SOUTHEAST EUROPE 2009: The higher they rise, the harder they fall

By bne IntelliNews December 19, 2008

Nicholas Watson in Prague -

The global financial crisis arrived relatively late to the shores of Southeast Europe, but arrived it certainly has. The only debate now is how bad things will get. There are dire predictions for the high-flying Romania and Bulgaria - a case of "the higher they rise, the harder they fall" - whereas the crisis-prone Turkey may be well placed enough to avoid another one.

Talking Turkey

"Turkey's third-quarter GDP signals a deepening slowdown," was the sober analysis offered by Deutsche Bank when the country's stats office revealed in December that GDP in the period had hit a six-year low with growth of just 0.5% from the year-earlier period.

Even so, the GDP figures were not unexpected (the consensus was for a flat reading). Analyzing the sources of growth suggests that the impact of the global crisis is mostly being felt in private sector investment and consumption, while public expenditure has gained some momentum, offsetting that weakness. Leading indicators suggest a further deterioration in the last quarter, so most analysts are now predicting a contraction then. "We stick to our forecast of 3.0% on-year contraction in fourth-quarter GDP and 1.5% growth in the entire year [and] a 1.5% growth rate in 2009," says Fortis.

According to the latest survey by the central bank, market participants are now predicting year-end 2009 inflation at an annual 8.54%, down from 8.95% in the prior survey and November's rate of 10.76%.

While the latest figures highlight Turkey's short-term vulnerabilities and the need for macroeconomic and political stability, analysts tend to agree that the country is arguably in a fundamentally better position on both fronts today compared with the last crisis in 2001. "The good news is that there are still important external factors that could stimulate change in Turkey. The most important ones are the International Monetary Fund when it comes to economic stability and the EU for political stability," says East Capital, a fund management firm focused on Central and Eastern European.

The government was initially sceptical about seeking out a new IMF deal and, indeed, Turkey isn't financially in the sort of position that has forced some other emerging economies to seek international help. However, the government needs to make sure it has no problems meeting a $130bn funding requirement in 2009 and economists have warned the country could slip into recession without a deal to support investor sentiment. Progress is being made now on a deal, with the IMF announcing on December 15 that a team would visit Ankara in early January. Local reports say the programme will be a standard standby agreement with a short duration of 18-24 months.

On the political side, nobody is in any doubt that Turkey is facing a critical year over its accession talks with the EU, as the reform effort that was so evident in 2000-2004 has since slowed to a crawl.

The International Crisis Group says the danger of an irretrievable breakdown will be especially great if there is no Cyprus settlement in 2009. Some member states could seize on this issue to suspend membership negotiations, especially if Turkey does not open its ports to Cypriot vessels by the autumn. And if negotiations are suspended, it will be nearly impossible to find the unanimity needed to restart them. "The cost to Europe would also be great," says Sabine Freizer, Crisis Group's Europe programme director. "Less-easy access to big, fast-growing markets, likely new tensions over Cyprus and the loss of leverage that partnership with Turkey offers to help stabilise the Middle East, strengthen EU energy security and reach out to the Muslim world."

However, optimists like East Capital claim, with some justification, that, "the Turkish accession process to the EU is still on track." They point out that despite political problems at home and problems within the EU itself over the Lisbon Treaty, the accession process has continued, with new negotiation chapters opened continuously. Also, there was little chance of progress being made as long as France, a notable cynic of Turkey's membership, was in charge of the EU presidency, but now supporters like the Czech Republic and then Sweden will take over in 2009. "Perhaps most importantly, EU membership is still an important goal in Turkey. Prime Minister Recep Tayyip Erdogan and his AK Party have been clear about Turkey's ambitions to join and this position has strong popular support," says East Capital.

No Romanian holiday

Romania's incoming coalition government on December 14 signed a protocol that is designed to help the country weather the tough times ahead. While the perpetually squabbling politicians seemed to have finally realised that the economy faces many problems, analysts say it's unlikely they have grasped the gravity of them.

The coalition is itself a surprise, as the Social Democrats (PSD), which came second in the elections held November 20, claimed they couldn't get along with President Traian Basescu, the founder of the Democrat-Liberal (PD-L), which narrowly won the elections but with no outright majority. More likely was some combination with the third-placed party, the National Liberal Party of outgoing Prime Minister Calin Popescu Tariceanu.

With the two main parties in alliance, the coalition will have a two-thirds majority in parliament, enough to push through the radical measures needed to weather the gathering storm. "The time of rows has passed," PD-L leader and the next PM Emil Boc declared, though added - perhaps ominously given the turbulence of Romanian politics - that, "we are partners, but we'll be in competition when the time comes for political competition."

The new government's task has been made all the harder by the previous minority government's inability to stop parliament's decision in October to give a pay rise for teachers that was calculated to be in the region of 50%. What this means is that wage pressures will weaken further the country's already deteriorating competitiveness and could drive inflation back above the 10% mark in 2009, compared with the 6.7% annual rate of inflation for November. "This would be the result in normal circumstances, but the Romanian economy is not in normal circumstances right now, and it is highly unlikely that the present credit crunch and the pressure from the international financial markets will leave time for this inflation spiral to run its course. Much more urgent matters are likely to make their presence felt first," says Edward Hugh, a widely read emerging market economist.

