The Financial Risks of Romania's Twin Deficits

(DANIEL MIHAILESCU/AFP via Getty Images)

The EU flag is projected on the facade of Romania's parliament building in Bucharest on the eve of Europe Day on May 8, 2024.

Romania's financial risks are manageable in the short-to-medium term and the next government will likely pursue gradual fiscal consolidation, but failure to reduce its fiscal and current account deficits would expose the country to external shocks. Romania's Fiscal Council, an independent institution in charge of overseeing the country's fiscal policies, warned on Aug. 20 that it expects Romania's fiscal deficit to surpass 7% of GDP in 2024 and could even exceed 8%, up from 5.7% in 2023. According to the council, this worse-than-expected performance (the Romanian government officially targeted a fiscal deficit of 5% for this year) is the result of higher-than-expected public spending, which was only partially offset by better-than-expected budget revenues.

Romania's fiscal deficit peaked at 9.3% of GDP in 2020 as Bucharest significantly increased public spending to cope with the economic fallout from the COVID-19 pandemic. Since then, a significant rebound in economic activity and, to a lesser extent, modest tax hikes have helped Bucharest take the fiscal deficit to 7.2% in 2021, 6.3% in 2022, and 5.7% in 2023.
Romania's fiscal deficit coincides with a large current account deficit, which rose from less than 1% of GDP in 2015 to roughly 9% of GDP in 2022, and then fell to around 7% of GDP in 2023. While Romania's current account deficit is largely a result of its widening of the fiscal deficit, Romania's role as an emerging Eastern European economy is also a factor. The country is experiencing relatively strong economic growth as it converges with wealthier EU member states; it is also an attractive destination for foreign businesses that repatriate a significant percentage of their profits, and is a large importer of capital goods that are meant to build future export capacity.

Romania's worsening fiscal deficit in 2024 is the result of the coalition government increasing public spending in a key electoral year. In June, Romania held European Parliament and municipal elections, and in November it will hold presidential elections followed by general elections in December. Romania is currently governed by a coalition between the country's two main political parties, the center-left Social Democratic Party and the center-right National Liberal Party — both of which are interested in increasing public spending to improve their electoral chances. As a result, Bucharest implemented a 13.8% increase in pensions in January and a 10% increase in the salary of several public sector workers in May (by contrast, the International Monetary Fund expects Romania's annual inflation in 2024 to be around 6%). In September, some 3.8 million pensions (representing around 83% of all state pensions) will rise by an average of 22% thanks to a new pensions scheme introduced in late 2023. While the European Union, the IMF and credit rating agencies have expressed concern about Romania's worsening fiscal situation, from a political perspective, the strategy is working, as the Social Democratic Party/National Liberal Party joint ticket received roughly 50% of the vote in the European Parliament elections and the two parties combined received almost 60% of the vote in the municipal elections. Opinion polls for the general election also suggest that the two parties will come on top.

In February, the IMF warned that ''effective fiscal consolidation (in Romania) is needed to restore the soundness of government finances'' and stated that ''new measures will be needed to reduce the deficit to sustainable levels.''
In March, credit rating agency Fitch confirmed Romania's BBB- rating (the lowest in the European Union) and stated that ''the pre-election fiscal easing of the governing parties, primarily the unfunded pension increases timed with the general elections, underpin the medium-term fiscal risks.''
Romania has been under the European Union's excessive deficit procedure (a mechanism that is meant to pressure member states to comply with EU fiscal rules) since 2020. In July, the European Commission stated that Bucharest ''has not taken effective action to correct its deficit and therefore the procedure should remain open.''

Despite the mounting risks, Romania's next government will have the political leeway to reduce the fiscal deficit and avoid a financial crisis. If Romania fails to address its twin fiscal and current account deficits, it will leave the country exposed to external shocks. Roughly two-thirds of Romania's current account deficit is financed through FDI and EU funds, and any events that negatively impact foreign capital inflows — which range from a severe global economic downturn to, less likely, EU sanctions under the excessive deficit procedure — would put pressure on Romania's currency and central bank reserves, and make it harder for the country to finance its imports. Failure to rein in Romania's fiscal deficit would also result in increased borrowing, which — especially if it coincides with downgrades in the country's credit rating — would make it increasingly difficult and expensive for Bucharest to take on new debt and service its existing debt. But while these risks are real, Romania will probably avoid a financial crisis. To begin with, Romania's economic growth in the coming years will be high by EU standards. The European Commission expects the Romanian economy to expand by 3.3% in 2024 and by 3.1% in 2025, up from 2.1% in 2022, thanks to accelerating private consumption, EU-funded investment in public infrastructure, declining inflation, and the progressive easing of monetary and financing conditions around the world in 2025. In addition, Romania's debt levels are relatively low compared with other EU countries (Romania's gross debt-to-GDP ratio stands at 51%, compared with 82% for the EU on average), which reduces the risk of a debt crisis. Moreover, the next Romanian government (which is likely to be another Social Democratic Party/National Liberal Party coalition with enough control of parliament to easily pass legislation) will likely start a slow process of fiscal consolidation after the busy 2024 calendar year. The multiplicity of elections in 2024 means that, unless there is a political crisis that results in the collapse of the government and early elections, the country will not hold any meaningful elections until 2028, giving Bucharest significant leeway to adopt a more conservative fiscal approach and reduce the risk of a financial crisis.

Some of the reforms that the IMF has recommended for Romania include an income tax reform to eliminate existing loopholes and exemptions, a value-added tax (VAT) reform to tax more items at the standard rate, and a reassessment of the country's pension reform to stretch out the fiscal burden resulting from it. Traditionally, the National Liberal Party has been more supportive of fiscal consolidation measures than the Social Democratic Party, which means that the debate over these recommendations will be one of the key factors determining the stability of the coalition government.
In February, Romanian Finance Minister Marcel Bolos admitted that it may take up to seven years for Bucharest to take the fiscal deficit below 3% of GDP in line with EU requirements, and that such progress would also depend on credit rating agencies not downgrading the country.