EUR-RON: Between Fundamentals and Speculation
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Romania's economy struggles to maintain lustre in ever-changing international markets
As internal economic indicators deteriorated in the second half of 2007 and turmoil reigns in global markets, the year ahead looks challenging, to say the least, for Romania’s economy and its beleaguered currency.
Romania’s economy slowed in 2007 (to an estimated 5.8% GDP yoy growth) compared to the previous year’s explosive and difficult to sustain figure of 7.7%. This deceleration was due to two factors: supply shocks (poor agricultural output after extreme weather conditions) and wider negative contribution of net external demand. Exports growth was the lowest in the last decade, while imports accelerated due to high demand pressures and low internal capacity by local industry to cover this demand but also due to a change in the registration procedure of reporting imported goods from the EU (effective from 1st January 2007, goods crossing Romania’s borders were immediately registered as imports; prior to that date it was not until the goods reached the market). Additionally, the sharp nominal appreciation of RON from 2005 through to July 2007 has negatively impacted exports and encouraged the acquisition of goods from abroad.
The Romanian economy still showed signs of overheating then, with high demand pressures (+10% yoy for consumption and +25% yoy in investments) passing on a wider external disequilibria. This is a reason why those demand pressures, at least that of household consumption, did not contribute to accelerating inflation (up to the first half of 2007), the RON appreciation against EUR and USD being a key factor. Demand pressures continued to persist as growth in wages and household credit remained high (around 22% and respectively 73% yoy average for 2007). Only in the second part of 2007 did inflationary pressures exacerbate, mostly due to supply shocks as higher food, fuel and EURlinked prices pushed inflation from 3.8% at the end of 2007 H1 to 6.6% in December 2007. Even if the core inflation measures, that usually should reflect demand pressures on prices, have increased considerably (adjusted Core2 rose from 2.7% in June to 5.5% in December 2007; calculated as CPI excluding regulated prices, a combination of volatile prices – associated with fruits, vegetables, eggs and fuel, and some prices of indirect taxation related items like alcoholic beverages and tobacco), this time the deterioration in the indices was driven mostly by exogenous factors (other food price increases due to the effects of drought).
If 2008 brings normal conditions for agriculture, we could see GDP growth at 6.4%, a favourable base effect coming from this sector with a positive growth effect on self consumption and implicitly on final consumption. We expect also high growth rate in investments driven by both building and engineering constructions, as a lot of projects deliverable for 2007 were postponed for 2008 and also because additional projects were announced.
We expect a further widening of the trade balance, but at a slower pace compared to previous years. The gap between growth in exports and imports is too large to be unwound in a short period of time. A weaker RON is required for the revitalisation of exports, but also more investments in industry. The industrial sector faced difficulty in 2007, as the gap between productivity gains and real wage increases became negative, impacting competitiveness. The latest investments in Romania’s economy were more concentrated towards services and construction sectors, which are not subject to exports of goods. For 2008 Nokia has begun activity in a plant opened recently near Cluj and Ford is expected to be a significant provider of future exports. However, these new investments will initially attract more technology imports with an impact on the trade balance, though with a corresponding positive impact on FDI.
Thus, if 2007 recorded a current account deficit of around 14% in GDP (a sharp increase from 10.3% in 2006), for 2008 we expect a deficit of 15.3% in GDP. The main concern remains FDI coverage of this deficit, the ratio remaining under 50%. For this reason, we also expect a continuous increase in external debt to finance the gap and even if its share in GDP would be still the lowest in the region, the international liquidity squeeze, higher risk premium set for Romanian borrowers and RON depreciation will increase vulnerability.
Inflation risks are pretty high in 2008 as demand pressures persist and in the current context these might be transmitted more aggressively in core measures. The EUR-RON would not confer support for disinflation as we expect RON to depreciate by 8% in 2008. For the first part of 2008 we expect inflation to go beyond 8% (from 6.6% at the end of 2007) on high increases in prices coupled with a base effect due to very low inflation rates in Q1 2007. If last year the disinflation process benefited from decreases in gas, fuel prices, RON appreciation and small increases in food prices, this year will be the opposite. In the second part of 2008 we expect inflation to ease as the harvest of new crops impact favourably on food prices. Our forecast for 2008 inflation is 5.4%, but that could be higher if the Government increases administered prices more than our estimations. But the bottom line is that the inflation target set by the NBR at 3.8% ±1pp is likely to be missed again. Even if the NBR increases interest rates in the first part of the year, this tightening effect would be seen on inflation in 2009. The immediate effect would be felt eventually on EUR-RON and on anchoring inflation expectations. Concerning interest rates for 2008, we see a peak at 9.5% - 10% and if inflation lowers and investors’ sentiment brightens then the key rate could be reduced again. But for the end of year we expect a level of 8.5%.
The fiscal stance will not be more supportive for improving Romanian fundamentals as 2008 is an election year. While there have been both internal and external demands for more fiscal discipline aimed at reducing the deficit, the government signalled the opposite by approving a higher deficit for 2008 (2.7% in GDP compared to 2.4% estimated for 2007) with a structure favourable to consumption. So the alleviation of external imbalances by limiting consumption remains in NBR’s yard, by raising interest rates. But on the other hand, using in excess this approach could affect the economic growth by limiting investments. It will be a difficult job for the NBR to manage by it self the disequilibrium Romania is facing.
