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CEE Quarterly

Regional Scenario

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

Yapi Kredi Bank

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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