Those urgent matters are principally the spiralling twin deficits. Outgoing Finance and Economy Minister Varujan Vosganian has warned that the proposed increase could push the budget deficit up in the direction of 7.0% of GDP in 2009. This would put it at more than double the 3.0% figure set under the EU's Maastricht criteria, which Romania must meet to qualify for the adoption of the euro. Tariceanu's outgoing government plans to end 2008 with a budget deficit equivalent to 2.3% of GDP. However, the country's budget gap for the 11 months through November widened to almost 3.0% of GDP due to lower-than-planned revenue. The European Commission said in November it projects a budget gap of 3.5% of GDP for Romania this year due to its loose fiscal policy. In fact, Romania's loose fiscal policy stance and the growing public spending commitments were among the main reasons cited by Standard & Poor's when in October it downgraded Romanian debt to junk status, just two years after the country joined the EU. Romania's current account deficit has been widening each year for more than half a decade and now stands at around 14% of GDP.

So far, the country's pace of growth has confounded the critics. On December 15, the stats office said Romania's final consumption growth accelerated to 13.7% in the third quarter from 9.0% posted in the same period of 2007, fuelled by domestic spending. GDP growth in the third quarter was an annual 9.1%, just a shade slower than the 9.3% in the second.

While nobody expects the country to maintain such growth in 2009, the government's forecast of 4.5% growth is seen by many now as overly optimistic. "The international financial crisis will not skip over the Romanian economy, but we stick to our core scenario regarding a weaker negative effect compared to Eurozone countries. The Romanian economy is less open and this might provide a certain degree of resistance to the global turmoil," reasons Eugen Sinca of BCR in Bucharest.

Indeed, Romania has a current account deficit of "only" 14% of GDP, a floating currency that gives it more flexibility, and is less dependent on exports to the slowing Eurozone than next-door Bulgaria. But given the growing imbalances in the country, increasingly people are of the view that the country will experience a hard landing like that suffered in Latvia, where the economy went from growing 8.0% in the fourth quarter of 2007 to shrinking by 4.6% in the third quarter of this year.

As evidence of this, economists point to falling retail sales and consumer confidence and rising bankruptcies in October. Perhaps most worrying is that bank lending appears to have ground to a virtual halt, falling by 0.6% in October, the latest month for which statistics are available from the National Bank of Romania, from the month before, when it rose 4%. "For an economy which has been experiencing a debt-driven consumer and construction boom it is hard to overstate the significance of this single fact," says Hugh. "We seem to have what is known as a 'sudden stop' in aggregate bank lending here, and the Romanian economy may now well fall rapidly into recession, following the tried and tested path so recently pioneered by Latvia and Estonia."

The outlook then is for a sharp slowdown in growth in the first half of 2009, which could turn into outright recession as soon as the third or fourth quarter. The government may also have to join Hungary, Latvia et al in having to turn to the IMF for support to help it finance its €59bn in external debt.

Bulgaria battering

The other big worry in the region is, perhaps not coincidentally, the other recent new EU member state Bulgaria.

Like Romania, the Bulgarian economy is still steaming ahead. On December 15, the stats office said Bulgaria's GDP continued to grow at a record annual pace of 6.8% in the third quarter. In the first nine months of 2008, Bulgaria's GDP grew 7% versus the same period of 2007.

A breakdown of the GDP figures, however, shows why this is unsustainable from even a technical point of view. The industry and service sectors are slowing considerably, while the agriculture sector has surged on the back of one-off base effects stemming from severe weather damage suffered in the same period last year. The share of agriculture in the total added value of Bulgaria's national economy in the third quarter grew to 11.5% from 8.9% in the same period of 2007, while the relative share of industry fell from 32% to 30%, and the relative share of the services sector dropped 59.1% to 58.5%. However, the positive base effects on the agricultural sector will cease to exist as of next year, while the negative external shocks to the industry and related services will further expand. This, say economists, will lead to a dramatic slowdown next year.

How dramatic remains to be seen. Most economists put growth this year at around 6.0% followed by a rapid decline, with some predicting zero or even negative growth in 2009. On December 15, the IMF predicted that Bulgaria's economy will grow by about 2.0% next year, compared with about 6.5% projected for 2008, though added that it hadn't yet analysed the impact on its projections of the strong GDP growth for the third quarter that had just come out, "so it could be that our final projection for 2008 might be a little bit higher, maybe 6.5%."

For the record, the official line is for economic growth to be 4.7% next year under a best-case scenario, but under a pessimistic scenario, if the external environment deteriorates considerably, Bulgaria's economic growth could fall to 2.1%.

On the plus side, Bulgaria's fiscal position is strong. The state has little foreign debt and runs a budget surplus, which should allow it to raise public spending as the economy slows. It can also borrow abroad, though the authorities say they have no plans to approach the IMF for help.

