is below its critical threshold. None of the fiscal and financial competitiveness sub-indexes point to short-term vulnerabilities. Financial markets’ perceptions of sovereign risk remain medium-grade, with a ‘BBB- stable’ or equivalent rating of the sovereign debt from the three major rating agencies. However, the financing cost of public debt has been increasing since mid-2017 (see Section 1). The public debt ratio is expected to gradually increase, leading to debt sustainability risks in the medium term (). Due to a high structural primary deficit, and assuming no-policy change, the debt-to-GDP ratio is set on an upward path and expected to go beyond the 60 % of GDP Treaty reference value by 2029. Adhering to the existing fiscal rules, i.e. full compliance with the requirements of the preventive arm of the Stability and Growth Pact, would set the government debt ratio on a significantly lower trajectory relative to the baseline scenario at unchanged fiscal policy (Graph 4.1.4). The structure of the government debt in terms of maturity longer than 1 year helps to mitigate vulnerabilities. However, the high share of government debt in foreign currency and the substantial holdings of debt by non-residents could be aggravating factors, as could the negative net international investment position. Graph 4.1.4:General government debt projections (% of GDP) Source: European Commission calculations. The high fiscal deficit and increasing ageing costs are set to negatively impact government fiscal sustainability over the long term. The relevant indicator (ʻS2ʼ), points to a required fiscal adjustment of 5.9 pps of GDP to ensure that the public debt ratio remains sustainable over the long term. This is driven by the initial budgetary position (a contribution of 3.7 pps of GDP) and aging costs, in particular pensions and health care (a contribution of 2.1 pps of GDP). These projections do not take into account the long-term impact of the new pension law. The law adopted by Parliament in December 2018 changed several parameters used to calculate pension benefits. It will lead to substantially higher long-term pension costs. In particular, the pension point value will rise as the indexation factor for existing pensions would no longer converge to prices but will, instead, remain permanently composed of wages and prices. Moreover, the contributory period used in the calculation of one’s pension is now shorter, leading to higher pension expenditure for new pensions. However, the abolishment of the correction index for new pensions (which used to partly link the first pension to wages) will mitigate the overall pension expenditure increase implied by the other parameters. 4.2. Financial sector Banking and insurance (*) Following several years of efforts to strengthen its resilience, the banking sector faces increased stability risks. Banking sector capitalisation has been flat since 2016 at around 19 %, well above the EU average. The common equity tier 1 ratio declined marginally in the first half of 2018, but remained reassuring at 17.5 %. The non-performing loans ratio declined to below 6 % by the third quarter of 2018, while the flow of new non-performing loans has again increased in the first months of 2018, in particular for household loans in local currency. With sovereign bond holdings of roughly 20 % of total assets (compared to 2.2 % in 2008) and a pronounced home bias, the banking sector is heavily exposed to domestic sovereign debt, leaving banks vulnerable to an increase in sovereign spreads and interest rate hikes. Due to their deposit-based funding model, banks have issued few debt instruments. Consequently, compliance with minimum requirement for own funds and eligible liabilities will entail higher costs, in particular in the context of Romania’s under-developed capital market. Tax measures have slowed down sales of non-performing loans by banks. In mid-2017, the government limited as of January 2018 the tax deductibility of expenditures related to non-performing loans sold by banks to third parties to 30 %. Full tax deductibility was previously the rule (European Commission, 2018a). Law 72/2018 introduced an additional tightening of the tax regime for the non-performing loans sold by banks, by taxing both the income from the sale and part of the losses recorded at sale. The law treats 70 % of the difference between the book value of the non-performing loans sold or written-off (covered partially or entirely by loan-loss provisions) and the sale price as being similar to income and, therefore, subject to taxation. This treatment goes against efforts to develop the secondary market for impaired assets in the EU. It discourages the sale of non-performing loans and would hinder balance sheets’ repair if these loans were to increase again. The Romanian secondary market for impaired assets, the most dynamic in Eastern Europe in recent years, recorded sales of EUR 8.5 billion in 2015-2017 but has stalled since Q1-2018. A recently introduced bank tax is likely to create strong headwinds for the banking sector. In December 2018, without impact assessment or consultation of stakeholders, the government adopted an emergency ordinance introducing a new tax for banks (the "tax on greed") levied on total assets and linked to the level of the interbank interest rate (ROBOR). The levy is calculated on a quarterly basis. It increases gradually from 0.1 % to 0.5 % of total assets depending on how much the quarterly average ROBOR surpasses an arbitrarily set threshold of 2 %. The tax is very pro-cyclical and raises calibration concerns, as it inhibits the price-setting mechanism in the banking sector. At the January 2019 level of the ROBOR, it will amount to 1.2 % of total assets per year. Based on a