Central Europe 2007 outlook

By bne IntelliNews January 16, 2007

Nicholas Watson in Prague -

Given the unremitting bad news out of Central Europe throughout 2006 - feeble and failing governments, widespread corruption, declining competitiveness, and a curious dichotomy of voter apathy mixed with explosive anger at the political establishment - it is easy to forget that in dollar terms the Czech Republic's stock market grew 28%, Hungary's rose 31% and Poland's was up 65%.

2006 was a tale of economics trumping politics. And while banks believe that in general 2007 won't be as kind to investors, the region's strong economics should once again win out over the depressing political scene as long as the US economy and the Federal Reserve decide not to end the party.

Even so, the lack of any reformist governments in the region mean that tough political choices to solve common long-term issues such as healthcare and pension spending will be avoided, storing up numerous problems for the not-too-distant future.

Poland: the Goldilocks economy

Politics in the largest Central European country has made for the best headlines, if not the best governance. Like the other countries in the region, the government is a coalition one, with the rightist Law and Justice (PiS) joined by the populist Samoobrona and the nationalist League of Polish Families, giving it a slim majority in parliament.

The three-party coalition alliance has managed to resist having to call snap general elections since it survived a crucial confidence vote in parliament late last year, but it has been repeatedly rocked by conflicts and infighting. The latest embroiled Deputy Prime Minister Andrzej Lepper of Samoobrona in a sleaze scandal. Ironically, some analysts believe these scandals could mitigate the chance of early elections because none of the ruling parties want to risk falling out with each other and so have to face the public in elections. But while the risk of early polls has diminished, so also has the hope for any substantial structural reforms.

Does a lack of reform matter for the economy? Tamas David-Barrett, head of research at Budapest Economics, doesn't think so.

"There has not been any major market reaction and there won't be any as long as the search for high yields is maintained," says David-Barrett. "It really is all down to the Fed. Fed policy determines everything; it determines the market sentiment, and as long as the market sentiment is optimistic, none of these problems matter."

HSBC dares to use the "Goldilocks" term to describe the Polish economy – neither too hot nor too cold in spite of the strengthening growth, which is expected to come in at around 5% this year.

Export growth has remained consistently strong in the last two years and in 2006 domestic demand started to pick up too, largely a consequence of a sharp rise in employment, particularly in the corporate sector. Strong growth also stems from robust investment expenditure, supported by EU transfers, which are set to rise significantly in 2007.

Inflationary pressures remain subdued, unemployment is falling and the interest rate outlook appears stable. The question is whether the Goldilocks scenario is set to last or she's just making a flying visit? Analysts agree that as long as the economy remains on a growth track of around 5%, Poland should continue to see modest inflation, a low current account deficit and a gradually declining public sector budget.

Low inflation and moderate wage growth, among other factors, have kept the central bank on hold through 2006, while the rest of the region was raising interest rates. With inflation expected to gradually rise in 2007, this should cause the central bank to start hiking rates in the first or second quarter.

The respected previous governor of the bank, Leszek Balcerowicz, whose six-year term expired last month, was an inflation hawk who had been arguing for a rate hike in recent months. Little is known about his replacement, Slawomir Skrzypek, voted into the job this month. He is a close ally of the Kaczynski brothers, who are president and prime minister, but other than a master's degree in economics he doesn't have much experience in either monetary policy or banking.

Close attention has been paid to his thoughts on Poland joining the euro, for which the bank has still not set a target date.

During his confirmation hearings, Skrzypek appeared to break with the bank's long-held line that joining sooner would be better than joining later, but said more detailed studies were needed to decide the best strategy. However, this was contradicted on Friday by the bank's deputy chief, Jerzy Pruski, who repeated that, "after meeting the necessary conditions ... the sooner the better." The fear is that this presages a rift between the new chief and the bank's policy making council over the euro strategy.

The strength of the stock market last year, up 46.7% in local currency terms, is considered by most analysts to be an aberration, which can't be fully explained either by the 2006 earnings growth or by profit growth expected in 2007 and beyond.