However, the Bulgarians have their hands tied by a currency board that pegs the lev rigidly to the euro. "That rules out devaluation to restore competitiveness, which is a concern as exports sag. It also removes a potential buffer, because the central bank cannot adjust interest rates," say economists at RGE.

Of particular concern is the current account deficit, which widened to an alarming 19.4% of GDP in the first 10 months of the year from 16% a year earlier due to strong imports. This comes at the same time that FDI is dropping and, embarrassingly, the EU is cutting off aid due to the rampant corruption that successive governments appear either unwilling or unable to address (though RGE notes it's still in line to get €11bn in the years up to 2013). The net inflow of FDI tumbled 42.3% on year to €315m in September and 29% to €3.2bn in the January-September period. This meant it covered only 60% of the current account deficit in the nine months, compared with more than 100% in the past several years.

The massive current account deficit is a particular worry, Michal Dybula, an analyst at BNP Paribas, told SeeNews, "especially since competitiveness has deteriorated markedly during the last several months, due to quickly rising unit labour costs and strong appreciation of the real effective exchange rate."

Slovenly Slovenia

The region's other EU state, Slovenia, saw its GDP growth rate slow to 3.8% on year in the third quarter from the 5.5% recorded in the previous quarter. That means for the first nine months of the year, GDP rose 5% compared with the same period in the previous year. Slovenia posted growth of 6.8% in 2007.

In October, the government's Institute of Macroeconomic Analysis and Development (Umar) said it expects Slovenia's GDP to grow by 4.8% this year and 3.1% next year. However, Umar said in December it would revise its economic growth forecasts by the end of the year and few doubt they will reflect the sharper slowdown elsewhere, especially its largest trading partners in the Eurozone. "Things are changing so fast that what we presumed a month ago is simply is not valid any more," Bozo Jasovic, a member of the central bank board, told a banking conference in November. Our forecast for "real growth of GDP is surely overrated."

Western Balkan blues

The region's states are in the incongruous position of having to deal with problems emanating from the West at the same time as they are all trying to integrate further with it. As Moody's Investors Service notes in a December report, EU integration in the Western Balkans is an important component of the sovereign ratings in the region. "Integration into the EU can provide a significant boost to countries' economic and institutional strength, implying greater economic resiliency and higher ratings," Moody's says. "EU integration should lead to greater wealth, larger economies and more rapid economic growth over time."

Croatia is an EU-candidate country and is considerably ahead of the rest in the accession process. Membership negotiations are advanced, but there's still a lot of work to be done. If the remaining negotiation chapters can be closed by end-2009 - the Commission's schedule - the country should join the EU by 2011.

The government will also have to deal with a slowing economy. The first-half GDP performance was in line with most people's expectations, with GDP growth moderating from 4.3% in the first quarter to 3.4% in the second. For the second half, Erste Bank sees a further moderation of economic activity, predominantly in private consumption, which remains hampered by weaker credit, inflation pressures and the pronounced slump in consumer confidence. "For 2008 overall, we see GDP growth a notch below 3.5%, given the still solid investment activity and stable tourist sector performance," says Erste. "On the other hand, risks to the 2009 forecast remain pronounced, given the uncertainties related to investment activity and tourist sector performance."

Serbia is much further back in its accession process, but has - somewhat surprisingly given the innumerable obstacles such as failure to hand over alleged war criminals - managed to get on the first step by signing a Stabilisation and Accession Agreement. That deal is illustrative of how the political issues that have dogged the country for many years have declined in recent months when early parliamentary elections in May brought in a new pro-EU government.

Sadly, however, the country is not expected to benefit overly from the diminishing political risks, as the financial crisis is putting lots of strains on Serbia's rather mixed finances. Though not directly impacted by the credit crunch, the economy is already slowing markedly. GDP growth slowed in the second quarter slowed to 6.2% on year from 8.4% in the first. GDP growth for the whole of 2008 is now put by many economists at 6.5%. 2009 is expected to see growth moderating further, to around 3.5%, as domestic demand weakens while the export performance is expected to deteriorate, given the falling economic activity in the region.

The current account deficit is alarmingly wide at an expected 17-18% of GDP at end-2008. This has caused the dinar to be hammered down, making it one of the biggest losers among all CEE currencies. Worryingly, FDI inflows moderated in the course of the third quarter and a weaker-than-previously-anticipated FDI performance is now seen in the coming quarters too. This would put pressure on debt-creating financing and usage of international forex reserves to cover the lack of FDI inflows. "Domestic demand is high, resulting in a current account deficit of some 18% of GDP," World Bank country manager for Serbia, Simon Gray, says. "As credit gets tighter, external borrowing will become more expensive. Foreign investors are going to be extra discriminating and very risk averse."

Even so, few are predicting disaster on the same lines as Romania. Serbia has negotiated a standby deal with the IMF, while short-term debt makes up less than 10% share of total external debt. Gray says that despite a faltering national currency, Serbia's banking system remains "well capitalized" with strong reserves that should help it weather the storm of the looming global recession.

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