preliminary analysis, the tax is likely to put a strain on financial stability by significantly impacting the solvency and profitability of banks and by worsening further the situation of weaker banks. The impact of the levy on banking sector profitability appears to be much higher than in other EU countries which introduced such taxes in the past, including regional peers. Moreover, the bank levy is likely to constrain credit activity, as banks may deleverage to reduce total assets, further lower banking sector intermediation, and reduce flexibility for monetary policy and hamper its transmission mechanism. Banking sector intermediation in Romania (measured as the ratio of private sector credit to GDP) is currently the lowest in the EU. Three laws with potential negative impact on the banking sector were recently adopted by Parliament. These laws are still to be enacted. The law capping interest rates in mortgage and consumer loan contracts raises significant concerns. The caps’ calibration () could potentially harm lending activity and financial intermediation (). They may have an adverse impact on the supply of banking services and financial products by credit institutions and hinder access to credit for clients with a higher risk profile. The law capping the value recoverable from non-performing loans sold by banks will further hinder banks' ability to further reduce non-performing loans and continue balance sheet repair. It will negatively impact the revenues of investors in these loans and of debt collection companies, increasing the likelihood of market exits, undermining the secondary market for impaired assets. Furthermore, the right granted to defaulted borrowers to buy the impaired assets from investors at capped values and obtain full debt discharge is likely to induce moral hazard and weaken significantly payment discipline in the banking sector. It may reduce access to credit for some categories of borrowers as banks are likely to become increasingly selective. Moreover, the retroactive application of the laws capping interest rates and banks’ receivables from credit agreements concluded in the past will increase legal uncertainty (). Without prejudice to legitimate consumer protection objectives, the law eliminating the writ of execution of loan contracts will prevent the out-of-court repossession of collateral by banks and increase the overall recovery time for collateral. This will further adversely impact non-performing loans resolution and disposal. Several other legislative initiatives by Parliament are also of concern. The Parliament intends to amend the 2016 law on debt discharge and has discussed the possibility of including the Prima Casă loans under the scope of this law. This would make the State guarantee on loans inapplicable, which could be regarded as an attempt by the State to backtrack on its financial obligations under the Prima Casă scheme. As such, it could put under strain the country’s rating. Attempts to modify the Statute of the National Bank of Romania and remove the legal protection of staff involved in prudential supervision of credit institutions, which go against good international practices, would significantly weaken prudential discipline and the supervision of credit institutions. The banking sector’s exposure to the real estate market has steadily increased in recent years. Banks are the financial intermediaries most exposed to the real estate sector. Real estate lending to households accounts for over one third of total credit to the private sector, with the bulk of loans being granted at variable interest rates. This increased exposure has been markedly supported by the government-sponsored Prima Casă programme (). The robust economic growth and developments in the residential real estate market in recent years, could justify a phasing out of the Prima Casă programme. Household indebtedness has increased in recent years, although from low levels. Due to the sustained increase in housing loans since 2015, household indebtedness has increased in absolute terms. Whereas household debt-to GDP stood at just below 17 % in 2017, well below the EU average, the indebtedness level of low-income borrowers constitutes a matter of concern as they are the most exposed segment to an increase in interest rates. To curb the risks from the high indebtedness of individuals with low income, the National Bank of Romania introduced as of January 2019 maximum levels of indebtedness for both RON and foreign currency denominated loans (40 % and respectively 20 % of net income). These levels can be increased by 5 pps for borrowers taking out a mortgage loan for the first time to buy an own occupied dwelling. The insurance sector is still highly dependent on compulsory car insurance. Insurance activity expanded further in 2017, when gross written premiums increased by roughly 3 % compared to 2016. Meanwhile, insurance penetration () has remained subdued (1.1 % at the end of 2017) and at low levels compared to EU peers. The insurance sector remains highly dependent on non-life insurance (in particular compulsory car insurance), which generated 79 % of the gross written premiums in 2017. Life insurance, the main driver of the insurance business in the EU, and household insurance have significantly lagged behind. The compulsory car insurance market (motor third party liability insurance) has been dominated by insurers subject in recent years to supervisory measures aimed at restoring compliance with solvency requirements. This market segment could benefit from further efforts to increase profitability, through cost-cutting measures and maintaining adequate levels of technical provisions, thus improving the insurers’ capacity to meet their obligations towards policyholders.

