Report No. 74635-RO ROMANIA Reviving Romania’s Growth and Convergence Challenges and Opportunities A Country Economic Memorandum June 21, 2013 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CURRENCY AND EQUIVALENT UNITS (Exchange Rate Effective May 24 2013) Currency Unit = Romanian Leu US$1.00 =3,365 Fiscal Year January 1 to December 31 Acronyms and Abbreviations AGWP Annual Government Work Plan ANRE Romania’s Energy Regulator ANSVS National Authority for Veterinary Health and Food Security ARD Agriculture and Rural Development CAP Common Agricultural Policy CC Competition Council CEM Country Economic Memorandum CFR Romanian Railway Company ESA European System of Accounts ESU European Size Units EU European Union EU-10 The 10 newest EU Member States: Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic and Slovenia EU-12 The EU-10 plus Malta and Cyprus EU-15 The 15 first EU Member States: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, United Kingdom EU-27 All European Union members states: Austria, Belgium, Bulgaria, the Czech Republic, Cyprus, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, the Slovak Republic, Slovenia, Spain, Sweden, United Kingdom FDI Foreign Direct Investment FR Functional Review GDP Gross Domestic Product GSG General Secretariat of Government GVA Gross Value Added HA Hectares HR Human Resources HRM Human Resource Management IFIs International Financial Institutions IMF International Monetary Fund ISPA EU Program for Transport Infrastructure IT Information Technology KG Kilogram KM Kilometers KM/H Kilometers Per hour M&E Monitoring and Evaluation MARD Ministry of Agriculture and Rural Development MEA Ministry for European Affairs MEC Ministry of Economy, Commerce and Business Environment MoPF Ministry of Public Finance MoTI Ministry of Transport and Infrastructure MTEF Medium-Term Expenditure Framework NAFA National Agency for Fiscal Administration NPL Nonperforming Loans NRP National Reform Program OECD Organization for Economic Cooperation and Development OPCOM Romanian Power Market Operator PCM Price-Cost Markup PFM Public Financial Management PIRLS Progress in International Reading Literacy Study PISA Program for International Student Assessment PMR Product Market Regulation PPD Public Policy Department PPP Public-Private Partnership PSC Passenger Service Contract PWC Price Waterhouse Coopers R&D Research and Development RDP Regional Development Program RNCMNR Romania’s Public Roads Company RON New Romanian Lei (local currency unit) SAPS Single Area Payment System SGM Standard Gross Margin SGP EU Stability and Growth Pact SOEs State-Owned Enterprises SOP Sector Operational Plan SPC Strategic Planning Committee STEP Skills Toward Employment and Productivity TI-CPI Transparency International’s Corruption Perception Index TIMSS Trends in International Mathematics and Science Study UAA Utilized Agricultural Area UK United Kingdom US United States VAT Value Added Tax WB World Bank WDI World Bank World Development Indicators WEF World Economic Forum WGI Worldwide Governance Indicators Vice President: Philippe H. Le Houérou, ECAVP Country Director: Peter Harrold, Mamta Murthi ECCU5 Sector Director: Yvonne Tsikata, ECSPE Sector Manager: Satu Kahkonen, ECSP2 Team Leader (s): Sudharshan Canagarajah, Simon Davies, and Pedro L. Rodriguez, ECSP2 Contents ACKNOWLEDGEMENTS ........................................................................................................... i EXECUTIVE SUMMARY ............................................................................................................ i INTRODUCTION ......................................................................................................................... 1 PART I: THE FOUNDATIONS OF A SUPPORTIVE STATE — ENHANCING PUBLIC- SECTOR POLICIES AND INSTITUTIONS ............................................................................... 3 1. MACROECONOMIC MANAGEMENT ............................................................................. 5 A. Introduction ....................................................................................................................... 5 B. Lessons from the pre-crisis and crisis periods................................................................... 6 C. Safeguarding macroeconomic stability ........................................................................... 16 D. Options for reform ........................................................................................................... 25 2. PUBLIC SECTOR REFORMS ........................................................................................... 28 A. Introduction ..................................................................................................................... 28 B. Context and Agenda ........................................................................................................ 29 C. Options for Reform ......................................................................................................... 41 PART II: THE FOUNDATIONS FOR THE ECONOMY TO COMPETE — ENHANCING CAPITAL AND LABOR MOBILITY ....................................................................................... 44 3. SOE PERFORMANCE ....................................................................................................... 46 A. Introduction ........................................................................................................................ 46 B. Current status and challenges ............................................................................................. 47 D. Recent progress ............................................................................................................... 54 E. Options for reform ........................................................................................................... 57 4. THE COMPETITION AND REGULATORY ENVIRONMENT ..................................... 60 A. Introduction ..................................................................................................................... 60 B. Current status and challenges .......................................................................................... 61 C. Recent progress ............................................................................................................... 66 D. Options for reform ........................................................................................................... 67 5. LABOR AND SKILLS ....................................................................................................... 70 A. Introduction ..................................................................................................................... 70 B. Current status and challenges .......................................................................................... 71 C. Recent progress ............................................................................................................... 80 D. Options for reform ........................................................................................................... 80 PART III: THE FOUNDATIONS FOR EXPLOITING COMPARATIVE ADVANTAGES — SETTING KEY SECTORIAL POLICIES RIGHT .................................................................... 82 6. ENERGY ............................................................................................................................. 84 A. Introduction ..................................................................................................................... 84 B. Current status and challenges .......................................................................................... 88 C. Options for reform ........................................................................................................... 94 7. TRANSPORT ...................................................................................................................... 96 A. Introduction ..................................................................................................................... 96 B. Current status and challenges .......................................................................................... 98 C. Recent progress ............................................................................................................. 101 D. Options for Reform ....................................................................................................... 102 8. AGRICULTURE AND RURAL DEVELOPMENT ........................................................ 104 A. Introduction ................................................................................................................... 104 B. Current status and challenges ........................................................................................ 105 C. Vision for the sector ...................................................................................................... 111 D. Options for reform ......................................................................................................... 112 REFERENCES AND BACKGROUND PAPERS ................................................................... 114 POWER POINT PRESENTATION ......................................................................................... 120 TABLES Table 1: Selected economic indicators, 2001-2012....................................................................... 7 Table 2: Social security contributions, EU 10, 2010 (percent) ................................................... 18 Table 3: Legal and implicit tax rates for VAT and social contributions, 2012 ........................... 19 Table 4: Selected social indicators for Central and Eastern European countries ........................ 21 Table 5: Projected long-term pension and health care costs, % of GDP..................................... 22 Table 6: Major Financial Sector Indicators (%) .......................................................................... 24 Table 7: Financial soundness indicators for the banking sector, 2011 and 2012 ........................ 25 Table 8: Organization of ministries of finance – Romania and international comparison.......... 36 Table 9: Romania, tax revenues collected by NAFA as percentage of GDP, 2004-2012 .......... 36 Table 10: Electricity and gas prices for households and Medium-sized industries .................... 89 Table 11: State-owned enterprises supervised by MoTI ............................................................. 97 Table 12: Average crop yields in selected EU countries ........................................................... 107 FIGURES Figure 1: Evolution of GDP per capita in Romania ....................................................................... i Figure 2: Convergence scenarios for Romania’s GDP per capita (in US$), 1990-2030 ................ i Figure 3: GDP per capita in Romania and selected MICs (% EU average), 1990-2011 ............. 6 Figure 4: Romania’s imbalanced macroeconomic management, 2005-2012 ............................... 8 Figure 5: Romania’s credit stock by currency, 2005-12, in percent of GDP ................................ 8 Figure 6: Gross external debt in Romania and selected countries, 2008- 2012 ............................ 8 Figure 7: Romanian trends in fiscal revenue and expenditure (% GDP), 2000-12 ....................... 9 Figure 8: Romanian trends in the structural fiscal balance and output gap (% GDP), 2000-12 ... 9 Figure 9: Contribution to labor productivity growth, 2002-10, % .............................................. 10 Figure 10: Index of real compensation per hour versus output per hour .................................... 12 Figure 11: Real compensation per hour as % output per hour .................................................... 12 Figure 12: Exports (% GDP) and wage bill (% output), 2000-2011 ........................................... 12 Figure 13: Share of high, medium and low tech exports (%), 2000-2010 .................................. 12 Figure 14: Romania’s external accounts (in bill. EUR), 2000-12 ............................................... 12 Figure 15: Changes in the cyclically adjusted fiscal balance, EU Countries .............................. 14 Figure 16: Evolution of public expenditure in Romania, % GDP............................................... 15 Figure 17: Convergence scenarios for Romania’s GDP per capita (in US$), 1990-2030........... 16 Figure 18: Capital spending, public sector (% GDP), 2010 and 2012 ........................................ 20 Figure 19: EU-10 Absorption of EU funds (all types), as of March 2013 .................................. 20 Figure 20: Governance has improved on all dimensions (Percentile rank) ................................ 28 Figure 21: Government effectiveness, compared (Percentile rank) ............................................ 28 Figure 22: Laws introduced through the Department for Parliamentary Relations .................... 31 Figure 23: Emergency ordinances have been frequently used .................................................... 31 Figure 24: Compliance burden, number of tax payments, 2012 ................................................. 38 Figure 25: Human resource management systems- success factors ............................................ 40 Figure 26: Romanian State-owned Enterprises by Sector ........................................................... 47 Figure 27: Progression of wages in national SOEs ..................................................................... 48 Figure 28: Profitability ratios compared, SOEs and the private sector ....................................... 48 Figure 29: Romania SOE arrears................................................................................................. 49 Figure 30: Structure of corporate governance in commercial Romanian state enterprises ......... 57 Figure 31: Board selection and appointment process .................................................................. 57 Figure 32: Planning, objective setting & monitoring process ..................................................... 57 Figure 33: Principles for benchmarking SOE performance ........................................................ 57 Figure 34: Product market regulation, EU countries ................................................................... 62 Figure 35: Business licensing as a major constraint (percent of firms) ...................................... 62 Figure 36: Enforcement of anticompetitive business practices rules, 2008 ................................ 62 Figure 37: PMR, State control of economic activity, EU countries ............................................ 63 Figure 38: PMR government involvement in infrastructure ....................................................... 63 Figure 39. Price cost markups by country: 2003-08 averages, selected sectors.......................... 64 Figure 40: PMR - Barriers to trade and investment .................................................................... 65 Figure 41: PMR - Barriers to FDI ............................................................................................... 65 Figure 42: Pre- and post-crisis (2009) FDI stock per capita (Euro) ............................................ 65 Figure 43. Contributions of measured variables to export propensity (Percent)......................... 66 Figure 44: EU10 employment rates, 2002–11*........................................................................... 71 Figure 45: EU10 unemployment rates, 2002–11*....................................................................... 71 Figure 46: Romanians with upper secondary and tertiary education .......................................... 72 Figure 47: Share of employment by sector ................................................................................. 73 Figure 48: Contributions of Within-Sector Growth and Labor Reallocation .............................. 73 Figure 49: Index of real compensation per hour versus output per hour .................................... 74 Figure 50: Average gross nominal wages index by sector .......................................................... 74 Figure 51: Education of the workforce as an obstacle to doing business.................................... 77 Figure 52: Energy production in Romania by type of fuel, 1971-2009, ktoe ............................. 85 Figure 53: GDP per unit of energy use in selected countries ..................................................... 85 Figure 54: Residential use of energy* ......................................................................................... 85 Figure 55: Structure of the Romanian electricity market and key players .................................. 87 Figure 56: Electricity and gas markets opening in Romania....................................................... 89 Figure 57. Degree of obsolescence of the Romanian energy sector ........................................... 92 Figure 58: Transport infrastructure, EU member states .............................................................. 98 Figure 59: Utilized agricultural area by economic size in new EU member states %, 2007 .... 106 Figure 60: Distribution of the utilized agricultural area in Romania, 2003-10 ......................... 106 Figure 61: Share of products in domestic agricultural production (%) ..................................... 106 Figure 62: Share of various crops in arable land (%) ................................................................ 106 Figure 63:Age structure of farmers in selected EU countries, 2007 ......................................... 108 BOXES Box 1: Romania - Public spending during the pre-crisis and crisis period ................................. 15 Box 2: International experience top-down budgeting ................................................................. 30 Box 3: International experience on delivering results ................................................................. 32 Box 4: International experience with expenditure reviews ......................................................... 34 Box 5: Maintaining reform momentum in tax administration .................................................... 38 Box 6: Political participation of civil service in OECD countries .............................................. 39 Box 7: List Authoritative Papers on Best Practice Corporate Governance for SOEs ................. 59 Box 8: Emigration ....................................................................................................................... 72 Box 9: Adult training and active labor market policies............................................................... 78 Box 10: Timeline of legal, regulatory and institutional reforms in Romania ............................. 86 Box 11: Wholesale trade in electricity in Romania ..................................................................... 90 ACKNOWLEDGEMENTS The World Bank appreciates the excellent collaboration with the Romanian authorities in the preparation of this Country Economic Memorandum (CEM). The Bank team would like to express gratitude for discussions held in preparation for the CEM including with staff of the Ministry of Public Finance; the National Bank of Romania; the Romanian Center for Economic Policy (CEROPE); the Fiscal Council; the Ministry of Economy, Commerce and Business Environment; the Ministry of Labor, Family and Social Protection; the Ministry of Transport and Infrastructure; and the National Energy Regulator (ANRE). The Bank team also benefited from consultations with staff at the International Monetary Fund (IMF), the European Commission (EC) and the Academy of Economic Studies. Peter Harrold, country director; Yvonne Tsikata, sector director; Satu Kahkonen, sector manager; François Rantura, country manager; and Ismail Radwan, country program coordinator all provided guidance. We also received helpful comments and suggestions from the members of the country team. Ron Hood, Carolina Renteria and Maria Vaglisindi peer-reviewed the report and provided comments and suggestions that helped to improve the draft. Background papers were discussed at two consultative workshops held in Bucharest in May 2011 and October 2011. “The Way Forward� (May 2011) was held at the Intercontinental Hotel. Presentations are available at http://go.worldbank.org/ZZG3IUO0I0. “Economic Recovery and Growth in Romania� (October 2011) was held at the National Institute of Statistics. Presentations are available at http://go.worldbank.org/PZ0IX0KQ30http://go.worldbank.org/67SRVN4080. Background papers for the CEM were prepared by Martin Brownbridge (Bank of Uganda); Mihai Copaciu (National Bank of Romania); Ionut Dumitru (Fiscal Council); Alexis Gressier (Romanian Center for Economic Policies); Kristine Van Herck (Center for European Policy Studies); Anca Paliu (IMF); Dragana Pajovic (Consultant); Delia Rodrigo (Allio|Rodrigo Consulting); Eugen Scanteie (Consultant); Evgenia Shumilkina (Consultant); Johan F.M. Swinnen (Center for European Policy Studies); Antti Talvitie (Consultant); Manuela Unguru (Institute for World Economy); and Liviu Voinea (Academy of Economic Studies). This CEM was initiated by a team led by R. Sudharshan Canagarajah, lead economist for Romania (through end-August) and Simon Davies, economist. The CEM was finalized by Pedro L. Rodríguez (lead economist, Romania and Bulgaria) and Simon Davies. The team included Arabela Aprahamian; Omar Arias; Nina Arnhold; Paulo Correa; Donato de Rosa; Doerte Doemeland; Mohammed Dalil Essakali; Mariana Iootty de Paiva Dias; Holger Kray; Martha Martinez-Licetti; Bernard Myers; Kari Nyman; Catalin Pauna; Jorge Peña; Ana Florina Pirlea; Irina Ramniceanu; David Robinett; and Alexandru Stanescu. The lead consultant was Luis Alvaro Sanchez, with Ana Otilia Nutu, and Euegen Scanteie contributing to specific chapters as well. In addition to contributing toward CEM chapters, team members also produced stand-alone background papers that are included in the bibliography. Christopher Pala helped with editing the final report. Raluca Banioti and Nancy Davies-Cole processed the document, handled consultant contracts and organized the consultative workshops. EXECUTIVE SUMMARY This Country Economic Memorandum (CEM) sets a framework for a dialogue on inclusive economic growth and income convergence in Romania. The report discusses the immediate constraints to economic growth in areas where the short-term pay-off is high (i.e., where resource allocation is most distorted or inefficient) rather than covering all potential sources of growth for Romania. Although these are only the initial steps to reignite growth, the challenges of addressing each of these constraints should not be underestimated. Tackling them effectively demands a strong strategic vision, meticulous planning, and policy coordination. A significant amount of strategic communication of the benefits of the outlined reforms for the country will also be required since the roadblock to shaping and implementing these policies is likely to be vested interests, institutional inertia and lack of political consensus. Key policy makers understand well the benefits and, commendably, have already advanced key reforms over the past 12 months. Future reports could delve into other potential growth-enhancing areas. Romania carried out a set of important reforms to join the European Union (EU) during 2000-2007 and was rewarded with strong growth, rapid convergence, and shared prosperity. Romania made significant strides in catching up with the rest of Europe between 2000 and 2008 (Figure 1). Per capita GDP (measured in purchasing power parity) increased from 26 to 47 percent of the EU average as markets opened and institutions were reformed in preparation for the EU accession, which came in January 2007. The economy also went through an important transformation. Legal and institutional reforms were launched and advanced through the process of adopting the acquis communautaire. Generous FDI and other financial inflows lifted consumer demand, built up key industries, modernized wholesale trade and unleashed the movement of labor from low-productivity activities like agriculture towards high-productivity activities like manufacturing. Public and private investments in education lifted tertiary education enrollment from 12 to 23 percent. Preliminary calculations suggest that this growth was shared even after the crisis, as the income of the bottom 40 percent of the population grew by 5.5 percent on average during the 2000-2011 period, a pace slightly above the 4.8 percent growth in the income of all households and the 4.1 percent average growth. Achievements notwithstanding, there is little room for complacency. Figure 1: Evolution of GDP per capita in Romania Figure 2: Convergence scenarios for Romania’s (% EU average), 1990-2011 GDP per capita (in US$), 1990-2030 50% 45000 40000 45% 35000 RO@6% 40% 30000 EU @1.5% 25000 35% RO@2% 20000 30% 15000 Low and 10000 Middle Income  25% @6% 5000 20% 0 Source: World Bank staff estimates based on data from the World Bank’s World Development Indicators. Note 1: EU Growth in 2012 and 2013 is assumed at -0.3 and 0.5 percent, respectively. Romanian long-term growth after 2012 is assumed at either 2 or 6 percent as indicated in Figure 2 Note 2: Calculations use GDP per capita, PPP (current international US$). Since 2008 Romania’s growth prospects have dimmed and the country needs to act quickly to resume economic growth and income convergence with the rest of Europe. Romania today stands at a crossroads. If it grasps the opportunities available and removes key constraints to productivity gains and growth during the next three years, it can climb out of its current stagnation and resume its convergence with other EU countries – though at a much slower pace than during the first decade of the millennium which in hindsight was unsustainable. If it does not remove key constraints to growth, it will lose momentum and miss some of the opportunities it has today, such as becoming a hub for trade between Europe and emerging Asian economies and attracting significant amounts of FDI to further develop manufacturing (the auto parts industry has rapidly developed in the west and other regions), IT, transport, food, and energy industries, as well as services, such as tourism (Figure 2). Romania’s medium-term growth prospects at around 3 percent a year at best are challenging. Even this pace might prove optimistic because it relies on an improved euro-zone outlook. Working against Romania’s long-term prospects is a population that is aging not only because of low birth rates, but because over 2 million young workers have emigrated to better-paying jobs in the rest of Europe over the past decade. Since many of them have acquired valuable skills abroad, their continued absence is a major drain on the country’s general productivity, tax base and entrepreneurial pool. To make things worse, emigration is continuing, especially at the high end of the skills distribution. Continued and credible reform efforts are needed to bring Romanian labor—and capital—back into the country. Romania has advantages that, with appropriate and timely action, can be harnessed to facilitate growth recovery. First is its EU membership, which gives it access to a large market for its products and to significant amount of EU grant funds. If allocated wisely and spent efficiently and quickly, the next sizeable allocation of EU funds for Romania (about €20 billion) could be used to improve the economy’s efficiency and boost flagging demand without increasing Romania’s debt or tarnishing its image as one of Europe’s strictest enforcers of fiscal discipline. Second, is its location on the edge of the EU: Constan‫܊‬a – the largest port on the Black Sea and the fourth-largest in Europe – gives Romania the potential to become a major trading partner for Turkey, Russia and several former Soviet republics–and a conduit for other EU countries’ trade with those economies. If this potential were better exploited, Romania’s export market would expand and diversify, strengthening its ability to withstand volatility. How was Romania dislodged from its fast—growth path? The global financial crisis in 2008 revealed fundamental weaknesses in the Romanian economy and policies. The global financial crisis of 2008 stalled Romania’s convergence process. The crisis interrupted the inflow of external capital and brought the economy to a halt. Net capital inflows fell from 17.6 percent of GDP in 2007 to a negative 2.5 percent in 2009. The short-term capital that had gushed into Romania during the boom years flowed back out because of the credit crunch in advanced economies and increased risk aversion among banks and institutional investors. Domestic demand, which during the boom had been buoyed by ready access to credit, fell by 12 percent in real terms in 2009. The largest percentage drops in the components of demand were in private and public investment, which each fell by about 25 percent in real terms. Private consumption dropped by 10 percent. Exports too fell in 2009, by about 5 percent in real terms, because of the recession in major destination markets in Europe. The collapse in aggregate demand triggered a severe recession in the Romanian economy, which contracted by 6.6 percent in 2009 and another 1.2 percent in 2010. By then, aggregate demand had plunged so far that the economy was operating with a negative output gap of 1.8 percent of GDP. The rise ii in unemployment was relatively modest, from a low of 4.4 percent in 2008 to just 7.0 percent in 2010. This was due to emigration, which shrank the labor force; to labor market rigidities, which prevented labor shedding, and to the cushion that low-productivity farming provides to households. Still, these households needed to sharply adjust savings and consumption as their disposable income fell. Private enterprises responded to the crisis in the expected way, via cost adjustments and by shifting to new export markets. In contrast, state-owned enterprises, which did not have professionally appointed managers and enjoyed soft budget constraints, adjusted little in the wake of the crisis. The recession had severe consequences for public finances as well. As the tax base shrank, the non- cyclically-adjusted fiscal deficit widened, from 3 percent of GDP in 2007 to 7 percent in 2009—far above the 3 percent of GDP ceiling stipulated in the EU’s Stability and Growth Pact. The fact that the rise in the structural balance between 2007 and 2009 was just 1.4 percent of GDP, down from 6 to 7 percent of GDP in the years prior to this, indicates that the main reason public finances deteriorated was the downturn in the economy rather than discretionary fiscal spending. Nevertheless, the widening fiscal deficit, and hence the larger government borrowing requirement, together with the contraction of real GDP and real exchange rate depreciation, increased the public debt. In 2007, before the crisis, the public debt was just 13 percent of GDP (according to EU methodology), but by 2010 it had risen to 31 percent—the stock of short maturities representing 13 percent of total debt. As in many other European countries, the global financial crisis showed that the macroeconomic stance adopted during the boom years was pro-cyclical and, thus, bad for long-term growth. The expansionary fiscal policy combined with macro-prudential regulations that allowed for fast credit growth fueled demand during the boom. These loose policies resulted in a rapid increase in wages and strong real exchange rate appreciation during the pre-crisis period. This appreciation biased investments in favor of non-tradable sectors such as real estate, rather than tradable sectors like manufacturing. As a result, the ratio of exports to GDP fell from around 35 percent of GDP during the 2002-2004 period to 29 percent of GDP in 2007 despite the significant gain in market access through the EU accession and FDI inflows. Reform fatigue after the EU accession (a feature common to other countries) took a toll on potential growth too. This was most noticeable in the energy sector, where institutional reforms early in the 2000s brought about significant investments into oil and gas extraction and power distribution at all scales. The reforms included the creation of a transparent and competitive power exchange serving an unregulated market that reached about forty percent of the country’s electricity consumption by the middle of the 2000s. This, together with a rich and well-diversified energy endowment, placed Romania among the top 20 countries in the Global Energy Architecture Performance Index of the World Economic Forum. Unfortunately, the energy sector liberalization stalled around 2006 before the authorities could address a number of important issues. The result is that Romania, relatively rich in renewable energy potential, natural gas and oil, has failed to become a significant exporter of either energy or fuel, despite having the largest refining capacity in the region. Reform slowdown after the EU accession was also noticeable in transport, health and in the process of modernizing key state institutions for the management of the economy. Fortunately, impetus on these reforms has picked up significantly in the aftermath of the crisis, with the authorities taking difficult but essential steps over the past year. A number of structural deficiencies with macroeconomic consequences were also revealed by the crisis. Significant amounts of cross-subsidization through pricing, mainly from the gas, district heating and electricity sectors toward households and enterprises in key sectors (e.g., chemicals and railways), also surfaced. When the revenues in these industries fell, inter-enterprise arrears started to be built up and, together with the arrears of government institutions, eroded the payment discipline in the economy. iii Arrears of state-owned enterprises (SOE)1 had been an endemic issue in Romania even during the boom period (with penalties accumulating) but their magnitude was considered manageable and was, thus, never addressed. The inefficiencies uncovered in the SOE sector handicap macroeconomic management of the economy and constrain the growth potential of the economy. During the boom, these enterprises, which make up nearly 15 percent of the public sector employment, made profits of less than 3 percent of sales. From 2008 to 2010, their losses averaged 4 percent of sales. In 2012 the operational losses (after subsidies) of all lost-making SOEs were about 1 percent of GDP, which pushed the overall deficit of the consolidated public sector up from 2.4 percent to 3.4 percent of GDP. The stock of the SOE arrears was still large at 3.5 percent of GDP in September 2012, stunting growth in areas they dominated. Budgetary subsidies to SOEs, which are around one percent of GDP, are not only significant but also independent of performance or service delivery. In short, the crisis revealed the weakness of Romania’s past growth model: it was based to a large extent on consumption and short-term capital inflows rather than on sustained productivity increases in tradable sectors and it concealed significant inefficiencies in the public sector. The authorities had a number of responses to the crisis that started to realign the growth model: x On the fiscal side, the government embarked on a major retrenchment, initially based on cutting public payrolls, public-sector wages and raising VAT rates by 5 percentage points and, in 2012 when the bulk of the adjustment in the structural deficit took place, the emphasis shifted towards rationalizing public investments. This reduced the structural fiscal deficit by over 6 percent of GDP between 2008 and 2012, one of the largest fiscal consolidations in the EU. Given the circumstances, such retrenchment was the right policy response. Expenditure cuts were necessary during the crisis since financing to fund deficits quickly dried up, but they came at the cost of exacerbating rather than mitigating the contraction in demand. Unfortunately, institutional constraints prevented Romania from adopting policies that would mitigate the impact of such fiscal consolidation, such as an increased absorption of EU funds that would have allowed an increase in public spending without widening the deficit or generating debt. x On the external side, and consistent with the country’s inflation-targeting regime, the leu depreciated in nominal and real terms in 2008 and 2009—a necessary correction given the large reversal of net capital flows. This helped exports, which grew by 14 percent in real terms in 2010 and 10 percent in 2011. The recovery in exports, together with the recession-induced collapse in imports, shrank the trade deficit by more than 8 percent of GDP between 2007 and 2010. x On the financial side, strong prudential measures raised bank capitalization and improved transparency. Credit, which increased by 33.7 percent in 2008 with much of it denominated in euro, was curtailed and, while the stock of non-performing assets rose, the overall stability of the banking sector was preserved. x On the SOE side, a monitoring system for arrears and losses was introduced by the Ministry of Public Finance, while the government designed a process to attract private sector participation for at least the 20 largest companies, mainly in energy and transport. The government also approved an Emergency Ordinance on corporate governance for SOEs requiring, inter alia, that all of them appoint boards of directors and managers that are selected competitively and based on merit. However, the implementation of the privatization and corporate governance plans has lagged 1 Refers to enterprises with majority state ownership. iv significantly since its introduction in mid-2011. Still, a number of important steps have been taken: x Two enterprises (Hidroelectrica and Olchim) have been place under insolvency procedures, with one (Hidroelectrica) expected to come out in a significant better shape than before due to its ongoing restructuring. x Successful public offerings of state shares through the Romanian stock exchange were carried out for Transelectrica (in 2012) and Transgaz (in 2013), and plans have been advance for a public offering of Romgaz to take place at the end of 2013. x Professional appointments of the Board of Directors and management were carried out for the large SOEs under the supervision of the Ministry of Transport. x On energy, road maps were approved that outlined a gradual process to finalize the market liberalization process in the electricity and gas sectors by around 2018. The road maps are been implemented (i.e., the envisaged deregulation of wholesale electricity trading has taken place, as well as the envisaged tariff adjustments in the gas sector). The macroeconomic reforms outlined above stopped the free-fall of output and restored the financial markets’ confidence in the country, but the bulk of structural reforms are still to be implemented, leading to an overall failure to re-ignite growth. Spurred by export growth, a recovery in investment spending and a bumper harvest, the GDP grew in 2011 for the first time since 2008—but only at 2.2 percent, which was not enough to overcome the economy’s negative output gap that remained at 1.1 percent of GDP. Further, the economy registered only a 0.7 percent growth in 2012. Re-igniting growth: the path to convergence continues with removing the brakes that some policies impose on the economy today. To re-start the convergence process Romania should boost productivity in areas where it has strong comparative advantages. These includes exports of sophisticated manufacturing products (building on, for instance, the automobile value chain that was created by FDI inflows in the past and the nascent food and beverage industries), key tradable services (including those related to the transport logistic chain and the information, communication and technology industries), and different energy products (such as gas and electricity). While earlier sources of growth such as construction and domestic consumption will still play a role, they cannot by themselves deliver the required rates of productivity growth. This in turn requires an environment supportive of private investments with competition and skills supported by effective government actions. This report outlines a post-crisis growth model based on three pillars as the first step in an ongoing and forthcoming dialogue on the long-term growth: x Macroeconomic and public-sector policies for growth: As the recent global financial crisis has shown, macroeconomic policies have a crucial role in mitigating external shocks (particularly fiscal policy as a counter-cyclical tool) and ensuring that price, wage and interest rate signals are clear to investors and, thus, induce reallocations of labor and capital from lower to higher productivity uses. Professional public sector policy-making and institutions are fundamental, as they determine the quality of macroeconomic policies and the effectiveness of public sector interventions. x Capital and labor markets policies for growth: Capital, whether in public or private hands, needs to be used efficiently. In Romania, a key issue is to ensure that the productivity of the assets managed by the state via state-owned enterprises matches that of the private sector. More generally, a sound business and investment environment is needed, one that facilitates competition, entry and exit. Equally important to deal with shocks and restore growth is labor market flexibility to facilitate movement across firms, sectors and regions. Flexible labor-market v policies need to be complemented with policies to improve labor quality (portability of skills; addressing challenges related to the aging of the labor force) and safety nets. x Key sectorial policies for growth: Regulated sectors (infrastructure) and sectors with important informational gaps and externalities (agriculture) generally require special attention by policy makers. In the case of Romania, three regulated sectors are key for restoring growth: energy, transport, and agriculture. Endowments in these sectors are substantial, whether measured in terms of already installed capacity (energy), privileged geographical location (transport) or land endowments (agriculture). This suggests that moderate but sustained policy attention to these sectors can rapidly attract private investments–even if of a different nature and scale, depending of the sector. Romania can resume the process of income convergence with the rest of the EU by first focusing on removing the most pressing constraints in the above three areas that impede the private sector from creating new enterprises and investing in existing ones. The foundations of a supportive state — enhancing public-sector policies and institutions. Reducing economic volatility and uncertainty can be done with a well-coordinated macroeconomic policy mix. The most pressing need is to ensure that the country is on a sound macroeconomic footing by continuing fiscal adjustment along the lines of the Treaty on Stability, Coordination and Governance. Currently, the authorities estimate a target of 1.6 percent of GDP for the structural deficit. This target is slightly above the ceiling of 1 per percent of GDP deficit under the Treaty. However, in line with the Treaty, the medium term budgetary objective is expected to be achieved in 2014 with a structural deficit of 1.0 percent of GDP. The adjustment so far has helped to build a fiscal buffer capable of anchoring a shift to countercyclical fiscal policies and generating trust on the overall fiscal management, with spread on Romanian bonds declining. But setting the macroeconomic conditions for long-term growth also demands a significant improvement in fiscal policy. Even without expanding the fiscal envelope, a lot can be achieved by making taxes more neutral and public expenditures more effective. Using available EU funds can boost growth-enhancing expenditures, notably in infrastructure (i.e. transport) and labor markets, without increasing the deficit. Prudent debt management will help to ensure confidence in Romanian debt, reducing spreads, lengthening maturities and allowing the government to fund growth- oriented investments at cheaper rates. Finally, encouraging investment in sectors that contribute to long- term growth requires curbing real exchange rate volatility and safeguarding price stability. This necessitates strong coordination of fiscal, financial and monetary policies. Improving the performance of the state. The public sector employs a relatively high 28 percent of the labor force, but performs poorly compared to other European countries and ranks below the 50th percentile in the government effectiveness ranking of all countries.2 To get back on the path to growth, Romania’s public sector needs to become strategic and be able to improve coordination across sectors. It should set clear policy priorities and carefully monitor and evaluate them; and needs to provide better services, particularly in areas such as tax collection, health care and roads. Strengthening the Ministry of Public Finance is the first building block to support the overall state reform. It requires a thorough modernization of the public expenditure management system, strengthening the role of strategic planning in the budget process; revamping the public investment management, its structure and its IT systems, and making payment of taxes easier, leading to a reduction in tax evasion and a lightening of the compliance burden on taxpayers. The second building block focuses on the professionalization of the Romanian senior civil service and the development of competency-based requirements. This report outlines how to achieve the required improvements in coordination and policy-making, expenditure oversight, human 2 World Governance Indicators. vi resources and revenue management. Here too, Romania can benefit from advice and funds from the European Union. The foundations for the economy to compete — enhancing capital and labor mobility. Reducing the dominance of inefficient SOEs in some sectors. The number of SOEs, now at about 645,3 must be reduced – particularly the ones that are failing to pay their suppliers, accumulating losses and generating arrears to the tax and pension authorities. Most harmful to the economy are the SOEs that either produce more than half of their sector’s output (such as gas and electricity) or heavily influence it (telecoms, railroads, road-building storage, mining and quarrying). Reducing the large fiscal burden imposed by SOEs by closing or privatizing some of them would improve efficiency and attract private sector capital needed to adapt old industries to modern conditions. The government has already begun a reform program, which includes: (i) ending subsidies for all SOEs without demonstrable social value; (ii) privatizing SOEs in chemicals, freight transport, and energy; and (iii) professionalizing the management of SOEs that remain in state hands. This reform program is sound but needs to be brought to completion. By end 2012 only four out of the 645 SOEs had appointed professional management competitively, and only two had been subjected to insolvency procedures. Ensuring that the regulatory framework encourages rather than hinders the creation and expansion of dynamic, competitive businesses. For instance, the cost of opening, operating and closing a company are among the highest in Eastern Europe. Enforcement of regulation is perceived as opaque, unpredictable and uneven and the administrative burden on start-ups is discouragingly high. Companies competing with SOEs often find that these are also involved in regulating the sector they dominate, often in un- transparent ways. This report outlines different paths to improving the situation. Helping the labor force become more flexible and acquire more marketable skills. Romania today is not making full use of its formidable human capital. Only 58 percent of the working-age population is employed, the lowest rate in the EU, as are participation rates in company-paid training and education. Employers find themselves chasing too few workers with desirable skills, while many unskilled workers are either unemployed or have left the labor force entirely. Enabling the economy to compete in internal and external markets requires removing barriers to labor force participation, such as the high taxation of labor, and promoting programs of adult education focusing on computer literacy and general problem- solving, as well as any specific gaps identified through employer surveys need to be addressed, along with a set of incentives to motivate companies to train new workers. Reversing the flow of emigration could help the economy grow by benefitting of skills acquired abroad. Meanwhile, the country saw a substantial increase in the number of universities during the boom, creating Europe’s highest percentage of university graduates. The full effectiveness of these efforts require that education and skills strategies be aligned with labor market demand. The foundations for exploiting comparative advantages — setting key sectorial policies right. Completing the liberalization of the energy sector is urgently needed. Romania consumes more energy per unit of GDP than most other EU countries due to subsidized tariffs, soft budget constraints, poor sector management, obsolete equipment and inappropriate institutional arrangements, notably with SOEs. In the power sector, sales and prices in the regulated market are determined by the energy regulator, 3 Source: These figures, which are based on data from the Trade Registry database for 2010, probably underestimate the actual number of SOEs in Romania. The Trade Registry, for example, does not have data on public research institutes. vii ANRE. While the overall economic losses coming from these are not large (at about a quarter of a percentage point of GDP in 2012), they create a complex set of cross-subsidies and soft budget constraints that encourage rent-seeking. In the gas sector, final tariffs for residential and non-residential consumers are controlled and only reach about 35 percent of border parity prices. The opportunity cost from this mispricing of gas is considerable: at least 1.2 percent of GDP in direct losses and significantly higher in non-realized investments.4 In addition, gas exports are de facto blocked because a state-owned company has not upgraded its pipelines to send flows in both directions, which contravenes EU single- market principles. Tariffs for gas will need to be adjusted and electricity output fully deregulated over the next four years, as envisaged in the road maps that the authorities approved for the liberalization of the power and gas sectors in mid-2012. In parallel, the country’s safety net needs strengthening to protect poorest households against increases in energy costs. Sound reforms to increase efficiency in the electricity and gas sector and address soft budget constraints were approved in 2012. They include attracting private capital via majority privatizations or raising it in the stock market via public offerings. They need to be fully implemented if the country is to attract the type of private capital it needs to modernize the energy sector, a project estimated to cost $35 billion5, which would be a boost to growth and employment. Improving roads, railways, and ports to reduce the cost of transport and trade would help the logistics sector expand. In a country nearly the size of the United Kingdom, only 240 km of new motorways have been built over the past 20 years and only 200 km of railways have been upgraded for higher-speed trains. The result is that road and rail transport is slow, expensive and inefficient. The railways have failed to adapt to the typical post-communist shift from passenger to freight and keep operating trains that carry very few passengers. Investments in rail are needed and the private sector could contribute to improving the management of the rail service. In addition, road-building needs to accelerate, using available but untapped funds from the EU. Implementing a sound agricultural policy anchored in EU directives and focused on enhancing productivity of all players is possibly the most challenging area of reform. Romania is one of the best endowed European countries in terms of land, water and rural people. Agricultural land occupies 62 percent of the country’s area and almost two-thirds of it is arable. It has one of the highest proportions of rural population within the EU: 45 percent of the total population, and 28 percent of total employment, compared to 3 percent in the EU15.6 Yet agriculture accounts for only 5 percent of GDP, making Romania the lowest ranking in the EU277 in farm labor productivity. Romania can make use of EU agricultural policy tools to address problems in land titling, knowledge transfers and irrigation that the sector needs. With the EU market to the north and the Middle East to the south, Romania, which now imports 70 percent of its food, is well-positioned to reclaim is former role as a food exporter. One of the main obstacles to increasing output and productivity is that the land once farmed by large state farms was broken up into small lots, so that half the land is made up of plots of fewer than three hectares. The government needs to primarily improve rural roads, irrigation and drainage systems as well as telecoms and electricity distribution. It should also help build wholesale markets, empower farmers to adopt new management practices and techniques and improve the working of the land market, create non-farm jobs and improve the quality of, and access to, education. 