The Curious Case of the Romanian Yield Curve
The single biggest evidence in favour of a recession looming on the horizon, which is on the lips of every single pundit in advanced economies at present, is an atypical relationship between the yields of government bonds of different maturities, called the inversion of the curve. Short term government borrowing has become more expensive than long term government borrowing, which goes against basic tenets of economic theory such as time preference. This atypical relationship between long term and short term maturities is thought to predict a recession, because the only reason why borrowing would become more expensive in the short run than in the long run seems to be a flight on the part of creditors to safe, highly liquid and easy to exchange assets, which pushes up demand for the near-end of the curve, and a pessimistic growth outlook for the future, which pushes down demand for the far end of the curve. In the United States, the model-economy in this regard, the inversion of the curve has so far predicted every recession in the last decades.
However, Romania is not an advanced economy. For one thing, according to the World Bank’s peculiar calculations, named the “Atlas method”, in 2018 the country was slightly below the level of USD 12,376 in GNI per capita, which marks the lower bound of high income status. For another, more important reason (because some emerging countries currently exhibit the same inverted yield curve as some advanced economies), the Romanian yield curve has not yet inverted. The spread between 10-year and 2-year Romanian Government Bonds stands at 70.5 bps as of August 18th, which, in the economists’ jargon, means that the Romanian yield curve exhibits normal convexity. Nevertheless, during the last month, the yield on the 10-year bond fell by 64 bps and for the last six months by 80 bps, while the yield on the 2-year bond fell by 52.2 bps and 23.5 bps respectively. The ratings on Romanian Government debt (BBB-/S&P) have not changed during this time span, in fact there have been speculations about a downgrade due to the Government’s litmus deficits geared primarily towards non-discretionary spending such as public wages and pensions; so the idea that Romanian debt got so much cheaper in such a short period of time due to a huge burst of confidence in the Romanian Government on the part of credit markets should be approached with caution. The recent flattening of the Romanian yield curve is clearly intertwined, to some extent, with the global phenomenon, particularly in advanced economies, that has led in some places to the inversion of the yield curve.
The Romanian economy is highly integrated with the European Union’s common market, the Eurozone and the world economy. Trade, or the sum of exports and imports, last year averaged 86% of the country’s GDP, according to World Bank statistics, which is the European Union’s average as a whole, but above the world average of 58%, the OECD average of 57% or the high income group of countries 62% average. Due to its integration in European supply chains and high degree of trade openness, adverse shocks to trade worldwide, such as new Trump tariffs and a no-deal Brexit, will reverberate within the Romanian economy as well. Germany is by far the largest export destination for Romania, followed by Italy and France, which are trailed in third position by the United Kingdom and Hungary. A stall in growth in these countries, as already is the case with Germany, will therefore no doubt negatively impact the country as well.
All this being said, interpreting the fall in the Romanian bond yields is made more complicated, compared to the situation in advanced economies, which is not clear cut either, by the outbound quest for yield that the superabundance of easy credit and low, even negative, real interest rates in those countries has generated over the last few years. In other words, how much of the fall in the Romanian yield curve is actually due to pessimism about the prospects of the Romanian economy and how much is due to pessimism regarding the economic prospects of the advanced countries from which the money is flowing in its quest for a higher return?
The data available on the Romanian yield curve unfortunately only goes back reliably as far as 2007[1]. Nevertheless, the curve did invert once, in 2008 and in 2009, in line with the predictive power it is generally presumed to possess regarding recessions. However, back then, this inversion of the Romanian yield curve manifested itself through an increase in risk premia over the whole range of the curve’s maturities as well as an increase in the spread between the short and long maturities. Thus, in 2007, the earliest date for which data is available, the 10-year Romanian bond yield hovered close to 7%, then jumped to 9.5% at the end of 2008 and stayed there for most of 2009, only to recover to its pre-recession level in 2012, while the 2-year Romanian bond hovered around 6.5% in 2007, then jumped to almost 10% in 2008 and 10.5 in 2009, from where it fell back to 6.5% by 2012. Now, however, Romanian yields are decreasing over the entire range of maturities, with a slight bias for the long end of the curve, as if the country risk premia have all but disappeared.
The Romanian yield curve, as already mentioned, only goes back reliably to 2007. Nevertheless, it seems a little bit of a stretch to think that the halving of the pre-recession bond interest rate over the last 7 years is entirely due to improvements in the confidence that investors have in the Romanian Government and is completely independent of the abundant liquidity and squeezed yields investors encounter in advanced economies due to large and prolonged quantitative easing programs, which are, in turn, supposed to be the result of a world savings glut and a corollary fall in the Wicksellian neutral rate of interest. The lowest ever 10-year yield on Romanian bonds was registered in February 2015, only 2.66% - the year a policy of monetary tightening and desire for interest rates “normalisation” was signalled in earnest by the central banks of the major advanced economies, the US Federal Reserve in particular, after the botched “taper-tantrum” of 2013. That year, Romania’s GDP grew by 3.9%, one of the highest rates in Europe, in sharp contrast to countries like Greece, and paid off its 2010 IMF loan. Clearly, in the case of Romania, the 2010 austerity kind of paid off. High risk premia on government debt became a thing of the past. But was Romania’s macroeconomic governance so radically improved in the aftermath to warrant a 3 pp cut in its borrowing costs?
There are only two answers to this question: the Romanian Government either rides on a wave of cheap credit and abundant liquidity created by the negative interest rates environment in the advanced economies, with an accompanying shortage of high quality bonds due to central banks’ buyouts, which will backfire when monetary conditions eventually begin to tighten, or the country really has graduated from a little known and uncertain debtor to become a credible and responsible international borrower. As of this moment, it is still too early to give a definitive answer. As to the Romanian yield curve, its flattening is indeed worrisome, particularly when analysed in the context of Romania’s convoluted exposure to the trade and production linkages of partners such as Germany, which find themselves at the very centre of the new trade wars unleashed by US President Donald Trump. It is less worrisome when analysed with regard to the current state of the Romanian economy, since a deceleration in the GDP growth rate from the 7% peak reached in 2017 to a more sustainable 4% was widely expected, despite the Government’s obstinate prognosis of 5.5% GDP growth.
Note:
[1] Cornelia Pop, Maria-Andrada Georgescu, Iustin Anastasiu Pop, “Romanian Government Bond Market”, Theoretical and Applied Economics, Volume XIX (2012), No. 12(577), pp. 73-98.
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