Private consumption had the highest contribution, generating 3/4 of the growth in 1Q15. For 2015, we expect an economic expansion of around 3.7%, boosted by private consumption to a similar degree. Under these circumstances, it is no wonder that consumer sentiment reached 7-year highs in June.
The buoyant consumer sentiment was supported through several channels, first of which being a significant increase in wages. The Romanian government implemented successive hikes to the minimum wage, which was taken from RON 700 to RON 1,050 in just three years. At the same time, the minimum wage is projected to reach RON 1,200 in 2016. As the level of the minimum wage increased, more and more employees benefitted from each hike, with the one in July 2015 affecting as many as one third of the employees in the economy (excluding armed forces and similar staff). The effect on spending is positive, but the one on the economy is negative because the wage growth outpaces productivity growth, impairing Romania’s competitiveness.
Moreover, there is a risk that high minimum wages will push more lowskilled employees to the grey market in order to find a job. Wage hikes on the one hand coupled with the very low inflation rate on the other hand kept the average real wage growth above 6% yoy during the first five months of 2015.
The lower VAT for food products (9% as of June, down from 24%) boosted consumption through a reduction in June food prices by 8.23%mom and by 5.95% in comparison to the prices prevailing in December 2014. On top of the above-mentioned positive effects, the government boosted consumer spending by paying the overdue wages for teachers in advance: at the end of 2014 for 2015 and in 2015 for 2016. Populist measures did not stop here in pre-election year 2015: the government doubled the child allowance to RON 84 per month from June, hiked wages for some categories of public sector employees and allowed local administrations to hike wages of their employees if the local budgets have the resources.
Besides wages, household lending in RON has accelerated continuously since bottoming out in October 2013, growing by 19.6% yoy in May 2015. Demand for new lending increased, although it remains below pre-crisis levels. A preference for RON lending was visible, supported by NBR’s easing cycle that led to a decrease in costs and a lower interest rate differential between RON denominated and FX-denominated loans. At the same time, clients became more sensitive to exchange rate movements, while the large stock of FX lending (still above 50% of the total credit stock) led the NBR to encourage RON lending in order to protect households from depreciation risks.
Consequently, during the past year, RON lending has been substituting FX lending, faster for consumer loans than for mortgages. According to NBR’s Bank Lending Survey published in May, households will borrow more in the coming months. This demand is supported by lax monetary conditions and expectations of further fiscal easing. At the same time, a controversial personal insolvency law will help distressed borrowers.
While lending is rebounding very fast, households continue to save a significant portion of their revenues, due to increasing income. Household deposits have been growing since 2008, despite the downtrend in deposit interest rates. As a result, the loan-to-deposit ratio for households decreased sharply to only 74% in May 2015 from 120% at the end of 2008.
Companies are yet to join in the consumers’ spending spree
The wave of optimism has yet to reach companies, which postpone expansion plans and are decreasing their exposure to bank loans (-6% yoy in May), with new lending to companies at only half the precrisis levels. This reduction is surprising since borrowing costs are at all-time lows and affected especially short-term financing lines (loans with maturity below 1 year), which have been falling at doubledigit rates since April 2013.
The drop in working capital lines might be explained by better cash positions, more intensive usage of supplier credit and loans granted by foreign parent companies. Longer-term corporate loans are not recovering either. Companies are probably postponing sizeable investments either because they continue to worry for the economic rebound in Romania and the euro zone - although we remain optimistic in this respect - or because of the unclear tax outlook. Most of the measures which were to benefit companies (such as cuts to the employers’ social security contribution and the flat tax rate) were postponed or eliminated in the final version of the Fiscal Code.
An additional reason for the limited demand for credit is the fact that many exporting companies are rich in cash and prefer to use their own funds before committing to bank credit lines. According to an NBR survey on the access to finance of non financial corporations published in June 2015, 44% of the companies prefer to rely on own funding from parent companies, reinvested profits or asset sales. The study reveals that they also intend to maintain or reduce bank exposure during the following period. Under these circumstances, the expectations for lending to companies remain subdued.
