Deteriorating public finances and limited external reserves drive the Negative Outlook. EU membership, high growth potential, and moderate public as well as external debt levels support Romania’s BBB- ratings.
Scope Ratings GmbH on Monday has recently affirmed Romania’s long-term local-currency and foreign-currency issuer ratings and senior unsecured debt ratings at BBB-. The agency has also affirmed Romania’s short-term issuer ratings at S-2 in both local and foreign currency. The sovereign’s senior unsecured debts in local and foreign currency are affirmed at BBB-. The Outlooks on the long-term issuer and senior unsecured debt ratings as well as on the short-term issuer ratings all remain Negative.
Summary and Outlook
The maintenance of the Negative Outlook on Romania’s sovereign ratings reflects the following two drivers:
Deteriorating public finances following multiple years of expansionary fiscal policies, including a 40% hike in state pensions scheduled for September, alongside in reflection of the impact of the global health and economic crisis, which weighs on tax revenues and requires fiscal stimulus measures to mitigate the economic impact of containment measures. Scope projects a general government deficit of around 9% of GDP in 2020, resulting in a debt-to-GDP ratio of 45%, up 10 percentage points from 2019. Upcoming parliamentary elections create additional uncertainties about the future path of fiscal consolidation.
Limited official reserves to cover outstanding foreign currency denominated debt in a more stressed environment, narrowing the scope of monetary policy action available to support the domestic economy beyond measures announced to date. Romania’s foreign exchange reserves covered 77.3% of short-term external debt (by remaining maturity) as of March 2020. The country’s history of current account deficits plus impacts from ongoing fiscal deterioration and a risk-averse market environment have required exchange rate-stabilising interventions of the National Bank of Romania (NBR) after the Covid-19 shock. The impact of the health crisis on domestic supply chains, especially on the manufacturing sector, presents additional medium-term risks to external sector stability.
The maintenance of the Negative Outlook is reflected under Scope’s assessments in the ‘public finance risk’ and ‘external economic risk’ categories in its sovereign methodology.
The affirmation of Romania’s BBB- investment-grade ratings considers the issuer’s multiple credit strengths, such as EU membership with resulting access to investment funds and lender-of-last-resort financing, the economy’s robust growth potential in spite of the health crisis, and moderate public as well as external debt levels.
The ratings could be downgraded within the next 12-18 months if, individually or collectively: i) continuous structural deficits or a lack of fiscal consolidation results in a deterioration in medium-run debt sustainability; ii) exchange rate depreciation and/or shrinking official reserves raise the likelihood of a balance of payments crisis; and/or iii) a weakening in support from European institutions exposes Romania to a shortfall in long-term financing sources required to stabilise its growth potential.
Conversely, the Outlook could be revised to Stable if, individually or collectively, an effective policy response leads to: i) an adjustment of fiscal policies, which allows a return to a sustainable debt trajectory over the next two years; ii) strong investment support from European institutions that facilitates a quick and sustainable economic recovery; and/or iii) the implementation of structural reforms to the education system and labour market, supporting Romania’s long-term growth potential.
Owing to the Covid-19 health crisis, Scope expects an economic contraction of around 4% in 2020, representing a marked decline from +4.1% growth in 2019 as well as from the robust expansion in previous years. Industrial production declined 38.6% year-on-year in April 2020, the largest such drop on record. Machinery and equipment, the automotive sector and furniture were hit hardest by the crisis with output declines up to over 80% year-on-year1. The resulting tax revenue losses and increased fiscal expenditure in preventing large-scale job loss and bankruptcies dominate this year’s budget with Scope’s 2020 deficit projection reaching around 9% of GDP. Despite the expected strong economic recovery in 2021 (+6.8%), longer-term growth potential remains constrained by the large skills mismatch in the labour market and relatively low absorption of EU funds. Alongside the weakened economic outlook, Scope identifies two major negative rating drivers, which support the maintenance of a Negative Outlook on Romania’s BBB- credit ratings.