Access to finance Retained earnings and asset sales are the main sources of financing for Romanian companies. Access to finance, mainly to bank financing, does not represent a pressing issue for most Romanian companies. In fact, appetite for external financing of their operations is low. According to a recent survey (NBR, 2018b), Small and medium-sized enterprises resort to bank financing less than larger corporations (22 % vs 50 %). They also report lower rates of success in obtaining the full amount requested compared to large companies (19 % vs 44 %). The appetite of small and medium-sized enterprises for non-bank financing has also remained subdued, mainly due to their low level of financial education and burdensome (and often costly) administrative requirements. Loan demand from non-financial corporations has picked-up in Q2-2018. This trend continued in Q3-2018 and is estimated to have continued in the last quarter, albeit at a slower pace. Credit standards applicable to corporate loans tightened moderately in Q3-2018 following the introduction of macro-prudential measures by the National Bank of Romania. In contrast, credit standards for corporates in the euro area continued to ease in Q3-2018 (NBR, 2018c). Box 4.2.1: Second pension pillar in Romania Since 2008, Romania has had a three-pillar pension system, including a second pillar based on defined contributions. The first pillar is a mandatory pay-as-you-go scheme. The second pillar, also mandatory, is fully-funded and is run by private pension funds’ management companies. The third pillar consists of voluntary individual pension savings. As of end-November 2018, the seven second pillar funds were managing assets worth RON 48.2 billion (EUR 10.3 billion) for 7.2 million individual participants. Around 63 % of their assets were invested in government bonds, 19 % in equity and 8 % in deposits. While investment in government securities is close to the prudential and legal threshold, exposure to equity remains well below the 50 % maximum limit. Several government decisions undermine the viability of the second pension pillar. The contributions to the second pension pillar, which were to be progressively raised to 6 % of gross wages by 2016, were just 5.1 % by 2017 and have been reduced to 3.75 % in 2018. Moreover, government emergency ordinance 114/2018, adopted in December, made the second pillar optional, with employees now having the possibility to opt out after contributing for 5 years to the second pillar and transfer future contributions to the first pillar. The government emergency ordinance also significantly increased the minimum capital requirements for pension funds’ management companies and reduced the administration fee levied on gross contributions from 2.5 % to 1 %. As such, the funds’ management companies can retain only 0.2%, since 0.5% are transferred to the National Pension House and 0.3% to the Financial Supervisory Authority. These changes make the operating environment for pension funds’ management companies highly unpredictable, negatively affect their financial results, and increase the likelihood of their market exit. They also reinforce the overall perception of an unpredictable legislative environment. The short-term budgetary gain from the likely reduction of the transfers to the second-pension pillar will dissipate in the long-term while the retirement income will be less diversified. The second pillar is classified outside of the general government sector. Therefore, the reduction of transfers to the second pillar, following the likely opt-out of some employees entirely to the first pillar, will decrease the general government deficit in the short term. However, this budgetary gain would dissipate in the long term as the diverted social contributions would be accompanied by an obligation to pay the corresponding pensions in the future. Furthermore, the changes to the second pillar are likely to result in even less diversified retirement income and subject pensions to higher political and demographic risks. Past pension cuts and recent significant increases to the pension point have shown a tendency to depart from the statutory pension indexation formula. The weakening of the second pillar can hamper the development of the capital market. Second pillar funds have invested approximately RON 8.3 billion (c. EUR 1.8 billion) in shares, mainly domestic. This accounts for some 5 % of the market capitalisation of the Bucharest Stock Exchange. In 2016, they were among the top performers in the region (European Commission, 2018a). Direct comparison with the performance of the first pillar is not possible since payments under the first pillar are the result of a political rather than an investment decision. Pension funds can support developing capital markets and boost investment if the assets they manage are allowed to grow and the predictability of the legislative environment is conducive to long-term investments. Empirical literature points to a positive impact of second pillar pension funds on market capitalisation (Enache et al., 2015). The likely market exit of some pension funds due to the recently adopted measures could deprive the Romanian economy of a potential source of investment funding, thus curtailing further development of what is currently a rather small and undeveloped capital market. 