ROMANIA: IMF AGREEMENT IMPLEMENTATION POSES REAL

C O N F I D E N T I A L SECTION 01 OF 03 BUCHAREST 000237

SIPDIS

STATE FOR EUR/FO DAS GARBER, EUR/CE ASCHEIBE, EEB
TREASURY FOR JBAKER/LKOHLER

E.O. 12958: DECL: 04/08/2019
TAGS: EFIN ECON PGOV PREL IMF EUN RO
SUBJECT: ROMANIA: IMF AGREEMENT IMPLEMENTATION POSES REAL
CHALLENGES

REF: BUCHAREST 205

Classified By: Charge d'Affaires Jeri Guthrie-Corn for reasons 1.4 (B)
and (D).

SUMMARY


1. (C) Romanian officials are congratulating themselves on
the external financing package (reftel) concluded with the
International Monetary Fund (IMF),European Commission (EC),
and World Bank (WB) as "much better than we expected,"
according to one Ministry of Finance (MOF) interlocutor.
With final approval anticipated and the first tranches of
money set to flow the first week of May, Romania is already
enjoying a modest market boost in response to the deal, as
the leu has appreciated some four percent against the euro in
the last week. The exuberance may be short-lived, however,
with implementation of the package's provisions looming as a
substantial political challenge in this presidential election
year. Full implementation will require not only cuts in
spending, but big changes in how the Government of Romania
(GOR) conducts its fiscal business. Package skeptics,
particularly in the Social Democratic Party (PSD),have lots
of room to create roadblocks should they so choose, since
some PSD-controlled ministries--especially the Ministry of
Labor--are key to making the provisions work. End summary.

LENDING TERMS: A "PLEASANT SURPRISE"


2. (C) While the contents of Romania's official letters of
intent to the IMF, EC, and WB have not yet been made public
pending official approval, several contacts told post's
EconCoun in recent meetings that the lenders agreed to less
stringent fiscal conditionalities and were much more
accommodating of Romania's concerns than the GOR was
expecting. MOF Director of Macroeconomic Analysis and
Policies Dorin Mantescu said Romania had the benefit of
getting in line after IMF-led rescues of Hungary and Latvia,
with the IMF and EC sharing perceptions that those deals had
been too severe and had contributed to political and social
instability. Mantescu believes GOR leaders got "good credit
points" for reversing their prior political "no IMF"
pronouncements and proactively seeking a deal before
worsening conditions forced their hand. WB Senior Economist
Catalin Pauna agreed, saying in addition that EC negotiators
seemed especially keen to avoid perceptions that Brussels was
demanding tough fiscal measures of Romania at a time when
budget red ink is flowing in many EU member states, including
some of the biggest. The EC representatives "seemed to feel
guilty about asking Romania to do anything really hard" and
exerted a moderating influence on the IMF in the talks, Pauna
observed.


3. (C) Under the deal, the IMF will loan 12.95 billion euros
at 3.5 percent interest to the National Bank of Romania (BNR)
to add to reserves, with the understanding that BNR will use
it to support the leu and to reduce bank minimum reserve
requirements. The first tranche of up to six billion euros
should be released as soon as the IMF Board approves the deal
on/around May 5. (Note: BNR has already announced that, as
soon as the IMF tranche is received, it will drop the reserve
requirement from 40 percent to zero for foreign
currency-denominated liabilities with maturities of over two
years, thereby freeing up some 800 million euros in new
liquidity.) Five billion euros from the EC and one billion
from the WB will go to MOF to support GOR deficit spending.
The European Bank for Reconstruction and Development (EBRD)
and European Investment Bank (EIB) have pledged an additional
one billion euros in lending for specific projects to be
determined later. IMF-led teams will conduct quarterly
monitoring visits.


4. (C) The agreement allows Romania to run a fiscal deficit
of up to 4.7 percent of GDP in 2009 and in excess of three
percent in 2010. The IMF is also requiring the GOR to adjust
its 2009 revenue and spending projections to conform to the
IMF's (admittedly very pessimistic) minus 4.0 GDP growth
projection. According to BNR Chief Economist Valentin Lazea,
that scenario would produce a deficit of 5.8 percent of GDP
without an IMF program, meaning that the GOR must trim
spending by 1.1 percent of GDP, or more than two billion
euros, to stay within the 4.7 percent target. EC and WB
funding will cover about half of the allowed deficit, Lazea

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believes, with MOF left to finance the other half itself by
continuing to auction T-bills in the local market. Lazea
observed that BNR's reduction in reserve requirements may not
lead to much new lending by banks, since a good part of the
money may simply go to buy T-bills to finance the
deficit*and nothing will prevent banks from repatriating
some of the capital if they choose, despite verbal assurances
to the contrary. Still, if the economy performs better than
minus 4.0 percent (and both MOF and BNR seem convinced that
it will),the required fiscal adjustment may be smaller.

