On the Shores of the Black Sea: Will Romania's Economy Sink or Swim?
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Romania, a country famed for its Olympic gymnasts, has often required its citizens, investors, and business community to perform some economic gymnastics of their own. After the hyperinflation crises that accompanied the transition to capitalism in the 1990s, Romanian equities vaulted upward between 2003 and 2007. However, those jumping into Romania’s stock market after mid-2007 may have felt as though they have had their own personal encounter with Vlad the Impaler, another famous Romanian.
Located at the mouth of the Danube on the Black Sea, Romania is one of Eastern Europe’s dozen or so emerging and frontier markets. Along with Russia, these Eastern European emerging markets are in a special class, distinct from the world’s core developed markets and from the emerging markets of the developing world. Eastern European emerging markets tend to be relatively industrialized, with highly literate, educated, and technically skilled populations. They have moderate standards of living, and while poverty is a significant issue, it is not generally as acute and pervasive as in much of Africa, Asia, the Middle East, and Latin America. Table 1 compares Romania with its regional peers, industrialized countries, and some other emerging markets.
Table 1: Comparison of Romania with Regional Peers, Developed Economies, and Other Emerging Markets
Sources: estimated figures for 2008 from the CIA World Factbook, February 22, 2009; corruption data from Transparency International’s 2007 Corruption Perceptions Index, February 27, 2009.
Eastern European economies like Romania benefit from their proximity to Western Europe, which offers a nearby source of foreign direct investment and markets for country exports. Romania’s entrance to the European Union in 2007 facilitated labor force mobility, allowing many émigrés to send funds home in the form of remittances, spurring domestic consumption, savings, and investment.
For all these advantages, Romania and similarly placed countries continue to work to overcome the legacy of nearly a half century of authoritarian politics and centrally planned economies. Decayed and inefficient physical capital and transportation networks from the previous regime are still being replaced by more modern technology. Unlike China and Vietnam, which made efforts to introduce the market system gradually and at the margins of an otherwise planned economy, the Eastern European transition was relatively abrupt. Citizens and state bureaucrats were unprepared to manage large economic resources or to make the business decisions with which they were suddenly confronted.
During the Soviet-modeled People’s Republic of Romania, running a business (particularly a profitable one) was a capital offense, punishable by death, and enforced by Romania’s secret police, the Securitate. Thus, when the transition to more freely functioning markets occurred in the 1990s, few outside the organized criminal class had any experience with business operations. It took the better part of the 1990s for most officials and citizens to learn to navigate a modern market economy.
The hasty political transition from a Soviet-style system did not ease economic adjustment. In 1989, a popular revolution resulted in dictatorial president Nicolae Ceausescu’s removal from power and subsequent execution by the army. Communist elites from the previous regime organized under the revolution’s leader, Ion Iliescu, who addressed some of the immediate pressures that had provoked revolt, such as food shortages and fuel rationing. But because the Soviet Union was still a major power and its collapse difficult to imagine, the new regime was slow to dismantle centralized production and distribution. That finally occurred in 1992, when the handwriting was truly on the wall for centrally planned economies.
The service sector dominates Romania’s economy today, accounting for over half its economic output, as shown in Figure 1. The remaining portion is dominated by industry, generating 36% of domestic output, with agriculture providing the remaining 10%.
Figure 1: Structure of Romanian GDP, 1985–2008
The large service component can be attributed to the population’s relatively high level of technical education, to Romania’s regional proximity to the rest of Europe, and to an attractive wage differential. There may also be a perception on the part of some Europeans that, in spite of lower labor costs in places like India, the time zone differential, quality, and the productivity of Romanian workers make the country an attractive alternative for outsourcing.
Figure 2 exhibits the expenditure structure of Romanian GDP (gross domestic product) in 2005 dollars as it evolved from 1989 through 2008. It also tracks inflation figures. The graph shows that domestic productive capacity has increased substantially since 2000 and that government expenditure in the economy has been disciplined and modest, ranging from 4.5% to 10% of GDP. Figure 2 also illustrates the stress of the 1990s economic transition in Romania, revealing substantial economic contraction. Inflation rates reached 300% per year in 1991, declining to 40% per year in 2000, then stabilizing below 10% in the mid-2000s.
Figure 2: Romanian Inflation and GDP Structure by Expenditure1989–2008 GDP converted to USD at 2005 prices.
Source: Economist Intelligence Unit, February 19, 2009.
Since 2000, both domestic production and net GDP have expanded markedly while inflation has declined. The economic catalyst appears to have been reversing the decade-long contraction in business investment, facilitated by a climate in which inflation has begun to come under control. The resumption of positive growth in business investment has fueled economic expansion elsewhere in the economy.
Figure 2 also tracks Romania’s rapid growth of imports and widening trade deficit, which has forced net GDP to grow more slowly than domestic production. Romania’s exports have expanded as well, but not quickly enough to counter the growth of imports. To the extent that imports are improving the industrial base of the economy and are not simply a taste for consuming foreign goods, the trade deficit represents long-term investment in economic productivity and upgrading the industrial base.
