Long shadows stretch across Central Europe

By bne IntelliNews December 19, 2014

Tim Gosling in Prague -


Long shadows stretch across the economies of Central Europe as they head into 2015. There was optimism a year ago that a fully-fledged recovery was finally underway. However, stuttering growth in the Eurozone and the Ukraine geopolitical crisis have dampened export prospects, creating a challenging scenario for the small, open economies of the Visegrad Group of the Czech Republic, Slovakia, Poland and Hungary. That leaves it up to domestic demand – in the doldrums for so long – to pick up the slack.

After the optimism in the first half of 2014, the Eurozone barely dodged a return to recession in the third quarter. Confidence surveys suggest economic activity is likely to remain subdued and uneven, while budgetary consolidation efforts continue to impede fiscal support from governments.

"Very few jobs are being created," note analysts at Citigroup, "and uncertainties pertaining to the strength of external demand will likely translate into a very slow recovery in business investment."

With typical understatement, the European Commission noted in November that the recovery is "struggling to gain momentum" and somewhat fragile. It now hopes to see a gradual return to growth next year, and forecasts 2015 expansion at 1.1%, followed by a push to 1.7% in 2016.

Others are less measured. Noting that the Eurozone recovery "ground to a halt in mid-2014”," Moody's says it expects no significant rebound in growth in the near term because of a lack of reform and high corporate debt. The rating agency now expects growth in the single currency area to top out at just 0.9% next year, with 2016 only marginally stronger at 1.3%. "By 2019, we expect the euro area economy to be 17%, or €1.7 trillion, smaller than it would have been had pre-crisis growth trends been maintained," the analysts say.

On a brighter note for Visegrad, the German economy – by far the biggest market for exports – looks more robust, though that will likely depend on developments in Ukraine, with German confidence highly exposed to the stand-off with Russia because of its high energy dependence and  German investment there. Citing "turbulent waters”, the German economy ministry cut its outlook for 2015 by 0.7 percentage points to 1.3% in October. The European Commission expects German growth at 1.1% next year and 1.8% in 2016.

Either way, the Eurozone's struggles are certain to dampen demand for exports from the Visegrad area, upsetting the only meaningful driving force for the region's small and open economies (save Poland) during the last few years of crisis. That must surely hit investment and encourage deflation.

While the European Central Bank is pushing to help out as it moves towards quantitative easing, Moody's insists the weaker euro will only have a small effect on growth and inflation. However, at least that ultra-dovish environment frees the hand of Visegrad central banks to offer further stimulus if they choose.

On the other hand, there is some hope that growth could be better than forecast. One potential dose of vitamins could be the recent dramatic and unexpectedly sharp oil price decline. That could become "a crucial catalyst for growth in the world economy”, analysts at Nordea wrote in early December.

At the same time, low energy prices will also push deflation onwards. Citigroup plots Eurozone inflation below 1% until the fourth quarter of 2015. As energy importers, persistently low pricing should offer Central European countries a little extra momentum, but they'll also import low inflation.

Cautious Czechs leaning on weak crown

Finally breaking free from its longest ever recession in the second quarter of 2013, the Czech Republic has motored on strongly in 2014, driven by the central bank's suppression of the crown, which has helped exporters. Domestic demand is also finally perking up after several years in the doldrums, helped by the centre-left government’s easing of fiscal policy, adding another motor to drive economic growth.

However, the country is still heavily dependent on demand out of the Eurozone for exports, leaving it vulnerable to a slowdown. Further than that, the overwhelming weight of the auto sector in the economy makes it susceptible to industrial cycles. A 9.9% drop in output from the industry in November led overall Czech industrial production growth to slow sharply.

The Czech National Bank insists it is happy with developments since it launched currency intervention to weaken the crown in November 2013. It is also careful to leave the way open for further action should it need to offer more stimulus to exports.

Analysts at Deutsche Bank note that "with inflation expected to remain subdued due to external factors (low imported inflation from the euro area and weak commodity price growth), we do not expect any changes in monetary policy until 2016”.

The economy remains exposed to external factors, said Capital Economics in December. "Sluggish demand from the Eurozone is still taking a toll on the industrial sector," it noted. "Coming alongside strong retail sales data, it looks like domestic demand is becoming an increasingly important driver of the economy."

The revival in domestic demand is getting help from loosened purse strings from the government, which took office in January, six months after the exit of the austerity-obsessed centre-right administration of Petr Necas. The labour market has been improving as recession recedes.

Yet, the Czech consumer is cautious and the banks conservative, while powerful Finance Minister Andrej Babis has pledged to pull the deficit below the budgetary target of around 2.1% of GDP and slash state debt levels, although he stresses the plan is based on improved efficiency rather than spending cuts. Domestic demand is still likely to remain highly susceptible to any loss of confidence stemming from a further slowdown in the Eurozone, however.

Events to the east could also impact sentiment, although without a border to Ukraine, the Czechs are somewhat insulated.

The chance of internal political intrigue remains because of the persistent lead in opinion polls of Ano – Babis'  political vehicle – over  Prime Minister Bohuslav Sobotka’s Social Democrats. However, politics rarely intrude on investment views on the country.

Deutsche Bank plots Czech GDP growth at 2.4% for 2014, with little deviation over the medium term. That has the bank offering a reasonably bright outlook of 2.5% next year and 2.7% in 2016.

"We expect these broad trends to continue into Q4 and 2015 – that is, moderate economic growth driven by domestic demand," writes Deutsche Bank. "Household consumption should continue to grow at a reasonable pace as inflation remains low and labour market conditions continue to tighten gradually. Investment will likely continue to the be the main driver of growth, both due to expanding private investment in the low interest rate environment and a pickup in government investment (mainly associated with a drawdown of EU funds). On the other hand, net exports should continue to have a small negative contribution to GDP."

The European Commission is slightly more optimistic, suggesting a reduction in the tax burden should help domestic demand continue to expand, Overall, it expects real GDP to grow by 2.5% in 2014, and to strengthen slightly to 2.7% in both 2015 and 2016.

It believes growth in government consumption should strengthen further in 2015 on the back of a relatively strong increase in healthcare expenditure and higher absorption of EU funds. A planned increase in public sector wages and pensions and VAT and tax changes should also help keep domestic demand afloat, it says.

Hungarian government still lonely in the driving seat

The Hungarian economy has outpaced all but the most optimistic expectations through 2014. However, the recovery remains overwhelmingly state-led, and analysts worry that without an upturn in investment from the private sector and bank lending, economic growth is set to fade in 2015 and beyond.

GDP growth in 2014 has been robust, moving the European Commission to plot economic expansion of 3.2% for the year. However, that strong performance is seen as almost exclusively due to government efforts. Strong state investment using EU funds has contributed most to stimulate the economy and the Magyar Nemzeti Bank's "Funding for Growth" remains the only meaningful lender.

Adding to that, the threat of the Eurozone slowdown is palpable for Hungary due to its strong exposure to demand for exports out of the single currency area. The main driver of growth in the private sector in 2014 has been expansions of capacity at its car plants, run by European manufacturers, and the associated supply chain.

Meanwhile major investment in other areas is being held back by government policy. International retailers and media companies were amongst those in the spotlight in late 2014, but the government of Prime Minister Viktor Orban has been bashing investors across the economy since it came to power in 2010.

"Additional downside risk comes from the possible deterioration in the investment climate due to the government’s interventionist policies (e.g. in the banking and utility sectors)," notes Deutsche Bank.

The government has overseen large cuts in regulated utility charges, and taken over many of the major assets after pushing down valuations. The banks are due to pay huge compensation to forex loan holders and convert all loans into forint, taking huge losses in the process. That is likely to go through in April.

Fitch Ratings summed up a bleak picture for the country's lenders in a December report on Austrian banks, which own two of Hungary's largest banks. Rather than increasing balance sheets, the banks are more likely to be seeking ways to reduce portfolios and find an escape route, Fitch suggests.

"The high recurring regulatory costs, tough operating conditions and weak asset quality mean Hungary is likely to be an earnings burden in 2015," the report reads. "The likelihood of Austrian banks leaving this country has increased with the uncertainty in the market's long-term recovery prospects."

Budapest is now in a high profile fight with the West, and especially the US. Despite some nods of apparent compromise from Budapest, the pressure on foreign investors continues, or is even increasing.

Put together, these issues serve only to strengthen uncertainty for investors, as well as concern over the economy. That continues to hit the hopes for increasing private investment and bank lending, which is needed to maintain the recovery.

The European Commission expects Hungarian growth to slow to 2.5% in 2015, and then further to 2% the following year. Deutsche Bank plots expansion at 2.4% for both.

