Tipping into a new recession, or what else? What lies ahead for Romania? Daniel Daianu

1. Tipping into a new recession, or what else?What lies ahead for Romania?Daniel Daianu COFACE conference, Bucharest, 28 September, 2011

2. contents • Global context: the Great Shift • A new recession (same crisis), or…? • Euro-zone crisis; impact on NMSs • Romania’s prospects • The future of convergence

3. 1.The Great Shift; black swans proliferate • The Great Shift: the rise of Asia • A proliferation of black swans (tail risks, crises): financial/economic; ecological; demographic, • Overstretched societies: economically; socially; militarily…political strain • Strain in the West (its decline) • Economic slowdown (quasi-stagnation?) in industrial societies (Japanization?) • The struggle over limited resources: oil, food, water (Malthus again?) • A crisis of globalization (over-dependency on external supply chains; inter-connectedness/ Financial markets and systemic risks • Financial markets as an in-built destabilizer • Governance bottlenecks (national; regional (EU); global) • Limits of openness • An age of uncertainty, insecurity and distributional struggle (volatility, domino effects/contagion; back up systems…costs)

4. 1.1 The Crisis impact • State intervention to rescue financial institutions: Massive costs of bail outs • A huge sovereign debt problem (compounded by aging and effects of climate change) • Sovereign debt crises (Reinhart and Rogoff) • Fear and lack of confidence factors • Global crowding out effect : impact on interest rates • Getting out of an era of profligacy in an orderly way… • Entering an age of diminished expectations and growing uncertainty (insecurity) • Wrecked economies (Iceland, Ireland, Greece) in developed countries; • Intensity of contagion effects • Social strain (erosion of the middle class, but which has started in the early 90s)

5. 1.2 Relapse into a new recession (same crisis)? • Visible signs: flight to liquidity (drops on equity markets); bonds valuations; banks’ funding (do markets freeze again?); rising CDSs • Economic slowdown: the IMF estimates for the EU in Q3 and Q4, and forecasts for 2012 revised downwards • Dysfunctional politics • Political 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…) • Avoiding a new recession by further intervention by the FED and the ECB; bigger firepower of the EFSF (leveraging it up), G20 coordination and IMF support… • A new Lehman Brothers….disorderly default in the Euro-zone: fall of output (rise of unemployment) followed by quasi-stagnation for years; impact on the banking sector • An orderly default of Greece; can contagion be avoided (is a firewall possible)? • A long stagnation/contraction? Kondratiev cycles, but with the difference of the great shift in the global balance of economic power?

7. 2. The euro-crisis • Herman van Rompuy: “the EU model is under threat”; is Europe 2020 a proper answer? • The Crisis, recession, stagnation…jobs • Rediscovering major cleavages in the EMU(EU) • The crisis of the EMU (EU): the reform of governance • “The Monti trade-off”:the single market may ask for intra-Union fiscal transfers • Lack of burden sharing arrangements in the EU; • Renationalization of policies? • Variable geometry on the rise? • The future of convergence (the case of NMSs) • More vs less Europe (integration vs. fragmentation): (what does it mean for the EU budget?).

8. 2.1 The EU budget framework • It seems to assume that we will get back to “business as usual” after the crisis is over… • If this assumption is discarded the new framework looks like a relic, a prisoner of the past…in spite of its pretense (Europe 2020, too); would its structure had been different in 2007/8? • There is a sort of disconnect between this new framework and what the current crisis tells us… • If the choice is for more Europe as a response to the Crisis, the EU budget should be bigger; the EP is right, philosophically, in this regard… • De facto, there is an additional budget in the making for the euro-zone, EFSF; the latter could be raised to over 2,000 euro (the American proposal to leverage it up) –double the EU budget for 2014-2020 • It does not consider the need for drastic changes in the functioning of the EU institutions and policies • Its own resources need to be bolstered

9. 2.2 Rescuing the euro-zone • Incrementalism does not work • Fiscal rules are necessary, but not sufficient • Eurobonds as a means for fiscal integration; bolster the EFSF to over 2,000 billion • ECB operations • Bank recapitalization • Orderly restructuring of sovereign debts where necessary • Fostering growth in the periphery

10. 2.3 Fortune reversals? NMS vs EMU periphery • Euro as shelter vs. euro as a major constraint on adjustment policy; the structural flaws of the EMU • The Great Moderation as a Great Misperception; CDS reflect market myopia and overshooting (misperception); when euro-zone weak links did borrow very cheaply –resource misallocation • NMS are better rated by markets than the EMU periphery (see CDSs)

11. CDS, 5y

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

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

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

15. Gross public debt 15 Source: Eurostat, European Commission Spring Forecast 2011

16. 2.4 Pluses of NMS, but…no decoupling possible • Low public debts • Capacity to fiscal adjustment • Being outside the euro-zone • Some NMS are more compatible, competitiveness-wise, with the hard core of the EMU

17. 3. Romania’s predicament • It very much depends on EU wide dynamics • Exports have been the driving force of its late feeble recovery • Diminished consumption • Fiscal correction underway • EU funds absorption

