EMERGING EUROPE
Q1 2011
ANALYST
Growth to slow in the second half
• The recovery in Emerging Europe remains broadly on track. GDP growth rates are likely to prove
solid, if not spectacular, in a number of countries over the coming years with Turkey, Poland and, in
the near term at least, Russia leading the way. Meanwhile, the strong rebound in German
manufacturing will continue to provide a near-term prop to growth in the highly-open Czech and
Slovak economies too.
• Nonetheless, while prospects are picking up, new challenges are coming to the fore. Indeed,
although Turkey’s outlook is amongst the strongest in the region, its recovery is looking increasingly
unbalanced and concerns of overheating will continue to build. Meanwhile, although Russia is
currently enjoying a windfall from the recent spike in oil prices, we think that the increase will prove
short-lived. More generally, with key export markets in the euro-zone facing a challenging outlook,
external demand is likely to weaken from here on in. The upshot is that the region’s current pace of
growth is likely to fade in the second half of this year. So while some Central Banks will deliver
further interest rate hikes in the near term, on the whole, the pace of tightening will be slower than
the market is pricing in.
• Rising oil prices will give a timely – although perhaps short-lived – boost to Russia’s lacklustre
recovery. We expect the economy to grow by 4.5% this year but the recent spike in inflation has
further to run. (Page 4.) Turkey should outperform the rest of the region over the next year or so but a
widening current account deficit is a major concern. Policy needs to tighten but June’s elections will
delay action on the fiscal front. (Page 5.)
• Poland should grow by a solid 4% or so this year, but twin budget and current account deficits cast a
cloud over the outlook for 2012-13. (Page 6.) Growth in the Czech Republic (Page 7) and Slovakia
(Page 9) will be slower and is likely to fade over the second half of this year as the German economy
cools. The Hungarian economy is on the road to recovery but political (and fiscal) risks will remain
high. (Page 8.)
• Recoveries are finally underway in Romania, Bulgaria and Croatia but large external funding
requirements leave them vulnerable to shifts in investor risk appetite. (Pages 10 & 11.) Meanwhile,
the recoveries in the Baltic States and Ukraine will continue next year, but in both cases, GDP is
unlikely to surpass its pre-crisis level for the next five years or so. (Pages 12 & 13.)
Neil Shearing & David Oxley
+44 (0)20 7808 4985
North America Europe Asia
2 Bloor Street West, Suite 1740 150 Buckingham Palace Road #26-03
Toronto, ON London 16 Collyer Quay
M4W 3E2 SW1W 9TR Singapore 049318
Canada United Kingdom
Tel: +1 416 413 0428 Tel: +44 (0)20 7823 5000 Tel: +65 6595 5190
Managing Director Roger Bootle (roger.bootle@capitaleconomics.com)
Chief European Economist Jonathan Loynes (jonathan.loynes@capitaleconomics.com)
Senior Emerging Markets Economist Neil Shearing (neil.shearing@capitaleconomics.com)
Emerging Markets Economist David Oxley (david.oxley@capitaleconomics.com)
Emerging Europe Analyst 1/2011 1
Key Forecasts
TABLE 1: REAL GDP & INFLATION
(2)
Share of GDP Inflation
(1)
% y/y World 2009 2010f 2011f 2012f 2009 2010f 2011f 2012f
Russia 3.0 -7.9 4.0 4.5 3.5 8.8 8.2 10.5 8.0
Turkey 1.3 -4.7 8.0 5.0 4.5 6.3 8.6 5.5 6.0
Poland 1.0 1.7 3.8 4.0 3.5 3.5 2.6 3.5 2.5
Ukraine 0.4 -15.2 4.2 4.5 3.5 16.0 9.4 10.5 9.5
Czech Republic 0.4 -4.0 2.2 2.5 2.0 0.6 1.2 1.8 1.8
Hungary 0.3 -6.7 1.2 2.0 3.0 4.0 4.4 3.3 2.5
Slovakia 0.2 -4.8 4.0 2.5 2.0 0.9 0.7 3.0 2.0
Romania 0.4 -7.1 -1.3 1.0 2.0 5.6 6.1 5.5 3.0
Bulgaria 0.1 -5.4 -0.1 1.8 2.5 2.5 3.0 3.0 2.5
Croatia 0.1 -5.8 -1.4 1.5 2.5 2.4 1.0 2.5 2.0
Estonia 0.03 -13.9 3.1 4.0 3.0 0.2 2.7 3.0 2.0
Latvia 0.05 -18.0 -0.3 3.0 2.0 3.4 -1.2 2.5 2.0
Lithuania 0.08 -14.7 1.3 3.0 2.0 4.2 1.2 2.5 2.0
Emerging Europe 7.2 -6.0 4.0 4.0 3.5 7.6 5.7 6.0 5.2
G4 Countries
US 20.4 -2.6 2.9 3.0 2.0 -0.3 1.6 2.2 0.4
Euro-zone 15.1 -4.0 1.7 1.0 0.5 0.3 1.6 2.8 2.0
Japan 6.0 -6.3 3.9 0.0 1.8 -1.4 -0.6 0.6 -0.5
UK 3.1 -4.9 1.3 1.5 1.5 2.1 3.3 4.0 1.3
(1) %, 2009, in PPP terms. (2) All % y/y annual average, except for Russia which is end-year %.
