Cablegate: Romania's Economy Set for a Landing, but How Hard?

DE RUEHBM #0920/01 3301548
P 251548Z NOV 08




E.O. 12958: DECL: 11/25/2018


Classified By: DCM Jeri Guthrie-Corn for Reasons 1.4 (B) and (D).


1. (C) The forward momentum in Romania's red-hot economy is already slowing and will definitely hit the brakes in 2009, government officials and outside analysts told visiting U.S. Treasury representatives last week. Still, while Romania can expect sharply lower growth due to the global downturn, the majority view is that Romania will still escape a recession. The banking system is generally stable and has so far shown few major effects from the meltdown that hit the financial sector in developed markets over the last two months. Emerging troubles in the real economy will further stress the banking sector, but will also force a tightening of the loose consumer credit boom which has fueled consumption and helped push the current account deficit to uncomfortably large levels. All eyes now are on the Government of Romania's (GOR) growing fiscal deficit amid concerns over how the deficit will be financed, especially given the GOR's effective lack of access to external borrowing in the current tough global environment. While GOR officials continue to maintain that Romania's high-flying economy will glide in for a soft touch-down in 2009, many outside analysts seem increasingly convinced that it's time to start fastening the safety belts for a rougher landing. End summary.


2. (SBU) Despite the turmoil in global financial markets over the last two months, Romania's banking sector is relatively stable, officials of the National Bank (BNR) told visiting analysts from the U.S. Treasury Department on November 18-19. According to BNR Director for Bank Supervision Nicolae Cinteza, close to 90 percent of Romania's banking sector is controlled by local subsidiaries of large European banks, and 94 percent of banks' foreign liabilities are owed to parent institutions. The level of financial intermediation in Romania is low compared to the rest of Europe, and local banks have little exposure to the types of distressed assets that have hurt institutions in the United States and elsewhere, Cinteza said. Banks' solvency ratios currently average nearly 12 percent, well in excess of the legal limit of eight percent, and BNR enforces very high reserve deposit requirements (40 percent of the value of loan portfolios in foreign currency and 18 percent for loans in Romanian lei). Romanian banks have generally been very profitable and BNR sees no movement by external parent banks to repatriate capital, although nearly all banks have sharply curtailed lending in recent weeks and parent banks are not providing additional capital to increase market exposure, Cinteza noted.


3. (SBU) While local banks have so far weathered the financial crisis well, potential signs of trouble from the real economy are emerging, according to BNR Director for Financial Stability Ion Dragulin. All banks have been pinched by extremely high overnight and inter-market rates stemming from inter-bank confidence problems, and the BNR has had to intervene occasionally to inject additional liquidity.

However, BNR sees these as episodic rather than systemic problems, and inter-bank rates have moderated since October, Dragulin said. Of greater concern are challenges posed by the impending slowdown in the real economy. GDP growth over the last couple of years has been led by construction, but this has slowed down in tandem with falling real estate prices which are currently down 25-30 percent from highs registered earlier this year. The rate of non-performing loans, though still low, is trending upward. The availability of credit is shrinking; banks have tightened their own lending policies in response to market uncertainties at the same time that BNR has imposed new restrictions on credit, with tougher loan-to-income ratios and better documentation required from borrowers. With unemployment starting to increase and evidence of easing in tight labor markets, demand for credit is moderating and borrowers are finding it much harder to qualify for loans, Dragulin observed. (This was confirmed anecdotally by a senior economic adviser to the Prime Minister, who told the Treasury analysts in a separate discussion that he himself had been unable to qualify recently for a mortgage loan.)

4. (SBU) Dragulin admitted that the banking sector had yet to be tested by a full-fledged economic downturn, and with signs of weakness just starting to multiply, the next several months would likely be tough ones. Even so, he insisted that BNR's recent "stress testing" scenarios -) accounting for further leu depreciation, higher interest rates, and a much softer economy -) continued to indicate that most banks would remain within BNR solvency limits and that the risk of a systemic financial sector failure in Romania is low. Dragulin did confess, however, that a recent, previously-scheduled technical mission from the IMF had recommended that BNR needed to be less optimistic in its stress test assumptions, and that the GOR needed to improve coordination and crisis management capability among state financial institutions. The GOR has set up an interagency working group on these issues, he said.


