The government has confirmed its intention to implement the precautionary two-year stand-by agreement concluded with the IMF in March 2011. On July 31st a joint mission of the IMF, the World Bank and the EU arrived in Bucharest, the capital, for talks on the sixth review of the stand-by agreement and fiscal plans for 2012-13. The Fund expressed concern at the impact of the current political situation on the economy and, in the context of the negative external environment, emphasised the need to maintain strict spending discipline, and to intensify efforts to reduce state-sector arrears, and accelerate the reform and privatisation of state-owned enterprises (SOEs) that are a drain on the budget.
The main task confronting the government is the introduction of private management in SOEs and their partial privatisation, either through stockmarket listings or through the sale of controlling stakes. The government has committed to the sale of minority stakes in energy companies over the next 12 months, and will implement proposals for the liberalisation of energy prices. It will bring the energy regulator, ANRE, under parliamentary control. It also plans to reform the system of excise duties on energy and natural resources, but will take a tougher line on the development of natural resources by foreign companies. Proposals to develop shale gas by fracking will be delayed until the environmental impact has been analyzed. The government will also review the controversial Rosia Montana gold mining project.
FISCAL POLICY
To allow some counter-cyclical spending, the IMF agreed to increase the budget deficit target from 1.9% of GDP in 2012 on a cash basis—equivalent to 2.3% of GDP on the EU's European System of Accounts (ESA 95) methodology—to 2.2% (2.8% ESA 95). This will enable the government to restore public-sector wages to pre-austerity levels, starting with an 8% increase on June 1st and a further payment up to a total of 15% in December if economic conditions allow. The repayment of illegally collected health payments to pensioners began in June.
The consolidated government budget posted a deficit of Lei6.79bn (US$ 2bn) in January-June 2012, equivalent to 1.12% of projected annual GDP, which is within the IMF's six-month target of Lei 7bn-8.8bn and in line with the full-year target. The six-month deficit narrowed by 39.4% year on year, and compared with a deficit of 1.94% of GDP in January-June 2011, and a deficit of Lei7.2bn or 1.19% of projected annual GDP in January-May. Despite the improvement, the government has little room for fiscal largesse, given that spending usually rises in the final quarter. The USL also proposes to reduce value-added tax (VAT) on agricultural products, which would reduce tax revenue. Given the likelihood that growth will be below official projections, we expect the 2.2% budget deficit target to be exceeded. However, in line with the six month improvement, we have narrowed our budget deficit forecast.
MONETARY POLICY
The National Bank of Romania (NBR, the central bank) operates an inflation-targeting regime with a year-end target of 3% (+ / - 1 percentage point) for 2012. It has established a target of 2.5% (+ / - 1 percentage point) for 2013 onwards. The government cut the monetary policy rate by 25 basis points at four consecutive board meetings, bringing it down to 5.25% in March 2012. The NBR abandoned its policy of monetary relaxation after the leu depreciated rapidly following the no-confidence vote at the end of April, and has maintained the interest rate at 5.25% since then. The NBR is not expected to resume further cuts in interest rates in the short term, given continuing uncertainty on foreign-exchange markets arising from the euro zone and domestic political crises. We expect the central bank to relax its monetary policy in 2013-16 as inflation falls and global market conditions normalise.
The outgoing government was committed to euro adoption in 2015 and entering the EU's exchange-rate mechanism (ERM2) in 2013-14. We consider this target unrealistic, as Romania will have to improve its competitiveness before joining European economic and monetary union (EMU). The government elected in November 2012 is expected to review the target date with the NBR.
ECONOMIC GROWTH
Recovery from recession in 2009 and 2010—when real GDP fell by 6.6% and 1.6% (on revised Eurostat data), respectively—has been modest, with real GDP growing by 2.5% in 2011. Although year-on-year growth reached 1.9% in the fourth quarter of 2011, quarter-on-quarter growth turned negative, at -0.2%. GDP fell again in the first quarter of 2012, by 0.1% quarter on quarter, partly as a result of extreme weather conditions, pushing Romania into a technical double-dip recession, although real GDP grew by 1.5% year on year.
Revised data from the National Institute of Statistics (INSSE) confirm initial flash estimates that real GDP grew by 0.5% (seasonally-adjusted) quarter on quarter in April-June. On a year-on-year basis, INSSE data show that real GDP (gross) grew by 1.2% in the second quarter. Romania's 1.7% growth is hardly dynamic, but compares with growth of minus 0.3% for the EU27 and minus 0.5% for the euro zone. Provisional estimates by INSSE show that real GDP grew by 1.4% year on year in the first half of the year on a seasonally-adjusted basis (and by 0.8% year on year on a gross basis). Quarter-on-quarter growth was driven by household consumption (1.4%) and gross fixed capital formation (4.4%). However, the boost to domestic demand leaked over to the external sector, with imports growing by 1.2% quarter on quarter and exports falling by 1.4%.
