A Multi-Country Evaluation of Trade Imbalances
Table of Contents
Prior to 1989 Romania consistently sustained a trade surplus. However, because Romania was the one of the last countries in Eastern Europe to start the process of economic reform the transition shock was particularly large. In the immediate outset of transition, Romania lost most of its trading partners from the former communist bloc but was also affected by the UN sanctions against other traditional export markets such as Iraq and former Yugoslavia. In 1990 exports collapsed while imports surged. During 1990s Romania consistently ran current account deficit and remained a net creditor nation until 1995. In 1995, Romania became a net debtor nation because of its heavy reliance on long-term debt to finance its import requirements and fiscal deficits. Romania's current account exhibits strong structural weaknesses, which indicate that the current account imbalances are likely to become unsustainable in the short-term. Coupled with increasing debt service burden, Romania is becoming unable to meet its import and interest obligations because the country has failed to pursue consistent policies aimed at stabilizing economic growth, transforming public enterprises and attracting foreign investment as well as reducing its dependency on imports.
Political and Economic Overview
While Romania is often portrayed as a poor country, the country has large development potential. With over 22 million inhabitants, Romania has the second largest population (after Poland) in Central and Eastern Europe and a large stock of skilled labor. It also has a generous endowment of natural resources, notably including energy and agricultural land. The economic choices of the communist regime led to the development of an industrial complex heavily dependent on domestic energy resources as well as imported energy and raw materials. Prior to the otherthrow of the communist regime Romania pursued the policy of economic autarky, which retarded technological development and lowered the standards of living. From the overthrow of the communist regime in December, 1989, until the November 1996 elections, Romania was led by the same president (Ion Iliescu) and the same social democratic government comprised of a disparate coalition of parties. The Iliescu administration reversed most of the policies imposed by the communist regime and adopted a pro-reform approach to the economy. Party divisions within the administration and frequent conflicts deterred the implementation of radical economic and political reforms. Instead, the Iliescu administration adopted a gradualist approach, which shielded the electorate from the pain of rapid restructuring. The exchange rate and most prices remained controlled, and loss-making enterprises, which were in dire need of restructuring, continued to operate with substantial government assistance. Excessive government spending combined with half-hearted efforts at economic reform resulted in a rapidly increasing fiscal deficit and rising inflation. The administration's inability to adopt a strongly reformist economic policy resulted in growing economic instability and rapidly increasing social costs.
The growing economic instability associated with delayed reforms shifted popular support toward a coalition of opposition parties in 1996, which led to the election of a pro-reform President, Emil Constantinescu, as well as to the dominance of the Democratic Convention in the Parliament. In early 1997, the coalition government committed the country to an austerity program and broad institutional reform in exchange for financial assistance from the international financial institutions. A package of over 100 laws was adopted in the course of 1997 in an effort to establish a market-based institutional framework. The government committed itself to tight fiscal and monetary policies to reign in inflation and adjust fiscal imbalances. Moreover, the administration pledged to privatize over 60% of all state-owned companies by the end of 1997. While the government has been relatively successful in achieving inflation and fiscal targets, it has failed to carry out the planned process of privatization. Inter-cabinet disagreements and conflicts within the ruling coalition derailed the successful implementation of economic reforms. In March 1998, Chiorbea handed in his resignation after the IMF criticized the political stalemate that was hampering reform. A new administration, headed by Radu Vasile, was appointed in April, 1998 and continues to experience the internal dissent that plagued the previous administration. Disagreements have been particularly bitter over issues concerning the budget and privatization.
Since the overthrow of the communist regime, Romania increasing relied on international trade as a source of economic growth: overall share of trade(exports and imports) in GDP has increased from 43% in 1990 to 60% in 1996. Because of the collapse of the CMEA trading system, Romania's current account showed a deficit of 8.5% of GDP in 1990 and deficits of 5.7% in 1991 and of 7.7% in 1992. The return to positive GDP in 1993 improved the current account but it did not return to a surplus. Current account deficits averaged 3.8% of GDP in 1993-1996 period compared with 7.5% average in the 1990-92 period. The current account deficits widened again in 1997 and 1998 as the economy severely contracted upon the implementation of the economic restructuring program.
As in all transitional economies after 1990, a strong redirection of trade flows also occurred in Romania. In 1996, OECD countries represented 65% of Romanian foreign trade, the most important partners being Germany (18.4% of exports) and Italy (17.1%). The Russian Federation and other transition countries accounted for a minor part of foreign trade. However, recently cross-border exports to Moldova, Hungary and Bulgaria registered significant growth. The share of the rest of the world, including developing countries, which absorb approximately one quarter of Romanian exports, has remained important.
