The impact of the political crisis on the national currency

Policy Brief, No. 15, August 2012

Author: Oana Maria Georgescu

This policy brief analyzes the effects of political instability in Romania over the last months. We identify the depreciation of the Leu towards the Euro as the main source of concern. Disentangling the political from the economic causes of the Leu depreciation is not a trivial task and is subject to some degree of uncertainty. Our results clarify the ongoing political debate on whether the external environment – the effects of the economic crisis in the region – are to be blamed for the depreciation of the Leu or whether the main cause is the internal political turmoil generated by the impeachment of the president.

Even assuming political tensions arise amid benign economic conditions, the resulting lack of predictability of government economic policies may erode investor confidence leading to a self-fulfilling financial crisis with severe consequences for the real economy. In many cases, political tensions develop on the backdrop of economic problems. Structural weaknesses of the Romanian economy coupled with the spill-over risk from the euro area sovereign debt crisis are two additional factors contributing to the depreciation of the Leu. Our aim is to estimate the share of the depreciation in the Leu that is not related to the above mentioned factors, but which can be attributed to political instability. In order to do this, we control for the common factor driving the Romanian currency and other currencies in the region (Polish, Czech and Hungarian currencies).

We find that over the last months, the political crisis was the one main factor contributing to the depreciation of the Leu, amplifying Romania’s main source of vulnerability: foreign denominated debt and high reliance on foreign capital. While other relevant currencies in the CEE region tended to appreciate towards the Euro, the Leu displayed a negative trend.

This depreciation signals a declining confidence of financial markets in the strength of the Romanian economy, fuelled by the ongoing political crisis and the negative expectations concerning the electoral year (parliamentary elections are due this fall). The open battle between President Băsescu and the Social-Liberal government will likely become a frozen conflict. The Romanian politicians should find a way to define cohabitation and make it work, otherwise it is conceivable that a short-term problem visible in the devaluation of the currency has deeper economic consequences, translating into higher inflation, a decline in consumption and investment and tougher refinancing terms for the public debt.

The report is available, here.