This paper examines Romania’s external stability risks. Recent Romanian data indicate high increases in real wages, not matched by comparable productivity gains. Both the government and the National Bank of Romania (NBR) have highlighted the importance of a responsible and stabilizing wage policy for macroeconomic stability in the country current juncture. A three-pronged approach is recommended that encompasses capacity building and improved transparency, a medium-term framework for fiscal policy, and increased use of independent fiscal expertise.

Abstract

This paper examines Romania’s external stability risks. Recent Romanian data indicate high increases in real wages, not matched by comparable productivity gains. Both the government and the National Bank of Romania (NBR) have highlighted the importance of a responsible and stabilizing wage policy for macroeconomic stability in the country current juncture. A three-pronged approach is recommended that encompasses capacity building and improved transparency, a medium-term framework for fiscal policy, and increased use of independent fiscal expertise.

III. ReTooling Romanias Budget Culture23

Core Questions and Findings

  • What have been the fiscal outcomes under Romania’s present budget culture? Since 2000, Romania has restored fiscal discipline, and public financial management has been strengthened in some areas. However, against a backdrop of fragmented politics, Romania’s short-term oriented budget culture has recently been associated with undesirable fiscal outcomes including a highly procyclical fiscal stance in the face of an absorption boom, biases in revenue projections, underutilization of EU funds, end-year spending surges, frequent intra-year budget revisions, and underfinanced spending commitments.

  • What are the main ingredients of a good budget culture? A country’s budget culture is largely shaped, over time, by its fiscal institutions. The latter should provide policy makers with incentives and constraints favoring sound policies. In particular, the budgetary procedures should support the setting of sustainable and credible budget targets and help avoid pro-cyclical policies. Other elements of a robust fiscal framework are the existence of a functioning medium-term fiscal framework and the availability and use of independent expertise and policy advice on fiscal issues.

  • How do Romania’s fiscal institutions fare vis-à-vis those of other EU countries? Indicators measuring the quality of fiscal institutions in the EU countries suggest that Romania’s fiscal institutions are still far away from best practices. In particular, the rules governing the budget process need to be strengthened to guarantee the stability and credibility of the budget targets, there is no operational medium-term fiscal framework, and independent expertise and advice on fiscal issues is scarce.

  • What are the key steps toward a new budget culture? A strengthening of fiscal institutions could gradually bring a change in Romania’s budget culture. The recommended reforms include: (i) technical capacity building and improved transparency in fiscal policy; (ii) reforms limiting the frequency of supplementary budgets and helping to anchor fiscal policy in a medium-term perspective; and (iii) developing and using more independent expertise and advice on fiscal policy issues.

A. Background

25. Since 2000, Romania has restored fiscal discipline. Following the 1999 currency crisis, macroeconomic imbalances narrowed, with fiscal adjustment, including measures to improve the financial performance of SOEs and privatizations, playing a key role. Guided by EU accession rules, as well as commitments under IMF programs, fiscal policy outcomes were relatively stable. In particular, the general government deficit was kept below the 3 percent Maastricht deficit benchmark, although it recently came close to it.

Figure 1.
Figure 1.

Romania: General government balance and debt

Percent of GDP

Citation: IMF Staff Country Reports 2008, 210; 10.5089/9781451832907.002.A003

Source: Eurostat. The aggregates are calculated according to national accounts concepts (ESA95).

26. Moreover, public financial management has been strengthened in some areas. A recent assessment by the Fund’s Public Financial Management Advisor in Ljubljana noted a number of positive changes, in line with the recommendations of the Fiscal Transparency ROSC (IMF, 2002) and the World Bank’s Public Expenditure and Institutional Review (World Bank, 2006). Among others, a framework for external and internal audit has been established, and institutional arrangements and operational programs have been developed for managing EU funds. The restructuring of the debt and cash management functions provide an important basis for developing a coherent debt management strategy. The revised budget circular is also a useful step toward a modern budget process.

