A Strong Track Record Needs to be Maintained. SERBIA & MONTENEGRO: Election Results Create Uncertainty. Exchange Rate Policy Uncertainty

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1 Country Updates South Eastern Europe & Mediterranean Emerging Market Economies Bulletin Volume, Issue 1 January 2004 Regional Overview: Current Accounts Widening Raises Policy Concerns TURKEY: A Strong Track Record Needs to be Maintained Strategic Planning & Research Department Director: Paul Mylonas : : pmylonas@nbg.gr ROMANIA: BULGARIA: Tough Measures Necessary to Keep the IMF Engaged A Widening Current Account Creates Policy Dilemmas SERBIA & MONTENEGRO: Election Results Create Uncertainty Emerging Markets Research Coordinator: Michael Loufir : : mloufir@nbg.gr Analysts: Evlabia Fetsi : : efetsi@nbg.gr Eugenia Gargana : : gargana.evgenia@nbg.gr F.Y.R.O.M.: ALBANIA: CYPRUS: EGYPT: The Recovery from a Crisis-Based Recession Accelerates Abated Political Tensions Brighten the Economic Outlook Fiscal Discipline is the Key to Improving Economic Fundamentals Exchange Rate Policy Uncertainty Markets Data Summary

2 Current Accounts Widening Raises Policy Concerns Against the backdrop of slow euro area recovery, the five South Eastern Europe (SEE) economies (Romania, Bulgaria, Serbia & Montenegro, F.Y.R.O.M. and Albania) displayed remarkable resilience, recording average real GDP growth of 4 per cent in 2003, compared with an estimated 0. per cent for the euro area, the region s main trading partner. It is now evident that the economic restructuring of the past few years is bearing fruit, as fixed investment is rising rapidly. Furthermore, in most SEE countries a key growth driver has been private consumption, supported by falling unemployment rates. The outlook for economic activity in 2004 is more favourable, and we expect real GDP in the region to grow by 4.6 per cent, with consumption and investment being once again the engines of growth, while exports should pick up in line with the recovery in the euro area. Real GDP Growth Euro Area SEE Average E 2004F It is important to note that high growth rates have been achieved at a time of improving fiscal discipline. In 2003, the fiscal stance in the region tightened further and the average SEE-country budget deficit fell to 2. per cent of GDP from 2.9 per cent of GDP in 2002, influenced by more efficient revenue performance and higher collection rates. For 2004, we expect a slightly looser stance with an average fiscal deficit equal to 2.7 per cent of GDP. However, in view of the region s worsening current account deficits, fiscal policy is not satisfactory. A tighter policy is warranted. That being said, it must be acknowledged that the region is going through an election cycle, which complicates the implementation of a tighter fiscal policy stance -- Romania (end-2004), Bulgaria (mid-200), Albania (mid-200), and probably soon in Serbia (unscheduled). The fiscal performance, combined with broadly appropriate monetary policies, has led to single digit inflation in 2003 (9.9 per cent from 24.1 per cent in 2001) -- the first time in decades -- and created an environment conducive for an economic renaissance of the region SEE Average Inflation & Real Credit Expansion to the Private Sector 1999 Inflation 2000 Real Credit Expansion to the Private Sector 2001 Ambitious structural reform efforts, especially of banks and enterprises, and an improving standard of living have resulted in a rapid acceleration of credit demand. In fact, credit expansion reached 33.1 per cent in real terms, compared with a decline of 2.6 per cent in 2001, with consumer credit in most cases being the most dynamic component. As a result of the growth differential with the euro area, which has hurt exports and boosted imports, combined with the credit-induced demand for imported consumer durable goods, the current account of the region has deteriorated significantly, to nearly 8 per cent of GDP in 2003 from 6 per cent of GDP in E 2004F Volume, Issue 1 January 2004 South Eastern Europe and Mediterranean Emerging Market Economies Bulletin

3 Current Accounts Widening Raises Policy Concerns SEE Average Fiscal and Current Account Deficits (as of GDP) Current Account Deficit reflecting renewed confidence in the economy following the end of an economic crisis and the successful implementation of an ambitious structural reform programme. 13 Real GDP Growth and Current Account Balance-to-GDP Ratio Fiscal Deficit E 2004F Clearly, considerable risks surround the mediumterm sustainability of such persistently large current account deficits. Since many privatisations have by now been completed in the region and only a few large ones currently scheduled, privatisation-related FDI will soon level off. Though greenfield investment has been attracted to the region, delays in structural reforms due, inter alia, to the electoral cycle may also slow such investments. At the same time, official financing to the region is decreasing as its recovery has taken hold. Finally, following the imminent tightening of monetary policy in the US, there may be a flight to quality in general from emerging markets, which will make access to international capital markets more difficult. In this environment, a timely adjustment of external imbalances becomes a primary challenge for the countries of the region. A tighter fiscal policy is the most logical response to the excess demand, though in the current political climate, this is unlikely. As a result, monetary policy will likely need to be tightened significantly, with the expected consequences on growth. It is interesting to note that a similar phenomenon is occurring in Turkey. The current account switched from a surplus equivalent to 2.3 per cent of GDP in 2001 to a deficit estimated to be 2.8 per cent of GDP in Real GDP growth 1Q00 3Q00 1Q01 3Q01 1Q02 Current Account Balance / GDP In addition, the policy dilemmas are similar. First, adjustment fatigue as far as fiscal policy is concerned -- Turkey already has a primary surplus equivalent to 6. per cent of GDP. Second, monetary policy is already stretched, with real interest rates at 1 per cent, and a real effective exchange rate appreciation of 8. per cent during Turkey s situation is also complicated by the large debt overhang per cent of GDP -- and investor wariness over the sustainability of the debt dynamics. On the other hand, the Government does not face upcoming elections. The external financing requirement is not an issue in 2004, however, in 200 large debt service payments will start coming due. In the case of Turkey, as well as the five SEE countries, relations with the IMF will play a critical role in maintaining foreign investors and markets confidence in their economies. In most countries, IMF programmes are expiring and progress on negotiations on new ones will need to be monitored carefully in view of the abovementioned policy dilemmas and policy constraints. 3Q02 1Q03 3Q03 1Q The same factors are at play; a rapid rise in demand South Eastern Europe and Mediterranean Emerging Market Economies Bulletin Volume, Issue 1 January 2004

