EC353
International Monetary Economics
The American University of Paris
MIHAELA RADNEANTU
PROF. GRIM
The American University in Bulgaria
ID # 019300025
/research paper/
PROBLEMS OF ECONOMIC TRANSITION IN ROMANIA The Inadequacy of a Managed Floating Exchange Rate
In an extremely unstable economic environment in the
period of the beginning of 1994 to mid 1995, the Romanian monetary authorities
had tried to hold inflation to a rate of about 30% per year, which they
considered a reasonable level since it could allow, under the existing
circumstances, for a relaunching of economic growth as well (1). One of
the tools used by the Romanian National Bank (RNB) for containing inflation
was the fixing of the exchange rate Romanian leu/US dollar at an artificial
level by means of a rather continuous and significant RNB's intervention
in the interbank foreign exchange market. The creation of the interbank
market allowed RNB to maintain a relatively tight control over exchange
rate determination; and RNB numerous interventions in this market had generated
negative economic consequences, the most apparent being those felt by the
Romanian exporters.
The interbank foreign exchange market was created by RNB in the spring
of 1994 as a step toward the full liberalization of foreign exchange and
of exchange rate determination. The macro-stabilization program, including
monetary austerity, started in the summer of 1993, and became more obvious
in October 1993, when interest rates soared to circa 90%. In the spring
of 1994, based on the program of monetary austerity backed by a fiscal
budget policy, an important process took place: the exchange rate was theoretically
allowed to float in response to conditions of supply and demand. Such decision
was viewed by many as vital for Romania. Having in mind the limited reserves
of Romania, a commitment to a fixed exchange rate would not be sustainable
and would quickly be tested by the foreign exchange markets, as well as,
by the inevitable in such scenarios domestic black market for "hard"
currency. Of course, there was the persistent argument, at the time, that
if Romania was to operate market-determined exchange rates, it would need
very sophisticated financial structures--such as forward and futures markets--that
are lacking in Romania. There was also a concern that floating the currency
after serious BOP difficulties in the period 1990-1993 (see tables 3.1
- 3.3), could lead to a steep fall in the value of the leu, which in turn
could adversely affect price stability and output in the short run. The
need for a floating exchange rate, however, outweighs the immediate consequences
of such decision. It is difficult for any country to try to determine a
sustainable equilibrium exchange rate under fixed or crawling regimes,
and at the same time keep its gross official international reserves at
a desirable level. The task becomes even more difficult and complicated
if the country is undertaking extensive macroeconomic and structural reforms
(2). Continuing with the old system of fixed exchange rate would mean that
if the rate is set far from equilibrium, the resulting effects may lead
the authorities to reset the rate to rectify errors, which in turn could
undermine confidence and clarity of signals and direction of government
policies during the stages of reform (3). Another factor in favor of a
system of floating exchange rate was the evident macroeconomic instability
in Romania and more precisely the continuing high rates of inflation (see
table 2.3) and the absence of sufficiently strong programs to fight back
the incredible rise in consumer prices. In these circumstances, fixed or
crawling exchange rates could not be adjusted quickly enough to keep up
with price realignments and, at the same time, neutralize significant arbitrage
possibilities against the parallel market exchange rate. The Romanian authorities
thus had little choice but to allow direct market determination of the
exchange rate if they were to avoid a shift of foreign exchan e transactions
to the parallel market, with its averse consequences in tax evasion, criminalization,
and loss of economic control. The mistake that the Romanian government
made was that it did not opted for a direct market determination of the
exchange rate. Instead they chose the precarious and finally devastating
approach of "managed floating" whereby the exchange rate is moved
administratively according to various economic indicators.
Thus, RNB created the worst of both systems – an interbank currency
market "where the rate was no longer determined from the physical
point of view, through the addition of demand and supply at the National
Bank headquarters, but it was established at the level of commercial banks
and through their own relationships," as Mugur Isarescu, the Governor
of RNB, declared. Instead, what really happened was that RNB would establish
a given level of the exchange rate leu/US dollar for the next day, announce
it to the commercial banks operating in the interbank currency market and
these banks would have to use that particular rate for their transactions.
It is reasonably certain that RNB took into account market conditions when
established the level of the exchange rate, but probably there existed
others factors, such as political ones, influencing the process. Thus,
exchange rate determination was not done through a market mechanism. At
the same time, commercial banks were legally required to perform their
foreign exchange transactions in the interbank market, and breaching this
provision would have resulted in big fines. In this way, RNB has been able
to exercise a relatively tight control over the interbank exchange market
in the period 1994-mid 1995.
