Leonardo Badea (BNR): Cause and effect, the twin deficits and the debt burden

Mihai-Alexandru Cristea 31/05/2022 | 14:17

Over the last 10 years, Romania has had a positive economic evolution from the perspective of the dynamics of the gross domestic product. An overview of this dynamic is provided by data published by Eurostat, which shows an increase in gross domestic product expressed in euro at current market prices from around € 131.8 billion in 2011 to around € 240.2 billion in 2021, i.e. over 82%, compared to around 27% at the aggregate level for the 27 Member States of the European Union and 25% for the 19 Member States of the euro area, respectively. In the same period, the economies of the states in the area also had significant growth rates, but lower compared to Romania: about 51% in Hungary and Poland, 64% in Bulgaria and 45% in the Czech Republic. Even in the years of crisis 2020 and 2021, the Romanian economy proved to be surprisingly resilient in relation to expectations and compared to developments at the regional level.

By Leonardo Badea, Deputy Governor of the National Bank of Romania


However, this favorable path has been overshadowed by a series of chronic structural imbalances that have deteriorated over time, and in the last two years have been further amplified by external shocks, especially the coronavirus pandemic and the impact of geopolitical tensions on commodity markets, raw materials, and energy. Concerns and broad discussions about the high level of the budget deficit and the negative current account balance are fully justified.

Since 2015, Romania has stood out negatively in the region through a persistent increase in the current account deficit given that in the period 2015-2019 the other countries with which we usually compare have recorded current account surpluses or at worst case negative balances of small magnitude, around 1%. In the case of Romania, the current account deficit reached about 2% in 2016 and then gradually accelerated to about 4.8% in 2019, a year in which Poland, the Czech Republic, and Bulgaria recorded surpluses, and Hungary had a deficit of less than 1 %. Even in the first year of the pandemic, when Romania’s current account deficit widened to almost 5% of GDP, Poland, the Czech Republic, and Bulgaria continued to record surpluses, and Hungary’s current account deficit continued to be around 1%. Last year, against the background of the shocks of the growing pressure on the markets of raw materials and energy, from the sample of mentioned countries only Hungary recorded a more significant deterioration of the current account balance, while for Romania its deficit rose to about 7%.

From the perspective of the fiscal balance, between 2015 and 2018 all the mentioned countries, including Romania, remained within the European limit outlined by the Stability and Growth Pact, respectively recorded a budget deficit of no more than 3% of GDP. In the Czech Republic, Bulgaria, and Poland, even a significant budgetary consolidation has been achieved. In 2019, however, the situation deteriorated for some of the countries mentioned, including Romania, which recorded an increase in the budget deficit to over 4%, in contrast to the other countries mentioned, which managed to stay within the 3% limit. So, as it has been written before, the pandemic shock found us in a much more vulnerable position compared to other countries in the region, so as a result of the effects of the pandemic crisis, in 2020 we had the largest current account deficit in the region. In 2021, however, Romania managed a favorable correction broader than that of Hungary, but not as ambitious as that of Poland, which moved to a deficit of less than 2%.

As a direct consequence of budgetary developments, during 2018 and 2019, when all the other countries mentioned decreased the share of public debt expressed as a share in GDP, amid robust economic growth and the effort to maintain the budget deficit within the limits of the European treaties, for Romania it remained largely unchanged, despite significant economic growth.

We could say that, from the perspective of the vulnerabilities represented by the high level of the budget deficit and the increase of the public debt burden, in 2018 and 2019 it was not possible to adjust them.

Romania needs to act promptly to curb debt dynamics as a share of GDP, otherwise it soon risks overtaking Poland, which has already undergone a significant correction in 2021, thanks to fiscal consolidation and which proved between 2013-2019 that it is able to maintain a better macroeconomic balance from this perspective.

A possible failure in managing this situation will probably lead us in a few years to a reversal of positions similar to the one that took place between Romania and the Czech Republic in 2016. Only this time, if we exceed Poland as a share of public debt in GDP, the consequences could be more serious, given that the Polish economy is more than twice as large and much better placed in terms of perception on the international financial markets. Therefore, such an event would probably have significant negative consequences for our position in these markets.