27. But, against a backdrop of political fragmentation, present fiscal institutions remain weak. Fiscal policy decisions are often driven by short-term political considerations, with little attention to the consequences for the functioning of the economy and the long-run sustainability of government finances. Symptoms of this short-term bias are the tendency to artificially inflate revenue forecasts, the high frequency of budget revisions, the pronounced end-year surge in government spending, the systematic underutilization of EU funds, and underfunded social commitments.

28. At the same time, the requirements and challenges facing Romania’s fiscal policy management have changed drastically. The present short-term focus of fiscal policies may well have been appropriate during Romania’s earlier transition stage, a time when establishing basic fiscal discipline was the order of the day. But Romania has now advanced well beyond that stage. Structural growth bottlenecks are looming that call for forward-looking fiscal planning. In particular, maximizing the benefits of EU accession and the availability of EU funds require the use of a medium-term fiscal framework.

29. Against this background, what could be done to improve Romania’s budget culture? Evidence for EU member countries suggests that sound fiscal institutions, including well-defined budgetary procedures, an effective medium-term fiscal frameworks, sound numerical fiscal rules and where non-partisan fiscal advice is available, tend to record lower deficits and debts, conduct less procyclical fiscal policies, and lead to more efficient allocation of public resources. On the basis of this evidence, documented in section B, this chapter reviews the roots and outcomes of the current budget culture in Romania (section C), and suggests concrete steps to improve the situation (section D).

B. Characteristics of a Good Budget Culture

30. Fiscal institutions are a key determinant of a country’s budget culture. Despite abundant literature on how fiscal policy should be set to be considered sound and sustainable, there are many examples of sub-optimal policies (pro-cyclical bias, high debt levels, low allocative efficiency). Most explanations point to political economy considerations and the short-term motivations shaping policy-makers’ behavior. Reforms to improve fiscal policy therefore tend to focus on a strengthening of fiscal institutions. The basic idea is that the fiscal framework should provide policy makers with incentives and constraints favoring sound policies and, over time, a positive change in a country’s budget culture.

31. Fiscal institutions consist of four main elements: (i) the procedures that govern the elaboration and implementation of the annual budget; (ii) a multiannual fiscal framework; (iii) the numerical rules imposing constraints on fiscal policy; and (iv) the independent bodies involved more or less directly in the conduct of fiscal policy. While (i) exist in all EU countries, the extent of reliance on (ii), (iii), and (iv) varies considerably. The countries generally considered to have strong fiscal institutions rely on several or all devices.

Budgetary Procedures

32. Sound budgetary procedures help contain deficits. A key element is to ensure a sufficient unification of the budget process. This forces participants to recognize the costs and benefits of each spending decision, which in turn helps addressing the common pool problem and favors allocative efficiency.24 For the same reasons, targets for the main fiscal aggregates should preferably be agreed at an early stage of the budget process and the amendment powers of the parliament subject to restrictions. A high degree of transparency at all stages of budgeting, including comprehensive fiscal coverage, and reliance on prudent economic and government revenue forecasts, are other key elements of a sound budget process.

33. Budgetary procedures should also support the credibility of the spending and deficit targets agreed in the budget. The binding force of the budget depends critically on the flexibility to incur additional expenditure during budgetary execution, including the ability to enact supplementary budgets during the fiscal year. Excessive reliance on the latter may be an important channel for fiscal indiscipline and inefficient resource allocation.

34. There is evidence of a link between the quality of budgetary procedures and fiscal performance. The European Commission recently calculated summary indicators measuring the quality of budgetary procedures in selected EU countries (see European Commission, 2007). Table 1 provides some evidence that countries with higher scores on budgetary procedures tend to have lower fiscal deficits and debts, more frequent countercyclical fiscal policies and a better efficiency of government expenditure. A recent study by Fabrizio and Mody (2006) on fiscal institutions in the new EU Member States also found a robust link between fiscal discipline and the quality of fiscal procedures. The same study suggests that the quality of Romania’s budgetary procedures is below the average of the new EU countries (Figure 2).

