Sovereign debt crisis seeps into CEE

By bne IntelliNews August 8, 2011

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Contagion from the debt problems in the Eurozone and the US is seeping into Emerging Europe, with stock, bond and currency markets tumbling alongside declines in manufacturing.

The crisis-hardened markets in Europe, as one bank strategist put it earlier on Monday, seemed to offer some resistance to the falls in Asia early on, helped by the announcement that the European Central Bank plans to buy up Eurozone government debt. But by the afternoon close, Europe's stock markets had extended last week's losses, with the FTSE 100 closing down 3.4%, the Cac 40 down 4.7%, and Frankfurt's Dax down 5.0%. The Dow Jones was down 2.6% in early trading.

This inevitably hurt emerging market stock markets. The MSCI Emerging Markets Index was down around 4.4%, while in Central Europe the Warsaw, Budapest and Prague stock markets were down. Regional currencies were also lower: the Polish zloty slid to its weakest in more than four months against the euro

The Russian stock market was particularly hard hit. As the Brent crudeprice shed 3.2%, the Micex dropped 5.5% and the RTS 6.41%, both on strong volume. Perhaps the worst news on Monday was that the ruble tumbled 2.2% as the flight to safety turned into a stampede. "We ... are firmly in grizzly bear market land," reported William Hammond, director of equity sales at Citigroup's Russian office. "With little market-moving Russia-specific news flow, and fundamentals amounting to bugs on the windscreen, there was little good advice to dole out today, save for not succumbing to the desire to be bullish when put on the spot by a client." He goes on to call the ruble's blowout "a clear slap in the face for the domestic growth story."

Capital Economics says the impact of the global turmoil on emerging markets will come via two main channels: weaker demand for exports and a disruption to global capital flows. At the same time, commodity producers like Russia and Kazakhstan may also be hit by a fall in prices. "In general, the economies of Emerging Europe look most vulnerable, for four reasons. First, they rely more heavily on exports to the troubled Eurozone. Second, they are more dependent on foreign capital to finance spending (particularly Turkey) and roll over external debt. Third, high budget deficits (if not debt) mean that there is limited scope for policy stimulus, if needed. And finally, the region's largest economy, Russia, will be hit hard if oil prices fall back, as we expect," it says.

While many are hopeful that the economic impact on Russia from the sovereign debt crisis in Europe will remain limited, the main risk as ever is the economy's high exposure to oil prices, which pulled back to $40 during the last economic crisis. "Both the ruble and the RTS have already overreacted relative to the oil price moves compared with their behaviour in 2011 so far, and obviously... the near-term dynamics might be quite wobbly," claims Alexey Zabotkin at VTB Capital. "That said, unless the longer-term oil price expectations are challenged in a major way, the relationships between current oil prices, the ruble and Russian equities are likely to be re-established."

Liam Halligan of Prosperity Capital Management posits that sky-high oil prices could now be compatible with recession in the West. Adding together the demand shortfall that emerging economies - particularly in Asia - could make up for, the oil supply restraints in the Middle East and North Africa, and the weakness of the dollar, that would obviously be good news for Russia's oil-addicted economy.

Although analysts at Citigroup suggest the current $100-plus cost of a barrel of crude could potentially dip to $50 in a full-blown crisis scenario, they also offer a model based on a range of $80-90, in which they "would expect a budget deficit of around 3% in 2011, requiring about $50bn in financing, which could be easily accommodated by the reserve fund."

Ivan Tchakarov of Renaissance Capital says a $15 decline in oil prices would lower Russian GDP growth by a maximum of 1.2%, but points out that the ruble could be hit far harder.

With public debt one of the lowest in the world and reserves above $500bn, Russia looks an island of stability in Europe. However, it's not what investors know about Russia that keeps them awake at night, but what they don't know.

Russia's macro numbers looked even more robust ahead of the crisis in 2008, before it fell off a cliff. Although corporate financial positions are far healthier today than in 2008 - "all Russian companies have better-matched forex P&L and balance sheet exposures," points out Ivan Kim from Renaissance Capital - transparency and corporate governance issues are still likely to suppress appetite for Russian risk, while whichever oil scenario transpires, the country's concentrated exposure to commodity exports is still likely to spook all but the bravest.