After four years of constant depreciation, the leu has manifested, starting
in 1994, a relative stability on the interbank market due to the intervention
of RNB. In order to support the exchange rate leu/US dollar at the desired
level of less than 1850 lei/$1, the National Bank intervened massively
and rather constantly, spending large amounts of hard currency reserves,
mostly US dollars. Independent Romanian newspapers referred to interventions
of about $ 200 million, substantially more than it was officially announced
(4). Thus, by RNB's constant buying of lei in order to make them appreciate,
the leu's relative stability with respect to the US dollar was assured,
within a very narrow range of fluctuations. With respect to one of RNB's
interventions in the autumn of 1994, it is interesting to note Governor
Isarescu's declaration: "As it happened in September, we have accepted
a certain move of the rate, a 3% depreciation that was enough. At that
moment, we intervened and we sold $18 mil. in two days, " (5) and
the rate fell below 1,800. As a result the average depreciation of the
leu with respect of the US dollar was 38% in 1994, while the inflation
rate was 60% in 1994 (6).
Even before RNB interventions in the interbank market in the autumn of
1994 through its sales of US dollars, the exchange rate leu/US dollar had
known a short period of relative stability. As the IMF and western observers
have noticed with unhidden admiration "The results are remarkable
[...] Between April 1994, when the leu stood at 1645 to the US dollar,
and the end of October the value of the currency slipped by only a further
6% to 1748 leu to the dollar. (7). This, however, was caused not by structural
changes in the real economy, as the IMF thought, but by the combined action
of an increase in interest rates and a growth in monetary issues less than
the inflation rate, so that a shortage of lei on the market had resulted.
Initially, RNB could collect on the market dollar reserves of economic
agents and households amounting to millions of dollars which resulted in
a relative increase in reserves (see table 1.2); later on, however, there
appeared strong pressures for an increase in the exchange rate in line
with the evolution of domestic prices, which meanwhile had increased. RNB
intervened then (autumn of 1994) by selling large amounts of US dollars
which led to a sharp decline in the reserves as shown in table 1.2.
The interventions of RNB in the interbank currency exchange market in order
to maintain the stability of the exchange rate leu/US dollar have represented
a tool of the monetary policy for containing inflation, and their implementation
has been done in close connection with the government's concerns. The level
of this exchange rate plays an important role in the policy of curbing
inflation since, as the Romanian government often explains, the essential
imports of Romania depend on it and its increase leads automatically to
an increase in the prices of imported raw materials and other materials,
energy being the most important in this category since Romania imports
about 40% of its total consumption of energy. As a consequence, the reason
for the artificial keeping by RNB of the exchange rate leu/US dollar below
1,850 lei for $1 in 1994 was that, above this level, the domestic prices
for energy should be changed in accordance with the agreement with the
World Bank concerning the FESAL credit for structural economic and financial
adjustments (8). Therefore, the interventions of RNB in the interbank market
were motivated mainly by the social and political concerns of the government
with respect to an increase in energy prices. The adjustment of domestic
prices depending on the exchange rate, that is, the assimilation in the
Romanian economy of the changes in the exchange rate, represents a normal
economic process and even an objective necessity. It is normal that the
dollar bill of the imported energy to be reflected in domestic prices since
someone has to pay it in the end. This adjustment should be done as soon
as possible so that the actual consumers of energy pay that bill instead
of the Romanian taxpayers and those profitable businesses that are subsidizing
in this way the great energy-consumers. A delayed adjustment represents,
thus, a rather unhealthy economic practice. Governor Isarescu has declared,
however, that "we have intervened in the market in order to avoid
a unjustifiable depreciation of the leu due to the 'winter' factor. In
Romania, the consumption of energy is almost double in winter compared
with summer. We could not let the leu to depreciate as long as none of
the basic economic indexes did justify such a thing." (9).