Table 1.

Quality of Budgetary procedures and Fiscal Indicators in EU countries 1/

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Sources: European Commission (2007), AMECO, Fabrizio and Mody (2006), and Staff estimates.

Based on the indicators measuring the quality of budgetary procedures in the EU countries calculated in European Commission (2007). The indicators capture several dimensions (transparency, centralization, use of top-down budgeting techniques, performance budgeting, prudent economic assumptions).

Frequency of years where the cyclically-adjusted balance and the output gap move in the same direction over the period 2005–2007.

New EU-10 Member States only. The estimates are based on Afonso, Tanzi and Schuknecht (2006). The indicators for each country were re-scaled to range between 0 and 10.

Figure 2.
Figure 2.

Quality of budgetary procedures in the EU-10 Member States

Citation: IMF Staff Country Reports 2008, 210; 10.5089/9781451832907.002.A003

Source: Fabrizio and Mody (2006) and Staff calculations. While focusing on the rules and procedures of the budget process, the index also includes information on the existence of numerical fiscal rules.

Medium-Term Budgetary Frameworks (MTBF)

35. MTBFs are increasingly considered as an essential fiscal policy tool. Single-year budgeting is a poor basis for strategic planning, and most fiscal policy decisions have effects which go well beyond the year in which they are taken. Many countries have therefore decided to supplement their fiscal institutions with MTBFs, which extend the horizon for fiscal policy beyond the annual budget calendar. Well-designed MTBFs are organized around multiannual expenditure ceilings, which take into account projected developments in government revenue and the desired path for the budget balance, and fully reflect past expenditure commitments and the cost of new policies. In the EU countries, the multiannual budgetary projections elaborated in the context of the national MTBFs generally constitute the basis for the preparation of Stability and Convergence Programmes.

36. There are several conditions for MTBFs to be effective. Projections should be supported by a clear policy statement and based on realistic macroeconomic assumptions. The budgetary targets should be vetted by the legislature, and there should be a clear link with the annual budget process, in the sense that the first out-year estimate in the MTEF should become the basis for the preparation of the next year’s budget, and deviations from previous plans should be explained. The overall expenditure targets should be translated into spending norms for individual ministries, with adequate monitoring procedures. Table 2 provides evidence that countries with sound MTBFs tend to have better fiscal outcomes. A recent study (European Commission, 2007) showed that well-designed MTBFs help stick to medium-term budgetary plans.

Table 2.

Medium-term Fiscal Frameworks and Fiscal Indicators in EU countries 1/

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Sources: European Commission (2007), AMECO, Fabrizio and Mody (2006), and Staff estimates.

Based on the indicators measuring the strength of the MTBFs in place in the EU countries calculated in European Commission (2007).

Frequency of years where the cyclically-adjusted balance and the output gap move in the same direction over the period 2005–2007.

New EU-10 Member States only. The estimates are based on Afonso, Tanzi and Schuknecht (2006). The indicators for each country were re-scaled to range between 0 and 10.

37. Romania does not have a well-functioning MTBF. Most EU member states rely on flexible forms of MTBFs, which foresee the possibility to revise the expenditure ceilings every year on a rolling basis. Some have decided to place the MTBF at the center of their fiscal framework (Slovakia, Czech Republic). Since 2006, Romania has prepared medium-term projections for the main fiscal variables in the context of the annual budget. However, these projections do not receive much attention in parliament, and do not serve as a basis for policy setting on a rolling basis. The absence of well-functioning medium-term fiscal framework in Romania is illustrated by Figure 3, which compares the strength of MTBFs in the EU countries.

Figure 3.
Figure 3.

