Monetary Policy
Since early 1999, the National Bank of Romania (NBR) has pursued the twin objectives of monetary policy (IMF,2003):
- Gradual disinflation
- Sustainable external competitiveness
As exchange rate changes account for 40%-60% of inflation (Gueorguiev, 2003), the exchange rate has been monetary policy’s main intermediate target. The policy has been successful so far, especially since 2001, when wage policy and fiscal policy has been in sync with monetary policy to stabilize the Romanian economy. The inflation rate fell from 256.1% in 1993 to 45.8% in 1999 to 15.3% in 2003. The NBR’s target for 2004 is bringing inflation into single digits.
How did NBR achieve its disinflation objective through exchange rate targets? The policy favored by NBR is to allow for a real appreciation of the Leu. From 1999 to 2003, the Leu has appreciated 7.4% against US Dollar and 6.8% against Euro on average in real term (Exhibit 27, 30). The underlying reason is that imported oil is denominated in US dollars. Given the importance of the oil industry, a depreciation of the US dollar against the Leu translates into lower energy prices, i.e. a beneficial supply shock.
However, the Romanian government is challenged by the dilemma of allowing real exchange rate appreciation to disinflate the economy or faster nominal depreciation to enhance export competitiveness. For the time being, the central bank does not have highly efficient instruments at hand to influence the interest rates on money market. The country’s financial market is not highly developed. Nevertheless, NBR has tolerated deliberately high interest rate (an average 27.8% nominal lending rate for the past five years as seen in Exhibit 22) in line with restrictive monetary policy.
IS/LM Schedule
All of these measures are expected to impact Romania’s IS/LM schedule and its aggregate demand. The IS curve is expected to shift rightwards due to increased investments required in the privatization and modernization of state-owned enterprises, as well as through capital inflow chasing higher interest rate. This is supported by the empirical data seen in the last five years: Real GDP has averaged 4.4% annual growth while tax, government spending, and net export decreased an average of 1.2%, 2.4%, and 21.6% per year respectively. On the other hand, investment increased steadily by an average of 16.4% in the same period (Exhibit 9). Another implication of ongoing investment in infrastructure is that improved multi-factor productivity will gradually drive natural GDP to a higher level. The LM curve should shift slightly leftwards due to restrictive monetary measures. However, our broad money data suggested that money supply has in fact increased 5.8% annually on average. Overall, aggregate demand is still increasing, but at a decreasing rate, as a result of tightening fiscal/monetary policy. In fact the good news of significantly lower inflation rates in Romania in the past few years have economic analysts and policy makers questioning whether the ongoing economic expansion is stifled by policies that are too strict.
LABOR MARKET ANALYSIS
As noted earlier, of extreme importance to Romania’s successful entry into the European Union (EU) is the establishment of a fully functioning free-market economy in the country and their ability to compete in a single European market. As with any nation, Romania’s labor market has and will continue to play a significant role in the development of a more independent and vibrant national economy. In a global economy where labor seeks its lowest costs, Romania has benefited from cheap but comparatively productive labor to that of other transition economies (e.g., Bulgaria, Croatia, Poland). This has supported the country’s economic recovery as it has contributed to the attraction of foreign investment. If, however, Romania is to maintain its external labor competitiveness over the long term, i.e., cheap but productive labor, it must effectively reorganize the percentage of the labor force employed by the government, “tighten the links between wage/employment decisions and economic performance and productivity, (EIU, 2003)” and address the informal labor activity in the country. The accomplishment of these objectives will imply improved efficiencies and productivity throughout the labor market.
Between 2001-2002, it was estimated that public sector employment (state-owned enterprises) comprised roughly 30% of the labor force in Romania and swelling to 50% in urban areas. And in the absence of budget constraints and wage policy accountability at the government level, wages have been allowed to increase without regard to its effects on external competitiveness, productivity measures, and most importantly profitability. It is thought that the higher wages in the public sector are less a result of productivity gains and more from rent-extraction by powerful trade unions. The effects of rent extraction on the economy have been detrimental in that it often leads to uniform increases in wage rates, inefficiently rewarding nonperformance and non-profitability.