5. (C) Dorin Mantescu, Director for Macroeconomic Analysis and Economic/Financial Policies at the Ministry of Economy and Finance (MEF), was surprisingly direct in acknowledging that election politics is playing havoc with the budget. Coming off a very strong year -) MEF believes GDP growth will average close to eight percent for 2008 despite the end-of-year slowdown -) politicians are primed to keep spending money despite warning signs that fiscal prudence is needed. Mantescu predicted that Romania's current account (CA) deficit will end the year at just over 13 percent of GDP, down slightly from 2007, helped by depreciation of the leu in the third quarter. Even so, Romania's external financing needs remain very large. FDI coverage of the CA deficit rose to 65 percent in the third quarter but will likely fall off by year's end as foreign investors start to curtail their plans. Foreign remittances from Romanians working abroad are also expected to decline, particularly as recessions in major destination countries like Italy and Spain affect the expatriate workforce.

6. (C) Mantescu lamented that for every positive trend, there is now a countervailing negative one. Slower growth will dampen consumption and act to bring down the CA deficit on its own, but FDI and remittance flows may fall even faster, creating a short-term financing squeeze. State budget revenues are up a healthy 31 percent in 2008 but government spending has risen at an even faster clip, with much of that coming in the form of permanent increases in public sector wages and pensions. Mantescu conceded that the GOR's official projection of six percent GDP growth in 2009 is much too high, with three to four percent the most optimistic estimate. Extremely tight conditions in international credit markets, combined with the recent downgrade of Romania's sovereign debt rating to "junk" status by Standard and Poor's and Fitch, have effectively closed off GOR access to external financing in the near term. Therefore, the fiscal deficit must be financed internally through T-bill auctions at very high yields. The GOR needs to raise about 2.5 billion euros more by the end of December, a sizeable amount for the internal market. Financing needs in early 2009 loom as an even greater challenge, Mantescu said, particularly in light of the exorbitant spending promises being generated in the current parliamentary election campaign. "The next few months will be very tough," he concluded.

7. (C) At the same time, Stefan Nanu, MEF Director for the Treasury and Public Debt, insisted to the Treasury visitors that sufficient domestic demand exists to finance the deficit on the local market. In contrast to Mantescu's gloomy assessment, Nanu predicted that the fiscal deficit for 2008 will come in well under three percent of GDP and will be easily financed; "our last auction was oversubscribed," he boasted. Nanu said 2009 GDP growth could be as high as five percent and that Romania's external financing needs would be minimal, noting that none of Romania's current external debt is due to roll over until 2010. He did express some concern about the 2009 budget, which won't be adopted until early in the year when a new government and parliament are in place, and agreed that big wage hikes for teachers and other public sector workers would put a lot of pressure on GOR finances if fully implemented. Still, he believed this could be partially mitigated through better MEF internal controls to keep other ministries from reprogramming funds and by forcing the ministries to return unused monies to MEF. Nanu was dismissive of the rating agencies which recently downgraded Romania, saying "they have been blind to anything that is positive" in the country's macroeconomic picture.


