COMMENT: Looking beyond the credit crisis

By bne IntelliNews December 19, 2008

East Capital in Stockholm -

The global credit crisis dominated most of 2008 and the last five months of the year in particular. The effects of the crisis will be very present in 2009 as well, but the main concern will shift from the financial markets to the real economy. So when looking beyond the credit crisis, one sees an economic crisis. Stock markets tend to be ahead of the real economy though, and might start to rebound when focus shift from sentiment to fundamentals. It will be a gradual process as liquidity from the various state and multilateral rescue packages gather speed. All economies in Central and Eastern Europe will experience a dramatic deceleration in economic growth, quite a few will even have negative growth rates. The outlook for the economies and the implications for the stock markets are discussed in more detail below

Disparate economic slowdown

Although all economies in CEE will experience a dramatic deceleration in growth, the effect and momentum will vary considerably. The slowdown should, however, be noticeable in both domestic demand and exports across the board. Put differently, no single economy or any part of the economy will be able to escape the slowdown, but it may play out quite differently. Inflation, which increased markedly in 2008, will come down considerably in 2009 on the back of falling commodity prices and reduced growth and will not be the main concern although the levels may still be quite high. It is less clear how interest rates should adjust since many economies have had negative or very low real interest rates. Some of the more advanced economies will probably lower rates, but not as much as or as rapidly as in Western Europe and some countries further east will be forced to maintain or even increase rates to defend their currencies, at least during the first half of the year. It is common to divide the countries in our universe into subgroups based on geography and level of economic and political development. It may, however, be useful to take another approach in 2009 given the disparate economic slowdown that is characterizing the region. The countries are, therefore, divided into three groups based on the economic outlook and the challenges they are facing rather than on level of development and geography.

Group 1: the imbalanced economies

The first group includes the economies with large economic imbalances that have to struggle to finance their external debt. Some countries wrestle with large current account deficits whereas others have uncomfortably high short-term corporate debt obligations. There are some differences between these subgroups but the real issue is the combined financing need presented by these kinds of external debt stocks. It should be noted that most of these countries do not have very large, some even have extraordinarily low public debt levels.

The Baltic States, Bulgaria, Hungary and Ukraine have accumulated large imbalances; some have already moved into recession and most are likely to have negative growth in 2009. These are also the countries where the IMF have or might become involved, which is something that should be welcomed not only by the market.

Apart from helping these countries to finance the external debt in the short term, the IMF also pushes for tight fiscal policies as well as some other reforms through the conditionality attached to the loans. The fund will thus push for reforms that are economically necessary but politically very difficult. One of the most sensitive albeit very important parts of the conditionality involves the monetary policy. The IMF is likely to demand higher real interest rates as well as exchange rate adjustments, which will be a contentious issue for the countries already in the ERM II mechanism. Tighter fiscal and monetary policy in combination with poor outlook for exports to Western Europe, which is the primary destination for these countries, suggests that growth will come down. And the most worrying part is that the recession will most likely be deeper and longer than previously assumed, due to current account dynamics and since neither domestic demand nor exports is likely to lead the way in the near future,

There are a number of countries in Southeast Europe that have similar albeit not as dramatic imbalances. Romania, Serbia and Croatia will also go through an adjustment next year, but should be able to keep growth in positive territory. The imbalances are not as profound and these economies are still going through the catch-up period and grow from relatively low levels. Even though Serbia has received an IMF package, it is quite different from the packages given to Ukraine, Latvia and Hungary as it is more of a way to ensure investor confidence and to help to implement fiscal tightening than actual financing of the deficits.

Some of the economies in this group have or might experience a depreciating currency or even a formal devaluation. It is, therefore, important to understand what happens when a country has to devalue (or depreciate) its currency. Most obviously, it makes the currency cheaper, which would make exports more competitive and imports more expensive. This should help to bring down the current account deficits and would thus be the most important benefit of the devaluation/depreciation. Normally, this benefits exporting sectors and domestic manufacturing, while hurting sectors dependent on imports. Possible, although it is not certain, negative side-effects can be a pressure on inflation (as imports become more expensive and demand for domestic products increases) and a worsened current account balance in the short term, as imports become more expensive from day one, whereas it will take some time before exports pick up (the so called J-curve effect). It could also lead to some more intangible or psychological negative effects in terms of loss of investor confidence and prestige.

