CIBR Blog

As Good as it Gets

by ING Bank Romania

 1. Output – the strong run continues

 2. C/A deficit at 11.6% of GDP, more to come

 3. Fiscal policy – entering a loosening era

 4. Consumer prices – the outlook deteriorates

 5. Monetary policy – tighter on strong RON

 6. Equity markets in 2007

Economic growth has been impressive for Romania in the last seven years. The most visible effects of this boom are higher wages, lower unemployment, lower inflation and also a whopping current account deficit. After such a performance, the inevitable question that springs to mind is: how long can we go on at this speed? This is a legitimate question as ‘emerging markets’ are known as volatile markets and the current period of stability for these markets is a bit of a pleasant surprise.

What is interesting about the Romanian economy and somewhat uncharacteristic for EM countries is that some economic reforms were implemented during 2000-2005 while the fiscal deficit was reduced from one year to the next. But unfortunately this reforming attitude seems to have disappeared as Romania became a member of the European Union. In fact we are concerned that the reform fatigue will put a stop to the current impressive growth and that what we are experiencing now is as good as it gets for the Romanian economy for some time.

On the growth side, we see the economy as overheating. The main evidence is provided by the widening external imbalance reaching 11.6% of GDP at end-1Q07, still strong excess domestic demand and increasing underlying inflationary pressures. But given the current momentum and EU euphoria among domestic consumers, we remain positive on Romania’s growth prospects with real GDP expected at 6.5% in 2007 despite the higher risk of a negative performance for agriculture, affected by the prolonged drought. More importantly, we are raising our real GDP growth forecasts for 2008 from 5.7% to 6.3% on the back of an acceleration of the catching-up process along with enhanced absorption capacity of EU structural funds.

Considering this picture of the economy, we do not expect any relief for the C/A deficit. In fact we see the C/A deficit widening and we are increasing our estimate to 13.8% of GDP for end-2007 and to 13.9% of GDP in 2009. And as before, we continue to believe that the C/A deficit poses the biggest threat to the RON’s appreciation potential in the medium term and expect this RON weakness to materialise in the first part of 2008.

Despite this, in the short term we expect the RON strength to consolidate around the current levels. Given the recent evolution of the EUR/RON pair, we change our medium-term forecasts. We expect the pair to be around 3.2000 levels for the end of the third quarter and 3.3000 at the end of the year. However, due to the large external imbalance, we pencil in a correction for the RON in the first half of 2008. The rate hike in the US expected at the beginning of 2008 could act as a trigger and the RON should be regarded as one of the main targets in a flight to quality sell-off scenario. As a consequence, we expect EUR/RON to revisit the 3.4500 level before returning to 3.2500 towards the end of 2008.

The RON strength has also been contributing to lower inflation in the last three quarters. Inflation continued to surprise on the downside reaching 3.81% YoY at end-May. The better-thanexpected disinflation performance, amid the overheating economy, was the result of volatile food prices (38.92% of the consumer basket) under pressure from greater competition from imported products in the context of a stronger RON along with a moderation of administrative price adjustments. However, the long-to-medium term inflation outlook looks likely to deteriorate further with CORE measures of inflation showing a strong downward rigidity.

It is this long-to-medium term outlook that guides our view on interest rates for the next eight quarters. Thus, we stick to our base scenario from our report Economic outlook: Choose your fairytale (released on 26 February) and expect the key rate to bottom at 7%, followed by a new tightening cycle to 7.75% (but no sooner than the first half of 2008) due to a weaker RON as a result of the unsustainable C/A deficit widening. Nevertheless, we acknowledge that the risks to our scenario are biased on the downside and this would probably lead to higher inflation expectations and force the NBR to hike rates earlier than in our scenario.

1. Output – the strong run continues

The Romanian economy is overheating, as evidenced by the widening external imbalance reaching 11.6% of GDP at end-1Q07, strong excess demand and increasing underlying inflationary pressures. The domestic, mostly private, demand remains the main engine of economic growth, expanding in double digits at 11.9% YoY at end-1Q07. From the GDP formation point of view, the recovery of industry, driven by strong productivity gains as a result of heavy investments and the finalisation of the restructuring process after the privatisation era, has almost ended.