A correlation analysis of growth in imports versus growth in domestic consumption and fixed investment shows that changes in import growth are highly correlated to investment growth, especially in the post-2000 period (Pearson’s r=0.62 pre-2000, while r=0.9 post-2000). Although import growth is highly correlated to consumption growth in the pre-2000 period (r=0.82), it is very poorly correlated in the post-2000 period (r=-0.08). This suggests that since 2000 Romania has been running a trade deficit to finance improvements in its capital base—an intelligent policy, provided that the target industries are truly productive.
Figures from the United Nations Conference on Trade and Development and the World Trade Organization show that the largest contributors to imports are machinery and specialized tools that are likely to become capital investments (https:// indexmundi.com/, February 25, 2009). Other major contributors are raw materials used in Romania’s major industries: automobile manufacture, machinery, specialized equipment, and textiles.
Figure 3 reveals the dollar-based performance of the BET (Bucharest Exchange Trading) index relative to other world, regional, and emerging market indexes from 1997 to the close of 2008. It shows that Romania strongly underperformed virtually everything (except Russia) in the 1997–2000 period. Starting in mid-2001, the BET index started to outperform most indexes and continued to do so until August 2007, when it began to fall off sharply. This drop preceded the collapse in most other emerging market indexes, including those for other parts of Eastern Europe and Russia.
Figure 3: Romania and Selected Indexes, Relative Performance, September 1997 through December 2008
Sources: for Romania, Bloomberg, February 19, 2009; for others, MSCI Barra,* February 21, 2009.
Table 2 offers a quantitative comparison of monthly returns on the Romanian BET index and several of the MSCI (Morgan Stanley Capital International) price return indexes from September 1997 to December 2008, using MSCI data. The top section shows average return and volatility over the period and appears on the risk–return chart in Figure 4. The chart places Romania, along with Russia, in the quadrant associated with the highest risk and lowest return, and suggests that concentrated exposure to Romanian equities has been a bad choice in both absolute and relative terms over the time period. Inclusion of dividends does improve returns for each country by 1.5%–2% without changing any of Figure 4’s qualitative observations.
Table 2: Romanian BET Stock Index versus Other Indexes, September 1997 through December 2008
Source: MSCI Barra,* February 20, 2009
Figure 4: Return versus Risk for Romania and MSCI Equity Indexes: Returns in USD, September 1997 through December 2008
The middle section of Table 2 compares indexes using a one-factor model with the MSCI World as a benchmark. Although Romania is the second most volatile index in the table (42.9%), its beta (0.893) is the lowest, primarily because of low correlation to the rest of the world (0.335). Romania can, therefore, be a good portfolio diversifier, but the negative alpha (-1.46%) suggests that a long-term short position is required. A more sophisticated analysis, however, finds that monthly alphas are highly autocorrelated, demonstrating that adding a monthly momentum factor and rebalancing can improve the investment model.
The bottom section of Table 2 regresses Romania’s returns against other indexes as one-factor benchmarks. It shows that there is indeed more correlation between Romania and other emerging markets, as well as between Romania and its regional peers, but the qualitative conclusions are more or less the same: Romania has performed poorly on a risk-adjusted basis, but can offer diversification benefits.
All of Eastern Europe has suffered from the banking crisis and collapse of credit availability, and Romania is no exception. Romania’s leu declined more than 30% versus the dollar in just over six months following July 2008. There is substantial pain, but the real economy may be somewhat safer than the financial markets. Internal productive capacity has grown substantially. Imports are certainly more expensive, but Romania may be able to run for a while on fixed investments already made, even if energy and raw materials will cost more. Export prospects would normally benefit from the new exchange rate, although the evaporation of global trade credit will dampen the effect. The fact that Romania’s total commercial debt rose dramatically this decade, from single digits in 2000 to over 40% of GDP in 2008, means that Romania’s fate is closely tied to Europe’s embattled banks.
Romania has many of the features that make emerging markets look appealing in normal times and frightening in a crisis, but it has underperformed badly overall, despite a spectacular run in the mid-2000s that is likely linked to the credit bubble. Romania still has a role as a portfolio diversifier, but not for long-only portfolios.
To its credit, the government has made good efforts to be fiscally responsible and has created a very business-friendly legal environment on paper. Endemic corruption, partly a holdover from the previous regime, is likely responsible for Romania’s underperformance. Romanian corruption is among the worst in Europe, according to Transparency International. Over the long term, if the credit obtained earlier in the decade has effectively upgraded Romania’s productive infrastructure, the country should survive the crisis with a fighting chance. If the easy money years led to too many unproductive political and business kickbacks, however, Romania can surely expect to meet its old friend Vlad the Impaler again.
–Bruce P. Chadwick, PhD, CFA, is principal at Chadwick Consulting, an independent consulting firm specializing in quantitative, emerging market, and SRI research and strategy.