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Fitch affirms Romania at 'BBB-', outlook stable, warns on growing budget gap

Fitch affirms Romania at 'BBB-', outlook stable, warns on growing budget gap Fitch Ratings Romania

BUCHAREST (Romania), November 9 (SeeNews) - Fitch Ratings said it has affirmed Romania's long-term foreign and local currency issuer default ratings (IDR) at 'BBB-', with stable outlooks, but warned that keeping 2019 budget deficit under 3% would require ad-hoc adjustments.

The issue ratings on Romania's senior unsecured foreign and local currency bonds have also been affirmed at 'BBB-'/F3, while the country ceiling has been affirmed at 'BBB+' and the short-term foreign currency IDR at 'F3', the rating agency said in a statement on Friday evening.

Fitch said that Romania's investment-grade ratings are supported by moderate levels of government debt, and GDP per capita and human development indicators that are above 'BBB' category peers. These are balanced against twin budget and current accounts deficits, reflecting pro-cyclical fiscal policy that poses risks to macroeconomic stability, and net external indebtedness that is higher than its rating peers, it added.

The ratings agency said that the structure of the deficit is increasingly rigid, as almost two-thirds of expenditure comprises wages and social transfers, while efforts to increase tax efficiency have been unsuccessful. 

"We believe there is still scope for the deficit to be only slightly above 3% of GDP deficit by end-2019 (and therefore avoid the Excessive Deficit Procedure), but this would require ad-hoc adjustments, which will not represent structural improvements in fiscal accounts," Fitch warned.

In a separate statement published on Saturday, Romania's finance ministry said that Fitch's decision to affirm ratings was supported both by the moderate level of public debt, which is much lower than the level of 40% of the countries in the same rating category with Romania, but also by the positive evolution of GDP per capita.

"In the following period, the finance ministry's efforts will focus on implementing the budgetary rectification and on the construction of the 2020 budget, which we consider absolutely necessary for strengthening macroeconomic stability," Romania's finance minister Florin City said.

Fitch last reviewed Romania in May, when it affirmed Romania's IDR at 'BBB-', with stable outlook, but warned that 2019 budget relies on unrealistic macroeconomic assumptions.

Romania's 2019 budget is built on projections for 5.5% economic growth and deficit equivalent to 2.76% of GDP.

Fitch also said in the statement:

"KEY RATING DRIVERS
Romania's investment-grade ratings are supported by moderate levels of government debt, and GDP per capita and human development indicators that are above 'BBB' category peers. These are balanced against twin budget and current accounts deficits, reflecting pro-cyclical fiscal policy that poses risks to macroeconomic stability, and net external indebtedness that is higher than its rating peers.

The toppling of the PSD government in October has raised political and policy uncertainty at a time when fiscal and external metrics are weakening. The centre-right PNL managed to form a government in early November but with less than one-quarter of the seats in parliament it will have to rely on support for smaller parties with divergent policy interest to implement legislation. A busy electoral calendar--presidential elections will be held in November, local elections in June 2020 and the next parliamentary elections should take place in 4Q20 or 1Q21--further complicates the outlook, as parties are unlikely to agree to major corrective economic measures. Vying for voter support could result in political paralysis. Early elections could provide a clearer mandate for reform, but agreeing to them will also prove challenging.

In the current political context, Fitch's baseline scenario is of a further gradual weakening of the public finances over the short to medium term. The general budget deficit reached 2.6% of GDP in January-September 2019 (compared with 1.8%, 0.8% and 0.5% in the same period in 2018, 2017 and 2016, respectively), with expenditure increasing by 15.3% yoy in the period on the back of higher personnel, transfers and capital spending. Moreover, the structure of the deficit is increasingly rigid (almost two-thirds of expenditure comprises wages and social transfers) while efforts to increase tax efficiency have been unsuccessful. We believe there is still scope for the deficit to be only slightly above 3% of GDP deficit by end-2019 (and therefore avoid the Excessive Deficit Procedure), but this would require ad-hoc adjustments, which will not represent structural improvements in fiscal accounts.

The fiscal outlook will become significantly more challenging in 2020-2021 given a weaker macro backdrop and already legislated pension hikes (leading to an annual average pension increase of 24% in 2020 and 26% in 2021). Fitch expects the deficit to widen to 4% of GDP by 2021, assuming that some offsetting measures to the pension increase are found (including potentially a delay or moderation of the pension measures, changes to discretionary expenditure, one-off revenue measures). This would push public debt levels to 38% of GDP in 2021 (from 35% in 2018), still below the current 'BBB' median of 40%. Failure to put corrective fiscal measures in place constitutes a key downside risk to the forecasts and Romania's rating. According to the IMF, under a no-offsetting policy scenario, the pension increase would add 3.2% of GDP to expenditure by 2022 and could lead to public debt increasing by 20pp by 2024.

The current account deficit (CAD) remains under pressure from weakening external demand and strong import growth underpinned largely by expansionary fiscal policies. On a 12-month rolling basis the CAD has been close to 5% of GDP since May, driven by increasing trade deficit (up 23% yoy in January August). Fitch expects the deficit to remain around 5% of GDP during the forecast period (compared with the current 'BBB' median of 1%), assuming no sharp fiscal deterioration and a gradual recovery in external demand by 2021.

