Documentof The WorldBank FOROFFICIAL USEONLY Report No. 48606-RO INTERNATIONAL BANKFORRECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENT FORA PROPOSEDFIRST DEVELOPMENT POLICY LOAN INTHE AMOUNT OF 300 MILLION (US$422.99MILLIONEQUIVALENT) TO ROMANIA FOR THE PROPOSEDPUBLICFINANCIAL MANAGEMENT, SOCIAL PROTECTION AND FINANCIAL.SECTOR STRENGTHENINGPROGRAM June 17,2009 Poverty Reduction and Economic Policy Department Central Europe and the Baltic Countries Department Europe and Central Asia Region This document has a restricteddistribution andmay be used byrecipients only inthe performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. ROMANIA GOVERNMENT - FISCAL YEAR Jan 1-Dec 31 CURRENCYEQUIVALENTS (Exchange Rate Effective as of June 5, 2009) Currency Unit RON US$1-00 2.97 Weights and Measures Metric System ABBREVIATIONAND ACRONYMS AMA Advanced Measurement IMF International Monetary Fund Approaches (Basel 11) IPSAS Institute for InternationalPublic CAS Country Assistance Strategy Sector Accounting Standards CFAA Country FinancialAccountability nu3 Internal Ratings Based (Basel 11) Assessment LDP Letter of Development Policy CFB Complementary Family Benefit LO1 Letter of Intent CNAS National Health Insurance Fund MDGs MillenniumDevelopment Goals CNVM National Securities Commission MoPF MinistryofPublic Finance COA Court of Accounts M O U Memorandum of Understanding CPAR Country Procurement Assessment M O H Ministry o f Health Report MTEF Medium-TermExpenditure Framework CPS Country Partnership Strategy NACS National Agency of Civil Servants CSA Insurance Supervisory NASB National Agency for Social Benefits Commission NBR National Bank of Romania CSPP PrivatePension Supervision NGOs Non-Governmental Organizations Commission OECD Organization for Economic DPL Development Policy Loan Cooperationand Development DRG Diagnosis Related Group PAL Programmatic Adjustment Loan EBRD EuropeanBank for Reconstruction PCF Per Capita Financing and Development P E R Public Expenditure and Institutional EC European Commission Review EIB European Investment Bank PETS Public Expenditure Tracking ESFS European System of Financial System Supervision PFM Public Financial Management FDI ForeignDirect Investment PHRD Japan Policy and Human Resources FRL Fiscal Responsibility Law Development Trust Fund FSAP Financial Sector Assessment PPIBL Public and Private Institution Program BuildingLoan FX QAG Quality Assurance Group GDP ForeignExchange SA Social Assistance GMI Gross Domestic Product SBA IMF Stand-by Arrangement Guaranteed MinimumIncome SDP Strategic Development Plan FOR OFFICIAL USE ONLY GNFS Goods and NonFactor Services GNP Gross National Product SDR Special DrawingRights IBRD International Bank for U C A Universal Child Allowance ReconstructionandDevelopment UNDP UnitedNations Development IDA International Development Programme Association UNICEF UnitedNations Children's Fund IFC International Finance Corporation VAT Value Added Tax IFRS International Financial Reporting Standards Vice President: Shigeo Katsu Country Director: Theodore Ahlers Sector Director: Luca Barbone Sector Manager: BernardFunck Task Team Leader: Swati Ghosh This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. Its contents may not be otherwise disclosed without World Bank authorization. ROMANIA FIRSTDEVELOPMENT POLICY LOAN TABLE OFCONTENTS ... LOANAND PROGRAMSUMMARY ......................................................................................................... 111 I. INTRODUCTION ............................................................................................................................. 1 I1 . COUNTRY CONTEXT .................................................................................................................... 1 A RECENTECONOMIC DEVELOPMENTS ................................................................ 1 B.. MACROECONOMICOUTLOOKAND DEBT SUSTAINABILITY ........................ 6 I11 . THE GOVERNMENT'S PROGRAM ............................................................................................ 12 A. IMPROVINGPUBLICFINANCIALMANAGEMENT ............................................ 12 B STRENGTHENINGSOCIALPROTECTION............................................................ 20 C.. STRENGTHENINGTHE FINANCIALSECTOR ...................................................... 25 IV. BANK SUPPORT TO THE GOVERNMENT'S PROGRAM ..................................................... 28 A. LINKTO THECOUNTRY PARTNERSHIPSTRATEGY ........................................ 28 B. COLLABORATIONWITHTHE IMFAND OTHER DONORS............................... 29 C. RELATIONSHIPTO OTHERBANK OPERATIONS............................................... 31 D LESSONSLEARNED................................................................................................. . 32 E. ANALYTICAL UNDERPINNINGS ........................................................................... 33 V. THE PROPOSEDOPERATION .................................................................................................... 34 A. CROSS-SECTORALPUBLICFINANCIALMANAGEMENT REFORMS.............35 B. SECTORALPUBLICFINANCIALMANAGEMENT REFORMS:EDUCATION ANDHEALTH ..................................................................................................................... 37 C. SOCIALPROTECTIONREFORMS.......................................................................... 38 D FINANCIAL SECTORREFORMS . ............................................................................. 40 VI. OPERATION IMPLEMENTATION ............................................................................................. 47 A. POVERTY AND SOCIALIMPACT ........................................................................... 47 B. CONSULTATIONS..................................................................................................... 49 C. ENVIRONMENTALASPECTS .................................................................................. 49 D IMPLEMENTATION,MONITORINGAND EVALUATION.................................. . 49 E. FIDUCIARY ASPECTS............................................................................................... 51 F. DISBURSEMENT AND AUDITING .......................................................................... 53 G. RISKS AND RISK MITIGATION.............................................................................. 54 TABLES Table 1: SelectedMacro Indicators ................................................................................................. 8 Table 2: Gross Financing Requirements........................................................................................ 10 Table 3: Public and External Debt Sustainability .......................................................................... 11 Table 4: Complementary Aspects of Fundand Bank Support to the Government's Program......30 Table 5: Investment Operations inDPL Areas .............................................................................. 32 Table 6: F A 4 Work inDPL Areas ............................................................................................... 34 Table 7: Summary of Prior Actions, Triggers and Milestones for DPLs 1-3 ................................ 43 Table 8: Objectives and Indicators ................................................................................................ 50 FIGURES Figure 1: Current Account Deficits 2003-2008 ............................................................................... 2 Figure 2: Structure of Private Debt.................................................................................................. 2 Figure3: Fiscal Policy Stance......................................................................................................... 3 Figure 4: GrowthinPublic Sector Wages ....................................................................................... 3 Figure 5: Romania Lags inthe Number of Graduates and Number of Graduates Achieving MinimumLevelof Quality............................................................................................................ 17 Figure6: Effectiveness ofNon-Contributory Social Benefits ....................................................... 21 BOXES Box 1: Good Practice Principles for Conditionality ...................................................................... 46 ANNEXES Annex 1: Letter of DevelopmentPolicy ........................................................................................ 56 Annex 2: Policy Matrix.................................................................................................................. 60 Annex 3: Assessment from the InternationalMonetaryFund....................................................... 65 Annex 4: RomaniaAt A Glance .................................................................................................... 70 MapIBRD 33469 .. 11 LOANAND PROGRAM SUMMARY ROMANIA FIRST DEVELOPMENT POLICY LOAN FORTHE PROPOSEDPUBLICFINANCIAL MANAGEMENT, SOCIAL PROTECTION AND FINANCIAL SECTOR STRENGTHENINGPROGRAM Borrower Romania Implementing Agency Ministry of Public Finance FinancingData IBRDLoanof Euro 300,000,000 ($422,990,000 equivalent) OperationType First Development Policy Loan (DPL-1) prepared as crisis response operation as part of an international support package. MainPolicy Areas Public financial management, social sectors, and financial sector. ProgramDevelopment Inthe context of the international financial crisis, the objective of the Objective(s) and proposed operation i s to support the Government's reforms in fiscal Contribution to CAS management, social protection and the financial sector. Specifically, these reforms aim to (i)strengthen public expenditure management which has been a key weakness that contributed to the buildup of Romania's vulnerability to the financial crisis; (ii)cushion the impact of the crisis on the poor and vulnerable; and (iii) minimize risks of a domestic financial sector crisis by addressing current and potential vulnerabilities as well as strengthening regulation and supervision for a more resilient and well functioning financial sector in longer-term. The ultimate objective i s to support the Government's efforts to emerge from the crisis on a stronger footing, so as to be able to resume and sustain high growth and convergence to the living standards of other more advanced EU economies. The Country Partnership Strategy (CPS) being presented to the Board with this operation focuses on three pillars: i)economic growth and competitiveness; ii)public sector reform; iii)social cohesiveness. The focus of this DPL series on public financial management, the social sectors and the financial sector i s fully aligned with all three of these pillars. Key Outcome Indicators Cross sectoral public financial management reform: MediumTerm ExpenditureFramework (MTEF) More strategic allocation o f budget resources and stronger budget execution controls. Measured by a reduction invariance between approved budget and actual expenditures for major ministries/functions. Public sector pay: More transparent and motivating system o f public pay. Measured by base salary comprising at least 70 percent of average total compensation and a legal cap on non-wage payments that any individual pubic servant can receive. 111 I . . Sectoral public financial managementreform: Health and education: better fiscal management and efficiency in public expenditures to provide better services and greater equity in access to services. In health, as measured by lower drug costs and lower acute admission rates per capita. Ineducation, as measured by an increase inthe average class size inthe eight counties involved inthe reforms. Social Assistance: Strengthened social assistance through the best targeted program (Guaranteed Minimum Income-or GMI) as measured by increased number of poor covered by the GMI. Pensions: Greater sustainability of pillar 1pension scheme as measured by reduction in fiscal deficit by 0.3 percentage points from baseline by 2011 (simulations based on WB Prost model). Financial sector: Strengthened contingency planning to reduce potential systemic problems in the financial sector during the crisis and improved resilience and functioning o f the financial sector over the longer-term. Strengthened contingency planning as measured by a significant number o f debt restructurings and corporate workouts. Improved resilience and functioning of the financial sector through regulatory and supervisory changes as measured byjoint supervision of financial conglomerate groups bythe relevant regulators. Risksand Risk The proposed DPL series is a relatively highrisk operation. Romania has Mitigation been hit hard by the global economic crisis. The large fiscal deficit that Romania had going into the crisis increases the need for adjustment at a time when the severity of the economic downturn increasesthe difficulties inachieving such anadjustment. The IMF's parallel programrests heavily on strong macroeconomic policy adjustments combined with large external financial support to stabilize the economy and support external debt rollover/debt service without excessive pressures on the exchange rate that could further weaken the banking sector. There are economic risks that could prove the macroeconomic assumptions underpinning the overall IF1program to be overly optimistic. There are also political risks-particularly in light of the coalition government-which could result in policy slippages. In turn, these policy slippages could undermine market confidence and increase balance of payments pressures. A key risk affecting the proposed operation is the uncertainty of the global economic outlook. There i s a possibility that international financial markets will remain frozen and that the global economic downturn, particularly in the EU, will be more severe and protracted than currently projected. Lower debt rollover rates or larger capital outflows would affect the domestic banking sector directly. A more protracted downturn would affect the Romanian economy and could also have serious implications for the domestic banking sector through increased corporate and household debt distress. iv This risk is partially mitigated by the size of the multilateral support package, which offers a small cushion in terms of a build-up of reserves under the program to deal with a worse-than-expected case scenario of capital outflows. The content of the program also mitigates risks. In the banking sector, the Fundprogram includes in-depth examinations of banks and recapitalization requirements inthe event of capital shortfalls, as well as the strengthening of regulatory and supervisory powers. Under the proposed DPL, these measures are fiuther reinforced through additional contingency planning reforms including the preparation of a strategic action plan to deal with potential interventions in the banking sector and establishment of a framework to facilitate debt restructuring. Finally, the fiscal reforms envisaged under the overall program will help to reduce the fiscal pressures both in the short run and over the medium term and contribute to loweringthe external financing needs. P102018 IBRD33469 The First Development Policy Loan is being prepared by a Bank team consisting of Swati Ghosh (Task Team Leader, ECSPE), Agnes Couffinhal, Cristobal Ridao-Cano, Lars Sondergaard, Mariana Moarcas, Richard Florescu, Son Nam Nguyen, Ufuk Guven (ECSHD); Antony Randle (FPDFS); Benoit Blare1 (ECCRO); Bernard Myers, Catalin Pauna, Stella Illeva (ECSPE); Bogdan Constantinescu (ECSPS); Cesar Niculescu, Lucian Bucur Pop (ECSSD); Martin Melecky, Michel Noel, Sophie Sirtaine (ECSPF). The document was processedby Nancy Davies-Cole (ECSPE). V I.INTRODUCTION 1. This document describes a program supported by a Development Policy Loan @PL) for "Public Financial Management, Social Protection and Financial Sector Strengthening" to Romania for a total of 1 billion. The proposed DPL program i s a part o f an international crisis response support package o f 19.95 billion, primarily involving the IMF and the European Commission. The IMF i s extending 12.95 billon and the EC 5 billion, and about 1 billion in incremental lending i s expected from the EBRD, EIB and IFC. 2. This operation is being proposed as the first of a series of three single- tranche programmatic loans totaling 1 billion. The first DPL is for 300, and the second and third DPLs would be 360 million and 340 million respectively. The proposed D P L program supports the Government's structural reforms in three key areas: a) improving fiscal sustainability and public financial management (cross-sectoral reforms and reforms in two key sectors-health and education); b) enhancing social protection systems-social assistance and pensions-to address the immediate needs o f the poor and vulnerable but also to ensure more effective social protection over the longer term; and c) strengthening the contingency planning and resilience o f the financial sector. Inthe fiscal and financial sector areas, which are also being coveredby the IMF and the EC programs, the proposed Bank operation reinforces and complements the measures envisaged under these respective programs. 3. The proposed DPL series is central to the Bank's proposed engagement in Romania, as discussed in the Country Partnership Strategy (CPS). The Country Partnership Strategy (CPS) being presented to the Board with this operation focuses on three pillars: i)economic growth and competitiveness; ii)public sector reform; iii)social and spatial cohesion. The focus o f this DPL series on public financial management, the social sectors and the financial sector is fully aligned with all three o f these pillars. 11. COUNTRYCONTEXT A. RECENTECONOMICDEVELOPMENTS GrowingMacro Imbalances and Buildup of Vulnerability 4. The Romanian economy experienced an economic boom during 2003-08, associated with the process of accession to the EU. Growth averaged over 6.5 percent per year during that period, reaching over 7 percent in 2008. A large part o f the domestic absorption boom was driven by private investment: with EU accession prospects secure, capital flows, particularly foreign direct investment, were attracted by perceptions o f lower investment risk that triggered a re-assessment o f Romania as a favorable investment location. Sharp increases in asset prices and rising collateral values added a self-reinforcing momentum to the absorptionboom. 5. The strong economic growth was accompanied by widening current account imbalances (Figure 1). Although exports to the EU countries grew at a robust pace, domestic demand grew at an even faster rate, and the current account deficit rose from just over 5.0 percent o f GDP in2003 to 12.4percent o f GDP in2008. 6. At the same time, in the past two to three years, the composition of the capital inflows moved increasingly towards private debt flows (Figure 2)-in large part the result o f borrowing by banks, often by subsidiaries o f foreign banks from their parent banks but also as a result o f direct borrowing by corporates. Figure 1: Current Account Deficits 2003-2008 Figure2: Structure of Private Debt Growing current account deficits were ..and the structure of private debt shifted toward increasingly financed with private borrowing shorter maturity until 2008.... Percent of Percent GDP of GDP *Other incl E&O 1 OLhor incl E 8 0 50 Public borr (oat) 40 30 NBR Res 20 10 ' Iboirowng(net) -40 Public 0 2003 2007 2008 2003 2004 2005 2006 2007 2008 7. The domestic overheating and external imbalance were exacerbated by the fiscal policy stance. Fiscal policy in Romania has traditionally tended to be highly pro- cyclical with fiscal management lacking in medium term orientation (Figure 3). Following efforts o f fiscal consolidation during 2003-05 that led to a narrowing o f the fiscal deficit to 0.8 percent o f GDP in2005, the fiscal deficit widened again progressively to reach 4.9 percent in2008 (while the structural fiscal deficit increased from 0.7 percent o f GDP in 2005 to 6.5 percent o f GDP in 2008) as a result o f excessive public spending policies. Government spending doubled between 2005 and 2008 pushingthe public sector share o f economic activity from 31 percent o f GDP to 37 percent o f GDP. The public sector wage bill more than doubled over these three years due to high wage increases (Figure 4), combined with a huge increase in government employment In the final months o f 2008, further expenditure hikes in the run up to the elections left a legacy o f precarious financing o f the deficit. 2 Figure 3: Fiscal Policy Stance Figure 4: Growth inPublic Sector Wages Fiscal policy was pro-cyclical and deficits grew.. ..driven in large part by loose public pay policy Percent of GDP Gross wage (2003=100) 0 350 PublicAdrninistrslion 1 300 2 250 3 200 4 150 Structural balance 5 100 -6 50 7 0 2005 ZOO8 2007 2008 2005 2006 2007 2008 8. The overheating and large capital inflows complicated monetary policy. Monetary policy was relatively tight-with the National Bank o f Romania (NBR) increasing reserve requirements and interest rates in an attempt to dampen inflationary pressures. In addition, a number o f measures were undertaken to contain credit expansion, especially in foreign currency lending. Between 2004 and 2008, policy interest rates were raised, as were minimumreserve requirements (to 18 percent on local currency liabilities and 40 percent on foreign currency liabilities); measures were taken to limit household debt exposures, especially with regard to mortgage debt; prudential regulations were strengthened to limit lending to unhedged borrowers o f foreign exchange, and restrictions on household debt service ceilings were tightened. These measures contributed to the subsequent deceleration in household credit growth, but pressure from an expansionary fiscal policy and capital inflows caused the NBR to miss its inflation target in 2007 and 2008. At the same time, the interest rate differential between domestic and international rates and the restrictions on credit growth mentioned above, may have served to further encourage direct external borrowing and short term capital inflows. Inparticular, large firms began to borrow directly abroad as reflected in an increase indirect borrowing by firms from the equivalent of 4 percent (on a net basis) o f GDP in2005 to nearly 11percent o f GDP in2007. 9. Romania's financial system-which i s dominated by commercial banks- played an integral part in the domestic overheating. Between 2003 and 2007, total financial system assets more than doubled from about 36 percent to 74 percent o f GDP (with the banking sector accounting for 83 percent o f total assets). At the end o f 2007, foreign-owned banks (mostly subsidiaries) accounted for 88 percent o f total banking sector assets. Growth inreal private sector credit rose fi-om 23 percent per year in2003 to over to 60 percent in 2007 before slowing slightly to 54 percent in 2008. Much o f banks' lending was directed towards households. Between 2003 and 2007, claims on households rose fi-om 12 to 28 percent of total banking sector assets (19.5 percent o f GDP in mid- 3 2008), while claims on companies declined from 37 to around 30 percent o f banks' assets. 10. The proportion of banks' lending funded from non-deposit sources- particularly foreign borrowing-rose progressively. While deposits grew relatively steadily, lending significantly outpaced the growth in deposits with the loan to deposit ratio increasing by over 43 percent during 2003-2008 to reach 130 percent at end 2008. The large resort o f banks to external financing o f lending i s reflected in the rise in net foreign liabilities o fbanks from the equivalent of -2 percent o f GDP in 2003 to around 18 percent at end 2008. 