ROMANIA AND IMF: REVISE AGREEMENT AS THE ECONOMY

C O N F I D E N T I A L SECTION 01 OF 03 BUCHAREST 000563

SIPDIS

STATE FOR EUR/CE ASCHIEBE AND AMB. GITENSTEIN
TREASURY FOR LKOHLER AND JBAKER

E.O. 12958: DECL: 08/12/2019
TAGS: EFIN ECON ETRD EIND PGOV IMF EUN RO
SUBJECT: ROMANIA AND IMF: REVISE AGREEMENT AS THE ECONOMY
WORSENS

REF: BUCHAREST 424 AND PREVIOUS

Classified By: Charge d'Affaires, a.i. Jeri Guthrie-Corn for reasons 1.
4 (b) and (d).


1. (C) Summary. Romania's economy is contracting at a much
faster pace in 2009 than originally forecast and its
agreement with the International Monetary Fund (IMF) requires
important modifications as a result, an IMF monitoring team
announced on August 10. Concluding their first quarterly
review of Romania under the agreement reached last spring
(reftels),the IMF said GDP would shrink by 8.0 to 8.5
percent this year, at least double the 4.0 percent decline
predicted just a few months ago. In a meeting with the
Acting DCM immediately following the team's visit, IMF
Resident Representative Tonny Lybek provided a first hand
analysis of the "staff level" agreement that the team had
negotiated with the Government of Romania (GOR). The
agreement is noteworthy because it will allow IMF funds to be
used directly to cover the Government's yawning budget
deficit. In return, the IMF is requiring that the GOR cut
spending by 0.8 percent of GDP before year's end and push
through structural reforms to include a new unified public
sector wage structure, fiscal management reform including
tighter control over local government spending, and changes
to the retirement pension system. While both of the
political parties in the governing coalition assured the IMF
team that they are committed to the deal, the terms of the
revised agreement are a signal that the IMF program is
entering its most painful and politically dicey phase. End
Summary.


2. (SBU) According to the IMF, the Romanian economy is on
track to contract by more than eight percent in 2009 due to a
"very tough external environment" in Romania's main export
markets, a collapse in domestic production, and an
accelerating decline in consumption. Latest GOR figures show
a drop of 7.6 percent in the first half of the year compared
to the same period in 2008, with an only slight moderation in
the rate of decline seen for the remainder of the year.
Officially, the IMF team predicted an 8-8.5 percent
contraction, but Lybek believes it could go as deep as nine
percent. This shrinking economy has blown a hole in the
GOR's budget, with an expected deficit of 7.3 percent of GDP
for the year provided that the GOR slashes spending by 0.8
percent in accordance with the IMF program. This is a tall
order, considering that the GOR must now cut spending in the
last four months of 2009 by nearly the same amount it had
originally committed to cut for the entire year.


3. (C) Despite the gloomy numbers, the IMF is predicting
(hoping) that this is as bad as it gets, and that Romanian
GDP will post very modest positive growth in 2010. The only
bright spot in the forecast is the rapid turnaround in the
twin demons -- inflation and a high current account deficit
-- which had plagued Romania during its recent economic boom.
Inflation is expected to fall to 4.3 percent for the year,
while the current account deficit has fallen faster than
expected to 5.5 percent of GDP from over 12 percent in 2008.
In Lybek's view, Romania may even outperform the program's
inflation targets. The IMF asserts that the GOR should get
credit for meeting its budget targets for the first three
months of the original program, noting that the
steeper-than-expected downturn and its effect on GOR revenues
have forced a program revision. Lybek did acknowledge,
however, that spending reductions so far had largely been
achieved through temporary measures -- such as delaying VAT
reimbursements, curtailing government travel, and suspending
new equipment purchases -- which contribute little to
long-term cost savings.


4. (SBU) The most notable revisions to the IMF program
targets are an increase in the allowed budget deficit, from
4.6 to 7.3 percent of GDP in 2009 and from three percent to
just under six percent in 2010, accompanied by additional GOR
budget cuts equivalent to 0.8 percent of GDP by the end of
2009 and 2-2.5 percent more in 2010. To help ease the pain,
the IMF will allow roughly half (or about $1.9 billion) of
its next two tranche disbursements to Romania to be diverted
to the budget rather than added to the National Bank of
Romania's (BNR) foreign currency reserves as originally
planned - a diversion which Lybek confessed is "very unusual"
under IMF practices. The IMF is worried that the amount of
GOR borrowing that would be needed to fully finance the 7.3
percent deficit would crowd out domestic lending to the
private sector at a time when domestic bank lending generally

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remains extremely tight. Direct budgetary support will
mitigate the downside risk of excessive government borrowing,
which could further choke an eventual economic recovery.


