OUTLOOK 2012: Blissful living in Central Europe

By bne IntelliNews December 20, 2011

Tim Gosling in Prague -

Ignorance is bliss, so they say. That should make Central Europe the happiest place on the planet in 2012, because as governments, analysts and the wider population try to gauge the depth and impact of the building crisis in the Eurozone, it's clear that no-one knows anything. Apart from the Hungarians of course, who know that everyone's out to get them.

EU officials may feel the same way as they struggle to assemble the bazooka that the markets have been urging them to aim at the sovereign debt crisis. Instead, domestic politics in member states has helped to shackle an already slow process and reduced the firepower of the various bailout vehicles put on the table. Irked by this - never get between a banker and another round of quantative easing - the financial markets have punished heavily indebted states, and even Germany has seen its cost of borrowing rise.

Early December saw EU leaders - sans the UK - agree to tighten fiscal regulation from Brussels, which is essentially a step towards attempting to avoid such a mess again in the future, but it does little to help the here and now. Hence, the bloc's newest members go into 2012 balanced on a knife edge, with the crisis not only weighing on their currencies and pushing their borrowing costs higher, but also threatening to severely undermine economic growth.

As East Capital suggests, the connections between Central Europe and the rest of the EU are so fundamental to the economies in the former that, "the starting point for any judgment on growth perspectives... is the rapid and marked slowdown in economic activity in the whole of Western Europe. The cooling down became apparent in late spring/early summer when economic indicators turned into a negative slope. Forecasters started revising their outlooks, first cautiously, later in huge leaps."

Still, as analysts point out, whilst many of the older members of the EU are facing recessionary scenarios, the Central European economies are likely to do much better. However, if the Eurozone goes into a deep recession, then Central European countries, with Hungary by far the most vulnerable, could go with it.

Juggling the numbers

It's no wonder then that the second half of 2011 saw Central European government officials juggling with more scenarios than you can shake a stick at, with GDP growth forecasts tumbling across the board as draft budgets were prepared.

While none of the countries has actually crossed the line to forecast a contraction, the hopeful predictions of 3-4% that reigned across the region before the summer are long forgotten in the face of predictions from the likes of the European Commission that forecast in November EU growth will remain at a near standstill throughout 2012, before returning to slow growth in 2013. "Since the last fully-fledged forecast in May," the Commission wrote in its Autumn Economic Forecast, "the outlook for the EU and the euro area has deteriorated. The protracted sovereign-debt crisis has taken its toll on confidence affecting investment and consumption. The first signs of improvements for GDP are projected for the second half of 2012, however, with very limited impact on job creation."

"No economic growth is now expected in the current and coming quarters," the report warned. "Consequently, GDP is forecast to grow at a rate of only 0.5% in the EU and the euro area in 2012. Some acceleration is expected in 2013, when growth is set to reach 1.5% in the EU and 1.25% in the euro area. While growth rates will differ across the Union, no group of countries will remain unaffected by the slowdown."

Whilst Hungary, Slovakia and the Baltics have responded to the uncertainty by simply lowering the bar as confidence sank - it felt like it was almost on a weekly basis at points in the late autumn - the Czech Republic and Poland considered differing scenarios. However, the Czechs dispensed with these as a base for the budget, allowing them to even scout out a "catastrophe" model in which the euro collapses. Warsaw, meanwhile, eventually plumped for the middle course, which envisages "some slowdown" in the EU.

Both countries ended up with a forecast of 2.5% GDP growth. While analysts broadly agree with Poland's prediction, the Czechs essentially admitted their number is a fallacy, but pointed out that without a crystal ball, who cares? "Nobody is able to estimate now how the Eurozone will deal with the crisis and what its impact will be on the Czech economy," said Czech Finance Minister Miroslav Kalousek after budget was passed on December 14.

As third-quarter manufacturing data for the region came in, it became more obvious that the problems in the EU were already hitting the Central European economies where it hurts: exports.

Whether, like the Czech Republic, it was set up several years ago or, like the Baltics, in the last 24 months or so, the region's exposure to export demand in the 27-member bloc has been a boon which now threatens a bust, with domestic demand in Central Europe's small open economies in no state to take up the strain. The one exception is possibly the far-larger Polish economy, but even there the eventual 2012 budget saw its GDP growth forecast cut from an original estimate of 4%, with a tough set of austerity measures promised on top.