4 World Bank calculations based on the different between the actual and border prices for gas. 5 Source: World Bank’s Energy Functional Review for Romania 6 Refers to the 15 first EU member states: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, and the United Kingdom. 7 Refers to all European Union member states: Austria, Belgium, Bulgaria, the Czech Republic, Cyprus, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, the Slovak Republic, Slovenia, Spain, Sweden, and the United Kingdom. viii The response from removing brakes on growth in these three areas can be significant. Although these are only the initial steps to reignite growth, the challenges of addressing each of these constraints should not be underestimated. Tackling them effectively demands a strong strategic vision and meticulous planning, policy coordination and change management. The focus will need to be on a few achievable objectives, the associated reforms, the required investments, the implementation strategies and monitoring efforts, which are supported by a strong center of Government, adequate administrative capacity and effective and efficient public sector institutions. The roadblock to shaping and implementing policies in this manner is not a lack in human capacity, which abounds in the country. Institutional inertia and lack of political consensus provides clues as of why an organized agenda of structural reforms has not taken root. If the obstacles to growth in these three areas are removed, Romania will have taken the most important step to return to a growth path that will ensure income convergence with the rest of the EU. As confidence in the reforms increases, Romania should attract home many of its emigrants, improve productivity, expand business and create a virtuous cycle of growth that could be supported by second- and third-generation reforms in the future. The broader long-term growth agenda is likely to be complex to sequence and implement, demanding strong strategic planning and policy coordination. A thorough analysis of five other potential growth-enhancing areas is left for the future: (1) the micro- foundations of growth, focusing on firm productivity and dynamics, with emphasis on the patterns and sources of productivity growth and their sustainability going forward; (2) trade quality and growth, focusing on how the composition of trade affects productivity and growth with emphasis on the quality of the export basket; (3) savings mobilization and growth, focusing on assessing the depth and the quality of institutions responsible for channeling funds towards investments (banking and non-banking sectors, stock and commodity exchanges); (4) the regional dimensions of growth, focusing on assessing how the various regions of the country are re-shaping their economic structure along key value-chains or clusters; and (5) the implications of various ageing and migration scenarios for growth. ix x SUMMARY OF RECOMMENDATIONS Objective Recommended Next Steps Part I: The foundations of a supportive state — enhancing public sector policies and institutions to re-ignite growth. 1. Macroeconomic management: Minimize economic volatility, avoid overheating, and create an environment to foster private investments in tradable sectors. x Maintaining the focus x Continue to reduce the overall fiscal deficit and maintain buffers. on fiscal discipline x Mitigate the impact of fiscal adjustment on growth by mobilizing EU funds (which show as both revenues and expenditures in the budget and, thus, do not undermine debt sustainability or increase the overall deficit). x Avoid further arrears build-up by developing detailed strategies for local governments, hospitals and state-owned enterprises to ensure that their income covers new commitments. x At the central level strengthen the systems to control arrears by developing a blueprint for treasury modernization, including a timetable for the introduction of commitment-based systems. x Ensuring fiscal policy x Reduce the tax burden on labor and fund the reduction by broadening the tax base and contributes to encouraging and enforcing compliance. establishing conditions x Review and model the likely composition of future spending given current sectorial policies in for long-term growth key areas (e.g., social, infrastructure, administration) and use the outcome of this review to create a reliable medium-term fiscal framework. x Focus public investments (via increasing absorption of EU funding) on improving needed roads, railways and other key elements of the transport/logistic chain. 2. Public sector reforms: Enhance capacity to develop strategic policy coordination and monitoring of implementation. x Improving policy x Strengthen the capacity of the central administration (center of government and MoPF) to management and facilitate inter-sectorial policy coordination and to link strategic planning to the budget process. coordination x Establish a monitoring and evaluation function to report on major policy priorities. x Improving x Set priorities for a program to modernize public expenditure management and implement these expenditure (i.e., strengthening the medium-term fiscal framework and the priority setting with the budget management implementation, the public investment management, and the overall orientation of the budget towards results) x Conduct a comprehensive and detailed IT audit to assess the MoPF's information systems, practices and operations. x Better integrate the IT systems that are used in budget management. x Easing compliance x Continue efforts to streamline the office structure of the tax administration agency and to costs modernize its business processes with the aim of reducing compliance burden on taxpayers and reducing tax evasion. x Clarify management and administrative roles, responsibilities, and functions to give the senior civil service more accountability and enable ministers to concentrate on strategic direction and communication. x Starting Human x Assign institutional responsibility for coordinating human resource management reforms across Resource government. Management x Prioritize the professionalization of the senior positions in the civil service and develop more Reforms competency-based requirements for such positions. x Increase the technical requirements for the most senior positions based on job-related competencies, skills and relevant experience, and limit political involvement in the selection process to only high-ranking civil servants. x Give the General Secretary greater powers to make decisions, but allow these to be delegated to subordinates. xi Objective Recommended Next Steps Part II: The foundations for the economy to compete — enhancing capital and labor factor mobility to re-ignite growth. 3. Competition and regulatory environment: Attract new firms and weed out inefficient ones. x Freeing up business x Set up a deregulation commission with private-sector participation to identify the most important from excessive constraints to doing business. regulation x Pass legislation, similar to that of the United Kingdom (UK), to require that any new regulation that places a cost or time burden on businesses must be counterbalanced with equivalent reductions in regulatory burdens. x Increase coordination among various regulatory agencies (including via consolidation) and ensure that SOEs and private firms can compete on a level playing field. x Introduce and expand computerized government services to facilitate private sector interaction with government. 4. The governance of SOEs: Tighten budget constraints; enhance the efficiency of those enterprises that are to remain in public hands, and launch majority privatization for those that are not. x Professionalizing x Implement Emergency Ordinance No. 44, 2011, on corporate governance across all SOEs, SOE governance including the appointing of independent, professional, experienced and qualified members of the boards (and executives) based on a transparent nomination and selection process. x Streamline reporting requirements by SOEs and their budget approval process by simplifying Law 329 of 2006 and Emergency Ordinance 73 of 1998 (and other related pieces of legislation). In parallel, grant greater autonomy to board members and management and enhance their accountability by subjecting them to performance reviews (through their Boards of Directors) based on the formally agreed strategic plans. x Implement Art. 47-50 and art. 58 from EGO 109/2011 introducing mandatory independent external audit for all SOEs by reputable auditing companies. Audits must be conducted according to International Standards for Auditing (ISA). x Ensure that financial reporting of SOEs is made on the basis of IFRS standards, which is needed for the state organ responsible for asset management as a basis for evaluating financial and operational performance. Accordingly, ensure fiscal reporting requirements are not burdensome. x Ensure a high level of transparency and disclosure in financial information and operational decisions to ensure financial and operational information is timely and up to date, and to detect potential problems early. x Professionalizing the x Establish a central SOE ownership entity to exercise the shareholder rights of the state, help state’s oversight role professionalize the state’s oversight and assist in holding SOEs accountable. x Apply the guidelines on Corporate Governance prepared by MoTI to all national level SOEs to systematically address issues that go beyond the scope of the ordinance and detail how to handle core governance like performance management, division of responsibility between board and ministries and the evaluation and wages of management. x Establish a clear division between the state’s functions as a shareholder of the SOE and the implementation of its policy objectives via the SOE. Shareholder responsibilities including overseeing that the board nomination process should be fully in the hands of the ownership entity. The negotiation of policy objectives may be retained by line ministries. x However, line ministries must maintain an arms’ length relationship with SOEs and should be prohibited from direct intervention in SOEs or engaging in the management of SOEs. Ministries should under no circumstances directly manage the SOE, and should engage with the SOE only via a professional board of directors. x Ensure that boards are first and foremost responsible for ensuring the performance of the SOE, and accountable to shareholders (including the State). x Develop and implement rules and procedures that regulate the interaction between the state and the SOE including ensuring performance assessment of boards and executives against agreed performance criteria. xii Objective Recommended Next Steps x Streamlining the role x Set clear and transparent criteria for determining whether an enterprise should remain state- of the government in owned, be privatized, or be subsidized in the event the political decision is unclear. industrial or service x Initiate privatization (majority shares) to strategic investors for those enterprises that could be sectors better run by private sector operators or are in need of major infrastructure investment. x Building capacity x Launch training programs for SOE board members, executives, financial market regulators, and systematically ministries staff involved in SOE-related issues to ensure the governance and management of SOEs contributes to the Government’s objectives. x Increase financial market integration (which will provide additional information and benchmarks for ongoing refinement of approaches and standards) x Work with the financial sector partners (including the stock exchange for listed SOEs) to enhance capacity of managers, SOE units in central and line ministers and all other key players. x Reducing SOE x Ensure mechanisms are in place to prevent future accumulation of arrears by SOEs as required by arrears systematically the EU Directive 2011/7 on late payments. x This will require broad-based reforms, such as deregulating prices in the energy sector and renegotiating or terminating contracts that provide for preferential treatment or require the provision of products or services at below market prices. These recommendations would have to be supported by broader regulatory reforms as discussed in chapters 4, 6 and 7. x Also needed is a hard budget constraint on SOEs and moving nonviable SOEs into bankruptcy. The intent is to hold SOEs accountable and improve their performance. 5. Labor, skills and education: Continue to upgrade the population’s skills and enhance labor market participation. x Enhancing labor x Increase wages in line with productivity growth. market policies x Introduce supply and demand policies to activate the large pool of underused labor including through training for adults and youth and increased opportunities for part time work. x Improving skills x Continue to monitor skills needs and track labor market outcomes for graduates. levels over the x Encourage firms to increase worker training. medium-term Part III: The foundations to exploit comparative advantages — setting key sectorial policies right to re-ignite growth. 6. Energy sector: Enhance the potential of the energy sector as an engine of growth for the country. x Enhancing conditions x Implement as planned the plans spelled out in road maps for the liberalization of energy and gas for private sectors over the next 2-3 years for non-residential consumers and 2-5 years for residential investments consumers. x Initiate all activities for ANRE to be able to issue the third regulatory package for the 2013-17 period by mid-2013. x Continue the process of modernizing financial products available through OPCOM, the Romanian power exchange, and eventually turn it into private hands. x Improving x Privatize enterprises that are unlikely to be able to remain viable over the medium-term without sustainability of significant capital injections for assets renewal (e.g., Oltenia). SOEs in the sector x Continue the efforts to list the companies that are expected to remain in state’s hands (e.g., Romgaz, Transgaz, Transelectrica, and Nuclearelectrica) in the Stock Exchange to raise capital, increase transparency, and enhance accountability. 7. Transport sector: Upgrade Romania’s road and rail infrastructure. x Building a modern x Draft a comprehensive transport policy. and efficient x Use EU funds to improve road and rail infrastructure. transport network x Rationalize the rail network by closing rail services on rarely used routes. x Integrate rail and bus services by ensuring timely connections or creating transport hubs. xiii Objective Recommended Next Steps x Improving x Reduce the number of state-owned enterprises in the transport sector (currently about 23) by sustainability of privatizing services that can be efficiently supplied by the private sector, such as freight SOEs in the sector forwarding. x Where full privatization is not possible, partial privatization should be pursued in order to introduce private sector governance standards, disclosure and incentives. x Bond offerings may be considered as a way to raise both capital and accountability. x Professionalize the governance practices of SOEs, in particular through the appointment of professional boards of directors. x Address the Ministry of Transport’s potential conflict of interest when performing its role as policy maker, regulator, owner, and client. 8. Agriculture and rural development: Enhance the potential contribution of agriculture and agro-business to growth. x Putting in place the x Draw a comprehensive and inclusive sector-wide strategy for rural development. key foundations x Pilot systematic registration of rural land titles in the national cadaster –and initiate its rollout. x Complete the implementation of the reform plan for agricultural administration to align it with the vision for the sector and of the emerging rural development strategy. x Improving key x Take immediate action to meet looming CAP implementation obligations. policies x Enhance the quality of services provided by the agricultural and paying agency administration to beneficiaries of the CAP program. x Update the capacity in counties to monitor and enforce food safety and quality standards. xiv INTRODUCTION 1. Romania’s economy grew by an impressive 6.3 percent a year on average between 2000 and 2008, narrowing by a quarter its income gap with other EU countries. But the crisis that ended the boom halted progress towards income convergence and revealed management problems that are preventing Romania from realizing its considerable potential. If nothing is done, instead of catching up with the rest of the EU, Romania will slip farther behind. 2. To resume economic growth and convergence with EU living standards, Romania needs to implement broad structural reforms. Romania’s potential lies in its location on the southeastern rim of the EU, from where it can import raw materials through its Black Sea port of Constan‫܊‬a, a potential regional hub, and process them for tariff-free export to the rest of the EU. Also, EU membership gives Romania access to a large and sophisticated market, with its private capital, structural and cohesion funds and skilled labor. But to capitalize on these assets, the authorities must undertake a series of reforms that will remove the roadblocks to renewed growth. They include: x Retooling the fiscal framework to ensure that fiscal policy is counter-cyclical, so that spending is reduced when the economy improves, to avoid inflationary pressures and to build rainy-day savings, and is increased when the economy contracts to avoid sharp increases in unemployment. x Reorienting the economy toward exports, which so far have played a minor role in the 2000- 2008 expansion, which was driven mainly by domestic consumption and non-tradables. x Streamlining the regulatory environment to allow the creation and efficient functioning of dynamic, growth-oriented private companies that can eventually bring back home some of the 2 million Romanians who emigrated over the past decade, many of them now possessing skills the economy needs. Each new firm that opens in Romania (whether domestic or foreign-owned) represents a new set of sorely needed jobs and investments. x Addressing the sclerotic, money-losing condition of state-owned enterprises, which dominate the energy and transport sectors and account for nearly 10 percent of the economy. They can be improved by enforcing budget constraints on them, professionalizing their management, attracting private sector participation and tearing down the regulatory walls that protect them from competition and/or prevent them from competing in international markets. x Accessing untapped EU funds to improve roads, ports, railways, sewage-treatment plants and other infrastructure complementary to the private sector. x Reforming the labor market and educational system to facilitate skill acquisition through on- the-job training, greater company investments in training and affordable adult education and vocational training. x Reorganizing agriculture by encouraging new investments into the sector to enhance productivity of farms through research, knowledge and basic irrigation. 3. The breadth and focus of these reforms are, however, subject to ongoing debate. This report aims to contribute to the debate. The report has been built around the topics and contributions received through two consultative workshops organized in 2011 as well as several background studies carried out during 2011-2012. Finally, it builds on the structural reform program that the authorities have begun to implement, notably in energy and transport. In addition, the report looks at potential new areas of reforms, including agriculture, the broader agenda of public administration reforms, and the labor market and skills challenges. 4. The report takes a broad approach to discussion of potential reforms in each area. Because of the slow pace of recent structural reforms, it stresses the urgency of the reform agenda and details the measures that could be taken in the short term. In choosing this approach, the report does not discuss deeper dimensions of these reforms. The transport chapter, for instance, does not examine the most effective ways to attract private sector capital and know-how into infrastructure. Likewise, the labor and skills chapter does not outline the exact design of lifelong education. Furthermore, for reasons of brevity, not all topics that are important for sustainable long-term growth in Romania are covered. These include, for instance, innovation and entrepreneurship. A better understanding of integration of Romania into the European gas markets or transport and logistics chains would require a much deeper analysis. Nonetheless, the topics discussed in the report are areas in which key reforms can help to achieve convergence with EU living standards. 5. This report is organized around three parts: x Macroeconomic and public sector policies for growth: These policies have a crucial role in mitigating external shocks (fiscal policy is a key countercyclical tool) and in ensuring that signals on profitability and cost of capital are clear. Public institutions determine the quality and efficiency of such macroeconomic policies and the efficiency of public sector interventions. x Capital and labor markets policies for growth: Capital, whether under public or private sector management, needs to move to its most productive use. In Romania, this demands, in addition to appropriate macroeconomic management, a sound business and investment environment. Equally important is to ensure that the productivity of the assets managed by the state (via state-owned enterprises) match that of the private sector. Finally, to contribute to the restoration of growth, the labor market needs to facilitate movement across sectors and regions. Flexible labor market policies will however need to be complemented with policies to improve labor quality (portability of skills; addressing challenges related to the aging of the labor force). x Key sectorial policies for growth: reforming two regulated sectors (energy and transport) and one with important informational gaps and externalities (agriculture) is essential to restore growth in Romania. Endowments in these three sectors are substantial, whether measured in terms of installed capacity, geographical location or land, indicating that moderate but sustained efforts can lead to rapid results. In all three cases, policy improvements can quickly attract private sector investments, although of course of different nature and scale.  2 PART I: THE FOUNDATIONS OF A SUPPORTIVE STATE — ENHANCING PUBLIC-SECTOR POLICIES AND INSTITUTIONS 3 4 1. MACROECONOMIC MANAGEMENT Fiscal policy during the pre-crisis period proved to be highly pro-cyclical: it exacerbated rather than mitigated aggregate demand. When the crisis hit, therefore, macroeconomic buffers to smooth the shock and launch a counter-cyclical response were not in place. Bold policy decisions by the government in the aftermath of the crisis reduced external and internal imbalances, but failed to foster economic recovery. Looking forward, macroeconomic policies need to continue to focus on maintaining stability, but should also provide the foundations for sustainable growth. Setting the macroeconomic conditions for long-term growth demands a significant improvement in the quality of fiscal policy. While the overall fiscal envelope is shrinking, a lot can be achieved by enhancing the neutrality of taxes and the effectiveness of public expenditures. Prudent debt management (aimed at reducing spreads and lengthening maturities) will also contribute to growth. Finally, long-term growth also demands stable relative prices for tradable versus non-tradable sectors or, in other words, avoiding sharp real exchange rate volatility and the safeguarding of low inflation. This will require strong coordination of fiscal, financial and monetary policies. A. INTRODUCTION 6. Romania, like many other EU members, confronts difficult macroeconomic challenges that center on the need to stimulate growth even as domestic demand is depressed and the external environment is uncertain. The latter problem is related to the economic environment in the Euro area, which provides Romania with its main export markets, remittance transfers and external finance. Furthermore, to sustain growth over the medium-to-long term, Romania must become more competitive and heighten productivity, especially since the labor force will shrink as the population ages. This chapter analyzes what Romania’s macroeconomic challenges imply for fiscal policy and macroeconomic policy coordination in the short and medium term. 7. Since the global economic crisis began, the Romanian government has implemented a number of difficult economic reforms. Its fiscal consolidation has been far larger than that of most other EU member states. This tightening was essential because, along with the global crisis, weaknesses in the domestic economy made Romania’s banking system more fragile. Nevertheless, to promote economic recovery in the short term and ensure sustainable economic growth in the long term, further difficult policy challenges will have to be overcome. For macroeconomic policy, the priorities are to keep the economy stable by controlling inflation and stabilizing output near its potential long-term level and to ensure that public finances are sustainable while reforming taxation and spending policies as the main instruments of growth. 8. Fiscal policy has numerous complex relationships with economic growth. In the short term, the fiscal stance can affect growth through its impact on aggregate demand, especially when demand is low and the economy is operating with a negative output gap. Economic growth also feeds back to fiscal aggregates: higher growth reduces deficits by boosting revenues, reducing public spending on unemployment-related benefits and can reduce public borrowing costs (Cottarelli and Jaramillo, 2012). Ensuring payment discipline helps to ensure fiscal predictability. In the medium term, fiscal policy also influences the supply side of the economy through numerous microeconomic and structural channels that affect incentives to work, save and invest and by providing growth-enhancing public goods and services. 9. Macroeconomic policies are those related to fiscal, monetary and prudential banking regulations used to manage aggregate demand and reduce volatility in key variables such as prices, growth and unemployment. This chapter focuses on economic growth and fiscal developments in 5 Romania. Section B looks at the growth pattern of the Romanian economy during the boom and the impact of the crisis. The growth pattern during the 2000s made Romania especially vulnerable when the crisis hit and had many consequences that hindered a return to growth. Section C discusses how best to safeguard future macroeconomic stability given the inherited growth pattern. It focuses on fiscal policy, which can be made a more effective growth-promoting tool. Section D proposes options for reform. B. LESSONS FROM THE PRE-CRISIS AND CRISIS PERIODS a. Pre-crisis growth 10. Romania made Figure 3: GDP per capita in Romania and selected MICs (% EU significant strides toward average), 8 1990-2011 income convergence with the 160 EU9 between 2000 and 2008. 140 During those years, GDP growth 120 averaged 6.3 percent, increasing 100 to 7.2 percent on average between 80 2006 and 2008, the peak years of 60 the boom. This strong growth helped Romania increase its GDP 40 per capita (measured in 20 purchasing power parity units) 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 from 26 to 47 percent of the EU average during the period (Figure BGR HUN POL SVK ROM 3). Source: World Bank staff estimates based on data from the World Bank’s 11. Growth was uneven World Development Indicators. across different sectors. Between 2000 and 2008, average annual growth was over 15 percent in construction but negative (-3.3 percent) in agriculture (Table 1). Industry10 grew at 5.2 percent per year – below the average for the economy – while services grew 6.1 percent. The fast growth in construction and services, which tend to be non-tradable in Romania, combined with relatively slow growth in industry and agriculture, which tend to be tradable, resulted in a shift toward non-tradable sectors. 12. Non-tradable sectors grew as a share of GDP during the economic boom from 59 percent in 2000 to 67 percent in 2008. 11 The largest increase was registered by the construction sector, which grew from 5.4 to 11.9 percent of GDP. Ideally, the construction boom would have improved infrastructure as well as housing, but in fact it affected mostly private construction, which was buoyed by easily available consumer credit. Commerce grew from 24 to 25 percent of GDP between 2000 and 2008, the result of increased private consumption. The share of the government’s consumption in GDP (which is only one component of the public sector’s share of GDP) increased from 13 percent in 2000 to 15 percent in 2008. Like construction and consumption, this growth was partly debt-funded, particularly towards the end of the boom when public deficits increased sharply. 8 Per capita GDP is measures in purchasing power parity. The denominator refers to the entire European Union members (see Footnote 1). 9 Refers to the first 15 members of the European Union by 2004 (EU-15), including Belgium, France, Germany, Italy, Luxembourg, Netherlands, Denmark, Ireland, United Kingdom, Greece, Portugal, Spain, Austria, Finland and Sweden. The EU-25 includes these plus the ten countries that acceded in 2004 (Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovak Republic and Slovenia). Today, the EU has 27 members (EU-27) including all of those mentioned plus Bulgaria and Romania. 10 Industry here groups sectors, such as manufacturing, mining, construction, and energy sectors. 11 Non-tradable sectors are broadly classified as construction, commerce, finance and public administration, and tradable sectors are manufacturing, other industry and agriculture. 6 Table 1: Selected economic indicators, 2001-2012 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 1. GDP growth, % change 2.1 5.7 5.1 5.2 8.5 4.1 7.9 6.3 7.4 -6.6 -1.2 2.2 0.7 By sector, % change Agriculture -14.1 29.2 -10.0 8.4 17.2 -29.5 0.1 -21.6 22.6 -9.7 -8.3 14.3 -21.6 Industry 6.0 7.3 7.1 -2.7 9.0 4.9 6.7 5.0 1.0 -2.6 5.2 7.2 0.9 Construction 1.5 16.1 12.9 7.3 11.6 16.0 22.6 30.3 24.2 -10.2 -7.0 3.4 -0.3 Services 4.6 -1.5 7.4 8.8 5.7 11.3 7.9 7.7 5.5 -7.3 1.0 -1.1 0.1 By spending category, % change Private consumption na 9.4 6.2 8.3 15.9 10.1 12.7 11.9 9.0 -10.2 -0.3 1.1 1.1 Government consumption na -4.4 -4.2 9.8 -8.6 3.8 -4.1 -0.1 7.2 1.6 -3.6 -4.0 -3.0 Investment na 14.8 0.7 12.2 17.7 3.4 20.7 29.4 14.1 -28.0 -2.1 6.3 5.4 Domestic demand na 8.4 4.1 8.3 12.0 7.9 12.9 14.3 7.3 -12.0 -1.2 3.0 1.4 M emo: Output gap (% GDP) 0.4 Ͳ0.8 Ͳ2.2 Ͳ3.1 Ͳ0.4 Ͳ1.3 1.9 4.3 8.2 Ͳ0.4 Ͳ1.8 Ͳ1.1 Ͳ2.1 2. Prices and wages, % change, y-o-y Harmonized CPI 45.6 34.6 22.6 15.2 12.0 9.1 6.6 4.9 8.0 5.6 6.1 5.8 3.4 Average nominal wage growth na 51.4 24.0 20.7 25.0 14.8 18.4 21.8 26.1 4.8 3.1 4.1 4.9 Average real wage growth na 12.6 1.2 4.7 11.7 5.3 7.5 17.7 16.5 -1.5 -3.7 -1.9 1.3 3. Unemployment rate, % 6.8 6.6 7.5 6.8 8.0 7.2 5.2 4.0 4.4 7.8 7.0 5.2 5.6 4. General Government, % of GDP Revenue 31.0 29.8 29.5 28.7 29.9 31.4 32.3 32.3 32.2 31.2 32.3 31.4 32.3 Expenditure 35.0 33.0 32.1 30.9 33.3 32.1 33.7 35.4 37.0 38.5 38.7 35.5 34.5 Fiscal balance -4.0 -3.2 -2.6 -2.2 -3.4 -0.7 -1.4 -3.1 -4.8 -7.3 -6.4 -4.1 -2.4 Structural fiscal balance -4.7 -3.0 -1.4 -0.6 -1.1 -0.6 -2.5 -4.2 -8.0 -8.9 -5.8 -4.5 -1.6 Gross public debt (excl. guaratees) 19.5 16.0 12.9 9.6 10.4 11.8 21.7 28.2 30.2 32.0 Gross public debt (incl. guaratees) 12.7 13.6 23.8 31.2 33.0 34.6 5. External Sector, % of GDP Exports 32.4 33.1 35.2 34.8 35.8 33.1 32.1 29.2 30.4 30.6 35.4 38.5 38.9 Imports 37.5 40.7 40.9 42.2 44.9 43.3 44.2 43.2 43.6 36.6 41.2 43.7 43.9 Current Account Balance -5.2 -5.5 -5.6 -5.8 -9.1 -10.2 -10.4 -13.4 -11.6 -4.2 -4.4 -4.5 -3.9 Real Effective Exchange Rate Index 100.0 107.6 112.5 116.5 125.8 152.1 169.6 188.5 179.1 171.7 173.1 174.3 165.2 Sources: National Bank, Ministry of Public Finance, IMF, JP Morgan, World Bank staff calculations. Preliminary data for 2012. Approved budget for fiscal data in 2012. 7 13. This pattern of growth was the result of both demand management policies and structural transformation. Domestic demand was boosted by large inflows of credit and a large fiscal deficit, despite the strong growth. At the same time, Romania underwent a structural transformation which helped increase productivity and speed convergence, although not all changes proved to be sustainable. i. Demand management 14. Romania pursued a more demand-driven growth strategy during the boom than some of its neighbors (Figure 4). The Romanian boom differed markedly from those of central European countries like the Czech Republic and Slovakia, which pursued a more balanced growth strategy. In these countries, the production of traded goods, notably manufacturing, expanded and capital inflows consisted of FDI into manufacturing rather than bank loans destined for construction and services. The pre-crisis trajectory of the Romanian economy, however, had more in common with that of Baltic economies and can be seen to have had an even more demand-driven growth than these countries. In particular, much like in Lithuania, Latvia and Bulgaria, the growth of demand factors in Romania (consumption and investment) was much faster than the growth of total GDP (supply). 15. The pre-crisis boom was partly Figure 4: Romania’s imbalanced macroeconomic funded by external credit flows, resulting in management, 2005-2012 increased debt levels. Total credit increased 5.0 from 15 percent of GDP in 2002 to 45 percent GDP growthdrivenby AnnualGrowthRateforDomesticDemand domesticdemand Romania in 2008. Household credit growth was 4.0 Poland particularly strong, increasing from 2 percent of (average2005Ͳ2012) 3.0 Estonia Bulgaria Slovakia total credit in 2002 to 35 percent by 2008. Most 2.0 Latvia of this credit growth was externally financed CzechRepublich and much was denominated in Euro (Figure 5). 1.0 As a result, external debt went above 50 0.0 Slovania Croaita GDP growthdrivenbyexports percent by 2008 (Figure 6). A further increase 0.0 1.0 2.0 3.0 4.0 5.0 Ͳ1.0 during the crisis (partly from IFI programs, Hungary which replaced private financing sources – see Ͳ2.0 AnnualGrowthRateforRealGDP(average2005Ͳ2012) e.g. World Bank, 2012a) meant that external debt topped 60 percent of GDP by 2010. Source: WB staff calculations based on Dumitru (2012). Figure 5: Romania’s credit stock by currency, Figure 6: Gross external debt in Romania and 2005-12, in percent of GDP selected countries, 2008- 2012 60% 160 50% 140 120 40% 100 30% 80 20% 60 10% 40 0% 20 2005 2006 2007 2008 2009 2010 2011 2012 0 BGR HUN POL SVK ROM RON Euro UDS Other 2008 2009 2010 2011 2012 Source: National Bank of Romania, World Bank staff calculations. Country short-forms used in Figure 16 are: BGR=Bulgaria, HUN=Hungary, POL=Poland, SVK= Slovakia and ROM=Romania. 16. In addition to increased private sector debt, Romania pursued a pro-cyclical fiscal policy during the 2000s. Romania ran fiscal deficits throughout the economic boom (Table 1 and Figure 7). 8 For instance in 2004, when the economy was growing at the vigorous pace of 8.5 percent, the overall fiscal deficit was 3.4 percent of GDP. Large increases in public-sector employment and wages during the period were therefore debt-financed at a time when the private sector was growing fast and did not need a boost. The deficits stimulated already-high demand. Comparing the structural fiscal balance to the output gap reveals a strongly pro-cyclical fiscal policy during the height of the boom (Figure 8). At its peak in 2008, output was 8.2 percent above its potential level, but even with this degree of overheating, the government ran a structural fiscal deficit of around 8 percent of GDP. As a result, the government built an insufficient fiscal buffer to maintain spending during an economic downturn. When the crisis hit and output fell below its potential, the government was forced to reduce the deficit. Figure 7: Romanian trends in fiscal revenue and Figure 8: Romanian trends in the structural fiscal expenditure (% GDP), 2000-12 balance and output gap (% GDP), 2000-12 40 10 38 8 36 6 34 4 32 2 30 0 28 Ͳ2 Revenue 26 Ͳ4 Expenditure 24 Ͳ6 Structuraldeficit 22 Ͳ8 Outputgap 20 Ͳ10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Ministry of Public Finance and World Bank staff Source: World Bank (ECSPE) fiscal data base. calculations ii. Structural transformation Employment, productivity and wages 17. Total employment in Romania declined during the boom and jobs shifted toward the fast- growing non-tradable sectors. Employment declined by over 13 percent between 2000 and 2008, reflecting a population decline of similar magnitude. However, as with output, the structure of employment changed during the boom; it fell by 35 percent in the tradable sectors and increased by 25 percent in the non-tradable ones. The percentage of workers employed by the tradable sectors fell from 67 percent in 2000 to 52 percent in 2008. Agriculture, industry and manufacturing saw average annual declines in workers of 7 percent, 3 percent and 0.1 percent, respectively. Urbanization was partly responsible for this labor reallocation as workers moved en masse out of agriculture, whose employment share fell from 45 percent in 2000 to 30 percent in 2008. At the same time, employment in construction increased by an average of 8.3 percent per year, from 3.6 to 7.8 percent of total employment. The commerce sector increased employment by 2.4 percent per year. Construction and commerce require relatively unskilled workers and they were able to absorb migrants from rural areas, following a classic Harris-Todaro (1970) development model. Employment in the financial intermediation sector grew by 5.8 percent per year, though from a small base, and public sector employment grew by 0.4 percent per 9 year, absorbing 15.2 percent of total employment by 2008, up from 12.8 percent in 2000. Romania increased the number of public sector workers even as the population declined. Romania went from having an estimated 6.3 public servants per 100 people in 2000 to 7.1 in 2008. 18. Growing output combined with decreasing employment boosted labor productivity in most sectors during the boom. On average, productivity, measured by output per worker, increased by 6.9 percent per year between 2002 and 2008. Among the non-tradable sectors, the largest private-sector productivity growth was seen in construction (8.3 percent per year). Productivity growth in commerce was also high, at 5.4 percent. Both benefited strongly from credit-fueled demand. As a result, supply was unable to keep pace with demand in the construction sector, leading to a property price bubble and hence the appearance of fast productivity growth. In manufacturing, productivity increased by 6.6 percent per year on average. That increase was led by a rationalization of the workforce and by increases in efficiency. 19. Productivity growth during the boom came from two main sources: increases in output-per- worker within each sector and gains from workers moving between sectors (structural change). The large reallocation of labor from less to more productive sectors (e.g., agriculture to construction) boosted productivity growth during the boom. 20. Within-sector productivity growth was the key driver of growth during the boom. It accounted for an average of 4.8 percent of total productivity growth between 2002 and 2008 (Figure 9). Despite shrinking in size relative to the economy as a whole, the manufacturing sector boosted output per worker by shedding workers and focusing on higher-value-added production. This was reflected in the increasing sophistication of Romanian manufacturing exports as industries like car manufacturing started to grow (De Rosa et al., 2012). Between them, increased productivity in the non-traded sectors accounted for over 43 percent of increases in output per worker between 2002 and 2008. Figure 9: Contribution to labor productivity growth, 2002-10, % Structuralchange 8 Publicadmin/community 6 2.1 services;householdactivities 4 1.4 Financialintermediation;real 1.2 estate 2 0.7 2.2 Wholesale/retail;hotels/ 1.6 restaurants;transport 0.2 0.9 0.3 0 0.1 0.0 Construction Ͳ0.2 Ͳ1.8 Ͳ2 Manufacturing Ͳ2.1 Ͳ4 OtherIndustry Ͳ0.9 Ͳ1.0 Ͳ6 Agriculture;fishing Ͳ8 2002Ͳ08 2008Ͳ10 Averagegrowth Source: Eurostat, World Bank staff calculations 21. Structural changes like the reallocation of labor between sectors also boosted growth during the boom. This shift from low-productivity sectors, mainly agriculture, to higher-productivity ones like construction contributed over 2 percent annually to productivity growth between 2002 and 2008 (Figure 9). Even during the recession (2009-10), the downturn was cushioned by continued reallocation of workers from less- to more-productive sectors. Agricultural workers were only around a third as productive as the average Romanian worker during the boom while construction workers were around 40 percent more productive than the average. Reallocating labor from agriculture to construction helped 10 boost economic growth. In 2002, 35 percent of the labor force was employed in agriculture, but by 2010, the agriculture workforce was down to 26 percent of the total. At the same time, construction workers jumped from 4 percent of the workforce to 8 percent, while the share of wholesale/retail rose from 16 percent to 19 percent. 22. Workers in all sectors benefited from the economic growth through higher wages. Between 2000 and 2008, wages increased by over 250 percent (Figure 10). Although rural wages increased fourfold during the period (albeit from very low levels), the large wage differential with all other sectors encouraged the rural exodus seen during the 2000s. Workers in financial intermediation, other industry and the public sector were the best-paid throughout most of the period. Public service wages increased faster than those of other sectors to become, by 2009, the highest paid sector in the country per hour worked (Figure 11). Fast-rising public service salaries put pressure on other sectors to raise wages accordingly to compete for workers. Still, the government continued to raise wages despite warnings of the developing problem (IMF 2007:220; 2008:210). 23. Wages increased faster than productivity in most sectors. Between 2000 and 2008, wages per hour increased nearly 50 percent faster than output per hour, resulting in wages increasing from 44 percent of output in 2000 to 59 percent in 2008. This increase put pressure on tradable sectors, which had to compete with imported goods, and in exports to countries where wage growth was more limited to productivity increases. Trade 24. Although high wages improved the living standards of some, they also harmed the competitiveness of the tradable sector, resulting in anemic export growth during the boom. Between 2000 and 2007, 12 wages in the manufacturing and other industry sectors averaged 51 and 64 percent of output, higher than in any other private sector (Figure 11). Worse, during the period, wages increased from 47 to 61 percent of output in these sectors. At the same time, exports declined from 32 to 29 percent of GDP despite a depreciating currency (Figure 12) as many companies in the tradable sector struggled to compete. 25. Low-technology companies struggled to compete in international markets, but medium- and high-technology exports grew (Figure 13). Low-technology exports collapsed from around 45 percent of the total in 2000 (much of it in the textile sector) to 25 percent by 2008 largely because of high wage costs. At the same time, however, Romania appears to have moved up the value chain. Medium- technology exports increased from 20 percent of the total in 2000 to 38 percent by 2008. High- technology exports took off from 2007. Integration into the EU appears to have allowed Romania to move into higher-value added industries, following the Akamatsu flying geese model of 1962 (Voinea 2011). 12 2008 excluded as output collapsed resulting in unusually high wage costs as a percentage of output. 11 Figure 10: Index of real compensation per hour Figure 11: Real compensation per hour as % versus output per hour output per hour 300 80 Total 250 70 60 Agriculture;fishing 200 50 OtherIndustry 150 40 Manufacturing 100 30 Construction 50 20 Compensationperhour Outputperhour 10 Commerce 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Eurostat, World Bank staff calculations Source: Eurostat, World Bank staff calculations Figure 12: Exports (% GDP) and wage bill (% Figure 13: Share of high, medium and low output), 2000-2011 tech exports (%), 2000-2010 80 Exports(%GDP,lhs) 70 Wages/Output(%,lhs) 60 50 40 30 20 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: National Bank of Romania; Eurostat; World Bank Source: De Rosa et al. 2012. staff calculations. Figure 14: Romania’s external accounts (in bill. EUR), 2000-12 50 16 14 40 12 30 10 8 20 6 4 10 2 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Current account deficit (RHS) Exports Imports Source: National Bank of Romania and World Bank staff calculations 12 26. While Romanian companies struggled to compete abroad, economic growth helped feed demand for imports, resulting in a widening current account deficit. While exports declined as a percent of GDP, imports picked up from 37 percent in 2000 to stabilize around 43 percent of GDP from 2005 to 2008 (Figure 14). As a result, the current account deficit increased steadily during the boom, from 5 percent of GDP in 2000 to a high of 14 percent in 2008. Poor export performance meant that imports had to be financed with external credit. 27. Despite the convergence toward EU income levels between 2000 and 2008, the roots of Romania’s current economic crisis lie in the growth pattern of that period. The boom was driven by rapid growth in domestic demand fuelled by short-term capital inflows. As a result, consumers were highly indebted by the time the crisis hit. Much of the credit growth was in Euro, making Romanians vulnerable to exchange rate depreciation. At the same time, rather than counterbalance high private sector demand, a pro-cyclical fiscal policy added to it, increasing public sector debt and reducing fiscal room for maneuver during the crisis. On the supply side of the economy, rising wages made it difficult for the tradable sectors to compete with imports. Low-technology manufacturing was hit hard. In addition, the private sector had to compete for high-caliber employees in the face of high public sector wages and a large public service (see chapter 6). Although the crisis was external in nature, Romania’s boom-period policies exacerbated its impact and reduced its ability to implement mitigating policies. b. Crisis and response 28. The global financial crisis in 2008 interrupted the inflow of external capital, precipitating Romania’s economic crisis. In two years, net capital flows reversed by 20 percent of GDP, from a surplus of 17.6 percent in 2007 to a deficit of 2.5 percent in 2009. 29. The short-term capital that had flowed into Romania during the boom years flowed back out because of the credit crunch in advanced economies and a sudden aversion to risk among banks and institutional investors. Domestic demand, which during the boom had been buoyed by ready access to credit, collapsed by 12 percent in real terms in 2009. The largest percentage drops in the components of demand were in private and public investment, which each fell by about 25 percent in real terms, but private consumption spending was also cut by 10 percent. Exports too fell in 2009, by about 5 percent in real terms, because of the recession in major markets in Europe. 30. The collapse in aggregate demand triggered a severe recession in the Romanian economy, especially in non-tradable goods. The economy contracted in real terms by 6.6 percent in 2009 and another 1.2 percent in 2010. By then, aggregate demand had plunged so far that the economy was operating with a negative output gap of 1.8 percent of GDP. Somewhat surprisingly, however, the rise in unemployment was relatively modest, from a low of 4.4 percent in 2008 to just 7.0 percent in 2010. 31. The recession had severe consequences for public finances. As the tax base shrank, the non- cyclically-adjusted fiscal deficit widened, from 3 percent of GDP in 2007 to 7 percent in 2009—far above the 3 percent ceiling stipulated in the EU’s Stability and Growth Pact. The fact that the rise in the structural balance between 2007 and 2009 was 4.7 percent, from 4.2 to 8.9 percent of GDP indicates that the main reason public finances deteriorated was the discretionary fiscal policy. The widening fiscal deficit, and hence the larger government borrowing requirement, together with the contraction of real GDP and real exchange rate depreciation, increased the public debt. In 2007, before the crisis, it was just 13 percent of GDP, but by 2010 it had risen to 31 percent. 