Romania’s rocky road to reform

ROMANIA IS PARTICULARLY vulnerable to the global credit crunch, unlike many emerging countries. It has a worryingly large current account deficit and an increasingly leveraged economy. The market is certainly pricing in tougher times ahead. Five-year credit default swap spreads for the sovereign doubled in the first six weeks of this year, reaching a high of 175 basis points, and the Bucharest stock exchange slumped by 24%.

Some believe that the pessimism is not warranted. "We think that the CDS widening in Romania has been a bit overdone and have been recommending selling CDS protection," says Arend Kapteyn, chief economist for Emea at Deutsche Bank. "The country is vulnerable but the government balance sheet is still OK and the central bank has about €25 billion in FX reserves, which covers 150% of short-term debt."

Alia Yousuf, head of emerging markets at Standard Asset Management, says: "Investors panic. It’s not so much that Romania has become a bad country – fundamentals don’t change that quickly. What has changed is people’s perception of the country. Investors focused on negative fundamentals like the current account deficit and funding requirement, and not the overall economy. This is when perception comes into play. If a market was ‘normal’ then these current account numbers would have been ignored." But crunch time is coming. In February, Standard & Poor’s and Fitch both changed Romania’s outlook to negative – a move that has brought the country close to losing its investment-grade status.

One of the main reasons for the change in S&P’s outlook is concern about a current account deficit of 14.8% of GDP. Worries about this are exacerbated when foreign direct investment figures are taken into consideration. In 2006, more than 90% of the current account deficit was financed by FDI. In 2007 this fell dramatically to 50%, even though total FDI increased. In the first nine months of 2006, Romania attracted €4.9 billion of FDI; in 2007 this rose to €5 billion. But as 2008 progresses there are fears that FDI flows could plummet.

"The privatization process is almost finished. This flow of money from foreigners is now coming to an end," says Dorin Mantescu, director of the ministry of finance. With 90% of the financial sector in foreign hands, only one state-owned bank, the National Savings Bank (CEC), is left and that is unlikely to withstand for much longer increasing competition in new products, improved risk management and high corporate governance standards. Most of the energy and communications sector is also in foreign hands. Romgas, Romania’s main natural gas producer, is the only big name slated for privatization in the near future, although the government has announced plans to sell off stakes in other companies (see box).

"It’s not so much that Romania has become a bad country. What has changed is people’s perception of the country" Alia Yousuf, Standard Asset Management

He estimates that greenfield investments increased by €1.5 billion between 2006 and 2007, and he expects up to 60% of the current account deficit to be financed by FDI in 2008. The rest of the deficit will be financed by portfolio investment. It is possible that Romania will manage to reduce its current account deficit to the government’s target of 13.9% of GDP.

To help achieve its current account ambitions, a new investment bill is pending. The new framework will give further support to foreign investors in terms of legal and tax assistance that could have a positive impact on Romania’s export capabilities. The government hopes this will secure more long-term current account receipts and reduce the trade imbalances. In the past year, the widening trade balance deficit has been identified as the main reason for the worsening current account.

Even before the passage of this legislation the trade balance has shown some signs of improvement. Imports went up by 11.3% in January 2008, compared with an average monthly increase of 24.9% in 2007. An Erste Bank country report, released in January, even predicts a reversal in the trade balance in 2009, when high-value-added exports will have reached their optimum level of more than 40%.

In line with depreciation of the leu – it has dropped 17% since mid-2007 – and food price increases, inflation is becoming a concern. In the 12-month period ending in January 2008, inflation was 6.6%. Analysts predict that this will have increased to 8.3% by March. As it became clear that the central bank had missed its inflationary target for 2008, it raised the target to 5.9% and started to increase interest rates. On March 26 the monetary policy committee voted to raise rates to 9.5%. They were 7% early in 2007.

Budget under pressure

Inflation is putting pressure on the government’s accounts. By the end of 2007, the budget deficit had risen to 2.8%. In February, the government reaffirmed that it would bring the deficit under control and reduce it to 2.3% by the end of 2008. Many market observers are sceptical about this target. It is an election year and the government has also been accused of factoring in unrealistic levels of new tax income.

Plans to capitalize on an economic growth rate of 5.5% in 2008 and better company profits could be dashed if the global picture continues to deteriorate. However, the finance ministry’s Mantescu is optimistic. "I don’t see Romanian businesses suffering that much from the global crisis," he says. "Changes in the bonus law will help – now bonuses are subject to tax and they weren’t before. The government is also cancelling some previous legislation on value-added tax to bring back some revenues that were exempt."