However, as state-owned enterprises become privatized, they will have more flexibility in hiring better skilled personnel and firing nonperformers, placing a needed emphasis on pay for performance, which has not been the norm in Romania. Although it was estimated that the labor market would experience a mild decline (2%-3%) in the employment rate in 2002 due to expected layoffs in the public sector, unemployment only recorded a 1% increase in 2002 and fell sharply in 2003 to 7.6%. It is plausible that an expanding economy and positive efforts at retraining and retooling the labor force with a skill set more applicable to an open-market economy have contributed to the early employment recovery. In effect, the demand for skilled labor as well as the supply for skilled labor has increased. (EIU, 2003)
As mentioned above, the Romanian government is relying heavily on the restructuring of fiscal policy, where the tax burden is shifted from the shoulders of corporations and more to their employees, to create a profitable business environment for these companies. The tax burden, however, has lead to a significant rise in employment in the informal or underground economy. For example, it was estimated that at least 1.5 million jobs or approximately 15% of the labor force were attributable to this sector of the economy. Additionally, another 1.7 million jobs were registered as civil contracts, where workers are exempted from social security payments and other taxes. The effort of Romanian workers to avoid burdensome taxes and other labor costs, has created severe underemployment and skill mismatch in the economy. Many laborers have opted to work fewer hours under civil contract agreements, work in jobs detrimental to society as in the case of the informal economy, or have taken jobs in areas not suited for their skill set, the best example in Romania being the agricultural industry. (EIU, 2003)
Overall, the improvements to the Romanian labor market must be made in regard to the country’s external competitiveness. To accomplish this, wage policies, i.e., increases or decreases in the minimum real wage, must be balanced with the controlled appreciation of the Leu to its foreign investor’s currencies. Again, one of the substantial forces behind the inflows of foreign capital has been both an inexpensive, yet productive labor force as well as attractive interest rates maintained by the government’s tightened monetary policy. Examining the gross wages and annual wages per capita GDP of comparable transition economies, Romania’s attractiveness to foreign investment is evidenced by the fact that in 2002, wage earners received only 26% of GDP while comprising 50%-55% of GDP for that year. This has allowed them to post one of the lowest annual wage per capita GDP (98 in 2002) ratios of any of the other transition economies. What is obvious, however, is that with the expanding economy (and subsequent increased demand), and the movement toward more private industry in the country (adding more upward pressure on wages as competitive firms seek to acquire skilled labor), real wages are expected to rise. This expected increase seems reasonable considering that while price levels (P) will continue to increase moderately (assuming an effective monetary policy) as the economy expands, so too must nominal wages (W) should the government wish to avoid increased labor participation in the informal activities sector. In fact, average real wages in Romania have increased 3.4% from a level of 2.49 million 1995 Lei in 2000 to 2.57 million in 2003. If ineffectively monitored, wage appreciation without corresponding productivity gains could negatively affect the country’s external competitiveness, increasing the wage per capita GDP ratio. (EIU, 2003)
The interesting relationship here between the government’s choices to affect wages and their subsequent effect on inflation, directly impact the real exchange rate of the Leu. One of the main determinants of Romania’s exchange rate is its increasing productivity gains relative to those of its trading partners. This productivity differential is positively correlated with the appreciation of the Leu in Romania as it has provided a substantial incentive for foreign investment. Consequently, efforts at maintaining external competitiveness by ensuring increased productivity also lead to non-competitive circumstances in that an appreciating Leu is sure to follow.
FORECAST
As forecasts go, they have an intrinsic degree of uncertainty. It remains to be argued whether Romania’s preset agreements with global organizations (i.e. IMF, EU) make forecasting a little easier, or if in fact, the transitionary character of its economy turns forecasting into a very difficult exercise. Nevertheless, the current section attempts to forecast three main macroeconomic indicators: real GDP growth, unemployment rate, and inflation.
Exchange Rate
Several considerations need to be made regarding Romania’s currency, the “Leu” (“Lei” for plural). The currency has appreciated against the U.S. dollar due to the high demand for Leu as compared to the dollar. This appreciation is important because oil prices are denominated in U.S. dollars and the real appreciation of the Leu against the U.S. dollar makes the large quantity of oil that Romania imports cheaper. This translates into a beneficial supply shock for the country. Concomitantly, the Leu has remained relatively stable as compared to the Euro over the last three years. This is of crucial importance because 70% of the country’s exports go to EU countries and 60% of its imports come from EU countries.
On the other hand, a sharp appreciation of the Leu could shift the balance of exports to imports, which could harm Romania’s economy. Ironically, in a country plagued until recently by inflation, now the largest risk to continued growth could be the prospect of high appreciation of the Leu. The authors of this study expect the Leu to continue to gradually appreciate against the USD as the demand for Leu remains high considering that state-owned enterprises continue to be privatized.