32. Deteriorating public finances prompted the government to embark on a major retrenchment, cutting public payrolls, public sector wages and public investment and raising VAT rates by 4 percent. Those efforts reduced the structural fiscal balance by almost 6 percent of GDP 13 between 2008 and 2011, one of the largest fiscal consolidations in the EU (Figure 15). Between 2008 and 2011, only Greece and Ireland implemented larger decreases than Romania in the cyclically adjusted fiscal balance; the average change in that balance across the EU was virtually zero. However, the retrenchment meant that fiscal policy, which had been pro-cyclical during the boom, continued to be pro- cyclical in the recession. Figure 15: Changes in the cyclically adjusted fiscal balance, EU Countries Average of 2007 to 2011 (Percent of GDP) 8 Greece,6.8 Ireland,6.5 6 Romania,5.7 4 Lithuania,2.3 2 Bulgaria,0.7 Spain,0.7 CzechRepublic,0.2 Slovenia,0.3Sweden, 0.3 0 Italy,Ͳ0.1 Germany,Ͳ0.4 United Kingdom,Ͳ0.4 Austria,Ͳ0.6 Portugal,Ͳ0.7 Belgium,Ͳ0.8 Poland,Ͳ1.1 France,Ͳ1.4 Ͳ2 SlovakRepublic,Ͳ1.6 Finland,Ͳ1.9 Hungary,Ͳ2.0 Netherlands,Ͳ2.2 Ͳ4 Denmark,Ͳ5.1 Ͳ6 Source: IMF, 2011, Statistical Table 3, except for Romania. 33. A nominal depreciation of the exchange rate against the Euro in 2008 and 2009 enabled the leu to depreciate in real terms, which helped exports. These grew by 14 percent in real terms in 2010 and 9.9 percent in 2011. The recovery in exports, together with the recession-induced collapse in imports, shrank the trade deficit by more than 8 percent of GDP between 2007 and 2010—an unavoidable correction given the large reversal of net capital flows. Spurred by export growth, a recovery in investment spending and a bumper harvest, the GDP grew in 2011 for the first time since 2008—but only at 2.2 percent. It was not enough to overcome the economy’s negative output gap, which remained at 1.1 percent of GDP. 34. To summarize, the economic crisis, which hit Romania in 2008 and continues, has made necessary a very large adjustment to unsustainable external imbalances and hence adjustments to patterns of both spending and production. External imbalances have been reduced substantially, mainly by cutting spending, but at the cost of economic recession and a weakening of public finances. Despite fiscal retrenchment public debt has soared. 14 Box 1: Romania - Public spending during the pre-crisis and crisis period During the peak boom years, public spending rose sharply but not uniformly. Between 2005 and 2008, it increased from 33.5 to 39.3 percent of GDP. Revenues grew by just 1.2 percent of GDP, financed mostly by public sector borrowing. A large part of the increase went to consumption. For example, compensation of public employees rose from 8.7 to 10 percent of GDP during the period. Spending on social benefits increased from 10.3 to 11.6 percent of GDP. However, the government also boosted growth-enhancing capital spending; net acquisition of non- financial assets rose from 3.9 to 6.6 percent of GDP. Spending increased in all functional classifications during the peak of the boom except defense, where it dropped. Between 2005 and 2008, spending as a share of GDP increased in health, education, social protection and economic affairs. In real terms, spending on education almost doubled, while it rose by around 70 percent on health and 80 percent on social protection. These increases were funded by higher revenues, which were boosted by the fast economic growth, public borrowing and a 20 percent cut in real defense spending. Some of the spending increases during the boom proved to be unsustainable and were reversed when the recession hit in 2009. Between 2008 and 2011, compensation of employees and spending on goods and services both fell (from 10 to 7.5 percent of GDP and from 7.2 to 6 percent of GDP, respectively). Capital spending was also cut from 6.6 to 5.2 percent of GDP, a fall that could be used to prioritize funds towards those with highest return and weed out white elephant projects. On a functional basis during the crisis, the government chose to cut back on health and education but boosted spending on social protection. It also maintained spending on economic affairs, which includes fuel, energy, transport and communications. Some of the recent changes in spending composition are wise, but there is room for further improvements. The decrease in the public sector wage bill will help to ensure a more cost-effective and sustainable sector, but this will need to be followed up with changes in the level and composition of public employment, which needs time. Although it was important to protect the vulnerable from the effects of the crisis, the sharp increase in social security spending needs to be judged against the efficiency of the social protection system. As the economy recovers, a review of the system may identify ways of reducing cost while more effectively protecting the vulnerable. Similarly, spending on economic affairs increased, but its impact on the quality of infrastructure needs to be assessed. At the same time education spending fell, although this might prove unsustainable given the needs of the economy to educate young people and train adults to ensure long-term sustainable growth. So maintaining access to quality education should be a priority. Figure 16: Evolution of public expenditure in Romania, % GDP Economic classification Functional classification 45 45 40 40 6.6 5.2 35 35 10.7 3.9 9.4 3.0 5.5 30 1.6 30 8.3 25 11.6 25 10.3 11.9 12.6 13.5 20 20 9.8 0.8 1.5 0.7 15 1.1 0.4 15 7.2 1.6 3.6 4.8 3.1 7.0 10 6.0 10 3.7 4.2 3.9 2.1 2.3 1.7 5 5.3 5 6.2 6.4 6.7 7.7 5.8 0 2.9 1.5 1.4 0 2005 2008 2011 2005 2008 2011 W&S Soc.Cont. G&S Interest Defense Economicaffairs Health Subsidies Soc.Ben. Other NANFA Education Socialprotection Other Source: Ministry of Public Finance and staff calculations. W&S=Wages and Salaries; Soc Cont.=Social Contributions; G&S=Goods and Services; Soc. Ben.=Social Benefits; NANFA=Net Acquisition of Non-Financial Assets. 15 C. SAFEGUARDING MACROECONOMIC STABILITY 35. As it emerges from the crisis, Romania Figure 17: Convergence scenarios for Romania’s finds itself at a crossroads: it can implement GDP per capita (in US$), 1990-2030 new policies that can put it back on a path to relatively rapid growth and narrow the gap with the EU average, or by settling into complacency it can watch other middle- income countries overtake it (Figure 17). To reach EU average income levels, Romania will need to replicate the 6.2 percent growth it averaged between 2001 and 2008 for about fifteen to twenty years more. This means it would have to double real GDP every twelve years. A review of growth episodes around the world found 80 instances of rapid acceleration in economic growth for at least eight years, but only 13 countries in the world have been able to sustain average rates of growth of 7 percent or more for at least 25 years.13 Replicating the experience of these 13 countries will be challenging. Source: World Bank staff estimates based on data from the World Bank’s World Development Indicators. Note 1: EU Growth in 2012 and 2013 is assumed at -0.3 and 0.5 36. Getting back on the path of growth percent, respectively. Romanian long-term growth after 2012 is necessary to catch up with the EU will assumed at either 2 or 6 percent as indicated in Figure 17 require that structural reforms be Note 2: Calculations use GDP per capita, PPP (current implemented under a stable and sustainable international US$). fiscal and macroeconomic framework. In the medium term, structural reforms to improve the business climate, the labor market, worker skills and infrastructure are critical for growth. Beginning now to invest in these areas can also reap shorter-term growth benefits. Fiscal policy has an important role to play in investing in growth-enhancing physical and human capital. It can also encourage private investment through tax or other policies that influence incentives. Other macroeconomic policy tools, including monetary ones, can also help boost growth and maintain stability. Their use can also help reduce the output gap that exists in the short term. a. Fiscal policy 37. The government was not in a position to respond to the crisis with fiscal stimulus. Previous profligate spending and the risk of a worsening external environment leave little room for maneuver. The result is that despite the slow growth, there will be a fiscal contraction over the short term, with the structural fiscal balance forecast to improve from negative 3 percent of GDP in 2011 to negative 0.6 percent by 2013. This fiscal prudence, though necessary, will moderate the recovery of aggregate demand. There has been much debate globally in recent years about the macroeconomic impact of fiscal consolidation, and in particular whether it might have expansionary effects (see, Alesina and Perotti 1997) or the standard Keynesian effects. Recent IMF research found no evidence for the phenomenon of “expansionary fiscal contraction,� but found rather that fiscal consolidations have the standard Keynesian effect of reducing output and depressing the economy; their results are robust to a variety of circumstances (Guajardo, Leigh, and Pescatori 2011). Research by Carmignani (2008) on transition 13 See: Commission on Growth and Development (2008), The Growth Report Strategies for Sustained Growth and Inclusive Development. 16 economies also reached the conclusion that fiscal consolidations have contributed to reduced demand. However, in the current economic climate, borrowing to fund larger-than-programmed deficits will put public debt sustainability at risk and increase borrowing costs for the public and the private sector alike. 38. Although public debt is not high, gross financing needs are significantly higher than the emerging-market average. Gross public debt was 37.8 percent of GDP in 2012 according to Maastricht criteria, which is considered sustainable. However, the government’s gross financing needs (maturing public debt plus the fiscal deficit) are quite high, about 11 percent of GDP for 2013. This compares with 6.7 percent for emerging markets on average and is slightly higher than the Eastern European average of 10.4 percent. External debt represents around 45 percent of the total debt and, thanks to the fact that about two-thirds of it is due to multilaterals, attracts a low average interest of 2.3 percent. However, Romania remains vulnerable to exchange rate fluctuations. Domestic debt interest averages 4.5 percent. Around 20 percent of total public debt falls due in 2013, of which 85 percent is domestic. A new medium-term debt management strategy 14aims to tilt borrowing away from the short-term, which creates the high short-term financing needs, and toward debt with longer maturities. 38. Romania still cannot afford a large fiscal stimulus to boost growth; it will need to improve the tax and spending regimes to achieve the same result. A more expansionary stance over the medium term would also jeopardize Romania’s ability to comply with the structural deficit ceiling in the EU Fiscal Compact. Therefore, Romania should reduce its fiscal deficit in stages in line with the Fiscal Compact and while ensuring access to financial markets. The eventual debt ceiling is 0.5 percent of GDP. With fiscal policies as planned, the structural fiscal deficit would be just below the ceiling in 2013- 15 and slightly above it in 2016-2017. In addition, further turbulence in European financial markets might jeopardize the government’s ability to access what it needs to finance its budget. i. Taxation 39. While measures need to be taken to bring the fiscal deficit under control, steps can be taken to mitigate their contractionary impact. Reducing taxes, such as the high social security contributions, can lower the cost of employing some workers and stimulate employment. The shortfall in tax revenue can be compensated by broadening the tax base by reducing exemptions, which would also simplify tax administration for employers. 40. Although Romania levies a low 16 percent tax rate on labor income, social security contributions, though similar to those in other new EU member states, are very high (Table 2). Total contributions as a percent of wages amount to 44 percent in Romania, of which the employee contributes almost 28 percent. Consequently, out of the total labor cost born by an enterprise, only about half is paid directly to workers. This drives a wedge between the marginal product of labor and the payment the worker receives, which reduces incentives to work in the formal economy.15 Instead, workers are tempted to enter the informal sector, where income taxes and social security contributions can be evaded, or to emigrate. The long-term supply of labor, which is crucial for long-term growth of the economy, could therefore benefit from lower labor taxation. If accompanied with a strong program to modernize the collection of payroll taxes, a reduction in the rate might well benefit from a Laffer curve effect, in that it might actually increase collections. Today, barely one-third of those employed formally contributed to payroll taxes. 14 See http://discutii.mfinante.ro/static/10/Mfp/buletin/executii/Gov_publicdebtmanag_strategy2013_2015.pdf  15 How large this wedge is depends on the extent to which workers expect to benefit directly from their social security contributions. The more these are perceived as general taxation, with no direct bearing on future benefits to the worker, the more likely it is that high contribution rates will discourage labor supply. 17 Table 2: Social security contributions, EU 10, 2010 (percent) Social Contributions SK HU CZ RO PL LT SI LV EE BG Old-age pension Employer 14.0 24.0 21.5 20.8 9.8 23.3 8.9 - - 8.9 Employee 4.0 9.5 6.5 10.5 9.8 3.0 15.5 - - 7.1 Total 18.0 33.5 28.0 31.3 19.5 26.3 24.4 - - 16.0 Unemployment Employer 1.0 - 1.2 0.5 - 1.1 0.1 - - 0.4 insurance Employee 1.0 - 0.0 0.5 - - 0.1 - - 0.6 Total 2.0 - 1.2 1.0 - 1.1 0.2 - - 1.0 Health Employer 10.0 2.0 9.0 5.2 0.0 3.0 7.1 - - 0.0 insurance Employee 4.0 6.0 4.5 5.5 9.0 6.0 6.4 - - 8.0 Total 14.0 8.0 13.5 10.7 9.0 9.0 13.5 - - 8.0 Other Employer 10.2 4.0 2.6 1.4 4.9 3.7 0.1 - - 1.8 Employee 4.4 3.0 0.0 - 4.0 - 0.1 - - 2.1 Total 14.6 7.0 2.6 - 8.9 3.7 0.2 - - 3.9 Total Employer 35.2 30.0 34.3 27.9 14.7 31.1 16.1 24.1 33.0 11.1 Employee 13.4 18.5 11.0 16.5 22.7 9.0 22.1 9.0 0.0 17.8 Total 48.6 48.5 45.3 44.4 41.2 40.1 38.2 33.1 33.0 30.5 Source: Ministries of Finance, 2012. Country short-forms used are: SK= Slovakia; HU= Hungary; CZ=Czech Republic; RO=Romania; PL=Poland; LT=Lithuania; SL=Slovenia; LV; Latvia; EE=average for Eastern European countries; BG=Bulgaria. 41. Unfortunately, the government’s pallid tax effort has narrowed the scope for Romania to reduce labor income taxes or social security contributions. Tax revenues amount to only 27 percent of GDP, the lowest in the EU and less than three-quarters of the EU average of 40 percent (Romania Fiscal Council 2012). If labor taxation is to be cut, compensatory revenue will have to be realized elsewhere. A growth-enhancing tax reform would shift taxation from labor income to consumption, so that personal income tax, social security contributions, or both would be cut; and VAT, excises and property tax would increase so as to produce a revenue-neutral result. However, because in 2010 Romania raised its VAT rate to 24 percent, which is well above the EU average, there is little scope to increase it farther. Imposing higher VAT rates might also be counterproductive because they would reinforce incentives for VAT fraud. Hence, a careful analysis of VAT loopholes might be necessary to find a way forward on this question (see below). 42. Instead of raising VAT rates, it would be preferable to work to improve tax compliance across the entire range of taxes, since overall compliance is very poor. For example, the implicit rate of VAT was only 13.1 percent in 2011, which suggests that almost half of VAT liabilities were evaded (Table 3). Compliance with corporate income tax is even worse: the implicit rate was only 3.6 percent in 2011 when the legal rate was 16 percent, bringing the efficiency rate for corporate income tax down to 22 percent. This means that given the size of the tax base, only 22 percent of the theoretical maximum was paid (Romania Fiscal Council 2012). A plethora of exemptions make corporate income tax inefficient. Total losses from tax evasion, such as VAT fraud, are estimated at about 10 percent of GDP (Romania Fiscal Council 2011). If tax evasion could be curbed through more effective tax administration, it would be possible to reduce tax rates on labor incomes and reinforce incentives for workers to join, or remain in, the formal labor force. This would in turn benefit the supply side of the economy. 43. The compliance burden on taxpayers and contributors is extraordinarily high: the World Bank/PWC Paying Taxes 2012 report ranks Romania only 154th out of 183 countries on ease of paying taxes, mainly because the number of tax payments 9 totals 113. This number exceeds by four times the number of payments in the second highest EU-1016 country, Slovakia. Filing compliance modestly 16 The 10 newest EU Member States: Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic and Slovenia 18 increased to 86.5 percent in the first half of 2011, from 84.6 percent in 2010 and 77.4 percent in 2009; payment compliance rose from 72.8 percent in 2006 to 83.9 percent in 2010. Table 3: Legal and implicit tax rates for VAT and social contributions, 2012 Country VAT Social Contribution (SC) Standard Implicit tax rate*) Taxation Legal rate for Implicit tax Taxation VAT rate (%) efficiency index SC (%) rate*) efficiency index Bulgaria 20.0 14.2 0.71 30.2 23.2 0.77 Czech 20.0 13.7 0.69 45.3 49.0 1.08 Republic Estonia 20.0 16.5 0.82 37.2 34.9 0.94 Latvia 22.0 10.9 0.49 35.1 24.7 0.70 Lithuania 21.0 12.3 0.59 39.8 31.8 0.80 Hungary 25.0 16.0 0.64 44.5 36.7 0.82 Poland 23.0 12.7 0.55 37.6 NA NA Romania 24.0 13.1 0.54 44.4 27.3 0.61 Slovenia 20.0 14.4 0.72 38.2 33.4 0.87 Slovakia 20.0 11.6 0.58 48.6 42.0 0.86 Source: Romanian Fiscal Council, European Commission, Eurostat. Note: For SCs, employer plus employee contributions. Where standard rates have been modified during the year, a weighted average of the standard rates was reported. * For VAT, calculated as a ratio between "VAT revenues" (ESA code D211R) and "Households and NPISH Final Consumption Expenditure" (ESA code P31_S14_S15 ESA). For SCs, computed as the ratio between "actual social contributions" (code ESA D.611) and “gross wages and salaries" (code ESA D11). Tax efficiency was computed as a ratio between the implicit and legal tax rate. 44. The government has made it a priority to reform tax administration. The plans and challenges to modernize revenue administration are discussed in the next Chapter, including the plans to address tax evasion and to build up its risk-assessment capabilities. ii. Expenditures 45. In addition to improving revenue performance and simplifying taxes, there is ample room for improvements in the efficiency of public spending, even in the short term. Improvements in the budget planning process are crucial to increase the economic returns to public investment. Better monitoring of outcomes would help target current spending more effectively. 46. Economic growth can be enhanced by shifting the composition of public expenditures toward those that that complement or enhance labor and capital in the economy. However, a simple reallocation of resources from public consumption to public investment is not needed because a substantial share of the budget already goes to capital investment. The key is to enhance the efficiency of those capital expenditures. For the period 2001-11, public investment commanded an average of 14 percent of revenues, or 4.7 percent of GDP, the highest proportion in the EU (Figure 18). Unfortunately, much of it was invested inefficiently because of its fragmentation into a large number of small projects and the length that it takes to complete a project (on average more than 5 years). Despite the magnitude of its investment, Romania still has the worst public infrastructure in the EU (Fiscal Council 2012: 33– 34). Investment expenditures carried out by SOEs might be also inefficient, as will be discussed in chapter 2 below.  19 Figure 18: Capital spending, public sector (% GDP), 2010 and 2012 Selected EU countries 7.0% 2012 6.0% 2010 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% UK CzechRep. Greece France Belgium Germany Poland Netherlands Ireland Denmark Portugal Italy Slovenia Cyprus Romania Luxembourg Sweden Malta Latvia Hungary Bulgaria Austria Slovakia Estonia Lithuania Spain Finland Source: OECD 47. Accelerated disbursement of EU structural fund grants would allow the government to focus on the biggest infrastructure bottlenecks. Romanian capital spending has had a broad reach. At the same time there remain many important infrastructure bottlenecks, especially in transport, that could have been addressed using EU rather than national resources. Romania has the second-lowest disbursement of EU structural grants among EU-10 countries.17 Greater use of EU funds (Figure 19) would both reduce the negative fiscal stimulus without increasing the public borrowing requirement or the structural fiscal deficit and remove barriers to future growth. Figure 19: EU-10 Absorption of EU funds (all types), as of March 2013 70 61.3 62.9 60 53.5 52.5 50.3 50 45.4 43.1 39.3 40 36.2 30 23.2 20 10 0 Romania Bulgaria Czech Slovakia Hungary Slovenia Latvia Poland Estonia Lithuania Republic Source: WB staff calculations based on DG REGIO data Note: figures include pre-financing 17 Despite vigorous government efforts to increase absorption of EU funds cumulatively 20 percent in 2012, the rate as of March 1, 2013 was only 12.2 percent (23.2 percent if pre-financing is included). The recent EU audit also found some governance issues in projects submitted which led to funds suspension and cancelation. 20 The effectiveness of current spending is also a concern, given the limited impact of recent rapid increases in resources spent. The surge in public spending from about €23 billion in 2004 to €46 billion in 2011 seems to have had limited impact. For instance, between 1999 and 2008, spending on education increased by 150 percent in real terms while Romania’s scores on international tests, such as PISA18 and TIMSS, dropped and are still the lowest in the EU. Similarly, although the country’s unit costs for road-building and maintenance are higher than in many other EU countries, infrastructure is still below par. Romania also remains behind its Central European peers in such human development indicators as child mortality and literacy (Table 4). Thus, although Romania has made significant progress over the last 20 years in transforming its public sector, fundamental changes in its structure and management are needed if the country is to achieve sustainable income convergence with the rest of the EU. Table 4: Selected social indicators for Central and Eastern European countries GDP per Infant Capita, Enrollment in Mortality Under-5 PPP Adult Illiteracy Secondary School Rate (per Mortality Rate, Life Expectancy at (2005 US$) (%) (% net) 1,000) (per 1,000) Birth (Years) 2010 1990 2009 1999 2009 1990 2010 1990 2010 1990 2010 Bulgaria 11,490 1.8 /c 1.7 85.8 82.8 17.7 10.7 22.2 12.7 71.6 73.5 Croatia 16,128 1.9 /c 1.2 80.3 92.1 11.1 4.7 12.9 5.5 72.2 76.5 Czech Republic 22,575 .. .. 79.4 /a 83.6 12.2 3.1 14.3 4 71.4 77.4 Estonia 16,561 0.2 /b 0.2 82.3 92.0 16.5 4.3 21.1 5.4 69.5 75.4 Hungary 16,958 1.0 /e 0.6 82.4 91.1 16.5 5.4 18.7 6.4 69.3 74.2 Latvia 12,948 0.3 /b 0.2 .. 84.8 15.9 8.1 20.6 9.6 69.3 73.5 Lithuania 15,534 0.4 /c 0.3 90.1 91.0 13.7 5.4 17.4 6.5 71.2 73.3 Poland 17,352 0.6 /e 0.5 89.1 /b 91.0 15.1 5.2 17.3 6 70.9 76.2 Romania 10,921 2.7 /d 2.3 75.8 82.3 29.1 11.3 37.4 13.6 69.7 73.5 Slovak Republic 20,164 .. .. .. .. 15.1 6.7 17.6 8.2 70.9 75.1 Slovenia 25,048 0.3 /e 0.3 88.7 91.9 8.7 2.3 10.4 2.9 73.2 79.4 Source: World Development Indicators. 48. Progress and challenges in improving Romania’s budgeting processes are discussed in Chapter 2. The systems used to prioritize and implement public spending should also be an essential component of any agenda to raise efficiency and effectiveness in the use of public funds. On this, progress notwithstanding, the various initiatives need attention and support to ensure that they strengthen over time. iii. Long-term fiscal sustainability 49. Over the long term, Romania’s biggest fiscal sustainability problems stem from adverse demographic trends: an aging population and a shrinking labor force (Canagarajah et al., 2012). These trends are likely to reduce the economy’s rate of sustainable growth, which in turn will worsen fiscal vulnerabilities because of the negative impact on revenue mobilization and on the denominator of the public debt/GDP ratio, an important measure of debt sustainability. To the extent that rising dependency ratios suppress savings, public borrowing costs might be pushed up. Modeling possible dynamics would however require a separate assessment 18 PISA (the Program for International Student Assessment) is an OECD-led international study evaluating education systems worldwide by testing the skills and knowledge of 15-year-old students in participating countries. The Trends in International Mathematics and Science Study (TIMSS) evaluates the achievements in mathematics and science of 4th- and 8th-grade students. 21 50. More critical even than its consequences for fiscal sustainability is the impact an aging population will have on demand for public services. Both health care and pension costs are bound to rise over the long term (Table 5). Between 2010 and 2030, the costs to Romania of providing public pensions are forecast to rise by 2 percent of GDP, double the average rise in Eastern Europe. The cost of providing health care will go up by 1.3 percent, about the same as Eastern Europe. By 2060, the EU projects that Romania’s public pension costs will rise by 3.7 percent of GDP, reaching 13.5 percent of GDP (EU 2012). Table 5: Projected long-term pension and health care costs, % of GDP Romania and Eastern Europe Pension spending NPV pension spending Health care NPV health care change 2010-30 change 2010-50 spending change spending change 2010-30 2010-50 Bulgaria -0.5 -2.5 1.3 44.6 Czech Republic 0.0 18.9 0.6 17.5 Estonia -0.8 -22.8 1.1 37.3 Hungary -0.3 6.3 1.6 51.9 Latvia 0.8 16.3 1.0 34.7 Lithuania 1.7 50.7 1.5 49.4 Poland -1.4 -42.4 1.8 58.7 Romania 2.0 74.2 1.3 43.0 Slovak Republic 0.7 25.8 1.2 37.1 Slovenia 3.2 110.4 0.7 22.2 Ukraine 6.0 172.6 1.2 38.8 average Eastern Europe 1.0 37.0 1.2 39.6 average emerging markets 1.1 37.2 1.0 33.2 Source: IMF, Statistical Tables 3, 7, and 9. 51. These budgetary pressures underscore the importance improving tax compliance, cutting inefficient spending and ensuring the sustainability of the social benefit system: x If the government curbed pension entitlements and generated higher contributions from workers, claims on general budget resources could be reduced. The pension law enacted in December 2010 is projected to reduce pension spending by about 3.5 percent of GDP by 2025 relative to what would have happened without the law. It is also expected to cut the pension deficit, which is funded from general budget resources, from 4.5 percent of GDP to 1 percent. x Tax reforms could broaden the tax base and improve compliance. It is estimated that a significant share are lost to the budget each year through evasion of taxes, both direct and indirect (see Section 2.6). Closing tax loopholes and reinforcing tax compliance would thus boost revenue. x The government could slash spending on areas that make no contribution to public welfare. One is SOE subsidies, both as direct budget subsidies and as forbearance of taxes. Worldwide experience, including in transition economies, show that hard budget discipline for state-owned enterprises can contribute to their strengthening and weed out those that are not viable. Such discipline has the added benefit of reducing arrears on tax liabilities, social security contributions and payments to suppliers. b. Monetary and financial stability 52. Monetary and financial stability play a crucial role in ensuring the stable and predictable macroeconomic environment that is the necessary backdrop to sustainable economic growth. The economic literature suggest that a monetary policy that targets price stability, minimizes short-term exchange rate fluctuations and is consistent with fiscal policy will create more certainty for companies, especially importers and exporters but also financial and institutional investors in the country. It is also well known in the economic literature that “leaning against the wind� could prejudice macroeconomic 22 stability by using up foreign reserves and reducing confidence in the ability of the authorities to manage monetary and exchange rate policy. Monetary policy during the post crisis in Romania has been consistent with best practice and the Central Bank’s mandate to ensure price stability. Looking forward, lower productivity in Romania relative to its main trading partners (the EU) would suggest that some real exchange rate depreciation may still take place over the medium-term, particularly if the productivity differential is likely to remain for some time. However, other factors will also affect the path of the exchange rate, including investor’s confidence in the country, external shocks, etc. 53. The main risk from any future nominal exchange rate depreciation lies in how it might affect the capacity of domestic borrowers to service foreign currency-denominated loans and their capacity to access future loans. Foreign currency lending comprises about 62 percent of total lending to the Romanian private sector. It has been on a descending path largely on account of the National Bank of Romania’s efforts to discourage lending in foreign currency to un-hedged borrowers. If exchange rate depreciation has a heavy impact on domestic borrowers, it might constrain private borrowing and spending and outweigh any positive impact on net exports. This squarely underscores the importance of a prudent regulation agenda, one that helps the banking sector become stronger and more resilient than it is now by addressing such issues as high levels of non-performing assets. 54. The fragility of the Euro area financial system may threaten Romania’s recovery, especially if it provokes further large-scale deleveraging by Euro-area banks. There are pressures on Euro- area banks to reduce their lending. Market funding for banks has become both more difficult to find and more costly, some banks are undercapitalized and EU regulators have asked banks to raise their tier 1 capital and accumulate capital buffers against sovereign debt exposure (IMF 2012a). To reduce assets, international banks are likely to prioritize lending at home over cross-border lending. Cross-border financing of subsidiaries in emerging Europe has been declining since the second half of 2011. Still, the extent to which commercial bank lending can recover depends as much on a reactivation of demand for credit as on the ability and willingness of banks to supply funds. 55. The Romanian economy is exposed to deleveraging by Euro area banks for three reasons. First, the largest banks in Romania are all subsidiaries of Euro area banks, mainly Austrian, Greek and French. Second, to mobilize funds, the Romanian banking system has been relying heavily on borrowing from banks outside Romania. Cross-border liabilities of Romanian banks to banks that report to the Bank for Inter-national Settlements currently constitute 61 percent of total credit (IMF 2012b). Thirdly, because the Romanian financial system is dominated by banks, the private sector has few alternative sources of financing. 56. The Romanian banking system is itself fragile in some areas, which suggests that banks might not want to lend even if their access to funding from foreign banks were not drying up. Although the banking system is well-capitalized—capital ratios average nearly 15 percent of risk- weighted assets, and the statutory minimum is only 8 percent—banks have made no profit for the last two years and their loan portfolios are seriously impaired. Nonperforming loans have surged since 2008 and inching upwards to around 18 percent by 2012. 57. The Romanian banking sector is largely owned by euro-area banks and remains vulnerable to spillovers from the euro area and domestic developments, and deleveraging remains a risk. The April 2012 Financial Stability Report estimates that without significant policy changes, deleveraging by EU banks would reduce the supply of credit in Romania in 2012–13 by about 4 percent of total private credit and by about 6 percent if strains in the Euro area intensify (IMF 2012b:45). Austrian banks dominate the market with a 38 percent market share, while subsidiaries of Greek banks held about 12.1 percent of system assets and 9.6 percent of deposits at the end of June 2012. The effect on economic growth from deleveraging in emerging Europe is estimated at about 0.7 percent, although it is likely to 23 vary by country depending on credit demand and the availability of alternative financing. The capital adequacy ratio has been relatively strong at 14.9 percent as of December 2012. Credit growth slowed and NPLs rose steadily during and since the crisis to reach around 18 percent in December 2012 (up from around 14 percent a year previously), mainly due to the weak economic activity and the vulnerability of foreign-currency loans to unhedged borrowers (see Table 6). Bank profitability is poor, mainly because of the need for higher provisioning, low interest-rate margins, high overhead costs, and low to negative growth projections in the near term. To mitigate the risk of NPLs affecting overall stability, the authorities announced amendments to the fiscal code that ensures a neutral tax treatment of bank receivables sold to Romanian asset-recovery firms, in order to enable banks to improve their balance sheet management. In the none-banking sector, they have proposed institutional regulatory reforms toward a single regulatory model. 58. The policy priorities for Romania going forward are: (1) maintaining financial sector stability; (2) restoring access to credit; (3) enhancing access to long-term finance. These three objectives have been selected on the premise that financial sector development is central to the resumption of sustainable economic growth in the country. There is well-established appreciation for the financial sector’s potential in accelerating economic growth. By allocating capital to its most productive use, shifting risks to those who can best bear them, enforcing corporate governance and easing exchange, financial systems can support real economic activity. In practical terms, a well-functioning financial system provides reliable and inexpensive payments services, makes available remunerative and safe deposit facilities and offers entrepreneurs access to a suitable range of sources for short- and long-term funds. Table 6: Major Financial Sector Indicators (%) 2008 2009 2010 2011 2012 GDP Growth (YoY)* 7.3 -6.6 -1.6 2.5 0.7 Assets Growth (YoY) 30.6 7.8 6 2.1 2,1 Deposits Growth (YoY) 17,3 10,8 5,8 5,6 5.3 Loans Growth (YoY) 33.7 0.9 4.7 6,6 1,3 Loans/Deposits 130,8 119,2 118,0 119,1 114,5 Foreign Liabilities/Total Liab. 30.6 26.2 26.6 26.3 23.2 FX Loans/Loans 57.8 60.1 63.0 63.4 62.5 NPLs/Gross Loans 2.8 7.9 11.9 14.3 18.2 CAR 13.8 14.7 15 14.9 14.9 ROA 1.6 0.3 -0.2 -0.2 0,6 ROE 17 2.9 -1.7 -2.6 -5,9 Source: WEO, National Bank of Romania, World Bank Staff calculations. *Latest figure is IMF’s estimate for the year 2012 59. The banking sector agenda would also need to look at medium-term issues of financial deepening. While vulnerability is an important focus on the short-term, there are many development issues of the banking sector that would need to be looked up more consistently for growth to take place. One such is to avoid a credit-less recovery over the next 18-24 months. While a recovery without private sector credit is possible, the empirical evidence suggest that such recoveries occur at a much slower pace (Calvo et al., 2006). 24 Table 7: Financial soundness indicators for the banking sector, 2011 and 2012 Dec 2011 Dec 2012 Tier 1 capital to risk-weighted assets 13.9 13.8 Total capital to risk-weighted assets 14.9 14.9 Return on assets -0.2 -0.6 Nonperforming loans to total gross loans 14.3 18.2 Liquid assets to short-term liabilities 138.8 141.2 Net open position in foreign exchange, in percent of capital -4.8 N.A. Lending in foreign exchange, in percent of private credit 63.4 67.1 Customer deposits to total (non-interbank) loans 84.0 84.7 Source: IMF, Jan 2013. D. OPTIONS FOR REFORM 60. Fiscal policy will be critical for keeping the economy stable and promoting sustainable growth. Romania would relinquish control over monetary policy if it achieves its objective of joining the euro over the next few years19, making fiscal policy the key tool to promote sustainable growth. Fiscal policy today will affect both the short-term recovery and the medium-to-long-term growth prospects. 61. In the short term, the fiscal policy should be more focused on growth within the framework of a low and sustainable deficit. The economy operated with a negative output gap estimated at 2.1 percent of GDP in 2012. The fiscal consolidation is planned to continue in 2013 and the structural fiscal deficit is expected to fall by a cumulative 2.9 percent of GDP between 2012 and 2013. Non-deficit- increasing measures to shore up aggregate demand could help to stimulate growth in the short run with measures that could include: x Intensify efforts to spend EU funds to reduce the negative effect that fiscal consolidation will have on the economy. Better use of EU funds will allow the government to boost short-term economic growth while respecting EU fiscal deficit obligations. Since EU funds increase infrastructure spending, they would also reduce bottlenecks to future economic growth. Improvements in the efficiency of capital budget spending would maximize the gains from these resources. x Identify ways to make spending more efficient, especially in the capital budget. To help achieve improvements, the government could give a clear mandate to the MoPF to lead public investment management. The MoPF could then identify opportunities to cut waste from existing programs and enforce the cuts. It would also have additional powers to reject new capital projects – whether they are proposed by line ministries or local governments – that do not clearly represent value-for-money. x Develop credible steps to ensure institutions in health, SOEs and local governments do not commit spending above their annual budgets. Currently, institutions in these sectors sometimes fail to adhere to their budgets and central government is called upon to cover the resulting resource gaps. Part of the problem is an unrealistic budget setting process (all parties know that the budget cannot be met and neither party cares because there are no consequences). Both the state and SOEs benefit from being able to ignore financial reality so that neither is held accountable for commitments, calling to examine the larger issues of: 1) realistic budgets; 2) a 19 The latest convergence program suggest this will not occur until [2016]. See XX 25 rational economic (not politically motivated) budget setting process; and 3) both the SOE and the state being held accountable for the commitments that they make in the budgets. x Accelerate tax administration reform and prepare the ground for improving tax policy to increase competitiveness. The government has outlined tax administration reforms focused on improving enforcement to reduce evasion and on making compliance easier. It will achieve these aims by reducing direct contact between taxpayers and tax officials and promoting e-filing to close opportunities for corruption. A speedy implementation would open up space for the design and implementation of tax policy reform that would support increased productivity and competitiveness. x Continue pension reform by putting in place a schedule for the gradual increase of the pension age. Actions are needed now to start counteracting the impact of the rapid aging of the population on the prospects for fiscal sustainability. Outlining a program to increase gradually the pension age could signal the commitment to balance contributions and payments in the pension fund over the medium to long term. 62. In the medium to long-term, the policy priority is to build up the supply side of the economy by: x Adopt counter-cyclical fiscal policies to support sustained growth. Attention to demand management in the short term can be accompanied by an appropriate countercyclical fiscal framework anchored on EU commitments. However, the Romanian government must maintain its commitment to keeping the fiscal stance sustainable over the medium-to-long term. x Broaden the tax base and curb evasion. Reforms may include the gradual reduction of social security contributions so that workers get a larger share of gross wages, which would create incentives to participate in the labor market. Efforts could also be made to lower direct taxation with reductions funded through improved collections resulting from improvements in tax administration. Improvements in the financial position of the SOEs, which are currently less profitable than private sector firms (and sometimes subsidized), could increase tax collections from SOEs. x Continue reforming the pension system to gradually reduce its deficits. In addition to increasing the pension age and reducing contributions, it will be necessary to align entitlements in rural areas with contributions, while protecting the welfare of the most poor. 26 27 2. PUBLIC SECTOR REFORMS20 The state provides essential services that enhance the productivity of businesses (e.g., transport, licenses and regulations) and the welfare of households (e.g., safety nets). As such, it is essential that it functions competently and efficiently. In Romania, a systemic approach to public sector reforms is needed to improve the state’s capacity for policy management and coordination, revenue policies and administration, public expenditure management for results, and for the professional development and motivation of its human resource base. The government has taken steps to enhance the efficiency of the public sector, with focus on consolidating the framework for public investment management and developing the capacity for monitoring and evaluation of policy-making. This effort is spare-headed by the center of the government and the Ministry of Public Finance. Accelerating the implementation of these measures and carrying out the key reforms discussed in this chapter would considerably enhance the effectiveness of Romanian public sector institutions. A. INTRODUCTION 63. Romania has made substantial progress to improve governance over the past decade, but weaknesses in government effectiveness put it at a competitive disadvantage compared to its EU neighbors. Effective institutions are essential for growth (Acemoglu et al., 2005) and the Worldwide Governance Indicators show that Romania has made substantial progress since 2000 on all six (Figure 20). The most progress has been made on regulatory quality (74th percentile), while government effectiveness only remains around the 50th percentile of countries worldwide. More significantly, Romania continues to lag behind several of its EU neighbors, including Hungary and Bulgaria. While the EU average is around 83 percent, Romania ranks at just over 50 percent. Figure 20: Governance has improved on all Figure 21: Government effectiveness, compared dimensions (Percentile rank) (Percentile rank) 90 80 70 60 50 40 BULGARIA CZECHREPUBLICHUNGARY POLAND 30 ROMANIA SLOVAKIA SLOVENIA EU 20 1996 1998 2000 2002 2003 2004 2005 2006 2007 2008 2009 2010 2. Source: Worldwide Governance Indicators, Kaufmann, Kraay, and Mastruzzi (2010). 20 The chapter draws on the conclusions and recommendations of a number of World Bank reports and papers, among them the Functional Reviews of the Romanian Public Administration (2010 – 2011); background Policy Notes for the Romania Country Economic Memorandum (CEM); Romania Public Expenditure and Institutional Reviews (2010, 2006); the Mapping of Reforms exercise (2011), and a number of government, IMF, and EU documents. 28 64. A modern and efficient public administration is essential to implementing the policy priorities that are discussed in this report. The functional reviews conducted by the World Bank in 2010 and 2011 highlight the challenges that ministries face in following through on their policy commitments with the EU (see World Bank, 2010b, 2010c, 2010f, 2011a-d). In spite of commitment, however, often the apparatus in public institutions is slow to react to the changing policy environment and the need for information-driven analysis. The composition of skills among ministry staff should be reviewed in order to be able to effectively respond to the changing business needs of the ministry, and the public sector should develop adequate instruments to attract and retain the best staff. Information systems, including those for financial management, need to be upgraded in line with best practice to support a performance-oriented culture. Moreover, in spite of efforts, the systems for monitoring and evaluating performance are in their infancy, and so accountability for outcomes cannot yet be traced properly. 65. In the context of the opportunities provided by EU structural and cohesion funds, improved effectiveness of public spending can accelerate the economic convergence with Romania’s EU peers. Public spending increased sharply from about €23 billion in 2004 to €48 billion in 2012 but the impact is limited. 21 For instance, between 1999 and 2008 spending on education increased by 150 percent in real terms yet Romania’s scores fell on international tests like PISA22 and TIMSS are still among the lowest in the EU. Similarly, although Romania’s unit costs for road building and maintenance are higher than in many other EU countries, infrastructure is still below par. Romania is also behind its Central European peers in such human development indicators as child mortality and literacy. 66. Public sector reform is a priority of the EU and will affect Romania’s financing opportunities in the next programming period. Draft EU regulations for 2014–2020 structural funds show that access to them is likely to be linked to administrative capacity; the draft23 states that a member state should “have in place and start implementing a strategy for reinforcing the country’s administrative efficiency including public administration reform.� In addition, effective governance will be required to ensure a better prioritization of resource allocation while meeting the medium-term objective of a structural consolidated budget deficit of below one percent of GDP24 required as a signatory to the EU Fiscal Compact. 67. The sustainability of public administration reforms requires both commitment and institutional capacity – e.g., to coordinate across sectors, to communicate effectively to stakeholders, and to monitor and assess results. Romania has had a long experience with plans not followed by implementation. Therefore, the Government should consider designating an individual or a group with clear accountability and political authority for coordinating public administration reforms across the public sector, supporting that with technical expertise, political leadership, and a mechanism for reporting on progress. B. CONTEXT AND AGENDA 68. The focus of this section is on four functions of public administration that are critical to an effective public sector: (1) policy management and coordination; (2) public expenditure management; (3) revenue management; and (4) human resources management. 21 See the reports cited in footnote. 22 PISA (Program for International Student Assessment) is an OECD-led international study that evaluates education systems worldwide by testing the skills and knowledge of 15-year-old students in participating countries. The Trends in International Mathematics and Science Study (TIMSS) evaluates achievements in mathematics and science of 4th- and 8th-grade students. 23 Draft Regulation of the European Parliament and of the Council laying out general provisions on the European Regional Development Fund, the European Social Fund, and the Cohesion Fund and repealing Regulation (EU) No. 1083/2006. 24 Stipulated in the Fiscal Strategy for 2012–2015. 29 a. Policy management and coordination 69. Strengthening the center of Government is essential for Romania to break a cycle of policy overload, conflicting policy mandates and weak policy implementation. Although line ministers may see themselves as losing something to a strong center, policy prioritization needs to take place by looking across sectors and “challenging� individual sectors to do more with the existing resources. The Ministry of Public Finance and the Chancellery of the Prime Minister need to adequately equip themselves to “challenge� policies pursued by the line ministries. The newly implemented Fiscal Responsibility Law implicitly demands a strong role for the center, but it is also in the self-interest of future governments to get better alignment between their policy priorities and the “machinery of government� that is supposed to implement them. Different institutional models are feasible for building this policy coordination function (e.g., MoPF, General Secretariat of the Government, Prime Minister Chancellery), but it is important that it combines both technical and political competencies. 