Instituto Politcnico do Porto

ISCAP

Romanias transition to Euro

International Organizations

Ctlin Vasile Moldovan

2015

Contents

Introduction

Romanias adherence to the European Union

Short history of Romanias transition to Euro

Inflation

Price stability

Recent inflation developments

Underlying factors and sustainability of inflation

Medium term prospects

Public finances

Exchange rate stabilty

Long-term interest rates

Balance of payments

Market integration

Opinions

Conclusions

Introduction

Romanias adherence to the European Union

Romania was the first country of post-communist Europe to have official relations with the European

Community. In 1974, a treaty included Romania in the Community's Generalized System of Preferences.

Since the Romanian Revolution of 1989, European Union (EU) membership has been the main goal of

every Romanian Government and practically every political party in Romania. Romania signed its Europe

Agreement in 1993, and submitted its official application for membership in the EU in 1995, the third of

the postcommunist European countries to do so after Hungary and Poland. Along with its official EU

application, Romania submitted the Snagov Declaration, signed by all fourteen major political parties

declaring their full support for EU membership.

During the 2000s, Romania implemented a number of reforms to prepare for EU accession, including the

consolidation of its democratic systems, the institution of the rule of law, the acknowledgement of respect

for human rights, the commitment to personal freedom of expression, and the implementation of a

functioning free-market economy. The objective of joining the EU has also influenced Romania's regional

relations. As a result, Romania has imposed visa regimes on a number of states, including Russia,

Ukraine, Belarus, Serbia, Montenegro, Turkey and Moldova.

Short history of Romanias transition to Euro

In May 2006, it was announced that the Romanian government planned to join the European Exchange

Rate Mechanism (ERM), a prerequisite for euro adoption, only after 2012. The president of the ECB said

in June 2007, that "Romania has a lot of homework to do ... over a number of years" before joining ERM

II. The Romanian government announced in December 2009, that they now officially planned to join the

eurozone by 1 January 2015. In April 2011, the Romanian government announced it would strive to

comply with the first four convergence criteria by 2013, but would not be ready to join the ERM II before

20132014, meaning that euro adoption was only likely to happen on 1 January 2016/2017.

EIU analysts suggested in May 2012, that 2016-2017 would be the earliest realistic dates for Romania's

adoption of the euro. However, in October 2012, ValentinLazea, the NBR chief economist, said that "the

adherence of Romania to euro currency in 2015 is difficult for Romania". The governor of the National

Bank of Romania confirmed in November 2012, that Romania would not meet its previous target of

joining the eurozone in 2015. He mentioned that it had been a financial benefit for Romania to not be a

part of the euro area during the European debt-crisis, but that the country in the years ahead would strive

to comply with all the convergence criteria.

In April 2013 Romania submitted their annual Convergence Programme to the European Commission,

which for the first time did not specify a target date for euro adoption. Prime Minister Victor Ponta has

stated that "eurozone entry remains a fundamental objective for Romania but we can't enter poorly

prepared", and that 2020 was a more realistic target. In April 2013, the National Bank of Romania

submitted draft amendments to the Romanian Constitution to the European Central Bank (ECB) for

review. The amendments would make the BNR's statue an organic law to ensure "institutional and

functional stability", and would allow for the "transfer of BNR tasks to the ECB and the introduction of

the euro as legal tender" using organic law. In 2014, Romania's Convergence Report set a target date of 1

January 2019 for euro adoption.

To simplify future adjustments to ATMs after the adoption of the euro, when the Romanian new leu

replaced the old leu in 2005 (at 10,000 old lei to 1 new leu) the new banknotes were the same physical

dimensions as euro banknotes, except the 200 lei bill, which had no euro size correspondent, and the 500

lei bill, which was the same dimension as the 200 bill.

Inflation

Price stability

The 12-month average inflation rate for Romania, which is used for the convergence evaluation, at the

last convergence assessment of Romania in 2012 was well above the reference value. Average annual

inflation increased from below 3% in mid- 2012 to 4.5% in mid-2013, before declining sharply thereafter.