Reliance on MTBFs in the EU Member States

Citation: IMF Staff Country Reports 2008, 210; 10.5089/9781451832907.002.A003

Source: European Commission (2007) and staff calculations. The index captures several dimensions: coverage of the MTBF, link with the annual budget, monitoring procedures, involvement of Parliament, etc.

Numerical Fiscal Rules

38. Numerical fiscal rules define permanent targets or ceilings for budgetary variables. These rules may target different aggregates (budget balance, expenditure, debt), and be more or less binding, depending on their statutory basis and the strength of their enforcement mechanisms. While all EU member states are subject to the numerical fiscal rules of the Stability and Growth Pact, a recent study shows that a large number of EU countries, including some recently acceded member states, have decided to strengthen their fiscal framework by introducing national-level numerical fiscal rules (Debrun et al., 2008). The same study suggests a statistically significant link between numerical fiscal rules and fiscal discipline. Table 3 provides additional evidence of a positive relation between fiscal rules and fiscal performance.

Table 3.

Numerical Fiscal Rules and Fiscal Indicators in EU countries 1/

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Sources: Debrun et al. (2008), AMECO, Fabrizio and Mody (2006), and Staff estimates.

Indicators measuring the extent of reliance on numerical fiscal rules and the quality of the rules in each country.

Frequency of years where the cyclically-adjusted balance and the output gap move in the same direction over the period 2005–2007.

New EU-10 Member States only. The estimates are based on Afonso, Tanzi and Schuknecht (2006). The indicators for each country were re-scaled to range between 0 and 10.

39. At present, Romania’s fiscal policy is not subject to numerical fiscal rules other than those of the Stability and Growth Pact (Figure 4). Its deficit and debt have to be kept below 3 and 60 percent of GDP respectively, and it is broadly agreed that Romania’s fiscal policy should aim at reaching a structural deficit of 1 percent of GDP in the medium-term. This framework is appropriate and there no clear pressing need for other binding numerical constraints. Reliance on strictly binding numerical rules could in fact be problematic in lagging transition economies like Romania, where the occurrence of potentially large shocks can not be ruled out and calls for keeping some discretion in fiscal policy.

Figure 4.
Figure 4.

Reliance on numerical fiscal rules in the EU Member States

Citation: IMF Staff Country Reports 2008, 210; 10.5089/9781451832907.002.A003

Source: Debrun et al. (2008) and staff calculations. The charts provide the value of the index for 2005. The index captures the existence, coverage and strength of the numerical rules in force in the country.

Independent Bodies

40. Independent fiscal expertise can contribute to improve fiscal policies in several ways. It can ensure that fiscal policy is based on unbiased inputs (e.g. through the provision of independent macroeconomic or revenue forecasts), provide analysis on fiscal policy issues (e.g. estimates of the cost of policy measures; of contingent liabilities; analysis of the sustainability of government finances), or/and release regular assessments and recommendations related to fiscal policy, with a view notably to increase reputational costs for unsound policies. These bodies are generally not mandated to carry out any particular fiscal policy task: there is no delegation of policy decisions.

41. The experience of other EU countries illustrates the benefits of independent fiscal expertise. According to a recent survey by the European Commission (2006), such institutions exist in 15 EU countries. Jonung and Larch (2004) showed that the macroeconomic forecasts prepared by independent institutions have no statistically significant bias, while such a bias seems to exist in some countries. There is also convincing evidence that some of these institutions have a considerable impact on the public debate and policy decisions (e.g. the CPB in the Netherlands, the High Council of Finance in Belgium, or the Economic Council in Denmark). In Romania, the Prognosis Commission is in charge of macroeconomic projections, and although it is a government institution, its forecasts have in general been accurate and not prone to a strong political bias.

