Isărescu: The strong monetary policy of 2005-2006 led to the growth of loans denominated in foreign currencies

The strengthening of the monetary policy in the 2005-2006 period, led to the unsustainable strengthening of the leu and caused a boom in loans denominated in foreign currencies, Mugur Isărescu, the governor of the Romanian National Bank said yesterday in a seminar on monetary policy.

He said: "The more we strengthened the monetary policy, because the second channel was expanding (ed. note: lending in foreign currencies) and we needed to offset that, the more we attracted speculative capital, causing the leu to strengthen. Was the simple theory of strengthening monetary policy working? Did something good come out of it? No, something that was relatively bad did".

The Governor of the Central Bank added that this mechanism created a vulnerability which inflated the "bubble" of lending in foreign denominated currencies, which "entrapped" many people.

Mr. Isărescu added that inflation is a monetary phenomenon, but one which has multiple ramifications. He quoted Henry Wallich (former member of the Federal Reserve): "To say that inflation is merely monetary phenomenon is the same as saying that shooting a man is merely a ballistics phenomenon (...) It"s not just a tautology, but it does put the spirit to sleep".

Furthermore, the Governor of the NBR explained, in yesterday"s monetary policy seminar, that in the long run the significant increase in the money supply causes prices to rise, but in the short term the correlation isn"t as obvious.

Mugur Isărescu said that the money supply is larger in countries with low inflation than in those with high inflation, but people perceive the phenomenon the other way around, due to the velocity of money, which is inversely proportional with the confidence in the Romanian currency. In a country which has low inflation, money is "preserved", and in a country with high inflation, money circulates faster, he claims.

The Head of the Central Bank said that in the short term, the evolution of prices has more to do with the economic cycle and with the income of the population (concentration, distribution) and less to do with the cash in circulation.

Mugur Isărescu said that Romania has faced a paradox, in the first part of the 90s, when the budget deficit was very low, the money supply was growing at a moderate 20%, while inflation stood at 300%. The arrears of the state owned companies provided the explanation for this paradox, which represented money that wasn"t being created by the NBR. These implied subsidies were leading to a quasi-fiscal deficit of 20% of the GDP, which was compatible with the inflation of 300%.

He said: "Those were implicit subsidies. Those state owned companies were only paying strong creditors - their workers, the management and perhaps some of their buddies, but they wouldn"t pay the utilities and their duties to the state budget. It took a lot of courage to shut down the power for the steel plants of the city of X".

The policy rate currently stands at 6.2%. The level of minimum required reserves for liabilities denominated in foreign currencies stands at 20%, and at 15% for liabilities in lei.