Mugur Isărescu: External deficit financing and macroeconomic
adjustment during the financial crisis - the case of Romania
Dissertation by Mr Mugur Isărescu, Governor of the National Bank of Romania, on the
occasion of being admitted to the Reial Acadèmia de Doctors, Barcelona, 24 November
2009.
* * *
Introduction
The issue of the financing-adjustment relation can be best described starting from the
corporate level. Here, an adjustment programme may attract financing only if the envisaged
changes are trustworthy. Corporations may raise the funds necessary to fulfil the new goals
via capital increases made by owners, via taking out new bank loans or selling newly-issued
corporate bonds to the public.
At macroeconomic level things are much the same, but instead of a company's balance
sheet, we speak about a country's balance of payments with its two accounts, i.e. the capital
account and the current account. These accounts register the continuous changes reflecting
the country's foreign transactions. The direction of such changes may differ from one year to
another. For this reason, not any change in the equilibrium of the two accounts may be
defined as an adjustment. In order to describe an adjustment in the balance of payments, the
key concepts are the improvement or the worsening in the balance of either account.
The improvement concept may apply, separately, both to the current account and the capital
account. According to economic literature, a reversal in the current account occurs if, at the
same time, the change in the balance is large relative to nominal gross domestic product
(GDP) and lasts for more than one year (Milesi-Ferretti and Razin, 2000). Thus, an
improvement in the current account occurs if, for several years, the current account deficit
narrows significantly both in relative and absolute terms. An improvement in the capital
account is indicative of substantial capital inflows. Since massive capital inflows are also
associated with troubles, including a sizeable appreciation of the exchange rate, an
improvement in the capital account is also referred to as "the capital inflows problem" (Calvo,
Leiderman, Reinhart, 1993).
Conversely, a worsening of the current account is reflected by the twin deficits or by relatively
wide deficits. Furthermore, a worsening of the capital account reflects the sudden stop in
capital inflows, or even net outflows of capital. A sudden stop is defined as a sufficiently large
reversal in capital inflows compared to the average for the previous years, accompanied by a
noticeable upsurge in capital cost (Calvo, Izquierdo and Mejia, 2004, and Calvo, Izquierdo
and Loo-Kung, 2006).
The difference between quasi-individual adjustments and global adjustments in the balance
of payments is useful in drafting economic policies. Quasi-individual adjustments emerge in
cases where, due to specific conditions, one country alone faces relatively heavy capital
inflows over a certain period, followed by a decrease in such inflows. Global adjustments are
characterised by synchronous, large capital inflows in a great number of countries, followed
by their relative reduction for the entire group. Usually, the number of countries facing large
capital inflows simultaneously is relatively small. However, from time to time, simultaneous
episodes of massive capital inflows occur in a relatively great deal of countries. Over the past
few years, very many countries, Romania included, were faced with the capital inflows
problem. For this reason, I will refer to synchronous, large capital inflows.
As recently pointed out by Reinhart and Reinhart (2008), there may be a relationship
between these synchronous, large capital inflows and external sovereign defaults, currency
crashes, inflation crises and banking crises. The authors defined the crises for each of the
above-mentioned components and constructed specific probabilities of crisis emergence for
the 1960-2007 period in 66 countries. The probabilities were defined both conditional and
unconditional on the episodes of heavy capital inflows. The final outcome is that, for low- or
middle-income countries, the conditional probabilities for a crisis to emerge are significantly
higher than unconditional ones.
In other words, the number of crises is higher around the episodes of large capital inflows.
One may conclude, in practice, the ensuing magnitude of adjustments and financings is
different from that seen in quasi-individual episodes of substantial capital inflows for a given
period, followed by their reduction. This owes to the fact that, if synchronised crises occur in
any of the cited components - sovereign debt, exchange rate, inflation and banking system -
synchronised recession episodes are likely to follow. Certainly, simultaneous resorting to
external financing with a view to underpinning a great many anti-crisis programmes makes
the resources to each country relatively less available and costlier than in the case where
only a small number of countries use a given amount of resources. In addition, synchronised
recession episodes could translate into greater individual recessions for the economies in
which the export-oriented sector holds a sizeable share in GDP.
