What is happening with the rates?

Different perceptions

Specialised studies earlier this year (see, for instance, Lucian Croitoru, “Economic programme for year 2000”), targeted at the general issues of economic recovery argued the need to maintain a restrictive character of monetary policy.

The interesting part is that, on the basis of such monetary policies, interest rates were thought to inevitable stay at high levels in 2000, too, but their tendency would still be downward.

It was also said that relatively high rates would not contradict the general goal of economic growth given that one of the current characteristics of the Romanian economy is self-financing (out of own savings) and not financing via domestic or foreign credit.

Ultimately, those evaluations have been confirmed. One of the things that were seen clearly in the past weeks has been the fact that rates have reached a minimum (for instance, rates on 3-year discount government bonds dropped from 69.70% on January 4 to 38.52% on June 25 the same year. But what will happen later?

Obviously the downward trend could continue if excess liquidity were forced more off the monetary market, which would lead to an amplification of inflation at a time when it already exceeded by 6.5% the target set by monetary policy.

Some commentators say that, normally, inflation, de-monetisation and dollarisation and developments that justify the affirmation of a contrary trend, one of rising rates, in the period to come.

Against the background of a depreciating national currency and that of the unexpected inflationist leap in July – which made the interest rates negative in real terms – it is proven that the populace is beginning to seek refuge in dollars again.

Against this background, specialists differ. For some, “There is the risk that real negative interest rates should become chronic. In July, they were 1-2% below inflation. Normally, interest rates should rise more to avoid the flight from the leu and the race for dollars.”

To others, “The market seems to be calming. The time of excessive interest rates determined by uncertainties is gone. Unless other phenomena show up, we should not expect rates to rise,” so that by the end of the year “we will not witness substantial changes in interest rates.”

Lucian Croitoru

Monetary relaxation and tensioning

I think the evolution of interest rates in the Romanian economy can be explained fairly convincingly by the correlation’s that exist between them, as determined variables, and changes in the money stock and budget deficit, as explanatory variables.

Consequently, it must be said from the beginning that, while in the Romanian economy interest rates have been following a downward trend in the last months, then one of the following situations exists: (I) a relaxation of monetary policy over the respective period; in which case fiscal policy can be contractional (which contributes to lower interest rates), or even expansionist to some extent; (ii) fiscal policy is contractional; monetary policy could be neutral or relaxed, or even restrictive to some extent.

The data shows that we are rather in the former case. Money base has risen in the first six months of the year by almost 1% in real terms.

The other monetary aggregates (M1, M2) or their components have had real-terms drops between 6.5% and 26.2% in the same period. If we consider that interest rates respond better to changes in money base, the correlated dynamics of variables suggests a certain relaxation of monetary policy.

I will try to clarify this monetary relaxation, and based on arguments, I will try to prove that the answer to the relaxation is not necessarily a more stringent monetary policy.

I will do this starting from the characterisation of the principal placements banks can do. Banks can place their excess reserves into loans to the enterprise sector, on the money market, in other assets (for instance, hard currency purchases) or in government bonds.

The characteristics of the Romanian economy in 2000 have made it impossible for excess reserves to be placed there in their entirety, which has exerted pressure to lower rates.

In the previous years, too, there have been excess reserves, but unlike this year, they have not led to lower rates, as it would have been normal, but coexisted with interest rates which, if not growing, were at least high.

Therefore, in 2000 there was a change that made a monetary relaxation lead to lower rates, that is, a normal tendency. To outline this change, I will make a brief characterisation of the economy from the viewpoint of potential bank placements in the first half of year 2000.

Lending to enterprises has dropped in the first half of 2000 by 2.2% in real terms compared to December 1999. Although it is a smaller decline than in the same period last year (20%), it shows that more loans are being repaid than taken.

On one hand, enterprises are reluctant to contract new loans. On the other hand, the banking industry seems to be resuming crediting in the enterprise sector with prudent steps, after it felt the outcome of loans extended without proper caution.