In search for lower production costs and skilled labour which is easier to find in university towns than in Bucharest, companies started migrating towards regional cities of Romania especially in the automotive, logistics, agriculture, IT and services sector. This has led to improvements in the construction sector as well, reflected in better demand for office and industrial buildings, while vacancy rates are decreasing. With prices bottoming out, the construction sector had a strong rebound at the beginning of 2015, although from very low output levels.
Romanian banks on the road to the European Banking Union
With the NBR expressing its wish for Romania to join the European Banking Union, several changes in the banking sector are welcome.
First, banks relied more on local funding sources in the aftermath of the financial crisis. External deleveraging has accelerated since 2012, fuelled by turbulences in the core markets of their parent banks. Although this external rebalancing will continue, we expect it to slow from here. The lower reliance on parent funding forced local financial institutions to attract funds through deposits and occasionally through bond issues or EMTNs. Consequently, the above-mentioned abundance of local liquidity on the local market was welcome, leading to a drop of the total loan-todeposit ratio to approximately 90% at the moment from a peak of 137% touched in November 2008.
We believe that banks are likely to continue focusing on attracting local deposits. However, using local funding sources creates a maturity mismatch for banks, as long-term loans are financed by short-term deposits. In May 2015, 34% of Romania’s RON deposits were overnight. As Romanian financial markets mature, deposit tenors will increase, but banks should also look for alternative funding sources, such as corporate bonds and covered bonds, the latter needing the appropriate legislation to allow for the issuance of bonds with a more attractive risk profile.
Second, the clean-up of balance sheets started in 2014 will continue during the following years, leaving banks in a better position to lend. With a peak in NPL ratio of 20.39% in March 2014, Romania still had one of the largest credit delinquency ratios in Europe, limiting available funds for new lending and keeping costs high. In mid-2014, the NBR made it easier for banks to clean up their portfolios by writing off or selling impaired loans. As a result, the NPL ratio fell sharply to 13.82% in March 2015. The clean-up started earlier for household lending but picked up pace only at the end of 2014 in the case of corporate loans. Consequently, lending to companies could be lagging to some extent due to the balance sheet clean-up.
During 2014, the clean-up process led to unprecedented losses of EUR 1 billion for the banking system, although this was the fifth consecutive year with negative profitability. Consequently, a revival of revenues through new lending is welcome, given that net interest income has contracted continuously since 2011. However, 2015 could be another difficult year for bank profitability. Lower interest rates and margins, new prudential regulation and the ongoing reduction in NPLs could weigh on bank results. More hardship might trigger a consolidation in the banking sector, with smaller and less profitable banks being acquired by the better performers.
The risk of doing too much too soon
The Romanian economy is rebounding in line with other Central European countries. For this sub-region, it looks like the crisis has been left behind. Yet, it is too early to celebrate. Higher revenues, better lending and a wave of populism not seen since 2008 threaten to overheat consumption and could lead to larger macroeconomic imbalances. Shortly put, the hard-fought, painful re-adjustment since the financial crisis could be overturned in a very short while, with very negative consequences. This comes at a time when political and regional tensions are high.
The domestic political situation and Greek debt woes forced the central bank to stop from cutting rates and led foreign investors to sell Romanian government bonds in a sign that Romania’s fragile macroeconomic equilibrium is not taken for granted. A massive VAT cut planned for next year could keep inflation below target but could push the budget deficit close to 3% of GDP. This will boost consumption further, running the risk of closing the output gap faster than previously anticipated, resulting in overheated consumption and upward pressure on prices masked by the planned VAT cuts. At the same time, this might lead to a reacceleration in imports, raising the risks of a deterioration in the commercial balance. Consequently, further key rate cuts could be off the cards in 2015, while the NBR could be forced to hike next year.
The new Fiscal Code will lead to significantly lower revenues to the state budget, increasing the risk of fiscal slippages. The estimated annual impact of the Code is RON 12 billion, representing 5.6% of 2014 total budget revenues and 1.7% of the estimated 2015 GDP. While the forgone revenues in 2015 for the fiscal stimulus already implemented can be compensated by the improved revenue collection and lower spending in the first part of the year (budget surplus of 0.9%of GDP in 5M15), the gap is more difficult to cover during the following years. The European Commission and the IMF warned Romania that such an ambitious code might lead to an overshooting of the fiscal deficit above the targeted level. Romanian authorities estimate a deficit close to 2.8-2.9% of GDP in 2016, well above the assumed target of 1.2%. The government assured that it intends to limit the 2016 deficit at 2.5% of GDP through a mix of lower expenditures and improved revenue collection. Although budget revenues during 1H15 were 10.2% higher than in 1H14, it is unclear whether these higher revenues were triggered by the improved tax compliance and thus sustainable.
