Cablegate: The Lion in Winter: Romania's Foreign Exchange

This record is a partial extract of the original cable. The full text of the original cable is not available.





E.O. 12958: N/A
SUBJECT: The Lion in Winter: Romania's Foreign Exchange
Policy Changes

This cable is Sensitive but Unclassified. Not for Internet

1. (SBU) Summary: The National Bank of Romania (BNR), the
country's central bank, has recently shifted from its long-
standing policy of closely managing the Romanian Leu (ROL)
foreign exchange (forex) rate to an infrequently managed
free float. The BNR now limits its interventions on the
forex market and refrains from announcing when they will
occur in advance. The Leu (Romanian for "lion") is gaining
strength, causing anxiety for exporters and prompting more
interest in tools to hedge currency risk. End Summary.

Increasing Unpredictability in Foreign Exchange
--------------------------------------------- ---
2. (U) The National Bank of Romania (BNR), on October 29,
switched to an infrequently managed float of the ROL on the
foreign exchange market. Since then, the ROL has
appreciated 6.3 percent against the Euro and 11.4 percent
against the USD, causing a boom for importers and increasing
concern among local exporters. The BNR's decision to cease
almost daily interventions in the currency market is based
primarily on its increasing forex reserves that have grown
more than $4.2 billion from the beginning of 2004, now
exceeding $14 billion. This amount is well within the IMF-
recommended range of reserves equivalent to four to six
months of imports. These robust reserves, coupled with a
surplus of currency in the forex market originating from
foreign remittances, foreign direct investment, and interest
income on the BNR's reserves increased the Bank's comfort
level with a freer float.

Handling Hot Money

3. (U) The BNR has defended its choice of allowing the ROL
to float wider and more often as discouraging inflows of
speculative or "hot" money. Although Romania officially has
always discouraged speculative foreign investments, they
were not seriously considered a threat until recently.
Historically, this so-called "hot" money naturally avoided
Romania due to high investment risk. Today, in spite of
incomplete liberalization of the capital account,
speculative foreign investment is dramatically increasing
due to growing signs of an improved investment environment
climate, including:
-Fitch, the international credit rating agency, recently
upgraded Romania to investment grade;
-Macro-economic indicators, including inflation,
unemployment and the budget deficits continue to stabilize;
-The IMF precautionary standby agreement allows Romania to
borrow up to approximately US$367 million if needed and
-European Union membership is expected in 2007; and
-Foreign investors have enthusiastically invested in
Romanian Eurobonds, which, according to the central bank,
may reach Euro one billion by the end of the year.

4. (U) Improved economic conditions set the stage for
increased hot money in the Romanian economy. BNR Governor
Mugur Isarescu predicts that speculative investments will
total approximately Euro one billion by the end of 2004.
Speculative investors have been particularly eager to
exploit the high interest rates offered on ROL accounts
through local banks. Investors can easily benefit from the
11.6 percent annual interest rate on ROL accounts by working
through middlemen, a positive spread of 7 to 8.5 percent
above Euro-denominated accounts. Speculators exchange hard
currency for ROL, invest in interest-bearing ROL accounts
controlled by local brokers, then withdraw the money with
the intention of quickly exchanging it for hard currency and
then exporting the profits. While exchange rates were
stable due to central bank intervention, this positive
spread was assured. Today, with increasing exchange rate
volatility, long-term bank investments, particularly those
exceeding six months, may become less attractive for
speculators if the ROL reverses its climb. Investments with
short-term maturities become more desirable; investors gain
both higher interest and benefit from the current ROL
appreciation trend.

5. (U) Foreigners resident in Romania will also soon be able
to join the group of potential speculators. Currently
prohibited from opening ROL accounts on their own,
foreigners will be able to open local currency accounts in
6. (U) The BNR decided to discourage speculative investment
by opting for a freer ROL float, rather than choosing to
place restrictions on local banks, such as mandatory
investment terms, interest-free short term accounts or early
withdrawal penalties. Although decreasing the spread
between high interest rates on ROL accounts and low rates on
hard currency accounts would also mitigate speculative
investments, large cuts are unfeasible at this time due to
relatively high Romanian inflation rates. Nevertheless, the
BNR has begun a process of lowering interest rates, which
now stands at 18.25 percent for commercial banks deposits, a
7.15 percentage point spread compared to the 11.1 percent
inflation rate. However, recalcitrant local commercial
banks have avoided following the BNR's lead to cut their own
interest rates on loans, due to a dearth of competition and
risk associated with the domestic lending market.

