Struggling to reduce large imbalances
Overview:
The countries of SEE (EU) operate a number of different exchange rate regimes and yet are all struggling to eliminate significant macroeconomic imbalances. Slovenia has adopted the Euro, Bulgaria has a Currency Board Arrangment (CBA), Croatia operates a managed exchange rate regime and Romania pursues Inflation Targeting (IT) but all are suffering from both rising inflation and large current account imbalances. The first three countries have fixed/ super-fixed exchange rate regimes. They therefore have no ability to set interest rates and must address these challenges through fiscal adjustment and administrative measures to rein in credit growth. Romania, by contrast, has it key interest rate as an additional policy tool to manage aggregate demand. However, in all cases it would seem that tighter policy is needed to avoid potentially disorderly adjustments in asset prices.
SEE (EU) recommendations:
We are neutral on local currency and external debt in Bulgaria, Croatia and Slovenia. Yields are low, and while disorderly exchange rate moves are unlikely in the first two cases and impossible for the latter in the face of large macroeconomic imbalances bursting of bubbles elsewhere (e.g. house prices) and associated sharp decelerations in growth cannot be ruled out. Indeed, these are already being played out in the Baltic States where fixed/super-fixed exhange rate arrangements are also in place. We are neutral on Romanian local currency interest rates and underweight on external debt. The central bank will need to hike rates further to moderate domestic demand but this will only likely compensate for potential currency weakness given poor fundamentals. Political risks are likely to increase yet further ahead of November parliamentary elections, creating doubts about the likelihood of necessary fiscal adjustment.