Facebook Blogging

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Thursday, November 1, 2007

Romania Monetary Policy and the Leu

Last week Romania's central bank raised its key interest rate a half percentage point to 7.5 %. This was the first increase in more than a year. The move came after the inflation rate rose to a one-year high of 6.03% and with a year end planned increase in government prepares spending as a backdrop. The central bank, which had previously cut the Monetary Policy Rate four times in the last year year raised the rate at their regular monthly board meeting held in Bucharest. Romania's annual inflation rate rose in September for the third successive month, and was up from 5 percent in August and a full 2.23 percentage points from the 3.8% rate recorded in June. Clearly this kind of rapid rise in inflation, apart from being disturbing, now puts the Romanian inflation rate well above the central bank's year-end target which is in the 3 to 5 % range . The central bank now estimates that the annual inflation rate will still be at 5.7% in December 2007 and at 4.3% in December 2008 (respectively 1.8 percentage points and 0.6 percentage points above the projections published in the August 2007 Inflation Report).

According to the news release which accompanied the decision:

"The persistence of negative supply-side effects, high household income dynamics, the projected rise in public spending towards year-end as well as uncertainties over leu exchange rate movements signal that end-2007 inflation will exceed the upper limit of the 3-5 percent target band, the central bank said in its news release today."

In fact the National Bank of Romania has a year-end inflation target of 4 percent, plus or minus a percentage point, but bank Governor Mugur Isarescu already admitted in an Oct. 15 interview that the bank is more than likely going to miss this target.

The benchmark interest rate, the rate which the central bank offers commercial banks for one-month deposits, was 8.75 percent when Romania joined the European Union in January, and at the time was the highest among the Union's 27 members. The bank initiated a rate reduction cycle when it cut the rate in February at what was its first monetary policy meeting of the year, citing at the time slowing inflation. It went on to cut again at its March, May and June meeting, after which it introduced a "pause" and left the rate unchanged at its last two meetings since inflation had stopped falling and started to rise once more. The central bank has continually indicated its concern that rising food costs combined with future government spending plans constitute a substantial threat to its inflation targets.

If we look at food costs, these are indeed rising, and fast. Some agricultural products were up in September by 10.8% just from June (and 8.4% from July). Also there have been substantial increases in the price of certain processed foods with significant shares in the core inflation basket - and these tend to exhibit fairly inelastic demand - which are the consequence of declining agricultural output following this year’s severe drought and of the negative base effect associated with the bumper harvest of 2006.

The government is targeting a 2007 budget deficit of between 2 percent and 2.8 percent of gross domestic product, a deficit which is up from the 1.7 percent deficit achieved last year, and adopting a "procyclical posture" which is very hard to understand or justify at a time when the Romanian economy is suffering from severe supply side capacity constraints and in all probability is operating already with a negative output gap.

The government has in fact posted a budget surplus of 0.3 percent of GDP in the first eight months of the year, and this implies that the full force of the forecast spending increase will be felt during the last quarter of this year, putting added pressure on an already over-strained economy. The government has said it plans to increase spending on infrastructure and social programmes this year as part of a longer term project of bringing Romanian living standards more into line with those which exist in other member states of the European Union.

The leu's gains against the dollar and the euro over the past two years have acted as a brake on rising prices and slowed inflation by making those items whose value is measured in euros, but which are paid for by Romanian citizens in lei, cheaper, since in Romania, rent, petrol, phone bills and many other goods and services are quoted in euros and paid in lei. The leu has however declined by 5 percent against the euro since the beginning of August, and this has been adding to pressure on consumer prices.

But while the inflation threat presented by rising food costs and the steady decline of the leu vis-a-vis the euro since mid August should not be underestimated, we should never forget that the big supply side constraint in Romania is labour supply - and especially with all those workers abroad being unavailable for domestic work yet sending mony home to fuel consumption and construction activity. The most direct reflection of this is to be seen in the wages data, and wage inflation which is now running at over 20% annually.

Also the widening current-account deficit clearly makes the Romanian currency vulnerable to further declines if the credit tightening which has followed the U.S. subprime crisis continues to work its way through the system and makes international investors reluctant to continue investing in countries they see as carrying a higher risk.

According to the most recent ECB bank lending survey (october 5th), banks told the ECB that they may make it harder for companies and households to borrow money in the fourth quarter of 2007. The European Banks surveyed reported more-stringent lending standards than those applied in the third quarter and said they expect "further net tightening of credit standards for enterprises and home purchases". Credit conditions for consumers would become "considerably" tougher, the survey found. It is just this sort of environment which may put the Romanian currency at ever greater risk.

The Romanian current-account gap widened in the first eight months of the year to 10.23 billion euros ($14.7 billion) from 5.47 billion euros a year earlier, according to data provided by the central bank said on Oct. 15. Much of the growth in the CA deficit has been created by a widening of the trade deficit caused by a surge in imports as the leu's longer term gains have made them comparatively cheaper for Romanians while at the same time import barriers came down following entry to the EU.

Foreign currency lending in Romania has, according to the central bank governor, "exploded" in the past five months, increasing the risk that any substantial depreciation of the local currency will make the loans harder to repay, and produce strong deflationary effects on domestic demand due to the balance sheet consequences for private households. In fact private debt in foreign currencies in Romania, which is mostly in euros, rose by 66% year on year to around 20 billion euros in September

"In the last four or five months, credit in foreign currencies exploded.....When we raise rates, foreign currency loans rise because they look cheaper. We have reached a limit of monetary policy.''
Mugur Isarescu speaking at a seminar in Bucharest last week

No comments: