t 4 )5 -4 9e POLICY RESEARCH WORKING PAPE R 2298 Public Disclosure Authorized Fiscal Deficits, Monetary Fiscal problems are a key factor behind the inflation Reform, and Inflation that has perststedin Eastern Stabilization in 1R*m*n*iEurope since 1989.Deficts Stabililzation in Romania need to be cut back, but by Public Disclosure Authorized how much for a given Nina Budina inflationtarget? A simple Sweder van Wijnbergen frameworklinks debt, the deficit, and inflation to assess the fiscal stance of the Romanian economy Public Disclosure Authorized Public Disclosure Authorized The World Bank Development Research Group Macroeconomics and Growth March 2000 POLICYRESEARCH WORKING PAPER 2298 Summary findings Unsustainable fiscal deficits were the chief reason for the Many of the issues in Romania are similar to tlhose in other inflation that has persisted in Eastern Europe since 1989. countries. But Romania is an interesting case because of its Deficits need to be cut back, but by how much for a history of unsuccessfulstabilization attempts. given inflation target? The authors' results suggest that fiscal problems during Budina and van Wijnbergen develop a simple 1992-94 were masked by shifting government expenses framework for debt, the deficit, and inflation to study to the books of the National Bank of Romania so that the interactions between fiscal and monetary policy in the government deficit did not fully reflect public Romania's economy. This framework can be used to 1) spending. In addition, the effects of delayed fiscal determine the financeable deficit and the required deficit adjustment were mitigated by exchange rate reduction for a given rate of output growth, inflation overvaluation and favorable debt dynamics. In the late rate, and target for debt-output ratios, and 2) to find the 1990s, however, debt dynamics worsened and the inflation rate for which no fiscal adjustment is needed. economy experienced significant real depreciation. That They use this framework to assessconsistency between exacerbated the fiscal problems and increased the fiscal inflation, monetary reform, and fiscal policy in Romania. adjustment needed to restore consistency. This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to study transition economies. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Nina Budina, room MC3 -353, telephone 202-458-2045, fax 202-522-3518, email address [email protected] Research Working Papers are also posted on the Web at wvww.worldbank.org/ research/workingpapers. The authors may be contacted at nbudinaCaworldbank.org and [email protected]. March 2000. (33 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues.An objective ofthe series is to get the findings out quickly, even if the presentations are less than fully polished. The paperscamy the namesof the authorsand should be citedaccordingly. The findings,interpretations, and conclusionsexpressed in this paper are entirelythose of the authors.They do not necessarilyrepresent the view of the WorldBank, its ExecutiveDirectors, or the countriesthey represent. Produced by the Policy Research Dissemination Center FISCAL DEFICITS, MONETARY REFORM AND INFLATION STABILIZATIONIN ROMANIA Nina Budina' and Sweder van Wijnbergen' JEL classification codes: E63, F34, E52, E41 Key words: Fiscal deficits, Public debt, Money demand, Seigniorage 'WorLdBank, ResearchDepartment, 1818 H Street NW, WashingtonDC, USA. 2University of Amsterdam,Roeterstraat 11, 1018WB, Amsterdam,the Netherlands,LSE and CEPR. INTRODUCTION Initial declinein economic activityand sharp inflatfionincreases are well-documentedstylized facts of transition economy from Central and Eastern Europe and FormnerSoviet Union.' Blanchard (1997) discussesthe causesof the initialdrop in economicactivity and the so-calledu-shaped pattern of real GDP growth in 5 transitioneconomies. Deep drops in output andlarge inflationincreases occurred independentlyof fiscaland exchangerate policiesadopted. Changesin economicstructures, caused by transitionprocess itselfwas accompaniedwith large primary fiscalimbalances throughout the region: tax revenuesdrop dramaticallyin early 1990sbecause of a decreasein both tax revenues and tax bases. Althoughthere was a substantialcut in government expenditures(most notable subsidies and public investment),social expenditureshave increased,so total expenditurecut did not match drop in tax revenues.In early 1990s,resulting budget deficitswere financedprimarily through direct centralbank creditto the governmentat bellow market interestrates 2 which resulted in accelerated money growth and inflationincreases in addition to the initial price liberalizationshocks. Budina