Friday, February 22, 2008

Rocky Road Ahead for Romania

RGE Analysts' EconoMonitor
Mary Stokes | Feb 22, 2008

Romania’s economic prospects seemed bright as it entered the EU to great fanfare in January 2007. Just over a year later, massive imbalances have clouded Romania’s sunny economic picture. Danske has classified Romania in the ‘danger zone’ for a hard landing, while Fitch
downgraded its outlook on Romania to ‘negative’ from ‘stable’ earlier this month.

Analysts, like those at Danske and Fitch, have pointed to Romania’s massive current account deficit (estimated at -14% of GDP for 2007) as the main economic risk. Meanwhile, the country’s ever climbing inflation rate (which came in at 7.3% y/y for January 2008 – the fastest pace in 20 months) suggests GDP growth, which is estimated at just under 6% for 2007, is well above its potential rate. Like its neighbor Bulgaria, Romania is clearly overheating.

The question is will Romania get its act together in time to avoid a hard landing. Here are some reasons that suggest it won’t.

1. Politics Matters

If political commentary is often an exercise in presaging disaster, Romania can make a good run for commentators’ European Union (EU) darling of the year award. (Serban Popescu from the Center for European Policy Analysis)

The ongoing feud between Prime Minister Calin Popescu-Tariceanu and President Traian Basescu has crippled Romania’s political process and led to stalled reforms over the past year. Beyond the damage to Romania’s long-term economic prospects, the tenuous political situation also has had immediate effects. For example, S&P singled out political instability as the main factor behind its downgrade of the outlook on Romania’s economy in November 2007. And as the EDC mentions in its political outlook, instead of focusing on dealing with Romania’s growing imbalances, the government spends lots of its time and energy trying to ensure its own survival and manage party infighting.

Under pressure with elections later this year, Romania’s government has effectively gone on a public spending spree instead of running a fiscal surplus to cool the economy. The parliament decided in 2007 to double public pensions (a 43% increase taking effect on January 1, 2008, plus another 33% increase taking effect in 2009). Meanwhile, in December 2007, a 28% hike in the monthly minimum wage was approved. The pension increases and the overly-fast pace of wage hikes compared to that of labor productivity have essentially added fuel to the fire. Unfortunately for Romania, these measures will likely have the undesired consequence of pressuring inflation and strengthening domestic demand, pushing Romania’s GDP growth further above its potential rate, according to ING.

The silver lining is that Romania still enjoys relatively low levels of public debt of around 20% of GDP, but this might not last for long. Romania's government has set its 2008 budget deficit target at 2.8% of GDP, following a 2.4% deficit last year, which should add to the public debt. Meanwhile, analysts and the European Commission have expressed concern that the 2008 budget deficit will overshoot the target and even the 3% of GDP limit required for eventual euro adoption.

In essence, Romania’s political situation suggests any expectations that the government will soon take steps to proactively help unwind the country’s imbalances are wishful thinking.

2. Current Account Deficit - Getting Worse Before It Gets Better

Current-account deficits are not always a sign of trouble, especially in transition countries like Romania. In fact, it’s rational for a country, with a low capital stock that is trying to ‘catch-up’ with the rest of the EU, to borrow from abroad in order to invest and achieve faster rates of growth going forward. But Romania’s -14%/GDP current-account deficit is clearly unsustainable, especially when the drivers of this deficit are examined.

One of the major concerns, according to Fitch, is that the recent deterioration in C/A balances in Romania has been largely domestic demand-driven. It comes from a sharp rise in import growth rates for consumption rather than capital goods, which can lift long-term growth potential. This import growth is also being driven by strong investment growth, but this is mainly in the construction sector where value-added is traditionally low.

While Romania’s imbalances have been primarily private sector-driven, its loosening fiscal policy (described above) should further bolster domestic demand growth and pressure the current-account deficit. The silver lining is that Romania’s currency – the leu – has weakened about 13% against the euro since August, and this weakening should reduce demand for imports. Nevertheless, many analysts expect the current account to deteriorate further before it improves. The Economist, for example, forecasts Romania’s annual current-account deficit will surpass 17% of GDP in 2008.

3. Low FDI Coverage + Lax Fiscal Policy = Hard Landing?

Romania's relatively low foreign direct investment (FDI) coverage is a concern. FDI is one of the more desirable ways for a country to finance its current-account deficit, as it’s generally considered more stable and less susceptible to rapid outflows than portfolio investment. According to Fitch, Romania’s FDI coverage of its C/A deficit was 42% in 2007, compared to 98% in Bulgaria. In 2008, Romania’s FDI coverage is expected to drop to 31%.

This relatively low FDI coverage, combined with Romania’s lax fiscal policy, could spell trouble. According to recent IMF research, more than one-third of 109 episodes since 1987, characterized by large net private sector capital inflows, resulted in a ‘sudden stop’ in capital inflows or a currency crisis.

The IMF found that the chances of avoiding such an outcome and achieving a soft landing were improved by high FDI coverage of the C/A deficit and fiscal restraint – neither of which Romania seems to have at the moment.

4. Households’ FX Lending

Romania is not alone among CEE countries in the fact that many of its citizens have borrowed in foreign currency, such as the euro and the Swiss franc, making them very vulnerable to currency risk. According to Fitch, foreign currency bank loans account for 54% of total bank loans in Romania.

Unfortunately, this substantial foreign currency lending limits the usefulness of monetary policy as an adjustment tool, as Edward Hugh mentions in a recent blog post. So while Fitch may trumpet Romania’s flexible exchange rate as ‘a significant advantage in helping the economy to adjust in a hard landing,' it’s really not much of an advantage. That’s because the ability of the Romanian economy to adjust through a depreciation of the exchange rate is limited by the fact that any significant depreciation of the leu would result in the insolvency of a great number of Romanian households, as those who took out fx-denominated loans would see their debt payments soar.

5. Global Credit Crunch

The elephant in the room is the impact the global credit crunch is having and will have on Romania's economy. As Danske notes, Romania's large funding needs - due to its high external imbalances - make it especially vulnerable to any potential slowdown or cut-off of foreign capital inflows. As a result of the global crunch, Romania is at greater risk of a sharp economic slowdown.

In conclusion, prudent fiscal policy seems like Romania’s best bet to cool the economy. Unfortunately, the realities of the current political environment mean this is unlikely to happen anytime soon. As a result, Romania’s vulnerabilities - accentuated by the global credit crunch - look set to grow in 2008, making a hard landing a growing possibility.

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