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CEE Quarterly

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CEE: Rebalancing proceeding fast, but don't fall for a false dawn…

Tue, Jul 14 2009, 08:34 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

• Rebalancing proceeding fast: We revised further lower our 2009 GDP forecasts during 2Q, though significantly improved our current account outlook. To the extent that the CEE rebalancing process is proceeding faster than expected, changes to our 2010 forecasts in 2Q were limited. We now forecast full year 2009 CEE17 GDP to contract 5.8% (from 3.5% previously) and for the regional current account balance – ex Kazakhstan and Russia – to improve to 2.8% (from 4.2% forecast previously).
• CEE no longer the bogey man: Following a tough 1H09, we see 3Q09 proving relatively benign for CEE. The sharpest period of rebalancing is behind us, ECB policy is set to remain accommodative and regional financial stability risks will only likely crystallize in the medium term (e.g. 2010). This should prove relatively FX and sovereign credit friendly in the near term.
• We'd be careful about falling for a false dawn, however: A combination of slow burning second round risks from 1Q09's growth crunch and a likely challenging longer-term global backdrop means near-term stabilization could to some extent mark a false dawn. From this perspective, 2H09 marks a window of opportunity for regional policymakers to put in place realistic medium-term fiscal plans, issue debt and bolster FX reserves. Countries which do are likely to see the most positive sovereign credit ratings newsflow.
• Latvian devaluation risk continues, despite EU payout in July: Although devaluation is not inevitable, it is our central scenario in the next 18 months given: the scale of nominal GDP contraction, the level of LVL overvaluation, the extent of private sector FX short positions and 2010 parliamentary elections. We see contagion risks from any Latvian devaluation as being relatively contained, however.

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Published on  Tue, Jul 14 2009, 08:34 GMT

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Global financial and economic weakness testing CEE

Tue, Oct 7 2008, 15:39 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

One year after the beginning of the international financial turmoil, high uncertainty and volatility persist at the global level, with no signs of abating. The US economy continues to perform poorly and signs of a slowdown are now materialising also in the eurozone. Strong inflation and declining employment are taking their toll on households’ spending, while a low level of construction activity – likely to persist for the whole forecasting period – will reflect the weakening capital formation until mid-2009, which will in turn slow down investment. With a large share of CEE exports being directed towards the eurozone which is experiencing declining growth, the situation is anything but favourable for CEE.

The financial sector crisis is deepening, moving from the US to the UK and to Western Europe. Stock markets have been dropping for weeks, liquidity is becoming an issue for the financial industry, while risk aversion is increasing sharply. Such a scenario is clearly unsupportive for emerging markets and for CEE.

The repricing of CEE market risk has clearly intensified in line with global trends. The 5Y CDS spread, though being a quite illiquid measure in some of the countries, is peaking, and strongly penalising those countries which show macroeconomic imbalances (see chart 1). The CDS spread for Ukraine is now trading at more than 700 bps, while the spread more than doubled in the last month in Kazakhstan, Russia and

Latvia (now at 430, 254 and 330, respectively). Risk pricing, although already high, also increased in South Eastern European countries (CDS spreads are currently above 200 bps in Romania, Bulgaria and Serbia) and Turkey, where CDS spreads are now close to 300 bps. While Central European countries have also been affected by a surge in CDS spreads in the last month, they continue to enjoy a relatively lower risk perception than other countries in the region and – with the exception of Hungary – their CDS spreads are far below 100 bps.

Going on declining world growth will reflect the high uncertainty, volatility and strong risk aversion characterising international markets, with a negative effect on international capital flows.

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Published on  Tue, Oct 7 2008, 15:39 GMT

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Regional Scenario

Tue, Jul 22 2008, 13:24 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

Global risks testing Central and Eastern European economies

Low economic growth in the US and the eurozone, strong concerns about inflation, high lolatility in financial markets and a general repricing of risk are the main characteristics of the global environment.

