News from the Eastern Front- Romania’s Euro Crisis Approach

While there was much debate and talk about the Euro area governments’ saving measures, aimed at appeasing jittery markets or securing long run stability, little is known of the countries at the periphery of the EMU.
Romania is set to join the Euro area in 2014 and like other countries in the region (and elsewhere) is looking anxiously at the development of the story. Most Romanian banks are owned by Euro-area banks, especially Greek and Austrian ones. Therefore the development of the Hellenic debt story was watched with much attention. More recently the Romanian government (a coalition of Liberal-Democrats and the Hungarian minority party ) announced fierce spending measures aimed at the oversized public sector.
While the debate in Germany about spending cuts revolved around a series of government programs and subsidies with each interest group well represented, the Romanian government’s choice was a black-and-white one. Either increase taxes (VAT, income tax, accises) or cut public worker’s pay by 25% and pensions by 15%. The latter choice was the one the government initially cheered for, underlining they would never do a thing as foolish as undermining the private sector by increased taxes. This strategy did not work out as planned, however, because of the Constitutional Court. The court dismissed the part of the law referring to pension cuts as unconstitutional because it infringes with the right to pension and affects the pensioner’s own contribution made while still in the labour force.
In a very quick move, the prime minister replied to the court’s decision by announcing a VAT increase by 5 percentage points to 24%, forgetting his previous role as savior of the private sector. Please note also that the Romanian tax code does not stipulate a different VAT rate for food and basic goods as in other countries, so the increase will be well felt by consumers, unless private companies choose to internalize the tax, an unlikely scenario in the current economic context.
It is clearly wrong to reduce the income of the poorest social category (according to data on poverty rates from 2006) but the proposed tax alternative seems to be an alternative which is just as bad, a foolish measure without any impact analysis performed previously. A complete ignorance of the economic crisis at its start seems to be matched by a reckless strategy in the recovery stage.

Let me return to the 25% reduction in public worker’s pay, which still stands and is predicted to cut government spending for this year by around 1.7 Billion Euros. And that is all. Why? Because the measure is supposed to be applied only for this year, as a concession given by the government to unions. “We can’t even do a bad thing right” is what the government seems to be saying, for where is the benefit of saving today if you will return to big spending tomorrow? A deal for a loan from the IMF was the trigger for the brute cut-first-think-later policy according to the government but the Fund pointed out the measures have been thought of by the Romanian side, washing the blood off their hands.
Yes, the public sector is overblown, hiring was too easy in the boom years and salaries are too high compared to the private sector. In the past they were the driver of pay increases in the private sector, which tried to compete for skilled workers.
A trimming strategy based on performance, efficiency and demand analysis would have been a sensible reform which was proposed by some a while ago but which wasn’t even mentioned in the current debate.

How about the hard facts? The main question here is if spending is justified in a low-growth context, and the conventional Keynesian anti-cyclist policy overrated and outdated. This question is probably the one Obama was whispering in Misses Merkel’s ear during the recent G20 summit. Romania is not Germany though and reducing consumption prospects while increasing insecurity will surely affect badly growth prospects. As a matter of fact, the Leu (the Romanian currency) is depreciating constantly in response to the instability. Here is a look at the exchange rate (in price notation) over the last 4 months since the measure were announced:

Source: Oanda historic exchange rates at www.oanda.com

How does the budget deficit and the Debt-to-GDP ratio look? Is there cause for concern? Yes, there is, but not as much as in other countries and not enough to justify the massive cuts. The government debt in 2009 was half of Germany’s (although it should have increased considerably after the loan from the IMF in 2010) and smaller than Greece’s and Spain’s (who announced public pay cuts of 15% respectively 5%):

The budget deficit is way off course and increased constantly in the last years, but so did
everyone else’s. Here is a comparison with Germany, and three of the troubled Euro-zone countries:

Could the wage cutting and tax increasing be a shock-and-awe strategy of the government? Trying to do more than was required of them by the IMF agreement to impress investors? When looking at the interest rate on 10 year bonds this might sound like a plausible explanation if for the middle of 2009 but not if we take into account the last developments which saw the spread to German Bunds roughly return to its pre-crisis level:

 Source: ECB

Maybe I have identified the reasons behind the awkward activist spirit the governments finds itself in for the last months. However, if this was the initial plan, it is likely that it backfires due to the insecurity it caused on capital markets. It is even more likely that it will have negative long-term effects on Romania’s development.

Daniel Herciu