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S&P Global Ratings revises outlook on Romania to stable from negative, affirms ratings at BBB-/A-3

S&P Global Ratings revises outlook on Romania to stable from negative, affirms ratings at BBB-/A-3 credit rating

BUCHAREST (Romania), April 17 (SeeNews) - Standard & Poor's said that it has revised the outlook on Romania to stable from negative due to decreasing fiscal risks, while maintaining rating at BBB-/A-3.

The stable outlook indicates that the government's fiscal consolidation agenda is perceived as credible and that Romania's public and external finances is seen stabilizing over the next two years, S&P said in a press release on Friday evening.

In the agency's view, risks from Romania's still-elevated twin deficits are mitigated by the prospect of sizable EU funds deployment, the government's stated reform ambitions, and a return to economic growth.

After contracting by a modest 3.9% in 2020, S&P expect Romania's economy to rebound by a solid 5% this year, based on EU-funded investment and the return of domestic demand.

S&P could lower the ratings if Romania's efforts to rebalance its budget endanger the consolidation of its fiscal and external finances or if financing for the country's twin deficits is oriented toward debt-creating foreign flows, signaling an inability to absorb EU funding sources and restore foreign direct investment (FDI) flows.

The agency said it could raise ratings if reforms strengthened Romania's institutional arrangements, giving it a more-robust fiscal framework and limiting the potential for costly policy reversals. "Aside from making Romania's fiscal design more predictable, these reforms would likely revitalize foreign investor interest in Romania's real economy and thus make the sovereign less externally fragile," S&P noted.

In a statement issued shortly after S&P's press release, Romania's finance minister Alexandru Nazare said the improved outlook is a proof of international recognition for Romania's efforts to ensure fiscal consolidation and confirms that the measures taken so far were the right ones.

"The finance ministry will continue to take steps in order to implement measures aimed at eliminating the negative effects of the Covid-19 pandemic and to boost economic recovery, while continuing its prudent fiscal-budgetary policy," Alexandru Nazare added.

S&P also said in the statement:

"Rationale

We revised the outlook to stable because we believe Romania's short-term fiscal risks have abated. The government, led by the Liberal party that assumed office after the December general election, has rolled back costly pension hikes that had previously been legislated. It has also charted a consolidation course that we consider will ensure that Romania's government and external debt stocks remain moderate through 2024.

We expect the government's fiscal efforts will be supported by an economic rally. Romania's economy demonstrated resilience in 2020, when it contracted by a relatively modest 3.9%. We forecast that it will return to pre-pandemic levels in 2021, when it is predicted to grow by 5%.

Rebuilding the economy after the pandemic shock will depend on EU-funded investments--Romania is a key beneficiary of the grants from the EU's Recovery and Resilience Facility (RRF). The country has a comparatively weak record of absorbing EU funds but we consider even an absorption rate of around 50%, in line with the 2014-2020 program period, would offer material benefits.

The ratings are supported by Romania's solid access to external financing markets. Its EU membership constitutes a key policy anchor and benefits the country's institutional framework.

Institutional and economic profile: New government has defused near-term fiscal risks and the reform window is now open until 2024, which is a super election year

We expect Romania's economic growth to average a solid 5% in 2021-2022 as investments bolster activity and consumption normalizes.
EU funds absorption will be key to the government's multiyear investment plan.
We expect the recently instated government to front-load reforms to 2021-2022.

Romania's economy contracted by 3.9% in real terms in 2020, a mild outturn by regional standards. It outperformed our previous expectation of a 5.2% decline. In particular, in the fourth quarter of 2020, Romania's quarter-on-quarter growth was the highest in the EU, at 4.8%. We anticipate that this growth will continue into 2021. The construction sector absorbed much of the pandemic shock in 2020; it expanded by almost 20% compared with 2019, supported by well-calibrated government support schemes for private construction and continued public investment.

We expect Romanian output to expand by 5% in 2021 and remain steady in 2022-2023, based on a recovery in private consumption and an uptick in investments, especially within the public sphere. The latter will be supported by the government's multiyear infrastructure plan, under which public spending is to increase by 15% in 2021. This will boost the investment-to-GDP ratio to a historical high of 5.5%.

