Our in-house estimates suggest real GDP excluding agriculture might have been flat in Q2 after it had grew by 0.4% qoq in Q1. In our view, real GDP excluding agriculture is a better aggregate to track underlying trend in economic activity in case of Romania as it is less impacted by volatile weather conditions and resulting volatile dynamics of agricultural output.
But the pace of economic recovery seems to have decelerated in the first half of 2013 (especially in Q2). Flat dynamics of real GDP excluding agriculture in Q2 is the worst performance since the end of 2011.
Industry (on the supply side) and net exports (on the demand side) were key drivers of GDP growth in the first half of the year. Industry remained a key driver of GDP growth in Q2 on the supply side, growing for the fifth quarter in a row. Positive dynamics seems to have been supported by export driven sectors (especially automotive industry). On the demand side, the main driver of growth in Q2 was net exports whose positive contribution was fuelled by the increase in exports, but also by the decrease in imports (a similar pattern was also recorded in Q1). We recall that especially exports of the automotive industry (passenger cars, parts and accessories for transport means) and exports of services (+32.4% yoy in Jan-Jun in euro equivalent) had an outstanding performance both in Q1 and Q2.
Domestic demand remained weak in the first half of the year. On the one hand, given the poor increase in public revenues and the increase in spending with wages of public servants, the government had to keep a strong control over public expenditure (both current and investment expenditure) in order to keep the public budget deficit at a low level. There was a substantial cut especially in case of public investment expenditures (-14.4% yoy in Jan-Jul for investment spending from own funds and from the European Funds). On the other hand, individuals and companies remained concerned on economic prospects and showed prudence in spending and investment. Dynamics of private consumption was almost flat in the first half of the year while total investments (public and private) decreased marginally. The increase in public wages by around 17% over the past year had almost no visible impact on consumption spending. Individuals focused to reduce their debt burden of loans taken before inception of crisis.
Data show also that labor market conditions might have deteriorated starting the end of 2012. The two measures used to track unemployment dynamics – the ILO unemployment rate derived from a survey on households and the recorded unemployment rate derived from the number of peoples officially recorded as being unemployed with the ANOFM – saw an increase starting Q4 2012. While having in mind the drawbacks of these indicators, we believe their coincident increase over the last three quarters could be a sign that labor market conditions might have deteriorated recently. Other indicators point also to more difficult conditions in the labor market: the number of employees in large companies (at least four employees, state or private majority owned) decreased marginally in Q2, and annual growth rate of nominal gross earnings in such companies decreased visibly in the first half of the year.
We believe the sharp fall in imports in H1 2013 was also a facet of fragile domestic demand. The plunge in imports of fuels (oil, natural gas) explains a lot of fall in overall imports. While the good weather conditions (mild winter and summer) are good reasons for the fall in imports of energy, we believe there are also structural factors behind fall in energy imports (the closure of some intensive energy production capacities in metallurgy and chemical industry).
Growing exports and rapidly falling imports resulted in a close to zero balance in foreign trade in goods and services. Moreover, for the first time since 1990, the current account balance switched to surplus in Q2 2013 (around 2.3% of GDP in annual terms and based on seasonally adjusted data). Low levels of foreign trade deficit and of current account deficit are both good news (lower external funding needs) and bad news (low level for consumption and investments, below their medium and long-term trend). We still believe that Romania is not yet in a position to have structural current account surpluses and we look for foreign trade balance and current account balance to return in the negative territory (deficits) in the following period.
We expect economic activity to remain on upward trend in the following quarters. Weather conditions were quite good this year and paved the way for an outstanding agricultural output. For many crops production might have increased even by 50% in 2013 from 2012 which was a bad agricultural year and set a low base. Outstanding agricultural output will boost GDP figures for Q3 and Q4 2013. For instance, annual growth rate for real GDP might surge to 3.5- 4.0% yoy in Q3 from 1.5% yoy in Q2. However, positive impact from agriculture is transitory (short lived) and the fast GDP dynamics in Q3 and Q4 would not be the facet of a substantial improvement in underlying activity. In order to assess the trend in underlying activity, the focus should be on dynamics of real GDP excluding agriculture. We foresee the aggregate to grow by around 0.3% qoq and 1.0% yoy in Q3 (substantially below the advance of 3.5-4.0% in real GDP). There are more chances for recovery to gain speed in the subsequent quarters on the back of recovering external demand, of a more accommodative domestic monetary policy stance (lower interest rates) and of increasing absorption of EU Structural Funds (increase in public investments).
