Metalurgia International Review, vol. XIV (2009), special issue no.1, p.

49-54, 2009, coautor, ISSN 1582-2214

Analysis of the Reaction Capacity of the Budgetary Fiscal Policy in Romania

Marin DINU Cristian SOCOL Academy of Economic Studies, Bucharest Abstract Alongside with Romanias adhering to the Euro zone, foreseen to be accomplished in 2014, the fiscal-budgetary policy will play a more and more important role in the absorption of the asymmetrical shocks which will be faced by the Romanian economy. This article deals with the reaction capacity of the Romanian fiscal-budgetary policy during 1999 2007, testing the reaction of the structural budgetary balance to the shocks manifested by the degree of indebtness level, of the output gap and the previous values of the structural budget balance. In this work, we have used the so-called CAPB model to estimate the rule of fiscal policy, model in which the discretionary fiscal policy actions are measured by the modification in the primary structural budget balance (CAPB). Last but not least, we have defined conclusions and recommendations regarding the increase of the reaction capacity of the fiscal budgetary policy and, implicitly, of the Romanian public finances sustainability. Key-words: structural budget balance, fiscal budgetary policy, the CAPB model, Johansens co-integration JEL Classification: E62, H62 At present, Romania prepares for taking part in the final stage of integration, which is adhering to the Euro zone. The criteria of convergence to the Economic and Monetary Union will represent the economic test of evaluating the preparation stage of the Romanian economy for adhering to this union. Even though the Treaty of Maastricht does not stipulate a strict calendar for adopting the Euro currency letting this process at the discretion of each country, in consultation with the European Commission and with the European Central Bank it clearly settles that only the countries proving to have reached a lasting convergence may take part in the final stage of the Economic and Monetary Union.

Introduction
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The inconsistent management of the fiscal budgetary policy in Romania could affect Romanias adhering to the Euro zone. Until reaching this objective, scheduled for 2014, the Romanian decidents of fiscal-budgetary policy will have to accelerate their reaction speed regarding the adjustment to the shocks upon the aggregate demand or offer, the next step being that of compatibilizing the action with the practices of European good governing. By the increasing development of the effects of the tye hands phenomenon of the authorities deciding the monetary and rate of exchange policies within the member countries, the decisions taken by the specialists in the public finances become more and more important. The authorities must be aware of the fact that the efficiency of the budgetary policy will become more and more important. This article analyses the reaction capacity of the Romanian fiscal budgetary policy, starting from a model (the CAPB model) which analyses the impact of the fiscal budgetary policy discretionary measures upon the modification of the structural budget balance. For this purpose, the international literature, which analyses the sustainability of the fiscal and budgetary policies promoted by the countries member to the European Union, uses the structural budget deficit indicator instead of the actual deficit, and an interpretation as accurate as possible of the information transmitted by the the indicators measuring the dimension of the budgetary dis-equilibriums is of a special importance. When the budget deficit is considered the cause of some phenomena, such as inflation or the crowding-out phenomenon, it is very important to know the concerned type of deficit (the actual budget deficit, the cyclic budget deficit, the structural budget deficit), and also the modality of quantifying the dimension of this budget balance (Eisner, 1989). In order to eliminate the short time influence of the fluctuations and especially to evaluate the real performance of the fiscal policy, institutions such as The European Commission (EC), The International Monetary Fund (IMF) or The Organization for Economic Co-operation and Development (OCDE) etc. estimate the structural budget deficit. For this purpose, the current budgetary component is defined in its two constituent parts: the cyclic part and the structural part. Moreover, calculating this variable is necessary because the current budget balance reflects the influence both of some cyclic factors (temporary) and of some structural ones (permanent). The cyclic constituent refers to the variations generated by the cyclic evolutions of the gross domestic product (GDP), while the structural constituent takes into consideration the modification of the budget balance, in case the economy is producing at the level of the potential GDP (Leeuw and Holloway, 1985).

In this work, the use of the structural budget balance and output gap indicators has been achieved on the basis of the estimations made by Socol and Chiriacescu (2008). Thus, we have considered the structural budget balance indicator as being one of the most relevant for the evaluation of the fiscal management performance in Romania, and also the extent to which the fiscal policy is prepared to act as a sole instrument, capable of stabilizing the national economy after adhering to the Euro zone. Moreover, this is a modality of investigating the sustainability of the public finances, recommended by Bohn (1998, 2005) and used, also improved / expanded by many other authors (Fatas and Mihov, (2002), Gali and Perotti, (2003), de Mello (2005) etc).

