The Romanian economy: What to watch for in 2006

23/01/2006

Romania faces a number of pressing challenges this year. As market conditions approach those of the EU, local firms face stiffer competition. That in turn has led to smaller growth in industrial output and GDP. The economy has also been affected by last year's heavy rainfall and floods, as well as the rise in energy prices. The international climate, meanwhile, is one of uncertainty, with economic stagnation in Europe and the rise of the Asian economies driving a shift towards protectionism. Romania's political and business leaders thus have much to contend with as they seek to make good on the country's EU commitments and guide it towards its expected entry into the bloc.

By Daniel Daianu for Southeast European Times in Bucharest – 23/01/06

The more domestic market conditions match those across the EU, the harder it is for numerous local companies to comply with the new terms of competition.

Forecasting Romania's economic performance in 2006 is a risky business. However, we can say with certainty that the outlook depends on a number of specific issues. Among them is the ability of the domestic economy to adapt to changing conditions.

Industrial output grew considerably less in 2005 than in the previous year. For the first nine months, the increase was a mere 2 per cent, while GDP for the entire year will likely not exceed 4 per cent. These unimpressive figures are partly attributable to the heavy rainfalls and floods that affected much of the country. At the same time, Romanian industry -- and certain sectors in particular -- were hit by the severe appreciation of the domestic currency, the rise in energy tariffs, subsidy cuts and fiercer competition.

In general, the more domestic market conditions match those across the EU, the harder it is for numerous local companies to comply with the new terms of competition. This is reflected in smaller growth of output and GDP. How will domestic companies fare in the period to come? Or, to put it differently, has industrial output reached a bottom, or will downward adjustment, with its related painful costs, continue for a while?

The economy was affected by last year's heavy rainfall and floods. [AFP]

If the bottom has not yet been reached, we may see worsening numbers in the months to come. If the bottom has been reached, the rate of growth in industrial output may rise in 2006, although signs are not likely until the second quarter. A speedier absorption of shocks would help GDP growth to recover as well. A better harvest would assist such a recovery considerably -- this year’s harvest fell an abysmal 12 per cent compared to 2004. However, too much optimism is not warranted, considering that productivity gains were relatively unimpressive in 2005.

The trade deficit has continued to grow rapidly, and the current account deficit may have exceeded 9 per cent of GDP in 2005. Given that GDP and industrial output growth have slowed significantly, a question is calling out for an answer: are such external deficits sustainable? In fact, there are several aspects related to the rise in external deficits which require clarification. The unimpressive productivity gains of the economy this year seem to confirm the qualms I expressed, in an article a couple of years ago, regarding a major competitiveness challenge. The economy must somehow cope with a sharp exchange rate appreciation resulting from heavy money inflows from Romanians who work abroad and other capital inflows which are attracted by Romania’s prospects of joining the EU (the so-called "Dutch disease").

Some would argue that the external deficits are not worrisome, given the "normal" growth of bank credit and the presence of foreign capital in the banking industry, which presumably translates into reliable long-term credit lines. But such arguments have limits. In the real economy there is no one-way street; painful corrections are inevitable once deficits exceed certain thresholds. Were such a correction to happen, it would involve a severe depreciation of the exchange rate that could rekindle inflation.

The real test of the new monetary policy regime of the National Bank, namely inflation targeting, will come this year. [NBR]

As for the new monetary policy regime of the National Bank (NBR), namely inflation targeting, the real test will come this year. The final four months of 2005, during which inflation targeting has been practiced, are not conclusive at all and it would have probably been better to postpone its introduction for a while. The test will be highly demanding since conditions are peculiar: Almost half of the money supply escapes the NBR’s control (because transactions are euro and dollar denominated); interest rate differentials are still high; and the boom of bank credit and capital account liberalisation has eroded the NBR's ability to control money supply. The 5 per cent inflation target for 2006 is overambitious; 6 per cent to 6.5 per cent would be more reasonable, considering the rise in gas tariffs and the underlying inflationary expectations. Last year's target was missed by a large margin -- inflation would have likely have been 8.7 per cent to 8.8 per cent in 2005 as against the 6 per cent initial target, prior to the introduction of the flat tax.

Though the public budget envisages a deficit of 0.5 per cent for 2006, some of its underlying premises are questionable -- specifically, those relating to GDP growth and inflation. A budget rectification would have to consider a revision of these premises. Budget execution must be tight next year. At the same time, the financing of infrastructure projects has to be increased. And special attention has to be given to raising the capacity to absorb EU funds. An adequate management of the key issues has the potential to enhance Romania's investment grade.

The international environment, meanwhile, is under the spell of major uncertainties, which are rooted in global imbalances and the economic impact of various geopolitical conflicts. Economic stagnation in Europe and elsewhere, as well as the rise of China and other Asian economies, prompts countries to resort to protectionism as a means of defending domestic markets (The gridlocked Doha trade round speaks for itself). The price of basic commodities and oil will continue to be impacted by the rise of Asian economies. These circumstances will have an influence on the Romanian economy, though it depends greatly on EU markets.

Last, but not least, Romania has to make good on its commitments to the EU; the better we do, the better our chances of getting into the Union. Romania's political and business leaders have the responsibility of better defining national interests better, and in concrete terms. The EU has its specific supranational interests; but it is also a constellation of national interests which often conflict. This reality poses numerous challenges to national decision-making processes. Failure to meet those challenges, however, could carry the price of a delayed membership in the EU, thanks to the safeguard clause. The stakes in 2006 are high.