Keeping Inflation at Bay
7. (U) In addition to a desire to discourage speculative
investment, the timing for the BNR's decision may also be
linked to a desire to apply downward pressure on the 2004
inflation rate, targeted for nine percent. At the nine-
month mark, the inflation rate stood at 6.6 percent, and,
anticipating the need to purchase fuel for heating for the
impending winter, the GOR recognized that maintaining the
nine percent goal in the face of significant fuel imports
was unlikely. A rapidly strengthening ROL has served to
keep inflation under control by making imports cheaper.

Exporters Concerned about Impact...
8. (U) Not everyone is happy about the new managed float.
Foreign imports are becoming cheaper for the Romanian
population and Romanian export goods are becoming more
expensive on foreign markets, hurting local manufacturers.
The National Association of Exporters and Importers (ANEIR)
recently declared that Romanian exporters lost seven to ten
percent of revenue within one month as a direct result of
the switch. Bank analysts are taking a more conservative
stance, preferring to wait for two to three months of data
to analyze to what degree the new forex policy affects
exporters. ANEIR is calling for dramatic cuts in interest
rates to slow ROL purchases from speculative investors,
which are a major factor in the currency's appreciation.

9. (U) In addition, Romanian businesses are becoming
increasingly interested in currency hedging strategies,
although this is mainly coming from more sophisticated,
medium- and large-sized firms. This growing interest is
apparent on the Sibiu commodities exchange where ROL-Euro
futures contracts have increased from ten in June, 2004 to
almost 1300 during the month of November. ROL-USD contracts
have also increased from 19 to 194. Exporters who deal
mainly in Euros, importing Euro-denominated inputs, and
selling finished products priced in Euros, are virtually
immune from the switch, although salaries and local
utilities continue to be paid in ROL, which will have a
negative effect on profits.

10. (U) Romania's Minister Delegate for Foreign Trade
recently defended the BNR's policy to let the ROL
appreciate, in spite of criticism from exporters. He has
called on Romanian exporters to better prepare export
strategies and examine ways to become more competitive. He
has also has insisted that lower inflation resulting from
the new policy will greatly benefit Romanian businesses in
the long term. The BNR agrees with this assessment and has
described the earlier ROL depreciation against major
currencies as an implicit subsidy for uncompetitive Romanian
exporters that could not continue.

...But Consumers are Happy
11. (U) While exports decline, imports are surging as
Romanians eagerly purchase cheaper products from abroad,
including machinery, textiles, minerals and automobiles.
Embassy's discussions with a major U.S. car manufacturer and
importer located in Romania found increasing first-time
customer interest in U.S. vehicles and increasing sales
overall on European imports. Low cost imports are also
benefiting Romanian businesses by allowing them to purchase
tools and raw materials for lower capital costs, which will
spur growth. However, as imports increase and exports fall,
the trade deficit is widening. ANEIR believes that given
the current ROL appreciation Romania may attain a record-
high trade deficit by the end of the year.

What the Future Holds
12. (U) Capital account liberalization will advance in April
2005, with the anticipated availability of ROL denominated
bank accounts for foreigners. This will allow foreigners to
benefit from high interest without requiring the services of
a middleman. This move may unleash a renewed ROL buying
frenzy as speculators move into these accounts. Soon
afterwards, The Romanian government will create a secondary
monetary market in which domestic T-bills, certificates of
deposit and mortgages will be traded and which will likely
also be open to foreign residents. This market may also
boost confidence in the ROL, perhaps again raising its

13. (U) The BNR hopes that an additional important
psychological boost for the public perception of the Leu as
a serious and stable currency will occur next year when it
introduces the "new" Leu to replace the old currency unit.
The BNR, between July 2005 and December 2006, will divide
all current denominations by 10,000, effectively removing
four zeros from the bills. The official currency trading
designation of the Leu will change from ROL to RON
("Romanian New"). The BNR hopes that this denomination
process will assist disinflation through a psychological
effect, similar to the results that followed Poland's
currency redomination. In the long term, as Romania
approaches European Union membership and eventual adoption
of the Euro, possibly in late 2014, the BNR believes
volatility between the two currencies will diminish.
However, where the rate will stand at that time is
impossible to predict, all the more so as a new president
with center-right leanings and somewhat undefined policy
preferences has just unexpectedly been elected.

14. (SBU) Recent foreign exchange policy has shown that
Romania has subordinated exchange rate price stability to
inflation targeting, a move that is consistent with
international standards and best practices. However, this
move makes business difficult for those Romanian exporters
that may be unprepared for increased international
competition as their goods and services become more
expensive. This situation is a good test for the more
competitive environment that Romania will face in the future
as it approaches EU accession. In the short term the ROL
will likely continue to appreciate, absent significant
interference from the BNR. In the longer term, if Romania's
taste for cheap imports continues, and the trade deficit
expands, demand for hard currency should slow and reverse
current Leu appreication.


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