OUTLOOK 2008: Inflation to be Central Europe's biggest foe

By bne IntelliNews January 14, 2008

Michael Logan in Budapest -

Central Europe's economies have enjoyed a period of massive growth in recent years, and with the exception of Hungary, 2007 was no different. Slovakia, Poland, the Czech Republic and the Baltic states all saw their growth rates remain impressive. However, the dash forward looks likely to slow to a brisk walk in 2008 as the nations battle rising inflation and the consequent risk of further delays to euro adoption.

Higher food and energy prices have been forcing up inflation around the world and Central Europe has also seen the process enhanced by a variety of factors, such as surging wage costs brought on by emigration-induced labour shortages and government tinkering.

As a consequence, every nation - once again with the exception of Hungary, which saw inflation balloon last year but which is looking at a downward trend - is expected to see faster rising consumer prices in 2008. Governments and central bankers will have to be on their toes to dampen these inflationary pressures.


Hungary has lagged behind much of Central Europe throughout 2007 as government austerity measures aimed at cutting a huge budget deficit bit hard, pushing up inflation as high as 9% and slashing growth.

The problems stemmed from attempts to bring down the budget deficit, which came in at 9.2% of GDP in 2006 - by far the largest in percentage terms in the EU. From a goal-driven perspective, the measures are working. The government lowered its 2007 deficit target to 6.2% - although the final figure could dip below 6% - and the 2008 target has been lowered to 4%. The government predicts the 2008 current account deficit will fall by 0.9 percentage points to 4.0%.

So the deficit reduction plans look good - provided, of course, the desperately-unpopular government doesn't do as feared and loosen the purse strings prior to the 2010 elections in order to regain its lost popularity, which pollsters have put as low as 16%.

The deficit reduction has hit the economy just as hard. Third-quarter economic growth in 2007 came in at an 11-year low of 0.9%, thanks to a 2% year-on-year drop in household consumption. The overall target for 2007 growth dropped to 1.7%, compared with the previous average annual growth of around 4%.

Official projections say growth will recover slowly to 2.8% in 2008. Analysts and other bodies back up this view. "Growth...is likely to recover over the projection period, supported by buoyant exports and gradually reaccelerating investment and consumption," says the Organization for Economic Cooperation and Development (OECD) in its outlook for 2008.

While inflation fell off in the summer from its March high of 9%, it rose again due to global pressures. The government expects inflation to average out at 7.9% for 2007 and analysts say it will rise again in the short term before falling away to around 4.8%. "We expect inflation (in Hungary) to accelerate further in the near term, on the back of the usual beginning-of-the year price adjustments in regulated prices and continuing elevated food and fuel prices," says investment bank Dresdner Kleinwort.

The National Bank of Hungary raised the main interest rate to 8% late in 2006 to dampen inflationary pressures and has only cut to 7.5% in 2007. Analysts expect the bank to hold rates for much of this year.

The small economic improvements may not be enough to save the unpopular Prime Minister Ferenc Gyurcsány and his reforms from the chop, though. Gyurcsány has supposedly been given until summer to turn the government's fortunes around. Should he fail, the ruling coalition may well be forced to backtrack on reforms.


While Hungary's government spent much of 2007 tottering, Poland's went one better by actually collapsing. The conservative-liberal Civic Platform (PO) won the ensuing snap elections, although analysts believe that this makes only a small difference to the economic outlook.

The finance ministry estimates economic growth was 6.5% in 2007, but the economy is expected to grow at a more moderate rate of around 5% in 2008. While Hungary's austerity measures teamed up with global factors to push up inflation, in Poland higher labour costs are the additional culprit.

Wages surged by 12% year-on-year in November as a consequence of labour shortages brought on in part by emigration, and this process is expected to continue in 2008. "A further increase in wage pressure and as a consequence in inflationary pressures is likely," Poland's central bank said.

Inflation was estimated at 4% in December, and newly appointed Deputy Finance Minister Stanislaw Gomulka says he expects it to stay there for much of 2008, adding there would to be need tighter fiscal and monetary policy.

Analysts feel that Poland's central bank will have to tighten rates, currently at 5%, with Danske Bank saying that increasing inflationary pressures "will clearly necessitate further interest rate hikes in 2008."

Some fear that government decisions - such as plans to introduce a flat tax - will also hit attempts to cut the budget deficit, forcing it up slightly to just over 3%. "The recent decision to increase spending and decrease revenues renders all the more uncertain Poland's EU commitment to reduce its excessive deficit," says the OECD. Analysts also see the current account deficit widening.