"But in the absence of clear negative catalysts, high valuations are unlikely to suffice to kill the bull," reckons the brokerage CDM Pekao.

Assuming no major external shocks, such as a hard-landing in the US, CDM Pekao is predicting the main WIG index will advance this year by around 10%.

The drivers of this growth will continue to be the flow of money from mutual funds -- both domestic and foreign. IPOs too are expected to keep up the hectic pace of 2006.

"We do agree that a market correction would be due and welcomed [and] an expectancy of some 10-15% weakening of the main indices during the course of 1Q07 appears to be quite common among the professional investors. However, the apparent popularity of this scenario constitutes, as we see it, its main weakness, as the widespread beliefs rarely take their toll in reality," CDM Pekao says.

"Consequently, a contrarian could anticipate fairly strong performance of the local market till April-May (growth fueled by the mutual funds fresh money inflows), and take a more cautious stance towards the year’s second half, when the fears regarding possible rate hikes in the US and Eurozone may intensify, and the local market’s valuations become even more stretched."

Hungary: deficit, lies and audio tapes

If Poland's politics bordered on the farcical, Hungary's was altogether nastier. What little credibility the government of Prime Minister Ferenc Gyurcsany had evaporated when a tape was leaked of him telling supporters that his government had continually lied about the country’s terrible public finances to win the parliamentary elections in April. The fallout of this "confession" culminated in running street battles between anti-government protesters and the police during the 50th anniversary of Hungary’s failed uprising against Soviet rule.

Gyurcsany survived and, against the odds, introduced an austerity package, including tax rises and expenditure cuts, to bring down the highest public deficit in the EU, forecast then to go over 11% of GDP.

On the face of it, the measures appear to be paying dividends. Expected to rein in the public deficit to 10.1% of GDP in 2006, Finance Minister Janos Veres said in December that Hungary would beat the target and end the year with a deficit of 9.5% of GDP.

However, analysts are divided over the medium-term effect of the measures, highlighted by Moody's Investors Service decision Friday to downgrade Hungary's government bond rating to 'A2' from 'A1', arguing the country's austerity program will fall short of its goals, just a day after Standard and Poor's revised the outlook on the country's 'BBB+' rating from 'negative' to 'stable,' praising the country's fiscal consolidation programme.

On the plus side, the current account deficit is likely to contract in 2007. Combined with higher EU inflows on the capital account, Hungary's external financing needs are set to contract by almost 2 percentage points of GDP from 2006 to 2007, which should slow the deteriorating trend of growing net foreign liabilities while giving the forint, the most vulnerable currency in the region due to the twin deficit problem, fundamental support.

On the negative side, the correction will result in economic growth weakening from approximately 4% observed in recent years to around 2.3% in 2007. "The recovery, anticipated to begin in 2008, will be a slow process, with the main impetus coming from large-scale investments, stimulated by EU funds and exports," says UniCredit Group.

Ultimately, analysts say the medium-term sustainability of the adjustment programme depends on the progress of reform. Yet Budapest Economics reckons far-reaching and profound reforms are unlikely since neither the socialists nor the liberals seem to be really committed to change.

"Furthermore, both parties are scheduled to elect their new leaderships in the February–March period, and internal divisions are likely to surface. This, combined with the unpopular effects of austerity measures, is likely to consume all the remaining political capital of PM Gyurcsany, leaving little hope for further reforms," the research house says.

The Hungarian people are certainly not particularly optimistic. On Monday, a business and consumer confidence compiled by GKI-Wallis was released showing that the index declined to a new low in December to mark its lowest-ever recorded level as consumers and business become increasingly concerned about the economic outlook.

Tomos Packer of the consultancy Global Insight says the further deterioration in the leading indicators in the final quarter of 2006 confirms the decline in real income growth and disposable income caused by the tax increases, "which will almost certainly press down very hard on domestic demand and growth."

Czech Republic: nice economy, shame about the politics

The Czech Republic has its own political troubles, but few of Hungary's economic problems.