Chart 1: Real GDP (% y/y) Chart 2: Inflation (% y/y)
15 15 16 Emerging Europe Russia Central Europe Baltics 16
Emerging Europe Russia Central Europe Baltics
10 10 14 14
12 12
5 5
10 10
0 0
8 8
-5 -5
6 6
-10 -10
4 4
-15 -15 2 2
-20 -20 0 0
2008 2009 2010f 2011f 2012f 2008 2009 2010f 2011f 2012f
Sources – Thomson Datastream, Capital Economics Sources – Thomson Datastream, Capital Economics
Emerging Europe Analyst 1/2011 2
Overview
The region’s recovery is on track but remains two-speed. In Both countries are likely to be the only ones to grow broadly
the near-term at least Poland and Turkey will lead the way. in line with their potential rates in the coming years...
6 6
6 2011 2012 6
5 Potential GDP Growth (% y/y) 5
5 5
4 4
4 4
3 3
3 3
2 2
2 2
1 1 1 1
0 0 0 0
...but conversely, they are also the most exposed to ‘hot- Elsewhere, a combination of weak labour markets, tight credit
money’ flows. Current account deficits are widening and the conditions...
quality of financing has deteriorated too.
6 6 25 Unemployment Rate (%, 2008 trough) 25
Current Account Balance (% of GDP, 2011f)
4 4 Unemployment Rate (%, Current)
20 20
2 2
0 0 15 15
-2 -2 10 10
-4 -4
5 5
-6 -6
-8 -8 0 0
...and fiscal squeezes... ...means that the robust rebound in industrial output will be
relatively slow to spread to other sectors of the economy.
0 0 40 40
NB: latest data available
-1 -1 30 30
-2 -2
20 20
Retail Sales (% y/y)
-3 -3 Croatia
-4 -4 10 10
-5 -5 0 0
-6 -6
-10 -10
Fiscal Balance (% of GDP, 2011f) Retail Sales
-7 -7 Outperform Latvia
-20 Estonia -20
-8 -8
Industry
-30 -30
Outperforms
-40 -40
-40 -30 -20 -10 0 10 20 30 40
Industrial Production (% y/y)
The looming slowdown in the euro-zone only adds to So while food inflation will push up headline CPI in 2011, no
headwinds facing the region. country is likely to embark on a substantial period of interest
rate hikes over the coming quarters.