Meanwhile, Kim points out how quickly that contagion is likely to spread to other sectors should GDP growth slow significantly. Transport companies will be the first to bear the brunt, he suggests, with autos following close behind. Peter Westin at Aton points out that telecoms and consumer stocks are consistently the best defensive plays when the Russian markets are hit by a jolt.

The slowdown in the Eurozone can already be seen in the manufacturing numbers for Emerging Europe, leading some economists to already start downgrading their GDP forecasts for the year.

Central Europe catches a cold

Following weak industrial output numbers from Germany, Italy and Spain, the Czech stats office said Monday, August 8 that annual growth in industrial production decelerated to 7.4% in June, while it actually declined 1.9% from May, when year-on-year growth came in at a huge 15.2%. The similarly export-dependent Hungary too reported weak numbers for June, with a 0.6% contraction in output on month and up just 1.0% on year. "Our previous outlook for this year's 8.5% growth in the industry seems too optimistic after this release," says Zoltan Arokszallasi of Erste Bank. "[This] increases the risk that second-quarter GDP may be closer to 2.0% than to 2.5%."

Purchasing managers indices - which are based on private business surveys and so regarded as leading indicators of the overall situation in manufacturing - released earlier in August suggest this trend is going to pick up. Manufacturing PMIs for July fell in three (Czech, Turkey, Russia) of the four countries (plus Poland) in the region that have reported such data.

Russia showed the sharpest fall, with its PMI falling below the 50 mark - the point that in theory at least separates expansion from contraction - for the first time since December 2009. Elsewhere, the Czech Republic dropped to 53.4 (from 55.1 in June) and Turkey dropped marginally to 52.2.

"A regional PMI - obtained by weighting together individual country PMIs by the size of their respective manufacturing sectors - suggests that, while industry is still growing on a month-on-month basis, the pace of growth has slowed to a crawl over the past quarter," says Neil Shearing, senior emerging markets economist for Capital Economics.

As yet, the crises in the US rating and Europe have had no more impact on Kazakhstan than on any other emerging country. However, according to Jean-Christophe Lermusiaux, head of research at Visor Capital, if big questions over the world economy linger, this will have implications for Kazakhstan and other frontier markets. "When investors lose confidence in the western world's economies, their first reflex is to look for value investments in the western world, as well as in segments of the economy that are considered as safe (infrastructure, telecoms)," Lermusiaux says. "Therefore, they tend to pull out from emerging and frontier markets."

With some exceptions, stock prices in the region are generally down by 20-50% since the beginning of this year. Lermusiaux points out that S&P's decision has been expected for several weeks, and has been largely pre-shadowed in the markets. "So far, we haven't noticed any impact from the Euro/US crisis on the Kazakh economy," he says. "If problems continue, the first impact will be the volatility in commodity prices."

Although oil prices have been affected, especially in the US, demand for oil remains resilient and driven by emerging economies.

While the Kazakh tenge is not officially pegged to the dollar, the tenge-dollar exchange rate is extremely stable. "In our view, the probability for the tenge to depreciate significantly is limited, given that Kazakhstan's reserves are at a record high of around $75bn," says Lermusiaux. "Conversely, some pressure on oil prices make us doubt that there will be a substantial tenge appreciation in the near term."

Elsewhere, so far the impact on the Mongolian stock market has been minimal. On Friday, Mongolia's benchmark TOP20 Index closed only 0.3% down and on Monday the index rose 0.42%, according to an analyst note from Frontier Securities titled "Mongolia: New safe haven".

"We believe that the fundamentals for the Mongolian economy are strong and the economy will maintain rapid growth this year," writes Dale Choi, chief investment strategist at Frontier Securities. "The credit rating crisis will continue to cause ripple effects on the global markets while Mongolian market because of limited exposure is essentially decoupled from the world financial markets at the moment."

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