The composition of the Romanian current account exhibits strong structural weaknesses that point to the increasing unsustainability of its current account. When Romania returned to the positive GDP growth, imports continued to grow much faster than exports. Another sign of a structural weakness is Romania's balance on services. Since 1990, Romania was consistently running a deficit even in tourism services. At the same time, servicing of its accumulating debt has become increasingly burdensome and Romania has shown a consistent deficit in its income account since 1991. Only net unrequited transfers (mainly workers remittances) are supporting the current account with a positive balance of around US$500 million in 1996. It is noteworthy that the net errors and omissions reached major proportions casting doubt on the overall interpretation of the balance of payments. In 1996 US$350 million were not identified while in 1997 net errors and omissions reached US$1.296 billion, almost fourfold rise compared to the previous year.
The composition of Romania's export base highlights the fragility of its current account. Romanian exports consist of a narrow range of labor-intensive and low-technology products including clothing, footwear, furniture, iron and steel and non-ferrous metal. Moreover, the technological content of Romanian exports has declined since the end of central planning. Romanian exports have suffered from further falls in the level of processing between 1993 and 1997. Although exports of iron and steel rose threefold between 1993 and 1997, exports of metal products with a higher degree of processing declined. Exports of consumer goods, including cookers and TV sets, also fell over this period. Similarly exports of unsophisticated chemicals such as caustic soda and soda ash increased while exports of sophisticated petrochemical products such as toluene declined. A similar situation prevails with regard to some agricultural products, with increase exports of live cattle and falls in exports of fresh beef. In addition, the maintenance of an overvalued exchange rate has adversely affected the performance of the Romanian export sector. Following the Asian crisis and the rapid depreciation of currencies in the region in late 1997 and early 1998, Romanian exports are facing increasing price competition from Southeast Asia. As a result, exports declined by 10.6% year on year in the first quarter of 1998 and are expected to further suffer from the lack of competitiveness unless the administration allows for depreciation of the Leu.
Romania's economy relies heavily on imports. Fully 80% of its import requirements are raw materials, primarily oil and gas. Romania is also a net importer of minerals, machinery, electrical devices, plastics, and rubber. Romania's vulnerability to import prices and its heavy reliance on imported inputs is exhibited by the disproportionate rise in imports generated by export-oriented growth. When the GDP peaked in 1995, exports rose by 29% while imports rose by 45% year-on-year. In 1996, exports rose by mere 2% while imports increased by 11%. While Romania has made attempts to increase its industrial efficiency and decrease its reliance on imports, a 7.6% increase in imports on a year-to-year basis over the first five months of 1998 reflects Romania's profound economic inefficiency.
During 1991 and 1992, GDP fell by around 20% and industrial output by more than 50%. GDP growth became positive in 1993 and peaked at 7.1% in 1995. The recovery was largely driven by export growth and a rise in domestic demand. The high export growth was accompanied by more than a proportionate increase in imports. Exports due to the weaker demand collapsed in 1996 but the domestic demand continued to be buoyant due to the continued support to agriculture and industry through direct credits and the artificial stabilization of the exchange rate. While Romanian GDP grew by 4.1% in 1996, it declined by 6.6% in 1997. The contraction was attributed to fiscal and monetary tightening as well as the lack of competitiveness of Romanian exports. Real GDP fell by 9.4% in the first quarter of 1998 compared with the year earlier period. Government consumption fell by 11.1%, reflecting the continuing squeeze on government services. Fixed investment fell by 2.1% in the first quarter compared with the year-earlier period. Under the impact of tight financial policies, industrial output fell by 12.7% in the first five months of 1998 compared with the corresponding period of 1997. The downward trend in GDP continued throughout 1998. Despite real growth in fixed investment of 0.5% and growth in retail sales of 5.6% GDP contracted by 5.2% in the first half of 1998. The deterioration in Romania's economic situation continued in the second half of the year, leading to 7.3% GDP contraction in 1998.
Foreign Exchange and Monetary Policy
Since 1993 National Bank of Romania (NBR) attempted to maintain tight monetary policy, which tended to relapse under the government pressure or when the Bank prematurely relaxed the monetary constraints. As of the end-1993, annual inflation reached 300%. In a major policy breakthrough during 1993-94 the National Bank of Romania dramatically increased nominal interest rates, which caused interest rates to become positive in early 1996. However, with the growing current account deficit and the depletion of foreign exchange reserves during 1995, a confidence crisis arose in the foreign exchange market and the Romanian Leu sharply depreciated in the final quarter of 1995. While NRB attempted to tighten monetary policy and stabilize the currency, the populist policies in 1996 resulted in the widening fiscal deficit which had to be financed through money creation. With a rapid growth in money base, inflation accelerated from 28% at end-1995 to 57% at end-1996, and was rising at 10% monthly rate. The monetary system was further destabilized in 1997 upon the liberalization of prices combined with generous compensation packages received by the laid-off miners when the government began shutting down loss-making enterprises. In 1997 annualized inflation was 151%.
