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Wednesday, March 5, 2008

Romania GDP Q4 2007 - Evident Signs of Strong Overheating

by Edward Hugh: Barcelona

Romania's economic expansion accelerated in the last quarter of last year, raising expectations of further interest rate increases from the central bank in an attempt to contain a strong upward movement in inflation which has been fuelled by a Romanian government increase in end of year spending and a steady household consumption boom. Gross domestic product (according to preliminary data, fuller details on March 12th) rose at an annual rate 6.6 percent in the fourth quarter, the fastest since the last quarter of 2006, and up from 5.7 percent in the previous quarter according to data released by the National Statistics Institute (INSSE) on Tuesday.

Romania's entry to the European Union on Jan. 1 2007 has seen a sharp increase in foreign investment and inflow of bank funds (and remittances as Romania's workers have moved abroad), and all of this has served to boost wages, lending and consumption to rates which are hard for the Romanian economy to absorb and sustain. Around 10% of Romania's workforce of around 10 million are currently working outside the country (largely in Italy and Spain), and of course many of these potential workers who have been lost are skilled and in the most economically productive age groups.

Spain and Italy have in fact been the principal destinations for Romanian migrants, athough surprisingly, and as can be seen in the Spain chart below, far from attempting to actually measure the extent of the problem, the official data - which only identifies those who have formally declared themselves to be permanent migrants - bears little relation to reality. According to the Spainsh national institute of statistics, the number of Romanians in Spain has increased in the following fashion in rcent years:

More detailed explanation of this phenomenon can be found in this post). The number of Romanians in Italy has also increased dramatically as the following chart from the Italian statistics office makes clear.

The problem is that while all these Romanians may be working out of the country, they are at the same time busily sending remittances home, and these remittances in their turn only serve to fuel domestic demand even further. Basically it is hard to get an accurate picture of the actual volume of remittances which are being sent home. One estimate comes from the World Bank, who openly recognise that what they provide is absolute minimum data. Noththeless, and even if the true numbers do not accelerate quite as sharply as the IMF data seem to show (which may be rather an indication of better data in more recent years), a sharp uptick has obviously taken place.

Another way of looking at the remittances issue is to take the current transfers item in the monthly balance of payments data published by the National Bank of Romania, and since this shows a rather smoother upward curve, and one which seems to be closer to the actual pattern of migrant outflow, perhaps it gives us a better general indication.

While such data is of limited validity in absolute terms - since it includes other kinds of transfer - in relative terms it can give us a much better appreciation of how the remittances situation has evolved over the years than the World Bank data can.

Be all this as it may, the world bank estimate the 2006 volume of remittances to have amounted to some 4.1% of GDP, and that is very large, and with significant macroeconomic consequences as we are currently seeing. I think what no-one had thought about before all this started happening over Eastern Europe was the way in which these remittances could be treated as an income stream and used to finance mortgage borrowing to fuel construction, with all the distortionary consequences we are now observing. Basically, the lesson from Romania (and elsewhere in the CEE) has to be that if you have very low fertility over a long period you certainly cannot live by exporting labour in the same way that high fertility societies like Philippines, Pakisatn or Ecuador do.

Signs of Overheating Everywhere

As a result of these pressures on capacity, Romanian inflation accelerated to 7.3 percent in January (up from 6.6 percent in December). Obviously the National Bank of Romania now looks set to raise and raise its main interest rate throughout the first half of this year.

More strength to their elbow will come from this weeks PPI reading which showed that producer-price growth in January accelerated for the fifth consecutive month, reaching an annual rate of 13 percent, the fastest pace since August of 2006, according to a separate INSSE report today.

The central bank raised its main interest rate to 9 percent from 8 percent at its last meeting on Feb. 4. This was the third consecutive increase, and the bank cited "inflationary pressures that have been amplified by persistent excess demand as a consequence of strong wage increases and fast growth of credit to the private sector".

The central bank next meets on March 26 to discuss its main interest rate.

One of the problems they will need to be thinking about is private indebtedness since this grew an annual rate of 66.8% percent in January, while foreign exchange loans to households grew at an astonishing and alarming 143.4% annual rate.

At the same time net monthly wages have been rising rapidly, with the rate slowing slightly in December but still increasing at an annual rate of around 15 percent.

Further indication of the kind of overheating which is currently going on can be found in the fact that retail sales grew in December at an annual rate of 20 percent in December while the construction industry increased its activity by 28 percent on the year.

Central Bank Double Bind and Currency Risk

In the face of all of this it is evident that the Romanian central bank will continue to increase its benchmark lending rate, which is already the highest in the European Union. The question is, what will be the objective of these increases? If we look over our shoulders a little to see what has been happening in Hungary, we can begin to see that the Romanian central bank will now be increasingly faced with conflicting policy objectives. Looking just a little further ahead - oh why is it that so many people have so much difficulty seeing what must be coming only round the next corner - at some point what can't continue won't, bank lending criteria will change (indeed it may well already be doing so, since only last week Hungarian mortgage bank OTP announced it was ceasing to offer unsecured loans in the Romanian market due to the high level of loan delinquency) and overheating will transform itself into its opposite, "rapid overcooling", or engine seize-up if you prefer (as we are now seeing in the Baltics).

At this point the central bank will face a dilema: whether to lower interest rates to give support to what at that point will be crumbling internal demand, or to pump rates up to defend the currency given the level of exposure to foreign currency loans. There are already signs that just this development may now be taking place. The leu has been under almost continuous downward pressure since last August (see chart below) and JPMorgan Chase are now predicting that by the end of the second quarter the central bank will need to raise its Monetary Policy Rate by at least 1 percentage point to 10 percent simply to keep the leu from dropping to the "never mind the quality feel the pain" level of 4 per euro. This point was made by Miroslav Plojhar, an emerging-market economist with JP Morgan in London in a client note earlier this week.

"Problems in the financial markets can cause banks, mainly in Central Europe, to cut credit lines causing problems in financing the current-account deficit and sparking a sell-off in the leu....The fuse needed for it keeps getting shorter" Plojhar said.

I would add to the problems in financial markets the issue of fears about levels of exposure as tthe overheating turns into its opposite, and the currency exposure of Romanian clients starts to mount. Certainly few would want to repeat the experience the Swedish banks appear to be starting to have as a result of the lending practices of their subsidiaries in the Baltics.

Conclusion. Romania is overheating strongly, not far from a "correction", and needs watching carefully from now on.


More details about Romanian background demography can be found in my Romanian Demongraphy at a Glance post,

more details on the argument about catch up growth, overheating and demographics can be found in Claus Vistesen's Catch Up Growth and Demographics post,

and some more elaboration of the central argument in this post can be found in my Alarm Bells Ringing in Romania post.