Economic growth slowed to around its potential of 6% in the first quarter of 2007. The increase of potential output from 5.5% to 6% is part of the catching-up process. The moderation of economic growth relative to the previous year is due to net taxes, which decreased by 7.8%, weighing negatively on economic growth by 1pps. The 7.8% YoY expansion of industry with a contribution of 2.1pps to GDP formation should insure the sustainability of the current pace of economic growth.

From the viewpoint of GDP formation, the construction sector remained the most dynamic, jumping by 30.7% YoY due to favourable weather conditions, contributing 1.3pps to GDP. Services increased by 6.4% YoY making up 3.4pps of GDP growth, relative to 2.1pps coming from industry and 0.2pps from agriculture. The high contribution of services to economic growth shields the Romanian economy from a more pronounced deceleration, or even a recession, due to a change in the business cycle, as services are less sensitive to boom-and-bust cycles. In our view, the most positive news for the sustainability of the economic boom comes from strong industrial production and its relatively high contribution to GDP formation after post-privatisation restructurings have brought heavy investments in this sector. Economic performance was negatively influenced by problems with VAT collection, which dragged GDP growth down by 1pps. This problem was solved in April and should be reflected in higher second quarter economic growth.

On the expenditure side, household consumption remained buoyant at 11.9% YoY and was the main driver of GDP growth. Furthermore, public consumption (+9.4% YoY) signals a further relaxation of the fiscal stance. The negative contribution from net exports (-7pps) was compensated by household consumption (+9.6pps) and gross fixed capital formation (+2.8pps), with insignificant contributions from public consumption (+0.8pps) and a change in inventories (-0.2pps). The evolution of gross fixed capital formation (+17.2%) was led by the increase of investment volume (+15.9% YoY) with investments in construction up by 28.4% YoY and investments in equipment and transport means increasing by 1.3% YoY.
 

We maintain our positive view on Romanian growth prospects with real GDP expected at 6.5% in 2007, despite the higher risk of a negative performance for agriculture due to a prolonged drought. Furthermore, we raise our real GDP growth forecast for 2008 from 5.7% to 6.3% on the back of an acceleration of the catching-up process, with enhanced absorption capacity of EU structural funds. Despite remaining above potential, some cooling down is expected as we consider the current pace unsustainable in the long run. Some upside surprise could come from higher manufacturing-oriented foreign direct investment – albeit limited by the tight labour market – which would be more expansionary than expected fiscal policy, and better-thanexpected agricultural performance, which is volatile. Services are expected to remain the main driving force while foreign direct investment would spur industry value added to grow. Construction is expected to maintain the current pace of growth and increase its impact on economic growth, mainly as a result of infrastructure investments financed through EU structural funds. In the next two years we expect structural funds to reduce the volatility of agricultural output and enhance its capacity.

2. C/A deficit at 11.6% of GDP, more to come

The C/A deficit widening accelerated above our expectations, reflecting strong domestic demand unmatched by domestic supply. We have been commenting on this since the beginning of 2006, but now the NBR has joined the choir of concerned voices. The recent sharp RON appreciation, wage hikes above productivity gains, strong credit growth and short-term external debt expansion, expected expansionary fiscal policy should accelerate future C/A gap widening. At this pace, a sudden temporary reversal of the RON strengthening appears inevitable in the next six quarters.

The C/A gap widening is showing signs of accelerating with the peak of the deficit yet to be reached. As a result we revise our C/A deficit forecast for end-2007 from 11.8% to 13.8% of GDP or EUR 16.7 bn. The main driver of the C/A shortfall will remain the widening trade balance deficit as a result of buoyant domestic demand and amplified by recent sharp RON appreciation. Furthermore, we expect FDI’s financing of the C/A gap to further decline to below 50% in 2007 from 91% at end-2006 as the privatisation era is near its end. However, limited portfolio inflows up to now could partially compensate the decline in FDI, but this scenario depends on the government’s ability to spend the money and issue a significant amount of debt, combined with the willingness to develop the stock market by floating stakes owned by the state in different public or already privatised companies.

The trade balance deficit, totalling EUR 14.052 FOB/FOB at end-April on a 12-month rolling basis, accelerated its deterioration to 61% 12-months/12-months and has been mainly driven by the domestic excess demand combined with the continuous real effective exchange rate appreciation (REER).

