October 9 (SeeNews) - Standard & Poor's maintained Romania's rating at BBB-/A-3, with a stable outlook, and said that the country's budget and trade deficits will widen due to the consumption-focused growth.
"Romania's procyclical budgetary stance is amplifying wage pressures in an already overheating economy. While wage convergence is desirable, pay increases that significantly outpace underlying productivity have historically led to boom-bust cycles," S&P said in a statement on Saturday.
S&P also said it expects the consumption-focused growth to generate wider fiscal and external deficits, increasing the economy's vulnerability to an abrupt downturn over the medium term, though public and external debt is modest.
The stable outlook reflects the analysts' view that general government and external debt is likely to increase only gradually over the coming two years, S&P added.
S&P last reviewed Romania's rating on April 7, 2016, when it affirmed it at BBB-, with a stable outlook and also warned on excessive fiscal loosening.
In July, Fitch Ratings affirmed Romania's long-term foreign and local currency issuer default ratings (IDR) at 'BBB-', with stable outlooks, but warned on a growing budget deficit and economy overheating.
In April, Moody's Investors Service has changed the outlook on Romania's Baa3 government bond rating to stable from positive due to deterioration in public finance and debt outlook for government of Romania.
In March, Japan Credit Rating Agency (JCRA) has affirmed the outlook on Romania's long-term government debt in foreign currency and local currency to BBB/BBB+ stable.
Standard & Poor's also said in the statement:
"RATING ACTION
On Oct. 6, 2017, S&P Global Ratings affirmed its 'BBB-/A-3' long- and short-term foreign and local currency sovereign credit ratings on Romania. The outlook is stable.
OUTLOOK
The stable outlook reflects our expectation that while Romania's twin deficits will widen as a result of the government's procyclical fiscal stance, general government and external debt will increase only gradually in the coming years--barring a major economic slowdown.
We could raise the ratings if Romania's government made more sustained headway with budgetary consolidation and put net general government debt firmly on a downward trajectory, including by successful restructuring or privatization of public enterprises; and if Romania's governance framework improved, translating into more predictable and stable macroeconomic growth and government finances.
We could lower the ratings on Romania if we considered that policy reversals could cause general government deficits, debt, and borrowing costs to deteriorate significantly. Moreover, we would consider a negative rating action if Romania's external imbalances re-emerged, in particular if an uncertain political environment led to lower foreign direct investment (FDI) inflows, implying that Romania's widening current account deficit would increasingly have to be financed with debt-creating inflows.
RATIONALE
The ratings are supported by Romania's moderate external and government debt, amid strong growth prospects. However, we estimate Romania's GDP per capita at just over $10,000 in 2017, the second-lowest in the EU. Low income and wealth levels therefore constrain the rating, alongside Romania's widening budget deficit and its weak institutional and governance effectiveness and continued political uncertainty.
Institutional and Economic Profile: A booming economy is weathering political volatility
Romania's economy is booming amid continued fiscal stimulus and a favorable external environment. During the first half of 2017, consumption was by far the largest contributor to GDP, while net exports detracted from growth (by 1.4 percentage points of GDP during second-quarter 2017).
The political environment remains volatile. Structural reform efforts remain weak, while fiscal policy is expedient and consumption focused.
A reversion to a loose fiscal policy stance amid a favorable external environment and pent-up demand is likely to make Romania the fastest-growing economy in the EU during 2017, according to our forecasts. We expect real economic growth will reach 5.5% this year, supported by strong consumption growth on the back of lower unemployment and, more importantly, strong wage increases and tax cuts that have lifted disposable incomes.
Given high levels of net emigration, wage increases are one means of retaining skilled workers; hourly industrial and service sector labor costs in Romania averaged €5.50 in 2016, according to Eurostat's estimate, the second-lowest in the EU after Bulgaria, and less than one-fifth of euro area labor costs. Nevertheless, despite the low starting point, recurrent double-digit increases well above productivity levels could put at risk Romania's strong gains in competitiveness over the past 10 years.