Capital Economics expects the crunch to deepen. "The government is likely to tighten fiscal policy following a blowout ahead of [the April 2014] election, which will remove a prop to domestic demand," the analysts write. They see growth sagging to 2% next year, before a slight revival to 2.4% in 2016.

Despite the expected slowdown, inflation is set to recover somewhat as the base effects of utility cuts introduced in 2013 wear off and domestic demand continues to grow. "Given the ongoing recovery in consumption, inflation is likely to pick up close to the 3% target by early 2016 as the impacts of utility price cuts and food price deflation drop out from the annual index," suggests Eszter Gargyan at Citigroup.

However, others expect imported low inflation from the Eurozone will cap price increases at lower levels. Either way, the pressures on the economy are likely to keep interest rates low.

The Magyar Nemzeti Bank has guided for the current record low rate of 2.1% to remain in place until the end of 2015. However, the MNB's independence from the government is questionable, and some suspect more monetary easing could take place  in early 2015 to make the conversion of forex loans more politically palatable.

Likewise, the MNB's refusal to cut rates in late 2014 is seen at least partially motivated by a need to cap government debt for the end of year reading to keep it within EU limits.

The deficit is eyed just below the EU threshold at 2.9% in 2014, having expanded from 2.4% the previous year – a result of the general election in April and continued purchases of utilities and banks. The EU expects the budget gap to fall to 2.8% in 2015, helped by the pick-up in private consumption, public wage restraints and declining public investment following the election year.

Poland seeks solid growth drivers

The Polish economy lacked strong momentum in 2014. Robust recovery in the early months gave way to a summer lull in confidence caused by the raised tension with Russia. But better-than-expected growth in the third quarter of 3.3% was accompanied by healthy data on retail sales and the labour market.

That suggests the Polish consumer is finally getting into gear, with investment also surging. The strength of domestic demand in Visegrad's biggest market has long set it to one side in the region. While the country is still heavily dependent on demand for exports out of the Eurozone and - in terms of trade volume at least - is more exposed to Russian sanctions than most, domestic demand made it the only EU country to avoid recession in 2009.

Real income growth, on the back of improving labour market conditions and low inflation, is boosting consumption. Unemployment has been the bane of the economy through the crisis, but has dropped to five-year lows in recent months. Analysts expect that improvement to continue through the next couple of years.

Investment growth has also been strong, and should remain so. Private investment has revived, driven by gradual credit growth and low interest rates. Commerzbank's local unit mBank  also says it expects "significant fiscal stimulus in 2015 onwards, focused mainly on public infrastructure spending and fuelled by the re-launch of EU funding".

Those elements will be vital to maintain growth in 2015, with exports continuing to drag due to the external environment. On top of the tangible effects of the Eurozone slowdown and Russian embargo on food imports from the West, Poland's leading role as a hawk against Moscow's policies has helped dent sentiment in 2014. Any rise in tension would likely hit confidence again next year.

The European Commission forecasts GDP growth will finish 2014 at 3%, before pulling back to 2.8% next year. A climb back to 3.3% is due in 2016 as exports revive, it suggests. Tipping Poland be the region’s best performer over the next few years, Capital Economics also looks for 2.8% GDP growth in 2015, but then predicts a surge to 3.8% in 2016.

Citigroup is of similar mind, expecting a quicker return to growth for exports. That would see economic expansion relatively flat at around 3% in early 2015, before "significantly accelerating".

External issues aside, however, politics presents a domestic risk to the economy, with a general election due by October 2015. On top of the standard rise in populist policy ahead of a national vote is the chance that heavier spending will persist whatever the outcome.

Analysts at Deutsche Bank note that although unlikely, the reviving fortunes of the conservative and populist opposition will put investors on edge as the election approaches. "Victory by the opposition Law and Justice Party (currently a relatively unlikely scenario) … would be negative for investor sentiment, as the party is likely to favour more interventionist economic policies," they write.

Yet PiS is clearly set to mount a stiffer challenge to the ruling PO at the very least. That will weaken the centre-right party should it manage to secure another term in coalition, with potential partners also likely to favour more populist policy.

The palpable result of PO's thinning lead in the polls is already on view in late 2014, with the government working feverishly to rescue the huge coal industry, rather than let its 100,000 or so employees face the market pressures squeezing it. State-run utilities, the state development fund and bank have been ordered to help the effort, draining capital from other potential state projects, and possibly crimping efforts towards fiscal consolidation.

