While investors worldwide remained concerned about medium and long-term global economic growth prospects and debt crisis in the Euro area, their appetite for risky assets showed an improvement.
On the other hand, local authorities showed commitment to go forward with the fiscal consolidation process and to maintain on track the agreements with international creditors (the IMF, the European Commission). So, there were no major constraints for central bank (NBR) to ease the monetary policy stance in line with requirements of weak domestic demand and low inflationary pressures. The NBR reduced the monetary policy rate to 5.25% at the end of March from 6.00% at the beginning of the year, while providing also increasing liquidity to the money market. In this context, both the interbank interest rates and the yields for government bonds decreased substantially during January-April. The easing cycle was also reflected in a decline in deposit and lending interest rates for individuals and companies.
The Finance Ministry took advantage of the benign external environment issuing USD 2.25 bn in 10-year international bonds and increasing its liquidity buffer aimed to offer protection in bad times. The leu did not benefit too much from the Q1 rally in the price of risky assets and of regional currencies as inflows of foreign private capitals in Romanian economy remained low.
…BUT TURBULENCES RETURNED QUICKLY
However, risk appetite of global investors deteriorated again in the second quarter as concerns about global economic recovery and the Euro area debt crisis intensified. On the domestic front, the change in the ruling coalition at the end of April increased the uncertainty on the course of domestic policies in medium and long term. The USL alliance between the Social Democratic Party (PSD) and the National Liberal Party (PNL) gained the parliamentary and the executive power at the detriment of the alliance led by the Democratic Liberal Party (PD-L). On the positive side, political transition was smooth and quickly, while the new government pledged to maintain in place the existing agreements with the IMF and the European Commission. On the negative side, the new ruling coalition - which has large chances to remain in power following the parliamentary elections due in December – has not detailed its intentions with regard to planned changes in economic policies and taxation system (expected to be enforced starting with 2013 as part of its governing program). Increase in risk aversion on external markets and increase in uncertainty on domestic market forced central bank to end the easing cycle and generated upward pressures on interbank interest rates and yields for government bonds which started to climb gradually in May-June. Pressures for leu depreciation increased also in intensity and started to materialize in May-June.
Political tensions accentuated in the third quarter when the USL ruling alliance voted in Parliament to suspend President Basescu. The USL’s legislative actions aimed to suspend the president generated vivid debates in terms of their number, the speed at which they were taken, the way to implement them and their impact. Concerns about the rule of law and constitutionality of moves emerged among European officials as well. Ultimately, the result of the national referendum for impeachment of the President Basescu (87.5% of total votes were against Basescu) was not validated as the participation quorum was not met (only 8.5 million persons went to vote, while 9.2 million were required). Developments on political scene had a negative impact on financial markets. Leu depreciated rapidly, losing around 4% against the euro in the first three weeks of July.
In order to limit depreciation, at the beginning of August the central bank decided to tighten the control over liquidity conditions in the money market. Accordingly, it reduced substantially the liquidity provided to banks in regular repo operations. The move came in place when the market already had a liquidity deficit. As a result, upward trend in the interbank interest rates and yields for bonds speeded up in August. Between end-April and end-August, ROBOR 1M moved up by 130bp between, while ROBOR 12M went up 100bp. Yields for 3-year government securities climbed up by 40bp during the same period. The move of central bank did have favorable impact on the exchange rate as leu erased in August all its losses from July.
Appetite of local and foreign players to buy government securities decreased also substantially over the summer. For four months in a row (May-August), debt issued by the Finance Ministry in local government securities was below the amount of debt coming to maturity, which means redemptions were made from the existing buffer of liquidity.
OUTLOOK REMAINS CHALLENGING
We foresee important challenges for local financial markets in the period to come. Uncertainty and risk aversion on the external markets is expected to remain high in the following quarters, while another tense episode of the Euro area debt crisis should not be excluded. At the same time, we expect politics to remain a key factor of uncertainty for economy and financial markets.
With a negative mood on external markets, net inflows of foreign private capitals in Romania are expected to remain at a low level. Not only external funding would remain scarce, but also the cost of external borrowing would remain elevated (as country risk premium is expected to maintain high). All these would hamper further the recovery in domestic private consumption and investments. Fragile external environment would have a negative impact on governmental policies and spending. There is a high requirement for government to tap external markets in the following quarters in order to rollover maturing debt and to finance the budget deficit. In order to maintain at a high level the interest of foreign investors for Romanian assets, the government must maintain appropriate governmental policies and it must go forward with the fiscal consolidation process. The government should maintain on track (and probably extend again in 2013) the agreements with the IMF and the European Commission given these are perceived by foreign investors as the main anchor of credibility. The room of government to boost economic growth by stimulative policies remains limited and the fiscal consolidation would further weigh on economic growth. Increasing the absorption of European Structural Funds would remain the best alternative to support the economic recovery.
The fragile external environment would not only hamper economic growth (by its impact on private consumption and investments, on exports, and on public spending), but also it could have a negative impact on leu exchange rate and local interest rates and yields. Romania is still highly depended on foreign capitals as it has to ensure debt service of existing external debt stock (around 74% of GDP) and to finance the current account deficit (around 4% of GDP). With risk aversion on the external markets expected to remain high and inflows of foreign capitals expected to remain low, high external funding needs suggest that room for leu appreciation is limited in the coming period. On the contrary, risks are that pressures for leu depreciation would persist in the coming quarters (given local uncertainty is expected to remain high in short term due to parliamentary elections). Risk premium required by foreign investors to buy and hold Romanian financial assets would be high in a fragile external environment. Such a high risk premium would be incorporated by local interest rates and yields for bonds.
Monetary policy decisions would become more complicated in the coming period. Recovery in domestic demand was slow until now and we expect it to remain further gradual. Moreover, a large negative output gap exists at the moment. So, domestic demand is a factor which supports an expansive monetary policy. Underlying inflationary pressures were low until now. However, clouds have arisen at the horizon. Adverse global and local weather conditions over the last quarters are expected to generate upside pressures on food prices (especially on volatile food prices of fruits and vegetables). Administrative prices (tariffs for electricity and natural gas) must be adjusted upwards as part of the liberalization process negotiated with the European Union. As a result, annual inflation rate should increase further in the following quarters, outpacing 4% yoy as earlier as September. With inflation rate on the rise on the local front and with high risk aversion on external markets, the central bank might be forced to tighten the stance of the monetary policy rate in Q4 2012. Accordingly, the interbank interest rates and yields for government bonds would very likely consolidate at their current higher levels, while risks are for additional upside pressures. For the time being, a hike in the monetary policy rate (currently at 5.25%) appears not to be necessary in the next year. However, such a move should not be completed excluded provided that inflationary risks (increase in food prices and administered prices) would materialize in a very large extent or the turbulences would increase on local and external markets.
Tense relations between President Basescu and the current majority in the Parliament led by the USL alliance and the parliamentary elections which are due in December, suggest politics would remain a major factor of uncertainty in the following period. Political uncertainty is expected to weigh also on the exchange rate, interbank interest rates and yields for bonds as investors would require a higher risk premium to hold these assets. A new episode of political tensions would have large chances to generate upside pressures on exchange rate (leu depreciation), interest rates and yields.