OUTLOOK 2014: CE to follow in Eurozone's stuttering steps

By bne IntelliNews December 20, 2013

Tim Gosling in Prague -

Central Europe's economies remain overwhelmingly dependent on export demand in the Eurozone. While that's partly a positive - especially as the Eurozone began posting steady signs of recovery in the second half of 2013 - the lack of diversification is clearly also a threat.

Central Europe has benefited from German growth and stability, but uncertainty remains. The periphery remains under huge pressure thanks to debt, deficit and unemployment, with the likes of France steadily succumbing also. The single currency area's banking networks also remain fragile. While the banks are stable in most of Central Europe, their markets are also heavily dominated by large groups based in the Eurozone, which is one of the main channels of contagion for crisis.

On the one hand, the recovery in Central Europe has shown signs of a robust recovery in the final quarter of 2013, particularly in Poland and Hungary. On the other, the Eurozone has seen output spluttering somewhat - and although it is keeping its head above water, the rate of recovery is likely to remain slow.

The European Commission expects that while the Eurozone will see broad growth in 2014, it will also remain fragile. It notes unemployment is likely to remain problematic, while further austerity can't be ruled out.

The International Monetary Fund (IMF) expects fiscal policy to offer more support to growth, but cautions that restricted credit markets will keep it capped. "In 2014, a major reduction in the pace of fiscal tightening, to less than 0.5% of GDP from about 1% of GDP in 2013, is in the offing," it says in its most recent World Economic Outlook. "However, the support for activity from the reduction in the pace of fiscal tightening is dampened by tight credit conditions in the periphery."

Overall, the IMF forecasts the Eurozone will record growth of 1.0% of GDP in 2014 to follow -0.4% this year. The European Commission plumps for 1.1% next year.

Turning to Germany, which accounts for by far the largest chunk of Central European exports, the IMF expects the economy to move from 0.5% growth in 2013 to 1.4% next year. Analysts at Citigroup are more bullish, suggesting surging domestic demand will drive growth, which would help circumvent the fragility of the wider Eurozone picture for Central Europe.

"We expect German economic growth to pick up to an above-trend 1.9% in 2014 and 1.7% in 2015, from 0.5% in 2013," the Citi analysts note. "Domestic demand should account for all of the increase, as robust employment and wage growth and probably a modest fiscal stimulus boost domestic consumption, and investment recovers amid an improved external outlook and low financing constraints."

Although domestic demand in the likes of Slovakia and the Czech Republic is finally starting to show signs of life after several years in the doldrums, that uncertain trajectory in the Eurozone will keep a rein on most of the region. The exception is likely to be Poland, which although dependent on exports for around 47% of GDP in 2012 according to the UN, traditionally has a far greater weight of domestic demand than others in the region (the next smallest share of GDP taken up by exports is the 78% seen in the Czech Republic). It is that element which kept Poland out of recession in both 2009 and 2013.

The European Bank for Reconstruction and Development (EBRD) suggests in its outlook for the year, published in November, that "overall, the CEB region [the Visegrad Four - minus the Czechs - the Baltic states, Croatia and Slovenia] will grow at 0.9% this year, before modestly recovering to 1.9% next year, as recovery finally takes hold in Croatia and gains momentum in Poland and the Slovak Republic." The Baltics - which have been exhibiting the fastest growth in the EU over 2013 - help push that forecast higher, while Croatia and Slovenia remain in recession.

At the same time, that performance could yet improve given the benign inflation picture that developed in late 2013. Particularly for the likes of Poland, that has released pressure on monetary policy, allowing regulators to extend guidance of low rates and therefore offer additional stimulus to the economies.

Capital Economics suggests this could offer the perfect conditions for accelerating the recovery. "[A]ssuming that the single currency bloc manages to muddle through without spiralling into a fresh crisis... the conditions may now be falling into place in much of Eastern Europe for a Goldilocks period of relatively strong growth accompanied by low inflation," Capital Economics wrote in November.

Another bonus is that, in contrast to many CEE peers, the Central European markets look set to largely evade any effects of tapering by the US Federal Reserve. The expectation now is that the reduction of the US central bank's asset buying programme will start in the first quarter of 2014; emerging market assets spent much of the second half of 2013 on a rollercoaster as investors watched the signs nervously.

Asset prices remain elevated for the meantime as investors hunt for yield. However, a bump will follow when the end of the programme raises returns on developed market assets, leading to a rise in bond yields in emerging markets. Those economies with the largest imbalances - Turkey and Ukraine - are the most exposed. By contrast, across Central Europe, governments have kept a fairly tight rein on the finances, so worries about the Fed have not hit yields much, and most analysts expect a muted response when the tapering finally begins.

