THE MITTELEUROPEAN VIEW: Looking for LUV — what shape will Europe’s recovery from this existential crisis be?

THE MITTELEUROPEAN VIEW: Looking for LUV — what shape will Europe’s recovery from this existential crisis be?
The global economy has been hit by the twin whammies of an oil price shock and the coronavirus. What shape will the eventual recovery be? L, U, or V?
By Gunter Deuber of Raiffeisen Research in Vienna with support from colleagues in Vienna & across the CEE region March 18, 2020

We all know this currently very trendy acronym from the encyclopaedia of consultants: VUCA. It is short for “Volatile, Uncertain, Complex and Ambiguous” as pundits are struggling to explain an environment that is changing rapidly. When it comes to the economic outlook for Europe we are currently in VUCA-times, we see a crisis that is coming at us from all sides simultaneously. How do the pieces fit together? Which are the most important factors? What numbers really matter and what are just collateral damage?

Now economists are looking for the “LUV”. All of these factors go into trying to work out what shape the eventual recovery following the looming deep recession in Europe will be: an “L” of a Great Depression; a “U” of gradual bounce-back followed by a return to where we were; or the most optimistic scenario, a “V” where all this is over quickly and economies quickly bounce back after the coronavirus (COVID-19) fades away in the summer and a new oil production cut by the OPEC+ producers lifts oil prices back to where they were.

Everyone is currently talking about the “VUCA world” we find ourselves in now, but people seem to want to stick to old forecasts: just last week the European Central Bank (ECB) communicated unsustainable and outdated 0.8% economic growth (!) expectations for the euro area in 2020, which nobody believes will happen.

In contrast the market reaction speaks volumes. Red results are a rash across the tables of most regular reporting of stocks, bond and growth results.

But in VUCA times one thing seems certain for us now: Europe is heading into a severe and frontloaded recession in 2020. We expect GDP growth in the euro area to be at around -4% in 2020 and economic output in Germany — the biggest economy on the continent — is likely to contract at least by the same margin. On an annual basis it sounds like the hit in the context of the global financial crisis (GFC) back in 2008/2009. But this time is different and there is more bad news: the slump in services and consumption will in all likelihood be much sharper than in the most severe quarters of contraction in recent existential crises for Europe (GFC, euro area crisis). Manufacturing may still fare a tad better than the service sector. But on a net-net basis gloomy or devastating Q2 GDP readings seem to be ahead of us, with economic indicators tanking in an unseen manner from April onwards. For some indicators tracking the health of the domestic economies in Europe we expect readings possibly never seen in recent decades! At present we see the most deterring measures restricting economic activity in peacetime. It is no coincidence that the public discourse in Western and Central Europe is determined by vocabulary such as emergency, disaster, restricted access or curfew.

Technically, the euro area will most likely slide into an unseen recession in 1H20 with two quarters of negative growth, one of them very brutal. In the second quarter we expect economic output inside the euro area to contract by around -7% on a quarterly basis — a reflection of the looming economic standstill!

This makes the outlook for the Central and Eastern Europe (CEE) region a very difficult one — despite all the current discussions about the region’s high degree of resilience compared to previous crises and the still limited number of confirmed coronavirus cases up to now. These points are all taken but given the economic shutdown and inevitable recession in Western Europe, it would be naïve not to decisively question growth (?) assumptions for the CEE region.

Whether the coronavirus will fully cover the CEE regions is currently unknown, although it is clear that only Russia and Belarus could possibly match China in quarantine measures. For the rest of the CEE countries locking the virus out remains much more unlikely.

Apart from the corona infections, it is relevant for the Central and Southeast European regions (CE, SEE) that the short-term outlook for the global and European economy and the flow of people and goods has worsened dramatically. In Western Europe we currently see the most restrictive measures, affecting the supply side of the economy, implemented in peacetime. At the moment there is still hope that these measures will last for a rather shorter time, but the up to now fragmented crisis response in Europe suggests that we will probably not be through in just a few weeks as in China.