50 50 12 12
40 Exports to Euro-zone (% of GDP) 40 10 CPI Inflation (% y/y, 2011f) 10
30 30 CPI Inflation (% y/y, 2012f)
8 8
20 20
6 6
10 10
4 4
0 0
2 2
0 0
Ukr Rus Tur Rom Pol Hun Est Bul Slk Lit Lat Cze
Sources – Thomson Datastream, Eurostat, Capital Economics
Emerging Europe Analyst 1/2011 3
Russia
Oil price spike brightens near-term outlook
• The recent spike in oil prices should give a Chart 1: GDP Growth (% y/y)
timely boost to what has otherwise been a
10 10
lacklustre recovery in Russia. But in reality 8 8
6 6
higher oil prices will only paper over the 4 4
cracks in Russia’s growth model and, since 2 2
0 0
they work against much-needed structural -2 -2
reforms, are likely to diminish medium-term -4 CE -4
-6 F'casts -6
growth prospects. -8 -8
-10 -10
• In the near-term at least, the recent spike in oil 00 01 02 03 04 05 06 07 08 09 10 11 12
prices will boost growth in two ways. First,
Russia’s terms of trade improve. Since most of Chart 2: Consumer Prices (% y/y)
16 16
this extra income flows to the government in
14 CE 14
the form of higher tax revenues, this could Forecast
pave the way for both a reduction in the 12 12
budget deficit and a renewed fiscal giveaway 10 10
ahead of parliamentary elections at the end of 8 8
this year and presidential elections in March 6 6
2012. The second way in which higher oil 4 4
prices boost growth is via increased capital 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
inflows. This should boost asset prices and the
ruble, as well as help to ease credit conditions. Chart 3: Key Interest Rates (%)
14 Refi 14
• As it happens, we suspect that the recent spike 12 O/N Repo CE F'casts 12
in oil prices will prove temporary. Accordingly, 10 O/N Depo 10
while we have nudged up our forecast for GDP 8 8
growth to 4.5% this year (from 4.0% 6 6
previously), we still expect growth to slow in 4 4
2012. (See Chart 1.) Likewise, we expect the 2 2
budget deficit to surprise on the upside, and 0 0
the current account surplus to diminish slowly Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
over time too. Any boost to the ruble should be
TABLE 1: KEY FORECASTS %y/y unless stated
short-lived. (See markets forecasts on page 15.)
2008 2009 2010 2011 2012
Private cons’ptn 10.8 -7.7 2.7 4.0 3.0
• Even so, the recent rally in oil means that
Total fixed invest. 10.4 -15.7 3.5 5.0 5.0
inflation is the major concern in the near-term.
GDP 5.6 -7.9 4.0 4.5 3.5
The government’s decision to effectively
monetise its budget deficit over the past two
Unemp. rate (%) 7.8 8.2 7.2 7.0 6.8
years has led to rapid broad money growth, CPI inflation(1) 13.3 8.8 8.2 10.5 8.0
which should keep inflation at double-digit
rates for most of this year. (See Chart 2.) We Fed’l gov’t bal(2) 4.1 -5.9 -4.1 -2.0 -3.0
expect further hikes in all benchmark rates, Gen’l gov’t debt(2) 6.0 7.0 8.5 10.0 12.0
and reserve requirements, but the deposit rate Current account(2) 6.2 4.0 4.6 3.0 1.8
will be hiked most aggressively. (See Chart 3.) Source – Thomson Datastream. (1) YTD at end-year (2) as % of GDP
Emerging Europe Analyst 1/2011 4
Turkey
Growth to slow, but overheating concerns will persist
• Turkey remains on track to outperform the rest Chart 1: Capital Account (US$bn, 12m Rolling Sum)
of Emerging Europe over the next couple of 50 Net FDI Inflows 50
years. Indeed, while growth is likely to slow to 40 Net Portfolio Inflows 40
Net Other Inflows
around 5% this year (from 8% in 2010) the big 30 30
risk is that policymakers fall behind the curve 20 20
and the economy starts to overheat. 10 10
0 0
• The key reason for Turkey’s outperformance is -10 -10
the strength of domestic demand. The banking -20 -20
sector is in decent shape, meaning that 2007 2008 2009 2010 2011
households and business do not face the credit
restrictions seen elsewhere in the region, Chart 2: Consumer Prices (% y/y)
capital inflows are strong and the labour 14 Core 14
Headline
market is strengthening. We expect private 12
CE Forecasts
12
10 10
consumption to grow by 6% over the next
8 8
couple of years.
6 6
•
4 4
But the strength of domestic demand means
2 2
that concerns over Turkey’s current account
0 0
deficit (which we have been flagging for some 2008 2009 2010 2011 2012
time) are likely to build. We expect the
shortfall to be around 7% of GDP this year. Chart 3: Interest Rates (%)
Moreover, a heavy reliance on short-term 12 12
CE Forecast
capital inflows has left the economy and the 11 11
Implied Benchmark Interest Rate from FRAs
lira highly vulnerable to shifts in investor risk 10 (New 7-day repo) 10
9 9
appetite. (See Chart 1.)