70. For strategic planning to be more effective, it needs a stronger link to the annual budget process. Although EU-financed technical assistance in the mid/late-2000s aimed at developing methodologies to assist line ministries in preparing strategic plans, the work brought little long term benefit. As long as strategic planning is disconnected from the budget process, it will fail to be a genuine management tool. To date, responsibilities for strategic planning and budget planning have been institutionally split between the General Secretarial of Government (GSG) and the MoPF. A more top- down budgeting process is needed that would translate government-wide priorities into sectorial/ministerial ceilings for the budget year and the following two years. The implementation of such a procedure could be led by a high-level strategic planning committee comprised of select ministers that helps arbitrage competing political demands, with support from a technical secretariat that coordinates estimates of the budgetary and socio-economic impact of potential policy commitments. Box 2: International experience top-down budgeting Sweden undertook significant fiscal governance reform after a financial crisis in 1993, which swelled the deficit to over 12 percent of GDP. Today Sweden is widely considered to have one of the strongest fiscal governance systems in Europe – with impressive results: between 1998 and the onset of the recent crisis in 2009, the Swedish government ran surpluses every year, except for 2003 and 2004. Sweden’s annual budget is anchored in a medium-term framework with firm, nominal spending limits for 3 years (the current budget year and two outer years). Every year the overall expenditure limit for the third year and allocations for 27 expenditure areas are collectively decided based on a proposal by the Minister of Finance during a two-day cabinet budget retreat, which takes place in mid-March. Changes to sectorial expenditure ceilings need to be accommodated within the aggregate spending limit and have to be agreed upon by all Cabinet members, including those that absorb compensatory cuts. 71. The development of a detailed annual government work program (AGWP), with quarterly progress reports, would be a useful starting point for prioritizing and sequencing of Government’s policy initiatives. This new process would require ministries to identify in advance all significant policy, financial and legal documents to be submitted for Government approval over the coming year. Two components of the annual government work plan are important: deadlines for submitting the priority policy and legal proposals (building on the legislative program already prepared by the Department for Parliamentary Relations) and key milestones for implementing major policy and financial commitments. The AGWP would be a key instrument to help the General Secretariat of Government (GSG) and the Prime Minister monitor compliance by line ministries in the preparation and 30 implementation of major policies. 25 Once an AGWP is developed, e-government tools could be engineered to facilitate the AGWP implementation process. Figure 22: Laws introduced through the Figure 23: Emergency ordinances have been Department for Parliamentary Relations frequently used Source: Functional Review of the Center of Government, World Bank, 2010b. 72. Evidence-based policy advice is critical for governments to develop well-designed programs and to avoid the tendency toward ad-hoc decision-making. Although procedures were introduced in 2005 to use public policy documents as an initial starting point in the adoption of new laws, the process had tepid political support and had disappeared by 2009 as the global financial crisis began to surface. The government therefore reverted back to practices where normative acts are prepared and discussed with limited policy substantiation offered. Consequently, civil servants who should be focusing on “policy� are instead focusing on legal conformity. A political and administrative culture has developed where ministries initiate policy without the benefit of having a firm analytical foundation on which to substantiate or defend it before colleagues or opponents. Likewise, key stakeholders are not consulted as much as could be done in the development of the policy, and prior to the posting of the draft normative act on the ministry website. 73. Better monitoring and evaluation (M&E) would help the government to assess the extent to which policies have been implemented and resources have achieved intended outcomes, and provide feedback for corrections and reallocations. In the short term, the central government is likely to have capacity only to monitor compliance and priorities. Over the medium to long term it may be possible to gradually introduce performance indicators, especially for services provided directly to the public (e.g., health, education, agriculture). 74. The government intends to put in place a system for monitoring policy implementation and has taken a number of steps in this direction. The Public Policy Directorate (PPD) of the Chancellery of the Prime Minister is working to put in place a system to monitor the implementation of reforms by line ministries. The system aims to also be integrated with existing systems for reporting to the EU on the implementation of the National Reform Program. If progress is sustained and capacity is enhanced, including by recruiting appropriate sectoral expertise, the PPD can develop and manage, in time and in coordination with the Ministry for Public Finance, a monitoring and evaluation system for policy- making based on good international practice (Box 3). 25 The European Commission, for example, produces an annual Commission Work Plan which translates the President’s political guidelines into concrete public policy and legal measures. The work programs are generally designed to ensure that the Commission’s policy priorities are advanced. Deadlines are set and monitored throughout the year by the General Secretariat. 31 75. The government has also plans to set up a Delivery Unit in the office of the Prime Minister. The Delivery Unit will help to strengthen the Government’s performance in critical policy and service delivery areas. The Prime Minister’s office and the Ministry of Public Finance have identified key weaknesses in critical policy implementation and service delivery areas. Specific issues identified by the Government include limited government-wide policy prioritization resulting in policy overload, conflicting policy mandates, insufficient coordination across ministries and shortcomings in policy implementation. The key functions of the Delivery Unit will be to identify programs contributing to key government goals; monitor their progress; identify options to overcome obstacles preventing effective and efficient implementation of policies and programs; and to provide advice to managers on how to improve delivery. Box 3: International experience on delivering results There are a number of public management tools that countries have recently been using to improve the delivery of government objectives. These can be broadly classified as Monitoring Systems (MS) and Delivery Units (DU), which are different but complementary tools. Their key functions are to identify programs contributing to key government goals and to identify and monitor progress made to reach those goals. Within this broad function, these systems are expected to set logical frameworks to identify causality among program outcomes and government goals, set program indicators to track progress in programs outcomes, provide information, and set the informational basis to evaluate the causes preventing the efficient completion of program outcomes. In addition, DUs are also expected to identify and propose actions to overcome obstacles preventing effective and efficient implementation of policies and programs and to provide advice to managers on how to improve delivery. Delivery Units: Their mandate is to drive performance improvements in critical service delivery areas. A DU would therefore need sufficient formal or informal authority from the center of government to be able to convene key officials across government to remove obstacles, improve coordination, and obtain timely information. However, a DU is not intended to replace the existing bureaucracy, and needs to be small, lean, with highly-skilled staff ideally coming from the private sector. For a DU to be efficient, it would need to cultivate a service mentality, helping ministries resolve problems and providing advisory services to program managers. Persuasion should be the instrument of choice rather than pressure. A DU’s key functions include: (1) signaling key government delivery priorities within and outside of the public sector; (2) focusing political pressure for results through progress-chasing on behalf of the head of government; (3) providing a simple and direct monitoring mechanism for key government priorities; (4) providing a clear signal that government is holding ministers and senior staff to account for delivering the government's key priorities; and (5) supporting innovation, coordination by various ministries, and providing a forum for problem-solving when needed. They are not responsible for tackling broader civil service reform or budget process issues, only making observations and helping to remove bottlenecks. They also do not substitute for the planning or policy functions; they provide inputs on how to exercise the functions but not the content. They do not reopen discussions on the annual budget, as this would likely undermine the main budget. Finally, they do not operate complex monitoring and evaluation systems (this is for Monitoring Systems). DUs require high-frequency and selective monitoring and reporting frameworks. Examples of delivery units include: less formalized examples, such as the Delivery Unit in the Prime Minister’s Office under the previous UK government, the Cabinet Secretariat for Performance Management in India, Indonesia‘s Presidential Unit, Malaysia’s Performance Management Delivery Unit (PEMANDU), South Africa’s Delivery Unit, and the Chilean and Colombian units. The US and Thailand have formalized DU even further in the form of the US Office of Management and Budget and Thailand’s Office of the Public Sector Development Commission. Monitoring systems: the purpose of monitoring systems varies depending on the need of a country. Some are used as the means for control, which requires the development of information on the advances, obstacles and 32 opportunities for the implementation of policies and programs. This also requires developing better information on the quality and coverage of government outcomes (regulation, service delivery). This information is often used to hold managers to account. Others are used as a tool for budget management and to inform budgetary decisions. In this case the information needs are closely associated with the use of the budget, but in addition to spending amounts should incorporate outputs (e.g., kilometers of roads built) and outcomes (reduction in the cost of moving goods). Such a system would facilitate the best allocation of resources between sectors and programs, and encourage operational savings. Finally, some monitoring systems are created as a means to increase accountability. This might refer to enhancing internal accountability of sectors to the PMO (or from sub-nationals to center), or external accountability towards legislature, stakeholders and the public. Below are some selected examples of how these systems are used. Source: GET Note: Center of Government Delivery Units; “Recently Asked Questions� Series, November 2010. Box 3 continued Purposes National examples Solving problems of x Brazil and UK: center-of-government monitoring and “trouble- implementation shooting� programs with political priority. Accountability within the x Brazil: compliance and process audits government x Canada, South Africa, and UK: departmental reporting to the center of government. x Colombia and South Africa: government reporting results to the public. Accountability & x Brazil: Supreme Audit Institution reporting program results to the public 5. Information to the (and imposing corrective measures on agencies). public x UK: education and health “score-cards� (or “league tables�) for consumer choice. x Chile: Budget Office evaluating programs (also budget impacts). Improving the design of x Colombia, Mexico, and Spain: specialized agency evaluating programs programs and policies. x Ireland: ministry evaluations of projects using European-Union Structural Funds (also for accountability). Coordinating and prioritizing x Australia (1987-97): evaluation system for policy and budget among programs prioritization. x Canada, Chile, Ireland, UK, US: spending reviews that feed into budget decisions b. Public expenditure management 76. Progress has been made in improving Romania’s budgeting processes, especially by enhancing fiscal discipline, but more needs to be done. While the underlying spending policies are essential to such functions as social protection, pensions, health, education and transport, the systems used to prioritize and implement public spending should also be an essential component of any agenda to raise efficiency and effectiveness in the use of public funds. 77. Since 2009 there have been a number of reforms leading to a more disciplined budget process: x Elements of a Medium-Term Expenditure Framework have been gradually introduced to expand the strategic content of the budgeting process, make budgets more policy-oriented, make funding more reliable and effective and preserve the integrity of budget figures: 33 x A Fiscal Responsibility Law passed in 2010 contains fiscal principles and rules on revenue, expenditure, deficit, public debt and risk management. x An autonomous Fiscal Council has been established to oversee the budget process and decisions that have fiscal implications. However, its capacity needs to be reinforced. x A three-year Fiscal Strategy is updated every year to tighten linkages between policy and budgeting processes and to make spending more predictable. 78. These initiatives need further attention in implementation to ensure that they yield the intended results. Their implementation has been hampered in part because complementary processes and institutions are not in place. Meanwhile, policy planning is generally unsystematic and the system does not produce the quality of technical analysis needed to support informed policy decisions. There is also a persistent gap between what the law mandates and what actually happens, and policy and budget processes are not fully integrated. 79. Effective linkages between policy priorities and resources will require a more effective medium-term budgeting process. Although budget estimates are made for two to three years beyond the budget year, the forecasts have not yet brought a major impact on the budgeting process. Moreover, for public infrastructure projects the financial commitments go beyond the three-year horizon and future costs are not subject to caps. While the three years is sufficient for most programs and activities, a longer budget planning horizon should be introduced to place financial ceilings on longer-term infrastructure investments. In addition, line ministries need to accept the medium term forecasts as real limits and be incentivized to prioritize spending within those limits. Likewise, medium term resource envelopes should be a more reliable basis for the financing of individual investment projects. Box 4: International experience with expenditure reviews Some countries have made regular selected reviews part of their budget procedures, where programs, including baseline allocations, are thoroughly reviewed once every few years. Others perform comprehensive reviews on a more ad hoc or need basis. Spending reviews are often led by the Ministry of Finance in terms of the overall methodology and guidelines but rely heavily on the line ministries themselves since they have a superior understanding of their own operations. Canada: The Expenditure Management System, implemented in 2007, is the framework for developing and implementing the government's spending plans, and encompasses a number of elements and activities (e.g. planning and evaluation) that guide decisions on the allocation of resources. Its various elements provide the information necessary to support the development of spending plans, the Government's priority setting process. A key pillar of this system is strategic reviews of key spending programs. All institutions receiving central appropriations are required to periodically (a 4-year cycle) undertake a strategic review covering 100 percent of their direct program spending and operating costs of their major statutory programs. Through these reviews organizations are required to identify reallocation options totaling 5 percent from their lowest-priority, lowest- performing program spending. Organizations can identify more potential savings in order to provide a greater range of options. 80. Fiscal discipline and financial control procedures need to be complemented by a greater focus on value-for-money analysis. Ministries of Finance in the EU must have the capacity and mandate not only to control the level of spending, but also to assess the quality of spending The structure of the budget and the information systems that support it could be better designed to capture information on the purpose of spending (e.g., through a functional or programmatic classification). In parallel the Ministry of Public Finance should be encouraging ministries to validate the efficiency and effectiveness of their spending. The Ministry of Public Finance in turn needs to assess sector/program performance periodically, and introduce such information when relevant into budget discussions. 34 81. Public investment management (PIM) should be the starting point for focusing attention on the quality of spending. In some sectors such as transport or regional development, the current investment portfolio far exceeds the available medium term resources and needs to be rationalized and old or poorly justified projects cancelled. In addition, the MoPF needs to exercise a stronger mandate to block such projects from entering into the budget. A positive cost-benefit analysis should not be sufficient criteria to justify projects from entering into the budget. Approval procedures need to take into account the existing project portfolio experience, and whether the project promoter has adequate expertise to manage the project if it is large or complex. 82. The Ministry of Public Finance is cognizant of these deficiencies and is committed to strengthen the budget process and the PIM framework. The public investment budget as a percent of GDP has been the largest in the EU over the last ten years. However, there has been little effort to assess whether the spending achieved the desired aims. Only recently are public investments underway being inventoried and efforts are made to control new initiatives. Preliminary findings are that about 40,000 projects are considered active. The Ministry of Public Finance (MoPF) has been leading these efforts, and its capacity and mandate need to be enhanced, including by making the necessary legal changes. Having a clear mandate to monitor progress on projects will help the MoPF to make investment spending more effective. The mandate will need to include the ability to close non-performing projects or order their scaling down, as well as the right to limit new projects to those that pass rigorous cost- benefit analysis and are likely to be completed. The recently established Unit for Evaluating and Monitoring Investment Projects in the MoPF, which reports directly to the Minister Delegate for the Budget, is an important step in improving public spending efficiency, but its capacity needs to be enhanced. 83. The modernization of Information Technology (IT) that supports the core public finance operations should be accelerated. While there have been initiatives to improve IT support within MoPF, financial reporting remains labor-intensive, with sub-optimal levels of automation. The consequent limitations in obtaining reliable, timely and detailed revenue, expenditure and commitment data for budget planning, monitoring, expenditure control, and reporting negatively impacts budget management. The current IT infrastructure and systems are based on a large number of custom-built applications that could be better integrated. A comprehensive and detailed IT audit could assess the needs and lead to a better understanding of how to integrate IT systems that support budget managements. 84. A more consolidated organizational structure at MoPF could also improve coordination across related functional areas. Below the secretary level, the first layer of non-political management comprises the heads of the first tier operational units. There are a total of 35 such first tier operational units, which compares to about eight major top-level operational departments in other European countries (see Table 8). There is no one right way or international best practice to structure a ministry of finance, but a few options have been discussed with MoPF officials to consolidate the senior line management structure around core public finance functions: x Creation of a DG Budget Formulation, overseeing units for budget synthesis, budgetary relations with the EU and expenditure programming, monitoring of budget execution. x Creation of a DG Budget Execution and Public Accounting, overseeing units for the treasury operations oversight, budget execution monitoring and cash release (credit opening), the accounting methodology and financial reporting functions, corporate accounting. x Creation of a DG Revenue Policy and Legislation, combining the existing directorates related to tax legislation, administration, customs and excises. 35 Table 8: Organization of ministries of finance – Romania and international comparison   France Germany UnitedKingdom26 Romania x Politically 2Ministers Minister Minister(Chancellor 2Ministers Appointed 2ParliamentaryState oftheExchequer) 4StateSecretaries Leadership Secretaries 5juniorministers x Senior Management 1GeneralSecretary . 3(Permanent)State . 1Permanent . 1GeneralSecretary Secretaries Secretary  x Top Level 17OperationalUnits . 9DirectorGenerals . 5ManagingDirectors . 34OperationalUnits Operational Management x Management board Cabinetmeeting . SeniorManagement TreasuryBoard27 . Ministry’sCollege Committee  Source: World Bank staff compilation 85. Public procurement practices should be strengthened to improve the quality of spending. Although the procurement law fully complies with EU requirements, the implementation of the law has created undesirable effects on the quality of procurement, and ultimately on value for money. Qualification criteria for bidders have not been sufficient to prevent unsatisfactory firms from competing and winning tenders; resulting in turn in poor quality work. In addition, risk sharing between contractor and client are not always balanced, which has at times results in large variation orders and claims for major cost adjustments. Quality control mechanisms for implementing the procurement law need to be reviewed and enhanced. c. Revenue management 86. Revenue mobilization is a key challenge for the government, but efforts to enhance revenues by improving tax administration are underway. Tax and social contribution revenues in Romania remain one of the lowest in the EU in spite of multiple changes in the tax policy regime. Revenue performance gains during the boom years of 2004 -07 were limited, with the revenue/GDP ratio rising from 27 to 29 percent; while revenue losses during the recession were important, with tax/GDP ratio dropping back to around 27 percent in 2010. The increase in the VAT rate to 24 percent in 2010 and a number of measures taken by the National Agency for Fiscal Administration (NAFA) to enhance revenue administration have improved collection by 2012 to 28 percent of GDP. Table 9 shows tax revenues as a percent of GDP from 2004 through 2012. The VAT collection to GDP increased from 6.7 percent in 2009 to 8.6 percent in 2012. Table 9: Romania, tax revenues collected by NAFA as percentage of GDP, 2004-2012 28 2004 2005 2006 2007 2008 2009 2010 2011 2012 Total tax revenues, o/w 27.2 27.8 28.5 29 28 26.9 27.2 27.91 28.26 - Value added 6.7 8.1 7.9 8.1 7.9 6.6 7.5 8.6 8.6 - Corporate - income tax 3.2 2.7 2.8 3.1 3 2.7 2.3 2.9 N.A. Personal - income tax 2.9 2.3 2.8 3.3 3.4 3.5 3.3 3.6 N.A. - Social security contributions 9.1 9.6 9.7 9.7 9.3 9.4 8.7 9.1 8.8 Source: Eurostat 26 These figures are derived from the Annual Reports of H.M. Treasury and H.M. Revenue and Customs for 2008-9. 27 Comprises the Permanent Secretary, Managing Directors, Director of Human Resources and Finance, CEO of the Office of Government Commerce, and four Non-Executive Directors 28 Breakdown does not include all sources of tax revenue. 36 87. The organizational structure of NAFA was adjusted to keep with international practice, but the extensive office network needs further reduction to increase efficiency and effectiveness of collection while reducing costs. Modern tax administrations seek to minimize direct contact with the taxpayer and taxpayer service is provided through the use of a robust website, through an accessible call center and other means available. Reduced physical contact also minimizes opportunities for corrupt behavior. Staff at the moment is not properly distributed across the organization, but NAFA is cognizant of the situation and intends to address it as part of its modernization plan (see below). Close to half of NAFA staff is in support or clerical roles, less than 15 percent of all staff are assigned to the management of large and medium taxpayers, and insufficient staff is assigned to key areas such as audit and debt collection. 88. Romania is making efforts to reduce the tax compliance burden, but it remains relatively high. The World Bank Doing Business Report 2013 shows that Romania is one of the worst performers in the EU in terms of the ease of paying taxes because of the large number tax payments29 required. Despite substantial improvements compared to last year, the number of tax payments in Romania stands at 41, the largest in the EU. Figure 24 depicts Romania’s results in this regard when compared to other countries in the region. Moreover, in the 2009 Enterprise Survey, 48 percent of male-managed firms and 51 percent of female-managed firms report tax administration to be a major constraint. 89. The government has made it a priority to reform tax administration. Modernizing revenue administration is central to the government’s reform agenda, and the government has approved a plan for 2012–2016 to do so. The plan has three objectives: improve voluntary compliance, eliminate tax evasion and increase collection efficiency. The outcome of the first two will be more revenue for the consolidated general budget. The third would redesign the National Agency for Fiscal Administration’s (NAFA’s) internal operations. The program calls for simplifying procedures and improving services using a new system of taxpayer segmentation. The main procedural improvements NAFA plans are to: (i) increase e-filing of all statements from legal persons to 98 percent; (ii) introduce a catalogue of taxpayer services and quality standards for taxpayer assistance; (iii) expand the areas of taxpayer assistance delivered by a single point of contact; (iv) introduce incentives to encourage payments via the banking sector; and (v) make it possible for taxpayers to access information on their tax situation and get documents from NAFA. The criteria for deciding whether to treat a taxpayer as large or medium will need to be expanded to take into consideration elements more complex than simple turnover. NAFA aims to gradually increase the revenue collected from these categories to at least 75 percent by 2016. 90. To address tax evasion, NAFA is building up its risk-assessment capabilities. NAFA gradually introduces audit and control selection based on risk, and has set up task forces with responsibilities in high-risk areas (VAT, excises), cooperating at the same time more closely with other EU members. Crucial operational reforms are also needed in revenue administration. NAFA has identified the need to simplify procedures, to improve service and to deal with non-compliance in both filing and payment. The following box (Box 5) summarizes recent operational advice provided by the IMF and is indicative of the type of operational reforms that lie ahead for NAFA. 91. While improvements are being made in the revenue administration, the Government could also review tax policies to assure that they facilitate growth. Greater capacity is needed within NAFA to monitor taxpayer compliance and to identify potential areas of tax evasion. This information can be used by MOF to identify potential changes in the fiscal code to enhance the tax base. In addition, 29 The Tax payments indicator reflects the total number of taxes and contributions paid, the method of payment, the frequency of payment, the frequency of filing and the number of agencies. Where full electronic filing and payment is allowed and used by the majority of medium-sized businesses, the tax is counted as paid once a year even if filings and payments are more frequent. 37 capacity in tax policy analysis is needed to assess the impact on growth of potential tax policy changes and to extrapolate from the experiences of other EU member states on tax policy.  Box 5: Maintaining reform momentum in tax Figure 24: Compliance burden, number of tax administration payments, 2012 Registration x Establish registration enforcement units to identify and register businesses that are outside the tax system. Tax evasion and arrears x Increase audit coverage systematically over the next three years (large taxpayers - 30 percent, medium taxpayers - 5 percent, and small taxpayers - 2 percent). x Increase audit staff over the next three years to at least 20 percent of tax administration staff resources. x Introduce a formal desk audit program. x Expand use of installment arrangements and review the conditions attached to their availability. x Complete an analysis of the debt stock and the most appropriate debt collection methodologies, policies and office structures for collection enforcement and consider technical assistance for this project. Prosecution x Ensure screening of prosecution referrals and train auditors and audit managers on fraud audit techniques and evidentiary requirements to ensure successful later prosecutions. Source: Doing Business 2013, the World Bank Source: IMF 2011 Technical Assistance Reports. d. Human resources management 92. Romania has put in place the legal and regulatory framework for a modern civil service, but the actual implementation still falls short of the objectives. Ministers and other senior officials consistently point to the difficulties they confront because of the rigidities in human resource management, the relative scarcity of high skilled professionals, and the difficulty in motivating and retaining those who do perform well. 93. Human resources need to be looked at comprehensively, because there are a broad set of policies and practices that have become major barriers to performance for most ministries. The substantial increase of salaries from 2004-2008 showed that pay alone is not sufficient to address the performance challenges in the public administration. The restrictions on hiring (replacing only 1 of 7 positions) are a more recent constraint for managers, but a more strategic approach is needed for Human Resource Management (HRM) before substantial hiring takes place. The over-arching problems are: (a) having the wrong composition of skills for the tasks, and (b) having structures and incentives in place that undermine rather than enhance performance. 94. As the first step, the Government should consider strengthening institutional leadership over HRM and developing a clear vision for reforming HRM in the public sector. Currently, the responsibility for the formulation of Human Resource policy is fragmented across various ministries and institutions and implementation is through different legal instruments. Although the functions, responsibilities and powers of the respective institutions are clear in legal terms, in practice problems are caused by overlapping and conflicting responsibilities. Some of the institutions lack the authority and 38 status to achieve results whilst others lack capacity and resources. Responsible ministers are also understandably distracted by other major policy issues within their mandate. 95. Overall responsibility for the formulation and coordination of HR policy across the public service should rest with a single state institution to ensure consistency and common standards, even while specific operational functions like payroll remain distributed among other bodies. The central unit should have overall responsibility for the formulation of HR policy proposals and the dissemination of best practice. 96. A major goal of the HRM reform should be to professionalize senior management functions. In most OECD countries (Box 6), overall responsibility for policy, strategy and outcomes rests at the political level, while authority and responsibility for executive and administrative decision- making normally rests with professional civil servants and managers. Although the Romanian civil service legislation reflects the principle of professional, stable and politically neutral managers and administrators, the actual practice has been different – reflected in part by the high turnover in senior positions. Political involvement in the selection process is facilitated by the low level of experience (5 years) required for entry to senior level positions and by the failure to specify and rigorously test for relevant management/technical skills and competencies for entry. Box 6: Political participation of civil service in OECD countries Principle of political Administrative law places neutrality spelled out in limits on political constitution, law or involvement in public service regulation administration New Zealand Yes Yes Korea Yes - Belgium Yes Yes UK Yes Yes Denmark No Yes Sweden No Partly France Yes Yes Poland Yes Yes United States Yes Yes Mexico Yes Yes Italy Yes Yes Note: Bold= strong public or customary support of political non-partisanship Note: For Poland, valid until the end of 2006. Since the end of 2006 new regulations regarding the civil service entered into force together with a new law on state staffing pool and high rank posts. Source: OECD (2007) 97. A second major objective of the HRM reform should be to enhance merit-based recruitment and promotion of staff. Currently, recruitment and selection is problematic, due to a focus on legalistic compliance with regulations and procedures, and insufficient attention to assuring that the necessary skills and competences are linked to the institutions’ mandate and functions. Likewise, performance assessment is not so much job- and task-oriented but generic and therefore is not used to improve job performance. Promotion seems to work well for junior posts, but for more senior positions the perception is that often one must have political connections. The Government could better link recruitment and promotion processes to specific job experience and competencies by taking several short- to medium-term actions: x Upgrade the mandate and capacity of the Agency for Civil Servants to support ministries in attracting and retaining required skills and ensuring meritocratic, depoliticized recruitment, selection, promotion, and dismissal. x Roll out a plan for revising job descriptions, starting with senior posts. 39 x Revise the performance appraisal system to take into account job-specific priorities and link it more closely to the pay system. x Increase the number of senior posts filled by people recruited from outside the civil service. 98. Ministries also need organizational structures that fit their business needs rather than having to create units to comply with rigid norms about span of control. The implementation of Government Ordinance 22/2009 and Law 161/2003 – which set universal management-staff ratios, such as 5 staff required for an office, 7 for a service, 15 for a Directorate, and 25 for a General Directorate – has resulted in dysfunctional structures. Ministries have become fragmented, overly hierarchical, less effective in coordination, and sometimes duplicative in some support functions. In turn, ministries need to be able to adjust the composition of positions to fit its evolving business needs and to more highly value the specialized, technical non-managerial posts within the organization. For example, as the MoPF becomes more policy- and less compliance-oriented, it should need fewer entry-level clerical staff and many more mid-level professional staff with higher-value-added responsibilities. 99. Skill shortages need to be identified and addressed, while retaining fiscal balance in the wage bill. While showing restraint in the overall employment levels, the government could strategically manage the number of positions in different functions so that some key areas are prioritized and others reduced more aggressively. The implementation of the unitary pay law should help to enhance salaries and make them more competitive for some key positions, but the fiscal situation and court decisions have prevented that from happening thus far. The impact of the unitary pay law may take years to assess, but it is likely to require some adjustments to better support retention of key skills. The government may also wish to consider fast-track options to attract qualified individuals in a limited number of highly critical and urgent functions. 100. Ultimately, performance management for civil servants and other public employees needs to be anchored under a broader umbrella of performance objectives for ministries, agencies, and departments. Improved pay and conditions of service will not automatically result in better motivated staff, less corruption or improved service delivery without accompanying improvements in accountability. International experience shows that close synergy is required between all the various elements in a performance management system if both the system and the various elements within it are to be successful. Performance targets are needed for all levels (down to individuals) of the organisation to support the achievement of the key objectives.  Figure 25: Human resource management systems- success factors 40 proffessional hiring/firing compensation andtraining Empowering(results basedmonitoring) C. OPTIONS FOR REFORM 101. The process of institutional change can take time and is challenging. However, the importance of institutions means that the benefits can be considerable. An improved institutional structure will make it easier to design and implement policies that boost Romania’s chances of achieving the levels of growth required for convergence with the EU. Reforms that can begin in the short term include: x Strengthen capacity of the Center of Government (COG) to facilitate inter-sectorial policy coordination and to link strategic planning to the budget process. This will likely entail developing an annual government work program which the COG can use to express priorities for the current year and future years. The reintroduction of the requirement for public policy documents would facilitate discussion on key major policy areas before legislation is drafted. The Medium Term Expenditure Framework can be integrated more deeply into the policy planning of ministries and especially in the management of public investment to help ensure priority spending is budgeted for. x Establish the Delivery Unit and the monitoring and evaluation function at the center of government to report on major priorities. This would allow the government to understand progress in project implementation and reallocate resources where appropriate. The Law 500 on the Budget (and related regulations) can be amended further to enhance the effectiveness of public investment management and to give MoPF greater responsibility for value-for-money analysis. x Establish priorities for the further modernization of public expenditure management, building on the recent initiatives of the Ministry for Public Finance. Key challenges include stronger linkages between budget planning, execution and results, strengthening the medium-term budget framework and the public investments management systems. x Conduct a comprehensive and detailed IT audit to assess the MoPF's information systems, practices and operations. A detailed review is warranted to ensure high performance, optimal use of IT resources and alignment of IT investments with business priorities. It should review the funding model, staffing levels, and distribution of functions between the IT staff at MoPF and its territories. 41 x Better integrate the IT systems supporting budget management. MoPF should consider the integration of expenditure management functions with a centralized database and general ledger to record all stages of the transaction processing. There are several technical options that could be explored ranging from computerized data exchange mechanisms between related sub-systems to investing in a new Integrated Financial Management Information System. x Make it easier to pay taxes. Continue efforts to streamline the office structure of the tax administration agency and to modernize its business processes, all with the aim of reducing compliance burden on taxpayers and reducing tax evasion. x Assign institutional responsibility for coordinating HRM reforms across government. The newly responsible unit should give priority to professionalizing the senior civil service and developing more competency-based requirements for such positions. The new unit can begin reforms by: x Clarifying management and administrative roles, responsibilities, and functions to give the senior civil service more accountability and enable ministers to concentrate on strategic direction and communication. x Increasing the technical requirements for the most senior positions based on job-related competencies, skills, and relevant experience. Monitoring of the appointment process can be extended to these positions and future turnover should be analyzed. Political involvement in selection should be limited to high-ranking civil servants. x Giving the General Secretary greater powers to make decisions, but allowing them to be delegated to subordinates. All directors general and directors could report directly to the General Secretary. 42 43 PART II: THE FOUNDATIONS FOR THE ECONOMY TO COMPETE — ENHANCING CAPITAL AND LABOR MOBILITY 44 45 3. SOE PERFORMANCE SOEs in Romania perform remarkably poorly because of antiquated methods of governing, monitoring and controlling them. The importance of public-sector reform (Chapter 2) cannot be ignored. Any reform initiative must be accompanied by a concomitant reform in the manner in which the state oversees and governs its SOEs. Many of them are technically insolvent. Not only is their financial performance weak, but so is their provision of services, notably needed infrastructure that is of critical importance to the country. The remedies are complex and challenging, but necessary for the country to emerge from its economic malaise. The SOE modernization and reform agenda is a cross-cutting issue for Romania’s growth. SOEs account for around 10 percent of the economy and their underperformance causes significant damage to the remainder of the economy and the country. Their financial fragility has a direct impact on state finances, capital markets, the banking sector and the social security system. Total SOE arrears account for almost 3.5 percent of GDP and have a knock-on effect in the private sector (Chapter 1). Furthermore, sectors in which SOEs are dominant are marked by weak competition among other players (Chapter 4). Finally, it is also a sectorial issue, as SOEs dominate energy, transport and mining (Chapters 6 and 7). The proposed agenda is challenging. Its principal focus is to reform the governance structure of SOEs so that their management has incentives to perform better. The reforms’ framework is already in place but needs to be duly implemented: (1) to professionalize the boards of directors and management of SOEs that are expected to remain in public hands, (2) to swiftly privatize the rest. Building the rest of the corporate governance agenda for enterprises that will remain in private hands – whose framework is still to be developed—can follow, including systems to enhance transparency and accountability and to introduce, in practice, corporate principles for accounting and reporting. Attracting private-sector participation via minority share-sales or IPOs should be next, along with tearing down regulatory walls that protect them or hinder their performance. A. INTRODUCTION 102. State-owned enterprises weigh down Romania’s economy by restricting competition, deterring productivity and innovation and unnecessarily draining the public purse. 30 While their exact number is not known, the best estimates put their number at more than 760 SOEs, of which 240 are owned by the central government and the rest by lower levels such as municipalities. 31 These SOEs are a heterogeneous group: some employ fewer than 10 people, others more than 10,000. 32 Some make a profit, while others incur losses. As of 2011, the 645 SOEs that reported financial statements to the Ministry of Public Finance had revenues amounting to about 10 percent to GDP and employed 10 percent of the labor force, or 15 percent of the entire public sector employment (Fiscal Council, 2012). The government controls at least one company in each of 16 key sectors. They have dominant positions in energy (53 percent of the sector turnover), transport and storage (34 percent) and mining and quarrying (27 percent), as shown in see Figure 26. They also have a substantial presence in roads and water. 103. SOEs usually do not respect their budget constraint as the government routinely covers their losses, so they often build up considerable arrears, both to suppliers and to the state budget. SOEs contribute 10 percent to economic output but are responsible for nearly a third of all arrears in Romania. Meanwhile, the lack of pressure on SOEs even to break even gives them an unfair advantage 30 SOEs are companies of which the state owns more than 50 percent. 31 These figures, which are based on data from the Trade Registry database for 2010, probably underestimate the actual number of SOEs in Romania. The Trade Registry, for example, does not have data on public research institutes. 32 Among SOEs that employ more than 10,000 are the postal company CN Posta Romania and the railway company CFR SA. 46 over the private sector. This and the barriers to entry erected by the state and restrictions on private- sector activity results in private-sector companies choosing not to invest, or in being unable to do so even if they wanted to. In addition, SOEs make up the largest group of debtors towards the social security fund, with arrears of 2.4 percent of GDP as of mid-2011 (Fiscal Council, 2012). Figure 26: Romanian State-owned Enterprises by Sector Construction Chemicalindustry Audit,researchandconsulting Other services Postalandcourier activities Agriculture,forestryand fishing Water supply, sewerage andwaste … Defense Miningandquarrying Transportandstorag Energyand gas 0 50 100 SOEactitivity (in% oftotal SOE economic activity) SOEactitivity (in% oftotal economic activity) Source: Trade Registry, Romanian Ministry of Finance; World Bank staff calculations. 104. Speeding up the downsizing, privatization and reform of SOEs would quickly boost growth. Given the importance of the sectors in which SOEs operate, their size and inefficiency impose costs on the rest of the economy: 33 x Excessive government presence in the economy—whether through SOEs or anticompetitive regulation in their favor—undermines competition, reducing incentives for firms to cut costs, innovate, and become more productive. x Poorly performing SOEs harm the energy and transport sectors, which affect the entire business climate; large investments are needed to bring SOE technologies up to date so that they do not become bottlenecks to growth. x Quasi-fiscal SOE losses and direct government transfers impose a significant fiscal burden. B. CURRENT STATUS AND CHALLENGES a. The consequences of poor SOE performance 105. Inadequate corporate governance, government subsidies and protection from insolvency or bankruptcy enable SOEs to engage in abusive related-party transactions and practices that distort competition downstream. The hydropower company Hydroelectrica, for example, sold its unregulated production at a discount to private partners not chosen competitively, thus foregoing €200 million a year. Government regulations, such as caps on energy, gas, and water prices, often prevent SOEs from recovering their costs (see Chapter 6). Because of their soft budget constraint, SOEs can ignore 33 Poor SOE performance may have become economically more costly in recent decades as a result of globalization, acceleration of technological change, and deregulation of previously monopolistic markets (OECD 2005). 47 competition from the private sector. Given the linkages between line ministries, regulators and SOE governing boards and the selective enforcement of laws and regulations, it is likely that regulators give SOEs preferential treatment. 106. The high benefits offered by SOEs Figure 27: Progression of wages in national undermine private sector competitiveness and SOEs lead to misallocation of labor. Including bonuses and nonmonetary benefits like meals, extra vacations, and children’s daycare, which account for around half of total benefits, average SOE salaries exceed the national average by about 20 percent. All components of SOE salaries have increased in recent years (see Figure 27), pushing up wages in the private sector and undermining its competitiveness. High SOE wage packages also attract skilled labor away from more productive private firms.34 107. The inefficiency of SOEs is particularly Source: Fiscal Council damaging to energy and transport. Inadequate infrastructure is a major constraint to doing business in Romania (WEF 2012). And since infrastructure is traditionally done by SOEs, much responsibility for this lies with them because their unprofitability and inefficiency limit their contribution to infrastructure. In the energy sector, for example, the technology of many facilities needs to be upgraded to reduce the risk of supply interruptions and to meet EU standards on emissions and reserve capacity. 35 This will cost an estimated €30–35 billion in the next decade. It is doubtful that SOEs will be able to invest these amounts while low energy prices deter private investors. 108. SOEs losses are covered, directly or Figure 28: Profitability ratios compared, indirectly, by the state. Despite government SOEs and the private sector restructuring efforts, many SOEs have been running deficits for years. As of 2010, SOE losses accounted for 0.6 percent of GDP on average and 1.1 percent for SOEs posting losses. To compensate for these losses, many SOEs receive subsidies. In 2011, 22 large SOEs ran deficits totaling about 0.4 percent of GDP, even after subsidies that corresponded to 0.5 percent of GDP (IMF 2012c), putting immense pressure on the national budget and absorbing resources that could be better used elsewhere. Under the rules of the European System of Accounts (ESA 95), SOEs that receive more than half their revenues from government subsidies over a three-year period should be treated as part of general government. In 2011, about 30 SOEs out of the estimated 760 met Source: Trade Registry, Ministry of Public Finance, this criterion, worsening the general government World Bank Staff calculations. EBIT = Earnings Before Interest and Taxes. 34 Usually SOE pays lower wages than the private sector (because they are often ruled by public sector pay rules, which typically set remuneration at lower levels than the private sector). In addition, it is usually the public sector and SOEs that have difficulty attracting skilled labor because of higher private sector compensation. While these findings would need to be further explored, strong unions and the ability of SOE executives and employees to extract rents might be part of the explanation. 