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S&P Global Ratings affirms Romania at BBB-/A-3, outlook remains negative


Standard & Poor's Global Ratings maintained Romania's rating at BBB-/A-3, with a negative outlook, and warned that the country's economic situation could deteriorate further if policymakers fail to produce a credible plan to lower fiscal imbalances.


Romania's ratings could be lowered fiscal and external imbalances remain elevated for longer than anticipated, for instance, because of challenges to fiscal policy design after the upcoming elections, S&P Global Ratings said in a statement late on Friday.

S&P projects that Romania's economy will contract by 5.2% in real terms in 2020 and that the fiscal deficit will widen to 9.2% of the gross domestic product (GDP).


The ratings agency added that Romania's funding cost could rise if the incoming government fails to present a credible fiscal policy framework. Also, S&P said that it could revise the outlook to stable if Romania's incoming government swiftly anchors fiscal consolidation, leading to a stabilization of public and external finances.


In a statement issued shortly after S&P's press release, Romania's finance minister Florin Citu said the rating reflects Romania's moderate level of public debt and the conviction that the government that will be appointed after general elections will reduce fiscal imbalances and continue to provide broad fiscal support to encourage economic recovery in 2021.


"The Standard & Poor's announcement reaffirms that the current government's measures to combat the socio- economic effects of the COVID-19 crisis and ensure sustainable public finances have been the right ones given the current global context," Florin Citu added.


S&P also said in the statement:


Despite deteriorating in 2020, Romania's government and external debt stocks remain moderate. Moreover, we anticipate that the government that assumes office after the December general election will reduce fiscal imbalances.


We believe that any incoming administration is likely to continue to provide ample fiscal support to foster economic recovery through 2021. That said, it would have to deal with, and potentially roll back, fiscal rigidities created through previous policy decisions. These include costly hikes to pensions and other social benefits. Policy uncertainty is exacerbated by the confrontational and complex political landscape, which could make it difficult to build a coalition after the December elections.


Institutional and economic profile: The December parliamentary elections will be key to providing visibility on the medium-term trajectory of public finances

· The implementation of a balanced and credible fiscal agenda will be crucial to support the economic recovery and maintain financial market confidence.

· We project that Romania's economy will contract by 5.2% in 2020 before rebounding by 4% in 2021.

·EU funds absorption will be key to aiding economic rebalancing, although implementation risks remain.


Romania has scheduled parliamentary elections for Dec. 6. The elections are being closely contested and will be crucial to Romania's future fiscal and economic policy direction. In our base-case scenario, we expect that the incoming government will take firm steps toward viable fiscal consolidation during its term. Rebalancing a rigid budget position will require rolling back costly social benefits and pension reforms; under current legislation, pensions are due to rise by 40%. Timing is of the essence, given that the Romanian Constitutional Court has previously decided that pension levels cannot be reduced once they have been paid out.


We estimate that Romania's output will contract by 5.2% in 2020. Although the firm lockdown measures employed over the year took a significant toll on full-year domestic demand, primarily in the second quarter, the construction sector has recorded solid performance for nine months, partly because Romania maintained its level of public investments. Weak external demand from key trading partners will eat into exports, of which over 20% go to Germany and 10% to Italy. Both countries also face deep recessions in 2020.


The forecast remains sensitive to the uncertain epidemiological situation and the possibility of fresh containment measures. We project Romania's economic activity will recover in 2021, with real GDP growing by 4%. However, we anticipate that the economy will return to its 2019 level only by 2022.


We continue to regard Romania's EU membership as an important policy anchor. Together with the policy choices of the incoming government, the fiscal stimulus forthcoming at the supranational level will be key to shaping Romania's macroeconomic rebalancing. Romania will be a strong beneficiary of the structural funds designated under the EU's upcoming Multiannual Framework, alongside the newly created EU Recovery and Resilience Fund (RFF). The grants portion alone under the RFF equals about 6% of Romanian 2019 GDP, and a similar amount in loans is available to unlock access to cheap financing. Should the funds be fully deployed and successfully absorbed, it would help sustain Romania's growth prospects, facilitating the budgetary rebalancing that we envision in our base case for 2021-2023.


Flexibility and performance profile: Past fiscal slippages have led to a government balancing act as authorities grapple with the problematic budget structure

· Rising interest costs add further strain to an already rigid budget.

·The external deficit's financing mix continues to deteriorate as net foreign direct investment (FDI) weakens.

· We expect inflation will remain steady and foreign exchange pressures contained as the central bank conducts measured policy easing through 2021.


Policy choices in recent years have weakened the foundations for sustainable public finances. In 2019, Romania had the highest structural budget deficit in the EU and also sported the lowest ratio of fiscal revenue to GDP. Furthermore, most of Romania's key budgetary allocations (such as pensions and child care allowances) are structural, rather than being attributable to one-off measures. This inflicts further medium-term strain on an already rigid budget structure.


