Tipping into what in Europe?What lies ahead for Romania?

Daniel Daianu

26 October, Bucharest, 20111

contents

• Global context: the Great Shift and the New Normalcy

• Euro-zone crisis; A new recession looming? (crisis management vs. solving the euro zone crisis)

• Romania’s predicament

• Policy issues and debunking myths

1.The Great Shift • The Great Shift: the rise of Asia• Uphill capital flows!• Black swans (tail risks): financial/economic, ecological; demographic

crises• The struggle over limited resources: oil, food, water (new terms of

trade) • Inter-connectedness and systemic risks/ Financial markets as

an in-built destabilizer and extracting an undue rent• Overstretched societies: economically; socially; militarily…political

strain;• Governance bottlenecks (national; regional (EU); global)• An age of uncertainty, insecurity and distributional struggle

(volatility, domino effects/contagion; back up systems…costs)• Economic slowdown (quasi-stagnation) in industrial societies

(Japanization)?

1.1 The Crisis impact

• Massive costs of bail outs • Debt problem compounded by dimmed growth prospects

(debt deflation?)• Fear and lack of confidence factors• Global crowding out effect : impact on interest rates• Social strain (erosion of the middle class, but which has

started in the early 90s)• A fairness issue (a winners’ take all society?)• An ethical issue (socializing costs)• Getting out of an era of profligacy in an orderly way…• Entering an age of forced diminished expectations • Intensity of contagion effects

1.2 Relapse into a new recession (same crisis)?

• Signs: flight to liquidity (equity markets); bonds valuations; banks’ funding (do markets freeze again?); rising CDSs

• Economic slowdown: the IFIs estimates for the EU in Q3 and Q4, and forecasts for 2012 revised downwards

• Dysfunctional politics; confidence crisis, market sentiment…

• Policy stalemate in the EU (EMU)• The specter of 1937…

1.3 Scenarios

• Tipping into a new recession by sheer dynamics of market forces and inaction of policy-makers; worsening of bank balance-sheets (new bank recapitalization…)…vicious circles

• Avoiding a new recession by FED and ECB intervention; bigger firepower of the EFSF (leverage it up), G20 coordination and IMF support…

• A new Lehman Brothers (disorderly default in the Euro-zone):

• An orderly default of Greece; can contagion be avoided (is a firewall possible)?

• A long stagnation/contraction (Kondratiev cycles, but with the great shift in the world economy

2. The Euro zone crisis• It is a structural/design crisis (EMU deficits are below those of the

US: 85% vs. 95% of GDP for public debt; cca.6% vs 8% of GDP for budget deficit in 2010)

• Public debts have gone up by 1/3 on average following bail outs and automatic stabilsers

• Public and private debts are to be blamed for the sovereign debt crisis; Spain and Ireland had public debts of below 40% of GDOP before 2008; Spain has a public debt inferior to Germany’s (60% vs. 75%) but markets judge growth prospects

• There is no Monetary Union without a common treasury (lender of last resort) and tools for coping with asymmetric shocks

• Crisis management vs. dealing with structural flaws• The political hurdle (no taxation without representation)• How to foster economic growth?

2.1 Rescuing the euro-zone: crisis management vs. dealing with

structural problems • Fiscal rules are necessary, but not sufficient• Bolster the EFSF to over 2,000 billion• ECB operations • Bank recapitalization• Orderly restructuring of sovereign debts where

necessary• Crisis management of long duration?

2.2 Fortune reversals? NMS vs EMU periphery

• Euro as shelter vs. euro as a major constraint on adjustment policy

• The Great Moderation as a Great Misperception; CDSs reflected market myopia and overshooting (misperception); when euro-zone weak links borrowed very cheaply –resource misallocation

• NMSs are better rated now by markets than EMU periphery (CDSs)