35 Since 2010 all EU members are required to have electricity reserve capacity of 5–10 percent to ensure a secure supply. Currently, Romania barely meets this requirement. 48 fiscal balance by about 0.5 percent of GDP. Meanwhile, SOEs that do not receive subsidies are forced to carry the losses themselves. This means that the quality of their balance sheet degrades continually over time. 109. SOEs have also accumulated arrears to both public and private entities. At the end of 2010, estimated arrears of SOEs corresponded to 5.5 percent of GDP and nearly a third of total arrears in the economy (Dumitru and Paliu, 2010). They declined somewhat to around 3.5 percent of GDP by the third quarter of 2012 and were further down to 2.2 percent of GDP by the end of May 2013. They owed taxes to state and local governments and to special funds, social security, health and unemployment funds as well as to suppliers, banks, and employees, along with penalties on overdue debt 36 (Figure 29). As documented by the IMF (IMF June 2013), measures to reduce arrears included the cancellation of arrears among SOEs, debt for equity swaps, the placement of SOEs into insolvency, and the liquidation of SOEs. Improved operating performance of central government SOEs, which was aided by an 11 percent cut in employees, supported the reduction in arrears as well. Figure 29: Romania SOE arrears a. Distribution of SOE arrears (2010) b. Arrears of SOEs (as of 1st quarter 2013) Taxestolocal Pastdue loans, Pastdue  5.0% budget,1% 2% interest, 0% 4.0% 3.0% Taxestostate  budget,20% Supplier,32% 2.0% Othercreditors, 1.0% 19% 0.0% Socialinsurance  2010 2011.4 2012.1 2012.2 2012.3 2012.4 2013.1 budget,25% year Special Central Local budget,1% Source: Trade Registry, Romanian Ministry of Finance; IMF and World Bank staff calculations. 110. Arrears also affect the quantity and quality of government services. SOE arrears mean less revenue for the government, social insurance, and health budgets, which depresses government services and narrows the space for financing much-needed government investments. Arrears can also trigger penalty charges to the owner of the debt that the government has to pay. Clearance of arrears constitutes a significant share of the government’s capital spending, diverting resources away from more growth- oriented expenditures. In December 2011, the government spent RON 7 billion on capital expenditures, of which RON 1 billion were used only to clear arrears to Electrificare and CFR Infrastructura (IMF 2012). 111. Arrears can cause liquidity shortages for both private and public suppliers of goods and services. For example, in early 2011, private companies that supplied energy to the public railway company CFR suffered losses of €500 million (RON 2 billion) from its failure to pay them. Delayed payments are particularly crippling for smaller, more financially vulnerable businesses and can make it difficult for them to meet their own obligations. 36 There tends to be a generalized culture of nonpayment in Romania. Private firms as well as SOEs tend to accumulate arrears. The government often tolerates arrears for social or political considerations. 49 112. The root cause of these arrears must be understood. Arrears do not simply stem from the unwillingness of SOEs to meet their financial obligations. They grow because SOEs are forced to provide services for which they are either compensated too late, too little or not at all. Anecdotal evidence also suggests that SOEs are also being mined by officials and executives for their own benefit, thus contributing to their cash flow problems. The state needs to acknowledge its part in the arrears problem through the way it arbitrarily mandates pricing and service requirements on SOEs so that a proper understanding of the arrears problem and a sustainable solution can emerge. SOE governance, notably the extent to which government can intervene in operational decision-making and the degree to which boards of directors fulfill their fiduciary duty to their SOE, can have a significant impact on the degree to which the SOE is forced to operate in an uneconomic fashion. 113. Poor governance of SOEs and the absence of a coherent state policy on them also contribute to this poor performance. Weak SOE policy and governance of SOEs is an issue across all branches of government. Chapter 8 discusses governance more broadly but it impacts SOE management in several ways. SOE boards tend to be politicized and dominated by civil servants who do not have the necessary commercial skills, strategic vision and independence to ensure the economic health of the companies for which they are accountable. The governance of Romanian SOEs falls far short of the governance criteria suggested by the OECD Guidelines on SOEs (2005), such as separation of state ownership and other state functions, particularly with regard to market regulation and rules affecting competitive conditions related to access to finance. Among the governance issues SOEs have to deal with are the following: x The state has no formal SOE ownership policy. It is best practice for the state to have a so- called “ownership policy� that provides the framework for the SOE’s governance. The policy details the state’s goals and its approach to SOE ownership. It provides direction on such critical questions as: justification for state ownership; types of companies subject to state ownership; the role of options such as privatization and mixed ownership; requirements for the commercial sustainability of SOEs; the role of shareholder value versus social objectives, and how each takes precedence when tradeoffs are required; the roles and responsibilities of specific institutions including the state, a central ownership unit within the state, the separation of financial oversight from policy oversight, the role of independent regulators; and transparency requirements and disclosure to the public among others. At present, none of these important features are formally defined. x The state’s policy, monitoring and governance functions are not clearly separated from its regulatory functions. National SOEs are governed by ministries, which combine ownership, policy, and in some cases regulatory functions. For example, the Ministry of Economy, Energy, and Business Environment (MEC) and the Ministry of Transport (MOT) administer SOEs but also play regulatory roles. Merging policy and ownership functions creates conflicts of interest, providing fertile ground for ad hoc decision-making in pursuit of policy objectives to the detriment of SOE performance and sustainability. The long-term impact is an inability to sustain pursuit of important policy goals. For example, aluminum, fertilizer, and steel producers buy energy at below-market rates as does the state railway company. To avoid the conflicts of interest that arise from simultaneously being a shareholder (whose duty is to never act contrary to the interests of the SOE) and a policy maker (who aims to achieve social and policy goals that are often at a cost to the SOE), many European and emerging market economies separate ownership and policy/regulatory functions by creating a specialized agency (referred to as an “ownership entity�) that exercises the rights typically attributed to shareholders. In addition, the ownership entity monitors SOE performance (OECD, 2005). In Romania, the Ministry of Public Finance (MoPF) monitors basic information about national SOEs, reviews their annual budgets and is represented on some boards and shareholder meetings. It does not, however, act as a shareholder or an advocate for good governance practices, or monitor performance; as it stands, it already has few resources to meet its current oversight mandate. Best practice (and in some sectors, EU 50 requirements) also call for separating ownership from regulatory functions. The independent energy regulator, ANRE, was established in 1999, but because of sustained budget and political pressure, it was unable to fulfill its role as an independent and professional regulator. In transport, specialized regulators have been established for aviation, maritime travel, roads and railroads, but most power still remains with the MoTI. x SOE public service obligations and responsibilities are not clearly set out in the law or in performance contracts and their costs are not assessed. Most SOEs have either explicit or implicit social objectives, such as providing access to cheap energy. But these objectives are not clearly identified in laws and regulations. Nor are they explicitly agreed to in performance contracts with SOEs. This leads to a situation where SOEs are expected by the state to provide services that are not paid for at the cost required to produce them. Real costs for services provided by SOEs are not made transparent under current accounting standards—unless these standards are International Financial Reporting Standards. Since costs are not compensated, it is common for the SOE’s capital base to erode until it has negative book value. Alternatively, the costs may eventually be passed on to the Romanian budget. x SOEs are often exempt from the application of general laws and regulations. They can be organized as commercial companies, 37 regies autonomes (financially independent SOEs designed to provide public services), 38 or research institutes.39 Most are organized under commercial company law, which also applies to the private sector and sets out rules establishing creditors’ rights and bankruptcy procedures. In practice, these rules seem not to be applied to SOEs. Regies autonomes are by law excluded from application of the bankruptcy or insolvency laws. Their core assets are considered public property that cannot be foreclosed. They can only be privatized if they are first reorganized as commercial companies. x The government micro-manages All SOEs and exercises political influence on their decision making. A serious problem is that state officials are involved in the day-to-day management of the SOE and intervene excessively in SOE operations. The problem with this practice is that state officials rarely have the education, experience or skills to manage enterprises in a competitive environment. Nor can they be held ultimately accountable for SOE performance. When the state dominates the SOE’s operations, social goals tend to take precedence over financial concerns thus predictably putting the SOE in financial jeopardy. Ministry representatives often approve decisions that should be left to a competent and accountable board. Approval and ministry input is often required for decisions that should be taken within the SOE. This occurs even with relatively trivial expenditures or investment. In short, business decisions are at times subject to outright political influence. x Until Emergency Ordinance 109 is fully implemented across all enterprises, and becomes the leading practice thereafter, board nomination processes are not transparent and members often lack the right qualifications. The 2011 Emergency Ordinance on Corporate Governance addressed the issue of how to select well-qualified independent board members. But, because ministries have traditionally nominated directors, it has been difficult for them to fully obey the new established rules. The majority of boards, therefore, tend to still consist mainly of civil servants and/or individuals with close connections to the ministry or to political parties (except for about five enterprises under the Ministry of Transport that have adopted the new process for the selection of board members and managers). As a result, very few board members have significant sector experience, such as the management of a private sector company and lack the expertise needed to successfully oversee a company. They also tend to be vulnerable to political pressure. 37 Law No. 31/1990 on commercial companies. 38 Law No. 15/1990 regulates regies autonomes. Regies autonomes can be found in sectors the government considers strategic, such as weapons manufacturing, energy, mines, gas, postal services, and rail transport. 39 Ordinance No. 57/2002 on scientific research and technological development. The law governing research institutes, including bankruptcy procedures and accounting, is similar to that for public institutions. 51 x Shareholders are not always treated equitably. Romanian law specifies that all shareholders receive equal and fair treatment. Minority shareholders have the right to sue the majority shareholder if its decisions have an adverse effect on the company or on the minority. Still, in several large unlisted SOEs, the only shareholder other than the government is the Property Fund. Moreover, there have been several cases where the state as majority shareholder decided to make donations to the state budget against the interest of the other shareholders. The ability of minority shareholders to contest actions is limited–In only one known case has a minority shareholder successfully exercised their right to redress.40 x The performance of SOEs is not rigorously assessed. Countries with developed SOE governance have SOE management systems that monitor their performance against key indicators and goals set down in their contract with the state. In Romania, few indicators are tracked and ministries lack a sophisticated understanding of the condition or performance of the SOEs they supervise. When indicators are tracked, they do not focus on issues of fundamental importance, such as cash flow, profitability, leverage or other key financial indicators. Also not tracked are such key non-financial indicators as growth or loss in market share and other indicators that would help assessing the SOE’s strategy. Issues such as the level of risk in the enterprise and whether or not effective systems of control are in place are not considered. A 2008 law requires Romanian SOEs to sign a management contract with the CEO, and SOE managers have contracts that mandate that their performance be monitored. Managers who fail to provide monthly data to the Ministry of Public Finance suffer sanctions. 41 However, such contracts with managers are, in reality, top-down directions emanating from ministries similar to 5-year plans under central control. Usually, they do not emanate from management, nor have they been tested for their realism. Finally, the key role of the board in guiding the SOE and holding the management accountable is bypassed by ministries which typically prefer direct intervention. x Few SOEs publish regular financial reports that meet International Financial Reporting Standards (IFRS). SOEs that are listed on the stock exchange or that have assets of at least €365,000, net turnover of more than €300,000 and an average of 50 or more employees have to prepare financial statements according to IFRS. However, only a few, mainly those listed on the Bucharest Stock Exchange or those that have raised funds from international financial institutions (IFIs), do so. Other SOEs produce annual reports with very simple statements that do not comply with IFRS. Furthermore, financial statements may not be audited by capable and reputable audit firms, which are expected to conduct audits in accordance with International Standards of Audit (ISA). The assurances provided by financial reports that are not audited in compliance with ISA are limited. Statements that are not prepared according to IFRS and audited in compliance with ISA are generally insufficient to describe the true condition of the enterprise and pose a significant risk. 114. Lethargic tax enforcement and poor public financial management practices have also undermined SOE economic performance in the past, but there is some improvement. These practices include failure of tax officials to follow up on nonpayment of taxes, lack of budgetary discipline (though that has improved somewhat since enactment of the Fiscal Responsibility Law in 201042), widespread arrears cancellation, especially before 2007, and rent-seeking behavior. 40 ROMGAZ, for example, donated RON 400 million to the government following a decision taken at a shareholders’ meeting in November 2010. A minority shareholder, Fondul Proprietatea S.A, filed suit. On June 1, 2011, the Alba Iulia Court decided against Fondul, which launched an extraordinary appeal in October 2011. The outcome of the court decision is still pending. For more information, see http://www.bvb.ro/infocont/infocont11/fp131011_en.pdf. 41 Emergency Ordinance 44/2011. 42 The Fiscal Responsibility Law (Law Nr. 69/2010) has imposed restrictions on the conduct of fiscal policy, e.g. by limiting the number of budget rectifications, and has mandated appointment of a Fiscal Council to support the government in elaborating and implementing fiscal policy. 52 b. Monitoring SOE performance 115. One of the most important roles of the government with respect to SOEs is to set and monitor their performance objectives clearly and transparently. This should be done in close cooperation with boards and executives. A collaborative and iterative process helps ensure realistic expectations for ministers, their SOE-overseeing units and the SOE board members and executives. The process also forces SOEs to engage in systematic planning and provides a framework for the state to approve SOE activities including funding by government. The Emergency Ordinance requires the Board to prepare an administrative plan within 90 days of its appointment. The administrative plan (the statement of corporate intent or SCI) is submitted for approval to the general shareholder meeting for a commercial company and to the relevant line ministry for regies autonomes. The plans provide the basis for indicators for monitoring and evaluation of the SOE boards and management, and these indicators can be used in the contracts signed with the boards and management. 116. A key element of the government’s supervision process for SOEs is setting realistic performance indicators and targets. They are important because they constitute the benchmark against which board and executive performance is measured. The quality of SCIs and performance monitoring can be improved by selecting the right indicators. While certain indicators such as profitability will be used to assess all SOEs, other indicators may be specific to the SOE or to the sector. The government representative (i.e., the unit overseeing performance of SOEs in the Prime Minister’s office, Ministry of Public Finance’s office, or within a line ministry) negotiates the performance indicators on behalf of the government. This requires that the supervising unit in government must have strong expertise to negotiate challenging and realistic targets, notably: x Focus on a small number of truly fundamental indicators; x Make performance easy to evaluate (avoiding complexity and bureaucracy in measurement) and are audited or auditable information; x Able to deliver results throughout changes in the business cycle; x Focus on outcomes, not processes; x Measure outcomes the SOE management can control and for which they can be held accountable; x Use realistic and precise indicators that are not susceptible to manipulation by SOE management; x Search for and eliminate potential perverse incentives, which are often the result of artificial performance weightings. 117. Performance indicators will likely vary from SOE to SOE. Furthermore, different industrial sectors track different measures. However, some financial indicators are standard across industries and allow for performance comparisons between SOEs. Indicators can be divided into four large categories: 1) profitability; 2) efficiency/return indicators; 3) leverage/solvency indicators and 4) non-financial indicators. These various indicator categories can give users a good understanding of the health of the SOE, how well it uses its resources in generating shareholder value and what its underlying level of risk is. The measures of profitability is the most important to gauge an SOE’s capacity for survival. Some indicators express return or profit as a percentage of equity investment or assets. Such indicators allow comparison to other companies in similar industries. Leverage indicators show how much a business relies on debt in order to operate. High leverage is often considered to be synonymous with high risk while excessively low debt is associated with an inefficient use of capital. Solvency indicators show the SOE’s ability to meet its financial obligations. Finally, sector-specific indicators provide further insight into the quality of operations. It is important to note that not all indicators are purely financial. SOEs should also have measurable non-financial performance indicators such as, for example, the achievement of a certain percentage of market share, or the establishment of a unit capable of professional risk management, improvements in service penetration and customer satisfaction and so on. 53 118. Benchmarking against peers can help bring objectivity and perspective to performance evaluation. The government may use benchmarking to prepare for negotiations on the indicators and independently establish values for performance indicators. Benchmarking creates a frame of reference for SOE performance by comparing performance against peers. It brings perspective to performance evaluation and provides essential information by which to judge whether SOEs are performing efficiently. Peers should be companies from the same industry of similar size, and subject to similar complexity and risk. These peers could be from the private or the public sector. If the SOE is in a sector with no similar public or private sector enterprises, benchmarking should be done with foreign companies active in the same sector. Figure 33 below includes a few strategic steps to take into account when benchmarking SOE performance. 119. Romania uses Public Service Obligation contracting but the system could be improved through better monitoring of service delivery. Public Service Obligation (PSO) contracting is widely used in Europe to provide subsidies to companies to operate services that are seen as being in the public interest and that would not function without the subsidies. It is particularly prevalent in the transport sector to ensure that remote areas remain accessible. The government could improve the use of PSO contracting by (i) ensuring that they are financial sustainable; (ii) ensuring that the services covered represent value-for-money (i.e., that the services are ones that are necessary) and do not exist merely due to historical accident; and (iii) the contracts should link compensation to service quality indicators like on-time performance, trains in good repair, cleanliness, and scores on a periodic customer survey. The contracts provide clear service delivery obligations that can be monitored to ensure the public receives value for money. 120. Increasing transparency in SOE governance is essential. It is essential that the state and SOEs are accountable to the public for their performance. This includes ensuring that SOEs make appropriate disclosure of their activities and performance. At the same time, the government must disclose information on the quality of its oversight of its SOE portfolio and the performance of the portfolio. This should be done through an annual portfolio report, as required by the Emergency Ordinance, which should be made available to the public online. 121. Citizens, the end users of many SOE products, could provide more oversight through the use of score-cards or other ways of increasing their involvement. When an SOE delivers services to the public, be it water, trains or heating, the public itself should be involved in the oversight of the company’s performance. Citizen Report Cards are participatory surveys that provide quantitative feedback on user perceptions on the quality, adequacy and efficiency of public services. They go beyond just being a data collection exercise to being an instrument to exact public accountability through the media coverage and civil society advocacy that accompanies the process. D. RECENT PROGRESS 122. Over the past year the government renewed its efforts to improve the efficiency of SOEs through a comprehensive set of measures, including: x Core corporate governance principles. The government approved in mid-2011 an emergency ordinance that, once fully implemented, would have placed competitive selected professionals in all Boards and management of SOEs. The Emergency Ordinance43 restricts national ministries and local equivalents from intervening in the management of SOE administration and clearly outlines the powers of board members and how they are to be selected. Except for a few ministry representatives, they must be independent and meet basic qualification criteria. The ordinance 43 Emergency Ordinance 109 of State Controlled Companies has been issued and recently ratified by Parliament. It applies to all government-controlled companies and regies autonomes, national or local, except for finance and defense SOEs. 54 requires boards to sign agreements with the ministry that specify performance indicators. Even though it shies away from a clear separation of government ownership and policy and in some cases regulatory functions—leaving, for example, the management of the government stake to line ministries—the ordinance does require close monitoring of SOE performance. All SOEs must publish audited financial reports, and each line ministry has to issue public reports on the SOEs it manages.44 As of early 2013, overall progress in implementing the emergency ordinance has been very slow. The Ministry of Transport has designated new boards and hired professional directors for all key transport companies (e.g., National Airline, railway infrastructure, railway passengers, Constanta port, post-office) although one was reversed (railway infrastructure). However, the achievements of the Ministry of Transport have not been paralleled elsewhere (see Table below for the case of Energy). This is unfortunate since the Emergency Ordinance (despite a few flaws) provides a very good roadmap for SOE performance and one that can work. Status of the implementation of the Emergency Ordinance 109 in the Energy Sector SOEs Independent Board (LDP date) Professional Management Company Initially expected date New expected date Initially expected date New expected date Transgaz EndͲJuly2013 EndͲSeptember2013 Romgaz EndͲSep2012 EndͲJuly2013 EndͲOct2012 EndͲSeptember2013 Electrica Furnizare EndͲJune2012 EndͲJuly2013 EndͲOct2012 EndͲSeptember2013 Hidroelectrica EndͲJune2012 EndͲAugust2013(tbd) EndͲJune2012 TBD(dependsoninsolvencyprocess) SC Oltenia Energy Complex EndͲSep2012 EndͲJuly2013 EndͲOct2012 EndͲSeptember2013 Nuclearelectrica EndͲSep2012 EndͲJuly2013 EndͲOct2012 EndͲSeptember2013 Transelectrica ?? ?? ?? Source: World Bank staff based on government reports x Monitoring SOE arrears. The government has compiled arrears data for about 240 SOEs owned by the national government. An amendment to ordinance 79/2008 requires that, like national SOEs, the regies autonomes and enterprises owned by local governments report to the MoPF quarterly on financial and operational indicators. Reporting arrears, however, is only the first step in the most difficult issue of addressing their root cause. The foundation of the arrears buildup is the requirement that SOEs provide services for which they are not compensated. This makes them unable to pay creditors. This is a systemic problem that must be solved simultaneously in all enterprises. A concerted and forceful policy intervention that goes far beyond the ordinance is therefore called for. x Restructuring and privatizing certain SOEs.45 In 2011, the government prepared an action plan to restructure or privatize some national SOEs. It also moved to enhance the operating efficiencies of SOEs in the rail sector, closing underutilized lines and streamlining operations. Several initial public offerings of shares have already taken place. For instance, in March 2012, the government completed a 15 percent secondary public offering of Transelectrica, an electricity transmission operator, resurrecting privatization efforts in the energy sector that had been moribund since 2006. This year it also completed a similar offering for Transgaz, the operator of the country’s gas pipelines, and is expected to complete one for Romgaz. The government has 44 The MoPF has to prepare a public report for all national SOEs and the Ministry of Interior for all local SOEs. 45 Restructuring and privatization are both tools for improving efficiency, but are radically different. For one, international experience, and experience in Romania, suggests that state-lead restructuring tends to fail, whereas privatization (even though there are lots of examples of failure) tends to work. Restructuring is generally view by experts only as a temporary fix on a problem, while privatization (if well done) is the permanent one. 55 also set out to increase private sector ownership of a number of smaller SOEs (see summary table below for the case of Energy Sector enterprises). Status of the implementation of the Privatization Program in the Energy Sector Enterprises Company Initially expected Completion Date Latest expected date SPO/IPO/Sale Stake Investment Consortium Selected Transgaz SPO–end June 2012 Completed April 2013 15.0% Raiffeisen, Wood & Company, BT Securities Romgaz IPO - mid Sep 2012 IPO: end-Oct 2013 15.0% Goldman Sachs, Erste-BCR, Raiffeisen Electrica * Majority sale- early 2013 Majority sale- End Nov 2013 50% + Contract to be signed by end-April 2013 Hidroelectrica IPO- mid Oct 2012 TBD due to insolvency procedu 10.0% Citi, Societe Generale,BRD,Intercapital Invest SC Oltenia Energy Complex Majority sale- early 2013 IPO- end Oct 2013 12.0% BRD Societe Generale and Swiss Capital Elcen Bucurseti Majority sale- early 2013 TBD (possible concession) concession Not yet started Private distribution companiesRemaining shares sold - early 2013 ** Not yet selected Nuclearelectrica IPO (capital increase)- end 2012 IPO- end 2013 10.0% Wood&Company, Intercapital Invest and Swiss Capital BT Securities Transelectrica SPO- March 2012 No further plans 10.0% BCR, Swiss Capital, Intercapital Invest * Including Electrica Furnizare and the three Electrica electricity distribution companies ** Refers to the remaining shares of electrica in the three privatized distribution companies. Source: World Bank staff based on government reports x The Ministry of Transport and Infrastructure (MoTI) has prepared a set of guidelines for the corporate governance of the SOEs it supervises. The guidelines provide clear directions for the professional governance of SOEs. They envisage an arm’s length supervision of the SOEs in the Ministry’s portfolio as illustrated in Figure 30. The legal bodies that provide governance to state enterprises in Romania are the General Shareholders Meeting, the Board of Directors and the company management. Under the guidelines, the MoTI will be represented in its role as a shareholder by a Shareholder Ownership Unit. The guidelines also elaborate the merit-based process to be followed for the selection and appointment of board members (Figure 31). At present, the Ministry is revising the guidelines and is considering the establishment of a Shareholder Ownership Unit to help in their implementation. Figures 30 to 33 below summarize the recommendations made in the handbook on the structure of corporate governance for SOEs, the Board selection process, the processes of planning and objective setting and benchmarking. These are compatible with best international practice. 56 Handbook recommendations on key SOE corporate governance issues Figure 30: Structure of corporate governance Figure 31: Board selection and appointment process in commercial Romanian state enterprises Figure 32: Planning, objective setting & Figure 33: Principles for benchmarking SOE monitoring process performance 1 Identify relevant peers: It is critical to identify relevant peers with which performanceofaspecificSOEcouldbecomparedmeaningfully.Thechoice ofpeersshouldbediscussedwiththeSOEboardandexecutives. 2 Develop relevant industry research: It is useful for the Unit in the Government (or the Ministry) to develop relevant industry knowledge, or to haveaneasyaccesstosuchknowledge,atleastforitslargestSOEs. 3 Collect performance information for peers and compare it with actual performance: The SOU should collect relevant industryͲspecific indicators, both financial and nonͲfinancial. Performance should then be compared to thepeergroup. 4 Interpret comparisons: Identify performance gaps and derive areas of potential improvement. Appropriate consideration should be given to the differencesamongtargetedpeers,includingthoseconcerningtheregulatory environment. Source: As recommended in the Ministry of Transport and Infrastructure’s draft guide for governance of state-owned enterprises (mimeo as of December 2012). Note: these processes are actually not followed yet in any ministry. E. OPTIONS FOR REFORM 123. While these recent reforms represent a step in the right direction, there is a considerable way to go to fully address the deficiencies in the SOE sector. In this regard, if Romania doesn’t follow a steady and firm path on improving the performance of SOEs, the consequences will be disastrous in the short term and possibly for generations. The OECD and a handful of other organizations 57 including the World Bank have done research on best practices for improving SOE performance and the lessons of this work could be applied quickly. Most of these assessments are embodied in the draft SOE guidelines of the MoTI which can be easily applied to SOE under other ministries (See Box 7).Recommended short-term reforms include: i. Professionalize SOE governance x Fully implement Emergency Ordinance No. 44 on corporate governance across all SOEs, including the appointing of independent, professional, experienced and qualified members of the boards (and executives) based on a transparent nomination and selection process. x Streamline reporting requirements by SOEs and their budget approval process by simplifying Law 329 and Emergency Ordinance 73 of 1998 (and other related pieces of legislation). x In parallel, grant greater autonomy to board members and management and enhance their accountability by subjecting them to performance reviews (through their Boards of Directors) based on the formally agreed strategic plans. x Introduce mandatory independent external audit for all SOEs by reputable auditing companies. Audits must be conducted according to International Standards for Auditing (ISA). x Ensure that financial reporting of SOEs is made on the basis of IFRS standards, which is needed for the state organ responsible for asset management as a basis for evaluating financial and operational performance. Accordingly, ensure fiscal reporting requirements are not burdensome. x Ensure a high level of transparency and disclosure in financial information and operational decisions to ensure financial and operational information is timely and up to date, and to detect potential problems early. ii. Professionalize the state’s oversight role x Establish a central SOE ownership entity to exercise the shareholder rights of the state, help professionalize the state’s oversight and assist in holding SOEs accountable. x Elevate the guidelines prepared by MoTI to the national level to systematically address issues that go beyond the scope of the ordinance and to detail how to handle core governance like performance management, division of responsibility between board and ministries, and the evaluation and wages of management. x Establish a clear division between the state’s functions as a shareholder of the SOE and the implementation of its policy objectives via the SOE. Shareholder responsibilities including overseeing that the board nomination process should be fully in the hands of the ownership entity. The negotiation of policy objectives may be retained by line ministries. x However, line ministries must maintain an arm’ length relationship with SOEs and should be prohibited from direct intervention in SOEs. Ministries should under no circumstances directly manage the SOE, and should engage with the SOE only via a professional board of directors. x Ensure that boards are first and foremost responsible for ensuring the performance of the SOE, and are accountable to shareholders (including the State). x Develop and implement rules and procedures that regulate the interaction between the state and the SOE including ensuring performance assessment of boards and executives against agreed performance criteria. iii. Streamline the role of the government in industrial or service sectors x Set clear and transparent criteria for determining whether an enterprise should remain state- owned, be privatized, or be subsidized in the event the political decision is unclear. x Initiate privatization (majority shares) to strategic investors for those enterprises that could be better run by private sector operators or are in need of major infrastructure investment. 58 iv. Build capacity systematically x Launch training programs for SOE board members, executives, financial market regulators, and ministries staff involved in SOE-related issues to ensure the governance and management of SOEs contributes to the Government’s objectives. x Increase financial market integration (which will provide additional information and benchmarks for ongoing refinement of approaches and standards). x Work with the financial sector partners (including the stock exchange for listed SOEs) to enhance capacity of managers, SOE units in central and line ministers and all other key players. v. Reduce SOE arrears systematically x Ensure that mechanisms are in place to prevent future accumulation of arrears by SOEs as required by the EU Directive 2011/7 on late payments. x This will require broad-based reforms, such as deregulating prices in the energy sector and renegotiating or terminating contracts that provide for preferential treatment or require the provision of products or services at below market prices. These recommendations would have to be supported by broader regulatory reforms as discussed in chapters 4, 6 and 7. x Also needed is a hard budget constraint on SOEs and moving nonviable SOEs into bankruptcy. The intent is to hold SOEs accountable and improve their performance. Box 7: List Authoritative Papers on Best Practice Corporate Governance for SOEs OECD Guidelines on Corporate Governance of State-owned Enterprises http://www.oecd.org/corporate/ca/corporategovernanceofstate-ownedenterprises/34803211.pdf OECD Principles of Corporate Governance http://www.oecd.org/corporate/oecdprinciplesofcorporategovernance.htm OECD Accountability and Transparency: a Guide for State Ownership http://www.oecd.org/daf/ca/corporategovernanceofstate- ownedenterprises/accountabilityandtransparencyaguideforstateownership.htm OECD Competitive Neutrality: Maintaining a level playing field between public and private business http://www.oecd.org/daf/ca/competitiveneutralitymaintainingalevelplayingfieldbetweenpublicandprivateb usiness.htm UNCDTAD Guidance on Good Practices in Corporate Governance Disclosure http://unctad.org/en/pages/PublicationArchive.aspx?publicationid=261 BICG Baltic Guidance on the Governance of Government-owned Enterprises http://www.ecgi.org/codes/code.php?code_id=298 BICG Governance of State-Owned Enterprises in the Baltic States http://corporategovernance.lt/uploads/docs/Governance%20of%20State- owned%20Enterprises%20in%20the%20Baltic%20States.pdf 59 4. THE COMPETITION AND REGULATORY ENVIRONMENT Improving the business environment will attract new firms, weed out inefficient ones and enhance Romania’s growth potential. The first priority is to reduce the dominant role of the state in the economy, in particular in transport, energy, and communications and give the Competition Council the tools it needs to increase competition. In terms of business environment, while Romania performs well in terms of the ease of starting a new business, it compares poorly to the EU and even globally in terms of the number of tax payments and construction permits required. Quick wins can therefore be obtained by reducing the cost of tax compliance and streamlining construction regulations. More generally, a program to systematically improve the investment climate (horizontally for all businesses, vertically in key economic sectors and regionally to enhance local competitiveness) is essential. A. INTRODUCTION 124. Excessive business regulation can divert resources from production to compliance, constraining productivity (Crafts, 2006). The regulatory environment has been recognized as a crucial driver of productivity differences across countries as inappropriate regulation can weaken incentives to invest and to adopt new technologies. This limits the positive effects that an increase in competition can have on productivity enhancements (Anos Casero and Udomsaph, 2009). In the EU context, aligning the regulatory environment with EU standards is essential to enable national firms to compete within the single market. 125. For Romania, as for other EU members, the mainstay of EU integration was regulatory convergence, driven by enactment as national legislation of the acquis communautaire. The objective of legislative harmonization is to dismantle legislative and regulatory barriers that may impede the free flow of people, goods and capital across member states in order to reap the benefits of a single European economic space. Starting in 2004, after a decade in which not much was achieved, Romanian lawmakers accelerated incorporation of the EU acquis into national legislation. In the years immediately preceding accession in 2007, most laws and regulations were aligned with EU directives, and public agencies were revamped to meet EU standards. 126. Following accession in 2007, however, many of the recent reforms were reversed or not fully implemented. Although there was formal alignment with EU legislation, both official and informal barriers to entry by foreign and domestic firms into potentially competitive markets remained pervasive, leading to excessive market power in several sectors – with negative consequences for productivity. Lack of competition and a generally poor regulatory environment, along with shortcomings in areas like transport (see Chapter 6), labor market regulations, and worker skills (see Chapter 7), have created an unreliable framework for the functioning of markets and limited the ability of businesses to export, invest, innovate, create quality jobs and compete. 127. This chapter analyzes the competitive environment in Romania, reports ways in which it affects productivity and other variables, and proposes short- and medium- term reforms. 60 B. CURRENT STATUS AND CHALLENGES A. Causes of an anti-competitive environment 128. Romania’s competitive environment compares badly with that of other EU countries, for three primary reasons: restrictive regulations, unreliable enforcement of rules and widespread state participation in the market. i. Restrictive regulations 129. Regulations in Romania are among the most restrictive of competition in the EU. The OECD’s Product Market Regulation (PMR) indicators rate the degree to which regulations restrict competition on a scale of zero (least restrictive) to six (most restrictive). They measure officially adopted policies, not implementation or enforcement.46 Of the 22 EU countries rated in the most recent survey, Romania ranks 20th for the economy-wide indicator (Figure 34); only Poland and Greece score worse. The 2012 Doing Business survey ranks Romania 72nd out of 183 countries—down from 65th in 2011 47 — on ease of doing business. This is below neighboring Bulgaria (59th), Poland (62nd), and Turkey (71st). Up to EU accession, Romania had been classified by Doing Business as the second most active reformer, but the country now seems to be lagging significantly behind many similar countries when it comes to improving the business environment. 130. Romanian regulations related to starting a business are particularly onerous. Romania’s ranking on the Doing Business indicator for starting a business fell from 31st in 2011 to 63rd in 2012, and it compares poorly with its neighbors on regulations and administrative procedures that are likely to affect new and expanding businesses. (For example, Doing Business 2012 ranks Romania 123rd out of 183 countries for dealing with construction permits.) This area is particularly important because new market entrants stimulate competition and thus raise productivity and encourage innovation. According to the most recent BEEPS survey (2009), Romanian firms are more likely than those in countries to cite business licensing as a major constraint to doing business (Figure 35). Also worrisome for new and expanding companies is the fact that at it takes 287 days to obtain a construction permit, far above the OECD average of 152. Romania ranks 123rd out of 183 countries rated. (Doing Business 2012). ii. Lax enforcement of rules 131. Other EU countries seem more committed than Romania to enforcing regulations and competition policy (Figure 36a). The Romanian Competition Council (RCC) is charged with guaranteeing market competition by enforcing compliance with the law. A World Bank review in 2010 showed that the RCC was less effective than its EU counterparts, partly because of some of its work practices (World Bank, 2010d). For example, just 5 percent of staff resources were dedicated to econometric analysis, which can help to demonstrate collusion and quantify damages, compared with about 15 percent for the best-performing agencies in Europe. This was largely because the RCC lacked the funding to attract the talent it needs. Also, unlike in the best-performing agencies, staff tended to be grouped by economic sector (manufacturing, retail, construction, etc.) rather than business activities (mergers, cartels, etc.), a practice that makes it difficult for staff to specialize, which in turn reduces the RCC’s efficiency. In 2010, it was completing review of fewer cases than any other EU country surveyed, 46 The PMR system covers three main policy areas: state control, barriers to entrepreneurship, and barriers to trade and investment. Its structure is composed of 18 basic indicators that each capture a specific aspect the policy environment and that are calculated on the basis of qualitative and quantitative information. The PMR information presented in this chapter reflects 2011 data for Romania and 2008 information for all EU comparators. For a discussion of PMR indicator methodology and a detailed analysis of the 2011 results for Romania see De Rosa, Iootty, Pirlea, Aprahamian, and Stanescu (2012). 47 Using the comparable 2012 criteria. See Doing Business (2011). 61 both in absolute terms and as a percentage of cases opened (Figure 36b). There was also evidence of a lack of timely resolution, which reduced the benefit of an RCC intervention. Figure 34: Product market regulation, EU Figure 35: Business licensing as a major constraint countries (percent of firms) Note: the vertical axis in Figure 34 denote go from zero (least restrictive) to six (most restrictive). Source: De Rosa, Iootty, Pirlea, Aprahamian, and Stanescu (2012). 132. Since 2010, however, there have been positive changes at the RCC. One major improvement is the allocation of specific staff to enforcing the cartel law. An internal mechanism for prioritizing cases also now helps the RCC to focus on those it has the best chances of bringing to closure. As a result of the review, efforts were also made to finalize the most delayed cases. However, about one-third of the staff is still assigned to territorial offices, where the incentive is to open local cases rather than those with national reach. Evidence also suggests that local staff is less productive than staff at RCC headquarters. Since the 2010 review, Romania’s ranking on ‘effectiveness of anti-monopoly policy’ in the Global Economic Forum perceptions-based index has even declined, from 66th to 93rd which suggests that enforcement of regulations and competition policy seems to have worsened. Romania’s recent ranking compares badly with such neighbors as Hungary (77nd), Poland (49th), and Slovakia (53rd), though it fares better than Bulgaria (119th). Figure 36: Enforcement of anticompetitive business practices rules, 2008 Source: European Case Statistics; Taken from Romania Competition Council Functional Review 2010. 62 iii. State Control of the Economy 133. The state’s control over a significant share of the economy (Figure 37) has detrimental effects. The Product Market Regulation (PMR) indicator for state control of the OECD covers five policy areas: scope of public enterprise, government involvement in network sectors, direct control over business enterprise, price controls, and use of command-and-control regulation. According to this indicator, Romania is the 4th most restrictive of 22 EU countries, surpassed only by Greece, Portugal, and Poland. In total, SOEs represented 11.5 percent of value added in the economy (Fiscal Council, 2012). The state controls at least one company in 16 economic sectors, including upstream sectors like gas, electricity, telecommunications, rail, road and water. In 2010, the operating income of the 10 largest SOEs represented 4.6 percent of GDP.48 The government’s share in the largest enterprise in many network industries is significantly higher than the EU average, especially for gas production and transmission, air transport and telecommunications. This is reflected in the poor ranking of Romania on the PMR indicator for government involvement in infrastructure (Figure 38). Excessive state interference in the economy is particularly detrimental because it tends to be inefficient (see Chapter 4) and reduces competitiveness. SOEs tend to be less transparent than private companies and their close relationship with the government blunts the enforcement of regulations. The negative impact of state inefficiency on the private sector can be seen in the 2012 Doing Business survey, where Romania ranks 165th out of 183 countries in the ease of “getting an electrical connection.� Inefficient SOEs act as a brake on business growth and reduce competition. Figure 37: PMR, State control of economic Figure 38: PMR government involvement in activity, EU countries infrastructure Note: Vertical axis go from zero (least restrictive) to six (most restrictive). Source: De Rosa, Iootty, Pirlea, Aprahamian, and Stanescu (2012). b. Consequences of the poor competitive environment i. Price distortions 134. Lack of competition means Romanian consumers and firms pay more. In many sectors, price-cost mark-ups (PCMs) are higher in Romania than in comparable countries, resulting in significantly higher cost to consumers and downstream sectors. In construction, which during the boom benefited from a large credit-fueled increase in demand, only Greece and Slovakia today have higher PCMs in the EU (see Figure 39), and Romania’s PCM is twice as high as Bulgaria’s. Estimations using Eurostat data show that between 2000 and 2008, construction output grew about 50 percent faster in 48 The top 10 network SOEs in 2010 were Electrica Furnizare, Romgaz, Hidroelectrica, Caile Ferate Romane, Translelectrica, Nuclearelectrica, Posta Romana, Transgaz, TAROM, and Electrica Serv. Including Petrom and Romtelecom, which are not majority publicly owned, the operating income to GDP ratio increases to 8 percent. 