Romania Quarterly Analysis – June 2006 SOURCE: ING www.ingfn.ro/?m0=1&m1=5&m2=0&lang=en
The effects of fiscal and monetary loosening in 2005 are starting to show up in economic growth. While in the near term we expect growth to surprise on the upside, the medium-term outlook needs to be viewed with caution.
There are five main themes that we have more or less emphasised from the start of the year:
Near term economic growth in Romania remains strong and is likely to surprise on the upside. We expect that the effects of last year’s fiscal relaxation and loose monetary policy will be felt throughout 2006 and the first part of 2007, showing up in strong consumption growth. Thus, we raise our GDP growth forecasts to 5.7% for 2006 and 6% for 2007.
Political complacency and growing domestic imbalances increase the risks around economic growth in the medium term. At this point in time we believe that the global environment represents the greatest risk to the Romanian economy. However, we believe this risk to be minimal as we expect global growth to match its trend of 3.4% and expect EU accession to provide enough of a strong anchor in the case of any global slowdown.
Inflation remains above target for the entire policy horizon and we expect the central bank to adjust its medium-term forecast upwards.
Romanian leu appreciation should continue for the medium term, albeit at a slower pace.
Monetary policy does not signal any change in interest rates for the next four quarters, but risks to the interest rate profile are on the upside.
Firing on all cylinders
Given the current global aversion towards emerging markets in general, we would like to start this report with some good news.
While everyone is worried about growing imbalances in EM, the Romanian economy started its sixth year of consecutive economic growth with an impressive 6.9% YoY for 1Q06, almost 2% above market expectations.
We start with this impressive figure as we know that there is tendency to lose track of the big picture when economic growth is losing steam as was the case in 2005. For those watching EM, it is not a surprise to see economic momentum around a medium-term trend, or the rate of growth referred to by economists as potential growth. In fact it is this trend growth which matters for future living standards and economic performance. Based on that alone, the Romanians have a lot to be happy about as trend growth is estimated at 5.5% per year.
Turning back to the 1Q06 economic growth figure, we see that the main contributions came from industry, up 4.8% YoY, and in particular from construction, up 20.4% YoY, and services, up 6.8% YoY. Impressive growth in construction continued from 4Q05 helped by the very good weather conditions for this period of the year. Possibly more impressive, 1Q economic growth was not helped by agriculture, which reported a negative contribution to economic growth of -5.3% YoY, and represented only a 2.7% weight in GDP formation. More good news for long-term economic growth came from gross fixed capital formation which expanded by 11.4% YoY, sustained by a 10.9% YoY investment boom, with a weight of 88.8% in gross fixed capital formation.
Our GDP growth forecasts are revised up to 5.7% for 2006 and 6% for 2007
Raising our GDP growth forecasts
We expect that the effects of last year’s fiscal relaxation and loose monetary policy will be felt throughout 2006 and the first part of 2007, showing up in strong consumption growth. At the same time, we expect domestic demand to remain strong as the government will be forced to increase expenditure, especially on infrastructure. Furthermore, at this point the central bank does not seem worried about strong growth, and because it still forecasts a strong disinflation process over the next couple of years, we do not expect any monetary tightening soon. However, we do estimate that further currency appreciation will erode some of the consumption growth by the beginning of 2008. Meanwhile we expect the effects of the current investment in technology to show their full effect in the latter part of 2007, replacing consumption in importance. On top of that, in the absence of any major floods we expect agriculture add an extra 1% to real economic growth. Against this new background we raise our GDP growth forecasts to 5.7% for 2006 and 6% for 2007.
Unemployment to trend lower at a slowing pace
Employment growth lost momentum in the second half of 2005 for the most part because of the bad weather which affected the agriculture and construction sectors. Thus, the unemployment rate increased from 5.6% in June 2005 to 6.3% in 1Q06, but then started to fall again reaching 5.9% in April showing the highly seasonal characteristics of the Romanian labour market.
For the near term we expect employment growth to pick up pace with unemployment moving closer to what we estimate to be the medium-term trend of 5.5%. As a result, we expect the labour market to remain tight, especially in such sectors as construction and financial services. Furthermore, we expect wage growth to remain robust through 2006 and 2007, with the possibility of rapid acceleration in the second part of 2006 as the unemployment rate consolidates its downward track.
