UniCredit Group -

One year after the beginning of the international financial turmoil, high uncertainty and volatility persist at the global level, with no signs of abating. The US economy continues to perform poorly and signs of a slowdown are now materialising also in the Eurozone. Strong inflation and declining employment are taking their toll on households' spending, while a low level of construction activity - likely to persist for the whole forecasting period - will reflect the weakening capital formation until mid-2009, which will in turn slow down investment. With a large share of CEE exports being directed towards the Eurozone which is experiencing declining growth, the situation is anything but favourable for CEE. The financial sector crisis is deepening, moving from the US to the UK and to Western Europe. Stock markets have been dropping for weeks, liquidity is becoming an issue for the financial industry, while risk aversion is increasing sharply. Such a scenario is clearly unsupportive for emerging markets and for CEE.

The repricing of CEE market risk has clearly intensified in line with global trends. The 5-year credit default spread (CDS), though being a quite illiquid measure in some of the countries, is peaking, and strongly penalising those countries which show macroeconomic imbalances (see chart 1). The CDS spread for Ukraine is now trading at more than 700 basis points, while the spread more than doubled in the last month in Kazakhstan, Russia and Latvia (now at 430, 254 and 330, respectively). Risk pricing, although already high, also increased in Southeast European countries (CDS spreads are currently above 200 bps in Romania, Bulgaria and Serbia) and Turkey, where CDS spreads are now close to 300 bps. While Central European countries have also been affected by a surge in CDS spreads in the last month, they continue to enjoy a relatively lower risk perception than other countries in the region and - with the exception of Hungary - their CDS spreads are far below 100 bps. Going on declining world growth will reflect the high uncertainty, volatility and strong risk aversion characterising international markets, with a negative effect on international capital flows.

While growth has so far remained quite strong throughout the CEE region, the gloomy international outlook will take its toll in 2009. High vulnerability and cost of risk combined with lower demand in the Eurozone will lead to a slowing of GDP growth from 5.8% in 2008 to 4.9% in 2009, with some recovery in 2010 (5.2 %).

Capital flows

We identify the high dependency on capital inflows and cost of risk as the main contagion channel for CEE. Most of the CEE countries are running wide current account deficits; an indication that the economy is unable to generate enough domestic savings. Economic growth has been financed by "importing" external funds - in the form of foreign direct investment or public or private debt. The banking sector has played a role, with strong lending growth - one of the main drivers of the retail and investment boom - being largely financed from abroad. The re-pricing of risk at the international level has led to an increase in the cost of such external financing, meaning a general tightening of monetary and credit conditions. Such tightening can be moderate, leading to some cooling of economic activity, or more abrupt, meaning a strong correction in terms of growth. Countries with greater dependency on foreign funding and facing a higher cost of risk are more exposed to a correction. It is interesting to note in Chart 2 that Kazakhstan, Latvia and Estonia, the three countries in the region which are already experiencing a strong credit and monetary tightening, are those which emerged as more sensitive using our indicator. Bulgaria, Romania and Lithuania follow. The most recent international sell off suggests the relevance of a contagion channel for CEE.

Lower demand from the Eurozone will negatively influence CEE export performance as the European Union absorbs roughly 60% of exports from Central and Southeast Europe and somewhat more than 40% of exports from the CIS countries. Central European economies are even more exposed as they have developed a strong trade specialisation within the EU in highly cyclical sectors like the automotive industry and the electrical and optical equipment. However, the production optimisation strategies of international companies could be interpreted as a possible stabiliser effect. It is true that European corporations are constraining investments at the global level, including those in CEE - meaning a stabilisation in the wave of delocalisation of production projects and lower FDIs in the region. In an effort to maximise efficiency, international and global companies will nonetheless try to fully profit from their past delocalisation choices, thus scaling down production in more mature/higher cost countries rather than in the CEE region. This might provide some support for CEE production activities, despite the decline in demand in world markets.

Lower demand from the Eurozone and slower consumption and investment activities are the main factors responsible for the slowdown in growth in Central Europe (Poland, Hungary, the Czech Republic, Slovakia and Slovenia). We forecast growth to decline from 4.7% on year in 2008 to 4.0% in 2009. Only Hungary will record some acceleration after the weak performance recorded so far in the wake of the implementation of the austerity package in late 2006. The region seems to be relatively less sensitive to potential shocks. Slovenia is already a member of the Eurozone, while Slovakia will adopt the new currency in January. In a surprise move, Poland has recently announced its intention to seek early adoption of the euro (targeting 2011/2012 as a possible date), and preparation has clearly accelerated.