In spite of the fast RON appreciation, export growth remained solid at 15% YoY on a 12-month rolling basis, confirming the shift towards higher value-added goods. Imports showed a 26.8% YoY on a 12-month rolling basis advance supported by the easing of trade barriers after EU accession. Given the higher base effect of imports and faster expansion, it is likely that the trade balance will further deteriorate in the medium term with EU structural funds expected to gradually diminish the trade gap in the long term, given the low absorption capacity of the Romanian economy in the first years after accession.

The 12-month rolling C/A deficit totalled EUR 12.359 bn at end-April, displaying a 67.8% growth. However, with the accelerating pace of RON strengthening, we believe that the peak of the deficit is still far away. The acceleration of the C/A deficit after 11.6% of GDP at end-1Q07 on four-quarter rolling basis has forced us to raise our end-07 forecast to 13.8% of GDP. One additional factor influencing the C/A balance is the increase of the negative impact from revenues, reflecting profit repatriation after the heavy offshore investment in the Romanian economy. Furthermore, the growth of current transfers is showing a slowdown, reflecting a change in the behaviour of Romanians working abroad.

We continue to believe that the C/A deficit poses the biggest threat to RON appreciation potential in the medium term. For the short term, however, healthy FDI inflows of EUR 8.405 bn on a 12-month rolling basis are enough to cover 70.4% (end- April) of the current account shortfall. However, as the privatisation era is nearing its end, we expect the FDI coverage of the C/A gap to further decline to 47.9% for 2007. Nevertheless, this could be partially compensated by portfolio inflows, currently at very low levels, if the Romanian government were to implement a coherent treasury policy and list some of the large state-owned companies on the stock exchange. Finally, 62% of the total FDI was represented by equity stakes and reinvested earnings while intra-group loans accounted for 38% of total FDI.

At these levels of the C/A gap, we would expect foreign investors to demand a higher premium for holding Romanian assets. Furthermore, the pro-cyclical fiscal policy and large public investment projects in the medium term point to a fiscal loosening era which would be simultaneously reflected in a higher C/A deficit. Current political uncertainties, likely to persist due to the heavy election calendar in the next two years could exacerbate fiscal slippages, raising the risk of twin deficits. In this context, among regional currencies, we see the RON as one of the most vulnerable to a shift in the risk appetite of international investors.

3. Fiscal policy – entering a loosening era

The government failed to meet its target for the budget deficit at 2.5% of GDP in 2006 as expenditures were postponed. The budget deficit came out at 1.68% of GDP, which signals a further relaxation of the fiscal stance. Government revenues were 31.8% of GDP and government expenditures 33.5% of GDP.

Thus, the postponed investment expenditures should be reflected in a higher deficit in the coming years, which combined with the implementation of the second pension fund pillar, compensation for communist regime expropriations and Romania’s contribution to the EU budget (1.1% of GDP in 2007), will likely put the budget deficit above the 3% of GDP Maastricht criteria in the coming years if the tax base is not broadened.

For 2007, the budget deficit target is set at 2.8% of GDP, or 3.2% of GDP according to Eurostat methodology. In the first six months of the year, government officials publicly expressed their intention to lower the target to 2.4%. This revision is aimed at avoiding an excessive deficit procedure from the European Commission. The budget programme assumes budget revenues of 35.2% of GDP and is heavily relying on improved absorption capacity for structural funds from the EU. If the government manages to start the national investment programmes and attains the scheduled budget expenditures of 38% of GDP, we would expect an overshooting of the budget deficit target for 2007, in light of the 2006 data on budget revenues, as no important taxes have been increased. Irrespective of the overshooting issue, the budget gap would simultaneously be reflected in a higher C/A deficit. This raises the problem of twin deficits and increases the vulnerability of the RON in the medium term.

Over the medium term, infrastructure projects, co-financing of EU funds, the implementation of the second pension fund pillar and compensation payments for communist expropriation are, in our view, the main risks to an overshooting of the budget deficit. The very low tax base and poor collection of taxes could also contribute to a widening budget deficit.