The composition of spending in the past years reveals that spending cuts came from investments, in the detriment of Romania’s price competitiveness, future exports and growth. In light of the planned stimulus to consumers in anticipation of the local and Parliamentary elections next year, there is a risk Romania will keep the deficit below the threshold by cutting again investment expenditure, despite having one of the worst infrastructures in the EU (the second worst score in the EU according to EC’s latest country report).
Given the low overall quality of infrastructure, Romania should allocate more funds to the sector before expecting a recovery of private sector investments. So far, Romania did not make the best use of the available EU funds, with the transport sector absorbing only 58.8% of the available funding by June 2015. The total length of the highway segments currently under construction is 263km. Completion of the ongoing works is crucial for attracting private investments, as net FDIs to Romania lag behind, amounting to only EUR 2.4-3 billion annually during 2012-2014 (around 2% of GDP).
The potential for development through EU funds is high, as Romania can still absorb funds from the 2007-2013 programming period. With a target set at 80% for year-end, Romania needs to absorb around EUR 6 billion this year (4% of GDP), but only cashed EUR 1.3 billion during the first half of the year. However, the 2014 data shows strong seasonality with inflows of EU funds doubling in the second part of the year, leading us to remain optimistic regarding the 2015 performance. Besides the funding under the previous programming period, Romania was allocated another EUR 41.5 billion under the 2014-2020 programming period.
The new Fiscal Code also produced disagreement between the representatives of the European Commission and the Romanian government in June, maintaining the current SBA suspended at a time when political and regional tensions are rising. The current SBA should conclude on 27 September. Although Romania would be interested in maintaining the IMF credibility anchor through a precautionary and liquidity line (PLL), currently there is a halt in negotiations. The news had so far a limited impact on the exchange rate and bond yields, as the attention is now focused on the external developments. We believe that should EM assets come under pressure due to external uncertainties, the government may make some concessions in order to secure the PLL, postponing or eliminating some of the major tax cuts. If the Code remains in the current form, investor perception will be negatively affected, possibly leading to higher financing costs. On the positive side, the financing needs for 2015-2016 are lower, in light of lower public sector debt repayments, while the Ministry of Finance is enjoying high fiscal buffers which limit the upward pressure on yields.
The Greek problems could affect Romania, but the impact is limited to the banking sector and should not lead to systemic problems. Subsidiaries of Greek banks accounted for around 12.1% of banking sector assets in Romania at the end of 2014. They are operated as local entities and are regulated by the local central bank, an important factor regarding prudential regulation and potential risks. The main strengths of Greek bank subsidiaries are: very good capitalisation, sizeable liquid assets and central bank support in case of stress.
Due to political and external volatility, EUR-RON is in danger of exiting temporarily the 4.40-4.50 range, but the NBR will likely favor an exchange rate in the above-mentioned interval, as Romania cannot afford sharp RON depreciation from here because of the large stock of FX loans. The main external factors generating exchange rate volatility and depreciation pressures are: the Greek debt woes, the uncertainty surrounding the timing of Fed’s first rate hike (expected by UniCredit in September) and the lingering geopolitical tensions in eastern Ukraine. Fundamentals and capital flows continue to favor a stable exchange rate. On 12M cumulated data, the positive extended basic balance could remain close to 4% of GDP in 2015, covering all bank outflows, conferring stability to the exchange rate.
In conclusion, the Romanian economy is growing strongly and is currently benefitting from good fundamentals after having corrected the imbalances that stood out at the beginning of the crisis. However, by adding too much stimulus to consumption, similar to the lending exuberance in the run-up to the financial crisis, Romania risks giving back some of the hard-fought gains made since the crisis. Not learning from past mistakes is very dangerous for the country.