The erratic changes in the Romanian monetary policy induced significant swings in the exchange rate, which rapidly depreciated in nominal terms. However, the administrations' efforts to control inflation led to the appreciation of Romanian currency, Leu, in real terms. According to the OECD, from January to July, 1997 the real appreciation against a trade weighted currency basket, in which Deutsche mark had a 60% weight and US dollar had a 40% weight, was 31%. The Central Bank has been actively intervening in 1998 to allow the Leu to appreciate in real terms as a part of government's objective of annualized inflation of 42%. As a result the Leu appreciated by 46% in real terms against a composite of several European currencies and the dollar in the first quarter of 1998, exacerbating the structural weaknesses of the Romanian export base.
The continuos support of the large unrestructured public sector through subsidies resulted in the ballooning of public deficit. The official budget deficit almost doubled in 1996 to 5.8% of GDP compared with 1995. Including quasi-fiscal items such as the National Bank of Romania refinancing of credits to the agricultural sector, the overall public budget deficit surged to over 10% of GDP. At the same time arrears of public enterprises rose to 36% of GDP at end-1996. The 1997 austerity program aimed to tighten the fiscal discipline by containing the budget deficit at 4.5% of GDP. While the revenue collection efforts continued to decline and the levels of arrears continued to increase, the government reached its budget deficit by continuously cutting its expenditures, thus putting a strain on public investment. The 1998 budget projected a deficit target of 3.6% of GDP, which estimated to have overshot despite expenditure cuts amounting to 2% of GDP.
International Investment Position
Romania remained a net creditor nation until 1995 predominantly due to the external claims on foreign countries accumulated during the Ceasescu regime, which stood at US$2.2 billion at the end of 1997. The flight of domestic capital abroad since the fall of the communist regime sustained its position of a net creditor nation. However, the increasing reliance on debt as a source of financing of Romania's fiscal deficit as well as of its import requirements resulted in an increase in external liabilities. It is important to note that Romania borrowed in international capital markets rather than through domestic treasury market, which did not open to foreigners until the end of 1998 when Romania lost access to all other sources of financing, both official and private.
In 1989 during the final years of the Ceaucescu regime, Romania paid off the balance of its commercial obligations, which amounted to over $4.6 million. Since the otherthrow of the communist regime Romania continuously borrowed with its external obligations reaching $8.3 billion as of year-end 1997 or 23.6% of GNP. The country's external obligations increased approximately eightfold since 1989 when its obligations totaled $1.09 billion (2.6% of GNP). Until the country obtained a credit rating in 1995, Romania relied on short-term borrowing, which stood at approximately 80% of total obligations as of end-1990. The levels of short-term debt dropped to 10% of total external debt in 1997. The share of private non-guaranteed borrowing remained low throughout the decade. Bilateral and multilateral creditors held the majority of claims on the Romanian government.
The share of commercial creditors' claims did not increase until 1996 when it reached 37% of total long-term obligations. Until 1993, all of claims against Romania consisted of trade-related debt. Since 1993 Romania has diversified its sources of commercial borrowing. Romania's access to capital markets started in 1995, when the country obtained two syndicated loans (for $110 million and $173 million) from a consortium headed by Citibank and successfully placed $50 million of National Bank of Romania debt securities in a private placement. In early 1996 Romania issued $520 million in Samurai bonds, which facilitated a $495 loan from Sanwa Bank. A second Samurai bond issue was launched in September 1996 on easier credit terms. A $225 million Eurobond issue and a $175 million syndicated loan were also completed in 1996.
While Romania's external debt burden is considered moderate (though rising) by most observers, an unfavorable maturity schedule coupled with the country's substantial external deficits means that it may face a shortfall in meeting its near-term financing requirements. Romania's debt service burden doubled from 6.1% of exports in 1993 to 12.6% in 1996 (twice Poland's 1996 ratio of 6.4%), and the country's recent reliance on short-term borrowing has increased the amount of principal repayments coming due in the next few years. In 1998, for example, Romania made approximately $1.2 billion in principal payments. Combined with a forecast $2.2 billion current-account deficit, the country's financing requirement for the year equaled approximately $3.4 billion. The forecast for 1999 is slightly higher with scheduled principal payments of $1.6 billion, and an estimated financing requirement of $3.8 billion for the year.