Against this background, the difficulty in adopting a package of reforms and in securing
external funding is bigger in the context of the quasi-singular episodes when a large capital
inflow cycle ends. Romania took this into account at the time of asking for financial
assistance from the EU, the IMF and other international financial institutions to cover the
financing gap estimated for 2009 and 2010. I will get back to this topic in the concluding
section of the paper.
The modern age of global finance saw several episodes of such synchronous, heavy capital
inflows. In principle, once in a while, foreign investors find enough reasons to invest relatively
large amounts of capital in emerging economies. Considering the time period that elapsed
after World War I, one may assert that the pattern failed to repeat itself in the '30s, the '40s
and the '50s.
The longest cycle of synchronous, massive capital inflows lasted from 1975 to 1982 and was
followed by the debt crisis. The heavy capital inflows resurfaced during the 1990-1993
period and were followed by debt restructuring in the emerging economies. Starting in 2002,
a large number of countries were faced with massive capital inflows. The end of the capital
flow bonanza overlapped the onset of the financial turmoil in July 2007. In Romania, this
episode became more manifest in 2004 and came to an end in 2008.
Next, I will elaborate on the causes generating synchronous, massive capital inflows in a
relatively great number of countries and the key developments emerging when the countries
are faced with heavy capital inflows. In so doing, I will show the stylised facts, as they can be
elicited from literature (Calvo et al., 1993). Then I will describe the case of Romania and the
major challenges to economic policies. Finally, I will resort to the results described in the
literature to present in a stylised manner the implications on some macroeconomic variables
in the event of a capital account worsening. I will draw on these results to show that the
provisions under the arrangement signed with the EU and the IMF are in line with the results
described in the literature.
1. Causes and effects of massive capital inflows
In recent years, one of the causes of massive capital inflows in emerging economies was
excess liquidity. The liquidity surplus in developed economies caused the persistence of low
interest rates and the reduction in volatility on financial markets. Moreover, despite excess
liquidity, economic growth in advanced countries slowed down in recent years, the
profitability in several industries dropping to relatively low levels.
In this context, investors started the search for yield and profit opportunities in emerging
economies. In such cases, interest rates acted via the portfolio channel (Calvo, Leiderman
and Reinhart, 1993). In addition, low interest rates and portfolio diversification led to the
improvement in debt default probabilities in emerging countries, implying the activation of the
channel suggested by Dooley et al. (1996). Gradually, investors were no longer wary of
emerging economies so that large capital inflows were further recorded for several years.
Reinhart and Reinhart (2008) showed that, during 1980-2008, the maximum period of
massive capital inflows in 181 countries was of 3 years for more than 50 countries and
4 years for more than 30 countries. Nevertheless, in almost 20 countries that period lasted
5 years.
This does not necessarily imply that large capital inflows were recorded solely by emerging
economies. They were relatively large in low-income countries, as well as in middle- and
high-income countries, OECD members. For instance, capital inflows were relatively high in
the US (2002-2007), in the United Kingdom and France (2005-2007), in Spain (2004-2007).
In Romania, large capital inflows were recorded during 2004-2008.
The favourable economic outlook associated with the accession to an economic union was
another major cause for synchronous capital inflows in several countries. It is the case of
countries joining the European Union or NAFTA. Foreign investors acted on the assumption
that the accession to a union is an anchor limiting exchange rate fluctuations, cutting capital
costs by lowering risk spreads and maintaining share prices at satisfactory levels.
MilesiFerretti and Lane (2006) provided a breakdown of sources of massive capital inflows in
Central and Eastern European (CEE) countries. The euro area countries provided
73-95 percent of total foreign direct investment in CEE countries. In 2004, in most CEE
countries, more than 50 percent of total portfolio investment on the stock exchange came
from the euro area, which was also the main source of foreign assets in the banking systems
of CEE countries as well as of debt-creating long-term investment.
