Inflation has been steadily accelerating since the 3.8 per cent level registered in June, as have retails sales, construction activity and prices and wages and salaries in the construction sector. A drought damaged two-thirds of Romanian crops earlier this year, and this has clearly had an impact on food prices. However the inflation process is much more generalised, and the services sector as a whole also registered a 6 per cent year on year rate in September.
The whole situation is not aided by the weakening value of the leu, since the steady increase in value over the last two years had acted as a break on the inflationary process. The Leu has however declined 5 around percent against the euro over the last two months.
This situation, however, is far from clearcut, since a reducing leu also can help restore cost competitiveness in the export sector, a competitiveness which, as we will see in my next post, has been dramatically undermined by the surge in wage costs and the higher leu. In this sense a steady downward adjustment in the currency would perhaps be a more palatable solution to the issue of lost cost competitiveness than is the drastic wage deflation one which is being applied in Hungary.
There are however two problems here. The first one is that any such adjustment downwards in the currency needs to be gradual, not abrupt. The big danger in Romania now is of a sudden correction, and the IMF in its World Economic Outlook was warning only yesterday of the dangers which a sudden reversal of capital flows would represent in the East European context.
The second is the presence in Romania, as elsewhere across the EU10 of substantial corporate and private debt liabilities which are not leu denominated (ie they are in euro, swiss francs, dollars, or whatever). Any large reduction in the value of the leu would immediately present a problem in this regard, and this has to be one of the big risk areas for the hard landing scenario in the Romanian context.
The International Monetary Fund mission which is in Romania at the present time have explicitly warned about the problem that a widening current account deficit makes the leu much more vulnerable to external pressures, such as the reluctance of investors to put money into emerging markets amid the U.S. subprime crisis. I can only endorse that warning.
Of course the other problem here is the loss of real monetary policy influence at the central bank. Romania's central bank targets a year-end annual inflation rate of 4 percent, plus or minus a percentage point, a rate which has been adopted as part of the background scenario for Romania's possible adoption of the euro in 2014 or after. The central bank cited higher-than-expected inflation in August when it decided on Sept. 26 to keep its key interest rate unchanged at 7 percent, after cutting it four times earlier in this year.
The key rate, the annual amount the central bank offers to commercial banks for one-month deposits, was 8.75 percent when Romania joined the European Union in January, the highest in all of the 27 member countries. The next central bank interest rate decision is scheduled for Oct. 31.
The cost of services is rising alarmingly, and one of the difficulties is that prices here are often indexed to the euro. Service prices rose by a monthly 1.4 percent in September after rising 1.1 percent in August, while the annual rate was 6.3 percent, up from 6 percent in August.
Food prices rose a monthly 1.9 percent in September from 1.7 percent in August and an annual 8.2 percent, from 5.4 percent. Non-food goods prices increased a monthly 0.2 percent, from 0.1 percent, and a yearly 4.1 percent, the same rate as in August.
The International Monetary Fund forecast yesterday that year-end annual inflation in Romania would be about 5 percent, which is again up from the 4.9 percent registered at the end of last year. I would say that there are upside risks on this estimate, given what we are seeing on the construction activity and labour shortages front.
The government plans for a 2008 budget deficit of about 2.7 percent of gross domestic product next year, from a deficit of between 2 percent and 2.8 percent this year. The central bank has also said that increases of wages, which grew at an annual pace of 23 percent in August, are unsustainable and are a threat to its inflation targets.
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