Foreign Direct Investment and Portfolio Flows
To prevent debt from rising too rapidly in the medium term Romania desperately needs to increase levels of foreign direct investment, which in turn would increase economic efficiency and facilitate domestic growth. While Romania has made considerable efforts to create a legal framework that would accelerate the pace of foreign investment, the implementation has been uneven and foreign investment has been falling short of expectations. Investors have remained cautious because of lingering concerns over the ability to repatriate profits, macroeconomic concerns over currency and inflation stability and a slower than anticipated rate of privatization. Moreover, the government has been modifying and constantly changing the investment framework, further increasing uncertainty. According to the Romanian Development Agency, cumulative foreign direct investment, excluding privatization proceeds, for the 1990-1997 period totaled $3.4 billion. As of the end of 1997, the largest foreign direct investors in Romania were France ($427.1 million), South Korea ($368.3 million), the Netherlands ($294.6 million), Germany ($290.1 million), the United States ($254.4 million), and Italy ($200 million). In 1997, FDI, excluding privatization, totaled $571.3 million, which represents 1.63% of GDP for 1997. The total stock of FDI, excluding privatization proceeds, since 1990 equals 8% of the 1997 GDP. Total FDI for 1997 is estimated at $1.22 billion, including privatization proceeds.
The foreign direct investment picked up in 1997 with privatization of four large companies in the metallurgy and machine building sectors. Those sales reflected the growing interest of primarily European investors in Romanian heavy industrial sectors with export potential. Despite the acceleration in privatization in 1997, the administration still fell short of its goals. In 1997 the privatization plan included a total of over 2,700 companies, of which 263 were large industrial enterprises to be sold that year. By the end of the year, only half of the companies were sold. The 1997 privatization plan was hampered by administrative hurdles, investor uncertainty over the privatization procedure, and the status of the current liabilities of these entities. The 1998 plan looks as unrealistically ambitious as 1997's, with 1,600 state-owned companies scheduled for sale. Most of these are small companies; 170 are classified as medium-sized and 50 as large (share capital higher than $2 million). The 1998 privatization proceeds are projected at around Leu 7,815 billion, or the equivalent of 2% of GDP. By the end of the second quarter of 1998, the sale of state-owned companies was behind schedule. By the end of August, 1998, the government had sold 825 of the 1,600 companies planned for sale.
Romanian assets are, in many sectors, antiquated, inefficient and energy-intensive. The process of restructuring will depend on the availability of investment funds. However, as already mentioned, the levels of foreign direct investment have been inadequate. According to the Romanian government, the capital needed for restructuring up to the year 2002 includes $1.8 billion for the oil and gas sector, $2.2 billion for the steel industry, $300 million for non-ferrous metallurgy, and $340 million for the chemical fertilizers sector. Given its severe budgetary constraints, the Romanian government plans limit its financial support to critical projects in the areas of energy, mining and geology, and environmental protection.
Up until the end of 1996, there was practically no portfolio investment. According to Deutsche Bank, foreign portfolio investors were estimated to be holding only $830 million in Romanian stocks by the end of 1997. Foreign investors have voiced complaints over abuse of minority shareholder rights as well as unsatisfactory disclosure. Romanian stocks markets tend to be illiquid and register low trade volumes. The acceleration of foreign portfolio investment has been linked with the flotation of the 60% stake in Romtelecom, Romanian telecommunications monopoly. However, the delayed sale of Romtelecom and delayed flotations of several other companies have put further developments in portfolio investment in jeopardy. Moreover, the increasing instability in the emerging markets investment climate in general further reduced the likelihood of successful flotations of privatized companies through the capital markets.
The requirements of an economic transition place an enormous strain on an economy undergoing the transformation but allow for long-term economic benefits if the change is properly implemented. Romania represents a case where transition has not been well managed, which made a lasting impact on its balance of payments. It appears that Romania's current account deficit is likely to become unsustainable and the country is likely to experience a payments crisis since it is becoming increasingly unable to meet its financing requirements. While economic growth rebounded in the early nineties after the initial shock, the economy contracted in both 1997 and 1998. The requirements of Romania's industrial sector leave the country highly dependent on imports. Simultaneously the appreciation of the currency in real terms significantly reduced the competitiveness of Romanian exports.
The increase in budget deficits in 1996 coincided with the change in the net investment position when Romania became the net debtor nation. Romania rapidly increased the size of its external debt obligations to offset the shortfalls in revenue and flows of foreign direct investment. Romania's modest levels of debt are deceptive especially when compared to the amount of repayments it had to make in the recent years. While Romania is current on its external obligations it is looking to meet its payments by running down reserves and using its gold reserves as a collateral for new private funding. The recent years demonstrate that Romania is facing financing restraints because it lost the credibility in the eyes of foreign creditors and investors in regard to implementing cohesive economic restructuring measures. In the short-term, Romania needs to enhance its privatization measures to stave off current account imbalances, boost FDI flows and increase its chances of a resumption of funding.
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©1999 The Elliott School of International Affairs, The George Washington University, ALL RIGHTS RESERVED Last Updated on 10/9/99