This year, public sector wages and the minimum wage have again increased by double digits, while the government reduced the standard value-added-tax (VAT) rate to 19% from 20%. Further public sector wage increases, which in turn will put upward pressure on private sector wages, will continue to support consumption growth in 2018. While export growth should remain strong over our forecast horizon to year-end 2020, import growth has overtaken export growth during 2017. The transport and information and communications technologies sectors continue to perform well, while we observe some diversification toward service sector exports in the tourism sector, as well. Lastly, we expect private sector investments will offset the drag from public sector investments this year, leading to positive investment growth. Overall, Romania's average per capita growth exceeds that of its peers. However, we expect this momentum to be transitory, albeit fairly long lasting, given that the increased absorption of EU funds should bolster solid investment growth--leading to average real GDP growth of close to 4% over 2018-2020.
That said, continued uncertainty regarding fiscal and macroeconomic policies and potential changes to the judiciary represent a downside risk to our growth forecast. On the institutional front, the government backtracked from an earlier emergency ordinance that decriminalized potentially corrupt behavior by public officials after public protests and objections from the country's resident and judicial institutions. Still, we note that draft laws are under discussion by parliament that could transfer important tasks, such as appointing chief prosecutors and the head of the anti-corruption agency (DNA) or judicial inspections to the Minister of Justice, thus opening the door to a politicization of the process. Currently, these tasks are carried out by the independent Superior Council of Magistracy, a body consisting of 19 members from the judiciary and executive branch, as well as from civil society. We note positively the progress Romania has made in its anti-corruption efforts over previous years, not least because of the work by the DNA, but see a risk that some of this progress will be reversed should these bills pass.
Moreover, the no-confidence vote against the first Social Democratic Party-led government under Prime Minister Grindeanu, brought forward by his own party and ultimately leading to his ousting, highlights the still-volatile political environment. This volatility is further underlined by the lack of visibility on future fiscal policies, which restricts the private sector's ability to make long-term investment and strategic plans. While the government has already decided on a further 25% wage hike in the public sector, it is currently debating a range of other measures, such as shifting all social security contributions to employees. Moreover, a proposed corporate turnover tax and a higher band of income tax had to be scrapped shortly after they were announced this summer, after strong protests from the business community. To some extent, this volatility distracts the government from pursuing more important reforms, such as improving the country's infrastructure or reforming the health and education sector. In the medium term, these structural factors could weigh on growth and act as a deterrent for foreign investors.
Flexibility and Performance Profile: Widening twin deficits amid remaining fiscal and external buffers
Public finances remain heavily dominated by fiscal loosening measures, including wage increases and tax cuts.
The current account deficit is widening, and we expect that external deleveraging is likely to come to an end shortly, as we forecast the current account deficit will widen beyond 4% of GDP from next year (though much of this will be funded by a capital account surplus and buoyant net FDI).
Inflation is gradually moving back into the central bank's target range and will move toward its upper target range by next year.
As a result of continuous fiscal easing, we expect the fiscal deficit will stay elevated this year and may even surpass the 3% of GDP deficit target set out by the EU's Maastricht criteria, a degree of stimulus that is partly masked by expected nominal GDP growth of 7.3% this year and next. Although we note the authorities' commitment to stay at or below 3%, we forecast a deficit of 3.1% due to a slightly lower growth forecast; in any case, our projections reflect the government's track record of spending windfall revenues primarily on public wage increases (including for state-owned enterprises [SOEs]), a tendency that is reminiscent of large real increases in the net wage bill of the general government sector, including SOEs, in 2002-2005.