Excess reserves could be placed on the monetary market, but this also has a limited absorption power. Some of the reserves could be used to buy hard currency, as in the previous years, perhaps unleashing a speculative attack on the leu, but in the first six months of the year 2000 the market has shown a permanent excess of hard currency supply.

This excess relies both on the continuing current account adjustment and on autonomous capital entries. In order to prevent the current account from deteriorating, the central bank has followed a programme of controlled depreciation.

The budget deficit could have attracted the available resources, but its retention within relatively tight limits in the first half of 2000 and the expansion of financing via treasury bills issued for the populace have limited this destination, too.

And, there is the possibility of keeping in the money in NBR deposits. If all excess reserves were accepted, there would have been no relaxation of the monetary policy.

But the central bank decided it would no longer accept all offered deposits, prompting banks to step up their efforts to channel resources into the enterprise sector. Thus, part of banks’ excess reserves could not be placed, which in fact was a relaxation of monetary policy. It reflected in falling interest rates.

This relaxation does not contravene, in the long term, to the fundamental mission of the NBR to reduce inflation. The rise of productive loans to enterprises will stimulate economic activity.

Still, falling interest rates and re-ignited inflation is pointing out that the limit up to which this relaxation is possible without extreme inflationist costs has been attained.

As such, it is more likely that interest rates should grow a little rather than keep falling.

Claudiu Doltu

Developments on the banking market

The growth of inflation in the last two months (2.8% in June and 4.3% in July) and the fall of interest rates has again highlighted the negative interest rates in the banking sector.

Since the median inflation rate in the first seven months of the year was 3.1%, the annual inflation rate will be superior to annual rates banks pay on clients’ deposits, unless significant changes occur on the monetary market.

The public seems to have understood what negative rates mean and is starting to choose hard currency deposits as a savings instrument. Since May, hard currency deposits have grown not only for natural persons but for companies, too.

The gap between active rates (on loans) and passive ones (on deposits) is also shrinking, possibly due to foreign banks and small private banks. The “pace” of active rates is set by large banks (such as BCR and BRD). The Romanian banking market has an oligopolic character and, in general, some developments are inspired by market leaders.

The fall in passive rates could be explained by the attitude of private foreign-participation banks and small private banks, which focus on lower-risk crediting. Usually, smaller banks’ asset portfolio is less risky, and this explains the smaller gap they have between active and passive rates.

Given that the National Bank of Romania (NBR) has as a goal of monetary policy the amount of money and not the interest rate, there are not certain elements, in that a change in interest rates will be imprinted, directly, by the authorities.

Another argument in support of this hypothesis is the high volume of spending with public-debt interest. The Government must cover these expenses with government bond issues and, consequently, the lower the interest rate on bonds, the lower the effort in the future.

Another element in favour of the hypothesis that rates will not grow in the near future is that on the banking market there is an surplus of liquidity, with rates dropping. In the last months, NBR interventions, with direct effects on liquidity (hard currency purchases, contributions to Banca Agricola, contributions to the bank deposits guarantee Fund) have resulted in its growth.

The fall in interest could result in a change of banks’ attitude in dealing with the client. Since the usefulness of crediting depends, first of all, on the degree of macroeconomic stability, on the rate of growth in the economy and on the general progress in the transformation process, a significant growth in the volume of business crediting cannot be expected.

On the other hand, introducing new banking products for natural persons can ensure a new market to banks.

It is not out of the question that, in case of a fast and massive depreciation of the leu, the NBR should start chasing more rabbits at once (inflation and exchange rate). In this case, significant immediate changes may come up in the evolution of interest rates.

Lucian-Liviu Albu

Positive signals

As we know, standard economic theory postulates an inverse relationship between interest rate and investments and, indirectly, between interest rates and economic growth.

But this is only a general relationship, because real-life situations are much more complex. Further down, we will discuss one of these situations in the specific context of Romanian transition.

Delays in reform, in the transition to a functional market economy in general, has restrained the flow of foreign direct investment compared to other countries in central and east Europe. Under these circumstances, the gap, especially the structural gap, between potential domestic supply and aggregated demand has amplified, and GDP growth has become negative.