As a consequence of the fixing of the exchange rate by RNB, the separation
of foreign exchange in parallel markets has been revitalized. After RNB's
interventions to keep artificially the exchange rate leu/US dollar below
1,850 lei for $1, the interbank market, which had commanded before that
about 95% of all foreign exchange transactions, decreased its share of
total transactions to about 70%. A new type of "gray" market,
where economic agents use an exchange rate much less overvaluing the leu,
has appeared again, after the introduction of the interbank market in April
1994 had eliminated it. The market of the authorized exchange offices increased
its share, taking over, either openly or covertly, up to 15% of all transactions
(10). The black market, which had previously remained with almost no object
of activity, had flourished again. It is interesting to notice the comments
and reports of the IMF at that time. Collin Jones, for example, boldly
declared that "led by Mugur Isarescu, the tough-minded youngish central
bank governor, and prodded by the international financial institutions,
the National Bank of Romania began to tighten monetary policy, raise interest
rates to positive real levels, unify the official and black market exchange
rates, and liberalize the foreign exchange market." (11). In fact,
the market of the authorized exchange offices and the black market have
a much greater flexibility and sensitivity to changes in the economy, and,
thus, had reacted very promptly and visibly both to the pressures facing
the leu due to the immobility of the real economy, and to the expected
inflation. The exchange rate leu/US dollar on these latter markets had
exceeded for quite a time, in 1994 and the beginning of 1995, 2000 lei
for $1, reaching 2100 and even 2200; in any case, the difference of 300-400
lei between the rate on these markets and the official rate on the interbank
market points to the overvaluation of the leu on the latter market. The
arbitrage between the two markets of foreign exchange is prevented by the
legal restriction for commercial banks and other economic agents to operate
in the market of the authorized exchange offices and, of course, in the
black market. If they break this legal provision, commercial banks and
economic agents are liable to pay large fines.
The Romanian economic policy makers consider the equilibration of the current
balance of payments as quite a significant achievement (see table 3.1),
but this is mainly due to the contractionary monetary policy, including
the overvaluation of the leu on the interbank market, and not to structural
changes in the real economy. Thus, the value of FOB exports increased from
$ 281 mil. in January 1994 to $ 695 mil. at the end of the year (12). Even
if the exchange rate had ceased to be that stimulative for exporters, since
the RNB's frequent interventions had kept the leu quite overvalued, economic
agents turned to exporting because of the lack of liquidity of their domestic
customers. At the same time, imports were relatively limited since the
lei needed to purchase hard currency were lacking due to the austere monetary
policy. Again the international observers were fooled by the increase in
exports and "the sharp decline in imports," which they contributed
to the "tax reforms and tough 1994 budget" (13). It is true that
the first seven months of 1994, Romania's hard currency trade deficit was
a mere $ 70 million, against $ 913 million in the seven months to July
1993, but to say that it was due to a tough budget and a tax reform that
never really materialized is unrealistic. In fact, the budget deficit in
1994 reached a staggering - 1248.5 billions of lei (see tables 4.1, 4.2).
A rather problematic aspect of the equilibration of the balance of payments
is that it might trigger a stagnant economic cycle. An economy that needs
significant economic growth -- as the Romanian economy does -- has more
chances to achieve it if it uses increasing imports for this, i.e. external
financing, but the prerequisite is that the deficit should consist exclusively
of imports for investment not for consumption (14). Anyway, the equilibration
of the balance of payments would be compromised as soon as the first significant
relaxation of the contractionary monetary policy occurred, because of the
accompanying increase in the demand for hard currency to buy imports, and
the exchange rate could then no longer be sustained by the intervention
of the National Bank.
The relative stability of the leu on the interbank foreign exchange market
over the period 1994 – mid 1995 (see table 0.1), which contributed
to a quite successful macro-stabilization policy (BOP equilibration, etc.)
and to an increasing confidence by the public in the national currency,
was destined to come to an end in the very near future due to the blockage
of reform in the real economy. The contractionary monetary -- and fiscal,
to a great extent -- policies adopted in 1994 had almost lost their capacity
to maintain the stability of the leu without any accompanying structural
real economic changes. This scenario is not an isolated and country-specific
one. In recent days the domestic currency of Bulgaria, where market forces
determine the exchange rate, has depreciated by an astonishing 200% only
for several days not only because the central bank ran out of foreign reserves
but because of the lack of any real structural reforms in the economy.
When the Romanian central bank tried to maintain a stability for the leu
which is artificial and was designed to be kept only for a short period
of starting restructuring, after which the real, "normal," stability
of the leu would come. Until this point is reached it is more than depressing
to observe how resources are still wasted in non-profitable and non-feasible
economic activities. No bankruptcy has yet occurred in the real economy,
and the privatization process has been literally blocked in 1994, after
1994 had been proclaimed as a year of accelerated privatization. The cause
of that delay consisted in the Parliament's initiative to introduce a new
privatization law that stirred much controversy in the political as in
the management and economic experts' circles. Another major component of
the reform--restructuring--has been brought into an impasse. It is obvious
that the relation between restructuring and privatization has not yet been
defined, while the national economy is still suffering from major -- and
old -- dysfunctions.