Group 2: the larger economies

The next group of countries are the largest economies without major imbalances. Russia is the most obvious example, but also Turkey and Poland make it into this group and possibly also Kazakhstan. One important feature of the larger economies is that they are less dependent on exports and are in a better position to stimulate growth through domestic demand. The ratio of exports to GDP in Turkey, Russia and Poland is only 16%, 26% and 33% respectively whereas it is over 70% in some of the smaller economies in the region. Investment as well as consumption should naturally be lower next year, but public investment from the welfare fund in Russia and the EU structural fund in Poland should be able to offset at least some of the reduced private investment. Turkey does not have the same kind of buffer but should, on the other hand, be the country in our universe benefiting the most from the lower interest rate environment in developed economies since it is the most correlated market in CEE. Consumption should also be able to hold up reasonable well since household consumption is not very dependent on credits. Total household loans (retail credit and mortgages) are only 10% of GDP in Russia and Turkey and 22% in Poland, which can be compared to around 100% in the US and the UK or over 40% in Estonia and Croatia, which have the highest ratios in CEE.

There is thus reason to be somewhat optimistic on growth, but there are at the same time some notable risks to growth in these economies as well, which does not make it unrealistic to assume a zero or possibly a minor positive growth average for the three economies 2009.

There is, however, a great amount of uncertainly in the forecasts and any of the three economies can surprise on either side, but for different reasons. Russia obviously remains very dependent on the oil price although the dependence tends to be exaggerated by the market. Oil and gas make up 25% of GDP, but almost 60% of RTS and as much as 75% of exports. The extremely rapid oil price fluctuations in 2008 make it very difficult to forecast where growth will end up in Russia in 2009. But if one assumes an average oil price around $50 per barrel for 2009, growth should be around zero. The budget and current account will be negative, which is not a major problem given the large reserves, but it will affect investments quite dramatically. It will also mean that the downside pressure on the Ruble should continue, at least during the first half of the year. An even lower oil price would press down growth clearly into negative territory whereas a higher oil price would result in positive growth and a balanced budget and current account. The budget and the current account in Russia are balanced around $70/barrel oil price. The sharply falling oil price during the second half of this year put a lot of pressure on the ruble and forced the Russian Central Bank to spend hundreds of billion dollars to defend the currency and to widen the band to the USD/EUR basket. The Russian authorities thus seem to prefer a soft depreciation strategy over the hard devaluation course, which is more understandable from a political than an economic perspective. Russia is, however, not a basket devaluation case given its strong financials but the downside pressure on the currency will most certainly continue if the oil price continues to fall. If, or rather when, the oil price stables and rebound, the Ruble should follow suit.

Turkey, on the other hand, is perhaps the country in our universe that most clearly benefits from a lower oil price. The main vulnerability in Turkey is rather the boom-bust experience of the Turkish economy and the notoriously high interest rates signaling a structurally weak currency. The fact that Turkey went through a financial crisis as late as 2001 means that parts of the economy, most notably the banking sector which is highly capitalized and subject to stricter rules, are in a relatively good shape. The reform momentum that has served Turkey well since then should be reinvigorated with another IMF agreement. An oil price at $50 means that there will be further downside pressure on inflation and a possibility to lower interest rates and thus reducing one of the main vulnerabilities. Turkey should also be one of the first emerging markets to benefit when sentiment turns more positive in the US, possibly during the second half of the year, given its relatively close correlation. All things considered, it is possible to be optimistic on growth in Turkey but optimistic in 2009 means that there will actually be growth.

There is arguably no particular sore point in Poland and growth should be positive in 2009. The growth levels will, however, come down quite significantly since consumption, investment as well as exports will fall from the present levels.

Group 3: the smaller economies

The third and last group of countries is the largest and most diverse. The common denominator is that they are all smaller countries that have not been in the limelight in 2008, which should be a good thing given the amount of negative news. Some of these countries, such as the countries in the Caucasus and Central Asia together with Belarus, Moldova and the smaller economies on the Western Balkans, are still frontier markets and more developing than emerging and have not seen much investment and did not come into the financial limelight in the first place. They have their own particular set of challenges but are less dependent on the global financial system than their peers in the region and the banking sector is still in its infancy. They are, however, dependent on the outside world in terms of trade and remittances. Remittances, which are expected to fall in line with economic recession in the West and lay-offs, make up as much as 35% and 25% of GDP in Tajikistan and Moldova respectively.

