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Regional Scenario

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

Yapi Kredi Bank

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