Wobble-U recovery

By bne IntelliNews April 28, 2009

Ben Aris in Berlin -

The shape of the recovery of emerging Europe won't be a "V", that's for sure. It probably won't be an "L" either. Most investors hope it will be "U", but many are pointing to the chance of a "W" this autumn instead. However, the most likely shape of the recovery over the next 18 months will be a "Wobble-U."

April was a good month for crisis-battered businessmen as the collapse slowed considerably and there were even a few "green shoots" to point to. Equity investors poured back into markets across the region, erasing all this year's losses in a few weeks. However, economies across the region are still contracting and the prospect of a banking crisis after the summer is very real. Still, despite the palpable fears and real problems ahead, the chances of a total economic meltdown, sovereign default or a pan-regional banking crisis have receded.

Rather than a full-blown crisis, what is more likely is a series of nasty surprises that will induce wobbles in the bowl of a "U"-shaped recovery. Going forward, everything depends on each government's ability to correctly identify the key issues and implement effective policy to counter these problems - admittedly, something none of the governments in the region has ever been particularly good at.

If the Central and Eastern European countries can make it through to the middle of 2010 without tripping up, then the prospects for the region in the medium to long term have actually improved in terms of their share of the global economy. Although no one is focusing on the long term at the moment, the point is that the crisis has done a lot more damage to mature economies in the west than it has to emerging ones, largely because the use of credit is so widespread in the west and so underdeveloped in the east.

Goldman Sach's head of emerging market research, Jim O'Neill, who coined the term BRIC (Brazil, Russia, India and China) in 2001 to highlight the long-term potential of these markets, says the current slowdown won't affect the growth of BRICs and he has even moved the point where they overtake the aggregate size of the G7 economies up by nearly 10 years to 2027. Indeed, Russia could overtake Germany, long the biggest economy in Europe, as soon as next year, according to O'Neill. "There is evidence of a rebalancing of the world economy as the BRICs, led by China, increase their share of global consumption. While the future of the BRICs is closely linked to that of the advanced economies, we see tentative signs they are pulling the world economy in a different direction, namely, upwards," O'Neill wrote in his March BRIC monthly strategy paper.

The Soviet sandwich is back

At first glance, CEE looks in far worse shape than its peers in the west. The International Monetary Fund (IMF) has become increasing pessimistic about the prospects for a global recovery as this year wears on, and that of CEE in particular. The fund's World Economic Outlook, released at the end of April, predicts a protracted global recession and falls in GDP in Eastern Europe to be amongst the worst in the world. Russia's economy will contract by 6% this year and that of Ukraine's by 8%, on a par with Japan, which has been another big victim of the crisis, says the IMF. The economies of the Baltic states, Iceland and Singapore, will do even worse, recording double-digit declines.

However, the Fund also predicts that the CEE countries will return to growth sooner than those in the west, starting in 2010. Where will this growth come from? The easiest way to understand what has happened to the economies of the region is to think of them returning to the "Soviet Sandwich" structure that was prevalent in about 2003.

Russia's economy, and to a lesser extent those of Ukraine and Kazakhstan, are neatly described as having two bread-and-butter sectors that earn all the money. The top slice is the extractive industries that make money by simply digging it out of the ground. On the bottom are things like food processing that makes money from selling simple things to a 142m-strong consumer market and are, arguably, the most competitive sectors in the economy. The middle of the sandwich is made up of the greasy pink kolbasa of unreformed Soviet-era industry. But as the economy grew in recent years, more and more pink companies were transformed into "raisins of growth," making the sausage layer increasingly appetising. What this crisis has done is to spoil that sausage, as middleweight industries have suffered the most from the absence of credit.

The return to the Soviet Sandwich is writ large on the latest industrial production numbers. Russia's industrial production fell by 13.7% in March on year. However, mining only fell by 1.8% after falling 6% in February and food processors actually put in positive growth. Compare this to middleweight manufacturing, where the fall in production accelerated, down 20.5% in March against a fall of 18.3% in February. Capital-intensive sectors are suffering the most at the moment.

The Soviet Sandwich provides grounds for both optimism, as it will drive the economy up, and pessimism, as it will cause wobbles. The two slices of bread are already doing relatively well: the profitability of Russian oil companies has actually improved as costs and their tax burden are down, while the food processors are also in the money as their foreign competition was priced out of the market. But the pink sausage companies are in real trouble and many famous companies could go bust.

Bad loans

The biggest wobbles in the near term will be caused by banking sectors in the region, which are facing the very real possibility of a crisis this autumn stemming from non-performing loans (NPL).

The problem is most acute in those countries that have not opened up their banking sectors to foreign investors like Russia and Kazakhstan, but the rapid rise in NPLs is happening in all the countries of the region. Turkey is probably doing best, as banks got their fingers burnt in a big banking crisis at the start of this decade. Kazakhstan is doing worst and has already been forced to recapitalise its leading banks, as they borrowed heavily on the international markets during the boom years. Ukraine has also started recapitalising its bank sector, but as half the banks are owned by foreigners, the sector is in a stronger position, as are most of the banks in the Central European counties.

