The president announces large cuts in public spending

However, it has become clear that without radical measures, the public budget deficit cannot decrease in the next period. While being enough flexible at the previous reviews, this time the IMF and the EC want to be sure that Romanian authorities really stick to the fiscal consolidation plan assumed for 2010 and 2011. At the same time, reducing the budget deficit and keeping the Stand-By Agreement with the IMF on track is largely perceived (by authorities, investors, rating agencies and analysts) as the best option for Romania, as it enhances credibility and should put the public finance on a sustainability path.

Several scenarios regarding increases in value added tax (VAT) and personal income tax were advanced in last days by local media (25% VAT from 19% and 20% flat tax on personal income and corporate profits from 16%). However, late yesterday, President Basescu announced that the budget deficit adjustment would be made basically on the expenditure side instead of hiking taxes. We think that this is the right decision from the economic point of view in the current environment, and we think it should be well received by the financial markets.

President said that the government is committed to take radical measures in the next period. The government would cut by 25% the expenditure with personnel in the public sector (which means lay-offs and cuts in wages). It would also reduce pensions and unemployment benefits by 15%. The details will be available in the next days. Most likely, we will have more information at the end of the IMF mission (officially scheduled for today, but the IMF and EC prolonged their stay two more days).

While welcomed by investors and rating agencies, such unpopular measures are likely to trigger some resistance from trade unions in the public sector. In this context, the commitment of government and Parliament to stick to these measures would be crucial.

In our opinion, with these measures in place, the real GDP growth this year would be negatively affected. Taken into account that economic activity in Q4 2009 and Q1 2010 was weaker than expected and that the confidence of households is already at a low level and shows no sign of improvement, our forecast for a 1% growth in real GDP this year has become too optimistic. A growth rate close to 0% is more realistic now. Also, a new contraction in real GDP in 2010 should not be excluded. However, the decision to adjust the social bill should be positive for economic growth in the medium and long term. If this adjustment will succeed, we think that there are good grounds to have a fast recovery of economic activity starting with 2011.