4 CONTENTS Contents TURKEY: Economic Growth Appears to be on the Mend The Current Account is Becoming a New Risk to the Programme An Additional Fiscal Package is Key to Economic and Financial Stability A Tight Monetary Policy to Keep Inflation on a Downward Trend The IMF Programme to Remain on Track in Spite of Numerous Hurdles Updates completed on January 28 th 2004 ROMANIA: Sources of Excess Demand -- Consumer Credit and Quasi-Fiscal Slippage The Current Account Deficit Deteriorates Significantly Monetary Policy Tightens to Hold Back Domestic Demand Tough Negotiations Ahead for a New IMF Programme BULGARIA: Continuing Political Pressure Moderates the Pace of Reform A New IMF Programme is Necessary to Maintain Investor Confidence Fiscal Discipline to Continue Ahead of Elections The Current Account Deficit Widens to Worrisome Proportions SERBIA & MONTENEGRO: New Elections May be Required Economic Growth to Gain Momentum Fiscal Consolidation Needs to be Kept on Track Financing of Large Current Account Deficits will Remain a Challenge A More Effective Monetary Policy to Keep Inflation in Check F.Y.R.O.M.: Economic Activity Strengthens Further Inflation to Remain Subdued Fiscal Policy Over-Performs The External Gap Closes to More Sustainable Levels ALBANIA: Reforms to Gain Momentum as Political Tension Dissipates Good Relations with IFIs to Continue The Fiscal Consolidation of 2003 to be Partly Reversed in The Positive Balance of Payments Trends are Set to Continue The Privatisation Programme Moves to Full Speed Ahead A Bright Outlook for a Fully-Privatised Banking Sector CYPRUS: Raising Hopes for a Settlement on Cyprus A Timid Recovery Following Two Consecutive Years of Economic Slowdown The Current Account Continues to Weaken EGYPT: A Step Back to a Managed Peg Exchange Rate Regime A Likely Fifth Consecutive Year of Economic Slowdown Inflation to Remain Artificially Subdued Investor Confidence is the Key to Improving the External Position MARKETS DATA SUMMARY Volume, Issue 1 January 2004 South Eastern Europe and Mediterranean Emerging Market Economies Bulletin

5 TURKEY Recent Conjunctural Developments Industrial Production & Capacity Utilisation in Manufacturing Industry Industrial Production (y-o-y change, left scale) 0/00 09/00 0/01 09/01 Capacity Utilisation Rate 0/02 09/02 0/03 09/ G Real GDP grew by.4 per cent in the first nine months of 2003 compared with 6. per cent in the same period of In view of this outturn, as well as a robust 8.2 per cent y-o-y increase in industrial production in October and November of 2003, and the rise in the average capacity utilisation rate to 80 per cent in the last quarter of 2003, we estimate that the 2003 GDP growth has reached.4 per cent compared with a target of per cent Inflation Expected end-year CPI CPI (y-o-y change) G End-year inflation stood at 18.4 per cent y-o-y, its lowest level since the 1970s, compared with the official end-year target of 20 per cent. The main contributing factors were the nominal appreciation of the TRL against most major currencies, the substantial fiscal adjustments, and a tight monetary policy /00 09/00 0/01 09/01 0/02 Interest Rates 09/02 Interbank Overnight Rate (Compounded) 3-M T-Bill Rate (Compounded) 0/03 12-M T-Bill Rate 09/ G Despite the widening of the current account deficit, which reached 2 per cent of GDP in the first ten months of 2003 from near balance a year before, foreign exchange reserves increased by almost USD 7 billion in 2003 to USD 33.8 billion (or 4. months of imports of goods and non-factor services). The bulk of this increase resulted from CBRT daily purchase auctions and direct interventions between June and September to contain the appreciation of the TRL /01 08/01 06/02 11/02 04/03 09/03 02/04 Real Effective Exchange Rate & Million USD Exports of Goods,200 4,700 4,200 3,700 3,200 2,700 Exports REER 2000= G Despite the appreciation of the CPI-based real effective exchange rate by 7.6 per cent in the first ten months of 2003 compared with the same period of 2002, merchandise exports increased markedly, by 27.8 per cent y-o-y in USD terms over the same period, albeit biased upwards by the depreciation of the USD. Strong productivity gains and declining real wages were behind this good performance. 2, /00 09/00 0/01 09/01 0/02 09/02 0/03 09/03 South Eastern Europe and Mediterranean Emerging Market Economies Bulletin Volume, Issue 1 January