The Model
The analysis of the fiscal and budgetary policies sustainability has been based on the tax smoothing model elaborated by Barro starting from 1979. Barro has been considering that the budget balance can be estimated depending on the degree of indebtness and on a series of control variables, which can determine its dimension 1 . Greiner et al (2005) have supplementary used, besides the variable which denotes the economic cycles, the real interest rate on a long term and the values from the previous periods of the public degree of indebtness. De Mello (2005) has estimated a reaction function of the fiscal policy based on the values from the periods previous to the budget balance, to the degree of indebtness, to the inflation rate and to some qualitative variables which detect the modifications occurred in the fiscal legislation. Basically, the estimation of a reaction function for the fiscal policy 2 is based on the following relation (Gali and Perotti, 2003): PBit = a PB it-1 + b DEBTit + c GAPit + constant + error term, where: PB = primary budget deficit; GAP = output-gap; DEBT = public debt; a,b,c = quotients. (1)

This reaction function of the fiscal-budgetary policy follows the logics of the Taylors rule applied in the case of the monetary policy. The variables (primary budget deficit, output gap, and public debt) are expressed as a percentage of the gross domestic product. If the quotient a > 0, we translate that there is a tendency to balance the budget, increasing the sustainability of the public finances. The quotient b > 0 shows the existence of an active constraint referring to the public debt 3 . If the quotient c > 0, then the budgetary fiscal
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In his original work from 1979, Barro was considering that the primary budget balance is influenced by the economic cycles and by the temporary government expenses. 2 Called in the economic literature the core reaction function of fiscal policy. 3 Although this condition does not guarantee the sustainability of the public debt.

policy is considered to be anti-cyclic. Subsequently, Gali and Perotti (2003) suggest the use of two different measures of the budget deficit: (i) the adjusted cyclic deficit (the structural budget deficit) in order to examine discretionary or anti-cyclic characteristic of the fiscal policy, and also its pro-cyclic or ant-cyclic characteristic, or (ii) the cyclic budget deficit in order to estimate the efficiency of the automatic stabilizers. The reaction capacity of the fiscal-budgetary policy for Romania will be analyzed using the CAPB model (Golinelli and Momigliano, 2007; Galli and Perotti, 2003; Giuliodori and Beetsma, 2006). This model estimates a certain rule of fiscal-budgetary policy, in which the discretionary fiscal policy actions are measured by operating a modification in the primary structural budget balance (CAPB). This modification is explained by the initial position of the public finances (measured by the structural balance and by the public debt, both of them in the moment t-1) and by the cyclic conditions (measured by the output gap level). (2) CAPBit = 1 CAPBit-1 + 2 DEBTit-1 + 3 GAP it(t-1) + uit where: CAPBit = the modification of the primary structural balance (cyclically adjusted primary budgetary balance); CAPBit-1 = the primary structural balance during the previous period; DEBTit-1 = the public debt during the previous period; GAP it(t-1) = output gap; 1, 2 , 3 = quotients. It is considered that the model is stable if the 1quotient is negative, while the public debt quotient has to be positive. Moreover, it is considered that the fiscal and budgetary policy is sustainable if the primary balances reaction to shocks of the public debt is instantaneous, and not time delayed. A positive value of the output gap quotient (3) shows the fact that the fiscal policy is anti-cyclic, while a negative value would mean that the fiscal policy is a pro-cyclic one.

The Estimations Results and the Results Interpretation

The choice of these variables has been made taking into account the economic literature, and also the results of the stationarity tests. There have been used quarterly time-series (the period between 1997 2007) regarding the used macro-economic indicators, having as a source the Ministry of Economy and Finance. In order to estimate the quotients of the above equations, the Johansons co-integration procedure has been used. The number of the lags used for the stationarity tests have been chosen following the SC minimization criterion (Schwarz information criterion). The 4

