CENTRAL EUROPE 2009: Polish growth not Czeched

By bne IntelliNews December 19, 2008

Nicholas Watson, Jan Cienski and Robert Smyth -

There's little disagreement about the overall outlook for Central Europe in 2009: in a November survey by the Centre for European Economic Research (ZEW) and Erste Group, some 66% of financial market experts questioned said they're not persuaded that the competitive advantages of the fast-growing countries in the region will be enough to stave off the effects of the economic slowdown from the Eurozone and they anticipate a widespread slowdown over the coming six months.

Czech mate

The outlook for the Czech Republic seems so much worse because, just a few months ago, it had seemed so much better.

Seemingly insulated from the global mayhem, preliminary GDP figures had showed the Czech economy actually picked up speed slightly in the third quarter, with annual real GDP growth of 4.7% compared with 4.6% in the second. However, revised figures showed GDP growth actually decelerated in the third quarter to 4.2% and with the revision of real GDP growth to 5.9% for 2007, it's now clear the economy actually reached the peak of the current business cycle in 2006 with a real growth rate of 6.8%.

With the slowdown seen picking up pace in the fourth quarter, economists have rushed to outdo themselves in predicting a dire 2009 for the Czech Republic. In December, the international economist Jan Svejnar, who unsuccessfully ran for the Czech presidency earlier this year, said if the Czech economy recorded any growth at all in 2009, it would constitute a success. "Based on developments elsewhere in the world, I expect the impact [of the economic crisis] to be tougher. We are an open economy, so my GDP growth estimate for next year is lower than the estimate of all institutions. I expect that if we have a positive growth, we will be glad and it would be a success," Svejnar said.

The Czech economy is indeed open compared with, say, Poland, and so weakness next door will impact it significantly. The share of Czech exports to the EU27 is 85% of total exports and 49% of total Czech industrial revenues are generated abroad (for key sectors, ie. the manufacture of transport equipment and electrical and optical equipment, this rate is above 60%). With the Eurozone predicted by the Organisation for Economic Co-operation and Development (OECD) to contract by 0.5% next year, it will of course have a big bearing on the outlook for Central Europe's economies. "2009 will see a further slowdown of the economy due to a further slowdown of the Eurozone, which won't be compensated by either any rise in domestic consumption or a rise of investment," says Martin Lobotka, of Erste Group.

The official GDP estimate is, needless to say, rosier than Svejanr's, though that's probably because unlike economists, the authorities can't downgrade their estimates on a weekly basis. Even so, the 3.0% growth rate for 2009 is already discredited, even by the Czech Finance Minister Miroslav Kalousek himself, who in mid-December started talking about growth between 2.5% and 3%. Komercni Banka's latest forecast is for the Czech economy to grow by just 0.8% next year.

A bright spot is, of course, that inflation is falling, meaning the central bank has more wiggle room to cut interest rates. On December 9, year-on-year growth in consumer prices slowed to 4.4% in the Czech Republic in November from October's 6.0%. Month-on-month inflation fell by 0.5 %, the biggest fall since October 2006. This means that inflation should fall below the central bank target of 3.0% next year and the outlook is that the new inflation target 2.0% will be fulfilled in 2010. Analysts see the key interest rate falling to 1.50% by March from the current 2.75%.

The stock market had a terrible year, one of the worst in its history. Until December 5, the main PX index was down 55% on the year, some way worse than the 24% decline in 1995. Things will probably get worse before they better time. Czech stocks are traded at 8.0 times their expected earnings, which is higher than both Poland (7.3) and Hungary (7.2), while the CEE average is substantially lower at 5.3. Indeed, the Czech multiple is also slightly higher than that of Western Europe or Scandinavia (7.4 and 7.7, respectively, according to Bloomberg on December 5). "We expect a market recovery together with a reversal of the trend to come no earlier than mid-2009," says Miroslav Adamkovic, an analyst with Komercni Banka.

Of course, the all-consuming event for the Czech Republic at least during the first six months of the year will be the country's presidency of the EU. This will be interesting for observers not least because the president of the country, Vaclav Klaus, is an irascible and often times plain rude head of state, who at time seems to actually despise the EU and everything associated with it. In December, Prime Minister Mirek Topolanek talked about setting a target date for joining the Eurozone next year; few would bet against that date happening in 2013 when Klaus will leave office.

Go Slovak

Dominating Slovakia's year will be its adoption of the euro on January 1, the second CEE country to do so after Slovenia joined in 2007. As such, the biggest challenge will be containing inflation, which has blighted countries that have previously joined the euro, rather than growth. "We reckon only a minor 'rounding' impact from euro adoption, worth up to 0.3 percentage points. In the medium term, we expect harmonized inflation in Slovakia within the 3.5-4.0% range, particularly driven by prices of services, due to continuing price convergence - service prices stood at just around 43% of the EU average in 2007, while goods prices have already converged to around 80% of the EU average," say analysts at Erste Bank.

