Share the article
twitter-iconcopy-link-iconprint-icon
share-icon

Romania maintains momentum

Romania is celebrating a successful 2004 in which taxes were cut and GDP grew. Now its sights are set on EU accession and newly elected President Basescu faces some tough decisions in the longer term. 
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon

Last year was full of surprises for Romania. There was the unexpected success of Traian Basescu and his reformist Democratic Alliance in last December’s elections – considered by some as representing the real end of Romania’s communist era. Romania recorded an impressive overall economic performance with real GDP growing by 8.3% and it was the first time in the country’s post-communist history that prices rose by less than 10%. The newly elected government rapidly reduced income and profit taxes from 25% to 16% and last October’s EU report declared Romania a market economy and set it firmly on course for EU accession.

Against this backdrop, 2005 is gearing up to be even more interesting and challenging than 2004. The government will have to balance early economic and political success, with the hard choices required to stay the course for EU accession.

Macroeconomic outlook

The Romanian economy entered 2005 at full speed but the economic performance of the previous year will be difficult to duplicate. Last year’s economic growth has led to a current account deficit of close to 8%, once reinvested earnings are counted as current outflows.

This largely resulted from an increase of 50% in household lending and of massive transfers from Romanian workers living overseas, which were then channelled into domestic demand for mostly foreign goods. As a result, the boom in domestic demand is expected to continue unabated in 2005, mainly because pre-election wage increases, coupled with the new government’s tax cuts, the announced pension adjustments and continued local currency appreciation are expected to boost household disposable income even more. Also, further pressure will come from the 90% increase in euro-denominated lending to the private sector, which is already significantly larger than local currency lending.

Furthermore, the current account deficit will be under pressure from the expected capital account liberalisation, which should take place in the first half of 2005. Even though the National Bank of Romania (NBR) is expected to implement measures to restrain lending in foreign currencies, it is difficult to see how the current account deficit will not continue to expand in 2005.

In 2005, the National Bank’s monetary policy will be faced with a new dilemma: whether to target inflation or exchange rates. This is because the new monetary policy regime, inflation targeting, implies that the NBR will let the Romanian leu float and will only target consumer price index (CPI) inflation. In the current economic conditions, ultimately it means that the NBR will allow the leu to appreciate, exacerbating the current account deficit and reducing the economy’s global competitiveness.

Dilemma over leu

Under the new monetary policy regime, the NBR is expected to stick to the announced inflation target of 7%, year-on-year based on CPI, within a band of +/- 1%. However, the appreciation of the leu is a very sensitive subject and is creating a dilemma for the NBR, particularly as there is an increasingly vociferous lobby from exporters to curb this development.

However, the NBR’s biggest problem is that the main transmission mechanism for monetary policy remains the currency. Under these circumstances, the bank will still have to use the exchange rate to control inflation, meaning that direct interventions in the foreign exchange market will continue, albeit they will be less frequent and more unpredictable in size.

With the NBR’s policy interest rate at 14.5% and one-month deposit rates just above 10%, it is likely Romania will continue to attract speculators’ attention, given the abundant global liquidity and the resulting interest in local debt markets. Already, special purpose vehicles, together with a burgeoning London market in non-deliverable forwards, have allowed limited foreign exposure, which it is estimated has attracted nearly €2bn in capital.

The current liberalisation schedule envisages the opening of leu deposits in April and full access for foreigners to leu-denominated government securities by the end of 2006. A longer postponement would have allowed a more gradual narrowing of the interest rate gap, but the possibility of a delay in accession has made commitments to the EU a priority. This could spell trouble for the NBR, which looks likely to lose much of its autonomy on interest rates.

Privatisation anticipated

The fiscal loosening undertaken at the end of 2004 is expected to be countered by a tighter budget deficit and an increase in government revenues through accelerated privatisations. Though strong growth boosted 2004 fiscal performance, with a 1.2% of GDP deficit outcome against the originally planned 3%, the introduction of the flat tax created some uncertainty regarding revenue for 2005. The government is in talks with the IMF for a budget deficit target of 0.5%-07% for 2005, and as part of its negotiations, the new government has vowed to introduce new measures to cut losses in state-owned enterprises.

Unfortunately, this might not be enough to cover the potential imbalances created by the introduction of the flat tax. Thus, at the IMF’s insistence, the government has introduced taxes on capital gains that cover stock market gains, real estate and bank deposit generated income. Increases in VAT and in the flat tax remain distinct possibilities.

Further relief for the budget and current account deficits should come from the sales of the CEC savings bank and the largest bank, BCR, which are promised in 2005 and 2006 respectively. Energy sector sales will also help, but it will still be difficult to exceed the €4bn (around 90% of the likely current account deficit) attracted in 2004.

Political outlook

Although presidential and parliamentary elections were held only recently, many local pundits claim that there is a good chance there might be early parliamentary elections in the second half of 2005.

Tensions have already accumulated within the present multi-party coalition, particularly regarding the Humanist party, which holds a small but pivotal role in the government. With little room for error (for example, the Alliance has a majority of one in the Senate) politicians of all parties are constantly weighing the pros and cons of early elections against a backdrop of EU accession, which requires political stability and the nerve for making tough decisions.

For now, opinion polls show that the Alliance coalition, dominated by the National Liberal and Democratic parties, remains popular with the electorate. Therefore, the Alliance might want to capitalise on this situation and call for elections soon after the signing of the EU accession treaty in late April. However, smaller parties, as well as the Social Democratic and Greater Romania opposition parties, would prefer later elections to allow them more time to reorganise internally.

While the EU’s October Annual Report is the last realistic chance for it to invoke the one-year delay safeguard for Romania’s accession, at present this is unlikely, given the early robust progress made by the government in addressing the EU’s concerns over corruption. The EU remains the principal driver of Romania’s political and economic priorities and is set to play an ever-increasing role in the country’s future.

Long-term risks

In the context of a more competitive fiscal environment, coupled with decreasing interest rates, Romania’s economy is set to continue its strong growth in the short term.

However, the further one looks into the future, the more clearly distinguishable certain risks become. Already there is some uncertainty created by the delay of the signing of a new programme with the IMF. Furthermore, looking at evidence from Hungary and Poland’s recent past, it is clear that once a country’s EU membership date has been achieved, there is great temptation to loosen fiscal policy. Although, Romania will have to wait until October to make sure that January 2007 will remain its EU accession date, conceivably that still leaves room for giving in to such temptation, particularly if early elections become likely.

The political arena could also create some uncertainty. Even though the government has popular support, the coalition has faced defections over controversial appointments and could prove unstable in the long run.

Also, measures to reform the state enterprise sector, impose hard budget constraints and cut the build-up of arrears (currently at around 40% of GDP) are likely to prove highly unpopular as the pain of reform begins to set in.

This year is bound to be a good one for Romania. But with euro entry unlikely until 2014, an appreciating leu and an ever-widening current account deficit, the medium-term convergence path is likely to be anything but smooth.

Was this article helpful?

Thank you for your feedback!

Read more about:  Central & Eastern Europe , Romania