How can we decipher what is currently going on with the economy? Assuming that we are regular people with average knowledge in the area. What might seemingly conflicting statements, such as “the inflation that we are able to keep in check, has dropped, this is really great” and ”the uncertainties and risks arising from medium-term inflation forecasts are significant” mean? Both issued on the same day: the first uttered by Mugur Isărescu, the governor of the Romanian Central Bank [BNR], the second found in a report on inflation by the same institution. It means that the serious issues are the ones out of BNR`s control: external risks, wage explosion and others. Are the two-digit rise in income and a booming consumption, with no additional VAT revenues into the budget a good thing? A bad thing?
Although it fell from over 6% to slightly over 4%, economic growth remains sound, doesn`t it? Exports are also increasing. And a 0.88% budget deficit is not much. And why would we worry when consumer credit is at a record low? So what if you can`t find people to hire? Low unemployment is good news, at the end of the day.
In this talk with Radu Crăciun, CEO of BCR Pension Fund and one of the economists I most admire, we set out to decipher – for the regular dummies – why and whether it is time to worry. And it is. Not right away. But we are at an inflection point.
I kept Radu`s answers almost untouched with minimum edits. To facilitate reading (it is quite a lengthy text), I divided the conversation into chapters. But it is without a doubt worth reading it through. We discussed about:
- How we get fooled by the “statistical averages”
- How long the economy is going to boom
- The pitfall that we are in and how to escape it
- Why the 4% growth can`t last forever
- What is the link between growth and the government budget
- For how long we can consider that we are safe.
How we get fooled by the economy of “averages”
On average, a family made up of two and a half members live in a 1.75-room flat. In reality, this does not exist. The 4% average growth hides huge gaps: almost half of what is going on in Romania, happens in Bucharest. Here, people live like they do in Spain. Go 400 kilometers away and the comparator is Albania: a 6:1 ratio. In the county of Arges, turnover grew by 250% from 2008 to 2016. The only driver here is the rise of the Dacia car manufacturer. In areas such as Timis or Sibiu, where most multinationals that produce in Romania for markets all over the world are located, the phenomenon is similar.
Therefore, the conflicting nature of statements about Romania that you hear is natural. Romania is a deeply fragmented country where opposite things may occur simultaneously, though, on average, we are doing fine.
Radu, where should we look, beyond the statistical averages, so that we have a somehow better grasp of facts?
Here is the thing: the macroeconomic data that we take have a serious flaw, namely that they are essentially averages claiming to capture the realities of a country.
The truth is that averages can hide major differences. Add 1 and 9, 5 and 5 and 4 and 6 and you get the same average. This is one side of the coin. And let me give you some examples of major fragmentations which may be misleading. On the one hand, Romania has multinationals whose sole interest is to export, Romania does not represent their market. They came here for cheap, skilled labor. All these companies contribute to the economy and the gross domestic product, though they do not manufacture for the Romanian market.
The Romanian Central Bank`s monetary policy is completely irrelevant to these businesses. Because they do not borrow in RON, they are funded by the parent company. And how much or little money the Romanian consumer has, makes no difference to them.
They are islets within Romania which are not impacted by the local monetary policy and macroeconomic changes. But they do have an impact on the country`s statistical data.
Because they invest, produce, hire …
Added value and the like. We can imagine a situation in which, for instance, the Romanian economy performs well while these companies do bad because of slow growth in their European export markets. Or the reverse: imagine that the Romanian economy does not fare that well while they are thriving.
Clearly, they do have a driving effect because they employ people whom they pay and if they do well, then their employees will have more and more money to buy things with. But the impact is not major. They generally invest in imported equipment, so they use rather few local manufacturers.
Which is the second type of misleading fragmentation?
The geographic fragmentation. I`m referring to the fact that you can have a region, such as Transylvania which is booming, and on the other hand regions such as Teleorman, Vaslui where basically nothing happens. Signals vary by region. If the local businessmen produce for multinationals, then they manage pretty well. If the entrepreneurs rely heavily on what happens in Moldova, that the picture changes. The former hire people, the latter fire people.
Or you are a provider on a niche market with a totally different behavior, based on that industry. Think about the courier business which has taken off due to the online retail growth …
Or about a construction firm specialized in residential projects, because residential construction is increasing, and if you had the misfortune to get specialized in public works, then you are in big trouble.
This is why at the grassroots, the real economy reflects very differently the aggregated national numbers.
Will the economy be booming in a year`s time?
When an economy reaches its limits which are the signs that warn us that we are there? The BNR`s inflation report talks about “the prospect of continued deceleration of economic growth during Q2 and Q3 slightly faster than that predicted in May”. In other words, what we hope for to happen in May will not take place. The economy is slowing. Wages are rising and there are increasingly fewer people available for work. The purchasing power, however, fell for the second month running. The demand, which so far has been driving growth, is dropping faster than expected, says the BNR. Public policies do not help. On the contrary. We trust the economy just enough to rank 16th in Europe.
So, will the economy be booming a year on?
No, it won`t. Because right now growth exceeds what we can afford. Proof lies in one indicator which suggests exactly that.
