Romania’s EU membership has brought an economic boom, on the one hand, and excessive credit growth and the acceleration of imports, on the other hand.
Crisis
The first decade of Romania’s membership in the EU has been one of two halves. The period up to September 2008 was characterised by a boom in economic activity. Enthusiasm amongst the EMU member states to draw off the newer EU states as a manufacturing base played an important role, as did widespread reform efforts in the lead up to EU entry. But anchored in part by the prospect of euro adoption, this boom in industry and exports was accompanied by rapid expansion in the non-tradables sectors, leading to excessive credit growth and a rapid acceleration of imports. Romania was plagued by a case of twin deficits, as the current account deficit reached 11.6% of GDP in 2008 and the structural budget deficit stood at 8.5% of GDP.
Adjustment
The 2008 global crisis highlighted the extent to which nominal convergence outpaced real convergence in the preceding years. Accelerating exports indicated that the relationship between the tradables sector remained strong, but the nontradables sector was forced to adjust. External sources of capital dried up and Romania was forced to offset its large current account deficit and swelling budget imbalances.
Romania was one of 3 newer EU states to request an IMF/EU programme in 2008/09 (Hungary and Latvia also requested stand-by arrangements) and is today the only country in CEE (including other CEE states such as Serbia and Ukraine) to maintain constant engagement with the ‘Troika’. The first stand-by arrangement (SBA) amounted to EUR 20bn from the IMF, the European Commission, the World Bank and other International Financial Institutions (IFIs) and focused primarily on a swift stabilization of fiscal and external imbalances. There has been some significant successes over the course of this engagement, concentrated primarily within fiscal policy. The first programme set strict fiscal targets, including a ceiling on public sector spending and arrears, though high taxes played a dominant role in consolidation.
The authorities introduced a new wage bill for public sector employees, revised social benefits, increased the flexibility of the labour market and enacted a new fiscal responsibility law, which included the setup of a fiscal council, limits on intra-year budget revisions and multi-year budgeting procedures. Romania subsequently signed two other precautionary programs, which were used as an anchor for implementing structural reforms. The programmes acted as a credibility anchor, bolstering transparency on fiscal performance and speeding up Romania’s return to investment grade.
Even though progress on structural reforms has been slow, Romania is in a significantly healthier fiscal position now. From a structural budget deficit of 8.5% of GDP in 2008, the authorities target a headline deficit of 2.2% of GDP this year. Furthermore, Romania signed the fiscal compact and committed itself to a structural budget deficit of 1% of GDP over the medium run. At less than 40% of GDP last year, public debt is less than half the EU average (85%), though it has increased from less than 15% of GDP since before the global financial crisis. Overall, Romania has managed to address the major imbalances of the economy, but growth is lagging, as consumers are still deleveraging and remain very risk averse.
The crisis of 2008-2009 also resulted in a series of changes in the structure of the economy. GDP growth sources shifted from domestic consumption to net exports, helped by declining unit labour costs with the help of the RON’s depreciation. The accelerating of exports coupled with weka consumer demand prompted a narrowing of the current account deficit from 13.4% of GDP in 2007 to 1.1% of GDP in 2013.
Following a period of exuberance in credit in the lead up to the global financial crisis, more recent years have been characterised by adjustment. The combination of a re-assessment of growth prospects for the newer EU states post-Lehman and the EMU crisis over 2011-12 has meant that credit growth on average across the region has been below deposit growth since 2010. In Romania, credit growth has been negative in real terms from September 2012.
This period of deleveraging has been costly in terms of growth but has also returned the banking sector to a more viable position. This is most obvious in terms of the loan to deposit ratio in Romania, which has declined to 102% in March 2013 from 134% in September 2008. The banking system is also in a very solid position from a capital perspective, with a solvency ratio of 15%, significantly above the legal requirement of 8%.
However, the banking system still needs to address legacy issues, primarily the deterioration of asset quality. The NPL ratio has risen significantly in the postcrisis period, reaching a maximum of 22.5% in February 2014. However, this ratio is expected to decline in the upcoming period, both due to organic factors as well as less strict write-off legal requirements from the NBR.
Outlook
For the first time since 2007, Romania managed to outpace the other CEE countries in terms of growth, registering a GDP expansion of 3.5% in 2013. This attainment was generated by the positiveperformance of the industrial sector and agriculture, which managed to offset static domestic demand, and weak investments.
However, growth is expected to slow down to 2% yoy in 2014, as the outstanding agricultural production 2013 creates a negative base effect. Exports and industry (both estimated to go up 6.1% yoy in 2014) will remain the biggest growth drivers, helped by demand from Germany and improved labour competitiveness. In addition, economic growth could receive a substantial boost from the absorption of EU funds, which is expected to accelerate markedly in 2014-2015.