C. Outcomes Under Romania’s Present Budget Culture

42. The combination of Romania’s fragmented politics with weak fiscal institutions provides particularly fertile ground for undesirable fiscal outcomes. The literature on the relation between a country’s fiscal institutions and its fiscal outcomes shows that strong institutions are even more important in countries where political powers are dispersed among different parties in the government, disputes between the government and Parliament over fiscal issues are frequent, and political systems lead to unstable coalitions and frequent elections (Roubini and Sachs, 1989; Annett, 2007). The relative instability of Romania’s politics is therefore another strong argument for building fiscal institutions that can provide pushback against political biases.

43. The weaknesses of Romania’s fiscal institutions have clearly hampered fiscal policy formulation and implementation. Given the weakness of budget procedures and the absence of other credible institutional constraints (apart from the Maastricht 3 percent deficit limit), fiscal policy decisions are mainly driven by short-term considerations and haggling. The annual budget target is determined on an ad hoc basis, lacks credibility, and is subject to frequent revisions: in 2006 and 2007 Romania had four budget revisions and, in 2008, the Budget was revised as early as March. The dominance of short-term political considerations on strategic planning and analysis has also contributed to slow progress in technical capacity building.

44. Perhaps most striking at the macro policy level has been Romania’s recent inability to eschew a highly procyclical fiscal stance in response to the capital-inflow-driven absorption boom that started in 2004. The massive and persistent capital inflows as EU accession prospects firmed were clearly unexpected, and led to overheating. In the case of Romania, the widening of the structural budget deficit despite highly favorable cyclical conditions points to a particularly pronounced procyclical loosening of fiscal policy (Figure 5). While some procyclicality is observed also in countries with strong fiscal institutions, usually in these cases reflecting large lower government sectors that operate with balanced-budget rules or large pay-as-you-go social insurance systems, in Romania procyclicality clearly reflected discretionary spending increases and changes in tax rates.

Figure 5.
Figure 5.

Selected EU Countries: Fiscal Policy Responses to Absorption Booms

Citation: IMF Staff Country Reports 2008, 210; 10.5089/9781451832907.002.A003

Sources: National Authorities; and Fund staff estimates.

The combination of weak institutions and fragmented politics has also led to other undesirable fiscal outcomes:

  • Underutilization of EU funds. Romania’s fiscal policy management has not yet fully adjusted to the increasing capacity and administrative needs associated with membership in the European Union. In its first year of EU membership, underutilization of EU funds was evident. From the maximum committed resources of more than 2 percent of GDP, the Romanian budget absorbed only about ¾ percent of GDP.

  • A large “end-year surge” in public spending (Figure 6). On average over the last three years, more than 15 percent of total consolidated expenditure were spent in December, i.e. about twice as much as in other months of the year. This end-year surge hampers the predictability of budget execution, weighs on allocative efficiency, results in a succession of destabilizing fiscal expansions and contractions, and renders liquidity management by the central bank more difficult.

  • Under execution of capital spending. On average over the last three years, capital expenditure has been significantly lower than planned in the budget, both in nominal terms and as a share of GDP (Figure 7). Some of the funds initially appropriated for capital expenditure seem to have actually been used to finance additional current spending.

  • Myopic policies. A recent example is the approval on a fast-track basis last year of a pension law stipulating massive two-stage increases in pensions in January 2008 and January 2009, although key decision makers agreed that at least the second-stage pension increase is underfunded.

  • Bias in revenue projections. Contrasting with the previous practice of conservative revenue projections, the revenue forecasts underpinning the budget have turned too optimistic in recent years. Inflated revenue forecasts were used as a way to artificially create margins for higher spending increases.25 This practice has not led to big shortfalls in nominal government revenue, but this was only because GDP growth surprised on the upside. The ratio of government revenue to GDP has however almost always been lower than expected in the budget (Table 4).

Figure 6.
Figure 6.

Romania: Monthly profile of budgetary execution

Citation: IMF Staff Country Reports 2008, 210; 10.5089/9781451832907.002.A003

Figure 7.
Figure 7.

Romania: Planned and observed capital expenditure

(percent of GDP)

Citation: IMF Staff Country Reports 2008, 210; 10.5089/9781451832907.002.A003

Table 4.