The rise in prices of goods such as crude oil, copper, diamonds, a. o. ("hard" commodities)
fostered capital inflows in countries exporting the aforementioned goods. Where capital
inflows in countries exporting such commodities are due to low or negative real interest rates
in the countries of origin of capital, then the prices for such goods come under the impact of
the interest rate channel (Frankel, 2006). Nevertheless, the empirical assessments of
Reinhart and Reinhart (2008) covering the 1967-2006 period do not clearly confirm the
reverse correlation between real interest rates and the prices for the above-mentioned
commodities.
Large capital inflows had similar effects in emerging economies. A stylised assumption refers
to a common pattern for developments in some variables and a relatively similar response
model of economic policies. Hence, relatively large capital flows entered rather small and
shallow markets. The discrepancy between the financial depth of emerging economies and
the volume of capital inflows led to currency appreciation, fast growth of asset prices and the
rise in prices for "hard" commodities. The favourable price changes entailed further increases
in capital inflows, which caused these growth rates to continue for relatively long periods.
Favourable price developments led to the improvement in fiscal indicators and the reduction
in the cost of foreign currency credit, thus fostering lending. The fast expansion of lending
caused the widening of the structural weaknesses of the banking system, which became
dependent on foreign capital inflows.
In terms of policies, the authorities' response focused on several common areas, such as
reserve purchase in order to prevent excessive appreciation. This process was more visible
in the countries exporting energy resources. Another area, closely linked to the first one,
envisaged the rise in required reserves, the levying of taxes on financial transactions, other
administrative restrictions in order to alleviate capital inflows and reserve accumulation.
Moreover, favourable price developments dampened the real need for structural
adjustments, which were postponed. This was probably the most important implication for the
respective economies since, in the long run, the delay in structural adjustments has a
negative impact on external competitiveness.
2. Developments after the end of large capital inflow episodes - stylised facts
It goes without saying that each country has its own particular features and this is why each
current account reversal, each episode of massive capital inflows, each sudden stop in
capital inflows and each financial crisis has particular features. However, they do have some
things in common, irrespective of the country or the period of occurrence. We show particular
interest in such common features in terms of the dynamics of selected indicators, such as
GDP, real exchange rate, inflation and current account both before and after the end of an
episode of large capital inflows. Certain patterns relating to the dynamics of the
aforementioned indicators can be identified based on the results described in the literature,
the latest ones belonging to Reinhart and Reinhart (2008). Since the pattern of these
dynamics during the episode of heavy capital inflows has been described both in general and
in the particular case of Romania, the focus will be on a matter of utmost interest these days,
namely the likely trajectory of the abovementioned indicators after the cycle of large capital
inflows ends. Following the methodology of various other works, Figure I sets out the
developments in current account, GDP, exchange rate and inflation in a stylised manner four
years ahead and four years after the end of the episode of large capital inflows.
Chart 1 in Figure I depicts the evolution of the current account deficit prior to the end of the
episode of sizeable capital inflows ("0" on the horizontal axis). This depiction reflects the
identity typical of the balance of payments, namely that the current account deteriorates
during the episode of massive capital inflows. At the same time, the end of the episode of
heavy capital inflows overlaps the initiation of current account adjustment towards levels
seen in the run-up to the reversal. The V-shaped pattern of current account developments is
sharper in low- and middle-income countries (Reinhart and Reinhart, 2008).
In line with expectations, real GDP growth is relatively high during a capital flow bonanza and
is followed by a sudden drop in the year when the episode ends and a relatively fast recovery
thereafter. In other words, subsequent to the end of the cycle of heavy capital inflows, the
GDP trajectory is V-shaped, as illustrated in Chart 2, Figure I.