All this suggests that the stabilisation and recovery, when it comes, won’t be a V but rather some sort of U shape with pronounced weakness in the second quarter, and possibly a still weak third quarter as well, for the CEE region.

Moreover, the overall scenario of pronounced economic weakness in Western Europe in the first and second quarter means the CE/SEE region will be affected possibly a tad later, but this scenario is still based on the optimistic hypothesis that infection patterns may follow by and large the Asian examples in China and South Korea. Hence, downside risks for a fat U in 2020 in the region are substantial.

Big picture changes for CE/SEE

The coronavirus has exacerbated existing economic vulnerabilities in the CE/SEE region, by further increasing the existing difficulties of globalisation and cross-border value chains, as it follows on from long-smouldering trade disputes and Brexit.

This is probably the greatest challenge for the very open CE countries with their pronounced direct and indirect links to Germany and China and trans-European value chains. China is Germany's number one trading partner, and Germany is generally the number one trading partner with everyone else in CE. Not to forget that now a recession in all four large euro area economies is looming.

With regard to the big picture that has shaped economic development in CE and SEE over the last few years, substantial downside risks are now looming.

CEE was already coming off a five-year long boom and economic growth was already slowing. Having said that, the boom years have left the CE countries stronger and to an extent they were already starting to decouple from their slavish relationship with the German economy. But the downturn that is beginning now will reconnect them to the rest of Europe’s economic health and to the protracted political response to the currently unfolding health crisis to some extent. The strong growth that the CE countries have been enjoying in recent years will evaporate more quickly as a result. Even partial decoupling from the industrial weakness in Germany does not seem to be likely to continue. Thus, the inflationary pressures that have recently emerged should ease. To that extent, key interest rates in the region should remain stable longer than previously thought, or even tend to decline.

Corona gearing in CE close to 50% of GDP

In most CE countries, which are very open to trade, external trade is well over 100% of GDP; trade with Germany alone is usually 30-45% of GDP. Including China and/or Italy, trade exposure to corona hazards in all CE countries is well over 50% of GDP.

Italy has been particularly hard hit by the coronavirus and its lockdown is a channel of contagion for the economic slowdown throughout the region. Slovenia is particularly exposed to trade with Italy, which accounts for almost 20% of its GDP. That means precautionary measures in CEE, like border closures and/or selective factory closures, could interrupt value chains, which would then cause noticeable production losses in Hungary, the Czech Republic, Poland or Slovakia.

South Korea also plays an important role in CEE. After China, South Korea is currently the second largest corona hotspot, and Slovakia is much more closely intertwined with South Korea than any other CE country. For Slovakia we may see a GDP drop by in the range of -5% to -7% in 2020; some other CE countries could still make a living with GDP drops in the range of -3% to -5%. Hungary may fall back by some -3.5%. Our regional GDP growth call for Central Europe now 2020 stands at around -3.5% y/y compared to 2.5-2.8% previously. Without the pandemic there might have been upside risks for GDP estimates in the range of 3-3.5%; so, our current revisions clearly show the looming brutal short-term downsides.

Drilling into the details a little deeper, not to be underestimated is the impact on tourism and its feed through to economic pain for many of the countries of the region. The disappearance of tourists from China, the rest of Asia, and Europe will hurt the Czech Republic and Hungary the most among the CE countries.

A mitigating factor to set against the economic shocks the region will feel is thanks to the recent boom years all the countries are in relatively robust financial health. With the exception of Hungary (fiscal) and Slovakia/Slovenia (monetary), the major CE countries of Czechia and Poland have room for manoeuvre in terms of fiscal and monetary policy, which can be used to soften the blow. Not to forget that bank balance sheets are really cleaned up nowadays.

When it comes to key interest rates, the Czech central bank’s decision to recently hike interest rates, which observers previously called a slip-up, looks less bad. A stagflation scenario was mooted but now becomes increasingly unlikely thanks to the weak economic and energy price outlook. Therefore, the Czech National Bank was able to already deliver a decent emergency rate cut. Even the ultra-conservative Polish central bank might cut rates decisively and may deliver large scale sovereign bond buying or QE going forward. 