Trade account to remain the Achilles’ heel
The trade gap continues to widen and it is not showing any signs of slowing down. In fact, every new month brings another record for the trade gap. The majority of this increase is due to strong import growth stimulated by domestic consumption and by a slowdown in export growth due to the stronger currency. Having said that, 2006 is shaping up as another year with double-digit growth for exports as in the EU, the main destination for Romanian exports, economic growth shows signs of improvement.
But on the imports side there remains an underlying bullishness even after adjusting for imports of oil and other commodities. This is mainly because domestic demand does not show signs of slowing down, especially as consumer confidence improves as the EU accession date nears. We expect both household consumption and dwelling investment to remain strong and this to be reflected in increasing consumption imports. Furthermore, the strong domestic currency along with strong domestic demand should lead to improvements in business investment, which will be fed by increased imports of capital goods and intermediate goods. As a result, we expect the drag on growth from net exports to remain negative in the next few years.
The main threat and the weakest link is the high C/A deficit
The main threat, and at the same time the weakest link, in the Romanian economic outlook is the high C/A deficit, in both EUR and as a percentage of GDP. Even worse we do not see any real improvement over the next couple of years. Most of the C/A deficit is due to the trade balance and thus is the result of private sector consumption. Until now, financing the C/A was not a problem as it was entirely financed by foreign direct investment. But we do not expect similar performances in the next couple of years given that the majority of FDI represented privatisations of state-owned assets and in 2006 the Romanian government will have sold most of its assets. We forecast C/A deficit to remain close to 9% of GDP over the next few years with FDI financing 60% of this in 2007 and 50% in 2008.
Fiscal policy on the loose
The budget deficit has declined in the past four years to a record low of 0.8% of GDP in 2005 and has remained under the 3% Maastricht requirement since 2002 at the expense of postponing the much needed government investments in infrastructure. Without a long-term fiscal and budgetary plan, the Ministry of Finance is implementing its policies randomly. Revisions to the planned budget deficit target already twice this year (from 0.5% to 0.9% and then to 2% of GDP) and the repeated revisions of the fiscal code are examples of the government’s inability to establish and strictly follow a clear fiscal strategy. Romania can finance its investment needs through privatisation revenues and domestic borrowing as internal interest rates are at historical lows and the market is flooded with liquidity.
Infrastructure projects, co-financing of EU funds, the implementation of the second pension fund pillar and compensation payments for communist regime expropriation are, in our view, the main risks to an escalating budget deficit. The very low tax base and poor collection of taxes could also contribute to a widening budget deficit. Furthermore, it looks difficult to forecast the budget balance as the fiscal code has been under review in the last two years, with different, confused drafts released during this period. This unpleasant situation affects business plans and future investment decisions.
We estimate the budget deficit to average around 3% of GDP for the next 3 years
Considering these constraints, we estimate the budget deficit will average around 3% of GDP for the next three years. A deteriorating budget balance would transmit into a widening current account gap and additional inflation pressures. Although the MoF stated that the larger deficit will have no inflationary impact as it is investment orientated, we expected the increase in government spending to fuel inflationary pressures in the near term. Thus we believe that the growing budget deficit will make it more difficult for the NBR to achieve its long-term inflation targets without further interest rate hikes.
The economic outlook contains more downside risk than up as the economy is entering a vulnerable stage in the economic cycle
Our bullish outlook requires a healthy dose of caution
The economic outlook contains more downside risk than up as the economy is entering a vulnerable stage in the economic cycle. Recent history has shown that given its structure, the Romanian economy is pushed off track very easily by exogenous events such as bad weather. However, as we move forward, the risks are more of the endogenous nature coming from a mixture of the strong currency, tightening monetary conditions, a widening current account, booming real estate markets, and an uncomfortable level of inflation. These by themselves do not necessarily have to push the economy into recession, but they clearly leave the economy vulnerable to any unforeseen future shocks. Those shocks could be a global economic slowdown or ever increasing oil and commodity prices.