11, The indebtedness of households and corporates also grew rapidly, with much of the borrowing denominated in foreign currency. Total borrowing by the corporate sector grew at an annualized rate o f 44 percent between 2004 to midJune 2008 entailing a near doubling o f indebtedness to 28 percent o f GDP. Although the proportion o f foreign currency (FX) borrowing declined slightly over the period, it was still over 70 percent in 2008. While household disposable income grew at an average annual rate o f 20 percent, household debt increased at a rate o f 77 percent, with FX denominated borrowing rising even more rapidly; by mid-2008, the share o f FX borrowing intotal householdborrowing had risen to 56 percent (from 45 percent in2005). 12. In sum, the Romanian economy had become vulnerable to liquidity and foreign exchange risks by the time the global financial crisis unfolded. The current economic crisis being faced by Romania has therefore both domestic (inparticular due to the path o f fiscal policy inrecent years) -as well as external origins. Impact of Crisis 13. The economy has been hit hard by the global economic downturn. Economic activity declined sharply in the last quarter of 2008 and has fallen further in early 2009. Real GDP growth shifted from an average o f 9 percent (quarter on quarter annualized) during the first three quarters o f 2008 to a 13 percent decline in the fourth quarter. The decline was driven primarily by a drop in domestic demand. Export growth also slowed. With imports dropping even more sharply, the correction in the current account deficit began towards the end o f last year. For the first quarter o f 2009, early indicators (confidence, industrial production, retail sales and tax revenues) all point to a continued sharp drop inGDP. 14. Asset and financial markets have been severely affected by the effects of the global crisis and economic downturn. The stock market has lost 65 percent o f its value since the peak in August 2008. The inter-bank market was disrupted in October 2008 by rumors of liquidity problems at a commercial bank, leading to a spiking o f rates; these rates remained relatively high thereafter due to lingering concerns about counterparty 4 risk, high risk aversion, and market segmentation due to an uneven distribution o f assets (T-bills) eligible for discount with the NBR. Balance o f payment pressures drove a 15 percent depreciation o f the RON against the Euro from October 2008, putting pressures on household, corporate and bank balance sheets. To dampen currency volatility, the central bank intervened inthe spot market, losing some 4% billion inreserves since end- October 2008. Despite the depreciation, financial conditions tightened significantly on increased sovereign credit default swap premium and monetary policy tightening. Romania's international credit rating was cut in late 2008 (to below investment grade in the case o f Fitch) by a larger margin than those o f other countries inthe region, reflecting market concerns about the sustainability o f Romania's large current account deficit, uncertainties surrounding the outlook for fiscal and incomes policies, and the financial health o f banks with subsidiaries or branches in Romania. This has translated into significantly higher external borrowing costs for Romanianbanks and corporates. 15. As conditions in the financial markets have worsened, the financing of the fiscal deficit has been increasingly concentrated at very short maturities. This has exposed the government to roll-over and funding risks in the current environment o f de- leveragingalthough the situation as improved somewhat inthe most recent months. 16. Romania's deteriorating macro-financial environment has created risks for financial stability. Over the last few months, liquidity risk has become substantial in view o f the difficulties in parent banks and the downgrading o f Romania by major international ratings agencies in late 2008 leading to a decline in the capital account flows. A sharp contraction or reversal o f inflows could threaten macroeconomic and financial stability through a drying up o f credit to the private sector, resulting in an even sharper slump in economic activity and larger increases in loan defaults. In addition, a reversal o f capital inflows would put additional downward pressures on the exchange rate. While banks' direct exposures to foreign exchange risk reflected in their net open positions are low, as noted above, many households and businesses are exposed to unhedged foreign exchange risks. Banks, therefore, have substantial indirect foreign exchange risk exposures, inthe form o f credit risk. 17. The rapid deterioration in economic conditions and depreciation of the RON will place strains on bank capital positions. The banking system entered the crisis well capitalized and with high liquidity buffers. However, stress testing analysis suggests that some banks may be at risk o f becoming undercapitalized as the downturn continues. Thus a strengthening o f capital positions i s warranted and it will be important for parents o f foreign owned banks to maintain lines of credit to their subsidiaries and borrowers in Romania. In addition, banks will need to be proactive in enhancing loan quality by developing and implementing effective debt restructuring or workout procedures for household and corporate clients. 5 B. MACROECONOMICOUTLOOKAND DEBTSUSTAINABILITY 18. The economy is expected to contract by about 4 percent in 2009 (Table 1). Domestic demand will contract as foreign direct investment and capital inflows, which previously helped finance high consumption and investment growth, will drop sharply. With no fiscal space and tight financing conditions, an easing o f fiscal policy to cushion the downturn will not be possible. 19. The deterioratingeconomic prospects havepromptedthe governmentto seek multilateralsupport, includingthe IMF, the EC and the World Bank. The Fund's program o f support seeks to i)strengthen fiscal policy further to reduce the government's financing needs and improve long term fiscal sustainability; ii)maintain adequate capitalization o f banks and liquidity indomestic financial markets; iii)sustainably reduce inflation; and iv) secure external financing and improve confidence. 20. The government has already initiated substantial measures to address the fiscal deficit. The 2009 approved budget contains important spending cuts and revenue increases yielding around 3 percent o f GDP in total. These measures include i)an increase o f 3.3 percentage points in social contributions; ii)higher property taxes due to an overdue increase in appraisals; iii)removal of a reduced VAT rate for the purchase of a first house; iv) significant cuts in the public wage bill by reducing bonuses and other benefits and by eliminating 137,000 vacancies (previously used to grant higher allowances to existing staff); and v) substantial cuts in spending on goods and services as well as subsidies. It i s estimated that the fiscal measures already approved in the budget would reduce the fiscal deficit to about 5.2 percent o f GDP (without these measures the fiscal deficit for 2009 would have been on the order o f 8-9 percent o f GDP); and the structural deficit would fall by about 1.7 percent o f GDP. 21. Under the Fund's program,the fiscal deficit is expectedto further narrow to 4.6 percentof GDPin2009 from4.9 percentof GDPin2008. Fiscal measures yielding an additional 1.1 percent o f GDP are to be implemented in 2009 as prior actions for the IMFprogram, concentratingon expenditure reductions. The fiscal deficit for 2009 is thus expected to be 0.3 percentage points lower than 2008, at 4.6 percent of GDP. In order to safeguard the targets, spending plans will be backloaded and their execution will be conditional on revenue performance. The structural fiscal deficit would decline by nearly 3 percentage points o f GDP (from 6.7 percent to 3.8 percent o f GDP). The authorities envisage additional adjustment efforts in 2010 to bring the deficit down to around 3.7 percent in that year, and to bring it to well below 3 percent o f GDP in 2011 to meet the Maastricht deficit criterion. 22. The current accountdeficit is projectedto decline from 12.5 percent of GDP in 2008 to 7.5 percent in 2009 and further to 6.5 percent in 2010. This adjustment process i s expected to be driven primarilyby a sharp import decline arising from the drop indomestic demand and the depreciation inthe real exchange rate. 6 23. The balance in the capital and financial account is expected to fall from a surplus of 18.8 billion in 2008 to a 2.7 billion deficit in 2009. Foreign Direct Investment (FDI) i s expected to decline considerably in 2009, and trade credit contracts will fall inline with import compression, consistent with developments inrecent months. The capital and financial account i s projected to reach a 3.8 billion surplus in 2010, on the back o f a slight recovery inFDIand reduced capital outflows. 7 Table 1: Selected Macro Indicators Actual Projected 2005 2006 2007 2008 2009 2010 2011 Annual percentage change Output and prices Real GDP 4.1 7.9 6.2 7.1 -4.1 0.0 5.0 Domestic demand 8.3 12.8 14.3 8.9 -8.2 -3.3 6.0 Consumer price index (CPI av) 9.0 6.6 4.8 7.8 5.9 3.9 3.5 Unemployment rate 5.8 5.8 4.3 4.0 8.9 9.7 7.7 Nominal wages 17.0 18.9 22.6 23.6 5.9 3.8 5.2 Public sector wages 25.9 27.3 18.5 31.0 5.1 3.9 3.5 Private sector wages 14.7 16.5 23.2 21.2 6.2 3.8 5.7 Inpercent of GDP Savings and investment Gross domestic savings 23.3 26.5 31.1 31.4 30.8 29.9 31.9 Gross national savings 14.4 16.1 17.3 19.0 23.2 23.4 25.7 General government Revenue 30.1 31.0 32.5 32.6 33.0 33.4 33.1 Expenditure 30.9 31.6 35.6 37.5 37.5 37.0 35.8 Fiscalbalance -0.8 -0.6 -3.1 -4.9 -4.6 -3.6 -2.7 Privatization proceeds 1.3 0.4 0.1 0.1 0.0 0.0 0.0 External financing 0.5 0.1 0.1 0.5 2.8 1.1 0.2 Domestic financing -1.0 0.1 2.9 4.4 1.8 2.4 2.5 Structural balance " -0.6 -2.1 -4.2 -6.5 -3.8 -1.7 -1.2 Gross public debt (direct debt only) 15.6 15.4 17.5 20.1 23.6 25.7 25.7 Annual percentage change Money and credit Broad money (M3) 36.5 28.1 33.7 17.6 6.6 6.5 11.5 Credit to the private sector 54.5 60.4 33.7 15.9 5.1 3.2 Inpercent Interest rates Euribor six months 2.8 3.2 4.8 3.5 NBRpolicy rate 7.5 8.7 7.5 10.2 NBR lending rate (Lombard) 14.0 14.0 12 14.2 Interbank offer rate (1 week) 7.0 7.4 7.8 15.9 Inpercent ofGDP Balance of payments Current account balance -8.9 -10.4 -13.8 -12.4 -7.5 -6.5 -6.2 Merchandise trade balance -9.9 -12.0 -14.4 -13.5 -7.5 -6.6 -6.8 Capital and financial account 15.6 15.7 17.3 13.9 -2.4 3.3 7.8 FDI 6.6 8.9 5.8 6.7 3.1 3.7 3.7 International investment position -29.9 -35.3 -40.9 -52.9 -56.8 -55.8 -54.1 Gross official reserves 22.0 23.4 22.1 20.5 23.4 26.1 25.6 Gross external debt 39.0 42.9 47.1 53.4 64.2 68.5 64.0 Exchange rates RON per euro (eop) 3.7 3.4 3.5 4.0 Real effective exchange rate CPI based (depreciation -) 17.9 7.6 9.0 -4.2 -10.3 -2.1 1.3 Nominal GDP (bn RON) 289.0 344.7 412.8 504.0 531.3 568.5 634.1 Nominal GDP (bn Euro) 79.7 97.8 123.6 136.8 119.7 118.8 130.7 " Actual fiscal balance adjusted for automatic fects o f internal imbalance (output gap) and external imbalance (absorption gap). Source: IMF. 8 24. Over the medium term, a gradual economic recovery is projected. Once confidence is restored and balance sheets readjust, domestic demand is expected to slowly rebound (Table 1). Output is projected to follow a U-shaped adjustment pattern, and positive growth should resume by the second quarter o f 2010. However, as noted growth would remain near zero in 2010, before recovering to 5 percent in 2011. After contracting sharply in 2009, the current account i s projected to adjust slowly over the mediumterm, supported by strong export growth and a recovery inworkers' remittances. 25. The outlook is, however, subject to exceptional uncertainties and risks. The recovery depends on global events and on restoring consumer and investor confidence. In the near term, output could be further compressed through balance-sheet effects arising from a further RON depreciation and higher-than-expected inflation, especially if capital outflows are larger than anticipated. Almost 55 percent o f banks' loans are in foreign currency-a large portion o f which are extended to households and corporates whose earnings are in RON-thereby exposing banks in Romania to significant indirect currency mismatch. The macroeconomic outlook would also clearly be affected by a further worsening o f global growth prospects. 26. Romania faces considerable balance of payments financing needs over the next 24 months. (Table 2) Based on the projected current account deficit and stock o f short term and maturing medium and long-term debt, Romania's gross financing needs would amount to 44 billion in 2009. The average rollover rates assumed for amortizing debt in2009 is around 90 percent for banks and 70 percent for corporates. These average % rollover rates assume a full rollover for foreign banks' exposure to Romania once the Fund program takes effect from May 2009 and a rollover rate o f 50 percent throughout 2009 for Romanian banks. For corporate external debt to their parents, the assumption i s a rollover rate o f 50 percent throughout 2009. Under these assumptions o f average rollover rates o f around 90 percent for banks and 70 percent for corporates in 2009, a financing gap o f approximately 11% billion would emerge. For 2010 and the first quarter o f 2011, the Fund's macro framework assumes that a strong adjustment program will reduce the financing gap to about 85billion, bringingtotal financing gap under the program to just under 20 billion, as the current account i s expected to continue to adjust and rollover rates and FDIto improve due to higher confidence in economic policies and the expected incipient recovery in the world economy. The financing gap for 2010 includes a build up in gross international reserves o f about 3 billion, increasing reserves coverage to about 100 percent o f short-term external debt at end-2010 from about 75 percent at end-March 2009, significantly reducing external vulnerabilities. 9 Table 2: Gross FinancingRequirements (billions of Euro) 2009 2010 2011 Total 2009-2011 Total financing requirements 43.9 40.4 38.9 123.2 l . A Current account deficit 9.0 7.8 8.2 25.0 1.B Short term debt 22.5 18.6 18.6 59.7 Public sector 0.3 0.3 0.3 0.9 Banks 10.6 9.6 9.6 29.7 Corporates 11.6 8.7 8.7 29.0 1.C Maturing medium and long term debt 9.3 11.7 12.2 33.2 Public sector 1.o 1.6 1.4 4.0 Banks 1.8 2.1 2.3 6.2 Corporates 6.5 7.9 8.5 23.0 1.DOther capital outflows '/ 3.1 2.3 0.0 5.4 Increase in gross reserves 0.0 3.0 2.5 5.5 Total financing sources 32.2 36.3 40.3 108.8 (a) A Foreign direct 3.5 4.2 4.6 12.2 investment 2.7 2.8 2.7 8.2 (b) B Capital account 18.6 18.6 18.6 55.8 inflows (EU) 0.3 0.3 0.3 0.9 (c) C Short term debt 9.6 9.6 9.6 28.7 Public debt 8.7 8.7 8.7 26.2 Banks 7.4 10.8 14.4 32.6 Corporates 0.7 0.7 2.1 3.5 (d) DMaturing medium and 1.7 2.1 2.3 6.1 long term debt 5.0 7.9 10.1 23.0 Financing gap 11.8 7.0 1.1 19.9 Memo items Rollover rates for amortizing debt (inpercent) Banks */ 91 100 100 Corporates 3' 76 100 100 Gross international reserves 28.0 31.0 33.5 -- monthsof short of imports of GFNS(next year) 7.1 7.2 6.9 share term external debt (in percent) 88 88 109 Source: IMF. Includes reduced trade credit exposures, as well as portfolio equity and deposit outflows in line with experience of recent months. 'Once Fund program takes effect in May 2009 full rollover is assumed for foreign banks' exposure to Romania (which is lending by subsidiaries booked abroad) as banks are expected to commit to full rollover as part of the program. For Romanian banks a rollover rate of 50 percent is assumed throughout 2009. 3' For corporate external debt to their parents, the assumption is a rollover rate of 50 percentthroughout 2009. 27. Public debt i s currently low at 21 percent of GDP and is expected to peak at just under 26 percent of GDP in 2011 before coming down to 22.6 percent in 2013. (Table 3). The magnitude ofpublic debt is not expected to pose a risk as the fiscal deficits are expected to decline and potential contingent liabilities on the government-including those arising from private sector indebtedness-are limited. Sensitivity analysis to public debt sustainability suggest that i)a one time real depreciation in the exchange rate of 30 percent in 2009 would result in a public debt to GDP ratio of 25 percent in 2013 (compared to the baseline of 22.6 percent of GDP in 2013) and ii)a one time 10 percent of GDP shock to contingent liabilities would result ina public debt to 30 percent o f GDP in2013 (compared to the baseline of22.6 percent ofGDP)'. ' Source: IMFstaff estimates 10 28. External debt i s expectedto peak at 68.5 percent of GDP in2010, and decline thereafter to reach 52.5 percent of GDP in 2013. (Table 3) Sensitivity analysis to external debt sustainability suggests that a one time real depreciation of the exchange rate of 30 percent occurring in 2009 would result in an external debt to GDP ratio of 66 percent in2013 (compared to the baseline of 52.5 percent of GDP)2. Table 3: Public and ExternalDebt Sustainability (Dercent of GDP) 2007 2008 2009 2010 2011 2012 2013 Publicsector debt Baseline public sector debt 17.5 20.1 23.6 25.7 25.7 24.2 22.6 o/w foreign currency denominated 6.5 6.7 6.9 6.3 5.7 5.2 4.8 Change in public sector debt 2.1 2.6 3.5 2.0 0.0 -1.4 -1.6 Identified debt creatingflows 0.1 1.7 3.5 2.0 000 -1.4 -1.6 Primarydeficit 2.5 4.5 4. I 3.1 2.2 -1.3 0.7 Revenueandgrants 32.5 32.6 33.0 33.4 33.1 32.9 32.7 Primary (non interest) expenditure 35.0 37.1 37.1 36.5 35.3 34.2 33.3 Automatic debt dynamics -2.3 -2.7 -0.6 -1.1 -2.2 -2.8 -2.3 contributionfrom interest ratelgrowthdiff -1.9 -2.7 -0.6 -1.1 -2.2 -2.8 -2.3 contributionfrom exchange ratedep. -0.4 Other identified debt creatingflows -0.1 -0.1 0.0 0.0 0.0 0.0 0.0 Residualincluding asset changes 2.1 0.9 0.0 0.0 0.0 0.0 0.0 Public sector debt to revenueratio 53.8 61.6 71.7 76.9 77.6 73.8 69.3 External debt Baselineexternaldebt 47.1 53.4 64.2 68.5 64.0 57.1 52.5 Change in externaldebt 4.2 6.4 10.7 4.3 -4.4 -7.0 -4.6 Identified debt creatingflows -0.9 3.6 7.8 3.6 -0.4 -1.4 -0.2 Currentaccountdeficit 12.7 10.2 5.1 4.1 3.9 4.0 4.1 Net non debt creatingcapital inflows (neg) -5.8 -5.8 -2.2 -3.0 -3.5 -3.5 -3.5 Automatic debt dynamics -7.8 -0.8 5.0 2.5 -0.8 -1.9 -0.8 contributionfrom nominalinterest rate 1.2 2.2 2.4 2.4 2.3 2.1 1.9 contributionfrom real GDP growth -2.1 -3.0 2.5 0.0 -3.1 -3.9 -2.7 Residual, including changes in gross -5.1 2.8 2.9 0.7 -4.1 -5.5 -4.4 foreign assets Externaldebt to exportsratio Source: IMF. Note: The IMFlendingto the centralbank is not includedin the public debt sustainabilityanalysis (it is only includedin the externaldebt sustainabilityanalysis.The proposedDPLprogramandthe ECprogramare included in the public debt sustainabilityanalysis. Source: IMF staffestimates 11 111. THE GOVERNMENT'S PROGRAM 29. The new government, which came into power in December 2008, is seeking to narrow fiscal imbalances and to improve fiscal credibility and sustainability over the medium term by putting in place mechanisms to ensure better public financial management and fiscal transparency. The government is also seeking to protect the poor and vulnerable from the impact of the financial crisis, to minimize risks of a domestic financial sector crisis and to strengthen the regulation and supervision for a more resilient and well functioning sector in the longer-run. The government's ultimate objective is to emerge from the crisis on a stronger footing to resume and sustain high growth and convergence to the living standards of other more advanced EUeconomies. A. IMPROVINGPUBLICFINANCIAL MANAGEMENT 30. As noted above, weakness in controlling public expenditures has been one of the main causes of large fiscal deficits in the past. A key element in the government's reform agenda therefore i s improving public financial management-in particular, strengthening the medium term expenditure framework, and improving the public sector pay system. 31. Under the IMF program, the authorities have proposed a series of key fiscal reforms to contain key expenditure pressures and improve the budgeting process. An important component o f these reforms will be the approval o f a Fiscal Responsibility Law (FRL) that should allow the government to strengthen the budget process and ensure fiscal sustainability over the medium term. Key features o f the FRL include i)a framework for improved multiyear budgeting; ii)limits on intra-year budget revisions; iii)fiscalrulesonexpenditures,publicdebtandtheprimarydeficit;iv)thecreationofan independent fiscal council; and v) a framework for managing guarantees and other contingent liabilities. The passing o f the fiscal responsibility legislation is an IMF structural benchmark. The public financial management/MTEF reform measures supported under the proposed DPL program build on this fiscal responsibility law. The IMF program also includes two structural benchmarks that are in the areas that the Bank's proposed DPL also covers. These are the passage of revised public compensation legislation and the passage o f revised pension legislation. The revised public compensation legislation envisages the establishment o f a unified, simplified pay scale and reform o f the current system o f bonuses (including a ceiling o f under 30 percent on the share o f all non-wage personnel expenditures as a share o f total compensation to be phased in over three years and the consolidation o f monetary bonuses-eliminating the large majority o f bonuses or rolling them into the base salary). The Fund program envisages that further attributes o f this public pay legislation will be coordinated with the reform measures supported by the Bank's proposed DPL program. Similarly, with regard to the pension legislation, the Fund program envisages that the reform o f the key parameters o f the pension system will be done in coordination with the Bank through the proposed D P L program (see paragraph 91 and Table 4 below). 12 Strengtheningthe MediumTermExpenditureFramework 32. Although Romania currently prepares a form of medium term expenditure projections, these have little impact in linking planning and budgeting. The annual budget i s changed frequently during the year to accommodate new measures-a reflection o f poor planning and weak commitment to budget discipline. Personnel expenditures inparticular, have grown rapidly and the agreements to increase wages have often been in excess o f the approved budget levels. Consequently, there are wide differences between the original approved budget and the actual spending at year-end, and strategic planning efforts o f the line ministries are so far not bounded by any resource parameters. Medium-term projections have been done in the past by the MoPF with limitedpolitical buy-inand weak analytical underpinnings. 33. Measures are needednot only to restore aggregatebudget discipline,but also to improvethe effectivenessand efficiency of public expenditure. Ad hoc reductions in spending during the year impede ministries' ability to plan and manage effectively. Capital investment projects also suffer from weak programming o f funds across the years, resulting in project delays and increased cost. Though efforts have begun to develop strategic plans for all line ministries, the process i s detached from the budget planning and so ministries have little incentive to prioritize within their policy area. Performance based budgeting may be a useful tool in the long-term, but greater stability inbudget fundingand stronger policy analysis will beimportant prerequisites. 