4.3. Labour market, education and social policies 4.3.1.Labour market Employment is growing but labour shortages continue to increase on the back of economic expansion. The employment rate has increased steadily for the past 5 years reaching 65.5 % in 2017, above the pre-crisis level of 64.4 %. The unemployment rate of 3.8 % in December 2018, was the lowest in a decade, pointing to a tight labour market. Meanwhile, the country continues to face serious adverse demographics () due to fast ageing (), low birth rates and emigration. The contribution of labour to potential GDP remains low but positive, supported by the low unemployment rate and remaining untapped potential in the labour market. The continued emigration of the labour force challenges sustainable economic growth. In almost three decades Romania lost 23.3 % of its working-age population due to emigration (World Bank, 2018). The decrease in annual GDP growth due to emigration is estimated at 0.6 to 0.9 pps (IMF, 2016). Over 3 million people are estimated to have left the country, with the highest numbers leaving from the larger cities (Roman, 2018). Emigration from poor rural areas and of the young population (15-34 years old) is prominent in the Nord-Est and Sud-Muntenia regions (Roman, 2018). While the main drivers of emigration are higher wages, better working conditions and public services, in particular education and health (European Commission, 2018a), the emigration of people with higher education is also due to the low quality of public governance (IMF, 2016). Some measures aimed at reducing outward labour force migration were adopted in December 2018, notably in the construction sector, by exempting employees from income tax as of January 2019, for a period of 10 years and the adoption of a new specific minimum wage for the sector () (see Section 4.4). Internal labour market mobility schemes are used to address labour shortages, but barriers persist. Unemployment rates vary significantly across regions. The capital region and the metropolitan areas in the Vest and Nord-Vest are service-driven regions which offer better labour market opportunities and attract more qualified workers. In contrast, in the regions with a manufacturing economic base, the urban industrial centres attract mainly unqualified workers from the neighbouring rural areas (World Bank, 2017a). Although internal mobility schemes are in place and supported by a national mobility plan, their implementation is lagging behind. Potential beneficiaries complain about the administrative burden related to its implementation and the lack of an integrated solution for the unemployed (such as limited provision of social and education services for family members). Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights The European Pillar of Social Rights is designed as a compass for a renewed process of upward convergence towards better working and living conditions in the European Union ( II ). It sets out 20 essential principles and rights in the areas of equal opportunities and access to the labour market; fair working conditions; and social protection and inclusion. Romania still faces a significant number of challenges in the areas covered by the Social Scoreboard supporting the European Pillar of Social Rights. The country has one of the highest early school leaving rates and a high number of people living at risk of poverty or social exclusion. While labour market performance has improved, the overall inactivity and especially inactivity of women remain a concern. The available skills are not keeping up with the needs of the labour market and future work patterns. The lack of basic competences among the Roma and people in vulnerable situations do not allow them to fully benefit from economic expansion and to gain a foothold in the labour market. The design of social inclusion policies, the availability of social services and social transfers are still not fully effective at getting people out of poverty and lack an integrated approach combining employment, health and education measures. Significant challenges persist on equal opportunities and social protection. Inequality of opportunity persists in education, healthcare and access to social services, with rural areas dispr oportionately affected. Territorial coverage of existing social services is very uneven, and not correlated with communities’ needs. The lack of consistent evidence basis for policymaking and unpredictability of reform timelines are preventing effective im plementation and sustainability of results. Conversely, the de-institutionalisation of children shows some positive results. The coordinated approach linking legislative changes, adequate funding mechanisms and support to the local authorities is showing its first results. The shift towards community-based support is accompanied by individualised assessment of children’s needs while capacity-building activities are being developed to support municipalities. Additional efforts are still needed to ensure the availability of foster families across the country and to improve and professionalise their care competences.

