Country Economic Report The Economist Intelligence Unit

Executive summary
March 2008
Outlook for 2008-09 Conflicts between the prime minister and the president, as well as between the ruling National Liberal Party (NLP) and the opposition Democratic Liberal Party (DLP), will underpin continued political discord. The minority government will remain under pressure to make policy concessions to the Social Democratic Party (SDP)on which it relies for a parliamentary majoritywith negative consequences for the macroeconomy. The annual consolidated budget deficit could exceed 3% of GDP in 2008, despite the March budget revision, as forthcoming local and parliamentary elections see government spending rise steeply. Strong consumption and investment will result in average real GDP growth of around 5-5.5% per year in 2008-09, following growth of 6% in 2007, but demand growth will slow in 2009, once the 2008 elections are over. Inflationary pressures are expected to remain strong throughout 2008, and inflation is forecast to average around 7.5% in 2008 and 4.5% in 2009. Imprudent fiscal and wages policies will fuel domestic demand and drive up the annual current-account deficit to about 16.6% of GDP in 2008. Monthly review A truce was called in the long-running battle between the prime minister and the president over control of the Ministry of Justice, with the compromise appointment of Catalin Predoiu to the post of justice minister. The government is to make cuts in spending in a budget revision in March, reducing the budget deficit target for 2008 to the equivalent of 2.3% of GDP.

The central bank's third consecutive increase in its main policy interest rate, to 9%, in February failed to stem the depreciation of the leu. Strong domestic demand was the main driving force behind real GDP growth of 6% in 2007.

 Year-on-year consumer price inflation rose to 7.3% in January 2008 and threatens to exceed 8% in the first quarter of 2008, where it is likely to remain until September. Central bank data show that private (non-guaranteed) external debt rose by 40% in euro terms between end-2006 and end-2007. The share of the current-account deficit covered by foreign direct investment (FDI) fell to 42% in 2007, from around 90% in the previous year.

Outlook for 2008-09

Political outlook
Domestic politics The minority governmentled by the prime minister, Calin Popescu Tariceanu, and comprising the National Liberal Party (NLP) and the Hungarian Democratic Union in Romania (HDUR)will continue to depend on the support of the former communist Social Democratic Party (SDP) for a parliamentary majority in the run-up to the general election scheduled for November 2008. The SDP has demonstrated its parliamentary power on several occasions, notably by forcing significant amendments to the original 2008 budget law, and pressure to pursue populist policies will be strong in the run-up to the election. The government's weak parliamentary position will mean that more prudent economic policies are postponed and reforms stymied. Despite continued threats by the SDP to force an early election, the Economist Intelligence Unit expects the government to serve out its term, especially given the limited timeframe for organising an early election under new voting arrangements. The local elections to be held in June 2008 will be a barometer of popular voting intentions in the parliamentary poll a few months later and are likely to reveal dwindling electoral support for the incumbents. The merger of the two centre-right opposition parties, the Democratic Party (DP) and the Liberal Democratic Party (LDP), to create the Democratic Liberal Party (DLP), is intended to establish a strong centrist party to support the president, Traian Basescu, in his battle to oust the NLP from power. However, both the president and his former party, the DP, appear to be losing support and it is unlikely that the DLP could win an outright majority. Despite the adoption by parliament of a uninominal (single candidate) voting system, replacing the system of party lists, another coalition or minority government is likely after the 2008 election, and one comprising the NLP, SDP and HDUR is a possibility. Whatever the political complexion of the next government, we expect that it will undertake a tightening of fiscal and incomes policies from 2009. International relations The European Commission has criticised the government for the slow pace of judicial reform and measures to counter corruption since Romania joined the EU in January 2007. On February 4th the Commission published its latest interim report under the Cooperation and Verification Mechanism, focusing on the area of judicial reform and the fight against corruption. The report noted weaknesses in all four monitoring benchmarks, and suggested amendments to the action plan. The main failures are delays in implementing a coherent recruitment strategy for the judiciary; the failure of the National Integrity Agency (ANI) to begin functioning;

parliament's endorsement of a Criminal Procedure Code and a Penal Code that will have a negative impact on the efficiency of criminal investigations; and delays in drafting a national anti-corruption strategy focused on key sectors and local public administration. The Commission will publish a more detailed assessment report in July 2008.

