EBRD revises down growth forecasts and warns on Ukraine crisis

By bne IntelliNews September 18, 2014

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The European Bank for Reconstruction and Development (EBRD) has slightly revised down its growth forecasts for Central and Eastern Europe, warning that the Ukraine crisis could have a long-lasting effect on the region.

"Permanently higher military spending in the transition region over the medium term, in response to the renewed geopolitical risks, could erode the peace dividend from the dissolution of the Soviet Union," the report states.

"Just when national governments remain financially strapped in the wake of the global financial crisis, any new buildup in military spending will be an additional fiscal burden that will stand in the way of the recovery and economic reforms for the future," said Erik Berglof, the bank's chief economist. 

The EBRD now expects growth this year to average 1.3%, down from its forecast of 1.4%  in May, and it only predicts 1.7%  next year. This would represent the fourth consecutive year of growth below  3% and would even be well below the modest  2.3 per cent figure recorded in 2013. 

Russian gloom

The EBRD's latest economic forecast is particularly glooming reading for Eastern  Europe. The EBRD  confirmed a prediction from May that the Russian economy would stagnate in 2014, after a slightly better-than-expected first six months. However, the bank is revising down the 2015 growth forecast to a contraction of 0.2%. In May it forecast that the economy would grow by 0.6% in 2015.

The EBRD's vision for Ukraine is significantly worse, underscoring the damage done  by Russia's support for east Ukraine rebels. EBRD forecasts a near 12% drop in Ukrainian GDP 2014-2015, with a 9% drop in 2014 because of the war to be followed by a continued sharp decline of 3% in 2015, as the economy absorbs an austerity package required to put government finances back on track.

The EBRD's predictions are significantly worse that those from the Russian government, which downgraded its growth target for this year to 1% from 2% earlier. However, the government believes Russia's economy will continue to grow next year, albeit by only 1.5%. "The Russian economy will come under pressure both from Western sanctions and the sanctions that Moscow has imposed on the West in response," the EBRD said.

The report pointed out that the last round of sanctions imposed in the middle of September are particularly painful, as they target both the main state-owned bank and the all-important oil sector. The state-owned oil major Rosneft has already asked the government for a $40bn bailout as it struggles to cover its financing costs after being cut off from the international capital markets by sanctions.

Sanctions are also affecting business confidence in Russia, which in turn has killed off investment as well as restricting the access of companies and banks to international capital markets and contributing to capital flight, the EBRD said. The economic pall now also seems to be affecting consumers as although nominal wages are still rising, retail turnover has slowed dramatically in the last quarter; consumption has been one of the few effective economic drivers in recent years.

This follows on from former finance minister Alexei Kudrin's prediction this week that $110bn of capital will flee Russia this year, almost double the capital flight of last year.

The report noted that Russian corporates need to make repayments of around $190bn on foreign debt by the end of 2015. As they were unable to borrow externally, international reserves - standing at $465bn in September - may come under pressure and interest rates may have to rise further.

Russia's foreign trade was expected to suffer while existing trade and financial links are restructured in the wake of the sanctions. These links were likely to be gradually reoriented from the West to the East and to Latin America.

Russia's own ban on food imports from countries that have imposed sanctions could drive up inflation in Russia by 1-2 percentage points to around 8% this year, well ahead of the central bank's initial target of 4-5%. Inflation was already running at 7.5% in September on an annualised basis.

The Kremlin has threatened to expand its own set of bans on European and US businesses if the international sanctions regime is extended. Amongst the most worrying is Russia's threat to close its airspace to international flights. "The imposition of a flight ban over Russia would affect both Russia and western countries. The potential ban on transcontinental flights may cost Aeroflot an annual $300m in lost royalties while European airlines may face cost increases of several hundred million dollars as they would have to take longer routes," the EBRD said.

Remittances fall

The Russian economic slowdown is taking its toll on the former Soviet countries of Central Asia and the Caucasus, which have experienced the first drop in remittance flows from Russia since 2009.

The EBRD says that Uzbekistan and Moldova were the worst affected by the drop in remittances recorded in the first quarter of 2014. Other countries whose economies are highly exposed to Russia’s have also suffered. In Tajikistan, remittances - mainly from Russia - make up 49% of GDP, while they contribute 29% of Kyrgyzstan’s GDP.

“Any further dampening of growth in Russia from the introduction of new sanctions would increase the effect on growth in this region,” according to the EBRD.

Despite this, GDP growth remained “quite strong” in Central Asia, driven by major extractive industry projects, although the region’s largest economy Kazakhstan had been held back by delays, in particular at the giant Kashagan oilfield.