34. The reform measures on public financial management (PFM) to be supported by the DPL aim at improvingthe quality of annual budget planning by rooting it more firmly in a credible medium term expenditure framework. The MTEFprocess would be strengthened so that it guides the strategic planningprocesses o f the line ministries and encourages prioritization o f expenditures within credible resource envelopes, especially for public investment. While the substantive changes in the culture o f budgeting inRomania will take time to take root, the reform measures in the proposed operation are intended to set in motion a process that could enhance the aggregate fiscal discipline on the one hand, and the strategic allocation o f resources on the other. In setting such objectives, the Parliament has to be more firmly integrated into the process for it to be credible. 35. In addition to outlining the high-level aggregate trends in revenue and expenditure, the initial reforms to the MTEF (supported under DPL1) entail specification of the broad composition of expenditure and the policy choices they represent-such as the trade-off between personnel costs and capital expenditure. Where the projections represent substantial changes from the budget year or the prior year's actual spending, the policy justification also needs to be explained. The initial reform entails approval o f the MTEF by Government so that it can form a basis for the budget preparation instructions to line ministries. 13 36. Further reforms aim at establishing rules that prevent ad hoc deviations from the agreed upon framework. The primaryobjective is to use the introduction of a new fiscal responsibility law to include a two stage process for approving the annual budget. This i s needed in order to deepen the political commitment to the overall revenue and expenditure limits o f the budget and to reduce the flexibility to make changes during the implementation o f the budget. The initial vote is on the MTEF framework. Once approved, the fiscal responsibility law would mandate that the annual budget must respect those limits. Thus, the debate within Parliament on the annual budget law would focus on the composition o f spending (and perhaps its effectiveness) rather than the level o f aggregate spending. A special provision will also be needed to specify that duringthe budget year, new measures may not be introduced if they violate the aggregate expenditure limits or the limit set specifically on personnel costs. This i s essential to assure that the annual budget execution i s not destabilized by ad hoc agreements with unions on wage increases. Any decisions to increase pay levels need to be explicitly accounted for when the budget i s first approved by the Parliament and may not be introduced through budget rectifications duringthe year. 37. Building on the first two reform measures, the MTEF will be further strengthened to set in motion a process by which the Government signals to major ministries the funding levels they should expect over the medium term and places responsibilityonthemfor outlininghow their publicinvestmentprogramfits within those parameters. This would not necessarily mean ceilings for every institution, but would include ceilings for the biggest policy areas covered by the budget (e.g., education, transport, public security, health). By having this indicative funding information, the following years' strategic planning documents should be obliged to prioritize activities and scale the policy agenda accordingly. 38. The MTEF will also be one of several instruments to encourage the Government to frame its public investment program within a multi-year funding window. For capital projects especially, the MTEF should provide the critical structure through which to program funding amounts for specific projects to be completed within a specific time frame. Once allocations for capital are agreed through the MTEF, then an annex to the annual budget law should list which specific projects are to be funded during the three years, and by how much each year until completion. The imperative is to put in place a series o f steps through which ministries can be assured o f getting the funding needed to complete projects, but also encouraged to drop projects for which funds cannot realistically be expected over a medium term horizon. 39. Including fiscal scenarios in the MTEF is intended to encourage a priori agreement by the government and the Parliament on the budget priorities in the case of an unexpected increase or decrease in revenues. This could help stem the tendency for ad hoc increases and decreases in budgets that occur during the year, by planning for some level o f fluctuation to occur. One policy choice government may 14 consider is to target unexpected surplus revenues toward deficit reduction or toward completion o f pre-designated capital projects. Improving the PublicSector Pay System 40. Personnel costs consume a large and rapidly growing component of the Romanian budget. Aggregate spending on personnel cost increased by 58 percent from 2005 to 2007, while GDP only grew by 42 percent duringthe same period. Despite these increases in expenditure, the effectiveness o f the public administration has not improved significantly. The government has relied each year on broad-based salary adjustments negotiated with public sector unions. However, the fundamental character or structure o f the pay system has changed little, and it i s out-of-sync with the need to motivate performance amongpublic sector employees and attract new talent. 41. Romania's public sector pay system is at variance with those in the rest of Europe in several ways: (1) Non-wage compensation represents a disproportionate share o f total compensation, which undermines transparency and equity; (2) there are wide . disparities in pay between positions with similar responsibility; (3) incentives to take on new responsibilities are undermined by a compressed salary scale and over-reliance on seniority; and (4) compensation decisions are not based on reliable information on private sector comparators. In addition, there are widespread reports o f substantial political interference in the staffing for senior positions, and abuse in the use o f bonuses. Therefore, the independence o f the civil service has been under attack, and principles o f merit-basedrecruitment have been weakened. 42. Since early 2009 the government has taken some initial steps towards reform. The government has approved a salary ordinance to reduce non-wage compensation. There have also been plans to develop a unitary pay law, which aims to integrate under one statute the pay ranges for all public sector workers. The specific characteristics o f the pay law have not been worked out yet. The National Agency for the Civil Service i s also proposing new rules that would increase their influence inrecruitment decisions, and thereby enhance their ability to assure merit is used. 43. The reform program supported by the proposed DPL envisions changes to the pay system that would enhance capacity to attract and retain critical skills in the public administration. Enhancingtransparency o f the public sector pay system would be one element o f the strategy as would more accurate benchmarking o f pay to the appropriate labor market. Functional reviews o f the public administration would help identify budget resources that could be released for better targeting o f pay rewards. 44. The reform measures are intended to encourage reform of the pay system to be better aligned with European practices and to enable the public sector to more effectively recruit and motivate high-skilled workers. The civil servants are one 15 component o f the broader public service, and a substantial body o f analytical work was completed for the National Agency o f Civil Servants in 2006. Some o f the recommendations from that project could be used now to form the principles behind a new public service regime. The reform measures envisaged are intended to recognize the Government's commitment to develop a new salary ordinance on public sector pay and to reduce the role o f non-wage compensation. Work has been underway for several weeks on this, led by the Ministry o f Labor. Consultations are underway to assess which allowances will be merged into base salary and which might be eliminated. The reform measures sets specific goals for the extent o f the reform, by indicating what would be appropriate limits on the use o f allowances. Improving Financial Management and Provision of Services inEducation and Health 45. In addition, the government's reform agenda focuses on enhancing expenditure management in two key sectors-education and health. These sectors have seen increases in public expenditures in the past few years (spending on the education sector rose from 5.5 percent o f GDP in2007 to 6.0 percent o f GDP in 2008 for example) and account for a sizable proportion o f the budget, but still lag in outcomes- both in terms o f quality and access-relative to other EU economies. Although they remain somewhat under-funded in terms o f expenditures to GDP relative to other EU economies, there are inefficiencies in spending and potential for savings within the sectors. In an environment o f overall fiscal constraint, improved fiscal management and greater efficiency in the provision o f services can generate savings that can, in turn, be used to broaden access to public health and education services. Education 46. There is scope for improving the efficiency of resource use while enhancing the quality of, and access to, general education. 47. The clearest evidence of poor efficiency of spending inthe education sector is the relatively small classes in Romanian schools and the large number of teachers relative to the number of students. The average class in Romania has 20.6 students and has been decreasing over time. While there i s no consensus on an optimal class size, most educators (and researchers) would agree that the same quality o f education could be provided insignificantly larger classes. Moreover, the average class size is low compared to many Western European countries (e.g. 22 students in Germany and France) and some neighboring countries (e.g. 24.5 inLatvia). 48. Largely-but not exclusively-as a result of small class sizes, Romania employs a large number of teachers relative to a shrinking number of students. According to the Ministry's report on the Status o f National Education System in 2008, the student teacher ratio was only 16 for primary schools and 11 for lower secondary schools in 2007/2008. By comparison, the OECD average for primary schools was 16.2 16 and 13.3 in lower secondary schools (in2006). Romania's low ratio is the result o f a very small reduction in the number o f teachers and schools in response to the decline in the number o f students. Between 1992 and 2006, the number o f primary school students declined by 24 percent, while the number o f teachers declined by only 4 percent. 49. The main cause of the low class sizes and highnumber of teachers is the poor financial incentives facing the local authorities and school principals to merge classes and close down schools. Inparticular, the financing for education which schools and local authorities receive i s tied to inputs-the most important o f which i s a teacher- rather than being tied to the number o f students. As a result, neither the schools nor the local authorities have any incentives to try and reduce the teacher numbers-doing so would only involve the difficult task o f dismissing a teacher but no additional resources to reallocate to remaining schools and teachers. In fact, a dismissed teacher (or a closed school) implies savings to the central government but not to schools and local authorities. 50. Improving the efficiency of resource use is particularly important in view of the fiscal constraints on the one hand, and the need to improve the quality and access to education on the other. Romania still lags behind most other EU countries in terms o f completion rates and the quality o f secondary education (Figure 5). Many disadvantaged youth (particularly Roma and poor rural residents) do not complete secondary school, and a large number o f secondary school graduates do not attain minimum quality standards. Improving the quality and skills o f its workforce is a key policy priority to help the Romanian economy emerge stronger from the crisis to sustain growth and faster convergence with other EUcountries. Figure 5: Romania Lags inthe Number of Graduates and Number of GraduatesAchieving Minimum Level of Quality3 100% 3 90% 80% $ 70% <,"60% 50% g 40% $ 30% 20% e? 10% 0% Old ELImembers New Member States, excl. Romania Romania "Minimum quality" i s defined as scoring above level 1 on PISA 2006 exam. To draw this graph a key assumption is needed, namely, that the distribution across different quality levels of 15 year old students (as measured by PISA) i s indicative of the distribution across different quality levels of upper secondarygraduates. 17 51. The reforms supported in the DPL program directly address the poor incentives currently faced by local authorities in using resources efficiently. In particular, it would support the introduction o f a per capita student financing formula in eight counties (accounting for 20 percent o f the total student population). While no triggers are envisioned for D P L l,legislation to enable per capita finance will be prepared and submitted to Parliament by the end o f 2009. Moreover, this legislation would be passed by June 2010 (trigger in DPL3) in time for implementing per student financing o f all schools located in the eight counties starting with school year 2010/2011 .4 Having money tied to students rather than teachers would provide substantially better incentives for these counties and schools to create larger schools and classes. 52. By creating better incentives for local authorities and schools, the reform measures are likely to generate fiscal savings, but the new scheme would have additional benefits. In addition, by tying resources to the number o f students, local authorities would face better incentives to prevent student drop outs. Moreover, a well designed formula would also provide for more horizontal equity in education services. In particular, the formula could explicitly allow for differences in costs based on structural features that make it more difficult to provide education in certain areas (e.g. rural, mountainous or low density areas) or to certain groups o f the population (e.g. minority, low income, special needs, etc). Health Services 53. Public expenditure on health increased from 2.9 percent of GDP in 1990 to 3.7 percent in 2007. However, Romania's health status remains poor compared with other European countries4espite significant improvements in Romania's basic health indicators since the 1970s. Although male and female life expectancies have increased, and infant and maternal mortality have declined, life expectancy is 6 years shorter than the EU average. Infant and maternal mortality are among the EU's highest. Romania also has one of the highest levels o f cardiovascular diseases inthe EU. 54. Health insurance and taxes are the two main sources of health financing. In 2007, the contributions to the National Health Insurance Fund (CNAS) accounted for 78 percent o f total public expenditure and taxes accounted for 22 percent. Part o f alcohol and tobacco taxes is earmarked for the M o H budget. Informal out-of-pocket payments by the patients are considered to be widespread and significant, although there are no firm estimates. CNAS provides universal coverage to the population and i s primarily funded by contributions collected from employers (5.2 percent o f the payroll), employees (5.5 percent o f the wage income) as well as the self-employed (5 percent o f the income). 55. As the purchaser of services, the CNAS is facing major challenges, which include the following: A small number o f very small schools may not necessarily receive their funding according to the formula. 18 0 The benefits package is very generous. Currently, the range o f services covered in the benefits package i s broad and there are very limited co- payment mechanisms - not even for more expensive and less essential interventions. As a result, providers (especially hospitals) are not adequately reimbursed and try to shift the costs o f drugs, medical supplies and food to patients who have to pay out o f pocket for items that are supposed to be free. 0 Drug costs are escalating. In 2007, drugs and medical supplies for outpatient care alone accounted for more than 30 percent o f CNAS expenditure, the second highest expenditure after hospital services. Inthis context, drug pricing, prescription and reimbursement policies need to be revisited. 0 Efficiency of the system could be improved through better purchasing, and in particular improved payment methods. Overall, the system is skewed towards hospital care. The CNAS spends more than 46 percent on expensive hospital care and less than 6 percent on primary care. Hospitalization rates are high in comparison with international standards. Primary care providers receive a combination o f capitation (90 percent) and fee-for-service (10 percent), but mechanisms to monitor their performance and ensure they act as gate-keepers are sub-optimal. For ambulatory care, the pricing policy tends to benefit hospitals' outpatient departments rather than stand-alone ambulatory centers. Hospitals, which are paid on the basis o f Diagnosis Related Group (DRG), are reportedly struggling with deficits as the DRG rates are generally too low to recover costs. The system also creates perverse incentives to perform more surgical procedures as their reimbursement rates are higher. Overall, provider payment mechanisms need to be thoroughly evaluated and revised to ensure that they contribute to improving technical and allocative efficiency inthe system. 0 Lastly, the burden of funding the CNAS is not equitably shared. Of the 22 million people entitled to coverage, only 5 million actually pay a contribution. Clearly, not all o f the 75 percent of the population exempted i s poor. This issue requires a separate debate in the broader context o f the governments' fiscal policy, but it will also have to be addressed to ensure the CNAS i s sustainable. 56. Romania also inherited a fairly large and poorly managed hospital infrastructure. Other than the introduction o f new payment mechanisms, the progress in hospital reform has been limited. The number o f hospitals has remained relatively constant since the 1 9 8 0 ~with 416 hospitals in 1980 and 422 in 2003. Including short- ~ 19 term acute care and long-term care, Romania had over 142,000 hospital beds or 6.5 beds per 1,000 people in 2004. There are large regional variations in the bed per population ratios, ranging from 8.5 inthe west and inBucharest to 4.1 inthe south. The bias towards hospital care is reflected in the high number o f hospital admissions (24.3 per 1,000 in 2006). A high number o f cases are treated in hospitals while they should be handled on an outpatient basis. There are no functional referral links between primary health care, ambulatory system and hospitals. Low funding levels, poor management systems, poor fiscal discipline and perverse incentives contribute to the low efficiency o f hospitals. Many Romanian hospitals have incurred financial debts in recent years, despite a substantial increase inhealth insurance collections and an expansion o f the health service budget. 57. The reform measures supported by the proposed DPL focus on mobilizing resources and improving the efficiency and equity of service provision. Inparticular, the proposed DPL operation addresses the factors listed above that are draining the resources o f the CNAS and which ultimately result in inadequate and less than equitable coverage o f the more essential health services. The measures o f the proposed DPL program also aim to redress the balance from the costly hospital based services towards the less costly outpatient and primary care services-as noted above a high number o f cases are treated in hospitals that would be more appropriately handled as outpatient cases. B. STRENGTHENINGSOCIAL PROTECTION Social Assistance 58. Although the poverty rate decreased dramatically from 36 percent in 2000 to 5.7 percent in 2008, Romania still had 1.2 million poor in 2008. Indeed, the poverty rate in Romania is one o f the highest in the EU25 countries. With the economy contracting by 4 percent in 2009, this number i s expected to increase to 7.4 percent (1.6 million people). The percentage o f children (between 0 and 14 years o f age) living in absolute poverty is expected to increase from 7.8 in2008 to 10.7 in2009. 59. Spending on the poor is low, and has declined over time, resulting in inadequate coverage. Although social protection spending as a percentage o f GDP has remained constant over recent years, two factors bear noting: (i) the social protection expenditure per capita i s the lowest inthe EU; (ii) spending on poverty-targetedprograms i s low (as a percentage o f GDP, and relative to the magnitude o f poverty). 20 Figure 6: Effectiveness of Non-Contributory Social Benefits NO4 -I"--I_ .- -I"_^ ed by social assistance cash transfers 60. At the same time, there is scope for improving some of the social assistance (SA) schemes. Inmost programs, benefits are not linked to actions that reduce exposure to risks, resulting in welfare-dependency and work disincentives. The Guaranteed Minimum Income (GMI) is the only program that has a work incentive built in (benefits increase by 15 percent if a family member works). The child raising allowance creates a work disincentive for women by granting generous benefits (85 percent o f the salary) for a long period o f time (2 years). The child allowance i s no longer conditional on the schooling o f children, and the school attendance conditionality for the income-tested family allowances i s poorly designed and not enforced. To the extent that a large number o f children from poor families continue to drop out o f school before completing secondary school, conditioning benefits on schooling up until the end o f secondary school may reduce future poverty. 61. Overall, there is a lack of coherence in the social assistance programs and weak targeting (Figure 6). Social assistance benefits are very fragmented, with a large number o f benefits going to families (with no clearly distinguishable objectives), while poor elderly (particularly from rural areas) are hardly covered by any program (about one half o f the poor elderly are not covered by social assistance). Most o f the benefits going to families are universal (child allowances, child raising allowances). Targeted programs use multiple criteria: most benefits are income-based and use different eligibility thresholds relative to the minimumwage per capita, which is significantly higher than the poverty line. The threshold for heating allowances i s actually higher than the minimum wage per capita, resulting in 50 percent o f the households getting this benefit. Income- based targeting i s problematic given the size o f the informal economy, which makes it hard to verify self-reported income. Some efforts to rationalize the system have been 21 made, including the piloting o f the unique payment system and some movement towards the adoption o f a "life c o ~ r s e "approach to SA. The government i s planning to conduct a ~ review o f SA system and to consolidate the benefits for newborns under one single benefit. 