Prime Minister Mirek Topolanek will try again on January 19 to get his centre-right coalition government through a confidence vote – the first attempt failed in October – and by most accounts he should succeed. However, few analysts hold out much hope this feeble three-party coalition will do much after that. Indeed, the last remaining manifesto pledge of the PM's Civic Democratic Party (ODS), the flat tax, will probably have to be dumped to keep the coalition together.

"It appears likely that there will be a majority government by early 2007 but, without new elections, it looks unlikely that decisive action can be taken to narrow the budget deficit. New elections should ease the deadlock when and if they are held," says HSBC.

This political deadlock riles the IMF, which in November castigated politicians for missing an excellent opportunity to tackle medium-term fiscal challenges, such as mandatory spending on healthcare and pensions, which are set to rise sharply over the next few years.

"Nice economy; shame about the politics," says HSBC. Quite; the Czech economy is, for the most part, looking solid. GDP growth, while still very strong, is expected to ease slightly to the 6% in 2006 to 4.5-5% in 2007. The high growth rate is not leading to much in the way of inflation, because, analysts argue, the potential growth rate of the economy is estimated to have risen from around 3% in 2003 to 5% in the second quarter of 2006 due to rising productivity gains and, to a lesser extent, increasing capital stock and rising employment.

"The rise in productivity also stemmed from continued EU integration and the new production capacities, mainly in the car industry, as the Czech Republic and Slovakia are on their way to becoming regional centres for car production in Central and Eastern Europe," says Budapest Economics.

Nevertheless, UniCredit Group says the deteriorating fiscal position, increasing inflationary pressures and negligible koruna appreciation will likely prompt the central bank to tighten monetary policy by another 50 basis points this year.

The euro? Though the new government reckons it might be able to push through selling a 6-7% stake in the hugely valuable state power utility CEZ this year, either via the Prague Stock Exchange or directly to CEZ as a share buyback, the opposition will fight any wholesale privatisation, meaning the public deficit will almost certainly deteriorate sharply to around 4.6 % in 2007.

"Such a development de facto cancels the previous 2010 euro entry target," says UniCredit. "PM Topolanek and [national bank] Governor Tuma agreed that it is unrealistic to enter the EMU by 2010 due to the poor state of public finances."

Slovakia: Slavic tiger

Slovakia has become one of the world's economic tigers with GDP growth for the third quarter reaching almost 10%, the fastest quarterly rise in Europe that lags Chinese growth by just several tenths of a percentage point.

"The Slovak GDP growth figure was a bolt from the blue – the pace is absolutely unprecedented within Central Europe," says HVB Bank analyst Pavel Sobisek.

While few expect the country to keep up that rate of growth, estimates in the EU Convergence Programme put the country's growth rate in 2007 at a conservative 7%, sustained mainly by domestic demand and recovery in net exports.

"On our forecast horizon, we expect the Slovakian economy to grow somewhat above its potential in both 2007 and 2008: for 2007 we expect GDP growth to exceed 7% before falling back to 5.6% in 2008," says Budapest Economics.

Despite the new government's decision to increase the public finance deficit – a populist move not unexpected, coming as it does from a coalition led by the leftist Smer party allied with the nationalist SNS and the party of the authoritarian populist Vladimir Meciar – the Maastricht criteria could still be met.

"Despite the risks connected to inflation developments and relaxed fiscal stance, we still reckon there is scope to meet all Maastricht criteria in time for euro adoption in January 2009," says UniCredit.

Budapest Economics also sees a high probability of Slovakia meeting the Maastricht criteria by early 2008, which should enable the country to introduce the single currency by 2009.

"We still expect the production boom in the car industry and sustained high consumption to drive GDP growth in the next two years, thus a very cautious policy mix is required that focuses primarily on supporting the necessary disinflation and avoiding the overheating of the economy. The success of this policy will be Slovakia's biggest challenge in the next 18 months," says Budapest Economics.

Send comments to Nicholas Watson

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