6 TURKEY NATIONAL BANK OF GREECE S.A. Recent Conjunctural Developments Money Supply and Credit to Private Sector (y-o-y change) Broad Money (M2Y) G Credit to the private sector continues its strong upward trend, recording a growth of 0 per cent y-o-y in November compared with per cent a year ago. This rebound provides more evidence of the ongoing strong economic recovery. The deceleration in broad money partly reflects the renewed domestic interest in treasury 2 10 Credit to Private Sector 2 10 securities /00 09/00 0/01 09/01 0/02 09/02 0/03 09/03 Gross FX Reserves (excl. gold) of CBRT USD bn and EUR/TRL Rate 1000 TRL 3 2,000 TRL: 1 EUR TRL 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 03/11/00 Gross FX Reserves 07/00 07/0/01 Stock Exchange Index: ISE 100 EUR Terms 30/10/01 07/01 1/04/02 30/09/02 07/02 TRL Terms 27/03/03 07/03 10/09/03 EUR /02/04 1,600 1,200 Turkey's USD Eurobond Spreads over US Securities Basis points Basis points 1,200 1,200 1, / 20/0/00 04/10/00 Turkey USD /12/08 18/02/01 0/07/01 19/11/01 Turkey USD /01/30 0/04/02 20/08/02 04/ 21/0/03 0/10/03 19/02/ , G The TRL has steadily appreciated against the USD, during the past three months to January, by 12 per cent to TRL 1,330,000 : USD 1, due to the better-thanexpected macroeconomic performance in 2003 and the positive economic and political outlook for As this trend is expected to continue in the coming months, the CBRT resumed its daily purchase auctions on January 23 rd, three months after their suspension. Should the TRL s rally continue, the CBRT will increase the amount of the daily auction, set now at USD 30 million, as well as intervene directly in the foreign exchange market. G Eurobonds strengthened further between end-october and end-january on the back of a series of good news. Indeed, the substantial improvement of economic fundamentals, the completion of the sixth review, and upgrades by major rating agencies have further sustained the view that Turkey is an improving credit. During 2003, Eurobond spreads narrowed by around 30 basis points, and since end-2003 by another 40 basis points, reaching historical record lows of 290 basis points. G The Istanbul equity market also reacted positively to the recent flow of good news. In fact, during the last two months of 2003, the ISE index increased by 1 per cent in EUR terms, carrying the 2003 gain to 76 per cent. 2 Volume, Issue 1 January 2004 South Eastern Europe and Mediterranean Emerging Market Economies Bulletin

7 TURKEY A Strong Track Record Needs to be Maintained GTurkey outperformed all expectations in Economic growth likely surpassed the government s per cent target, the disinflation process continued at a rapid pace, with consumer price inflation finishing the year well below the 20 per cent target. On the public finances front, the primary surplus is likely to come very close to the IMF-agreed target of 6. per cent of GDP, and debt ratios fell markedly with the appreciation of the TRL. GIn 2004, Turkey could strengthen its track record. Indeed, there is growing evidence of the Government s commitment to the IMF-supported economic programme, increasing popular support for the Government, and continued progress in implementing reforms required for membership negotiations with the EU. Furthermore, the possibility of a positive outcome at the December 2004 EU Summit in Amsterdam, during which a decision will be made about whether accession negotiations can begin in 200, highlights further potential upside. GHowever, there are concerns over the widening current account deficit. A large current account deficit could engender downward pressure on the TRL, which will risk the revival of inflationary pressures, with both developments leading to a tightening of monetary policy. This problem is compounded by the continued low level of FDI, in good part due to delays in the privatisation programme. Economic Growth Appears to be on the Mend Real GDP growth in the first nine months of 2003 averaged.4 per cent, compared with 6. per cent in the same period of The drag on growth was from weaker net exports, as imports of goods and services surged by nearly 30 per cent. Falling public consumption and investment also contributed, as the Government scaled back spending to increase the primary fiscal surplus as targeted. Domestic demand, however, accelerated on the back of stronger growth in private consumption, fixed investment, and the accumulation of inventories. Growth in private consumption surged, despite a further decline in real income, as improved confidence and falling real interest rates sparked a surge in spending on durables. Furthermore, stepped-up bank lending to businesses combined with improved profitability, as unit labour costs declined, supported an increase in private fixed investment. Growth Performance () Jan.-Sept Jan.-Sept Private Final Consumption Government Final Consumption Gross Fixed Capital Formation Public Sector Private Sector Exports of Goods and Services Imports of Goods and Services Gross Domestic Product These trends likely continued in the fourth quarter. Credit to the private sector continued to surge (0 per cent y-o-y in November) compared with 18 per cent y-o-y in January 2003, after having declined by 4 per cent in In addition, industrial production in October and November increased by 8.2 per cent y-o-y on average, while the capacity utilisation rate reached 80 per cent in the fourth quarter. Overall, we estimate that GDP growth has reached.4 per cent for 2003 as a whole, compared with 7.8 per cent in For 2004, we expect a strengthening of economic activity, on the back of firmer foreign demand as well as a further recovery in private consumption and investment. Indeed, despite the recent investment boom, private sector investment as a share of GDP is around 14 per cent, 8 percentage points below the past decade s average of 22 per cent. We believe that this large investment gap is set to release pent-up demand for private sector capital formation. Furthermore, the recently announced rise in minimum wages (34 per cent) and in state pensions (21 per cent) -- well above the 1 South Eastern Europe and Mediterranean Emerging Market Economies Bulletin Volume, Issue 1 January