62. Monitoring and Evaluation of the SA programs is needed. The only way to learn about the efficiency and effectiveness of SA programs and to refine the design and implementation o f those programs accordingly, i s by setting up a sound monitoring and evaluation system (M&E). This system would monitor program costs, beneficiaries, outputs and outcomes. It would also assess the effectiveness o f key or innovative programs against their stated objectives. The new unique payment system is a step inthe right direction to develop an integrated information system for SA programs. 63. The financing and administrative setup for social assistance benefits is also fragmented-resulting in inefficiencies. There have been some efforts to bring SA benefits under a unique payment system (National Agency for Social Benefits, NASB) under MLFSP (Ministry o f Labor, Family and Social Protection), with a single form for all benefits, a single payment system and a single beneficiary registry. However, this system i s not fully operational yet, and the most important benefit for the poor (GMI) i s not part o f it. The GMI is currently financed from a conditional block grant to local governments (based on needs estimates reported by local governments). The transfers from the central budget for the GMI have to be matchedby local governments. However, this system has generated horizontal inequities, as some local governments are not able to meet the demand, resulting in some benefits not being paid to entitled beneficiaries and partial payments6This system also suffers from a lack o f transparency in the allocation o f funds as well as little control over the flow and use o f funds.7 The capacity o f the Social Inspection to control and monitor has improved, but its sanctioning authority and capacity to enforce compliance with SA program rules are still relatively low. 64. As a result the impact of social assistance programs on poverty is limited and i s achieved at a high cost. About 29 percent o f the poor are not covered by any social assistance benefit. For those who are covered the benefit levels are low relative to the minimum wage (between 10 and 20 percent) and the consumption of poor beneficiary families (between 9 and 31 percent). Clearly, not all social assistance programs have poverty reduction as the main objective. However, even if the objective i s to increase fertility or to improve the health and education o f children, these benefits should be given A life course approach involves looking at the different demographic groups (e.g. children, elderly) and the risks faced by these groups and determiningwho within these groups are the most vulnerable. According to MLFSP, an additional 90 million RON would have been needed in 2008 to cover all entitled beneficiaries. In terms of partial payments, the 2008 Social Inspection report shows that in some communes only 80 ;percentof the due amounts (according to entitlements) are beingpaid. The allocation of funds is done in two steps. The first step is the allocation to counties, which then further distribute the funds amongst local governments. No formula or transparent criteria is used. There is a large disconnect between the programmed GMI budget (provided by MoPF) and the actual spending(provided by MLFSP), due to many factors, including the block grant approach (in which the local governments have the discretion to allocate amongst various benefitshocial assistanceexpenditure categories). 22 to families for whom receiving the benefits would affect their decision to have children or to invest in their education and health. Given the limited fiscal space and the significant challenges in terms o f poverty and vulnerability, there is a need to focus SA efforts around programs with clearly-defined objectives and design those programs (including the target population) to meet those goals at the lowest cost possible. 65. The reform measures supported bythe DPL program relate to increasing the coverage and improving the design of the -most efficient and well targeted social assistance program-the GMI-while progressively rationalizing and reducing the coverage of the less efficiently targeted programs and improving the targeting of these programs. Currently, a large number o f benefits go to families with no clearly distinguishable objectives, while one half o f the poor elderly are not covered by social assistance at all. Pensions 66. The Romanian public pension system (pillar 1) i s projected to run a fiscal deficit amounting to 1.7 percent of GDP in 2009. Comprehensive reforms since 2001 combined with better revenue collection performance and supported by steady economic growth, improved pension system financial performance to achieve a fkagile surplus o f 0.3 percent in2006 and 0.2 percent in2007. This favorable fiscal situation i s projected to reverse due to the decisions in2007 and 2008 that introduced sizable increases inpension point value (hence a generous indexation o f benefits) and granted additional pension increases to certain groups o f workers and due to the impact o f the projected economic slowdown on pension system revenues. In order to respond to this fiscal pressure the government maintained contributions to the second pillar at 2 percent in2009 (instead o f the previously legislated increase to 2.5 percent in 2009) and increased the overall contribution rates from 27.5 percent in 2008 to 31.3 percent in February 2009. Even taking into account the recent increase in the overall contribution rates, the pillar 1 pension system i s projected to run a fiscal deficit o f 1.7 percent o f GDP in 2009. The pension scheme would face even greater fiscal challenges as a result o f the rapidly aging population. Based on the existing benefits scheme and projected dependency ratio, the deficit is projected to increase from 1.7 percent o f GDP in2009 to 2.0 percent o f GDP by 2012 and to 3.5 percent o f GDP by 2050.' 67. Generous indexation rules in Romania contribute to the fiscal deficit. Under the current pension system, a working individual accumulates points based on his wages relative to the average wage. Benefits are based on total accumulated points at retirement. Once the individual has retired, the number of points accumulated is multiplied by the point value. The point value in turn i s a percentage o f the current gross average wage- (currently set at 42.4 percent). Thus even after retirement, changes in the individual's * Theseprojectionshave been made usingthe World Bank's PROSTmodel (the World Bank's pensiontoolkit) and the macro projections of the government. These projections are optimistic as they don't take into consideration the potential decrease in formal employment.The reduction in formal employment due to economic slowdown and due to the recent increasein overall contributionrates is difficult to predict. 23 benefits are linked to current wages and can vary if either wages increase or as has been the case, the point value as a percentage o f wages i s changed. In fact, over the past few years prior to 2009, the increase in the point value has resulted in pensions rising faster than wages because the point value, as a share o f the average wage, increased from 31 percent in early 2007 to 45 percent in December 2008 (an increase o f about 50 percent). Overall, the Romanian indexation rule i s generous compared to most OECD countries that index pensions to inflation (including Belgium, Canada, France, Japan, Korea, Spain, Turkey, UnitedKingdom and United States). 68. The absence of a transparent pension indexation rule in Romania-unlike most OECD countries-also makes the pension system extremely vulnerable to political pressure leading to uncertainty for the system participants, and for Romania's fiscal outlook. As discussed above, existing pensions are re-valued based on changes in the point value by multiplying an individual's average points by the new point value. Currently (for the first three months o f 2009), the point value i s set at 41.2 percent o f gross average wage and has been legislated to increase first to 42.4 percent in April 2009 and then to 43.2 percent o f average gross wage inOctober 2009. This highlightsthe non- transparency and uncertainty embedded inthe current indexation rule inplace. 69. Relatively low retirement ages also contribute to the fiscal pressure in the first pillar. The reforms introduced in 2001 gradually increase retirement ages fiom 55/60 to 60/65 for women and men respectively. For men, life expectancy at retirement i s 13.5 years, making it difficult to increase the retirement age beyond the legislated gradual increase. For women, however, life expectancy in retirement i s 20.9 years and will go down to 20.6 years in 2014 at the time when the retirement age reaches 60. Current retirement rules raise both the issue o f gender equity, and add to the fiscal pressures on the pension system. Most OECD countries have equalized retirement ages between men and women, and some have increased the retirement age beyond 65, 70. With regard to the first pillar, the reforms supported by the DPL entail gradually indexing benefit adjustments to inflation (and de-linking retirement benefits from the point value) and eventually equalizing retirement ages between men and women to improve fiscal sustainability. Indexation to inflation would maintain the living standards o f the pensioners and could reduce the fiscal deficit by 0.7 percentage point relative to the baseline by 2015. 71. A new second pension pillar was enacted into law in 2006 to address future fiscal constraints and its sustainability is now jeopardized. The second pillar can be important in easing pressures on the government budget. Its success in doing so and in providing better benefits depends on motivating contributors to declare correct earnings and on the effectiveness o f supervision. Almost 3.5 million workers participate in the second pillar. The contribution rate to Pillar I1 schemes was set at 2 percent and was supposed to increase by 0.5 percent per annum until it reached 6 percent. However, the 24 increment that was to be made in 2009 was suspended by Emergency Ordinance 4/2009 (art. 9). The suspension potentially threatens the viability o f the schemes andjeopardizes the government's long term objective o f reducing the fiscal impact o f pensions. In addition, the suspension has the potential to drive out from the market pension fund management companies that are already operating on very tight margins and long pay- back periods due to the low level o f fees permitted under the law. This would reduce competition and choices for contributors, and ultimately risk translating into higher fees for contributors. 72. The reform measure with regard to the second pillar entails restoring the pace of increase in contributions. The contributions would increase by a minimum o f 0.5 percent in 2010 and see contributions increase by 0.5 percent per year thereafter until they reach 6 percent. C. STRENGTHENINGTHE FINANCIAL SECTOR 73. The slowdown in capital inflows, depreciation pressure on the currency, and decline in demand pose significant risks to financial stability. The contractionary effects on economic activity and adverse valuation effects for household and corporate financial positions could affect the banks through credit risks. Stress testing suggests that, although most banks are fairly well placed in terms o f capital positions and liquidity ratios to date, any significant deterioration inbanking sector credit portfolio quality could result in undercapitalization o f some banks. Difficulties in some banks could potentially trigger a more systemic crisis through contagion effects. 74. Important steps have been taken to improve liquidity management and strengthen domestic coordination. The National Committee for Financial Stability (NCFS) was established in July 2007 as the Domestic Standing Group (DSG), following the MOU signed by the domestic supervisory authorities and the Ministry o f Public Finance (MoPF), and several working groups have since been set up.' The NBR has taken a range o f important steps to enhance its monitoring and management o f liquidity conditions. These include stepped up contacts with market participants' trading desks, and daily monitoring o f banks' foreign currency debt payment schedules. The NBR has also re-introduced rep0 operations to provide short-term liquidity additional to overnight Lombard lending, and has also conducted occasional bilateral swaps against euro. The NBR has further agreed with the IMF that it will impose more detailed reporting requirements on liquidity. 75. The minimum level of the capital adequacy ratio also will be raised from 8 percent to 10 percent as part of the IMF program. Stress tests o f individual bank balance sheets and lending portfolios under different scenarios will be used to assess the The NBR and MoPF have also been also participants in the longer-standing crisis simulation exercises organized at the EUlevel by the Economic and Financial Committee of the Council. 25 potential increases in own funds needed to ensure that solvency ratios remain above 10 percent. The NBR will require banks to secure sufficient resources to cover potential shortfalls. 76. The government has also started to review some aspects of contingency planning as part of the IMF program. These include reviewing the bank resolution framework and the means for potentially injecting capital into systemically important banks. It i s also addressing weaknesses in the deposit insurance framework, moving towards adoption o f IFRS accounting standards, and seeking an agreement with commercial banks to facilitate the restructuring of household debt contracted in foreign currency. 77. Further aspects of contingency planning need to be considered. If negative spillovers from the ongoing global financial crisis were to intensify, the worsening situation inthe Romanian banking sector could significantly deteriorate. 78. A Strategic Action Plan needs to be prepared to deal with potential future strengthening within the financial sector under adverse but plausible scenarios. The materialization o f certain risks may require policy interventions from the Romanian government (the NBR or the MoPF). Timeliness of such interventions will be critical in such a situation so that preparedness is highly warranted to sustain stability o f the Romanian financial system looking forward. 79. A debt restructuring plan-for both mortgages and corporate debt-is also needed as part of the contingency planning. There is an increasing number o f insolvency proceedings filed in Romania. The number o f cases filed was 8,297 in 2007 compared to 14,483 in 2008. In the first three months o f 2009, 4,967 insolvency cases were filed. Most insolvency cases end up as liquidations because the formal reorganizationproceedings are not widely used due to several legal features that make the mentioned proceeding rather rigid. Infact, only about 1.5 per cent o f insolvency cases are reorganizationproceedings. 80. Out-of-court corporate restructuring mechanisms ("workouts") are almost unknown in local practices. In highly critical scenarios, formal insolvency law proceedings should be complemented with out-of-court mechanisms for corporate restructuring because in systemic crises environments: (i)even sound formal reorganization proceedings typically are ineffective (costly, lengthy, value destructive); and (ii) are not prepared to handle massivenumbers o f corporate insolvencies inan courts effective manner. 26 81. Consumers are not eligible for insolvency proceedings. Because consumers are not able to restructure their debts under a formal insolvency mechanism, consumer debts in default are individually dealt with under individual enforcement proceedings. Given the large amount o f mortgage credit supplied to individuals in Romania, in a systemic crisis scenario the lack o f formal restructuring mechanisms could cause a highly undesirable situation, in which creditors could exercise their individual enforcement rights massively and debtors could try to put procedural obstacles to execution, thereby delaying credit recovery. 82. Creating a favorable restructuring environment demands a strategy that includes several components. First, this strategy needs to contemplate special guidelines to preserve asset values and to induce corporate restructuring. Taking as a starting point the London Approach and the Bank o f England's Pre-Foreclosure Protocol, a framework for mortgage debt and corporate debt restructuring should be created to complement foreclosure and insolvency proceedings. The restructuring strategy also needs to consider and review potential impediments to restructuring inthe insolvency law (such as stringent avoidable transactions provisions, and sanctions for debtors who do not file for formal insolvency proceedings within certain time periods) and possibly in other laws. Finally, out-of-court negotiated restructuring plans need to be protected through legal provisions allowing expedited court approval o fpre-negotiated agreements. 83. There are also several regulatory and supervisory issues that need to be addressed to ensure greater resilience and stability of the sector over the longer term. First, it i s important that the sectoral regulatory and supervisory bodies, the Insurance Supervisory Agency (CSA) the National Securities Commission (CNVM), and the Private Pension Supervision Commission (CSSPP) are politically independent, inline with the NBR, and that these bodies have financial autonomy. Currently the process for appointing Board members involves Parliament preparing a list o f possible appointees, shortening that list and then selecting members from that list. This process does not fully guarantee that members are free from political interest as recommended by international standards o f regulation and supervision. In addition, it will be important to maintain the financial independence o f these institutions and to ensure their capacity to establish their staff salaries inline with market levels. 84. The implementation process of Basel I1is a major prudentialpolicy decision, which can have a significant effect on the resilience of the banking system. Hence, a robust assessment process for all advanced models (Internal Rating Based (1RB)I Advanced Measurement Approaches (AMA)), as well as a governance structure involving all stakeholders within the NBR, are necessary as part of the NBR's Basel 11 implementation. In addition, it i s critical that the minimum capital requirements o f the first pillar be accompanied by a robust implementation o f the second and third pillars. The Basel I1 Framework i s composed of three mutually reinforcing pillars that are intended to be implemented simultaneously. There are three main areas that are assessed under Pillar 2: risks considered under Pillar 1 that are not fully captured by the Pillar 1 27 process (e.g. indirect foreign exchange risk, residual credit risk, credit concentration risk); those factors not taken into account by the Pillar 1process (e.g. interest rate risk in the banking book, business and strategic risk); and factors external to the bank (e.g., business cycle effects). A robust Pillar 2 implementation process should be tailored to the specific risks o f the Romanian banking system, including for the local subsidiaries o f foreign banks. This also needs to include a timely assessment o f capital adequacy by all Romanian banks and a systematic indepth review o f the latter by the NBR.A framework for the proper implementation o f Pillar 3 should also be developed by the NBR at the same time. 85. The ongoing modernization of supervision entailing stronger consolidated supervision is important in an increasingly sophisticated market. Despite the existence in Romania o f financial groups whose activities span various sub financial sectors, supervision remains largely sector based and silo oriented. While there i s an MOU between the supervisors on collaboration, in practice this collaboration has been limited. For instance, there have been no joint inspections o f financial groups by various supervisors and little supervisory attention seems to be devoted to intra-group transaction and risk concentrations. 86. The government's reform program in the financial sector supported by the proposed DPL aims to address the key issues mentioned above. This includes the preparation o f a Strategic Action Plan for potential bank interventions, the preparation o f mortgage and corporate debt restructuring guidelines, the strengthening o f consolidated supervision for financial groups, improvements in the decision making process and implementation o f Base1 I1 and measures to ensure the political and financial independence o f the sectoral regulatory and supervisory bodies. IV. BANKSUPPORT TO THE GOVERNMENT'S PROGRAM A. LINKTO THE COUNTRYPARTNERSHIPSTRATEGY 87. The proposedDPL programis centralto the Bank's proposedengagementin Romania, as discussed in the Country Partnership Strategy (CPS) beingpresented to the Boardwith this operation. The Bank's strategy duringthis CPS period will be to help Romania mitigate the impact o f the current financial and economic crisis, while putting in place the fundamental structural reforms needed to both put Romania onto a sustainable economic growth path and to prevent such imbalances arising again. The main pillars o f the CPS are: i)economic growth and competitiveness; ii)public sector reform; iii)social and spatial cohesion. The focus o f this DPL program on public financial management, the social sectors and the financial sector i s fully aligned with these pillars. 28 88. The DPL series will constitute the bulk of new lendingin the early years of the CPS. Given the severity o f the crisis and the exceptional need for large-scale budget support, almost all new lending inthe first year or two o f the CPS will be concentrated on this DPL series. A large existing portfolio o f investment loans is being restructured to provide a better fit with the Government's priorities and absorption capacity. Selective, new investment lending could be considered in the outer years provided there i s headroom from the portfolio restructuring to accommodate it. The CPS outlines a substantial AAA program that supports the design o f the DPL program. B. COLLABORATIONWITH THE IMFAND OTHERDONORS 89. The proposed Bank operation supports and complements an overall multilateralpackageprimarilyinvolvingthe IMFand the EuropeanCommission,as well as potentiallythe EBRD, EIB and IFC. The overall financing package amounts to 19.95 billion, o f which the IMF i s extending 12.95 billon and the European Commission 5 billion. The proposed loan (DPL 1) represents a part o f the Bank's share o f 1 billion in the package. The Bank team has collaborated very closely with the IMF and the EC from the start o f the multilateral support program. The measures under the proposed DPL program have been discussed with both the IMF and the E C to ensure that the measures envisaged reinforce and are complementary to the measures under the IMF and EC operations. In the area o f public sector reforms, the Fund's Stand-By Arrangement (SBA) envisages a new Fiscal Responsibility Law (FRL) that will, among other things, set up procedures for improved multiyear budgeting and the medium expenditure framework reforms supported by proposed DPL program could be enforced eventually through the new fiscal responsibility law when this i s passed in 2010. The main advantage o f the FRL might be a requirement o f some sort o f super majority to change. Similarly, in the area o f social protection, the Fund's SBA envisages a reform in the key parameters o f the pension system to be undertaken in coordination with the Bank and the DPL measures seek to determine the changes inthese parameters. Inthe financial sector, the measures under the proposed D P L are directly complementary to those in the IMF program. Together, the programs o f support in the financial sector address the key areas identified in the recent Financial Sector Assessment Program (FSAP) for Romania. The complementary aspects o f the Bank and the Fund support to the government's reform program are summarized inTable 4. 