Analysis-Romania's new president faces uphill battle to reduce EU's widest deficit

By Luiza Ilie, Libby George and Gergely Szakacs

BUCHAREST/LONDON (Reuters) -Romanian centrist Nicusor Dan may have defied the odds to win the presidency, but now he faces an even more daunting task: forming a government that can implement years of painful austerity - and revenue-raising measures - to tame Europe's widest fiscal deficit.

Sunday's come-from-behind victory for the soft-spoken mathematician over hard-right rival George Simion averted, for now, a eurosceptic turn for Romania, and markets rallied in relief.

JPMorgan economists dubbed the result a "pullback from the brink", and said a much-feared credit rating downgrade, to below investment grade, was now less likely.

But Dan must now select a prime minister who can lead Central Europe's second-largest economy - where last year's budget deficit of 9.3% exceeded highs hit during the COVID-19 pandemic - back into the black, or at least towards it.

"Nicusor Dan's victory in Romania's presidential election eases political tensions and supports EU alignment," said Brian Marly, a senior analyst with ratings agency Scope.

"But addressing the widening fiscal deficit, the weak absorption of EU funds and a backlog of reforms remain stark challenges for the authorities."

Although Romania's ratio of government revenue to GDP is one of the lowest in the 27-member bloc, Dan ruled out tax hikes before Sunday's vote and has said he would focus on tapping EU funds and cutting public sector waste.

Cuts to wages or pensions could trigger a backlash; measures aimed at cutting spending earlier this year led to protests.

Romania held four elections last year, and big hikes to public sector wages and pensions drove up inflation, keeping benchmark interest rates at 6.5%, the EU's joint-highest.

A new government will have to involve at least three of four pro-EU parties to have a majority, while the far-right, which controls a third of parliament, could build on its recent gains to stoke sentiment against budget cuts.

GREATER COMFORT

But with no more elections scheduled until 2028, the new government, likely to be formed in the next three to four weeks, has some space to take action.

Some investors said Dan's track record of stabilising city finances as Bucharest mayor was promising, while his preferred pick for prime minister, interim President Ilie Bolojan, comforted markets.

"We came overweight into this event, and we think the pro-reform president and PM will be able to do the necessary reform Romania needs to reduce imbalances and receive the EU funds," said Alexandru Ursu, senior vice president of emerging markets debt with Neuberger Berman.

Romania's international bonds rose as much as 3 cents in morning trade, and the leu currency jumped more than 1%, moving away from record lows.

JPMorgan moved its exposure on Romania's international bonds to "marketweight" from "underweight", and moved local government bonds to "overweight" from "marketweight". ING said that FX should be the biggest beneficiary, "with 5.05 as the new line in the sand."

But Romania's growth has steadily slowed since a post-pandemic bounce in 2021, and the European Commission forecasts its budget deficit at 8.6% this year and 8.4% in 2026, well above the government's 7% 2025 target outlined in a seven-year EU-approved plan.

The Commission said that, if properly implemented, Romania's fiscal plan could materially reduce the deficit, but that the country's debt, which has surged by nearly a fifth of output since 2019, would continue to rise.

Romania is currently hanging on to the lowest investment grade rating from S&P, Fitch and Moody's. All three have it on a "negative" outlook.

S&P warned in a May 8 bulletin that policymaking in Romania would become more fragmented and less stable over the coming months regardless of the election outcome.

"After the initial (post-election) bond rally, we believe the market will want to see more action from the government on the fiscal side to stave off negative views from rating agencies," ING economist Frantisek Taborsky said.

(Additional reporting by Marc Jones; Writing by Gergely Szakacs; Editing by Hugh Lawson)