Romania enjoyed a remarkable reduction of inflation over the past few years-from
over 14 percent in 2004 to less than 5 percent at end-2006. Unfortunately, this decline came to an abrupt halt recently, and year-on-year inflation increased to nearly 7 percent in October, driven by sharp increases in food and services prices. While outside factors-such as rising world food prices-have been at work, there is no question that domestic factors-including an overheated demand and rising labor costs-are playing their part, as signaled by core measures of inflation. The National Bank of Romania (NBR) is now projecting that year-end inflation will be well above its 3-5 percent target band.
Rising inflation must be fought forcefully. Low and stable inflation benefits the entire economy, and particularly pensioners and low-wage earners, who are most vulnerable to rising prices. The NBR already developed a first line of attack by raising interest rates at end-October. But interest rate policy can only go so far. With a fully open external financial account in Romania, capital flows react quickly to a widening differential between domestic and foreign interest rates.
An effective response requires coordinated action on both monetary and fiscal fronts. Fiscal policy plays a particularly significant role in Romania, controlling directly about forty percent of the economy's spending. If the NBR is left alone to fight inflation, the resulting higher interest rates will affect the share of investment in GDP, and therefore future growth. Thus, the appropriate policy reaction by the NBR, which may include further interest rate increases, needs to be supported by tight fiscal and prudent public-sector wage policies, both to lower inflation and to promote growth.
Policy Conflicts or Complementarities?
In Romania, over the past few years, fiscal and monetary policies did not come into conflict. The result was that both inflation and long-term interest rates were brought down, while capital formation increased as a share of GDP. This favorable environment, if maintained, should boost growth for years to come and help Romanian incomes converge to levels in Western Europe.
But monetary and fiscal policies could start working against each other. In the face of higher expected inflation, the NBR raised interest rates by 50 basis points on October 31st, and may have to do more sooner rather than later. This is consistent with the NBR's inflation targeting framework. Fiscal discipline, on the other hand, is expected to loosen. Not only are pensions to rise by over 40 percent cumulatively November-January and minimum wages by about 30 percent, but the overall fiscal deficit is estimated to widen significantly to 2.7 percent of GDP in 2008.
What can be expected from a combination of tight monetary and loose fiscal policy? As the real interest rate increases, other things equal, we would expect less real investment. Although the economy may continue to grow strongly in the short run, the effects of lower investment will be felt in lower future growth. Capital inflows responding to interest rate differentials will tend to appreciate the leu. While this will help disinflation, the external current account deficit is bound to widen because of lower exports. The interest rate differential will also increase incentives for foreign currency-denominated borrowing, and banks will likely oblige because they have ready access to foreign financing. Increasing the share of banks' foreign currency assets from the current level of 50 percent-without adequate currency risk hedging by borrowers-will make banks more vulnerable to exchange rate changes.
There is Still Time to Get Fiscal Policy Right
Romania is expected to grow by over 6 percent this year and next, and unemployment has fallen to 4-5 percent, with shortages starting to appear in certain labor skills. Public sector wages have more than tripled in the past five years. In this setting, an expansionary fiscal and incomes stance will represent an additional demand impulse to be offset by the central bank, which is already hard-pressed to lower inflation. Thus, the Ministry of Finance should build on the small general government surplus observed at end-October and avoid the year-end fiscal splurge seen in 2006. And that would lay the ground for a very prudent fiscal policy in 2008: aiming for a smaller deficit than in 2007 and an increase in public sector wages strictly in line with expected inflation and productivity growth.
Admittedly, with elections coming up, it will be difficult for fiscal policy makers to do the "optimal thing". But their leadership remains essential for restoring low and stable inflation. If a significant fiscal tightening is implemented in 2008, the IMF estimates that a moderate increase in interest rates will bring inflation back within the target band around mid-2008, without much adverse effects on investment and growth. If not, it may take longer to bring inflation down, and interest rates will need to increase by much more, affecting investment, growth, and the external current account deficit through a more appreciated exchange rate.
A strong fiscal policy will be required to defend the longer-term interests of the most vulnerable in society. The good news is that there is still time to implement it.
 Senior IMF Regional Representative in Romania and Bulgaria.
 Mission Chief for Romania, European Department, IMF.