November 2009

1. The Impact of the Financial Crisis on the Romanian Economy and External Deficit Adjustment Mugur Isărescu Governor November 2009 NATIONAL BANK OF ROMANIA

2. I. 2000-2008: a period of catching-up and growing imbalances

3. Real GDP • Steady economic growth between 2000 and 2008 • Annual average: 5.8 percent • Drivers: catching-up, increased capital inflows due to improved risk perception (EU accession, NATO membership)

4. Inflation rate • Disinflation manifest for most of the period • Since 2004, national currency appreciation and falling external prices channelled excess demand pressures toward widening current account deficit • Temporary trend reversal in August 2007 due to supply-side shocks on both domestic and foreign markets (food and energy, in particular) and to the first wave of the global financial turmoil

5. Widening of current account deficit to unsustainable levels

6. Significant FDI flows, but lower coverage of current account deficit towards the end of the period

8. Fast-paced deepening of financial intermediation …

9. …but not as fast as in some peer countries

10. Financial intermediation* still below region’s average in 2008

11. Strong reliance of banks on foreign resources

12. Rapid increase in external debt after 2004 Fastest components • By maturity: short-term debt • By debtor: private debt

13. General government balance • “3 percent” SGP threshold observed for most of the period, but… • … progressive deterioration in fiscal position since 2006, culminating in a substantial breach of the threshold in 2008

14. Following the liberalisation of forex market in the 1990s, the NBR implemented a managed float regime Rationale Allows flexibility in dealing with real external shocks (including terms of trade shocks) External competitiveness is preserved, mitigating the consequences of an external demand contraction on the current account deficit and further on the real sector Avoids excessive exchange rate volatility, which negatively affects expectations Such a regime was consistent with gradual capital account liberalisation

15. Reasons for maintaining the managed float after adopting inflation targeting in 2005 The constraint deriving from massive capital inflows, which would have led, should the NBR not have intervened, to an even larger overappreciation of the national currency The loose wage policy resulting in pay rises overtaking productivity dynamics, reducing the previously accumulated competitiveness gains The pro-cyclical stance of fiscal policy that added to the vulnerabilities associated with the current account deficit widening

17. II. Impact of the global financial crisis on the Romanian economy

18. Limited impact on the Romanian banking system and domestic economy due to: Non-exposure to “toxic assets” which lay at the root of the crisis Prevalence of traditional banking products, which were attractive enough to credit institutions Prudential and administrative measures adopted by the NBR Global financial crisis: direct effects on Romania

19. Indirect effects have become manifest, their spill-over being detected via the following channels: I.Foreign tradechannel II. Financial channel III. Confidence channel IV. Exchange rate channel V. Wealth and balance sheet effects channel Global financial crisis and recession: indirect effects on Romania (1)

20. I. Foreign trade channel Worsening economic growth prospects in EU Member States, Romania’s main trade partners => negative impact on exports Mitigating factor: lower trade openness as compared to other Central and East European countries II. Financial channel Diminished access to external financing => impact on the lending volume, especially forex loans, and higher debt service for private companies Mitigating factor: still low level of financial intermediation Global financial crisis and recession: indirect effects on Romania (2)

21. III. Confidence channel Decrease in risk appetite of foreign investors relative to emerging economies => decline in foreign (direct and portfolio) investments IV. Exchange rate channel Lower foreign currency inflows => downward pressure on the leu V. Wealth and balance sheet effects channel Deterioration of households’ and companies’ net assets owing to: Large share of foreign currency financing and a weaker domestic currency Reduction in asset prices Global financial crisis and recession: indirect effects on Romania (3)

22. Significant economic contraction in 2009, gradual recovery ahead

23. Disinflation resumed in 2009 …

24. … and it is projected to continue in 2010-2011

25. More difficult access of private sector to bank loans

26. The authorities’ response (1) Arrangement signed with the IMF, EU and other IFIs meant to: Reduce the magnitude of the recession Restore credibility regarding external solvency Ensure time consistency of macroeconomic policy mix Function as a “crisis management programme” Enhance the stability of the foreign banks’ exposure to Romania

