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Tuesday, July 10, 2012

Whom The Gods Would Destroy

The Times They Are A Changin, as the old song goes. Neither in jest nor in total earnest was a truer word ever said in terms of the 2 year old Euro Debt Crisis. The to-ing and frowing of the last few days as the commitment to decision of the most recent summit started to wobble only serves to underline how hard it is at times to change. These days I have no central "Euro" scenario. Only tail scenarios exist, under which the debt crisis veers in either one direction or the other accodring to the decisions taken or the absence of them. Naturally this makes the eventual outcome very hard to forsee, which is why the financial markets are having such a hard time of it, and why we see so much volatility.

In the case of the full banking, political and fiscal union scenario the efficient causes which could make it happen are obvious: just keep the various participants looking down into the abyss often enough and long enough. In the case of complete breakup things are rather different, since it is hard to concretise what would actually bring it about, although the risk is evident, and indeed in many ways it seem a more probable end point than the other one.

After thinking about this for some time, the conclusion I have reached is that it is towards political risk, and the progressive destabilising of Europe's democratic systems, that we need to look, which is what makes recent events in Romania look like something rather more than a mere historical footnote.

According to Princeton Professor Kim Lane Scheppele:
"A political crisis has gripped Romania as its left-leaning prime minister, Victor Ponta, slashes and burns his way through constitutional institutions in an effort to eliminate his political competition. In the last few days, Ponta and his center-left Social Liberal Union (USL) party have sacked the speakers of both chambers of parliament, fired the ombudsman, threatened the constitutional court judges with impeachment and prohibited constitutional court from reviewing acts of parliament – all with the aim of making it easier for Ponta to remove President Traian Basescu from office. They hope to accomplish that by week’s end".
Well, in fact it was on Saturday President Basescu's opponents finally achieve that last objective, since in a majority vote by the two chambers of the country's Parliament he was effectively impeached. He was suspended from office for 30 days, during which time a referendum on his future is to be held.

As Lane Scheppele points out, it is hardly coincidental that the country has just fallen back  (Spain style) into a double dip recession following a very sharp drop in output in 2009/10. Despite having received an initial 20 billion euro EU/IMF rescue loan in 2009 and a further 5 billion "top up" one in 2011 the economy still struggles to find air. The country's economy plunged by 6.6% in 2009, only to fall  by another 1.6% in 2010. It then recovered slightly in 2011, before finally fall back again in the last quarter of last year - output fell by 0.2% in Q4 2011 and by a further 0.1% in Q1 2012 according to Eurostat data. Thus GDP is still below the pre crisis peak - at levels first seen towards the end of 2008 and moving backwards in time.

IMF East Europe Programmes Under Increasing Pressure

Whom the gods would destroy they first make mad, as the saying goes. Romania, a country which urgently needed an IMF bailout just two years ago, and which is now back in recession,  saw fit to decide that June would be a good time to restore public sector wage cuts introduced to restore competitiveness under their IMF programme.

The decision followed a series of anti austerity riots back in January, which lead to the demise of the then  Liberal Democrat government lead by Emil Boc.

"The protests escalated on Jan. 14 and Jan. 15 in Bucharest, when people threw stones, torched cars and broke into stores, injuring about 60 persons, before winding down in the following days after riot police tightened security and set up checkpoints".
The government which replaced the Boc administration, lead by the former head of Romania's foreign intelligence services  Mihai-Razvan Ungureanu, lasted barely three months.

"Voter support for the current coalition was cut by more than half in the past two years to about 18 percent after Boc’s government slashed public wages 25 percent and increased taxes to meet international pledges. Boc resigned on Feb. 6 after protests over austerity turned violent."
At the heart of the protests were the 25% public sector wage cuts introduced under the IMF austerity programme. In fact both President Traian Basescu and prime minister Victor Ponta are in favour of restoring them, and the IMF even agreed to a relaxation in this years deficit targets to make some improvement possible, even though unrealistic increases in public salaries lay behind the countries high pre crisis inflation level, and formed part of the background which lead to the call to bring in the Fund.