We expect real GDP to advance by around 2.5% in 2013. However, the growth rate is inflated by large positive contribution of agriculture (1.2 percentage points resulting from an expected 23% increase in gross value added in agriculture). A higher GDP growth rate should not be excluded provided a better agricultural output. We look for real GDP excluding agriculture – our preferred measure of underlying tendency for economic activity in case of Romania – to advance only by 1.4% in 2013. This is below the growth rate recorded in 2012 (2.2%) which means economic growth has slowed down this year from 2012.
Faster than expected disinflation process
Due to their large share in CPI basket, the very volatile dynamics of food prices on the back of volatile weather conditions resulted in large swings in annual inflation rate around its medium and long term trend in the last years. Large fluctuations in inflation rate were also fuelled by ad-hoc adjustments of administered prices (i.e. electricity, natural gas) and episodes of volatile exchange rate moves. When looking behind this volatility, a downward trend in annual inflation rate is evident. Our estimates suggest that medium-term trend in inflation rate might be close to 3.6% at the moment.
Adverse weather conditions in 2012 resulted in a sustained increase in food prices (especially the most volatile ones for fruits, vegetables and eggs) starting the summer of 2012 and ending the first months of 2013. Volatile food prices were 25% higher in January 2013 compared with January 2012. Household tariffs for electricity and natural gas were hiked in the ending months of 2012 and in January 2013, which generated additional pressures on inflation rate. Administered/regulated were expanding by 10% yoy as of January 2013 and they were still increasing by 10.0% yoy in August.
Fuelled by large supply side shocks, annual inflation rate came in substantially above its medium-term trend over the past year (Jul 2012 to Jul 2013). Annual inflation rate fluctuated between 5.0% and 6.0% yoy between December 2012 and June 2013.
Good agricultural output this year should help volatile food prices not only to reverse their last year’s increases but also to decrease below their medium-term trend. While their increase in last year fuelled the annual inflation rate, their decrease starting this summer would result in a negative contribution to inflation rate this year. So, the adverse statistical base effect induced by dynamics of volatile food prices and in place between Aug 2012 and Jul 2013 will be replaced by a favorable statistical base effect starting Aug 2013 and ending Jul 2014. According to our estimates, decline in food prices can help annual inflation rate to fall by 1.6-2.0 percentage points from June to September 2013.
In June, the government decided to postpone payments in green certificates to energy producers from renewable sources. The measure resulted in a decrease in electricity tariffs for households. Electricity tariffs decreased by 2.5% in July. At the end of July, the government decided to cut VAT for bread from 24% to 9% starting 1st of September. This can result in a 0.4pp negative contribution to inflation rate in September assuming only 50% of the maximum impact is translated to final consumer prices.
Annual inflation rate has good chances to fall substantially below its medium and long term trend in the following year (from 2013Q3 to 2014Q3). Due to weak consumption demand, underlying inflationary pressures should remain low. Helped by favorable supply side shocks (decrease in volatile food prices, in electricity tariffs, and in VAT for bread) the annual inflation rate should decrease rapidly in the second half of the year and it might reach historically low levels in Q1 2014. Rapid decline from 5.4% yoy in June to 3.7% in August was only the first step of the disinflation process. We expect the annual inflation rate to fall below 2.5% yoy by end-September and to remain close to this level by end of the year. While our baseline scenario puts annual inflation rate a touch below 2.0% yoy in Q1 2014, incoming information suggests a lower level should not be ruled out. In a very favorable scenario (no shocks occur on external market or on domestic front) inflation rate can fall even below 1.5% yoy in Q1 2014. The annual inflation rate would move upwards towards its medium term trend of 3.0% in the second half of 2014.
Interest rate on the way to reach historically low levels
Following strong portfolio inflows and pressures for leu appreciation (Dec 2012-Feb 2013), the National Bank of Romania (NBR) started easing the control over liquidity conditions in the money market in March. This has been reflected in a rapid decline of interbank interest rates (ROBOR) in Q1. Increase in appetite of foreign investors for Emerging Market assets in April following announcement of additional monetary policy easing measures by central banks in Japan and the Eurozone gave rise to expectations of monetary policy key rate cuts by the NBR starting the summer. Concerns about tapering of quantitative easing measures by the US FED resulted in an increase in risk aversion of investors on Emerging Market assets globally in May and June. The NBR did not rush to tighten the control over liquidity conditions in the market during this episode and interbank interest rates went up only marginally. Overall, the downward trend in interbank interest rates (ROBOR) was preserved in Q2. Ease of control over liquidity conditions in the money market was accompanied by cuts in monetary policy rate starting July. The NBR cut the monetary policy rate by 25bp to 5.0% on 1 July. At its most recent monetary policy meeting on 5 August, the National Bank of Romania (NBR) reduced the monetary policy rate by 50bp to 4.5%. Market consensus and our expectations were for a 25bp reduction. Larger than expected cut of the monetary policy rate came in place shortly after the government announced the reduction of the VAT for bread from 24% to 9% as of 1 September and negotiations with the IMF and the European Commission on new precautionary financial agreements were concluded.
ROBOR 6M fell by 220bp between end-November 2012 and end-August 2013 (from 6.3% to 4.1%). Decline in interbank interest rates started to be translated by banks in lower lending and deposit interest rates in the economy. Yields for RON government securities fell also substantially since November 2012 (i.e. yields for 3Y RON government securities fell by 210bp between end-Nov 2013 and end-August 2013). Decision of JP Morgan and Barclay’s to add RON government securities to their Emerging Market local debt indexes boosted demand of non-residents for RON government securities from December 2012 to February 2013. Monetary policy easing prospects keep it alive further in April and May. So, non-resident players ended by holding round 25% of local government securities at the end of May (up from a share of 6.0% in November 2012).
In our view, favorable inflation outlook, weak domestic demand and positive sentiment for the leu support the monetary policy easing cycle.
The fall of annual inflation rate below its medium-term trend in the following quarters would be fuelled to a large extent by favorable supply side shocks: low level of volatile food prices, cut of electricity tariffs and reduction of VAT for bread. But these shocks are outside the control of monetary policy and they are transitory (results in a favorable dynamics of inflation rate only for a short period of time). So, when calibrating monetary policy stance we expect central bank to have in mind that such favorable developments would be short lived and that medium-term trend for inflation rate is higher (we estimate it to be at around 3.6% now and to decrease towards 3.0% by end-2014).
When taking into account the medium term inflation rate trend and the weak consumption demand (negative output gap), we believe there are incentives for central bank to act in order to lower further interest rates. Lending activity is quite fragile at the moment and central bank wants to boost lending in RON, which creates another incentive for central bank to promote low RON interest rates. Only bold monetary policy easing is likely to speed up decline in RON lending rates.
Our baseline scenario has 4.0% as a floor for monetary policy rate. We expect two cuts of 25bp at each of remaining two monetary policy meetings this year (on 30 Sep and on 5 Nov). But we do not rule out a cut of 50bp in September. Also we not completely rule out key rate to bottom at a lower level (even 3.5%) provided that the favorable inflation outlook is confirmed and no major shocks occur. In fact, we believe the central bank would lower key rate as much as possible. Also, reducing ratio for RON minimum reserve requirements has return on the cards as a potential action able to speed up downward trend in RON lending rates.
But there are also some constraints for the monetary policy easing cycle. The most important we have in mind are represented by increase in risk aversion for Emerging Market assets and potential political tensions on domestic front (we believe that USL alliance will survive in the following period, but a breakdown cannot be fully ruled out as 2014 elections approach). The negotiations over the SBA terms concluded sooner than expected by us and this should be good news for RON assets (government debt instruments and exchange rate) as the agreement is seen as an anchor of credibility by foreign investors. However, we do not see the agreements with the IMF and the EC as a panacea. Recent two SBAs showed that making progress on the structural reform agenda is a lengthy process.