Falling risk appetite and reduced financial flows are also likely to continue to effect the cost of borrowing for sovereigns, and in one case, Hungary, could even risk closing access to debt markets altogether should the situation take a bad turn and the government continues to play the maverick.

That leaves governments across the region facing a conundrum, especially should they all sign up to the EU fiscal compact, handing Brussels greater powers to oversee their national budgets. Tasked with commitments to lower deficits, and debt in the case of Hungary and Poland, they're left with little room to stimulate the economy, particularly via interest rates. However, without growth, it will be difficult to reduce debt and deficits sufficiently.

Private borrowers are unlikely to find it much easier or cheaper to get hold of credit. With the catastrophe in Greece - and worries over the likes of Italy and Portugal persisting - banks in the EU have been instructed to raise their Tier-1 capital ratios to 9%. The latest European Banking Association stress tests in December said that overall the banks need to find €115bn to satisfy that stipulation. With their markets largely dominated by Western European banks, Central European borrowers are likely to find credit harder to get, adding another drag on growth. On top of weakening local currencies, this bodes ill for investment also.

That said, Commerzbank analysts suggest that one silver lining from the last crisis is that it pushed the region to drastically cut its dependence on foreign financing. They estimate that the potential external funding gap for Central and Eastern Eurtope in 2012 is likely to narrow to just $10bn or so "from over $100bn in 2008 (estimated pre-IMF, pre-Vienna initiative)."

Meanwhile, the final outlier for the individual Central European economies is the swift contagion still seen across the region. For instance, the Czechs can run as conservative a fiscal policy as they like, or the Poles can enjoy robust domestic demand, but their currencies and bond yields are still hit when Hungary earns itself a downgrade.

Czech Republic - steady as she goes

While a conservative fiscal policy means that the Czechs head into the euro storm in a relatively robust state - state and private debt levels are relatively low, the currency relatively stable, inflation under control, and the banks reported to be well capitalized - the risk to 2012 growth of this small, open and export-led economy ranks amongst the highest in the region. Low domestic demand, and that very same conservative policy which promises further austerity, are expected to compound the effects of the EU slowdown.

The state budget for 2012 went through based on a growth forecast of 2.5% and targets a deficit of 3.2% of GDP. However, analyst forecasts range from recession to a peak of 1%. Finance Minister Miroslav Kalousek admitted weeks before the plan was passed that 1% is more likely, and that there are downside risks even to that prediction. The Czech National Bank tops the latest forecasts at 1.2%, although the deputy governor, Vladimir Tomsik, was fretting in early December that the effect of the EU crisis could be similar to 2008, when the economy nosedived by 4.5%.

That contraction was largely due to the country's massive reliance on trade with the EU, which constitutes around 75% of total GDP, and nothing has changed there. In turn, a full 80% of exports go to the EU, with next year's defensive markets such as China (1%) and the former Soviet Union (6.3%) providing little demand. Moreover, as Deutsche Bank points out, the country's lack of diversification goes even further than that: "Germany is by far the Czech Republic's largest export partner, accounting for 22% of GDP in exports. A more protracted recession in Germany leaves a significant risk of recession in the Czech Republic."

Compounding this risk is another of the country's perceived strengths. The Czech population has been lauded for its conservative spending and propensity to save, but that leaves the country "with net exports being the only meaningful driver of growth," points out Martin Lobotka at Ceska Sporitelna. "With VAT rises [due in January 2012], employment forecast to fall, and zero growth of the real wage rate, one should expect another outright fall of household consumption."

"Additionally," points out Jaromir Sindel at Citigroup, who forecasts the economy will see no growth at all in 2012, "the government is likely to introduce additional fiscal austerity measures to keep public finances under control."

Meanwhile, the worry over external demand is already being encouraged by data from the third quarter, with the country seeing it's first GDP contraction (0.1%) in two years, while manufacturing data illustrated a sharp slowdown in September. Analysts across the board are fretting that the fourth-quarter numbers are headed over a cliff.

One of the central pillars of defence is said to be the stability of the banks, which, like the government, have ploughed a conservative and classical course, while the population likes to stash its cash with them rather than spend. The Czech National Bank reported in November that the sector is well capitalized, pointing to an annual rate of lending growth of around 5% in October to back up its claim.

One of the keys for the sector is that it is extremely liquid, with a loan/deposit ratio of 78%. Those resources may well be needed to continue supporting growth however with the Western European banks that control the vast bulk of the Czech market set to deleverage to raise their own capital ratios throughout the year.