63 Romania than in Bulgaria. In the transport, storage, and communication sectors, where SOEs control a significant share of the market, particularly in urban, rail, and air transport (see Chapter 4), Romania’s PCM is higher than that of any other EU country except Greece. 135. However, Romania has the lowest PCM in the EU for electricity, gas, and water supply because price controls prevent companies from recovering their costs. This has a number of detrimental consequences: the sector swallows state subsidies, diverting resources away from critical and poorly funded areas like health and education; the controls discourage private investment in cleaner and more efficient energy-generating facilities; and they discourage potentially efficiency-stimulating FDI. In the long run, the latter two problems will increase electricity generation costs, which will negatively impact households and downstream industries. The lack of competition in key industries has negative trickle-down effects on other sectors, making them less competitive both domestically and internationally. Figure 39. Price cost markups by country: 2003-08 averages, selected sectors Source: De Rosa, Iootty, Pirlea, Aprahamian, and Stanescu (2012). ii. Poor quality private investment 136. Romania’s barriers to FDI are rated higher than the EU average by the OECD’s PMR index (Figure 41) and barriers to trade and investment are ranked even higher (Figure 40)49 . In the current economic environment, Romania cannot afford to discourage potential investors with burdensome regulation, especially in the presence of other negative factors like inadequate transport infrastructure, corruption and lack of a suitably skilled workforce. 137. Restrictive regulation and a lack of real competition discourage FDI in Romania. FDI is a function of numerous complex determinants, such as a large and growing internal market, good transport (see Chapter 7) and communication networks, an appropriately skilled labor force and a well-regulated 49 The PMR barriers to trade and investment indicator covers four policy areas: barriers to FDI, tariffs discriminatory procedures, and regulatory barriers. 64 labor market (see Chapter 5). Capaciu (2011) found that FDI in the tradable sector is positively related to the quality of competition policy legislation; investors also appear to value high-quality competition policy. In the energy sector, the Romanian Foreign Investors Council (2011) has underscored the importance of regulation that sends the right investment signals and that is evenly applied to all companies in the sector. Fair competitive practices and the real political independence of regulators also help to attract investment. FDI in Romania from EU partners increased during the boom years and inflows represented between 6 and 9 percent of GDP in each year between 2004 and 2008. Nonetheless, among the EU-10 countries, Romania continued to have the lowest per-capita inward FDI. Figure 40: PMR - Barriers to trade and investment Figure 41: PMR - Barriers to FDI Note: The vertical axis go from zero (least restrictive) to six (most restrictive). Source: De Rosa, Iootty, Pirlea, Aprahamian and Stanescu (2012). Figure 42: Pre- and post-crisis (2009) FDI stock per capita (Euro) 10,000 9,000 8,000 7,000 6,000 2009 5,000 2011 4,000 3,000 2,000 1,000 0 BG CZ EE LT LV HU PL RO SL SK Source: Eurostat, Own Calculations and Copaciu (2011). * Country short-forms used are: BG=Bulgaria; CZ=Czech Republic; EE=Estonia; HU=Hungary; LT=Lithuania; LV=Latvia; PL=Poland; RO=Romania; SL=Slovenia; SK=Slovak Republic. 65 iii. Uncompetitive exports 138. Questionable regulation, lack of competition and the brakes these put on FDI lower productivity and competitiveness. Romania’s manufacturing productivity, for instance, is 10 to 20 percent lower than that of most EU-10 countries. Though foreign-owned firms drive productivity growth in many other EU-10 countries, in Romania they have been growing more slowly than domestic firms. Romanian companies that are exposed to competition are more productive than other firms and create more jobs: those exposed to intense domestic competition are 3 percent more productive on average, and those exposed to international competition are 11 percent more productive.50 An analysis of the impact of competition (proxied by PCM) on productivity found that a 10 percent PCM drop over the average margin of 23.3 percent for 2003–2008 would have accelerated Romanian labor productivity by 3.6 percent a year (De Rosa, Iootty and Pirlea, 2012). 139. Less-productive firms struggle to compete in export markets. An analysis of Enterprise Survey data for Romania finds that the more productive a firm is, the more likely it is to export (Figure 43). It is likely that only highly productive firms can afford the substantial sunk costs required to enter export markets. The lack of competition at home means that Romanian firms are not pushed to become export-competitive, even if the regulatory environment would allow them to do so. Similarly, Porter and Sakakibara (2004) found that Japanese firms that are in highly competitive industries at home also perform well in international markets; firms that do not have the discipline and experience of intense competition at home struggle to compete internationally. Romanian firms in noncompetitive sectors may similarly find it difficult to compete abroad. This will make it harder for the economy to integrate more closely with EU markets, which will result in slow productivity growth and insufficient job creation. Figure 43. Contributions of measured variables to export propensity (Percent) Source: Peña (2012). C. RECENT PROGRESS 140. In the run-up to joining the EU in 2007, the Romanian Government significantly improved the formal regulatory and competitive frameworks. The EU acquis were incorporated into national legislation and laws and regulations aligned with EU directives. Notable improvements included the adoption of a “silence-is-consent� rule and the introduction of one-stop shops. The silence-is-consent 50 In terms of total factor productivity; see Peña (2012). 66 rule can reduce the uncertainty businesses face when waiting for administrative decisions and increase the efficiency of public administration, and one-stop shops may help speed up business registrations. The government also made efforts to better communicate rules and procedures to stakeholders. The energy sector saw the unbundling of companies and the privatization of gas and electricity distribution firms, which made room for competition in subsectors that were not natural monopolies. The national oil company, Petrom, was privatized. 141. However, EU accession is what motivated the reform agenda; once Romania became a member state, many reforms were not fully implemented or were dropped altogether. Some steps to improve regulation or the competitive environment were even reversed: notably, the energy regulator, ANRE, lost its independence.51 142. Efforts to improve the competitive environment have recently been rejuvenated. Particularly to be commended are steps to introduce competitive market pricing and curb public subsidies in the energy sector; the introduction of electronic filing of tax returns and other increases in the use of e- government services, which will reduce compliance costs for firms; and improvements in the organization of the RCC to increase its efficiency in applying competition-related laws. However, significant further efforts are needed in areas related to the competitive environment. 143. If Romania will reform its regulatory and competition framework, it will reap the benefits of growth and convergence toward EU living standards. This will occur through several channels. First, a more competitive environment will benefit Romanian consumers and downstream production as costs fall. Second, fairer application of regulations and reduced state involvement in the private sector will encourage private investment, foreign as well as domestic, which will increase competition and productivity. Third, a better business environment will reduce costs for firms and make it easier for new firms to enter the market and for efficient ones to expand, again increasing competition. Fourth, increased competition will raise productivity as firms reduce costs and become more efficient. It will also stimulate growth and employment as more efficient firms enter the market and become more active. Finally, enhanced productivity will help Romanian firms to compete in international as well as domestic markets, which should boost exports. D. OPTIONS FOR REFORM 144. Achieving this vision will require reforms that encourage investment in the most productive sectors, increase competition and reduce business costs. A medium- to long-term reform agenda is required, but efforts can be made to improve the business climate today. Potential key short- and medium-term reforms are: x Establish a “deregulation commission� that is mandated to identify and remove the most cumbersome regulatory barriers to business entry and operation. A “regulatory chop� to reduce onerous licensing regimes and problems obtaining construction permits would make it easier for productive firms to expand and new firms to enter the market. It would also reduce motivation and opportunities for corruption. x Promote the use of e-government services to improve state interaction with businesses. E- government can help to reduce the cost to businesses in both and money of complying with regulations. It also minimizes direct contact between public officials and economic agents, which reduces the opportunities for improper behavior. The task in the short term is to lay out the strategy and goals to build toward over the medium term. 51 It regained its independence in October 2012. 67 145. Reforms options over the medium term, include: x Reduce the presence of the state in network industries like energy and transport. An invasive state presence is not conducive to fair competition, innovation, and cost reduction. It discourages badly needed private investment because firms are not confident that the rules will be applied fairly. Reforms required in the energy and transport sectors are discussed in more detail in the following chapters. x Minimize business regulation. To prevent unnecessary burdens on businesses from new regulations, enact a law, similar to that of the United Kingdom (UK) to require that any new regulation that places a cost or time burden on businesses must be counterbalanced with equivalent reductions in regulatory burdens. x Ensure that regulations are fairly applied to all firms, whether private or state-owned, in all sectors. To do this, RCC investigative powers and capacity to tackle hard-core cartels may need to be reinforced. This will invite private investment in sectors with SOE presence because the playing field will be more level. Thus, the government needs to eliminate discretionary rules, apply regulations fairly to all firms, whether private or state-owned, and strictly enforce anti- monopoly regulations. 68 69 5. LABOR AND SKILLS To meet the ambitious targets of the Europe 2020 strategy, Romania needs to continue to upgrade the skills of its work force. In the short term, the focus should be on the alignment of education services delivered at the pre-university, technical and vocational, and tertiary levels with labor market requirements. At the same time, it would be relatively simple to align the relevance and effectiveness of special training programs with employer needs. Two medium-term reform agendas could also be initiated: (i) improving the institutional set-up for the sector by increasing the capacity of the Ministry of Education to focus on its core function, and enhance operational efficiency and accountability in the system; and (ii) steadily addressing quality issues while paying special attention to rural education and disadvantaged groups. The magnitude of these two set of reforms should not be underestimated. A. INTRODUCTION 146. Human capital is vital for economic growth. Endogenous economic growth models give human capital accumulation a primary role in both theory (Lucas, 1988) and practice (Barro, 1991; Sachs and Warner, 1997). Education and skills, including ‘soft’ (i.e. generic or transferable) skills (Heckman and Kautz, 2012; Sondergaard and Murthi, 2011), will be central to raising Romania’s productivity to EU standards. 147. Romania faces two major labor market challenges: raising the employment rate and upgrading the skills of its workforce. Increasing employment will boost growth by bringing people into the productive sector. An upgrade of worker skills will help to ensure that they are more employable and more productive by making it easier for them to adapt to the new technologies that modern industries require. 148. At less than 60 percent, Romania has one of the lowest rates of labor market participation in the EU-10. Making it easier for firms to hire workers and more attractive for workers to enter the labor market would help to increase the employment rate. Raising the employment rate is essential to counter the effects of a declining population and an aging workforce. But existing regulations have not yet been adapted to an aging workforce and keep employment rates low. In addition, wages increased significantly more than did productivity, especially in the public sector, eroding competitiveness in some sectors and discouraging hiring. A step in the right direction was taken with the amendment of the Labor Code in 2011 to allow for some increased use of fixed-term contracts and part-time employment. Though this seems to have had beneficial effects, it is still too early to evaluate the full impact. Efforts could be made to encourage part-time work or job sharing during extended training periods. This could involve an expansion of vocational training for the young but also allow and encourage older workers to remain in the labor market for longer and ensure their skills are relevant. 149. Upgrading worker skills will make them more employable. The 2009 Enterprise Survey showed that finding employees with appropriate skills is one of the three biggest concerns about doing business in Romania. Students routinely leave schools and universities without the skills that employers require. Despite this, the percentage of firms that provide training in-house is among the lowest in the EU, and only slightly over 1 percent of the adult population is engaged in continuing education, the lowest percentage in Europe. These facts suggest gaps that need to be bridged if Romanians are to acquire the skills they need to compete better at home and abroad. 150. Undermining efforts to deal with these challenges is the lack of information on worker skills and job-matching, a process that the Ministry of Education is rightly addressing. Until mid-2012, little was known about what skills students acquire in the education system or what skills employers are demanding but are unable to find. This made it very difficult for both policy makers and educational establishments to better respond to a rapidly evolving labor market. In 2012, the Ministry of Education 70 conducted several labour market forecasts and based on these, the structure of the prospective demand was forecasted on various fields of the vocational and technical education (pre-university) at national level – but adjusted to local level realities based on various consultations with local communities. An Action Plan (AP 2011) was produced, which is now monitored regularly by the Strategy and Policy Unit of the Ministry. Further, in 2013 the jobs-absolventi.ro platform was launched to gather data on the employability of higher education graduates, which suggest Romanian graduates find jobs easily abroad (e.g., in medicine, oil and gas engineering, mining). These are positive steps for an evidence-based policy making by both, the Ministry of Education and the Ministry of Labor). They should facilitate the exploitation of the complementarities between the efforts to improve education and skills and those directed at enhancing competitiveness in the product and labor markets. B. CURRENT STATUS AND CHALLENGES a. Labor market i. Employment and unemployment 151. Romania’s large pool of underemployed labor could be tapped to boost economic output. Its employment rate, among the lowest in the EU throughout the boom years, stayed relatively constant, fluctuating between 57.6 and 59.0 percent (see Figure 44). They are especially low for adults in the poorest quintile even after controlling for skill indicators such as education. Other countries saw employment jump during the boom, but not Romania. Similarly, when employment rates collapsed in most EU-10 countries during the crisis, the Romanian employment rate moved very little. About one- quarter of those employed work in agriculture, where they are considerably underemployed, exacerbating the failure to use labor resources efficiently. 152. Faster population growth among the Roma than in the general population has labor market implications. Due to higher birth rates among the Roma than in the general population, the Roma represent a growing proportion of the Romanian labor market. Although they are only about 8 percent of the total population, Roma represent about 20 percent of new labor market entrants as they tend to be younger.52 Failure to mobilize human resources effectively–including among minorities such as the Roma lowers potential output and delays convergence with EU living standards. It may also increase inequality, because those who cannot access the labor market cannot benefit fully from economic growth. Figure 44: EU10 employment rates, 2002–11* Figure 45: EU10 unemployment rates, 2002–11* Source: Eurostat. * Country short-forms used are: BG=Bulgaria; CZ=Czech Republic; EE=Estonia; HU=Hungary; LT=Lithuania; LV=Latvia; PL=Poland; RO=Romania; Sl=Slovenia; SK=Slovak Republic 52 For a full discussion on the need to ensure Roma inclusion in the labor market see De Laat and Bodewig (2010). 71 153. Compared to other countries in the Figure 46: Romanians with upper secondary and region, unemployment, like employment, was tertiary education remarkably stable during both the boom and the 2002–2011 (Percent) crisis. Unemployment fell from 8.0 percent in 2004 to 5.8 percent in 2008—a small decline compared 71 with neighboring countries, although the initial rate of unemployment was low (see Figure 45). 66 Similarly, during the crisis, comparable countries Uppersecondary saw steep increases in unemployment (over 6 61 Uppersecondaryortertiary percentage points on average between 2008 and 2010), yet in Romania it increased by only 1.5 56 percentage points despite a cumulative increase in 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 GDP over the period of over 8 percent. During the crisis, emigration seemed to act as a safety valve, Source: Eurostat minimizing increases in unemployment, but given labor market conditions in major destination countries, this safety valve will undoubtedly close as job opportunities there dwindle. Box 8: Emigration One reason the Romanian population is declining is emigration, mostly by the working-age skilled—a serious problem given how important they are for sustainable economic growth. The population declined from 22 million in 2002 to an estimated 19 million in 2011.53 A large number of Romanians, taking advantage of access to EU labor markets, chose to emigrate. Workers with less education tended to go to Italy and Spain, where they are concentrated in the construction and home help sectors. Workers with more education tended to go to Germany, the UK, the United States, and Canada. A recent survey conducted by the International Agency for Source Country Information (IASCI) and the Soros Foundation of Romania showed that migrants are increasingly well-educated. During the boom years, the proportion of the population with upper secondary or tertiary education rose from 65 percent in 2002 to 70 percent in 2008 (see Figure 46) but stalled during the recession. Romania needs to keep its skilled workers if it is to become integrated into sophisticated European production networks. The return of emigrants presents both risks and opportunities for the country. According to the 2010 World Bank Bilateral Migration Database, some 2.8 million Romanians live abroad. A large-scale return could increase unemployment and create social problems for Romania. However, correctly managed, the return of these workers could also benefit the economy. Those who took the risky choice of emigration to improve their lives are likely to have qualities that can be positive for the economy; those who return are likely to have picked up both hard and soft skills that Romanian employers will find useful. The recent IASCI-Soros Foundation survey of Romanian emigrants suggests, for example, that they tend to me more entrepreneurial. Efforts to encourage them to use their skills and entrepreneurial instincts in Romania could be fruitful, for example, by improving the business climate for SMEs. 53 Preliminary data. 72 ii. Employment by sector 154. Since 2000, Romania has experienced a major change in allocation of workers toward more-productive sectors, boosting economic growth. The proportion of the workforce in agriculture, which is comparatively unproductive, fell from 35 percent in 2002 to 26 percent by 2010. The drop was particularly steep during the crisis years (see Figure 47). During the boom, workers tended to move to sectors that drove economic growth: between 2002 and 2010, the share of employment in construction increased from 4 percent of GDP to 9 percent. In the wholesale/retail sector, it increased from 16 percent of GDP to 21 percent. Interestingly, despite the steep declines in output in these sectors during the crisis, they continued to absorb labor through 2010. 155. Reallocation of labor from less to more productive sectors helped boost economic growth during both the boom and the recession. Between 2002 and 2010 labor reallocation contributed an average of about 2 percent a year to total growth (Figure 48); the rest was generated by increases in output per worker within sectors. The positive contribution of labor reallocation held even during the recession as workers continued to leave agriculture for more productive sectors. Figure 47: Share of employment by sector Figure 48: Contributions of Within-Sector Growth and Labor Reallocation 100% Public 10% admin/community 16% 16% 15% 16% services; household 90% activities 8% Financial Demographic 3% 4% 5% 5% intermediation; real change 80% estate 6% 16% 17% 70% 19% 21% Wholesale/retail; 4% Employment rate 4% hotels/ restaurants; 60% 5% transport 8% 2% 9% Construction 50% 22% Structural change 21% 20% 0% 40% 21% 4% Manufacturing 3% -2% 30% 3% Within sector 3% -4% growth 20% Other Industry 35% 33% 30% 26% 10% -6% Average per Agriculture; fishing capita growth 0% -8% 2002 2005 2008 2010 02-05 05-08 08-10 02-10 Source: Eurostat and World Bank staff calculations. iii. Productivity and wages 156. During the boom, labor costs rose much faster than productivity. Between 2000 and 2008, output per worker-hour increased by about 50 percent, in line with economic growth, yet unit labor costs per hour nearly tripled (see Figure 49). This eroded competitiveness in tradable goods and partly explains the shift from tradables to nontradables during the boom (see Chapter 1). For example, the industrial sector declined as a share of GDP from 28.1 percent in 2005 to 25.8 percent in 2008. Not only did exports fail to grow as a percentage of GDP, but between 2004 and 2008, they actually fell from 31.1 to 24.1 percent of GDP, partly because of the loss of competitiveness. Since 2008, both public and private sectors have shown wage restraint and the country has begun to reap the benefits in terms of exports, which reached 33 percent of GDP in 2011—perhaps a nascent industrial rejuvenation. 73 157. Increases in public wages drove wage inflation and made it difficult for the private sector to compete for high-caliber employees. The IMF (2007:220; 2008:210) warned that large increases in public pay were driving wages up; between 2005 and 2008, public-sector wage increases outstripped increases in most other sectors (Figure 50). Between 2000 and 2008, only employees in science and technology saw their wages increase faster than public servants. Public wages fell in 2010 after a 25 percent cut in nominal wages, but the Constitutional Court partly reversed the cut in 2011 and wages were fully restored by the end of 2012. Figure 49: Index of real compensation per Figure 50: Average gross nominal wages index by hour versus output per hour sector 300 1000 Agriculture Manufacturing 900 Energy 250 800 Construction 700 Retail 200 Transport 600 Mail 150 500 Hotel/Restaur 400 ICT 100 300 Finance Science/Tech 200 50 Compensation per hour Administration 100 Output per hour Education 0 Health/SocSec 0 2000 2002 2004 2006 2008 2010 Culture 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Public sector Source: Eurostat, World Bank staff calculations Source: Haver Analytics. b. Education sector 158. An educated and skilled population is fundamental to a competitive economy. It enables companies to compete by being more efficient, adopting new technologies and innovating. As the world production system evolves, the profile needed to compete is changing toward more demanding skills that focus more on problem-solving abilities than on routine tasks. Over the last decade Romania, like neighboring countries, has seen a shift in occupation and skills matchups. This will continue and the country needs to be prepared. However, a better understanding is required of the types of skills—not just education—that are required. 159. The educational level of Romanians has been evolving, but not fast enough, and access to education is unequal. Today’s 20-44-year-olds are somewhat more educated than their elders: they average 12.2 years of schooling compared to 10.7 years for 45-50-year-olds. This rate of improvement means that the implicit increase in average skills over the next 20 years will be slow. Moreover, given concerns about the quality and adequacy of the education system, improving educational and skill levels may be even slower. Of particular concern is the lack of education of the Roma. Ensuring that this group acquires the skills necessary to participate productively in the labor market will be essential to boosting growth. i. Primary and secondary education 160. The ten years of compulsory basic education are provided mostly by the public sector. Elementary school lasts eight years and less than 2 percent of the students attend private elementary school. At the end of the eighth year of school, at age 14 or 15, all students take a nationwide test to 74 determine where they will be in the next two years of compulsory education. Students with high grades are admitted to secondary school; those with lesser grades go to trade schools. The final years of higher secondary education are optional. Graduation rates from secondary education are high. The educational attainment of youth is impressive considering Romania’s current GDP per capita; however, it is still far behind many EU countries and even further behind top performers like South Korea. 161. There are some concerns about the effectiveness of pre-university education. The system seems to be well-organized, but questions have arisen about its quality, efficiency, and equality. In 2006, 53 percent of Romanian students failed to attain basic proficiency in reading and mathematics on the PISA international assessments of 15-year-olds, and nearly 90 percent scored below the OECD average. The 2009 PISA results showed improvements, but still about 40 percent of Romanian 15-year-olds were functionally illiterate (Babic and Baucal, 2011; OECD, 2010)54, even though spending on education increased. Between 1999 and 2008, real per-student funding quintupled, yet in the Trends in International Mathematics and Science Study (TIMMS), math scores barely improved. 162. The government has launched a reform of the pre-university education system in conjunction with its other decentralization efforts. The emphasis on decentralization seeks to give local governments and schools more autonomy while the central government focuses on setting standards and developing curricula. The initiative calls for the Ministry of National Education to lead and for school boards and other local institutions to concentrate on delivery. The plans have been discussed with teachers, local authorities and parents, whose roles are critical to the effectiveness of the initiatives; however, given the sensitivity of reforming the education system (which will necessarily need to consider some school consolidation as well in light of regional emigration patterns), communication remains essential for the success of these plans. Over recent years, this process advanced but more efforts are needed to continue the progress considering the expected shift in population and its consequence in the number of incoming students. Financing already follows students rather than being directed towards schools regardless of their enrollment levels (capitation criteria). At the same time, the average age of teachers is rising and few are updating their skills. In a broader context, the government should also look into the impact of its reforms and decentralization efforts in terms of quality and drop- outs, and make sure adversary effects are mitigated. Avoiding politicization of the education reform agenda is key as well. ii. University education 163. Over the last decade, the number of young people with a university education increased at one of the fastest rates in Europe. Between 2002 and 2009, the percentage of the population aged 25- 29 with some tertiary education increased from 12.4 percent to 23.3 percent, and between 2000 and 2008 the number of university graduates increased by 450 percent, while enrollment rose by about 250 percent. The percentage of the age-appropriate population who graduated (the gross tertiary graduation rate) is second only to Finland in Europe and far higher than in several more developed countries. 164. A change in the structure of higher education accompanied this transformation. A salient characteristic has been the increasing role of private universities. In 1995/1996, 22.5 percent of university graduates came from private education; this increased in 2009/2010 to 42.7 percent. Meanwhile, the number of private universities expanded from 36 to 62, while the number of public 54 OECD (2010) defines functional literacy as: “PISA’s conception of reading literacy encompasses the range of situations in which people read, the different ways written texts are presented, and the variety of ways that readers approach and use texts, from the functional and finite, such as finding a particular piece of practical information, to the deep and far-reaching, such as understanding other ways of doing, thinking and being. Research shows that these kinds of reading literacy skills are more reliable predictors of economic and social well-being than the number of years spent in school or in post-formal education�. 75 institutions actually declined, from 59 to 56. The private sector dramatically expanded in distance education and in “soft� (humanities and social sciences) disciplines. More than 40 percent of all students in private universities in 2010 were in part-time (35 percent) or long-distance (5 percent) programs; in state universities, students in non-traditional programs totaled 17 percent. There are concerns about the quality of this education, often among businesspeople, but lack of information makes it difficult to confirm the assessments and discern the causes. 165. Equality is a concern in higher education. The expansion in tertiary education took place mostly among the highest-income group. In 2009, 52.4 of the 25–29-year-olds in the richest quintile had received tertiary education, a major increase from 33.9 percent in 2002; in contrast, only 3.8 percent in the poorest quintile had any tertiary education in 2009, although in 2002 it was 1 percent. Access is also limited in rural areas, where the corresponding percentages were 7.1 percent in 2009 and 2.8 percent in 2002. The poor and those living in rural areas leave the education system earliest. After middle school (grades 5-8), they are more likely to enter a vocational school and then drop out after two years. The 2005/2006 household survey found a wide gap in the percentages of 19-20-year-olds who completed secondary education in urban (66 percent) and in rural (39 percent) areas. The income gap was even more extreme: an 80-percent completion for the highest-income quintile, 28 percent for the lowest. Among students of Romanian ethnicity, 57 percent finish upper secondary; among the Roma only 5 percent do. c. Education as a path to work 166. From 2002 to 2009, net job creation occurred only in occupations that require tertiary education: professionals, technicians and managers. While total employment shrank by more than 500,000 jobs, employment opportunities for tertiary graduates grew by about 400,000, so the number of people employed who had less than a tertiary education decreased. Given the rapid growth in demand, virtually all graduates found employment. However, there is some evidence that a small but growing number of graduates have to resort to jobs as low-end service workers. This could mean either that the demand for university graduates are slowing or that the skills that some of them are acquiring are unsuited for higher-end jobs. 167. Wages grew for all occupations in 2002-2009 but faster in occupations typically reserved for university graduates. In fact, the earnings premium (the additional earnings that a graduate makes compared with a non-graduate) rose between 2002 and 2009. After controlling for other characteristics, such as age, level of experience and geographic location, in 2009 a university graduate made on average 41 percent more than an upper secondary graduate; in 2002 the premium was 33 percent. 168. Despite the recent economic crisis, fewer university graduates were unemployed than those with no more than upper secondary education. In 2009, rates of unemployment in Romania were 4.1 percent for university graduates of all ages, 7.3 percent for those with upper secondary education and 8.9 percent for those with less education. The same pattern was evident for Romanians in their late 20s and 30s: those with university degrees were only half as likely to be unemployed as those who had lower secondary education or less. i. Skills adequacy and quality 169. Lack of skills is a major problem for Romanian businesses. The Enterprise Surveys provide evidence that the inability of the private sector to recruit suitably skilled workers had already become an issue between 2005 and 2009. The proportion of companies citing education of the workforce as an obstacle to doing business increased from 10 percent in 2002 to over 40 percent in 2009 (see Figure 51). Unfortunately, the survey does not go deeper into the type of skills workers lack. In general, in Romania 76 and the rest of the region, there is a dearth of data on the types of skills, both soft and hard, that employers require. 170. Information is now being systematically Figure 51: Education of the workforce as an collected on what students learn or on the obstacle to doing business match between education and employment. The Ministry of Education conducted several labor market forecasts in 2012: x Forecasting study on the professional training demand, for the timeframe 2013 – 2020 by the National Institute for Scientific Research in the Labor and Social Welfare Fields (SOPHRD project - 2012) x Medium-term forecast and correlation with the labor market demand for the lifelong training offered by the National Center for the development of the Vocational and Technical education (SOPHRD project - 2012) x Assessing and forecasting the prospective Source: Enterprise Surveys labor demand for the higher education (http://www.enterprisesurveys.org/) and World graduates, on the labor market, until 2020, in Bank staff calculations. order to properly develop higher education policies (INCSMPS - project funded from the MEN budget - 2012) 171. On the basis of this information (and other ongoing efforts) on the relevance of upper secondary and tertiary education, the authorities can now identify mismatches between market needs and educational outputs or the reasons behind the mismatches. But the agenda of using this information to inform policy making is still significant, in particular since it requires strong coordination at the level of the government. The data itself outlines some of the policy challenges, including that current statistics may be overstating the achievements. Given Romania’s very high rates of transition from secondary to tertiary education, there is reason to believe that many students are entering university lacking the skills expected of entrants in most OECD and EU countries. A consensus to this effect has been evolving among university officials. Moreover, as Romania’s universities struggle to absorb the sizable influx associated with Europe’s highest entry rate, the rapid growth in enrollment has not been accompanied by an expansion of the teaching force; the student-faculty ratio has doubled since 2000. At 33 students per teacher, it is by far the highest in the EU. 172. As the university system was expanding rapidly, its governance, oversight and accountability were deteriorating. Since 2005, the autonomy granted to tertiary institutions has expanded rapidly, before any measures to hold institutions accountable could take hold. Many private institutions were established while the Romanian Council for Accreditation was not fully functional. By 2005, the government responded by creating the Romanian Agency for Quality Assurance in Higher Education55, modeled on the European Standards and Guidelines for quality standards. Low standards, plagiarism, nepotism and lack of transparency in the decision-making and academic processes were widespread. A new law in 2011 restricted the administrative, financial and staffing autonomy of 55 See: http://www.enqa.eu/files/ESG_3edition%20(2).pdf 77 universities and tightened accountability for performance, but there is concern about how stable any norms can be. At the same time, as shown in a World Bank review of the higher education system in 2011, there needs to be a balance between autonomy and accountability; when universities are fully accountable and competition between universities is strengthened, they can be given much more autonomy. The Ministry could selectively give more autonomy to universities that consistently perform well and provide full reports on their performance that are made public. Box 9: Adult training and active labor market policies There is widespread recognition that employee training also benefits employers (Card et al., 2010). While employees benefit through higher employability and higher wages, employers benefit through increased productivity. Nevertheless, adult education in Romania is among the lowest in the EU. Taking steps to improve workers skills can have benefits in terms of employment, earnings and growth and are therefore welcome. However, the optimal modalities of implementation depend on country context and the underlying reasons for the lack of training. This box summarizes some of the lessons that can help achieve successful implementation of adult training based on evidence from programs around the world. 1. The underlying problems should determine the types of intervention - Institutional arrangements: These can encourage firms to invest in workers’ training in cases where firms have difficulties appropriating the benefits of training, for example where workers are poached after training. Corrective actions can include enforceable contracts, payback clauses and apprenticeships. For example, workers can be obliged to stay with the firm providing training for a minimum length of time or else have to repay the cost of training. Under apprenticeship schemes, the cost of the training is shared between the employer and employee by allowing the firm to underpay the worker, thereby reducing risk to the firm. Firms benefit as they are able to use apprenticeships as a means to recruit workers while employees often see their wages rise sharply upon accreditation as they become more attractive in the market place (Almeida et al., 2012). In some cases, regional and sectorial cooperation in training may help firms to overcome poaching or, for smaller firms, reduce the fixed costs of training workers. The Korean government implemented training cooperation services with great success. Counseling and advisory services can help both firms and workers understand better training opportunities, skills demand and supply, and the courses and providers on offer. For workers, these services can also help prepare job applicants for interview. - Training subsidies: These can be used to encourage training and employment. With regard to training, they can be used to overcome poaching and credit constraints felt by firms or workers. However, subsidies also risk crowding out private sector training and creating labor market distortions. Employment subsidies can reduce the risks firms face when employing workers deemed as being risky prospects – for example, young workers with little experience. However, they can also displace more productive workers as less productive ones become cheaper to employ. Given the risks, subsidies should be designed with care. Training subsidies can also be useful where firms are concerned that they may lose their investment. However, if under-training is occurring due to a lack of knowledge among firms, then subsidies are unlikely to be effective and would simply displace privately funded training at cost to the taxpayer. Rodríguez-Planas (2010) and Rodríguez-Planas and Jacob (2010) find in reviews of ALMPs in Romania in the early 2000s that offering subsidized training for young people helped increase their employment rate. However, other assistance such as small-business assistance (SBA) to help the unemployed start businesses were not successful among the young, who chose to start businesses only as a second-best option. They exited as soon as they were able to (their constraint was their inability to get a job, which would be have been better served through counseling or employment subsidies rather than training subsidies). SBA however worked well for more experienced people. Cho and Honorati (2012) find similar results in an international comparison. Experience shows that the private sector can be a good provider of training. However, the closer the relationship between the training firm and the company, the more successful the training tends to be (Richard, 2012; OFSTED, 2012). - Appropriate targeting: Key to reducing the potential negative consequences of training or employment subsidies is good targeting. Subsidies should be limited and made available only to groups where problems are known to exist and where conditions make training likely to be effective. This will also reduce the cost to the taxpayer. - Employment subsidies: Young workers often do not have an opportunity to prove themselves in the market and therefore they struggle to find jobs. Subsidies or reduced social security contributions reduce the risks for employers. Forcing employers to repay subsidies in the event that the new employee is not employed for a long period may reduce effectiveness as firms continue to shoulder the risk burden. Subsidies are unlikely to be as 78 effective for workers with more experience. Only 14 percent of Romanian students report having had a job before entering higher education; this is half the EU average 2. Focus government’s efforts on ensuring quality standards - Continually monitor and evaluate: The importance of choosing the right tools to address the right problems mean that it is important to understand the initial issues–usually through surveys and/or focus groups. Tools exist to monitor the impact of projects – including in real time (e.g. Efforts-to-Outcome software) and training or ALMPs can be continually modified to ensure success and value-for money. In addition, training programs need to be able to produce the skills required by employers for them to be valued by either workers or firms. Continued tracking of employer requirements and outcomes for trainees will help to ensure relevance. 173. The social sciences have led the increase in tertiary graduates. Romania has the second- highest proportion in the EU (73 percent) of graduates in soft disciplines and the lowest in hard sciences. Private institutions specialize mostly in soft disciplines because those programs can be offered far more cheaply than programs in engineering and the exact sciences. The gap in 2008 between the share of graduates in the soft fields and those in the hard was 48 percentage points, the largest gap in the EU except for Latvia at 52. The gap has grown by 25 percentage points since 2000, the largest increase in Europe. This shift toward soft disciplines is to some extent a response to the needs of a market moving from a socialist to a market economy, where services are more prominent. However, the erosion of the hard sciences, combined with the quality problems, should raise concerns about competitiveness, because it makes the country less attractive than its neighbors for investment, especially in manufacturing. 174. Too little emphasis on student preparation through work experience and foreign study threatens to leave Romanian graduates behind EU counterparts in the increasingly competitive regional labor market. Only 14 percent of Romanian students report having had a job before entering higher education; this is half the EU average and one-quarter the level reported by students in Sweden and Finland in the 2005–2008 survey. Once in university, only 36 percent of Romanians report having a job, and just 15 percent of those who work say that their job is closely related to their studies; both rates are again among the lowest in Europe. Reportedly, a heavy academic load of about 41 hours a week, the highest in the EU, leaves little room for valuable hands-on learning. This likely prevents the accumulation of the soft skills employers need, but because skills (as opposed to education) are not monitored, it is not clear whether that assumption is correct. ii. Adult learning opportunities 175. Adult education is rare in Romania. The rapid transformation of the global economy suggests that skills depreciate faster than in the past. This means that to remain competitive, workers now in the labor force will have to update their skills continuously. Romania does not seem to be well-prepared to meet this challenge. Indeed, the percentage of the population aged 25–64 who participate in training is the lowest in Europe: about 1.3 percent is in training and education, compared to more than 30 percent of adults in Denmark and Sweden. This percentage has remained relatively constant over the last decade, while the corresponding percentage for other EU countries has been increasing. 176. Most companies offer little in the way of in-house training. Only 25 percent of firms in Romania offer formal training for permanent employees. This is the second lowest percentage in the EU11 countries and far below countries like the Czech Republic, where 71 percent of firms do. Skilled workers are more likely to be trained than unskilled workers. The low percentage of firms providing training may be due in part to the high shares of agriculture and services in the economy. Not surprisingly, larger firms offer the most training. 79 C. RECENT PROGRESS 177. On the employment side, the 2011 Labor Code represents significant progress. For instance, it makes it easier for companies to employ workers on part-time and temporary contracts. Early evidence suggests that this contributed to an increase in formal employment; however, further study is required to fully understand the scope of the impact. Increased ability to work part-time, notably for older workers, is only half the equation. Greater efforts are also needed to increase access to training for older workers. 178. The government has been actively reforming the rules and institutions of the education sector to align them with EU framework. Overall, Romania has been taking steps in line with the Europe 2020 strategy that gives priority to continued upgrading of the skills of its population. During the last decade, most study programs were restructured in line with the Bologna Process56.Financing of higher education was moved from input-based to enrollment-based funding. An Education Law in force since early 2011 promotes changes in all areas of education. For instance, there is an added focus on early education; a shift to competence-based curricula; new systems for professional development, evaluation and assessment and classification of universities; a new approach to university management and a renewed focus on adult education. Legal challenges to the law have not succeeded. 179. Accumulation of human capital can be accelerated by upgrading the quality of education and skills. How to overcome unfavorable demographic trends in Romania is a daunting problem. The country is already past what is considered the demographic window of opportunity, when growth of the labor force was peaking. Today, Romania requires a plan for a drastic upgrading of skills, especially those that can meet the demands of a rapidly transforming global economy. It should pay special attention to those who were not adequately schooled as children, and include adequate provisions for minorities such as the Roma. 180. A comprehensive approach to upgrading education and skills is needed. The traditional view of education and skills-formation in Romania has been to better educate new generations entering the labor market. This approach gives priority to the signaling role of diplomas and less attention to the actual acquisition of skills. It puts too much emphasis on expanding the formal system and virtually none on post-school education. Specifically, it is well- known that (a) skills are obtained and maintained in the work place, and (b) significant gains can be achieved from continued education of adults—gains that Romania desperately needs. 181. It is necessary to move to evidence-based design and realization of education policy. The fluidity of the demand for skills and the uncertain impact of current institutional changes make it necessary to fine-tune policy in response to actual results. Experience over the last two decades has shown that if rapid expansion is not carefully managed, quality can deteriorate. The recently collected information about the demand and supply for skills should enhance the capacity of the authorities to fine-tune policy and hone implementation. An ongoing World Bank Europe 2020 study will help to provide additional evidence on how best to expand and improve education. D. OPTIONS FOR REFORM 56 The Bologna Process, initiated in 1999, aims to ensure compatibility and comparability in tertiary education across the Europe. Tertiary education will be undertaken in three cycles (bachelor/master/doctorate) and the process aims to ensure a quality higher education system, promote mobility of students and staff and emphasizes the importance of skills that lead to employability. 