Friday, July 27, 2007

Romania: Is the Party Over?

Oxford Business Group Latest Briefing

Many analysts have come to believe that, like all good parties, the peak of Romania's economy - a hot spot of the European emerging markets scene over the last several years - may soon come to an end. While most economic indicators predict only a modest dip of one percentage point in real GDP growth to 6.5% for 2007, there are some worrying trends, which if they are not tended to, could slow growth even further.

Among the most worrying is Romania's growing current account deficit which widened in the first quarter of 2007 by 125% year-on-year to reach $4bn. Foreign Direct Investment (FDI) receipts, which have been used in previous years to offset the deficit gap, seem incapable of keeping up. In the period of January to March they fell 30% compared to last year, and they now only account for 46% of the deficit gap (as opposed to 90% in 2006). Most analysts agree that with the expected decline in privatisation receipts, there is little hope this issue will resolve itself by the end of 2007.

Much of the growth in Romania's current account deficit can be blamed on the 30% increase in imports over the last year. Imports have soared on the back of Romania's growing middle class, which has been plied with steadily rising wages and easy credit. In turn, this has fuelled domestic demand for luxury foreign goods such has electronics, clothing and, most notably, foreign cars, which have seen a 40% rise in sales in the first three months of this year. This has been exacerbated by the high value of the lei, which has made imports increasingly attractive to consumers and manufacturers alike.

While growth in domestic demand has yet to spill over into inflation, many worry that it may soon begin to have an effect in this area as well. As domestic demand is soaring, most areas of the retail market and domestic suppliers are struggling to expand their operations, modernise their factories and expand their labour force. With labour costs rising more than 100% in year-on-year terms in some manufacturing sectors, real estate prices soaring and the costs of metals, agricultural goods and other input materials at record highs, such expansion comes at a hefty cost. For these reasons it is no surprise that retailers have privately told OBG they expect a double-digit increase in prices over the next year.

Such reports add credence to recent statements by the International Monetary Fund, the World Bank and other international institutions. Analysts from these organisations have argued that the Central Bank's modest inflation targets for 2007 - a decrease of only 1% this year - is a sign the bank is finding it increasingly harder to control inflationary pressures.

What is most worrying to many outsiders is that the government seems largely unconcerned about these trends. Minister of Economy and Finance Varujan Vosganian has publicly stated he thinks that the tighter fiscal policies advocated by the IMF make no sense and would have a dampening effect on growth. He went further to say Romania would not follow the fund's advice to reduce the general budget deficit to less than 1% of GDP this year. Instead, he warned that public expenditure may be increased.

Vosganian's warnings became a reality last week when Prime Minister Calin Popescu-Tariceanu's plan to increase pensions given to many of Romania's elderly by 43% came one step closer to becoming a reality. Vosganian argues that the plan, which is estimated to cost $8.3bn, will not require an increase in taxes and will instead be supported by the growing Romanian economy.

While the government almost certainly will not increase taxes, many analysts worry that these recent plans, combined with promises to invest further in education, health care and infrastructure, may force Romania's budget deficit, which the European Commission considers is already too high, to even higher levels.

What is less discussed is how such an increase in government spending will affect an economy that is already showing signs of inflationary pressure and overheating. Analysts seem to agree that the planned expansion of the pension scheme will only exacerbate the domestic demand issue. Despite a dramatic increase in the value of their homes, pensioners have largely remained out of the domestic spending binge that has occurred in the last several years. An increase in the size of their monthly pension payments may be exactly what is needed to push them over the edge into the spending bracket. This in turn could expand the growing account deficit even further.

Despite these worries, many of the challenges Romania faces are common among emerging markets throughout the world and some analysts say they are more due to growing pains than structural problems within the economy. The spending binge, which is fuelling the account deficit, is largely due to the steady gains in employment and wages. If local retailers and manufacturers, which are hurting from the high value of the lei and rising labour costs, can adapt to Romania's evolving marketplace, then they may be able to capitalise on the growing domestic demand and thus cut their exposure to the export market.

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