The first driver relates to the ongoing significant deterioration in public finances with fiscal slippage having seen an estimated deficit of 4.3% of GDP in 2019, equal to a deviation of 1.7% of GDP from the initial target2. This led to the European Council’s decision to initiate an Excessive Deficit Procedure in April 2020, but currently put on hold during the ongoing crisis. The high 2019 deficit was a consequence of generous spending on public wages while revenues remained weak despite strong economic growth following a number of tax cuts, including a two-step decrease of the VAT rate by 5pp to 19% in 2017. The revised cash deficit projection of 6.7% of GDP for 2020 by the minority government remains on the optimistic end of projections, partly explained by its expectations for only a moderate recession (-1.9%)3.
Finally, the pension reform, enacted by Law No 127/2019, raises substantial medium-term risks to debt sustainability if executed absent counteracting fiscal measures. Scope projects the 40% hike in state pensions to raise fiscal spending by 0.7% of GDP this year followed by another 2.7% of GDP in 2021, reflecting the growing number of incoming pensioners. Absent a fiscal response to counterbalance the additional pension spending, Scope’s debt sustainability analysis shows another increase in debt levels to above 50% of GDP by 2021. At the same time, recent official statements by government authorities of future measures against rising deficits are important towards a future adjustment of the reform. Longer term, Romania faces an additional challenge from the expected increase in its old-age dependency ratio, which is set to rise from 29.6% of the working-age population (i.e. those 15-64 years old) towards 45.7% by 20404.
Overall, a weak fiscal record alongside debt accrued in the midst of the Covid-19 crisis will require substantial efforts from the current and future governments to revise fiscal policies over the next 12-18 months to ensure long-run debt sustainability. While debt levels remain moderate, securing Romania’s creditworthiness will require a turnaround of the currently negative debt trajectory.
The second driver for the maintenance of the Negative Outlook is Romania’s limited available reserves to cover foreign currency liabilities in a more stressed environment. While foreign exchange reserves cover 77.3% of short-term liabilities by remaining maturity at the end of March (the latter which account for 41.5% of gross external debt), the current crisis has exposed Romania to higher exchange rate risks and risks of sudden capital outflows. Gross reserves declined to 16.3% of GDP as of 2019 from 21.9% in 2014, while the current account deficit widened to 4.6% of GDP in 2019, from -0.2% in 2014. For this year, Scope expects an improvement in the economy’s current account deficit to 3.3% of GDP, based on net positive contributions from primary and secondary income alongside a smaller trade deficit in goods due to the health crisis shock to import demand. External competitiveness with Romania’s trading partners remains weak, however, based on higher inflation and wage increases than in peer economies and is only modestly compensated for by the Romanian leu’s depreciation of about 3-4% since 2019 against the euro. The real effective exchange rate versus 37 industrialised economies has appreciated in previous years and is projected to increase a cumulative 25% by 2021 relative to 20155. A change in global risk appetite, combined with weaker investor confidence, could reduce current international reserve buffers, which covered around 5.4 months of imports through 2019 and are bolstered by the successful placement of 5-year and 10-year Eurobonds (totalling EUR 3.3bn) in May this year. Gross external debt remained broadly stable at 47.4% of GDP at year-end 2019 while general government external debt increased to about EUR 40bn in March 2020 (equal to 18.3% of GDP), from about EUR 33bn in January 2019. At the same time, the projected deterioration in the fiscal deficit outweighs the mitigant of a lower external deficit in 2020 and could prompt additional pressure on the NBR to intervene in foreign exchange markets. Upcoming general elections as well as the opposition holding a majority of seats in Parliament add to risks to external stability. While the NBR has sufficient capacity to respond to external shocks today, its capacity to minimise external sector and foreign exchange risks depends on political decisions that ensure fiscal sustainability.
Despite these structural weaknesses, Romania retains considerable credit strengths.