On growth, the OECD said in its latest Economic Outlook report that Slovakia should continue to maintain the highest growth rate among OECD countries over the next two years. It predicts the Slovak economy should grow by 7.4% in 2008 and post growth of 4% in 2009. Projected growth in 2010 is 5.6%.

The country's banking system is also considered sound, given its relatively conservative risk profile. Tighter lending conditions and a moderate slowdown in the economic growth are likely to translate into a slowdown in loan growth and a slower increase in revenue generation, resulting in lower banking sector profitability. "The fundamental credit outlook for the Slovak banking system is stable, reflecting the rated banks' focus on traditional banking activities, their generally sound financial fundamentals and low risk appetite. The outlook is also underpinned by the operating environment, which has not deteriorated as rapidly as in some other Central and East European countries, and by the relatively limited impact of the global banking crisis on Slovak financial institutions," says Moody's Investors Service.

The rating agency warns, however, that the introduction of the euro, increased funding costs and growing provisioning will likely put some pressure on profits in the short to medium term. However, Moody's expects the impact to be relatively modest and on its own unlikely to exert pressure on bank ratings unless other financial indicators deteriorate more than currently anticipated.

Baltics burning

Of the three Baltic states and, indeed, out of all the EU states, Latvia is currently in the direst position. The government has agreed a bailout package with the International Monetary Fund and the EU; no sum was available at the time of writing, but the package is thought to be worth at least €5bn. The GDP figures released December 9 show just why such a loan is required: Latvia's economy shrank by 4.6% in the third quarter of this year compared with the same period of 2007, marking the Baltic nation's worst contraction since 1993. Latvia has slid into the sharpest recession in the 27-nation EU as consumption tailed off in the face of double-digit inflation and tighter credit rules, as well as the global crisis that's hitting exports. The economy began cooling fast in the first quarter, when growth slowed to 3.3% compared with the same period in 2007, after growing 8.0% in the final quarter of 2007. The hard landing many feared has come to pass.

The outlook is for a prolonged recession. The Latvian economy had been growing way too fast in recent years, with the boom fuelled by strong credit growth. However, the main problem is not so much the level of credit stock, although it is relatively high to other EU states, but the speed of change, which clearly was unsustainable. The adjustment to a sustainable and slower GDP growth track is now underway, and the correction is very rapid. "We expect to see a clear outright decline in both investment and private consumption in 2008-2009. Growth in consumption and housing investment is not likely to resume until housing prices have stabilized," says Anssi Rantala of Nordea.

Pēteris Strautiņš, an expert at the department of macroeconomic and financial markets analysis at Swedbank, says his bank is forecasting a 5% GDP decline in 2009. "However, in the light of consumption trends since November, this already looks somewhat optimistic. We do not yet have a precise data on retail trade in November, but state budget revenue suggests a more than 20% fall in turnover year-on-year. Thus GDP might be already falling by more than 5% in the current quarter and it could go lower still in the first half of 2009."

A big question mark has hung over the lat's peg to the euro. The lat has recently been forced to the weaker side of the trading band against the euro and there has been much speculation that the central bank, which has been forced to intervene in the FX market in order to support the currency, would be forced to abandon it. It was suspected that the IMF might demand Latvia give up the peg as a condition of the loan. The precedent for the IMF demanding that Latvia give up the peg is Argentina, which in 2001 got the IMF to finance its currency board for several months before promptly devaluing the currency in December - something that severely damaged the institution's credibility. "It's unlikely the IMF will want to repeat that mistake," says one analyst. However, given over 80% of private sector loans are in euros, a sizeable devaluation would mean a marked increase in debt servicing costs for an average debtor with income in the local currency at the same time the debtor may find himself out of a job.

Even if the government does convince the IMF to let it keep the peg, the danger won't be over. If inflation turns out to be more persistent than projected, it will erode price competitiveness further. And if the slowdown is considerably deeper, the risk increases of an even deeper crisis with sharply rising unemployment and a strong surge in the government deficit. "Then the currency peg would be threatened, and devaluation could be used in a desperate attempt to save the economy from a total crash," says Rantala.

However, Strautiņš says there is some good news too. "If the correction proceeds really rapidly, as it apparently is doing, then Latvia's current account could move quite close to balance next year and inflation will continue the downward trend, despite the VAT increase in January. Low inflation and an increase of unemployment as well as acceleration of EU fund flows will definitely stimulate exports and we hope that exports will grow, despite adverse global circumstances - the latest data are from October and these are quite good."