Warsaw will not want to upset its push to trim the deficit however. The "fiscal deficit looks like it could come below 3% of GDP this year, whilst for 2015 the Ministry of Finance forecasts a deficit of 2.5% of GDP, which would allow Poland to be taken out of the excessive deficit procedure," notes Standard Bank. The European Commission expects a similar outcome, with economic growth opening the way for increased public spending.

However, one area where hardly anyone agrees completely is monetary policy. That reflects the poisonous atmosphere that has formed around the National Bank of Poland's monetary policy council, in particular since Governor Marek Belka was exposed on tape insulting fellow board members and making comments that allegedly came close to trading policy for personal political influence.

"Writing on Poland is really about monetary policy decisions. This is partly due to the unpredictability of the MPC, and partly due to the maturity of the economy and its institutions," Standard Bank noted in November. "This MPC likes to surprise markets."

The MPC kept the market on tenterhooks with surprises in late 2014. Persistently low inflation means any hike from the current record low benchmark interest rate of 2% is highly unlikely. But many analysts insist further stimulus for growth and prices is needed.

Deutsche Bank expects rates to remain on hold to the end of 2015. Yet others are convinced further large cuts are imminent. mBank suggests the "MPC got stuck in [the] decision process, but the combination of local and global factors should be enough to break the stalemate and lead to new cuts.

"The timing is hard to pin down precisely," the analysts add, before predicting two 25 bp cuts in the first quarter of 2015, with more to come through the year to push rates to 1% by the end of the year.

Those calls are informed by the theory that easing has only been held back by concern that the end of year state debt reading is struggling to meet EU rules. Once the new year starts, stronger depreciation of the zloty in the wake of interest rate moves would boost exports and support import substitution, the European Commission notes.

Slovakian shoppers to the fore

Domestic demand finally woke up in 2014, to offer Slovakia's large car plants some help in pushing the economy forwards. That's just in time, with the country one of the most exposed in the region to demand out of the Eurozone.

The economy also suffers from a lack of diversification; its big ticket exports led by cars, and to a lesser extent consumer electronics, are unlikely to fare well in the event of a deep slowdown in Europe. Capital Economics worries about "renewed weakness in Germany," in particular, predicting it "will weigh on exports over the coming quarters".

Consumption and investment is expected to do most of the heavy lifting. After three years of decline, and boosted by low interest rates and inflation, as well as a relaxation of recent state austerity, domestic demand has already picked up this year. Those same elements are expected to continue to push in 2015.

The European Commission predicts growth at 2.4% this year, growing to 2.5% in 2015, and then 3.3% the following year. Citigroup and Capital Economics are both in broad agreement.

Key for consumption is the improvement on the labour market. Although it's been on a downward trend for 19 months, Slovakia’s unemployment rate remains one of the highest in Europe, falling to 12.9% in the third quarter of 2014. However, it is widely predicted to continue to drop in the medium term.

Gross fixed capital formation grew strongly in the first half of 2014, the European Commission notes, mainly due to the expansion of equipment investment. In the second quarter of the year, however, investment in construction also showed strong growth, suggesting a broader recovery is underway.

Government spending has helped drive both of those trends. The deficit is expected to widen to 3% of GDP this year, despite much stronger-than-budgeted growth in tax revenue. Bratislava, however, hopes to trim the budget gap back down to 2.6% in 2015.

However, populist spending could yet interrupt that effort. While the ruling Smer party maintains a healthy lead in polls, that's largely thanks to the lack of a credible opposition. However, Prime Minister Robert Fico, previously seen as invincible,  has clearly been rattled by protests in late 2014, and has made pension and public sector pay rises to try to shore up his support.

"While we do not expect major political changes," Citigroup stresses, "the leftwing SMER-SD party is unlikely to be able to form another one-party majority government after the [next] election."

A further risk for growth and public finances is the Russia-Ukraine gas fight. Slovakia earns huge transit fees from carrying Russian gas exports from its border with Ukraine to Western Europe. An interruption to those flows would hit it hard.

The abandonment of the South Stream pipeline will have come as a relief to Bratislava, as the giant gas route designed to bypass Ukraine would also have cut Slovakia out of the action. Slovak gas transit system operator Eustream – 51% state owned - makes most of its €800m or so in annual revenue from gas transit.

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