At the same time, some worry over the quality and diversity of the assets on their balance sheets and rising non-performing loans (NPLs). It was just this picture that prompted Moody's Investors Service to cut its outlook on the sector from stable to negative in December. As bne reported, some in the industry say that exposure to real estate is a huge risk in particular, with a huge volume of loans coming up for refinancing.

Meanwhile, UBS analysts worry that the country's strong inflation record is about to break in 2012, with the introduction of a VAT rise (from 10% to 14% for the lower rate) in January teaming up with rising utilities costs to "add around 1 percentrage point to the headline rate."

However, not everyone is as confident as UBS that "an inflation rise to 2.9% in 2012, from 1.9% in 2011, before falling back to 2% in 2013" will be enough to prevent the central bank from cutting its 0.75% policy rate in a bid to stimulate growth.

Hungary - sensing the danger?

A weak recovery since 2008; high debt; high borrowing costs; a currency under attack; a strong aversion to austerity; close to 80% of exports going to the EU; a vicious fight between the government and the banks; a reviving fight between the government and the central bank; rising international and domestic criticism of a roll back in democracy; a downgrade to junk status; and a request for a €20bn bailout from the IMF - after kicking them out last year - with no strings attached: it's hard to see how Hungary could be any less shipshape as it sails into the storm.

The main hope is that the government might be shaking off its paranoia that the markets have been hammering it purely out of vengeful spite, to realize the extent of the danger the country faces.

Until now, Prime Minister Viktor Orban and his Fidesz government has firmly rejected criticism of his "unorthodox" economic policy, pointing at a likely budget surplus in 2011 and lowering debt as proof that the country is being unfairly targeted. However, the markets note that the relative health of the country's macro indicators is down to one-off events that have raised state income. For instance, the government effectively nationalized around €13bn from the pension system and has levied "crisis" taxes on several sectors.

However, it will have fewer tricks up its sleeve in 2012 even as it faces greater restraints on growth. The government is preparing to amend the 1.5% GDP growth forecast on which it based the budget, with the central bank saying the expected drop to 0.5% - the maximum expected by most analysts - will leave it struggling to achieve the 2.5% deficit target. That may not look too ambitious a target from a 2011 surplus that could hit around 3.6%, but as UBS points out, it is actually "based on a huge fiscal adjustment of 4.5% of GDP. The main reason [being] that the 'underlying budget deficit' in 2011 - excluding the impact of the pension fund asset takeover - [is] closer to 5% of GDP."

Overall, while Hungary faces similar exposure to dropping demand for exports in the EU as its neighbours, with those trade routes driving over 70% of GDP, it looks in far worse shape to absorb the shock, with debt and currency issues also tying its hands.

While the country currently has the highest policy interest rate in the EU at 6.5%, it also has the highest state debt/GDP ratio in Central Europe at close to 80%, despite the attempts to deleverage. Alongside the government's unorthodox policies - which are also set to dampen lending and investment in 2012 - this is likely to see continued pressure on the forint, leading analysts to speculate that despite the likely need to stimulate the economy, the central bank could be forced to raise rates instead.

Aside from the impact of the crippled currency on the state's own liabilities, the need to support the forint is cemented by the huge volume of foreign currency-denominated debt amongst the population - mostly in the form of Swiss franc mortgages. This conundrum has prompted the government to call forex debt the biggest macro-economic policy risk in the country, which ties its hands on policy. "The rising debt burden, due to currency weakening," warns Eszter Gargyan at Citigroup, "is likely to lead to an ongoing contraction in household consumption."

Although there is certainly evidence that the banks share no small amount of the blame for the trouble that borrowers are now facing, the government's solution thus far has only reduced the economy's growth prospects even further, as legislation forcing the banks to shoulder losses in a scheme to encourage people to pay down their debt has upset the markets and the EU, and already seen two of the biggest banks announce investment cuts for their local units.

With 80% of the banking sector in Hungary dominated by Eurozone banks, even the governor of the central bank, Andras Simor, has warned of the potentially devastating effect on future lending. At a time when Western European banks are facing extremely tough choices, Hungary looks to be making it easy for them. "Banks, burdened by the high loan-to-deposit ratio (135%), losses related to the FX prepayments and the special bank tax, are likely to continue to shrink their balance sheets," point out analysts at UBS.