Thus, the only available solution for a balanced budget is lending. But due to a faltering credibility, sources of foreign aid and loans were difficult to attract even with high rates. Another sources that was been resorted to were loans on the domestic market, whose weight in the total public debt has been rising lately.

The coverage of budget deficit in this way has generated inflation and depreciation of exchange rates. At a budget level, distortions induced via high interest rates are illustrated by the fast changes in the last few years of the weight of public-debt interest in the total state budget expenditures.

Year 2000 has debuted with even higher weights. The jump in the first half was, partly, the consequence of the policy adopted in the previous period, that of increasing the attractiveness of government bonds, and has competed with bank deposits.

But the lever of interest rates on government bonds must be used with much precaution, given both the frailty of the domestic banking system, and the impact on the behaviour of potential buyers of government guarantees. A level too low of lei-deposit interest rates might discourage savings in banks and encourage “investments” in hard currency or other venues (gold, jewellery, art, real estate and non-commercial land).

Excessively high interest rates can also impede investments and kick-start the inflation spiral, also generating imbalances in the system of commercial banks.

Therefore, a careful management of the interest rate and an optimal variation margin should be the priorities of the government action programme this year. In the same context is the transition toward real-positive interest rates, along with a decisive decline in the interest rate. For instance, in the latest years the annual average passive interest rate paid by banking companies to non-banking clients (figures in brackets represent active rates) has evolved as follows: 36.5% (48.6%) in 1995, 38.1% (55.8%) in 1996, 51.6% (63.7%) in 1997, 38.3% (56.9%) in 1998 and 45.4% (65.9%) in 1999. In the same period, inflation (yearly average) had the following course: 32.3% in 1995, 38.8% in 1996, 154.8% in 1997, 59.1% in 1998 and 45.8% in 1999.

After the 1997 deterioration of the ratio between rates and inflation, there is a sharpened trend of return to the area of real-positive interest rates.

This year, the interest rate fell significantly, from 41.8% (63.4%) in January to 34% (57%) in May, correlated with falling inflation (against the same period last year) from 56.8% in January to 44% in May.

According to the latest NBR report, the beginning of May found banks in a dearth of reserves, which led to higher rates on new deposits, in excess of 40%, a situation that has repeated at the end of the month.

Beginning with the second week, the gradual passage of the banking system towards an excess of reserves has meant a drop in median rates under the 40% threshold.

Over the whole month, the median interest rate on newly established deposits (including NBR operations) grew 4.2% on the previous month, to 37.7%. These developments, corroborated with a 3-point drop in inflation, has allowed real inter-bank rates to return to the positive region.

The growth of the median interest rates on inter-bank transactions (aside from NBR) was determined by a growth in interest rates afferent to main maturities, on overnight and one-week deposits, by 4 percentage points and 3.2 points, respectively.

In contrast with developments on the inter-bank market, the trend of falling rates continued on the primary government bond market; the average rate in the seven tenders this month, 46.4%, was 2.1 points below the previous month.

Thus, the gap between primary bond returns and returns on the inter-bank market diminished considerably, from 14.1 points to 8.1 points. In the following months, positive developments are expected to consolidate.

Dragos Negrescu

More Catholic than the Pope?

It was odd to see such strong emotions over the now-predictable fact that the inflation target will be exceeded. The inflation rate will, still, be the lowest in the last five years, and in all the years that elapsed since the command economy was abandoned, it exceeded the initial forecasts (whence the traditional ritual of the autumn budget correction).

Simultaneously, positive performances with GDP, and especially with exports, seem to be depreciated by the a more accelerated price growth, reminding of the sceptical Caragiale character, who is unimpressed by the excellent wheat crop because “rapeseed is bad.”

What is curious is that this hyper-sensitivity to inflation is apparent after, for years on end, the presumed macroeconomic orthodoxy “imposed” by the IMF was stashed away on grounds that it neglects the demands of the “real economy,” suggesting that the economy should be stimulated instead by a lax macroeconomic policy.

Although confirmed indirectly by a recent (quasi-) government statement, there is no contradiction between control of inflation and growth.