Czechs look to intervention and an end to austerity

The Czech Republic held elections in late October, though coalition talks between the left-leaning Social Democrats (CSSD) and Ano 2011 - the brand new political vehicle of billionaire businessman Andrej Babis - which both won around 20% of the vote were not finalized until mid-December. Alongside President Milos Zeman's pledge to interfere in the make-up of the cabinet, the political success of the owner of the country's biggest employer, Agrofert, points towards a wider breakdown of the democratic process in country, and invites the prospect of government instability. However, investors have been brushing that off for decades.

While the markets will be hoping Babis has enough clout to derail previously professed plans from CSSD - such as the imposition of special taxes on certain sectors of the economy - the basic outlook is moulded by the fact that the previous administration's tough austerity will come to an end. There is a risk that unless the caretaker cabinet can push a 2014 budget past parliament by the end of the year, austerity will continue automatically.

Most commentators spent 2013 complaining that fiscal consolidation under former PM Petr Necas' right-wing coalition was holding back the economy. Six consecutive quarters of contraction is testament to that view. However, despite pulling out of the longest recession in Czech history in the second quarter, contraction (-0.1% GDP) returned in July-September. Again, that illustrated the problems in such a high level of dependence on the Eurozone, which also struggled to maintain momentum in late summer and early autumn.

However, the recovery in Germany and the likelihood of some much-needed stimulus from the government brightens the picture going forwards, even if it will take some time for the population to regain confidence. "While stronger external demand and restocking are likely to support the recovery in 2014, household consumption and gross fixed capital formation are expected to become the key drivers of growth in 2015," suggests the European Commission.

The international institutions forecast a contraction of 0.4-1.0% for 2013, before the country climbs back to growth of 1.5-1.8% next year. However, those estimates were made ahead of the move in November by the central bank to weaken the crown to improve export demand and stave off deflation. That intervention to peg the currency at CZK27 to the euro saw Citigroup increase its growth forecast for 2014 by 2 percentage points to 1.9%.

While noting in a ranking of CEE markets in its equities strategy for 2014 that "growth is the weakest point for the Czech economy," Erste Bank has the country third overall, behind Austria and Romania. "The Czech Republic receives comfort from low inflation," the analysts note, "but also low risk and a low [current account] deficit and public sector debt."

Although Czech sovereign bonds led the dip to record low yields seen across the region this year, external borrowing remained subdued as the finance ministry instead tapped its large financial reserves. Kommercni Banka says that although it expects gross borrowing needs to rise sharply in 2014, to CZK 269.5bn, the country should also maintain its status as a safe haven.

That should help steer it through tapering from the Fed, analysts suggest, although they still think the expected €2bn Eurobond issue will come early in the year.

Hungary looking good (in the short term)

Having shaken off the "double-dip" recession that plagued it throughout last year at the start of 2013, Hungary spent the rest of the year mostly beating expectations on macroeconomic indicators. For 2013, the EBRD expects growth to be marginally positive, with GDP set to expand 1.2% next year. The EU - persistently at odds with Budapest since the ruling Fidesz party came to power in 2010 - is more positive, suggesting growth of 0.7% this year and 1.8% next.

However, political uncertainty rules the roost, meaning the state is the only significant driver of credit and fixed investment is likely to remain suppressed. Elections are due by April, and polls suggest Fidez is set to retain office. While Budapest has avoided an expensive election budget as it reins in fiscal indicators, it has instead hit the utilities and the banks for cash.

The utilities have seen energy prices cut by 20% in 2013, and another 10% has been promised before the vote. Meanwhile, special taxes on the banks have been raised further, and lenders are bracing themselves for another round of losses as the government concocts a scheme to do away with the huge volume of foreign currency mortgage loans.

As the EBRD points out, alongside the sluggish economy that has only helped raise the level of non-performing loans (NPL). The international development bank lumps Hungary in with the likes of Kazakhstan, Ukraine and Slovenia in noting that NPLs continue to rise and weigh heavily on bank balance sheets.

The worry, however, is that once the election is over, policymaking could take a turn for the worse. With Fidesz seemingly set for another four years, the banks are now not only cutting investment - ie. lending - even more drastically, but several of the large Eurozone groups that dominate the sector have indicated in recent weeks that they have given up the ghost and are considering leaving the market. Meanwhile, expectation of more pressure on the country's finances has the likes of Erste fretting that further fiscal adjustment packages "are expected to be based on revenue increases, probably by taxing the corporate sector, and thus maintaining the unpredictability of economic policy."

That leaves the government-influenced Magyar Nemzeti Bank as the main driver of the economy. The MNB's "Funding for Growth" scheme, which disseminates cheap credit to small businesses and also perhaps for households next year, is "the big story for monetary policy" in 2014, according to Morgan Stanley. The analysts note that with the scheme equal to almost 10% of GDP, "almost all new loans" in Hungary are now financed by the central bank.