Despite all the negative newsflow, one shall not forget that the CE region will also be a beneficiary of decisive support measures for the German economy made by the Bundestag, which are in the works. But such measures will only help later in Q3 and Q4, when supply side-restriction are hopefully a thing of the past.

SEE and its extensive Italy plus tourism exposure

On the face of it SEE is characterised by less corona downside risk than Central Europe.

This is because it is less integrated into the global economy. But spoiler alert: SEE will also be adversely affected, as an “emergency rate cut” in Serbia or government bond buying by the Croatian National Bank last week already suggests.

On the one hand, the SEE region is also very closely intertwined with Italy’s economy (where GDP is expected to contract by 5-7% in 2020!) and there is now certainly a threat of significant trade losses, while on the other hand tourism is an extremely important economic sector for many of the SEE countries.

Trade with Italy accounts for about 10% of the GDP of the SEE countries. Should the corona danger continue well into the second quarter of this year, then a miserable tourism season is imminent.

A shortfall here would hit Croatia, Albania and to some extent Bosnia & Herzegovina especially hard. For countries like Croatia or Albania, tourism officially accounts for at least 15-20% of GDP. The SEE region will likely see GDP drop by -2.5% to -4.5% in the larger economies on average in 2020, but Croatia stands out with an expected -4.8% growth shock to its extensive tourist industry, according to our current assumptions.

Some incorrigible optimists may still expect some increase in the tourism sector in SEE as holidaymakers divert from Italy to other countries in SEE. However, Croatia and Albania in particular are so closely intertwined with Italy that it is rather unlikely that tourists will feel much more secure in these countries. Moreover, the high prevalence of private accommodation for tourists is likely to have a strong negative impact on the economic sentiment and consumption domestically. Not to forget that bank balance sheets in SEE are not as clean as in Central Europe in all countries yet.

Another channel of economic shock contagion into the SEE region is from an expected sharp fall in remittances as many of these countries remain very dependent on workers abroad sending money home, including the four heavily corona-affected larger euro area economies of Italy, Spain, Germany and France.

For Romania the coronavirus may bring a silver lining that will end the recent political infighting as the government rallies to face the pandemic and puts short-term, pragmatic action on the agenda. But a political ceasefire has to be weighed against the increased risks for the currency. The Romanian Central Bank could tolerate a managed depreciation of the RON as the fiscal coffers to provide stimulus are limited in Romania. In case of doubt, the central bank could also loosen its monetary policy somewhat, if the ECB takes bolder action at some point. Moreover, an expected GDP drop by at least -2.5% in 2020 will fully reveal the imprudent pro-cyclical fiscal policy of the past. Hopefully, markets will be so much focussed on downsides in Western Europe that they will not push Romania into an external support package.

Russia and Eastern Europe: short-term peaks, then even lower interest rates?

In terms of general trade and globalisation-related downside risks, one might think that countries like Russia, Ukraine or Belarus are less affected by corona-related downsides than the CE/SEE countries. 

In Russia, Ukraine and Belarus, growth momentum should decline from an average of 2.1% to -0.2% in 2020. Ukraine and Belarus will certainly be hit hard, Russia will most likely face stagnation in 2020 as well. Here we would expect GDP growth to decline from 1.3% to 0%. But this also means that Russia is far away from the more promising 2% GDP growth seen in 2018, and further away from the government’s goal of boosting growth to over 3% by 2021. Even a GDP contraction in 2020 can only be achieved by further increasing state influence and largely tapping into accumulated reserves. 

In countries like Russia or Ukraine, however, it is precisely the financial market-related downside risks that need to be considered first, as global financial markets are currently pricing in a long L-shaped recession, not a V or even a U. Therefore, high risk premiums are called for in emerging markets such as Russia or the Ukraine, at least in the short term. Nevertheless, the National Bank of Ukraine (NBU) did exactly the opposite on March 12, cutting rates again by a full percentage point to 10% to stimulate the economy. This overambitious monetary policy course is increasingly challenged by markets.

