One of the top concerns for policy makers and foreign creditors is Romania's budget deficit. Over the past few years, the government has been successful at reducing the budget deficit from 5. 4% in 1998 to 2. 6% of GDP in 2002. They achieved this reduction through the application of fiscal restraints, wage controls in state-owned enterprises, reductions in the losses of the state-owned energy sector, and measures for improving revenue collection (EIU, 2003). With regard to tax policy, a value-added tax system (VAT) was implemented to meet the EU norms.
The corporate tax was reduced from 38% to 25%, but higher income tax and high social charges (country's equivalent social security payments) raised overall employment taxes. This creates high social costs that weigh heavy on the government's shoulders. Under IMF pressure, the government is also withdrawing tax and customs exemptions while maintaining numerous VAT exemptions, especially for the agricultural and energy sectors. As exchange rate changes account for 40%-60% of inflation (Gueorguiev, 2003), the exchange rate has been monetary policy's main intermediate target.
The policy has been successful so far, especially since 2001, when wage policy and fiscal policy has been in sync with monetary policy to stabilize the Romanian economy. The inflation rate fell from 256. 1% in 1993 to 45. 8% in 1999 to 15. 3% in 2003. The NBR's target for 2004 is bringing inflation into single digits. How did NBR achieve its disinflation objective through exchange rate targets? The policy favored by NBR is to allow for a real appreciation of the Leu. From 1999 to 2003, the Leu has appreciated 7. 4% against US Dollar and 6. 8% against Euro on average in real term (Exhibit 27, 30).
The underlying reason is that imported oil is denominated in US dollars. Given the importance of the oil industry, a depreciation of the US dollar against the Leu translates into lower energy prices, i. e. a beneficial supply shock. However, the Romanian government is challenged by the dilemma of allowing real exchange rate appreciation to disinflate the economy or faster nominal depreciation to enhance export competitiveness. For the time being, the central bank does not have highly efficient instruments at hand to influence the interest rates on money market. The country's financial market is not highly developed.
Nevertheless, NBR has tolerated deliberately high interest rate (an average 27. 8% nominal lending rate for the past five years as seen in Exhibit 22) in line with restrictive monetary policy. IS/LM Schedule All of these measures are expected to impact Romania's IS/LM schedule and its aggregate demand. The IS curve is expected to shift rightwards due to increased investments required in the privatization and modernization of state-owned enterprises, as well as through capital inflow chasing higher interest rate. This is supported by the empirical data seen in the last five years: Real GDP has averaged 4.
4% annual growth while tax, government spending, and net export decreased an average of 1. 2%, 2. 4%, and 21. 6% per year respectively. On the other hand, investment increased steadily by an average of 16. 4% in the same period (Exhibit 9). Another implication of ongoing investment in infrastructure is that improved multi-factor productivity will gradually drive natural GDP to a higher level. The LM curve should shift slightly leftwards due to restrictive monetary measures. However, our broad money data suggested that money supply has in fact increased 5. 8% annually on average.
Overall, aggregate demand is still increasing, but at a decreasing rate, as a result of tightening fiscal/monetary policy. In fact the good news of significantly lower inflation rates in Romania in the past few years have economic analysts and policy makers questioning whether the ongoing economic expansion is stifled by policies that are too strict. As noted earlier, of extreme importance to Romania's successful entry into the European Union (EU) is the establishment of a fully functioning free-market economy in the country and their ability to compete in a single European market.
As with any nation, Romania's labor market has and will continue to play a significant role in the development of a more independent and vibrant national economy. In a global economy where labor seeks its lowest costs, Romania has benefited from cheap but comparatively productive labor to that of other transition economies (e. g. , Bulgaria, Croatia, Poland).
This has supported the country's economic recovery as it has contributed to the attraction of foreign investment. If, however, Romania is to maintain its external labor competitiveness over the long term, i. e., cheap but productive labor, it must effectively reorganize the percentage of the labor force employed by the government, "tighten the links between wage/employment decisions and economic performance and productivity, (EIU, 2003)" and address the informal labor activity in the country. The accomplishment of these objectives will imply improved efficiencies and productivity throughout the labor market. Between 2001-2002, it was estimated that public sector employment (state-owned enterprises) comprised roughly 30% of the labor force in Romania and swelling to 50% in urban areas.
