At a Crossroads: Budget Deficit Endangering Romania’s Economic Growth

Romania’s economy finds itself in a “soft landing” scenario in 2023, i.e., a slowdown in economic growth, but not a recession. We are at the end of an economic cycle that began ten years ago, in which the economy grew at a rapid pace every year, allowing us to close much of the gap that separated us from the European Union average in terms of GDP per capita. But even though we are not going through a crisis, there are major problems regarding the budget deficit and the current account deficit, which must be corrected by the government in order for the country to receive the European funds from the National Resilience and Recovery Plan (PNRR).

By Aurel Constantin

This year’s economic growth will be around 2-3%, significantly lower than last year’s 4.8%, but nevertheless, a number that demonstrates the country is not experiencing a crisis. There’s been real wage growth even in conditions of high inflation—another positive sign.

“Our GDP growth is moderate compared to previous years, but it is higher than the one in the EU and other countries,” said Eugen Radulescu, director of the Financial Stability Directorate of the Romanian National Bank (BNR), at the ZF Bankers Summit event.

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Moreover, the economy has proven resilient in the face of the multiple crises that have followed each other in recent years: after the covid-19 pandemic in 2020 and 2021, last year came with a war on the border between Ukraine and Russia, an energy crisis, and rampant inflation. Romania’s economy continued to grow throughout these events, with levels well above the EU average, and it will remain in the positive zone this year as well, despite the uncertainties that persist across the board.

Inflation stood at 10.3% in June 2023, slightly lower than May’s, when it was 10.4%. But while still high, it is significantly down from the levels recorded in the second half of last year, when it topped 17%. Fortunately, the BNR estimates further tempering to a level of 7-8% at the end of the year. The decline of inflation is mainly the result of the decrease in energy prices (electricity, natural gas, and fuels). But, as shown by the minutes of the last meeting of the BNR Board of Directors, the prices of consumer products remain high, especially for non-food and services, which also keeps inflation high. Companies have essentially passed on the rising costs of raw materials and wages to the consumer in order to preserve their profits—a phenomenon commonly referred to as greedflation.

“Longer-term inflation expectations of financial analysts had seen only a marginal drop in June 2023 against December 2022, thus remaining above the variation band of the target, while the consumer purchasing power had posted a relative recovery in March-April, as the annual growth rate of the average net real wage had returned to positive territory, especially following the decrease in the annual inflation rate,” the BNR meeting minutes read.

As for future developments, BNR members pointed out that the annual inflation rate would probably continue to fall over the following months, in line with the latest medium-term forecast published in the May 2023 Inflation Report, which had anticipated its drop to a one-digit level in Q3, to 7.1 percent in December 2023, and to 3.9 percent at the end of the projection horizon. The future decrease in the annual inflation rate would be driven primarily by supply-side factors, mainly disinflationary base effects and the improvement of global production and supply chains, alongside the sizeable downward corrections of some commodity prices, especially for energy, crude oil, and agri-food items, seen in the recent quarters amid the easing of wholesale markets. The base effects would continue to be manifested particularly in the energy segment, as well as in the processed food segment, thus also visibly affecting core inflation dynamics in the period ahead, while the decreases in some commodity prices would feed through gradually, according to the BNR statement.

Inflation Versus Interest Rates

A direct effect of inflation, in addition to the lower purchasing power of the national currency, has  been the rapid increase in bank interest rates. Loan payments rose by up to 20% due to the increase in the ROBOR and IRCC indices, which are used to calculate interest on personal loans and mortgages. Fortunately, the banking system has not experienced any issues regarding the number of non-performing loans (NPL), which are at very low levels—2.7% according to the latest BNR data. In fact, the central bank last changed the indebtedness limit—setting it at 40% of income for mortgage loans—in 2019, at a time when bank interest rates were at their lowest, which allowed the rising payments to be covered after the interest rate increase.

The good news is that with inflation on a downward trend, the reference interest rate of the National Bank is no longer increasing. At the last BNR meeting, the monetary policy interest rate was maintained at 7%—it will remain at this level until the end of the year and will likely decrease next year. Currently, the ROBOR and IRCC are at around 6%, below the BNR level.

But the rate hikes of last year and the first part of this year did have an impact on bank lending. Data from the Romanian Banks’ Association (ARB) show that lending to the population has decreased slightly compared to last year, a change that comes after years of consecutive growth. The situation is identical across the rest of Europe: bank rates have risen everywhere due to inflation, and people have been putting off taking out a loan until interest rates go back down and inflation cools off. In Romania, lending to companies increased instead, with most loans going to investments, which is good news for the economy.

“In the first and second quarters of 2023, we experienced an increase in investments, on the side of protecting and securing energy independence, namely in alternative sources of energy, as well as in the expansion of production capacities. There were many relocations from the East, from China, and even relocations from the West, from Germany, France, Spain. It’s been an extremely active year in the field of investments,” said Cosmin Calin, Corporate Executive Director at Banca Transilvania, during the ZF Bankers Summit.

In the first quarter, the loans granted to companies had a weight of 61.6% in the total of new loans granted, while those given out to the population had a share of 38.4%.