Considering these constraints, we believe that the budget deficit is likely to spike above the 3% of GDP Maastricht criteria in 2008. The MoF statement that the larger deficit will have no inflationary impact as it is investment-orientated was contradicted by parliament’s unanimous decision to double public pensions over the next two years (a 43% increase from 1 January 2008 plus another 33% in 2009). This implies an additional budget expenditure of RON 14.3 bn and raises serious inflationary risks and accentuates the overheating risks. We believe that the high political uncertainty was at the basis of this unanimous decision and we are expecting more populist decisions to follow in the near future due to the heavy election calendar over the next two years. Furthermore, we do not see this as sustainable in the medium term without an increase in budget revenues. As the profit/income flat tax of 16% were the deciding issue in the previous elections, it is hard to believe that the rate would be raised. As a result we see a higher probability for the 19% VAT tax to be increased. This should have an immediate inflationary effect, which is most likely to be considered by the central bank as a one-off effect. However, we view the pension hikes combined with the irrational wage increases in the public sector as having a permanent income effect on inflation, and we believe that in the first half of 2008 the NBR will be forced to react by tightening monetary policy with at least 75bp in hikes. Thus we believe that the growing budget deficit will make it more difficult for the NBR to achieve its long-term inflation targets without resorting to a more restrictive monetary policy stance in 2008.

4. Consumer prices – the outlook deteriorates

Inflation continued to surprise on the downside reaching 3.81% YoY at end-May. The better-than-expected disinflation performance, amid an overheating economy, was the result of volatile food prices (38.92% of the consumer basket) under pressure from higher competition in imported products in the context of the stronger RON along with a moderation of administrative price adjustments. The inflation profile remains affected by growing risks due to its quick and asymmetric response to exchange rate developments, with depreciation having a greater inflationary impact, and the expansionary fiscal policy, which is likely to pump in money via public sector wages and pensions.

The long-to-medium term inflation outlook looks likely to further deteriorate with CORE measures of inflation showing a strong downward rigidity. Nevertheless, with the prolonged drought expected to have a substantial effect on inflation, which should be amplified by the low base effect of food prices, we expect end-2007 inflation to come in above the NBR’s 4% target at 4.3%, but comfortably inside the target band of ±1%. Administrative prices, weighting 21.4% in the consumer basket, are due to be liberalised by end-2008. We expect the government to review the deadline with the European Commission, but we are not very confident in their success. The latest available data on the most important prices (natural gas, heating and electricity) which account for 10.2% of the consumer basket are expect to increase by 6.8% in 2007 and 10.8% in 2008. Any delay of the adjustments announced for the current year should be reflected in higher 2008 inflation.

Continuing our monitoring of different inflation measures, CORE1 inflation (which excludes regulated prices) increased by 2.21% YoY due to the higher base effect. CORE2 inflation (formerly the NBR’s favoured inflation measure), which excludes administrative prices and volatile prices (vegetables, fruit, eggs and fuel), decreased to 3.7% YoY but still shows persistent signs of stickiness. The NBR’s newly favoured inflation measure, CORE3 (CORE2 minus the effect of the vice tax on alcohol and tobacco), which represents 58.9% of the consumer basket, stood at 2.69% YoY. The evolution of CORE3, which is showing strong downward rigidity and varied only by 103 basis points over the last twelve months, shows that monetary policy’s influence on prices was limited and most of the disinflation was caused by supply-side factors and the government’s decision to smooth the adjustments of regulated prices over the next two years.

As the graph Inflation and its components shows, non-food and services prices showed signs of stickiness, hovering at levels substantially above headline inflation. The same pattern was displayed by CORE3 inflation, which decelerated by only 1.34% in May relative to the same month of the previous year.

The outlook for inflation over the next two years is deteriorating due to administrative price adjustments and the effects of the drought on food prices. Second-round effects from fast private credit growth at 49.1% YoY, wage increases above 21.5% YoY and fiscal loosening are expected to add to demand-side inflationary pressures. A VAT tax hike is not excluded over the next two years but should be seen as a one-off effect. Furthermore, as most of the accelerated disinflation process is due to fast RON appreciation, RON depreciation should be asymmetrically reflected in higher inflationary pressures. In this context of greater risks than certainties on the inflation outlook, we maintain our inflation forecast for end-2008 at 4.8% YoY.

