In my last post I was arguing mostly from a theoretical point of view that Inflation Targeting has failed in Romania. To be fair it was never been given a fair chance. Two years into implementing the regime the NBR decided not target inflation but the exchange rate . One perverse result from this in an economy with historically high inflation and no growth is dominance of local currency by ones from countries with economic growth and low inflation. In other words the central bank has implicitly subsidized the dominance of EUR by undermining RON.
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This dominance can easily be seen in the preferred currency for domestic transactions. In fact if the Romanian government will allow taxes to be paid in other currencies than RON will cease to exist.
As I showed here NBR responds more to the exchange rate than does to the inflation rate. It does so by intervening in the FX market by buying RON and selling EUR. When the NBR buys RON it lowers the M1 measure of money. The graph below show the almost perfect correlation of M1 and the exchange rate EURRON. A fall in M1 is correlated to a fall in the exchange rate which means RON appreciation.
There are real negative implications for the economy in the short term which I covered before from such a policy especially if interventions are not sterilized. But today how the economy has responded to this new regime. You will see that it has led to a substitution of RON with EUR in almost all transactions. The only function left for RON is that of a legal tender, i.e. we use it to pay taxes.
The first question marks show up when we look at a measure of money multiplier (m3/m1) compared to private sector credit(it includes credit in EUR and RON). As money multiplier falls private sector credit increases. Pretty odd I would say.
The mystery is half solved if we look at what the corporate sector prefers as the borrowing currency. As you can see until 2008 the corporate sector was keeping the balance between RON and EUR borrowing. However, after the NBR made it clear that it targets the exchange rate, October 2008, the corporate sector has moved to borrowing almost exclusively in EUR. We see some signs of life for the RON credit market in 2011 but I suspect is very much connected to short term borrowing for working capital.
However, the demise of RON is nowhere more obvious than when we look at the credit market for households. We observe a similar pattern as in the corporate sector until 2008. Afterwards the effect is more dramatic. Once the population has learned that the central bank will not allow the currency to depreciate , it borrowed exclusively EUR. The decrease in the RON stock for credit might mean that some debts in RON were payback, unlikely, or that some switched their RON credit to EUR. There is no sign of reversal like in the corporate sector which means that for the population RON is just a currency they are forced to carry but in which they do not have any faith.
What are the implications from all of this?
It is always hard to guess what is in the mind of a central bank – objective function. Does it care about inflation or growth? Does it care about both and if yes does it care about them equally? Does it care about the political cycle?
The central banks all over the world have understood that it is inefficient to let the population guess their intentions. They came up with rules, like the Inflation Targeting one. Of course no one believed them that they will only care about inflation and credibility had to be gained. The easiest way was by thwarting inflation.
As Romania is a country with a history of rampage inflation it made perfect sense that in 2005 it adopted de jure Inflation Targeting as a policy regime. To make it work NBR had to gain the trust of the markets and the only way was to be tough on inflation. It was not to be. Starting with 2008 the evidence shows that the central bank cared about inflation at best a secondary objective and that the main one has become a stable exchange rate.
It took the markets some time to learn this but not to the private sector. Both households and corporates have understood that NBR has a “sweet tooth” for a stable RON and is almost indifferent to inflation volatility. Both categories acted on it as per the info in those graphs.
Going forward it will be even harder for the NBR to switch back to an IT regime. But it remains an option although only if the flexible exchange rate regime is brought back. I do not see a chance of this happening. Rather I expect the NBR to keep the RON stable via direct interventions in the FX market. In the same time when there is no risk of liquidity dry up globally the central bank will sterilize those interventions at least partially in order to support the Ministry of Finance to borrow at a lower price. Of course the NBR will only sterilize those interventions at very short maturities.
Macroeconomic policies implemented so far have undermined the existence of RON. Trying to save it means free float and the risk, at least in 2012, of a negative shock to growth. I am afraid that the election year will not allow for this to happen, unless the NBR is independent de jure and de facto. It is obvious to me that the NBR and the Government have lost interest in RON. Thus, in this game of musical chairs make sure you are not the one left standing.