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Moment of truth

Despite significant structural change over the past five years, Romania faces daunting macroeconomic challenges as it gears up for EU membership.
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These are wearing times for Romania as it enters the final stretch in its gruelling preparations to join the EU. After signing an accession treaty, along with Bulgaria, in April 2005 with a view to entering the EU in January 2007, the coalition government of premier Calin Popescu Tariceanu has been struggling to complete the adoption of the acquis communautaire, the body of EU law, by the deadline of April 30.

The European Commission, which has been mulling postponing Romania’s accession by one year to January 2008 after issuing a critical report last October that cited several areas of concern (notably the fight against corruption), will make a final decision on May 16 whether to admit Romania in 2007 or 2008. While the government’s courageous efforts to stamp out graft are likely to convince the EU to opt for 2007, Romania’s ability to pursue far-reaching reforms is in doubt.

Rifts between the two main partners in the ruling coalition – the centre-right National Liberal Party (NLP), which favours free-market policies, and the centre-left Democratic Party (DP), which is more socially-minded – and between Mr Tariceanu and Romania’s president, Traian Basescu, are imperilling the 15-month-old coalition, raising the spectre of a snap election this year.

Lagging reform

However, as a report on Romania by rating agency Standard & Poor’s notes: “EU membership is the central objective of all mainstream political forces, the reform process has slowed down after the signature of the accession treaty and political cohesion has weakened.”

Moody’s, another rating agency, adds: “While the focus on accession has forced a measure of policy coherence, [Romania suffers from] an inconsistent and sometimes erratic track record in macroeconomic policy.”

Yet Romania’s policy makers insist the reform process is in full swing and is “anchored” by the prospect of EU membership. “We have implemented a lot of reforms over the past several years under strong external pressure,” says Sebastian Vladescu, the country’s finance minister.

The Romanian economy has grown briskly over the past five years. While growth slowed markedly last year, falling to 4.1% compared with 8.4% in 2004, largely because of the effects of a rising currency and severe flooding, Mr Vladescu is happy with the trend and the structure of growth.

He says: “8.4% was described as overheating and now 4.1% is being viewed as a spectacular drop.

“This is missing the point. For some time now, growth has been based on real factors, not subsidies or government inputs. There’s no reason why we can’t have strong growth of at least 5% for the next several years.”

Mugur Isarescu, governor of the National Bank of Romania (NBR), says Romania has finally achieved a “critical mass” of economic reforms after shunning institutional and structural changes in the 1990s. “There is a consistency in our reform efforts, which was previously lacking. We have seen [steady] disinflation and economic growth since 1999.

“The crucial catalyst was the EU accession process. Even after we joined the North Atlantic Treaty Organisation [in 2004], there was a sharp increase in foreign direct investment. This was the turning point,” he notes.

Banking sell-off

The privatisation process has advanced considerably. Last December, the government sold a 62% stake in Banca Comerciala Romana (BCR), Romania’s largest lender and the last big state-owned bank in central and eastern Europe, for €3.75bn to Austria’s Erste Bank. This is the largest amount paid for a central and eastern European bank.

In 2004, the government sold a strategic stake in SNP Petrom, Romania’s oil and gas concern, to Austria’s OMV. The government plans to complete the privatisation of RomTelecom, the national carrier, and has launched the privatisation of Casa de Economii si Consemnatiuni (CEC), the state savings bank.

Although Romania still needs to restructure its large state-owned firms, which, according to Moody’s, “act as a drain on the public finances and distort the efficient allocation of resources in the economy”, privatisation receipts and capital inflows have boosted foreign exchange reserves.

According to data from the Romanian central bank, foreign direct investment (including capital transfers) covered 110% of the country’s current-account deficit in 2004 and 85% in 2005. In a recent note on Romania, HSBC says the favourable composition of Romania’s external financing reduces the likelihood of a currency crisis stemming from the country’s large current-account deficit, which last year stood at a perilous 8.7% of GDP.

Flat tax controversy

On the fiscal front, Romania has made good progress in trimming its budget deficit. Last year’s deficit was only 0.8% of GDP, after a deficit of 1.2% in 2004 and 4% in 2000. The 2005 figure appears all the more impressive given that last year the government introduced a 16% flat tax on personal and corporate incomes (from 20% and 18-40% respectively) and granted public-sector employees a massive 50% pay rise.

Yet if it was not for buoyant domestic demand, stemming from a consumption boom, the budget deficit would have been much bigger. According to the International Monetary Fund (IMF), the flat tax resulted in a revenue loss of 1%-1.5% of GDP.

However, the finance ministry was able to recoup the shortfall through higher indirect taxes, particularly value added tax (VAT) receipts. The IMF, in its latest assessment of Romania’s economy, also claims “a significant relaxation of fiscal policy took place in December [2005], swinging from a budget surplus of 1% of GDP in January-November to a deficit of 0.8% of GDP for the year.”

Relations between Romania and the IMF are fraught following the Fund’s decision last October to declare its ‘stand-by arrangement’ with the country “off-track”. The IMF claims the government is not doing enough to entrench macroeconomic stabilisation at a time when voracious consumer borrowing is stoking inflation and increasing the current account deficit.

It advocates “targeting a balanced budget in 2006 and small surpluses over the medium-term, [while introducing] an ambitious and transparent medium-term budget framework”.