8 8
7 7
• The upshot is that policy needs to tighten. The 6 6
CBRT’s innovative approach of cutting interest 5 5
Forecasts
rates in order to deter speculative inflows and 4 4
Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12
using macro-prudential measures (such as bank
reserve requirements) to rein in credit growth
TABLE 1: KEY FORECASTS %y/y unless stated
is not necessarily a disaster waiting to happen,
2008 2009 2010 2011 2012
as many have suggested. But with core
Private cons’ptn -0.3 -2.2 6.0 6.0 5.0
inflation likely to pick-up, we do expect the Total fixed invest. -6.2 -19.1 20.0 8.0 7.0
Bank to resort to a more conventional GDP 0.7 -4.7 8.0 5.0 4.5
approach to monetary tightening and raise
interest rates (albeit modestly) later this year. Unemp. rate %
(2)
14.0 13.5 11.4 10.5 10.5
(See Charts 2&3.) The bigger worry is fiscal CPI inflation 10.4 6.3 8.6 5.5 6.0
policy. While the government has outlined
plans to lower its deficit, they do not address Fed’l gov’t bal(1) -2.0 -5.7 -3.8 -3.5 -3.0
the need for structural reform. In any case, Gen’l gov’t debt(1) 39.4 45.5 42.8 42.0 40.0
June’s elections mean that in the near-term at Current account(1) -5.7 -2.3 -6.4 -7.0 -6.5
Source – Thomson Datastream. (1) as % of GDP, (2) end of period
least, progress is likely to disappoint.
Emerging Europe Analyst 1/2011 5
Poland
In a ‘sweet spot’ for now, but twin deficits a growing concern
• The Polish economy is in a ‘sweet-spot’ at the Chart 1: EU Structural Funds Left to Spend (EUR bn)
moment. GDP growth is likely to remain close
40 40
to its potential rate of around 4% in the near 35 (8.0) 35
30 (Total percent of GDP in brackets) 30
term while underlying inflation pressures 25 25
should remain subdued. But while the 20 20
15 (8.4) (12.0) (8.6) 15
economy should stay at the front of the pack 10 10
(8.5)
5 (9.7) (12.5) (12.5) 5
for the time being, the twin fiscal and current (5.2) (12.1)
0 0
account deficits cast a cloud over the outlook
further out.
• In the near-term at least, domestic demand
should continue to drive growth. This is for Chart 2: Fiscal Deficit (% of GDP)
9 9
three reasons. The first is the solid banking CE Forecasts
8 8
sector. Credit conditions, particularly for 7 7
consumers, are likely to ease further this year. 6 6
5 5
The second is the likelihood of an investment 4 4
boost ahead of the 2012 European Football 3 3
Championships (partly funded by EU Structural 2 2
1 1
Funds). (See Chart 1.) Finally, while the 0 0
country will not be immune to the expected 00 01 02 03 04 05 06 07 08 09 10 11 12
slowdown in the euro-zone later this year, the
fact that it’s less reliant on exports than its CEE Chart 3: Inflation (% y/y)
peers should help to cushion the impact. 6
Headline Inflation
6
Core Inflation CE
5 Forecast 5
• The only major blot on the outlook is the fiscal 4 4
position, particularly in the context of a 3 3
widening current account shortfall. Admittedly,
2 2
we expect the budget deficit to fall to around
1 Inflation 1
6% of GDP this year. (See Chart 2.) But the Target
0 0
government’s consolidation plans to date have
2007 2008 2009 2010 2011 2012
relied on one-off measures and do little to
tackle the substantial structural shortfall. This TABLE 1: KEY FORECASTS %y/y unless stated
means that monetary policy may need to do 2008 2009 2010 2011 2012
more of the leg work over the coming years Private cons’ptn 5.7 2.0 3.2 4.0 4.0
than would otherwise be the case. Total fixed invest. 9.6 -0.8 -2.0 8.0 7.5
GDP 5.1 1.7 3.8 4.0 3.5
• But with inflation set to fall back to target in
early-2012 once last July’s VAT hike and the Unemp. rate % 7.1 9.1 10.0 9.5 8.5
recent food and energy price shocks drop out HICP inflation 4.2 3.5 2.6 3.5 2.5
of the annual comparison, we still think that
the pace of rate hikes will be slower than the Gen’l gov’t bal(1) -3.7 -7.2 -8.0 -6.0 -5.0
market expects. (See Chart 3.) We expect one Gen’l gov’t debt(1) 47.1 50.9 55.9 57.9 59.5
more 25bp hike to 4% this year, while the Current account(1) -4.8 -2.1 -3.3 -4.5 -4.0
Source – Thomson Datastream. (1) as % of GDP
market is pricing in a rise to more than 4.5%.