Low inflation is not, in itself, a generator of growth, but is positive effects are felt in the interest rate mechanism, which, in a context of high and variable inflation, incorporates an important risk margin, attaining exorbitant real levels and thus halting the principal engine of growth: investments.

And this situation is the opposite of that described above. Interest rates have been on a constantly descending curve, and their real levels have become very attractive for the borrowers.

What does this trend show, other than a much more solid credibility of the macroeconomic policy promoted since the beginning of the year? The very recent alarm signals derived from the pronounced decline of some interest rates should not be exaggerated.

Brief periods of real-negative interest rates are inevitable as long as inflation is not durably brought to a single-digit level, and their impact on bank profitability should be seen as relative in that the aforesaid risk margin allows them to easily overcome such sporadic turbulence.

And the correct comparison term for nominal interest rates is future, not past inflation, and – excepting the case of a dramatic change of orientation in the economic policy promoted by authorities (present or future) – we have no reasons to fear a sizeable re-ignition of inflation.

Let’s not forget that inflation has been affected by unpredictable phenomena: the explosion of the international oil price (coupled with a dollar exchange rate closed to the historic maximum) and the prolonged drought, which significantly altered the structure of domestic electricity-production costs.

We could accuse the NBR of failing to respond to these exogenous shocks with a more strict monetary policy. It would be atypical case of inadequate treatment, as macroeconomic instruments are used to correct structural deficiencies.

Because the vulnerability of the Romanian economy to this “energetic micro-shock” only reflects the ongoing establishment of a significant proportion of GDP by energy-intensive industry branches and, within them, of excessive energy consumption.

Paradoxically, the most fierce critics of the relative failure in managing inflation are deploring the growth of light industry as a part of total exports: with pre-1990 levels of industry shares held by cement, steel and oil, things would have been even worse.

Florin Pogonaru

From “small steps” to “determined steps”

Developments in the latest interest rates reflect the assimilation of the surprising growth of the general prices index in July (4.3% compared to the 1.5% official estimate), by economic agents. They represent the reaction to the failure to achieve inflation expectations and are under the impact of contradicting actions (at least, of forcing reality) by the Finance Ministry and the National Bank.

The Finance Ministry has initially attempted, with little success, to place treasury bonds for rates up to 42%. In a consensus with it, the National Bank hesitated to give the signal for the growth of inter-bank rates (as banks maintained passive interest rates on three and six month deposits within the 30%). At the same time, to create pressure on the exchange rate, it significantly raises the daily appreciation rate of the leu.

Banks no longer accept three or six-month placements by the Finance Ministry (at 42%), preferring to “park” the excess lei liquidity in overnight or one-week deposits, with interest rates of 25-26% and 32-35%, respectively.

In the context of circa 30% passive rates on three- and six-month deposits and an accelerating depreciation of the leu, we expect a growth in the demand for hard currency placements, both from banks and the populace.

The conclusion is that, to avoid unwanted effects on the exchange rate and inflation we will witness repeated rate growths to a level given by the new inflation expectations.

The Finance Ministry recently had the first adaptation reaction, raising interest rates on six-month government bonds to 44%. It is to be expected that in the following period “the small steps policy” will also become “a frequent steps policy” to raise rates, to re-attain a market balance.

The balance being dynamic, inflation expectations will be crucial for interest rates (considering the lei surplus which cannot find a placement in private-sector lending).

The situation is sharpened by the ill fortune of a dry agricultural year (with an impact on the growth of food prices and anticipation on the need for agricultural imports), developments of the European currency, and the oil price, which strengthen expectations of more depreciation.

This is the background against which the restructuring of loss-making enterprises is creeping, and successes in exports and industrial output appear to be increasingly generated by the fiscal relaxation and not by structural microeconomic changes.

What will the effects be on economic growth? It is to be expected that “flawed financing” of growth, via non-performing loans, or via arrears, will be diminished in the context of recent National Bank regulations on credit provisioning, and due to the monitoring of international financial institutions.

Financing growth on “strictly economic bases” will collide with high interest rates, and inflation above 45% is far from being “the oil that lubricates economic mechanisms.”