Economic policy outlook

Policy trends The momentum for reform in critical areas of economic policy including labour markets, competition policy and agriculturehas slowed since Romania joined the EU in January 2007. The government has also failed to address the risks posed by lax fiscal policy, wage growth in excess of productivity and the burgeoning current-account deficit, despite warnings from the IMF and the EU of the risks in continuing with current policies. This neglect has contributed to rapidly rising inflation and growing external deficits. Signs of a loss of investor confidence have been reflected in the depreciation of the leu and falls in stockmarket indices. Partly under pressure from the National Bank of Romania (NBR, the central bank) and in response to negative external perceptions of fiscal policy, the government is to undertake a budget revision in March aimed at reducing the 2008 budget deficit by 0.4 percentage points to 2.3% of GDP. However, even this reduced deficit, if achieved, will generate inflationary pressures and a large current-account deficit. There is therefore a continuing risk that a loss of market confidence will lead to a sudden capital outflow. The original 2008 budget law had envisaged a consolidated budget deficit equivalent to 2.7% of GDP (compared with an actual deficit of 2.4% of GDP in 2007) and increased expenditure on social programmes. Under the forthcoming March budget rectification, the government will cut central government spending and impose greater controls over local budgets in response to warnings from the EU that the Maastricht limit of 3% of GDP could be breached. Without stringent controls over expenditure, however, the 2008 deficit is likely to exceed the revised target of 2.3% of GDP and could even exceed the original target of 2.7% of GDP, as the budget's basic planning assumptions appear unrealistic. The government has already succumbed to pressure from opposition parties to increase social expenditure, and will face further pressures that will be hard to resist in view of the impending elections. Budget revenue projections look optimistic and the full costs of implementing the increases in pensions, together with a cut of several percentage points in social security contribution rates, will drive up the budget deficit. The cost of financing a new fund to compensate citizens who lost property in the communist era could add to spending costs. Furthermore, Romania is required to contribute the equivalent of just over 1% of GDP to the EU budget and about 0.5% of GDP to co-

Fiscal policy

funding EU projects. The consolidated budget deficit is forecast to fall to around 2.5% in 2009, following the adoption of a more prudent fiscal stance by the incoming government. Monetary policy The NBR operates an inflation-targeting regime and established year-end inflation targets of 4% for 2007, 3.8% for 2008 and 3.5% in 2009, with a band of 1 percentage point around each target. The NBRs February 2008 Inflation Report forecast that year-end inflation will exceed the target band by more than 1 percentage point in 2008, reaching 5.9%, before falling to 3.9% at end-2009. Year-onyear inflation surged to 7.3% in January 2008, the highest rate since May 2006, and is expected to exceed 8% in the first quarter of 2008. Inflation has been driven upwards mainly by the steep rise in food prices, following the severe drought in 2007 and increases in world market prices for agri-food products, the sharp depreciation of the leu, rapid wage growth and surging producer prices stimulated by rising energy prices. CORE-2 inflationthe consumer price index (CPI) stripped of volatile and administered prices, but including some basic foodstuffshas risen for six consecutive months since August 2007, the first increases since the introduction of inflationtargeting in 2005. The NBR board has reiterated that persistent excess demand, supported by lax budgetary and incomes policies, requires monetary policy to remain restrictive. The board raised its monetary policy rate by 100 basis points on February 4th, to 9%. Interest rates have now been raised three times, by a total of 200 basis points, since the current cycle of monetary tightening began in October 2007. The NBRs latest move was made in a bid to hold back the depreciation of the currency and to counter strong inflationary pressures. Rising interest rates and leu depreciation will have a negative impact on the budgets of households that have a large amount of debt denominated in foreign currencies. The NBR has also adopted additional prudential rules, including higher provisioning for foreignexchange-denominated credits extended to unhedged borrowers, amid evidence that previous rate rises have so far failed to curb strong lending growth to households for consumer purposes.

