Highflying Romania starts its descent

Highflying Romania starts its descent
The question now is how hard Romania’s landing will be.
By Clare Nuttall in Bucharest June 20, 2018

The pace of growth in Romania is already slowing after the stunning consumption-fuelled 7% achieved last year – faster than even emerging markets powerhouse China. With warnings of overheating backed up by fast-rising inflation, the question now is how hard Romania’s landing will be. 

Forecasts for how much the Romanian economy will slow this year are mixed. Erste anticipates growth of just 4.1%, taking into account the Q1 figures released so far, and no more than 4.5%. This is well below the government’s optimistic 6.1% projection, while those from most IFIs fall somewhere in between. The World Bank anticipates 5.1% (a 0.6pp upgrade from its January forecast), as does the International Monetary Fund (IMF), while the European Commission projects a more conservative 4.5%. 

Data from the last couple of quarters shows the slowdown has already started; after growing 0.3% q/q in October-December 2017, q/q growth was flat in January-March this year, with the economy expanding by just 4.0% y/y during the quarter — the slowest rate since Q3 2015. 

“Some slowdown in consumption expansion was indeed inevitable, but there is some component of the economic slowdown which could have been avoided,” says Erste’s chief economist in Bucharest Horia Braun Erdei. 

“I am talking, on the one hand, about the worsening of the consumer confidence, which was associated with, firstly, the changes in the Fiscal Code that came into force this year and which increased at least in the short term uncertainty with respect to net wage income growth, and secondly, with the sudden jump in inflation and in interest rates,” commented Erdei. “These dented consumer sentiment in the second half of 2017 and showed up in the slowing retail sector activity in Q1 of 2018.”

Erdei notes two additional factors: the economic slowdown in the Eurozone, in particular in the manufacturing sector, which affected industrial production in Romania, together with adverse weather effects, though these are expected to wane over the coming quarters.

Is Romania overheating? 

Alongside the slowing growth, there are a number of signs that point to overheating in the economy, in particular rapidly rising inflation, raising fears of a possible hard landing. 

“Overheating is certainly an issue in a number of countries,” said Roger Kelly, EBRD lead economist, economics, policy and governance, singling out Romania and Turkey at the EBRD’s presentation of its latest Transition Report at the Romanian central bank on June 12. 

“It stems from different factors but there’s a common denominator of an over-exuberance of policy support in periods when the economy perhaps doesn't necessarily need it. This is often characterised by pro-cyclical fiscal policies, for example,” Kelly said, voicing one accusation that was repeatedly levelled at the Romanian government last year. 

“The problems are compounded in Romania and other SEE countries by the labour market issue, the extremely tight labour markets which put pressure on inflation,” Kelly added. This emerged first in Poland and other Central European countries, but is increasingly also an issue in Romania which saw the fastest hourly average labour cost rise in the EU in April, as well as the largest hike in employment of any EU country in Q1, according to Eurostat. 

“Romania’s economy is overheating,” concurred Capital Economics analysts in a June 12 note, adding that, “Unless monetary policy is tightened markedly in the months ahead, a nastier adjustment and more abrupt slowdown in GDP growth lies in wait.”

On June 6, the IMF also “expressed concern about the risks of overheating of the Romanian economy due to higher inflation and the twin deficits, as well as lagging investment and slower structural reforms, and called for a tighter macroeconomic policy stance.

Rising deficit 

When it comes to the 2018 budget deficit, Erste’s forecast is for 3.4% of GDP — well above the 3% of GDP threshold for the European Commission’s excessive deficit procedures — provided that no other fiscal adjustment measures are undertaken by the government. 

“Officials may nevertheless have a few aces up their sleeves, such that a below 3% budget deficit remains a plausible scenario,” commented Erdei to bne IntelliNews. “When I say aces I mean some other temporary fixes, which nevertheless do not solve the structural problem of the budget which is that revenues are too low compared to GDP and that expenditures are growing too fast and they are sticky, whilst revenues are not, especially in case of a more severe economic retrenchment.”

Some mentioned by Finance Minister Eugen Teodorovici, for example, include “refinancing” some of the local investment expenditures from EU funds or incentivising taxpayers with arrears to the budget to pay down their overdue amounts in exchange for some discounts. 

“In my view, these measures are questionable and the mere fact that the finance minister is mentioning them reflects an admission of the fact that there is a material pressure on this year’s budget deficit,” says Erdei.

At the same time the National Bank of Romania has been tightening its monetary policy, raising the benchmark interest three times this year, by a total of 0.75pp, to tame inflation.

“Our central view is that the policy rate will be raised to 3.50% by end-2018, with the next hike likely to come in July. We envisage a further 75bp of hikes in 2019. If this pans out as we expect, inflation will return to within its target range next year and the current account deficit will narrow. In this base case, we see GDP growth slowing to 3.5% over 2018 as a whole, before easing to 2.0-2.5% in 2019-20,” commented Capital’s analysts. 