and van Wijnbergen(1997) dscuss the role of fiscal policy in transition process and stress on the negative impact of unsustainable fiscal policies on inflation and macroeconomicstabilization. Our paper draws on the theoretical findings of Sargent and Wallace (1981) Buiter (1985) Drasen and Helpman (1990), Blanchard(1993), Van Wijnbergen(1991) Kawai and Maccini (1995) about fiscal roots of inflation and researches the implicationsof fiscal policy sustainabilityfor inflationstabilization in Romania.Many of the issuesin Romaniaare familiarfor other countriesas well.' Romania,however, is an interestingexample on its own right, because it has by now a historyof unsuccessfulinflation stabilization attempts. FollowingAnand, R. and van Wijnbergen(1989), and van Wijnbergen(1990) we develop a simpleframework on debt, deficitand inflationto study the fiscal and monetary policy interactionsfor the Romanianeconomy. We apply this frameworkto assess consistencybetween inflation,monetary reform and fiscalpolicy for the Romanianeconomy. 2 A central aim of this frameworkis to derive a measure of mediumterm consistencybetween fiscal and monetarypolicy, the required deficit reduction,representing the differencebetween funding requirementsand fundingsources, given the target debt-outputratios and the real output growth rates. We discussthe mediumterm impact of real exchangerate depreciationand delayedfiscal adjustmenton our measure of fiscal sustainability. We also discussand showthe importanceof using a proper definitionof the public sector when calculatingpublic sector deficit.Instead of concentratingon the centralgovernment budget deficit,we use the general government budget, including all the local governments' budgets and the extra- budgetary accounts, which might conceal a significant part of the governrnent expenditures. Furthermore,we are stillmissing a very important part of the public sector expendituresand revenues, such as, quasi-fiscaldeficit accumulatedin the CentralBank. Althoughfamiliar from other countries, this issue was especiallyacute in Romaniaand we show the impact of using differentconcepts of public sector deficitson the consistencybetween monetary and fiscal policies in Romania. This part of the public sector is especiallyimportant for the countries experiencingsevere fiscal restraints since the governmentsare tempted to shift some of their fiscalexpenditures to the CentralBank balancesheets. A key designfeature of this frameworkis parsimoniousdata requirements,for obviousreasons. A second necessaryfeature is the abilityto capture the type of monetaryreform transitioneconomies are going through; otherwise much of the analysiswould suffer from structural instability.The only econometricsrequired is the estimationof some components of money demand, which is becoming possiblefor most countries.The focus is on mediumrun consistencygiven a varietyof macroeconomic policy objectives.In the model the primarydeficit is taken to be a policyparameter. Debt management is summarizedby targets for the debt to GDP ratio for both foreign and domesticdebt. Implicitin this approach is the view that lenders will impose such a constraintbecause potential tax revenues, the ultimatesource from which debt willneed to be serviced,are obviouslylirnited as a share of GDP. Base money growth, for any given inflationtarget, is endogenouslydetermined by the path of the primary 3 deficit, debt policy,the real interest rate, the financialstructure and the real GDP growth rate. The model is designedto indicatewhether any given inflation(money growth) target is consistentwith the other policy parametersand structuralcharacteristics of the economy;alternatively, consistency can be imposedwhich yields the inflationrate consistentwith structuralstability, other policyvariables and the financialstructure of the economy. In what follows, Section 2 presents the analyticalframework for assessingthe link between inflationand fiscal deficits. Section 3 elaborates on calculation of the public sector deficit for the Romanianeconomy. The results of estimated asset demand equations are presented in Section 4. In Section 5 the model is put together and appliedto a series of policy issues, most of which have been mentionedin the precedingparagraphs. The last sectionconcludes. 4 2 AN ANALYTICALFRAMEWORK Fiscal problemsare widelyrecognized as a key factor behind persistent inflationin Eastern Europe post-1989.But little has been said beyond these generalities.Deficits need to be cut back, but how far for a given inflationtarget? What are the effects of a shifting financialstructure, the external debt managementor the exchangerate