Central Bank holds inflated view on revised inflation

On the backdrop of rising concerns about economic imbalances, widening deficits and everyday-higher imports, the National Bank of Romania (BNR) revised its outlook for the headline inflation last week by a massive 0.8 percent. The bank changed its views on 2007's inflation rate from the 3.9 percent level announced in August and the worst-case maximum of 4.9 percent to an estimated 5.7 percent.

Analysts fear that even this new figure might be overly confident. “For this year, I expect the yearend inflation to be at least 5.8 percent, following a peak in October of at least 6.7 percent. The drop in the annual inflation rate in November and December will result from a basis effect coming from the growth of energy prices last year. However, if food prices continue to go up rapidly in the last two months of the year, it is possible that this estimate will prove to have been too optimistic also,” said Catalina Constantinescu, financial analyst with ABN Amro Romania. “We expect CPI inflation figures to remain high in the next months, peaking at 6.7 percent in October and slightly decelerating to 5.9 percent through the end of the year,” said UniCredit researchers quoted in the CEE Biweekly released last week. “I would not be surprised if the new inflation target were tested. One way or another, all this will sooner or later result in a period of economic ‘consolidation',” said Matei Paun, managing partner with BAC Investments. Several factors contributed to the inflation hike, including the depreciation of the exchange rate, the subsequent higher cost of imports, and the persistent drought this year.

The annual inflation rate went to 6.03 percent in September, said BNR governor Mugur Isarescu, and the growing trend will persist for the coming months due to the 8-9 percent food price hikes in the summer months resulting from the severe year-long drought. “From an extremely favorable situation toward the end of May and June, when the consumer price index remained in the lower part of the interval, prices went above the upper margin in less than two months and there is a good chance that they will stay there for several months to come,” said Isarescu. The governor has more than the problem of inflation on his hands. The widening current account deficit, which is nearing the 14 percent level, has long been pointed out by rating agencies and international organizations as a disconcerting factor. “If we look at the Czech Republic, Hungary and Poland, countries that have a relatively flexible exchange rate, Romania's current account deficit is a regional exception. We cannot compare ourselves to Bulgaria or the Baltics, where the deficit is bigger but cannot be adjusted through the exchange rate, which is fixed,” said Constantinescu of ABN Amro.

UniCredit researchers revised upward their forecasts for the current account deficit to 13.5 percent of GDP this year, driven by the very strong import dynamic. “Despite the expected deceleration in the imports' pace of expansion, we continue to anticipate further deterioration in the external gap in 2008 (14.1 percent of GDP) with some signs of improvement only starting from 2009 (13.8 percent of GDP),” UniCredit analysts said. The bigger problem, also pointed out by Isarescu, is that Romania's deficit has become unsustainable, as the coverage by foreign direct investments has dropped appreciably, said Constantinescu. “In theory, in emerging economies the deficit can be high if FDI levels are high as well. The current issue is in fact the commercial deficit whose widening was determined by an increase in imports and a slowdown in exports,” she added. “Current account deficits are often encountered in emerging economies, but this by no means makes them less dangerous! They present policy makers and central bankers with the classic dilemma between fear and greed – a choice between short-term gains with an ensuing correction, or slower but more sustainable long term growth. Unsurprisingly, many chose the short-term gains,” said Paun. Shortsightedness from the administration is particularly what S&P sanctioned last week, when it announced it might drop Romania's rating to negative, which is the last step before lowering the country rating. “Certainly, if one wants to see if there will be a mix of policies in the future meant to reduce imbalances, one would have to wait a certain period of time, which is why the S&P said the downgrading might occur in the next 18 to 24 months. Therefore, I do not expect any downgrading this year. In the worst case, other agencies might revise their outlooks on Romania also,” said Constantinescu. However, the risks are there, and their timing coincides with a global rise of investor risk-aversion and uncertainty about emerging markets. “The risk of a downgrade is significant, as Romania's macro-economic situation continues to deteriorate against a background of global risk reassessment,” said Paun. “Clearly the

BNR should have increased interest rates more aggressively to forestall the above-average economic growth and ensuing inflation. It is true that the bank was, and is, faced with a difficult choice, but I believe not doing anything was the worst option to choose,” he said. The Central Bank should certainly further increase rates in the medium term, and one should not be surprised to see rates above 10 percent, the BAC Investment partner added.Constantinescu said she did not expect any benchmark rate rises in the short term. “At least for the first meeting in 2008, I do not expect the Central Bank to up the benchmark interest rate unless the outlook deteriorates, inflation reaches a level where real interest rates are dropping and the exchange rate is excessively depreciating. The BNR has already stated that the decision to up the benchmark rate by 0.5 pp was difficult to make, which means that another increase of a comparable size is unlikely. At worst, I expect an increase of 0.25 pp next year, if circumstances call for it,” said the ABN Amro analyst. In the end, most of Romania's economic imbalances boil down to the growing mis-managed consumption and to the administration's lack of commitment toward improving it, said analysts. “Since the Central Bank is clearly committed to slowing down consumption, but the administration's reactions do not seem to suggest the same, it is only natural that there be concerns about the future, especially since the BNR's monetary policy measures are limited. There is a need for structural reform, not merely interest rate increases, which might eventually decelerate the economic growth,” said Constantinescu. Government spending must be improved in favor of capital expenses and salaries should be upped moderately; this would be a good signal that the administration was concerned with economic imbalances, she added.

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