So one of the most sensitive issues in the current crisis of Romanian leadership is the question of public sector wages, and this whole question has a long history. What happened back in 2009 was not a case of long established living standards being suddenly slashed, it was a case of them being cut back to where they were before they were raised in an unsustainable way in order to win elections. As I said in my December 2008 post "Romania's Economy Heads Off Quietly And With No Fanfares Into It's Deepest Crisis in a Decade". (More background information about how wages and prices were accelerating out of control in the run in to the crisis can be found here, and here.)
"Perhaps the highest profile decision in the context of the recent Romanian fiscal deficit "cause celebre" was the one taken on 8 October by the Romanian Parliament, when it agreed to a pay rise for teachers which was calculated to be in the region of 50%, and this against the explicit wishes of Calin Popescu Tariceanu, the prime minister, who headed the then minority liberal government. The main worry arising from the teachers’ pay increase, aside from the concerns over how it will be funded, centres on the impact it will have on the pay demands of other public-sector workers and, in turn, of private-sector workers. If such wage pressures are not resisted, then they will obviously only weaken further an already weakened Romanian competitiveness and in all probability would drive inflation back above the 10% mark in 2009. This would be the result in normal circumstances, but the Romanian economy is not in normal circumstances right now, and it is highly unlikely that the present credit crunch and the pressure from the international financial markets will leave time for this inflation spiral to run its course. Much more urgent matters are likely to make their presence felt first".
But the problem is only partly that undoing these wage reductions is a highly questionable measure - Romania, like so many other periphery countries, is, after all, supposedly going through an "internal devaluation" process - the other part of the equation is that the austerity measures - as we are seeing elsewhere in Eastern Europe - just aren't working in the sense of restoring stable, sustainable growth, and we aren't getting an adequate analysis of why this might be. Exports are falling back as the Euro Crisis deepens, and raising wages is seen as a way to unerpin growth in difficult times. But is the Romanian economy really competitive enough, is the export sector large enough, and is it not overly dependent on demand from a  European Union which isn't going to enter a positive momentum dynamic anytime soon? Instead of applying what is evidently a populist measure wouldn't the money be better spent on putting these issues straight for the longer term.

Extreme Example Of A General Problem?

At the end of the day Romania is not that different from many other countries in the region, and the political problems we are seeing there could easily arise elsewhere, if perhaps in a more restrained form. Following the bursting of a forex credit driven boom in 2009, domestic demand is now notably underperforming.

Construction has fallen into a slump.

Unemployment, while not that high in comparison with the Baltics or Spain/Greece, has been rising. And with the rising unemployment has come a surge in non performing bank loans - they reached 15.9% of the total in March, a number which may be even higher if the IMF's warnings about the need for vigilance over loan "evergreening" are anything to go by.

And the flow of credit, while hard to quantify, has all but seized up.

The reason the availability of credit is hard to measure is that some 60% of total private sector borrowing is forex denominated, which means that as the value of Leu falls the total stock of debt rises, distorting any attempt to measure new credit (the above chart is for local currency denominated household loans only, but it gives a clear impression of the state of affairs). This issue misleads some observers - IMF analysts included - into concluding that credit is flowing again. The IMF state in their latest report that during the first quarter "lending to the nonfinancial corporate sector increased 8.1 percent, while household credit grew only 2.1 percent", but much of this apparent increase is surely due to the upward revaluation effect, especially as the leu fell sharply in the aftermath of February's disturbances.

Internationally Competitive?

Despite the fact that exports have done comparatively well since the onset of the global financial crisis, the country still runs a goods trade deficit as well as a current account one, even if both of these have improved since 2009. They have notably gotten better, and then gotten stuck.

The initial surge in exports post the great recession was impressive, even if as in so many other countries it has petered out as 2012 has progressed and the uro crisis deepened. Exports year on year are now down over the comparable month in 2011.

Romania was awarded a second EU/IMF loan of 5 billion Euros in February 2011, due to the country's exposure to the European sovereign debt crisis.