The attempt at identifying a pattern on how inflation fared was the most difficult, because the
data presented in the literature vary to a great extent, which could be an indication of the
major role played by monetary policy both before and after the large capital inflows. I tend to
believe that the end of the cycle of heavy capital inflows is followed by a short-term bout of
inflation (basically on account of the exchange rate channel), while the subsequent decline in
inflation is triggered by the recession and the downbeat expectations that are typical of the
periods following capital flow bonanzas. This view may be explained by a relatively large
nominal depreciation. However, over the following years, inflation reverts to levels more or
less similar to those seen prior to the stop in the heavy capital inflow episode. The stylised
profile is depicted in Chart 3, Figure I.
Chart 4, Figure I sets out the stylised trajectory of the exchange rate. If massive capital
inflows span over several years, the real appreciation on an annual basis tends to be
significant, so that the cumulated appreciation is also significant, leading to the downward
path in the chart. Nevertheless, the end of the episode of large capital inflows results in a
cumulated real depreciation even higher than the cumulated appreciation. The literature
shows that in most cases real depreciation becomes manifest via a nominal depreciation of
the currency. In the stylised trajectory shown in Chart 4, Figure I, real depreciation is driven
by the drop in prices no earlier than the first year after the end of the episode.
Figure I
2. Real GDP
1. Current account deficit
(annual change)
(% in GDP)
percent
percent
No. of years No. of years No. of years No. of years
before LCI after LCI before LCI after LCI
-4 -3 -2 -1 0 1 2 3 4 -4 -3 -2 -1 0 1 2 3 4
4. Real exchange rate
3. Inflation rate
(annual change)
(Dec./Dec.)
percent percent
appreciation
depreciation
No. of years No. of years No. of years No. of years
before LCI after LCI before LCI after LCI
-4 -3 -2 -1 0 1 2 3 4 -4 -3 -2 -1 0 1 2 3 4
LCI: large capital inflows
Source: Stylised facts based on the results shown in the professional literature.
For the most recent empirical assessments, I resorted to Reinhart and Reinhart
Charts 1-4 in Figure I allow an overall view of what can be expected in terms of the
developments in the aforementioned indicators after the episode of large capital inflows
comes to an end. They are an indication of which curve profile cannot be precluded by a
country after an episode of large capital inflows draws to an end. However, while the curve
profiles are similar for most countries, the curve slopes both before and after the end of an
episode of large capital inflows may be sharper or less sharp. It is up to policy-makers to
draft policy measures during such an episode in order to influence both the level where a
U-turn occurs and the slopes following the end of an episode of sizeable capital inflows. I will
show in the following section that the policies envisaged by the arrangement Romania signed
with the EU and the IMF are aimed at smoothing out the slope of the trends of the
abovementioned indicators so that the necessary adjustments unwind at a reasonable pace,
without destabilising the economy.
3. Case study - Romania
3.1. The period of massive capital inflows
Foreign capital inflows in Romania have picked up since 2004. The current account deficit
widened from 8.4 percent of GDP in 2004 to 13.5 percent of GDP in 2007 and to
12.3 percent of GDP in 2008. The medium- and long-term external debt of the private sector
posted an almost twofold increase (Chart 1), from 12.9 percent of GDP in 2004 to
25.6 percent of GDP in 2008.
Chart 1
Total External Debt
MLT External Debt
percent of GDP
percent of GDP
60 60
ST debt
public and publicly
55 55
(majority private debt)
guaranteed debt
50 50
private debt
MLT debt
16.2
45 45
40 40
16.0
deposits of non-residents
12.8
7.9
35 35
7.8
5.3
30 30
8.2
25 25
14.1 10.9
16.5
20 20
37.4
25.6
31.3
30.9
30.0
15 29.3 15
20.4
17.4 10
15.6
12.9
4.0
2.6
1.2
0.6 1.0
1050
50
2004 2005 2006 2007 2008 2004 2005 2006 2007 2008
Source: National Bank of Romania, Ministry of Public Finance,
National Institute of Statistics
In 2004, the Romanian economy had little financial depth (measured as a ratio of M3 to
GDP) of only 25.6 percent. The financial depth increased on the back of massive capital
inflows, yet it remains relatively low by advanced economy standards (34.5 percent of GDP
in 2008). Given the relatively little financial depth, the effects of capital inflows emerged fast
and were significant (Chart 2).