Emerging Europe Analyst 1/2011 6
Czech Republic
Everything hinges on Germany
• The outlook for the highly-open Czech Chart 1: Real GDP (% y/y)
economy remains closely tied to the 8 8
performance of key export markets in the euro- 6
CE
6
F'casts
zone. The rapid rebound in German 4 4
manufacturing should continue to provide a 2 2
decent prop to growth in the near term. GDP is 0 0
likely to accelerate to 2.5% this year. But with -2 -2
the euro-zone’s recovery set to fade, we expect -4 -4
-6 -6
Czech growth to slow to around 2% in 2012.
00 01 02 03 04 05 06 07 08 09 10 11 12
(See Chart 1.)
Chart 2: Industrial Production & Euro-zone GDP
• The outlook for the industrial sector, which has
driven the recovery to date, remains 20 CE Forecasts 6
16
4
reasonably bright. While the recent gains in the 12
8 2
koruna may start to take the edge off exports, 4
0 0
firms should continue to benefit from their -4 -2
strong links to the booming German -8
-4
-12 Industrial Production (% y/y, LHS)
manufacturing sector in the next six months or -16
Germany GDP (% y/y, RHS) -6
-20
so. (See Chart 2.) -24 -8
01 02 03 04 05 06 07 08 09 10 11 12
• However, with the economy still not growing
fast enough to create jobs, and a fiscal squeeze Chart 3: Interest Rates (%)
now underway, the recovery in the domestic 3.0 3.0
CE Forecast
demand will continue to lag behind. 2.5 Implied Benchmark Interest Rate from FRAs 2.5
Accordingly, economic prospects largely hinge 2.0 2.0
on the strength of external demand. If the
1.5 1.5
recovery in the euro-zone (and Germany in
1.0 1.0
particular) fades later this year as we expect,
0.5 0.5
the Czech Republic will inevitably suffer. GDP Forecasts
0.0 0.0
growth is unlikely to collapse, but we expect it
Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12
to remain below its potential rate of around 3%
over the coming years. TABLE 1: KEY FORECASTS %y/y unless stated
2008 2009 2010 2011 2012
• The upshot is that underlying inflation Private cons’ptn 3.4 -0.2 0.3 1.5 2.0
pressures should remain muted. The likelihood Total fixed invest. -1.5 -7.9 -4.6 4.0 3.5
of at least one interest rate rise in the euro- GDP 2.3 -4.0 2.2 2.5 2.0
zone means that it is now more likely that
Czech policymakers will also raise rates at Unemp. rate % 4.6 7.4 7.7 7.0 6.5
some point this year. However, with fiscal HICP inflation 6.3 0.6 1.2 1.8 1.8
policy starting to tighten, we think that
monetary policy will be kept supportive for Gen’l gov’t bal(1) -2.7 -5.8 -5.5 -5.0 -4.0
some time. In fact, we still think that the Gen’l gov’t debt(1) 30.0 35.3 39.6 42.7 45.1
Current account(1) -0.6 -3.2 -3.8 -4.0 -4.3
balance of probabilities is skewed towards no Source – Thomson Datastream, Bloomberg. (1) as % of GDP
hikes at all this year. (See Chart 3.) Emerging Europe Analyst 1/2011 7
Hungary
Fiscal risks continue to cast a long shadow
• Hungary’s economy is edging slowly back to Chart 1: Industrial Production & Euro-zone GDP
health, but significant vulnerabilities remain. 15 4
3
On the growth front, manufacturing is still the 10
2
5
main driver of recovery and forward-looking 0
1
0
indicators, such as the manufacturing PMI, -5 -1
-10 -2
suggest that output should continue to grow at -3
-15 CE
double-digit annual pace in the near term. But -20 Industrial Production (% y/y) (LHS) F'cast
-4
-5
the rebound in manufacturing remains highly -25 Euro-zone GDP Growth (% y/y) (RHS) -6
-30 -7
leveraged on the continued growth in German
01 02 03 04 05 06 07 08 09 10 11 12
industry, which we expect to lose some steam
over the second half of this year. (See Chart 1.)
