The Great Shift: Europe and Romania in the Era of Uncertainty

1. Tipping into what in Europe?What lies ahead for Romania?Daniel Daianu 26 October, Bucharest, 2011

2. 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

3. 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 anin-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)?

4. 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

5. 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…

6. 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

7. 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?

8. 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?

9. 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

10. CDS, 5y

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

12. Current account dynamics Source: Eurostat, European Commission Spring Forecast 2011

13. Budget deficit Source: Eurostat, European Commission Spring Forecast 2011

14. Gross public debt 14 Source: Eurostat, European Commission Spring Forecast 2011

15. 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

16. 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)

17. 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

18. 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)

19. 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

20. Budget expenditures Source: European Commission Spring Forecast 2011

21. Budget revenues 21 Source: European Commission Spring Forecast 2011

22. Budget/Tax revenue: RO, NMSs and EU27 22 Source: European Commission Taxation Trends, 2011, European Commission Spring Forecast 2011

23. 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

24. 3.4 The 3L and 3H • 3 L (low EU funds absorption; low fiscal revenues; low productivity) • 3H (high corruption; high waste, high inefficiency)

25. 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

26. 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

27. 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

28. 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

29. 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?)