results of the ADF stationarity test reveals the fact that the series are integrated by order I, fact which allows to investigate the existence of a co-integration relation between the variables. The series non-stationarity allows the use of the co-integration procedure in order to identify the presence of a stationary relation on a long term between the nonstationary series. Regarding the number of lags taken into account within the cointegration, this has been determined on the basis of the estimation of the VAR type model (Autoregressive Vector) in which we have introduced the variables used for the analysis. In order to choose the corresponding lags number, we have used the econometric criteria known as Hanan-Quinn Information Criterion (HQ), Akaike Information Criterion (AIC) and Schwarz Information Criterion (SC) The estimated quotients are presented in Table 1. Based on them, there have been made estimations of the relations between the variables. CAPBit = 1 CAPBit-1 + 2 DEBTit-1 + 3 GAPit(t-1) + uit CAPBit = (-0,034) CAPBit-1 + 0,078 DEBTit-1 + (-0,742) GAPit-1 0,010
Table 1. The co-integration vectors for the structural deficit Vector Error Correction Estimates Date: 08/05/08 Time: 12:06 Sample (adjusted): 2000Q2 2007Q4 Included observations: 31 after adjustments Standard errors in ( ) & t-statistics in [ ] Co-integrating Eq: MODIF_DEF_STRUCT (-1) DEF_STRUCT_1(-1) CointEq1

DAT_PUB_1(-1)

OUTPUT_GAP_1(-1)

1.000000 0.034177 (0.03500) [ 0.97641] -0.078489 (0.01472) [-5.33330] 0.742512 (0.11397) [6.51488] 0.010931 D(MODIF_DEF_ D(DEF_STRUC D(DAT_PUB_1 D(OUTPUT_ STRUCT) T_1) ) GAP_1) -4.445064 (3.84772) [-1.97525] 0.244817 (0.20929) [ 1.16974] 3.517703 (1.31612) [ 2.67279] 1.149950 (0.34060) [ 3.37624]

Error Correction: CointEq1

The estimation of the fiscal-budgetary policys reaction capacity for Romania by means of the shown model had the following results. The structural budget deficit quotient at the previous moment (1= -0,034) is not important from a statistical point of view. It reveals the fact that the fiscal-budgetary policies decidents from Romania do not make analyses of the previous structural budgetary balance indicator evolution within the process of taking decisions. Actually, there is a poor literature in Romania regarding the analysis of the structural budget balance indicator. Because of the fact that the indicator mentioned in the Treaty of Maastricht which provides the member states obtaining a budget balance of maximum 3% of the GDP is more frequently used, the analysis of the structural budget deficit evolution is ignored, this one being an indicator with a more increased informational relevance and being much more frequently used by the European Commissions experts in studying the health of the public finances within an EU member country. The quotient of the public debt weight in the GDP (2= 0,078) is positive, demonstrating the fact that the fiscal-budgetary authorities take into account the constraint regarding the public debt, but with a quite low importance. This fact is explainable to a great extent for Romania, where the public debt weight in the GDP (an average of 12% of the GDP during the period between 1999-2007), complying without any problems with the criterion mentioned in the Treaty of Maastricht a public debt weight in the GDP lower than 60% of the GDP. But, the increase of the structural budget deficit in Romania will have to modify the vision of the Romanian decidents of fiscal-budgetary policies, under the terms of a rapid increase of the need to finance the twin deficits the budget deficit and the current account deficit -, which are more and more unsustainable, increases the risk of occurrence of the ricardian equivalence phenomenon. The analysis of the factors which influence the modification of the structural budget balance shows the fact that the only indicator taken into consideration by the authorities, when scientifically proving the decisions, is the output gap. The quotient (3=-0,742) argues the fact that during the analyzed period, the fiscal-budgetary policy was mainly procyclic, thus decreasing the sustainability of the public finances. Moreover, the International Monetary Funds and the European Commissions recommendations regarding the adoption of an anti-cyclic fiscal-budgetary policy and a forward-looking one have not been effectively taken into consideration by the Romanian authorities. A pro-cyclic fiscalbudgetary policy, in combination with the relaxation of the consumer credit during the last 2 years resulted in the deepening of the macroeconomic dis-equilibriums generated by the over-heating of the Romanian economy. Thus, the excessive aggregate demand has results 6