As reflected by our baseline case scenario of a EUR/RON reversal in 2008, average inflation in 2008 is expected at 4.8% versus the 4.3% expected for 2007. We maintain our end-2007 rate call for 7.00% with the risk for more aggressive cuts as CORE measures of inflation are declining due to the sharp RON strengthening. Nevertheless, aggressive rate cuts would reignite inflation expectations and increase the risks of a new tightening cycle in 2008, causing a high credibility cost for the central bank.

5. Monetary policy – tighter on strong RON

The NBR has cut the key rate by 175bp to 7% so far this year and we expect it to bottom at the current level for this year.

On 9 February, the NBR began a monetary policy easing cycle by cutting the key interest rate by 75bp from 8.75% at the beginning of the year to 8.00%. From thereon, each and every monetary policy decision saw a rate cut, confirming our view of the NBR reducing the monetary policy rate in order to curb the RON’s sharp appreciation by narrowing the interest rate differential. At its latest monetary policy decision, the NBR decided to further cut the key policy rate by 25bp to 7%. In this whole period, the NBR’s decisions were each time supported by better-than-expected inflation figures. The disinflation process was supported by rapid RON appreciation and by the government postponing the previously planned increase of administrative prices.

We stick to our base scenario from our Economic outlook: Choose your fairytale (released on 26 February) and expect the key rate to bottom at 7% followed by a new tightening cycle to 7.75% (but no sooner than the first half of 2008) due to a weaker RON as a result of the unsustainable C/A deficit widening. Nevertheless, we acknowledge that risks to our scenario are biased on the downside and this would probably lead to higher inflation expectations and force the NBR to hike rates earlier than in our scenario.

Monetary conditions have remained moderately restrictive this year due to the strong RON and higher real interest rates due to accelerated disinflation.

One of the main focuses of the NBR’s latest post-meeting statements was the increase in the real monetary policy rate, which is viewed as contributing to tighter monetary conditions.

To assess the NBR’s view on its monetary policy stance, we take a closer look at the real key policy rate over time. The latest NBR decisions and the abrupt disinflation drove the real key rate to 3.2% at the end of June. The question remains whether this rate reflects a restrictive or accommodative monetary policy stance. One way of evaluating this benchmark is to consider what level of the real key policy rate would put economic activity at its potential and keep inflation low and stable. If the actual real rate is below that benchmark level, policy can be viewed as accommodative, in that if that stance were maintained, ultimately pressures on resources would build. If the actual real rate is kept above that benchmark level, policy would seem to be contractionary.

One way of estimating the neutral (also called natural or equilibrium) real rate is by taking averages of the actual real rate over long periods of time. The available relevant sample period starts with 2000, which may not be enough to confirm that resource slack averages near zero and thus imply the sample average of the real interest equals the natural real rate. The average of the real key interest rate over this period was 3.3%. Nevertheless, considering the NBR’s dual interest rate policy due to RON appreciation, the real effective policy rate is 2.9%. However, the average interest rate that seems to have brought aggregate demand and aggregate supply into rough balance in the past may not be the same rate required in every conjectural setting.

Furthermore effective exchange rates computed by the BIS in both nominal and real terms contribute to a tighter monetary policy stance than that reflected only by the key rate. The nominal effective exchange rate (NEER) is calculated as the geometric weighted average of a basket of bilateral exchange rates. The real effective exchange rate (REER) is the NEER adjusted with the corresponding relative consumer prices. The weights are derived from manufacturing trade flows and capture both direct bilateral trade and third-market competition by double-weighting.

Current economic developments have the potential to make the equilibrium real rate higher than it would otherwise be. The rapid expansion of labour productivity has raised potential economic growth (also acknowledged by the NBR as raising potential GDP from 5.5% to 6%), increased permanent income and wealth, and created an important incentive to add to the capital stock. All else equal, a higher productivity growth rate is associated with a more elevated equilibrium real rate. In addition, upward pressures for capital and labour resources, households’ low savings rate and added fiscal impetus point to a higher-than-historical average neutral key policy rate at the moment.

