Oxford Business Group Latest Briefing
Last week Standard & Poor's (S&P) downgraded its outlook on the Romanian economy, singling out the country's political instability as the main factor behind the shift in the country's credit rating.
S&P credit analyst Marko Mrsnik said, "We assigned the negative outlook to Romania to reflect its pursuit of policies inappropriate to its growing macroeconomic imbalances. These result from the worsening political environment."
Of particular concern for S&P is the dramatic increase in public spending over the past year and which is expected to continue in 2008. The rise in government spending has outpaced GDP growth by 7.4% this year, compared to 1% in Bulgaria and 1.4% in Croatia. This has been mostly due to increases in public sector salaries. The doubling of pension payments scheduled to begin in the coming months will only add to the strain. As a result, while the public sector debt, as a percentage of GDP is moderate, it is expected to further increase, after reaching a low in 2006.
The situation is aggravated by the prospect of next year's election cycle, which Mrsnik said he believes is "likely to stimulate further increases in current expenditure, reduce the overall quality of governance and intensify inflationary pressures".
The rating agency is not alone in its concerns. Mugur Isarescu, the governor of the National Bank of Romania, has consistently warned the government of the dangers of increasing spending during next year's election cycle.
In an interview with OBG, Isarescu said, "For the past several years, the burden of fighting inflation and controlling the various other macroeconomic pressures has been primarily carried by the country's monetary policy. Now it is time for fiscal policy to do its part. We have asked the government to control its spending and not promise too much in the upcoming election. The national bank understands this requires a political cost, but price stability is not a free lunch. It requires sacrifices."
Such sacrifices will not only be politically difficult, but they will be difficult to implement. Almost every area of the public sector is in desperate need of increased spending. Pressure for the government to step up services is coming from all sides. The business community has consistently complained about public servants, citing their pay as the main barrier to attracting better qualified candidates. The public has also complained about the quality and quantity of essential public servants such as doctors, 50% of who responded to a recent survey by a medical school in Iasi that they are planning to leave the country for higher paying jobs abroad.
Without increasing public sector wages, these problems will almost certainly get worse. If state employees cannot make a living, they will leave for higher paying jobs in the private sector. This will in turn deteriorate the quality of public services further. It is unclear how the government can combat these problems without increasing spending.
In this sense, S&P's downgrade is understandable. Romania is facing a very difficult situation. The ongoing feud between Prime Minister Calin Popescu-Tariceanu and President Traian Basescu has crippled the political process and the fractured political system has led to many stalled reforms throughout the past year. With a minority government that lacks power and stability, the outlook for progress in the near future is cloudy.
In the past, Romania's political instability was balanced by impressive economic growth.
At the height of the political unrest earlier this year, almost every sector of the economy was booming. GDP growth was strong, inflation was under control, and many businesses were reporting record earnings. This signalled to investors and to the rest of the world that Romania had entered a new stage in its development: the economy was finally separate from domestic politics and was free to prosper on its own accord.
As macroeconomic concerns have grown, the potential cost of the political crisis has risen as well. Analysts now worry that the paralysed Romanian government will be unable to manage the delicate balancing act it now faces. On one hand, the government has an expanding current account deficit and a growing inflation problem - both closely linked to the country's spending binge. Traditional measures to control this - such as increasing bank reserve requirements - have been of little use. Raising interest rates may help some but the tendency of Romanian banks to lend in euros' and list their loans abroad will limit the effect of this monetary tool.
In the end, the burden of controlling inflation - the more dire of the two problems - may fall on Romania's fiscal policy. Analysts have agreed that public spending should not increase in 2008. Given the pressure of the upcoming election this may be difficult, if not impossible. Politicians from all sides will be tempted to placate the public's demands for additional spending. To resist this temptation it would be smart for all parties to provide a united front to the Romanian population.
No one can deny that Romania has made progress over the past decade. And in no place is this progress more visible than in the economy. Analysts, businessmen and politicians are right to celebrate these victories. But whether Romania's politicians are willing to put their past differences aside to solve the economies problems will prove an important test of whether the entire country - not simply one area of it - has truly entered a new stage of development. Now that would be something to celebrate.