Despite the astronomical 8.8% YOY real GDP growth in Q3, domestic risks have started to emerge once more on the Romanian market, with hundreds of protesters gathered again on the streets of Bucharest in early November to express their anger with the government’s latest set of fiscal reforms and corruption allegations against top public officials. While the scale of protests is much smaller than the wave of public discontent that led to the resignation of Grindeanu as prime minister earlier in the year, it serves to highlight the policy unpredictability of the Romanian political system, caused by persistent political tensions and growing public deficit. Indeed, the latest iteration of Romania’s fiscal code not only seems to reduce the purchasing power of consumers, but it also has considerable implications for MNCs operating in the country.
The New Fiscal Code: A Symptom or a Remedy?
In H1 of 2017, Romania boasted a 5.9% YOY economic growth, supported by robust consumer demand as well as a pickup in exports and investment. These positive developments, however, are overshadowed by a growing public deficit, which reached 4.1% of GDP in Q2 2017 and is projected to reach well-above the government’s target of 2.96%, not to mention the EU’s demand of 3%. Furthermore, growing uncertainty over specific legislative proposals and the government’s reluctance to disclose greater details about its intentions has not only made business planning difficult, but it also deterred some private investment. In fact, The Foreign Investors Council’s survey, published in September 2017, revealed that while 60% of multinationals expect their revenues and business to grow in 2018, 90% indicated that the unpredictable legislative environment is affecting their business planning (Chart 1) and 75% report that the legislation affecting business environment in Romania has worsened (Chart 2).
Therefore, in the beginning of November, the government adopted a new fiscal code that set out to at least partially address budgetary issues and provide a degree of predictability. The proposed changes can be summarized broadly under four key pillars, all starting in January 2018:
- A reduction of individual income tax to 10% from 16%
- A cut in social contributions to 37.5% from 39.25%, and forcing employees to pay 35% of the 37.5%, (previously social contributions were paid in roughly equal parts by the employer and the employee)
- Increased threshold (from EU 500,000 to EUR 1 million) for companies that pay a 1% turnover tax on profits instead of 16%
- Limiting the deductibility of interest rates paid by subsidiaries of MNCs, which is aimed at both limiting the ability of multinationals to externalize their profits but is also meant to increase tax collection from them
Impact on the market
The proposed changes have been widely criticized by both businesses and trade unions, with the latter claiming that the proposed social contributions transfer will negatively affect the wage of employees, and will in turn reduce their purchasing power. The government has pointed out that it plans to increase the minimum wage by 30% but so far has not taken any concrete steps in enshrining the measure in law. Businesses are not required to do so, however, and thus will be unlikely to implement such measures. On the other hand, a potential increase in the minimum wage will drive labor costs up and put financial strain on businesses employing low-skill labor, but is likely to fail in producing significant boost to real wages for high-skilled employees. While the reduction of the income tax is meant to partially offset the damage to the purchasing power of consumers, local authorities, which receive 71% of the current income tax, have indicated that they expect to lose over EUR 1.5 billion of their combined budgets. In short, MNCs should expect that the new fiscal code is likely to negatively impact both consumer and local government demand, decreasing business opportunities in the process.
Additionally, the reduction of the ability of MNCs to externalize their profits and the additional tax breaks provided to local small businesses will represent another disincentive for foreign firms to invest in Romania. Both policies are aimed at increasing the competitiveness of domestic firms over multinational corporations and will negatively impact the latter’s revenues by limiting the deductibility of interest rates paid by MNC subsidiaries. In fact, Prime Minister Tudose has openly voiced his support for the latter, going as far as to suggest that the latest protests are in fact organized by foreign corporations, which are unhappy by the proposed changes.
It is of no surprise then that MNCs will continue to see a deterioration of the business environment, lower domestic confidence in the economy, and increased currency volatility. These dynamics were also clearly visible in the 4% depreciation of the leu in mid-November compared to the same period in September, following the adoption of the new fiscal code and the public protests (Chart 3). The latest set of reforms have thus done little to address initial concerns over the sustainability of the government budget. What is more, unless the public deficit is addressed, Romania will see both an Excessive Debt Procedure initiated against it, which will lead to a reduced access to EU funding in the case of a public deficit surpassing 3%, and a likely downgrade of its credit rating.
Course for Action
MNCs should plan for these changes accordingly and account for them in their 2018 strategy for Romania through developing different scenarios, including weaker domestic demand and a tightening of the credit environment. While the current state of the fiscal code is unlikely to impact local partners negatively, potential changes to the minimum wage will. In fact, the proposed increase of 31% is likely to raise operation costs for distributors if adopted, with firms employing low-skilled labor having to hike gross wages across the organization by roughly 9% from the current rate (when the social contributions transfer is factored in). The latter means that MNCs will have to work closely with local partners to understand the labor burden costs on their operations and the impact on their financial position.
With that said, the size of the Romanian economy and the projected growth in 2018 is expected to remain elevated, and in fact the recent announcement that the economy in Q3 grew by a real 8.8% YOY has helped the leu to regain some ground (Chart 3). The better-than-expected growth points out that the underlying macroeconomic fundamentals remain solid and will support new business opportunities; however, MNCs should expect to meet stronger competition by domestic firms and still price sensitive consumers, whose confidence will be eroded by the new fiscal changes in 2018.
For our latest updates and insights, FSG clients can access the client portal.