Romania Political Risks Rising

The Arch of Triumph (Arcul de Triumf) from Bucharest Romania

Political tensions are running higher after the cabinet passed a decree containing controversial changes to the criminal code.  Corruption has been an ongoing problem, and these latest moves are seen as an effort to roll back the progress that’s been made.  Romanian assets are likely to underperform near-term. 

POLITICAL OUTLOOK

The ruling Social Democratic Party (SDP) just won elections in December with 45% of the popular vote.  This gave them 154 out of 329 seats in the lower house and 67 of 136 seats in the upper house, so the party needed to form a coalition with Alliance of Liberals and Democrats (ALDE) to get a working majority in both houses.  The victory clearly emboldened the party to push through these changes, but the move so far is backfiring.

Opposition parties Liberals (PNL) and the Save Romania Union (USR) announced they would file a parliamentary no-confidence motion against the government.  The situation remains fluid, but for now, it appears that the SDP can hang onto power.  If it does not back down, we believe that court challenges could take months to be heard, leading to another period of heightened political uncertainty.

Basically, the decree decriminalizes graft offenses that cause damages less than RON200,000.  The cabinet also proposed pardons for those serving sentences less than five years (except for violent offenders), though this needs parliamentary approval.  The government said the moves are meant to address prison overcrowding, but critics see them as an effort to weaken the ongoing anti-corruption drive.

Over the last three years, the National Anti-Corruption Directorate has prosecuted 1170 cases of abuse of power, which has claimed many leaders of the ruling parties.  Ironically, the changes were made on the same day that the leader of the ruling Social Democrats Liviu Dragnea went on trial for abuse of power.  Many believe that Dragnea is still running the SDP government, and the criminal code changes would likely allow him to hold public office again.

The largest protests since the fall of communism in 1989 were seen ahead of the decision, yet the government pushed ahead anyway.  Protests have since spread to other cities besides Bucharest.   President Iohannis urged the cabinet to reverse its stance, and he has also asked for a court challenge with the Constitutional Court.

 

ECONOMIC OUTLOOK

The economy remains fairly robust.  GDP growth is forecast by the IMF to decelerate modestly to around 4% in 2017 from 5% in 2016.  Private sector consensus forecasts are slightly lower.  Note GDP rose 4.3% y/y in Q3.

Deflationary conditions are easing, with CPI falling -0.5% y/y in December.  This is near the lowest rate of this cycle, and low base effects should lead to outright inflation of nearly 2% in 2017.  The central bank has as 1.5-3.5% target range, which it has pretty much missed since the end of 2013.

Indeed, the central bank cut rates aggressively from 2013-2015 as it undershot its inflation target.  It has been on hold since the last 25 bp cut to 1.75% in May 2015.  If the inflation forecasts prove true, the next move will most likely be a hike, probably in Q4 2017 or at the latest Q1 2018.

Fiscal policy bears watching.  The SDP campaigned under promises to boost spending on healthcare, salaries, and pensions.  Prime Minister Grindeanu has since pledged to boost the minimum wage and improve access to prescription drugs.  The budget deficit widened to an estimated -3% of GDP in 2016, the largest since 2012.  It is expected to widen modestly to -3.2% in 2017, but there are clearly upside risks given the promises of the SDP.

The external accounts are worsening.  The current account gap was about -2% of GDP in 2016, and is expected to widen to -3% in 2017.  Foreign reserves rose to $41.3 bln in January, and cover nearly 6 months of import and are almost double its short-term external debt.

 

INVESTMENT OUTLOOK

Despite recent weakness, the leu has done better this year after weakness last year.  In 2016, RON lost -4% vs. USD.  This was behind only the worst performers ARS (-18%), TRY (-17%), MXN (-16%), CNY (-6.5%), and PHP (-5%).  So far in 2017, RON is up 2% YTD and is in the middle of the EM pack.  Our EM FX model shows the leu to have STRONG fundamentals, so this year’s “so so” performance might turn around.  Much will depend on political developments, however.

Both USD/RON and EUR/RON are likely to move higher.  USD/RON posted an all-time high near 4.4420 back in December, and the pair should go on to make new all-time highs as political tensions worsen.  EUR/RON tested this year’s high near 4.55 earlier today, and seems likely to test nearby levels that include the June 2016 high near 4.56 and the February 2016 high near 4.5740.  The all-time high from August 2012 near 4.6520 is not far away either.

Romanian equities have been mixed.  In 2016, MSCI Romania was up 7% while MSCI Frontier was -1%.  So far in 2017, MSCI Romania is up 3.6% YTD and compares to 7.3% YTD for MSCI Frontier.  This underperformance should continue due to the recent political developments.

Romanian bonds have underperformed.  The yield on 10-year local currency government bonds is up 35 bp YTD, the worst performer in EM.  With inflation likely to return and the central bank likely to hike rates late this year, we think Romanian bonds will continue underperforming.

Our own sovereign ratings model shows Romania’s implied rating at BBB/Baa2/BBB.  This suggests modest upgrade potential to actual ratings of BBB-/Baa3/BBB-.  However, the agencies are likely to remain on hold until the political outlook becomes clearer.