18. 3.1 Impact of the crisis in Romania • Deep recession (why?) • Income per capita in Romania has gone down from cca 47% to 45% of the EU average (PPS terms) since 2008; euro based the drop was from 26% to 23.4% (Eurostat data) • It has, likely, reduced the level of potential output; • It has, likely, diminished the durable potential yearly economic growth rate: from cca. 5-5,5%, before the crisis, to about 3-3,5%, but… • Twin deficits syndrome since 2009 • The computations on economic growth rates are optimistic were Europe to revisit a recessionary period, and, moreover, lapse into a lasting quasi-stagnation (A “Japanized” dynamic…”the lost decade”); • A double deep recession would heighten the strategic importance of EU funds

19. 3.2 Pieces of good news • Fiscal consolidation underway: see table (cca.4.5% in 2011 and, hopefully, cca 3.5% in 2012, though a double deep in Europe would make it quite hard to achieve) • Strong reduction of the CA deficit (from double digit numbers before 2009 to around 4.5% during 2009-2011) • Booming exports, though they are likely to slowdown; ULCs seem not to be the main issue • Still low public debt • Restart of strong disinflation after the VAT shock of 2010 • Not least: not being in the euro-zone (autonomous MP and Ex rate policy)

20. 3.3 Pieces of bad news • The big rise in public debt (speed of borrowing): from cca 18% end 2008 to 36% in 2011, with a big rise in external borrowing • Fiscal consolidation needs further major steps: the deficit of the social security system; the inefficiency of the public sector • The rising cost of sovereign debt service (in spite of sovereign rating improvement): CDS have climbed over 450 basis points lately (from around 250 basis points three months ago • Low fiscal revenues (at 28% of GDP they cca 4% lower than NMSs average and about 10% below EU-27 average) • High euroization • Low EU funds absorption capacity

21. Budget expenditures Source: European Commission Spring Forecast 2011

22. Budget revenues 22 Source: European Commission Spring Forecast 2011

23. Budget/Tax revenue: RO, NMSs and EU27 23 Source: European Commission Taxation Trends, 2011, European Commission Spring Forecast 2011

24. 3.4 Economic policy in Romania in the period to come • NBR: provided inflation continues to go down, lower the policy rate; • Do the utmost to increase EU funds absorption • Raise fiscal revenues (fight tax evasion; increase royalties and tax land adequately, etc) • Continue structural reforms (labor markets; state companies;) • Agriculture, infrastructure, education, industrial rejuvenation; the role of EU funds • Trade links outer the EU

25. 3.5 Estimates for 2012 • Provided there is no “black swan” engulfing the European economy, the GDP growth rate could be around 2.5% (it considers the economic slowdown in the EU) • A new recession in the EU could reduce the GDP growth rate toward 1% • The budget deficit: cca.3.5% of GDP (the lower the GDP growth rate the harder is to keep the budget deficit close to 3%) • End of the year inflation: between 3.4-3.8% assuming an economic slowdown in Europe and no big pressure for depreciation of the exchange rate • The CA deficit: around 4.5%

26. 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 Great Misperception • The competitiveness challenge in the EMU (in the EU); • Weaknesses of the growth model in NMSs (big external deficits and non-tradable sector overinvestment) • redesigning growth models in a new world context • What can EU policies do? • The role of the EU budget

27. 4.1 The role of EU funds in NMSs • A macroeconomic function; to help limit pro-cyclical policies in a a crisis • A developmental function: infrastructure and rural modernization projects; • A structural reform function: help improve the use of public funds, the reform of public administration • A social function: the job issue (social strain) • Help reduce EU economic discrepancies • Planning for a double deep and mounting crisis in the EMU

28. 4.2 EU funds in Romania • Very poor absorption ratio until now • Raising the level of EU budget expenditure: 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); nota bene: Romania has one of the lowest fiscal revenues ratio in the EU, 27- 28% of GDP during 2004-2010, as against an average of 39% in EU-27 and cca 33% in NMSs • A net rise in budget revenues/expenditure of 2% of GDP could, ceteris paribus, increase the economic growth rate by 0,6-1%, and bring the durable economic growth rate above 4%; a net rise in budget revenues/expenditure of 3% could bring the economic growth around 4.5% of GDP. • The estimates above do not factor in a new recession in Europe and, what would be worse, disorderly defaults in the euro-zone with ensuing lasting bad effects • Should worst case scenario occur, EU funds could play a significant damage limitation function

29. 4.3 EU funds in Romania (II) • In the case of deeper euro-zone crisis, of defaults, Romania should be allowed to use EU funds in order to protect its banking sector (Greek banks hold cca 20% of Romania’s banking sector assets) • Agriculture is a golden activity in view of rising world 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

30. 4.4 Convergence prospects are dimmer • By using PPS terms, an annual economic growth rate differential of 3%, as against the EU area, would permit to reach cca 80% of the EU average income level in about 18-20 years time (from the current level of about 45%); on euro based calculations the rise would be from around 23.5% in 2010 to cca 40% n 2030; a median value would give 60-65%. • the lower the rate differential the longer the convergence period • These are back of the envelope calculations and based on uncertain premises; but they provide a measure of challenges ahead. But consider the “Great Shift” and its impact, and not least, a new recession and long stagnation period in Europe… • There is need for more tailor made policies –fitting Romanian circumstances, even if EU rules are constraining (see slide which follows)

31. 4.5 Rethinking economic policies • The Washington Consensus has been disputed since long • Questionable IFIs policies (neglect of industrial policies; premature opening of the capital account, etc) • Diversity of policy/ instruments (Dani Rodrik) • Taming financial markets is a must for regaining financial stability