Economic forecast
International assumptions
International assumptions summary
(% unless otherwise indicated) 2006 Real GDP growth World OECD Euro area EU27 Exchange rates 100:US$ US$: 4.9 3.1 2.8 3.1 1.2 1.256 2007 4.6 2.6 2.5 2.8 1.2 1.369 2008 3.8 1.6 1.7 1.9 1.0 1.458 2009 3.9 2.0 1.9 2.1 1.0 1.328

SDR: Financial indicators 3-month interbank rate US$ 3-month Libor Commodity prices Oil (Brent; US$/b) Gold (US$/troy oz) Food, feedstuffs & beverages (% change in US$ terms) Industrial raw materials (% change in US$ terms)

0.85 3.08 5.19 65.3 604.5 10.2 49.6

0.89 4.27 5.30 72.6 696.7 37.8 10.8

0.92 4.18 2.59 79.5 827.5 27.4 -8.0

0.86 4.00 3.16 72.0 706.3 -3.7 -13.1

Note. Regional GDP growth rates weighted using purchasing power parity exchange rates.

Global economic growth at purchasing power parity (PPP) exchange rates is estimated to have slowed to 4.6% in 2007, from 4.9% in 2006. We expect a further slowdown in global economic growth to an annual average rate of 3.9% in 2008-09. Following estimated growth in the euro area of 2.5% in 2007, we expect a slowdown in the forecast period, owing to fiscal tightening and less rapid expansion in external demand, and forecast average growth of 1.8% per year for 2008-09. Our oil forecast for the next few years reflects our view that the global supply-demand imbalance will persist and that OPEC will not release enough crude oil to ease the situation. Prices for dated Brent Blend crude are expected to rise in 2008, from the average of US$73/barrel in 2007, before falling back in 2009. Persistently high international oil prices will have a negative impact on domestic inflation in Romania and on its current-account deficit in 2008-09. Economic growth
Gross domestic product by expenditure
(Lei bn at constant 2002 prices where series are indicated; otherwise % change year on year) Private consumption Public consumption Gross fixed investment Final domestic demand Stockbuilding 2006 a 169 12.6 11 2.7 51 16.1 231 b 12.8 b 3b
b

2007 b 189 12.2 12 8.0 62 23.0 264 14.4 4 0.3 d 267 14.4 89 9.8 153 24.1 -64 -11.2 d

2008 c 207 9.2 12 6.0 75 20.0 294 11.6 3 -0.2 d 298 11.3 99 11.2 181 18.2 -81 -8.6 d

2009 c 217 5.0 13 3.0 86 15.0 316 7.5 3 -0.4 d 319 7.1 111 11.6 203 12.2 -92 -4.9 d

Total domestic demand Exports of goods & services Imports of goods & services Foreign balance

0.1 d 234 b 12.7 b 81 10.6 123 23.0 -42 -8.5 d

GDP incl statistical discrepancy

194 e 7.7

205 e 6.0 a

217 e 5.8

228 e 5.0

a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts. d Contribution to real GDP growth (as a percentage of real GDP in the previous year). e GDP data reflect the redenomination of the leu on July

1st 2005.

Our baseline forecast is for real GDP growth of 5.8% in 2008, following growth of 6% in 2007, as rapid growth in government spending ahead of the 2008 local and parliamentary elections and fast-growing wages fuel domestic demand. Growth is expected to slow to 5% in 2009 as fiscal and incomes policies are tightened following the elections. The risk to our baseline forecast, which is not inconsiderable, is that a continued deterioration in Romania's macroeconomic situation, combined with an intensification of the recent problems in global financial markets, could cause a further negative change in market sentiment. This could put further downward pressure on the leu and result in a significant exchangerate correction, pushing inflation even higher and causing growth to slow more sharply. Strong domestic demand growth is expected to persist into 2008, driven by a pro-cyclical fiscal policy, rapid real wage growth and surging credit expansion. Although the worsening global financial environment will encourage some restraint in fiscal policy, government spending will continue to grow rapidly in 2008 because of the approaching parliamentary election. The government will make a more serious attempt to adopt more appropriate fiscal and incomes policies in 2009, and demand growth will slow quite sharply once the election is out of the way. On the supply side, expansion of both services and industry (including construction) will continue at a robust average rate of about 5.7% and 5.3% per year, respectively, in 2008-09. Inflation After averaging 4.8% in 2007, consumer price inflation is forecast to rise to 7.5% in 2008, partly because price increases that occurred in the second half of 2007 will boost price levels in the first half of 2008 compared with the year-earlier period, with year-on-year inflation likely to exceed 8% in the first quarter. Planned large increases in public expenditure, rapidly rising wages, further increases in administered prices and higher excise duties on tobacco and alcoholic drinks, together with high food prices, will all fuel inflationary pressures in the coming months.