Raiffeisen Research: Romania - Painful fiscal consolidation process

At the beginning of May, during the negotiations with the International Monetary Fund (IMF) and the European Commission (EC), Romanian authorities pledged to take radical measures in order to reduce the budget deficit. Projections at that time showed that consolidated budget deficit would have reached more than 9% of GDP at end-2010 without corrective measures. During the negotiations, there was reached an agreement for a deficit target of 6.8% of GDP for this year and 4.4% of GDP for 2011. rnrnAt that moment, the Government decided to adjust the budget deficit largely by cutting public expenditures. The focus was on expenses with personnel in public sector and on social transfers, including pensions, which were the main drivers for the rapid increase in the budget deficit over the last years. The Government announced a cut by 25% in public servants wages and a cut by 15% in social transfers (including pensions) as key measures in the austerity program. Moreover, the Government announced that special pensions would be recalculated based on contribution rule. rnrnOn 15 June, the Government succeeded to pass the Parliament these key measures by surviving the no-confidence vote initiated by the opposition parties. However, on 25 June the Constitutional Court ruled that pensions’ reduction is unconstitutional. Also, the Constitutional Court ruled that the recalculation of special pensions is constitutional, excepting the pensions of magistrates which should remain special. rnrnIn order to counteract for this outcome, the government decided to hike the value added tax (VAT) from 19% to 24%. Along with the cut in public wages and increase in VAT, the government took additional measures in order to reduce public spending and to decrease the budget deficit. rnrnBellow are listed the key austerity measures to be applied (most of them starting July 1st) in order to reach the budget deficit target of 6.8% of GDP agreed with the IMF and the EC for the end of this year: rn§ cut in wages in public sector by 25%; rn§ increase in VAT from 19% to 24%; rn§ cut by 15% in most of social transfers (excepting pensions); rn§ 16% tax on interest on deposits and on luncheons tickets (instead of 0% previously); rn§ 16% tax on capital gains from securities hold by more than 1 year (instead of 1% previously); rn§ transformation of special pensions in normal state pensions (excepting the pensions of magistrates); rn§ cut of expenses with goods and services in ministries, governmental agencies, local administrations and state companies; rn§ lower transfers from state budget towards local budgets; rn§ decrease in subsidies for population (the measure is not yet effective and it refers to subsidies for thermal heating) rn§ lay-offs in public sector (ministries, governmental agencies and local administration). The current plans are to lay-offs up to 60,000 peoples in the coming period. rn§ a “solidarity tax” for people owning more than one dwelling. The tax on housing property is 65% higher for the second dwelling, 150% higher for the third dwelling, and 300% higher starting with the third dwelling; rn§ higher taxes for owners of passenger cars; rn§ lower deductibility for expenses in case of revenues from intellectual property rights; rn§ measures to limit tax evasion; rnrnrnEven though the most measures will start to be implemented as of July 1st, we think that reaching this year’s budget deficit target is still challenging. Moreover, reaching next year’s budget deficit target (4.4% of GDP) is extremely challenging. rnrnWhat can be done in order to progress on the fiscal consolidation path and to succeed to achieve the budget targets? First of all, we think that the Government should be focused primarily to improve the tax collection (tax evasion is a key problem for the budget) and to increase the efficiency of public spending, including a rebalancing of the expenditure structure from social expenses to more public investments. Secondly, one of the main challenges the Government will have is to find solutions to reduce the large deficit in public pensions system, as this budget should be balanced in a medium and long term perspective. In this context, a reform of the public pensions system is strongly needed. Thirdly, there is room to increase taxation in several areas (such as higher taxes on property and land, higher royalties for natural resources exploitation), to broaden the tax base, to eliminate exceptions from taxation, and to simplify the fiscal code (with positive effects on tax collection and tax administration). Should all of the above not be enough, a change in flat tax has to be considered also. rnrnIn last weeks, there were more and more talks about the opportunity and necessity to increase the flat tax on the personal income (currently at 16%) or to reintroduce a progressive taxation system. Failure of the government to go forward with the planned fiscal measures, to increase the efficiency of public spending and to limit tax evasion would increase the chances for such a measure. A prolonged recession, potentially protests from labour unions, and the fragility of the current Parliamentary majority are the main risk factors in this case. rnrnIn our opinion, events in the last two months had a strong impact on the economic outlook. As a result, many of our previous forecasts have to be adjusted. While the new figures would be available in our next reports, we want to stress at this time the main tendencies we expect for the period ahead: rn§ The austerity measures should result in a decrease of real disposable income. This means that consumption (which remained on a downward trend in last quarters) should contract further and this would have a higher negative impact on the overall GDP. rn§ We expect the real GDP to fell again this year, before starting to recover in 2011. The decline could be rather large given also recent floods. rn§ Inflation rate should jump in July following the hike in the VAT. Although we are looking for a pass-through of around 70% from the hike in VAT to the increase in final consumption prices, leu depreciation, elimination of subsidies for thermal heating tariffs, and possible adverse negative shocks in food prices due to recent floods should push the inflation rate at a high level at the end of this year (above 8% in Dec-2010 according with our preliminary estimates). rn§ As inflation rate will increase substantially, there is no room for central bank to cut further the monetary policy rate. NBR remained on hold at this week monetary policy meeting keeping the key interest rate at 6.25%. We think that the risks are to see even a hike in the monetary policy rate in the following months if the second round effect of the hike in VAT will emerge and inflationary expectations will increase. Also, the risks are also to see the interbank interest rate going up. rn§ If the fiscal consolidation plan will succeed, we think that the exchange rate has large chances to consolidate at the current levels in the coming quarters. rnrnrnThe IMF postponed the assessment of Romania’s letter of intention by one week and it should take a decision today. In an official statement on 28 June, EC said that “until now the Romanian government has shown a strong commitment to implement measures necessary to reach the programme targets and to put Romanian public finances back on a sustainable path.” Given these circumstances, we expect both the IMF and the EC to approve the disbursement of new funds from the external financing package agreed in 2009. Also, technical missions from the IMF and the EC would return in Romania for the normal quarterly assessment at the end of July. rnrnIn our opinion, the agreements with the IMF and the EC will remain a key anchor for the Romanian economy. If the government goes forward with the fiscal consolidation process, then these agreements should remain on track and the confidence of foreign investors in Romania should improve. This is our baseline scenario. Unfortunately, the risks to this scenario remain on the downside.