27. The authorities’ response (2) Made necessary by the loose fiscal and income policy stance pursued during the economic upturn Worsening of external conditions (weaker external demand; investment reliance on external financing sources) Insufficient public investment to offset the decline in private investment Insufficient efforts to qualify for EU funds

28. Seven-step increase in monetary policy rate during October 2007 - July 2008 by a total of 3.25 percentage points Maintenance of minimum reserve requirements at high levels: On lei-denominated liabilities: 20 percent On foreign-exchange-denominated liabilities: 40 percent Pursuance of a firm management over liquidity via open-market operations against the background of a gradual decline in the liquidity surplus Prudential and administrative measures aimed at slowing down the expansion of credit to the private sector and at supporting lending in domestic currency to the detriment of forex credit Policy measurestakenby theNBR before September 2008

29. Gradual reduction in the monetary policy rate to 8 percent from 10.25 percent starting with 5 February 2009 Gradual lowering of the minimum reserve requirements: On lei-denominated liabilities to 15 percent from 20 percent On foreign-currency-denominated liabilities with residual maturities of less than two years from 40 percent to 25 percent On foreign-currency-denominated liabilities with residual maturities of over 2 years from 40 percent to 0 percent Liquidity management aiming to ensure adequate functioning of the interbank money market Bilateral liquidity injections, mainly via banks’ access to the marginal lending facility Amending the rules on interbank interest rates Monetary policy measurestakenby the NBRafter the change in global liquidity conditions

30. III. Current account adjustment: stylised facts and the case of Romania

31. Romania: part of a synchronous cycle • Massive synchronous capital inflows are cyclical. Recent cycles: • 1975-1982, followed by the debt crisis • 1990-1993, followed by debt restructuring in emerging economies • 2002-2008, which ended with the deepening of the financial crisis that broke out in July 2007; manifest in Romania from 2004 to 2008

32. Determinantsof the latest synchronous cycle Positive economic outlook (and implicitly higher yield expectations) in emerging economies • Ample liquidity on international markets • Low yields in advanced economies also triggered the financial crisis

33. Trajectory of variables Pattern for developments in key macroeconomic variablesamid lower capital flows (Reinhart and Reinhart, 2008; Algieri and Bracke, 2007): Drop in GDP, as the pace of resuming growth depends on the destination and manner of managing capitals during inflow periods Real depreciation of the domestic currency, due originally to nominal depreciation and subsequently to declining inflation Short-term increase in inflation, as a result of nominal depreciation of the domestic currency, followed by a fall in inflation owing to the economic slowdown and pessimistic expectations on future performance of the economy; monetary policy renders this pattern less certain Narrowing of the current account deficit

34. Reversal in capital flows: stylised facts

35. Sharp adjustment in current account deficit to below 5% of GDP in 2009

36. The adjustment would have occurred even without the crisis Some developments had become unsustainable Sources of adjustments would have been the same: Lower external financing Confidence crunch Decline in external demand for pricier exports

37. The crisis acted as a trigger Starting with the latter half of 2007: Considerably lower liquidity on world markets Growing risk aversion of foreign investors as regards investments in emerging economies Difficulties faced by host economies

38. The crisis sped up the adjustments Due to the crisis, the following adjustments took place earlierand faster: Lower external financing for Romania Decline of confidence in Romania’s capability to adjust, given the external imbalances Weaker external demand for Romanian exports

39. Depreciation, followed by moderate exchange rate volatility

40. NBR’s interventions in the forex market Meant to keep the exchange rate in line with macroeconomic fundamentals by: Avoiding excessive weakening of the domestic currency Ensuring that exchange rate developments are consistent with the progress in current account adjustment Calibrated in line with developments in official forex reserves Used also as a tool for money market liquidity management, especially given that the public deficit has been financed, over certain periods, by resorting chiefly to funds released under the arrangement with the IMF, EU and other IFIs

41. Adequate resources for forex interventions Historical build-up of forex reserves in the period of massive capital inflows Outright purchases in order to limit the overappreciation of the domestic currency and for precautionary reasons High minimum reserve requirements on foreign liabilities Disbursements under the multilateral arrangement with the IMF, EU and other IFIs Still comfortable levels of forex reserves after interventions in support of the domestic currency after the onset of the crisis