The exposure passes through three channels, dependence on European markets where demand is falling for exports, the domestic banking sector depends heavily on credit from West European parent banks which are themselves affected by the crisis in their own countries, and thirdly the fact that the country is perceived by investors as one of the weak links in the Eastern chain, implying it is very exposed to contagion risk. In particular, with more than 80 percent of the Romanian banking system controlled by foreign banks (including a number of Greek-owned banks which account for around 14 percent of total bank assets), Romania is particularly vulnerable to spillovers from banking issues elsewhere in Europe.

But In Some Ways Romania's Problems Are Not Typical

Like so many of the country's in the region (the Baltics, Bulgaria, Hungary, Serbia, Ukraine, etc), Romania's population of around 21.5 million is now steadily falling.

And like the Baltics, many Romanians now work outside the country. But unlike the Baltics, where demographers like Mihail Hazans have carried out systematic research to try to determine the extent of the problem (research which has even helped the Latvian government formulate policy), no such care has been taken in the Romanian case. Indeed, a search for information on Romanian migration on Eurostat reveals an empty data field.

Yet large numbers of Romanians now live and work outside their country. According to the Romanian statistics office, the Romanian labour force in 2011 totalled 9.9 million people, of whom 9.1 million were employed. At the same time, as of 1st January 2012 there were 896,000 Romanians registered as residents in Spain.

And on 1st January 2011 there were 969,000 Romanians registered as resident in Italy.

So it is safe to say that - given some Romanians must be in countries other than Spain and Italy - the total number of Romanians living and working outside their country must be more than 2 million. So the population numbers must be significantly overstated, as must the size of the labour force. The Latvian statistics office are in the process of revising their data (see table below, especially the revisions for 2011, which have yet to be interpolated into the earlier data, the correction is large and significant, click on graphic if you can't read), and it is incredible that neither the EU nor the IMF are enforcing a similar procedure on other countries in the region, and in particular Bulgaria and possibly Poland (in an EU context).

The real issue is that a growth model which involves a country with long term below replacement fertility living in part from remitances raised via population export is not sustainable, and someone in a responsible position somewhere should be warning on this.

Between A Rock And A Hard Place

Naturally, opinions vary about the degree of success of the IMF programme. Andy Macdowall, writing on the FT Beyond Brics blog is prepared to give the fund a qualified thumbs up - "While eurozone policy makers thrash out the growth vs austerity debate, the evidence from Romania seems to be that the traditional medicine works."

And many may say, well Romania is a poor country so aren't you being a bit harsh on these public sector wages issues Edward? Possibly. But for anyone following the whole evolution of the Romanian inflation/wage rises dynamic over the last decade, alarm bells should be now ringing.

Romania's problem is one of growth, and how to get it. With the country in a severe credit squeeze, and domestic demand so weakened by the population exit, the only way to sustainable growth, as in so many other cases, is through exports, and in particular through exports beyond the frontiers of the EU. Artificially boosting demand by paying government employees more won't solve that problem, and arguably it will make it far worse.

The easiest way to raise exports would be to devalue, but in Romania's case this is hard, due to the high level of exposure to forex loans. In fact the IMF try to argue that such devaluation is not necessary. "The exchange rate remains in line with fundamentals and Romanian exports remain competitive.", they say. In fact we see this argument in one country after another. The issue is not that existing exports are not competitive, but that the country as a whole is not sufficiently internationally competitive to produce a large enough export sector to support growth. The Fund still expect private demand to do the work: "Private demand, buoyed by solid credit growth, is expected to rebound and contribute to growth along with stronger absorption of EU funds. Growth should accelerate to around 3 percent in 2013 and average 3½-4 percent through 2016".

I think they just haven't grasped yet the importance of the demographic components in a CEE context. These growth numbers are way too high, and internal demand (with all those middle age range people gone "missing") just isn't going to become a driver again. Higher wages in the public sector isn't going to solve this problem.