Q1 GDP growth settled at 2.5 % yoy in the US and at 2.1 % yoy in the eurozone, and expectations point to a further slowdown, with 1.4 % and 1.7 % growth for 2008 as a whole, respectively, and 2.0 % and 1.6 % for 2009. Oil prices have doubled this year as a result of strong demand and clear constraints in terms of supply, and food prices are peaking due to structural rather than temporary factors. With concerns mostly focused on growth, proactive monetary policies have led to rapid declines in interest rates in the US, accompanied by direct fiscal interventions. Other central banks, including the ECB, are more concerned about inflation, reacting to the new environment with higher interest rates. In less than a year, stock markets have lost 30 % of their value in Europe and 15 % in the US. The repricing of risk at the international level is also apparent: CDS spreads have doubled or tripled since July 2007, with several rounds of rebounds.

The region still appears to be resilient …

The usual growth drivers remain constant in CEE, and we continue to forecast an average yearly growth of 4.6 % in Central Europe, 5.1 % in SEE and the Baltics and 6.0 % in broader Europe in the period from 2008 to 2010.

Consumption is fuelled by rising household incomes and declining unemployment, although high inflationary pressure and tighter monetary conditions are resulting in moderation. Moreover, households in the region are now coping with more stretched balance sheets than in the past because they have increasingly been financing their consumption with debt, making them more sensitive to potential shocks.

Even though the cycle peaked from 2006 to 2007 and despite credit tightening, prospects for investment remain relatively positive thanks to fairly robust business activity and a number of infrastructure projects financed by structural funds (in EU member countries) or investment and growth funds (in former CIS countries). Lower growth levels in the eurozone and rising production costs will be reflected in a certain amount of pressure on the export performance of CEE countries. Foreign direct investments (FDI) and M&A deals could also be affected by global uncertainty. However, the CEE region still remains competitive and selected industries might even benefit from decisions by international companies to maximise the return on their past delocalisation strategies. Oil and raw material prices remain supportive for former CIS countries, but there is still the risk that a reversal of the current trend would harm these countries.

… but the international environment reveals longterm weaknesses

It is very clear, however, that vulnerabilities exist. In recent years, most countries in the region have relied on external savings to finance their growth. Rising current account deficits were financed by foreign direct investment, but also by external debt. The banking sector has also played a role, with strong lending growth – one of the main drivers of the retail and investment boom – being financed largely from abroad. In 2007, the region accumulated roughly EUR 100 bn in international debt, while the banking sector almost doubled net access to foreign funding. The repricing of risk at the international level has led to a hike in the cost of such external financing, enhancing the risk of a general tightening of credit conditions. Countries with larger external imbalances and greater dependency on foreign funding are also the ones facing a larger increase in the cost of risk, and are thus more likely to suffer from credit and liquidity tightening. The countries whose banking sector is more dependent on foreign funding are the Baltics, Ukraine, Kazakhstan and Romania. The countries that most need to finance the current account are the Baltics and Southeastern Europe (Serbia, Romania and Bulgaria).

Global inflation problem particularly pressing in CEE

Driven by food and oil price hikes, inflation is a global problem. However, in CEE it seems to be particularly pressing, given the weight of energy and food on households consumption basket. In addition to the international component, CEE countries also face a number of domestic inflation challenges: Remaining market inefficiencies, price liberalisation and simple price convergence towards Western standards are fuelling price increases. Labour market conditions are also not supportive, with unemployment generally in decline and labour scarcity fuelling wage increases. In some countries with very high growth levels, such as Russia and Ukraine, partial bottlenecks, for example, in building materials, are also increasing price pressures.

In addition to these, inflation has been fuelled in some countries by the relatively easy monetary conditions perceived so far, with abundant capital inflows financing strong domestic credit growth. Given the high relevance of foreign credit and exchange rate arrangements in SEE, the Baltics and Ukraine, monetary policy mechanisms have also had quite a limited corrective impact, with only administrative measures proving to be successful in constraining domestic liquidity. In such a scenario, the struggle against inflation will remain a priority, even if finding the proper instruments will be extremely challenging.

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Published on  Tue, Jul 22 2008, 13:24 GMT

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Regional Scenario

Wed, May 7 2008, 14:23 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

Clouds remain at the international level …

The turbulence on the financial markets is showing only mild signs of abating and more evidence has emerged that the US economy is strongly slowing down, with mounting pressures on consumers. Indeed, financially overstretched US households are suffering from declining housing wealth, tightening financial conditions and increasing consumer prices. The combined effect of the monetary and fiscal stimulus will provide some relief in the second half of the year. It is clear, however, that this rebound will be short-lived and growth will slow again thereafter, with a likelihood that we will see a protracted period of growth with rates well below potential.

