Romania - Economic Outlook: Expect the Unexpected!

Martie 2008

FLORIN CÎŢU - Head of Sales, Financial Markets NICOLAIE ALEXANDRU-CHIDESCIUC - Chief Economist VLAD MUSCALU - Economist ING BANK ROMANIA

We forecast a pick-up in growth in 2008, but expect the RON to continue to depreciate in 1H08, though interest rates should rise. Inflation prospects have deteriorated significantly and the NBR risks missing its end-2008 inflation target once again.

Although risks have increased recently, next-year’s economic growth prospects remain strong. We now see 2009 as the year that will bring the required macroeconomic adjustments.

For 2008, the main driver of growth is strong domestic demand, coming from both private and public consumption and strong investment activity. Thus, we revise our GDP forecast upwards for 2008 to 6.6% and, at the same time, downwards for 2009 to 5.1%.

We expect inflation to stay above the NBR’s target for the entire monetary policy horizon with the central bank raising its inflation forecast in February, showing an even greater deviation against the end-2008 inflation target. The culprits are the negative supply shocks that are expected to manifest during 1H08, a depreciated exchange rate and persistent inflationary pressures. Nonetheless, we forecast that inflation will enter the target band in the second quarter of 2009.

We expect the sharp reversal of the Romanian Leu to continue in 1H08 and to hit the 4.00 level temporarily. Rising external and internal imbalances, against a backdrop of volatile global investor sentiment, are putting strong pressure on the already weakened Leu. Still, we expect EUR/RON to end 2008 at 3.55.

Monetary policy is being forced to react to the deteriorating inflation outlook and the depreciating exchange rate. Thus the central bank is likely to increase the key policy rate to 9% in the next quarter with risks on the upside depending on the exchange rate’s path.

 

Still in Wonderland

The last part of 2007 brought a series of unpleasant surprises, as inflation jumped to a level that was totally unexpected at the beginning of the year and the RON exchange rate depreciated significantly. Yet, the demanddriven economic growth remained the sticking point. With the continuation of these trends, greater uncertainty will be the mark of events unfolding in 2008.

We favour a soft landing scenario, but we do not rule out a hard landing

We do not rule out a hard landing scenario, but we still expect a soft landing for the economy. Romania experienced impressive economic growth, averaging 6% during 2001 – 2007, and it is likely that GDP growth will remain above-trend in 2008. Nonetheless, the pattern of recent growth is typical for an overheated economy. The justification for this characterisation includes the brisk domestic demand (fuelled by wage increases above 20% in nominal terms and very high credit growth – both of which suggest Romania’s will stubbornly remain in Wonderland for the coming year, without tackling the imbalances at the macro level), an everincreasing current account deficit, declining unemployment rates and growing labour shortages. All these raise concerns about medium-term prospects (the unfolding of a hard landing scenario?) if the economy remains trapped in theWonderland of excessive consumption, unsupported by a higher productivity-wage differential and by FDI inflows large enough to alleviate the pressures coming from a widening C/A deficit.

Growth is expected to accelerate to 6.6% in 2008

The political framework for 2008 also allows for a continuation of the easing cycle, which is likely to emphasise the unsustainable growth in an overly-optimistic, superficial manner, characteristic of another Wonderland approach to the economic environment. We forecast a pick-up in growth for 2008 to 6.6%, especially as domestic demand will likely remain elevated, due to a continuation of rapid real wage growth and high credit growth, which are also sustained by unemployment currently below the NAIRU. Furthermore, these factors will likely be amplified in an election year, as the fiscal policy is expected to be very loose. A loose fiscal policy will impact wage policy as well. The government has already agreed to a substantial increase in the minimum wage and, most likely, other wage increases are on the way for the public sector.

Consequently, higher wages in the public sector will put pressure on private sector wages. The pick-up in growth will likely be propped up by a recovery of exports on the back of exchange rate depreciation; some of which we already saw in the second half of 2007, with more forecasted for the first half of 2008.

 

The ‘pool of tears’

Contrary to other economies in the CEE region, Romanian exports have not benefited from the upswing registered by the Euro area in 2007, mainly because of the strong appreciation of the national currency during 1H07. At the same time, EU integration led to a surge in imports, on the back of strong domestic demand. As a result, the trade deficit widened considerably and there is a growing risk of a painful adjustment for the C/A deficit.

Risks have considerably increased lately

Given the recent developments at the global level and the weak fundamentals of the Romanian economy, we see increased risks for a hard landing. This means a significant slowdown in GDP growth and higher inflation as compared to what we expect currently. A strong depreciation of the Leu would hit both consumer demand and investment, leading to a significant economic slowdown. In terms of inflation, a jump in the exchange rate would impact CPI strongly and quickly through direct and indirect channels.

The process of real convergence will maintain the potential for real RON appreciation through structural changes, but the weakened economic fundamentals are putting upward pressure on the nominal exchange rate in the short and medium term. So, we think that most of the real appreciation will come through higher inflation. Loose fiscal policy, along with strong domestic demand, is expected to lead the C/A shortfall to new record levels. As we expect twin deficits in 2008, they should reinforce the negative impact on the Leu. All these consequences suggest the Wonderland economy will turn into a weakened economic fundamentals’ ‘pool of tears’.

 

Economic growth: a rising tide lifts all boats

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