Romania Nicolaie Alexandru-Chidesciuc Weekly update Senior Economist Vlad Muscalu Economist Growth could fall like a rock __ Key policy rate and CPI We always talked about 2009 as an adjustment year, and now we see growth at about 2%. The RON should depreciate 15 gradually during 2009 so, although disinflation started in F'cast August, the NBR risks missing the inflation target again. 11 7 Recent developments 3 • 3Q08 GDP growth above expectations. Nonetheless, the breakdown Jan-05 Jan-06 Jan-07 Poli cy rate (%) Jan-08 Jan-09 CPI (%YoY) reveals highly worrying developments as services contracted sharply. Source: NBR, NIS, ING estimates • Finance minister says budget deficit widened to 2.9% of GDP in __ November. • Industrial production contracts 3% YoY in October. Industrial output Romanian leu (eop) growth turned negative, in line with our expectations. 4.1 IN G EU R/R ON forecast • Wage growth softens up in October. The net average nominal wage 3.9 Im pli cit EUR/RON increased by 22.4% compared to 24.6% YoY in September. 3.7 The week ahead 3.5 • On Friday, we expect Romania’s CPI to drop to 7% in November due to 3.3 sharply lower crude prices and a favourable base effect. With regards to 3.1 external trade, we expect a slight widening because of seasonal imports Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 and less demand from abroad. At the same time, we do not exclude Source: Reuters and ING estimates another sharp increase in the C/A deficit as profit repatriation most likely _ was stronger in October than in September. Core projections 2007 2008F Real GDP (%YoY) 6.0 8.0 Current account (% of GDP) -13.9 -14.2 Inflation (%YoY, avg) 4.8 7.9 Key policy rate (%) 7.50 10.25 Source: ING estimates This publication has already been published under the ING Bank Wholesale Banking brand Romania Weekly Update 8 December 2008 Assessment The dismal industrial output, along with the weak data on construction activity released on Friday (which suddenly fell from 28.3% to 19.1% YoY), implies our 4Q08 GDP forecast carries a sizeable downside risk. The outlook remains dire for the industrial sector for the rest of the year and especially in 2009, which is negative for next year’s growth prospects, though our 2009 GDP forecast is already at 1.7%. Given our bleak view on economic activity, we expect a considerable decrease in wage growth in the following year. We do not exclude growth in real wages turning negative, chiefly in the private sector. The public sector is likely to have a different development if the hike in teachers’ wages is actually implemented. However, this will not be enough to compensate for the expected fall in incomes of workers in other sectors, thus we expect consumption growth to fall substantially in 2009. The acceleration in private consumption in 3Q08 is explained by self-consumption and by possible issues in estimating deflators (this view is supported by the fact that inventories – which have no substantial economic meaning – contributed -7.7ppt to third quarter growth). The inventories impact is striking by any measure. On the election front, the PSD (social democrats) just announced they will start negotiations with the PD-L (democrat liberals, the president’s party), but they conditioned such an alliance on excluding the UDMR (ethnic Hungarians). Nonetheless, talks with the PNL (ruling liberal party) cannot be excluded as PSD members are divided between an alliance with the PD-L or the PNL. Therefore, although some steps in the right direction were taken, we still have to wait for a final outcome. Romania needs the approval of a new government as soon as possible given current and expected fiscal developments. We want to point out that Romania also needs a government to implement harsh measures with short-term costs, but medium-term benefits. Otherwise, we are afraid that, in the medium term, we may end up with sluggish economic growth for several years. It seems that political parties have become more aware about the impact the global crisis is having on Romania, but did not announce any important measures yet as they remain focused on negotiations. The news is positive as the move came faster than expected and since the two parties have 70% of the seats. However, we think the measures to be announced by any new government are of utmost importance. Data releases 3Q08 GDP growth above expectations Nonetheless, the breakdown reveals highly worrying developments as services contracted sharply. Agriculture expanded at GDP increased by about 9.1% YoY in 3Q08, slightly above our forecast (8.7%) and a fierce pace of 35% market consensus (Bloomberg: 8.7%, Reuters: 8.9%). The explanation of the still YoY but services strong expansion comes from agriculture, which grew by about 35% YoY vs our slowed down sharply forecast of 15%, which means agriculture added 4ppt to 3Q08 