How long can the party last?
While Romania booms, its current account deficit expands.
Nicholas Bruch of the Oxford Business Group examines the dangers this could offer
In a booming economy, the central banker often plays the role of a party host. He must work the room, assess the mood, ease any minor tensions and keep the drinks and festivities flowing. He must not intrude too much on his guests. His hand needs to be ever-present, yet never noticed.
But he must know when to turn off the music and send the guests home. If the host does this too early, a good party leaves the guests in a sudden limbo. End it too late and the guests may be reeling the next morning.
This task now faces Mugur Isarescu, Governor of Romania’s central bank (BNR). For several months, the economy has shown signs of overheating. As the worries pile up, the bank must decide when and how to act.
One major issue is the bank’s laissez faire approach to controlling the country’s widening current account deficit. Over recent years the deficit has grown at a rapid pace. In the first six months of 2007 it reached a record 16.8 per cent of GDP. The concern is that these problems will spill into the broader economy and materialise in the form of inflation and slowed growth.
Isarescu now must decide how much of a problem the current account deficit poses to the economy and what, if anything, should be done to control it.
Most commonly, the current account balance is portrayed as the difference between a nation’s exports and imports. The factors determining this include exchange rates, prices and incomes at home and abroad. Economists who take this viewpoint often attribute Romania’s widening current account deficit to the strong Leu, the rise in wages and global changes in commodity prices.
The appreciating Romanian currency has decreased the cost of imports at home and has made Romanian exports less competitive abroad. The dramatic increase in real wages has fueled a consumption binge in luxury imported goods such as foreign cars and consumer electronics.
Another view defines the current account balance as the difference between a nation’s savings and investments. Emerging economies such as Romania require huge investments to upgrade or replace old capital. This can take the form of construction of new factories, office buildings and residences and purchases of new equipment.
These investments do not come cheap. And they do not typically pay off in the short term. Upgrading emerging economies like Romania requires huge capital inflows long before production and efficiency catch up.
While this may increase the country’s current account balance in the short term, it is not necessarily undesirable. Modernising offices and factories allows for future expansion and increased efficiency. In turn, Romanian goods and services will become more attractive at home and abroad. Romania can then reduce its dependence on foreign goods and increase its exports, thus decreasing the account balance.
The difficulty with assessing the current account balance is that a deficit can either represent an opportunity or an imbalance. The central bank must be careful to cool the unbalanced parts of the economy without affecting the country’s attractiveness to international investors.
One place to start the cooling process would be the housing market. Residential investments provide few or no long-term benefits for the overall economy. Controlling this sector frees up labour and capital that could be more effective elsewhere. Another could be to promote savings at home through tax incentives and increased support for the capital markets.
But the country may need to look at its growing labour shortage. Labour seems to be the bottleneck of the Romanian economy. Governmental spending on education and serious changes to the country’s immigration policy may stabilise wages and signal to the international business community that Romania is serious about solving the problem.
However, a general cooling of the economy is not necessary. While interest rates may be useful in targeting indicators such as inflation and growth, they are generally regarded as a blunt instrument in fighting a growing current account deficit. For this reason, a targeted approach seems prudent.
Few countries have been able to achieve this balancing act and the central bank needs praise for its efforts. It has managed to keep the party going. At some point the bank may want to simmer down the festivities, but should let the drinks flow a bit longer.