Deflation Cries Are Just Noise in Romania as Investors Dump Debt

Updated on
  • Central bank sees inflation returning as VAT effect fades
  • Romanian bonds fall most in emerging markets as elections near

Romania’s bond investors are taking to heart central bank warnings that higher interest rates may be around the corner even as the country grapples with the deepest deflation in the European Union.

A slump in the nation’s bonds has pushed 10-year yields up the most in emerging markets since policy makers reiterated at a March 31 rate meeting they were preparing ways to tackle an expected surge in inflation. While consumer prices slid by a record 3 percent in March, the central bank forecasts inflation will snap back to reach 3.4 percent by end-2017.

Rival political parties that backed an interim technocratic government in Romania last November are driving this outlook by circumventing the cabinet with legislation aimed at wooing voters before elections set for June and November. The policies include a child-care benefit plan that threatens to widen the budget deficit beyond EU limits, and a controversial law allowing citizens to hand back homes in exchange for release from mortgages.

"The level of headline noise going into the elections will be largely negative," said Roxana Hulea, a strategist at Societe Generale SA in London, who recommends investors reduce the weightings of the nation’s debt in their portfolios. "Romania’s local-currency bonds will underperform peers, particularly at the longer end of the curve, due to higher bond issuance needs and a relatively hawkish central bank prompting foreign portfolio outflows."

Higher Rates

By shunning monetary stimulus, Romania’s central bank is breaking ranks with regional peers because it anticipates the government’s spending spree will send consumer prices in the opposite direction as the deflationary effects of value-added tax cuts introduced last year fade. Annual wage growth exceeding 10 percent for the fourth month in February is also boosting consumption. The outlays are seen driving economic expansion to an eight-year high of 4 percent in 2016, according to the median estimate of 21 analysts surveyed by Bloomberg.

Central bank Governor Mugur Isarescu said Feb. 24 policy makers were ready to "react more rapidly" to tighten monetary policy, first by narrowing an interest-rate corridor and then potentially raising the benchmark from a record-low 1.75 percent.

Romania’s policy stance runs counter to peers contemplating easing after the European Central Bank boosted monetary stimulus in March. As the country’s 10-year yield climbed 34 basis points to 3.72 percent in a record 17-day slump through Tuesday, the rate on similar-maturity Hungarian notes has increased 13 basis points to 3.08 percent, while that on Russian debt is up nine basis points.

Fiscal Slippages

"The rally we’ve seen over the past few years is over," Gintaras Shlizhyus, a strategist at Raiffeisen Bank International AG in Vienna, said by phone. "The central bank, which was always prudent in Romania, is more likely to remain on alert for possible fiscal slippages. That removes most of the likelihood that interest rates will go down, as in Hungary or Poland."

While on the surface consumer prices are falling faster in Romania than anywhere else in the EU, the main catalyst for the deflationary spiral was a move last June to reduce the VAT on food by almost two-thirds to 9 percent. A plan to raise wages of some government employees to level out discrepancies has been shelved as unions demand wider increases.

Romania’s economy isn’t overheating, but “is running the risk of consumption-driven growth” and a wider deficit, Liviu Voinea, central bank deputy governor, said in an interview on April 15.

Close Race

Local politics have been in limbo since Prime Minister Victor Ponta resigned last November following a night-club fire that culminated months of protests over his alleged involvement in corruption. Following Ponta’s departure, major parties came together to back formation of the nation’s first technocratic government since the fall of communism.

With just two months to go before local elections, polls are showing the Social Democrat and Liberal parties are neck and neck. That’s cause for caution, said Raiffeisen’s Shlizhyus. Raiffeisen cut its recommendation on Romanian debt to hold from buy in January and expects the yield on 10-year local-currency bonds to rise to 3.8 percent by the end of the year.

Romanian local-currency bonds have handed 1.98 percent in losses to investors this month, trimming an advance in the last 12 months to 5 percent in dollar terms. That’s behind comparable returns in the Czech Republic, Serbia, Bulgaria and Hungary.

“We are seeing the end of a cycle and that could bring a partial reassessment of valuations,” Slizhyus said, adding investors tend to adopt a more cautious strategy leading up to elections.