Our simple calculation of the natural rate of interest – the real interest rate consistent with output equalling potential and stable inflation – does not exclude it changing over time. Nevertheless, empirical literature shows that the natural rate varies about one-for-one with changes in the trend growth rate. The NBR monetary policy rate is close to its neutral level, in our view. Nevertheless some comments from NBR officials have pointed that the central bank sees the neutral interest rate lower at 2%. In the case of the NBR reducing the real key interest rate from this level, we would expect the upward revision of potential growth to force the NBR into a new tightening cycle, most probably in the first part of 2008.

Furthermore, restrictive broad monetary conditions have been cited by the NBR as the main reason for lowering the monetary policy rate in view of faster RON appreciation. Our monetary conditions index (MCI) shows a moderately restrictive stance.

The monetary conditions index (MCI) is a combination of short-term interest rates and the exchange rate, which could be considered as an operational target for monetary policy. We have opted to use a price equation, similar to other emerging economies, instead of an aggregate demand equation, as we consider the exchange rate to be the driving force of CPI developments in recent years. Our analysis has revealed that the MCI weights are distributed as follows: 27% for the short-term interest rate and 73% for the exchange rate, in line with MCI estimates for other emerging economies. Furthermore, our estimation shows that the monetary policy stance is currently moderately restrictive both in real and nominal terms.

The main results of the model are presented in the following graph and are consistent with recent economic developments, and coincide what we intuitively have considered periods with tight and respectively loose monetary policy. It is important to mention that the graph below represents the evolution of MCI and RMCI (Real Monetary Condition Index) relative to the previous period as the base period is arbitrarily chosen as it is hard to pick a period with an absolute neutral monetary stance.

 
Our model shows that the recent accelerated disinflation process is mainly due to exchange rate appreciation. The weight in the MCI of the key policy rate is rather small and is explained by the low effectiveness of the interest rate channel. Furthermore, the NBR’s achievements in the disinflation process appear, in light of our analysis, exposed to high exchange rate risk. The high and asymmetric (stronger in the case of depreciation) exchange rate passthrough poses a high inflationary risk, especially given the large and unsustainable C/A trend. We see the NBR as aware of this risk as we consider the current easing cycle as loading the gun for a tightening cycle in case of a RON correction. The NBR’s concern with the inflationary effects of RON weakening was confirmed in June 2006 when the NBR raised the key rate by 25bp to 8.75% as a reaction to RON depreciation due to contagion from the May-June emerging markets sell-off.

Overall our model shows that the modestly tight monetary conditions due to RON appreciation more than compensate for the reduction in the key interest rate. This conclusion supports the NBR’s easing bias. However, a loose sterilisation policy with monetary conditions below neutral is not seen as favourable. A cut below 7% would bring monetary conditions below neutral if the RON no longer contributes to monetary tightening as before.

The NBR Board decided to leave the minimum reserve requirement ratios unchanged so far this year. We expect a gradual drop for the MRR, at least for leu-denominated liabilities due to the rebound of FX credit which has substituted RON credit as the effectiveness of this instrument has been diminishing. This is expected to be on the NBR’s agenda only after the monetary policy rate bottoms, to avoid an especially dovish message. Furthermore, the NBR might consider continuing to align its minimum reserve requirements regulation to ECB standards by removing the reserve requirements for FX liabilities with residual maturities of over two years.

The NBR’s main objective is price stability but the RON’s rapid appreciation remains one of the most important concerns given the pace of growth of the C/A deficit and almost unanimous view of it being unsustainable on the long run.

Short of intervening in the FX market, the NBR has done its best to curb the RON’s strengthening. The aggressive rate cutting together with several verbal interventions expressing concern about the sustainability of the exchange rate at these levels has proved inefficient in curbing the fast RON appreciation. We maintain the view that the NBR could choose to directly intervene in the FX market, through a sharp depreciation, when the rapid and unsustainable RON appreciation is perceived as endangering the inflation outcome for 2008.

