Romania on a wing and a prayer

By bne IntelliNews March 16, 2011

Phil Cain in Graz, Austria -

Romania is widely thought to have emerged from its first recorded recession - one of the longest and deepest among EU states - but some doubt its inflation-riddled economy can sustain growth much beyond next year's general elections.

There certainly has been some more welcome news on the economic front. Greece and Romania were the only EU member states to have seen a year-on-year decline in GDP in the fourth quarter, but Romania's GDP is reckoned to have grown marginally in the first quarter of 2011 and the Romanian National Bank forecasts GDP growth of 1.5% this year and over 4.0% in 2012. "The economy has probably touched base," says Liviu Voinea, head of the Group of Applied Economics, a Bucharest think-tank

The central bank's optimism is buoyed by the prospect of improved trade figures. "Faster growth in exports than imports will be proof that this country is restructuring its economy and that growth will be sustainable, not just a flash in the pan," the bank's governor, Mugar Isarescu, was quoted as saying in the Ziarul Financiar newspaper in March.

The International Monetary Fund (IMF), EU and World Bank would like to believe him, having provided a €20bn emergency loan facility in May of 2009. "Romania is a patient that has undergone a successful operation, but his condition is still critical," according to Jeffrey Franks, head of the IMF mission to Romania.

Perfidious disease

At the top of patient's chart is inflation - a "perfidious disease," acknowledges Isarescu, and one which the Romanian economy has contracted a nasty dose of. Year on year it rose to 7.6% in February, up from 7.0% the month before, on the back of rising food and oil prices. The price of potatoes went up 45% after a poor domestic harvest.

Given February's inflation figure, Dutch bank ING in mid-March increased its inflation forecast for the full year from 5.0% to 5.7%. Local bank BCR acknowledges the inflation risk posed by rising prices of food and oil, but is less worried, expecting inflation to tail off to 4.3% by December. "A slight appreciation of the leu and continued weak domestic demand will support the disinflation process," reckons Florin Eugen Sinca, a BCR analyst.

There is also concern about the long-term effects of the "austerity package" introduced in July last year by the government. The main pillars of the package were a 25% cut in public sector wages, a 15% cut in state benefits and pensions, and an increase in VAT.

Some like Daniel Daianu, a former finance minister, argue the government's unpalatable emergency medicine was brutal, but unavoidable. "There was no way to avoid painful correction measures," says Daianu, who reckons more of the same needs to be administered. "Increasing VAT hasn't helped keep inflation down, but it was the only alternative available. Whether you can reduce VAT now is debatable because Romania still has to work on reducing its structural budget deficit."

Sinca of BCR also says the austerity measures produced quick positive effects on the state budget and reinforced foreign investors' confidence in the determination of the government to bring the budget deficit under control. He reckons the budget deficit could decline to around 3% of GDP in 2012-13. "With a current account deficit at around 5% of GDP and the fiscal consolidation process well on track, there are high chances for Romania to experience a sustainable economic growth in the future."

Others aren't so sure. Group of Applied Economics' Voinea argues that the austerity package has done more harm than good, worsening the immediate economic woes, while shying away from the reforms needed to improve the country's economic prospects over the longer term. "It would have been possible to get out recession sooner in the absence of these measures," she says.

What was missing from the package was a concern for the bigger picture. "Increasing VAT is a desperate measure to increase government revenues in the short term, but it also produces inflation," she says. And no Romanian politician hoping for re-election can afford to hold down public sector wages for long. "You need to give them back or someone else will give them back after the next elections."

Indeed, the government has already promised a 15% rise in public sector wages this year and Voinea thinks they are likely be restored to 2010 levels ahead of the general elections next year.

Holistic approach

The 70% appreciation of the leu since 2005 is also not the success some might suggest either, according to Voinea. The rationale for bolstering the leu were to ease the burden of repaying debt denominated in foreign currencies, while pinning down inflation and creating the overall impression of economic stability. But it has also made an export-driven recovery less likely. "With the exchange rate having appreciated, I don't see room for a recovery based on exports," says Voinea.

A more "holistic view" was needed, Voinea argues. "Do you want economic growth but with some inflation or inflationary growth? Or do you want a recession with hard reforms and deflation. What we ended up with was recession plus inflation."

Voinea argues that measures should have been taken to stimulate domestic demand rather than slash it. "The results of the 2010 package, in terms of inflation, were the same, while the economy shrank rather than grew. With wages lower than last year and inflation higher and private credit yet to be restored, I do not see the drivers of a recovery based on domestic consumption."

The government should have concentrated its efforts on collecting existing taxes better, rather than hiking sales tax, Voinea says. Romania has the lowest level of government revenue as a percentage of GDP in the EU, around 32% compared with the EU average of just over 44%. "Tax evasion is huge," says Voinea, estimating the losses to the public purse to be around 10% of GDP. By comparison, the government's clampdown on public sector wages hoped to claw back savings of 2% of GDP over five years.

Another missed opportunity was to find savings in the public sector elsewhere than in wages. "There is very large share of GDP spent on public acquisitions - not investments, but the acquisitions of goods and services. It amounts to around 6% of GDP and did not decrease during the crisis." Public investments, amounting to around 7% of GDP, were also a viable target for a more far-sighted austerity programme, lacking "any kind of prioritisation" based on return on investment. Very few of the 40,000 public investments underway at any one time are ever completed.

Daianu agrees that a more results-driven public sector would be a great help. And two other steps would also help: "Romania has to absorb EU funds much more and much more productively, and the banking sector has to rethink its lending priorities and lend more to production."

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