From the above mentioned perspective, it is relevant to note that for some time now Romania has been facing the highest level of yields in the region for government bond issues denominated in euro (in this case for the maturity of 5 years), so implicitly with the highest cost of foreign debt newly issued by the public sector.

At a time when fixed income instruments were at a very low level, close to zero, these differences were less important in the overall macroeconomic equilibrium, being less than one percentage point.

For example, in June 2021, when Poland and the Czech Republic could borrow in euros for five years by paying slightly negative yields, Romania had a similar debt issue cost of about half a percentage point per year.

With the general increase in interest rates in international markets, fueled by rising risks and inflation expectations, these differences are becoming more significant. During this period, the five-year government bonds in euro issued by Romania are traded at yields of almost 3.5% per year compared to just over 1% in the case of the Czech Republic and, slightly, over 2% in the case of Poland. A gap of more than 1 percentage point is not small given that the public debt stock has grown significantly during 2020, in the context of efforts to manage the effects of the pandemic, and has continued to grow in 2021, albeit at a slower pace.

A major negative change in investors’ perception of credit risk related to sovereign bonds issued by Romania took place towards the end of 2018. So we are talking exactly about that period 2018 – 2019 which stood out so clearly, also from a negative perspective, regarding the evolution of the budget deficit, the current account deficit, and the public debt.

During 2018 and 2019, the cost of default risk insurance for Romania’s five-year bonds clearly rose above that of similar securities issued by Bulgaria and Hungary for the first time since 2014. Subsequently, it remained at marginally higher levels than all other countries in the region with which we compare. In the last two years, respectively immediately after the initial pandemic shock of March 2020 and until now, this unfavorable gap for Romania has increased significantly, especially in recent months.

If we accept that the price of these credit risk insurance instruments is relevant from the perspective of investors’ perception and corroborating with the previously presented data on the evolution of the cost of additional borrowing in foreign markets, we see that coherent and firm actions aimed at improving investor expectations regarding the future evolution of Romania’s macroeconomic equilibria are becoming more appropriate.

Of course, the structure of debt is also very important in this equation of credibility: the share of internal and external debt, respectively the share of long-term debt and short-term and medium-term debt. From this perspective, Romania has managed in recent years to obtain a favorable structure of total debt through good management. However, the costs of new domestic bond issues have also risen, as they have risen for all countries in the region amid rising inflation and interest rates in local money markets. Thus, the cost of rolling over existing debt has in itself become a significant budgetary effort for all countries in the area, including Romania, so the pace of additional borrowing should be slowed down as much as possible, and this can only be achieved through a significant and sustainable fiscal consolidation.

Romania has also managed in the past to reduce the share of public debt in GDP, in a consistent manner, in the period 2002-2006, as a combined effect of the macroeconomic consolidation effort that preceded the accession to the European Union and the generally favorable economic development before the onset of the global financial crisis in the second half of 2007.

The years 2008-2013 followed, with the predominance of the effects of the global financial crisis and the sovereign debt crisis in some European countries, years in Romania that were initially characterized by large government deficits, and later by a difficult fiscal consolidation effort in conditions of economic development below potential. However, once the fiscal balance has been restored within the limits of the European Stability and Growth Pact, the positive effect on the evolution of public debt has become visible again, with 2015-2017 being overall years of debt burden reduction as a share of GDP.

Returning to the current situation, we cannot ignore the very special problem of the simultaneous deterioration of the budget balance and the current account balance. The theory (hypothesis) of twin deficits was widely analyzed during the 1980s, when the United States faced for a significant period of time the simultaneous worsening of the budget situation and the deterioration of the current account.

From a theoretical perspective, even the equations specific to the national accounts system provide us with the macroeconomic factors that determine the fluctuations of the current account balance. To these are added the theory of absorption of the gross national product and its connection with the balance of payments (Alexander, 1952), the IS-LM-BoP model (Mundell-Fleming, 1962-1963) and the additions proposed later as a result of the relaxation of some initial assumptions considered inconsistent with reality or of the adaptation to specific economic conditions (e.g. Dornbusch, 1976).