Meanwhile, the state itself also faces tough lending conditions, with yields on 10-year sovereign bonds spiking in the fourth quarter of 2011 to pass the 9% mark. Gargyan worries that the country could find its access to the markets cut off altogether as things get worse: "Due to its high external debt, Hungary is likely to remain vulnerable to external financing conditions, and may face difficulties in rolling over maturing debt if euro zone financial stress intensifies."

The big question for Budapest in 2012 then will be: do they realize the full extent of the danger yet?

Hope was raised in November when the country's loss of its investment grade rating from Moody's saw Orban perform a u-turn to announce that the government would ask the IMF for help. Preliminary talks began in mid December, and the debate is now all about how serious the government is about the request.

Some worry that Orban is simply "doing a Turkey" and intends to drag out negotiations in a bid to keep the markets off his back and stay the hands of the two other major ratings agencies, without actually having to agree to any conditions. Others assume that the bullish words coming out of Budapest - the latest at the time of writing is that it wants a €20bn insurance policy with no strings attached - are no more than advance negotiating tactics and/or for the domestic political audience.

Deutsche Bank analysts are wary that this approach will prove counter-productive, though: "Likely policy conflicts between the authorities and the IMF/EU risks prolonged program negotiations, which could mean continued pressure on the currency, a larger hiking cycle and further rating downgrades. It could also mean a very difficult backdrop to meet external refinancing needs."

Poland - ready to retake the EU championship crown

Poland's large and robust economy was the only one in the EU to avoid recession in 2009; it could yet have a similar feat to boast of in 2012, depending on the performance elsewhere.

Whilst the outlook on growth is reasonably upbeat, despite promises of a muscular austerity programme, questions remain on the budget deficit, debt levels, the currency and inflation. On the upside, it will get an extra shot in the arm from hosting the Euro 2012 football championships.

It's the country's strong domestic demand that marks Poland out though. Certainly it's exposed to slowing export demand from the Eurozone like everyone else, but with no more than 55% of its exports heading to Western Europe, nowhere near the extent of the other Central European economies. That allows consensus to anticipate GDP growth of around 3% in 2012 - as opposed to the 2.5% in the budget.

The official target, as analysts at Royal Bank of Scotland stress, is "much to the credit of the recently re-elected Polish government... [and] will provide some reassurance to the market on fiscal slippage concerns." Prime Minister Donald Tusk also made a tub-thumping speech on the need for austerity as he opened his second term, and the budget also targets a deficit squeezed to 2.5%.

If there's one worry over the November victory of the centre-right government - the first consecutive term in Poland since the fall of communism - it's a sense of over-confidence and the potential for complacency. Officials have already started demanding ratings upgrades on the country's somewhat problematic debt. The likes of S&P have suggested they get the promised austerity and reform programmes up and running first. Forecasts for income of EUR10bn next year from the privatization programme also look debateable.

Still, even though Capital Economics frets over November data showing that "Polish manufacturers, which have so far escaped the turmoil in Western Europe remarkably unscathed, now seem to be feeling the squeeze," analysts maintain that domestic growth remains in the driver's seat, and that the key is to weigh the effects of the austerity programme on that consumption.

Danske Bank says that while "investment expansion looks set to lose steam, it is in domestic demand that we expect to see the largest slowdown next year, as austerity measures will inevitably take something off consumption activity." Yet with "the biggest challenge [being] to cut the budget deficit to 3% of GDP in the next two years from 5.5% in 2011," as UBS points out, the government looks to have little choice but to press on regardless.

That impetus comes from Warsaw's struggle to keep state debt levels below 55% of GDP, which has only provoked a spike in borrowing costs and downward spiral for the zloty as risk aversion has risen in the second half of 2011. The currency fell 16.9% against the US dollar in just the third quarter and remains vulnerable, which is why Citigroup analysts are bucking the trend in predicting that the "additional fiscal tightening ... will help create room for interest rate cuts of 75-100bp in 2012."

In contrast, most others suggest that a sufficient level of domestic demand and the weakness of the currency will see "inflation remaining sticky," as RBS puts it, restraining the National Bank of Poland's (NBP) hand through the year. The hawkish rate board spent the first half of 2011 raising rates to fight price rises, and intervened several times in the latter part of the year in a bid to support the currency. Assuming these twin pressures persist in 2012, it seems unlikely to baulk at sacrificing a little economic growth to continue to resist.

