There are comments on the relationship between public investment and the budget deficit that maintain a lack of clarity: it is argued that if this investment is close to the budget deficit, the health of public finances will not be at risk.

An interesting thesis, especially considering the size of Romania’s budget deficit. This deficit has been around 6% of GDP over the past two years, as capital spending has been cut significantly compared to what was planned to be cut in cash terms. Below are arguments why this interpretation of the relationship between the deficit and public investment is incorrect.

Deceptive equality

From half to 60% of public investments, which averaged more than 5% of GDP in recent years, were financed from European funds. European resources appear in the budget on both sides, revenues and expenses, so they do not have a large impact on the deficit. Indeed, the share of co-financing and the cost of some loans (from PNRR) affect the deficit, but the size of these effects is much lower than the contribution to the state budget of European funds. European money supports economic activity, increases potential GDP, helps the balance of payments, made it easier for Romania to survive extremely difficult years.

A hypothetical exercise shows why the above interpretation is misleading. If European money did not exist and we abstracted from part of the co-financing and cost of loans from the PNRR, the deficit would remain the same, but with a different ratio, mentioned in a different light – because the deficit would be much higher than the public investment that was b to capital expenditures (which are financed by own resources and loans).

Let’s recall, for example, that in 2023, state investments accounted for 5.9% of GDP, of which more than 3.6% of GDP was financed with European money. In the same year, the deficit according to the European/ESA methodology was about 6% of GDP.

This conclusion needs to be supplemented: the absence of European money will significantly weaken the economy and reduce tax revenues, which will lead to an increase in the budget deficit (or reduce, even cancel out the “benefit” of the disappearance of the necessary co-financing). It is true that there were cases when European money was not involved in order to keep part of the public expenditure co-financed so that the deficit was smaller, but this strange situation is not commendable for budgetary programming.

The described situation shows that Romania’s budget deficit does not arise mainly because of actual public investments; a significant part is related to other expenses. Even if we consider spending on education and health care as investments in human capital, the vulnerability of the state budget due to the size of the budget deficit is obvious. This reality should be understood as there is a need for structural (rather than conjunctural) means of fiscal/budgetary consolidation.

In an optimal situation, public investment (including European resources) should significantly exceed the budget deficit given the European money available to Romania.

Budget deficit and monetary policy

It is worth noting one more aspect regarding the budget deficit. European resources help to finance the current account (the current account deficit in 2023 is estimated at below 7% of GDP, debt financing is about 40%), the balance of payments. We are not discussing now that this money greatly increases liquidity in the market and can make it difficult for the BNR to manage the situation on the monetary market.

A large budget deficit puts pressure on monetary policy, given that the attractiveness of Romanian bonds depends on the stability of the leu, making yields attractive to financiers. Large deficits, uncertain fiscal consolidation, increase risk aversion and may cause an outflow of money from Romania, may increase the return required by financiers (cost of financing and refinancing). This will be seen both in the domestic and foreign markets. And for this reason, the BNR advocates fiscal consolidation. It should be emphasized that Romania is not part of the euro zone, so there is a currency risk.

One cannot ignore the fact that Olivier Blanchard, the former chief economist of the IMF, is urging EU countries to take their time to reduce deficits in view of anemic economic growth and the need to increase defense spending. But he is referring to the Eurozone (where there is no currency risk) and countries with deficits lower than Romania’s. Our country has significant economic growth and has significant European resources. In addition, the correction must be made in years of economic growth and when the infusion of European money is massive.

This can also be seen in the influence on monetary policy, how carefully the connection between the budget deficit and public investment, European funds should be investigated. The corresponding interpretation connects the budget deficit with state investments at the expense of own or borrowed resources; by 2023, the budget deficit will be about 6% compared to about 2% of GDP in capital spending. You can see how far the two percentages are. A deficit of this magnitude must be corrected, even gradually.

Rating agencies evaluate the amount of available European resources, BNR reserves, economic growth, public debt, the country’s total foreign debt in the sovereign rating, but ultimately do not take into account budget corrections that ensure budget stability.

Correction is necessary in the following years

Achieving a budget deficit of 2% of GDP in accordance with the new system of fiscal management in the EU (which also requires fiscal space in relation to the traditional 3% of GDP) is not a whim of European institutions, some economists, but it is an aspiration of common sense for budget structures in a world with many unforeseen, huge problems. This is a false thesis that still resonates in our country, that a deficit of 3% of GDP hinders development, it would be the equivalent of austerity. It is kept silent that the BNR does not issue reserve currency and that Romania has too large a deficit, including an external one. Romania has a very thin domestic financial market which is not conducive to deficit financing – banks have limited access and you cannot rely too much on pension funds as financiers. And it is very dangerous to finance yourself only on the foreign market

You stimulate development through the production of public goods in the appropriate amount, which requires significantly higher revenues to the budget (it is a shame to see that Romania’s fiscal revenues are 26-27% of GDP compared to the incomes of its neighbors – 31-35% of GDP, compared to the European average ( about 41% of GDP), through policies that encourage investment in high value-added production, massive absorption of European funds, reforms, etc. And PNRR as a multi-year financial structure plays a key role in this equation.

Recommendations for increasing tax revenues from the latest OECD study on Romania should be taken into account, as well as recommendations from the analysis of other specialized institutions. It is necessary to manage to significantly increase tax revenues, because a correction only in the expenditure part is a fantasy.

To the extent that EU-level tools are developed to support the defense industry with European money, it will be possible to talk about the financing of defense costs (that is, state budgets) from such resources.

The Fiscal Council sees a deficit of more than 6% of GDP in 2024, assuming no forced cuts in capital spending.

The government must resist pressures to increase fixed budget spending, even if 2024 is an election year. In 2025, the full effect of the correction of pensions (1.5-1.6% of GDP) will be felt, which will make it difficult to get on the path of correcting the budget deficit to 3% of GDP. And we also have wage reform, climate change costs, energy transition, geopolitical and military security.

N. Red: Daniel Dayanu is an academician, former Minister of Finance and member of the Board of Directors of the BNR, currently the president of the Fiscal Council.