Florin Citu of ING -
The data shows that 2006 was a year full of surprises. The Romanian economy surprised with a growth rate above potential at 7.7% versus 6.3%. At the same time, CPI inflation fell at the end of the year below the central bank's target of 5% to 4.9% from 8.6% in December 2005. The outcome is more surprising given that domestic wages increased by 29.7% and private credit by 53.7%.
Some explanation comes from the Romanian leu's strong appreciation against the euro, at 8% in nominal and 11% in real terms. However, the strong wage and credit growth along with the strength of the leu contributed to a ballooning current account deficit, which finished the year at 10.3% of GDP. This picture full of contrasts does not, in our view, resemble an economy that is not too hot and not too cold ie, a Goldilocks economy. In fact, we are starting to see some signs of overheating even as data released by the National Institute of Statistics on Friday showed that real GDP growth moderated to 6% on year in the first quarter. This was below our 6.7% forecast and market expectations of 6.4%.
Quality not quantity
The first sign is obvious if you pay attention to the quality of work. Here, we are talking about either the quality of services provided or the quality of production. Regarding the latter, there is plenty of hard evidence and anecdotal stories showing that quality is starting to deteriorate. But we also think that it will take time until this effect works its way through the system and allows for a correction to clean it up.
Going forward, we see the current economic dynamic continuing for at least the next four quarters, but slowly deteriorating in 2008. Thus, we are adjusting our GDP estimates upwards for the next eight quarters mostly based on the current momentum. Although we see GDP growth decelerating from the 2006 level, we are increasing our estimate for 2007 output from 6% to 6.5%. For 2008, we only marginally increase our estimate from 5.5% to 5.7%, which still represents a 0.8% slowdown in economic growth from the previous year.
Why are we so optimistic in the short term?
As we said, one reason is the current momentum, but the second and most important is the beginning of a monetary policy easing cycle. In this respect, we see the central bank's key policy rate to fall to 7% in 2007, but acknowledge substantial downside risks to our scenario. This will give the private sector, be it corporates or households, access to cheaper funds. The third is that there are clear signs from fiscal policy that we are entering a period of strong public demand.
Furthermore, we do not expect any second-round effects from the relaxed fiscal and monetary policies to show up in prices in 2007. Thus we are bringing down our inflation forecast for 2007 from 5.3% to 4.3%. In the same base-case scenario, we see the EUR/RON exchange rate sharply lower in the first nine months of the year to 3.3 and then returning to 3.35 by December. All of these developments should deepen the disequilibria in the Romanian economy, with, especially, a worsening of the current account deficit.
In our view, this cannot go on forever, and the second-round effects from higher wages and strong credit growth should show up in domestic consumer prices, but not before 2008. We expect the trigger to be the reversal of the disinflation process in the latter part of 2007 with a continuation in the first quarter of 2008, when we see inflation above 5% on year. That is why we expect the EUR/RON rate to jump to 3.5 in the first quarter of 2008, which in turn should trigger a response from the central bank to raise the key policy rate to 7.75%.
However, our 2008 estimates depend very much on a correct and rapid response from the central bank. Otherwise, given the size of the current account deficit and a more developed bond market, which in our view is biased on the downside for yields due to the lack of instruments, the exchange rate move could be more pronounced, resulting in higher inflation with higher interest rates to be required in 2008 and 2009.
On the face of the current data, it seems the Goldilocks scenario of a "not too hot and not too cold" economy fits the Romanian economy in the short term. But we see more questions than answers with the current economic dynamics in Romania. In this respect, we believe that another fairytale fits this profile better: Little Red Riding Hood. This is because, like in the story, we have a lot of questions about the Romanian economy and no real answers. And finally, as in the story, we believe that 2008 might be the time when the big bad wolf will be revealed. We hope the economic policymakers will recognise it early on.
Florin Citu is Chief Economist of ING in Bucharest
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