Will elections pave the way, at last, for some political stability?

Last November’s re-election of pro-European President Iohannis (National Liberal Party - PNL) for a second five-year term could pave the way for a period of political stability in Romania. Iohannis, president since 2014, obtained an easy victory against former PM Dancila from the ruling Social Democratic Party (PSD). It had been a blow for a party that, as the successor of the Romanian Communist Party, had largely dominated governments since the 1989 Revolution. The election outcome, the lowest for the PSD since 1989, comes after three years of high political instability fueled by a strained cohabitation between President Iohannis and the PSD-led coalition. The PSD constantly attempted to harm justice’s independence and weaken the fight against graft in order to protect parliamentary members from future prosecutions, starting by former PM and PSD’s strongman Liviu Dragnea who was sentenced in 2016 to a 3 years suspended prison sentence due to electoral fraud. This process was not only opposed by Iohannis but also led, in addition to the dismissal of the former anti-corruption top prosecutor, to persisting massive street protests and EU pressures. Last May, Dragnea was jailed for 3.5 years for power abuses. With Ludovic Orban as PM, after the parliamentary no confidence vote against Ms Dancila in October, the liberals are holding the country’s reins. In order to capitalise on a favourable electoral dynamics, they are pushing for snap legislative elections to take place in the coming months (instead of November as scheduled). Those elections will decide whether Romania will enter a more stable political period, an outlook that was strengthened by Ms Dancila’s ousting and Iohannis’ re-election. The prospect of normalised relations with the EU institutions and of a stabilised and harmonised political framework would improve Romania’s political risk outlook and potentially investor confidence. 

This being said, the current or next government will face substantial challenges, from the reduction of the widened fiscal deficit (including unpopular cuts in heavy social spending) to the need to restore business and people confidence in a country undermined by a deep emigration crisis (a regional trend). Another goal for the government will be to reaffirm the independence of the judiciary.  

Weakening growth and wider imbalances after years of economic boom 

Romania’s economy has been the fastest growing economy in emerging Europe between 2015 and 2019 with a 4.8% average. After having overheated until 7% in 2017, GDP growth cooled down to around 4% in the next two years and is forecast to decrease further to a still robust 3% in the MLT. A dynamic construction sector and a booming domestic demand, in a context of low unemployment and swift wage increases, have been the main drivers. The car industry, the country’s largest sector, continued to perform strongly despite the EU economic slowdown. Looking ahead, adjustments will be required to prepare for major technological and environmental changes. Romania’s growth potential has further increased thanks to solid economic performances. However, the dramatic brain drain since EU accession in 20071, facilitated by the EU’s freedom of movement, could eventually harm them if the authorities do not decisively address this issue.

Strong economic performances and weakened government policies have led to rising macroeconomic imbalances and a deepening twin deficit. These are the dominant downside risks, as external headwinds are accumulating through global trade tensions and a further slowing Eurozone demand to which Romania’s economy, notably manufactured exports, is much exposed. Moreover, any adjustment policies will be postponed until the parliamentary elections. On the positive side, accommodative monetary policies in the USA and the EU will mitigate the risks of capital outflows. 

The deepened twin deficit is expected to moderate gradually

The current account deficit has steadily widened from 1.2% in 2015 to an expected 5.5% of GDP in 2019, mainly due to rapidly increasing demands of imported goods, while exports have been slowly growing due to falling competitiveness. Therefore, as in 2018, the current account deficit has driven the balance of payment into negative territory. Since the FDI finance less than half of it, debt flows have been increasingly needed to meet increasing financing needs. In the MLT, this moderate deficit is likely to decline as a result of a slowing domestic demand and diversified current account receipts whereas FDI might strengthen under a more business-friendly and stable government, thereby allowing the balance of payments to be again in surplus. A higher absorption of EU funds (cf. below) could also bring more foreign capital inflows. In this environment, the Romanian leu (RON) has been under pressure and gradually depreciating against the euro since the 3rd quarter of 2016 (-7.6% by January 2020). While the RON has yet to enter the ERM II system, the country’s target for euro adoption is 2024.

As for public finances, the legacy of the 2008 crisis remains visible with a public debt above 35% of GDP (from 11.8% of GDP in 2008). It slightly dropped between 2015 and 2018 on the back of a strong economic momentum but started again on an upward trend in 2019. Public debt is expected to rise gradually and pass the 40% threshold as of 2022, still a sound level though. Since 2016, the shift from fiscal discipline to pro-cyclical fiscal stimuli (increased pensions and public sector wages, tax cuts but weak public investments) under the previous government has inevitably deteriorated the fiscal balance from 1.4% of GDP in 2015 to an expected 3.7% in 2019. The new government has pledged to consolidate public finances. In a country with the highest share of social spending within the EU (about 70% of public revenues), lowering the big size of social expenditures and raising fiscal revenues are necessary steps to bring the deficit down and finance rising pension costs. Current projections point to a fiscal deficit around 3.5% in the MLT. However, the change of fiscal stance required by the “EU’s excessive deficit procedure” is likely to be postponed to 2021 given this year’s election cycle (including local polls in June) and the decelerating economy. 

Meanwhile, Romania will continue to benefit from large EU cohesion funds even though their magnitude is uncertain given high disapproval between member states about the EU 2021-2027 budget. Nonetheless, Romania has the weakest absorption rate of those funds, with less than 15% of them spent in the end of 2018. Therefore, public spending has to be more efficient and raised (e.g. in the infrastructure to reduce the EU largest gap) to speed up convergence to the EU average.

On the positive side, the banking sector remains stable and sound, strengthened by the sharp decline in NPL ratio to 5% in 2018 (from 20.7% in 2014), i.e. close to EU average.

A sharply improved financial risk over the years 

The dominating financial risk has sharply improved over the past years. Over the past decade, external debt ratios have been steadily decreasing from 211% in 2009 to less than 110% of current account receipts in 2019, and from 74% in 2010 to less than 50% of GDP in 2019. Private debt deleveraging and strong economic performances explain this favourable trend. The external debt service has also followed a similar trajectory since 2015 as it has been squeezed from about 35% to less than 20% of current account receipts in 2019. For all external debt (stock and service) indicators, the decreasing trend is forecast to continue albeit at a very slow pace. The liquidity position has continued to deteriorate as slightly lower foreign exchange reserves cover 3.5 months of stronger imports (against 5 months in 2016) and barely exceed the ST debt (1/3 of current account receipts last June). Still, they easily cover the external debt service and are forecast to stabilise at their current level in the coming years. 

After years of strong economic performances and private debt deleveraging, and as an improved political outlook could contribute to run coherent government policies and normalise EU relations, Credendo decided to upgrade Romania’s MLT political risk rating to 2/7 (from 3/7) in January.

Analyst: Raphaël Cecchi – r.cecchi@credendo.com

1 Whole Eastern Europe has been hit by an emigration crisis. It has been the most pronounced in Romania as nearly 15% of the population (i.e. more than 3.4 million people) has left the country since 2007. Meanwhile, immigration has been modest.