80 182. Labor market policies can make a significant contribution to sustainable economic growth. Many of these can be implemented in the short term. For instance: x Adopt wage increases that track productivity growth. The public sector can lead the way in this and the government also has a role to play in tri-partite discussions that include trade unions and the private sector. This will help to keep the tradable sector competitive. It suffered from disproportionate wage increases during the boom, preventing many companies from expanding production and creating jobs. The public sector is in a position to lead the way by restraining wage growth. x Make efforts to mobilize Romania’s large pool of underused labor. A mixture of supply- and demand-side policies can help to bring underemployed workers into productive sectors. Measures can include increased use of active labor market policies, such as training for adults and youth; these need to be tailored to both the age of the workforce and the skills firms require. Labor market regulations that encourage part-time work – notably in conjunction with training opportunities – can help to ensure that workers have relevant skills and remain productive. 183. Several areas can be considered to improve the skill level of the population in the medium term: x Monitor which skills are needed most and track what jobs graduates take. It is important to monitor both the skills acquired and the demand for different skills by employers, not only in terms of level of education. This could be achieved by augmenting the labor force surveys (e.g., every three years) with an assessment of respondent skills, using, for example, the World Bank's Skills Toward Employment and Productivity (STEP) measurement surveys, which allow for international comparisons. In addition, the Enterprise Surveys could be augmented to elicit more details on the types of skills that firms lack. This information can be used to adjust both standard education and lifelong learning to ensure that people are gaining relevant skills. Romania has already committed to track labor market outcomes for graduates through the Romanian Tracer Study Project, a platform upon which depend other efforts to track the quality of higher education institutions. x Open up more lifelong learning opportunities, including by encouraging firms to train workers. The market for adult learning is potentially very large in Romania, even if it is only in gradual expansion. The role of the state is to help build the market by setting institutional norms for service providers, both public and private. This will require a shift away from government- defined programs toward a well-regulated market of private and public providers that deliver training to both working and unemployed adults. If it is to be effective, it will require close coordination between government agencies and the private sector, giving the demand side a voice. Monitoring of data on outcomes and effectiveness can over time steer the system. Romania can benefit from ample experience in other countries and the support provided by international organizations, such as the OECD Programme for International Assessment of Adult Competencies. 81 PART III: THE FOUNDATIONS FOR EXPLOITING COMPARATIVE ADVANTAGES — SETTING KEY SECTORIAL POLICIES RIGHT 82 83 6. ENERGY57 The energy sector can become a motor for growth by producing energy more reliably and efficiently for export and the population and to boost Romania’s industry. To unleash its potential, the reforms initiated in the early 2000s, which brought investments and the development of a vibrant domestic energy trade, should be deepened. Swiftly privatizing all non-strategic companies in the energy chain and improving the governance framework for the remaining SOEs is key. Equally important is the implementation of the Gas and Electricity Road Maps recently enacted by the Government, which would bring Romania closer to being part of a common EU energy market. The implementation of a comprehensive reform agenda, as proposed below, not only would reduce Romania’s dependence from energy imports by exploiting the domestic resources more effectively, including from the Black Sea, but would also transform Romania into an important regional player in the energy market. A. INTRODUCTION 184. Relative to its neighbors in Europe, Romania has a significant energy potential (Figure 52). On the electricity side, generation reached about 60 TWh in 2010, 58 the largest in South-East Europe. Only about five percent of the electricity generated is exported and it is mainly to balance supply and demand. Nuclear contributes 19 percent, renewable 28 percent (2 percent wind, 26 percent hydraulic, but nearly nil from residues and biomass) and all types of thermal units account for the remaining 53 percent (coal and natural gas). The gross installed generation capacity of about 22 GW could be relatively easily increased by rehabilitating old plants with private investments. Romania has also a significant potential to attract investment in renewable energy, either in small and medium-sized hydropower plants or into wind and solar generation farms. On the gas side, Romania’s production was about 11 billion cubic meters in 2012, small by world standards but similar to that of Germany and about 70 percent of the current production of oil and gas rich countries across the Black Sea like Azerbaijan. Ongoing exploration in the Black Sea coast of Romania, if successful, might significantly enhance the potential of Romania as a gas producer. Romania’s energy transit potential is also large, both for electricity (as its system is integrated with the rest of Europe) and gas (a key pipeline from Russia through the southern Balkans passes through Romania). 185. The dynamics of the energy sector in Romania mirrored the tremendous changes in the post-communist economy. On the demand side, the restructuring of the economy led to a drop in energy consumption, matching a structural shift away from energy-intensive heavy industries. Between 1990 and 2007, the country’s energy intensity–or amount of GDP produced per unit of energy–more than halved, surpassing the 40 percent energy gains made by the EU-10 countries (Figure 53). However, on the supply side, investments and maintenance fell, 59 leading to obsolescence and deteriorating output. Today, about half of Romania’s energy sector needs upgrading across all sources (thermo, nuclear and hydro). 57 This chapter draws on a Functional Review prepared by the World Bank for the Ministry of Economy and Energy in May, 2011. 58 Sixty TWh is equivalent to about 5,000 tons of oil equivalent (in Figure 48). As of early 2012, gross installed generation capacity was approximately 22 GW (after increasing by about 2 GW over the last two years mainly due to the development of wind generation), but only about 9 GW are utilized because many groups/plans do not function at installed power due to endemic failures. 59 Except for wind and solar electricity generation, which benefit from generous incentives. 84 Figure 52: Energy production in Romania by type Figure 53: GDP per unit of energy use in selected of fuel, 1971-2009, ktoe countries 60 (constant 2005 PPP $ per kg of oil equivalent) 10.0 9.0 8.0 7.0 6.0 1990 5.0 4.0 1995 3.0 2000 2.0 2005 1.0 0.0 2010 Ktoe: 000s tons of oil equivalent. Source: World Bank World Development Indicators Source: International Energy Agency. * Refer to the average for developing countries in the Europe and Central Asia Region (ECA) of the World Bank. 186. The potential for energy savings by improving efficiency is still substantial, and with renewed reform, further shifts in the structure of consumption can be expected. From 1990 to 2008, energy efficiency improved by 4 to 5 percent annually, but energy intensity today still remains well above the EU-27 average. Energy-intensive industries like steel, aluminum, fertilizers and chemicals represent a high share of Romania’s GDP. Industry in 2008 consumed 38 percent of Romania’s energy, 11 percent for metallurgy alone. With economic restructuring and improvements in living standards, household consumption also increased: the share of residential electricity consumption grew from a mere 6 percent in 1989 to 25-30 percent of the total today (Figure 54). While it continues growing, it is still only half the EU average. The low pricing of alternative sources of energy (gas and district heating) explains this paradox. Figure 54: Residential use of energy* ResidentialUseofEnergy,MJ/capita,2011 30.0 20.0 10.0 0.0 RO BG NL DE HU SE SL CZ Sl UK FI GR EUͲ27 DK LV EE ES IT PT BE AT FR PL LT IL Electricity OtherEnergy Source: Eurostat *Country short-forms used are: AT=Austria; BE=Belgium; BG=Bulgaria; CZ=Czech Republic; DE=Germany; DK=Denmark; EE=Estonia; ES=Spain; FI=Finland; FR=France; GR=Greece; HU=Hungary; IL=Ireland; IT=Italy; LT=Lithuania; LV=Latvia; NL=Netherlands; PL=Poland; PT=Portugal; RO=Romania; SE=Sweden; Sl=Slovenia; SL=Slovak Republic; UK=United Kingdom. 60 Note that Romania produced in 2012 about 60 percent more output than in 2000 with the same amount of energy—thus more than halving its energy intensity. 85 187. Serious reform efforts were made during the 2000s. The liberalization of the energy sector in Romania started in 2001 and was forcefully carried out after the adoption of a Road Map in 2003 that spelt out a timetable for energy liberalization. Strategic investors purchased one of the two upstream oil and gas companies, the two gas distribution companies and five out of eight electricity distribution companies. The bulk of electricity generation and the transmission of gas and electricity remained in public hands. As the number of market-based players grew, a vibrant trade in electricity emerged. Between 2004 and 2007, the percentage of energy traded in the free market grew from 10 to 50 percent. The state-owned Romanian Electricity Trading Exchange (known in Romania as OPCOM), founded in mid-2000s, was hosting important volumes of day-ahead transactions. However, by the mid-2000s the reform lost steam, leaving the electricity and gas markets only half-liberalized (Box 10). Past experiences offer lessons on how reforms might be sequenced and the need for continued attention to energy efficiency. Box 10: Timeline of legal, regulatory and institutional reforms in Romania Step-by-step progress from late 1990s to mid-2000s: x energy strategies adopted, including the 2003 Road Map (EC: “exemplary reform package�) x energy laws and regulations approved in accordance with EU’s 2003 “Second Package,� framework for sector restructuring, energy regulator ANRE, tariff reforms and commercialization x electricity market opened from 2001 to free trade x OPCOM power exchange established x Privatization of national oil and gas company PETROM, 5 of 8 electricity distributors and both gas distribution companies x public and private sector investments Step-by-step reversals and stagnation followed: x privatization program stopped in 2006 – energy champions/rebundling proposals and debated from 2007 (an issue still being considered today from time to time) x electricity market opening stalled in 2007 x electricity and gas pricing reforms stalled in 2007 x gas exports prohibited against EU law x non-competitive bilateral contracting practices spread out at a major loss x series of actions taken since 2005 that have undermined energy regulator ANRE’s professional management, operational capability and financial autonomy, affecting its credibility and performance x railways (CFR) not paying electricity bills while suppliers are forced to continue electricity service Source: World Bank staff compilation 188. Today, the energy sector is hamstrung by commitments to supply selected consumers including some companies, both private and state-owned, at below-market prices. This increases rates for other users and when the state-owned companies don't pay their electricity bills, it forces electricity generators to become a burden on the budget through arrears and subsidies. For example, Hidroelectrica, a state-owned hydro-power generator, has since 2007 registered over €1 billion in foregone profits from sales at low prices to preferred clients. It was declared insolvent in June 2012. The tax arrears of power generation companies are conservatively estimated at €2 billion, even after various write-offs over the years. Very large equity investments by the state in the energy sector have not produced significant dividends except for Petrom, which was majority privatized to a strategic investor back in 2004. District heating subsidies continue to exceed €200 million a year. Some state companies and agencies simply don't pay their energy bills, most notably the railways. Municipal energy companies (e.g., Radet, the district heating company serving Bucharest) in turn don't pay state suppliers. 86 Figure 55: Structure of the Romanian electricity market and key players Source: KPMG, Overview of the Romanian electricity sector: development and investment opportunities, March 2012 87 189. This is an unfortunate situation for a sector that could easily attract the private investments necessary to improve its efficiency and its reliability. The construction of two nuclear reactors at Cernavoda, in which the state-owned Nuclearelectrica was to partner with six top foreign companies, would have brought the Romanian economy a €4 billion investment. However, four of the six private partners withdrew from the project because of legal, regulatory and policy uncertainties with respect to domestic prices and quantitative restrictions on sales and exports. Oltenia, another potentially major power-generation plant that has fallen in disrepair for lack of investments, offers a similar example. Its three power generation plants (Turceni, Rovinari and Craiova) only use about 70 percent of their capacity of 5.3 GW. Figure 55 shows the role of the Oltenia complex and other SOEs in the electricity sector. B. CURRENT STATUS AND CHALLENGES a. Institutional transformation 190. As it strived to meet the criteria for a fully functioning market in the run-up to EU accession, Romania made good progress with energy liberalization, economic pricing and privatization to raise resources for investment and modernization. The country opted for the most liberalized energy model, with competition in both wholesale and retail markets and private funds brought in to cover investment needs. The government had by 2005 drafted a sound commercial code for the wholesale electricity market, set up the OPCOM power exchange for both short- and long-term power transactions, established ANRE as the electricity regulator and built technical capacity in the transmission system operator—all prerequisites for a competitive electricity market. 191. It also began to tackle district heating, one of the most challenging areas for energy efficiency improvements. The government approved district heating strategies in 2004 and 2006 that covered pricing, subsidies and restructuring and rehabilitation for heat production, distribution, and consumption. It also authorized metering and control measures. However, subsidies still amounted to over €200 million a year in 2010. 192. After EU accession, the impetus for reform weakened. Political considerations halted the full liberalization of prices while vested interests and political interference put pressure on energy SOEs to keep subsidies or soft budget constraints in place. In the enterprises controlled by the state (see Figure 55), the energy strategy back pedaled: for four years after 2006, the government tried to set up one or two integrated power companies, which would have allowed SOEs to cross-subsidize each other and reduce the transparency for both procurement and sales.61 Privatizations stalled after 2006, in part because of accusations of corruption in earlier privatizations, before any generating company could be sold. Privatization had also become unpopular because of public discontent with the alleged low oil royalties the government had agreed to accept from an oil and gas company for the 10 years after its sale, which had been designed to help the new investor address the backlog of basic operation, maintenance and investments. As a result, although five of the eight electricity distribution companies, both gas distribution companies and one oil and gas producer are private, the state still owns all electricity producers and one large gas producer. Uncertainties about market liberalization have deterred private green- or brown-field investments. State producers thus have virtually no competition. There are, however, more than 100 suppliers of gas and more than 60 of electricity, but most of these are small and unable to compete with state producers, though the electricity market is more developed than the gas market in terms of institutional design and market mechanisms. 61 One motivation for creating integrated energy companies (now abandoned) had been to use the relatively profitable Hidroelectrica and Nuclearelectrica to subsidize future losses in thermal generation and coal mining. 88 193. Market reform halted. Wholesale gas and electricity markets were opened to competitive tariff- setting in 2004. By 2008, half of the output of both markets was sold at tariffs set by the free market, a percentage that has remained at that level since then (Figure 56). However, the other half of the energy is sold either in the regulated market, which covers households and part of the industrial sector. Tariffs in the regulated market are well below its border-parity equivalent. In addition, a large, parallel market involving bilateral and non-transparent agreements had emerged by 2009. This was mainly the practice for energy SOEs that sold cheap electricity to favorite private partners without open tenders. Hidroelectrica, the national hydro-electric power generation company, sold around 70 percent of its production to partners that were selected non-competitively at prices between 25 and 50 percent below OPCOM levels. This resulted in foregone profits of at least €200 million a year. In the meantime, the gas SOE Romgaz sold its production at prices regulated at 40 percent of the gas import price and offered additional discounts to favored partners. These tariff-setting practices emerged from the incomplete process of liberalization and the lack of transparency and accountability in the energy SOEs. Figure 56: Electricity and gas markets Table 10: Electricity and gas prices for opening in Romania households and Medium-sized industries Electricity (euro cents/kWh) Gas (euro/GJ) ElectricityandGasMarketOpening,2004Ͳ2012 Households Industries Households Industries 100 Romania* 8.5 8.0 4.1 4.2 90 EU 12.8 9.3 12.0 9.0 80 70 Bulgaria 6.9 6.4 10.0 8.0 60 Croatia* 9.2 9.0 8.5 11.2 50 40 Germany 14.1 9.0 12.1 11.6 30 Hungary 13.4 9.8 12.5 8.3 20 10 Netherlands* 12.5 8.2 11.5 7.6 0 Poland 11.5 9.6 10.5 9.1 2004 2005 2006 2007 2008 2009 2010 2011 2012 United Kingdom* 13.7 9.4 11.2 6.5 Electricity Gas Turkey 9.8 7.6 6.5 5.8 Source: ANRE, 2004-2012; electricity openings through Source: Eurostat, 2011; excludes taxes September, 2012 * gas producer country 89 Box 11: Wholesale trade in electricity in Romania There are several mechanisms for wholesale transactions of electricity in Romania: x OPCOM Power Exchange: OPCOM operates a functional power exchange, currently ranking 8th in Europe in terms of volume traded, and may eventually provide market services to the regional market in South East Europe. OPCOM operates platforms for centralized auction and trading of bilateral contracts, daily trading (called a day-ahead market), and, soon, intra-day trading. Trading in OPCOM platforms has grown steadily since 2001 and accounts for about 20-25 percent of total electricity supply or about one half of the trading in the liberalized market. The use of the OPCOM platforms is voluntary to the market participants, except for five public sector generators which have been mandated to use it since 2006. x Directly negotiated bilateral contracts: As OPCOM platforms account for about one half of the trading in the liberalized market, bilateral contracts negotiated directly between generators and their clients account for the other half. Such contracting is a common feature in the European Union’s electricity markets. However, as virtually all generation in Romania is state-owned and as the biggest public generators have been mandated to use the OPCOM platforms since 2006, the fact that such a large share of electricity is still sold through direct and opaque negotiation between public sellers and private buyers instead of OPCOM platform or other transparent competitive processes is a major governance issue. x ANRE’s Portfolio Contracts: In spite of full market liberalization, about half of electricity supply is still provided to captive consumers by the electricity distribution companies under retail tariffs regulated by ANRE. For such supply, ANRE requires two state-owned generators (Hidroelectrica and Nuclearelectrica) to sell electricity to the supply companies affiliated with the eight distribution companies under regulated wholesale tariffs. These contracts are known as ANRE’s portfolio contracts. Such regulated prices are not in accordance with the EU electricity directives and regulations. An infringement process by the European Commission is underway. x Balancing and ancillary services markets: As electricity cannot be stored, supply must meet the exact demand. This balance is achieved by having enough generation or demand-side participation at any moment. In the short-term, wholesale markets achieve an approximate balance in voluntary transactions between participants. Fine-tuning and outage compensation is done by the Transelectrica which ensures the security of supply on a real-time basis, by requiring dispatchable generators and balancing responsible parties to enter mandatory transactions. Transelectrica administrates the balancing of energy markets with the buys and sells structured in such a way as to simulate the trading in a competitive market, with Transelectrica as the broker between buyers and sellers. As Romania’s ancillary services market is largely dominated by the hydro producer Hidroelectrica, ANRE sets a price cap for ancillary services to mitigate the monopoly position. x In addition, 5-7 percent of electricity is traded cross-border: The allocation of cross-border interconnection capacity is done by Transelectrica and neighboring Transmission Service Operators (TSOs) on a bilateral basis, by auction, but still not fully in accordance with the EU electricity directives and regulations. 194. Energy companies suffer from non-payment of bills by SOEs. Poor management of non- energy SOEs has led to considerable delays in electricity bill payments. The biggest culprit is the state- owned railway company CFR. In 2011, its unpaid bills to various private and state-owned generators and to commercial banks reached about €500 million. In 2012 CFR paid one-third of its debt to private companies, but since the operation of the passenger railway lines is very inefficient and several lines are unviable, arrears are likely to accumulate again. Also, fertilizer and chemical companies were offered discounts on the price of gas by the Romanian Energy Regulatory Authority. This caused losses of €200 million a year for two gas suppliers alone. At some point, cheap gas from domestic production was by law made available directly to large consumers in the fertilizer and chemical industries. Since the domestic production of gas does not fully cover domestic demand, the measures forced the two suppliers to import some gas at market prices and sell at a loss. Such measures benefited energy-intensive sectors and distorted markets through cross-subsidies to some companies at the expense of others. 90 195. Investors’ appetite for public-private partnerships disappeared. Early in 2011, regulatory uncertainties and preferential treatment of some market players caused investors to abandon seven proposed partnerships in thermal generation and a €4 billion investment in the nuclear generator Energonuclear. Several recent private investments in electricity generation, such as in wind and lately also solar farms, have become possible through a generous green certificates scheme. However, the scheme may not be sustainable as ultimately its cost is to be borne by the final consumer. The only significant investment made in electricity generation was made by a privately run oil and gas producer, which developed a 860 MW gas power plant and is in operation since late 2012. 196. At the heart of the distortions is the manner in which the government played its role as regulator and owner of key assets. In terms of regulation, ANRE lost its independence in 2010, mid- way into the transition to a fully liberalized market. ANRE was therefore required to place greater weight on social and industrial policy objectives than on economic ones as it regulated prices for the sector. Commendably, in the fall of 2012, Parliament granted ANRE operational and financial independence, which would hopefully empower it to retake leadership of the reform (in particularly the implementation of the electricity and gas road maps that were developed to implement the EU’s third regulatory package). The ownership role of the government also weakened; distorting the way energy SOEs function in Romania. To some extent, SOEs suffered from the same problem ANRE did, as they were required to fulfill social or industrial objectives of the government: tariffs for final consumers were to be kept low, even if wholesale tariffs were high (on average or seasonally, e.g., during periods of drought). Politics and strong vested interests also started to meddle with contracting and sale practices. 197. As a result, the incentive framework in energy is highly distorted. Because the SOEs in the energy sector can rely on government to write off arrears and receive subsidies, they fail to pursue potential revenues even as their costs increase. And the write-offs and subsidies come with conditions that further drive the SOEs into the ground. At the same time, the social support that SOEs are supposed to provide through reduced energy tariffs for residential and some companies is poorly targeted and sometimes appropriated by intermediaries. In district heating, there is an annual subsidy burden of more than €200 million of which only about 30 percent are direct subsidies to poor households. The rest reflect the cost to the state of price regulations and soft budget constraints (subsidies for fuel for generators, “reference� prices set below market, etc.), which provide disincentives for energy efficiency and channel most of the support to the largest and richest consumers. ANRE’s regulation of electricity prices for captive consumers and the suppression of domestic gas prices add up to poorly targeted social protection. Noncompetitive sales of energy at below-market prices (Hidroelectrica, Romgaz) reduce not only SOE revenues but also the dividends the government could earn as the majority shareholder. The current pricing system provides cross-subsidies, direct and indirect, to loss-making enterprises, and several companies sell energy well below cost. 198. Between EU accession in 2007 and 2012, Romania passed laws and followed policies that were not fully compatible with EU law. To introduce EU-wide market principles in the energy sector, the EU adopted packages to liberalize the energy market, separate competitive from monopoly activities and allow energy to be traded freely across borders. While many countries have had difficulties with adhering to these regulations, Romania appears to be the farthest behind. The EU started infringement procedures against Romania for delays in implementing EU energy market rules: there are a total of five procedures underway on infringement of EU energy directives.62 In late 2011, the EU initiated a lawsuit against Romania at the European Court of Justice for distortions in the gas market. In 2012, concerned about market distortions caused by SOE contracting practices, the EU Directorate General for 62 More information on the latest EU energy directives (the second and third Energy Package) is available from: http://ec.europa.eu/energy/gas_electricity/legislation/third_legislative_package_en.htm. 91 Competition launched an investigation into why Hidroelectrica allowed traders, two large steel and aluminum companies and others to buy electricity below market rates. 199. Delays in upgrading energy infrastructure Figure 57. Degree of obsolescence of the raise serious concerns about energy security and Romanian energy sector the possibility of shortages of energy in the medium term. As Figure 57 shows, a large share of the country’s energy assets are obsolete. Bringing them up to date will require an estimated €30-35 billion in investment over the next decade, of which more than half would be for electricity. Substantial thermal capacities will have to be closed or upgraded in the next four years to meet EU emissions standards. 200. The government cannot afford to modernize the energy sector. Fiscal consolidation demands that scarce public resources be focused on improving basic public sector services, such as judiciary services, Source: ANRE public health or basic education. Financially, the state or its enterprises simply do not have the ability to attract the funds that the energy sector needs. Also, except for environmental rehabilitations and investments in energy security, most public investments would in any case fall foul of EU state-aid rules. And the private sector is not likely to come through on the scale needed because of the legal, institutional and regulatory uncertainties. These concerns are greatest in the electricity and gas sectors, less so in oil, because electricity and gas involve substantial natural monopoly infrastructure and need regulation for access and tariffs. 201. Not only is energy security at risk, so is economic growth. As power-generating facilities deteriorate in the absence of investment in maintenance and modernization, the likelihood of blackouts increases. The major risk is in thermal generation, which represents 40 percent of electricity production and where the infrastructure is 80 percent obsolete. Moreover, all EU members are required to have electricity reserve capacity of 5 to 10 percent in case of sudden changes in demand. Romania barely meets this requirement now. The situation will be aggravated from 2013 onward by environmental and climate change standards that are more restrictive of emissions. Matters will be even worse if the economy starts growing. b. Renewing reform efforts 202. Romania has a significant energy potential and is halfway toward realizing it. The large and well-diversified energy sector is at the core of Romania’s economy. Supply risks could be controlled. A sustained program supported by private investment to replace out-of-date assets, accompanied by full market pricing and effective regulation, could drive improvements not only in the energy sector but also in downstream industries. The delay of reforms after 2007 has discouraged investor interest in a sector that would otherwise be attractive; success stories could boost investor confidence and have a spillover effect onto other sectors. 203. Despite setbacks, Romania still fares better than most of its peers in southeastern Europe in terms of the institutional design of the energy sector. Its electricity market is partially liberalized, even if the regulated electricity supply market is still relatively large. The regulated market covers mainly households and a part of the industrial sector and, thus, large industrial consumers represent the basic pool for the unregulated market. This is an advantage to build on. The changes that Romania initiated a decade ago constitute a solid foundation. The challenge now is for the country to build on it a 92 more open and competitive energy sector that engages the private sector and benefits the consumer. Improving the legal, regulatory, and policy environment would give Romania a major comparative advantage in the energy sector. 204. In the aftermath of the global financial crisis, the government re-launched the reform program in the energy sector. The following steps have been taken so far: x Good steps have been taken towards the introduction of transparent and competitive contracting for Hidroelectrica – through its insolvency process that started in July 2012 – and awarding transparently the electricity released from previous bilateral contracts. x The new Electricity and Gas Law became effective in July 2012 and the Law introducing the financial and corporate independence of ANRE, the energy sector regulator, was adopted by the Parliament and promulgated by the President in October 2012. ANRE has by end-2012 fully returned to the pre-2009 approach of funding its operations from license fees instead of from the Government budget. ANRE has also developed its new business plan. Under the new law, ANRE is now accountable to the Legislative rather than the Executive branch of the state. The selection of members to ANRE’s Regulatory Committee, however, was not carried out in full alignment with the legislation. x The percentage of energy that is sourced from the deregulated market by electricity supply companies has been increased to 45 percent for non-residential customers as of April 2013. Further increases are expected to take place this year for non-residential consumer (brining the percent of energy sourced in the deregulated market to 85 percent by October 2013), as well as for residential consumers (where the percentage of total energy outsourced in the deregulated market should reach 20 percent by end of this year). x Nonresidential gas prices were adjusted by 5 percent in December 2012 and an additional 5 percent in April 2013 (with slight delays relative to the road map for gas). A further 8 percent adjustment is envisaged this year for non-residential consumers, and an initial 10 percent adjustment for households is also expected. Current levels however are below 40 percent of border-parity levels. x Progress has also been made towards agreeing on the key parameters for the safety net to offer protection to the poorest households from energy tariff increases. In particular, additional resources were allocated in the 2013 budget to provide enhanced social protection through existing instruments (e.g., the Guaranteed Minimum Income Program, the Family Benefits and the Heating Benefit) and additional funding will be available as the revisions to the eligibility criteria (to minimize errors of exclusion) are enacted in the fall of 2013. iii. Progressive scenario 205. In the progressive scenario, Romania not only achieves everything in the moderate scenario but also starts to act as a serious player regarding energy in the EU, elaborating and projecting a vision on shale gas and the promotion of regional interconnection projects. Romania influences negotiation of climate change targets within the EU and in international negotiations. To achieve the status necessary to influence EU policy, substantial long-term investments are made in the latest technologies. The country becomes a hub for electricity and gas and an important player in the Black Sea area, with interests in the 93 Caucasus and Central Asia. For example in gas, Romania improves the region’s connections and storage capacity and builds a regional gas market platform on OPCOM, which in turn is eventually turned over to the private sector rather than kept as a subsidiary of Transelectrica. By improving competition with domestic sources, pipeline connections such as Nabucco and shale gas development, Romania improves the gas-contracting policies in Europe, easing the transition from oil-indexed contracts to the more market-responsive ones. Romania also becomes an electricity hub with regional interconnections, a regional market platform and ancillary service exports in the region, developing with private partners the Tarnita pumping storage 1000 MW project and exporting electricity throughout the region. C. OPTIONS FOR REFORM 206. Romania can become a key energy player and exporter in Europe and the Black Sea region. To achieve this, the recently enacted reforms that allow for further deregulation and transparent operation of energy market would need to be expeditiously implemented, including: x Continue to liberalize energy markets as per the latest EU energy directives.63 In particular, ANRE needs to continue the liberalization of energy markets it started to implement in the fall of 2012 and cease to regulate price for electric and gas supply for nonresidential consumers. x Implement privatization plans. To attract much-needed and substantial investments, it is key for the state to divest its control of all companies except for a few core ones that might be considered strategic. While market consideration would always be an issue, at this point the speed of privatization is more important than the revenue it brings to the state or to the companies themselves. Besides, as privatization processes are designed, they might consider blending up- front payments with requirements to invest and deliver specific services. To generate public consensus on these processes, they must be run transparently, including through a well-thought communications strategy. x Improve the corporate governance of SOEs. For the few SOEs that are likely to remain in the energy sector, the best principles of corporate governance must be introduced. This will include appointing boards and managers with relevant professional experience and introducing IFRS to companies that do not currently use it. 207. Over the medium-term, Romania could reposition itself as an energy hub for Europe. This would require a deeper understanding of the role Romania could play in the international energy market including analyses of each energy subcomponents (e.g., oil and gas, electricity, district heating and renewable power). The broad direction could include steps such as: x Attract green-field investors at all levels of the energy-value chain. In oil and gas, efforts have already been made to allocate exploration lots in the Black Sea and on shore. Early signs are encouraging, as two of the exploring companies have announced positive pre-discoveries. Such steps could be complemented by accessing shale gas, but this would have to be weighed against its environmental risks. x Position Romania to become an energy exporter. Romania has several potential markets on its doorstep. Turkey, which diligently studied Romania’s power sector transformation experience in 2005 and by now has reached a more sophisticated stage than has Romania, could buy any electricity surplus that Romania could generate. This would require an institutional infrastructure between Romania, Turkey and Bulgaria, the obvious transit country. Italy, Hungary or other Balkan countries could also become energy clients for Romania. There are, thus, significant 63 Known as the Third Energy Package. 94 obstacles to overcome to ensure international trade in electricity grows smoothly. But there is plenty of international experience to learn from, in and outside Europe. 95 7. TRANSPORT Romania is falling behind the EU averages in key highway and rail indicators. Focusing on four priority areas can help Romania to catch up. First, it is important to maintain momentum in using available EU structural funds to implement signed contracts, finalize project preparation, and lay the groundwork to take advantage of the 2014-20 programming period. Second, the corporate governance framework for transport SOEs can be improved, particularly for roads and railways. Changes can include privatization, the establishment of clear performance management contracts and clear rules and procedures based on incentives for infrastructure management and service provision. Making government funding conditional upon on these improvements taking place can help to spur the improvements. Third, allocate resources to implement the Road and Railways Transport Strategy, which covers strategic objectives, policies and proposed investment programs for the next several years, and is backed by sound reflection on the corresponding financing resources (from the budget or other alternatives) and the review of critical project cycle hurdles. Fourth, complete the framework for public-private partnerships (PPP) to start attracting private investments on a scale consistent with market expectations. A. INTRODUCTION64 208. Romanian companies require an efficient transport system to reduce costs, increase their access to the European market and enhance their competitiveness. A well-functioning transport system facilitates integration of Romanian production into European value chains. It stimulates foreign investment and the associated introduction of new technologies, improving productivity. It improves the mobility of the domestic labor force. And it introduces much more competition into domestic product markets, partly through supporting more efficient retail and distribution operations. These are all critical to Romania’s growth and convergence aspirations. 209. The transport system has multiple interdependent components or subsectors: roads, railways, ports and airports along with all the services that constitute the logistics chain. National performance can be compromised by weaknesses in any one of them. Currently, transport performance is far below the expectations of Romanian citizens and businesses, and very far below European quality standards. In general, the links in the logistics chain that are in private hands—finance, communications, warehousing, and road-transport services—are well-developed. Sectors that are owned and operated by the government are where the problems lie. In particular, Romania’s roads are underdeveloped relative to its needs, and there is a lack of good roads sufficiently connected to the main European arteries. The railways are also ill-suited to the country’s needs, mostly because there is a reluctance to close uneconomic lines, which means that the system has become highly dependent on the public budget and has accumulated serious arrears to suppliers, electricity providers, tax authorities and social security and insurance agencies. As noted in chapter 4 on energy, this undermines the sustainability of public finances generally. 210. Reforming SOEs is central to improving the transport system. Currently there are 23 SOEs in the transport sector, most of them under the Ministry of Transport and Infrastructure (MoTI). The four largest are the SOEs responsible for road system development and maintenance, maintaining railway tracks, operating the rail passenger service and rail freight operations. All of them are among the top 10 Romanian arrears generators. 64 This chapter draws on the World Bank Functional Review for the Transport Sector (World Bank, 2010e). 96 Table 11: State-owned enterprises supervised by MoTI Name Status Compania Nationala Administratia Canalelor Navigabile SA Commercial Company Compania Nationala Administratia Porturilor Dunarii Fluviale SA Commercial Company Compania Nationala Administratia Porturilor Dunarii Maratime SA Commercial Company Compania Nationala Administratia Porturilor Maratime SA Constan‫܊‬a Commercial Company Compania Nationala Aeroportul Bucuresti SA Commercial Company Compania Nationala de Autostrazi si Drumuri Nationale din Romania SA Commercial Company Compania Nationala de Cai Ferate (CFR) SA Commercial Company Compania Nationala de Radiocomunicatii Navale Radionav SA Commercial Company Regia Autonoma Administratia Romana a Servicillor de Trafic Aerian - ROMATSA Regia Autonoma Regia Autonoma Administratia Fluviala a Dunarii de Jos Regia Autonoma Regia Autonoma Autoritatea Aeronautica Civila Romana Regia Autonoma Regia Autonoma Registrul Auto Roman Regia Autonoma Societatea Comerciala Compania Nationale de Transporturi Aeriene Romane TAROM SA Commercial Company Societatea Comerciala de Transport cu Metroul Bucuresti (Metrorex) SA Commercial Company Societatea Comerciala Grup Exploatare si Intretinere Palat CFR SA Commercial Company Societatea Comerciala Institutul de Cercetari in Transporturi INCERTRANS SA Commercial Company Societatea Comerciala Maratime Training Centre Television Commercial Company Societatea Comerciala Telecomunicati CFR SA Commercial Company Societatea de Administrare Active Feroviare (SAAF) SA Commercial Company Societatea Feroviara de Turism (SFT CFR) Commercial Company Societatea Nationala Aeroportul International Mihail Kogalniceanu – Constan‫܊‬a SA Commercial Company Societatea Nationala Aeroportul International Timisoara – Traian Vuia SA Commercial Company Societatea Nationala a Cailor Ferate Romane (SNCFR) SA Commercial Company Societatea Nationala de Transport Feroviar de Marfa (CFR Marfa) SA Commercial Company Societatea Nationala de Transport Feroviar de Calatori (CFR Calatori) SA Commercial Company Source: Ministry of Industry and Transport draft Guidelines on Corporate Governance 211. Problems in meeting the transport needs of the Romanian economy are not due to lack of funding. Failure to maintain and expand assets, especially roads, is primarily the result of poor planning and implementation capacity rather than lack of funds. In fact, Romania trails the rest of the EU10 in using European cohesion and structural funds, even though between 2007 and 2013, about €4.6 billion were allocated to transport. EU funds could have significantly supplemented budget funding of transport investments during a period of severe fiscal stress in Romania. 212. With regard to railways, especially passenger service, the asset base is too large. Networks and services need to be rationalized to eliminate uneconomic low-traffic lines. Romania’s inability to exploit the EU funds allocated for transport, inadequate spending on maintenance and continuation of uneconomic passenger services illustrate serious issues related to sector and corporate governance and company management. Reforms that could address these problems span a considerable range. At the highest level, there are strategic considerations, such as the need for a comprehensive policy for the sector and a definition of appropriate public and private roles. Practical issues also need to be considered, such as establishing viable intermodal competition and adopting governance standards in the state- owned portion of the sector. 213. Drawing on a recent World Bank review of the MoTI, this chapter analyzes the challenges facing the ministry and outlines reforms needed to address them. However, further analysis and data collection will be needed to refine the reform agenda and define more specific implementation arrangements. Accordingly, besides offering recommendations, this chapter also offers a vision for the future that includes additional work expected to be part of the whole reform process. 97 B. CURRENT STATUS AND CHALLENGES 214. The sector performs badly despite past reform efforts. Inadequate infrastructure is a major problem for those hoping to do business in Romania, according to the Global Competitiveness Report 2012–2013 (WEF 2012). The report ranks Romania’s transport infrastructure near the bottom among 144 countries surveyed and at the bottom among the 27 EU member states (Figure 58). These low scores reflect the facts that in Romania, (a) there is as yet no motorway network despite high road traffic on the country’s major transport corridors; (b) a fifth of the national road network is in poor condition and (c) the railway grid suffers from an ever-increasing number of speed restrictions due to overdue maintenance and overhaul of the tracks, which reduces the average railway speed by 0.8 km per hour a year (Government of Romania, 2009). Figure 58: Transport infrastructure, EU member states QualityofOverallInfrastructure Czech… Netherla… Luxemb… Portugal Greece Germany Bulgaria UK Belgium Italy Hungary Romania France Ireland Cyprus Austria Denmark Sweden Spain Malta Poland Finland Estonia Lithuania Slovenia Latvia Slovakia QualityofRoads QualityofRailroadInfrastructure Netherlands UK Portugal Luxembourg Greece Germany Spain Denmark CzechRep. Malta Poland Bulgaria Belgium Italy Estonia Hungary Romania France Cyprus Ireland Lithuania Austria Sweden Finland Slovenia Slovakia Latvia Netherlands Luxembourg Portugal Germany CzechRep. Bulgaria Greece Belgium UK Italy Hungary Estonia Romania Cyprus Ireland France Malta Austria Sweden Spain Denmark Poland Finland Lithuania Slovakia Latvia Slovenia Source: World Economic Forum (2012). 215. Transport infrastructure and services problems are concentrated in the public part of the system. The performance of both road and railway networks is below the standards that modern logistics chains require. There are also some very serious problem areas, such as physical access to parts of the port of Constan‫܊‬a by both road and rail and the lack of dedicated regional intermodal terminals. Many industries require sophisticated logistics services (e.g., loading, repackaging, redirecting) where speed is essential; whether such industries will ever be attracted to Romania will depend partly on how efficiently it can deliver those services. 216. Railways make heavy demands on the national budget. As they have become more and more dependent on the government, the railway SOEs’ arrears threaten the sustainability of public finances. The three state-owned railway companies are in dire financial straits: 98 x The national rail freight company, CFR Marfa, was able to balance its accounts for a few years, but with its rigid business and management structure, it could not adjust after the financial crisis when competition from private freight companies intensified. In 2008, it lost RON 183 million and in 2009, RON 361 million; since then, despite significant cost-cutting, CFR Marfa has been facing the prospect of bankruptcy. It generated a loss in 2012. Under the direct tutelage of the transportation ministry since 1998, CFR Marfa has become increasing squeezed between a deregulated road freight industry and a private rail freight industry. It seems unlikely to survive without a more selective and aggressive business model, and the ministry is unlikely to adopt one. Because it is one of the largest freight transport companies in the region, and its personnel skills, assets and customer base are valuable, privatizing it would give CFR Marfa the commercial freedom and opportunity to contribute positively to the rapidly changing European rail freight market.65 x The passenger rail service, CFR Calatori, lost RON 267 million in 2008 even after receiving government subsidies of RON 1.34 billion under a Passenger Services Contract (PSC) and for rolling stock. In 2009 the loss was reduced to RON 229 million, after subsidies of another RON 1.44 billion (RON 1.11 billion from PSC payments and RON 326 million in rolling stock subsidies). x The rail infrastructure company, CFR SA, lost RON 892 million in 2008 after income from track access charges of RON 1 billion and a government infrastructure contribution of RON 96 million. In 2009, the losses increased to RON 1.215 billion after access-charge income fell to RON 938 million and government infrastructure contributions fell to RON 55 million. 