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CEE Quarterly

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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, 13:35 GMT