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Policy clash leaves economy vulnerable

In theory, joining the EU should force a country to adopt greater policy discipline. In practice, Romania’s muddy political waters and an appetite for spending are about to magnify its vulnerabilities, putting fiscal and monetary policy at odds, writes Adina Postelnicu.
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It was no more than six months ago when, speaking to The Banker, Mugur Isarescu, the governor of National Bank of Romania (NBR), the central bank, warned of “a continuous pressure on fiscal policy” and the risk of not having continuity in disinflation.

Since then, Romania has gone through changes that have overshadowed the euphoria of joining the EU in January. The reshuffle of the government in April, followed by the impeachment of president Traian Basescu and the referendum that reinstated him, effectively put reforms on hold.

For a while, Romania’s economy seemed to chug along undisturbed by the endless political turmoil. But that has changed. Standard & Poor’s downgraded Romania’s country risk from positive to stable, due to what the rating agency described as “a lack of transparency of the public policies in 2007”. The current account deficit has reached €4.4bn in the first quarter, a 78% increase on the same period of 2006, and analysts are saying it might go above the expected target of 11% of gross domestic product (GDP) for the whole year. But most recently, an ominous sign has made both analysts and officials pause: a widening gap between fiscal and monetary policy that risks pushing up the trade and budget deficits and undermining Romania’s most precious macroeconomic achievement since the fall of communism – reducing inflation to single digits.

Mr Isarescu has warned recently in the local media that Romania cannot afford to relax either fiscal or monetary policy. Still, the former has loosened up lately, and that did not go unnoticed. “Until 2007, fiscal policy has been consistent with the objective of reducing inflation,” says Lucian Croitoru, Romania’s representative at the IMF. “Starting this year, it appears that both fiscal and income policy are procyclical, fuelling domestic demand, which is already at a high level.”

Florin Citu, chief economist at ING Bank in Romania, shares these views. “The imbalance between fiscal and monetary policy had been maintained for a while, but has recently started to get more serious. Along with the current account deficit, it poses the higher risk for the next four to six months,” he says.

Romania is facing yet another risk, according to Mr Croitoru: “The resurgence in inflationary pressures.”

Is the NBR afraid of such a risk?

In an interview with The Banker in Sibiu, Mr Isarescu says, diplomatically: “It would be a bit too much to say [that].”

However, he acknowledges that the central bank faced the problem of having few tools left to counteract a derailment in fiscal policy. In other words, with limited monetary tools at hand, an inflation rebound would have to be addressed with tougher fiscal measures, such as a lower budget deficit, which could be achieved through higher taxes or lower budgetary spending. While this is not the case yet, concerns are mounting.

Mr Isarescu says his concerns came more from recent public statements by government officials – favouring higher wages and spending – than from statistical data. “Unfortunately, the public discourse is focusing on a single direction: higher wages and higher [budgetary] spending. Fortunately, the reality is better than the public discourse,” he says.

Mixed policies

Despite the bright picture of macroeconomic stability coming from Romania’s 8% economic growth and 4.8% inflation (slightly lower than the expectations), a question remains: what lies behind the country’s more lax fiscal policy? Are there objective constraints, an ‘original’ budgetary philosophy or simply a lack of discipline?

Mr Croitoru says that the main reasons behind the fiscal policy this year are that the government wants to spend more on infrastructure projects and social programmes, while paying its contribution to the EU budget, which amounts to 1% of Romania’s GDP. This has led the government to project a deficit of 2.8% of GDP for 2007, despite the IMF’s advice to lower it and keep spending under control.

While 2.8% might not sound much, it is the context that makes the difference. The budget was revised four times last year, a sign that “indicates problems with transparency and effectiveness of planning and execution”, in Mr Croitoru’s view. And there are other issues that seem to muddle the situation, he says. “There is no accountability for the budget and no independent institution to assess the budget. And there is always political pressure to justify a deficit target.”

In an economy that is stretched to the limit by higher trade and current account deficits, an appreciating currency, with local and general elections likely next year, “things are getting complicated”, says Mr Citu. The overheated economy is fuelled by a 20% increase in public sector wages, significantly higher that the 4.7% rate of inflation in 2006 and 12% rise in productivity.

More challenges ahead

In addition to the short-term risk of inflation, Mr Croitoru says there are two significant challenges that Romania has to cope with in the longer term. First, it has to increase its GDP per capita, now at 33%-35% of the EU’s median income. Second, it has to adopt the euro. “These targets cannot be achieved except with an appropriate mix of fiscal, income and monetary policy,” he says.

A chain of weaknesses follows higher inflation, he says. “It would translate into higher interest rates that, added to a rapid credit growth in the private sector, can magnify Romania’s medium-term vulnerabilities.”

According to Mr Isarescu: “A major risk is coming from this deviation of the money allocated for investments [through the budget] towards the consumption area.”

Putting all these risks into one equation – emerging inflation, high current account deficits and the risk of more hot money coming into the country – the question is, how vulnerable is the economy? “There is a vulnerability, yes, but not a major one. Still, we are preoccupied by it,” said Mr Isarescu.

If the NBR responds to inflationary pressures by increasing the interest rates, it may raise the question of vulnerability of the banking sector. But Mr Croitoru says: “I’m not too worried about it because the banking sector is well capitalised.” In addition, the national currency appreciation against the euro will appease some of these effects, household debt is low (less than 10% of GDP) and the corporate sector is well hedged, he says.

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Read more about:  Central & Eastern Europe , Romania