8 TURKEY NATIONAL BANK OF GREECE S.A. A Strong Track Record Needs to be Maintained per cent (implicit) period average inflation target -- should provide a major boost to private consumption. Finally, despite a more favourable external environment, with an albeit weak recovery expected in the EU -- Turkey s main export market -- the continuing surge in imports will result in a larger negative contribution to growth from net exports. All told, real GDP should grow 6.2 per cent next year, above the per cent assumed in the 2004 Budget. The Current Account is Becoming a New Risk to the Programme The current account deficit widened considerably in 2003, reflecting the strong recovery, weak tourism due to the war in Iraq, and the surge in credit, especially consumer credit. In the ten months to October, the current account deficit reached 2 per cent of GDP from near balance in the corresponding period of 2002, and the gap is likely to reach 2.8 per cent of GDP for the full year. It was financed mainly by the recovery in shortterm capital inflows as well as resident inflows (a reversal of over USD 10 billion from 2002, equivalent to over 4 per cent of GDP). Looking forward to 2004, the imminent further widening of the current account deficit is a source of concern. The acceleration in domestic demand and its impact on imports will far exceed the envisioned recovery in exports, including tourism -- with the latter supported by the large depreciation of the real effective exchange rate (ULC based) that occurred in 2003 (see next Figure). As a result, the current account could approach 4 per cent of GDP in 2004, while its financing is vulnerable in view of its continued dependence on short-term capital flows. The anticipated slowdown in these inflows will likely result in downward pressure on the exchange rate, from the heights attained in 2004 (see above in recent conjunctural developments). As a result, market concern will be intensified further as twothirds of the public debt is denominated in foreign exchange, and a more severe exchange rate correction could halt progress in achieving positive debt dynamics. Finally, without significantly tighter policies, it is not clear how the current account deficit will narrow in 200, when large IMF disbursements start to fall due. Real Wages and Partial productivity in Manufacturing Industry (Annual Rate of Change) Partial Productivity Real Wage Q1 00Q4 01Q3 02Q2 03Q1 03Q4 An Additional Fiscal Package is Key to Economic and Financial Stability Following a substantial fiscal slippage in the first half of 2003, the authorities introduced two fiscal packages, in August and November. As a result, tax compliance improved and public investment and other non-wage outlays were cut. Nevertheless, the fiscal performance is likely to fall slightly short of the target of a primary surplus of 6. per cent of GDP for the public sector, though it will be well above the 2002 outcome (4.1 per cent of GDP). Moreover, fiscal adjustment is approximately 1 percentage point of GDP smaller than would otherwise have been required due to the redefinition of the concept of the public sector, which mainly added previously excluded revenues (e.g. land sales). Combined with sharply lower interest payments, the overall 2003 deficit is likely to have narrowed to 11 per cent of GDP from 1.3 per cent in The fall of interest outlays resulted from the decline in Treasury-bill yields as well as a strong exchange rate. The real exchange rate appreciation was also the main factor 4 Volume, Issue 1 January 2004 South Eastern Europe and Mediterranean Emerging Market Economies Bulletin

9 TURKEY A Strong Track Record Needs to be Maintained behind the reduction in the government debt to 69.8 per cent of GDP from 80.2 per cent at end Domestic debt, on the other hand, has remained little changed at roughly 4 per cent of GDP, reflecting the shift towards domestic financing of the deficit. Regarding 2004, the draft Budget approved by Parliament on December 24 th, targeted a public sector primary surplus of 6. per cent of GDP -- as in and an overall deficit of 11 per cent. Meeting this target required new measures equivalent to 1. per cent of GDP, most of which have already been approved (see October 2003 Issue). However, the Government s decision to raise pensions by 10 per cent at the beginning of the first and again the second half of 2004, as well as the minimum wage by 34 per cent is inconsistent with the 12 per cent (end-year) inflation target foreseen for 2004, and will burden the Budget by an estimated TRL 3,00 quadrillion (0.8 per cent of GDP). To offset this impact, as well as the expected small shortfall in the 2003 Budget from its target of a primary budget of 6. per cent of GDP (TRL 1. quadrillion, equivalent to 0.3 per cent of GDP), in late-january the Government announced its intention to reduce discretionary expenditure by 10 per cent. Further measures are necessary, and are expected to be announced after the end-march local elections. Candidates include price increases in public enterprises and new tax measures. terms despite their increase in USD terms. The fiscal adjustments necessary to achieve the primary fiscal surplus target of 6. per cent of GDP. The continuing decline in real employment earnings from 2001 through to the first half of The steady implementation of a tight monetary policy, reflected in an inverted yield curve. On the back of positive inflation developments, monetary policy stance has been gradually eased. In fact, the central bank (CBRT) reduced interest rates six times during 2003 with the last cut in October. At that time, overnight rates were reduced by 300 basis points to 26 per cent compared with a rate of 44 per cent at the beginning of the year. Subsequently, despite the good inflation performance, and a renewed strengthening in the TRL, the CBRT did not cut rates further. Nevertheless, real interest rates remain high, though lower than in early In fact, real interest rates, based on the CBRT's overnight policy rate and yearahead inflation expectations, have again risen to above 14 per cent. (Compounded) CBRT Overnight Rate Adjusted for Expected Inflation A Tight Monetary Policy to Keep Inflation on a Downward Trend 30/06/02 30/08/02 30/10/02 30/12/02 28/02/03 30/04/03 30/06/03 30/08/03 30/10/03 30/12/03 CPI inflation fell to 18.4 per cent y-o-y in December, Despite tight monetary policy, meeting the percentage points below the target. The main factors inflation target of 12 per cent by end-december may not behind this over-performance were: be that easy. The main challenges will come from wage The TRL s nominal appreciation of 18.2 per cent inflation, the economy hitting capacity constraints, the pass through from scheduled hikes in administered against the USD during 2003, which also kept import agricultural prices and/or a correction of the exchange prices for oil and natural gas little changed in TRL rate overshooting that occurred in Though end- South Eastern Europe and Mediterranean Emerging Market Economies Bulletin Volume, Issue 1 January 2004