29 Table 4: Complementary Aspect 3f Fund andBank Support to the bvernment's Program Area World Bank (full DPLDroeram) IMP Cross-sectoralpublic financial managementreforms Medium term expenditure The form and content ofthe MTEF to Fiscal ResponsibilityLaw (FRL) to management be elaboratedprogressively(across bepassedin 20I O which among other the DPLprogram) with ceilings at the things sets up proceduresfor multi- aggregate level, economiclevel and year budgetingand limits budget finally the sector level. revisionsduring the year. Fiscal ResponsibilityAct and implementationplanto bepresented The 20IO- 12 MTEF to bepresented to Parliamentby endNovember to Parliament with the annualbudget 2009. law. Budget process rules would be integratedinto the new fiscal responsibilitylaw to makefuture MTEF ceilingsbinding rather than merelyindicative.Public investment programto bereconciledwith annual MTEF ceilingsreflecting prioritization ofprojectsacross years. The 2011 13 MTEF to beapproved - by Parliament prior to the annual budget law. Public pay Somenon-wagepaymentsto be cut New Unitary Pay and GradingLaw back immediatelyby Emergency to be approvedby October 2009 Ordinance (May 2009). which limits non-wagepersonnel expendituresto below 30% of total personnelcost and caps the receiptof A regulationimplementing the new bonusesby individuals (at an Unitary Pay andGrading Law to be unspecifiedlevel). The legislation approvedby Dec 2009. It includes focuses on establishmentof aunified measuresnot only to reducenon pay scale implementedover 3 years. wage expendituresbut also more specificprovisionsto improvelinks betweenpay andjob responsibility andto benchmarkto labormarket. The pay adjustments are to be made in accordancewith the implementing regulationsandnew procedures enactedto enforcemerit-basedhiring andpromotion(June 2010). Sectoralpublic financial managementreforms Health Measuresto increasefiscal savings No measures Education and improvequality and access of No measures services. 30 Table 4 (cont'd). Complementar Ispects of Fund and Bank suppor to the Government's program Area World Bank (full DPL uroeram) IMF Social assistance Measures to increase the coverage o f No measures but fiscal deficit target - best targeted program (GMI) and o f the Fund program allows for consolidate other less well targeted increased Social Assistance coverage SA programs. Measures to protect as envisaged in Bank's DPL elderly poor. program. 250 million Ron allocated for 2009 and 500 million RON for 2010. Social protection Measures to move towards indexing Letter o f Intent (LOI) includes reform o f pillar 1 pension benefit increases o f pillar 1 pension parameters. The to inflation instead o f wages and exact revision of pillar 1 pension gradually equalize retirement ages parameters to be coordinated with the between men and women (Dec Bank as determined through reform 2009). measures in DPL program. Financial sector Contingency planning Strategic action plan to further Bank stress tests (Prior Action) and strengthen the financial sector based recapitalization o f banks; on results o f the stress tests; Strengthening o f bank resolution Establishing a corporate and framework; mortgage debt restructuring Ensuring prompt payout o f deposit framework. insurance and adequate resources to do so. Structural reforms Strengthening political independence Moving towards adoption o f IFRS o f regulators; accounting standards. Strengthening decision making process and methods for Basel I1 adoption; Strengthening supervisory arrangements for financial conglomerates. C. RELATIONSHIPTO OTHER BANKOPERATIONS 90. The current economic and political context provides a good opportunity to revive the structural reforms agenda, with support from the the IMF, the EC and the Bank under the agreed multilateralsupport package.The DPL continues reforms launched under the 2003-2006 P A L program. The previous programmatic adjustment loan (PAL) was designed as three-series program to support Romania's accession and integration with the European Union by accelerating economic growth and promoting social inclusion. The P A L supported a wide range o f reforms in public finance management, education, health, social assistance, pensions, judiciary, and private sector development. Following the successful implementation o f P A L 1 (rated Highly Satisfactory by the Bank's Quality Assurance Group (QAG) the subsequent PALSwere canceled, as the government's appetite for bold and painful structural reforms dropped 31 after EU accession in 2007 and the Government sought to diversify its sources o f financing. 91. The DPL agenda is complemented by reforms and activities undertaken in a series of investment operations, as well as the substantial technical assistance provided under the Public and Private Institution BuildingLoan (PPIBL), which closed in December 2008 (Table 5). Table 5: InvestmentOperationsinDPLAreas Area of reforminthe DPL I Ongoinginvestmentprojects 1Recently closedprojects Public financial management I I i PubliciPvt InstitutionBuilding Loan, PAL Education Rural Education ~ Health Health Sector Reform APL#2 Health Sector Reform APL #I ~ Pension Social Sector Development ~ Social Assistance Social Inclusion Project i Mine Closure and Social Mitigation i Social Sector Development Mine Closure and Socio-Economic j Social Development Fund 2 D. LESSONSLEARNED 92. The Bank has played an important role inRomania since 1990, the beginning of the transition period. Between 1991 and 2008, the Bank supported a total o f 54 Bank financed projects, with a total commitment o f about US$ 5.5 bn, representing on average a commitment o f US$ 326 mn per year. The largest lending volumes (US$ 343 mn per year on average) were registered between 1995- 2000. Adjustment operations accounted for 33 percent o f the total lending since 1990. The Bank's financial assistance accounts for 39 percent o f all net multilateral assistance over 1991-2008, and 8 percent o f all net (long term) inflows. 93. About one third of the Bank lending (33 percent) has been directed towards the structural adjustment of the enterprise and agriculture sectors. The Bank has financed projects in the health, social protection & inclusion, agriculture and sustainable community development areas representing about 23 percent o f the total lending. A similar 23 percent o f the financing has supported infrastructure operations, as well as the energy and mining sector restructuring. Targeted TA to public institutions and the support for judicial reforms has accounted for some 7.5 percent o f total lending. The remaining 13.5 percent covers operations in a variety o f areas including but not limited to private sector development and KE, hazards mitigation, cadastre reform, trade and transport facilitation. 94. The EU accession objective succeeded in bringing together the main political parties and mobilizing the support for deep structural reforms. However, once the political goal o f joining the EU was attained in January 2007, the support for difficult reforms substantially subsided. The prospects o f accessing substantial grant funds from 32 the EUunder the Structural and Cohesion Funds also contributed. These prospects have not materialized so far. 95. The capacity to design and implement coherent policies, programs and projects has been a central factor in the success or failure of the previous operations. The Bank and the EU, through the pre-accession programs, have contributed substantially to enhancing administrative capacity in various areas targeted by reforms. However, in general, the capacity o f the public sector to prioritize, plan and implement policies in an effective and efficient manner remains limited. Further assistance may therefore be needed to pushthrough complex reforms. 96. Strong leadership from the center of the government, i.e. Cabinet of the Prime Minister, and support from the Presidency has been crucial for the successful implementation of the previous reforms, especially the politically sensitive ones. It i s important that the support o f these institutions is mobilized for the program from the early stages. 97. Flexibility has been also an important factor in the success of the previous programmatic adjustment operations. The policy reform agenda needs to be realistic interms o f content and timing, andrisks, includingthe political ones, needto be carefully weighed in the preparation o f the operation. Ensuring the understanding o f and the appropriate popular support for reforms through a carefully planned and implemented communication strategy o f the government should be part o f the agenda. E. ANALYTICAL UNDERPINNINGS 98. The agenda promoted by the DPL is strongly anchored in the past and ongoing analytical work done by the Bank and complements several investment operations. The Bank has undertaken substantial analytical work in recent years in all areas covered by the DPL (Table 6). Most recently, a Public Expenditure Review (PER) i s underway and focuses on identifylng opportunities for efficiency gains in the major expenditure categories o f the public budget. The main purpose o f the PER is to analyze: a) the recent aggregate and sectoral expenditure patterns; b) the effectiveness and efficiency o f spending; and c) the policy and institutional challenges faced by the government in the main public spending areas in the context o f the ongoing crisis, including in education and health. There i s also on-going work on the impact o f the crisis on poverty. In the financial sector the proposed DPL draws on the FSAP that was undertaken with the FundinNovember 2008. 33 Table 6: AAA Work inDPL Areas Area of reformin the DPL UnderpinningAAA work Publicfinancemanagementreform Public ExpenditureandInstitutionalReview Update(inprogress) RomaniaPolicy Briefs 2009 Public ExpenditureandInstitutional Review2006 Pay andemployment reform Public ExpenditureandInstitutional Review Update(in progress) RomaniaPolicy Briefs 2009 Public SectorPay Practicesin Romania2007, and2008 PublicExpenditureand Institutional Review2006 Educationreform Public Expenditureand Institutional ReviewUpdate (in progress) RomaniaPolicy Briefs 2009 DiscussionPaper on Introducinga Student Loan Schemein Romania2008 EducationPolicyNote2007 Public Expenditureand Institutional Review2006 Healthreform Public Expenditureand Institutional ReviewUpdate (in progress) RomaniaPolicy Briefs 2009 HealthSectorPolicyNote 2007 Public Expenditureand Institutional Review 2006 Socialassistance andpension reform RapidAssessment of the Impactof EconomicCrisis on Poverty(in progress) RomaniaPolicy Briefs 2009 Programmatic PovertyAssessment -Phase2 (2008): - Are the Most VulnerableProtected? - LaborMarket Vulnerabilities ProgrammaticPovertyAssessment - Phase 1 (2007): - Povertyand InequalityUpdate: Trends andProfile - EconomicGrowth and PovertyDynamicsin Romania Pension SectorPolicy Note2007 Public Expenditureand Institutional Review2006 Financialsector FSAPNovember 2008 ConsumerLiteracyandProtection2008 V. THE PROPOSED OPERATION OBECTIVEAND RATIONALE 99. The objective of the proposed operation is to support the Government's reforms in fiscal management, social protection and the financial sector. These reforms aim to cushion the impact o f the financial crisis on the poor and vulnerable, while strengthening the resilience o f the economy to better position Romania to resume and sustain highgrowth over the medium-tem. 100. The proposed operation would achieve its objective by contributing to the international financial support package of the IMF, EC and other development partners. The direct financial contribution o f this operation i s relatively modest at 1 billion inan overall package of 20 billion. However, the contribution o f this operation to reform agenda is significant as it tackles the structural reforms needed to improve fiscal sustainability and the quality and equity o f access to public sector programs, enhance social protection systems to address the immediate needs o f the vulnerable but also to ensure more effective social protection over the longer term, and strengthen the resilience and functioning o f the financial sector. The Bank is well placed to engage in these areas 34 as it can draw on its rich base o f analytic work, as mentioned above, and an ongoing policy dialogue. OPERATION DESCRIPTION 101. The proposedoperation is the first of a programmatic series of three DPLs, envisaged to span the 24 months of the IMF Stand-by Arrangement. The proposed operation (and the two subsequent DPLs) focuses on structural reforms in the three board areas that are o f critical importance in the current economic context in Romania: public expenditure reforms; social protection; and financial sector strengthening. The prior actions, triggers and milestones are summarized inTable 7. A. CROSS-SECTORALPUBLIC FINANCIAL MANAGEMENT REFORMS 102. The proposed operation focuses on reforms related to expenditures. As discussed above, the large fiscal deficits o f the past few years were driven primarily by excessive and poorly managed public spending. Inparticular, the reforms envisaged will improve the predictability o f public spending as well as the quality o f public services. The cross-sectoral reforms covered in the proposedprogram include measures relating to the a) Medium Term Expenditure Framework (MTEF), which would be consistent with the Fund's proposed introduction o f a Fiscal Responsibility Law and consistent with the reform measures suggested by the EC; and b) initial steps on public sector pay reforms. Inaddition, the proposed operation focuses on sectoral reforms in education and health, where, again, the measures seek to improve fiscal management while promoting more efficient service provision and more equitable access. MediumTerm ExpenditureFramework 103, The specific measures are: A medium term expenditure framework (MTEF) has been approved by Government prior to the budget instructions being sent to line ministries (DPLl prior action) 0 For D P L l the MTEF i s the one submitted to the EC in the Convergence Program. The MTEF includes macroeconomic assumptions, aggregate revenue, aggregate spending, and fiscal balance for a two-year forward looking period (2010-1l), well as the estimates for the current year and the actual spending as for the prior year. For expenditures the MTEF includes a breakout by type o f budget (e.g., State, local, etc.), and as well as expenditures by major economic classification - Personnel, Operations and Maintenance, Transfers/Subsidies, Capital (fixed and non-fixed), and Debt Service. The MTEF updated by MoPF (for macroeconomic changes) will be presentedto Parliamentwith limits on aggregate expenditures and the rules 35 enforcing the ceilings are integrated into the draft Fiscal Responsibility Law (DPL2trigger) 0 The MTEF would include analysis o f fiscal risks and provisions for respondingto them under different scenarios. The draft Fiscal Responsibility Law would require Parliament to approve the MTEF prior to voting the annual budget and would prohibit new measures during the budget year that increase aggregate expenditures beyond the limits agreed under the MTEF. Collective bargaining agreements on public sector wages would be subject to MTEF ceilings for personnel costs and would only be valid within that framework. The MTEF(2011-13) will be approved by the Parliament (prior to the annual budget law) with ceilings for major ministries that collectively comprise at least 70 percent of the spending (DPL3 trigger) A Fiscal Responsibility Law would be enacted, with rules on the MTEF, including limits on the ability o f the Parliament or the Executive to breach 2011 spending ceilings approvedunder the MTEF. 0 A detailed annex would show how the three year MTEF envelope for capital expenditure would be allocated across existing projects inorder to assure their timely completion. 0 Projects that could not be completed within the period due to funding limitations would be prioritized for redesign, cancellation, or new funding authorization. 0 The MTEF would include an explanation for the policy basis for the allocations and fiscal scenarios for years 2 and 3. Public Sector Compensation 104. The specific measures are: An Emergency Ordinance (EO)" has been adopted reducing non-wage personnel expenditures on 2009 (DPLI prior action) Some allowances have been eliminated or redefined to achieve savings. A regulation will be issued for implementing a Unitary Pay and Grading Law for public service over three years. (DPLZ trigger) 0 The regulation would phase in a limit of 30% on non-wage personnel expenditures and caps on individual bonuses for non-military personnel. The salary grading structure would be based on job responsibility and qualification. 0 The salary grades established would more closely align pay for selected lo Although the Bank discourages the use of Emergency Ordinances in general, the Government has explained that given the time neededto pass legislationthrough the Parliament this would be the only feasible solution to meet the crisis needs. EmergencyOrdinances becomeeffectiveimmediatelybut they are still requiredto go through Parliament andonceapproved inParliament,they becomelaw. 36 benchmarkjobs to actual labor market conditions (through a salary survey). The disparities inpay between similar performing positions would be reduced and the pay reform would provide enhanced career advancement for high- performing public servants invarious occupational categories. The implementation plan would be fully costed, and would be consistent with the mediumterm budgetprojections. Pay adjustments in 2010 will be made in accordance with the implementing regulation of the new Unitary Pay and Grading Law, and procedures will be introduced to enhance compliance with personnel policies (DPL3 trigger) The regulations will (a) enforce compliance with merit-based principles o f employment and promotion, and (b) report quarterly statistics on the effectiveness o f human resource management policies (e.g., turnover by position, qualified applicants for positions, etc.). B. SECTORAL PUBLICFINANCIALMANAGEMENTREFORMS: EDUCATIONAND HEALTH 105. Ineducation, the specific measures are: Legislation will be submitted to Parliament to enable per capita financing starting with school year 2010/2011 in eight counties (accounting for 20 percent o f total student enrollment) (DPLZ milestone) Legislation will be in place to allow all schools in eight counties to receive their budget accordingto a per capita finance formula (DPL3 trigger) A few very small schools would not necessarily receive their funding according to a formula. 106. Inhealth, the specific measures are: Legislation has been adopted to raise overall tobacco excise taxes from 50 to 57 per 1,000 cigarettes (DPLl prior action) Considerationto be given to increase the budget o f the health sector A ministerial order on drug pricing has been issued and joint order has been issued promoting the prescription of generic drugs in the framework contracts with service providers (DPLI prior action). A government decision will be issued to adopt updated hospital rationalization strategy (DPLZ milestone). Legislation for a revised benefit package will be adopted which includes: (DPLZ trigger) Introduction o f co-payment system and exemption mechanisms for the poor (e.g. targeted voucher system). 37 0 Evidence-based transparent mechanisms for the inclusion of new technology and drugs inthe benefitspackage. A public awareness campaign will be conducted nation-wide for (i) introducing co-payments for health services and (ii) discouraging informal payments (DPLZ milestone) Legislation will be adopted for revised provider payment mechanisms (DPL3 trigger) Legislation will be adopted for development of supplementary voluntary health insurance (DPL3 milestone) C. SOCIAL PROTECTIONREFORMS 107. The measures to strengthen social protection focus on social assistance programs and pensions that cushion the impact of the current financial crisis and economic downturn as well as improve the efficiency and viability of these programs for the future. 108. The specific measures insocial assistance are: An Emergency Ordinance (EO)" has been adopted to incorporate the following: (DPLIprior action) 0 An increase in the GMI eligibility threshold level by 15 percent starting in July 2009. 0 100percent financing of the GMI from State budget Agreement has been reached to undertake a Public Expenditure Tracking System (PETS) o f the GMI starting in September 2009 (DPLI milestone) The revised Minimum Income Guaranteed (GMI) Law (416/2001) will be approved to incorporate the following (DPLZ trigger) 0 Increase the GMI eligibility threshold level by 15 percent (i.e. incorporate the changes inthe EO under DPLI). 0 Maintain indexation o fbenefits to inflation as in current law. 0 Ensure 100 percent financing o f the GMI from the State budget (i.e. incorporate the changes inthe EO under DPLI). 0 Depending on the results o f the PETS, include the GMI under the National Agency for Social Benefits (NASB) starting with January 2011 (adjusting the software accordingly) " Although the Bank discourages the use of EmergencyOrdinancesin general, the Government has explained that given the time needed to pass legislation through the Parliament this would be the only feasible solution to meet the crisis needs. Emergency Ordinances become effective immediately but they are still required to go through Parliament and once approved in Parliament, they become law. 38 Depending on the results o f the PETS, implementation o f regulation on including GMIinNASB will be issued (DPL3 milestone) The current level of the Universal Child Allowance (UCA) for children up to 2 years of age and 3 years of age in the case of disabled children will be maintained for the period 2009-2011. For children above these age limits, the UCA will be unified with the income-tested Complementary Family Benefit (CFB). The thresholds andor benefit levels could be increased without exceeding the existing aggregate envelope of UCA and CFB. (DPL2 trigger) An improved design of the school conditionality among CFB beneficiaries will be adopted (DPLZ milestone). 0 Mechanisms for verifying compliance with the conditionality will be introduced. 109. Inpensions the measures relate to improving the fiscal sustainability of the public pension scheme, designing an appropriate social protection for elderly poor who are not covered at present and protecting and strengthening the integrity and equity of the multi-pillar pension system. 110. The specific measures are: Legislation will be adopted that gradually links benefit adjustments in pillar 1to inflation (and de-links the indexation of already awarded retirement benefits from the point value) and increases retirement ages for women to equalize women's retirement ages with that of men at 65 (DPLZ trigger). 0 Indexation of retirement benefits would be gradually linked to inflation. The legislation would de-link the point value from indexation o f pensions after the pension i s awarded. The point value would be kept at the current level and would be used to calculate the pension at the time o f retirement only. At the time o f retirement, the pension would be calculated by multiplying the average points accumulated by the point value as is currently the case. Once the individual retires his pension would be completely de-linked from the point value and the indexation o f this pension from this point would include some component o f wage growth initially. However, the weight on the wage growth component would be progressively reduced while the weight on the inflation component would be progressively increased. The weights and speed o f adjustment will be determined with the authorities prior to DPL2. 