While noting that interest rates could be raised more gradually, they warn: “If policy is tightened too slowly, it’s likely that there would be a further build-up of macro imbalances. Unless some steam is taken out of the labour market, wage growth will rise further and price pressures will remain elevated. And if domestic demand doesn’t cool, the current account position will continue to deteriorate, bringing the leu under pressure. This could cause inflation expectations to spiral out of control,” Capital analysts warn. 

New model for Romania 

While the central bank looks to address the current issue of rising inflation, Matteo Patrone, the EBRD’s country director for Romania, Bulgaria and Turkey, believes that for the longer-term Romania needs a new growth model. At the development bank’s presentation on June 12, he stressed that Romania faces similar problems to other middle-income countries in sustaining growth once they reach a certain level of GDP per capita. 

“GDP has been growing above potential based on consumption fuelled by higher salaries, not necessarily met by corresponding increases in productivity, so to continue and possibly accelerate on the path of convergence Romania and many of the countries in our region … requires a new model based on innovation and integration in the global the global value chain,” Patrone said. 

To some extent he takes a positive view on Romania, commenting that, “It is my personal conviction that Romania is very well based on this path because of human capital in leading edge technologies like IT, aerospace or automotive, to name a few.”

“But there are a number of ingredients that are still missing or that should be nurtured. I believe that infrastructure is the crucial ingredient.”

A similar position was set out in the European Commission’s annual country report on Romania. In the absence of structural reforms and fiscal consolidation, Romania’s buoyant economic growth risks setting the stage for a hard landing, the Commission concluded. Some structural reforms were reversed in 2017 while others stalled, and no tangible results were achieved on public administration reforms, the report said. 

Investment needed 

Erste’s Erdei describes the recession in public investments as “endemic”; “the government faces important constraints both in terms of available fiscal space to finance investments and in terms of administrative capacity to handle especially large infrastructure projects,” he notes. 

He also warns of the short-term fallout from the so far very effective anti-corruption fight that has “discouraged public officials from assuming responsibilities in public procurement processes and in other public procedures out of the fear that they may come under the Anti-Corruption Prosecutor’s Office (DNA)’s scrutiny”.

Investments in the private sector, meanwhile, are at risk of being disrupted by political uncertainty. Associations representing major investors such as the Foreign Investors’ Council, Amcham and the Romanian-German Chamber of Commerce and Industry (AHK) have been warning about this since of last year. The uncertainty was caused first by the government’s attempts to undermine the anti-corruption fight that sparked mass protests, and later by the repeated collapse of governments (the current incumbent Viorica Dancila is Romania’s third prime minister since early 2017) and policy reversals. 

“[Private investments] have stepped up their pace somewhat in 2017, but the growing local uncertainties related to the fiscal and the political environment and global uncertainties related to trade tensions and growth momentum especially in Europe represent important headwinds,” said Erdei. 

Neither political nor policy uncertainty has eased in the first half of this year. The government’s efforts to strike at the DNA, that has targeted many key figures from both government and opposition, had a breakthrough when the Constitutional Court ruled President Klaus Iohannis had to comply with a request from the justice ministry to dismiss DNA chief and emblem of the anti-corruption fight Laura Codruta Kovesi. While the anti-corruption protesters that once flooded the streets in their hundreds of thousands appear to be losing hope, a constitutional crisis is looming with Iohannis’ refusal so far to comply with the Constitutional Court’s ruling. There are already rumours the ruling coalition plans to launch procedures to impeach the president, which could tie up political decision making in legal wrangling until the next electoral cycle begins with the 2019 presidential election. 

Meanwhile, the ruling coalition faces its own internal problems as the verdict in the trial of its head, Social Democratic Party (PSD) leader Liviu Dragnea, approaches on June 21 after repeated postponements. Should Dragnea be sentenced to prison this would lead to a speedy withdrawal of support for his protégée Dancila and the collapse of yet another government. The PSD has so far managed to counter efforts by the Pro Romania, a party co-led by former PSD head Victor Ponta, to skim off its MPs and erode its parliamentary majority, but it would be weakened if the verdict goes against Dragnea. 

Meanwhile, on the policy front the government finally appears to be taking measures to address the yawning deficit. Having already angered public sector workers with changes to the social security system that cancelled out promised wage hikes, it more recently turned its attention to the pensions system. While not official confirmed, speculation is rife that Bucharest plans to temporarily suspend contributions to the second pillar of the pension system to finance the widening budget deficit. It’s not clear what steps the government will take in this regard, but the rumours have already hit Bucharest’s once buoyant stock exchange.  

“In the case that a major overhaul of the private pension system were to be the end game, the short-term direct implications on the economy may be limited, however financial market implications can be more significant, given that private mandatory pension funds are big players both on the local government bond market and the local equity market,” says Erdei. 

“Should their investment flows disappear from the local financial markets, these markets will lose in terms of depth and liquidity and especially in terms of local buying power. 

This would also have long-term consequences that go far beyond the current slowdown as Romania, like most EU countries, has to ensure it has a sustainable pensions system capable of providing for its ageing population in future.