At the crossroads – again

Romania is poised in a familiar position: its sovereign credit is shaky, structural weaknesses persist, and the government is promising reform. Trevor Utting warns that transformation of the economy demands tough action, something for which the current government has shown little stomach.

Romania has experienced a bumpy ride over the past decade, with many a false dawn. The near-crisis of the late 1990s gave way to a period of tentative recovery in 2001 and 2002, but once again the sovereign credit is facing a stern challenge. Further delay in tackling the country’s longstanding structural weaknesses – high unemployment, an overstaffed public sector, anaemic domestic demand and weak government finances – may provoke another financial crisis. The Romanian authorities cannot afford to rely on monetary and fiscal tools alone: transformation of the economy demands tough action, which the government has, thus far, proven unwilling to contemplate.

The Moorgate Group’s analysis suggests that investors should – on the credit fundamentals – resist any near-term downward pressure on credit spreads, although with demand for European high-yield assets gathering pace, fundamentals might be ignored in the rush for assets.

Underplaying risks

Romania has become accustomed to far more positive press from analysts in recent times, reflecting better economic growth, lower inflation and lower unemployment (Figures 1 and 2). Meanwhile, the government has, more or less, remained in control of the budget deficit, encouraged by the International Monetary Fund (IMF). To be fair, sovereign credit ratings remain firmly in the speculative range, i.e. from B1 (Moody’s) to BB- (S&P), but investors have bought into the recovery story, subscribing to new bond and loan facilities.

Of course, all major analytical sources list the ‘conditions precedent’ to sustained recovery, but hesitate to spell out the possible downside scenario should the reform process stall. In fact, the stakes are high: Romania has a lot to win or lose, with the outcome dependent upon a narrow range of key issues.

Ultimately, we believe that Romania’s medium-term prospects depend crucially on the success or failure of the transition of a significant part of the workforce into more efficient segments of the economy. The management and outcome of this process will prove the key driver for wider economic, and credit prospects.

‘Political-economic’ cycles

Romania’s current ‘reform phase’ is hardly new; the economy underwent a similar reform attempt in the previous decade, with limited success. In 2003, key macroeconomic indicators – GDP, inflation and unemployment – are basically unchanged from those back in 1995, scant reward for eight years of political and economic turmoil.

The 1995 ‘peak’ had been achieved by relatively strict monetary policy and some tightening of fiscal policy, but marginal loosening of the economic reins almost brought the country to its knees in 1997, amidst a currency collapse and runaway inflation. Underlying this setback was a more fundamental weakness, however – the inefficient structure of the productive economy. Attempts to solve Romania’s entrenched problems through purely economic means failed as the fundamental inefficiencies of the economy began to take a toll on GDP growth. Indeed, monetary and fiscal policy was, with hindsight, failing as early as 1995 and in recognition of this fact, the government proposed, but ultimately postponed, several important structural reforms in 1996. These tough measures were abandoned in the face of social opposition. Figure 1 demonstrates the economic consequences of a stop-go approach to the reform process.

Today the government is once again considering the implementation of meaningful reforms. It remains to be seen whether this nominally socialist government will demonstrate the political will to carry through a reform programme, and to what extent the electorate will oppose drastic increases in the cost of energy, transportation and other infrastructure services alongside severe job cuts in the public sector.

The challenge of reform

As in the period of economic depression in 1997-1999, today’s government (under IMF tutelage) is taking on board a quite restrictive monetary policy through appreciation of the Leu (Figure 2) and a fiscal policy aimed at a modest decrease in the budget deficit. This orthodox stance has been rewarded by a fall in inflation and unemployment, and an acceleration in economic growth. But, as before, it appears that this positive trend is unsustainable. This explains why Prime Minister Adrian Nastase’s government is once again trying to introduce structural reforms.

Nastase’s government is facing a substantial test:

Despite positive changes since 1996, approximately 30% of Romania’s labour force worked for the government in 2002. Moreover, the position in the manufacturing sector is more problematic: approximately 50% are state employees, concentrated in urban areas – a potential source of social unrest;
Key utilities have not been touched by privatisation and remain entirely in state hands. Most energy prices remain highly regulated;
Public-sector wages are a key source of inflation, showing higher growth than in the private sector. Going forward, the targets embedded in Romania’s IMF programme will be difficult to meet given wage pressures in the public sector;
Worse yet, the government has to subsidise most state-owned enterprises (SOE), the majority of which are unprofitable. Little surprise then that Romania failed to comply with IMF targets on SOE performance under five consecutive programmes.

In consequence of all these structural problems, and irrespective of the stage of the economic cycle, the share of state budget expenses within total GDP has remained stable at around 30% of GDP since 1994. In Moorgate’s opinion, this ratio is the single most important measure of failure to transform the wider economy.

No reform, no economic growth

The Nastase administration should be looking for immediate action aimed at the reduction of private-sector subsidy of a value-subtracting public sector. This requires the speedy shift of employees from the public sector into the private sector, the prompt deregulation of energy prices and the freeing of budgetary resources to improve the depleted basic infrastructure of the country. Also required is modernisation of the retail residential sector, possibly through a system of guarantees for public-sector companies. Such measures would not only transfer government funds to more useful purposes, but would also stimulate internal demand.

Additionally, the government should drop its policy of controlling inflation through appreciation of the Leu; this is distorting Romania’s export structure and impairing an important driver of economic growth. At the same time, protectionist measures should be phased out since they distort the economic structure of the economy by benefiting those importers with the political lobby to fix tariff exemptions.

A political gamble

The incumbent administration is in a far better position than the politicians attempting to implement reforms back in 1996, when the private sector constituted only 55% of GDP, compared to around 67% in 2001. Nevertheless, the situation remains very difficult. If structural reforms are introduced it would not be irrational to expect, at least at the outset, a far higher level of unemployment, concentrated in some areas of the country. This could lead to unwelcome social and, therefore, political pressures on the broadly pro-reform Nastase cabinet.

The shift of political preferences on the part of Romanian society over the past eight years – first towards an unorganised rightist spectrum of parties and then back to the nominally socialist PSDR – reflects the instability of social support for any government, including the current administration. It is important to mention that the PSDR majority relies on an alliance with representatives of the Hungarian minority party.

The real test for success of economic policy will come in 2004, when Nastase must return to the polls. While waiting for this critical point, Romania’s likelihood of success should be measured by:

The ability to consolidate political power to vote on reforms;
The ability to contain social unrest once reforms are introduced;
The capacity of the economy to generate employment;
The reduction of state funds directed to the public sector.

For more information on Moorgate Group research, telephone +44 (0)20 7071 0007.

Trevor Utting is head of research for the Moorgate Group in London.