Hard times loom for Romanian economy

Newsroom 17/05/2010 | 09:19

With severe measures to reduce the budgetary deficit pending, Romania is facing one of its toughest economic periods in the last two decades. But as anger foments and citizens prepare to take to the streets in protest, specialists say that the government was left with no other choice that would bring immediate results or cause less damage.

Anda Sebesi


The austerity measures announced by the Romanian government last week – that public sector salaries would be cut by 25 percent, and pensions and unemployment benefit by 15 percent – have already begun to ratchet up the tension, with some protests being announced for the weeks to come. The measures discussed by the government with International Monetary Fund (IMF) representatives are extreme, from the downsizing of public sector staff to swingeing salary and pension cuts and the withdrawal or reduction of benefits. In other words, hard times lie ahead for Romanians.

How have financial analysts responded to these measures and what do they think their main impact on the local market will be? Romania’s current public finances need urgent adjustments even though the country’s debt is not yet too high, say specialists. But the pace at which the country is running up debts to a high budgetary deficit level and the unfavorable international context for all countries with big public debts is a real concern at the moment. “Plus, the way that public money is used needs to be rethought, because we are on an unsustainable path. A budget that allocates 75 percent of revenues to salaries and social assistance simply cannot ensure resources for public services and investments for development,” says Mihail Ion, president and CEO of Raiffeisen Asset Management (RAM). He adds that even though the money-saving measures are very unpopular, they reflect the simple fact that Romania cannot afford any largesse at the moment. “The medium- and long-term impact on the economy will be positive, because the measures bring about progress in the fiscal consolidation process that will free up more resources for investments. Moreover they will contribute to reducing the cost of the state’s debt. The short-term impact on the economy will be negative, with the limitation of the expenses contributing to an economic contraction, assumed through the new macroeconomic parameters agreed with the IMF,” says Ion.

The pension, unemployment benefit and public sector salary cuts will depress consumption, with knock-on effects on economic growth. “On the other hand, it is possible that lenders – who won’t be able to advance retail credit to these customers but could offer smaller loans to pensioners and public sector employees – will be prompted to speed up lending activity to companies, with positive effects on the local economic environment,” says Dragos Cabat, managing partner of consultancy company Financial View.

One thing is clear: the government has to make very difficult choices to reduce the budget deficit and maintain its loan agreements with the IMF and the EU, which are essential for economic recovery. Niculae Done, tax partner at KPMG, sees two possibilities – either a significant rise in taxes (such as VAT, profit tax and income tax) or big reductions in public spending. “Overall, it is better to cut public spending than to raise taxes,” says Done.

But while the current measures are dramatic, they will have a cumulated effect of about 4 percent of GDP, according to Ion. “This means that if the authorities manage to implement these measures from June 1, it would save about 2.3 percent of GDP by the end of 2010, the sum needed to end the year with a deficit of 6.8 percent of GDP, compared with 9.1 percent if no measures were taken,” says Ion. He cannot see any other choice the government could have made that would reap immediate effects and be less destructive. “The option of increasing taxes might have been less effective than expected in terms of the improvement of budgetary incomes and would have adversely affected the local economy on the short, medium and long term,” says the RAM representative. But Cabat thinks that encouraging the real economy by offering government liabilities and simplifying the tax system would have been a much better choice.

One thing is beyond doubt: the social cost of these measures is brutal, with reduced pensions and fewer public hospitals both unfortunate outcomes. “While the average wage in the public sector could be adjusted – as it is higher than the average private sector salary – and some pensions are too high compared with the income earned or contributions paid as an employee, it is quite clear that small pensions should remain the same. As for the precarious health system, what can you say?” says Ion. In his opinion, there are enough reserves to boost the state coffers by reducing tax evasion. But it is important for these measures to be implemented. “There are also other categories of expenses that can be rationalized such as local ones made by city halls that are not in accordance with the situation of the economy,” says Ion.

As for the potential increase in VAT from the current rate of 19 percent to 24 percent, Cabat says that this would generate a slow rise in inflation and depress economic activity. “The impact is greater the smaller a company is,” he says. Cabat predicts that an increase in VAT (up to about 22 percent) is inevitable on the medium term – six to eighteen months. Elsewhere, Ion says that a hike in VAT could be considered as an alternative for reducing the budgetary deficit, especially because Romania is among the countries with a relatively low level of VAT. Furthermore, IMF programs in Central and Eastern Europe have involved increasing VAT. But not everyone is in favor. “A rise in VAT could reduce consumption, erode Romanians’ incomes through inflation, give impetus to fiscal evasion and reduce or eliminate profit margins for some companies,” warns Ion.

In addition, tax increases, such as a 5 percent rise in VAT to 24 percent, could be undesirable because they could slow the recovery, and this would ultimately reduce budget revenue.

“They would increase costs for businesses and reduce the spending power of most of the public. Tax rises would also be likely to increase the size of the underground economy. So they would not necessarily raise budget revenue by enough to reduce the deficit to acceptable levels,” says Done. In his opinion, the government has decided instead to take measures which will affect some but not all of the public. “There is some logic to this, as it might be a way to mitigate the macroeconomic effects of a reduction in people’s spending power. However, rather than simply cutting salaries and pensions, the state should consider how to reduce public spending by eliminating waste. This is exactly the time for a long-overdue evaluation of public administration,” says Done. He adds: “Rather than impose a blanket salary reduction, which affects those who are highly productive as well as non-performers, the government should implement measures to review the performance of public officials.” Poor performers should be dismissed, while the high achievers may even need to be rewarded. In Done’s opinion, there is a danger that the blanket 25 percent salary reduction could lead to the best public officials seeking employment in the private sector, so efficiency in the public sector could suffer.

As for the reduction of pensions by 15 percent, this will hit some of Romania’s poorest citizens. Under the pension law, the sum received relates to the contributions that individuals have made to the system. “However, the government should take measures to protect the most vulnerable by guaranteeing that no pension should fall below the level of the minimum salary. This would be logical, as the idea of the minimum salary is that it is considered the lowest sum needed to provide the basic necessities of life,” concludes Done.


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