10 TURKEY NATIONAL BANK OF GREECE S.A. A Strong Track Record Needs to be Maintained year inflation expectations already reflect a significant deceleration in inflation, to only 1.1 percentage points above the end-year target, in the event of any signs of a pick-up in inflation, the CBRT would not hesitate in raising rates. We expect inflation to overshoot its 12 per cent target, especially as exchange rate developments will not be as favourable as in As a result, policy rate cuts should not be expected to exceed 00 basis points, declining to 21 per cent. Furthermore, monetary easing is likely to resume only in the second quarter, after the end-march local elections, and after the Government has come up with a new and credible fiscal package. Moreover, the CBRT will monitor carefully the risk from pass through of the minimum wage increase to wages more generally, and developments in the current account. The IMF Programme to Remain on Track in Spite of Numerous Hurdles In a break with the past, and to accommodate the extensive reform agenda and the Bayran holiday, the seventh review will be held in two phases. The first phase took place between January 12 th -21 st and the second phase is likely to start in mid-february. The discussions will focus on 2004 economic policy and the details of the programme's public finance and structural reform elements. Preconditions for the completion of the review are unlikely to be difficult to satisfy (see October 2003 Issue) and progress on almost all of the necessary measures has already been made. The main obstacle will be reaching an agreement on the fiscal measures necessary to compensate for the higher wage and pension costs and for the 2003 fiscal shortfall. The IMF is likely to require at least a TRL quadrillion supplementary budget (1.2 per cent of GDP) in order to assure the attainment of the 6. per cent primary surplus target for We do not expect the wage and pension hikes to be a deal breaker. Experience has shown that the Government is very keen on maintaining relations with the IMF on track, and comes up with a credible fiscal package every time there is fiscal slippage. However, as the required fiscal adjustment is somewhat larger than expected, the Government is unlikely to announce sufficient measures to close the budget gap until after the end-march local elections. This could draw out the seventh review until April. More importantly, we expect the IMF to be increasingly vocal on the medium to long-term sustainability of the social security system. The budgetary transfers to social security institutions, which declined from 3.6 per cent of GDP in 1999 to 2.6 per cent of GDP in 2000, have soared since then. Including the impact of the latest wage and pension rises, the budgetary transfers are likely to amount to. per cent of GDP in Budgetary Transfers to Social Security Funds ( of GDP) Overall, Turkey is expected to complete successfully the ongoing IMF programme, which will expire in December. With government repayments on external debt peaking at USD 21 billion in 2006 (7.6 per cent of projected GDP in 2004) -- of which USD 10 billion is due to the IMF -- the Government will clearly consider it in its best interests to agree to a new IMF programme for E 2004F Volume, Issue 1 January 2004 South Eastern Europe and Mediterranean Emerging Market Economies Bulletin

11 TURKEY A Strong Track Record Needs to be Maintained Long-Term Credit Ratings: Next Elections: S&P: B + Presidential: May 2007 Moody s: B1 Legislative: Nov Fitch: B Economic and Financial Indicators e 2004f Real Sector Nominal GDP (USD billion) GDP per capita (USD) 2,193 2,698 3,7 4,048 GDP growth (real, per cent yoy) Unemployment Rate (per cent aop) Prices, Money and Banking CPI (per cent eop) Broad Money (per cent, eop) Credit to the Private Sector (per cent, eop) External Accounts Merchandise Exports (USD billion) Merchandise Imports (USD billion) Trade Balance (USD billion) Trade Balance (per cent GDP) Current Account Balance (USD billion) Current Account Balance (per cent GDP) Foreign Direct Investment (USD million) 2, ,80 International reserves (USD billion) International reserves (Months a ) Public Finance Fiscal deficit b (per cent GDP) Primary balance b (per cent GDP) Public debt (per cent GDP) Public domestic debt (per cent GDP) External Debt Gross external debt (USD billion) Gross external debt (per cent GDP) External debt service (USD billion) External debt service (per cent reserves) External debt service (per cent exports) Financial Markets 3-M T-bill rate (compound, per cent, eop) Y T-bill rate (per cent, eop) Spread of the 2030 Eurobond (bps, eop) Exchange rate: USD (eop, Thousands) 1,440 1,6 1,401 1,20 Exchange rate: EUR (eop, Thousands) 1,283 1,734 1,77 1,976 Stock market index: ISE100 (XU100, eop) 13,783 10,370 18,62 17,819 c f: NBG forecasts, a: Imports of goods and non-factor services, b: Central Government budget (excluding profits transfers from the CBRT, interest receipts, privatisation proceeds), c: as at January 27 th South Eastern Europe and Mediterranean Emerging Market Economies Bulletin Volume, Issue 1 January

