Vivid Economics and Business December 2004

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From one extreme to the other

by Matei Paun
December 2004

Access to financing is the cornerstone of capitalism and material progress. There would not have been an Industrial Revolution without financing. The Age of Discoveries and the empires it spawned would not have occurred were it not for financing. In Romania, however, the financial markets that normally provide such capital hardly exist.

Romania's banking sector, the foundation of any nation's financial sector, has one of the lowest economic penetration rates in all of Europe. Were it not for the EBRD's generous handouts, mortgages would hardly have registered on the local market and SME's would be even more starved of capital than they are at the moment. While it is true that the banking sector has made great strides from the days when all it did was reinvest its deposits into government bonds, there is still much to do.

A dearth of banking products haunts the Romanian economy. As regulators take a dim view of new products, there is a clear disincentive to innovate. Derivatives, in particular, are lacking. Though often perceived to be the preferred tools of financial speculators running hedge funds, they also serve a key role in the risk management strategies favoured by CFOs trying to steer multinationals through choppy waters.

Domestic government bonds denominated in local currency are still inaccessible to foreign investors. These same foreign investors are not allowed to invest in local bank deposits, as capital controls imposed by the National Bank are still in force. In effect this means more expensive borrowing costs not only for the government (and ultimately, its citizens) but also a higher credit cost to Romanian companies and consumers interested in tapping credits from the banking sector.

Some will argue that capital controls are necessary in order to isolate Romania from the risk of a crisis generated by sudden capital flight. Without delving into macroeconomic theory and the recent history of financial crises, two things are certain. At the root of every crisis lie unsound government economic policies and/or an overheated private sector, resulting in poorly invested loans.

The first point is easily addressed by sound government policies. Romania has a big problem if its central bank needs to enforce capital controls as a means of ensuring the government's economic discipline. As for the private sector's potential inability to properly manage its own appetite for credit, it should best be left to the markets to regulate.

In any case, crises are notoriously difficult to forecast and to prevent. The mere fear of a potential crisis should not starve an entire economy of financing. Conservative regulatory policies are presently doing more harm than good to Romania's financial sector.

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Turning to other financial sectors, we find that the total size of Romania's life insurance market is tiny, at about $150 million. Total funds administered through mutual funds amount to less that $40 million. And while the total market capitalisation of the Bucharest Stock Exchange is over $3 billion, in fact, only around ten per cent is investable; its daily turnover hovers around a paltry million euros. No significant new company has listed or undertaken a secondary issue of stock on the exchange in years.

The size of corporate and municipal bond issues is irrelevant, as they are few and far between and rarely break the million dollar mark. One reason for this lack of success will once again be found in overly restrictive regulatory requirements, which for example, require a bond issue to be insured, thus defeating the reason for a bond!

Privately managed pension funds are long overdue ñ a recent study claimed that in the first year alone, over $400 million would be attracted and reinvested into Romania's economy. Unfortunately, the legislative process which should give rise to such funds seems to have turned into a political minefield, with labour unions and other interest groups battling for control.

Romania has failed in organising and tapping its own internal capital as a source of financing, and at the same time, it is restricting itself from accessing a wall of foreign capital that would like nothing more than to be permitted to stream into Romania. Money makes the world go round but Romania's regulatory authorities are too frightened of all the nasty excesses it might lead to, and fail to see the benefits it would bring.

A conservative predisposition, an inherited obsession with control and a large divide between market participants and regulators result in Romania being starved of capital. Fear of the unknown, apprehension at giving up control and thus power, as well as no practical financial experience creates a glacial intellectual environment where one is always better safe than sorry.

The fear of repeating the errors of the past, meaning under-regulating markets (remember the many banking and investment fund failures of the past decade) is leading today's financial sector regulatory authorities to over-regulate, and thus err to the same extent, if only in a different direction. Romania and its people have already paid the price of under-regulation once; they should not continue to pay through an over-regulated environment that keeps capital away from Romania's economy.

Matei Paun is an investment banker who has covered Romania since 1997.