AND NOW COMES THE TRICKY PART...


5. (C) The GOR won't have to cut spending as radically as it
feared going into these negotiations, and the package
requires no major increases in VAT rates or the flat tax on
income. Even so, the required cuts won't be painless. The
GOR is already moving to impose wage and hiring freezes
across government ministries and will attempt to enforce
reductions in public sector bonuses (which often represent a
big chunk of annual pay for low-salaried workers) as well as
cuts in transportation subsidies for government employees and
suspension of "holiday tickets" for free visits to GOR-owned
spas and other resorts. Government procurements of
big-ticket items like cars and furniture will be blocked for
the rest of the year, and new excise taxes on luxury goods,
tobacco, and alcohol will be imposed. For the time being it
appears the GOR will avoid having to resort to substantial
layoffs, but public sector unions are still hopping mad.
Their ability to hit back through work stoppages hasn't been
fully tested: they have staged a series of small protests,
but no crippling strikes big enough to really hurt so far.


6. (C) All post's interlocutors agree that these stopgap
measures will ultimately not be enough, and it is the IMF
conditionalities for larger structural reform which will pose
the biggest political challenges for the GOR. These reforms
focus on public sector wages and pensions, precisely because
they are a major source of the explosion in GOR deficits in

2008. BNR's Lazea explained that several successive years of
double-digit wage hikes for government employees, along with
last year's increase of more than 20 percent in "Pillar 1"
(i.e. fully state-funded) pensions, would produce an annual
deficit of more than two percent of GDP even if all other
revenues and spending were in balance. There are currently
4.8 million workers contributing to Pillar 1 and 4.6 million
pensioners drawing from it, a demographic time bomb which is
clearly unsustainable, Lazea said.


7. (C) To begin to address the problem the GOR has already
implemented at IMF urging a 3.3 percent hike in social
security contributions for workers and employers, and froze
GOR contributions to Pillar 2 (private) pension funds at 2008
levels despite howls of protest from international fund
managers (including U.S. firm AIG) that this is a violation
of the law which partially privatized social security.
Normally the IMF would frown on such blatant reneging on
funding commitments, but had acquiesced in this move due to
the system's dire funding problems, Lazea said. In addition,
the GOR will begin indexing pensions to inflation rather than
to the average wage, meaning much smaller percentage
increases in the COLA in future years. The IMF will require
the GOR to accelerate its schedule for extending the minimum
retirement age, so that it reaches age 65 by 2011 instead of
2013, and the GOR must extend social security payroll
deductions to the Romanian military and police, which until
now were exempted. These steps will allow the GOR to muddle
through for a while, but much bigger hikes in social security
taxes or a rollback in benefits will eventually be required,
Lazea insisted. The "newer, nicer" IMF won't require such
politically poisonous steps this year but could push harder
on pension reform in 2010, Lazea believes.


8. (C) According to the World Bank's Pauna, the centerpieces
of structural reform under the IMF package are multi-year
budgeting and public sector wage reform, two areas in which
WB technical assistance will be crucial. The first aim is
for the GOR to craft and pass legislation putting in place a
system for long-term budget planning and multi-year
appropriations for major expenditures, thus ending the
practice of frequent "budget rectifications" throughout the
year. The second goal is establishment of a unified pay and
benefits system extending across the GOR, eliminating the

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current hodgepodge in which every ministry or agency sets its
own pay scales and determines its own bonuses for workers.
This will require a "vast untangling" of hundreds of separate
laws, executive orders, and other regulations and will
require several years to implement, Pauna said, but the
IMF/EC/WB are expecting Romania to demonstrate some initial
progress in terms of legislative action by the end of 2009.

COMMENT


9. (C) All our interlocutors agree that the reforms
stipulated under the IMF program are badly needed to put
Romania on a path toward sustainable fiscal health. However,
they equally agree that Romania's previous track record
(several IMF accords, but none fully completed and
implemented since 1990) is not especially encouraging. Lazea
of BNR openly questioned whether a more accommodating IMF
could really get Romania to conduct major surgery on such
sacred cows as pensions and public sector compensation when
the "old, bad" IMF could not. The GOR must take some initial
steps, including legislative action, on certain items before
the end of this year, but the Parliament will likely be
taking up such legislation in the midst of the fall
presidential election campaign, making for a combustible
political atmosphere. There are plenty of opportunities for
IMF program skeptics to throw a wrench into the works;
Catalin Pauna said he is especially worried about the
PSD-controlled Ministry of Labor, which could easily derail
government pay reform simply through "selective inertia".
Romania has prided itself on being a reliable NATO partner
and responsible new EU member; it now has the opportunity to
demonstrate whether that reliability extends to matters of
money. A lot is riding on the answer. End comment.
GUTHRIE-CORN