Mugur Isarescu, NBR Governor: Disruptions in the transmission mechanism of the monetary policy

Autor: Bancherul.ro
2015-06-04 17:05

Mugur Isărescu, NBR Governor - Speech at Euromoney Conferences - The Regional Finance and Investment Conference for SouthEast Europe

Mr. Prime-Minister,

Ladies and Gentlemen,

First of all, I would like to thank Euromoney for inviting me again at its Regional Finance and Investment Conference for South-East Europe. I have to confess that I am fond of the Euromoney magazine, which dates back to the beginning of my career as an economist at the Institute for World Economy, in the early seventies. As already mentioned in the February 2015 Euromoney issue with focus on Romania, this was among the first foreign magazines I have read and one of the primary sources of information on currency issues and modern banking. As a matter of fact, I liked the magazine so much that one of the persons I was very keen on meeting during my first visit to London in 1976 was Padraic Fallon, editor-in-chief at that time.

In my speech today, I intend to briefly touch the most relevant developments in the Romanian economy, which would hopefully provide further arguments for Euromoney’s choice to organise the event in Bucharest for the second year in a row.

Of course, any such account is bound to start with the lessons from the global crisis. In my opinion, the most important is that there is no substitute for consistent economic policies. The correction of economic policy errors is always painful everywhere and, while difficult to be comprehended by the public at large, it is absolutely necessary.

Romania is a case in point. Against the background of capital account liberalisation in the run-up to EU membership, massive foreign capital inflows fuelled fast economic growth in 2004-2008 (with an annual average of 7.2 percent), thus leading to the build-up of large macroeconomic imbalances.

While the monetary policy stance was countercyclical at the time, it was very difficult to control expansion in foreign currency lending undertaken by the local subsidiaries of foreign banks with the instruments available and even with the recourse to unorthodox measures. Furthermore, fiscal and wage policies remained strongly pro-cyclical, particularly in the last two years preceding the crisis outburst. Therefore, when the crisis broke out, Romania grappled with a wide structural fiscal gap (around -8% of GDP in 2008), a double-digit current account deficit (between 2006 and 2008) and high inflation readings (7.85 percent on average in 2008).

Faced with the realities of the crisis, Romania had to make the necessary corrections to mend these imbalances in an orderly way. The three agreements with the EU, the IMF and the World Bank – initially, a financing agreement and later, precautionary ones – provided the framework for such an adjustment.

The struggle seems to have borne fruit already: crisis-inflicted output losses have been made up for, as the economic advance is not only robust, judging by the prevailing European standards, but – this time around – sustainable, as well. The current account deficit narrowed to 0.4 percent of GDP in 2014 from a peak of 13.4 percent in 2007, inflation hit historical lows (1.1 percent on average in 2014 and an annual rate of 0.65 percent in April 2015 as compared to the 8-9 percent figures in 2008), while the sharp fiscal consolidation (among the highest in the European Union) brought the deficit back into the comfort zone (1.5 percent in 2015, down from 9 percent in 2009). Moreover, Romania fully complies with the requirements of the preventive arm of the Stability and Growth Pact by reaching in 2014 the medium-term objective, defined as a structural deficit of 1 percent of GDP.

Against this background, whilst at the onset of the crisis, Romania fell short of all four Maastricht criteria, they are currently fully met, but the big challenge that lies ahead is to ensure the durability of this achievement.

While Romania seems to have wrapped up the period of macroeconomic adjustments, the future mission of economic policies is to keep in place the balances restored with so many efforts, by shifting the focus towards structural reforms meant to boost the economy’s growth potential in the long run and to underpin the viability of the economy in the monetary union by enhancing its flexibility and resilience to shocks. I have in mind keener competition and increased efficiency in key sectors of the economy, such as energy and transportation, addressing the issue of youth and long-term unemployment, also via reforms in the education system, a better absorption of EU funds, as well as an improved quality of infrastructure, roads in particular.

Moving to monetary policy, while it is true that in the case of Romania it did not have to navigate in the uncharted waters of quantitative easing and negative nominal interest rates, this does not mean that it is bereft of challenges. I would mention first the difficulty in designing monetary policy in a context where the negative output gap is closing fast, while a perfect storm of favourable supply-side shocks – namely oil and food price drops and indirect tax cuts – has been generating low inflation readings for quite a while now, with the potential to alter inflation expectations in the medium term.

Moreover, the conduct of the monetary policy with a view to ensuring price stability over the medium term in a manner supportive of economic recovery, but also synchronised with the monetary policy cycles of central banks in the region and the euro area is further conditional upon the behaviour of the other components of the policy mix (fiscal, structural, EU fund absorption).

Another challenge is the fact that there are still disruptions in the transmission mechanism of the monetary policy. Specifically, even though the interest rates on new loans in domestic currency have declined further (by around 2 percentage points over the last 12 months) in response to the policy rate cuts, the annual growth of credit to the private sector has levelled off in recent months (to around -4 percent in 2015 to date).

While this was mainly the outcome of the ongoing banking system balance sheet clean-up (in the absence of which the annual growth rate in real terms would have been positive and slightly increasing), it also reflected the impact of a number of factors that are hampering the functioning of the monetary policy transmission mechanism (in particular that of the risk-taking channel). The still high, albeit significantly declining, level of NPLs (just below 14 percent in March 2015 as compared with above 20 percent a year ago), the persistently elevated risk aversion of banks, and the deleveraging of euro area credit institutions are such factors that further depress credit supply. At the same time, the insufficient gains in confidence, particularly in the case of businesses, hinder credit demand.

On the bright side, with reference to the transmission mechanism, I should point out the steady improvement testified by the ever expanding share of local currency-denominated credit in total lending, which has recently increased to 45 percent and looks set to reach 50 percent by the end of the year.

Another challenging objective of the central bank is to normalise the operational framework of the monetary policy, which was affected in time by several constraints. Obviously, I am talking about the still high reserve requirement ratios (given the need to contain credit expansion, foreign currency lending in particular, during the economic boom) and the relatively large width of the interest rate corridor (initially warranted by the imperative of cooling off speculative capital inflows and domestic currency appreciation). The NBR has capitalised, in the past two years, on the window of opportunity provided by the favourable macroeconomic and financial background to rectify the situation to some extent, yet the process needs to be continued until nearing the prevailing levels across the EU. Looking ahead, it is essential that the NBR identify, as it has until now, the right timing for the upcoming stages of the alignment process to unfold without impairing the smooth functioning of the markets and without deteriorating key indicators for investor sentiment or, more generally, public perception.

Last but not least, I should mention that the neighbourhood we live in is a powerful source of risks: I am referring, of course, to the still unsolved issue of Greece’s debt financing and the smouldering conflict in Ukraine. Both factors have the potential to influence investor risk appetite and, as such, the volume and direction of capital flows, entailing larger fluctuations in the exchange rate of the domestic currency. Apart from the unrest in the region, the expected growing divergence between the monetary policy stances of the world’s major central banks could also have a bearing on the dynamics of capital flows and therefore on the exchange rate volatility on the domestic market.

I will not go any further with my monetary policy considerations, as I am convinced that the subject will be extensively dealt with by the speakers in the second panel of the conference. Most surely, a lot of interesting ideas will emerge during the debate and I look forward to getting a flavour of other central bankers’ perspective. As a matter of fact, this is true for all the other panels and workshops, as they encompass topics particularly relevant to the present and future of the economies in South-East Europe.

4 June 2015

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