Extreme Budget Deficit

The biggest problem of Romania’s economy in 2023 is the budget deficit. According to this year’s budget, the deficit should decrease to 4.4% of GDP, from 5.7% last year, and go below the target 3% level in 2024. Unfortunately, the budget execution for the first five months showed a deficit of 2.32% of GDP, compared to 1.48% in the same period last year. At this rate, there is basically no chance of it reaching 4.4% of GDP this year, but rather 6.5-7%, even higher than last year’s. The problem of the budget deficit isn’t only the result of the crises triggered from 2020 onwards; the deficit had increased between 2015 and 2019 from 0.5% to 4.3% of GDP, in the context of an average annual economic growth of 4.7%. At the beginning of the covid-19 crisis, Romania already had the largest budget deficit in the EU, and the crisis only exacerbated the issue. Our country has pledged to exit the excessive deficit procedure—which is applied when the level exceeds 3% of GDP—no later than 2024, but that now seems almost impossible.

The decline in purchasing power caused by inflation has brought several categories of professionals into the streets this year. Teachers and other employees in the education system went on strike for several weeks until they obtained salary increases, which are to be introduced gradually starting this year. They were followed by employees from the healthcare system, which also receives insufficient funding from the state budget, as well as by law enforcement employees.

The government is under major pressure to increase wages and pensions, and 2024 will have four rounds of elections, making the current Executive’s task of cutting spending even more difficult. Meanwhile, the PNRR funds are conditional on certain milestones being achieved, such as the elimination of special pensions.

Correcting the budget deficit is also very difficult because tax revenues in Romania are among the lowest in the EU relative to the GDP: in 2022, they represented 27.4% of GDP, well below the European average of 41.4%. If we had a level closer to the EU average, one or two percentage points of the deficit would be easier to cover, as shown by the Fiscal Council, which warned that the 2023 budget was built on a massive overestimation of revenues and an underestimation of expenses. In 2022, the budget was fuelled by inflation and special energy taxes, but the same cannot be said for 2023.

Another major problem has to do with Tax Code, which is full of preferential regimes, reduced quotas, and exemptions from the payment of certain taxes and contributions for certain categories of income earners. The most publicised are the facilities granted to employees in IT, construction, and agriculture. However, they are very difficult to eliminate during the quasi-electoral period, as is the financing of local town halls, which cannot survive from local taxes alone. The government led by Marcel Ciolacu is now working on a set of policies that should lead to higher budget revenues, and so far it looks like the focus will be on rather basic measures such as increasing VAT for certain products, higher excise duties on tobacco, alcohol, and fuel, and the introduction of some new taxes such as the “sugar tax.” We are also very likely to see the dividend tax increase from 8% to 10%.

European Funds

The members of the BNR Council insisted on the importance of attracting European funds from the PNRR and Next Generation EU programmes as a way to maintain a high level of investments, which are necessary for the digitalization and modernisation of the economy. Moreover, economic growth is one of the easiest ways to reduce the deficit: even if the value level is maintained, its share of the GDP decreases. The problem arises when the deficit increases faster than the GDP and so its share of the total ends up being even higher. And since GDP growth won’t be so high this year and next year, we might witness this phenomenon.

“The annual GDP growth rate also shrunk faster than forecasted, to 2.3 percent in Q1 2023 from 4.5 percent in 2022 Q4, but mainly on the back of the change in inventories, while the annual rate of increase of household consumption continued to step up and the two-digit annual dynamics of gross fixed capital formation gathered pace again. Moreover, the negative contribution of net exports to GDP growth posted a relatively modest widening, as the slowdown in the dynamics of the export volume slightly outpaced that in the dynamics of the import volume of goods and services. Trade deficit and current account deficit, however, recorded significant decreases in 2023 Q1 versus 2022 Q1, mainly amid the improved terms of trade,” the BNR stated.

What’s more, the fiscal consolidation measures that the Ciolacu government is expected to announce might even be harmful to the economy. “We are concerned that hastily implemented and insufficiently analysed measures, albeit generating budget revenues in the short-term, could have direct or secondary negative effects on the medium and long term, including on economic growth. In other words, let’s not sacrifice long-term economic growth for short-term gains,” says the American Chamber of Commerce in Romania (AmCham Romania).

“The business community understands the urgency of accelerating efforts to consolidate fiscal-budgetary measures to meet the budget deficit target and the need to correct deviations that generate opportunity costs for Romania, culminating in the danger of suspending European funds. The National Recovery and Resilience Plan (PNRR) is the main, if not the only, stimulus not only for avoiding economic recession but also for sustainable economic growth. Therefore, we cannot afford the risk of compromising the absorption of such funds,” AmCham Romania members add.

It is obvious that in order to get out of the budget deficit trap, the country will need a significant improvement in its tax collection, which on the one hand means reducing the possibility of “tax optimisation,” i.e., people using various legal methods to pay lower taxes (such as being an independent contractor instead of an employee), and on the other hand the reduction of tax evasion. Fighting tax evasion and improving revenue collection are the stated goals of every political party before elections or as they take power. Unfortunately, besides the barely-legal“agreements” between some businessmen and political decision-makers, the legislation regarding tax evasion provides for low levels of penalties, noted Valentin Lazea, chief economist at the BNR, in a post on the BNR Opinions blog.

The good part of the current economic picture is that we are maintaining a good level of growth this year as well, despite the problems that all EU states are experiencing and the uncertainties caused by the war in Ukraine.

“We have a forecast of 3% economic growth for this year, which may seem small, but it is not small at all compared to other states in the region. Romania will see better economic growth and I think we should be happy about this,” said Ionut Dumitru, chief economist at Raiffeisen Bank, at the Annual Conference of the Association of Financial-Banking Analysts in Romania.

And economic growth is the best way to solve our budget problems as well, especially since the necessary reforms are being carried out rather slowly.