CENTRAL EUROPE 2010: Fragile - handle with care

By bne IntelliNews December 28, 2009

Nicholas Watson and Mike Collier -

The consensus is that emerging Europe will recover in 2010, albeit at a slower pace than certainly other emerging markets, but also perhaps even than the US and Western Europe. However, this view encapsulates what has become a growing problem in looking at the region since the crisis exposed its many vulnerabilities - that it's now simply too diverse to regard as a single entity.

In its top 10 economic predictions for 2010, the consultancy IHS Global Insight says growth in all the emerging regions will recover in 2010 and, with the possible exception of emerging Europe, will outpace the US, Europe and Japan. "Non-Japan Asia will be at the forefront, with GDP growth of 7.1%. Latin America, the Middle East, and Africa will see gains in the 3-4% range. The laggard will be emerging Europe, which will expand only 1.7%."

The CEE region's generally high dependency on foreign credit made the effects of the global economic crisis, when it eventually arrived, that much worse. The forecasted decline in GDP for the ex-communist region as a whole - including the former Soviet Union - is more than 6% for this year, compared with 4% for the Eurozone. However, the European Bank for Reconstruction and Development (EBRD) notes that this regional average hides a multitude of variations.

Neil Shearing, emerging markets economist at Capital Economics, agrees with Global Insight's overall contention that Asia is best placed to prosper, followed by Latin America and Brazil in particular, with CEE continuing to lag behind. He also notes there will be some bright spots in emerging Europe, generally speaking those economies that have received a competitive boost from weaker exchange rates and have comparatively low levels of foreign currency debt. The losers will be those with fixed exchange rates and high external imbalances. Thus Central Europe, bolstered by Poland, will see its GDP contract by only around 3.5% in 2009, while Southeast Europe, where all the economies (except for Albania) entered recession, will likely decline 6.5%.

Danske Bank expects a contraction in CEE in 2009 of 7.5%, while most economies should grow in 2010 - the Baltics notably not until 2011 - though at just 0.8%, it will only be a fragile recovery. "There are large differences between the countries in the region, but in general the recovery will be fragile for most countries due to years of excessive spending and unsustainable credit growth rates," says senior analyst Lars Tranberg Rasmussen.

Those imbalances make countries particularly vulnerable to the kind of shocks delivered from Dubai World and Greece. Those two events might have been absorbed fairly well by the markets, but what will happen when the next shock arrives? And few doubt another will come - in mid-December, the nationalisation of Austria's sixth-largest bank Hypo Group Alpe Adria put the focus firmly back on EU banks with large exposure to CEE. Capital Economics says it has long argued that the pressures facing CEE banks are likely to persist for some time. "While the rebound in global risk appetite over the past six months or so has helped to stem the outflow of capital from the region and ease tensions in interbank lending markets, it is still far too soon to sound the all clear," it says.

In case of another shock, the Baltics, Bulgaria and Hungary all remain worryingly exposed, with foreign debt levels that exceed 100% of GDP. Newsweek talks of a "quiet crisis brewing in Eastern Europe, where Bulgaria, Hungary and the Baltic states face staggering foreign debts in excess of their GDP." Capital Economic's Shearing says the rising sovereign debt concerns on the back of recent events in Greece and Dubai even posed the question of whether investors should be worried about a government default in emerging Europe. However, "while recent developments suggest that it would be complacent to rule out such an event altogether, we think the prospect of an outright default remains fairly low down the list of challenges facing the region."

The crisis was a terrible blow for the region just as it was celebrating 20 years after throwing off the yolk of communism. However, that blow has been felt and absorbed differently by the regions within the all-encompassing CEE, and differently by states within those regions. As renowned investor Warren Buffett noted back in 2001, "You only find out who is swimming naked when the tide goes out."

Finally, East Capital, the CEE-focused investment firm, highlights a developing trend in the region where countries are not only recovering, but are about to enter a period of what it calls "more normal" development after the years of boom and now bust. "The main feature of this new 'normal' is growth in line with potential - rather than over potential - that is not based on low base effect or cheap credit, but rather on low inflation, low positive real interest rates and political stability," East Capital says. "Most countries in the region are still in recovery mode and will remain so during the first half of 2010, before entering this new normal in the second half of the year." It adds that for some of the worst-hit economies in the region, such as the Baltic states, the recovery period will be longer.

