Wednesday, May 21, 2008

Romania: IMF Takes Stock

Oxford Business Group Latest Briefing

Gentle cooling, overheating or bust. These are the scenarios for Romania's economy posited by a recent report by the International Monetary Fund (IMF). While praising the growth of recent years, and the caution of the central bank, the IMF warned that macroeconomic policy is disturbingly pro-cyclical, contributing to inflation and the growing current account deficit. For the time being, a gradual slowdown in economic growth, easing the pressures on these two symptoms, seems the most likely - but the IMF warned that considerably less positive outcomes are likely if fiscal policy in particular is not tightened.

The IMF's report opened on a positive note, commenting on Romania's strong economic performance in recent years. "Romania's per capita income, while still at the tail end of the EU's income league, has been catching up fast," it said, observing last year's "robust" 6% growth, achieved despite the poor performance of the agriculture sector. The Fund remarked that, while income levels are still low at just over one third of the EU average, this gap has narrowed by an "impressive" 10% over the past five years.

However, this praise was tempered by worries about growing macroeconomic imbalances, which, given the shaky global financial market situation, have created what the fund terms "stability concerns". Specifically, these concerns relate to high levels of spending growth and the ballooning current account deficit (which jumped by two-thirds to 14% of GDP last year), as well as dependence on external funding, which the IMF fears increases the country's vulnerability. The inflows of foreign capital have driven up expenditure on consumption and investment beyond the pace of income growth OR have acted as a demand-pull factor, further widening the current account shortfall.

Furthermore, inflation has reared its head, reaching 8.6% in March, compared to around 5% in 2006. As the IMF noted, this is in large part attributable to external supply shocks which are outside the government's control. The oil price increase above $100 and rising global food prices due to changing consumption trends, as well as the damage to Romania's agricultural output following last year's droughts, have all played their part.

However, the IMF had tough words for Romania's "very short-term oriented" and pro-cyclical macroeconomic policy, including increases in public sector wages well above productivity growth which have fed through into the private sector, as well as for what the report wearily calls "the traditional end-year spending surge". These have contributed not only to inflation, but also to the current account and fiscal deficits. The minority government, which rules with Socialist support from outside the government coalition and faces an election this autumn, has been reluctant to tighten its fiscal stance.

Therefore it has fallen to the National Bank of Romania (NBR) to hike interest rates up in an attempt to fulfill its inflation-targeting brief. Over the past decade, the NBR, under the guidance of the widely-respected Governor Mugur Isarescu, has consistently been a reliable institution, including at times when the political leadership was found deficient and again the IMF has welcomed the bank's moves to limit banking system vulnerability. However, the IMF indicated that its job was not being made easy by the pro-cyclical fiscal policy.

In early May, the NBR increased its base rate to 9.75%. Ironically, the resulting squeeze on homeowners and small businesses which borrow domestically may annoy the country's growing middle class, counterbalancing the electoral effect of the government's largesse elsewhere. Having said that, the central bank has hinted that a moderate slowdown in growth and a possible strong harvest later this year may mean that inflation has peaked.

The IMF remarked that "the main challenge for Romania is to adopt economic policies that are much more coordinated and forward looking... Fiscal and incomes policies under the baseline will need to be tightened relative to plans". However, this is not a call for brutal retrenchment; the fund included in its policy suggestions improvements in infrastructure and workforce skills, which will surely involve continued public investment, and the judicious use of European Union

As for the outlook, the fund's baseline scenario is upbeat, but with the caveats that, without the necessary policy shifts, the situation could swiftly flip to negative. The core forecast sees a gentle slowing of growth to 5.5% this year and 4.75% next year, with inflation returning to within the NBR's target range of 3.5% +/-1% in 2009. Imbalances would gradually shrink. With the global economic cooling and the tightening of credit (which should reduce capital inflows), as well as the likelihood of improved harvests and the effect of the NBR's vigilance (counteracting supply shocks and demand pulls respectively), this seems a realistic prediction.

Nonetheless, the IMF also outlined two scenarios at opposite ends of the spectrum: "a continued boom" or "a sharp slowdown". The former foresees a continuation of capital inflows, better than expected economic performance by Romania's European trade partners and continued consumer confidence, which would keep inflation high and the current account deficit growing. The latter could occur if there is a sharp drop in consumer and business confidence and the economies of trading and investment partners contract more than expected. In this case, which seems marginally the more probable of the two scenarios given worries about Romania's macroeconomic stability, the global credit crunch and the US economy's travails, "the risk of a sharp slowdown turning into an economic bust would also be significant".

Global and local factors should help cool the economy gently over the next two years. But the IMF has sent a clear warning that if the authorities are unwary, this may not necessarily be the case.
(EU) funding.

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