growth. We advised that from 7.6% to 2.6% YoY agriculture output could bring positive surprises, but farming output growth was so Romania Weekly Update 8 December 2008 strong that it even more than compensated the sharp slowdown in services from 7.6% to about 2.6% YoY in the third quarter of 2008. This should sound The contraction in services was faster and stronger than we expected (we had 6.2% alarm bells as the YoY) and this should sound alarm bells as this component accounts for about 50% of services component GDP. We had forecasted similar numbers only in 1Q09 and afterward as we thought accounts for about 50% services should show some persistence by looking at historical developments. Looking of GDP at the structure, the biggest deceleration was registered in “Financial intermediation; real estate, renting and business activities” from 6.5% to 2% YoY, followed by public administration. The component “Wholesale and retail activities, personal and household goods, hotels and restaurants; transport, storage and communication” corrected as well quite sharply from about 9.5% to 4% YoY growth in 3Q08. GDP growth excluding As a result of the above developments, the growth of GDP excluding agriculture output agriculture fell abruptly fell abruptly from 9.6% to about 5.8% YoY, according to our calculations. If we exclude from 9.6% to 5.8% YoY net taxes besides farming, it fell to 5.6% YoY. Moreover, our forecast implies a further deceleration towards 4% in the fourth quarter, with risks for a lower number. The agriculture effect The sharp slowdown should become visible in 1Q09 as agriculture’s impact should should dissipate in dissipate. Furthermore, additional worsening of Eurozone growth along with a bad 1Q09, revealing a sharp agricultural year – that we have not included in our forecast – could push GDP growth slowdown into negative territory in 2009. Fig 1 GDP growth and supply-side components’ contributions (pps) 10 9.8 9.3 9.1 9.5 7.9 8.4 8.2 7.9 6.6 8 7.0 7.0 6.3 6.0 6.1 5.7 5.7 6 4.7 4.3 4 2.6 2 0 -2 -4 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 Industry Services Agriculture Construction Net Taxes GDP Growth (%) Source: NIS, Eurostat, ING estimates _ Private consumption Also, we feel the need to highlight that most likely the private consumption acceleration less self-consumption in 3Q08 from 12.2% to 14.6% YoY is based on self-consumption – which is a very has probably important component and is highly dependent on agricultural output. Therefore, we decelerated, which believe that the exclusion of latter component from private consumption would reveal a translates to less deceleration, which means pressure on prices is decreasing. In addition, we stated pressure on prices previously that the National Institute of Statistics has issues in estimating deflators for imports and exports, thus consumption data could suffer as well as rendering private consumption growth numbers unreliable. We think this is the reason for the strong impact from inventories. Investments, mainly As regards fixed investments, more than 50% of it represents construction activity and driven by construction another significant part is cars. Both these are likely to decrease considerably in 4Q08. activity and car Moreover, 4Q04 data showed that elections had a terrible impact on investment purchases, are likely to decelerate in 4Q08 Romania Weekly Update 8 December 2008 activity and we believe this is likely to repeat this year. This would imply lower imports as well. As regards fixed investments, more than 50% of it represents construction activity and another significant part is cars. Both these are likely to decrease considerably in 4Q08. Moreover, 4Q04 data showed that elections had a terrible impact on investment activity and we believe this is likely to repeat this year. This would imply lower imports as well. Fig 2 GDP growth and expenditure components’ contributions (pps) 18 13 8 3 -2 -7 -12 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 Individual consumption Public consumption Gross Fixed Capital Formation Inventories Net Exports GDP Growth (%) Source: NIS, Eurostat, ING estimates Finance minister says budget deficit widened to 2.9% of GDP in November Budget shortfall The finance minister confirmed earlier speculation saying the budget shortfall expanded to 2.9% of expanded to 2.9% of GDP in November. This is a sharp expansion past the latest- GDP according to the available official data, which shows a 1.42% of GDP deficit was recorded at the end of finance minister September, and, given December expectations, it could be above our year-end forecast of 3.5% of GDP (cash basis). There are significant risks that this turns out to be true. A widening to 4% of A widening to 4% of GDP at the end of this year – as suggested by some other MoF GDP is harmful for the officials – could prove