5. (SBU) Despite his concern about high levels of GOR
borrowing, Lybek was relatively sanguine about the health of
the financial sector and the amount of liquidity available.
To date the financial sector has experienced no bank
failures, and the nine largest banks in Romania have renewed
their pledge to the IMF to keep capital in the country as the
BNR gradually relaxes reserve requirements. While the IMF
believes that continued GOR borrowing will eventually start
to "vacuum up" available liquidity, Lybek does not believe
that this is the case so far. He noted that interbank rates
have been falling and are currently close to policy rates.
Business complaints about the lack of credit can be
attributed as much to the recession as GOR borrowing,
according to Lybek. The IMF support to the GOR will be
accompanied by recommendations that the GOR work to increase
the maturities on bonds and consider a Eurobond issuance,
something the GOR has already announced it is preparing to do
later in the fall.


6. (C) Structural reforms have been a part of the IMF package
from the beginning, but the steep downturn has made their
completion a matter of urgency if Romania is ever to return
to fiscal sustainability. Reform of public sector wages
through standardized rates across all parts of the GOR,
increased transparency, and a reduction in bonuses and
non-salary compensation remains the centerpiece of reforms
the IMF is requiring. Lybek said the Government remains on
track to complete a draft wage law in October and that the
IMF was pleased with the provisions of the draft so far.
Improved fiscal management remains a critical area for
long-term improvement. Lybek is particularly focused on
improved tax collection as an opportunity for the GOR to
raise funds to close the budget deficit. To this end, a team
of tax experts visited Romania last month and provided a
series of recommendations to the GOR, many of which can be
implemented without legislative changes. (Comment: In
post's view, "improved tax collection" is a double-edged
sword, given the GOR's demonstrated proclivity to focus
intrusive tax audits on easy, high-profile targets such as
multinational investor companies. End comment.)


7. (C) A major new area of IMF concern is the fiscal
management of local governments, which are major employers
and spenders but which currently have very limited taxation
powers and are almost exclusively dependent on central
government transfers for funding. Romania has no systematic
methodology for allocating these funds, and there is little
control over how the money is spent once it leaves the GOR's
coffers. The IMF, perhaps a tad nave as to the political
firestorm it will induce, correctly believes that this is an
area ripe for reform and plans to push the GOR to implement
structural changes in how local governments operate. Cutting
off the money train, however, will likely raise the ire of
regional party bosses, who hold real political power,
especially in the Social-Democratic Party (PSD).


8. (C) The leitmotif of the IMF monitoring team's visit was
missed opportunities, a point that the delegation head,
Jeffrey Franks, alluded to in polite but unmistakable terms
in his concluding press conference. These include allowing
public sector spending to spiral out of control even while
tax revenues remained high through Romania's previous
economic boom. As a result, there is no cushion remaining to
limit the pain of the economic downturn and the very
necessary personnel and other cuts that are needed if the GOR
is going to remain afloat. Rather than directing tax
revenues to capital investments, political expediency, poor
planning, and bureaucratic inertia destined most monies
toward current consumption. Rather than reforming the
pension system, pensions were raised. Loss-making state
enterprises were not restructured and sold during the boom
years, saddling the GOR with a too-large state sector and
structural expenses that it can ill-afford. The worst sin,
however, has been the failure to access and spend EU
structural funds. It is only now, in the midst of a crisis,
that the GOR is getting serious about tapping pre and
post-accession funds. Had previous (and current) governments
not dithered over the last few years, the Romanian economy
would now be receiving a huge boost from the inflow of EU
funds instead of finding itself in a serious crunch.


9. (C) Comment. The IMF's forecast early this year of a four

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percent decline in GDP was dismissed by GOR officials at the
time as an excessively gloomy, "worst case" scenario. With
the real numbers now twice as bad as even the IMF predicted,
all parties accept that the existing program requires major
modifications. So far the IMF, in conjunction with the
European Commission and World Bank, has correctly identified
the most important structural reforms and is pushing the GOR
to make them. The next few months, however, will be "crunch
time" when the real pain of a shrinking economy will, if the
GOR intends to meet its revised commitments, be combined with
very disruptive and far-reaching cuts in the public sector.
(No sooner had the IMF team left town this week than the GOR
began announcing eye-popping personnel reductions, agency
consolidations, and furloughs; post will report on these
developments septel.) If the IMF is to be faulted, it is for
being a tad too trusting of the current government's promises
and chances of survival. With a presidential election
sucking up most of the political oxygen at the same time that
the IMF is prescribing more big budget cuts, the odds
increase that Romania's very carefully balanced governing
coalition may buckle under the strain. This would put the
legislative agenda for enacting the structural reforms the
IMF is demanding in serious jeopardy.


10. (C) Comment continued. Lybek took pains to emphasize
that, as an EU member state, "Romania is not some African
country" and that the IMF team was therefore trying hard not
to "micromanage" structural reforms. He said the team had
agreed to broad targets and was willing to defer to the GOR
to determine how to reach them. While post agrees that the
proposed revisions to the standby agreement are probably
necessary, the fact of the matter is that the GOR has only
stuck to the program so far through substantial budgetary
sleight-of-hand -- coupled with a hope that the downturn
would not prove too severe and that an early rebound would
provide breathing room for the upcoming election season.
That hope is gone, and even with direct IMF support for the
budget, the adjustments now required will be genuinely
difficult and politically costly. End Comment.
GUTHRIE-CORN