0 The legislation could allow for the indexation to include some percentage o f the real wage growth (instead o f the regular formula outlined above) if the real wage growth exceeded a certain threshold in a specific year. The threshold for real wages and the percentage o f real wage growth to be included in the indexation o f pension benefits in that specific year will be determined prior to DPL2. 39 The retirement ages for women will be equalized with that o f men at age 65. The timing (start and completion) o f the increases in retirement age for women will be determined with the authorities prior to DPL2. An Emergency Ordinance will be issued increasing the contribution rate to the second pillarby a minimumo f 0.5 percent for 2010 (DPL2 milestone). 0 The level o f contributions to the second pillar will be increased by 0.5 percent per annum thereafter untilthey reach 6 percent. Measures will be designed and implemented to deal more effectively with the social protection of elderly poor (DPL3 trigger) This would be a zero pension pillar or an additional component to GMI, depending on the results o f AAA work currently being undertaken. D. FINANCIAL SECTOR REFORMS 111. In the financial sector the reform measures supported by this operation fall under two broad categories-contingency planning and reforms to enhance the governance and supervision of the financial sector with a view to strengthening the resilience, functioning and stability of the sector. 112. With regard to contingency planning, complementing the measures already envisaged under the Fundagreement, the specific measures are: A Strategic Action Plan for further strengthening of the financial sector has been approved by NBR and M o P F (DPLlprior action). 0 The Action Plan i s based on the results o f the ongoing banking sector stress tests being undertaken by the NBR and envisages future interventions within the financial sector under adverse but plausible scenarios. 0 The Action Plan has been prepared at the level o f the Domestic Standing Group with adequate confidentiality. 0 The Plan includes, among others, a dynamic classification o f banks into systemically important banks and others, and a typology o f potential interventions o f the NBR and the MoPF (and other financial supervisors as needed) in the resolution o f illiquid or insolvent banks according to their systemic importance and other relevant parameters - e.g. the quality o f governance, the capacity o f shareholders to raise capital, etc. In addition, a strategy for containing reputational risk in case o f a bank's failure, including an adequate communication strategy, should be prepared. Mortgage debt and corporate debt restructuring guidelines will be issued and necessary amendments to the Insolvency Law will be issued (DPL 2 trigger). 0 The legal amendments to the Insolvency Law would aim to remove obstacles to out-of-court insolvency proceedings and allow pre-packaged reorganization plans approval (based on an assessment o f the law). 40 113, The specific measures to improve the governance and functioning o f the financial sector are: A Law on the Political Independence and Financial Autonomy of the Financial Sector Regulators and Supervisors will be approved by Parliament (DPL2 trigger). The de LarosiereReport recommends the establishment o f a European System o f Financial Supervision (ESFS). In the framework o f the ESFS, the report recommends that financial sector supervisors o f Member States be independent o f the political authorities and have sufficient resources and powers. The report further recommends that the powers o f all financial sector supervisors be harmonized and increased to reach a highlevel standard. A legal fi-amework should be established that aligns the degree o f political independence and financial autonomy o f the non-bank regulators, the CSA, C N V M and CSSPP with that o f the NBR. The law should guarantee inter alia that: these institutions determine their staff compensation policies and levels based on transparent market benchmarking principles; the selection and dismissal process o f staff o f these institutions i s not subject to political decisions; the nomination process for Board members and statutorily- appointed executive members o f these institutions i s based exclusively on technical qualifications; these institutions' budgets are not subject to Parliament approval; and the directors and supervisory staff o f these institutions have statutory indemnity for actions taken in good faith inthe course o f their duties. An internal regulation governing the decision making process and methods for Basel I1implementationwill be adopted (DPL2 trigger). An internal governance structure, preferably with NBR Board involvement, for Basel I1policy and accreditation decisions needs be established within the NBR. The implementation process o f Basel I1is a major prudential policy decision, which can have a significant effect on the resilience o f the banking system. Hence, a robust assessment process for all advanced models (IRB/AMA), as well as a governance structure involving all stakeholders within the NBR, needs to be rolled out as part o f the NBR's Basel I1 implementation. For consolidated supervision, an assessment will be made, and amendments will be made as necessary on a) the adequacy of the definition of "Financial Conglomerate" in Ordinance 98/2006 in capturing all financial groups operating in Romania with material operations across more than one financial sub-sector and b) the adequacy of supervisory arrangements in the Memorandum of Understanding between the financial regulators for 41 financial groupsinRomania (DPL.3 trigger). 0 The EU Financial Conglomerates Directive gives the national authorities the discretion to apply supplementary supervision to financial groups which, although they do not exceed the minimum thresholds set in the Directive to qualify as a financial conglomerate, have material operations across more than one sub-sector o f the financial system. The Directive requires the identification, regulation and supervision of financial conglomerates on a collegiate basis under a coordinating agency agreement between domestic financial sector supervisors. Prudential requirements to be monitored at the level of a financial conglomerate relate to capital adequacy, risk concentration, intra group transactions, internal control mechanisms and risk management processes. Ordinance 98/2006 transposes this Directive into Romanian law and outlines the conditions under which a financial group i s considered a financial conglomerate. To mitigate the risk that certain financial groups are exposed to material intra- group risks not covered by the definition of a Financial Conglomerate in Ordinance 98/2006, the financial sector authorities should compare the existing financial groups operating in Romania against the definition o f Ordinance 98/2006. The NBR should review each group to assess whether there are material intra group risks, such as contagion risk, across sectors. Where the NBR judges such risks to exist, they should consider whether the application o f the existing definition of financial conglomerates i s adequate to identify these groups. Ifnot, they should amend the definition accordingly. 0 Ifsuch groups areidentified, the regulators must ensure that allmaterial intra- group transactions and risk concentrations are monitored under joint supervision arrangements. Where this is currently not the case, the relevant regulators should establish appropriate regulation and supervision arrangements and, ifnecessary, amend the relevant MOU. 42 Table 7: Summary of Prior Actions, Triggers and Milestones for DPLs 1-3 Objectives I I DPL1 ii DPL2 j DPL3 I I Public financial anagementreforms Cross sectoral MTEF:Improve strategic Budgetframework (MTEF) MTEF(2010-12) presentedto MTEF(2011-13) planningprocessesof the approved by Government Parliament and provisionson approvedby Parliament line ministriesand with spendinglimits by MTEF are incorporatedinto draft with ceilingsfor the 3- prioritization of major economic classes prior FiscalResponsibilityLaw so that in year periodfor select expenditureswithin credible to budgetinstructions being the future the MTEF is approvedby ministriescomprisingat resourceenvelopes sent to line ministries Parliament with bindingaggregate least70% of spending expenditurelimits prior to the and detailed annex of review of the annual budget law. capital investment projects to be funded duringthe period Publicsector pay and employment: Enhance transparency of the EmergencyOrdinance Implementing regulationissuedfor Pay adjustmentsare publicsector pay and adoptedto reduce non- the Unitary Pay and Grading Law, madein accordancewith employmentsystemwith a wage personnelexpenditures establishing labor market implementingregulations greater link betweenpay and benchmarksto guide future wage of the new Unitary Pay job responsibility adjustmentsand phasesin over 3 and GradingLaw and years a limit of 30% on non wage new procedures personnel introducedto enforce expenditures,and caps on merit basedprinciples of individual bonuses employment Sectoral Health: Improvefiscal position: -Increase cigarette taxes Legislation adopted to increase the overall tobacco excise duty from 50 to 57 per 1,000 cigarettes -Reduce excessive Ministerialorder issuedon expenditureson drugs drug pricing andjoint order issuedto promotegeneric drugsin framework contractswith service providers -Redress balancebetween Governmentdecisionissuedthat hospital servicesand adopts updatedHospital preventivehealthcare RationalizationStrategy -Reform socialhealth Legislationof revisedbenefit Legislationfor revised insurance packageadoptedwhich includesco- provider payment paymentand exemption mechanismsadopted mechanismsas well as systemfor inclusionof new technologyand drugs Publicawarenesscampaignconducted nationwideto introduceco-payments in healthservicesanddiscourage -Develop supplementary informalpayments Legislationfor voluntary insurance supplementaryvoluntary healthinsuranceadopted Education: Legislationsubmittedto Parliamentto Legislationto be in place Achievefiscal savings to enableper capitafinancingstarting to allow all schools in improve quality & access: with schoolyear 2010/2011in eight eight countiesto receive Per capita financing counties (accountingfor 20 percentof their budgetaccordingto total student enrollment) a per capita finance formula Note: Prior actions for D P L 1 and trieeers for DPLs 2 md3 inbold. I" 43 Table 7. cont'd Objectives I DPLl I DPL2 I , DPL3 I I Socialprc d o n reforms Social assistance: Increasecoverageof EmergencyOrdinance Amended legislationadoptedon 1 Implementationregulation targeted adopted to increase G M I to increaseeligibility on includingGMI inNASB programs eligibilitythreshold levelof threshold level by 15%, (as issueddependingon results GMI by 15% startingin outlined under EO in DPLl), of the PETS July 09 and finance 100% of finance 100% of GMI from State , the GMI from State budget budget (as outlinedin EO in DPLl), index to inflation and to Committo undertakea PETS move GMI under NASB startingin September 2009 dependingon resultsof PETS Protect the elderly poor Measuresintroducedto deal more effectivelywith the socialprotectionof elderly poor e.g. through introductionof zero pillar or expandedG M I Consolidateand Maintain the current levelof the rationalize SA programs to Universal Child Allowance better serve the poorin (UCA) for childrenup to 2 years most cost efficient manner of age and 3 yearsof age in the case of disabledchildren,for the period 2009-2011. For children abovethese age limits, unify the UCA with the income-tested ComplementaryFamily Benefit (CFB). The thresholdsand/ or benefit levelscould be increased without exceedingthe existing aggregateenvelopeof UCA and CFB. Improveddesign of school conditionalityamong CFB beneficiariesadopted Pensions: Improve fiscal Legislationadoptedto delink I sustainability of pillar 1 pensionindexationfrom the I pensions point value; gradually index j already awarded pensionsto i inflation and include a percentageof real wage growth in pensionindexationin specific ii years when realwage growth is above a certainthreshold and ~ ~ gradually equalize retirement ~ ages betweenmen and women at 65 Ensuresustainability of Emergencyordinanceissuedto pillar 2 increasecontributionrateto the secondpensionpillarby a minimumof 0.5% for 2010 Note: Prior actions for 1 'L1andtriggers for DPLs and 3 inbold. 44 Objectives I DPLl DPL2 DPL3 I I l Financial st or reforms Strengthencontingency Strategic Action Plan for Mortgage and Corporate Debt planning financial sector Restructuringguidelines strengtheningapproved by publishedand necessarylegal NBR and MoPF amendmentsto the Insolvency Law issued Improvefunctioningof Internal regulationgoverning Assessment of the financial markets decisionmaking processand adequacyof the definition methodsfor BaselI1 of a Financial implementationadopted Conglomeratein ordinance 98/2006 and any necessary Law on the Political amendmentsthereto Independenceand Financial issued; assessmentsof and Autonomy of the Financial amendmentsto, as Sector Regulators and necessary, the adequacyof Supervisorsapproved by supervisoryarrangement Parliament in the MOU betweenthe financial sector regulators for Financial Groupsin Romania Note: Prior actions for D1 ,1and triggers for DPLs 2 and 3 inbold 45 Box 1: Good Practice Principlesfor Conditionality Principle 1:Reinforce Ownership There is ownership and commitment at the executive and parliamentary level as evidenced by a number o f policy actions taken under the multilateral package. The government had already embarked on a fiscal adjustment path prior to seeking the multilateral support package. The Bank's contribution i s based on analysis conducted during preparationand accepted by the authorities as the basis for further policy actions to add to and strengthen the set o f reforms underway. The Bank team includes experts with lengthy field experience in the country and knowledge o f the executive, parliamentary, and other consultative and consensus building procedures. Principle 2: Agree up front with the government and other financial partners on a coordinated accountability framework The program is very closely coordinated with the other collaborating donordpartners, namely, the IMF and the EC. The accountability framework delineated in the policy matrix contains very specific actions with associated indicators for measuring results to gauge success o f the program. Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances The financing package and associated policy measures are specifically geared to address both the government's actual (and contingency) funding needs as well as reducing the economy's vulnerability to future shocks. As such, the measures are tailored directly to Romania's situation. The financing will address actual fiscal gap and provide a cushion for potential gaps that may emerge in light o f the uncertain global environment with a view toward ensuring macroeconomic and financial stability, while the program lays the foundations for sustained growth inthe future. Principle4: Chooseonly actions criticalfor achieving resultsas conditionsfor disbursement The policy actions focus only on those that are considered crucial toward strengthening the public sector expenditure management, social protection and financial sector. The actions are those which contain key added value features as contributions from the Bank to the policy agenda. Other actions, already agreed with the other donors/partners, are essential to the overall basis of the program and complement the policy measuresdeveloped by the Government incollaboration with the Bank. Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial support Monitoring will take place during loan implementation as two other single-tranche DPLs are embedded within the program period. Program conditions are aligned with the appropriate cycles: public sector conditions are aligned with the government's budget cycle; conditions in education are aligned with the academic year. 46 VI. OPERATION IMPLEMENTATION A. POVERTY AND SOCIAL IMPACT 114. The social assistance policies supported by this operation are expected to have significant positive poverty impacts. Although poverty decreased sizably in2008, it is expected to rise again in 2009-with the number o f very poor people expected to increase from 1.2 million in 2008 to almost 1.6 million persons, the very poorest of whom would need to be covered by the social safety net. The proposed DPL envisages an expansion in the coverage o f the best targeted social assistance scheme, the Guaranteed MinimumIncome (GMI) and aims to reduce leakages to non-poor by freezing the benefit level o f the Universal Child Allowance. 115. With the GMI reform measuresupported bythe proposedDPL program, the coverage of the GMI program is expected to increase by 30 percent or by an additional 70 thousand of very poor families. Inparticular, the program supports a 15 percent increase in the current threshold level which would amount to 21 percent o f the gross minimum wage. (The current threshold-RON 108 for a single person family- amounts to only 18 percent o f the gross minimum wage in 2009 and i s 25 percent lower than the $2 a day international poverty line). Raising the threshold level by 15 percent would result in a 25 percent increase in the average benefit level. The proposed DPL program i s also supporting the reform measure to finance 100 percent o f the GMI benefits from the central budget rather than the current formula in which 80 percent i s financed from the central budget and 20 percent by local governments. The current formula results in a situation in which some fiscally constrained local governments are unable to cover all eligible applicants. (The difference between what would have been paid ifall eligible families receivedpayments and what was actually paid was reportedby the Ministry o f Labor to be 90 million RON). 116. The pension reforms envisaged under the DPL program also aim to protect the elderly and vulnerable over the longer term. The measures related to pillar 1 o f the pension system aim to restore the sustainability o f the pension system and hence protect all the future generations o f retirees. At the same time, the real income o f current retirees would be maintained under the reforms envisaged since their benefits, once retired, would be linked to inflation. Although current retirees may perceive themselves as losing from the reform measure since over the past years wage increases have outpaced inflation, the present system o f linking retirees' benefits to wages i s in effect allowing current retirees to benefit from the productivity gains o f the current workers-whose retirement benefits, moreover, may be jeopardized unless the fiscal sustainability o f the pension system is improved. (It should also be noted that the reform measure could allow for pension indexation to include some component o f wage growth in cases o f highreal wage growth (for example, exceeding 10 percent)). Improving the fiscal sustainability o f the pension scheme would allow the Government to use these resources in other sectors such as health, education and social assistance that are also essential for poverty reduction. The DPL program also supports pension reforms to protect the elderly poor 47 who are not at present covered by any retirement schemes. The exact mechanism through which this protection will be provided-whether through the introduction o f a zero pillar pension or through an expansion o f the GMI-will be determined following analytic work duringthe course o f the first and second DPLs intime for DPL3. 117. The other measures envisaged in the DPL program are not expected to have direct adverse impacts on poverty and would likely have positive indirect effects. In particular: (a) The public sector pay reforms would not be expected to affect the poorest segment directly. Indirectly, the pay reform conditions and the public expenditure management conditions would be expected to contribute to fiscal and macro stability which i s beneficial for the population as a whole. The pay reform in particular seeks to restrain public sector pay awards from outpacing the private sector labor market rates thereby fuelling inflationary pressures; b) the conditions in the health and education sector aim to achieve fiscal savings which could be used to promote greater equity and access to these services with improved quality. For instance the increase in cigarette excise taxes (while these in and o f themselves could be regressive) would be expected to generate additional revenues a part o f which could be used for health services. Furthermore, special attention is being paid in the measures to address poverty/equity issues. Thus in education, the per capita financing reform measure, which involves allocation of funds to schools for operational expenditures (salary and non salary) primarily based on the number o f students, would generate cost savings which could be invested in quality improvements and ensure horizontal equity across schools and regions. In health, health insurance reform is expected to help discourage informal payments-which affect the poor-and the introduction o f co-payments for health insurance will include a targeted exemption mechanism to ensure continued access o f health services by the poor; c) the financial sector conditions aim to minimize the risks o f a financial crisis by enabling the authorities to address current and potential vulnerabilities in the banking sector and strengthen regulation and supervision in the long-term. Thus, they aim to avoid potential costs on depositors that could be very large, ifa bankingcrisis were to develop, or on tax payers in case a bailout of banks became necessary. As such, while there i s no immediate impact on the poor, these measures would be expected to bebeneficial for all segments o fthe population. 