In the Eurozone, the first signs of deceleration are materialising, with April industrial confidence declining in all of the three largest countries (IFO was rising in Q1). While it seems likely that consumer spending will prove resilient and prevent a huge drop in the pace of growth, this will not be able to counterbalance the decline in external demand (also due to euro appreciation) and investment (in the euro area, corporates are more financially exposed than consumers and will be hit harder by the financial turmoil). Finally, but likely only towards the end of 2008, the ECB will cut rates slightly, acknowledging that the growth slowdown will progressively alleviate inflationary pressures coming from commodities (food included); no particular relief will arrive in 2009 and a growth rate of around 1.5 % will likely prevail in both years. In this context, the USD will likely recover somewhat on the back of better news on the economy in 2008 H2 and thereafter, but only to a limited extent, closing 2008 at around 1.40.

The main risks pertain to the interrelation between the financial strains and the real economy: a pronounced slowdown in the real economy in fact will heighten uncertainty on the financial markets and balance sheet problems for financial institutions, rendering the recovery slower and more problematic.

… but CEE is still able to live up to the challenge

We continue to recognise two main contagion channels for the CEE – namely a tightening of credit conditions, associated with a tightening of capital inflows and the expected lower Eurozone growth.We also believe that international investors’ risk aversion may strongly aggrevate domestic weaknesses in some countries. International investors are quite nervous and increasingly selective. They actually seem to be searching for signs of potential crisis to play against them and in such a context large current account deficits, poor economic data or political tensions can be even more dangerous.

Still, we believe the region remains in a position to face up to the challenges. We continue to forecast relatively strong economic performance, with growth at 5.6 % in 2008, versus 6.7 % in 2007, and our previous estimate for 2008 of 5.7 %.

Central European countries in a good shape

We keep our yoy growth forecast of 4.7 % in Central Europe, down from 6.0 % in 2007. Despite expected lower Eurozone demand, competitiveness remains good, and we generally see a positive contribution of net exports to growth. On top of that, both investment and consumption, despite moderating, remain supportive. Slovakia, which is ready for Euro adoption in January 2009, will register dynamic 6.9 % growth in 2008 and 6.0 % expansion of GDP in 2009, smoothly driven by both domestic and internal demand. The automotive industry and the electrical and optical equipment sector continue to be the key drivers on the production side, as competitiveness continues to be supported by improving labour market conditions, combined with wage growth still remaining well below productivity growth.We expect a moderate but positive contribution of net exports to growth in the Czech Republic as well, combined with strong positive investment growth overshadowed by a combination of weaker stock-building and especially faltering private consumption, as a consequence of the new tax reform. Overall, growth should settle at around 4 % this year, recovering to some 4.5 % in 2009–2010. In Poland, we forecast 5.2 % growth in 2008, decelerating to some 4.4 % in 2009. The economy is increasingly facing pressures from rising capacity constraints, with higher inflation, higher interest rates and stronger currency weighing on consumption and, to some extent, export performance. Growth should settle around 4 % in both 2008 and 2009 in Slovenia, with some slowing in exports as a consequence of increasingly slack European demand and some moderation in consumption, together with the impact of high inflation, as the Slovenian CPI features the highest growth among all euro area members.

It should be noted that markets are pricing in quite favourable developments in Central Europe. The Slovak, Czech and Polish currencies are all on an appreciation trend, while the 5Y CDS spread stands at 30, 44 and 39 bps respectively.With inflationary pressures high all over the region, due to a large extent to rising international food prices, monetary policies have been rather tight in all the countries.We do not expect further tightening in the Czech Republic, while in Slovakia the Central Bank should start following the ECB interest rates decisions since confirmation of euro adoption. In Poland, we see potential for further two 25bp hikes in rates by the middle of 2008.We also discern some upside risk, amid uncertainty about energy and food prices at the world level.