Which one?
Inflation. Then the exchange rate and in particular, the interest rates. They are all going up. That means that Romanian businesses are not able to produce more, they have reached the upper production limit. I have already heard companies say that they can`t cope with the demand.
Why not invest in building more capacity?
No one will invest when everybody warns that what is going on is unsustainable. So the only option is to push up prices. That creates inflation. As prices go up, imports become more appealing. And that increases trade deficit which puts pressure on the exchange rate. And inflation and FX rates eat away at salary increases.
That is picked up by consumption. A dropping consumption affects the GDP.
It does. Growth slows down. You don`t necessarily need to be in the red. But I can easily imagine a slowdown to 2%. And, mind you, that is valid for when nothing bad happens internationally. If the US falls into recession, we will quickly go in the red.
What are the first red flags of a wet blanket over the real economy?
The first clues are those that I just mentioned: deficits and inflation. As inflation rises, the firefighter to first respond is the central bank which has no choice but to increase the interest rate. Such an increase is a way to put the brakes or the wet blanket on.
Loans become more expensive and what happens is that people start buying less, businesses invest less and the economy starts to lose pace. By law, the central bank targets inflation. If they meet their target, no one can point the finger of blame at them.
How should we take the 0.5% interest on deposits?
Sadly, this is another way to adjust the economy: it destroys the capital gathered by households by remunerating savings below inflation. It is actually making those saving and putting money aside poorer.
Do puny deposit interest rates mean that banks have a cash surplus and they don`t know what to do with it?
Currently banks have too much cash. There are not many options to pump all that cash into. On the one hand, you have the multinationals getting funds from abroad, they do not take out loans in Romania. The number of local credit-worthy firms is relatively low and all banks fight for them. So you are left with the small and medium-sized enterprises with poor capitalization and higher risk profile. And thus, Romanian banks` exposures to government bonds are very high. Why increase deposit interest rates?
Where will the signs of the vehicle going on lower gear be first apparent? In Carrefour`s case? Toyota`s? Beef sales?
I think it will be first apparent across all buys funded by loans: cars, houses, building materials.
That`s the pitfall that we are in. In order to escape, we need lots of money and brains.
The economy resembles a simpler animal: it can grow without breaking as far as the capital, labor and innovation existing at some point permit it. Beyond that, as happens with a car that you push too much, it starts to fall apart at the seams. And Romania is at an inflection point. A 4% economic growth is pretty much all we can handle based on our current model. With a record growth of labor costs of nearly 13% (especially in the public sector) and a productivity growth of only 4% (down from 6.7%), our model is reaching its limits. Income is rising five times faster than the economy. And even as it stands now, we are paid on average just EUR 6.3 per hour, against EUR 24, the EU average. It`s easy: if we want to plug the gap, then carrying on increasing wages won`t do.
What is the problem with the current model?
Increasing wages and consumption is a completely naïve answer to a very serious problem facing Romania: the middle income trap. There are tens of countries worldwide which for 20-30 years have failed to escape it. The Romanian government`s solution was to raise public salaries and thus force private employers to do the same. But a sound wage rise can only be achieved only when productivity increases. Businesses cannot increase their productivity if the infrastructure is not there to support them.
What phenomenon underpins the middle income trap?
In the first phase, growth is based on productivity gains which are easier to obtain without a too intricate approach. At some point, though, growth is achieved only in the presence of innovation, infrastructure and corporate governance. Many countries do not manage to move to the next level.
No surprise, then, that countries such as Israel and South Korea which focus on innovation pushed forward. If the country fails to tap into its brain pool, it stays put for decades. At the end of the day the key to success is to outrun others as far as competitiveness goes.
How do you know which is the inflection point of the current model? When does the situation become alarming?
Something called potential GDP comes in. An economy underpinned by the capital, labor and the innovation available at some point has the ability to generate a certain GDP before going haywire. That is a fact. A higher potential output needs investments: either in innovation or in people.
Right now we live above our potential which is somewhere at 3% or 4%. An increasingly long period of time during which Romania stays above its potential GDP will create the potential for imbalances: high inflation, current account deficit and so on. Our mistake is to imagine that tax incentives or salary rises are sustainable by themselves. It doesn`t work like that. The economic capacity needs to be boosted.
So what is the way out?
Increasing the potential GDP means investing in human capital. And it also means having capital to invest in the first place. Local capital is paramount. There is nothing to invest if you don`t own any capital. And other people`s money must always be returned. Romania`s problem lies in a massive lack of local capital.
Local capital can be collected through banks, pension funds, investment funds. We have a short tradition in capitalism, with no past as a colonial power and therefore we have a long way to go to catch up with the rich countries that managed over hundreds of years to amass their current development capital. This discussion also ties into pensions Pillar II. Meaning, if you scatter what little capital you have collected and rely on others` willingness to invest or not in Romania, what`s the point?
So we need lots of money or lots of brains …
A country will only manage to develop as long as it has financial capital or if it can make up for the lack thereof with brain capital. What is the beauty of it all? An IT firm does not need much capital, it needs smart people. This is why, internationally, the most successful Romanian company is in IT – Bitdefender. A Romanian steel maker or chemical plant could have never gone global because they are very capital intensive.