Getting real

A reversal in the real estate market and a tightening of capital inflows are behind the abrupt correction currently experienced in the Baltics. Following a decade of excessively rapid growth, driven by strong consumption and investment and a boom in the real estate market, the situation started to stabilise at the beginning of 2008. The real estate market has experienced a sharp downturn in both Latvia and Estonia, while the banking sector, which was relying highly on external funding, has reacted to the general increase in the cost of risk, substantially contracting lending growth. The resulting monetary and credit tightening has led to a marked contraction in economic activity. Estonia and Latvia are already in recession. Lithuania, which has a more developed industrial base, is slowing down more gradually, but also traditionally lags behind the cycle of the other two Baltic countries.

With high current account imbalances, strong dependency of growth from international capital inflows (with a large share of FDI being directed towards the real estate or the financial sector) and strong inflationary pressures, Southeast European countries (Bulgaria, Romania, Croatia, Serbia and Bosnia-Herzegovina) face similar challenges. We price in a slowdown in growth in the region from 6.8% in 2008 to 4.5% 2009. The real estate market is showing signs of a correction, especially in some overheated sub-segments (ie. the tourism sector in Bulgaria or the residential and commercial property market in Bucharest, Romania). Investment is also slowing down, while growth in consumption is impeded by a deterioration in the financial position of households and tightening access to the credit market. We nonetheless see a smoother slowdown taking place in the region compared to the Baltic states. Signs of economic overheating are much less clear in Southeast Europe than they were in the Baltics. Moreover, the economic structure in Southeast Europe is much more diversified, with a higher share in economic activity of tradable rather than non-tradable sectors.

Russian unbalanced

While oil prices have been stabilising, the Russian economy has revealed imbalances related to its lack of diversification and to the dependency of some sectors on capital inflows. In the last months, the global financial turmoil (more than the Russia-Georgia conflict) caused large capital outflows, resulting in a stock market slump and liquidity shortages in the interbank market. While the strong position of the large state-owned banks and the resolve of the authorities to tackle the problems - made possible by huge international and fiscal reserves - prevented a major systemic crisis, we reinforce our view that this situation will result in some additional concentration in Russia's banking sector. Moreover, lower capital inflows resulting in tighter credit conditions will combine with still high but lower oil prices to reduce investment appetite and income growth. As a consequence, real GDP growth will likely slow to 6.0% in 2009 from 7.4% in 2008.

Dependency on international capital inflows and a persistently high cost of risk represent a challenge for Ukraine. While clearly being illiquid, the 5-year CDS spread is now settling at more than 700 bps, the highest in the overall CEE region and among the highest in the emerging markets. Such a high cost of risk is already leading to a tightening of credit and monetary conditions. The real estate market is showing the first signs of overheating, though still limited to a few sub-segments. Political instability predominates with the collapse of the "Orange" coalition. In addition, Ukraine continues to be highly dependent on the development of steel prices, which tend to slow down somewhat, while the fight with Russia which wants to further increase gas prices is still unresolved. Overall, we keep as a baseline scenario a decline in growth from 6.3% in 2008 to 4.2% in 2009, mostly due to a slowdown in consumption and investment activity.

In Kazakhstan, scarce cross-border capital inflows due to the global liquidity crisis very much constrain credit growth. This combines with the burst of the residential construction bubble and lower oil price to limit real GDP growth to probably only 3.8% this year and 4.2% in 2009. Inflation will nevertheless average 17.6% this year and perhaps 9.5% in 2009. Loan growth has become very weak and will accelerate only slightly also in 2009. Credit quality has deteriorated, but the Kazakh authorities are working to establish a distressed assets fund to ring-fence potential risks. Oil prices have peaked in 2008 and will now be lower for some time. The revival of the Kazakh economy nevertheless has to come from the oil and gas industry, which accounts for 70% of exports. Much will depend on the situation of global financial markets however, and thus on the environment for the Kazakh banks to roll over their cross-border debt and renew lending.

In Turkey, amidst the stress exported from the European and US markets and weak private expenditure (especially private investments, the flagship of growth for some years), growth was very weak in the second quarter (1.9% on year). However, the growth environment can now benefit from the absence of political risks (during the summer the Constitutional Court ruling on AKP avoided a major political impasse), which will have positive effects on consumer and business confidence. We forecast growth in Turkey, supported by some easing by the central bank, to gradually accelerate in 2009 and 2010. Turkey, nevertheless, remains extremely vulnerable to international investor sentiment, with risks being mostly on the downside.

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