Hungary remains the tricky country in Central Europe, and is still reaping the consequences of the fiscal correction plan in terms of growth at least. The results in terms of stabilisation in 2007 were better than expected, at the cost of a much slower recovery, while inflationary pressures, combined with political tensions and volatile and selective international capital markets forced the central bank to hike rates by 50 bps at the end of March and by another 25 bps at the end of April, bringing the key rate to 8.25 %. Still a quite tight monetary policy stance is likely in the next few months.We are again revising our growth forecasts from 2.8 % to 2.4 % in 2008, assuming moderate cuts in rates only at the end of the year to 7.5 %. The country is the most sensitive in Central Europe to deterioration in the global environment, as proved by the strong increase in the 5Y CDS spread, which stood at 116 bps in April.

Repricing of risk at the international level triggers a correction of existing imbalances in South Eastern Europe and the Baltics

We forecast some deceleration in growth rates in SEE and the Baltic countries, from 6.8 % in 2007 to 5.3 % in 2008, compared with our previous forecast of 5.7 % for 2008. These are all small, open economies, which have been financing their growth in recent years from external funding, resulting in large current account deficits and widening external debt. Global repricing of risk has hit the region particularly hard, leading to substantial increases in the cost of external funding.We expect the new global environment to bring some cooling, through lower capital inflows or higher cost of external funding, which will also translate into tighter domestic credit conditions, given the local banking system dependency on foreign funding.

Marked deceleration in economic growth already materialising in Estonia and is likely in Latvia and, t o a milder extent, in Lithuania

A pronounced slowdown in growth is materialising in the Baltics, following the clear overheating of some of these economies. Reduced capital inflows, a turnaround in the real estate sector, high inflation and interest rates and reduced lending activities in Estonia have already led to a contraction in growth from 6.4 % in Q3 2007 to 4.8 % in Q4 2007 and we expect further deceleration.We forecast growth at around 2.6 % in 2008, with a recovery starting only from 2010. A very similar pattern is expected in Latvia, where short-term economic indicators for the first months of 2008 already point to some slowdown.We forecast growth at 4.7 % this year, declining to 3.0 % in 2009. A turnaround in the real estate segment is materialising, as the number of transactions and prices in the capital city have dropped by almost 18 % in 2007. Skyrocketing inflation and decelerating lending activities are curbing consumption and reduced capital inflows are putting a cap on investment growth. In Lithuania, a more moderate deceleration, to 6.5 % this year and 5.3 % in 2009, is expected, thanks to the rather more balanced macroeconomic background. One aspect worthy of note is that in the current global context, international financial markets are negative on the three Baltic countries and local currency markets are pricing in some devaluation risk. With markets being too shallow for a successful speculative attack, we believe, however, that the necessary readjustment of existing economic imbalances will more likely come from the ongoing economic downturn.

SEE countries still on track for smooth correction of imbalances

After expanding by more than 6 % in the past several years, we expect a slowdown in Bulgaria to some 5.6 % in 2008 and 4.8 % in 2009. Higher cost of capital and increased risk aversion will bring deceleration in both foreign capital inflows and investments, especially in the holiday home segment. The reduced availability of international funding and increased borrowing costs will make it more difficult to satisfy the large external financing requirements. With a high current account deficit and rising inflationary pressures, international markets are starting to question the long-term sustainability of the currency board. In our view, however, macroeconomic policies are very coordinated, focused on some moderate cooling, to prevent overly strong real appreciation, and on increasing flexibility to enhance the economy’s efficiency and competitiveness. International repricing of risk might even be supportive, by indirectly leading to more forceful tightening of monetary conditions.

Some cooling in terms of growth is materialising in Croatia, as a result of the ongoing financial crisis and, probably even more relevant, due to domestic measures implemented to curb lending growth. While Q1 2008 will remain strong, sagging credit activity, combined with high inflation and worsening outlook for the Eurozone economy should lead to roughly 4.3 % performance for the full year and 4.2 % in 2009, with a rebound in 2010, thanks to the EU effect. It is interesting to note that despite the 5Y CDS being at 82 bps, Croatia is still relatively attractive for foreign capital, as proved by the strong appreciation pressures faced by the kuna, even in combination with a high current account deficit and wide external debt.