• Huge externality (the euro zone crisis): finance, trade, market sentiment, etc

CDS, 5y

10

0

100

200

300

400

500

600

700

800

Jan-09

Mar-09

May-09

Jul-09

Sep-09

Nov-09

Jan-10

Mar-10

May-10

Jul-10

Oct-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

RO

de

bg

hu

pl

cz

0

200

400

600

800

1000

1200

Jan-11 Mar-11 May-11 Jul-11 Sep-11

it

es

pt

ie

0

1000

2000

3000

4000

5000

6000

gr

GDP dynamics

Source: IMF-World Economic Outlook, Sep 2011, Eurostat 11

2008 2009 2010 2011p 2012p

Gr 1 -2 -4.5 -5 -2

Pt 0 -2.5 1.3 -2.2 -1.8

Es 0.9 -3.7 -0.1 0.8 1.1

It -1.3 -5.2 1.3 0.6 1.3

Ie -3 -7 -0.4 0.4 1.5

De 1.1 -5.1 3.7 2.7 1.3

-8-6-4-202468

% ch

ange

Gr

Pt

Es

It

Ie

De2008 2009 2010 2011p 2012p

RO 7.3 -7.1 -1.3 1.5 3.5

Bg 6.2 -5.5 0.2 2.5 3

Hu 0.8 -6.7 1.2 1.8 1.7

Pl 5.1 1.6 3.8 3.8 3

-8

-6

-4

-2

0

2

4

6

8

% ch

ange

RO

Bg

Hu

Pl

Current account dynamics

12Source: Eurostat, European Commission Spring Forecast 2011

2008 2009 2010 2011p 2012p

RO -11.6 -4.2 -4.1 -4.4 -4.8

Bg -23 -8.9 -1 -2 -2.6

Hu -7.3 0.4 2.1 1.6 1.9

Pl -4.8 -2.2 -3.4 -4.1 -4.1

-27

-22

-17

-12

-7

-2

3

8

%G

DP

RO

Bg

Hu

Pl

2008 2009 2010 2011p 2012p

Gr -14.7 -11 -10.5 -8.3 -6.1

Pt -12.6 -10.9 -9.9 -7.5 -5.2

Es -9.6 -5.2 -4.5 -4.1 -4.1

It -2.9 -2.1 -3.3 -3.5 -3.3

Ie -5.6 -3 -0.7 1.2 1.8

De 6.2 5.6 5.7 4.7 4.6

-17

-12

-7

-2

3

8

% G

DP

Gr

Pt

Es

It

Ie

De

Budget deficit

13Source: Eurostat, European Commission Spring Forecast 2011

2004 2005 2006 2007 2008 2009 20102011p

2012p

Gr -7.5 -5.2 -5.7 -6.4 -9.8 -15. -10. -9.5 -9.3

Pt -3.4 -5.9 -4.1 -3.1 -3.5 -10. -9.1 -5.9 -4.5

Es -0.3 1.0 2.0 1.9 -4.2 -11. -9.2 -6.3 -5.3

It -3.5 -4.3 -3.4 -1.5 -2.7 -5.4 -4.6 -4.0 -3.2

Ie 1.4 1.6 2.9 0.1 -7.3 -14. -32. -10. -8.8

De -3.8 -3.3 -1.6 0.3 0.1 -3.0 -3.3 -2.0 -1.2

-37.0-32.0-27.0-22.0-17.0-12.0-7.0-2.03.08.0

% G

DP

Gr

Pt

Es

It

Ie

De

2004 2005 2006 2007 2008 2009 20102011p

2012p

RO -2.3 -1.5 -1.4 -0.1 -1.8 -6.0 -5.6 -4.7 -3.6

Bg 1.8 1.0 1.9 1.1 1.7 -4.7 -3.2 -2.7 -1.6

Hu -6.4 -7.9 -9.3 -5.0 -3.7 -4.5 -4.2 1.6 -3.3

Pl -5.4 -4.1 -3.6 -1.9 -3.7 -7.3 -7.9 -5.8 -3.6

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

%G

DP RO

Bg

Hu

Pl

Gross public debt

14Source: Eurostat, European Commission Spring Forecast 2011

2004 2005 2006 2007 2008 2009 20102011p

2012p

RO 18.7 15.8 12.4 12.6 13.4 23.6 30.8 33.7 34.8

Bg 37 27.5 21.6 17.2 13.7 14.6 16.2 18 18.6

Hu 59.1 61.8 65.7 66.1 72.3 78.4 80.2 75.2 72.7

Pl 45.7 47.1 47.7 45.0 47.1 50.9 55.0 57.4 55.1

10

20

30

40

50

60

70

80

%G

DP

RO

Bg

Hu

Pl

2004 2005 2006 2007 2008 2009 20102011p

2012p

Gr 98.6 100.0 106.1 105.4 110.7 127.1 142.8 157.7 166.1

Pt 57.6 62.8 63.9 68.3 71.6 83.0 93.0 101.7 107.4

Es 46.2 43.0 39.6 36.1 39.8 53.3 60.1 68.1 71.0

It 103.9 105.9 106.6 103.6 106.3 116.1 119.0 120.3 119.8

Ie 29.6 27.4 24.8 25.0 44.4 65.6 96.2 112.0 117.9

De 65.8 68.0 67.6 64.9 66.3 73.5 83.2 82.4 81.1

30507090110130150170

% G

DP

Gr

Pt

Es

It

Ie

De

2.2 Pluses of NMSs, but…no decoupling possible

• Lower public debts (except Hungary)