Although the topic is widely discussed by prestigious economists, the conclusions regarding the existence of a certain level of interdependence between the evolution of the budget deficit and the current account deficit are not always in full agreement, from the perspective of empirical research results:

  • Some authors (Islam, 1998; Salvatore, 2006; Rault & Afonso, 2009) found in the analyzed data a seemingly causal link between the impact of the fiscal deficit on the external deficit, thus confirming the hypotheses of Mundell-Fleming and Keynesian theories.
  • Other authors (Anoruo and Ramchander, 1998; Marinheiro, 2008 and Stiglitz, 2010), also observed the existence of an inverse relationship, starting from the external deficit to the internal one. This opposite relationship is found in the literature under the name “current account targeting”, following a reference article published by Summers in 1988, which shows that the deterioration of the current account could, under certain conditions, slow down growth and indirectly reduce revenues, which could lead to an increase in the budget deficit, ceteris paribus.
  • There are studies that show that the link between the two deficits could be bidirectional. Thus, Feldstein and Horioka (1980) observed that investment and savings are significantly correlated and this leads to bi-causality between the two variables. Similar empirical results were later obtained by Kalyoncu (2007).
  • The list of all possible combinations of conclusions starting from empirical data is completed by a series of authors who did not find any causal relationship between the two deficits (Garcia & Ramajo, 2004; Michalski, 2009), which is consistent with the Ricardian equivalence which postulates that the budget and current account deficits are not interdependent (also called the Ricardo-Barro effect, but considered to be based on unrealistic assumptions about the functioning of capital markets, the ability of individuals to save and borrow, or their availability to save for future higher taxes; this effect was refuted by empirical observations in the US in 1976-1985, but could partly explain some developments in European states in the aftermath of the global financial crisis and sovereign debt crisis).

Beyond these controversies, for our analysis it is relevant to find a series of particular evolutions in the case of Romania. Thus, we notice an apparent medium-term synchronization of the two deficits, as a general trend over longer periods of time. So we see that in the last 20 years we have successively gone through a cycle of deepening deficits, followed by one of consolidation and then a further aggravation during the period 2015-2021. The common trend that is broadly visible over several years of cycles cannot necessarily be confirmed for each of the calendar years for those periods. This observation in the case of Romania confirms more recent approaches of some economists, who choose to focus on the particularities of certain periods and countries or on smaller or specific groups of countries (Algieri, 2013; Sinicakova et al., 2017).

The cause-and-effect approach is in fact a useful way to see more broadly and clearly where we need to act. We must choose to address the cause of these imbalances, and the above data show that to a large extent the budget deficit is a cause for the unfavorable dynamics of debt and current account balance. In a complex system, the causes can be a whole bunch, but once we have identified a significant cause with certainty, it is counterproductive not to act on it immediately, preferring first to channel our efforts to detect and test other possible and probable causes, whose transmission effect is more complex and more difficult to estimate. It is hard to believe that we will be able to find a treatment that is easier to manage, as macroeconomic vulnerabilities are, unfortunately, always difficult to correct and involve effort to manage them consistently, no matter what path is taken, assuming that there are alternatives. Clearly, we need to increase budget revenues at a time when, as has been seen, the structure of spending is almost completely inflexible and therefore difficult to adjust in a timely manner to curb the aforementioned unfavorable trends.

The Romanian economy has evolved significantly in size and complexity in the last three decades. The status of an open and relatively small market economy, a member of the single market in the European Union, makes the causal links between various macro-financial variables and the response to changes in external conditions not at all easy to anticipate or forecast, especially in the short to medium term.

Therefore, but also as a result of successive and overlapping external shocks, decisions on adapting the policy mix are made under conditions of heightened uncertainty. Perhaps today more than ever it is necessary not to lose sight of the principles found in the common core of many of the more sophisticated contemporary variants of classical economic theory. That is why it seems full of meaning and relevance to our present situation the approach that Adam Smith (1776) had centuries ago, when he emphasized the importance of a balanced budget. In the current conditions dominated by uncertainty, such a balanced budget must also take into account a multi-annual programming with clear strategic objectives.

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Mihai-Alexandru Cristea | 12/04/2024 | 17:28
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