For the government, successfully executing its investment ambitions will depend on its ability to absorb the plentiful EU funds designated for Romania. We see the country's comparatively weak historical absorption rate of EU funds as a downside risk. Romania is one of the key beneficiaries of the structural funds designated under the EU's upcoming Multiannual Framework, alongside the newly created EU Recovery and Resilience Fund (RRF). The grants portion alone, under the RRF, equals about 6.5% of GDP, on top of RRF loans of about 7.0% of GDP, which unlock access to cheap financing. To access the EU funds, Romania will need to design eligible projects and implement the accompanying reform agenda. At year-end 2020, Romania had absorbed 50% of the total EU budget allocated to it during the 2014-2020 programming period.

Our economic forecast remains sensitive to the still-evolving situation regarding the pandemic, and to possible delays in vaccination roll-out. In particular, success in administering immunization programs, both domestically and abroad, will determine the extent to which Romania's economy can reopen. On this front, Romania's vaccination campaign has performed relatively well. Its current vaccination rate is largely on par with the EU average. The country aims to have 70% of the population immunized by September 2021.

Romania completed term elections in December 2020, after which a three-party coalition led by the Liberal Party (PNL) formed a government that has the backing of 52.4% of the parliament. Since assuming office, the PNL-led government has taken decisive steps to control the spending trajectory, which had suffered from previous policy choices. Efforts include freezing public sector wages and bonuses--we estimate this will result in budgetary savings of about 2% of GDP.

Importantly, government has defused near-term fiscal risks by rolling back, through emergency ordinance, legislation passed by the previous administration that would have hiked pensions. We understand that the PNL-led government aims to present legislation that more clearly charts the fiscal framework regarding future wage and pension increases, by the end of this year.

Despite a recent flare-up of intracoalition tensions, stemming from the prime minister's dismissal of the USR-Plus tied health minister, we expect the coalition to remain united in its approach toward fiscal sustainability and to front-load reform ambitions to 2021-2022, before politics gradually adapts in the run-up to the 2024 super election year. We anticipate that the complex and confrontational political landscape will remain a factor, however, which could test the three-party coalition's ability to find agreement on more sweeping reforms, for example, to the tax code.

We continue to regard Romania's EU membership as an important policy anchor that is important in what is otherwise a confrontational and complex political landscape. We expect the excessive-deficit procedure the European Commission initiated in February 2020 will resume in 2021, helping to instill fiscal discipline and support the budgetary rebalancing that we envision in our base case for 2021-2023.

Flexibility and performance profile: Front-loaded NextGen EU inflows will be necessary to fund the external deficit and will assist fiscal consolidation

We expect the government's fiscal rebalancing efforts to stabilize Romania's net general government debt at around 50% of GDP while keeping interest expenditure below 5% of revenue.
We forecast inflows from the NextGen EU funds and returning FDI to fund most of Romania's still-elevated current account deficits in 2021-2023.
Despite rising demand-side inflation pressures, we forecast that the annual consumer price index (CPI) inflation rate will remain within the central bank's tolerance band of within 1 percentage point of a 2.5% midpoint through 2023.

Given that spending on wages and pensions took up about 90% of tax revenue, we see Romania's budget structure as highly rigid. As a result, Romania entered 2020 with the highest structural budget deficit in the EU. We estimate the fiscal deficit in 2020 at 9.7% of GDP in cash terms, one of the largest in the Central and Eastern Europe region.

We project that the government deficit will stand at 7% of GDP in 2021, with fiscal policy gradually adapting in a bid to assist the near-term economic recovery. We also forecast that the fiscal deficit will gradually reduce to 3% of GDP in 2024 supported by the government's medium-term consolidation ambitions and the recovering economy. We believe this will halt the erosion of Romania's government balance sheet and we see its net general government debt to GDP stabilizing at around 50% of GDP by 2023.

Thus far, the government's consolidation efforts have primarily focused on the expenditure side of the budget. We anticipate that the government will broaden its budgetary rebalancing efforts to include revenue-side measures. In our view, such efforts are key to improving Romania's dismal revenue generation performance and closing the largest value-added tax gap in the EU.