Another group of relatively small economies - such as the Czech Republic, Slovakia and Slovenia - are among the most developed economies in our universe. They do not have any major macro imbalances, but tend to be very export and FDI dependent and should suffer from the sharp slowdown in Western Europe. Exports to GDP are over 70% in the Czech and Slovak Republics, out of which more than 80% is to the Eurozone, and there is a very strong dependence on the struggling automotive industry in particular. The exposure of the car industry to GDP is 20% and 25% in the Czech Republic and Slovakia respectively.

Most of the countries in this group should, despite the challenges, be able to record some growth although it should be substantially lower than during past years and below potential. This growth will remain very vulnerable to the external environment.

Market implications

It should be clear that 2009 will be a very difficult year in terms of growth throughout the world and CEE is no exception, although the region is expected to continue to outperform the established economies. This has important implications for stock markets, as underlying growth is a prerequisite for companies to grow over time. Although the growth will be much under potential and even negative in a number of economies in the region, there will be some selective stocks rather than entire sectors that may be attractive from a growth perspective. Leverage will continue to be an important factor to look out for, both in terms of corporate debt and in terms of credit-related consumption, as will differentiation between private and public investment. Ultimately, unleveraged consumption companies that are targeting non-credit related consumption and infrastructure companies that benefit from state investment ought to be interesting.

There are, however, quite a few companies or even sectors or entire markets that look attractive from a value perspective. Valuations have been pushed down considerably after the heavy and indiscriminate sell-off in 2008. But since most equity markets around the world look quite cheap at this point, low valuations are not necessarily enough for a rebound. Capital became more expensive and scarce in 2008 and investors turned more risk averse. A series of rescue and stimulus packages in late 2008 sought to provide liquidity and demand globally, which should help global equity markets to rebound although it is very difficult to say exactly when it will happen. We believe that the markets and sectors in CEE that are both cheap and offer some, although relatively modest, growth forecasts are likely to experience the rebound first. There are two groups of markets in the region that look interesting based on these assumptions.

First, the largest economies in the region do not have any major economic imbalances and are trading at attractive multiples even if earnings will be revised down. Poland and Turkey are at the time of writing trading at 7.9 and 5.1x 2008 earnings respectively and should be able to have some underlying growth. The Russian market is even cheaper at 3.2x but the growth outlook is more uncertain given the volatile oil price. These markets are also index countries that are likely to be among the first markets to benefit when portfolio investments come back to Eastern Europe.

Second, there is a set of smaller economies that have attractive valuations and that will continue to have some catch-up growth. Serbia, Croatia and Romania are currently trading at 4.1, 6.6 and 6.1x 2008 earnings respectively and will continue to benefit from the rapid integration with Europe. These markets are not in the index but are also very small - the market capitalization of the Croatian market, which is the largest of the three, is only $26bn - and relatively small flows could move these markets considerably. There will certainly be opportunities in the other markets as well but they will be even more selective. And not all sectors or companies within sectors in the relatively more attractive markets mentioned above will perform. The cost and availability of credit will continue to be an important factor in 2009 so leverage will certainly be an important issue throughout the year. And since a range of markets will continue to see their currencies depreciate or even devalue, the cost and revenue structure of companies will also play a very important role in 2009.


The most immediate effect of the global credit crisis, which dominated the second half of 2008, will be over and the main concern will shift from the financial markets to the real economy. All economies in Eastern Europe will experience a dramatic deceleration in economic growth in 2009 after almost a decade of very rapid growth. The medium-long term catch-up potential is still there but most economies will grow below potential in 2009 and some will go through a difficult adjustment period with negative growth rates. The fact that 2009 will be a very challenging year in the real economy does not necessarily mean that the financial markets will be under pressure. This does not imply that they necessarily will perform strongly, some might even be pressed down further, but rather illustrates that financial markets and underlying economies do not always move in tandem. Economic growth was overall strong in CEE in 2008 whereas most markets corrected substantially, which has resulted in very attractive valuations. The slowdown in underlying growth means that investments and consumption as well as exports will be reduced and corporate earnings pressed down. There should, however, be some selective markets, sectors and companies that will perform relatively well although the rebound may take longer than in previous periods. Some of the largest economies in our universe, such as Poland and Turkey, do not have any major economic imbalances and also have among the most attractive market valuations in the region. Russia could surprise on the upside but remains vulnerable to low oil prices. Some markets in Southeastern Europe, most notably Serbia, also look relatively attractive based on the continued convergence with the EU and low valuations.

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COMMENT: Looking beyond the credit crisis

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