12 ROMANIA NATIONAL BANK OF GREECE S.A. Recent Conjunctural Developments 6 Real GDP and Industrial Production (y-o-y change) 14 G In the first three quarters of 2003, real GDP grew by 4.7 per cent against 4. per cent in the same period of Q00 2Q00 3Q00 4Q00 Real GDP 1Q01 2Q01 3Q01 4Q01 1Q02 Industrial Production 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q with industry rising by 4.7 per cent y-o-y. However, in view of the deteriorating trends in net exports and industrial production -- industrial production rose by 3.4 per cent y-o-y in October and November of 2003 against 10.1 per cent in the same period in we estimate real GDP to have decelerated to 4.4 per cent in 2003 against 4.9 per cent in CPI and Nominal Wage Rate (y-o-y change) 62 G In the first 11 months of 2003, exports grew by 6.7 per cent y-o-y (in EUR terms), supported by improving 2 2 competitiveness -- the CPI-based real effective 42 Gross Wage per Worker 42 exchange rate depreciated by per cent. However, due to surging credit and high wage growth, imports rose strongly by 11.8 per cent, leading to a further 22 CPI 22 deterioration in the current account deficit ( per cent of 12 0/00 09/00 0/01 09/01 0/02 09/02 0/03 09/03 12 GDP against 2.8 per cent a year ago). Indeed, the acceleration in imports appears to be continuing. 70 Money Supply and Credit to Private Sector (y-o-y change) Credit to Private Sector 70 G Following rating upgrades, Eurobond spreads declined by 17 basis points to 120 basis points between end- October and mid-january. Indeed, Romanian sovereign debt received rating upgrades of one notch by Moody s 40 M2 40 and Fitch in December, to Ba3 and BB, respectively, though these moves by the rating upgrades had already 2 2 been priced-in by the markets /00 09/00 0/01 09/01 0/02 09/02 0/03 09/03 G Inflation fell to 14.1 per cent y-o-y in December from 19 Government Securities Yield Curve in October, in line with the end-year target of 14 per cent. The slowdown occurred despite higher energy / / prices, as the deceleration in core inflation was larger. Looking ahead, achieving the end-2004 target of 9 per cent will not be easy due to: i) the risk of a loose incomes policy in this election year; ii) rapid credit 1 1 growth; and iii) further energy price hikes (increases in electricity and heating prices by 8 per cent and 12 per cent, respectively). 3-M 6-M 12-Μ 2-Υ 3-Y Maturity 8 Volume, Issue 1 January 2004 South Eastern Europe and Mediterranean Emerging Market Economies Bulletin

13 ROMANIA Recent Conjunctural Developments USD bn 9 7 Gross FX Reserves (excl. gold) of NBR and EUR/ROL Rate ROL: 1 EUR Gross FX Reserves ROL 42,000 37,000 32,000 27,000 G Despite three consecutive policy rate hikes (totalling 300 basis points), credit expansion continued to accelerate, reaching 47.2 per cent y-o-y in real terms in November, with consumer and mortgage loans being the main contributors to the boom /00 09/00 0/01 09/01 0/02 09/02 0/03 Real Effective Exchange Rate and Million USD Exports of Goods 1,800 1,600 1,400 REER 09/03 22,000 17, = G Following the latest NBR rate hike -- by 100 basis points to 21.2 per cent in November -- the 3-month T-bill rate rose by over 300 basis points, reaching 18. per cent. As a result, the domestic debt yield curve has become more inverted, with 3-year rates 40 basis points below short-term ones. 1, , /00 Basis points /10/00 09/00 Exports 0/01 09/01 0/02 09/02 Romania's Eurobond Spreads over German Securities Romania EUR /11/0 29/03/01 2/08/01 0/03 Romania EUR /06/08 21/ 19/06/02 1/11/02 13/04/03 09/ Basis points 7 09/09/03 0/02/ G The ROL depreciated by 14. per cent against the EUR in 2003, exceeding the level of ROL 41,000 : EUR 1, in December. For 2004, the NBR will target a 3-4 per cent real appreciation of the ROL against a weighted basket of the EUR/USD with new weights of EUR 7 : USD 2 (compared with 60 : 40 in 2003), implying a slower targeted rate of nominal depreciation compared with 2003, assuming the USD continues to depreciate. Foreign exchange reserves reached a record high of USD 7.9 billion in 2003, covering 4.1 months of imports, despite the deterioration in the current account and central bank interventions, in December, to support the ROL. About two thirds of the total 30 per cent rise in reserves was due to the depreciation of the USD against the EUR ROL Bucharest Stock Exchange Index EUR G In 2003, the BETC index rose by 6.8 per cent in EUR EUR Terms and 26 per cent in local currency terms, with the two largest companies (by market capitalisation), SNP / 03/07/00 08/ 09/07/01 10/ 12/07/02 ROL Terms 23/ 31/07/03 04/02/ Petrom and BRD-Groupe Société Générale, contributing 6 per cent of this gain. Looking ahead, success on the privatisation front will be the key driver of the stock market, especially that of SNP Petrom. South Eastern Europe and Mediterranean Emerging Market Economies Bulletin Volume, Issue 1 January