The immediate result from the April 1994 "liberalization" of
the foreign exchange market was the IMF approving in May of a long-delayed
arrangement with Romania for a $450 million (plus a possible additional
$250 million) in standby and systematic transformation facility funds over
a period of 18 months. This in turn was supposed to pave the way for the
disbursement of at least another $1 billion by the World Bank, European
Bank for Reconstruction and Development, European union and other public
sources. This was, however, promised provided that Romania continued to
demonstrate sufficient evidence of its willingness to pursue an effective
macro-stabilization program and implement economic reform(15). The followed
artificial upholding of the exchange rate by RNB's interventions in the
interbank market, however, had been criticized by the representative of
the World Bank. Joseph Owen, the deputy representative of the World Bank
in Bucharest, denounced the keeping of the present exchange rate, considering
it artificial and designed only to contain inflation. "We are expecting
a measure which to give a more important role for market mechanisms in
determining the exchange rate."(16) The World Bank and the International
Monetary Fund expressed their concerns about the "generous" use
of hard currency reserves by RNB in order to ensure the stability of the
national currency at a moment when the two institutions examined granting
Romania the additional $250 million loan. A representative of IMF affirmed
that "we cannot make financial analyses until we can see real and
credible plans," while Owen argued that RNB's interventions to sustain
the national currency against the tendencies manifested on the financial
market represent an unhealthy economic policy.
Romanian exporters were rather seriously affected by the artificial upholding
on the interbank market --on which economic agents were legally required
to perform their transactions--of an exchange rate that overvalued the
leu quite significantly. Exporters complain that this exchange rate was
at their disadvantage and did not stimulate them to sell on foreign markets.
Thus, even if there existed some measures designed to encourage exports,
such as preferential interest rates, the exchange rate appeared to be a
barrier to the expansion of exports. Exporters maintained(17) in February
1995 that they were in the situation to operate with great losses because
internal costs had increased several times, while the amount of lei they
received in exchange for the value of their exports was computed by using
an exchange rate that had not changed for a year. Thus, RNB found itself
in a delicate situation: on the one hand, it faced the exporters' pressure
to let the exchange rate float naturally -- in exporters' circles, it was
considered as appropriate an exchange rate of circa 2,000 lei/US dollar,
on the other hand, RNB faced the government's pressures, which did not
want an increase in domestic prices due to more expensive imports. A moment
when exporters had partly imposed their view was the delay of the application
until June 30, 1995, of a regulation designed by RNB to strengthen the
confidence in the national currency by de-dolarization. According to this
regulation, payments between Romanian legal economic entities are denominated
and made in lei, even between exporters and the international trade enterprises
that serve them. Beyond old mentalities and the incapability of some to
adapt, exporters know when the economy does not work, and that is why they
tended to distrust the 1994 – mid 1995 financial "stability."
Although RNB's interventions in the interbank market in order to keep the
exchange rate relatively stable and below 1,850 lei/US dollar, included
in the austere monetary policy, had greatly produced the desired results
concerning inflation--at the end of 1994 the inflation rate was about 60%
per year, while at the end of 1993 had been about 295% per year-they also
had negative economic consequences. Most apparent, exporters had great
difficulties in their activity, while imports, including those for investment
purposes were, to a certain extent, also affected. Another important consequence
was manifested on the image of RNB for international financial organizations
like the World Bank and the International Monetary Fund, which had expressed
concerns about RNB's policy of artificially keeping the exchange rate leu/US
dollar stable and below 1,850 lei for $1 when economic and financial conditions
in Romania would require the devaluation of the leu.
Today, the RNB has become aware of its blunder and although the repercussions
are still to be perceived in the economy, it is reaffirming that the RNB
policy is mended in the right direction. Although Romania has not yet created
the perfect foreign exchange market, the trend is towards real stabilization
of the existent market and towards less intervention by the central bank.
This trend is, however, still very fragile and precarious. To illustrate
this I would like to describe a recent event in Romania, which has produced
quite a substantial reaction in the Romanian society.
On April 2, 1996, Dumitri Paslaru, spokesman for the ruling Party of Social
Democracy (PDSR), announced his party's intention to fix the leu/dollar
exchange rate arbitrarily at 2680 lei to the dollar. Financial authorities
in Romania and abroad reacted with a mixture of scorn and disbelief. Bank
managers condemned the idea as "totally unrealistic". Experts
at the IMF described it more politely as "uninspired". It was
left to President Ion Iliescu to point out that neither the Government
nor the ruling party has any right to interfere with the currency market.
