Nicholas Watson in Prague -

Romanian exporters lost about €1bn in the first half of the year because of the strengthening of the local currency and few expect these businesses to get much respite for the rest of year. The outlook for 2008 is marginally better, however.

The country's Association of Exporters and Importers (ANEIR) said on July 11 that Romanian exporters lost €200m in June alone because of the strengthening of the leu, which has risen about 8% in value against the euro since the beginning of the year. ANEIR's chief, Mihai Ionescu, estimates that Romanian exporters lose €25m with each percentage point the Romanian leu appreciates against the major currencies.

The inevitable result, says Ionescu, will be a considerable number of bankruptcies in the second half of this year, as exporters bear the brunt of the cost of the higher currency both in terms of lower revenues and lost orders. The central bank and the finance ministry, therefore, should take steps to slow the strengthening of the leu, he argues.

This call was backed by Ioan Cezar Coraci, president of the General Union of Romanian Industrialists 1903 (UGIR-1903), who warned that the country's economic growth was threatened by the costs incurred by the higher leu.

Happily for the exporters the central bank has obliged, causing the leu to stabilise around the 3.1000 level against the euro by mid-July. However, because of the nature of the factors behind the leu's appreciation, few expect the currency to return to the previous level of 3.4000 seen at the start of the year.

An intervention

The leu's initial appreciation at the start of year was put down to the country joining the EU in January and the generally positive feeling towards the Romanian economy given its robust GDP growth and high productivity gains. These attributes attracted massive inflows onto a relatively thin local market.

Indeed, Romania's current-account deficit for January-May more than doubled form the year before to €5.94bn, driven by the surging domestic demand and the stronger currency. And on July 18, a survey by Eurostat ranked Romania second in the EU by growth in imports, after neighbour and fellow EU newcomer Bulgaria. Romania's imports rose 31% from January to April, while Bulgaria's imports rose 48%, Eurostat said. Romania had in the first four months of the year imports worth €15.1bn, putting the country 18th in terms of value. New passenger car sales in June increased by almost 25% from the year before.

"Romanian imports continue to surge, boosted by surging domestic demand and by the ongoing strengthening of the leu as capital flows in from abroad," says Charles Movit of Global Insight. "Import demand is further supported by rapidly expanding domestic credit to the private non-financial sector."

On June 25, Romania's central bank responded by cutting interest rates 25 basis points to 7%, justifying the fourth cut this year on the continued disinflation that has brought annual inflation in May down to 3.8%.

However, analysts say the effect of this rate cut was to fuel rather than halt the leu's rally, because the central bank's inappropriate operational framework caused short-term rates to spike into double-digit territory. This yield advantage encouraged new international investors to get exposure to the local currency.

"As a result, we believe that the leu's appreciation of 8% against the euro this year is mostly the result of financial markets’ conditions and less supported by economic fundamentals," says Florin Citu, deputy head of financial markets at ING in Bucharest.

This "hot" money pushed the currency to a historical high of just 3.0900 against the euro on July 2 in what Citu described as "a speculative currency attack," leaving the central bank with little option but to consider intervening to push the currency lower. The central bank has so far avoided intervening directly in the market, but has done so covertly it is believed between July 3 and July 12, with dealers reporting the central bank buying the local currency through a large local bank to bring the rate down to 3.1350 against the euro. According to economists, the market now reckons the central bank is committed to defending the 3.1000 level, with 3.1250 - the last floor at which the central bank has intervened - being a strong psychological support level.

So what are the predictions for the rest of the year and next?

The economy, which has done so much to attract investors into the currency in first place, could well come to the exporters' rescue. When the central bank lowered rates at the end of June, it warned that: "risks related to wage rises, a pro-cyclical fiscal policy and to wider external imbalances require the maintenance of a prudent monetary policy stance."

Indeed, the expected higher inflation – the Economist Intelligence Unit reckons inflation will overshoot the central bank target and measure 4.4% at end-2007 - and the widening current account deficit, which shows no signs of slowing down, should make foreign investors demand a higher risk premium for holding Romanian assets, say analysts.

"Thus, we pencil in a correction of the leu in the first half of 2008 due to a bond market sell-off with a considerable contribution from deteriorating fundamentals with an ever-widening current account shortfall and probably very expansionary fiscal policy," says Citu. "The rate hike in the US expected at the beginning of 2008 could act as a trigger and the leu should be regarded as one of the main suspects in a flight to quality sell-off scenario. As a consequence, we expect euro/leu to revisit the 3.4500 level before returning towards the end of 2008 to 3.2500."

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