Meanwhile, a stable banking sector should help support that strategy by remaining open to lending, the NBP reported in December. "The key takeaway," suggests RBS, "is that even in the stress test scenario of funding shortages, most banks would maintain liquidity. This is a silver lining in the rather stormy cloud formation of EU bank deleveraging."

Slovakia - politics compounds risk

Slovakia is not only the most exposed of any Central European country to the decline of demand in the Eurozone, but is also hampered by its fractious politics.

As a member of the Eurozone, Slovakia is not exposed to the type of currency risk affecting next-door Hungary, but neither can its export-led economy benefit from cheaper prices to help support sales abroad. While public debt remains relatively healthy at around 44% of GDP and the banks look stable, the vital investment seen over the past few years is at risk due to global sentiment and the political mess in Bratislava, putting more pressure on the high unemployment rate, and therefore already meager domestic demand.

With the governing coalition of Prime Minister Iveta Radicova having collapsed in October, but forced to limp on until fresh elections in March, the country has already seen a less-than-ambitious budget pushed through parliament, which saw a planned 3.8% budget deficit target rise to 4.6%. "We agreed to prepare a budget which will respond to a worsening economic outlook," Radicova told journalists in Bratislava on November 16.

"Further cuts would have a serious impact on the life of citizens and they would cripple the economy," she claimed. In other words, the main opposition party Smer would allow no greater austerity measures.

Worries over the longer-term reform programme in Slovakia - the tax and pension systems need a serious overhaul - will take a backseat then during the struggle through 2012. However, the concern is that with Smer looking likely to retake office in March, fiscal policy will slacken and the privatisation process - frozen the minute the government fell - could even go into reverse, as happened during Smer's last administration. As Jaromir Sindel at Citigroup puts it, "the big uncertainty is over fiscal policy, reflecting the early election planned for 10 March... we think there is likely to be a negative surprise in 2012."

The growth forecast in the budget was halved to 1.7% from the finance ministry's original standpoint. However, the European Commission forecasts just 1.1%, while other analysts expect it could very well fall even shorter.

That pessimism reflects the extreme exposure - even by Central European standards - of Slovakia's small and open economy to the Eurozone slowdown, with Neil Shearing of Capital Economics calling the outlook "bleak" and including the country as one of "the big risks" in 2012. With exports accounting for a full 81% of GDP in 2010 according to the World Bank, and a whopping 84% of those heading to the EU, analysts find little optimism save for Sindel's suggestion of "some upside due to the introduction of new car models," for the country's relatively huge auto making sector.

Meanwhile, like the Czechs, the Slovak population has shown itself extremely wary of the coming crisis, and with unemployment still sitting just below 15% despite reasonable recovery from 2008, already low domestic consumption is set to drop even further, suggest analysts at Komercni Banka. Therefore, they also see "no demand-pulled inflationary pressures" for the coming year, suggesting that price growth will "decelerat[e] to 1.9% in 2012" from a forecast 3.9% in 2011.

Falling inflation is likely a bad sign for the vital investment flows that have been behind the economy's dramatic growth over the last decade or so, says the European Commission, which worries that lowered external demand and trade will "put on hold private investment decisions."

However, many of the car and electronics manufacturers that have piled into the country in recent years have said in 2011 that they will commit to further investment as they relocate more capacity from Western Europe, but of course it's unclear whether they will go through with all their plans should the eurozone see a deep recession. Again, political uncertainty could also affect these decisions; it's unclear if the next government will continue to hand out the handsome concessions that the current government has.

Either way, East Capital is dubious that investors can keep up the pace, pointing out that while investment "has been ... one of the main attractions of EU accession ... it will be a source of weakness in the coming years."

A definite positive for Slovakia, however, is that its banks look likely to remain ready to lend should investors choose to go forwards, with Raiffeisen Research crediting the country's sector with plenty of room to expand and extolling its "low dependency on external funding." The only thing needed is demand, which the analysts appear less certain of across both the retail and corporate segments in 2012.

At the same time, new legislation poses some risk to liquidity. "The strongest impact on the regulatory front is expected from the bank levy that is likely to be introduced as of 2012 and will apply to non-insured primary deposits with a net effect of some €40m-50m (almost 8% of the 2010 net profit of the banking sector)," Raiffeisen points out. "On a positive note, the envisaged revenues will not go to the state budget, but are instead earmarked for a buffer for potential future financial sector troubles."

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