On a year-on-year basis, household consumption grew by 1.4% in the second quarter and by 0.9% in the first six months. Gross fixed capital formation grew by 15.2% and 14.1% over the same periods, with the increase in demand partially met from stocks. Industrial output staged a very modest recovery, growing by only 0.5% (gross) year on year in the second quarter and by 0.2% in the first six months. Construction grew faster, by 5.2% and 3.1% respectively.
The disaggregated data show some worrying signs that domestic output has not responded to the modest boost in consumption and significant growth of gross fixed capital formation. The latter has been met largely by destocking; meanwhile industrial growth has been modest and exports have fallen. The widespread drought is expected to have a major impact on agricultural output in the third quarter, which will also drive up food prices and affect consumer demand.
The outlook for the year as a whole is bleak, as exports to the EU, which account for 30% of GDP, are vulnerable to recession in the euro zone. Romania is also dangerously exposed to fallout from the sovereign debt crisis, given multiple linkages with Greece and other euro zone economies. The scenario of disorderly defaults in peripheral euro zone countries is a significant possibility, as is a partial euro zone collapse, bringing with it the risk of turmoil in the Romanian financial system, which is dominated by Western banks. The EIU is forecasting real GDP growth of 1% in 2012, which may turn out to be slightly optimistic when the state of the harvest is revealed.
Growth is forecast to pick up in 2013-16, to an annual average of 4.1%. There is little prospect of a strong recovery in foreign direct investment (FDI) and other external flows until later in the forecast period. Proposals for off-budget investment in infrastructure were scrapped by the outgoing government, but could be reinstated by the new government, stimulating a recovery in construction from 2012 onwards, assuming that financing can be provided by the negotiation of larger than planned budget deficits. Improved absorption of EU funding would contribute to essential investment in infrastructure, which would boost export potential over the longer term. However, administrative deficiencies and the need for the government to co-finance projects will limit prospects for significant improvement.
INFLATION
Until June 2012, when it accelerated to 2% year on year, inflation had been on a declining trend since October 2011. Year-on-year inflation fell to 1.8% in April and May, the lowest level since post-communist price liberalization. However, this was largely owing to base effects.
The increase in June was in line with expectations. Inflation is expected to continue on an upward trend in the second half of 2012, reflecting base effects as volatile prices rise back to normal levels after falling last year. Excise duty on cigarettes, a leading driver of inflation, increased by 3.4% on July 1st, and will also have an impact on the consumer price index (CPI) in the coming months.
The drought will also drive up food prices. Another driver of inflation will be the uncertain external environment, which has led to significant exchange-rate volatility in recent months. We forecast year-end inflation of 3.5%. We expect inflation to come down gradually in 2012-16, to 2.7% by December 2016.
EXCHANGE RATES
The leu has depreciated to record lows against the euro and the dollar in recent weeks, driven down by domestic political instability and concerns regarding the euro zone. The leu fell by 3% against the euro between the end of December 2011 and the end of June 2012; and by 5.9% against the dollar over the same period. This reflected political developments related to the fall of the DLP government on April 27th, as well as the worsening economic outlook in the euro zone. However, the recent political strife connected with the move to impeach the president has led to a further deterioration in the value of the leu. The central bank was unable to prevent the leu from falling to an historic low against the euro of Lei4.6481:€1 on August 3rd, following a brief recovery after its 3.3% fall against the euro in the three weeks of the referendum campaign.
The authorities have intervened only moderately to support the currency or to absorb excess liquidity, prompting speculation that the NBR is happy to allow the currency to depreciate within certain limits. However, if the currency were to come under severe pressure, we expect that the central bank would step up its intervention. We expect the leu to be subject to turbulence throughout the year, given that a parliamentary election is due in November, and there is no end to the euro zone crisis in sight. The leu is forecast to appreciate modestly in real terms against the euro in 2013-16, in line with productivity differentials, as the economy recovers.
EXTERNAL SECTOR
Current-account data for the first half of 2012 indicate a significant improvement in the balance of merchandise trade, which—if sustained throughout the year—would narrow the current-account deficit below forecast levels. Given that the euro value of trade with countries outside the euro zone was adversely affected by euro depreciation, this reflects a real improvement in exports to non-EU countries. The current-account deficit is forecast to stabilise at 5-8% of GDP in 2012-16. Although Romania has been successful in narrowing external deficits since 2008, its low level of absorption of EU funding, falling inflows of FDI and relatively high levels of maturing debt make it vulnerable to serious deleveraging in the future, which would in turn reduce its import capability.
