Romania’s outlook, kept stable at BBB-. S&P warns on rising fiscal gap before elections

Standard & Poor’s (S&P) maintained Romania’s ‘BBB-/A-3′ long- and short-term foreign and local currency sovereign credit ratings, with a stable outlook, the rating agency stated. The stable outlook reflects the balance between the likelihood of Romania’s twin deficits widening on the one hand, and its modest government and external debt on the other.

“BBB-” is S&P’s lowest investment grade rating.

S&P warns on the elevated policy uncertainty in the run-up to the November general elections might lead to a further deterioration in public finances.

“Despite the likely widening of Romania’s fiscal and external deficits, we expect that government and external debt will not rise significantly and that unpredictability will subside after the elections,” S&P said in a statement.

The ratings are supported by Romania’s moderate external and fiscal debt amid reasonably firm growth prospects. The ratings are constrained by low GDP per capita (estimated at USD 9,300 in 2016) relative to peers’, alongside procyclical fiscal policy and Romania’s weak governance framework, although we note important efforts to reduce corruption in recent years.

„We believe that this interim government’s reliance on the main parliamentary parties – including on the PSD – for support makes it harder for it to reverse recent tax cuts and wage hikes. We expect that the looser fiscal stance will drive fiscal and external deficits higher, but our base-case expectation is that these will prove manageable and not return to levels observed before 2008, when general government deficits exceeded 5 percent of GDP.

Despite Romania’s improved absorption of EU funds last year, S&P’s estimates that investment in 2016 will still be about 10 percent below the highs seen before the 2008 global financial crisis,” the rating agency says.

Another related risk to macroeconomic stability is the possibility that wage growth will outpace productivity gains, leading to a loss of external competitiveness.

„We project that wage growth will likely continue during 2016, given the possibility of further relaxation of fiscal policy ahead of the general elections,” S&P says.

After a series of high deficits, which peaked at 9 percent of GDP in 2009, Romanian policymakers have been consolidating government finances by imposing tough expenditure constraints. S&P expects this trend to reverse from 2016, with the general government deficit peaking at 3.5 percent in 2017.

„We see several risks to our base-case fiscal forecasts. Pre-election measures could weigh more heavily on the government’s finances than we currently expect, not only this year but in subsequent years. These would be over and above the recent spate of changes to the fiscal code and wage hikes, the impact of which we include in our forecast. Because we do not expect a subsequent government will be able to roll back such measures, Romania’s path to consolidation from 2018 will likely be only gradual, and conditional on continuing economic recovery in the private sector,” the rating agency notes.

S&P projects that general government debt will reach 43 percent of GDP in 2019, up from the estimate of about 40 percent in 2016. Nearly 60 percent of gross general government debt is denominated in foreign currency, predominantly euros, indicating some vulnerability to adverse exchange-rate movements, S&P says. Moreover, the banking system’s exposure to the government slightly exceeds 20 percent of its total assets, which „we believe signals reduced ability to increase exposure to the sovereign in times of stress.”

Another impact of the stimulus to consumption from the looser fiscal stance is likely to be on Romania’s external finances.

„We project that the current account deficit will widen toward 3.5 percent of GDP in 2019 from 1.1 percent in 2015. The external deficit could be larger if fiscal policy is relaxed further or the country’s export competitiveness suffers from rising wages. Nevertheless, we believe that an improvement in energy efficiency and gradually increasing value-added in some pockets of Romania’s expanding export sector (especially services) are likely to prevent large external imbalances from re-emerging. (…) We anticipate that, from 2018 onward, Romania’s current account deficit will be fully financed by surpluses on the capital and financial accounts. We think the latter will benefit from continuing foreign direct investment, public-sector borrowing, and slowing net outflows from the financial sector as domestic lending opportunities increase,” agency’s analysts say.

The rating agency notes the brisk pace of bank lending to households in 2016, with mortgage loans in February increasing 16 percent year on year. With most new lending in local currency, outstanding loans denominated in foreign currency, particularly euros, continue to decline, reaching less than 50 percent of the total loan book. „We believe that, if this trend continues, it is likely to improve the transmission of monetary policy over time while reducing the domestic economy’s vulnerability to exchange rate fluctuations,” S&P shows.

Downside risks to S&P forecasts could also stem from legislation, which, if applied retroactively, could worsen financing conditions for Romania’s private sector. An example in this context is the law on debt discharge, which, in S&P’s opinion, could undermine the recent stabilization of real estate values, slow the recovery of lending growth, and even potentially discourage foreign investment in the nonfinancial sector.

„As we understand it, the aim of the proposed law is to improve debtors’ negotiating powers with financial institutions and it would give them the right to discharge debt by transferring the title over mortgaged immovable property to creditors, without entitling creditors to a claim on other personal assets. In this respect, the proposed law appears to us to depart from personal bankruptcy procedures in other jurisdictions, and it could act as a potential incentive to opportunistic default and other forms of moral hazard,” S&P also notes.