There was also positive news from Bosnia-Herzegovina, as an agreement on the reform of the police system has finally been reached, which was a precondition for signing the Stabilisation and Association Agreement with the EU. The country is facing the same challenges as other neighbouring economies, with strong growth fuelling a widening current account gap, which likewise is associated with strong imports of machinery and equipment.

Political tensions are in the spotlight in Serbia and may severely affect economic performance in 2008. Following the tensions in recent months, the 5Y CDS is at around 295 and one of the highest in the region. While a victory in the May 11 parliamentary elections by pro-EU parties centred around the Democratic Party of President Tadic would be welcomed by the EU and investors, the political environment is likely to remain messy. Amid rising inflation and strong investor risk aversion, the Central Bank has been forced to hike rates by 525 bps since the beginning of the year, while passing technical measures which force banks to increase holdings in local currency, to keep the dinar stable. We forecast further 225 bps in rate hikes by the end of the year, and believe that the stability of the exchange rate can only be preserved if the political noise calms down. So far, there is clear evidence that investment is being delayed, while consumption growth and credit remain strong. Overall, we expect growth to decelerate to 5.0 % in 2008, from 7.5 % in 2007, versus our previous forecast of 6.0 % for 2008.

International investors sentiment on Romania has deteriorated substantially over recent months, as proved by the 5Y CDS spread which now stands at around 147 bps. Increasing risk aversion has led to a reversal in capital inflows and rapid depreciation of the currency (17 % since August last year), also triggering a highly restrictive monetary policy (250 bps in hikes since October 2007). While growth should settle at around 5.5 % this year and 5.0 % in 2009, the country is clearly paying the cost of its long-term vulnerabilities.We also expect some cooling in lending growth, as banks face an increase in their cost of funding and in the cost of risk.

Tough political agenda in Turkey again at the worst possible moment, preventing a full recovery in growth

The Turkish economy slowed down significantly in 2007, which was a very eventful year, dominated by both local elections and global uncertainties. While the Central Bank was ready again to start an easing cyclecycle to support consumption and investment growth, a new challenge has materialised in relation to the possible court decision to ban the governing party as unconstitutional. With the 5Y CDS spread at around 241 bps, the lira starting to depreciate quickly and inflation continuing to rise, the Central Bank had to start playing the card of higher nominal rates, to avoid excessive capital outflows and excessive strong depreciation of the currency, at the cost of economic growth.We now forecast growth at 4.2 % in 2008, slightly recovering to 5.0 % in 2009.We expect the Central Bank to maintain a relatively tight monetary policy stance, allowing some moderate cuts in rates only if international sentiment on the country stabilises.We continue to expect lots of political noise and tensions, which will be reflected in market volatility.

Russia is the bright spot – strong enough to exceed all expectations despite all the ongoing challenges

The repricing of risk at the international level since July has hit Russia, as both banks and medium and large Russian companies relied heavily on external funding in recent years. Limited access to international markets and the increase in the cost of funding led to some moderate credit tightening. This tightening mainly materialised as a contraction in yoy growth in retail lending, matched by an acceleration in corporate lending growth – all in the context of increasing spreads applied by banks to their clients. Still, the economy continues to perform very well. Strong consumption and investment remain the key drivers, prompting us to revise our growth forecasts upward from 6.7 % to 7.0 % in 2008. The major threat for the country is still rising inflation. In the current high inflation/low liquidity environment the Central Bank clearly faces the challenge of tightening while providing sufficient liquidity, making monetary policy a fairly sophisticated task.

In Ukraine, high inflation and some tightening of monetary policy will slow GDP slightly more than we originally expected in 2008 and 2009. We now see real GDP growth at 5.4 % in 2008 and 4.6 % in 2009, with inflation peaking at 22 % and 10 %, respectively. Later, some fiscal loosening in view of the 2010 Presidential elections and preparation for the 2012 European Football Championship should allow for a rebound.