Chart 2
Monetisation of economy*
percent
40
35.9
34.5
35 32.2
29.9
30
25.6
25
20
15
10
5
0
2004 2005 2006 2007 2008
* M3/GDP
Source: National Bank of Romania, National Institute of Statistics
The exchange rate appreciated in both real and nominal terms. The domestic currency
appreciated in nominal terms from nearly RON/EUR 4.1 in January 2004 to RON/EUR 3.1 in
July 2007 (about 24 percent). Along with the relatively high fiscal dominance and the net
debtor position of the National Bank of Romania (NBR), heavy capital inflows became a
serious matter of concern in terms of implementing inflation targeting, i.e. the new monetary
policy strategy adopted in August 2005. While boosting disinflation, the domestic currency
appreciation was so strong that it tended to affect the external competitiveness of Romania.
To this added the episodes of high volatility on the foreign exchange market.
As in other CEE countries, foreign banks operating in Romania took funds from their euro
area parent-banks. In 2004, nearly 72 percent of liabilities came from the euro area and
21 percent from the United Kingdom. During 2004-2008, foreign liabilities of the banks in
Romania increased more than six times, from EUR 3.8 billion to EUR 24.5 billion. Such rises
were reported across the entire maturity spectrum.
The surge in banks' foreign currency holdings and the appreciation of the domestic currency
acted jointly towards boosting lending in foreign currency. Loans expanded for several
successive years at annual growth rates ranging from 60 percent to 80 percent in real terms.
The share of foreign currency-denominated loans to households grew more than five times,
from 2.2 percent of GDP in December 2004 to 11.6 percent of GDP in 2008. Moreover, the
share of foreign currency-denominated loans to the corporate sector picked up substantially
(Chart 3). Overall, financial intermediation (loans to the private sector/GDP) increased from
16.6 percent in 2004 to 39.3 percent in 2008 (Chart 4).
Chart 3
Breakdown of foreign currency-denominated loans granted
by financial institutions
percent of GDP
14
loans to households
11.6
12
10.6
loans to non-financial corporations
9.8
9.2
10
7.5
8 7.1 7.1
6
4.7
3.3
4
2.2
2
0
2004 2005 2006 2007 2008
Source: National Bank of Romania
Chart 4
Breakdown of loans to the private sector
percent of GDP
45
39.3
loans to non-financial corporations a.o.
40
35.9
loans to households
35
foreign-currency-denominated loans
19.6
30 lei-denominated loans
26.8
22.7
18.6
19.5
25
20.7
12.7
20
16.6
15.4
11.3
15
13.3
10.2
11.8
19.7
10
17.3
16.6
16.4
14.1
11.4
9.4
5
7.4
6.3
4.8
0
2004 2005 2006 2007 2008
Source: National Bank of Romania, National Institute of Statistics
Chart 5
Government credit
percent of GDP
4.0
3.4
3.5
3.0
2.3
2.5
2.0
1.5 1.2
1.1
1.0
1.0
0.5
0.0
2004 2005 2006 2007 2008
Source: National Bank of Romania, National Institute of Statistics
Banks came to rely heavily on external financing, while the mismatch between foreign
currency-denominated assets and forex liabilities of both companies and households
widened. In 2004, the difference between forex-denominated deposits and loans in the
corporate sector stood at around lei -5 billion, increasing sevenfold by March 2009, i.e.
lei -34 billion. As for households, the differences stood at lei +5 billion and lei -28 billion
respectively (Chart 6). These imbalances stand out as one of the most serious vulnerabilities
faced by the domestic economy, as they are the main channels whereby the potential halt in
external financing feeds through into exchange rate depreciation.