In Russia the situation is not so clear. Inflation there is a low 2.3% but it expected to grow in the first half of this year. But set against that, growth is expected to fall to 0% or less and so the economy could do with some stimulus. In Russia's case, measured key rate hikes might be still due in the short term in view of the growing uncertainty on financial markets due to the collapse in oil prices and mounting inflation risks. Moreover, the Central Bank of Russia (CBR) still has a track-record of erring on the cautious side. Possibly the Ukrainian central bank will be also challenged by markets going forward.

Putting the short-term financial market volatility aside for a moment, Russia’s economic situation is radically different from what it was in 2014. Russia now has such solid macro-financial indicators that it can even now afford a hard-hitting global market share/price war on the oil market for at least several quarters. 

Strategically Russia had already prepared itself for these shocks although the timing could be more of a result of Russian gambling. Russia, according to its own narrative, is now once again simply challenged by the malicious outside world and thus economic growth counts less than a fortress mentality in relation to the outside world. 

Ironically, the Russian gambling is also a stimulus package for China, Europe and, to some extent, the world. From a global point of view, an L-shaped economic scenario can be therefore averted. This holds especially true as it seems that the oil market itself could now be shaped by a longer L-shaped price pattern. 

Russia has the ability and seems to have the willingness to engage in a price war for at least the next two to four quarters. Russia seems to be serious about hitting marginal US shale producers hard and winning back some of its market share lost to these competitors in recent years. The resulting longer L-shaped oil market growth means the Russian central bank in particular should then be able to lower its key rate significantly compared to current levels and previously intended terminal rates.

What’s it going to be: LUV? 

In recent days, many forecasters have slightly trimmed their economic forecasts for 2020 downwards. In some cases, the virus can even be seen as a good excuse to adjust growth forecasts made at the turn of the year that were too optimistic beforehand, for example growth forecasts for the euro area still above 1% or Russia above 2%. The European Commission was possibly already more outspoken with its call for GDP contracting by -1% in 2020 inside the euro area.  

However, revisions that have been made so far are probably a mixture of moderate setback or V-shaped economic recovery assumptions for 2020 and no one has yet included an L — a long-lasting global stagnation. 

If an L were to occur, it would be very difficult for the CEE region, as positive growth in the euro area would then no longer be possible in 2020 and 2021. In CE, a sharp and sustainable drop in growth would then be expected. In SEE the prospect of convergence would fade. And Russia, already in a state of de facto stagnation, would become one of the worst economic performers after it has already had at least one lost decade following the no-growth of the 2013-2014 crisis years, despite its great current macro-financial indicators. 

Currently, there is still hope that we do not see an L-shaped economic development in Europe in 2020 and 2021. That said, we see the CE/SEE region facing a mixture of U- and V-shaped recoveries following a hefty setback in 1H20, but the oil-price war will easily lead to a Russia’s continued stagnation — in a position of macro-financial strength. Short-term Russia seems to be the winner in the region with one of the lowest GDP downsides, while we see existential recessions in CE/SEE in 2020 with GDP drops in the range of -3% to -7% y/y. Be prepared for negative Q2 GDP readings in the range of -7.5% to -13% q/q in CE/SEE, with annual drops in economic activity by and large stronger than in the GFC. However, we also expect a decisive fiscal and monetary policy response in Europe and hence a tentative economic rebound may kick in later in Q3 and Q4 2020. For 2021, following a U-shaped economic development in 2020, we would expect even growth rates in the range of 3-5% in CE/SEE, which is good news.

It goes without saying that human issues are currently in the forefront of our thinking and our economic base scenario also relies on the fact that we expect some stabilisation of the current health crisis in Europe in the second half of this year. That said, the forecasts presented here are not made by Dr. Doom, but by a team of economists in Raiffeisen Research who are experienced in economic crises in developed and emerging markets and who are guided by their personal experience that it is reasonable to make faithful forecasts in fast-moving VUCA times characterised by the most severe restrictions to economic life seen in peacetime in Europe being implemented currently.