In April 2014, the reference value was 1.7%, calculated as the average of the 12-month average inflation

rates in Latvia, Portugal and Ireland plus 1.5 percentage points. The corresponding inflation rate in

Romania was 2.1%, i.e. 0.4 percentage points above the reference value. Romania's 12-month average

inflation rate is projected to remain above the reference value in the months ahead.

Recent inflation developments

Romania has recorded volatile and elevated inflation rates in recent years. Annual inflation peaked at

8.5% in May 2011 following an increase in the standard VAT rate in mid-2010 and a rise in food prices.

It fell significantly during the second half of 2011 and in early 2012 to a low of 1.9% in April 2012,

mainly due to a favourable base effect supported by a good harvest in 2011 and lower energy commodity

prices. Inflation picked up again in the second half of 2012 due to rising food prices, the impact of which

was exacerbated by the large share of food items in the consumer basket, and the pass-through effects

associated with the leu's exchange-rate depreciation. Energy price increases following the roadmap to

phase out administratively-set prices also added to inflationary pressures, especially by end-2012 and at

the beginning of 2013. As a result, annual inflation remained above 4% between September 2012 and

June 2013. Weak domestic demand and an abundant harvest induced considerable disinflation in the

second half of 2013 which was supported by the reduction in the VAT rate on bread and flour from 24%

to 9% in late 2013. In early 2014, annual HICP inflation thus hovered around 1.6%.. Core inflation

(measured as HICP inflation excluding energy and unprocessed food) has been on a downward trend from

3.6% in the first quarter of 2012 to 1.9% in the first quarter of 2014. The main drivers were slowing

inflation for services and processed food. The levelling off in late 2012 was on account of the evolution in

processed food prices, which are correlated to overall food commodity prices. Annual average producer

price inflation for total industry decreased strongly to below 1% in 2013 and turned negative in first

quarter of 2014, in line with overall receding inflation pressures.

Underlying factors and sustainability of inflation

The Romanian economy growth accelerated to 3.5% in 2013 and is estimated to continue to operate

slightly above potential in 2014 and 2015. A very weak harvest and the difficult external environment

resulted in a slowdown of GDP growth to only 0.7% in 2012. GDP growth increased to 3.5% in 2013 on

the back of a very good harvest and strong exports, while domestic demand remained weak.

The labour market situation was considerably affected by the economic downturn. After three years of

continuous decline, total employment grew in 2012 only to decrease somewhat again in 2013, despite a

strong pick-up in economic growth. It is expected to expand only gradually in 2014-2015. The

unemployment rate has fluctuated between 7.0% and 7.3% in recent years and is expected to remain at a

similar level.

Medium term prospects

According to the Commission services' 2014 Spring Forecast, annual inflation is projected to decelerate

from 3.2% in 2013 to 2.5% in 2014, mainly due to falling food prices, reaching historical lows in the first

half of 2014. Inflation is expected to return to the upper part of the central bank's target band (2.5%1pp.)

in the second half of the year. In 2015, a gradual recovery in domestic demand and continued price

convergence towards the EU average are expected to translate into higher annual average inflation

(3.3%). It should nevertheless still remain within the central bank's target band.Risks to the inflation

outlook are broadly balanced.

Domestic demand might surprise on the upsideleading to inflationary pressures. Upside risks arealso

related to a possible rise of global commodityprices, with the overall impact amplified by therelatively

large weight of commodities in theconsumption basket. A gradual withdrawal ofmonetary stimulus in the

US and associated capitaloutflows from emerging markets might exert somedownward pressure on the

exchange rate whichwould feed into higher inflation. On the otherhand, the continued need for banks to

repair theirbalance sheets might constrain credit flows. Lowinflation in the euro area might also spill-over

viathe extensive trade links with the Romanianeconomy.