Therefore, at this point we believe that the global environment represents the greatest risk to the Romanian economy. However, we believe this risk to be minimal as we expect the global growth to match is trend of 3.4% and expect EU accession to provide enough of a strong anchor in the case of any global slowdown.
In our view inflation will most likely remain above target for the entire current policy horizon
For 2006 the NBR targets inflation at 5% +/-1% but it forecasts inflation of 6.8% while for 2007 the central bank envisions inflation smack on target at 4%. We are not as optimistic. In our view, inflation will most likely remain above target for the entire current policy horizon (the next eight quarters).
In our view, accelerating growth will keep pressure on resources and inflation. In its latest inflation report, the central bank pushed forward the date when excess demand will become negative to the first part of 2007. Our own forecasts paint a different picture with positive excess demand continuing throughout 2007. This is due to real economic growth above trend and thus fuelling inflation through the non-tradable sector of the economy. As it takes time for this dynamic to work its way through the economy, we expect these inflationary pressures to remain strong until the second half of 2008.
Romanian leu appreciation against the euro, historically a very good supporter of disinflation, has lost power in the last six quarters. Looking forward, things look a bit worse as we expect RON appreciation to slow down due to a narrowing interest rate spread. At the same time, a more benign RON appreciation would not protect the Romanian economy from higher international oil prices as it has done for most of last year.
The path of inflation for the second half of 2006 and throughout 2007 is the result of the interaction between cost-push and demand-pull pressures and the further elimination of subsidies for administered prices. Our central track for inflation contains a high degree of inflation stickiness. Cost-push pressures are to come particularly from the labour market and higher international energy and commodity prices.
But we expect demand-pull to remain the dominant dynamic for future inflation. In 2006 and 2007 we expect the full effect of last year’s negative real interest rates to show in above-trend economic growth. Thus excess demand will remain strong and businesses will find it easy to pass on price increases in an environment where consumer spending is booming.
Another topic that we considered when estimating inflation over the next few years was the experience of countries from the first wave of EU-integration which showed inflation picking up immediately after accession around 2% YoY due to nominal convergence. We expect a similar shock for Romania, albeit not as strong given that we do not expect fiscal relaxation until the second half of 2006 due to the EU’s postponement of a recommendation until October this year.
We see inflation remaining around 7% until the end of 2007
Finally, we expect a high degree of inflation stickiness over the coming years due to the Balassa-Samuelson effect and nominal convergence to the EU. Thus, in our view, inflation should remain around 7% until the end of 2007.
Based on our estimates for inflation and recent comments from the NBR, which have continued to warn that monetary conditions will tighten, the risks to interest rates are on the upside. However, we are not ready to forecast an interest rate hike as most of the NBR’s recent actions consist of only tough talk. Nevertheless, the central bank has ruled out any interest rate cuts until the middle of 2007. This makes sense if we take for granted the NBR’s own forecasts with inflation reaching 4% by the end of 2007. But the forecast is at odds with forward revisions to the output gap and hawkish comments from the central bank.
The experience of the last six quarters has taught us that the central bank watches the path of the leu very carefully and it is not willing to increase the pressure on the exchange rate through an interest rate hike. Although we do not agree with this way of implementing monetary policy under an inflation targeting regime, we believe that the longer the EUR/RON remains above 3.5, the bigger the probability of an increase in the policy rate.
Under these conditions we see the key policy rate at 8.5% for the next four quarters but with risks on the upside
Under these conditions we see the key policy rate at 8.5% for the next four quarters but with risks on the upside. Our core strategic view is built around the notion that the NBR is behind the curve in delivering further tightening as it has imbedded in its reaction function a too strong response of interest rates to inflation. This characteristic of the reaction function makes the NBR’s inflation forecast drop in the second part of 2007, even though the interest rate remains unchanged. Although an inflation forecast obtained in this manner bears little resemblance to the reality, the central bank is more than happy to use it to explain its non-responsive attitude towards the current build-up in inflationary pressures.
The Romanian money market is confronted with excess liquidity, depending very much on the NBR’s sterilisation policy and instruments used for draining liquidity. The NBR’s net debtor position versus the banking system hampers the effectiveness of the interest rate channel, although lately the importance of this channel has increased relative to that of the exchange rate channel.