Why can`t we stay at a 4% growth forever?
If we look at figures (the averages, as there is little else), we see a chain of events: an industrial slowdown coupled with increases in prices, trade deficit (in the first five months imports were up by over 12%), a twofold number of insolvencies compared with the Central and Eastern Europe average. Wages are on the rise, productivity on the wane. Can we carry on with this model?
So why can`t we continue to grow at 4%? It`s a splendid figure, after all.
There are two things here. It`s not just growth that matters, but the type of growth. In terms of its structure. We are at 4% growth, 80% of which is spurred by consumption.
Consumption-driven growth cannot ensure long-term sustainability. No nationwide productivity gains means that Romanian companies will gradually become less and less competitive compared with foreign companies. Consumption will be funneled towards better quality products, namely imports, and local firms will lose their attractiveness in terms of products on offer.
Moreover, Romanian businesses have to deal with the labor problem …
Should they want to expand because the demand is there, they will be hard pressed to find people to move them forward. Therefore they are somehow doomed to lag behind, to put it differently. Except for when they invest more in automation. But that is quite costly and not within everyone’s reach.
Bit by bit, as the local economy loses momentum due to lack of infrastructure and skilled workers, the fire goes out. It is a hay fire. As the hay burns up, the fire burns out.
How does the government budget impact the mathematics of growth?
One might assume that it is the government`s job to solve at least in part the investment issue. But it can`t. With a share of only 26% or 27% budget revenues of total gross domestic product, it does not have the money (rich countries achieve 40% or 50%). The bulk goes on wages. And growth so far has yet to yield as expected more money into the government pot: an extra 7.4% in revenues would come in particular from changing the social contributions system. The budget deficit, ridiculously small as it might seem at 0.88%, is several times higher than last year.
Have we sacrificed long term growth for immediate gains?
Here is what happens: the budget can be spent in various ways. You may have a budget where expenditure is allotted to consumption or to investments. The drawback with investments is that you rarely see the results in the short term. It takes years for tangible effects to be felt in the economy.
Whereas spending money directly on wages and pensions brings immediate benefits. From this perspective, people go for the “A bird in the hand is worth two in the bush” principle. So we have a short-term thinking according to which expenditure is spent on consumption. Wages.
I can`t tell whether a 0.88% deficit is high or low …
It is not relevant at this stage. Deficit is strongly seasonal and the bulk is generated towards the end of the year. That is when the large expenses occur pushing up the deficit considerably.
It is relevant only when it is compared with the same period the previous year. That brings home how much things have worsened in relation to a year back. I would not rush to conclusions after Q1. Two quarters into the year, however, and we can come to some conclusions.
What happens if the deficit reaches 4%?
Hitting the upper budget deficit limit is problematic given the growth rate currently seen in Romania. The bulk of budget expenditure is fixed costs. The option to decrease investments is no longer on the table as for years they have been the punching bag, and stand at a minimum low. When growth slows down, budget expenditure will automatically drop. And then, in order to avoid massive public debt, you have to take drastic measures: let public employees go. Increase taxes. A large portion of consumption is supported by government employees from much higher wages. That will impact the economy immediately..
The higher the deficit, the lower the country`s credit rating. Funding costs soar as you borrow at a higher rate. A prolonged deficit is a sure path to inflation.
We are safe for now…. For about a year.
An economy is like a large ship. It takes quite a while to see the ship turn from the time the manoeuvre was performed. The signs are already here. But there is still time.
So we can relax for a while at least?
It requires ambition and time to derail an economy. Rarely is one or more decisions taken that turns the economy upside down in three or six months. This goes both ways. You can have deficit for another year and still continue to make the same mistake and miss clear signs.
I think that in the short term, six months, nothing extraordinary will happen which is not to say that we are not sinking deeper. So for six months from now we will still do pretty well.
What is the problem?
The problem is that the longer we carry on like that, the more severe the unavoidable adjustments. And there are two options: it is either a controlled adjustment that you apply yourself through monetary and fiscal measures; or you leave it to others. In 2008 it was others doing the adjustment. And we were in a lot of pain.
Right now an entrepreneur can say “money`s pouring in and I have demand”, and at touch-down it`s “ups! I have overcapacity, I`m in debt, what am I going to do?”. Or they can say that everything is fine and dandy and stick to their current capacity and raise prices. Which we are seeing right now.
It is all down to confidence at the end of the day.
If the business environment would feel that growth was sustainable, it would be more at ease with investing. This is the perverse side of things. At a lower growth rate without any question marks attached, the business environment would be more willing to engage in long-term investments.
Take the GDP changes in Romania and notice that it is the most volatile in Europe. Extreme volatility in the economy does more harm than good. People wish for untouched taxes, not lower taxes.
The incentive from the Government to the business environment is wrong. They want decent and sustainable growth, and taxes which are not the lowest in Europe, but are consistent and untampered with. This is exactly what politicians fail to provide.
Interview performed by Andreea Rosca and published on the author’s blog www.andreearosca.ro.