The country’s EU membership supports Romania’s continued access to capital markets and provides support with long-term investment funding and related institutional knowledge and capacity in support of the economy’s high growth potential. The European Commission has already allotted EUR 1.5bn to Romania by reassigning funds from the current multiannual budget in April earmarked to mitigate the health crisis shock. In addition, under adverse scenarios, the EU could provide direct financial support via its Balance of Payments financial assistance programmes, which was used by Romania between 2009-2011. If EU member states agree on the European Commission’s proposal on a Next Generation EU recovery fund, Romania could also benefit from net allocations of grants and loans amounting to EUR 21bn (9.4% of 2019 GDP) between 2021-24.
In addition, Romania’s credit ratings remain supported by its robust growth potential, which averaged 4.5% between 2015-19 according to European Commission estimates. While the health crisis is expected to result in a 2020 recession, quarterly growth of 0.3% in Q1 2020 (+2.4% year-on-year) signal a less severe shock than in peer countries due in part to Romania’s more moderate infection and mortality rates during the pandemic to date. After an initial economic recovery phase, economic prospects will rely strongly upon successful infrastructure investments and attraction of foreign capital. If structural reforms continue and the absorption of investment funds increases, Scope expects Romanian growth potential to remain in the range of 3-4%6.
The BBB- ratings are also underpinned by Romania’s still relatively low to moderate levels of public and private debt. Public debt amounted to 37.9% of GDP as of March 2020 with a long weighted average maturity of 7.2 years, which mitigates refinancing risks7. The latest issuance in May was a five-year local currency bond denominated bond with a yield of 3.79% p.a., implying low risk premia with projected average inflation of 1.4% in 20208. Scope anticipates gross refinancing needs for 2020 of around 13.5% of GDP, including the projected fiscal deficit of 9% of GDP, the former below the average for Romania’s bbb-rated peers. Private debt stands at 45.3% of GDP, following a downward trend since 2010 (when it was 74.7% of GDP) in the cases of both non-financial corporate debt (30%) and private household debt (15.3%).
Romania’s financial sector remained robust through 2019 with an improvement in the non-performing loan (NPL) ratio for household loans to 4.0% in December 2019, 0.8pp lower than a year before. Similarly, the NPL ratio decreased by 1.5pp to 7.1% for corporate loans. The banking sector remained profitable and adequately capitalised with a common equity tier 1 ratio of 17.9% of risk-weighted assets, according to prudential data at December 2019, which, together with the abolishment of the bank tax, increases the sector’s resilience against adverse macro-economic shocks. Scope, however, expects this year’s economic contraction to markedly weaken asset quality as well as profitability in the sector.
Also, effective monetary policy support by the NBR has contributed to date to the macro-economic stabilisation of the domestic economy during the health crisis. The central bank was able to stabilise the exchange rate with interventions on foreign exchange markets while at the same time introducing quantitative easing as a new policy tool to ease financial conditions. The NBR has widened its mandate to allow gradual purchases of local currency denominated governments bonds on the secondary market and lowered the monetary policy rate to 1.75% in June, the second cut following an initial cut in March by 50bps from 2.5%. The European Central Bank has provided additional support by setting up a new repo line of EUR 4.5bn with the NBR, to remain in place until end-20209.
The interim minority government led by Prime Minister Ludovic Orban has enacted gradual reforms of the justice system, establishing a higher degree of trust in its anti-corruption and business-friendly policy framework after the enforced imprisonment of former Socialist leader Liviu Dragnea. One important step in raising institutional credibility was a vote in Parliament in 2019 to reverse a law that effectively decriminalised corruption. The minority government has also abolished the “greed tax” for banks, thereby contributing to re-strengthening the financial system, facilitating the conduct of monetary policy and restoring investor confidence. Scope expects these measures to support investment after the upcoming elections bring a better predictability of future policy-making. Going forward, Scope also anticipates ongoing improvements in authorities’ relationships with European institutions, with the EU having repeatedly prompted the former Socialist government to stop the rollback of judicial reforms and to comply with national and European fiscal rules. Scope expects the re-building of a constructive relationship with the EU to support negotiations regarding the breach of Stability and Growth Pact fiscal regulations in 2019 and facilitate allocations from the EU’s future recovery fund.