Public finances

Since 2009, Romania benefited from medium-term financial assistance from the EU provided in

conjunction with a stand-by arrangement by the IMF. Romania was able to regain market access during

the first financial assistance programme (2009-2011) and has treated the second programme (2011-2013)

as pre-cautionary. In July 2013, the authorities requested a third financial assistance programme, also of

pre-cautionary nature, which was granted by the Council in October 2013. The current programme,

running until 2015, aims to support Romania in reaching its medium-term budgetary objective in 2015, as

recommended by the Council, to improve fiscal governance and to implement other structural reforms.

During the crisis, the headline government deficit peaked at 9.4% of GDP in 2009. The authorities opted

for a front-loading of fiscal consolidation focused on the expenditure side, but also involving some

revenue measures. This included reduction of public wages, reduction in social spending and an increase

in the standard VAT rate and helped the deficit to decline to 5.5% of GDP in 2011. Total expenditure

declined from 39.4% of GDP in 2011 to 35.0% in 2013. Since 2011, the revenue to-GDP ratio decreased

from 33.9% to 32.7% in 2013.

In 2012, the deficit decreased further to 3.0% of GDP. This was mainly driven by measures on

theexpenditure side. Social security spending waslowered by keeping pensions mostly flat and

bystreamlining the social assistance programmes.Excises for tobacco and diesel were raised tostrengthen

the revenue side. 2013 saw a furtherdecline of the headline deficit to 2.3% of GDP. Reductions in

expenditure provided for theadjustment of the deficit, including savings insocial assistance.

Exchange rate stability

The Romanian leudoes not participate in ERM II. Romania has been operating a de jure

managedfloating exchange rate regime since 1991 with nopreannounced path for the exchange

rate. Defacto, the exchange rate regime moved graduallyfrom a strongly managed float

including throughthe use of administrative measures until 1997 toa more flexible one. In 2005,

Romania shifted to adirect inflation targeting framework combinedwith a floating exchange rate

regime. The BNRhas, nonetheless, stressed that currencyintervention remains available as a

policyinstrument.

After the global financial crisis in late 2008 andearly 2009, the leu broadly stabilised and

mostlytraded between 4.1-4.3 RON/EUR from 2009 untillate 2011. The lower short-term

volatility of theleu reflected in addition to the positive effectsassociated with the EU-IMF

international financialassistance to Romania and easing global marketconditions also

operations by the BNR in theinterbank as well as in the foreign exchangemarket. The leu

depreciated towards historicallows of above 4.5 RON/EUR in July 2012. Itfirmed somewhat in

late 2012 and early 2013, asforeign interest in leu-denominated assetsincreased following the

parliamentary elections inDecember 2012. The leu's exchange rate againstthe euro temporarily

depreciated in May-June2013, reflecting heightened global risk aversion,but the weakening was

more moderate incomparison with other regional peers operatingunder floating exchange rate

regimes. The leucame again under depreciation pressures in early2014. During the two years

before this assessment,the leu depreciated against the euro by 1.9%.

Long-term interest rates

Long-term interest rates in Romania used for the convergence examination reflect secondary marketyields

on a single government benchmark bondwith a residual maturity of around nine years.

However, the limited number of Romanian longtermbonds issued and the illiquidity of thesecondary

market may pose some difficulties ininterpreting the data.

The Romanian 12-month moving average long term interest rate relevant for the assessment of theTreaty

criterion stayed above the reference value ateach convergence assessment since EU accessionin 2007. It

peaked at 9.7% in the fourth quarter of2009, but gradually declined thereafter and hovered at just around

7% in 2011. It was abovethe reference value at the time of the lastconvergence assessment of Romania in

2012.Since then, it declined further to around 5.5% bythe end of 2012 and floated around 5.3% over

themost of 2013. In April 2014, the latest month forwhich data are available, the reference value, givenby

the average of long-term interest rates in Latvia,Portugal and Ireland plus 2 percentage points,stood at

6.2%. In that month, the 12-month movingaverage of the yield on the Romanian benchmarkbond stood at

5.3%, i.e. 0.9 percentage pointsbelow the reference value.