very harmful for the RON. Moreover, it increases the chance the RON budget shortfall for 2009 will stand above our estimate of 5.5% of GDP, with negative implications for both economic growth and the local currency. Industrial production contracts 3% YoY in October Industrial output growth turned negative, in line with our expectations. Industrial production Although the September headline figure showed a 3.8% YoY increase, the seasonally- registered the sharpest adjusted rate was barely positive. In October, industrial production registered the contraction in more than sharpest contraction in more than three years and this may only be the beginning. three years… Large chemicals-producer Oltchim has announced a 20-40% cut in output in November while Renault-owned carmaker Dacia has extended an almost three-week halt in production by another month. ...and the outlook This should lead to a sharp contraction in November and the downtrend is likely to remains dire continue as Eurozone leading indicators point to a considerable deterioration in business activity. All these also imply sluggish profits and wages growth that could lead to a deterioration of consumer and business confidence. Therefore, at some point in future, policymakers' attention might shift away from inflation to the real economy. Romania Weekly Update 8 December 2008 The industry breakdown shows the largest contraction took place in the manufacturing sector where output dropped by 4.7% YoY as this sector is most exposed to external demand. A softer deceleration took place in the energy sector while mining activity remained roughly unchanged. Among goods categories, the capital and intermediate goods contracted sharply, while energy and current goods proved more resilient. Fig 3 Industrial output (%YoY) 25 20 15 10 5 0 -5 -10 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Total Mining Manufacturing Energy Source: NIS, ING estimates _ Wage growth softens up in October The net average nominal wage increased by 22.4% compared to 24.6% YoY in September. The pace of wage We were expecting a mild slowdown, but the deceleration slightly surpassed our growth in the private estimation. Although public sector wage growth decelerated less than our sector is likely to follow expectations, the slowdown in the private sector more than compensated the former a decelerating trend… soft deceleration. Workers are feeling the effects of the companies’ struggles to cope with falling demand and, since we expect economic activity to soften going further, the pace of wage growth in the private sector is likely to follow a decelerating trend. …but a sharp slowdown A sharp slowdown seems unlikely as the dynamic of public sector wages is strong and seems unlikely workers in this sector account for almost 25% of total employees. This could prevent sharp falls in annual growth rates in particular if the 50% increase in teachers’ wages is implemented. Romania Weekly Update 8 December 2008 Fig 4 Average wage dynamics (%YoY) 74.8 52.6 35 30 25 20 15 10 5 0 -5 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Private Sector Public Sector Average wage Source: NIS, ING estimates _ FX and money market strategy The front end of the depo curve is likely to continue to soften as flows from the MoF return to the market around this time of the month. Sharp falls should not be expected as the central bank is likely to step in the money market absorbing excess liquidity. News that the budget deficit has almost reached 3% of GDP in November is likely to drive EUR/RON upwards. The 3.8500 resistance level has been broken and the pair seems to be biased to the upside as this is also supported by low interest rates. Money market and fixed income The increase in available liquidity, caused by the cut in RON reserve requirements, continued to drive interest rates lower. Short-term funding rates opened the week at 15% and traded at the end of Friday’s session at 12%. As we anticipated, short-term funding rates slipped below the NBR credit facility and look likely to fall below the key policy rate of 10.25% during this week. Large falls below this level should not be expected as the central bank will probably hold open-market operations to prevent the building of cheaply funded large short-RON positions. On the primary debt market, the MoF sold RON612m in 3M T-bills and RON221m in 5Y T-bonds at yields up to 14.25% and 13%, respectively. This week it plans to sell RON1bn in 6M T-bills for which it paid a maximum yield of 14.25% in the previous month. The MoF has repeatedly stated that it will not accept yields above the 14.25% credit facility level of the NBR, but demand below this level is turning thin as the average accepted yield have risen sharply and now stands at a maximum 2bp below 14.25%. The news that the budget shortfall reached 2.9% of GDP in November could