The activity rate of women is low despite the overall positive economic conditions. The activity rate of women aged 20 to 64 is 63.7 % (20 pps below that of men). The situation is particularly critical for young and middle-aged women whose inactivity rate is 5 pps above the EU average (), mainly due to personal and family responsibilities () (Graph 4.3.1). This is primarily due to low participation of children aged 0-3 in formal childcare (15.7 % in 2017). The lack of efficient measures to promote an early return of women to the labour market further aggravates the situation. Regions such as Centru, Sud-Est and Vest have female employment rates below 50 % (). Further investments in childcare facilities could increase the labour market participation of women. Graph 4.3.1:Inactive female population by reason for inactivity Source: European Commission The number of young people neither in education, employment or training is steadily decreasing. The share of young people neither in education, employment or training stood at 15.2 % in 2017, down from 18.1 % in 2015 and 17.4 % in 2016, but is still among the highest in the EU. Implementation of the Youth Guarantee shows some signs of improvement. The proportion of beneficiaries taking up an offer within the 4-month target has increased significantly from 25.9 % in 2016 to 40.2 % in 2017. However, the Youth Guarantee coverage of the young people neither in education, employment or training is poor (only 14 % of this group aged 15-24 are registered). This points to the limited outreach measures implemented so far and to ineffective coordination between the education, employment and social sectors. In the meantime, emigration remains very high among young people, with Romania being one of the EU countries with the highest numbers of emigrants aged 15 to 24 (European Commission, 2018b). Access to the labour market is particularly challenging for certain social categories. The share of long-term unemployment in total unemployment declined from 50 % in 2016 to 41.4 % in 2017. However, a large part of the people in this group either remain unemployed (73.2 %) or fall into inactivity (13.2 %), with only about one in eight (12.3 %) being registered with the public employment service, one of the lowest registration rates in the EU. At the same time, the employment rate for people with disabilities (43.5 %) is slightly below the EU average (48.1 %). The labour market participation of people with low educational attainment, which also include persons from the Roma community, is low, as only 46 % of them are active (Graph 4.3.2). Measures co-financed by the European Social Fund such as targeted employment subsidies and job coaching are planned but their implementation is delayed.