We estimate the public-sector financing requirement in 2021 will constitute about 12% of GDP, and expect most of this will be sourced from the domestic market. Romania has no Eurobond redemptions in 2021, lessening its external financing need. We anticipate that the domestic banking sector will support the government's financing needs, although its capacity to digest the total financing needs of the government is constrained. The sector's existing exposure to the government, at more than 20% of its assets, is already substantial.

We forecast that Romania's interest expenditure will remain below 5% of government revenue. Although rising interest expense would further strain an already-rigid budget, we acknowledge that Romania's solid market access and benign financing conditions would mitigate its higher debt burden. Current borrowing costs are less than the effective interest rate on existing debt. The state treasury enjoys flexibility from a sizable hard currency buffer of about 4% of GDP and has recently restarted its retail issuance program to expand its domestic sources of financing.

The National Bank of Romania (NBR) executed a government bond purchasing program in March 2020. This provided liquidity to the market and helped to unfreeze the domestic government bond market, which had been erratic. The NBR demonstrated its attentiveness when it returned to the secondary market in March 2021 to smooth out the repercussions of bond sell-offs. At present, the NBR holds 2.5% of total domestic government commercial debt on its balance sheet. Although we anticipate that the NBR will absorb additional government debt via secondary market purchases in extraordinary circumstances, we do not expect a return to full-scale monetary financing of the government's budget.

We expect Romania's current account deficit to average 5% of GDP through 2024 as domestic consumption and investments spur imports. Although, to a large extent, Romania's external deficit is a consequence of the fiscal imbalances, we also see the widening trade deficit as stemming from underlying competitiveness problems, such as the relatively high unit labor costs.

Over the past three years, the current account deficit has increasingly been covered by debt-financed inflows. This pushed Romania's narrow net external debt ratio toward 35% of current account receipts (CARs) in 2020. We believe the financing mix of Romania's external deficit will improve in 2021-2023 on the back of front-loaded absorption of NextGen EU grants, together with a resumption of FDI flows. We forecast that Romania's narrow net external debt will stabilize below 45% of CARs in 2023.

A further widening of the fiscal and external imbalances could precipitate external financing stress and complicate monetary policy execution under the Romanian leu's managed float regime. These risks are pronounced, especially in the context of a still-meaningful degree of euroization. Elevated exchange rate volatility could have severe repercussions for public- and private-sector balance sheets because about half of Romania's government debt and an estimated 35% of financial sector deposits are denominated in foreign currency.

We expect the NBR will uphold its policy credibility, retain its independence, anchor inflation expectations, and help domestic markets to digest the government's financing requirements over 2021. In response to the pandemic, the NBR has cut its key monetary policy rate in four steps to 1.25% from 2.50% since the onset of the pandemic, most recently in January 2021.

In addition, it introduced a series of easing measures that include:

Providing banks with liquidity through repurchase agreements; and
Reducing the reserve requirement ratio on foreign exchange (FX) liabilities.

Despite increasing demand-side inflation pressures, we anticipate that CPI will remain within the NBR's tolerance band. Inflation of 3.2% in February suggests that prices were boosted by the increase in electricity charges that followed the recent market liberalization. We believe this effect will subdue over 2021 and that CPI will reach 3% by the end of the year. We foresee the NBR will continue to ensure that the FX rate remains stable. NBR's FX reserves reached a high of €37 billion (17% of GDP) at year-end 2020, giving it plenty of room to assist the currency if needed.

Romania's predominantly foreign-owned banking sector remains stable, in our view, and we see it as a limited contingency risk for the government. That said, the underbanked Romanian market prevents the financial sector from acting as an intermediator and catalyst to economic activity. Loans to the private sector stood at 27% of GDP in December 2020; therefore, the Romanian banking sector ranks last in Europe in terms of financial intermediation.

The system is largely deposit-funded, with a sectorwide loan-to-deposit ratio of 69% at March 2020 (compared with its peak of 142% in 2010). The system also benefits from low levels of nonperforming loans (NPLs). At 4%, NPLs are markedly lower than the June 2014 level of over 21%. However, some deterioration in asset quality might be inevitable as support measures are withdrawn over 2021."

(1 euro=4.9243 euro)

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