Saturday, December 15, 2007

Romania: Election Inflation

Oxford Business Group Latest Briefing

November's inflation rate, which exceeded expectations, is likely to lead to interest rate rises early next year. Romania is expected to overshoot its inflation target for this year, due to the leu's recent fall and global price increases. However, as the minority government enters an election year, fiscal policy is not realistically expected to tighten, meaning the central bank will have to ratchet up interest rates to counter this inaction.

On December 11, the National Statistics Board announced that year-on-year inflation had fallen slightly to 6.67% in November, a decrease of only 0.17% from the previous month's figures. Monthly inflation was 0.93%, and food and service prices grew 1.21%. A recent international news service's poll of analysts predicted monthly inflation of 6.5% and monthly inflation of 0.8%.

The National Bank of Romania (BNR) has revised its 2007 inflation forecast to 5.7% from an initial 3.9%. The bank cited rising food prices, partly caused by a drought in the country, and a decline in the local currency, the leu, as major causes for missing its target of keeping inflation in the 3% to 5% band this year. An increase in global prices for food and construction materials are also feeding into domestic inflation.

The recent depreciation of the leu has increased the costs of imports. The currency hit a two-year low of 3.69 against the euro on November 23, having dropped 7.6% since September. It is possible a rise in the interest rate could bolster the leu, dependent on continued faith in the stability of the Romanian economy. It has already been creeping upward against the euro in the last two weeks.

BNR is presently aiming for 2.8% to 4.8% inflation in 2008. This will probably necessitate further hikes in interest rates early next year. The bank increased rates by 50 basis points to 7.5% on October 31 after cuts earlier in the year when the slowdown of developed economies and political wrangling seemed in danger of putting Romania's high growth at risk. Bets are generally on a 0.5% increase in January, followed by another in February. This could slow the property market and construction industry, which have been buoyant for several years, and make life more difficult for small- and medium-sized businesses that do not borrow abroad.

But monetary policy will have to come about without much government guidance as a general election is due to be held before the end of November and is expected to be hotly contested. Until then, the country will be run, as at present, by a minority administration of Prime Minister Calin Popescu-Tariceanu's centrist National Liberal Party (PNL) and the Democratic Union of Hungarians in Romania (UDMR), backed by the left-of-centre Social Democratic Party (PSD). This awkward arrangement has not always been able to deliver the policy mix that Romania

After 17 years of post-Ceausescu flux, Romanian politics are solidifying into left-right-centre blocs. In December, the Democratic Party (PD) of President Traian Basescu announced it would merge with the Liberal Democratic Party (PLD), which largely consists of disillusioned former members of the PNL. The PD and PNL were previously in coalition in the Justice and Truth (DA) alliance, which fell apart in April when Tariceanu expelled PD ministers from his government. The new party will align itself with the European People's Party (EPP), a bloc of conservative and Christian Democrat Parties. The PD took the largest share of the vote in November's European Parliamentary election and, cut free of the PNL and effectively led by the popular and irrepressible Basescu, is looking like a formidable force. Meanwhile, on the left, the PSD remains the largest party in parliament and is shedding the taint of association with communism that has long dogged it. Many analysts expect it will mount a strong challenge for government after the election, albeit in coalition with other parties.

In this environment, a tightening of fiscal policy through increasing taxes and/or cutting spending is unlikely. The government has already agreed to a 28% increase in the minimum wage, with a further 8% rise slated for July, to ensure the PSD's support for the 2008 budget. The wage increase and expected high levels of inflation mean wage demands are likely to increase in the private sector as well. This move will probably be unpopular with businesses, which will also be feeling the pinch from any interest rate increase.

Cynics point out that Romania no longer has the enticement of European Union membership to keep it on the fiscal straight and narrow. Certainly, inflation has worsened since membership. In 2006, when Romania's accession in 2007 was still in question, inflation dropped to 4.9% from 8.6% the previous year.

In an ideal situation, the authorities use a mix of monetary and fiscal policy to control inflation. However, with a divided parliament led by a minority administration entering an election year, decisive leadership making unpopular decisions is unlikely. This is unfortunate, as the higher interest rates that will be required to restrain inflation will also hurt small businesses and home owners, the middle classes who have been responsible for much of Romania's recent development. If they turn out at the polls next year, the government may pay the price.
requires, and has resorted to populist moves to maintain the coalition and fend off the resurgent right.

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