Romania: The Global Financial Crisis' Next Victim?

International rating agency Standard & Poor's lowered Romania's foreign currency debt rating to "junk" status (BB+, which is below investment grade BBB-) Oct. 27. As result of the downgrade the Romanian Central Bank enacted "drastic steps" — as the British Daily Telegraph reported — to prevent capital flight, letting overnight lending rates shoot up 900 percent. As global illiquidity grips Europe's emerging markets, Romania faces the possibility of severe speculative attacks against its currency the leu, depreciation of the leu and a likely base interest rate cut that could precipitate further rate cuts across Central Europe and the Balkans. The global credit crunch, which began as a U.S. liquidity crisis, spread quickly across the world following the collapse of Lehman Brothers on Sept. 15. As it spread, the crisis unearthed existing problems that were not as visible or pressing while capital was freely available. The emerging European markets — Central Europe and the Balkans — are the dry kindling for the global financial conflagration. Western capital rushed into these virgin markets, reassured that political and economic stability was vastly improved in the region as the countries went through the membership process for the European Union. The economies were already immensely overheated before the liquidity crisis, and many were already starting to come back to earth. In 2002, Central Europe and the Balkans replaced East Asia as the favored destination of foreign capital. Poland and the Czech Republic are seen as the region's economic juggernauts, but ancillary economies benefited from the free-flowing capital as well. Particularly active in the region were Austrian, Italian and Greek banks looking for markets where they could compete and carve out a niche without having to compete with the banking behemoths from Switzerland, the United Kingdom and Germany. Austrian banks are now particularly active in the region, with Viennese giant Raiffeisen particularly exposed to the Hungarian and Romanian markets. Italian and Greek banks are also quite involved in the Romanian banking system. The foreign banks rushed into Central Europe and the Balkans and expanded offerings in retail banking such as private loans and mortgages, services many customers had never been offered before since no such banking products were available behind the Iron Curtain. The credit for these transactions were provided by the Swiss franc carry trade — the process in which banks transferred low-interest rate Swiss franc loans to Central European and Balkan countries that had high interest rates. Therefore, customers in Romania, Bulgaria and Hungary were able to finance a car or a house at low interest rates — often 8 percent — offered by the Swiss franc loan or a euro loan as opposed to the more than 10 percent interest rate on a leu loan. At the same time, however, consumers were exposed to the risk of the leu depreciating against the Swiss franc or the euro, and thus the risk of unexpected increases in their monthly payments should the foreign market shift the "wrong" way. Romania's situation is therefore similar to Hungary's — rocked by the credit crunch that is uncovering poor economic fundamentals and a banking system dominated by foreign banks using Swiss francs and euros to finance consumer and business lending. On the issue of economic fundamentals, Romania is faced with a budget deficit of 2.5 percent of gross domestic product (GDP) and a sizable trade deficit (14 percent of GDP). While the government debt is not extraordinarily high — only 19 percent of GDP — there are questions about how Romania would finance budget deficits during a liquidity crisis, particularly now that the country's credit rating has been dropped, making it almost impossible to issue bonds. The Romanian problem is further accentuated by the fact that almost all of the economy's productive sectors — particularly the car manufacturing and industrial cement production sectors — are foreign-owned and are already lowering production as the crisis spreads through the region. For instance, Renault announced Oct. 20 that it will be closing for four days per month. Overall, Romania's fundamentals still look better than Hungary's, but Romania is nonetheless in trouble. On Oct. 16, Piraeus Bank, Credit Europe Bank, Volksbank and Bancpost all stopped foreign lending, and on Oct. 17 Raiffeisen announce it would "limit" foreign currency-based loans as well. With the leu depreciating against the euro and the Swiss franc, Romanian consumers might be looking at appreciating loan values and increased inability to service their mortgages or personal/business loans. One of the ways to prevent speculative attacks against the leu and protect from further depreciation against the euro is to increase the interest rate, following similar moves by Hungary on Oct. 22 and Denmark — another victim of the Swiss franc carry trade, it would seem — on Oct. 24. The Romanian Central Bank intervened in the currency market Oct. 10-20 to fend off the attacks by injecting 40 million euros (nearly US$50 million), and it will probably get additional help from the European Central Bank and use its own foreign reserves — which are substantial, at $35 billion. However, raising interest rates may be the only sure way to dampen capital flight. The cascading interest rate increases would be very reminiscent of the beginnings of the 1997 East Asian crisis and the panic rate hikes that triggered a contagion that ultimately spread across the region. But if the speculative attacks intensify — which is certainly a possibility following the Standard & Poor's downgrade — Romania may have no other option. A rate hike and the possibility of International Monetary Fund involvement may now be in the cards not only for Romania, but for the rest of the region as well.