Fiscal Consolidation Is a Must to Restart Economic Growth

Noiembrie 2010

IONUT DUMITRU - Chief Economist / Treasury and Capital Markets NICOLAE COVRIG - Financial Analyst / Treasury and Capital Market RAIFFEISEN BANK S.A.

Delayed and difficult economic recovery

Exactly one year ago, the expectations were to see Romanian economy restarting to grow slowly at the beginning of this year. The revival of the economic activity on the external markets and the rebounding in the industrial output were seen as key drivers of the recovery. However, this proved not to be enough to compensate for the continuing decline in the domestic demand (consumption and investments). In fact, the inflows of foreign private capitals, the main driver of economic growth over the last years, were much lower than initially expected. As a result, the deleveraging process at the level of individuals and of the companies triggered a contraction in expenditures with consumption and investments.

In order to better understand the economic recession in Romania, a look at the other economies in the region (in particular the new EU member countries) might be helpful. In this case, one can see that the size of the contraction in economic activity during the actual recession has been largely proportional to the size of the imbalances at the onset of the crisis (the size of the current account deficit and the size of the structural budget deficit). The economies relying in a large extent on foreign capitals and that were strongly overheated at the onset of financial crisis were the most affected (Baltic Countries, Romania, Bulgaria, Hungary) and they are struggling to exit from recession. The economies with law imbalances (Poland, Slovakia, and Czech Republic) dealt much better with the crisis, while they are already increasing for several quarters (in fact, in Poland there was no recession).

Most likely, the speed of the recovery in the next period would remain proportional to the actual size of macroeconomic imbalances. Of course, the ability of the authorities to manage these imbalances would be essential, with bad macroeconomic policies making the recovery even more difficult. Unfortunately, the news is not good in case of Romania. At the end of Q2 2010, the imbalances were still very high in case of Romania. Romania had the highest public budget deficit and the highest current account deficit among the nine EU member countries included in our analysis (based on 4 quarters rolling data). Similar to the other countries in the region, the private sector adjusted substantially in Romania as well (sharp fall in consumption and investments). But while all other countries with large imbalances started to implement clear fiscal consolidation plans very early in 2009 based on strong cuts in public expenditure and hike in taxes, the Romanian government refrained to take any radical measure by end of Q2 2010. In this context, the fiscal austerity measures introduced in July were a requirement in order to allow a "orderly" adjustment of imbalances existing at the end of the second quarter and to avoid these imbalances be adjusted "arbitrary" by market forces (a Leu depreciation with a negative impact on the financial position of households and companies, an increase in the inflation rate, and ultimately additional and substantial contraction in consumption and investments). The fiscal austerity measures aimed at allowing the "orderly" adjustment of the existing macroeconomic disequilibria would hamper the economic growth in the short-term (second half of 2010 and the beginning of 2011), but they should result in a sustainable economic growth in medium and long-term.

Although painful, fiscal consolidation is a must

After being more optimistic than pessimistic in the past, we think at this moment that the task of rapidly restoring the economic growth is not easy at all as the constraints are very high. Ignoring the constraints and focusing exclusively on restoring economic growth in short term by any means could be the worst thing to happen. On the contrary, we think that focusing more on dealing with the constraints and on structural reforms rather than on restoring the economic growth by any means would be the best solution at this moment.

We see two major constraints at this moment which impede on the capacity of the authorities to engage in expansionary economic policies: (1) difficulty in financing the current account deficit and (2) difficulty in financing the public budget deficit. These two constraints are strongly interrelated and the government has the main responsibility to deal with them. In this context, going forward with the fiscal consolidation program and structural reforms is the only option as this would lower the constraints and would create the ground for the economy to embark on a sustainable growth path in the following years. While fiscal consolidation is a painful process, we think it is a requirement at this moment. Failing to due this could deepen the recession and it would make the recovery even more difficult.

Once recession has deepened, discussions about its negative impact on the living standards of the individuals and on the financi situation of companies have intensified. Enforcement by the government of important austerity measures starting July made such discussions even more acute. In this context, the voices saying that the government should increase public spending (in one form or another) or lower taxes in order to put the economy again on an upward trend have multiplied. However, there is little attention paid to the impact of these measures on the size of the public budget deficit and to the capacity of the country to ensure the financing of this budget deficit. We think it is impossible for Romania to finance a high budget deficit at this moment.

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