Chart 2: Real GDP (% y/y)
6 6
• With domestic demand likely to be held back
4 4
by a combination of tight credit conditions and
2 2
a weak labour market, GDP growth is unlikely
0 0
to rise much above 2-3% – a disappointing -2 -2
outcome given the depth of the recession over -4 -4
CE Forecasts
the past two years. (See Chart 2.) -6 -6
-8 -8
• Meanwhile, fiscal risks remain high. The 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
government’s ‘structural revamp’ of the public
finances is big on rhetoric but short on detail Chart 3: Interest Rates (%)
and appears reliant on a combination of strong 10 CE Forecasts 10
growth and one-off measures (e.g. the raid on 9 Implied Benchmark Interest Rate from FRAs 9
private pensions) to reduce the deficit and cut 8 8
debt. We remain skeptical that this will work in 7 7
the long run. While the overall deficit is likely 6 6
5 5
to 2.5% GDP this year, the structural shortfall
4 Forecasts 4
will be closer to 5% of GDP. In the absence of
3 3
accounting tricks, public debt is unlikely to fall
Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12
below 70% of GDP this decade. The lack of
fiscal credibility means that the forint and TABLE 1: KEY FORECASTS %y/y unless stated
(given the prevalence of FX debt) the banking 2008 2009 2010 2011 2012
sector, will remain vulnerable to swings in Private cons’ptn 0.6 -6.8 -2.2 0.8 2.0
investor risk appetite. Total fixed invest. 2.9 -8.0 -5.6 2.0 2.5
GDP 0.8 -6.7 1.2 2.0 3.0
• Accordingly, while inflation is likely to fall
later this year as the food and energy shock Unemp. rate % 8.5 10.8 11.8 11.0 10.0
fades, there is little scope for the National Bank HICP inflation 6.0 4.0 4.4 3.3 2.5
to cut interest rates. We expect the benchmark
rate to fall to 5.50% by the end of the year, Gen’l gov’t bal(1) -3.7 -4.4 -4.0 -2.5 -3.0
leaving it well above the levels seen elsewhere Gen’l gov’t debt(1) 72.3 78.4 78.1 75.0 74.1
Current account(1) -7.3 0.5 0.0 -0.5 -1.0
in Central Europe. (See Chart 3.) Source – Thomson Datastream, Bloomberg. (1) as % of GDP
Emerging Europe Analyst 1/2011 8
Slovakia
Industry-led bounce to fade
• The outlook for the highly-open Slovak Chart 1: Real GDP (% y/y)
economy remains leveraged on the 12 12
performance of key export markets in the euro- 10 CE 10
8 F'casts 8
zone. In the near term at least, prospects
6 6
remain reasonably robust. However, with 4 4
external demand set to fade later this year, we 2 2
0 0
expect Slovakian GDP growth to slow to -2 -2
around 2% in 2012. (See Chart 1.) -4 -4
-6 -6
• The strong rebound in German manufacturing, 00 01 02 03 04 05 06 07 08 09 10 11 12
flattered by sizeable base effects at the start of
Chart 2: Euro-zone GDP & Slovakian Exports
last year, helped Slovakia post one of the
5 25
strongest recoveries in the region last year. 4 20
GDP grew by 4% in 2010 as a whole. 3 15
2 10
However, two factors mean that the pace of 1 5
0 0
expansion is unlikely to be maintained over the -1 -5
next few years. -2
CE
-10
-3 Euro-zone GDP (% y/y, LHS) -15
F'casts
-4 Slovakia Exports (% y/y, RHS) -20
• First and most important, the expected -5 -25
-6 -30
slowdown in the euro-zone will hit export 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
growth later this year. (See Chart 2.) Second,
with unemployment set to remain close to a Chart 3: Fiscal Deficit (% of GDP)
five-year high, domestic demand is likely to
9 9
CE Forecasts
remain weak too. Although the finely-balanced 8 8
7 7
political situation means that the pace of fiscal
6 6
consolidation is likely to be slower than 5 5
planned, the government’s measures will still 4 4
3 3
act as a brake on the domestic recovery. We 2 2
forecast a budget deficit of 6% of GDP this 1 1
0 0
year against the official 4.9% of GDP target.
