Romania’s overheating economy

Author: Countries and Consumers

Date published: 14 Mar 2008

In early February 2008, the Romanian central bank raised interest rates for a third consecutive time to 9.0%, as inflation and currency pressures threaten to derail the heated economy and burden consumers and businesses with unsustainable debts.

Issue

Despite continued strong growth in 2008, there is a growing risk that Romania's macroeconomic imbalances – rising current account and budget deficits and renewed inflationary pressures – will put downward pressure on the leu, exposing indebted consumers and businesses to higher financing costs. Investment inflows may decline as cautious investors shy away from countries perceived as higher risk amid the global credit crisis.

Importance

Real GDP growth in Romania – which averaged 6.4% in 2003-2007– has been built on a surge in consumer spending, facilitated by wage and credit growth and increased macroeconomic stability as the government overhauled the economy ahead of EU accession in 2007:

Wages and disposable incomes have been rising quickly, from a low base:

In 2007, net monthly wages rose an annual 23.5%, while public sector wages rose 20%;

The proportion of households with a disposable income above US$15,000 reached 33.7% in 2007, from only 4.0% in 2003;

Consumer expenditure reached €85.3 million in 2007, up from €33.0 million in 2002.

The growth in consumer spending has been heavily debt-fuelled. There has been a rapid increase in domestic lending, in the context of a marked decline in inflation and interest rates since 2003:

Annual inflation averaged 4.3% in 2007, down from 22.5% in 2002;

Domestic credit growth averaged around 55% annually in 2005-2007, while credit growth to households was even higher.

Approximately 50% of private sector loans (household and corporate) are foreign currency (i.e. euro) denominated, amid low interest rates and a strengthening exchange rate ahead of EU accession. This leaves Romania exposed to a shift in external conditions.

Romania household disposable incomes: 2002-2007

Source: Euromonitor International from national statistics

Implications

Romania's economy is at risk of overheating, as strong private consumption and increased government spending are accompanied by a renewed rise in inflation.

Inflation has been driven up by supply-side pressures, particularly food and energy prices, as well as demand pressures from rapid GDP and consumption growth. The central bank missed its 2007 annual inflation target of 4.0% (+/- 1.0%):

Inflation ended the year at 6.6% in December 2007, up from 4.9% in December 2006.

There are rising current and fiscal account deficits:

In 2007, the current account deficit, driven by consumer goods imports, was worth 14.1% of GDP, while the fiscal deficit was an estimated 2.4% of GDP.

Real GDP and consumer price inflation growth and current account as a percentage of GDP: 2002-2007

Source: Euromonitor International from International Monetary Fund (IMF), International Financial Statistics and World Economic Outlook/UN/national statistics

The IMF and international ratings agencies have warned that Romania could be particularly vulnerable to a downturn in global financing conditions. The local currency, the leu, came under depreciatory pressure in the second half of 2007, amid fears about the impact of the global credit crunch on the indebted Romanian economy:

The exchange rate ended 2007 at RON/€3.58, down from RON/€3.39 at end-2006.

A fall in FDI, combined with a weaker currency, could have severe implications for the economy, by making the deficits unsustainable:

FDI inflows averaged US$5.6 billion a year in the period 2003-2006, typically financing 70%-80% of the current account deficit.

For consumers and businesses, the lower exchange rate has raised the cost of repaying euro-denominated loans. The private sector will also feel the pinch as other costs rise – for example, rent and utility bills are quoted in euro but paid in leu.

The central bank has been forced to tighten monetary policy in an effort to stem inflation and currency pressures and also rein in the record local credit growth:

In early February, the bank raised interest rates for a third consecutive time to 9.0%. It also left its minimum reserve requirements on commercial bank deposits at 40% for foreign-exchange deposits and 20% for local currency deposits.

Future scenarios

In 2008, economic growth will continue to be driven by government spending and private consumption, amid generous wage and pension settlements ahead of elections in the final quarter of 2008:

On January 1st 2008, the minimum wage was increased by 28%;

Real GDP growth is forecast at 6.0% in 2008, following estimated growth of 6.3% in 2007.

Amid growing concerns about the risk of an inflationary spiral the government has announced slower public wage increases in 2008. Public sector wage increases are typically mirrored in the private sector. Nonetheless, fiscal policy will remain quite accommodative, with expected higher government spending on infrastructure and social programs ahead of the elections.

In February, the central bank revised its year-end inflation projection to 5.9% annually, from 4.3% previously. However, inflation has not yet peaked and the currency remains under pressure. This means that further interest rate hikes are likely in the near term.

As the impact of monetary tightening gradually kicks in, inflation and consumption growth will be more muted in the second half of the year. This will result in lower business profits, while tighter lending conditions may also slow investment growth.

In the worst case scenario, a sustained downturn in external conditions could put further downward pressure on the leu and on local consumers and investors. In this scenario, real GDP growth could be more sharply affected.

Romania

Countries and Consumers

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