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Friday, April 11, 2008

Romania: Current Account Deficit, Labour Shortages and the Risk of Correction

by Edward Hugh: Barcelona

According to the IMF Global Financial Stability report (published this week) parts of Eastern Europe now face a continuing and growing risk of having a "hard landing" as the global financial crisis continues to spread. The fund also drew attention to the possibility of serious spillover problems arising for the Scandinavian, Italian and Austria banks that have lent heavily in the region.

At the heart of the IMF's concerns are the large current account deficits being run in certain CEE countries, deficits which have now reached extreme levels in some cases, running to the tune of 22.9pc in Latvia, 21.4pc in Bulgaria, 16.5pc in Serbia, 16pc in Estonia, 14.5pc in Romania and 13.3pc in Lithuania.

"Eastern Europe has a cluster of countries with current account deficits financed by private debt or portfolio flows, where domestic credit has grown rapidly. A global slowdown, or a sharp drop in capital flows to emerging markets, could force a painful adjustment,"

The IMF said lenders in Eastern Europe had built up "large negative net foreign positions" during the boom, especially in the Baltic states. "Liquidity for these banks has all but dried up and [interest] spreads have widened 500 basis points."

Many of these countries concerned rely on credit from branches of West European and Nordic banks, but these foreign lenders are now themselves having difficulty raising money in the wholesale capital markets.

"A soft landing for the Baltics and south-eastern Europe could be jeopardised if external financing conditions force parent banks to contract credit to the region. Swedish banks, the main suppliers of external funding to the Baltics, could come under pressure,"

So Why Not start With The Trade Situation

Behind the current account deficits lie - more often than not - trade deficits, and in Romania's case the trade deficit widened again in February as rapidly rising wages wages and a consumer lending boom lead citizens to buy more imports even as the currency weakened. And it is here that the heart of the problem exists, since a rapidly accelerating wage price spiral is raising producer prices in a way which will ultimately make domestic industries uncompetitve in their export markets without a strong downward adjustment in the currency, and this downward adjustment will not be possible in Romania's case without considerable pain in the household sector due to the presence of rapidly growing unhedged foreign exchange (mainly euro) loans .

This tendency towards lack of competitiveness is already attested to by Romania's February trade deficit, which totalled 1.46 billion euros ($2.3 billion), compared with 1.4 billion euros in February 2007 and 1.41 billion euros in January, according to data fromthe Bucharest-based National Statistics Institute this week, although it should be noted that Romanian industrial output has been rising, and as a result the deficit is now significantly down from the record highs touched last October and November.

Import consumption has risen in Romania on the back of rapidly rising wages and soaring household borrowing, although again we can note how domestic demand seems to have weakend slightly back in November and December (possibly on the back of interest rate rises at the central bank, and the initial shock of the falling leu), but that imports are now once more starting to pick up pace again, even if at a slightly slower rate than exports (see chart below). So we can say that rising disposable income has in the longer run more than offset the effects of a weaker leu, and imports in February rose at an annual rate of 14.2 percent to 4.24 billion euros.

On the other hand exports were up an even larger 20.3 percent to 2.78 billion euros. This reading confirms the strong picture we have been getting for industrial output, which was up in February by 7.7 % on February 2007 as Romania's new factories steadily ramp up production.

Romania's trade deficit is, as I have been suggesting, the main component of it's current-account deficit, which widened in January to 1.135 billion euros from 972 million euros a year earlier. Fitch Ratings and Standard & Poor's have both lowered their outlooks on Romania's credit rating, citing the continuing current account shortfall as justification.

Foreign Exchange Debt

At the same time part of the recent boom in consumer spending is a result of growing indebtedness. Romanian retail sales growth accelerated in February as rising wages and increased household borrowing gave citizens more disposable income. Sales increased by an annual 23.5 percent in February, compared with 16.6 percent in January, according to the latest data from the Bucharest-based National Statistics Institute. Sales increased 8.3 percent from January.

And a lot of this spending is being financed by borrowing, much of it in euros. According to the latest figures from the National Bank of Romania, in February 2008, non-government credit grew by 2.7 percent in money terms, or 1.9 percent in real terms, from January 2008 reaching a level of RON 158,345.4 million. RON-denominated loans went up month on month by 3.0 percent (2.3 percent in real terms) and foreign currency-denominated loans rose by 2.4 percent when expressed in RON and by 1.6 percent when expressed in EUR. At end-February 2008, non-government credit climbed year-on-year by 65.8 percent, or 53.6 percent in real terms, on the back of a 44.4 percent increase in RON-denominated loans (33.7 percent in real terms) and a 88.9 percent advance in foreign currency-denominated loans expressed in RON (when expressed in EUR, forex loans expanded by 72.1 percent). Forex credit in the household sector was up a whopping 142.3% year on year in money terms.

The possible inflationary consequences of all this borrowing are not far from anyone's mind and especially not from those who are responsible for making policy over at the central bank. Rising wages and economic growth in Romania may spur a "second round" of price increases in coming months, central bank Governor Mugur Isarescu warned only this week.