soften demand for MoF instruments, forcing the MoF to accept higher yields to access liquidity. When the 14.25% threshold is broken, yields are likely to jump in large steps Romania Weekly Update 8 December 2008 after a period of one month and a half during which they should have strangely stalled at this level. Fig 5 Short-term rates – weekly assessment Direction Comment NBR key policy rate path ◄► The central bank kept its powder dry at the last rate-setting meeting. The expected sharp adjustment in economic growth could turn the NBR’s attention away from inflation, which means a cut in the key rate during 1Q09 and more cuts in the MRR for both RON and FX should not be excluded. NBR open-market operations ◄► If the central bank organises the usual Monday open market operation, it will probably not raise any significant interest as SW rates trade above the key policy rate. Since we expect the front end of the curve to slip below 10.25% in the following session, there is a possibility the NBR will drain excess liquidity from the market in the last trading sessions of the week. Autonomous liquidity factors ▼ Flows from the MoF return to the market around this time of the month, increasing market liquidity. Although flows to and from the MoF are very important from a liquidity- management point of view, they are hard to predict. Offshore interest in RON ▼ FX swap implied yields for RON stand about 2ppt below depo rates, signalling that local l demand for hard currency funding outweighs the offshore need for RON liquidity. We expect this tendency to become more pronounced in the future, thus increasing the likelihood of cuts in the MRR for FX. Furthermore, this should put upside pressure on the EUR/RON. On balance ▼ The front end of the depo curve is likely to continue to soften as flows from the MoF return to the market around this time of the month. Sharp falls should not be expected as the central bank is likely to step in the money market absorbing excess liquidity. Source: ING estimates FX market The Romanian currency weakened about 1.5% in the last week. Intraday trading has been quiet and the RON seems to have somewhat decoupled from its regional peers, which lost more ground against the euro. The 3.8500 support level was broken on Friday and EUR/RON seems biased to the upside. The fall in short-term rates is likely to induce a weakening trend, but a larger impact is likely to come from the statement of the finance minister who said the budget shortfall expanded to 2.9% of GDP in November. However, very large depreciation moves look less probable as profit taking orders are likely to be triggered quickly since the low levels of liquidity amplify the impact of a FX intervention. Romania Weekly Update 8 December 2008 Fig 6 EUR/RON weekly assessment Direction Comment Current account deficit ▲ We look for a widening to slightly above 14% of GDP based on our view that the Eurozone slowdown will negatively impact export growth. Short-term interest rate gap ▲ Short-term interest rates have fallen to 12% and we expect they will weaken further, which eases the cost of funding short RON positions. Remittances ◄► Remittances flows should have a limited impact on exchange rate developments. Risk premium ▲ Regional currencies continued to follow a weakening trend and RON is likely to follow. As Romania is the only EU member state rated below investment grade, the Romanian currency may come under more pressure than its peers if the wave of selling orders continues. Technical ▲ For the short term: Support 3.8000; Resistance 3.9500; upward bias. On balance ▲ News that the budget deficit has almost reached 3% of GDP in November is likely to drive EUR/RON. The 3.8500 resistance level has been broken and the pair seems to be biased to the upside as this is also supported by low interest rates. Source: ING estimates Economic outlook Fig 7 Economic forecast summary Current 1Q08 2Q08 3Q08 4Q08F 1Q09 2Q09 2007 2008F 2009F EUR/RON* 3.87 3.7216 3.6475 3.7336 3.90 3.95 4.05 3.3373 3.68 3.96 5Y bond yield end period (%)* 13.25 9.4 9.6 10 14.8 15 14.3 7.5 11 14.1 3m interest rate end period (%)* 15.9 10.96 12 13.7 19.3 19.8 16 7.9 14 15.6 CPI (%YoY)* 7.4 8.6 8.6 7.3 7 6.6 6.1 4.8 7.9 7 GDP (%YoY)* 9.1 8.2 9.3 9.1 5.4 2.5 1.6 6 8.1 1.7 NBR key policy rate end period (%) 10.25 9.5 10 10.25 10.25 9.75 9.5 7.5 10.25 9 *Quarterly forecasts are eop; yearly forecasts are average over the year _ Romania Weekly Update 8 December 2008 Disclaimer This report has been prepared on behalf of ING (being for this purpose the wholesale and investment banking business of ING Bank NV and certain of its subsidiary companies) solely for the information of its clients. ING forms part of ING Group (being for this purpose ING Groep NV and its subsidiary and affiliated companies). 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