Meanwhile, although exports are forecast to accelerate in 2014, "domestic demand is expected to be the main driver of growth," by the Commission. That, again, is almost entirely dependent on the state. With investment dropping, government job schemes are driving the small uptick in employment, while the Commission notes the utility price cuts are a major issue behind the return of consumption growth thanks to the extra cash it leaves in households. However, without a broader investment base, the Commission expects "high unemployment and ongoing deleveraging to keep spending contained."

Investors are also wary. In its outlook for equities markets in the coming year, East Capital frets that the country remains "risky from a regulatory point of view... We believe the market has not yet fully priced in the negative effects of... the populist policies expected in connection with the Hungarian parliamentary elections."

Given such questions hang over Hungary's fiscal health, and that it has the highest debt/GDP ratio in Central Europe at around 80%, the country's debt appears the most vulnerable in the region to the rise of yields expected from the Fed's tapering. At the same time, Hungarian sovereign bonds remain the top EMEA pick in 2014 for Societe Generale. "One important consideration in favour of Hungary is the high real rate, together with the policy supportive environment," the bank notes, although it does suggest investors should "wait until after the elections".

The uncertainty over the effects of tapering has meanwhile weighed on the forint in late 2013, despite high current account and trade balance surpluses. That again will only see the government push harder to "solve" the forex debt issue as quickly as possible.

Removing that vulnerability of the population to currency risk will also free the central bank from a major constraint on its easing cycle, which had persisted for 17 months by the end of 2013. While interest rates were at a record low of 3.2% in early December, the drop of inflation to similarly historic lows - thanks to both the Europe-wide pressures and domestic factors (the utilities price cuts and poor domestic demand) - may well entice further easing in early 2014.

Polish populism to power rapid recovery

With the additional boost of reviving domestic demand to add to the Eurozone-led recovery, Poland looks to be revving up for a strong economic expansion in 2014. It remains to be seen whether that will prove sufficient to breathe new life into the government's flagging approval ratings ahead of elections in 2015, raising worries of a more populist bent in policy.

Poland is alone in Central Europe in traditionally boasting strong domestic demand. It was consumption and investment at home that kept recession at bay in 2009. However, the strength of that pillar dwindled in 2013. Tumbling consumer confidence, increasing unemployment and subdued wage growth hurt GDP performance, while the government's fiscal consolidation curbed public investment.

The IMF expects to see Poland post growth of 1.3% in 2013, with GDP expansion accelerating to 2.4% in 2014. The Commission says that while growth in the Eurozone will help out, it is clearly not the central element. "Foreign trade is set to support growth over the whole forecast horizon but at a diminishing scale. In 2013, the effect is expected to be particularly strong as Polish exporters increasingly expand their sales into non-EU markets, while import growth lags behind," the analysts write.

Erste is even more bullish, forecasting that domestic demand is set to take off once more. "Recent releases give a reason for upward revision of next year's growth (currently we see it at 2.7%)," the bank's analysts wrote in late November.

"In our view, domestic demand is regaining its strength and importance, and its positive contribution to the growth figure should increase over the course of next year," they continue. "It is good news that the structure of GDP points to a stronger than expected rebound in domestic demand (especially on the investment side) and it should, in our opinion, support our forecast for a strengthening zloty towards year-end."

However, others are wary of the strength of domestic demand, suggesting the weak labour market could yet pull the rug from under it. The IMF worries that high unemployment is structural and insists, "a bold reform agenda will be needed to alleviate growth bottlenecks".

The state's push to expand investment, particularly in infrastructure, will be key to helping create more jobs. Launched late in 2012, investment fund PIR is yet to really get going in promoting projects and attracting private investment. Meanwhile, the state-controlled utilities continue to baulk in the face of demands for huge new projects due to low electricity prices.

Yet the ruling Civic Platform is unlikely to take its foot off the throttle. It has seen the parliamentary majority of its coalition sliced to wafer thin through the year as it battles a resurgent populist opposition on one hand and its own socially conservative wing. A sweeping cabinet reshuffle in October saw the respected finance minister Jacek Rostowski replaced by a young economist with no political pedigree. The worry is that fiscal policy is now at the mercy of Prime Minister Donald Tusk, although few expect significant policy changes, which had already loosened the purse strings.

"The major macro risk is political," insists Deutsche Bank. "If by the end of the year Civic Platform is still trailing Law and Justice in the opinion polls, investors will begin to worry about the imposition of Hungarian type policies after the parliamentary elections in mid-2015."

The move away from its pledge of fiscal consolidation in early 2013 is widely praised by analysts, but higher spending has put deficit and debt targets under threat. From 3.9% of GDP in 2012, the deficit is forecast to increase to 4.8% in 2013 due to a revenue shortage. Meanwhile, much of this year was spent juggling numbers to avoid breaching constitutional debt limits. When the debt ceiling of 50% of GDP was breached, parliament simply suspended the attached sanctions, and the risk of further fiscal slippage persists in 2014.