East Capital identifies this normalisation trend in Russia, Turkey and Poland. "That these countries are normalising from a macro perspective does not mean that they are fully-fledged market economies, but it should send a message to investors that emerging Europe is moving in the right direction," it says.


By mid-December, the Polish, Czech and Hungarian stock indices had surged by 48%, 28% and 71%, respectively, so far that year. This led Deutsche Bank to look at the biggest underperformers in 2009 as investment prospects, "with the assumption that mean reversion is taken into consideration in the portfolio construction process."

The list of its 15 "suspects" had returned from minus 14% to plus 20%. Within that list, Deutsche Bank highlighted the good prospects for PKO BP, TPSA, TVN and Cyfrowy Polsat, because the scenarios that would trigger an appreciation in the stock price of those companies are still realistic. On the other hand, it was very cautious on PKN Orlen, CEZ, Kredyt Bank and some small caps (Police, Pol-Aqua), "as in all those cases we view the likelihood of a significant turnaround in both the fundamentals and the stock prices as small."

Poles apart

The country that has proved itself most during the crisis is Poland, which will be the only EU member state to record growth in 2009 and, indeed, will be one of the best performers in the world. Polish GDP grew by a stronger-than-expected 1.7% on year in the third quarter, putting the economy on course to grow by around 1.75% for the whole year.

Analysts say Poland ended up with Europe's strongest economy through a series of unrelated coincidences, rather than any particularly skilled crisis strategy.

The first piece of luck was the structure of Poland's economy, which is heavily oriented toward its large domestic market of 38m people, unlike its export-oriented neighbours the Czech Republic and Slovakia. Crucially, Polish consumers did not slam their wallets shut when the crisis hit the region a year ago. Poles have become significantly richer over the last two decades of economic transformation; GDP per capita came to about $6,000 in 1989 and now is above $17,000, and Poles enjoyed double-digit wage increases during the final years of the boom. That made them flush enough to continue spending. Spending and investment were also maintained thanks to continued inflows of EU funds into Poland, particularly for infrastructure projects like highway construction. Another factor helping the economy was the steep depreciation of the zloty earlier this year.

All this led the authors of a report that accompanied the Deloitte Business Sentiment Index, a survey of the views of leading corporate executives from the largest organisations across Central Europe and some of Southeast Europe, to note that the huge differences between Poland's upbeat answers compared to its more pessimistic partners in the index suggests a new era in the business dynamics of Central Europe, with Poland pulling away for good from its neighbours. "Polish executives gave every indication that the country will emerge not just as the most important player in Central Europe, but also as a significant force in the global markets," says Deloitte.

That said, there are a number of reasons to think that Polish growth will remain sluggish over the coming years. The first is that the government is in serious danger of public debt breaching the 55% level of GDP (it is currently just below 50%). At that level, Polish law mandates painful steps to put the budget back in balance, steps which would be unlikely to enhance the electoral prospects of Donald Tusk, the prime minister, in next year's presidential elections. As such, Capital Economics believes Tusk is likely to find ways around the constitutional limits on public debt, meaning that GDP could expand by 2.5% in 2010. Although helping growth in the short term, this will only delay much-needed fiscal consolidation, which will keep GDP growth firmly below its potential rate for at least three years. "As one of the region's least open and capital dependent economies, Poland's near-term prospects are brighter than that of its peers. Nonetheless, medium-term headwinds are building, and we expect growth to remain below its potential rate of around 4% for at least three years," says Capital Economics.

The fiscal problems will also hold back Poland's euro-adoption plans. The government made a surprise announcement in the autumn of 2008 that Poland would join the euro by 2012. In December, PM Tusk said only by 2015 will the country have fulfilled all the Maastricht criteria required to join the euro, which include a public debt ceiling.

Growth Czech'd

In December, data showed that the Czech economy contracted by 4.1% on year, improving from the 4.7% contraction in the second, which is consistent with quarter-on-quarter growth of 0.8%. Komercni Banka expects the economy to shrink by 4.3% in 2009, which would be the deepest fall in recent history, though it should return to growth of 1.3% in 2010.