118. Further analysis on the poverty, social and distributional impact of the measures envisaged under the proposed DPL program will also be undertaken during the course of the program. In particular, once the design o f the co-payment system (in health) has been decided, simulations o f the distributional impact o f this measure will be carried out based on the existing surveys (e.g. Household Budget Survey) and administrative data provided by the Ministry o f Health. For the per capita financing measure in education, an impact evaluation will be carried out using the pilot areas and a control area, paying special attention to the poor and vulnerable communities and risks o f student drop outs. The distributional impact o f the public pay measures will be monitored yearly based on the HBS data and administrative data provided by the Ministryo f Labor, Social Protectionand Family.As far as social protectionmeasures are 48 concerned, the Ministry i s monitoring and reporting the impacts o f main social programs on an ongoing basis. These assessments will include the measures under the DPL program. The findings o f these analyses will be reflected inDPLs 2 and 3. B. CONSULTATIONS 119. The proposed DPL series builds on current analytic work and some consultations have already been conducted as part of the dissemination activities associated with the work. For example in the case o f the Per Capita Financing (PCF), the Ministry of Education, representatives of the teachers' union and local governments participated in a consensus building workshop organized by the Bank that brought in international experience, and discussed the current situation inRomania and steps needed for implementation in Romania. In the area o f social assistance, a workshop in May, organized jointly with the UNICEF, will bring together local governments, the Ministry o f Labor and Social Protection, NGOs, members o f the Parliament and the press. Further consultations will be undertaken inkey areas duringthe course o f the DPL program. C. ENVIRONMENTALASPECTS 120. The specific country policies supported by the operation are not likely to have significant effects on Romania's environment and natural resources. The measures contemplated under the loan are primarily geared toward ensuring stability and future financial system solvency, to allow an economic reactivation once the global and EU economic distress turns around. These will cover public sector reforms, social protection and financial sector strengthening. None o f the sectors included in the operation are expected to have any significant links to the environment. Moreover, Romania has adequate environmental controls in place. Romania's environmental legislation and regulation i s reinforced by EU environmental directives, including the EU's guidelines on adoption o f environmental assessments at the planning and programming level (June 2001) and the EU's Environmental Liabilities Directive setting out liability for damage to properties and natural resources (April 2007). D. IMPLEMENTATION,MONITORINGAND EVALUATION 121. The implementation of the loan will require close coordination among the Bank and the respective institutions responsible for implementation. These include the Ministry o f Finance, the Central Bank, the Ministryof Labor and Social Protection, Ministry o f Health, Ministry o f Education, Ministry o f Justice, and National Agency o f Civil Servants (NACS), all o f which will provide the requisite baseline data from which to measure outcomes by the end o f the program (Table 8). The Ministry of Public Finance will assist in the coordination of information reporting on the program's monitoring indicators. These will be tracked, discussed and assessed among the Bank team and implementing agencies both by staff based in the field and during visits between the three DPLs. 49 Table 8: Objectives and Indicators Long run desiredoutcomes Indicative outcomeindicatorsat end of program Publicfinancialn agementreforms Public financial management More strategicand transparent allocationof budget A significant reductionin: resourcesand stronger budgetexecutioncontrols variance betweenthe original approved budgetand the actualexpendituresfor major ministriedfiunctions. (cf: PEFA indicator #2) variancebetweenthe original approved budgetand the actual expendituresby economic classification Planned and actual spendingfor major capital projectsare disclosedin budget documentationfor the MTEFperiod. Public sector pay A more transparent and motivatingsystemof public sector Base salary comprisesat least70% of average total Pay compensationamongpublic servants in all occupational categories. Regulations implementinga unitary pay and grading system are enacted Education A schoolfinancingsystemin placethat would: Increasein averageclass size in eight countiesinvolved in Provide better incentives for local authorities and reformsrelative to the average classsizeobservedin schools to increase average class size according to the academicyear 2008/9. [Baseline: 19-81 norm of the government on maximum class size (currently 25 and 30 students per class in primary and secondaryschools, respectively).Larger class sizes could be achieved without adversely affecting access and quality and would generate savings which could be re- investedfor quality enhancements; Health Greater efficiency of public expenditures to provide better Reduction in drug expenditures in ambulatory care (MOH healthservicesand greater equity in access to services and CNAS data) [Baseline4277 million Ron in 2008) Lower rate of admission to acute care facilities per capita by end DPL 3 (CNAS data) [Baseline:229 per 1,000 people] Coverage of co-payment exemption among eligible population Social protc on reforms SocialAssistance Strengthenedsocial assistancethoughwell targeted programs Number of GMI unpaid entitled beneficiaries and partial paymentsreducedto zero IncreasedGMI program coverage (by 30 percent by 2010) More transparent and predictable budget allocation and benefits delivery based on individual registry computerized databaseof the NASB Pensions: a public (pillar 1) pension system that is more The fiscal deficit of pillar 1 pension reduced by 0.7 fiscally sustainable percentage points from baseline by 2015 through indexation of benefitsto inflation [Baselinedeficit is 2.7 in 2015 basedon WB Prost model1 Financial s or reforms Contingencyplanning Reducepotentialfor systemicproblemsin crisis Increasein the percentageof corporate insolvencycases dealt with through reorganization proceedings [Baseline 1.5% of total insolvencycasesin March 20091 Regulatoryand supervisorychanges Improved resilienceand functioningof the financial sector Regulators maintain controlover staff salaries Joint supervision of financial groups by the relevant regulators '* The average class size in eight pilot counties have been calculated as the total number of students enrolled in all schools located within the counties (522,546) divided by the number of classes in those schools (26,379). 50 E. FIDUCIARYASPECTS 122. The Bank has extensive knowledge of the country's Public Financial Management (PFM) system. A CFAA was completed at the end o f 2003, while a Country Procurement Assessment Report (CPAR) was done in 2005 and a Public Expenditure and Institutional Review (PEIR) was published in 2006. Regular updates o f PFM recent reform activities and their impact have been carried out over the recent years as part o f the continuous dialogue with Romania. 123. The 2003 CFAA deemed the overall fiduciary risk associated with the PFM system moderate. Inthe areas o f accounting, financial reporting and internal control, the fiduciary risk was considered significant, partly due to the heavy dependence on manual accounting and reporting processes, weak arrangements for management accountability and the limited modern internal audit capabilities. Considering the introduction o f program budgeting, the generally reliable cash distribution facilities provided by the Treasury system and the Court o f Accounts capacity, the fiduciary risk was considered moderate in the fields o f budgeting, treasury, cash management and external audit and parliamentary oversight. The fiduciary risk related to World Bank investment operations was considered low. 124. Inresponse to the recommendations of the 2003 CFAA, the Government has taken action to improve coordination and management of PFM reform and strengthen internal control, financial reporting and auditing systems. An Inter- Ministerial Committee;headed by a State Secretary o f the Ministry o f Public Finance (MoPF) endorsed a PFM Strategic Development Plan (SDP) in 2005 and has since monitored its implementation. A number o f the CFAA recommendations have already been addressed by the Government, including in the areas o f treasury management, harmonization o f accounting standards and practices, decentralization and rationalization o f ex-ante financial control and strengthening internal audit functions. The organization and effectiveness of the Court o f Accounts has also been improved. Overall, steady progress has beenmade inthe development o f PFM systems and institutions. 125. Romania has made significant progress in government budget transparency as measured by the 2008 Open Budget Index assessment (OBI). Romania has been promoted from the OBI category "provide some information" to the next one, "provide substantial information". According to OBI, the remaining budget issues are the absence o f pre-budget statements, o f a citizens' budget and o f a mid-year review; whereas only partial information i s available for areas such as Executive's budget proposal, in-year reports and audit reports. However, several important P F M challenges remain. While the introduction o f program budgeting has enhanced budget management, budgets lack realism. A Medium Term Expenditure Framework is not yet fully developed. There are still several budget adjustments done during the year, as needed, with no formal mid-year review. Timely budget approvals and timely reports on changes in budget allocations 51 remain a challenge. While internal control and internal audit have recorded substantial improvements, there are several unfinished reform agenda points. An extensive decentralization o f the ex-ante control functions has been rolled out to most line ministries however, this has not yet happened for several line ministries, which include some major budget spenders, that account for about half o f the total budget funds. While overall the internal audit function has increased and most o f the internal audit procedures have been developed, however, professional capacity, development and training requirements to apply those remain problematic. Several line ministries, including some main budget spenders, have low internal audit capacity. Also, despite the use o f internal audit planning tools, a large part o f the assignments i s done on an ad-hoc basis. 126. Several achievements have been made in accounting and reporting, but challenges remain. While accruals accounting has been rolled out, the new chart o f accounts introduced in2006 and a major assets revaluation exercise carried out, reporting i s still done both on accruals and cash accounting methods. Good progress has been recorded towards gradually introducing IPSAS. However, the budgets are developed using the cash basis only, with additional information on commitments. Inaddition, there i s still significant reliance on manual accounting and bookkeeping processes. A substantial unfinished agenda is left for the local public finances area. 127. The treasury and cash management functions have improved, but there is still not a fully integrated financial management information system in place. The existing treasury system has further developed, with significant improvements in the payments processing, but there are still no direct links with the line ministries. A web based integrated system, with centralized databases and servers, i s being envisaged, with the technical specifications being defined. This will address several current issues, including the ability o f the treasury to ensure the contracts monitoring, optimized prognosis o f cash needs; foreign currency payments, letters o f credit and online banking functions. 128. Some progress has been achieved on external audit. The Court o f Accounts (CoA) has developed and updated its procedures manuals on compliance, financial and performance audits. Still, the main CoA activities are to a great extent focused on the budget holder's compliance for individual transactions. The external audit Parliamentary oversight committees appear to have a limited use o f the CoA reports and thus the subsequent impact o f the CoA reports i s limited. 129. The fiduciary risk associated with the Public Financial Management System i s moderate. 130. The Central Bank can be relied on to hold proceeds from development policy operations. The IMF's safeguards assessment completed in June 2005, concluded that safeguards in place at the National Bank o f Romania (NBR) generally appear adequate. However, certain weaknesses were identified inthe internal audit and control system, and the safeguards assessment recommended measures to address them. Based on the IMF's assessment the National Bank o f Romania can be relied upon to account for the World Bank's proceeds from development policy operations, assuming that the arrangements are otherwise in accordance with the World Bank's policies and with specific mutually agreed terms for the operation inquestion. F. DISBURSEMENTANDAUDITING 131. The proposed loan will follow the World Bank's disbursement procedures for development policy loans. Disbursements will not be linked to specific purchases, thus evidence will not be needed to support disbursements, nor will procurement requirements be necessary. The front end fee will be covered from the Borrower's own sources. The Government will submit a withdrawal application to the Bank. At the request o f the MoPF, the Bank will deposit the proceeds o f the loan into a foreign exchange deposit account (deposit account) designated by the Government that forms part o f the general foreign exchange reserves o f the country and acceptable to the Bank, such account to be held at the National Bank o f Romania (NBR). The deposit account i s available for budget financing and will be managed by the MoPF. The proceeds o f the loan will be used as needed by the MoPF, either in foreign currency, or converted into local currency, to cover the budget deficit. If the proceeds of the loan are used to ineligible purposes as defined inthe Loan Agreement, the Bank will require the Borrower to promptly, refund an amount equal to the amount o f said payment to the Bank upon notice from Bank. Amounts refunded to the Bank upon such request shall be cancelled. 132. The administration and accounting of the loan proceeds will be the responsibility of the Ministry of Public Finance. The standard country rules will be followed by treasury for administration and accounting. The government will maintain accounts and records, or ensure that such items are maintained, showing that the loan disbursement i s in accordance with the provisions o f the Loan Agreement. Such accounts and records will be maintained in a form acceptable to the Bank. The proceeds o f the Loan deposited at the NBR will be used to cover the budget deficit. The MoPF will be responsible for the operation's administration and for preparing the withdrawal application, maintaining the deposit account as required. The MoPF, with the assistance o f the NBR, will maintain records o f all transactions under the deposit account in accordance with sound accounting practices. The Borrower will report to the Bank within 30 days after receiving the loan amounts, by sending a confirmation letter on the loan amounts deposited inthe foreign currency deposit account. 133. The proceeds of the loan will be deposited in a single tranche by the Bank in an account chosen by the Borrower at the National Bank of Romania (NBR) and an audit of that account will not be required. The currency o f the chosen NBR account will be the currency o f the loan. Given the positive IMF assessments o f the NBR, the 53 unqualified NBR audit reports for 2005-2007, as well as the satisfactory audit compliance under the previous P A L and PSAL-2 development policy lending operations (disbursed in 2005), an audit of the NBR account for the proceeds of the loan is not considered necessary. The above mentioned confirmation letter will be inlieu o f the audit. G. RISKS AND RISKMITIGATION 134. The proposed D P L series i s a relatively highrisk operation. Romania has been hit hard by the global economic crisis. The large fiscal deficit that Romania had incurred going into the crisis increases the need for adjustment at a time when the severity o f the economic downturn increases the difficulties in achieving such an adjustment. The Fund program rests heavily on strong macroeconomic policy adjustments combined with a large package o f external financial support to stabilize the economy and support external debt rollover/debt service without excessive pressures on the exchange rate that could further weaken the banking sector. As discussed below there are economic risks that could prove the IMF's assumptions underpinning the program overly optimistic. There are also political risks-particularly in light of the coalition government-which could result in policy slippages. In turn these policy slippages could undermine market confidence and increase balance o f payments pressures. 135. A key risk affecting the proposed operation is the uncertainty of the global economic outlook. There i s a possibility that international financial markets will remain frozen and that the global economic downturn, particularly inthe EU, will be more severe and protracted than currently projected. Lower debt roll over rates or larger capital outflow would directly affect the domestic banking sector. Balance-sheet effects arising from a further RON depreciation beyond the current program assumptions (and the resulting higher than expected inflation), would further compress Romanian growth. The domestic economy would also be affected by a further worsening o f the global growth outcome through trade and through continued erosion o f investor and consumer confidence. In turn a more protracted downturn in the Romanian economy could have serious implications for the domestic banking sector through increased corporate and household distress. 136. This risk is partially mitigated by the size of the multilateral support package. The size o f the package provides some cushion in building up reserves that would help deal with a worse-than-expected case scenario o f capital outflows and prolonged financial sector distress. 137. The content of program also mitigates risks. In the banking sector, the Fund program includes in-depth examinations and recapitalization requirements inthe event o f capital shortfalls, as well as the strengthening o f regulatory and supervisory powers. Under the proposed D P L program, these measures are further reinforced through 54 additional contingency planning reforms including the preparation o f a strategic action plan to deal with potential interventions and the establishment o f a framework to facilitate debt restructuring. Finally, the fiscal reforms envisaged under the overall program will reduce the fiscal pressures both in the short run and over the medium term and contribute to lowering the external financing needs. 55 Annex 1:Letter of DevelopmentPolicy LETTEROF DEVELOPMENTPOLICY June ,2(109 4. Mr.RobcrtZocllick Prceident Woi'ldBank WashingtonDC Ref:LettwofDevelopmentPolicyRomaniaFirstDavelopmmiPolicyLoan"Public FinancialManagorncnt, SocialProtectionandPhrncfalSector Swcngtheninf This letttr t d z a in a selective mann& critical a q a t s of our proyrun ~ r t strengthenpubliclinancial management,midprdtcctiwand the hancial mtor. h i n g 2003-2008 the Romanian economy experienced an economic boow sssaciatcdwith theprooeasofmesaionto the EU.Gmwth avetaged aver 6.5 pementpel ycar dudng that pm'od, reaching aver 7 'percent in 2008- A large port of hoominy domestic growth WBS drivm byprivate investment with EUaccessionprospectssecure, clrpitil flows, parliculatly foreign direct investment, were atlracttd by the existcnuc ol' signiticant productivity diffmntials, as well byperceptions of lower invcrrtnmt risk that trlggdtd a rc-as~csmcntof Romania qs a favorablc Invcatmmt IOCR~~OIL Rapld credit p w t h complcmcntdinvatmcnt, but also aervcdto fuel nrapidrirc indomestit consumption, qilling over into nn incrmshgcurrent account deficit. Sharp incwes in asstt pricee nnd rising coUat#ol values added extra momentum tu rhcr rdpid ~puw(bin domestic absorption. Fiscal policy cxacchatcd ovqhaatiag and &ing UrFemal imbalances. l~nllowiny cffortr of fuiacrl convolidalionduring2003-05 that led to Dnarrowingofthe fircnl dsficit tn 0.8parcentof CDPin2005, the fiscal deficitwidened againprogressivelyto nuch4.(J pmmtin2008. Governmentqmdhgdoubledbditweeh2005 und2008, With the udolding of thc internationalfinancial crisis and the global economic downturn, the Ronlaniaacconomybaa b m hit hard. Eoonomioactivity declinedaharpl) in the last quarter nf 2008 and has fallen fder inearly 2009. Real ycar-on-year CIDP growth shifted hin an averageof 9 pmmtduringthe kat h e quarim of 2008 to an increase ofj u t 3.4 percent in the fourthquart?, wh-s the flash estimate fur ZWQ1 indidos rr JAcmaso of 6,4 percent. As coditions in the inteknationat frnancirl market5 have womnud, the fmncing of the fiscal deficit in Oetdbcr 2008 -Match2009wa.* dutdcon by using the domestic market whm the vuy short maturities wen. predominantlydemanded, with progreadveLengthcningbdng camcd out at prctmt. T h concmmtuiononshort manrritlcs cxpoeodthogovemmntto mll-nverrisks inthocurrent 56 anvjronmenl or de-leveriiging. However, there are viaible k i p s of iniprovemmtof tht Iwmnvingconditionsbothonthcdomcsticmarketan8onthG cxtcm~lmarkct,intcmR of' ykldti mdCDS IOVOIS. Since laking o f h c in Dcccmbcr 2008, thc Uovmnicml htw wuLhI 10 namu fiscal imbdlanws wd to impnn%fiseul crdbilily lmd sustuinrrhiliiy ovur Lha rnd'tuii term byputring in place mcchanfsmsto msm bcacr public flnanciqt mmqement wd fiscal transparency. The Covcrnmcnt is also iccking to pmcct &e pooI and vulot~ablcfioui thv impact of the financial crisis Rad lo bothhhimize risks of II domatic fiirancial fimmi orisis 89 wcll ~9 strcngthcn thc rcgulationand mpmlrrion for a mol-crcriilicnt wid wcll functioning rectorin thelonger-run. By implomentiry structuial reforms ina prognumatic way that would sddrcw themotcauses ofecowink and socialdadnbilitie, Ourulthmteobfectivchi10 cnlcipt fmm the crisis on a strongertbotingto resutneand sustain high p w h andconva-gmw tothe tivingstandardsofotlicrniorcadvandBIJacronnmieq. Fiscalandpublic fmancialmanagement 'Ihc Oovcmmcnt L a d r d y hplcmcntd substantial mcmura b d b r thr ffwal deficit and ro rducc niamccommic imhaldnocs. Thc 2000 np,provoribudgel contains important epcnding cuts and mmue inprcascs yicldinfi around 3 percent or GDP intotal. These measuresinclude i)anincrcasc of 3.3 percentage points in swial contributions;ii)signiticant cuts B the public W ~ billby rcduucing hoiruscs and nthn C bcndits and by replacingonly 1 ef 7 dcpmhg cmplrryccs; and v) rukPtanlinl cuts 11) spendingon goodsand~ m ' c m well as aubsfdics a5 Morerecentlyf i ~ mewurcvyield& anadtIitioaOl1,lprrrccntofOIW arctwiny d hnplemenkd as prior actions for the IMF supportid program, concmtratinp on cxpcoditurc rcductions.Thc fiscal dcficit for 2009 iR thus expectedlo he 0.3 percmlagt. pointslowcrthan 2008, at 4.6 pofccntof GbP. In ohdmto safeguardthetug&, spandinp plans will be back-loaded and their execution will bt conditional 011 w~lliuc performance. A keyelement ofourreformagendaIsimprovingpublicfinancial rnmagehhl in partioular,strcngthmingthe mediumhrmexpmnJilur0 Limework, urd impmvir~gthe public sector paysystem. Wcahaqa inpublic finand mmqpnenl mindincontrolljng public cxpmditurcahawban mcoflhhe&causesoflugefiscal deficits intho pan.. We mestrengrheningour mdiumtcimcxpeodkuiu:hinework (M'fW)(0.ensun* , astratqic stmger link between plannina and budgeting. Thc MTFP process will pide hc plmuhg pmcsscs of the line n1inish-k and mroumgo prioritization ot expendinires withh credible rceourcc envdopcs, @pccially for public invtdmunl, TIN initial refonnentails approvalofthoM7'EFhy Oovcmmmt YOthatit cart form nbasisfor tho hudgetpreparationinstruction8tn lineminishie. 