Charles Robertson of Renaissance Capital -
There are two types of countries: those countries where debt rose too fast up to 2008 and those countries where there is room for debt (and therefore asset prices) to grow. In the former camp, we obviously find most developed nations although some Emerging Europe nations fall within this category too, including Latvia and, probably, Hungary. In the latter camp are many of the most attractive emerging markets (EM). Two countries are presently in the centre of this Venn diagram, namely Kazakhstan and Romania. In both cases, debt soared in the middle of the last decade and both countries suffered harsh crashes, but their absolute levels of debt remain low enough, which means that there is a good chance that these countries will experience another period of strong growth during 2012-2015.
The highly effective implementation of IMF recommendations in Romania supports our view and this implementation is expected to continue under the new precautionary standby agreement. Reforms were needed. The former government allowed massive public sector wage hikes and a credit boom in 2006-2007, which saw the current account deficit balloon to 14% of GDP - double the level we found worrying in the late-1990s. The current government has taken away two months of salaries from the public sector and have also reformed the pension system, thereby helping slash the current account deficit to 4% of GDP in 2010. It could halve in 2011 as exports are now rising by 30-40%. On the fiscal side, a deficit of 8.5% of GDP in 2009 was cut to around 7% of GDP in 2010 and government aims for 3% of GDP in 2012. Even if this is not met, we assume public debt will be less than 40% of GDP in 2012, about equal to the aggregate private sector debt held by households and corporates. The combined public and private sector debt total of 75-80% of GDP in 2011-2012 will be less than Poland, half that of Hungary and dramatically better than the 240- 280% of GDP ratios in Spain, Portugal or Greece, let alone the 300%+ of GDP ratios in the UK and the US. With a small current account deficit as well, Romania will look like one of the safest credits in Europe. A credit rating rebound back to investment grade from Fitch and S&P (to join Moody's) should therefore be of no surprise, in our opinion.
EU membership continues to offer a supportive backdrop. While Romania has yet to utilise 90% of the EU funding available under some programmes for 2007-2013, finding the money to co-finance investment with this EU cash is the top priority for government spending in 2011-2012. Romania is evidently trying to move away from a consumption boom to an investment-led growth boom. The success of Renault's Dacia car plant has already led Ford to invest in Romania as well and others are likely to follow as wages are considerably lower in Romania than in Central Europe, while EU cash will (eventually) result in a better infrastructure in that country. The 16% flat tax regime also offers simplicity to investors.
Can the government stick to its budget target of 3% of GDP in 2012? Achieving 3% will be a surprise, as we (and others) assume the government will be keen to raise public sector wages following the 25% cut in wage costs ordered in 2010, especially given the local elections which are scheduled to take place in June 2012 and the parliamentary elections which are to be held at the end of 2012. This year is already proving tough for the Romanian population given the VAT hike to 24%, as well as rising food and energy prices, and the hit to domestic consumption means that we assume no household consumption growth at all in 2011. Only exports, industry and some investment growth is expected to help net exports deliver the 1.5% GDP growth planned for this year - in our view Romania is much like the UK in this respect. A possible 10-15% rise in public sector wages in 2012 will encourage households to not cut back too dangerously in 2011. Even if this means that the budget deficit is 4% of GDP in 2012, we doubt that the IMF and EU will be too upset. Romania will still look very good relative to certain other countries.
The surprise announcement to target euro adoption in 2015 was triggered by domestic political rivalry, which implies that whoever wins the 2012 elections will then reduce the budget deficit below 3% of GDP in 2014. The markets will certainly reward any post-election government which achieves this, but there is another hurdle to overcome first. In order to join, the euro requires at least two years in the ERM-2 and while there are no formal pre-conditions for this, the ECB has a de facto veto as it has to agree to a parity rate with the applicant country, around which it will intervene to defend a currency. The ECB refused to do this for Bulgaria in 2007, despite 10 years of Bulgarian lev stability. We therefore cannot predict whether the ECB will let Romania join the ERM-2 in 2012, despite the excellent reforms that have taken place in recent years and entry in 2012 will be necessary for euro adoption in 2015. If the ECB says yes, then we can assume that Romania will target the ERM-2 parity rate within a EUR4.0-4.3 range and that the central bank will resist any appreciation pressure on the Romanian leu to strengthen beyond EUR/RON4.0 in 2011 (and probably 2012 as well). For this reason, and because household consumption is so weak, we assume no change in the 6.25% interest rate in the near term.
In conclusion, we expect industry and exports to drive growth this year and consumption to pick up in 2012 and accelerate in the following years as bank lending rises. A return to investment grade is likely given the current low debt levels and better twin deficit data, in our view.
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