2004 2005 2006 2007 2008 2009 2010 2011 2012
(See Chart 3.)
TABLE 1: KEY FORECASTS %y/y unless stated
• Indirect tax hikes introduced at the start of this
2008 2009 2010 2011 2012
year, and the recent spike in food and energy 6.2 0.3 -0.3 1.0 1.5
Private cons’ptn
process, means that headline inflation is likely Total fixed invest. 1.0 -19.9 3.6 4.0 2.5
to average 3% for 2011 as a whole (up from GDP 5.8 -4.8 4.0 2.5 2.0
just 0.7% in 2010) This will keep a lid on real
wage growth. However, with GDP growth set Unemp. rate % 9.1 14.3 14.5 14.0 13.0
to remain below its potential rate over the HICP inflation 3.9 0.9 0.7 3.0 2.0
coming years, we expect underlying price
pressures to remain subdued. We expect Gen’l gov’t bal(1) -2.1 -7.9 -8.0 -6.0 -5.0
headline CPI to average 2% in 2012. (See Gen’l gov’t debt(1) 27.8 35.4 41.8 45.4 48.5
Chart 3.) Current account(1) -6.6 -3.6 -3.3 -3.5 -4.0
Source – Thomson Datastream. (1) as % of GDP
Emerging Europe Analyst 1/2011 9
Romania
Recovery set to remain a slow grind
• Having contracted in both 2009 and 2010, the Chart 1: GDP Growth (% y/y)
Romanian economy is on course to return to
10 10
positive growth in 2011. However, with the 8 CE 8
Forecasts
domestic recovery continuing to face 6 6
4 4
significant headwinds, and external conditions 2 2
likely to take a turn for the worse later this 0 0
-2 -2
year, the recovery will be slow. We expect
-4 -4
GDP growth to remain below its potential rate -6 -6
of around 4% until 2014 at least. (See Chart 1.) -8 -8
2004 2005 2006 2007 2008 2009 2010 2011 2012
• The Romanian economy is still struggling to
find its feet following last July’s deep fiscal Chart 2: Exchange Rate (vs. euro)
3.00 3.00
cuts, which were needed to meet the
3.20 3.20
CE
conditions of its IMF-led loan programme. 3.40 F'cast 3.40
After lagging behind the rest of the region so 3.60 3.60
far, the industrial sector is slowly picking up. 3.80 3.80
But as elsewhere, prospects are overshadowed 4.00
Currency
4.00
4.20 4.20
by expected slowdown in key export markets strengthens vs.
euro
4.40 4.40
in the euro-zone. Meanwhile, the ongoing 4.60 4.60
process of deleveraging, coupled with tight 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
credit conditions, mean that the domestic
recovery will continue to disappoint too. Chart 3: Inflation (% y/y)
16 16
• Admittedly, the recent strengthening of the leu 14 CE 14
should, at the margin at least, take some 12 Forecasts 12
10 10
pressure off the majority of borrowers with FX-
8 8
denominated debt. However, with the political 6 6
situation on a knife-edge, the risks to the 4 4
currency remain skewed on the downside. (See 2 2
0 0
markets forecasts, page 15 and Chart 2.) We
2004 2005 2006 2007 2008 2009 2010 2011 2012
expect GDP to grow by just 1% this year
(below consensus) and 2% in 2012. TABLE 1: KEY FORECASTS %y/y unless stated
2008 2009 2010 2011 2012
• So while a combination of last July’s VAT hike 9.0 -10.3 -1.6 1.5 2.5
Private cons’ptn
and food and energy effects mean that inflation Total fixed invest. 15.6 -25.3 -13.1 3.0 4.0
will remain well above the 3±1% target until GDP 7.4 -7.1 -1.3 1.0 2.0
the middle of the year, we expect headline CPI
to fall back to target by the end of the year. Unemp. rate % 4.4 7.8 6.9 7.5 6.5
(See Chart 3.) Accordingly, we are sticking to HICP inflation 7.9 5.6 6.1 5.5 3.0
our long-held forecast for interest rates to
remain on hold until 2012. In fact, further rate Gen’l gov’t bal(1) -5.7 -8.6 -8.0 -6.0 -5.0
cuts in the second half of the year cannot be Gen’l gov’t debt(1) 13.4 23.9 25.8 26.6 27.9
ruled out completely. Current account(1) -11.6 -4.5 -5.5 -5.5 -6.0