14 ROMANIA NATIONAL BANK OF GREECE S.A. Tough Measures Necessary to Keep the IMF Engaged GFourth quarter developments have resulted in a significant re-evaluation of the economic vulnerabilities of the Romanian economy. A creditfuelled acceleration in domestic demand, especially consumption, combined with a large quasi-fiscal impulse has resulted in a worrisome deterioration in the current account deficit (from 3. per cent of GDP in 2002 to an estimated 6. per cent of GDP in 2003). GThough the higher external borrowing necessary to close the external financing gap should not be an issue in 2004, any further policy slippage that occurs in this double election year (local elections in June and Parliamentary elections in November) or failure to adjust policy to a further deterioration in the external account will certainly raise market concerns. GThe fact that Romania is unlikely to complete negotiations with the IMF on a new arrangement in the foreseeable future compounds Romania s vulnerability to changes in market sentiment. Sources of Excess Demand -- Consumer Credit and Quasi-Fiscal Slippage Following the rapid decline in NBR interest rates during 2002 (1 percentage points), to the point where short-term market rates were 2.8 per cent in real terms (ex post basis), credit to the private sector accelerated from 2 per cent y-o-y in early-2003 to 68. per cent in November. Moreover, consumer credit has skyrocketed, increasing by 230 per cent y-o-y, to comprise 18 per cent of total private sector credit, compared with only 8 per cent one year earlier. Regarding the fiscal stance, policy slippage in public enterprises appears to have been offset by overperformance at the level of general government. Indeed, the deficit of general government was broadly on target at 2.7 per cent of GDP, unchanged from 2002, though its composition was different than projected. First, the budget data through November indicate a deficit of only 0.8 per cent of GDP (compared with 1.9 per cent of GDP in the same period of 2002) and the end-year deficit estimate contains 1 per cent of GDP spending in December. Second, the primary surplus, partly due to the slowdown in activity, was smaller than targeted. However, lower interest payments -- both due to lower rates as well as the valuation effect from the depreciation of the USD (40 per cent of the debt is denominated in USD) -- offset this primary balance slippage. More importantly, the authorities have stated that they will include previously off-budget infrastructure spending (mostly on roads) -- equivalent to around 1 per cent of GDP -- into the 2003 Budget. In this case, the 2003 deficit, on an annual basis, would provide a muchneeded contractionary stimulus to demand of around 1 per cent of GDP. Turning to the quasi-fiscal stance, delays in implementing energy price increases, especially in the natural gas sector, as well as slippages in collection rates, resulted in a deterioration in the deficit of these public enterprises by nearly 1 per cent of GDP (from 2.1 per cent of GDP in 2002 to almost 3 per cent in 2003). As a result, the overall conclusion one should draw regarding fiscal policy is that the potentially contractionary impact from the budget (if the target is met by the inclusion of roadworks rather than by new spending), has been offset by slippage at the level of the public enterprises, leaving fiscal policy broadly neutral in However, this impact is distributed unevenly over the year, with a contractionary stance in the first eleven months of the year compared with an expansionary one in December, when domestic demand is already excessive. Looking ahead to 2004, the risk of policy slippage in an election year will certainly be heightened, and from an already looser policy stance compared with 2003 (a 10 Volume, Issue 1 January 2004 South Eastern Europe and Mediterranean Emerging Market Economies Bulletin

15 ROMANIA Tough Measures Necessary to Keep the IMF Engaged target of general government of 3 per cent of GDP). To put the situation in perspective, the IMF had argued for a deficit closer to 2 per cent of GDP, as well as quasifiscal adjustment equivalent to 1 per cent of GDP (see below), with a view to tamping down domestic demand and reducing the current account deficit. It appears to have lost the first battle but is likely to get the authorities to adjust energy prices so as to contain the quasi-fiscal deficit (see below). The Budget s financing will require privatisation revenue from the sale of SNP Petrom (around USD 1 billion or 1.7 per cent of GDP) and the sale of four energy distributors. In addition, domestic debt issuance is planned to rise in 2004, as the Government aims to reach a 0:0 ratio of domestic against external debt issuing, both with a view to developing the domestic market as well as to reduce its external vulnerability. The Current Account Deficit Deteriorates Significantly The current account deficit reached per cent of GDP in the first eleven months of 2003 against 2.8 per cent a year ago. This deterioration reflects weakening export growth (6.7 per cent y-o-y in EUR terms), but more importantly, strong import growth (11.8 per cent y-o-y in EUR terms). Surging imports were supported by the strong credit expansion (47 per cent y-o-y growth in real terms in November) and high real wage growth (7. per cent y-o-y in November). Despite weak activity in Europe, export growth was likely supported by the depreciation of the real effective exchange rate in the first eleven months of 2003 ( per cent). The current account deficit widened further by end- 2003, due to the above-mentioned 2004 fiscal impulse as well as to seasonal factors. In fact, we estimate the current account deficit to have reached 6. per cent of GDP in 2003 against a target of 4. per cent of GDP, and a 2003 outcome of 3. per cent of GDP. Its financing consisted mostly of FDI (2.7 per cent of GDP) and the eurobond issue (1.3 per cent of GDP). Official lending and private inflows covered the remainder of the current account gap and amortisation payments, and were sufficient to also boost the country s external position. That being said, the increased reliance on external borrowing -- despite the low debt stock -- is not a positive development, especially as it appears set to continue. Foreign currency reserves rose by 30 per cent in 2003 (USD 1.8 billion), reaching a record high USD 7.9 billion (3. months of imports), and two thirds of this rise is due to valuation effects (ceteris paribus), because of the depreciation of the USD against the EUR. Balance of Payments ( of GDP) 2002 Outcome Jan-Nov Jan-Nov Official Projection Current Account Goods and Services o/w Trade balance Exports Imports Income Current transfers Capital and Fin. Account o/w FDI Portfolio Investment Net Errors and Omissions Overall Balance Looking ahead, the 2004 current account should improve slightly on the back of higher export growth, in line with the global recovery and the recent gains in competitiveness. However, domestic demand will continue to be supported by strong consumer credit, despite the introduction of new credit measures (see below), while fiscal policy appears unlikely to act as a restraint on demand. As a result, the current account deficit is expected to exceed 6 per cent of GDP in Privatisation-related FDI (around 2 per cent of GDP) will be key to financing this deficit (e.g. the sales of SNP Petrom, and electricity and gas distribution companies). Nevertheless, Romania will continue to depend on significant amounts of foreign private sector borrowing, South Eastern Europe and Mediterranean Emerging Market Economies Bulletin Volume, Issue 1 January