in the strong inflationary pressures, in the deepening of the current account deficit and of the budget deficit. In Romania, the structural budget balance modified during the analyzed period, irrespective of the weight of the previous structural budget balance, the fiscal-budgetary policy decisions being taken depending on the evolution of the previous primary budget deficit. The preference for using the primary budget deficit indicator is justified in Romania at present to some extent taking into account the fact that our country has not been constrained by the provisions in the Stability and Growth Pact yet, but it relates to the performance criteria imposed by the Treaty of Maastricht, which take into consideration the threshold of primary budget deficit < 3% of the GDP, and not a certain reference level of the structural budget balance. Moreover, there must be taken into consideration the fact that, from a technical point of view, the European Commission analyzes the efficiency of the fiscal-budgetary policy management based on the evolution of the structural budget balance indicator, even during the period previous to adopting the unique currency. Moreover, together with the adheration to the Euro zone, the evaluation of the fiscalbudgetary decisions efficiency will explicitly relate to the structural budget balance indicator. Moreover, from the new trade-off point of view, the prices stability the output stability, the model concludes that, during 1999 2007, the Romanian governments gave an greater importance to the GDP gap (to the economic growth) despite the inflation stability. This vision will have to be re-analyzed regarding the adheration to the Euro zone, situation in which the fiscal-budgetary policy will play an important role in the absorption of the asymmetrical shocks, foreseen to affect most of the macro-economical deficits types.

Conclusions and recommendations

During the analyzed period, Romanias fiscal-budgetary policy was strongly pro-cyclic and weakly anchored on a medium term. The analysis of the structural budget deficit clearly proves the lack of efficiency of the public finance policies when settling a fiscal position as favorable as possible. Moreover, during certain periods, there can be observed a determination in carrying on the fiscal consolidation process, but the evolution of the structural budget deficit in Romania during the analyzed period (1999 2007) (see Socol, Chiriacescu, 2008) reveals an inconsistency regarding the applied fiscal and budgetary policies. The numerous budget rectifications (three-four per year), the practice of huge budget expenses made at the last moment, the decreased potential of the administration to spend 7

the allotted public funds, the repeated overestimation of the incomes and of the expenses to the state budget (differences of 2 4% of the GDP between the data foreseen in the substantiation of the state budget and reality) and the exaggerations regarding the capacity of absorption of the European funds encumbered the consolidation of the public finances sustainability in Romania. The risks of the low efficiency in the case of the public finances management will produce serious effects, especially on a medium term. The side-slipping of the budgetary policy will be felt during the period 2008 2013 only, putting pressure upon the twin deficits (the budget deficit and the current account deficit) and upon the inflation. Watching towards the future, taking into account the loss of some policy instrument available to the National Bank of Romania (for example, together with the adheration to the Euro zone the monetary policy and rate of exchange instruments become inoperative), the cautious fiscal-budgetary policy in order to strengthen the healthy public finances represents more than a desideratum. In other words, the budget deficit must be treated with a lot of caution. There must be avoided the excessive injection of money in economy, which would result in the increase of the aggregate demand, with an immediate impact upon the prices level. The budget expenses must be re-structured, so that they aim to the development of the national infrastructure, both that of transports and in the fields of education, health, rural development and environment protection. The budget expenses must mainly stimulate the offer, and not the demand, so that there could not be perceived inflationary dis-equilibriums, especially if a budget deficit of over 3% in Romania in 2007 is not complying with the convergence criteria from Maastricht. In order to avoid the pressure of the increased budget deficit upon the delaying of the economic growth, upon the deepening of the external deficit and upon the inflation through the internal demand, we consider that it is necessary to proceed to a structural adjustment of the offer, to manage the budget in a more balanced manner, this having benefits both on a short and on a long term. An intensifying factor of improving the structural budget balance is constituted by the multi-annual planning and the following of a pre-determined strategy. Other modalities through which the budget could satisfy its need of funds, besides the assimilation of the European financings, could be the increase of the indirect taxes, yet a solution difficult to foresee under the terms of the promises of not modifying the levels of the main fees and taxes on a medium term, promises coming from behalf of the Minister of Finances and Economy. 8

On a medium term, we recommend pressed economic policies to the monetary and fiscal authorities. The fiscal caution (an objective of a budget deficit of maximum 1% of the GDP) will allow to the automatic stabilizers to act most efficiently during the boom period which Romania is passing through, and the restrictive monetary policy will allow reaching the inflation target settled by the central bank. Moreover, the fiscal and budgetary policy will have to solve the nominal convergence real convergence trade-off through qualitative investments, which could help in creating a favorable environment for the development of the private sector. Basically, under the terms in which the Romanian economy prepares to adhere to the Euro zone, we consider the implementation and the maintenance of a restrictive fiscal policy imperatively necessary for a period of at least few years, which could improve both the actual budget deficit and the structural one. In order not to generate negative consequences, the government must not adopt expansionist discretionary policies, but it has to continue the fiscal consolidation process.

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