Since February 2006, the NBR has set a timetable for 1-month deposit-taking operations designed to increase the predictability and efficiency of its main open market instrument. In our view, the lack of transparency in monetary operations still affects the accurate implementation of interest rate policy, as the NBR does not publish its liquidity forecasts over the minimum required reserve period.
Nevertheless, market depth has increased by more than 2.5 times since January 2004. The NBR operations remained dominant, on average accounting for more than 90% of the total deposit stock. However, on daily flows, deposits between commercial banks have become preponderant, reflecting a shift in liquidity preference toward shorter terms and persisting uncertainties about future rate moves. This is reflected in the maturity structure of interbank deposits, of which we estimate that around 95% are on the short-end of the money market yield curve (eg, ON and 1 week).
The inconsistent interest rate and sterilisation policies influence quoted rates, translating into higher spreads on longer tenors. The dominance of deposits versus others money market instruments also drives the large bid/ask spreads.
In June 2004, the NBR introduced a new instrument – 3-month CDs – designed to switch the NBR role from price-taker to price-maker. In the absence of a developed secondary market for this instrument, it remains a lock-in instrument, being very sensitive to interest rate risk.
After the next step of capital account liberalisation set for 1 September, which will allow the acquisition by non-residents of domestic money market securities and instruments, we expect that spreads will tighten as a result of deeper markets and more active trading.
In the near term, we expect money market interest rates to remain highly correlated with the NBR effective rate. In the longer term, we might see rates decouple from the NBR rate as the market develops new instruments.
The exchange rate
Since January 2004, FX market turnover increased by almost 4 times, and almost doubled since the capital account liberalisation of April 2005. We estimate that almost half of this increased was due to swap transactions. During this time, the RON appreciated against EUR in nominal terms by around 15%.
In the past two and a half years, NBR interventions were aimed at smoothing the RON’s rapid appreciation. However, in November 2004 the NBR announced that it would be comfortable with more exchange rate flexibility, preparing the market for the 11 April 2005 stage of capital account liberalisation. This measure was followed by sharp RON appreciation, which caused the NBR to step in the market sporadically buying larger than usual amounts directly and through intermediaries. Since February 2005, the NBR has not published FX intervention data. Most of the FX interventions were then sterilised through open market operations, which we interpret as the NBR aiming to smooth the pace of appreciation and the short-term volatility, in order not to affect the long-run trend.
Our estimated intervention volume from foreign reserve data shows aggressive NBR euro buying in August 2005 which was in vain as the RON continued to appreciate. Further, large capital inflows pushed the central bank to adopt more extreme measures such as leaving large amounts of liquidity in the market which leaded to a sharp drop of the NBR effective interest rate.
In the near term, we see the RON remaining correlated with its peers. The Romanian currency showed its strong correlation with the regional currencies at the beginning of the recent EMEA correction. However, recently the correlation weakened as most international players have managed to reduce their RON exposure. This means that the amount foreign capital in the Romanian market was limited by the scarcity of liquid RON instruments. Underdeveloped local financial markets (especially the equity and bond markets) buffered the transmission into the Romanian FX market of the large swings in regional currencies during the large EMEA sell-off.
In the long run we expect the RON to appreciate both in nominal and real terms as a result of stronger fundamentals (eg, strong economic growth, increasing productivity, the improving prospects of the economy), the still attractive interest rate differential between domestic and international markets accompanied by expectations of further nominal and real appreciation of the national currency and the convergence play (in anticipation of nominal and real convergence). The corroboration of these factors gives RON moderate appreciation potential in the long run, but the pace of appreciation should slow, otherwise financial stability could be endangered.
Outstanding government bonds total RON3.310bn with the maturity range between 2 and 15 years. The primary market yield curve is inverted on the short end reflecting the sharp increase in money market rates. Further out, the curve flattens, incorporating greater risks, ranging between 7% and 8%.
Total issued value of the corporate bond market is only RON 230m. The municipal bond market is even smaller, totalling RON 84m, as a result of unclear legislation regarding financing for municipalities. The yield curve of these instruments is irrelevant as almost all are indexed to money market rates and the dormant secondary market.