Romanian Recession Deepens on Cuts, BOA Merrill Says (Update1)

July 12 (Bloomberg) -- Romania’s recession this year will be deeper than previously seen as the government cut spending and raised the value-added tax to curb a swelling budget deficit, Bank of America Merrill Lynch said.

BOA Merrill lowered its forecast for the European Union member’s 2010 economic performance to a 1.3 percent contraction from a previous forecast for a decline of 0.7 percent, Mai Doan, a London-based analyst at the bank, wrote in an e-mailed note. The economy shrank a record 7.1 percent in 2009.

“As spending cuts and a VAT hike become effective in the second half of 2010, while euro-zone demand slows into 2011, there is little support for economic growth in Romania,” Doan wrote. “Private consumption and investment continued to subtract from annual growth” in the first quarter, “a reflection of high unemployment and stagnant lending.”

Prime Minister Emil Boc’s administration, raised the value- added tax as of July 1 by 5 percentage points to 24 percent and made further cuts to public-sector wages to secure further disbursements from a International Monetary Fund-led 20 billion- euro ($25 billion) bailout program. The IMF backs a budget- deficit target of 6.8 percent of gross domestic product this year.

‘Fiscal Slippage’

Even with the additional measures, “fiscal slippage” is likely to occur, according to Doan, who forecasts the budget shortfall at 7.3 percent of GDP. Political wrangling over the cutbacks risk delays in unlocking further installments of the loan, threatening the stability of financing, Doan wrote.

“Financing in the short term is covered with the fifth disbursement from the IMF and EU, but remains a concern in the medium term,” Doan said. “Continued blocks by the opposition and challenges at the Constitutional Court against austerity measures risk delaying future IMF aid, with early elections a possible scenario.” A materialization of that risk would also make it difficult for the country to borrow in international bond markets, Doan said.

The value-added tax increase will push the inflation rate above 8 percent by year-end and halt the central bank’s interest rate cuts until next year, according to Doan. Inflation was unchanged at 4.4 percent in June, a month before the tax increase, the Bucharest-based statistical office said today.

The central bank’s inflation target is 3.5 percent, with a percentage point divergence allowed on either side. The Banca Nationala a Romaniei left the monetary policy rate at a record-low 6.25 percent on June 30. While central bank Governor Mugur Isarescu said there’s “no reason for the interest rate to react” to the value-added tax increase, Bank of America Merrill predicts it will prevent any reduction to borrowing costs until next year.

The central bank’s “hands are tied,” according to Doan. “The easing cycle has likely come to a halt as the VAT hike will likely see inflation overshoot the target, but further cuts may resume in 2011 to counterbalance fiscal austerity and support economic growth,” she wrote.

--Editors: Alan Crosby, Balazs Penz