Chart 6
Deposits and loans in foreign currency
non-financial corporations
households
lei billion lei billion
40
30
20
10
0
-10
-20
-30
-40
deposits in foreign currency
deposits in foreign currency
-50
loans in foreign currency
loans in foreign currency
-60
net position
net position
-70
2004 2005 2006 2007 2008
2004 2005 2006 2007 2008
Source: National Bank of Romania
These developments reinforced each other, so that during 2005-2007 there were periods
when inflation expectations coexisted with a markedly stronger domestic currency. Under the
circumstances, the central bank was faced with a serious dilemma in terms of the
newlyadopted monetary policy regime. Policy rate hikes, required for bringing expectations in line
with the inflation target, attracted further foreign capital, which entailed the appreciation of the
leu.
Along with policy rate changes given the coexistence of upward pressures on the domestic
currency and inflationary pressures, the central bank also increased required reserves in
order to dampen capital inflows. Required reserves for foreign currency-denominated
liabilities were gradually raised from 20 percent at the onset of 2002 to 40 percent in early
2006 (Chart 7). The measure failed to deter capital inflows, which managed to find ways of
circumventing the restriction. Despite higher required reserves, commercial banks'
foreigncurrency-denominated liabilities advanced EUR 4.8 billion in 2006, then EUR 7.8 billion in
2007 and a further EUR 5.8 billion in 2008. Nearly 75 percent of the increase in foreign
banks' liabilities during 2005-2008 occurred after required reserves had been raised to
40 percent.
Chart 7
Required reserve ratio
percent percent
42 42
40 40
38 38
36 36
34 34
32 32
foreign currency
30 30
28 28
domestic currency
26 26
24 24
22 22
20 20
18 18
16 16
14 14
Dec.04 Apr.05 Dec.05 Apr.06 Dec.06 Apr.07 Dec.07 Apr.08 Dec.08
Aug.05 Aug.06 Aug.07 Aug.08
Source: National Bank of Romania
The constraint deriving from the large capital inflows was severe enough for the NBR to opt
for maintaining a managed float regime of the domestic currency. This led to criticism by
some analysts who claimed that the inflation targeting strategy adopted in 2005 involved the
free float of the domestic currency in order to avoid potentially conflicting targets. The NBR
explained that it would not target a particular exchange rate, but rather seek to deter its
movements towards unsustainable levels. Consequently, during 2005-2008 the NBR did not
refrain from making discreet forex market interventions by purchasing considerable amounts
of foreign currency so as to preclude the fast overappreciation of the leu, which was likely to
cause a dangerous erosion of the Romanian economy's external competitiveness and to
lead to a fall in inflation, yet in an unsustainable manner.
At this juncture, I should bring to the fore other arguments in favour of a managed float policy
for the Romanian currency. The major reason underlying the NBR's purchases of foreign
currency consisted in the fact that the leu strengthened in both nominal and real terms,
concurrently with an extremely loose wage policy in 2006 and especially in 2007. During
those years, pay rises overtook productivity gains, thus reducing the previously accumulated
competitiveness gains and contributing definitely to the worsening of the balance of
payments current account.
Another argument I would like to point out is of a precautionary nature. As it has been
noticed in practice, the end of cycles of synchronous large capital inflows coincide with
somewhat abrupt depreciation episodes, which can be avoided provided sufficient reserves
are available.
The pro-cyclical conduct of fiscal policy that added to the vulnerabilities associated with the
widening of the current account deficit during 2004-2008 also underpinned the NBR's
purchases of foreign currency. In principle, fiscal policy may either cushion or magnify the
undesired effects of large capital inflows. Such effects are intensified because the cyclical
components of GDP, large net capital inflows and higher budget outlays in real terms boost
one another. From this perspective, but also judging by the fact that large capital inflows are
associated with financial crises, Romania opted for an imprudent fiscal policy during
2004-2008. There were two reasons for this and both are fully explained in the literature.
The first reason was that policymakers believed "good times" would be permanent, which
obviously meant that the spending spree could last forever. The second reason relates to
2008 being an election year, which pushed up budget expenditures further. The loose fiscal
policy laid the groundwork for an involuntary fiscal contraction in the event of an economic
downturn.