Romania's economic expansion remains strong, and in fact accelerated in the last quarter of 2007, adding to expectations that the central bank would continue to raise interest rates in an attempt to contain the strong upward movement in inflation which was further fuelled by a strong increase in end of year spending from the Romanian government and the steady household consumption boom. Gross domestic product rose at an annual rate 6.6 percent in the fourth quarter, the fastest pace since the last quarter of 2006, and up from 5.7 percent in the third quarter.

Against this background Romania's inflation has continued to rise and accelerated again in February, reaching the fastest pace in two years and increasing the chances of another interest rate increase, as the government raised natural gas prices and a weaker leu boosted the cost of services. The inflation rate rose to 8 percent, the highest since March of 2006, and up from 7.3 percent in January. Consumer prices rose 0.7 percent in the month, from 0.9 percent in January.

Inflation may continue to suffer further pressure from wage growth, central bank governor Isarescu said at a conference in Bucharest earlier this week , and if we look at what is happening to producer prices - which were up by 13.6% in February - we can see why he is concerned.

Labour Shortage Driven Wage Inflation

``The danger is that a second round of price increases, a so- called inflation spiral, will appear because of higher wages,'' Isarescu said. ``Economic growth is OK, but you have to not push it. I have to accept that politicians address
economic growth because this seems like a simple success.''

Romanian net wage growth, which the central bank says is one of the main drivers of inflation at the present time, slowed somewhat in February when compared with January, but was still very very strong. Net wages rose at an annual 20.5 percent rate, as compared with a 30.7 percent in January, bringing the average net monthly wage to 1,134 lei ($493), according to data from the Bucharest-based National Statistics Institute this week.

Romania's central bank has highlighted wage growth is a main driver of inflation and the main threat to this year's inflation forecast. The central bank increased its main interest rate last month by a half point to 9.5 percent, its fourth consecutive increase. The difficulty is that further increasing the policy rate may simply drive more people to take out euro denominated loans at the cheaper interest rates which are associated with them.

One of the problems monetary policy faces in Romania is the ability of consumers to resort to foreign exchange loans to circumvent it, another is the fact that Romania's labour force is not expanding rapidly enough to feed the economic growth. If we look at the chart below for both economically active and employed population we will see that both of these have been almost stationary since 2002, so what we are seeing here is almost "jobless" growth.

On the other hand Romania's official unemployed population has been trending down, from nearly one million at the start of 2002 to just over 600,000 at the present time.

Only last November Romanian Labor Minister Paul Pacuraru was arguing that Romania needs at least another 300,000 workers to meet current needs and will need more than 1 million within a decade. The labor shortage, Pacuraru said, is caused partly by a migrating workforce and partly by a declining population, and is most acute in construction, and the textile, automobile and food processing industries.

And finance minister, Varujan Vosganian, aims even higher, saying Romania lacks half a million workers."We need more engineers, mechanics and bricklayers," he is quoted by the UK Daily Telegraph as saying "We have a labour deficit of 500,000 employees."

And Vosganian wasn't simply talking about the elites - doctors and IT programmers gone to make their fortune elsewhere, though that would be damaging enough. Romania needs its skilled labourers to return - the people who are going to build up the infrastructure that the country so severely lacks. But when we look at the wage differentials, this idea of a mass return - rather than a steady trickle - would seem to be a forelorn hope to me, whether we are talking about Latvia, Poland, Ukraine or Romania.

The recent settlement in the Dacia strike gives us some indication of just how extensive the labour supply problem now really is in Romania. Basically Employees of Dacia, which is the Romanian carmaking unit of France's Renault today ended an 18-day strike at their Pitesti plant - located about 100 kilometers northwest of Bucharest - after accepting a higher pay offer.

The 13,000 employees returned to work this afternoon after accepting a monthly pay increase of 360 lei ($158). Dacia employees started the strike on March 24, halting production of 1,300 cars a day from the factory, to back demands of a wage increase of 550 lei a month each. This pay increase brings the average wage of a Dacia employee to 2,256 lei a month before tax. The company had originally offered a raise of 155 lei per month per employee. Dacia's sales increased 17 percent last year to 230,000 vehicles as it boosted exports to France and Germany and Romanian wages and lending soared, giving citizens more purchasing power. Average net wages increased an annual 20.5 percent in February.

Dacia, which has more than a 30 percent share of Romania's car market and exports Logan sedans worldwide, produces more than 1,300 vehicles per working day at its Pitesti factory. Dacia is also a main Romanian exporter, with exports rising 44 percent last year from 2006 to more than 128,000 cars, the company said.

So the simple issue is, what is now the normal capacity neutral growth rate for Romania at this point (remember this rate will tend to get gradually less as the population continues to decline)? That is, what is the annual growth rate which Romania is capable of without seeing the sort of inflation we are seeing at the moment? Noone really knows, but it is obviously well below the rate Romania is currently growing at.