Iliescu explained that exchange rates are a matter for the National Bank
and "the National Bank is subject only to Parliament." Knowing
that any plan to control the exchange rate is unfeasible, some observers
have wondered at the real motivation behind Paslaru's statement. Most experts
see it as a bit to discredit Vlad Soare, Vice Governor of the National
Bank, in his ongoing negotiations with the IMF. Soare flatly stated that
the idea of trying to fix the exchange rate is "stupid". He also
refused to offer any false hopes for the fate of the national currency
over the next few months. "In 1996, the leu will depreciate by at
least the rate of inflation," Soare said, adding: "If inflation
reaches 20% or 30%, the national currency will depreciate that much. Ideally
we would like to keep devaluation of the leu below the rate of inflation.
But the gap would have to be covered by an increase in real economic productivity
(18). In 1996, that's just not possible."(19)
Many lessons could be drawn from the Romanian experience in its transition
to market economy, but what I think would be true for any country, however
diverse its economic structure might be, is that the key to ensuring macroeconomic
stability is to floating exchange rate determined by market forces, limit
the central bank interventions to a minimum, and support this floating
exchange rate with conservative monetary and fiscal policies. The experience
with countries adopting floating exchange rates indicates that this decision
does not necessarily lead to a free fall of the currency, nor does it imply
higher inflation or lower output. Rather, it demonstrates that if in countries
such as Romania the right monetary and fiscal policies are in place, the
economic indicators can be expected to improve. This would, however, mean
a persistent devotion to imminent structural changes.
Although, Romania is slowly entering into a virtuous circle of increase
in real growth, decline in inflation and containment of budget deficit
and overall balance of payments in relatively acceptable limits, the Romanian
government, in collaboration with the the central bank, has to speed up
the process of reforms before it has been too late, having in mind the
uneasiness and continued impoverishment of a majority of Romanians. With
unemployment reaching more than 10% from 3% in 1991 (see table 5.3), the
possibility of another revolution similar to the December 1989 revolution
does not sound so unrealistic. After all, the 1989 revolution was a consequence
of Ceausescu's practiced a sclerotic form of communism, over-concentrating
upon heavy industries and huge industrial plants, squeezing the rest of
the economy dry in order to re-fashion Bucharest and pay off all the country's
external debt. Moreover, unlike in Hungary, Poland, Slovenia, and even
in the former Soviet Union under Gorbachov, the post-communist transition
to a market economy was not proceeded by earlier period of reform under
the previous regime. The purpose of the 1989 revolution, thus, was to change
drastically the regime and the system. The political paralysis that has
followed the revolution, however, meant nothing but lack of progress on
economic reforms such as restructuring state-run industry and agriculture,
privatization, and budgetary discipline. In conclusion I would say what
is obvious to many: the future of Romania now hangs upon how rigorously
the government sets about implementing privatization and industrial restructuring,
as well as upon its ability to maintain its stabilization policies. Endnotes:
1). Mugurul Isarescu interviewed in Observatorul
Economic Roman, Nov. 16-22, 1994, p.3
2). e.g., privatization, reducing the size of the state, and trade and
foreign exchange liberalization.
3). Finance&Development, June 1993.
4). Ilie Serbanescu, "Will the Leu Be Devalued or Not? , " Adevarul,
Feb. 21, 1995, p. 1.
5). Isarescu interviewed in Observatorul Economic Roman, Nov. 16-22, 1994,
p. 3.
6). Telegrama Nr. 243, Mar. 3, 1995, Fundatia pentru Strategii de Comunicare
Romania.
7). The Banker, Dec., 1994. p.29. Also see table 0.1.
8). Serbanescu, Adevarul, Feb. 21, 1995, p. 1.
9). Mugur Isarescu interviewed in Adevarul, Feb. 24, 1995, p. 1.
10). Serbanescu, Adevarul, Feb. 21, 1995, p. 1.
11). The Banker, Dec, 1994, p.29
12). Telegrama.
13). The Banker, Dec, 1994, p.29
14). Ilie Serbanescu, "The Leu in Difficulty, " 22, Jan. 4-10,
1995, p. 10.
15). The Banker, Dec, 1994
16). Adevarul, Feb. 18, 1995, p. 3.
17). Mihaela Pantea, "The Leu, " Romania Libera, Feb. 15, 1995,
p. 4.
18). It is useful to mention that Romania still holds the last place in
the chart "GDP per head" in Eastern and Central Europe, with
a GDP per head of only $ 3000. /Source: World Bank; at PPP exchange rates/.
19). Halcyon, an independent Romanian on-line journal. Web address: www.halcyon.com.
The two articles I used are at www.halcyon.com/rompr/48ebriefs.html
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