Therefore I ask myself this very simple question: is Inflation Targeting the rightregime for Romania?
I am a strong supporter of this regime as I find it superior to the income targeting one but it is an inferior one to the price level targeting regime. But in my view is not working for Romania. Especially for the structure of the economy as we have it today.
Theis a euroized economy. It means that while people, corporate and government have their income – the asset side of their balance sheet –in RON their debts –the liabilities part- is in majority denominated in euro. The concept was developed for the Latin American and which went through a similar process. One could say that this is an emerging markets’ “disease”.
Unfortunately, Inflation Targeting in this type of an economy is suboptimal or to put it bluntly useless. This has been recognized by the NBR which is now trying, but very timidly, to de-euroize the economy by making it more difficult for households to borrow in EURO. I will tell you now that it will not work. As long as RON is perceived as the riskier currency agents will find ways to borrow/save in a much safer currency. Furthermore, as long as there is no real risk of depreciation this “campaign” to de-euroize the economy will be in vain.
To be fair the NBR recognized this problem and it has de facto abandoned inflation targeting in October 2008. It has just not communicated it yet to the markets thus creating lots of confusion and uncertainty. As I showed before here the NBR uses M1 to keep the stable. This is indeed one of the solutions recommended for a euroized economy. There is a whole body of research showing that once you allowed your economy to be dominated by another currency it is beneficial to keep the exchange rate from depreciating. Depreciation for an economy with almost all liabilities denominated in a will have real costs for economic growth. But the problem with this solution is that it makes monetary policy useless to the rest of the economy via the interest rate channel. In fact it cancels monetary policy all together.
However, this is only a short term solution. In the long run policy makers have to decide:
- they fully euroize the economy and peg the exchange rate (similar to what we have today)
- de facto adopt the foreign currency (like Ecuador or Montenegro)
- or be fully committed to de-euroizing the economy and stick to Inflation Targeting
The first two solutions require giving up your monetary policy while the third requires a fully flexible exchange rate while enforcing a monetary policy regime. Furthermore, research and history has shown that aregime is superior to a fixed one. But there is a catch: not for euroized/dollarized economies.
Considering all this, NBR has to make a choice and communicate it clearly to the market. So far it has claimed to follow an inflation targeting regime but it has acted almost like in a, going as far as communicating the comfortable level for exchange rate volatility.
What NBR should not do is to continue like this going forward. It cannot attempt to de-euroize the economy while keeping the exchange rate fixed. It will not work. It will further confuse the markets. And it will draw resources from the economy into this area as agents will try to overcome this hurdle in order to keep borrowing in a foreign currency
As I see it things are very simple. If the NBR wants monetary policy to work then it needs to allow the currency to float freely. Otherwise it should just peg the RON to the EUR or just adopt. It cannot have it both ways. The current situation creates uncertainty and unnecessary costs for the entire Romanian economy. Even more, in the current set up monetary policy cannot be used in the short term to help economic growth during recessions or stop irrational exuberance during booms.