A recent statement of the Governor of the central bank has sparked heated public discussions. Mr. Mugur Isarescu said that Romania’s macroeconomic situation in the last 26 years has never been better than now, neither were the risks higher for the macroeconomic stability. This article aims to explain to the public this (apparent) paradox.
First, there’s the bright side.
Since September 2014, Romania meets all five Maastricht criteria (for inflation, long-term interest rates, budget deficit, public debt and exchange rate stability), considered a precondition (not sufficient though) for adopting the euro.
Moreover, Romania meets 13 of the 14 criteria from the so-called „scoreboard”, monitored by the European Commission, which places the country on par with the Czech Republic and Poland, but ahead of Germany, the Netherlands, Austria, Sweden or Finland (!!) which meet fewer criteria. It should be noted that this enviable macroeconomic situation was reached after a series of necessary (and painful) reforms undertaken between 2010-2014 that rectified the serious imbalances accumulated before the crisis.
Unfortunately, some legislative initiatives for electoral purposes, launched starting mid-2015 are likely to weaken again the macroeconomic situation of the country, reversing the gains obtained with so many sacrifices and proving that lessons from the crisis are completely ignored and / or forgotten.
A comprehensive and thorough risk analysis is contained in the BNR’s Financial Stability Reports. In the following, without claiming to rank them, we will refer to four categories of risks that may materialize if the populist direction initiated by the legislature in 2015 continue: budget deficit and public debt risk; external (current account) deficit; risk relating to the „punishment” for banks; risk relating to the imbalance (again) of the pension system.
For the uninformed reader, it is important to understand that Romania is evolving within an international context, where potential investors compare investment opportunities between 150 emergent countries. Any improvement of the country’s macroeconomic parameters attracts more abundant and cheaper financing; any worsening lead to more precarious and expensive funding because investors would prefer to place their money in other countries.
The budget deficit and public debt risk
Romania had in 2015 a budget deficit of 0.8 percent of GDP, but it will reach 2.8 percent of GDP in 2016, following of the Tax Code change, and probably about 3.3-3.4 percent of GDP in 2017, which would lead to violating one of the Maastricht criteria (maximum budget deficit of 3 percent).
Among the EU countries, only France, Spain and (maybe) Poland will exceed the deficit threshold in 2017. Our country would consequently get downgraded from the leader position to the laggards’ group, chances of triggering the excessive deficit procedure being high.
We will be told that the Commission did not actually penalize any EU country yet. True, but a friendly treatment from the Commission (politically motivated) does not imply a friendly treatment from the markets / private investors who may ask for higher interest rates on the loans approved for the country.
We will also be told that, in practice, no Romanian government will let the deficit to exceed 3 percent of GDP. Possibly, but that will be achieved (as usual) by sacrificing the public investment, that is the country’s opportunity to have a sustainable growth in the future.
What the Romanian political elite (and not only) refuses to understand is that the 3 percent of GDP threshold for the budget deficit is set for the bad days, when growth is below the potential, not for the good times when economic growth is above the potential as is currently the case in Romania. In other words, in circumstances such as the current ones, the budget deficit should be close to zero, to have space for increase (in the event of crisis) without exceeding the threshold of 3 percent of GDP.
Another constraint ignored by legislators is that the budget deficit needed to preserve the current level of public debt is about 1.8 percent of GDP. Any level of deficit above this limit pushes the public debt (currently about 40 percent of GDP) toward the threshold of 60 percent of GDP, considered the alert level for the emerging markets.
To those who believe that it takes a long time to get public debt from 40 to 60 percent of GDP I would suggest to examine more closely Romania’s post-crisis experience (the increase of public debt from 13 percent to 37 percent of GDP between 2008-2012) or Spain’s case, whose debt grew by 64 percent of GDP (!) between 2007-2014.
To those who consider that all the above seem too esoteric and far from reality, I propose a simple calculation (the assumptions are simplified to the maximum, i.e. the entire debt is assumed to be due in the first year):
- the Romanian state is currently refinancing the annual debt (about 40 percent of GDP) on average interest of about 3 percent per year, so that the interest expense charged to the consolidated budget is of 0.40 * 0.03 = 1.2 percent of GDP each year;
- suppose that foreign investors lose confidence in the country’s macroeconomic stability and demand double interest rates (6 percent per year) to maintain the financing. In this case, the interest expense would double in the consolidated budget from 1.2 percent to 2.4 percent of GDP, leaving less money for education, health, infrastructure, etc. The same effect is obtained if the interest rates remain unchanged, but the public debt doubles (by getting the budget deficit out of control);
- lastly, suppose that both the interest rates and the public debt double in a short time. In this case, Romania would get to interest cost four times higher (4.8 percent of GDP) than today, with harmful effects on all the other expense categories.
External (current account) deficit risk
Romania made exceptional progress in the period 2007-2014, reducing the current account deficit from 13.8 percent of GDP to 0.7 percent of GDP.
Unfortunately, the fiscal loosening in 2015 that encouraged excessive consumption (without having a domestic supply that could meet this extra demand), will bring the external deficit to about 2.3-2.4 percent of GDP this year.
At first glance, that does not seem much, but things should be assessed in an international context. The EU member states, guided by the Germany’s example, are generally countries with either very small external deficits or surpluses.
