Raiffeisen Research: The foreign trade deficit deteriorated following Romania"s EU entry

Economic activity remained strong in the first quarter of the year, especially in industry and construction. Industrial output increased by 7.7% yoy in Jan-Mar 2007 against the same period in 2007. Manufacturing output expanded by 9.7% yoy in the first quarter. In the first quarter there were recorded large increases in the following sectors: manufacture of wood products (25.4% yoy), paper products (19.4% yoy), plastic products (18.3% yoy), and chemical products (16.5% yoy). Output in construction also expanded by 30.6% yoy in Q1 2007 (or by 19.9% after seasonally adjustment) on the back of a strong activity both in residential and non-residential sectors. Despite the fact that activity in industry and construction accelerated in Q1 07, Raiffeisen analysts estimate that the GDP growth rate will be lower than in previous quarter (somewhere around 6.5% yoy).

Firstly, they expect data to show that both agriculture and services have put a drag on GDP growth in Q1 07. Secondly, but more importantly, analysts think that the lower rate of growth will be explained by a substantial decrease in net taxes on products (VAT, excises). Raiffeisen specialists expect to see a deceleration both in government and household spending.

The foreign trade deficit deteriorated sharply following Romania"s EU entry on 1 Jan 2007, as imports accelerated strongly. Total imports increased by 30.1% yoy in Q1 07, mainly due to a sharp increase of imports from EU countries (+40.7% yoy in Q1 2007). A part of the increase in imports from EU is explained by a change in the accounting methodology due to the adoption of INTRASTAT system. In fact, similar dynamics were recorded also in some countries that became EU members in 2004 (Hungary (HU), Poland (PL) and Czech Republic (CZ)). Although is very difficult to evaluate the impact of this change in methodology, Raiffeisen analysts think that the abolition of the custom duties with the EU (starting 1January 2007) and the exchange rate appreciation also explain the acceleration of imports. Given these circumstances, foreign trade deficit (FOB/FOB) expanded by 88.42% yoy in Q1 07, while the current account deficit increased by 125% yoy. As expected, coverage of C/A deficit by FDI inflows decreased. In Q1 07 FDI inflows accounted only for 43% of the current account deficit, substantially below the level from 2006 (91% if total FDI is taken into account or 69% if the EUR 2.2 bn received from the privatization of BCR is excluded).

Annual rate of inflation stood at 3.77% yoy in April, slightly up from 3.66% yoy one month before. The monthly inflation rate was 0.52%, slightly higher than market consensus (0.4%). This is also the highest level since the beginning of the year and it is due to increases in electric energy and fuel prices (by 4.16% mom and by +1.62% mom respectively). Fruits and vegetables prices also increased more rapidly than in previous months. CORE2 monthly inflation rate remained almost unchanged from previous two months, coming in at 0.23% mom. Increases in fuel prices will put some pressures on inflation rate in short term. However, leu appreciation will continue to compensate for the increase in fuel prices, which should keep monthly headline inflation rate at a low level. At the same time, the annual inflation rate will decrease substantially this month and the next one (below 3.6% yoy) due to a statistical base effect (high rate of inflation in May 2006 due to the introduction of vice tax). This fall will be also visible in the case of CORE2 annual rate that decreased only marginally in last months. Another expected development is the increase in annual rate of inflation of food prices (currently at 0% yoy). The lower than expected inflation rates in the first months of this year, lower expectations for increases in prices of energy and gas by the end of the year, and a stronger level of domestic currency than Raiffeisen analysts had forecast determined them to change their inflation forecast. Thus, annual inflation rate could end the year somewhere around 4%. The risks with this forecast came mainly from developments in food prices, which might increase due to adverse climatic conditions.

The exchange rate appreciated very rapidly in the first months of this year. The leu gained more than 3% against EUR since the beginning of the year. A large part of this appreciation came in place during this month (1.7%) especially due to the very high interest rates in the money market. The appreciation of the currency so far has been above our expectations. Financial flows rather than commercial ones continue to be the main drivers behind the exchange rate development. The rapid increase in the foreign trade deficit and in the current account deficit had no impact on the exchange rate. Even though the risks associated with the larger and larger external imbalance are on the increase, investors" mood is still positive. Given these circumstances, it is very likely that the leu will remain at a strong level in the next period.