• Capacity to adjust

• Being outside the euro-zone

• Some NMSs are more compatible, competitiveness-wise, with the hard core of the EMU

3. Romania: a fragile growth model

• Overreliance on external indebtedness (mostly done by the private sector!)

• Premature opening of the capital account (EU rule; it has overlooked Asian/Latin American experience and the danger of fickle capital flows)

• Rising external (CA) deficits during 2005-2008 (3/4 due to the private sector)

• Non-tradable sectors oriented growth• massive euroisation induced by financial liberalization

and high interest rate differentials• Very low fiscal revenues (at 28% of GDP,cca 4% lower

than NMSs average and about 10% below EU-27 average)

3.1 Impact of the crisis

• Deep recession • The level of potential output has been reduced;• The potential yearly economic growth rate has

probably come down from cca. 5-5,5%, before the crisis, to about 3%, but…

• Twin deficits syndrome since 2009• Debt service up• The crisis of the euro zone: CDS spreads + economic

slowdown in Europe + undermining confidence in local markets too + the Greek conundrum (banking sector)

• Strategic importance of EU funds

3.2 Romania (1)

• Fiscal consolidation underway (but a new recession in Europe?)

• Strong reduction of the CA deficit (from double digit numbers before 2009 to around 4.5% during 2009-2011)

• Higher exports, though they are likely to slowdown;

• Strong disinflation after the VAT shock of 2010• A plus: not being in the euro-zone

(autonomous MP and Ex rate policy, but partially emasculated by euroization)

3.2 Romania (2)• Rising public debt (speed of borrowing): from cca 18% end 2008 to

36%, with a big rise in external borrowing• The rising cost of sovereign debt service (in spite of sovereign rating

improvement)• Fiscal consolidation needs further steps: the deficit of the social

security system; the inefficiency of the public sector• EU funds and better tax collection can prevent a strongly pro-

cyclical fiscal correction (a 3% budget deficit in 2012 involves a correction of cca 2.5% of GDP assuming a 2% GDP growth rate, and a higher correction if growth is below 2%). For a 2% budget deficit the correction would rise above 4% since GDP dynamics is impacted by the very fiscal correction.

