Romania’s currency weakened by 0.2% in just one hour toward the end of the trading day on June 14, after rumours about tensions between the majority leader Liviu Dragnea and Prime Minister Sorin Grindeanu were confirmed and ministers loyal to the former reportedly resigned. 

The exchange rate fall was the first sign of the impact of the rampant rise in political instability that unfolded during a single day but is expected to continue with a substantial impact on economy. Romania’s absorption of EU funds, improvement in tax collection and reforms at state-controlled companies (including some expected major IPOs) are all at risk. 

The first effects of the political crisis will be driven by the most risk-averse investors (on foreign exchange, money and equity markets) and by the worsening of the already problematic functioning of the public administration. But strategic investors are also likely to put some projects on hold or at least wait until the situation becomes clearer. 

The weakening of the local currency, not likely to be resisted by the central bank within reasonable limits, will have a stabilising effect vis-a-vis the main macroeconomic threats (widening current account and budget deficits) while adding incremental impetus to inflation, which is already accelerating. 

The Treasury was planning to raise €750mn-€1.25bn from another Eurobond issue this year, after draining €1.75bn in April. On the local market, the government plans to sell RON5.3bn (€1.1bn) in treasury bonds and bills in June versus RON3.7bn-RON3.9bn per month during February-May, data from the finance ministry showed on May 31. In addition, the ministry plans to borrow €100mn in a local euro-denominated T-bond. The above-average borrowing plans for June were prompted by the very high redemption volume in the month, and the timing of the change in investors’ confidence is unfortunate. 

However, the fiscal buffer is large enough to absorb delays in Eurobond issues and Romania’s public finances are robust enough to absorb an expected rise in the borrowing cost on the local market in the short term. Romania’s public debt increased by 4.6% y/y to €63.6bn at the end of March under ESA methodology, but the debt to GDP ratio edged up only marginally to 38% from 37.9% one year earlier. In its Spring Forecast, the European Commission projects Romania’s public debt to GDP ratio to rise from 37.6% of GDP at the end of 2016 to 40.9% two years later as the government is expected to run wide budget deficits in 2017 and the years to come.

The demonstrations in February against the ruling majority’s attempts to weaken anti-corruption laws had only a short term impact on investor sentiment. By contrast, the current crisis might hurt confidence more seriously in both the short and the medium term. The range of political scenarios has broadened and early elections were mentioned for the first time by Grindeanu when he warned Dragnea in a June 11 Facebook post about the need for political stability. Such an option remains remote, but the political outlook is far more volatile than in February.

The tensions within the senior ruling Social Democratic Party (PSD) have reached the point where a split becomes a scenario that can no longer be ignored. Those advocating radical views such as economic nationalism, electoral populism and confining the powers of prosecutors, headed by Dragnea (unless his political future is finally compromised by a ruling in his ongoing court trial), might join the Alliance of Liberals and Democrats (Alde) led by Senate head Calin Popescu Tariceanu, while Grindeanu might lead the more moderate faction of the PSD. It is unclear at this moment whether either of the two sides would be able to form a parliamentary majority.

With most of the ministers having already resigned, the functioning of the public administration is at risk at a critical moment for several reasons. 

Firstly, procedures for the absorption of EU funds are dragging on. The local management units have not been certified yet and the head of the Court of Accounts indicated that the first evaluation of their status is expected in early August. There are problems with the IT system, Court of Accounts audit head Aron Ioan Popa confirmed to Ziarul Financiar daily on June 13. Romania has not absorbed any EU funds under 2014-2020 financial programme, other than the funds extended to farmers (direct payments) and some advance payments

Secondly, the budget execution is under pressure as more public wage hikes effective July this year will put pressure on public expenditure. Much needed improvements in tax collection will be hindered by uncertainty among civil servants. 

Thirdly, critical public acquisition programmes, particularly in defence, are on the parliament’s agenda. A €9bn multi-role vessels, missiles and armoured vehicles acquisition programme was sent by the government to lawmakers, after the ruling majority scrapped the €1.6bn multi-role missile acquisition planned by the former government. Further delays will puts the country’s credibility as a Nato member at risk.

Finally, the crisis occurs at a time when President Klaus Iohannis was striving to improve the country’s diplomatic profile with major Western leaders; he has just returned from the US after meeting with President Donald Trump. Iohannis will go to Berlin on June 19 and 20, where he will meet his counterpart Frank Steinmmeier and Chancellor Angela Merkel. Later in the month, Iohannis is expected to meet recently elected French President Emmanuel Macron. Any potential economic benefits from his visits to European capitals are now at risk given the unstable government in Romania.

On the upside, the political crisis puts on hold by default some very risky plans voiced by the majority coalition. The household income tax law has not yet been made public and will probably not be on the agenda for the coming months, and even the controversial unified public wage law might be deferred. Labour Minister Olguta Vasilescu claimed earlier in June that if  Iohannis sends the bill back to lawmakers, it would be endorsed again in the same form. Now, with the political turmoil, this will not necessarily be the case.