16 ROMANIA NATIONAL BANK OF GREECE S.A. Tough Measures Necessary to Keep the IMF Engaged which -- in conjunction with the wider current account -- should lead to a deterioration in financing conditions (e.g. a widening of credit spreads). Monetary Policy Tightens to Hold Back Domestic Demand In view of the serious deterioration of the current account deficit and the increasing inflationary pressures due to the November energy price adjustments, the NBR has tightened monetary policy and raised its key policy (deposit) rate in three steps by a total of 300 basis points to 21. per cent between August and November. As it appears that the interest rate hikes have been insufficient to curb the demand for credit, in December the NBR announced new administrative measures targeted to limit credit expansion, especially the buoyant credit to households (consumer credit and mortgage loans). above their repayment capabilities from different banks), though it may take time to set up such a database. Given the rapidly developing intermediation in the Romanian economy, it is doubtful how far these measures can subdue overall credit growth, and help bring inflation towards its 9 per cent target by end-2004 from 14 per cent in December As a result, monetary policy may need to tighten further, perhaps to 24 per cent by mid-year The recent shift in the weights of the EUR/USD basket used to adjust the exchange rate from 60 : 40 to 7 : 2 will also act to tighten monetary policy by reducing the weight of the (depreciating) USD. As a last resort, reserve requirements could be raised Consumer and Mortgage Loan Share in Credit to Private Sector Growth in Real Consumer Credit (y-o-y, right scale) NBR Policy Rate, Reserve Requirements & Credit to Private Sector Consumer Loan Share in Credit Mortgage Share in Credit NBR Deposit Interest Rate /02 0/02 07/02 09/02 11/02 03/03 0/03 07/03 09/03 11/ FX Reserve Requirements 0/01 09/01 0/02 ROL Reserve Requirements 09/02 0/03 09/ Tough Negotiations Ahead fοr a New IMF Programme The measures announced so far require that: a) the monthly instalment of a consumer loan (including interest) be lowered to 30 per cent of the net income of the debtor from 0 per cent, and that 2 per cent of the loan must henceforth be deposited or the totality of the loan guaranteed; and b) for mortgage loans, the monthly instalment (including interest) should not exceed 3 per cent of household income. Additionally, the NBR plans to constitute a credit registry for commercial banks to monitor lending (as currently individuals can borrow Following the conclusion of the IMF Stand-by Agreement in October, negotiations for a successor agreement have been held up by disagreements over the content of the new programme, in part due to the forthcoming June local and November general elections. A second round of negotiations will resume in February, but a new agreement with the IMF, which in all likelihood will be a precautionary agreement, is unlikely to be forthcoming soon. 12 Volume, Issue 1 January 2004 South Eastern Europe and Mediterranean Emerging Market Economies Bulletin

17 ROMANIA Tough Measures Necessary to Keep the IMF Engaged The negotiations will focus on the following targets and measures needed to contain the strong domestic demand pressures and reduce the current account deficit: The Fund will again raise serious concerns about the fiscal deficit target of 3 per cent of GDP, though enacting a mid-year supplementary budget is unlikely. It will likely aim to restrict spending in the first three quarters of the year. Consolidated Budget ( of GDP) 2002 Outcome Jan.-Nov Jan.-Nov Official Projection Total Revenue Total Expenditure Fiscal Balance To reduce the quasi-fiscal deficit, back to 2 per cent of GDP from near 3 per cent of GDP in 2003, the Fund will require a new schedule for further energy Energy sector privatisations must be completed in 2004, both to signal progress on structural reform as well as to finance the fiscal and external gaps. First, the sale of the two electricity distributors (Electrica Banat and Dobrogea) scheduled for end-2003 was postponed to end-march Second, the privatisation of SNP Petrom, initially set for March, was deferred by three months. Third, the sale of the two gas distributors (Distrigaz Nord and Sud) for which the bidding process has been launched is set for June. The Government must show up front progress on these transactions Current Account Balance to GDP Ratio price hikes. To this end, at USD 130 per tcm, target - domestic gas prices are significantly below world levels of USD 180 per tcm, and the Fund is Forecast suggesting a USD 6 per tcm rise in domestic prices Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec. each quarter of 2004 with the aim of reaching cost recovery levels by Electricity and heating prices are near import levels, and the Government has announced increases of 8 per cent and 12 per cent, respectively. Moreover, the Fund would aim for debt-burdened mining and railway companies to be downsized further, with 8,000 layoffs in mining and 9,000 in railways in Incomes policy raises concerns in view of past slippage in this area, in concert with the forthcoming Overall, an agreement with the Fund on these measures appears unlikely in the short term, and negotiations will be drawn out. At this stage, the pressure on the Government to come to an agreement is not strong. However, to placate markets in the event they become worried by the size of the current account deficit, as well as to reassure the EU that it is taking the necessary steps for accession, Romania will ultimately reach an agreement with the Fund, though the political cycle may push this to the second half of the year. elections, and the pressure excess domestic demand is already posing to inflation and the current account. Though public sector wage increases are currently targeted at 9 per cent, and minimum wages are targeted to rise by 12 per cent (in line with expected 2004 average inflation), signs of slippage would be an anathema to the Fund. South Eastern Europe and Mediterranean Emerging Market Economies Bulletin Volume, Issue 1 January