Graph 4.3.2:Activity and employment rates for selected groups Source: European Commission Active labour market policies provide a limited response to the labour market needs. The measures in place still focus mainly on financial incentives for companies rather than on tailor-made approaches addressing the comprehensive needs of the unemployed, notably upskilling and integrated services delivery. Despite the increase in the amount of subsidies for employers who hire young people neither in education, employment or training and other vulnerable groups, the take-up of the measures is slow, pointing to a limited evidence- base behind this policy. Nevertheless, the measure for unemployed people aged over 45 and single parents () shows some positive results. The excessive administrative burden associated with accessing labour market measures remains unaddressed. The planned reform of the public employment service has been significantly delayed. The public employment service has a very limited case management approach. The lack of integration of employment, social and education services and the ineffective cooperation with employers remain important barriers. The accumulated delay in the implementation of the European Social Fund co-financed measures is undermining the service’s effectiveness as a broker in the labour market delivering services for employers and the unemployed. Wage increases are large, particularly in the public sector. After years of moderate wage growth, Romania displays one of the fastest wage increases in the EU, strong even for a catching up economy faced with high poverty rates. Between 2011 and 2015, nominal compensation per employee grew at an annual average rate of 3.5 %, below productivity. This relationship reversed in 2016, when compensation per employee increased by 15 % (Graph 4.3.3). Subsequent increases of 12.3 % in 2017 and an estimated 13 % in 2018 are much faster than the pace consistent with an unchanged real effective exchange rate or expected based on inflation, productivity growth and unemployment. Gross wage growth was mainly driven by the public sector (see Section 4.4.1). The minimum wage was increased again in January 2019 without an objective mechanism. A government decision issued in December 2018 increased the minimum wage from RON 1 900 (EUR 413) to RON 2 080 (EUR 450) from January 2019. Moreover, a higher minimum wage of RON 2 350 (about EUR 510) was introduced for people with a university degree and, in a subsequent emergency ordinance, an even higher level of RON 3 000 (EUR 652) for workers in the construction sector. Previous ad hoc increases of the minimum wage resulted in one in three employees earning the minimum wage in 2017, a rate almost four times higher than in 2011 (Romanian Labour Inspectorate) (). Graph 4.3.3:Productivity and labour costs (GDP deflator) Source: European Commission Skills are not evolving in line with the needs of expanding economic sectors. 81 % of employers declare having difficulties filling job vacancies The hardest profiles to fill in are electricians, welders, mechanics and engineers in the chemical, electrical, civil and mechanics sectors (Manpower, 2018). The ICT sector is growing, also based on the development of specialised business clusters i.e. in the Cluj county area, and it represents a valuable future economic potential. However, the number of Romanians aged 20-29 holding a science, technology, engineering and mathematics degree fell from 16.6 per 1 000 individuals in 2014 to 14.4 in 2016 (19.1 in the EU). The available IT skills are not keeping up with the emergence of IT hubs, as only 29 % of individuals have basic or above basic digital skills (European Commission, 2018k). Skill mismatch represents an additional challenge for Romanian firms (EIB, 2018). The upskilling of the labour force would benefit from a comprehensive approach. At present there is neither a global assessment available of skills needs nor one at economic sector level. The labour market relevance of vocational education and training is limited. Some steps have been taken to recognise learning outside formal education and training and to steer the new dual vocational education and training system (see Section 4.3.3), yet important challenges remain. Other important barriers are: (i) the limited offer of non-formal education and training; (ii) limited participation in vocational qualifications' programmes for people with a low level of qualifications; (iii) insufficient coordination between stakeholders; and (iv) insufficient system monitoring, quality assurance and staff training. Collective agreements coverage is low, particularly at sector level. According to national authorities, around 15 % of employees were covered by collective agreements in 2017. The current delineation of sectors does not facilitate collective bargaining at sector level and only one agreement at this level was in force in 2017. In 24 out of the 30 industrial sectors there is no complete representation of social partners able to negotiate a collective agreement. The authorities have initiated plans to revise the definitions of economic sectors but no agreement has been reached yet. Trade unions consider that employee representatives, who signed 8 out of 10 existing collective agreements, were not selected through a transparent procedure. Social dialogue is insufficiently used for engaging social partners on policy issues and reforms in a timely and meaningful manner. Beyond the collective bargaining framework, social partners do not enter into a voluntary dialogue to improve labour market conditions. Most social dialogue takes place formally, within the Economic and Social Council and the Social Dialogue