After having remained at just above 7% for mostof the period 2010-2011, long-term interest ratesdeclined

gradually to below 5.5% in the secondquarter of 2013, reflecting a reduced country riskpremium backed

by a solid fiscal consolidationtrack record as well as a gradual downwardadjustment of the expected path

of interbank ratesand the precautionary EU-IMF programme. Theythen remained broadly stable, hovering

between5% and 5% until early 2014. At the same time,the long-term spread vis--vis the

Germanbenchmark bond declined from above 500 basispoints in late 2012 to below 350 basis points in

late2013 and it stood at around 380 basis points inApril 2014.

Balance of payments

Romania's external balance (i.e. the combinedcurrent and capital account) improved markedlyduring the

global crisis. After having recorded adeficit of around 4% of GDP in 2009-2011 itnarrowed somewhat in

2012 and then shifted into asurplus in 2013. The improvement in the external balance reflected a

significant decline in the tradedeficit, due to strong export growth and mostly flatimports. The negative

net income balance widenedin 2012-2103, reflecting an increase in FDI-relatedprofits. At the same time,

the positive balance ofcurrent transfers remained broadly stable. Finally,the capital account recorded an

increasing surplusdue to improved absorption of EU funds.

Romania's saving-investment gap continued tonarrow from 4.5% in 2011 to 1.0% in 2013. Bothgross

savings and investment declined somewhatin 2012. While savings increased again in 2013,investment

continued to decline, inducing thesignificant adjustment of the current accountbalance. The need of the

corporate sector to repairits balance sheets appears to have been the maindriver, while the savings-

investment gap of thepublic sector also continued to narrow.

External price and cost competitiveness continuedto improve in the first half of 2012, largely due toNEER

(Nominal effective exchange rate) depreciation. Competitiveness thendeteriorated somewhat in 2013, as

NEERappreciation was accompanied by relatively higherprice and cost increases in Romania compared

toits main trading partners. Nevertheless, Romaniamanaged to increase its export market

shareconsiderably in 2013.

Market integration

Romania's economy is well integrated into the euro area through both trade and investment. The

tradeopenness of Romania has increased significantly inthe aftermath of the crisis, but is still

relativelylow. Trade openness in 2012 stood at around 43%of GDP. Trade with the euro area dominates,

andin particular with Germany, Italy, France and theNetherlands.

Romania's trade pattern reflects the country's labour-cost advantages and price competitiveness.

However, its trade specialisation has changed tosome extent in the recent years, taking advantagefrom its

increased integration with the EUeconomy and from substantial technology transfersby companies from

the euro-area Member States.The cumulative share of a few sectors (namelymachinery and electrical

equipment, vehicles,aircraft, vessels) increased significantly in recentyears, reaching almost 40% in 2012.

However, theupward trend in the share of high-technologyproducts in exports reversed to just 6.3% GDP

in2012 in comparison with the 8.8% reached in2011. This decline is explained to a large extent bythe

relocation abroad of an important cell phonemanufacturer. The high-tech trade balance deficitdeclined

significantly from 2007 to 2011, butexperienced a slight rebound in 2012. This is inpart explained by

reduced investment,deleveraging and a significant fall in FDI inflows.

Due to wage competitiveness, favourable corporate tax rates and a relatively large domestic

market,Romania attracted substantial FDI inflows in theyears before the crisis. However, in the

aftermathof the crisis FDI inflows declined considerably. FDI inflows have remained relatively low,

ataround 1.5% of GDP in 2011-2012. Despite aslight recovery in 2013, they are expected toremain

substantially below their pre-crisis level.The FDI stock reached 56% of GDP in 2012, muchlower than in

other non-euro area Member States.The main FDI inflows originate from euro-areaMember States, with

the Netherlands, Austria andGermany accounting for more than half of the FDIinflows in 2012. In terms

of sectoral allocation, theFDI stock was 31% in manufacturing, some 19%in financial intermediation and

insurance, and 9%in construction and real estate. In Romania, FDIhas a tendency to concentrate in the

mainmetropolitan areas, with the Bucharest regionattracting more than two-thirds in 2012.