Serious concerns for Kazakhstan in the short term, with medium- to long-term potential preserved (hopefully)

Kazakhstan is an example that economic overheating can lead to a bursting bubble. Stalled credit growth and double-digit inflation on the back of soaring food prices will reduce real GDP growth to perhaps 4.5 % this year. The good news is that reduced domestic demand as global commodity prices remain high will sharply reduce the current account deficit again in 2008 to probably 2 % of GDP. This makes a substantial tenge devaluation very unlikely. A strong increase in net exports will mitigate the decline in GDP growth although both private consumption and investment will turn out rather weak. Credit quality will show a significant deterioration this year as the economy slows, the residential construction bubble has burst and monetary conditions have tightened.We still do not expect a crisis of the banking system as a whole, but competition has increased and some redistribution of economic power among the large banks will occur. Continued strong global demand for commodities should combine with an easing of the tensions in the banking sector globally and locally to re-ignite GDP growth in 2009 and 2010 to some 6–7 %.

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Published on  Wed, May 7 2008, 14:23 GMT

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Regional Scenario

Fri, Feb 29 2008, 09:01 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

CEE region copes with the new global environment

Lower growth in the US and the euro zone, great uncertainty and volatility and a general repricing of risk are the main features characterising the new global environment. Our scenario is now assuming growth at 1.5 % in the US and 1.4 % in the euro zone in 2008, with proactive monetary policies leading to fast declines in interest rates to 2.5 % in the US and 3.5 % in the euro zone. The risk of a potential deeper recession in the US remains, however, and the view of international financial markets is on the pessimistic side. Uncertainty about the true size of international banks’ write-off related to the US sub-prime crisis is still great and likely to remain so until the end of the final 2007 results disclosing period. Equity markets have proved to be extremely nervous and volatile, as the mid- January sell-off week testifies (–7 % on average in one week). Repricing of risk at international level is also clear – CDS spreads have doubled or tripled all around the world since July 2007. Moreover, international investors are starting to be quite selective, penalising most countries which show greater imbalances. We recognise two possible contagion channels for the CEE – namely a tightening of credit conditions and low euro zone demand. Still, we believe the region remains in a position to cope with the new environment. We continue to forecast relatively strong economic performance, with growth at 5.7 % in 2008, versus 6.8 % in 2007, and our previous estimate for 2008 of 6.0 %.

Usual growth drivers remain supportive …

Consumption is fuelled by rising household income and declining unemployment, though high inflationary pressures and tighter monetary conditions are leading to some moderation. Despite credit tightening, prospects for investment activities remain positive thanks to a relatively lively corporate sector and a number of infrastructure projects financed by structural funds (in EU member countries) or investment and growth funds (former CIS). Lower growth in the euro zone and rising production costs will be reflected in some pressure on export performance. Still, the region remains competitive in absolute terms and selected industries might even benefit from international companies’ decision to maximise the return on their past delocalisation strategy. Oil and raw material prices remain supportive for former CIS countries. ...

...but vulnerabilities arising from financing domestic growth with international savings will now be a feature

In recent years most countries in the region have been relying on external savings to finance their growth. Rising current account deficits were financed by foreign direct investment, but also by external debt. The banking sector has also played a role, with strong lending growth – one of the main drivers of the retail and investment boom – being largely financed from abroad. In 2007 the region has attracted roughly 100 bn euro of international debt, while the banking sector has almost doubled net access to external funding, with the net position between external liabilities and external assets increasing to 143 bn euro, i.e. 8.2 % of total banking assets in the region.

The repricing of risk at international level has led to a hike in the cost of such ex-ternal financing, enhancing the risk of some general tightening of credit conditions. Countries with bigger external imbalances and greater dependency on foreign funding are also those facing the bigger increase in the cost of risk, thus being more likely to suffer from some credit tightening.

Central European countries largely unaffected, with some cyclical tightening on the cards