The stock market, which has boomed in recent years and has become the region's largest, is regarded by strategists and fund managers as facing its toughest period in more than five years, thanks to falls in confidence in local mutual funds, rising interest rates and the knock-on effect of the US sub-prime crisis.

Returns on the stock market for the average investor have been outstanding. Poland's construction boom made investment in building stocks a no-brainer: the WSE index measuring the industry, WIG-Budownictwo, rose 142% on year in the year to June 30. The main WIG Index tracking all stocks rose by 50% during the same period. Investment in information-technology companies has been another winner; the WIG-Informatyka Index that measures this industry gained 64% over the same period, driven by such companies as Asseco Poland, a business software maker which is the largest stock in the index. Some individual stocks even boast four-digit returns. Property developer Polnord recorded a 1,390% growth in profits to June 30. Overall, capitalization of the WSE rose to €156.7bn from €89.7bn for the year ended June 30.

However, the worsening global sentiment has driven the WIG20 index down 10% since the start of the year and 20% since October. Outside of the sub-prime mess, stock valuations look tight and the worsening property market, due largely to rising interest rates, look set to slow the growth of the banks which have been led the exchange higher.

Czech Republic

As in Hungary and Poland, inflation is expected to rise in the Czech Republic. The cause of this spike, along with the fuel and food increases, is a rise in regulated prices and indirect taxes.

Inflation leapt to a six-year high of 5% in November, and some feel it could head toward 6% in the first half of the year before fading. The Czech National Bank is predicting inflation as high as 5.8% by September 2008, while estimates for the year range from 4.6% to 5% - a large jump from below 3% in 2007. The key two-week repo rate is currently at 3.5%, but the central bank is expected to raise this to fight inflation.

While final figures are not yet available, the Czech economy is expected to have grown by more than 6% for the third year in a row in 2007. This run is set to come to an end, though, and Finance Minister Miroslav Kalousek said it would fall to under 5% in 2008. Some analysts believe it could go as low as 4-4.5%.

However, the Czech government delivered good news on the deficit, saying it would be around 1.9% in 2007 - way below the forecast - and that it should also stay below 3% in 2008 despite the slowdown. The current account deficit is expected to stay stable.


Unlike its neighbours, Slovakia has a real chance of adopting the euro within a year and thus the inflation battle is perhaps even more crucial despite the lower levels. Inflation in Slovakia fell from 4.5% in 2006 to an estimated 2.7% in 2007, but should rise to around 3.2% in 2008 with some indirect tax rises, food price increases and the drive to adopt the euro in January 2009. Demands by trade unions for large wake hikes also pose a potential inflationary risk.

The nation's fearsome economic growth is expected to slow from an estimated 8.3-8.5% in 2007 to around 6% as domestic demand growth slows. It is unclear whether the central bank will hike interest rates from the 4.25% level it has held since last April, but analysts feel that the highest level of core inflation for six years could possibly force a small hike.

The budget deficit is expected to decline further, from an estimated 2.5% in 2007 to 2.3%, while the current account deficit is also expected to drop.


The Baltic states, with ultra-speedy economic growth, are facing serious inflationary issues. Their economies have proven particularly vulnerable to global pressures, and wages have ballooned due to fast growth and tight labour markets. The EU statistics agency Eurostat reported a 30% rise in nominal hourly labour costs in Latvia in the third quarter of 2007, while Estonia and Lithuania saw labour costs jump by around 20% at the same time. Credit rating agencies such as Fitch have warned that the rising inflation and ever-widening current account gaps put the Baltic states at risk of painful economic corrections.

In Latvia, inflation stormed to 13.7% in November, and analysts are predicting this could possibly hit 15% in 2008. However, new Prime Minister Ivars Godmanis said that measures to calm consumption are expected to take effect in the second half of 2008. Economic growth is expected to drop to around 7.5% in 2008 from an estimated 10.7% in 2007.

In Lithuania, inflation rose to 8.1% in December and the Finance Ministry warned it could hit 10% in the first half of 2008. 2007 inflation was estimated at 5.7%. The finance ministry has forecast Lithuania's 2007 growth to come in at 9.8% for 2007, but slowing to 5.3% in 2008.

Estonian inflation hit 9.6% in December and is expected to stay high, while GDP growth is expected to drop to around the 5.2% mark from an estimated 7.5% in 2007.

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OUTLOOK 2008: Inflation to be Central Europe's biggest foe

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