57 Wc arc also undatakhg rcfonns inthc hcdthand&cation rtulmwwith uview Lo enh;mcin& fiscal savings md improving financial managmonl, In M tmvirunmml01 overdl fii3cnl restraint, improved fiacal managemcnl wid greeter eficimcy in lh's provision of public saviccs can j p c d c IuIvipgs 681 can, in turn, bu u s 4 to brvair uccew andimprovethe qualityofthese services. We havebeguninilidly wilh refornibiu thc halth setor. Wc havaundtrtakenthroe hpomtmwurcsIn this scctor i)wc b a v ~ dopled legislationto raise overall tobacco awirretaxas from C'50to 457 per 1,000 ;ii) wc hilve passed a minkimal ordw on h g pricing which q u i m suppliers to w g j r l ~tbc productionpricca of drugs (for which &cy havc market authorimions) with the Moll andraquhs that the pncd &illqphua oTr&rbecqudor Icsstlm the lowest priceof thr same dncy olTered mywhere in 12 EuropeaacounrriLI9ina itfcmcc list and iii)we Iiaw passed a lcefslatim to promote tho premjpdan of gccndc h 8 in~thc fnamework conkxtu w i h stmice providers. Specifidly the legislationrryuhes that, for dnrgS tbi have genericultmaliveu, doctors preacribd the goncric altcmativcs inordcr for paticnth to be fully iriinbursed by the. national lusumce fqiid, Tits latter two rneasurcA utsc" designed to improveths efficiencyoftheNationallnswaoce Fund. Publicpay Pcmxmnel costs hilve consumed P large and rapidly growing compoiient of thi- budget. Aggregate spending on pasomel coet hc!rcasCd by S7,R percent from 2005 Lo 2007, while GDP only grcw by 42 pcrccnt during tho lame panod in nominal tmnb not irnpnivedsignificantly.Morwver,b o m dc0-e Dcspifothcnc Incrcascsincxpcndture,thc cffcctivcnesstoo&e public udminislruliunha5 of ~ muchoftotal campennatim. therc is no unified wage scwrule and hem am a lwse numberof laws regulatingwages 11) different partsof tlrc system, This has addedto thedIfYiicrlltyofcantmllinfi annual wgi* costs. As a fmt step therefore we havc ~ntmducoda new salary odinwcr: &bot rcZluc.c$ non-wagcpcrsoilnclcxpcudjturcsin2009. Social protection Althou&hthe povertymtc inRomaniadcweaocddmnialicdly him 36 percentit1 2000 to 5.7 porcont in 2008, the munw still hgd 19 million poor in 2008. With Ulc mnnnmycxpwtingtt) wnlrulby 4 prrcenlin2009, thisnumber is anticipatedloiacrcwsl: to 7.4 percent(1.6 millionpeople). Spauding on the poor Ius ddcllued over @c, rtRulting in low covernyr irnd inadcquate bncfita. Wc havc thorefore incr&.d Lhe covcairga 01 the Ouarantd Minimum Income (GMljour most cf'fioicnt and well [ilrgdd social assiamc ptogritm-by 30 pcrcent andr a i d hc uligibilitythreshold levelby 15 pcrctnt Wc will also be financing 100 ycment of the CiMf through rhe Cbnrral Budget to enwc full paymcntof thc bcncfitgto theeligiblebmeGcivias bythe local govcniinuntc. Financialsector hthe fmcirtl iector, inagroomfnt 4ththa 1MFRomanianiiulhoritioshaw already talcen impoitatrt steps, These include strcngthcniny liquidity mtuiugancnt swenglhenhg doniesric cowdinarionmong dhmealjo supervirury hufliutitiw, mavin): 58 k w d r adoption of lPRS acctlunling dandarcIs, and sccking an ilgmment with c.cirnrnercia1bwlcs to facilitate the rerrttuctwing ohsehdd debt coiitracted m foreip~~ cwcncy. Tho govwnmtnt has also s W lo review Sonic aspcccts of contiqencv planning,It is also strcugthcningimplemmnlationinthodcposhinsuranceframework. In addtion, thcminimumlevel oftho Gepital adquecy ratiowill bom i 4 Rom * pemcntto 10percent. S k x s tcrrtrr af~ndiddudbankbalancesheets and I d i n gporifoliw undcr diflwent scenarios have been 4Lo awes3 the potmtial incwitw b own fmdN needed to cnsuro that solvency mtia mdn &QVC 10 patent. The NBR 1- initiated cljauuwionswithbanksto s c a m mficitat resomcs lowwr poldalrshonfalls, In pwild, we have prcparcd a Suatrgic Action Plan tts complcnicnt the rm& tcsts by definingwgulntnry actions and other avwuesto dealwith potentialfutw i s t u w in thc financial scctor wider odvrrse, YUWX~OB so ns to cnmm tlnmwial shbility. Tht matddi7ation of e m i n risks may indd rquim policy intcrvcntiaru &om flu, Romnrrian govcmmcnt. Wc rocoguizethat t i m e ~ofsuchinlcrvcntionswill becritxal ~ s iiisucha situationa1[ha1prquednessis essential.Thus, the Strntrbir Action Ylnn defines prampliw regulatory rneaww to comirc finandial stability, HY we11 as avenues, tools, rcspotuibililia, und prindplen for patentid govcmncnl actions in the flnitncial scctor. Furthemom, in the spirit nfthc dc Larositrc,R.epo& we are caininittedto put it) placc a legal kamework that dim the dcgcc ofpolitical indpndcnce q d financial autonomy of thc non-bank regulatoryand supmimry agmciw, thk PSA, !he CNVM andthoCSSPP, withthat oftheNBR Summary The stmtclfic; vision of this Govcinhtht encompasses G mcrowononiic: fratncwork conducive lo reloring mmeconomio halanceo, improvc publlc fldancial rnmaganac,enhancesocialprotection, andstrengthenthercsilimocand Autctioningof the financial am.76 that effect, we havecritical pfigr& underway a d wehhna Ihl- suppori lfom the World Bank through thc Pu'blic Filmncial Maun&inmt, Social Rrbtation afid Finuncial Sector Strcngthming kqlopmqt Policy Lending (PPI.I Fro&m. Amordingly, thc G0Vcmme.m of Rotnnnia rqueatr [hut he first DPL in tbt. programbc approved. Sincerelyyours, I' P O . 7 ,: ' 59 .r c 52 c L s .r c c; a c E 4 E c.l n en w B c 3 L c c G h v Annex 3: Assessment from the International Monetary Fund On May 4th, 2009 the IMF Board approved a Stand-by Arrangement o f Euro 12.95 billion for Romania. This annex provides the Public Information Notice/Press Release o f the SBA. Press Release No. 09/148 International Monetary Fund FOR IMMEDIATE RELEASE Washington, D.C. 20431 USA May 4,2009 IMFExecutiveBoardApproves 12.9 BillionStand-By Arrangement for Romania The Executive Board o f the International Monetary Fund(IMF) today approved a 24-month SDR 11.4 billion (about 12.9 billion or US$17.1 billion) Stand-ByArrangement for Romania to support an economic program designed by the Romanian authorities and intendedto cushion the effects o f the sharp drop incapital inflows while addressing the country's external and fiscal imbalances and strengthening the financial sector. The approval makes SDR 4.37 billion (about 4.9 billion or US$6.6 billion) immediately available and the remainder will be available ininstallments subject to quarterly reviews. The Stand-By Arrangement entails exceptional access to IMFresources, amounting to 1,111 percent o f Romania's quota. The Stand-By Arrangement will be combined with other multilateral financial support to fill the country's 2009-2010 financing gap. The total international financial support package will amount to 19.9 billion (about US$26.4 billion), with the European Union providing 5 billion (or about US6.6 billion), the World Bank 1 billion (or about US$1.3 billion), and the European Bank for Reconstruction and Development (EBRD), the European Investment Bank (EIB), and the InternationalFinanceCorporation (IFC) a combined 1billion (or about US$l.3 billion). Following the Executive Board discussion on Romania, Mr.John Lipsky, First Deputy Managing Director and acting Chairman, said: "The Romanian authorities are to be commended for seeking early international support to assist them with an orderly correction of the large external imbalances and vulnerabilities built upduringrecent boom years, and leavingthe country highlyexposed to global financial turmoil and exchange rate volatility. Excessive public spending inrecent years also produced sizeable fiscal deficits which, inthe current tight financing environment, are destabilizing. With the global downturn increasingly spilling over to Romania, a rebalancing of the economy i s unavoidable. "The Romanian authorities have launched a comprehensive program to respondto the current challenges. The program aims at reversing the deteriorating fiscal path with significant 65 expenditure cuts and additional revenues. Planned fiscal reforms are designed to contain future expenditures pressures, improve the budgetingprocess, and enhance the efficiency o f tax collections and government operations over the medium-term. An action plani s being implemented to maintain confidence inthe banking system, including by preemptive bank recapitalization, agreements to maintain foreign banks' exposure inthe country, and efforts to strengthen bank supervision and resolution. This program, combined with significant external financial support, should ease short-term funding pressures and enhance medium-term economic prospects. "The joint financial assistancebeing provided by the IMF, the EuropeanUnion, and the World Bank will help cushion the economic downturn and will provide reassurance to markets that Romania's external obligations will be met. It sends a strong signal o f the international community's confidence that, with the consistent implementation o f the program, Romania will weather the current difficulties and emerge with a better-balanced and more flexible economy," Mr.Lipsky said. 66 RecentEconomicDevelopments Romania experienced an economic boom over the past five years that led to overheating and unsustainable imbalances. GDP growth averaged over 6% percent per year from 2003-08, as foreign direct investment and capital inflows, inpart through subsidiaries o f foreign banks in Romania helped finance highconsumption and investment growth. The rapid increase in borrowing that fueled the boom left Romaniahighly exposed to global financial difficulties and to exchange rate volatility. Loose fiscal and incomes policies also contributed to the overheating o f the economy and to its current vulnerabilities, with excessive spending, especially on wages and pensions, as the main culprit. Economic activity turned down sharply inlate 2008 and has fallen further in 2009. Growth i s projected at about 4 percent in2009 on account o f a sharp contraction indomestic demand, which inturnwill set off a correction inthe current account deficit from 12%percent o f GDP in2008 to 7%percent in2009. Foreign direct investment and capital inflowswill drop sharply. Increased financial stress, tightening credit standards and limitedaccess to external fundingwill inhibit lendingto the private sector. Once confidence is restored, domestic demand is expected to slowly rebound, but growth will remain near zero in2010, before recovering to 5 percent in2011. Inflation i s expected to fall in2009 to within the official target (3.5 percent, plus or minutes 1percent) and remain there in2010. ProgramSummary The IMF-supported program combines strong policy measures with sizable financial support. Keyto restoringconfidenceis a reversal o fthe sharp increase inpublic spending, which caused a large deficit to accumulate even duringa period of strong economic growth. Short- term budget cuts will be combined with fiscal policy reforms to place the public finances on a more sustainable path. The effects o f the fiscal adjustment andbudget reforms will be cushioned byboosting social safety net spending and safeguarding capital spending. Banking sector measures will also be implemented to ensure that banks remain sufficiently strong to weather the economic downturn. Specific program objectives include: 0 Reduce the fiscal imbalance to bringthe deficit back under 3 percent o f GDP by 2011 0 Maintain adequate capitalization o fbanks and liquidity indomestic financial markets. 0 Bringinflation within the target range o fthe National Bank o fRomania (NBR) by end- 2009 and maintain it there. 0 Secure adequate external financing and improve confidence. 67 Romaniajoined the IMF on December 15, 1972, and its quota is SDR 1.03 billion (about 1.16 billion or US$1.54 billion). Its latest arrangement with the IMF was a Stand-By Arrangement that expired on July 6,2006. 68 Romania: Selected Economic and Social Indicators, 2005-1 1 2005 2006 2007 2008 2009 2010 2011 Proj. Proj. Proj. Output and prices (Annual percentagechange) Real GDP 4.I 7.9 6.2 7.1 -4.1 0.0 5.0 Domestic demand 8.3 12.8 14.3 8.9 -8.2 -2.7 5.7 Net exports (contribution) -6.1 -10.2 -16.6 -6.3 7.8 3.9 -2.6 Consumer price index (CPI, average) 9.0 6.6 4.8 7.8 5.9 3.9 3.5 Consumer price index (CPI, end of period) 8.6 4.9 6.6 6.3 4.5 3.5 3.5 Unemployment rate 5.8 5.4 4.3 4.0 8.9 9.7 7.7 Nominalwages 17.0 18.9 22.6 23.6 5.9 3.8 5.2 Public sedor wages 25.9 27.3 18.5 31.0 5.1 3.9 3.5 Private sector wages 14.7 16.5 23.2 21.2 6.2 3.8 5.7 Saving and Investment (In percent of GDP) Gross domestic investment 23.3 26.5 31.1 31.4 30.8 29.9 31.9 Gross national savings 14.4 16.1 17.3 19.0 23.2 23.4 25.7 General government finances Revenue 31.4 32.3 32.5 32.6 33.0 33.4 33.1 Expenditure 32.1 33.7 35.6 37.5 37.5 37.0 35.8 Fiscal balance -0.7 -1.4 -3.1 -4.9 -4.6 -3.6 -2.7 Privatization proceeds 1.3 0.4 0.1 0.1 0.0 0.0 0.0 External financing 0.5 0.2 0.1 0.5 2.8 1.1 0.2 Domestic financing -1.1 0.7 2.9 4.4 1.8 2.4 2.5 Structural fiscal balance I / -0.6 -2.1 -4.2 -6.7 -3.8 -1.7 -1.2 Gross public debt (direct debt only) 15.6 15.4 17.5 20.1 23.6 25.7 25.7 Money and credit (Annual percentage change) Broad money (M3) 36.5 28.1 33.7 17.6 6.6 6.5 11.5 Credit to private sector 54.5 60.4 33.7 16.5 5.2 3.1 Interest rates, eop (In percent) Euribor, six-months 2.79 3.23 4.79 3.52 NBR policy rate 7.50 8.75 7.50 10.25 NBR lending rate (Lombard) 14.00 14.00 12.00 14.25 Intebank offer rate (1 week) 7.00 7.42 7.81 15.95 Balance of payments (Inpercentof GDP) Current account babnce -8.9 -10.4 -13.8 -12.4 -7.5 -6.5 -6.2 Merchandise trade balance -9.9 -12.0 -14.4 -13.3 -7.1 -6.3 -6.4 Capital and financial account balance 15.6 15.7 17.3 13.7 -2.3 3.2 7.4 Foreign direct investment balance 6.6 8.9 5.8 6.6 2.9 3.5 3.5 lntemational investment position -29.2 -35.3 -39.8 62.9 -55.6 64.6 -53.0 Gross official reserves . 22.9 23.2 23.2 21.5 24.6 27.3 26.7 Gross external debt 39.0 42.9 47.1 53.4 64.2 68.5 64.0 Exchange rates Lei per euro (end of period) 3.7 3.4 3.5 4.0 Lei per euro (average) 3.6 3.5 3.3 3.7 Real effective exchange rate CPI based (depreciation -) 17.9 7.6 9.0 -4.2 Memorandum Items: Nominal GDP (in bn RON) 289.0 344.7 412.8 504.0 531.3 568.5 634.1 Nominal GDP (in bn euros) 79.7 97.8 123.6 136.8 119.7 118.8 130.7 Social Indicators (reference year in parentheses) Percaplta GNI (Atlas method, 2005): US $4445; Income distribution (GIN1index, 2000): 30.3; Poverty rate (2005): 13 P.c.; Primary education completion rate (2004): 94 percent: Gender pay gap (2003): 18 percent; Llfe expectancy at birth (2004): 71.3; Infant mortallty per 1000 llve Mrths (2004): 16.8. 69 Annex 4: Romania At A Glance Romania at a glance 9/24/08 Europe& Upper Key DevelopmentIndicators Central middle Romania Asb income &e dstribution. 2007 (2007) M l e Femie Populatbn, mid-par (milions) 21.5 445 823 Surfacearea (thousand sq. km) 238 23,972 41,497 Populatbngrowth(%) -0.2 0.0 0.6 Urban population ("hoftotal population) 54 64 75 GNI (Atlasmethod, US$billions) 158.4 2,694 5,750 GNI percapta(Atlas method,US$) 7,370 6,051 6,987 GNI perca#ta(PPP, international$) 10,980 11,116 11,868 GDPgrowth (Oh) 6.6 6.8 5.8 10 5 0 5 10 GDPpercapita grouvth(%) 6,5 6.7 5.1 pscent (mast recent estimate, 20013-2007) Povertyheadcountratioat $1.25 aday (PPP, Oh) 10 5 Povertyheadcwntratioat$2.00aday(PPP,%) 11 Jnder-5 mortality rate (per 1,000) Life expectancyat bitth(@ars) 72 69 70 Infant morlalty (per 1,ooO live births) 16 n 22 Childmalnuhitim (% of children under 5) 4 Adult literacy,male(% of ages 15and dder) 98 99 94 Adult literacy,female ("A ofages 15 anddder) 96 96 92 Grossprimaryenrolment male(%ofage grwp) 105 98 112 Gross primaryenrolmen, female (Ohofagegrwp) 104 96 109 Access to animpIDvedwater source(% of powIation) 88 95 95 Access to improvedsanitatbnfaclities(% of population) 72 89 83 Net Ad Flows 1980 1990 2000 2007 (US$milims) Net ODA and official aid 243 432 914 3rowth of GDP and GDP per capita (%) Tqo 3donors (n 2006): European Comrnisson 62 264 695 Germany 68 25 51 France 0 17 42 Aid (% of GNI) 0.6 1.2 1.3 Aid percapla(&$) 10 19 42 Long-Term Economic Trends 85 M Consumerpricffi(annual %change) 45.7 4.8 GDP implict deRator (annual %change) 121 13.6 44.3 12.7 +GDP -GCP p e capita Exchange rate(annua1average,local per US$) 0.0 2.2 2.4 Termsoftradeindex(20M) = 100) 83 100 90 1980-90 1990-2000 2000-07 (averageannual gvMh %) Populatbn, mickpar (milims) 22.2 n.2 22.4 21.5 0.4 -0.3 -0.6 GDP(US$ milimsl 38,299 37,053 169,283 1 3 -0.6 6.1 (?hdGDP) Agnculture 16,4 23.7 12.5 6.4 1.9 -1.9 7.1 Industry 56.6 49.9 36.4 37.1' -1.0 -1.2 5.6 Manufacturing 33.8 14.5 21.9 Sewices 27.0 26.3 51.1 56.5 0.9 5.1 HwseMd final cmsumption expenditure 53 7 65.9 79.0 75.3 1.3 6.8 Generalgovt fnal consumptionexpenditure 123 13.3 7.2 7.6 0.8 7.I Grosscapla formation 36.3 30.2 19.5 31.I -5.1 9.4 Expcitsofgccdsand services 16.7 32.9 29.5 8.1 10.4 Importsofgoods andsewices 26.2 38.5 43.5 6.0 12.4 Gross savings 21.5 15.4 17.6 Note: Fouras initalicsarefw pars other than thosespecfied. 2007 dataare plininary. ..indicatesdata are not avalable. a. Aiddata arefor2006. DevelopmentEconomics,Development Data Group (DECDG). 70 Romania Balance of Paymenis and Trade 2000 2007 (US$milicns) GovernanceIndicators,M O O and 2007 Total merchandise exports (fob) 10,366 40,445 Total merchandise inports (cif) 13,054 70,245 Voice andaccomtablly Nettrade in goodsand services -1,930 -23,740 FQltlcal slablily Workers' reminances and I 1 cmpnsationot employees (recepts) Yti 8,5BY RegAabryqLaity curentacmunt Mance -1,355 -22,826 Rule of law asa%ofGDP 3.7 -13.5 Cmtml ofcaruptm Reserves,indudinggdd 3,396 37,211 0 25 50 75 1M CentralGovernment Finance ~ 2 0 3 7 ozmo Countrjs pscantYe fa& (0.100) h#wve'urrrn@yba'lsrelngs (% d GLP) Curent revenue(includhg grants) 31.I 30.6 S o m e KaUfmenmKraeY-MartNRl Worn Bank Tax revenue 29.2 28.5 Curent experdlure 31.8 29.2 Tedrnology and Infrastruchrre ZOO0 2007 Overallsurplusldeficit 4.O -2.8 Paved roads (% of total) 49.5 302 Highest magna1tax rate ("10) nxea ineana mmiep m e Individual 40 16 subscribers(per 1,OW people) 29 126 Colpcaate 25 16 Hgh techndcgyexpats (%of mnufacturedexports) 5.5 4 4 External Debt and Resource Flows Environment (US$milim) Totaldebtoutstandingand disbursed 11,160 88,374 Agialturai land (% of landarea) 65 63 Total debt servim 2,500 11,721 Forest area (% of land area) 27.7 27 7 Debt relef(tiPC, MDRI) - - NatioMly protectedareas (% oflandarea) 25 Total debt (% ofGDP) 30.1 47.1 Freshwaterrasources percapita(cu. meten) 1,955 Total debt service (YOof exports) 20.1 19.0 Freshwaterwithdrawal(% of internal resouces) 54.8 Foreigndirect investment(net infbws) 1,037 9,834 CO2 emissionspercapita(mt) 3.9 4 2 Podfdio equity(net inflows) 58 301 GDP peruritofene~~use (2005PPP$ per kg d o l equivalent) 4.2 53 ompositionoftotalexternaldebt 2006 Enew usa percapita(kg of oil equivalent) 1,616 1.772 (US$ mlicns) IBRD Tdai debt outstandingand disbursed 1,898 2,634 Disbursements 384 232 Principalrepaynents 91 211 Interestpaynenb 104 132 104 Total debtoutstandingand disbursed 0 0 Disbursements 0 0 Private Sector Development 2000 2008 Tdai debtservice 0 0 Time requiredto start a busness(days) 10 IFC(r7scaJyear) Costtostarta business(% ofGNl percapita) 3.6 Tdal disbursed and astandngpwtfdio 284 438 Time required to registerproperty(days) 83 ofwhich iFC ownaccount 112 391 Disbursementsfor IFCo m account 17 47 Rankedas a maja cmsbant to business M O O 2007 Podfdb sales, pepayments and (% of manaQerssurveyedwho agreed) repaymentsfor iFC ownaccount 5 162 Tax admilistration 35.6 Tax rates 34.1 MlGA Grossexposure 20 136 Stcckmarketcapitdizatim(%ofGDP) 2.9 27.1 New g~arantees 0 0 Bank capitalto asset rat0 (%) 8.6 8.9 Note: FQuesinitalicsare for pars other than thcsespecfied. 2007 data are preiininary. 9/24108 ..hdicatesdata arendavaihble. -irdcatesobserlatior is notapplicable. DevelopmentEcwomics, DevelopmentData Group (DECDG) 71 Millennium DeveloPment Goals Romania Wth selected targets to achievebetween I990 and 2015 (estimatedosest to date shown, +/- 2ye& Goal 1:halve the ratesfor extreme poverty and malnutrition ISSO 1945 ZOO0 2007 Poverty headcount ratio at $1.25 a day (PPP, %of population) 9.6 Poverty headcount ratio at national povertyline (% ofpopllatbn) 25.4 36' 13.9 Share ofincome orconsumptbnto the pomstquniW ( O h ) 9.9 8.9 8.2 8.2 Prevalence of malnutrition(% of chiklrenm& 5) 3.7 Goal 2: elawethatchildrenare able to completeprlmaryschooling Primaryschoolenrdtnent (net, %) 81 94 93 Pdmarycornpietion rate(% of &\ant age gmup) 96 e6 102 101 Secondary school errdiment (gross,%) 92 81 86 Ywth literacy rate(% of peopleages 15-24) 99 98 Goal 3: eliminategenderdisparityineducationand empwerwomen Ratioof sills to boys inprimarvand secondarveducation(%) 99 100 100 Women ~mpb)edlnthenonagrcukutalsBct& (% ofndgr'bultural employment) 42 46 46 PmpoTtion ofseats heidby women n national parlament (%) 34 7 7 11 Goal4: reduceunder4 morlality b/ bo-thirds Under6 mortalityrate (per 1,000) 31 26 22 18 infantmwtalityrate(per 1,Mx) Ike biltk) 21 21 19 16 Measbs imnmization (pupwtionoforeyear dds immunized. %) 92 93 98 95 Goal 5: reducematernal mortalii bv three4ouths Maternalmoitaltyrata (modeled esWrate, per 100,000 livebrh) 24 Bilths attendedbyskilled health staff (% oftotal) 99 98 98 Contraceptile prevalence(%of v.om ages 1549) 57 e4 70 Goal 6:hdtandbeginto revemthespreadofHNlAlDS andotbrmaja dseases Prevalenceof HIV (%of populatanages 1549) 0.1 0.1 lncidenceoftubeccubss (per100.000 people) 74 112 136 128 Tuberculosiscases detected underDOTS (%) 9 79 Goal 7 :hdvetheproportiond peoplewithoutsustainable access to basicneeds Accessto an mptoved water swce (%of populdon) 76 80 85 88 Accessto inyxovedsantatm facilbes (% ofpopulatan) 12 72 73 72 Forestarea (% of total land area) 21.8 27.7 27.7 Nationaly protectedareas (%of totailardarea) 2.5 032 emisaors (metnc tons percapita) 6.7 5.5 3.9 4.2 GLP per umtof enelgy use(constant2005 PPP $per kgofal equvabnt) 2.9 3.5 4.2 5.3 Goal 8:developaglobal partnershipfor development Telephone manlnes(per100people) 10.2 13.1 17.4 20.O M l e phonesubscnbets (per100 people) 0.o 0.0 11.1 106.2 Internetusers (per 100 people) 0.o 0.1 3.6 55.7 Personalcomputers (per100 people) 0.2 1.3 3.2 14.8 7Educationindicators (%) Measlesimmunizdion(% of lyearolds) ICT indicators(per1,WOpeople) 1501 I"1 . . --O-Pnmrynet mrdlmntr&io +Ratio of gds to boys inprimary 8 Note: F~uresinitaicsarefw)earsotherthanthosespeciied. ..indicatesdataare not available. 'nationaldata 9/24/08 DevelopmentEcommics,DevelcpmentDataGrcup (DECDG). 72 22°E 24°E 26°E 28°E UKRAINEUKRAINE ROMANIA To To Uzhhorod To To Ivano-Frankivs'k SELECTED CITIES AND TOWNS COUNTY (JUDET) CAPITALS To To NATIONAL CAPITAL ROMANIA Balti 48°N BOTOSANIBOTOSANI RIVERS Satu Mare Siret MAIN ROADS MARAMURESMARAMURES Botosani SATU MARE SATU MARE SUCEAVASUCEAVA RAILROADS Baia Mare C Suceava M Somes a o Prut COUNTY (JUDET) AND MUNICIPALITY To To BISTRITA-BISTRITA- r (MUNICIPIU) BOUNDARIES p l Chisinau a I A S Id INTERNATIONAL BOUNDARIES To To NASAUDNASAUD Bistrita t a Iasi Budapest Oradea Zalau Dej Bistrita h v SALAJSALAJ i Piatra- To To 30°E HUNGARYHUNGAR a Neamt i Chisinau C L U J a n Roman To To B I H O R Budapest Mures MOLDOVA Cluj- MURESMURES NEAMTNEAMTM Vaslui Napoca Gheorgheni Târgu Târgu t Husi Mures HARGHITA s .Bacau Crisul Turda Alb Miercurea- B A C A U V A S L U I Cuic Siret A L B A Arad A R A D Onesti To To Birlad Subotica Brad Alba Mures Iulia Medias 46°N COVASNA Deva S I B I U UKRAINEUKRAINE Sfântu Sfântu VRANCEAVRANCEA B Timisoara BRASOVBRASOV Gheorghe Tecuci Lugoj Hunedoara Sibiu GALATIGALATI a T I M I S Timis HUNEDOARA Moldoveanu Focsani (2,544 m ) Brasov SERBIASERBIA n Petrosani i a n Galati a l v a n s ARGESARGES A l p s BUZAUBUZAU Buzau Braila To To t Resita y n VÂLCEALCEA VÂLCEA Novi Sad Tulcea T r a CARAS - CARAS Buzau G O R J Râmnicu Râmnicu Vâlcea Vâlcea PRAHOVA SEVERINSEVERIN Târgu Jiu Târgu BRAILABRAILA Târgoviste Târgoviste Ploiesti T U L C E A Pitesti Jiu DÂMBOVITA DÂMBOVIT a Danube Orsova Drobeta- j Turmu Severin W a l a c h i a ILFOV IALOMITAIALOMIT IalomitaIalomita Black Arges BUCURESTI u Slobozia Slatina MEHEDINTI BUCHAREST Fetesti r To To Sea Nis Craiova O L T b Navodari Olt CALARASICALARASI Calarasi TELEORMAN Medgidia 0 25 50 75 100 Kilometers o Constanta 44°N D O L J GIURGIUGIURGIU Danube CONSTANTACONSTANT Caracal D 44°N 0 25 50 75 Miles Calafat Alexandria Giurgiu Mangalia IBRD FEBRUAR Turnu Magurele This map was produced by the Map Design Unit of The World Bank. 33469R2 The boundaries, colors, denominations and any other information Y shown on this map do not imply, on the part of The World Bank 2008 Group, any judgment on the legal status of any territory, or any To To To To endorsement or acceptance of such boundaries. BULGARIABULGARIA Sofiya 24°E To To To To Shumen To To 30°E Veliko Turnovo Shumen VarnaVarna