Saturday, September 15, 2007

Romania: Inflation Concerns

Oxford Business Group Latest Briefing

This week, Romania added inflation to its long list of economic worries. The consumer price index (CPI), a key indicator for measuring domestic inflation, reported on Tuesday, showed that Romania's inflation rose to 5% year-on-year in August, up from 4% in July.

While a one-percentage point jump in inflation does not represent an economic meltdown, the numbers are worrying when considered in the broader context. The country's current account deficit - which rose 108% in the first half of 2007 - has continued to grow at a rapid pace. The consumption and borrowing booms have been similarly difficult to rein in. Added to this are an ongoing political crisis, a turbulent global investment climate and an expensive pension increase that promises to tap the government's coffers. However, up until this point, inflation and growth were among the few economic indicators that Romania could boast about. Thus, when the recent inflation statistics were published, analysts had reason to take notice.

Concerns deepen when analysts look at Romania's neighbours for hints of where the country is heading. The comparison that some are beginning to draw between the Romanian and Hungarian economies is particularly worrying. Hungary entered the European Union three years before Romania and has endured many of the same economic challenges Romanian is now facing. The Hungarian economy, after experiencing trouble with a widening current account deficit, increasing domestic demand and an appreciating currency - a combination of indicators that mirror Romania's current situation - now faces an inflation rate of 8.3% and has seen growth slow to 2.4%. Many worry this is to be the fate of the Romanian economy.

Optimists argue the comparison and the accompanying concerns are unfounded for several reasons. While they agree that the fundamentals of the Romanian economy are unbalanced, they point out that this is common in emerging economies. They argue that these indicators - particularly the current account deficit - are the result of an economy that is catching up to the developed world at an accelerated pace.

Much of this catching up must be done with capital inflows and benefits will not materialise in the short term. They also quarrel with the argument that these inflows will spill over into inflation and slow growth.

To support these claims, analysts argue that one should look at countries such as Poland and the Czech Republic, which have been able to contain inflation while growing at a steady pace. They have managed huge capital inflows and the pressures of a growing economy through prudent macroeconomic and fiscal policy.

The Romanian National Bank's (BNR) historic record of fighting inflation offers a strong case for such optimism. In the 1990s, inflation was one of Romania's most serious economic problems. Retail price inflation reached 256% year-on-year in 1993. Through market reforms, the BNR, assisted by the International Monetary Fund and the World Bank, was able to gradually reduce inflation to a manageable 4.9% in 2006.

Regardless of any differing views, analysts agree on one essential point: inflation figures will be the ultimate indicator that will decide which path the Romanian economy will take.

Luckily, August's numbers will not be the final word in this debate. There is reason to believe that this month's inflation increases have more to do with global and regional conditions than with the fundamentals of the Romanian economy. While wage growth and the deteriorating state of the Romanian currency were cited as contributors to inflation, food prices represented the bulk of this month's inflation increase. The price of food rose by an average of 1.7% in August (1.4% after adjusting for normal seasonal changes).

"There was a definite food price upswing during August," said Adrian Ciocoi, Bucharest-based head of research for emerging Europe at the Riedel Research Group. "The price for wheat may increase further - in Romania the drought destroyed many wheat crops - which in turn will push other food prices up further in the coming months."

Part of August's food price increase can be explained by the drought, which the region experienced this summer. This phenomenon ravaged Southeastern European crops and has forced countries like Romania, traditionally net exporters of agricultural goods, to become net importers.

An additional factor contributing to the pressure on local food prices is the situation in the international agricultural market. Global demand has soared in the last year on the back of Asia's booming economies and the increasing usage of ethanol as an alternative source of energy. These two factors have combined to raise prices globally for everything from milk to wheat.

While these factors may not fully account for Romania's one percentage point rise in inflation over the past month, they do provide enough room for optimists to remain hopeful. August's numbers may turn out to be more connected to global food prices and weather patterns than they are to the Romanian economy. Before celebrating however, these analysts may want to ask themselves how comfortable they are cheering for an economy that teeters whenever the weather changes.

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