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Managing a financial crisis: Romania story, 1998-1999 Ilie SIMON Academy of Economic Studies Bucharest Agenda 1. Short economic background 2. Worsening economic situation in 1988 3. The threat of payment default in 1999 1. Short economic background Real GDP was in 1992 down by 8.8 percent as compared to 1991. 1993-1996, GDP grew at an average annual rate of 4.1 percent. 1997-1999, real GDP declined at an average annual rate of 4.1 percent. 1.1 First recovery During the first recovery, the current account deficit worsened from USD 428 million (1.4 percent of GDP) in 1994 to USD 1774 million (5 percent of GDP) in 1995 and USD 2571 million (7.3 percent of GDP) in 1996. NBR borrowed USD 1.5 billion at relatively short maturities from international capital markets in 1996 (7 credits: 2 were credits in euro and 5 were bond issues in euro and in yen.) The maturity for a good part of these credits was 36 months, that means payment concentration in 1999. 1.2 The economic program I would only emphasis the two key components of the Program: The liberalization of the foreign exchange market; The increase of energy prices towards their border parities. 1.2 The economic program( 2) The exchange rate depreciation stimulated exports and discouraged imports. The exports went up from USD 9648 million in 1996 to USD 9955 million in 1997 (an increase of 3.2 percent). Import went down from USD 12503 million in 1996 to USD 12349 million in 1997 (a decline of 1.2 percent), net exports having a positive contribution to GDP. However, real GDP dropped in 1997 by 6.1 percent. The shock induced by the increase of energy prices apparently was stronger than the positive demand shock due to the depreciation of the exchange rate. 2. Worsening economic situation in 1988 contraction inflation external deficit of about 7 percent of GDP an overvalued currency (ROL) foreign debt repayment: 2.2 billion USD 2.1 Market sentiment towards Romania Worsened after the Russian crisis in August 1998. Plus the external deficit together with the peak of external debt service scheduled for 1999. The major rating agencies downgraded Romanian sovereign ratings: in 1996 before launching a Eurobond issue, Romania was rated similar with other countries from the region (BB-). Starting with 1998 the grade has diminished reaching in 1999 the level B and even B-, which means high level of risk. At end-1998, the spreads between the Romanian external debt in a very thin secondary market and comparable US treasuries bonds were about 13 percentage points. 2.2 Major macroeconomic indicators The Russian crisis in August caused a serious turmoil on international financial markets and changed the market sentiment towards emerging economies, including Romania; Official foreign exchange reserves of Romania declined from USD 3 billion at the end of 1997 to USD 2.3 billion at the end of 1998. Inflation was in 1998 much lower than in 1997, but persisted at a relatively high level, consumer prices having been in December 1998 by about 41 percent higher than in December 1997. Inflation and the average exchange rate 2.2 Major macroeconomic indicators(2) The change in the exchange rate was well below inflation: the ROL turned significantly overvalued against the USD by mid-1998. The accelerated depreciation towards the end of 1998, and in early-1999, corrected ROL overvaluation. But exports dropped from USD 9955 million in 1997 to USD 9519 million in 1998, while imports increased from USD 12349 million in 1997 to USD 12798 million in 1998. 2.2 Major macroeconomic indicators(3) Following the contraction of 6.1 percent in 1997, real GDP further declined in 1998 (by 4.8 percent). Imports increased despite the contraction of the domestic economy, which points to the severity of ROL overvaluation. The prolonged economic contraction appears to have played its role in worsening the market sentiment towards Romania and putting downward pressures on the ROL. 2.3 Central bank interventions As indicated by the decline of official reserves, NBR was a net seller of foreign exchange on the market, which contributed to ROL overvaluation. Market participants understood towards the end of 1998 that the exchange rate was unsustainable. Consequently expectations of downward correction of the ROL firmly consolidated, and it made no sense to the central bank to go on fighting against such strong expectations. 