We forecast growth at 4.7 % in Central Europe, down from 6.0 % in 2007 and compared to our previous 5.0 % forecast for 2008. Countries in the region are less sensitive to a possible credit squeeze, as external imbalances are under control and the cost of risk, despite increasing sharply, remains relatively low (the 5Y CDS stood on average at around 48 bp at the end of January 2008, up from 35 bp at the end of 2006). We expect some cyclical tightening in the wake of rising inflationary pressures and growing production capacity constraints, particularly in Poland and the Czech Republic. In the latter, the new tax system is likely to have a negative effect on consumption growth, which made us revise our growth forecasts from 4.8 to 4.0 %. It should be noted that the strong pace of growth, combined with inflationary pressures, suggests some counter-cyclical tendencies where the euro zone is concerned – this might become an issue for Slovakia, which is planning to enter the euro zone at the beginning of 2009 and should then adopt an easier monetary policy stance, and for Slovenia, which entered the euro zone in 2007. Hungary remains the tricky country in Central Europe, still reaping the consequences, in terms of growth, of the fiscal correction plan. Results in terms of stabilisation in 2007 are better than expected, but recovery in terms of growth is very slow, while inflationary pressures allow only moderate cuts in rates. We are now revising our growth forecasts from 3.1 to 2.8 % in 2008, assuming 50 bp cuts in rates in 2008, unlikely to be achieved before end Q1 2008. The country is the most sensitive in Central Europe to deterioration in the global environment, as proved by the strong increase in the 5Y CDS spread, which stood at 79 bp at the end of January, versus 21 at the end of 2006.

The new international environment reveals long-term vulnerabilities in South Eastern Europe and in the Baltics

We forecast some slowing in rates of growth in SEE and Baltic countries, from 6.7 % in 2007 to 5.7 % in 2008, compared with our previous forecast of 7.4 % for 2008. All these countries have small and very open economies, which have largely financed their growth in recent years from external savings. Such funding has come in the form of foreign direct investment, but also in the form of external debt, with the – largely foreign owned -banking sector playing a role. Global repricing of risk has particularly hit these countries in view of their structural imbalances, e.g. CDS spreads jumped from 16 bp at the end of 2006 to 115bp in January 2008. Such an increase in the cost of risk is likely to lead to some restriction in capital inflows. While we expect credit growth to moderate as banks find it more expensive to finance themselves and companies´ direct access to international markets will come at a higher cost, we do not see any major deterioration in the local operating environment, something which could affect the appetite for foreign direct investments. If this is the case more pronounced deceleration would be on the cards.

Some slowing in growth is welcome in the Baltics, where overheating concerns were repeatedly addressed in recent years. The increase in the cost of risk is leading to some credit tightening (both where direct foreign funding and bankmediated funding are concerned). Local currency markets are pricing in some devaluation risks, but very minor (the market is, however, possibly too shallow for speculative attacks).

We forecast growth close to 6 % in Bulgaria. Markets are starting to price a higher cost of risk for the country, amidst its high current account deficit and rising inflationary pressures, which raise questions about the long-term sustainability of the currency board. We claim, however, that macroeconomic policies are very coordinated, focused towards some moderate cooling, in order to prevent overly strong real appreciation, and towards increasing flexibility in order to enhance the economy’s efficiency and competitiveness. International repricing of risk might even be supportive, by supporting some tightening of monetary conditions.

In Croatia, the Central Bank’s strategy of cooling domestic credit growth, while limiting local banks’ external indebtedness and forcing their recapitalisation, has proved successful. Domestic lending is being squeezed, constrained by fixed targets, while the economic impact of such tightening is smoothed by the increasing relevance of cross-border lending. The current account deficit remains strong, at an estimated 7.4 % of GDP in 2007, with no financing problems, as continuing pressures towards an appreciation of the kuna suggest.

The markets’ mood towards Romania has changed substantially in the last year. While growth prospects remain positive, the country is paying the cost of its longterm vulnerabilities and of a rather incoherent political environment. The CDS spread has increased from 20 bp at the end of 2006 to more than 170 bp in February 2008, while the exchange rate, despite a rather tight monetary policy, has lost roughly 20 % in half a year, and remains quite volatile. We forecast growth at around 5.4 % and some moderation in lending growth and we continue to highlight the fact that structural risks exist. Even more than in the case of other countries, we believe sustainability of current imbalances in Romania can only be achieved if the country remains attractive to international capital. In the short term, the Central Bank is opting for high interest rates as a strategy. In the long term, we believe the challenge is to preserve overall competitiveness, remaining attractive for productive FDI.

In Serbia, even though incumbent Boris Tadic won February’s presidential election, the political environment will remain uncertain with a continued high risk of early parliamentary elections. The consequences of Kosovo’s unilateral declaration of independence are still not clear. Meanwhile, economic growth is forecast to be moderate, from last year’s peak, on the back of tighter global credit conditions and more hawkish NBS rhetoric. Though gradually easing, continued high external imbalances might pose an additional threat in the context of a new deteriorated global environment.