8. (C) IMF resident representative Juan Fernandez-Ansola and Raffeisen Bank Vice President John Stewart told the Treasury visitors in separate meetings that, from their perspectives, the near-term prognosis for Romania is very worrisome. Both predicted that the fiscal deficit for 2008 would exceed the GOR's predictions, and that funding pressures into 2009 would be severely aggravated by the lack of access to external financing. Not only does Romania need to find a way to cover the deficit )- and Stewart observed that the potential shortfall could equal nearly the entire value of liquidity available in the internal commercial market - but it must do so at a time when economic growth is slowing rapidly. To get back on sound fiscal footing, the GOR needs a budget correction of four to five GDP percentage points. If the deficit continues to balloon, the correction could be forced on Romania in the form of a rapid depreciation of the leu and a potential balance-of-payments crisis. In that regard, both interlocutors said the BNR will use its substantial foreign currency reserves to try to prevent dramatic movements in the exchange rate, but will likely not resist a gradual weakening of the leu, even past the psychologically important level of four lei to the euro (the current rate is about 3.8). Stewart opined that Romania may have no choice but to seek assistance from the IMF in early 2009. Fernandez-Ansola was noncommittal on that point, but observed, "the next three to four months will be crucial."


9. (SBU) Construction cranes still dot the Bucharest skyline and shopping center parking lots are as full as ever. Still, evidence is mounting that the Romanian economy is slowing down after averaging well in excess of six percent GDP growth annually over the last five years. Romania's biggest domestic car maker, the Renault-owned Dacia, suspended production at its Pitesti assembly plant for the first half of November due to weak demand. Similar suspensions have been announced by steel maker Arcelor Mittal and Rompetrol's petrochemicals division. Occasional announcements of new FDI projects still appear in the local press, but they are far outnumbered by reports that investors are scaling back or deferring plans altogether. (Post will report septel on FDI trends.) The notoriously tight labor market, which has driven wages in some sectors to near Western European levels, is slackening. The MEF's Ion Dragulin said IT engineers, attorneys, accountants, and other professionals cannot command the same high salary increases which they were demanding just a few months ago.

10.(C) The rapidity with which the economy has begun to show signs of stress has taken political leaders by surprise, and many of them remain in denial. While Prime Minister Calin-Popescu Tariceanu was insisting as late as mid-October that Romania would largely escape the financial crisis, the debate now is over just how bad the economic slowdown is going to get. Politicians across the spectrum had berated Standard and Poor's and Fitch for downgrading Romania, while praising Moody's for not following suit. However, when Moody's local analyst announced November 24 that the situation is worse than estimated and that Romania may actually face a recession in 2009, the Prime Minister retorted that that "Moody's has a problem with respect to their insufficient knowledge of the Romanian economy". For his part, President Traian Basescu stressed to the media that Moody's had not opted to downgrade Romania at this time despite the gloomy analytic forecast.


11. (C) Romania is certain to face tough going because of the global economic crisis, particularly through the first half of 2009. The big question now is whether the economy will simply glide in for a soft landing or will hit the ground harder. There are factors that should soften the blow. Government debt as a percentage of GDP is very low (about 12 percent) compared to the rest of Europe. While private credit growth has been dramatic in recent years, the average household's indebtedness remains very modest by European standards. Analysts across the board praise the BNR for its stewardship of the banking and monetary system, and the financial sector remains relatively stable. Leu depreciation and tightening of lending standards have already boosted exports, trimmed imports, and dampened consumption, reversing the growth trend in the CA deficit.

12.(C) Analysts also agree, however, that the GOR is fiscally ill-prepared for tough times, and their critique of the political leadership (or, more accurately, the lack thereof) at MEF is especially harsh. MEF appears to have no coherent debt management policy and has proven inept at paying the bills even in good times. In the coming crunch, the MEF will do anything it possibly can to avoid going hat-in-hand to the IMF, meaning that some creditors and contractors - including important U.S. corporate names like Bechtel and Lockheed-Martin - are probably not going to get paid. This situation comes against the backdrop of elections, in which all political parties have made dramatic spending promises in an effort to woo voters (reftel). If even a portion of those commitments are implemented, the fiscal deficit will mushroom. Add to that the drying up of consumer credit, drops in FDI and foreign remittance levels, and a fall in exports to troubled, major European markets, and the forecast for 2009 starts to look bleaker indeed. Whatever government emerges from the November 30 elections, it will have its hands full. End comment.


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