Next, I will now focus on the pattern displayed by developments in certain indicators once the
episode of large capital inflows has ended.
3.2. Macroeconomic adjustment following the end of large capital inflow episodes
The slope curve, which illustrates adjustments, relies directly on foreign investors'
expectations and decisions relative to macroeconomic and structural policies. In 2008, the
global financial crisis induced a general lack of trust and fuelled markedly investor aversion
to risk. Romania has become a risky destination for investors due to the size of its current
account deficit, banks' hinging on external financing, the relatively large foreign borrowing
requirements and the high ratio of foreign currency-denominated loans to foreign
currencydenominated deposits. Estimations showed that Romania's deficit financing for 2009 could
have ranged between EUR 7.5 billion and EUR 16 billion, dependent upon foreign investors'
sentiment and their willingness to roll over the credit lines extended to banks and private
companies. This gloomy sentiment was reflected in the weakening of the leu during October
2008 - February 2009. In this context, the authorities have decided to implement policies
aimed at ensuring minimum cuts in Romania's foreign financing.
As early as December 2008, the economic programme was envisaged to focus on narrowing
the external deficit of both public and private sectors, containing the impact of recession,
averting a currency crisis as well as on easing inflationary pressures. Attaining these
objectives required the design of adjustment measures meant to bring the economy onto a
sustainable path with minimal losses, including in terms of employment.
Given the sudden stop of the massive capital inflow episode, the leu's exchange rate
developments posed serious challenges. While in the past foreign currency inflows
generated the overappreciation of the leu well above the level indicated by exchange rate
fundamentals, the reduction in external financing and the degree of uncertainty tended to
result in the unwarranted depreciation of the leu.
The challenges were all the more so great that, despite the heavy foreign currency
purchases performed during 2005-2007, the NBR only managed to contain the
unsustainable appreciation of the leu, instead of completely avoiding it. Moreover,
foreign-currency-denominated loans (Chart 6) posted a fast-paced growth and any rapid and
excessive depreciation of the domestic currency would have generated negative chain
reactions across the banking system. Hence, the central bank's policy on forex market
intervention was further steered in this new environment by the philosophy that a high
volatility of the exchange rate is detrimental to the inflation target as well as to the financial
soundness of the real and financial sectors. A small emerging economy with a significant
openness is exposed on an ongoing basis to the threat of capital movements likely to
adversely affect the stability of the financial market, the foreign exchange market in
particular.
Firstly, the NBR's interventions in the foreign exchange market were meant to avoid an
excessive weakening of the domestic currency, while also linking the level and the pace of
the depreciation to the progress in the current account adjustment. With this goal in mind, the
central bank monitored the developments in the real effective exchange rate of the domestic
currency, along with the pressures on external competitiveness stemming from wage
bargaining.
Secondly, foreign exchange market interventions were calibrated in line with developments in
foreign currency reserves. The foreign currency reserves resulting from market interventions
during the overappreciation period, to which added the funds received under the financing
arrangement concluded with the IMF, the EU and other international financial institutions,
enabled the central bank to support the domestic currency; despite these interventions,
official reserves stood constantly at safety level. The central bank monitors not only the
absolute value of forex reserves, but also the derived indicators: foreign currency reserves
expressed in months of imports of goods and services and the ratio of forex reserves to
short-term debt remained unchanged or improved (Chart 8).
Chart 8
Foreign exchange reserves with the NBR: derived indicators
months times
10 10
official foreign exchange reserves - months of
goodsand-services imports
official foreign exchange reserves/ST external debt
8 8
(right-side scale)
6 6
4 4
2 2
0 0
Jan.05 Jul.05 Jan.06 Jul.06 Jan.07 Jul.07 Jan.08 Jul.08 Jan.09 Jul.09
Source: National Bank of Romania, National Institute of Statistics
Thirdly, the magnitude and the timing of forex market interventions were also related to
money market liquidity management, given that public deficit was financed, over certain
periods, by resorting chiefly to the