COMMENT: CEE is better prepared for the new storm

By bne IntelliNews October 27, 2011

Juraj Kotian of Erste Bank -

The reaction of the Central and Eastern European region to the global slowdown should be less severe (in relative terms to the Eurozone) than in the post-Lehman crisis, as CEE economies are in a completely different stage of their economic cycle and have reduced their imbalances.

Global economic sentiment has been deteriorating in recent months and, on top of that, we are witnessing the worst situation on the financial markets since the stress peak in March 2009. Credit default swaps (CDS) on sovereigns have gone through the roof and the interbank market is paralyzed again. The growing debt overhang of advanced economies and too many unanswered questions about the future model of the Eurozone increase the uncertainty, with direct implications for a whole set of economic decisions, starting with denting consumer sentiment, investments in the manufacturing sector and ending with abnormal risk aversion, higher costs of financing and a strong preference for cash or other highly liquid assets worldwide.

Hungarian growth should be the weakest in the CEE...

This does not help economic growth, which decelerated already in the second quarter. The breakdown of GDP for the second quarter published in September revealed that, in many CEE countries, investments and net exports were the only contributor to the GDP growth, while household and government consumption stalled or even contracted. The gloomy global outlook has also hit our forecasts, which have recently been revised down. The most anaemic growth is expected (0.9% on year in 2012) in Hungary, where, on top of global factors, local policy decisions play an important role.

... because recent domestic policy will have adverse effect on growth in 2012

In particular, the forex mortgage loan repayment programme should result in the erosion of capital of banks, which will thus be a limiting factor for the credit supply and therefore investment. Even more important is the high legal uncertainty. Household consumption should remain depressed, as fiscal consolidation will be conducted through further tax increases (VAT hiked to 27%). The Hungarian economy is thus the only one in the CEE that should not outperform the Eurozone growth next year. The GDP growth of CEE8 economies is to slow down next year to an average 2.6% on year, from 2.8% expected for this year. These forecasts are based on 0.9% growth of the Eurozone next year, where the risks are currently skewed to the downside.

Poland, Turkey and Ukraine continue to exhibit strong growth, but the risks of a hard landing have increased for the Turkish economy. The widening current account deficit, which has been financed predominantly through foreign borrowing, could be challenged soon by the global deleveraging and force the country to rapidly narrow its current account deficits, unless the sentiment improves.

CEE countries are not decoupled, but they should do much better

At the first glance, the current situation might look similar to the post-Lehman period, as the spill-over channels remain the same - the potential collapse of global demand and sudden stop or even reversal of capital flows. The CEE8 economies contracted sharply (excluding Poland), by about 5% on average in 2009, meaning one percentage point more than the Eurozone. The post-Lehman development proved that no CEE economy is decoupled from developments in the rest of the world. So, if the Eurozone decelerates sharply, CEE will not avoid contagion.

But there are three reasons why the CEE region should do much better this time (relative to the Eurozone) than in the post-Lehman period.

1. Debt levels finally matter

The first is that none of the CEE8 countries would be in such a challenging situation in terms of balance of payment problems, sustainability of the public debt or contingent liabilities in the banking sector like Eurozone peripheral countries. This argument was partially valid also in 2009, when markets were focused on external imbalances of some CEE countries, but at that time markets were completely ignoring the fact that CEE countries are far less indebted than governments or the private sector in the Eurozone. We raised our concerns about the fiscal space of some Eurozone countries already in February 2009 and recommended the relative value trade - shortening of peripheral countries against CEE, which proved to be correct. Easing access to the ECB refinancing facility helped to mask the balance of payment problems of some Eurozone peripheral countries. The current situation shows that now markets better differentiate countries according to their level of debt.

2. Structural budget deficits have improved

The fiscal deficits of CEE countries increased during the crisis, but remained well below more problematic Eurozone countries. The debt level has never been an issue apart from Hungary, where the debt to GDP ratio is still more than 10pp below the Eurozone average (2011F is 85%). Other CEE countries have their debt/GDP well below the 60% of GDP required by the Maastricht treaty. Widening of fiscal deficits in CEE had its roots in the pre-crisis period, as countries did not consolidate their public finances sufficiently in the boom years. The high growth of cyclically boosted tax revenues had helped to mask the underlying structural deficits, which later showed up in full force. Almost all CEE countries entered the crisis with a structural deficit above 3% of GDP. In the meantime, governments which were under strongest market pressure (and under the IMF programme) took decisive steps towards fiscal consolidation and brought down their structural deficits below the pre-crisis levels. The most striking result was achieved in Romania, where the structural deficit has been reduced from almost 9% of GDP in 2007 to about 3.3% of GDP estimated by the European Commission for 2011. Hungary made a huge achievement too, but through either one-off measures or temporary measures, often with an adverse effect on economic growth. These measures will need to be replaced by real reforms and savings in public expenditures