Real GDP Growth
Continued privatization of state-owned enterprises shows no slowing down. Therefore fixed capital investments from these newly-privatized firms will continue to rise. The positive effect of investment on real GDP will be somewhat countered by the constant rate of consumption. This will remain stable at approximately 68% of GDP, since there will be no real wage growth in the near future.
Concurrently, the government will maintain the tight fiscal policy, containing the budget deficit at less than 3% of GDP. Romania’s tax structure, in general, is constantly evolving as it becomes more in line with EU norms. The current high interest rates should continue to spur increased foreign direct investment (capital flows in capital account), an aspect that will be underlined by an increasingly stable and reliable legal environment. At the same time, increased savings will occur in response to higher interest rates as well as greater confidence in the banking systems. This, in turn, will spur investment as more money will be available for lending.
In conclusion, taking into account the stability of the Leu’s appreciation, of saving rates, and of foreign domestic investment, this study deems that GDP will continue to grow at its 2003 rate of 4.9% in both 2004 and 2005.
Unemployment Rate
In 2003, the unemployment rate was 7.2%, indicating its lowest level since 1993. Based on the real wage recorded in 1997 and 2001 – years where actual GDP was near natural GDP – the equilibrium wage rate is approximately 2.2 million Lei/person/year (based on 1995 Leu). In 2003, the real wage rate was 2.6 million Lei/person/year, higher than the relative equilibrium wage. Although the real wage is high and one would expect its level to fall and thus the unemployment rate to decrease, there is an uncertain employment impact associated with the privatization of SOEs. As firms are privatized, many workers are laid-off and have to find new, similar jobs or retrain themselves for new occupations. This adds a considerable amount of uncertainty to the unemployment forecast. Nevertheless, the authors of this study predict that the unemployment rate will indeed fall from its current 7.2% level, due to the high real wage. Yet, the study remains hesitant to predict a large drop. More specifically, the forecasted unemployment rate will be 6.5% in 2004 and will continue to fall in 2005 to 6.0%.
Inflation
This issue is of key importance since Romania had been confronted with high inflation rates until late 2001. The current tight monetary policy will remain active during the forecast period in an effort to curb inflation. This is essential because the rapid expansion of the Romanian economy is pressuring the price level to increase. However, tight monetary policy coupled with high productivity gains (i.e. GDP per capita has increased at 2.8% per year since 1993) will continue to put downward pressure on future price increases. In retrospect, Romania has made great progress, reducing inflation from 60% in 1998 to 15% in 2003. This study predicts that this trend will successfully continue. Effectively, the continuing tight policy will allow inflation to fall to 12% in 2004 and on to 10% in 2005.
CONCLUSION
Romania has enjoyed an impressive economic expansion between 1999 and 2003. When comparing this expansion with the economic reality of the early 1990s, a more correct adjective to describe this process is “incredible.” The country has managed to make large strides toward a free-market economy by selling many of the 6,200 state-owned enterprises that were in existence in 1989. Important successes were also achieved in lowering the double-digit inflation that has typically beleaguered many of the Eastern European countries attempting the transition to a free-market economy. These encouraging accomplishments have been correlated with fruitfully following the path towards EU integration. The legal environment has been restructured and continues to be reformed to be in accord with EU directives.
In summary, the analysis contained in this study provides evidence that Romania will continue to prosper and will achieve the stability and efficiency necessary for it to compete with other EU nations. Romania’s real GDP will continue to grow at nearly 5% per year, while the inflation rate will drop steadily (to 12% in 2004, and 10% in 2005) as tight fiscal and monetary policies are kept in place. Last but not least, the country’s unemployment rate will also continue to fall from its already low level. Although there is a degree of uncertainty as to how low the unemployment rate can fall, the authors of this study forecast that the rate will decrease to 6.5% in 2004 and down to 6% in 2005.
REFERENCES
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International Financial Statistics Web Page. Product of the International Monetary Fund. Accessed 21 Feb. 2004. <>.
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World Development Indicators Online. Product of the World Bank. Accessed 21 Feb. 2004. <>.
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Various Articles. The Economist Intelligence Unit. The Economist. Accessed 7 Apr. 2004. <>.
