Romania is on fire, says Ashmore’s Dehn

Jan Dehn, head of Research at Ashmore, discusses why positive noises from the IMF bodes well for early disbursement of emergency funding, the default of China’s Chaori Solar Energy and the Romanian rapid growth rate.

EU/US discussions about Ukraine are aimed at managing the political fall-out from the Russian annexation of Crimea and avoiding another debt crisis in Europe. To create an economic success in Ukraine, we expect strongly supportive Western rhetoric to be followed by emergency financial support from both the IMF and the EU/US. We believe a fully-fledged IMF standby arrangement will then follow after the elections scheduled for May. But turning Ukraine into an economic success cannot be achieved with public money and reforms alone. In particular, it is also essential for Ukraine’s economic recovery that the country also attracts new private investment.

Past crises show unambiguously that the critical test in any adjustment program – that is, whether it succeeds or not – boils down to re-establishing a country’s access to international markets. New private money to Ukraine could be forthcoming if (a) official sector lenders would welcome private money and (b) Ukraine commits to the reforms required under an IMF agreement.

The critical question for the official sector should be to establish whether Ukraine is technically insolvent or merely facing an illiquidity crisis. Given the country’s 39.5% debt to GDP ratio (as of the end of 2013), it would seem that liquidity rather than solvency is the problem. If this is confirmed by the IMF then it would be a major policy mistake to demand debt restructuring (economic restructuring is a different matter – Ukraine needs plenty of that). A debt restructuring would be counter-productive by discouraging private investment and deepening the country’s economic woes rather than fixing them. Ultimately, debt restructuring would also backfire politically by forcing Ukraine once more into the arms of Russia for financing.

In China, the announcement last week that Chaori Solar Energy, a CNY 1bn domestic Chinese corporate bond had defaulted is a pity for holders of the bond, but a major positive for investors in China more broadly. The Chinese authorities recently announced the intention to allow market forces much greater sway in resource allocation. This will help Chinese bond markets – and credit markets more broadly – to move towards a fairer pricing of risk. In turn this should be seen as precursor for a wholesale shift away from exchange rate targeting to inflation targeting in China. Inflation targeting using interest rates as the main policy instrument requires a well-functioning bond market.

But why the rotation toward inflation targeting and interest rate liberalisation? China is undertaking these draconian changes not because of major problems of resource misallocation at home (we do not think there is a systemic problem in China’s credit markets), but in preparation for the major realignment of global currencies that will be unleashed once inflation returns to the heavily indebted/money printing economies of Europe and especially the US. Strong resulting appreciation of the CNY will render export-led growth less profitable and domestic demand the main driver of growth. And, unlike exports that are easily managed by exchange rate policies, domestic demand is best managed using interest rates. China’s policies are far more forward looking that any other country on the planet.

India’s external balances continue to improve sharply on the back of last year’s adjustment measures, underlining the profound difference between basic macroeconomic misalignments (which are easily and quickly fixed with simple demand management tools and currency measures) and crises (which require profound and sustained reforms). The current account deficit in the third quarter of India’s fiscal year fell to a four-year low of 0.8% of GDP.

This compares to a deficit of 4.9% of GDP just two quarters previously. India has rapidly made the transition from ‘Fragile to Frugal’, illustrating once again how sentiment about EM, especially in the media tends to be shrill, prone to exaggeration and often outright wrong. EM fundamentals are in most cases robust, even if economies can become imbalanced in a cyclical sense. Last week India’s PMI index rose to a one-year high with strong gains in new orders and output forward indicators.

Romania is on fire. Growth in Q4 reached 5.2% yoy, accelerating from the real GDP growth rate of 4.1% yoy achieved in Q3. Consumption was strong (3.2% yoy), but exports rose even more strongly (13.7% yoy). In the past week Romania’s president signed off on a new coalition agreement for the government led by Prime Minister Ponta and Ioana Petrescu as Finance Minister. Romania has successfully implemented an aggressive fiscal adjustment since 2009, reducing its fiscal deficit from 7.2% of GDP to 2.5%.

Romania’s strong Q4 growth was achieved despite the collapse of its coalition government a few months ago, illustrating the point that political instability is not always a reason to turn bearish. After all, political noise is an entirely normal part of any country and 95% of political noise tends to be irrelevant for returns over the cycle. The establishment of a new government against a stronger fiscal backdrop bodes well for investment going forward and therefore a sustained upswing. Fitch, the ratings agency, last week affirmed Romania’s investment grade sovereign debt rating (BBB- with stable outlook).

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