• EU economic slowdown further complicates the policy choice

Budget expenditures

20Source: European Commission Spring Forecast 2011

2006 2007 2008 2009 2010 2011p 2012p

RO 35.5 36.3 38.3 40.6 40.8 38.8 36.1

Bg 34.4 39.7 37.6 40.7 37.7 37.4 36.6

Hu 52.0 50.0 48.9 50.6 48.8 50.4 45.3

Pl 43.9 42.2 43.2 44.5 45.7 45.8 50.4

30

35

40

45

50

55

%G

DP

RO

Bg

Hu

Pl

2006 2007 2008 2009 2010 2011p 2012p

Gr 44.9 46.3 49.6 52.7 49.6 49.7 49.5

Pt 44.5 44.3 44.6 49.8 50.7 47.7 46.9

Es 38.4 39.2 41.3 45.8 45.0 42.9 42.0

It 48.7 47.9 48.9 51.9 50.6 49.9 49.2

Ie 34.5 36.7 42.8 48.2 67.0 45.5 43.9

De 48.6 48.4 50.1 54.0 53.0 53.1 53.6

303540455055606570

% G

DP

Gr

Pt

Es

It

Ie

De

Budget revenues

21Source: European Commission Spring Forecast 2011

2006 2007 2008 2009 2010 2011p 2012p

RO 33.3 33.7 32.6 32.1 34.3 34.1 34.5

Bg 36.2 40.8 39.3 36 34.5 34.7 35

Hu 42.6 45.0 45.2 46.1 44.6 52.0 42.0

Pl 40.2 40.3 39.5 37.2 37.8 40.0 40.1

30

35

40

45

50

55

%G

DP

RO

Bg

Hu

Pl

2006 2007 2008 2009 2010 2011p 2012p

Gr 39.2 40.0 39.9 37.3 39.1 40.2 40.2

Pt 40.5 41.1 41.1 39.7 41.5 41.8 42.4

Es 40.4 41.1 37.1 34.7 35.7 36.5 36.7

It 45.4 46.4 46.1 46.5 46.0 45.9 46.1

Ie 37.4 36.8 35.5 33.9 34.6 35.0 35.1

De 43.7 43.8 43.9 44.5 43.3 43.3 43.2

30

35

40

45

50

% G

DP

Gr

Pt

Es

It

Ie

De

Budget/Tax revenue: RO, NMSs and EU27

22Source: European Commission Taxation Trends, 2011, European Commission Spring Forecast 2011

2004 2005 2006 2007 2008 2009 20102011p

2012p

RO 32.3 32.4 33.3 33.7 32.6 32.1 34.3 34.1 34.5

NMSs 38.1 38.4 38.2 38.8 38.3 38.7 38.2 39.2 37.7

EU27 44.0 44.4 44.9 44.8 44.6 44.0 43.9 44.5 44.5

30.032.034.036.038.040.042.044.046.0

%G

DP

Budget revenue

RO NMSs EU27

2004 2005 2006 2007 2008 2009

RO 27.2 27.8 28.5 29.0 28.0 27.0

NMSs 38.8 39.1 39.6 39.6 39.3 38.4

EU27 33.1 33.4 33.5 34.1 33.9 33.41111

25.027.029.031.033.035.037.039.0

%G

DP

Tax revenue

RO NMSs EU27

3.3 Economic policy in Romania, next (the 3L and 3H)

• Continue fiscal consolidation• Do the utmost to increase EU funds absorption• Raise fiscal revenues (fight tax evasion;

corruption; increase royalties); a more optimal taxation is needed

• Structural reforms (labor markets; state companies); privatization

• Agriculture, infrastructure, industrial rejuvenation projects: the role of EU funds

• Trade links outer the EU• Plan B

3.4 The 3L and 3H

• 3 L (low EU funds absorption; low fiscal revenues; low productivity)

• 3H (high corruption; high waste, high inefficiency)

4. The convergence challenge in the EU

• It is of long vintage (structural and cohesion funds)• Only very partial success: the “mezzogiornification of the

southern fringe”/ fractures in the EMU (EU), which were obscured by the Great Moderation period (cheap credit and imports)

• The competitiveness challenge in the EMU (in the EU);• Weaknesses of the growth model in NMSs• Redesigning growth models in a new world context• What can EU policies do?• The role of the EU budget

4.2 EU funds in Romania

• An absorption ratio of above 3% of GDP would increase budget revenues by 2% (cca 1% of Romania’s GDP is its contribution to the EU budget)

• A net rise in budget revenues/expenditure of 2% of GDP could increase the economic growth rate by 0,6-1%

• Should worst case scenario occur, EU funds could play a significant damage limitation function

4.3 EU funds in Romania (II)

• In the case of deeper euro-zone crisis: can EU funds be used in order to protect the local banking sector?

• Agriculture in a world with rising relative food prices; it should be seen as a priority for the EU as a whole;

• Infrastructure development• The scarcity of capital worldwide puts an additional

premium on EU funds;• The opportunity cost of not absorbing EU funds is

enormous: a/ EU funds could be reoriented to other users; b/ the economic cost per se; c/ it could backfire by signaling fiscal indiscipline and resulting sanctions

5. Debunking myths

• The EU as a shelter (the euro zone)• The EMH (efficient markets hypothesis)• FDI as a deus ex machina (the role of domestic

saving)• Crises do not befall mature economies on a

large scale (due to strong institutions and good practices)

• Sovereign debt crises have fiscal origins par excellence

• The Great Moderation as a Great Misperception

6. Rethinking policies for longer term dynamics

• A premium on “Policy space” (policy flexibility)• Diversity of policy/ instruments (when policy aims are many (Dani

Rodrik) • Questionable policies: neglect of industrial policies; premature

opening of the capital account, etc• Stimulate domestic savings• Diminish euroization• Foster tradable goods oriented investment. There is need for

hands on policies• Dealing with fairness (burden sharing and income distribution)• Managing expectations in an age of frugality• Taming financial markets is a must for regaining financial stability

and fostering economic growth (Glass Steagall: implementing anti–trust policies; segregating banks geographically?)