Committees. Despite the established framework of dialogue and consultations, the stability and the role of these institutions has weakened over the last year. 4.3.2.Social policies The poverty rate decreased in 2017 but remains very high. One in three Romanians are still at risk of poverty and social exclusion. Despite a decline of 2 pps compared to 2016, monetary poverty is one of the highest in the EU, affecting 23.6 % of the total population in 2017. The main drivers of poverty are inactivity, low education attainment, intergenerational transmission of poverty and lack of inter-regional mobility. Poverty and social exclusion levels in rural areas are more than twice as high as those in cities (Graph 4.3.4). Vulnerable groups in rural areas (children, people with disabilities, members of the Roma community and the elderly) face particularly high poverty rates. Moreover, the country has the highest rate of in-work poverty in the EU (17.4 %). Income inequality remains high, with regional and gender gaps. Despite a considerable decrease since peaking in 2015, income inequality remains well above the EU average. As shown in the Social Scoreboard accompanying the European Pillar of Social Rights, the income of the top 20 % of the population exceeds by 6.5 times the incomes of the bottom 20 % (EU: 5.1) (Eurostat). High income inequality levels are experienced particularly within the working-age population, and can be attributed more to the poorer being relatively poorer rather than the richer getting relatively richer. The rate of in-work poverty is five times higher for low-educated workers than for university graduates. Men are more exposed to this risk than women. However women are twice as likely as men to be inactive (see Section 4.3.1). Graph 4.3.4:People at risk of poverty or social exclusion by degree of urbanisation Source: European Commission Children living in poverty are more likely to remain poor in their adult life due to inequalities of opportunity. Romania has the highest share of children living in poverty in the EU. The poverty risk for children is indirectly correlated with parents' education level, and this correlation grew stronger in 2017. Moreover, due to shortcomings in the education and health systems, children born today are set to enter the labour market with only 60 % of their real potential, the lowest level in the EU (). Compared to the EU average, families with low incomes report higher difficulties in affording education for their children. The existing offer of public services and the education system do not manage to address this challenge. Growing inequalities of opportunities also affect other vulnerable groups such as young adults and the Roma community. People with disabilities have limited support to achieve independent living and access employment. Care for people with disabilities is mainly focused on providing medical assistance rather than enabling independent active living. Children in this group have limited access to pre-school facilities and drop out of school twice as often as other children. The education system does not prepare them sufficiently for an independent life. Employment quotas have been set to boost employment of people with disabilities, but this reform has not been matched with sufficient and targeted active labour market policies. The lack of synergies between the relevant benefits and the community-based social and employment services aggravates the situation further. A dedicated European Social Fund co-financed project aiming to increase the employability of people with disabilities is under preparation. Preparing the deinstitutionalisation of adults with disabilities is just starting, with the first visible results expected for 2021. The situation of the Roma community shows very little progress. The living conditions of part of the Roma community are characterised by informal, unhygienic and irregular settlements. Eight in ten Roma live in a house without running water and only one in two has medical insurance. Lack of identification documents and/or property deeds precludes some Roma from accessing public services and claiming their rights. Implementing the National Roma Inclusion Strategy is being hampered by the fact that coordination between line ministries is not always a priority. The implementation of the National Roma Platform is still pending. Several Roma inclusion projects through integrated measures, co-financed by the European Social Fund, are under implementation. Sustainability of the measures is, however, challenging as the existing projects are fragmented and rely heavily on external funding. According to the European Pillar of Social Rights, social transfers have a low impact on reducing poverty and income inequality. Government spending on social transfers is low (Graph 4.3.5). This contributes to the overall low impact of the tax and benefit system on income inequality (Graph 4.1.3). The social reference index used as a basis for most social benefits has not been updated since its introduction in 2008. It also depreciated considerably in relation to the minimum wage from being almost equal to it in 2008 to roughly five times lower in 2018. As a result, poverty rates for people with low and very low work intensity increased by half since 2010. The impact of social transfers on reducing income inequality is also low. Graph 4.3.5:Redistributive power of social transfers Source: European Commission The minimum inclusion income reform is not yet completed. The minimum income benefit in Romania is among the least sufficient in the EU (). A law adopted in 2016 is designed to increase coverage and adequacy of benefits and to pair them with activation mea