And in the absence of budget constraints and wage policy accountability at the government level, wages have been allowed to increase without regard to its effects on external competitiveness, productivity measures, and most importantly profitability. It is thought that the higher wages in the public sector are less a result of productivity gains and more from rent-extraction by powerful trade unions. The effects of rent extraction on the economy have been detrimental in that it often leads to uniform increases in wage rates, inefficiently rewarding nonperformance and non-profitability.
However, as state-owned enterprises become privatized, they will have more flexibility in hiring better skilled personnel and firing nonperformers, placing a needed emphasis on pay for performance, which has not been the norm in Romania. Although it was estimated that the labor market would experience a mild decline (2%-3%) in the employment rate in 2002 due to expected layoffs in the public sector, unemployment only recorded a 1% increase in 2002 and fell sharply in 2003 to 7. 6%.
It is plausible that an expanding economy and positive efforts at retraining and retooling the labor force with a skill set more applicable to an open-market economy have contributed to the early employment recovery. In effect, the demand for skilled labor as well as the supply for skilled labor has increased. (EIU, 2003) As mentioned above, the Romanian government is relying heavily on the restructuring of fiscal policy, where the tax burden is shifted from the shoulders of corporations and more to their employees, to create a profitable business environment for these companies.
The tax burden, however, has lead to a significant rise in employment in the informal or underground economy. For example, it was estimated that at least 1. 5 million jobs or approximately 15% of the labor force were attributable to this sector of the economy. Additionally, another 1. 7 million jobs were registered as civil contracts, where workers are exempted from social security payments and other taxes. The effort of Romanian workers to avoid burdensome taxes and other labor costs, has created severe underemployment and skill mismatch in the economy.
Many laborers have opted to work fewer hours under civil contract agreements, work in jobs detrimental to society as in the case of the informal economy, or have taken jobs in areas not suited for their skill set, the best example in Romania being the agricultural industry. (EIU, 2003) Overall, the improvements to the Romanian labor market must be made in regard to the country's external competitiveness. To accomplish this, wage policies, i. e. , increases or decreases in the minimum real wage, must be balanced with the controlled appreciation of the Leu to its foreign investor's currencies.
Again, one of the substantial forces behind the inflows of foreign capital has been both an inexpensive, yet productive labor force as well as attractive interest rates maintained by the government's tightened monetary policy. Examining the gross wages and annual wages per capita GDP of comparable transition economies, Romania's attractiveness to foreign investment is evidenced by the fact that in 2002, wage earners received only 26% of GDP while comprising 50%-55% of GDP for that year. This has allowed them to post one of the lowest annual wage per capita GDP (98 in 2002) ratios of any of the other transition economies.
What is obvious, however, is that with the expanding economy (and subsequent increased demand), and the movement toward more private industry in the country (adding more upward pressure on wages as competitive firms seek to acquire skilled labor), real wages are expected to rise. This expected increase seems reasonable considering that while price levels (P) will continue to increase moderately (assuming an effective monetary policy) as the economy expands, so too must nominal wages (W) should the government wish to avoid increased labor participation in the informal activities sector.
In fact, average real wages in Romania have increased 3. 4% from a level of 2. 49 million 1995 Lei in 2000 to 2. 57 million in 2003. If ineffectively monitored, wage appreciation without corresponding productivity gains could negatively affect the country's external competitiveness, increasing the wage per capita GDP ratio. (EIU, 2003) The interesting relationship here between the government's choices to affect wages and their subsequent effect on inflation, directly impact the real exchange rate of the Leu.
One of the main determinants of Romania's exchange rate is its increasing productivity gains relative to those of its trading partners. This productivity differential is positively correlated with the appreciation of the Leu in Romania as it has provided a substantial incentive for foreign investment. Consequently, efforts at maintaining external competitiveness by ensuring increased productivity also lead to non-competitive circumstances in that an appreciating Leu is sure to follow.