The pace of the slowdown in Estonia has also been faster than expected, with GDP growth plummeting from double-digit levels to below zero in little more than in a year. 2008 growth is expected to settle close to minus 2%, and the economy is projected to contract markedly through 2009 and to show only modest growth in 2010.

At home, Estonia faces a similar problem as Latvia in the housing market, which is in a slump after the bubble burst. Private consumption is expected to decline this year and to continue shrinking in 2009 as falling house prices will lower consumption through wealth effects and plummeting confidence. Consumption spending will not speed up until inflation is in check and house prices have stabilised. Investment will fall through 2008 and 2009 as construction contracts rapidly.

Externally, while Latvia will be hit by the slowdowns in the other Baltic states, Estonia will be hit by the problems with its biggest trading partners, Finland and Sweden. In Sweden the economy is projected to contract in 2009, and in Finland the economy is expected to grow by a mere 0.5%.

Estonia's peg against the euro is seen as stronger than Latvia's, but some economists predict that, like dominoes, if one goes, they all go.

Unlike the other two, Lithuania isn't in recession, and as such the new PM, Andrius Kubilius, said in December the country did not need to turn to the IMF for financial aid, arguing the government's anti-crisis plan would be enough to weather the financial crisis. That plan includes a 20% flat tax, pay cuts for lawmakers and civil servants - except teachers - and reductions in social security payments.

However, there's no escaping the slowdown. GDP growth is expected to further slow to below 4% for 2008 (2007 growth was a robust 8.8%) and actually contract in 2009 as the domestic economy weakens and external demand subsides due to the global downturn. "Growth will drop way below its potential rate over the next couple of years," reckons Nordea.

Inflation is also coming down. Lithuania saw month-on-month disinflation in November for the first time in two years, as consumer prices fell 0.2% month-on-month in November from a rise of 1.0% in October due to lower transportation costs on the back of falling petrol prices, and lower clothing prices. The annual rate fell to 9.1% from 10.5% in October.

Something unique to Lithuania the government will have to deal with will be closing the Soviet-era Ignalina nuclear power plant at the end of 2009, which was part of the country's deal to join the EU. The closure will have a two-pronged effect, which many economists are not yet accounting for in their predictions. For inflation, the closure will push up energy prices, perhaps as much as by 2 percentage points in 2010, because the state will have to import higher energy. It will also suppress GDP growth considerably in 2010, as local energy production would fall and imports would grow. The negative impact on GDP growth in 2010 could be 2-3 percentage points.

Going Hungary

Another hard year is expected for Hungary. The economy was already in trouble before the global economic crisis hit, with the government labouring to implement a series of austerity measures to bring its deficit down to manageable levels, so it was no surprise that Hungary was the first Central European country to have to turn to the IMF for help.

Erste puts GDP growth at a miserable 1.1% in 2008 after the third quarter managed just 0.8%, and then to contract by 0.8% in 2009. "The third-quarter slowdown seems to have been just a beginning of a slump expected in Hungary for the coming quarters. Poorer growth prospects in the Eurozone should reduce demand for Hungarian exports and a recession affecting its major export partners could eliminate the last engine of growth in the country," says Nyeste Orsolya of Erste. "The negative impacts could be the strongest in the first half of the year, with some revival possible in the second, depending mainly on how long the global crisis negatively impacts the biggest economies of the Eurozone."

A particular problem is that there is no room for stimulating domestic demand from budgetary sources, as fiscal policy has to remain contractionary to reduce the external financing needs of the state and, consequently, the financial vulnerability of the country. "Aside from the extreme risk aversion seen on the markets, the strings attached to the IMF support will enforce very strict budgetary discipline in 2009. This will result in a further deficit reduction and prevention of pre-election overspending in 2009 and 2010," says Orsolya.

Politically, the current, seemingly perpetually unpopular Prime Minister Ferenc Gyurcsany will manage to muddle through until the next general elections in 2010, extending his reign as the country's longest-serving post-communist PM - though he's unlikely to survive any further than that. "Gyurcsany has a good chance of remaining in power until 2010, since nobody, especially not the opposition, wants to replace him in the current dire economic climate," says Balint Torok, an analyst at BudaCash brokerage.

Burnishing his somewhat threadbare reputation is that Gyurcsany is seen as having acted promptly in lining up October's $25bn rescue package from the IMF, the EU and the World Bank, rather than pussyfooting around and leaving it too late to act. "He's proved himself to be a dynamic leader and has been quick to react to the current economic crisis," reckons David Somogyi, political analyst at Vision Consulting in Budapest. "A paradigm shift in the way that the public view the PM may have occurred. He's done what he had to do regarding the crisis and may have stepped out of paradigm that had him labelled him a liar."