Romania: Summary of Consolidated General Government, 2003–07 1/

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Sources: Ministry of Public Finance; and Fund staff estimates and projections.

Figures for 2003 and 2004 are based on the old fiscal classification.

D. A Road Map to a New Budget Culture

45. Improving fiscal policy management will require a strengthening of fiscal institutions in line with best EU practices. To this end, a three-pronged approach is recommended that encompasses capacity building and improved transparency, a medium-term framework for fiscal policy, and increased use of independent fiscal expertise.

46. Capacity building and fiscal transparency. Key will be improvements in current practices of public financial management and analysis, at all stages of budgeting (Table 1 provides detailed suggestions). This includes:

  • Ex-post analysis of macroeconomic and budget developments. Budgets and supplementary budgets should incorporate an analysis of past macroeconomic and budget developments, including an explanation of deviations between projections and actual developments.

  • Better consideration of macro-fiscal linkages in setting budgetary targets. Budget documents should provide an assessment of the position of the economy in the cycle and of the expected cost and economic impact of the measures introduced in the budget.

  • Improved regulations and budgeting techniques. Regulations need to be revised to ensure that the budget captures the impact of all legislative changes, including changes in public sector wages. In addition, greater emphasis should gradually be placed on performance-oriented budgeting.

47. Anchoring fiscal policy in a medium-term perspective. The current practice of focusing on the day-to-day operations of fiscal policy needs to shift toward a medium-term strategic thinking setting. This involves two key steps:

  • Limit the frequency of supplementary budgets. Timelines and trigger mechanisms for supplementary budgets should be clearly defined (e.g. budget revisions take place in the context of a mid-term review of fiscal developments). Rules ensuring that the first supplementary budget will not be submitted before the mid-year review could be considered (barring exceptional circumstances).

  • Introduce a fully-functional MTBF. Projections should be based on a clear policy statement and realistic macroeconomic assumptions, have a broad fiscal coverage, and be fully integrated in the budget process. They should be articulated around multi-annual expenditure targets vetted by parliament, possibly revised annually on a rolling basis and set in real terms, to avoid the budget being affected by unexpected developments in inflation.

48. Using independent expert panels. A first step would consist in further strengthening the independence of the Prognosis Commission. Other steps would consist in the development of non-partisan bodies providing analysis and advice on fiscal issues:

  • Independent revenue forecast. An independent expert panel or body providing fiscal revenue forecasts would help address the optimistic bias in revenue projections observed in recent years. Examples in the EU are the Working Party on Tax Revenue Forecasting in Germany and the CPB in the Netherlands. The timing of the independent revenue forecasts and updates should be aligned with the budget calendar (e.g. preparation of the budget and mid-term budgetary review).

  • Expert analysis and recommendations on fiscal issues. Setting up an independent agency in charge of providing independent analysis on fiscal issues (e.g. costing and impact of measures and reforms; analysis of the sustainability of government finances) could be considered at a later stage. Based on this analysis, the agency could be mandated to provide normative assessments and recommendations on fiscal policy. Examples of such institutions in the EU are the High Council of Finance in Belgium and the Government Debt Committee in Austria.

Table 1.

Strengthening Public Financial Management

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References

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23

Prepared by Costas Christou and Laurent Moulin.

24

The common pool problem arises when several actors bargain on the allocation of public resources. Each player tends to maximize its own spending, without internalizing the overall budget constraint. In the absence of a proper unification of the budget process, such behavior leads to a spending (and deficit) bias.

25

This point has been documented in Milesi-Feretti and Moriyama (2004). Overly favorable growth and revenue assumptions help opportunistic governments to avoid the political cost associated with the implementation of consolidation measures. Difficult policy choices can be avoided ex ante, while ex post negative surprises are blamed on bad luck.

Romania: Selected Issues
Author: International Monetary Fund