217. Furthermore, all the main transport SOEs are among the top 10 generators of arrears. CFR SA is by far the worst; it owed over RON 4.5 billion at the end of 2011, partly as a result of the non- collections from other rail service companies. In 2012, the government agreed to an arrears-clearance scheme: it would provide an early payment and a bridge loan to CFR SA for it to be able to pay the electricity companies that are its main creditors. Under the scheme, CFR SA paid back RON 1.2 and the creditors cancelled accumulated penalties close to RON 800 million. A restructuring program sponsored by EBRD will follow to ensure that CFR SA addresses the structural problems behind its arrears to electricity companies. 218. Romania is one of the worst performers in Europe in terms of EU funding for transport projects. As of September 2011, halfway through the program period, the value of Sector Operational Plan (Transport) (SOP-T) projects approved was less than 20 percent of the 2007–2013 allocation. Payments, which reflect the rate of implementation, were less than 3 percent. A similar situation occurred in 2000–2006 with the previous large EU program for transport infrastructure (ISPA). Most ISPA projects had not been completed even into 2011. 219. Delays and cost overruns seem to be general features of Romanian transport projects. The direct consequences are easily observable: in the last 20 years, only about 240 km of new motorways have been opened and less than 200 km of railway lines have been upgraded to higher speeds. Repairs of national roads also move at a sluggish pace. Although absorption has improved somewhat recently, a brief note on the implementation status of the Operational Program for Transport indicated that by May 2012, reimbursement of cohesion funds for Priority Axis 1.1 (TEN-T roads) projects had reached 20.5 percent and for Priority Axis 2.1 (national roads) it reached 17.7 percent; however for Priority Axis 1.2 (railways, CFR SA), it was only 4 percent. 65 The government approved a decision to privatize CFR Marfa in February 2013. 99 220. SOEs have not adapted to the market. While the number of passengers that CFR Calatori carried roughly halved between 2000 and 2009, the number of passenger trains fell only 4 percent. The passenger service contract (PSC) between the government and CFR Calatori contains few incentives to rationalize service, improve efficiency or bring in more revenue. It needs to be rewritten to set operational and commercial targets and incentives. Also, very low passenger flows on many branch lines are neither an efficient use of expensive equipment nor environmentally friendly. An integrated network of rail and connecting bus services could provide much better value and lower greenhouse gas emissions. x CFR Marfa tried to adapt to a market for rail freight that was declining due to both the restructured economy and competition from road transport and private freight train operators. It managed to marginally improve its average trainload, but it still retained far more staff and assets than its operations justified. Labor productivity, quite high in 2000 compared to European norms, had halved by 2009, as had locomotive and rail car productivity. It has since made very significant cuts in staffing and costs, though still not enough for a full adjustment. x The average infrastructure standard has been dropping steadily on all performance indicators. The network and staff reductions made by CFR SA, which serves CFR Calatori, CFR Marfa, and private freight train operators, have not been significant. A number of freight train operators cite the quality and reliability of their routes through the system as a serious problem when they are competing with road transport. The condition and reliability of rail infrastructure assets will continue to decline if the public funding likely to be available over the next few years is distributed over a network as large as the current one. Around 80 percent of railway business is handled on just 30 percent of the 10,000-km network.66 CFR SA will need to work with the government and train operators to evaluate realistic options for a financially sustainable network that can fully serve core markets where railway services may have a long-term competitive advantage. After that assessment, the ministry can focus on a public network that is more affordable. Even with network and efficiency improvements, railway infrastructure, like the roads, will require steady long-term support from the Romanian budget, and the arrears problems must be solved. However, as is clear from past experience, arrears clearance schemes make sense only if networks and staffs are downsized and relationships with other operators (especially public ones) in terms of payments are normalized. x The national roads company, RNCMNR, faced the opposite challenge: here, demand was rising rapidly, not dropping. However, despite their significant budgetary resources in the past decade, RNCMNR has been unable to deliver the much-needed capital investments in motorways and roads on time and within budget, and the efficiency of its road construction and maintenance functions is not improving. 66 See for example General Transport Master Plan, June 2009. 100 C. RECENT PROGRESS 221. Despite the challenges remaining, it is important to recognize that the Romanian authorities have taken significant steps in the past 20 years to transform all areas of the transport sector from one that served a planned economy to one that supports a free market. The government has privatized road construction and maintenance services, and railway staff was significantly restructured in the 1990s. Moreover, Romania has put in place the reforms necessary to align transport policy with EU common market requirements. During the accession phase, transport services were further liberalized; access to railway infrastructure was opened and Romania committed to bringing its infrastructure up to European standards over time. Some specific actions included: x The environment was made more conducive to private participation. For example, in port operations, this type of change reinforced Romania’s position as a key player in the container transshipment market in the Black Sea. It has also stimulated the emergence of a competitive trucking industry, with a modern fleet and efficient operations. x Romania has also taken steps to streamline the process of infrastructure investment. It passed a new law on land acquisition, tendered a few projects while their approval for funding was still pending, standardized contracts and renegotiated the Brasov-Bors motorway contract. x The railways were vertically unbundled. Instead of a monolithic structure, there is now an infrastructure manager (CFR SA) and separate passenger (CFR Calatori) and freight (CFR Marfa and private) operators. With open access to railway infrastructure, there emerged a vibrant private railway freight business; in the EU, Romania is second only to the UK in terms of the share of rail freight handled by the private sector. Railway reform also brought transparency to the financial accounts of the railway SOEs and to intercompany transfers, as well as to the transfers from the state budget to the railway sector. Romania earned a relatively good score on the Rail Liberalization Index and Rail Competition Index (IBM, 2011), which measure the degree of liberalization of and competition in the rail markets of EU member states. x A company structure was adopted for the main railway and road SOEs. This put Romania many years ahead in the transition to a market economy. The use of company law to reconstitute transport infrastructure and service entities was intended to keep the delivery entities at arm’s length from both the structural bureaucracy of government departments and the influence of short-term political decision-making. In reality, however, the road SOE gets all its revenue from the budget as tolls and other levies are not used in Romania. 222. The Romanian authorities should now focus their interventions on sector governance. Romanian and EU policies for the sector are now aligned; industry structure generally follows good practice. What is missing is that Romania needs to put into operation the EU model it has adopted. That would allow it to receive the full intended benefits of previous reforms and prevent them from being captured by vested interests. A key step in this process is an overhaul of the scope of SOE operations. In particular, privatization of CFR Marfa67 would allow more productive deployment of assets than the current arrangement has allowed. Reduction in the range of passenger services would contribute to their financial viability as would reducing the network to viable lines for both freight and passenger traffic. 223. A second area for governance reform is to overhaul the SOEs board and management structures. Part of the problem with the performance of the SOEs is that their boards lack strategic vision and commercial experience. Boards are dominated by career officials from the transportation 67 Privatization proceedings began at the start of 2013. 101 ministry who often have political backing. This has resulted in a long-term decline in many performance indicators. The composition as well as the size of the boards and the contracting terms of directors should be revisited to improve planning and management of the transport SOEs. 224. Reforms are also needed within the Ministry of Transportation. The difficulty Romania has experienced in making use of EU funding and in expanding the road network point clearly to the need for changes in administrative structures and procedures at the ministry. Problems arise from weaknesses in project preparation, lack of use of external consultants and experts and an overly complex decision- making processes. The ministry also needs to devote more attention to developing its medium-term planning capacity so that budgets can be elaborated within the available medium-term. Currently, in Romania’s program of transport infrastructure investment, most projects are either not funded, not started or not completed. The annual expenditure on capital works implicitly authorized by the program is many times greater than what has traditionally been spent, or than is actually available. Yet as already noted, only a small fraction of the EU funds already pledged for Romanian transport infrastructure have been used. This process would be enhanced by a medium-term strategic transport plan and by the use of three-year ceilings in the budget process. The ministry also suffers from conflicting roles as a policy- maker, regulator, owner and client. Separating them will help improve transparency and efficiency. 225. Deregulation could build on the reforms of Romania’s road and rail transport service. Previous decisions have already led to growth in the private bus and road-haulage industries and the licensing of private operators to use Romania’s railway system, so that Romania now has one of the highest proportions of private rail freight operations in Europe. However, attempts to attract private financing to the more challenging sphere of transport infrastructure through PPPs have not been successful. Policies for encouraging private participation in transport services and infrastructure should be part of the Transport Strategic Plan. Options might include the provision of integrated rail/bus systems, piloting of private concessions for regional passenger rail services and the adoption of performance-based contracts for road maintenance.  D. OPTIONS FOR REFORM 226. The lack of quality transport infrastructure in Romania places additional cost burdens on the private sector and prevents integration with EU markets and value chains, reducing Romanian productivity. Better efforts need to be made to tap the large EU resources available for improvements. Key short- to medium-term reforms include: x Draft a comprehensive transport policy. A medium-term Strategic Transport Plan to chart a clear policy path would make it easier to focus on priorities and establish a realistic medium-term public resource envelope to achieve the aims. x Use EU funds more effectively by setting priorities and putting three-year ceilings in the budget process. The program needs to be realistic—using the three-year ceilings in the government’s fiscal strategy as a start—and it needs to be organized in a more disciplined way. If Romania is to obtain maximum leverage from scarce domestic funds, there is a solid case for giving immediate priority to projects for which EU funds are available. x Privatize CFR Marfa. Declining labor and equipment productivity and the dire financial situation of CFR Marfa reflect the fact that it has become increasingly squeezed between a deregulated road freight industry and a private rail freight industry. Privatizing it would allow it to contribute positively to the rapidly changing European rail freight market. The government has 102 launched this process in January of 2013 with the expectation that it will be completed in the fall of 2013. x Separate the MoTI’s potentially conflicting policy-making, regulatory, ownership, and client roles. The relationship between the MoTI and the SOEs that it oversees needs to be more transparent. Hopes of achieving additional private investment into the sector will be reduced if private companies are not able to compete on a level playing field with SOEs. x Rationalize the scale of the rail network. CFR SA could work with the government and train operators to evaluate realistic options for a financially sustainable network that can fully serve core markets where railway services may have a long-term competitive advantage. After that assessment, the transportation ministry can draw up a public network that is more affordable and efficient. Railway infrastructure will still need support from the Romanian budget in such areas as the resolution of arrears and network and staff reductions if the reforms are to be successful. x Integrate rail and bus services and allow for rationalization of branch rail lines. Very low passenger flows on many branch lines mean that an integrated network of rail and connecting bus services could provide much better value and lower greenhouse gas emissions. At the same time, private concessions could provide some regional passenger railway services. 103 8. AGRICULTURE AND RURAL DEVELOPMENT Romania has one of the best resource endowments in Europe and was once a breadbasket for Europe, but its agriculture remains underdeveloped. Challenges include a large sector of unproductive subsistence holdings, low productivity - far less than optimal use of production factors, serious exposure to various risks factors (climate change, economic crisis, financial – prices), severe generational and excess labor problems and institutional and administrative bottlenecks. Quick actions to take include: (i) implementation of the reform plan for agricultural administration; (ii) develop a new rural development strategy; (iii) streamline decision-making and sharpen targeting of rural development projects (iv) scale- up property title registration to improve rights and working of rural credit and land markets; and (v) update the capacity to monitor and enforce food safety and quality standards in counties. A. INTRODUCTION 227. Transforming agriculture is central to Romania's European integration and social cohesion objectives. The modernization of the Romanian economy and the rise in living standards have by and large bypassed the rural economy. With one of the highest proportions of rural population in the EU (45 percent of total), Romania also has the highest incidence of rural poverty (over 70 percent of total poverty), a gap in living and social standards between rural and urban areas, and one of the least competitive agriculture sectors. Although agriculture covers 30 percent of total employment (compared to some 3 percent in the EU15 and 3–13 percent in the EU8), it accounts for only 5 percent of GDP (compared to 1 percent in EU15, and 0.5–2.0 percent in the EU8). As a result, Romania ranks the lowest of the EU27 in farm labor productivity, with only 22 percent of the average EU27 farm income per unit of full time employment equivalent in agriculture. 228. There is a discrepancy between the potential of Romanian agriculture and its contribution to sustainable growth and poverty reduction. Romania is one of the best-endowed European countries in terms of land, water and people. Agricultural land occupies almost 62 percent of the country’s surface area and almost two-thirds of it is arable. Properly exploited, this endowment could employ rural labor far more productively while at the same time releasing labor to sectors facing shortages. It could also help reduce rural poverty and narrow the income gap with urban areas and contribute far more effectively to growth, public savings and a more sustainable trade balance. 229. Conditions are right for taking advantage of Romania’s natural and human endowment. The world is facing an increasing demand for food but the supply is relatively inelastic and increasingly affected by adverse weather. Romania has easy access to world markets through its Black Sea ports, and EU membership provides access to both important markets and substantive financing. Through the 2007- 13 EU Common Agricultural Policy (CAP) and budget, Romania gained access to the European Agricultural Guarantee Fund (EAGF) under Pillar I, and the European Agricultural Fund for Rural Development (EAFRD) under Pillar II, receiving a total of €14.5 billion. For the next EU programming period, 2014-20, Romania is expected to secure equally sizeable support allocations for Agriculture and Rural Development (ARD). Romanian farmers can therefore benefit from the opportunities offered by market integration and the stability and predictability of the CAP policy and support framework. 230. Romania is making progress toward accessing CAP funds; yet the absorption rate needs to be improved, and how the funds will affect sector restructuring and rural economic development remains uncertain. By August 2012 Romania had committed a cumulative €5 billion for rural 104 development investment and non-investment68 measures under EAFRD, and disbursed almost €4 billion. These represent about 50 percent and 40 percent respectively of its total public financial allocation for rural development for 2007–13. With one more year until the end of the current EU financial period, Romania needs to greatly accelerate its efforts so that it can also commit the rest of its ARD allocation, which otherwise will be lost.69 The advent of the global financial and economic crisis provides an opportunity for progress. The crisis has demystified Romania's apparently good economic performance in recent years and unveiled the prerequisites of sustainable growth and poverty reduction. One of them is the ARD program. The very large funding opportunities offered by the CAP and national programs are a unique opportunity to remove the obstacles that stand in the way of turning Romanian agriculture into a competitive sector. B. CURRENT STATUS AND CHALLENGES a. Unique dual farm structure 231. With Romanian agricultural land almost equally divided between small and large farms, the country has a dual farming structure that is unique among EU new member states. About half the land and the livestock are tied up in unproductive subsistence holdings that account for 94 percent of the 3.9 million farms (Figure 59). They are not eligible for direct payments (Pillar I) because they are too small and have little chance of becoming competitive. At the other extreme, about 2,719 large farms (over 100 European Size Units, ESU), averaging 1,750 hectares, operate on close to 17 percent of the utilized agricultural area. These farms are likely to be competitive and take full advantage of the high production and market potential as well as the income and investment support opportunities the CAP offers. One central objective of the Ministry of Agriculture and Rural Development (MARD) is to support the emergence of competitive intermediate, family farms which are currently under-represented, under-exploited and under-served. 232. Over time, smaller and middle farms have released land, to the benefit of larger holdings (Figure 60). Farms below 5 hectares have steadily decreased in numbers. However, with the farm sector overall shedding more than 600,000 holdings since 2003, the number of very small farms has consistently remained at above 90 percent of total numbers, though, importantly, the utilized agricultural area (UAA) decreased in relative terms to 30 percent in 2010. Farms in the 5–50 ha range saw a relative peak in terms of UAA operated in the run-up to EU accession (25 percent), only to drop back to 18 percent in 2010. Holdings bigger than 50 ha have absorbed the land thus freed; they are currently using the highest land share in the last decade, 53 percent. 233. But this shift of land resources to larger-scale farmers has failed to translate into a matching increase in economic performance. In the run-up to 2007, the economic performance of the smaller farms deteriorated steadily, and more and more land slipped into subsistence uses (49 percent of the UAA was being used by holdings smaller than 2 ESU 70 in 2007, up from 41 percent in 2003). Yet, the performance of the large holdings (over 100 ESU) also tanked; their share in UAA fell to 17 percent, 68 Investment type measures include modernization of farms and food processing units, development of rural infrastructure, and support for rural business. Non-investment type measures cover, e.g., compensation for farming in less favored areas or rewarding farmers for adhering to higher agri-environmental standards. 69 EU absorption accelerated significantly during the second part of 2012 but the challenge of efficiently absorbing EU resources for rural development is still there.As of mid-2013, the country was discussing with the European Commission the possibility of receiving a one year extension for the absorption of the 2007-13 resources. 70 For each farm activity (e.g., wheat production or dairy farming), a standard gross margin (SGM) is estimated, based on the area (or the number of people) and a regional coefficient. The sum of these margins for a farm is its economic size, expressed in economic size units (ESU). One ESU corresponds to a €1,200 SGM. 105 down from 25 percent. The semi-subsistence (2–8 ESU) and middle (8–100 ESU) segments remained virtually unchanged, together accounting for about one-third of the total UAA. Figure 59: Utilized agricultural area by economic Figure 60: Distribution of the utilized agricultural size in new EU member states %, 2007 area in Romania, 2003-10 by physical (above) and economic (below) farm size clusters <2ha 2Ͳ5ha 5Ͳ10ha 10Ͳ50ha 50Ͳ100ha >100ha 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 2003 2005 2007 2010 2003 2005 2007 2010 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% <1ESU 1Ͳ2ESU 2Ͳ8ESU 8Ͳ40ESU 40Ͳ100ESU >100ESU *For 2010, Eurostat employs an economic size classification that is not comparable with the ESU classification used in 2003-2007. Figure 61: Share of products in domestic Figure 62: Share of various crops in arable land agricultural production (%) (%) Romania and Selected Eastern European countries, Romania and Selected Eastern European 2011 countries, 2010 80 100 oilseeds milk potatoes fruit 90 70 freshvegetables wheat 80 60 corn 70 60 50 50 40 40 30 30 20 20 10 10 0 Romania Poland Hungary France EUͲ27 0 Romania Hungary Poland EUͲ27 France wheat corn othercereals oilseeds freshvegetables fallow Source; Eurostat 2010 and 2011 234. As a result average yields remain low, which suggests a far less than optimal use of production factors. Average farm yields for major agricultural products are only half of those in the EU-27: for common wheat, 2.33 tons/ha compared to 5.1, for corn, 3.3 tons/ha compared to 6.5, and for sugar beets 26 tons/ha compared to 60.4. Recent, exceptionally severe droughts, alternating with floods, have only widened these gaps. On average, it appears that little progress has been made in increasing yields: from 1999 to 2009, wheat and maize yields stagnated. Overall, and as Figure 61 and Figure 62: 106 Share of various crops in arable land (%)Figure 62 illustrate, low value production has higher contribution to Romanian agricultural output than in other Eastern European countries, while using a comparable share of arable land. However, these numbers have to be considered in light of the bipolar farm structure: it is likely that a small number of efficient and competitive farms is making yield and productivity gains while the majority is falling farther behind. This duality affects sub-sectors differently, but mainly cereals. Animal output (including production and derived products) in 2009 represented 33 percent of the value of agricultural production. The cattle population (2.6 million animals, primarily dairy cattle) is concentrated mainly in the north, the north-east, and the northern part of the southern plain. Most of the livestock production is consumed by the households that produce it. Romania does not have a sufficiently robust beef industry to meet the requirements of mass-market retailing. Dairy production is still very fragmented, with about a million farms that have just one or two cows. Dairy yields are still low compared with countries in Western Europe and have even declined in recent years; milk quality usually does not meet EU standards (NRDP 2009). 235. Building up the medium-size farm segment is essential for tapping the potential of the Romanian ARD sector. To become competitive, these intermediate-size farms will have to overcome multiple obstacles, one of which is access to markets. Several market failures constrain the transition from semi-subsistence to commercial farming, among them access to commodity markets, farm inputs, machinery services, credit and irrigation services. The difficulties most farmers experience in pre-financing and co-financing Common Agricultural Policy (CAP) Pillar II fund investment suggest that lack of capital is a major impediment to the absorption of EU funds. While secure land titles will over time facilitate access to credit, the limited depth of the financial sector is a serious problem. Recent experience with the Farmer Program has shown that providing more liquidity to banks will not help overcome the problem of credit access for family-operated farms, although it improved access to capital for the more competitive, mainly larger farms. Other approaches can be effective, including greater reliance on well-designed partial guarantee programs, supporting micro-lending, and linking access to credit to complementary risk mitigation measures (e.g., marketing or production contracts to reduce market or price risk; access to advisory services to reduce production and market risks). Table 12: Average crop yields in selected EU countries . Average crop yield and coefficient of variation (100kg/ha; 2007-2009) Wheat Barley Grain maize Potatoes Sunflower Yield C.V. Yield C.V. Yield C.V. Yield C.V. Yield C.V. Romania 24,5 0,31 22,7 0,29 27,7 0,28 146,1 0,05 11,7 0,32 EU15 61,4 0,05 48,0 0,02 94,6 0,01 390,6 0,02 n.a. n.a. Czech Republic 53,2 0,08 43,2 0,09 75,3 0,09 259,1 0,01 23,3 0,06 Estonia 32,2 0,06 26,3 0,02 n.a. n.a. n.a. n.a. n.a. n.a. Latvia 36,9 0,03 24,3 0,03 n.a. n.a. n.a. n.a. n.a. n.a. Lithuania 41,3 0,04 28,9 0,06 44,5 0,06 133,2 0,13 n.a. n.a. Hungary 41,4 0,15 36,5 0,16 58,6 0,27 248,2 0,07 23,6 0,10 Poland 40,6 0,02 32,3 0,06 62,0 0,05 201,4 0,05 17,8 0,01 Slovakia 42,4 0,11 35,8 0,12 64,2 0,28 171,5 0,06 22,8 0,10 Source: Eurostat 107 236. Other problems are severe generational Figure 63:Age structure of farmers in selected EU and excess labor problems. To raise countries, 2007 productivity, small and intermediate farms need to become larger and release excess labor. That is challenging when too much land is tied up with older farmers, especially subsistence farmers, and when excess workers stay on the farm because they lack skills, adequate social protection and employment opportunities in nearby towns. Farmers beyond retirement age account for 44 percent of all farmers, and another 23 percent are older than 55 (Figure 63). About 70 percent of the land held by subsistence farms is managed by holders who are 55 or older. With pensions low and food prices increasing, there are few incentives for poor and old rural households to 19. Source: Eurostat give up farming. This sustains over-employment in agriculture, keeps incomes low, and keeps down the supply of farm land for restructuring and consolidation. Transfer of land from less to more competitive farms through sale or lease is complicated by the lack of secure land titles, sometimes unclear boundaries, and the high survey and registration costs associated with land titling. As already noted, the absence of secure land titles further restricts access to bank credit. 237. Older farmers are not well-educated. A 2003 survey found that about 60 percent of the farm population had only primary or secondary school education. Less than 2 percent had any higher education. Moreover, the quality of education in rural areas is low. Many children graduate without acquiring the skills they need to succeed in the labor market; children in rural areas score even worse on general assessments than children in urban areas. For example, results of the Progress in International Reading Literacy Study (PIRLS) 4th grade reading assessments showed that in 2006 scores were 11 percent higher in urban areas than in rural (World Bank 2010a). 238. Client-responsive advisory services targeted to the needs of the farming population have yet to be expanded. Field assessments have shown that, while many farmers are aware of the support programs currently available, they know very little about: (1) how support opportunities will evolve in the future, e.g. how Single Area Payments (SAPS) will increase over time; or (2) the standards that farmers will have to observe to meet cross-compliance obligations starting this year. Similarly, the coordination and adaptation between national programs and CAP Pillar II support measures in a particular rural area to respond to local needs often suffer from lack of administrative coordination across programs or departments, as well as inadequate delegation of decision-making power to the local level, or exclusive reliance on poorly motivated or equipped public servants. 239. Delivering advice and information to smaller farms not only has specific challenges, it requires substantial administrative capacities. Farmers from small agricultural holdings are often not accustomed to formal paperwork and have difficulties filling out applications for support. Furthermore, ownership of small holdings is often unclear and farmers are not accustomed to keeping detailed records. Consequently, administrators must devote a great deal of resources to advising them on how to complete application forms, even filling out the forms for them. 108 b. Food safety and quality management 240. Free access to the EU market offers a wealth of opportunities to Romanian food producers, but they will be better tapped if some challenges are addressed first. With regard to food safety standards, Romania generally met the commitments arising from the EU accession negotiations. A number of food enterprises were allowed transition time to become compliant with the EU norms. This period expired at the end of 2009. About €1 billion of public funds were made available under the NRDP to facilitate adaptation and modernization of Romanian food enterprises. 241. There are still serious concerns about veterinary public health, in part because of a complex institutional environment for policy formulation and implementation in the food safety area. The National Sanitary Veterinary and Food Safety Authority (ANSVSA) is considered to be relatively weak, with limited capacity to fulfill its mandated functions as the main coordinator on food safety in Romania. Effective implementation of a reliable food safety system is further complicated by the involvement of a number of other players, including the Codex Alimentarius activities of the Ministry of Public Health, the MARD, and the National Authority for Consumer Protection. ANSVA’s recent handling of incidences involving the mislabeling of horsemeat and aflatoxine contamination shows positive signs, and the agency has also been proactive in establishing a number of agencies and subcommittees for labeling, sampling and analyzing methods, food hygiene, inspection of import/export and certification systems, additives, contaminants, and pesticide residues. Nevertheless, concerns over safety and reliability have curtailed opportunities for selling Romanian agricultural products in the rest of Europe, helping to bring down the competitiveness of Romanian agriculture. Inability of the government to ensure proper standards is deterring investment in food processing and farm production, even leading to the exit of some foreign investors who wanted to take advantage of Romania's considerable potential. For instance, because of concerns about control of swine fever, Romania is prohibited from trading live pigs or exporting pork products. 242. Romania's dual farm structure makes establishment of a farm-to-fork integrated food safety supply chain particularly problematic, but the problem is not insurmountable. The main problem is dissemination and enforcement of on-farm quality assurance programs in a fragmented farm environment. It is exacerbated by the sheer number of EU regulations and provisions that are yet to be aligned, operationalized, and eventually met at farms and processing plants along the value chain. c. Institutional and administrative bottlenecks 243. For more than a decade, Romania’s ARD Administration has been the object of numerous reform initiatives. Many of these reforms were drastic, ranging from the challenges of acquis transposition and institutional expansion in the run-up to accession to current consolidation efforts in response to the national fiscal crisis. None of these reforms was system wide, but most were fundamental and were also heavy consumers of resources. Alongside with frequent senior management changes and moving policy targets, they left the administration with virtually no room for a systemic strategic consolidation of reforms. Nevertheless, across all administrative domains, the ARD Administration could use significant capacity building efforts to enhance policy and service delivery. 244. The obvious performance divide within the ARD Administration presents both challenges and opportunities. In the areas studied, all those in charge of programs co-financed by the EU or co- managed by the EC ranked at the upper end of the performance scale with regard to the assessed dimensions. Those working on internal services or national programs generally achieved lower performance ratings, and had performance-reducing spillover effects on implementation of the EU- related programs. This evident bipolarity means the services and agencies that perform less well need to 109 be reformed significantly faster and more deeply than the EU-related services, which are themselves in the process of continued adjustment to CAP-compliance. But the relatively higher performance of EU- related services also presents an opportunity: good practice models and solutions are available and have been tested in-house. They require adaptation and roll-out, but not fundamental development. 245. A consistently reformed ARD Administration could effectively deal with the structural challenges facing agriculture and rural development in Romania, such as: x Lack of a comprehensive and inclusive sector-wide strategy to guide ARD policy formulation and implementation: Development of EU-funded programs adheres strictly to the EU’s demanding strategy and program formulation requirements, but strategic documents cover only CAP-funded domains—Ministry of Agriculture and Rural Development (MARD) national programs and policies are not yet integrated into this framework. As a result, ARD policy-making is in part driven by EU absorption requirement rather than being results-driven and path- dependent. There appears to be no document that captures the vision and strategy for the ARD Administration itself. x Pronounced institutional fragmentation, both across ARD agencies and in territorial branches. This creates extra administrative costs and challenges in the interface with policy beneficiaries. It also causes overlap in the delivery of functions, most notably processing of EU funds applications, delivery of advisory services, and controls. x The compartmentalization of MARD activities, the complexity of management layers, and poor delegation and communication: Management and implementation needs for EU programs have led to a structural schism within MARD, making challenges more pronounced in the departments less involved in EU fund management. An internal reorganization of MARD activities and functions is needed that better reflects CAP requirements, promotes competence teams, simplifies reporting lines, and reduces spans of control. x The bipolar MARD budget formulation process between EU-funded and national programs. Formulation of budgets for EU-funded programs is based on agreed medium-term expenditure frameworks, but for national programs it does not reflect the underlying medium- term strategic priorities but is mainly a function of semi-constant allocations based on the previous year’s spending. x Strategic planning of MARD activities and programs that is not supported by a consistent structure for program budgets. The current functional budget structure in MARD is an accepted means of accounting, but neither its structure nor its presentation make it useful strategic resource allocation, effective management, performance management, and accountability. Most MARD managers have expressed a deep desire for a program-based display that can evolve into a performance-based program budgeting structure. d. Climate change and natural calamities 246. Droughts, floods, and the soil erosion caused by deforestation are major problems. The expected effects of climate change will affect the availability and predictability of water resources for agriculture. Total annual rainfall will decrease, but the rain that does fall will be more intense and of shorter duration. Heavy rainstorms will generate high runoff and more flash floods, exacerbating soil erosion and damaging steep streams and waterlogged low areas. Demand will increase for flood protection and drainage facilities. Meanwhile, the volume of water available for irrigation will decrease gradually, requiring better management to achieve more effective and efficient use of water. 110 C. VISION FOR THE SECTOR 247. The rural economy can become more competitive through sustained increases in productivity, contributing to rising income opportunities that help bridge the gap with the urban economy. Romania needs to unleash a process to gradually close the productivity gap with Europe and then keeps abreast of technological advances in the areas of specialization. Factor markets in the rural areas will need to operate more efficiently. An active market for land is in place, supported by improvements in tenure security and lower transaction cost on land transactions. The land market, jointly with improved delivery and availability of inputs and supporting services, facilitates financing the modernization of the sector and the process of land consolidation. Better compliance with quality and food safety rules would facilitate access to EU and other markets abroad. The transformation of the rural economy generates employment opportunities for the increasingly qualified rural population. 248. Institutional strengthening is required to support an increasingly competitive rural economy. MARD capacity to draw strategy and design policy will need to be significantly enhanced. The current compartmentalization in policy formulation would need to give way to integration of the strategic functions under uniform management arrangements, and to an improved interface with other agencies of government. Better financial management is required to remove the institutional distortions introduced by CAP, in particular by leading to the adoption of budget programming that consolidates all financing sources, common and uniform implementation rules, and institutional simplifications that ease the interactions between the government agencies and the beneficiaries. 249. Partnerships between the government and farmers are essential. The Government would also need to enhance partnerships with farmers’ and industry associations, commercial banks, NGOs, academia, and others at both central and local level. Likewise, the coordination between rural and regional development policies and institutions would increase to facilitate labor mobility and attractiveness to non-farm business investments by improving the quality of infrastructure. An empowered MARD would take a lead in managing catastrophic risks brought by natural calamities, and invest in mitigation of the impact of climate change. 250. There are various options for boosting farm productivity. The first focuses on assisting the movement of some workers to urban areas as it will naturally occur in any case. While this may initially increase further the average age of farmers left behind, it could raise their productivity if they receive training in modern farm technology. If land titles are sufficiently transferrable, more out-migration may also encourage some land consolidation and increase the number of larger, more efficient farms. The second option is to invest in activities that boost farm productivity directly, notably: x Building rural infrastructure such as roads, irrigation and drainage systems, telecoms, electrification and wholesale markets would raise the share of the retail price received by farmers and provide off-farm work for farm households; x Agricultural research and development and diffusion of its findings would lower farm costs and raise farm product quality; x Improved rural education and health services could raise productivity, improve decision-making of farmers and facilitate movement by some farm workers to non-farm jobs or to tertiary education; and x In the case of farm products in which Romania could differentiate itself in international markets, some financing of generic promotion may be warranted. 251. The above would encourage private-sector lending, leasing and crop storage and would reduce the need for subsidies. The rewards from boosting such investments will depend on the types of 111 institutions in place and the scope for institutional innovation. One question that might be asked at the outset is: is the government crowding out activities that private entities might engage in, such as crop seed production, animal health services or even agricultural research and extension? If so, might public agencies be required to compete for them with private providers? Another question is: to what extent can land be used as collateral, including for non-farm investments? That flexibility is needed if landholders are to have the opportunity to invest in the most profitable activities available to them, such as improving downstream value chain activities like direct sales or processing their produce, which may be a bigger bottleneck to farmer productivity growth than on-farm investments (Deininger, Jin and Xia, 2012). 252. The government needs to articulate an integrated agricultural and rural-development strategy. After virtually ignoring agriculture for much of the transition period, the government, as it did when it approached EU accession, has moved to selectively adopt agricultural policies sponsored by Common Agricultural Policy, such as subsidies, rather than those related to efficiency (extension) or green growth (research and innovation). This approach has now proved to be ineffective. It needs to be replaced by a new one that integrates agriculture into the broader economy. It should build on the emerging networks of modern retailers and processors, whose participation in grocery sales in Romania grew from 16 percent in 2004 to 42 percent in 2009. D. OPTIONS FOR REFORM 253. Specific policy steps to be considered in the short- and medium-term includes: x Draw a comprehensive and inclusive sector-wide strategy for rural development. This strategy should capture a comprehensive vision for the country; it should be results-driven and path-dependent rather than designed mostly to absorb EU funds. It would meet the demanding EU requirements and provide a joint framework for the user of CAP and domestic resources. It would set the basis for overhauling the institutions in the sector. A first step is to ensure timely preparation of the National Rural Development Plan for the post-2013 Financial Perspective. x Take immediate action to meet looming CAP implementation obligations. Failure to comply may result in significant financial penalties for delinquent farmers. The focus should be on addressing the challenge of cross-compliance by tightening the participation and coordination of relevant agencies (the Agency for Agricultural Interventions and Payments [APIA]; the National Authority for Veterinary Health and Food Security [ANSVSA]; and organizations in charge of environmental inspections). x Pilot systematic registration of rural land titles in the national cadaster–and initiate its rollout. Much progress has been made with developing active markets for rural land, but further gains can be obtained in reducing transaction costs and assuring tenure security. To this effect, the National Cadaster Agency (ANCPI) under the Ministry of Administration and Interior (MAI) and MAR intend to carry out pilots on parcel demarcation and registration. x Make advisory and training competencies increasingly available at the local level. A scaling-up of the Integrated Agricultural Offices (IAO) initiative can build on the success of current pilots in four judets (counties) that have proven to enhance significantly the effectiveness, efficiency and synergies of local agricultural administration and advisory services. Scaling-up IAOs would help tailoring advisory services to the evolving needs of Romanian agriculture, improving its staffing structures from mainly generalists to teams of specialized experts, and exploring further fee-for-service revenue opportunities that, over time, could reduce pressure on state budget. x Complete the implementation of the reform plan for agricultural administration to align it with the vision for the sector and the emerging rural development strategy. The central focus 112 of the reform of the agricultural administration could be the transformation of MARD, enabling it to consolidate national and EU driven programs in planning, implementation, and institutional interaction with beneficiaries. Integrating functions under a single institutional roof for policy areas shared with other agencies will aid in streamlining the supporting bureaucracy (e.g., transfer flood protection functions entirely to the environmental administration). Besides scaling up the Integrated Agricultural Offices into one-stop shops for application processing, payments, and advisory services, the government may want to consider merging the two pay-out agencies into a single Agricultural and Rural Development Agency, effective in 2014 and setting up a one-stop shop to cover both Agriculture and Rural Development (ARD) and structural funds. Private actors could provide more services, such as in technical advice. Working with the regions and local governments can emphasize the work with small farmers. With the core functions in place, the MARD can lead in managing catastrophic risks brought by natural calamities, and invest in mitigation of the impact of climate change. x Enhance the quality of services provided by the agricultural and paying agency administration to beneficiaries of the CAP program. Front-office services that are pro-active and client-oriented are crucial to ensuring that CAP and national support programs are fully subscribed to and have maximum, lasting and sustainable development impact. The elaboration of farm standards as binding foundation for the approval of investment requests and future control of cross-compliance obligation has been initiated, but it requires stronger attention. x Update the capacity to monitor and enforce food safety and quality standards in counties. 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Integrating the Flying Geese Paradigm into Porter’s Diamond: A Forward Looking Approach.� Background Paper for the CEM, World Bank, Washington, DC.   118 119 POWER POINT PRESENTATION         120          121      122     123          124          125          126          127          128          129          130          131          132          133          134          135          136          137          138          139          140          141          142          143          144          145          146          147          148          149          150          151          152    153 22°E 24°E 26°E 28°E UKRA INE ROM ANIA To Uzhhorod To Ivano-Frankivs'k CITIES AND TOWNS COUNTY (JUDET) CAPITALS To NATIONAL CAPITAL ˘ Balti ROMANIA 48°N BOTOSANI RIVERS Satu Mare MAIN ROADS Botosani Si MARAMURES re t MA RE SATU MARE SUCEAVA RAILROADS Baia Mare C Suceava COUNTY (JUDET) AND MUNICIPALITY M a Pr To Somes (MUNICIPIU) BOUNDARIES ut o Chisinau BISTRITA- r l IASI p INTERNATIONAL BOUNDARIES NASAUD NASAU D d Iasi a To Bi Zalau a Budapest str t Oradea Dej Bistrita ita To h Piatra- v SALAJ Chisinau 30°E HUN G ARY Neamt i i a CLUJ a s Roman To BIHOR re n NEAMT M OL DOVA u M Budapest Cluj- MURES Gheorgheni Vaslui M Napoca rgu Târgu Husi ts Crisul A Turda Mures HARGHITA Bacau VA S L U I BACAU . lb Miercurea- Ciuc ALBA Si re ARAD Onesti t Arad Birlad To Subotica Brad Alba Mures Iulia Medias 46°N COVASNA UK R AI N E UKR Deva SIBIU BRASOV Sfântu Sf ntu VRANCEA Timisoara Tecuci Hunedoara Sibiu Gheorghe B Lugoj TIMIS Moldoveanu Focsani GA LATI GALATI HUNEDOARA Tim (2,544 m ) Brasov a is SERBIA Petrosani M o u Galati i a n n a a t h ARGE S n ARGES t a i n s BUZAU Buza u Braila To t Resita r p LCE A VÂLCEA Novi Sad a Buzau Tulcea C mnicu Râmnicu CARAS - GORJ lcea Vâlcea PRAHOVA Târgu rgu Jiu BRA ILA BRAILA TULCEA SEVERIN Târgoviste rgoviste Ploiesti Pitesti MBOVITA DÂMBOVITA a Jiu Danub Orsova Drobeta- ita e IALOMITA Ialom j Turnu Severin W a l a c h i a ILFOV B l ack u Ar ge BUCURESTI Slobozia Slatina s Fetesti MEHEDINTI BUCHAREST r To OLT CALAR ASI Calarasi CALARASI Navodari Sea b Nis ˘ Craiova TELEORMAN Medgidia Ol nube Constanta o t 0 25 50 75 100 Kilometers Da 44°N DOLJ GIURGIU CONSTA NTA CONSTANTA 44°N Caracal D 0 25 50 75 Miles Calafat Alexandria Giurgiu Mangalia IBRD 33469R3 Turnu Magurele SEPTEMBER 2012 This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, or any endorsement or acceptance of such boundaries. To Sofiya 24°E BULGA RIA To To To Shumen To Varna 30°E Veliko Turnovo ˘ Shumen