At the same time, we flag some measures the government has already implemented to remain around the 3% fiscal deficit level in 2017, which in our view are not sustainable. First, the government has repeatedly asked SOEs for dividend payments to the state budget, including from the companies' reserve buffers. Second, during the budget revision this summer, the government reversed a cut in fuel excises that was implemented at the beginning of the year. Third, as in previous years, the government continues to underspend on capital expenditures. Moreover, the government has already announced further fiscal easing measures for 2018, including further wage and pension increases. As a result, we forecast a deficit of 3.5% of GDP in 2018 that will only gradually narrow to about 3.1% in 2020. Romania continues to post the largest VAT gap--the difference between VAT owed and VAT collected--in the EU according to data from the European Commission. In the first half on 2017, despite very strong and tax-rich consumption growth, VAT revenues actually declined compared with 2016. While some of this trend can be explained by the reduction of the standard VAT rate, it also shows the failure to address Romania's large VAT gap. Closing this gap will be key to ensuring the sustainability of public finances in the medium term.
In line with our deficit forecast, we also expect Romania's general government debt to continue to increase gradually. While still modest in an EU comparison, we forecast Romania's debt will surpass 40% of GDP by 2020. Moreover, its debt profile remains constrained by a relatively high share of foreign currency-denominated debt, as well as the domestic banking sector's high exposure to the government. Should the government decide to lower contribution rates to the second pension pillar or make these contributions optional, it could affect the sovereign's ability to refinance itself on the domestic market, given the banks' already high exposure to the government. We note positively, however, that domestic auctions are frequently oversubscribed, which could mitigate the impact of lower demand from second pillar pension funds. Moreover, the government continues to cover a large part of its financing needs on the domestic market at low yields--the average yield on five-year bonds is currently 2.47%--and at long maturities. Lastly, the government maintains a hard currency buffer covering four months of gross financing needs, which provides an additional safeguard during periods of market turbulence. We do not expect any significant impact on government debt from potential privatizations in the medium term. The Romanian government is in the process of setting up the so-called Sovereign Development and Investment Fund (FSDI). According to draft legislation that is currently being publicly debated, the fund will pool the state's shares in a number of SOEs, such as Hidroelectrica, and is supposed to more efficiently carry out and finance larger investment projects. Together, with a to-be-established development bank, it could give a boost to investments. The government aims to create the FSDI outside the general government sector as defined by the European system of national and regional accounts (ESA).
Strong and increasing domestic demand and rising import prices will also have a negative impact on Romania's current account balance in our view, notwithstanding strong export growth. We forecast an average current account deficit just above 4% of GDP over our forecast horizon, significantly higher than the 1.3% average over 2013-2016. Still, we expect that this current account deficit will remain overfunded by surpluses on the capital and financial account as EU fund absorption accelerates and FDI remains steady. That said, we expect that the strongly improving trend of Romania's external debt metrics over the past seven years will slow down. Over our forecast through 2020, gross external financing needs will gradually increase toward 100% of current account receipts (CARs) and usable reserves, while narrow net external debt could climb above 30% of CARs.
Overall, Romania's predominantly foreign-owned banking sector remains sound, since the system's loan-to-deposit ratio declined to just over 80% at end-2016, down from its peak of 137% in 2008. Liquidity and solvency ratios remain strong. Moreover, banks have maintained their profitability, and overall lending growth has remained positive, with loans to households and loans denominated in Romanian leu growing particularly strongly, so that the share of foreign currency loans declined further to less than 43% of total loans at end-2016, down from almost 64% in 2011. Credit growth is particularly driven by mortgage loans that benefit from the government's Prima Casa program, designed to support first-time homebuyers through a 50% guarantee by the government. Nonperforming loans declined further to 8.3% of total loans by mid-year 2017 from 9.5% at year-end 2016.
Romania continues to operate a managed float of the Romanian leu under an inflation-targeting regime. While inflation has remained outside the National Bank of Romania's (NBR's) target band for the past three years, we expect it will gradually increase and reach the upper end of the target by year-end 2018. The fading out of the effects from cuts to administered prices and imported prices, paired with strong wage growth, should drive up inflation."
1 euro=4.5775 lei