For example, even the „undisciplined” Greece is expected to have an external deficit this year of only 1.1 per cent of GDP and Italy is expected to have an external surplus of 2.5 percent of GDP. And what about the states from the Visegrad Group (to which we seemed to be converging at some moment, then we preferred to relax): the Czech Republic will have a current account surplus this year, as well as Hungary and only Poland will record a small deficit (1 percent of GDP).
Of course, things seem to be under control for the moment as long as the foreign direct investments are higher than the current account deficit (in other words, financing it is easy). We cannot ignore though the crisis lessons that proved how volatile is the foreign investors’ confidence and how the sudden withdrawal of the external funding can lead to rapid and painful adjustments. The mere fact that Romania is among Europe’s laggards in terms of external deficit is likely to be at least a warning light for potential investors.
Moreover, the fundamental question remains: how do we want to integrate ourselves in a sustainable way into a competitive and export-oriented Europe? By only being an outlet for their products or competing by our own means to conquer markets?
Risk of „punishing” the banks
The public success that the recent legislative initiatives have enjoyed (Law on debt-to-equity swap, Law on CHF loan conversion) is based on the widespread belief that banks should be punished. This perception comes from ignoring some fundamental truths:
- the silent majority, who will ultimately pay for these benefits created for some minorities, is not aware that will largely bear the costs of these laws. We are talking about more than 5 million depositors and over 800 thousand good payer borrowers who will have to bear more disadvantageous bank fees and interests; it is also about all taxpayers, in case that the international courts will decide that the Romanian state is chargeable; it is lastly about the entire country’s population if some of the foreign banks decide to withdraw from Romania, which will lead to a decreased competition and lower quality of banking services.
- in terms of exchange rate, risks are symmetric: if the local currency would have appreciated against the Swiss franc, the creditor banks would take in the entire loss, without requesting for sharing the burden with borrowers. Why, then, the materialization of the converse risk of the depreciation of Leu against the Swiss franc should also be borne (in full, on top of it !!) by the banks?
- perception that banks have wallowed in money in Romania in the recent years has no basis. Between 2008-2015, the entire banking system from Romania (40 banks) registered a cumulative net profit (after loss deduction) of about 1.4 billion lei, that is less than EUR 350 million (!!!). There are some banks that have not even recovered the initial investment yet and rightly wonder if it is worth remaining in Romania any longer.
- no debtor can invoke in her defence the lack of free will (nobody forced them to sign the contracts in question) or the ignorance of the consequences (this is no argument whatsoever in justice. Otherwise, we should also pity those who get behind the wheel without knowing the traffic rules and suffered a fatal accident).
- commercial banks have already paid dearly for their mistakes made before the crisis. They have cut down the number of branches by about a third and fired about a quarter of employees. Saving the banks in crisis was made in Romania (unlike many Western countries) without involving to taxpayer money. Those who bore the cost of adjustments were their shareholders, as the budget was not asked to pay any money to rescue banks.
But the biggest risk induced by these laws is the moral hazard, that is implicitly encouraging the payment indiscipline of those who could pay, but will not. Recognizing the validity of the contract between parties is one of the basic pillars of a market economy toward which we pretend that are moving.
The fact that we are not different from Hungary, Poland, Croatia or other countries that adopted similar populist laws might be an excuse, but only on short term. On the long run, investors will remember and sanction such behaviour.
Risk of unbalancing (again) the pension system
Following the pension reform undertaken in early Nastase government, a balance in terms of pensions budget has been reached. Then in 2008, lawmakers from all political spectrum have decided to declare war to…arithmetic. Instead of a replacement rate of 0.31 (average pension to average wage ratio) that ensured the fiscal sustainability of the pension system, given the number of taxpayers approximately equal to the number of beneficiaries, the legislators decided to increase the rate to 0.45, the financing gap being made from the general budget, not from CASS. A large part of the record budget deficit registered in 2009 (9.5 percent of GDP) was the result of this populist measure.
Several years of painful adjustments followed, when the budget arithmetic regained its rights to the electoral arithmetic. There have been approved a further increase in the retirement age, the pension indexation to wages below par and other measures that, without restoring the budgetary balance from the past, lowered the burden of the budgetary transfers. In these circumstances, the pension budget deficit is currently about 2.2 percent of GDP, being the source of almost the entire consolidated budget deficit.
In these circumstances, it cannot but surprise us the resumption of talks about returning to the pre-crisis indexation system, with the initial pension-wage ratio amended to the legislation then in place, which proves that the lessons of the crisis have been completely forgotten / ignored. Adding to the (past or future) cuts of the social security contributions, such legislative initiatives only serve to add a new risk for the general macroeconomic sustainability.
And again, they lose sight of the substance of the problem: as Romania sits on a demographic bomb at the post-2030 horizon, the message that the state should give to citizens, young and old alike, would be to wait as little as possible from the state pension and increasingly rely on their own savings, including private pensions. Instead, the state sends subliminal messages that everything is under control and that it will perpetually play the role of „protector daddy”, so that people can be relieved of the responsibility of ensuring the resources for the old age.
Materialization of one or another of the above risks does not necessarily lead to a crisis. However, the combination of several risks will certainly lead to a new crisis and the need for further painful adjustments. In the next period, Romania must prove whether it learned to develop sustainably or is condemned to repeat as Sisyphus boom-and-bust cycles.
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Valentin Lazea is the Chief Economist of the National Bank of Romania
The views are personal and do not in any way reflect the official opinion of the National Bank of Romania.
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