Non-debt creating inflows (net equity FDI and capital transfers) covered only 74% of the CAD in 2018 and we expect coverage to fall to 60% in 2019-2021 as FDI inflows remain stagnant. This will lead to a modest widening of Romania's net external debt position to 18% of GDP by 2021 from 15.2% in 2018 and compared with the current 'BBB' net external position of 7.5%. On the positive side, the country maintains adequate foreign reserve coverage (over four months of current external payments coverage) and a relatively flexible exchange rate that serve as buffers to external volatility.

Fitch continues to forecast a gradual slowdown in economic activity over the next two years, although a stronger investment performance in 1H19 has led us to revise our 2019-2021 growth forecasts to 3.5% (from 3.1% previously and above the current peer median of 3%). Private consumption will remain the key growth driver in the forecast, albeit at a lesser pace as wages moderate from recent highs (gross average wages rose by 14% in January-August). Although volatile, investment will be supported by rising EU fund absorption, as was the case in the previous financing cycle.

External dynamics represent the main downside risk to growth. Weaker external demand, particularly in Germany (Romania's main trading partner) has had a clear negative effect on overall export performance and in industrial sector activity. Industrial output has declined since March in yoy terms, with the August print (latest available data) the weakest in almost nine years. A more pronounced or prolonged deterioration could start to spill over to other segments, contributing to further GDP slowdown.

Recent CPI data point to ongoing pressure from domestic factors but risks of sharply higher inflation are low, with inflation moderating to 3.50% in September from a high of 4.12% in July. Underlying trends suggest a gradual easing of inflation in the coming quarters, but this will depend in part on adjustments to administrative prices. Fitch currently expects inflation to average 3.4% in 2020-2021, within the upper limit of the National Bank of Romania inflation target (2.5% plus minus 1.0%).

Romania's banking sector remains sound, with high levels of capital adequacy (19.6% in June) and liquidity. The credit cycle appears moderate in the context of very rapid economic growth in recent years, with lending growth to private sector remaining broadly flat in 3Q (around 7% yoy). The ratio of non-performing loans is at a 10-year low (4.6% in June) while household and corporate indebtedness are well below the EU average.

Romania's percentile rankings in the World Bank's composite governance indicator are broadly in line with the 'BBB' range median, although they have fallen in recent years, in particular in terms of government effectiveness. Weak institutions and erratic policymaking have halted structural reforms and limited investment, while concerns surrounding corruption cases affecting top public officials and controversial judicial measures have fuelled political and social tensions. A new political backdrop could help reverse the deterioration but addressing institutional weaknesses will take time.

ESG CONSIDERATIONS
- Romania has an ESG Relevance Score of 4 for Human Rights and Political Freedoms as World Bank Governance Indicators have the highest weight in Fitch's Sovereign Rating Model (SRM) and are therefore relevant to the rating and a rating driver.
- Romania has an ESG Relevance Score of 5 for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and a key rating driver with a high weight.
- Romania has an ESG Relevance Score of 5 for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and a key rating driver with a high weight.
- Romania has an ESG Relevance Score of 4 for Creditors Rights as willingness to service and repay debt is relevant to the rating and a rating driver, as for all sovereigns.

SRM and QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Romania a score equivalent to a rating of 'BBB+' on the Long-Term Foreign-Currency (LT FC) IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
- Macroeconomics:-1 notch, to reflect the risk of macroeconomic instability posed by pro-cyclical and /or unpredictable fiscal and wage policies, and a position in the economic cycle that has boosted some economic variables beyond sustainable levels and flattering Romania's SRM output.
- External Finances:-1 notch, to reflect Romania's higher net external debtor and net investment liabilities positions than the 'BBB' range median, as well as its widening CAD.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES
The main factors that could, individually or collectively, lead to positive rating action are:
-Reduced risks of macroeconomic instability and improved macroeconomic policy credibility
-Implementation of fiscal consolidation that improves the long-term trajectory of public debt/GDP
-Sustained improvement in external finances

The main factors that could, individually or collectively, trigger negative rating action are:
- Reduced confidence in policymakers' ability to avoid higher-than-projected fiscal deficits, or adverse policy actions that leads to a rapid increase in government deficits and debt/GDP
-An overheating of the economy or hard landing that undermines macroeconomic stability
-A sharp deterioration in the balance of payments

KEY ASSUMPTIONS
Fitch assumes Romania's main economic partners in the EU will grow in line with its September 2019 forecasts in the Global Economic Outlook.

The full list of rating actions is as follows:
Long-Term Foreign-Currency IDR affirmed at 'BBB-'; Outlook Stable
Long-Term Local-Currency IDR affirmed at 'BBB-'; Outlook Stable
Short-Term Foreign-Currency IDR affirmed at 'F3'
Short-Term Local-Currency IDR affirmed at 'F3'
Country Ceiling affirmed at 'BBB+'
Issue ratings on long-term senior unsecured debt affirmed at 'BBB-'"

(1 euro=4.7615 lei)

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