In terms of resilience during the crisis, the capacity of the Romanian labour market to adjust has

beenimproved. Since the major reform of the socialdialogue code in 2011, wage-setting is

largelydecentralised, with only few multi-company wageagreements being in place. Changes in the

labourcode implemented in 2011 affecting provisionsregarding fixed-term contracts, collectivedismissals

and individual redundancies, workingtimeflexibility and temporary agency contracts,started to pay off.

Yet in terms of capacity togenerate new jobs and income, labour marketcontinues to under-perform as it

remainscharacterised by a low employment rate (20-64 agegroup around 64% in 2012-2013), high

youthunemployment (around 23% in 2012-2013) and alow share of temporary and fixed-termemployment

contracts. The 2011 reform of thelabour and social dialogue code is beingcomplemented by only very

limited active labourmarket policies and only hesitant reforms ineducation and vocational training that

aim toaddress skill mismatches. Due to a limitedrecovery of employment in 2012-2013, thepropensity to

emigrate in search of better jobopportunities abroad is still strong among theRomania's labour force:

population at working agecontinued to decline faster than total population in2011-2012.

The Romanian financial sector is highly integrated into the EU financial sector, in particular throughthe

strong presence of foreign banks in Romania.The share of foreign-owned banks, mainly euroarea parent

banks, in the total assets of theRomanian banking sector has slightly increasedand reached some 90% in

2012 compared to 88%in 2007. Concentration in the banking sector, asmeasured by the market share of

the largest fivecredit institutions, declined marginally between2007 and 2012, but remained above the

euro areaaverage.

After a rapid financial deepening in the years before the onset of the financial crisis, creditactivity in

Romania has weakened considerablysince 2007, reflecting both demand and supply sidefactors. Romania

still lags considerably behind theeuro area as regards bank credit to the private nonfinancialsector (around

34% of GDP). Foreigncurrencyloans have played an important role inlending to the private sector, as the

share of theseloans increased steadily in the period 20072012to roughly 67% of the total loans to

households in2012, i.e. up by roughly 14 percentage pointscompared to 2007 (though part of this increase

isdue to the depreciation of the leu). Lending to nonfinancialcorporates has also been dominated

byforeign-currency loans, albeit to a lesser extent.Foreign-currency loans to corporates increased to59%

of total loans in 2012, compared to 55% in2007. However, recent trends show a decrease inforeign-

currency lending for both households andcorporates, inter alia due to the measuresintroduced by the

National Bank of Romania tocurb foreign-currency lending to unhedgedhouseholds and corporates, in

particular SMEs.Private sector debt declined from 124% of GDP in2009 to 74% by end-2012.

Opinions

We can see that 74% of the Romanians are in favour of the introduction of Euro and only 24% are against

it.

Conclusions

On the one hand both before the start of the international financial crisis in 2007 and in the next period the

Romanian economy could not meet the convergence criteria in their entirety and the unfavorable

conditions have affected the two indicators which fit in the benchmark values.

On the other hand, in the context of a high uncertainty on the future of the euro but also the real

convergence that Romania fails to reach should slow the Euro adoption process taking theexample of the

states that are also in the process of accession, more likely to fulfill criteria of nominal convergence and

certainly a more solid real convergence as Poland and which were delayed this decision for 2020.

References

Convergence Report, 2014 European Commision

Flash Eurobarometer 400 European Commision

Orastean, R., Marginean, S. (2010) Nominal convergence: the case of Romania, Romanian

Economic and Business Review Vol. 5, No. 3.

Pop, N. et al. (2005) Monitorizarea trecerii la euro a rilor recent devenite membre ale UE.

Analize i sinteze, Vol. II, research project, Bucharest, CCFM Victor Slavescu.