Erste Bank -

• Monetary policy and flexible exchange rates provide buffer against external shocks - repeat of Baltics problems unlikely;

• Inflation worries are fading;

• Deceleration of credit growth, but no credit crunch.

CEE economies have been enjoying strong growth in recent years, but the current global economic downturn is testing how solid the roots of this growth really are. Recently, Latvia and Estonia, the two economies with the fastest growth in CEE during the last decade, have showed how quickly high-growth economies can fall into recession. Should a similar scenario be expected for the rest of the region?

No Baltics scenario

Erste analysts do not think so. The Baltics have had a unique cocktail of three risk factors that made these economies significantly prone to a slowdown - economic overheating for a long period of time, currency pegs, no anti-cyclical monetary policy - in place and furthermore have had the highest proportion of short-term external debt in their economies, says Juraj Kotian, co-head of CEE macro/fixed income research at Erste in Vienna.

On the contrary, the structure of external debt is much better in non-Baltic CEE countries. Forex reserves comfortably cover all short-term external debt - which is less than half that of the Baltic countries in relation to GDP. Furthermore, central banks in CEE countries (ex-Baltics) have taken action against excessive growth by tightening monetary conditions or introducing other restrictive measures to hamper credit growth to avoid overheating in the future. Sovereign monetary policy and flexible exchange rates have helped CEE economies react to external shocks in a much better way, says Kotian.

Inflation worries are fading

Since the summer of 2007, all CEE banks have raised interest rates, slowing down economic growth and keeping inflation in check. Erste analysts think the tightening cycle could be close to an end. A risk of rate hikes persists in Romania and Ukraine, but the expected disinflation in the next couple of months makes further tightening unlikely. On the other hand, elevated interest rates and diminishing inflation risks could trigger a rally on CEE currencies soon. Central banks in CEE might start with rate cuts next year in reaction to currency moves and disinflation. Leading the way, the Czech National Bank has already started with a 25-basis-point rate cut, and it will probably deliver another cut in November.

Credit growth to continue at slower pace

Erste analysts consider it is almost certain that investments will slow next year because of eroding external demand and the higher cost of capital. They say banks will be more selective in lending, charging higher credit spreads, which will decelerate the loan growth - especially in the corporate sector and foreign currency loans. The deceleration of credit growth (no credit crunch expected to happen) should not liquidate investments, though, as the return on capital and share of capital return in value added are relatively high (also because of low labour costs), which means that companies should be able to finance increased credit spreads and some capital expenditures from their operating profits.

Economic growth 4.3% in 2009, no recession

Deteriorating confidence among both manufacturers and consumers in the Eurozone is pointing to a further economic slowdown in the Eurozone, or even towards stagnation. That is not good news for CEE economies, which have been exporting a sizeable portion of their export production to Western Europe. However, these tough times will put more pressure on evaluating efficiency worldwide and, at the end of the day, may speed up the process of shifting production from Western Europe to CEE, where labour costs are far below the European average, says Juraj Kotian.

The average economic growth in CEE is expected to decelerate to 4.3% in 2009, from the 5.4% estimated for 2008. Therefore, GDP growth will, until the dust settles, be below expected output for a while. The biggest risk to economic growth in CEE currently lies in the fear of a more extensive economic slump in Euroland, which would dampen external demand. Stagnation or a recession in the Euroland economy would shave about 0.2-0.5 percentage points from forecasted growth rates in CEE. Nevertheless, growth in CEE economies should remain very solid and the threat of recession seems rather distant, concludes Kotian.

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