The severity of the Czech recession took many by surprise. It can, of course, be largely explained by the country's heavy dependence on exports to the EU and, moreover, that items most affected by the recession, such as automobiles and consumer electronics, feature prominently in its export profile. It's also undoubtedly true, though, that the recent rebound in growth in the Czech Republic has been boosted by Western European car-scrapping schemes. "Given that these schemes are beginning to expire, and to the extent that they have just brought demand forward, this means that growth is likely to fade from the fourth quarter onwards," says Capital Economics. "We estimate that Western European car-scrapping schemes accounted for around half of the recovery in exports since the start of the year. Now that such schemes have started to expire, we expect the pace of economic recovery to ease and, to the extent that the schemes have just brought demand forward, there is a real risk of a double-dip recession."

That risk is clearly shared by the central bank, which in mid-December surprised the markets by cutting rates another 25 basis points to a record low 1.00%. "The decision is due to the weakness in domestic demand and the still significantly favourable medium-term inflation outlook," says Raffaella Tenconi of the Prague-based brokerage Wood & Company. "The [Czech National Bank] research department maintained the expectation of inflation close to the 2% target in the medium term."

On the plus side, the banking system is strong and Czech people's conservative nature meant that they are not heavily indebted by regional standards. It should come as no surprise that the two countries that will probably come out best from the crisis, the Czech Republic and Poland, have low loan/deposit ratios, which is mirrored in their low dependence on external funding. The rest of Central Europe, by contrast have loan/deposit ratios well above the 100% level.

Czech politics remain volatile, which poses risks for the recovery. The Civic Democrat-led (ODS) government of former prime minister Mirek Topolanek humiliatingly collapsed during the Czech presidency of the EU in the first half of this year, and the country is currently governed by a technocratic caretaker administration of PM Jan Fischer. Though popular, his difficulties were exemplified by left-wing parties, the Social Democrats (CSSD) and Communists, sabotaging the 2010 budget by pushing through around CZK12.5bn (€475m) in fresh spending, mostly on wages of teachers, civil servants and other public workers, and higher income for farmers. This left Fischer's administration scrabbling to fill in the holes that would allow the PM to pledge to the IMF and EU that everything had been done to keep the 2010 budget deficit at the original target of around 5.3% of GDP, already pretty high by regional standards. The move by CSSD was an attempt to get its nose out in front in the run-up to the elections in May, which polls show is wide open.

Hungary votes

Hungary is firmly in the category of "hardest hit by the global economic crisis," but unlike some - notably Romania and Ukraine - it has at least had the semblance of a government prepared to take action to right the listing ship. Even so, the data shows it will be a long and arduous climb back up the pole - the Economist Intelligence Unit picks it as one of the 20 worst performing economies in 2010 - not helped by worrying signs of growing discrimination against foreign investors.

Third-quarter figures released in December showed that GDP contracted slightly less than first reported at 7.1% versus the year-earlier period. Analysts put the 2009 contraction at 6-7%, with either slight growth of 1%, flat growth or a contraction of 1-2% in 2010.

Looking in detail at the recent data shows just why, even though the worst of the economic downturn has probably passed in Hungary, the recovery will nonetheless be extremely slow and painful. Private consumption in the third quarter fell by 8.8% on year following a 6.0% drop in the second quarter. Investments also recorded a further decline in the quarter by falling 6.8% versus 3.4% in the second. Consumer activity is being hammered by a combination of difficulties. Previously, consumers had heavily financed consumer activities using foreign credit, betting on a stable forint. However, with the sharp slide of the Hungarian currency at the end of 2008 and the beginning of 2009, these loans became substantially more expensive, both to repay and to take on anew. Along with this loss of credit availability, labour markets have deteriorated sharply in 2009, with unemployment rates soaring and earnings growth choked off. Finally, the government has been unable to pump loads of money into the economy given the weak fiscal position that predates the crisis. "This year's GDP growth will probably fall by more than 6% on the back of extremely weak private consumption, still relatively weak investment and inventory adjustment," says Piotr Kalisz of Citigroup Global Markets.