Yet Warsaw won't be reporting a deficit next year. Instead, it will give itself the capacity to continue spending to support the recovery (and the government's ratings) with a pension grab. "In 2014, the general government balance is projected to turn into a surplus of 4.6%. This is mainly due to a one-off transfer of assets from the second pillar of the pension system (8.5% GDP)," the Commission notes.

However, that move has put financial investors on edge. The move has put the future of the country's private pension fund managers (OFE) under question, and they constitute a huge volume of trading on the Warsaw Stock Exchange. East Capital suggests that the move is yet to be fully priced in by the market.

Deutsche Bank, however, sees Polish equities as defensive in the context of emerging markets. "Poland has been one of the few emerging equity markets to deliver a positive total return in dollar terms over 2013," the analysts note. "Changes in pension fund regulations will have a more visible impact over the longer term, but not necessarily in 2014 as both pension fund members and managers weigh up what policy to adopt towards the domestic equity market. Meanwhile, retail flows into domestic equity mutual funds have picked up by a significant amount over the course of 2013."

With the delay in the Fed's tapering, Warsaw has been pushing in late 2013 to pre-finance next year's borrowing. However, combined with the effects on sentiment of the pension grab - OFE will lose all of its government bonds - yields have been rising, with analysts at local bank PKO BP suggesting Poland's "multi-year bull market for bonds," may be coming to an end. At the same time, Baring Asset Management told Bloomberg in early December that Polish debt looks oversold, while Societe Generale features it in its top three in EMEA for 2014.

The elections in 2015 are also likely to see the government pushing the National Bank of Poland to keep interest rates low for as long as possible. The hawkish and fiercely independent NBP has already ended its easing cycle at a record low of 2.5%, but has also guided for interest rates to remain on hold through the first half of 2014.

Yet the quicker-than-expected recovery could yet see it switch its attention back to inflation (that focus pushed it into becoming the only central bank in Europe to raise rates in 2012) although the rate stood at just 0.8% in October. Societe Generale does not stand out from the pack in forecasting a first hike of 0.25% will come in September, with a repeat in December.

Slovakia pinned to the Eurozone by fiscal demands

Slovakia is the most dependent of all the Visegrad Four on export demand from the Eurozone. While that suggests steady progress for the economy in 2014, limits on fiscal policy make a revival in domestic demand unlikely.

Indeed, Slovakia is so anchored to the uncertain growth in the single currency area - and even within that it is overwhelmingly dependent on the auto sector - that economic expansion has remained somewhat capped in late 2013. Despite the country exiting its longest recession ever (six consecutive quarters of contraction) in April-June, third-quarter growth of just 0.2% on quarter came as a big disappointment.

Unlike its regional peers, Slovakia's forecasts for 2014 have not moved through the year. The EBRD said in November that, "Growth projections... remain unchanged from our May forecast, at slightly under 1% for this year, and about 2% in 2014." The Commission plus several investment banks concur.

"Developments abroad remain a key factor," say analysts at Kommercni Banka. "The performance of Slovakia's main trading partners, ie. Germany and the Czech Republic, will be crucial. Germany is now operating close to potential and this is backed by the recently published economic data... Developments in the Czech Republic represent a bigger risk."

While the country saw a revival in its vital manufacturing sector in the third quarter of 2013, lack of diversification leaves the economy with few other real props, despite recent hints that consumption may have passed the bottom. "Private consumption continued to stagnate, in part due to the still serious unemployment problem in the country (which remained 18% in August)," the EBRD points out. "Gross investment similarly remains a drag on growth, showing a contraction of 8% in first half of the year."

Those issues are unlikely to help pep up domestic demand over the next 12 months. "Despite ongoing solid economic growth, employment remains in contractionary territory," notes Citigroup. "The unemployment rate is likely to come in at around 14.3% this year and 2014."

A major element is that the government's hands are tied by fiscal concerns. It has spent the past couple of years desperately trying to keep pace with consolidation targets, as it has seen lowered tax income disrupt efforts to raise revenue. While analysts have complained that the consolidation strategy is one sided, there is little fat to trim in terms of direct spending.

In order to remain below the EU's deficit threshold of 3%, Citigroup suggests a further €0.7bn--1.5bn of consolidation measures will be needed in 2014-2016. More immediately, there is a risk that constitutional debt limits could be broken.

Komercni Banka says its forecasts suggest public debt should breach the threshold of 55% of GDP this year, which would prevent any increase in spending in 2014. "There is also a risk that the total debt will exceed... 57% of GDP in 2014," the analysts go on to warn. "Thus... the government would have to present a balanced budget for the entire public administration for the following year."

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