Overall, economies in Central Asia are expected to grow by 6% this year (down from an earlier forecast of 6.2%). The Eastern Europe region is expected to contract by 0.5%, but the forecast average is pulled down by Ukraine, while forecasts for the three Caucasian economies, Belarus and Moldova are all in positive figures.

Some countries in the region may yet benefit from the sanctions imposed by Russia on Western producers of food and agricultural products. The “impact [of the sanctions] could be offset, particularly in Kazakhstan, by increased exports to Russia,” EBRD analysts say.

However, the biggest change within the region is not directly connected to the Russian slowdown. In Mongolia, the EBRD has slashed its 2014 growth forecast from 12.5% in May 2014 to just 5%. This dramatic deceleration is due to lower prices of key export commodities, delays to the second phase of the Oyu Tolgoi mining project and weaker investment activity, the EBRD says.

Waiting for QE

For Central Europe, the EBRD views the reviving Eurozone economy as a more important driver than the Russia slowdown, arguing that quantitative easing by the European Central Bank  is likely to help strengthen the recovery in the region. "An effective Eurozone QE may help lessen the risk of setbacks in the recovery of those regions,” it says.

The fighting in Ukraine, and the sanctions imposed on Russia, will do the most to reduce economic activity across the whole region, the bank says. However, while they admit that any impact on the Eurozone economy from the deterioration in relations with Russia would also feed through to Central Europe, the analysts are unconvinced that the region's major economies will suffer too much.

"Countries in Central Europe are expected to continue recovering at a moderate pace," the report sums up. "Positive influences from the eurozone [will be] only partly offset by the weaker demand from Russia and the impact of a ban on some food exports to Russia”. It has raised its forecast  for 2014 growth, powered by Poland - up  0.2 percentage points from the May forecast to 3% - and  Hungary,   leaping to 2.8% from  1.6%. 

In the face of continued recovery in other Central European states, much has been made of weaker macroeconomic data out of Poland in the summer. However, the EBRD joins the crowd of analysts rejecting suggestions that reduced exports to Russia and Ukraine are behind the slowdown.

The food embargo put in place by Moscow in July "will weigh somewhat on Polish growth”, the EBRD said, before pointing out that the country's exposure to its eastern neighbours is limited because food exports to Russia only account for 0.2% of GDP.

Because of the fact that a far greater share of their economies are dedicated to exports to Russia, the Baltic states will not escape so lightly, the EBRD worries. "They have already have been more directly impacted by the sanctions and the significant slowdown in Russia," the report said. "In addition to agricultural firms with large export exposure to Russia, transport firms shipping goods between European countries and Russia may also be severely affected."

To the south, Hungary has been even less affected by the sanctions than Poland, but the EBRD notes that there are other elements of concern. The government's populist policymaking targeting large foreign investors has left the state as the prime driver of the economic recovery, and many worry that it could run out of steam in the mid-term without  new investment and bank lending.

"In addition to being driven by exports, the Hungarian economy has been supported by a number of effects that [are] only temporary," the EBRD frets. Those measures include "public infrastructure spending funded through EU grants and administrative price cuts as well as mortgage debt relief... provided at a cost to the banks.

Southeast slips

Southeast Europe (SEE) is only slowly recovering from the 2009 economic crisis and is held back by failure to reinvigorate reform efforts, the European Bank for Reconstruction and Development’s (EBRD) regional economist told bne

But Peter Sanfey also highlighted reasons for optimism in a region which has suffered a more difficult transition from communism than its neighbours to the north. From Croatia’s tourism sector to Bulgaria’s competitiveness as an foreign investment destination, there are long-term economic upsides on which SEE countries can capitalise if they tackle structural limitations and fiscal issues. “We have dropped our growth forecast for SEE from 2.2% in May to 1.9%, whereas in Central Europe and the Baltics we raised it from 2.5% to 2.8%,” Sanfey said. “For SEE, we have pencilled in 2.6% growth for 2014.”

By some margin the region’s biggest economy, Romania, is also set to be the best performer – the small states of Macedonia and Kosovo aside. The EBRD was more pessimistic than most when it forecast 2.6% growth for 2014 back in May; following disappointing second-quarter growth figures, the bank’s judgement looks prescient. It has stuck with the figure, which Sanfey concedes is now more optimistic than the average, while projecting 2.8% next year, suggesting that the 5.2% growth racked up in the fourth quarter of 2013 may have been a flash in the pan.