So far, the Russian state has avoided the need to rescue banks, but the government is clearly becoming increasingly worried by the unexpectedly fast rise in NPLs, which have been increasing by 20% a month over the first quarter. The Central Bank of Russia (CBR) is sticking to its official forecast of 10% of total sector loan portfolio going bad by the end of this year, which would wipe out the sectors earnings for the year - an acceptable result given the severity of this crisis. But more recently the first deputy head of the CBR, Alexey Ulyukayev, started to talk about the possibility of 30% in NPLs. To add to the worries, Finance Minister and First Deputy Prime Minister Alexei Kudrin said the real level of NPLs was actually 2.5-times higher than the official number of 3.3% at the start of April, due to flaws in the CBR's accounting methods.

Having said that, the chances of an NPL-induced crisis is receding, even if the level of debt passes into the red-zone over 10%. Alfa Bank's chief economist, Natalia Orlova, has been the most pessimistic of all analysts, predicting NPLs could rise as high as 16% by Christmas. But, ironically, Alfa Bank actually has the highest NPLs in the sector, which topped 10% at the start of April. Already in the red-zone, Alfa Bank is unfazed and says it expects to end the year flat and with its capital intact, as it has made adequate provisions for its NPLs.

Even if NPLs do go as high as 30%, Russia probably has enough money in reserve to bail out the sector. Moreover, the Kremlin will do everything it can to save the banks, which it sees as the most important tool for getting the economy moving again. It has been ploughing resources into the sector to the tune of hundreds of billions of dollars in an (unsuccessful) effort to get banks lending again. And more help is on its way: just under half of Prime Minister Vladimir Putin's $90bn anti-crisis package approved in April will go to supporting the bank sector.

Funnily enough, the Kremlin will probably cause a big wobble anyway even if an NPL-induced crisis is avoided. The CBR has made it very clear that it wants to use this crisis to consolidate the massively over-banked financial sector, reducing the number of banks from the current 1,100 to anywhere between 800 and 300, depending on who you listen to. The CBR has been closing about one bank a week in recent months, but the main thrust will come at the start of next year when new minimum capital requirements come into effect that could force hundreds of banks to close. The difference between a bank being closed by administrative fiat and one that's closing because it's gone bust will probably be lost on most observers. "We could see bank failures in Russia and it will spook the market, as it will be taken as the start of the bank crisis that everyone is talking about now," says Prosperity Capital Management's Liam Halligan. "But there is no chance of a systemic meltdown. Closing banks should be welcomed, as it is a prerequisite for a functioning financial services sector. It will take time for people to see that and in the meantime we could see a big sell-off [in equities] if and when this starts."

Fragile politics

Another wobble could come from the political fractures caused by the crisis. Already governments have collapsed in Latvia, the Czech Republic and Hungary, and experts now worry about a political revolution in Russia as Putin's unspoken deal with the people - namely, you don't interfere in politics and I will deliver prosperity - has shattered along with the falling incomes and rising unemployment. "This is the end of Putinism and his deal with the people is fundamentally broken," reckons the head of one big US investment bank in Moscow, who predicts there will be big political changes ahead. "The Kremlin was totally unprepared for the speed of this turn about and how can the system survive this whiplash without substantial change? Even if they rescue the system, you will be left with a fat, self-satisfied bureaucracy, with a less competitive economy that will underperform for years."

But so far there are little signs of popular dissatisfaction. There was one highly publicised demonstration in Vladivostok in February, but protesters were complaining about hikes on secondhand car imports from Japan - a local, not national, issue. Putin and Russian President Dmitry Medvedev remain probably the most popular leaders in the world with approval ratings north of 70%, according to recent polls.

More likely to cause a wobble is the possibility of a power struggle amongst Russia's elite. Putin has co-opted many of the oligarchs into an informal "ZAO Kremlin" corporation and some of the impoverished oligarchs could be forced out of this circle now. "Some [oligarchs] will go, but not all of them will go quietly," says the American banker.

Dealing with deficits

There has been a lot of talk about several countries in the region - Ukraine and Latvia to name two - actually failing. Yet despite the apocalyptic headlines, it's highly unlikely the public finances of any country in the region would be allowed to collapse. The countries in the worst shape have already tapped the now super-charged IMF for help, while others in better shape like Poland are now taking advantage of the Fund's new flexible credit lines, which are designed to strengthen economies that are fundamentally sound, but which could face an unexpected shock due to the extreme conditions of the crisis.

The problem of corporate debt is much more severe and will almost certainly cause some wobbles in the near term. However, the underdevelopment of lending in the region means those countries should recover from the crisis faster than their western peers. "The falls in GDP across the region have been dramatic and much greater than the falls in GDP in the west. However, falls in the west are much stickier than those in emerging Europe and so the recovery time in the east will be shorter," says Karine Hirn, a co-founder of East Capital, one of the biggest funds operating in emerging Europe.

What Hirn means is that average debt per capita in the US is $45,000 and in the UK $22,000, but in Russia it's only $900 per head. Losing your job in the US with this kind of debt hanging over you is a major personal disaster, whereas in Russia it's possible to scrape together $900 from friends and family so no one's life is ruined. The same arguments apply to corporate debt and the economies of the region as a whole.

Prosperity Capital's Halligan expands on the same point, arguing that none of the countries in the CEE region have big debts and, consequently, all the countries are in a much stronger position to rebound than most of their peers in the west. "Just look at the total debt of a country: Japan owes 350% of GDP, America 320% and the UK 215%. What's the number in Russia? Only 38% of GDP," he says. "Russia turned in a current account surplus in January and February even with oil at $40 a barrel. On every point, the fundamentals look extremely strong and the point everyone forgets is that this economy is vastly superior to the one that collapsed in 1998."

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