EC Report: Romania on Brink of Default

Politics - March 31, 2024

Romania missed its budget deficit target last year and there is every chance that this will happen again in 2024. At the same time, the Romanian economy has slowed down and there is a risk that it will not grow significantly in 2024-2025 either. These are the conclusions of the European Commission’s Interim Report on Romania’s economic and financial situation. The recently published report analyses Romania’s macroeconomic vulnerabilities. The document criticises the government in Bucharest for a number of measures taken or the lack of others and insists on the need to implement urgent fiscal policy measures, without which the country could be exposed to shocks. 

The report by the European Commission’s Directorate-General for Economic and Financial Affairs shows that the budget deficit is one of Romania’s biggest problems, as its increase will affect the current account deficit and external indebtedness, making it vulnerable to investors. Other concerns expressed by the Commission relate to tensions in the labour market, the fact that wages are growing faster than productivity, the government’s discretionary increase in the minimum wage and demands for wage increases in the budget sector, which may affect competitiveness. 

The European Commission forecasts, however, that the Romanian economy could grow by up to 3 percent in 2024-2025, but only if its trading partners – especially Germany and Italy, on which it is dependent – do not shrink, and only if it absorbs European funds on time. The report also praises the stability of the leu-euro exchange rate over the past two years and of the banking system, despite the war and rising energy prices. The report also notes that Romania has no significant trade relations with non-EU countries and is not affected by external crises.

Romania has some of the highest inflation rates and public and current account deficits in the EU

Romania’s fiscal consolidation stalled in 2023, EC experts say, and argue that the government in Bucharest has not taken sufficient measures to address its high budget deficit. European experts warn that Romania’s current account deficit remains high amid high external debt and budget deficit. The difficult situation the country has reached – practically on the verge of default – is mainly due to very high government spending, coupled with lower than expected receipts to the state budget amid the economic slowdown. Keeping the budget deficit high will increase external indebtedness, making Romania vulnerable to changes in investor sentiment and exogenous shocks, commission experts say. 

According to the report, Romania’s current account deficit fell to 7% of GDP in 2023 from 9.3% in 2022, against a target of 4.4% of GDP set in the 2023 convergence programme. The decline is due to lower domestic demand – meaning that Romanians have basically become thriftier, from the corporate to the household level – and energy prices. The trade deficit has also been reduced by almost 25% as imports have fallen and exports of goods and services have increased.  According to Commission forecasts, Romania’s current account deficit – covered in recent years by massive European funds and foreign investment – should stabilise at around 7% of GDP in the coming years. But a number of factors could prevent this from happening. In practice, exports are expected to continue to grow, but imports are also expected to increase as domestic demand recovers amid a recovery in private consumption.  However, European experts warn that the budget deficit – which is forecast at 5.3% of GDP in 2024 and 5.1% in 2025 – will remain high and prevent the current account from adjusting. They also argue that slower recovery in private consumption, slower disinflation, failure to absorb European funds in time or even a smaller-than-projected advance of the economies of Romania’s most important trading partners would ultimately lead to a missed target of stabilising the current account deficit at around 7 percent of GDP. 

“The Romanian economy is highly dependent on imports of German and Italian goods and services, while Germany and Italy are important destinations for Romanian exports. As far as external demand is concerned, most of the total value added in the Romanian economy is generated to satisfy domestic demand in Germany and France, while domestic demand in Romania is mostly satisfied by value added generated in Germany and Italy. As Romania’s direct exposure to non-EU partners is low, geopolitical and trade tensions do not seem to pose a risk to its economy,” the report says. 

European experts also point out that any increase in public sector pensions and wages – as promised by the government in Bucharest – will only make the situation worse.

On the other hand, commission experts note that while pressures on domestic demand have eased, the labour market remains tight. Real wages are rising faster than productivity, which will slow disinflation and could, over time, erode cost competitiveness. The Commission therefore asks Romania to monitor these issues carefully. While in 2021 and 2022 real unit labour cost growth was broadly in line with the EU, in 2023 nominal wages in Romania increased by about 15% and real wages by almost 5%, well above labour productivity. The increase in real unit labour costs was also helped by the increase in the minimum wage, with experts criticising the government’s “discretionary” mechanism for setting it. In 2023, it was increased by 32%. They are also sounding the alarm over wage increases demanded by employees in the budget sector. Over time, these could fuel further increases in real unit labour costs and affect Romania’s cost competitiveness and external accounts.

Overall, Romania’s vulnerabilities persist and leave the country exposed to shocks, which is why urgent policy action is needed, the commission’s experts point out, arguing that only substantial progress in fiscal consolidation would reduce these vulnerabilities. According to European experts, the most effective way to address these internal and external vulnerabilities would be for the authorities in Bucharest to pursue a credible and sustained multiannual fiscal consolidation path. They stress that the recently adopted fiscal consolidation package “is a step in the right direction, but it is insufficient”.

The package, worth about 1.2% of GDP, was adopted last year and is to be implemented from 2024. It includes spending cuts of 0.4% of GDP by reducing the number of holiday vouchers and food allowances for state employees. Also, through a series of tax increases, the package is expected to increase revenue from GDP by 0.8%.  These include an increase in corporate taxation (introduction of a 1% minimum turnover tax for non-financial companies with a turnover of more than €50 million and a turnover tax for credit institutions), a phasing out of preferential tax regimes for the construction and agriculture sectors and the elimination of reduced VAT rates for certain goods and services.

 “The implementation of ambitious tax reforms, as set out in the Recovery and Resilience Plan, would go a long way to addressing fiscal vulnerabilities. Romania’s public revenue-to-GDP ratio is one of the lowest in the EU and remains below the average of countries at a similar stage of development,” the institution says.

A correction of the deficit can also be achieved through the implementation of the reforms undertaken in the PNRR, which aim to modify, among other things, the highly advantageous tax regime for micro-enterprises and to carry out a comprehensive overhaul of Romania’s tax system. The PNRR also includes a reform of the National Tax Administration Agency, which aims to address the urgent need for its modernisation and digitisation. 

“A comprehensive approach is needed, combining much tighter budget execution than in recent years and reforms to strengthen tax revenues by streamlining the tax system and improving tax administration. Additional measures, such as expenditure reviews and improved procurement and public investment planning, budgeting and monitoring practices, can increase the efficiency of public spending in the context of very limited resources. In this context, consideration could be given to increasing the rate of EU support for infrastructure investment, in particular in transport and health, and limiting and targeting over-contracting. The implementation of reforms aimed at better quality education, efficient functioning of state-owned enterprises, effective public administration and a better functioning judiciary and control of corruption would strengthen the business environment, foreign investment and potential growth. Where possible, additional measures could help reduce vulnerabilities. All these measures are to a large extent reflected in Romania’s NRRP,” the report adds.