While business sentiment has been noticeably picking up elsewhere in Europe, Hungary's business sentiment index slipped in November, as measured by its Purchasing Managers' Index (PMI). The PMI in November stood at 47.5, the 15th consecutive month in which the reading was below the 50-point level delineating either a pick-up or a slow-down in manufacturing activity. This is the longest such streak in Hungary's history. "Continuing worries about how deeply the government will need to consolidate its budget in the coming years, including potential closing or overhauling of loss-making state-owned enterprises, is one issue that is weighing down manufacturers' outlook," argues IHS Global Insight.

That budgetary position is a constant thorn in the government's side, but one that isn't being ignored, not least because the government had to call in the IMF and the EU as early as October 2008 for a massive $25.4bn financial support programme, the conditions of which are based on getting the budget deficit under control.

In the first 11 months of 2009, the budget was in deficit by HUF1.124 trillion ($5.525bn). Already, with one month remaining, the consolidated budget deficit reached 4.3% of estimated GDP for 2009 as a whole. With December a month in which deficits are traditionally run, the government's plan to have a budget surplus over the fourth quarter in the hope of keeping the annual deficit below 4% of GDP lies in tatters. Rather than the planned 3.9% of GDP shortfall, analysts now expect it to approach 4.5% of GDP.

The government had closely cooperated with the IMF in drawing up an austerity budget for 2010, aiming to reduce the deficit to 3.8% of GDP from that estimated 3.9% this year. That now seems fanciful, more so when you bring the political risks into consideration. The centre-left government of former prime minister Ferenc Gyurcany fell apart in March to be replaced by a caretaker government of Gordon Bajnai, pending regular parliamentary elections in April 2010.

The opinion polls put the centre-right opposition party Fidesz as a clear favourite to win those elections, although it may need to form a coalition. Fidesz, which is prone to bouts of populism, has indicated it will seek to renegotiate the agreement with the IMF to render the programme more "growth oriented" - code for making its impact more socially tolerable, hence more diluted. Fidesz's economic spokesman has also questioned its basic macroeconomic assumptions. "2010 thus promises to be an interesting year in Hungary," says Vlad Sobell of Daiwa Securities.

That interest could be heightened by what some seasoned observers on the ground are picking as the 2010 issue in Hungary: a loss of confidence in the country as a favourable investment destination.

On November 18, nine embassies in Hungary (including the US, French, German and UK) issued a statement expressing their great concern at a growing number of cases of suspected discrimination against foreign investors.

The first case concerned an Indian company that Fidesz stopped from building a tire factory in the town of Gyongyos in 2008. The party used mostly groundless environmental arguments, killing off an investment that would have created 800 jobs in the town. Then this year the local government of Pecs tore up an agreement with Suez, the French company that was running the local waterworks. The town didn't bother going to the courts, preferring simply to send in heavies to occupy the offices and lock the management out. A legal case is now under way after Suez sued; French President Nicolas Sarkozy demanded an explanation of the motives leading to the decision in a telephone conversation with PM Bajnai.

The most damaging case happened this autumn when the National Radio and Television Commission (ORTT), the body that oversees Hungary's airwaves, decided not to extend from the end of October the licence of two radio stations, whose owners are foreign consortiums, on technical grounds. Instead, it awarded the licenses to two start-ups, one of which is linked to Fidesz. "Since the members of ORTT's decision-making body are nominated by political parties, most people suspect a stitch-up," says Balint Szlanko of Transitions Online.

Some observers note the strong reaction from the foreign embassies probably stems from exaggerated fears that the likely winner of the general elections, Fidesz, will run a policy that is unfavourable towards foreign investors. However, they stress that the recent cases should be treated as political elements trying to promote companies with certain political affiliations rather than a government campaign against foreign firms in general. Interesting, indeed.

Slovak slide

The big worry for Slovakia leading up to it adopting the euro at the start of 2009 was whether it would see a similar spike in inflation as other countries that had adopted the euro had. The crisis put paid to that possibility and Slovakia's annual inflation in November of 0% was lower than the rate of the whole of Eurozone, which was 0.5%.

Some then worried that Slovakia had joined the euro "just at the wrong time." A big exporter to the EU, it couldn't devalue its currency to make the price of its exports, hard hit by the contraction of demand in the EU, that much cheaper. But as the initial shock of the downturn begins to fade, it appears the euro hasn't been much of a drag on the Slovak economy. Andreas Tostmann, head of Volkswagen's Slovak operations, says that when looking at future investments, the stability of the exchange rate is much more important than any temporary gain provided by exchange rate swings. "Slovakia being in the Eurozone is a real advantage for us," he says.