The experience of the last six quarters has taught us that the central bank watches the path of the leu very carefully and it has been willing to ease the pressure on the exchange rate through interest rate cuts. We believe that this action has reached its end with the key rate bottoming at 7% for 2007. However, there remains a risk for the central bank to further cut the rate, but we attach a low probability to this scenario as it would imply a high credibility cost for the NBR and would reignite inflation expectations due to the expansionary fiscal and wage plans. As the central bank should have a forwardlooking behaviour, it should be concerned, and it has mentioned this before, about fiscal policy loosening. With an unclear budget deficit target for 2007, a very bad history in spending money on non-productive issues and in view of the 2008 parliamentary elections, fiscal policy remains one of the most important factors to be taken into account when formulating monetary policy decisions. As a result we see cutting the key rate below 7% as endangering the inflation outlook, and under these conditions we believe that the key policy rate is to stay flat at 7% until the end of 2007 and then return to 7.25% by the end of 2008 after increasing to 7.75% in 1H08. Although the 2008 reversal in interest rates seems a ways away, we believe that ultimately the lagged effects from higher wages, strong domestic credit and expanding short-term external private debt will show up in CPI inflation. Also, we believe that at about that time, the strength of the RON would have worked its way through the system and contributed to the first clear signs of an economic slowdown. It is unfortunate, but when rate cuts will be needed most, the reckless developments in the C/A deficit will force a rapid and sharp capital outflow. As a result, the NBR will be forced to defend its credibility within an inflation targeting regime and will likely increase rates.
 

6. Equity markets in 2007

The Romanian stock market followed in the footsteps of its more advanced CE peers as regards its run in the six months following EU accession in January 2007. The large cap BET index increased 26.4% during the first half of the year. At the same time, the widest market index, BET-C, shot up 38%, reflecting an impressive run of the small cap section of the market, on the back of improved operational environment and risk appetite. The financials continued to make history, with the BET-FI way up at 46.4% YTD. The banks trade at historic high multiples, while the run in the SIFs showed no signs of abating, on a flurry of legal and regulatory news flow.

Still, despite historic highs being recorded every other day, the market cap only stands at 30% of GDP, way behind CE levels and a fraction of the norm in developed markets. Significant market drivers could prove to be the continued inflows triggered by the risk revaluation following EU accession, the growth inherent to a still grossly underdeveloped market, the listing pipeline and the future of local pension funds.
New money on the market
As in the previous EU accession stories among CE peers, the market took about three month’s period to really become the focus of new entrants. Once familiarity with the local market reached appropriate levels, the market saw a spike in inflows, which is still ongoing. In all fairness, uncertainties are induced by the future evolutions in the sub-prime lending market in the US, as well as the sustainability of the US dollar depreciation against other currencies and the rise in commodity prices. While the global macro context plays a big role in the risk appetite for emerging markets, the Romanian economy – and the entire region – shows strong fundamentals and high growth that shows no signs of abating just yet.
Value is in the growth
Industry turnover in GDP is still 45-50% of levels in the CE in most sectors, for instance. Even allowing for adjustments, high growth continues as a convergence-driven process. Many sectors – banking, retail, construction – remain in the double-digit growth realm and will most likely stay there in mid-run.
New listings would give market a liquidity boost
The market has been historically hindered by the low liquidity – listed stocks are, with few exceptions, small and very small caps by international standards, and the free floats of larger caps are on the slim slide. The government did miss a chance to fix this when privatizing large companies in the past, by not listing them before or during privatization. However, there is still an interesting listing pipeline of state owned stakes, not least in utilities and energy infrastructure, let alone the potentially huge, yet protracted and fraught with uncertainties Property Find listing.
Local pension funds to make an impact in the mid-run
Local liquidity on the institutional side has been lagging, due to a gross underdevelopment in mutual funds following the scandals of the late 1990s. The next big story waiting to happen is the private pension funds, inexistent up till now. The Pillar III optional private pension funds have just been given green light to operate. However, we expect that the funds under management will only take off once the Pillar II obligatory private pension funds will start to operate next year. Allowing for the time slack to amass funds, significant liquidity from this side would probably kick-in in 2009.

ING Bank NV Amsterdam, Bucharest Branch
Soseaua Kiseleff, Nr.11-13, Sector 1,011342, Bucuresti
Tel.: +40 21 222 1600
Fax: +40 21 222 1401

Contact:
Florin Citu, Head of Sales/Deputy Head of Financial Markets
E-mail: florin.citu@ingromania.ro

Ciprian Dascalu, Senior Economist
E-mail: ciprian.dascalu@ingromania.ro

Nora Rusu, Economist
E-mail: nora.rusu@ingromania.ro
Florin Ilie, Director, Head of Equity Markets
E-mail: florin.ilie@ingromania.ro