Gyurcsany's admission to his party cronies that they'd screwed it up in the wake of the 2006 general election was recorded and leaked to widespread public indignation and no short amount of rioting when the world's press turned its attention to Hungary. While the Hungarian PM might be seen as a good crisis manager vis-à-vis his handling of the current recession, the recession itself further exacerbates Gyurcsany's unpopularity, opines Torok. Many still blame Gyurcsany, or at least his party MSZP (Socialist Party), for the mess that Hungary now finds itself in.

Although his Socialist party is very much behind in the polls and could already be looking at damage limitation to prevent the opposition FIDESZ from gaining a strong majority in the next expected general election in 2010, Gyurcsany hasn't done his chances of pulling off an extremely unexpected comeback any harm at all. "At the moment I don't think they can win, but because of the crisis there is a slight feeling that anything could happen and Gyurscany has a better chance of being re-elected than before the crisis," says Somogyi.

Ironically, given his unpopularity, Gyurcsany could even embark on reforms that could steer the Hungarian economy out of the worst of the recession that many feel he and his party is responsible for. "I want to see more changes irrespective of public support considerations, but it's hard to imagine they would want to sacrifice what little public support they have for unpopular fiscal reforms. However, [Gyurcsany's] popularity can't get any lower, so he could go ahead with them," says Balint Torok, an analyst at BudaCash brokerage.

Losing its Polish

Given that the Polish economy is not as open as those in neighbouring Czech Republic and Slovakia, there was widespread hope the global financial crisis would only deal a glancing blow to the country. Those hopes are now gone.

The government has since scaled back its projections for the pace of growth from 4.8% to 3.7%, while Slawomir Skrzypek, the central bank governor, foresees a rate of growth as low as 2.8% and has called for wider rate cuts (more than 25 basis points) in the coming months to keep the rate up. "Looking at the macroeconomic indicators in Poland, there are obvious signs of a reduction in economic activity," Slawomir Skrzypek, the governor of Poland's central bank, has said. This means that growth will have peaked in 2007 when growth came in at 6.5%, the fastest pace in a decade and above Poland's potential rate of growth estimated at 5-5.5% per year.

The Polish government has also announced an economic stabilization package totalling PLN91bn (€24bn), although it contains almost no new spending. Major items were PLN60bn to revive the interbank market and a series of smaller measures to make it easier for Poland to gain access to EU funds. "For my government, the most important thing is to retain the foundations of a healthy economy," says Prime Minister Donald Tusk, who adds that he has no plans to follow in the footsteps of Western Europe and the US where government are hoping to revive the economy with the help of enormous infusions of money. "I don't think borrowing money on a huge scale is a good method of resolving the crisis."

Rate cuts and this package have given some reason for optimism. "I think we've seen some limited effects in the car and car parts industry and really very little else that would indicate that we are seeing any slowdown greater than we were already expecting in August," Jacek Rostowski, Poland's finance minister, told bne. "Now, I don't deny that given what is happening in Western Europe, we expect the effects to be somewhat greater, but in terms of what we've actually seen, so far it hasn't shown up."

Indeed, the country's fiscal position is strong - government projects the deficit to come in below 3% of GDP in 2008, though analysts warn that the fiscal deficit could deteriorate going forward unless reform measures are implemented. The economy also doesn't have major imbalances like that seen in the Baltics. The current account deficit is among lowest in the region, coming in at 3.7% of GDP in 2007 and much of this is funded by foreign direct investment. However, the quality of the current account deficit is deteriorating: net FDI inflows financed over 56% of current account gap from in the first nine months of this, compared with almost 100% in 2007; The Polish think-tank Center for Social and Economic Research (CASE) expects FDI coverage of the deficit to deteriorate further going forward.

Poland's car industry, which makes up about 5% of the economy, is expected to slow further, which will start to affect suppliers. Other exports of products like flat screen televisions are also going to be reduced.

Many corporations, especially those who have short-term loans that fall due in the next 12 months, are going to find it very difficult to get those loans refinanced by skittish banks. That could mean a wave of corporate bankruptcies will sweep through the economy next year, driving up unemployment and denting consumer confidence, which has been one of the mainstays of the Polish economy.

Even so, there's evidence of current global turmoil spilling over into Poland through financial channels - banks are very profitable, have scant exposure to US subprime assets and structured products, and the corporate bond market is small. Except for largest bank PKO BP and one bank that is owned by Citigroup, all other large banks are owned by banks from the euro area, which CASE says should theoretically give Polish banks access to foreign currency swaps should they need euros to fund their credit expansion.

Most analysts, therefore, still feel that the crisis will be milder in Poland than further west. "Once things settle down in the first half of next year, although I can't be sure, then there is no reason... that the long-established relationship between the Polish and European rate of growth, which is about 4%, will not be re-established," says Rostowski.

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