3. The threat of payment default in 1999 On top, the external debt service was scheduled to reach a historical high in 1999. The service of the medium and long-term external public debt amounted in 1997 to USD 1581 million and in 1998 to USD 1520 million. It was programmed to surge to USD 2160 million in 1999. The gross foreign exchange reserves (including gold) of the central bank amounted at the end of 1998 to only USD 2299 million. The strong market sentiment at the end of 1998 and early in 1999 was that Romania would default on its external obligations. 3.1 Fiscal and budget adjustment in 1999 In 1999 a new finance minister was nominated, and a close cooperation with NBR has developed: -Tax increases – notably social security contributions, excises and property taxes; the main component of fiscal adjustment. -Elimination or suspension of previously granted tax facilities and exemptions; -Expenditure cuts – notably wages in the public sector and capital expenditures. 3.1.1 Budget revenues in Romania Budget revenues Current Tax Profit tax Income tax Social security VAT Custom duties Excises Other Non-tax Capital Grants 1998 29.7 29.7 27.8 3.0 4.0 8.9 6.0 1.5 2.3 2.1 1.9 l0.0 0.0 1999 31.9 31.8 30.1 3.1 3.2 10.7 6.0 1.4 3.0 2.7 1.7 0.1 0.0 3.1.2 Budget expenditures in Romania Budget expenditures Current Goods and services Wages and salaries Material expenditures Interest Subsidies and transfers Subsidies Transfers Capital Lending minus repayments 1998 1999 35.1 30.9 11.4 5.0 6.4 4.7 14.8 1.7 13.1 l3.6 0.6 34.7 31.7 11.5 4.9 6.6 5.2 15.0 1.6 13.4 2.8 0.1 3.2 Deficit financing in Romania The budget deficit shrank from 5.4 percent of GDP in 1998 to 2.8 percent of GDP in 1999. The adjustment in 1999: budget deficit financing (Percentage of GDP) 1998 Financing 5.4 Domestic borrowing 3.9 External borrowing 0.0 Privatization revenues 1.8 Bank asset recoveries 0.0 Discrepancy -0.3 1999 2.8 1.6 0.4 0.9 0.0 -0.2 3.3 Real GDP and inflation in 1999 The fiscal and budget adjustment in 1999 played its part in entailing a decline of 1.2 percentage point in real GDP. However, inflation – measured on the basis of the GDP deflator – dropped from 54.1 percent in 1998 to 47.8 percent in 1999. 3.4 Interest rates in 1999 Interest rates on government borrowing stayed high in 1999 because of the likelihood of payment default. They surged at 104 percent in May on account of the scheduled peak of external payments, but they declined to about 70 percent towards the end of the year. Gross fixed capital formation was in 1999 down by 4.8 percent. However, lower interest rates played their role with a lag, gross fixed capital formation having picked up in 2000 by 5.5 percent. Borrowing and interest rates 3.5 The exchange rate and the external current account in 1999 The ROL depreciated in 1999 by 72.8 percent against the USD, which was well above the inflation rate. Exports were up by 3.5 percent (from USD 9519 million in 1998 to USD 9854 million in 1999). Imports were down by 9.8 percent (from USD 12798 million in 1998 to USD 11538 million in 1999). The deficit of the external current account was down to USD 1469 million (4.1 percent of GDP). 3.6 Foreign exchange reserves in 1999 Market expectations that the central bank would exhaust its foreign exchange reserves in 1999 did not materialize. Romania could meet its external obligations and, increased its reserves to USD 2493 million towards the end of 1999. Eventually Romania avoided the threat of payment default but the price paid for this success was the GDP decline. However, had the situation of payment default occurred, the associated financial turmoil would have presumably caused a much larger drop of real GDP. 3.7 Changing the rating A positive change in rating for Romania came only on September 2002, to the grade B. Romania came back to the capital market on October 2000 with a bond issue of 150 millions USD for 36 months at 11 percent. In 2001, an issue of 600 million bond at 10,625 percent was followed by one in 2002 for 700 million at 8, 5 percent. One can notice the diminishing of the risk premium for Romanian borrowings.