This tendency towards "labour market pinch" is in part produced by Romania's long term low fertility - which makes sustained growth in the 6% range over any lengthy period of time look frankly virtually impossible - and by strong out-migration in recent years - in particular to Italy and Spain where there are a combined total of over 1 million Romanians (out of a population of around 20 million) now living and working.

The Double Edged Prong Of Inflation and Global Credit Risk

Romania needs to cut its inflation rate, and rapidly. In particular it needs to be down to 3 percent by the end of 2010 or -among other issues - it will risk missing its target of adopting the euro in 2014, according to the latest statements by central bank governor Isarescu. Isarescu also suggested that he found the leu's current exchange rate "more sustainable'" than the level the leu was tradinga t in early 2007. The leu has dropped 9 percent against the euro in the past year and was trading at 3.6566 to the euro as of 9:30 a.m. in Bucharest.

As the IMF note in their report, awareness of higher risks in the CEE countries has been rising in recent months, and this rising awareness has been been reflected in the performance of bank stocks exposed to the region, in Credit Default Swap spreads, and in the performance of the Romanian leu (see chart below) given that the leu is the only floating currency with a liquid forward market among the group of eastern European countries with large external imbalances. As we have seen it has depreciated substantially since July 2007, as investors have been expressing their negative views on the region as whole The stocks of Swedish banks exposed to the Baltics have underperformed other Nordic bank shares (and here) partly owing to significant short-selling and CDS spreads on sovereign debt have surged since August 2007, as investor demand for credit protection has pushed up prices. The interesting point to observe is how this is now all moving in tandem.

In fact the IMF specifically notes how in Bulgaria and Romania, tighter credit risk controls by parent banks have not been effective in slowing aggregate credit growth, as new entrants, notably Greek and Portuguese banks, have sought to expand market share. Since Bulgaria and Romania only recently joined the European Union, they are still seen by many banks as offering attractive growth opportunities. However, there is a danger that local banks may underestimate the deterioration in the quality of loan portfolios that often accompanies rapid credit growth.

Banks active in Eastern Europe also face risks on the asset side of their balance sheets. House prices have soared in tandem with domestic credit growth, and the credit portfolios of banks in emerging Europe have increasingly become exposed to the real estate sector. In Estonia and Latvia, house prices have now started to fall, which has led banks to curtail lending to many construction projects, while more developers have resorted to preselling apartments - thus sending the credit risk back on round to the banks via the circuitous route of household default risk - in order to receive financing up front for them. Banks have not experienced a significant increase in loan losses so far, and they have centralized and strengthened risk management in a manner similar to mature market banks. Internal risk controls could force a sharp reduction in credit at some point simply to protect bank capital, if asset quality is thought to be about to deteriorate sharply. So a win-win dynamic could rapidly turn into a lose-lose one under the right circumstances. True the ratio of household credit to GDP is considerably higher in Estonia and Latvia (above 40 percent in 2007), than it is in Romania (18 percent in 2007), but credit dependence is growing rapidly, and as we have been seeing there are special difficulties in Romania which make sustainable and inflation free 3 per cent plus growth structurally difficult over any lengthy period of time, and this reality should, at the very least, be making people rather nervous at this point.

By Way of Conclusion

So what gets to happen next in Romania? At this point this is very hard to say. Emerging markets have - as the IMF argues - so far proved broadly pretty resilient to the global financial turmoil. Improved fundamentals, abundant reserves, and strong growth have all helped to sustain flows into emerging market assets. However, important macroeconomic vulnerabilities do exist - especially in the context of quality labour supply and inflation free growth potential, coupled with the dangers of a current-account-deficit/capital-flows unwaind - in a number of the CEE countries which make them rather susceptible to any significant deterioration in the external environment (see chart below).

(Please Click On Imgage For Better Viewing)

Eastern Europe contains a hard core of countries with current account deficits financed by private debt or portfolio flows, and where domestic credit has grown rapidly. A global slowdown, or a sharp drop in capital flows to emerging markets, could lead to a very painful adjustment process in those countries. The IMF identify - as follows - a number of distinct risks to CEE economies arising from the current turmoil.

First, mature market banks may pare back funding to their local subsidiaries, particularly in circumstances where external imbalances are large.

Second, balance sheet contraction by global financial institutions may reduce funding for investments by hedge funds and other institutions, raising their dollar funding costs, and inducing fi nancial stress within some emerging markets.

Third, emerging market corporate credit risks may continue to increase. Emerging market corporate debt spreads have already moved ou about as much as those of similarly rated credits in mature markets.

Fourth, emerging market financial institutions may yet prove vulnerable to financial contagion through exposure to subprime or other structured credit products.

Fifth, a spike in exchange rate volatility could slow or reverse fl ows into emerging market fixed-income assets, leading to higher funding costs. Negative terms-of-trade shocks could raise diffi culties for emerging markets in Latin America and elsewhere that have benefi ted from the commodity price boom. More broadly, a global slowdown could affect fl ows into emerging market assets.

If we add to this list the fact that a number of Eastern European economies are now visibly overheating while others seem getting near to the point of doing so, then the risk and the dangers of the potential outcome seem plain enough to see.