In response to the effects of the pandemic lockdowns, the authorities have launched a series of fiscal and economic measures to shield companies and workers from the economic standstill. We estimate the overall size of the fiscal stimulus package at 3% of GDP. Including the budgetary effect of automatic stabilizers, such as from unemployment insurance, we anticipate that the measures introduced will increase fiscal expenditure by 1.2%.


The contracting economy, combined with pandemic-related stimulus, falling fiscal revenue, and another bout of increases to social spending (pensions and child care allowances) will widen Romania's budgetary deficit this year. For 2020, we estimate that Romania's fiscal deficit will be about 9.2% of GDP, including a decline in revenue due to the economic contraction, which will push net general government debt past 40% of GDP. In addition, credit support, in the form of government guarantees on bank lending to small-and-midsize enterprises for working capital and investment purposes, will add a total 1.5% of GDP to the state's guarantee commitments.


With spending on wages and pensions now standing at about 90% of tax revenue, Romania's budget structure is highly rigid. Although it is not part of our base case, if the 40% pension hike were to be implemented, we estimate that spending on wages and pensions alone would exceed government fiscal revenue in 2021. We do not expect the government to tighten fiscal policy through 2021, in a bid to foster economic recovery. However, we believe authorities will seek to adjust the budget's structural composition, making spending less rigid and improving revenue collection, while steering toward a gradual reduction in the deficit. We project the government deficit will stand at 7.2% of GDP in 2021 and decline to 5.5% in 2022.


We estimate the public-sector financing requirement in 2021 will comprise about 10% of GDP, and we expect most will be sourced from the domestic market. In this regard, we anticipate that the domestic banking sector will support the government's financing needs, but its capacity to digest the total financing needs of the government will be constrained. The banking sector's existing exposure to the government, at more than 20% of its assets, is already substantial.


The state treasury has recently restarted its retail issuance program to expand its domestic sources of financing. Moreover, the treasury enjoys flexibility from a sizable hard currency buffer of about 5% of GDP and recently replenished by the inflow of €3 billion (1.4% of 2019 GDP) worth of SURE funds from the EU in November 2020. The SURE program offers temporary support to mitigate unemployment risks in an emergency.


Given the magnitude of government's financing need in 2021, we expect the National Bank of Romania (NBR) could again be needed to backstop financing in 2021. The NBR deployed and executed a government bond purchasing program in 2020 that provided liquidity to the market and settled the erratic domestic market. At present, the NBR holds Romanian leu (RON) 4.8 billion of government securities (1% of total government commercial debt) on its balance sheet. It put its program on hold after the November monetary policy meeting. 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 2023. In our view, the widening trade deficit demonstrates the underlying competitiveness problems. At the same time, we observe that the current account deficit is increasingly covered by debt-financed inflows, which pushes Romania's narrow net external debt ratio toward 45% of current account receipts in 2023. There are risks of further strains on net FDI as international companies face pressure.


Romania's twin deficits reinforce each other: on the current account, as rising fiscal stimulus pushes up demand and imports; and on the financial account, as a chunk of higher financing requirements is met by selling debt to nonresidents. Therefore, any sizable increase in permanent spending, such as a 40% pension hike, would be detrimental to both Romania's fiscal and external performance, and would likely prompt a disorderly budgetary correction that would have repercussions for the economy's fragile rebound after the pandemic.


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 on public- and private-sector balance sheets because about half of Romania's government debt and an estimated 40% of financial sector deposits are denominated in foreign currency.


In response to the pandemic, the NBR cut its key monetary policy rate in three steps to 1.5% from 2.5% in 2020. 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.


With inflation below target at 2.2%, we believe the NBR could consider additional monetary easing to fuel recovery in 2021. That said, we anticipate that the NBR will proceed with caution, prioritizing FX stability and maintaining the attractiveness of leu savings. We expect the NBR will uphold its policy credibility, retain its independence, and successfully anchor inflation expectations as it helps domestic markets to digest the government's financing requirements over 2021.


Romania's predominantly foreign-owned banking sector remains sound, 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. With loans to the private sector at 25% of GDP in March 2020, the Romanian banking sector ranks last in Europe in terms of financial intermediation.


The system is predominantly deposit-funded, with a sectorwide loan-to-deposit ratio of 69% at March 2020 (compared with its peak of 142% in 2010). We anticipate that the system is likely to be able to absorb lower profitability owing to the Ministry of Finance's nine-month loan moratorium. The system also benefits from low levels of nonperforming loans, which, at 4%, are markedly lower than over 21% in June 2014. However, some deterioration in asset quality might be inevitable as support measures are withdrawn over the next year."