Even so, the economy dropped precipitously from its previously rip-roaring pre-crisis rate of about 10%. In the third-quarter, GDP shrank 4.8% on year, which was slightly better than the "flash" estimate that had put the decline at 4.9%. In seasonally adjusted terms, third-quarter growth was confirmed at up 1.6% on quarter, which was the fastest rate in the Eurozone. With signs of improvement emerging in the Eurozone, particularly Germany, there should be better results in the fourth quarter. IHS Global Insight's latest forecast projects a full-year decline of 4.8% in 2009, which assumes a 3.4% drop during the fourth quarter. Daiwa sees Slovakia's real GDP falling by at least 4.5% this year. However, with the Eurozone forecast to resume growth in 2010 (of 0.6%), Slovakia's economy will likely follow suit by expanding by about 1.5%.

The biggest near-term risk, say analysts, is the worsening labour market. The latest labour survey indicates that the jobless rate jumped to 12.5% in the third quarter, up from a year-earlier figure of 9.0%. Meanwhile, employment was down by 4.3% on year in July-September, after falling just 0.6% on year in the first half. "The poor labour market raises risks for the near term, and personal consumption is likely to remain weak throughout the coming months and into 2010," says IHS Global Insight.

Slovakia will hold regular parliamentary elections in mid-2010. The opinion polls point to the re-election of the dominant member of the current coalition, the centre-left Smer party headed by Prime Minister Robert Fico. Should this happen, Smer will again need to seek coalition allies - its most likely partner will be (again) the Slovak National Party (SNS), as Fico has enjoyed a relatively trouble-free relationship with the SNS leader, Jan Slota.

While maintaining credible economic policies, the new Smer-SNP government will also likely indulge in bouts of populism, with the state becoming more involved in economic management. "The SNS has imparted on the government a nationalistic face, demonstrable in particular in Slovakia's troubled relations with Hungary. Unfortunately, this feature too would persist," says Daiwa's Sobell.

On October 28, the Fico government approved a draft Strategic Companies Act that would outlaw mass layoffs at companies with over 500 employees or that are major suppliers of gas or electricity. The measure would also require owners to "ensure the uninterrupted operation" of their companies, and would give the state pre-purchase rights on their holdings if they wanted to sell; the price would be determined by a state-appointed evaluator, not by the market. The state would reserve the right to define which companies it regarded as "strategic" and thus which are bound by the law. The measure now heads to parliament for approval in accelerated legislative proceedings, which means no debate. It should be in force by the start of 2010. The Economy Ministry, which scripted the bill, says it will be applied only in special cases, and only for a limited period, such as until the end of 2010. Independent analysts said the measure seemed to be a populist response to rising unemployment, which at 12.5% has reached a four-year high and looks set to spike with the threat of mass layoffs at chemicals firms Chemlon and NCHZ. The latter, which has 2,000 employees, is a key employer in economically depressed central Slovakia, but has recently entered bankruptcy. However, critics of the bill say it will do little to address joblessness because it contains too many legal stumbling blocks.

Baltics: things can only get better?

Balts are generally a dour lot - at least until a couple of vodkas have thawed them out - so it's hardly surprising that after a year in which all three Baltic states experienced their deepest recessions since regaining independence, predictions of what's in store for 2010 vary all the way from shrugs to rolled eyeballs to pitiful groans.

Yet even the most miserable Balt will harbour the secret hope that next year will see the economic situation improving, at least in relative terms. Double-digit reductions in GDP can't happen back to back, can they?

Lat's your lot

Latvian central bank governor, Ilmars Rimsevics, could barely contain his enthusiasm - though he somehow managed - on Decemeber 14 when he said during an interview that the Latvian economy could contract by just 2% next year instead of the 4% previously forecast.

Certainly that's preferable to the 18% contraction expected for 2009, but it's worth bearing in mind that he was still talking about a contraction and that unemployment, which has already crossed the 20% barrier according to Eurostat data, looks set to account for more than a quarter of the working population in early 2010.