What else has put the CEE countries in a much better position compared to the post-Lehman shock? It is their narrowed current account deficits, the former Achilles Heel of some CEE countries. The Romanian current account deficit narrowed from almost 14% to below 5% of GDP, Croatia's from 7% to 1.4% and Hungary's turned into a surplus of 2.8%, from a deficit of 7% of GDP in 2007. This has substantially reduced the new external financing needs of CEE countries, which had made them so vulnerable in the past. The progress was achieved very quickly and much faster than in some peripheral countries.

3. Cyclical component of GDP is low

Ultimately, the most relevant argument as to why the reaction of the CEE region to the global slowdown should be different or not as severe (in relative terms to the Eurozone) as in the post-Lehman crisis is that CEE economies are in a completely different stage of their economic cycle. The CEE economies were hit by a strong external shock in the year or a year after their economies peaked, speeding up contraction of the output gap. What would normally take years in a normal growth cycle, only took months. Thus, the economic contraction in 2009 was decisively affected by a huge scale-back of the cyclical component of GDP. Indeed, investments and inventories were the biggest contributor overall to the economic slump in 2009, corresponding to 4/5 of the contraction.

We believe that the slowdown has little chance to repeat to such an extent, given that investment rates have already declined sharply - from the pre-crisis peak of 30% of GDP to a more neutral 20% of GDP. Furthermore, the CEE economies are running close or even slightly below their potential, compared to an output gap ranging between 1.8% and 10% one year before the Lehman collapse.

Currency depreciation is usually supportive for growth, but this is not the case for countries in which households are exposed to FX loans. However, the Lehman collapse hit the CEE countries at a time when CEE currencies were much stronger than they are these days. The external imbalances of the most vulnerable countries have narrowed considerably and we do not see any fundamental reason for further currency depreciation. In countries where the FX weakening has a clear adverse effect on their economies, central banks actively stepped in and intervened against increased volatility. The FX reserves have increased rapidly in countries where the IMF was present (Hungary, Romania, Serbia) and the coverage of their gross external financing needs (the short-term and other maturing external debts, plus the current account deficit) by FX reserves is at a more comfortable level. On the other hand, Turkey and Poland look the most vulnerable in the region, given their widened current account deficits and high amount of short-term external debt relative to their FX reserves. However, their currencies recently depreciated sharply, which should trigger adjustment of their current account deficits.

The growing uncertainty on financial markets led to enormous risk aversion, sending CDS on CEE countries to levels last seen in 1Q09. CEE currencies were also under pressure. The most striking move happened on the Polish market, where the zloty fell about 10% in one month, reaching 4.50 EURPLN. We have been arguing for a long time that the vulnerability of the Polish currency has increased, due to rising external imbalances, the lack of fiscal discipline (the fourth highest structural deficit) and increased dependence on external borrowing in recent years. Unfortunately, risks have materialized and the Polish zloty has become one of the worst-performing currencies this year, together with the Turkish lira. The Hungarian forint was doing relatively well, despite the approval of the above-mentioned controversial law that would allow clients to repay FX loans at an artificially low exchange rate. The statement that the CB will allow commercial banks to tap its FX reserves eased downward pressure on the HUF related to the closing of short EURHUF and CHFHUF positions used for the funding of FX loans. The Polish, Croatian and Romanian central banks were reported to have intervened on FX markets, while the Turkish central bank has been conducting FX auctions for a couple of weeks. Interventions had an adverse effect on domestic yields, which increased in the aftermath of the interventions (due to drains on local currency liquidity). The persistent pressure on FX reduces the chance for rates to be cut soon, which could otherwise be an adequate reaction to the more benign inflation outlook and gloomy economic outlook.

CEE markets would benefit from any progress in solving the Eurozone debt crisis

It is hard to believe that the damage done by the slow progress in solving the Eurozone debt crisis could be completely reversed. However, if there is a solution that could calm the markets, this could open the door for some central banks in CEE to proceed with rate cuts. We think that CEE countries are much better prepared to deal with the crisis than they were three years ago. Due to the fiscal and external turn around of the local economies, the economic contraction should not be as severe as in 2009.

Juraj Kotian is Co-Head Macro/Fixed Income Research CEE at Erste Group

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