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European Parliament Report on Romania’s Progress Towards Accession. Committee on Foreign Affairs, Human Rights, Common Security and Defence Policy. 24 Feb. 2004.
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Business Guide to Romania 2001/2002. Price Waterhouse Coopers. 2001.
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Factbook: Romania – Yahoo! Reference. Bartleby.com. 2000. Accessed 9 Apr. 2004. <>.
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Monthly Bulletin – Statistical Section. National Bank of Romania. Dec. 2003. Accessed 21 Feb. 2004. <>.
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Annual Report – Statistical Section. National Bank of Romania. 2003. Accessed 21 Feb. 2004. <>.
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Country Forecast: Romania. The Economist. 2003.
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Romania: Financial System Stability Assessment, Including Reports on the Observance of Standards and Codes on the following topics: Banking Supervision, Securities Regulation, Anti-Money Laundering and Combating the Financing of Terrorism, Monetary and Financial Policy Transparency. International Monetary Fund. 2003.
APPENDIX GUIDE
Exhibit 1: Table of Real GDP, Inflation and Unemployment Data
Exhibit 2: Chart of Real GDP, Inflation and Unemployment Data
Exhibit 3: Chart of Real GDP with Trendline
Exhibit 4: Chart of Inflation and Unemployment Data
Exhibit 5: Table of Real GDP per Capita Data
Exhibit 6: Chart of Real GDP per Capita Data with Trendline
Exhibit 7: Table of Leakages and Injections Data
Exhibit 8: Chart of Leakages and Injections Components (in Lei)
Exhibit 9: Chart of Leakages and Injections Components (as % of GDP)
Exhibit 10: Table of GDP Revenue Components
Exhibit 11: Chart of GDP Revenue Components (in Lei)
Exhibit 12: Chart of GDP Revenue Components (as % of GDP)
Exhibit 13: Table of GDP Expenditure Components
Exhibit 14: Chart of GDP Expenditure Components (in Lei)
Exhibit 15: Chart of GDP Expenditure Components (as % of GDP)
Exhibit 16: Chart of Romania’s Imports and Exports as a % of GDP
Exhibit 17: Table of Employment Statistics
Exhibit 18: Chart of Employment Population, Employed and Unemployed Persons
Exhibit 19: Chart of Private Sector Employment
Exhibit 20: Table of Wage Statistics
Exhibit 21: Chart of Real Wage and Unemployment Rate
Exhibit 22: Table of IS-LM Data (Inflation and Real Interest Rates)
Exhibit 23: Chart of Real Interest Rate versus Real GDP
Exhibit 24: Chart of Real Interest Rate over Time
Exhibit 25: Table of Balance of Payments Data
Exhibit 26: Chart of Current and Capital Account Balances over Time
Exhibit 27: Table of Exchange Rate Data
Exhibit 28: Chart of Nominal Exchange Rate over Time
Exhibit 29: Chart of Romania, Europe and United States Price Level
Exhibit 30: Chart of Real Exchange Rate over Time
Exhibit 31: Table of Government Budget and Deficit Data
Exhibit 32: Chart of Taxes, Government Spending and the Deficit over Time
Exhibit 33: Chart of Taxes, Government Spending and the Deficit as % of GDP
Exhibit 34: Chart of Real Exchange Rate versus Net Exports
Exhibit 35: Chart of Romania’s Price Level versus the Output Ratio
Exhibit 36: Chart of the Real Wage versus Employment
Exhibit 37: Chart of Romania’s Inflation versus the Output Ratio
Exhibit 38: Table of Trade Data
Exhibit 39: Chart of Export Partners
Exhibit 40: Chart of Import Partners
Exhibit 1
Exhibit 2
Exhibit 3
Exhibit 4
Exhibit 5
Exhibit 6
Exhibit 7
Exhibit 8
Exhibit 9
Exhibit 10
Exhibit 11
Exhibit 12
Exhibit 13
Exhibit 14
Exhibit 15
Exhibit 16
Exhibit 17
Exhibit 18
Exhibit 19
Exhibit 20
Exhibit 21
Exhibit 22
Exhibit 23
Exhibit 24
Exhibit 25
Exhibit 26
Exhibit 27
Exhibit 28
Exhibit 29
Exhibit 30
Exhibit 31
Exhibit 32
Exhibit 33
Exhibit 34
Exhibit 35
Exhibit 36
Exhibit 37
Exhibit 38
Exhibit 39
Exhibit 40