Nevertheless, there is reason for some exceedingly cautious optimism regarding Latvia. Prime Minister Valdis Dombrovskis may have the look of someone who comes in to fix your computer, but the geeky exterior hides a determined and intelligent political operator who has somehow managed to maintain the trust of the IMF and EU even though Finance Minister Einars Repse insists on wearing a bizarre three-piece pinstriped suit made of leather to meetings with them.

Repse's attempts to reform Latvia's hopeless tax collection regime are more praiseworthy than his fashion sense, though there still remains a lot of work to do if money is to be clawed back from the "grey" economy and fiscal targets are to be met. A successful sale of Parex, the bank that caused Latvia's plunge into the abyss in the first place, would do wonders for morale and investor confidence.

But a general election is due in October, and it seems unlikely the Dombrovskis government will survive in its present form until then, as political parties jockey for position, desperate not to get saddled with the blame for causing the recession in the first place. Indeed some parties are attempting to shift the blame onto the shoulders of the IMF, which could still lead to the collapse of Latvia's €7.5bn bailout package if the voters fall for this crude conspiracy theory.

Lithuania the one to watch

If Latvia had it hardest throughout 2009 as a whole, Lithuania has been catching it up pretty rapidly and could come under the severest pressure in 2010.

The new year arrives with a bang - hopefully not literally - as the Ignalina nuclear power plant gets taken offline. That single act could dictate much of what Lithuania can expect over the next 12 months. "Sustained recovery of the Lithuanian economy will occur only after a potential energy price shock at the beginning of 2010," Danske Bank's Baltic specialist, Violeta Klyviene, tells bne. "It will then become clearer how the economy will be able to absorb such a shock due to rising electricity prices. We expect the economy to contract to up to 4% in real terms. We assume in this analysis that electricity prices will increase by 30%."

Other analysts that bne spoke to have a sneaking suspicion that Lithuania will be "the one to watch" in 2010: and not in a good way.

Public sentiment is declining rapidly as austerity measures taken by the government of Andrius Kubilius seem to be having little effect. Kubilius likes to talk of himself as a "crisis prime minister," but after more than a year in office, voters are starting to wonder if he's perhaps a little too fond of crisis for his own good.

Odeta Cickauskaite-Bloziene, head of the Institute of Private Finances at Swedbank in Vilnius, believes 2010 will actually be worse than 2009 for many Lithuanians. "The year 2010 will be more difficult since the growth of unemployment and a decline in wages and social benefits will affect more social groups. Wages will decline in the public sector as well and, with the general income getting smaller, more households will be affected, which will certainly entail difficulties in making payments for heating or meeting financial liabilities," she says.

Estonia turns pain into gain

The most notable economic performance over the last 12 months in the Baltics has come from Estonian Finance Minister Jurgen Ligi and his boss, Prime Minister Andrus Ansip. Neither man is overburdened with charisma, but their cool, methodical approach has managed to restore some confidence to the markets, while the Estonian general public seems more stoical about the cuts and taxes being heaped on them than their counterparts in Latvia and Lithuania.

Most important of all, Ligi and Ansip have managed to keep euro adoption as their number one priority or "exit strategy," using it as the reason for clamping down on public spending, introducing boss-friendly labour laws and streamlining administration. The 2010 budget restricts the national deficit to the 3% of GDP limit required by the Maastricht criteria and the European Central Bank will decide after an inspection tour in April and May if Estonia can be waved into the Eurozone in 2011. "The main event is whether Estonia will get accepted into the eurozone," says Morten Hansen of the Stockholm School of Economics in Riga. "They will strangle their economy as much as it takes to make it - the budget deficit criterion is the toughest part - and it will be seen as a big blow for them, almost a humiliation, if they don't achieve it.

"I think they will make it although the odds are long - but Estonians can be quite bloody-minded - and are certainly tougher than most," he concludes.

If Estonia does join the euro club, the consequences are potentially huge across the Baltic states. Policymakers in Latvia and Lithuania like to talk up the fact that an Estonia in the euro makes it more likely that their countries will also be waved in sooner rather than later. They are less keen on discussing a wave of business relocations and the redirection of capital that would also follow as investors seek to combine the security of the euro with the growth potential of an open economy with a welcoming tax regime. "A stable Estonia can capture investment and trade from a more chaotic and unpredictable Latvia and Lithuania. Baltic collaboration certainly does not prevail - as it usually never does," says Hansen.

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