Mr Vladescu disagrees: “The IMF is saying that [the central bank’s] monetary policy can’t be entirely responsible [for curbing inflation and reducing the current-account deficit]. They’re asking us to support the central bank. But we have lots of [EU-related] expenditures, particularly on infrastructure.

“Can we really afford to postpone our development until inflation and the current-account deficit are at a low enough level? We have very good relations with the central bank. This is a philosophical and policy debate [about post-communist transition economies].”

Central bank dilemma

Romania’s central bank, which has won plaudits for reducing headline inflation from more than 40% as recently as 2000 to 8.6% last year, is in a quandary. Following its decision in August 2005 to abandon exchange-rate targeting and switch to a regime of formal inflation-targeting, the central bank is confronted with an acute policy dilemma stemming from what HSBC calls “an unfortunate coincidence of events in 2005”.

Just as Romania liberalised its capital account, drawing in “hot money” from portfolio investors in search of higher yield, the government fuelled a consumption boom by introducing a flat tax and increasing public-sector wages.

As Moody’s notes: “While high interest rates are necessary to restrain domestic demand, slow down credit growth and break inflation expectations, they also attract speculative inflows, pushing up the value of the currency.”

Mr Isarescu says: “The main motor of growth has moved from exports to domestic consumption. I would have no problem with this if inflation and the current account deficit were low. But that’s not the case. The flat tax came at the worst possible time from the economic point of view. We have to solve this problem [not by tweaking with] interest rates [but] by using unorthodox measures.”

Lending curbs

In an effort to tighten monetary policy with the aim of curbing credit growth (which according to an IMF working paper soared by 165% between 2000 and 2004) without strengthening the leu, the NBR has made it more difficult for Romania’s commercial banks to borrow and lend in foreign currency – which last year accounted for more than half of non-government bank lending.

Since banks are the main external borrowers, with much of the borrowing made by local subsidiaries from their parent institutions abroad, the NBR has raised the minimum reserve requirement on foreign currency-denominated liabilities to 40% and placed curbs on banks foreign lending to unhedged borrowers.

While credit growth has slowed, it still increased by 50% last year, reflecting the undeveloped nature of the banking sector in Romania where the ratio of private-sector loans to GDP is only 21%, compared with more than 40% in the Czech Republic, 66% in Croatia and a eurozone average of 115%.

Moreover, Romanian banks, like their Croatian counterparts which also face stringent regulations on foreign currency borrowing, have found creative ways to circumvent the restrictions, making it difficult for the NBR to limit foreign currency lending.

As investors become increasingly skittish about rising interest rates in the US and the eurozone, the ‘carry trade’ – borrowing in low-yielding currencies and investing in higher-yielding assets, such as emerging-market bonds and currencies – is showing signs of going into reverse. The fall in investors’ risk appetite has been most evident in those economies with large current account deficits, such as Iceland, New Zealand, Hungary and Turkey.

According to HSBC, Romania, whose current account deficit is large by international standards (but not as high as some other eastern European countries, such as Estonia, Latvia and Bulgaria), could be vulnerable to a sharp fall in global risk appetite and a consequent capital outflow, partly because of its floating currency regime.

“If a capital outflow were to take place, Romania runs a much higher risk that the effects of such an outflow would be transmitted to the exchange rate quickly and, possibly, painfully,” HSBC notes.

Bumper reserves

However, unlike Hungary, which has used the flood of global liquidity to run a large budget deficit, fiscal policy in Romania, despite criticisms from the central bank and the IMF, has not been loose.

The country has also accumulated significant foreign exchange reserves, which grew from €10.8bn at the end of 2004 to €18.3bn as of April this year, covering 5.4 months of imports.

“I think we have very good defences. First, we have huge reserves and a low stock of public debt. Second, the Romanian capital market is very small,” says Mr Isarescu.

“Romania’s capital market is much smaller and less liquid than Hungary’s. I don’t think we’re at risk [from a sell-off in emerging markets],” he adds.

Infrastructure needs

A much bigger challenge for Romania is to secure the necessary funds to invest in its ramshackle infrastructure. Despite several years of brisk growth, Romania’s GDP per head (at market exchange rates) in 2004 was a mere $3362, according to Standard & Poor’s, ranking it as the poorest EU accession country along with Bulgaria.

Mr Vladescu says that in order for Romania to catch up with EU living standards, the government needs to commit to significant investments in education, healthcare and the network industries. “Infrastructure development is the number one challenge and the key to catching up with the west,” he says.

Mr Isarescu agrees that there is an urgent need to modernise but is concerned that an investment boom could stoke inflation and further widen the current account deficit, endangering Romania’s path to adopting the euro in 2012-14. “There are a lot of pressures to develop rapidly and invest in infrastructure, and this is perfectly understandable. But we need to be patient. We are finally getting the consistency in [economic] reform that was lacking in the past. We have to be careful not to put this at risk,” he says.

For the time being, however, Romania’s policy makers are more concerned about being admitted to the EU in January 2007, fearing that a one-year delay could imperil the reform process. “There are two ways to deal with a pupil [with difficulties]: put the student in the back of the classroom and tell him to improve or get out, or bring him to the front of the classroom and encourage him to learn. We will accomplish much more if we feel we are part of Europe,” Mr Vladescu insists.

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Read more about:  Central & Eastern Europe , Romania