Will the crisis be powerful enough to reinvigorate Romania? A recession to benefit the economy

Călin Rechea

The economic recession, an unavoidable phenomenon that the world economic crisis has only accelerated, has reached Romania as well. It"s actually been here a while, but the latest statistical data have forced our authorities to admit it. Now our hopes lie with the financial support of the international financial institutions, but judging by what happened to other emerging economies in Eastern Europe, we should expect extremely unpleasant surprises by the end of the year.

Romania"s issue is not the lack of money, but rather the lack of economic activities that generate real money. Construction and services do not fit the bill. They were only temporarily the "engines" of the economy, on the back of favorable economic circumstances and of pro-cyclical economic policies.

Given these factors, can the drop of the last two semesters be considered a surprise (see chart)? Or is the only thing that is surprising the authorities" lack of reaction before the economic slowdown of the previous two quarters?

It seems Romania"s is now in the same situation that Latvia was in last year. As part of the negotiations with the IMF, authorities in Riga have taken into consideration a 5% economic drop and a maximum budget deficit of 5%. In just a few months, the contraction reached economic depression levels, the government fell, and the new government is looking at a 7% budget deficit as a pipe dream.

The unexpected drop in the first quarter shows that the economy would have to return to growth quickly and abruptly, just to be able to meet the IMF prognosis. As the probability of such an evolution is almost null, Romania"s National Bank and the government will be forced to come up with reasons for receiving the next installments of the foreign loans, in order to avoid putting Romania in Latvia"s situation.

Even though inflation, measured by the Consumer Price Index, was overshadowed by the drop in demand, the latest data in Hungary and Poland also show an unexpected increase. Is it a new trend or, as the officials of Poland"s Central Bank claim, just a temporary problem?

If the inflationary trend in the region continues, a new risk factor will affect the demand for funding. An inflation higher than expected would cause interest rates for government-bond auctions to rise, and they would become the benchmark for setting the interbank interest rates, regardless of the key interest rate of the central banks.

How will Romania"s Central Bank succeed in stopping the threat of inflation, just as it has initiated a new relaxation of the monetary policy? The statements of Central Bank governor and the articles published in financial publications seem to point that the Central Bank has not even carried out its duty to secure the stability of the exchange rate.

When the NBR is forced to defend the leu against the market"s attack for a longer period, it"s not the "evil" speculators that are to blame, but rather the intrinsic fragility of the national currency, which is a direct result of the monetary policy. The stability of a nation"s currency can not be achieved just by large scale interventions of the central bank, the effects of which can only be temporary, but rather through persistently working on building its credibility. Even if the leu didn"t break the 5 lei/euro threshold by the end of the year, a 4.2 lei/euro is enough to deepen the tensions on the currency market, (author"s note: right now we are just witnessing a market that is kept stable by fear) and to cause the depreciation to resume in 2010.

If the economy"s downward trend continues, the difficulty in keeping the budget deficit within the limits required by the secret agreement with the IMF will increase exponentially. Reducing government spending will not be enough, as it will have to decrease faster than the economy contracts.

What can we expect to happen in the coming quarters? A deepening of the recession, if lending fails to resume within a few months, because the current structure of the economy relies on cheap funding. Unfortunately for Romania, the resumption of lending is not only subject to the stabilization of the annual growth rate of non-government borrowing at around 30%. Fiscal and monetary policies, these past few years have caused the economy to become dependent on non-government lending growing at a rate of more than 50%. How can this happen from now on, given that the government is trying to cover its deficit at an annual rate of almost 200%, according to the latest data posted by the NBR?

Aside from the extremely negative domestic outlook, a recovery fueled by exports is unlikely, because Romania"s main trading partner is facing a recession of the same nature.

"The Euro zone is entering a hole so deep, that recovery, when it comes eventually, will be a long and hard journey", "The Economist" writes in its Friday electronic edition. The journey to recovery need not be long one, but it will be hard, because the imbalances accrued in the last decades need to be rectified.

After the warnings we got last year, looking at the Baltic countries can give us an idea on the possible evolution of Romania"s economy. Estonia"s shrinking lending rate, which went down from 30% in March 2008 to 3% YOY, was accompanied by a 15.6% contraction of the GDP (see table). On average, the drop of the lending rate below 10%, from around 30%, has caused the economy to drop more than 15%.

What"s even more concerning, is the fact that even an economy such as that of the Czech Republic, where the growth of non-government borrowing did not exceed 30%, went into a recession deeper than that forecasted by the most pessimistic prognosis. Its excessive reliance on exports had the last word.

The forecasts made in the beginning of the year, which showed a shrinking of the borrowing rate to less than 10% in 2009, indicate a contraction of the GDP of at least 10%, according to the correlations between Eastern Europe"s emerging economies.

As domestic demand, due to the current revenue levels of the population, can not replace foreign demand, whose slump is illustrated by the violent adjustment of the trade deficit, Romania needs a new economic strategy.

Increasing government spending and "investments" should not be part of that strategy, not even to build the needed highways. Cutting taxes and government spending could lead to the accumulation of the nation"s capital, the main factor in fighting recession. But most of all, Romania needs economic freedom to escape the crisis.