Nonetheless, Sanfey is upbeat about the country’s prospects and impressed by the country’s tough policy response to a savage recession and near fiscal crisis in 2009. “Romania has turned around impressively in recent years,” he says. “This is not just about getting some growth back, its about inflation coming down, fiscal deficit really coming under control, from 9% a few years ago, 3% now. In 2013, Romania exited the EU’s excessive deficit procedure. It has the advantages of relatively large economy, strategic location, diversification. There has not been so much [foreign direct investment] in recent years, but investors are there and there will be more to come in future.”

Bulgaria blues

To the south, fellow EU member state Bulgaria has endured an unenviable year that saw anti-government protests over ties to oligarchs, the suspension of EU funds and ostracism from Brussels over Bulgaria’s persistence with Gazprom’s South Stream gas pipeline in the wake of Russia’s seizure of Crimea and its role in the fighting in east Ukraine. Most recently, a banking crisis has shaken faith in the system, called the national bank into question and once again revealed links between politicians and controversial businessmen. The EBRD has lowered its growth forecast to 1.5% this year, and expects 2.0% in 2015 – sluggish for a relatively poor country that was an investor darling until 2008. “For a country that has GDP per capita still below 50% of the EU average, there should be a lot of catch-up potential, but it requires Bulgaria to really seize the opportunity and start reforming again – there’s a big job ahead,” says Sanfey.

“It will be important to have government in place that has a mandate and medium-term perspective, which has been lacking,” says Sanfey of the early elections scheduled for October 5. “The problem with Bulgaria is that there hasn’t been a stable political situation for some time and that has held back economic policy making and held back transitions in sectors like energy – and of course there has been the banking crisis."

Since before the last government, Bulgaria’s policymaking has been inconsistent, and, as elsewhere in the region, structural reform has stalled. “The energy sector is very important in Bulgaria and is in a mess at the moment,” says Sanfey. “You cannot expect to attract serious investment in the sector if you cut energy prices as Bulgaria has. It’s very short sighed in our view, though we understand that the last government but one fell because of energy prices. More generally, there are a lot of petty obstacles to doing business that our clients point to. The government can do a lot more to really tackle those and sell Bulgaria as an investment destination.”

On the other side of the Balkan Peninsula is the EU’s newest member state, Croatia. Accession has not provided the hoped-for fillip to Croatia’s economy, which has not registered meaningful growth since 2008, and where the left-leaning government, hobbled by the electoral cycle, seems unwilling or unable to tackle reform. “Year after year the performance has been disappointing,” says Sanfey. “If it’s another year of negative growth, it’ll be the sixth year in a row of downturn – we expect minus 0.5%, and have pencilled in a very modest positive number for next year, 0.5%. We gave Croatia credit as everyone did for joining the EU, but they didn’t address underlying issues. The state is very bloated, and the labour market rather inflexible. Reform efforts have been a bit hesitant and for that reason we don’t see any sign of a major turnaround yet, and indeed next year is an election year.”

The EBRD economist tempers his concerns about stalled reform with optimism about Croatia’s potential, pointing out that it is a small economy open to Western Europe, and an economic recovery in the Eurozone would help bring growth into positive territory. There is scope for “quality upgrading” in tourism, which generates more than 10% of GDP – an observation with which many in the Croatian tourism sector would agree as they seek to develop businesses beyond sun, sea and sand – while some tourism businesses are still to be privatised. The EBRD is also active in the promising agribusiness sector, where big local companies such as Agrokor have become great success stories.

Floods of problems

Landlocked Serbia to the east has been hit hard by catastrophic flooding in May, the worst on record. The EBRD expects the economy to shrink by 0.5% this year, recovering to 2.0% in 2015.

The Progressive Party of Aleksandar Vucic won an absolute majority two months before, with a mandate for sweeping reform, including privatisation and changes to the labour code, but its appetite for austerity has yet to be proven. “Serbia faces a very difficult situation in the short term, particularly the fiscal situation,” says Sanfey. “The level of the deficit [is worrying] and public debt is now somewhere between 65% and 70% of GDP and still rising, whereas it’s supposed to be capped at 45%. This has been recognised by the government.”

Serbia’s last standby agreement with the International Monetary Fund (IMF) was suspended in January 2012 because of its fiscal incontinence. Since then, the prospect of a new deal has been much-discussed, with little concrete progress. “Serbia needs to really demonstrate that it’s getting its fiscal situation under control as a matter of priority, and an IMF agreement would help in that regard, so I expect one to be signed. This would give some comfort to investors.”

While some in Serbia doubt Vucic’s commitment to reform and liberal democratic values, Sanfey is upbeat about the outlook. “I see Serbia as a country with a lot of potential in the region, they have a government with a strong mandate which cal look forward to being in power for a few years. They have started the EU accession process, negotiations are underway, and they have been very pragmatic on the Kosovo issue.”


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