As the economy continued its shift towards an export-led growth model in 2013, the current account deficit narrowed. Romania registered a deficit of 1.1% of GDP in 2013, marking a significant correction from the 4.4% deficit of 2012. The main factor of adjustment for the balance of payments was the goods’ trade deficit (which shrank by 53.6% yoy to EUR 3.7bn), due to very strong exports (+10% yoy in 2013).
The structure of goods exports reflected a sharp acceleration of auto exports, whose weight in total exports increased from 40% in 2012 to 42% in 2013. External demand for automobiles has been very strong in 2013, helping lift production throughout the CEE region. Furthermore, the country has a substantial competitive advantage due to cheap labour force, a relatively stable exchange rate and generally predictable economic policies. In addition, the bumper harvest from 2013 also helped boost Romania’s exports. Consequently, the weight of agri-food products, beverages and tobacco in total exports increased from 7.5% in 2012 to 8.5% in 2013.
Imports of goods rose by 1% in 2013, undercutting the acceleration of exports by a significant margin. Fuel imports marked the sharpest change in the structure of imports, as their weight declined from 12.2% in 2012 to 9.9% in 2013. This decline was most likely caused by benign weather conditions, which generated a decline in domestic demand for fuels. Conversely, the weight of car imports increased from 33.7% in 2012 to 35%, which indicates a slight improvement in consumer demand.
While Romania has managed to address the major imbalances of the economy, internal demand is still lagging, as consumers are deleveraging and remain very risk averse.
The Romanian banking system has undergone a substantial rebalancing process during 2013, which was reflected in the decline of the loans-to-depo ratio from 114.5% in Dec-2012 to 101.3% in Dec- 2013, the lowest level since April 2007. Loans to the private sector shrank by 3.3%, followed by a decline of 1.2% for consumer loans and a contraction of 5.4% for company loans. The decline of loans to companies was entirely concentrated in the bracket of short-term loans, which declined by 14% yoy. By contrast, medium and long term loans to companies were broadly unchanged from 2012 (0.4% yoy increase).
The structure of loans to companies shows a rebalancing towards RON lending in the detriment of FX loans. The former category increased by 0.3% yoy while the latter shrank by 9.5% yoy. This transition has been accelerated by tighter lending standards aimed at limiting un-hedged FX exposures and a large RON surplus in the financial system. The rebalance probably stemmed both from demand factors (RON depreciation highlighted FX risks) as well as supply factors (the external financing lines diminished during 2012, the banking sector external liabilities diminishing by around EUR 3bn).
Annual inflation ended 2013 at 1.55%, a substantial decline from 2012’s reading of 4.95%. As a caveat, this downward adjustment was facilitated by temporary factors as an exceptional harvest and the reduction of VAT for bread products. The elimination of these factors along with changes in the fiscal framework (an additional excise duty on fuels) could push inflation to 3.7% by the end of 2014. Nevertheless, consumer price inflation excluding the volatile dynamic of foods and tax changes remained on a downward path since 2008.
The central bank has capitalized on the favourable dynamic of inflation and started an easing cycle from July 2013, bringing the key rate down to 3.5% by February 2014. In addition, the bank permitted the accumulation of excess RON liquidity in the banking system, which led lead to a downward adjustment of interbank rates. The bank also reduced the level of Minimum Reserve Requirements to 12% for RON and 15% for FX liabilities in early 2014. No rate changes are expected during 2014, but the central bank could reduce MRR further provided that lending activity will restart.
Romania cleared the first political hurdle of 2014, the break-up of its governing coalition and its replacement with a new government. Public finances remain sustainable under IMF/EU monitoring, but the reform fatigue has risen. Considering the election year, the Government should prioritize avoiding budget slippages. In turn, a sensible fiscal policy should enable a boost in investment spending in order to maximize the absorption of EU funds.
Exchange rate fundamentals for the RON are encouraging, as the underlying economic growth rate will pick up, and inflows of EU funds, foreign direct investments and portfolio inflows should offset outflows from banking system deleveraging and temporary episodes of risk aversion in the international markets. Romania has so far weathered relatively well the turbulences between Russia and Ukraine. Direct trade links between with both Russia and Ukraine are small and the reliance on Russian gas is low by regional standards. Links between the Romanian and Russia banking systems are also small. However, there is still potential for financial spillovers in the event that tensions would escalate.
The RON could benefit from an inclusion of Romania into the investment grade bracket by S&P. The upgrade would be warranted by Romania’s solid economic performance, stable fiscal policies under the IMF agreement and sustainable financing needs. In addition, the S&P upgrade should result in a ROMGB rally, also considering a dovish stance from the ECB.