Really I think the problem with the Fund's current approach is that they have locked themselves into an ideological corner (austerity, privatisations and structural reforms) and just are not open to listening to "out of the box" perspectives. Given the complexity of the problems we face this is a very dangerous way of doing things.

Of course, not everything about Romania is problematic - compared to Western Europe, for example,  the fiscal deficit problems have been comparatively smaller - which makes it strange that so much of the Fund's attention has been focused on fiscal issues rather than the broader macro economic structural problems . But, then agan, we are talking about emerging, and not developed markets here, so a deficit of 6.5% of GDP last year is not to be sneezed at.

And last year gross government debt was only around 32% of GDP, although it has been rising rapidly.

The thing is the structural problems need to be addressed, and the economy needs to be put back on a sustainable path, and this just isn't happening at present. If government money is to be spent it would be far more worthwhile to use funds finding a solution to the Forex loans problem (as to some extent they have done in Hungary) rather than offering stimulus to an economy that won't be stimulated in its present condition.

While government debt is low, external debt isn't, and is was just over of 72% of GDP at the end of 2011. If the country continues to run a current account deficit and experience weak growth this debt looks set to grow - and especially if the leu maintains its trend of hitting ever lower levels against the Euro. As a rapidly ageing society Romania, like all CEE societies needs to reduce its external indebtedness and built up its savings base for the future.

So resources should be consumed resolving this external debt problem, and making the country less sensitive to movements in the exchange rate. That way the central bank could once more have access to independent monetary policy. The current monetary policy rate is 5.25%, for a country having a double dip recession after a very sharp fall, that is quite incredible, and compares with the 0.5% benchmark rate now offered by the central bank in the Czech Republic, where the cheap forex loans trap wasn't fallen into to anything like the same extent.

In addition serious efforts need to be made to stop the negative migration drift. If this doesn't happen neither the country nor its economy will ever be stable and sustainable. The IMF praises the fact that the country has met its programme targets despite the evident deep structural deficiencies the economy faces. In the latest programme review they even state that “Romania’s overall track record under the programme continues to be strong.” I almost choked when I read that bit, but maybe it is a typo, and they are talking anout another country, since it is hard to see how the observation applies to Romania. There is a lot of talk about structural reforms in the energy and transport sectors, but from a macro point of view what is going on there looks more like a total mess to me. Perhaps they should take a second look at the programme, maybe there was something less than adequate about the objectives and  targets which were set in the first place. Curiously, while the report mentions the fact that "weather related disruptions weakened performance in the first quarter", I couldn't find a reference to the fact that the country is back in recession - rather than experiencing fragile growth - in the entire document.

Stop The Slide To The Edge!

Recent events make clear that in addition to all its economic woes Romania is now increasingly facing the added issue that the politics of austerity are crumbling. This phenomenon has already been seen in Hungary, and to some extent in Ukraine. Short term risks to Romania’s economy have risen substantially due to the ongoing euro area financial crisis which is being transmitted to the country via credit stress in the financial sector, reduced export growth, and more difficult sovereign debt financing. In the longer run the outlook is bleak, as the country’s population is steadily falling – over 15% of the country’s workforce now live and work abroad – and finding ways to support the continually ageing population is becoming a real challenge.

Romania’s GDP contracted during 6 of the 8 quarters between Q3 2008 and Q3 2010, with a total fall peak to trough of 8.7%. Despite a timid recovery since (boosted largely by exports and agriculture) the economy was still 5% below its pre-crisis peak at the end of last December. What little growth there is comes entirely from exports, as domestic demand continues a slow decline. Romania has enjoyed substantial export growth since the crisis, but still runs a goods trade and current account deficit, making the country continually dependent on external financing.

This connection between political instability and IMF programmes in the East is becoming habitual. We have seen it in Ukraine, and we have seen it in Hungary. There is obviously something deeply wrong with the way these programmes are designed, since none of them (including Latvia) could be claimed to have achieved the objective of returning the country to robust and stable long term growth. We can only hope that what we have seen in the East will not now spread to the South, though I can't say I am especially convinced it won't.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".