In Bosnia-Herzegovina the domestic political environment is also focal and raises questions about whether agreement on the form of a new constitution will be reached and signing of the SAA (Stabilization and Association Agreement) with the EU will take place. On the economic front, robust credit growth and strong manufacturing activity point to strong growth in 2007 and this year too.

Countries in the rest of Europe more sensitive to international repricing of risk, but continuing to show very high growth

The repricing of risk at international level since July has hit Russia, as both banks and medium and large Russian companies relied heavily on external funding in recent years. Limited access to international markets and the increase in the cost of funding has led to a moderate credit squeeze. The main evidence so far relates to a deceleration in corporate deposit growth and hikes in corporate lending growth, which are both a sign of reduced access by the corporate sector to direct external funding. So far a real slowdown in domestic lending has not materialized. While some small banks are running into short-term liquidity problems, the bulk of the banking sector has been able to withdraw its foreignheld assets, thus continuing to finance its expansion plans. Overall we do not expect any major impact on the Russian economy, as the banking sector in general remains liquid and banks like Sberbank, VTB or the smaller foreign-owned banks continue to have wide access to international financial markets and cheap funding. Big companies could have access to international markets as well – they will probably refrain, in order to not show that they are paying higher margins. We forecast lending growth at 35,3 % in 2008, fuelling consumption and investment growth. Overall we forecast growth at 6.7 % in Russia, little changed from our previous bet of 6.6 % for 2008, with high oil prices remaining a key driver for the economy.

We forecast growth of 5.6 % in 2008 for Ukraine, down from 7.3 % in 2007. The country continues to experience a consumption and investment boom, largely financed by strong capital inflows and by a rapidly expanding banking sector. Imbalances are present, with the current account deficit standing at –4.1 % of GDP and inflation peaking at 16.6 % in December. We keep a positive short-term view of the country and we expect strong inflows of capital to continue, as FDIs are searching for a lowcost production base in Europe and banks, which are increasingly under foreign control, continue to target the market. We believe, however, that the long-term potential of the economy can be realised only if investments are effectively channelled towards enhancing local production capacity and competitiveness is preserved. It should be noted that the economy remains quite sensitive to potential external shocks, such as a sudden drop in steel prices or another gas crisis with Russia.

The Turkish economy slowed down significantly during 2007, which was a very eventful year, dominated by both local elections and global uncertainties. Despite the fragile global environment, prospects for the Turkish economy are not gloomy. Firstly, policy rates are now 225 bp lower than five months ago (now at 15.25 %) and this trend will provide support for investment activity and growth prospects. Secondly, the political uncertainties were dispelled, and the government, backed by the president and by a stable parliamentary majority, is promoting important reforms (reform of the controversial article 301 of the penal code, a new constitution, the Kurdish issue and the “turban problem”). The inflation target has been missed again in 2007, and the Central Bank will probably suspend interest rate cuts until the second half of the year, depending on the disinflation process and on the global scenario too. The latter is a source of concern as Turkey – as an emerging and “high beta” country – is very exposed to financial contagion stemming from abroad. However, the banking sector is sound and relatively protected by relatively limited dependency on international borrowing (the loans/deposit ratio is still below one).

More serious concerns for Kazakhstan in the short term, with medium- to long-term potential preserved

A liquidity crisis is visible and already translating into a clear credit squeeze in Kazakhstan. The consumption and investment boom which has been behind the impressive growth of recent years is severely constrained. Companies have reduced access to international debt markets, while the banking sector, which was fuelling a credit boom through external borrowing, now has to severely limit lending expansion to its deposits’ attraction capacity. The construction industry, which was one of the most dynamic sectors of recent years, is now overheating and cooling is likely to further impact on banking sector performance. We now forecast growth as low as 5 % in 2008, after rates close to or above 10 % in the last few years. We still expect the country’s long-term potential to be maintained, as with high energy and raw material prices the country has money and commitment enough to prevent any major crisis.

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Published on  Fri, Feb 29 2008, 09:01 GMT