Source – Thomson Datastream. (1) as % of GDP
Emerging Europe Analyst 1/2011 10
Bulgaria and Croatia
Recovering, but growth set to lag behind
• The Bulgarian and Croatian economies are Chart 1: Real GDP (% y/y)
recovering, but both are likely to remain 8 8
amongst the region’s laggards over the coming 6 CE 6
Forecasts
years. (See Chart 1.) 4 4
2 2
•
0 0
In Bulgaria, the economy continues to face
-2 -2
challenges on three main fronts. First, the -4 -4
Bulgaria Croatia
government is planning a significant fiscal -6 -6
squeeze over the coming years. Second, while -8 -8
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
the immediate threat of a meltdown in Greece
has been avoided, Bulgaria’s exporters and its
Chart 2: Foreign-Owned Banking Asset Share by Country (%)
banking sector remain heavily exposed to the
country. (See Chart 2.) Credit conditions are 120 Other Greece Italy Germany Austria
120
100 100
therefore likely to remain very tight for the
80 80
foreseeable future. Finally, the lev’s fixed 60 60
exchange rate with the euro means that a 40 40
prolonged period of sluggish wage and price 20 20
0 0
growth is still needed to restore
competitiveness lost during the boom period.
• Meanwhile, Bulgaria’s large external financing
requirement – a hangover from last decade’s Chart 3: Croatian Unemployment (%, NSA)
credit boom – leaves it vulnerable to shifts in 26 26
investor risk appetite over the coming years 24 24
too. All told, with the household sector set to 22 22
20 20
remain pressure, GDP growth is likely to
18 18
remain firmly below its potential rate of around 16 16
4% over the coming years. 14 14
12 12
• Although the Croatian banking sector is less 10 10
99 00 01 02 03 04 05 06 07 08 09 10 11
exposed to Greece, and the government is
unlikely to embark on a meaningful fiscal
TABLE 1: KEY FORECASTS %y/y unless stated
tightening ahead of elections later this year, the
2008 2009 2010 2011 2012
country faces a number of challenges too. The Bulgaria
most pressing is the surge in unemployment, GDP 6.3 -5.4 -0.1 1.8 2.5
which seems on course to top 20% in the HICP inflation 12.0 2.5 3.0 3.0 2.5
coming months. The challenging outlook for Gen’l gov’t bal(1) 1.7 -4.7 -4.5 -4.0 -2.5
the euro-zone economy overshadows Current account(1) -24.1 -9.5 -3.0 -3.0 -3.5
prospects for the country’s important tourist Croatia
sector too. After contracting for the second GDP 2.4 -5.8 -1.4 1.5 2.5
consecutive year in 2010, we expect GDP to CPI inflation 6.1 2.4 1.0 2.5 2.0
grow by just 1.5% this year and by 2.5% in Gen’l gov’t bal(1) -1.4 -4.1 -5.0 -6.0 -5.0
2012. Current account(1) -9.2 -5.3 -4.0 -4.0 -4.5
Source – Thomson Datastream. (1) as % of GDP
Emerging Europe Analyst 1/2011 11
The Baltic States
Recovery to continue, but growth to slow in 2012
• The recoveries in the Baltic States remain on Chart 1: Estonia Capacity Utilisation & Unemployment
track, and the pace of growth should stay
85 0
impressive in the first half of this year. 80 2
However, much of the ‘low-hanging fruit’ has 75
4
6
now been picked and, while banking sectors 70
8
have stabilised, the recovery will get more 65
10
Capacity Utilisation (%, LHS, Adv. 2Q)
difficult from here on. We are sticking to our 60
12
Unemployment (%, RHS, Inverted)
55
below-consensus forecast for regional GDP 14
50 16
growth to slow to around 2-3% in 2012.
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
• Like elsewhere in the region, the industrial
sector has so far driven the recovery in the Chart 2: CPI-Based Real Effective Ex. Rates (Jan ’04 = 100)
Baltics. Encouragingly, the unemployment rate 135 135
130 Latvia 130
looks set to fall – particularly in Estonia – over Estonia
125 125
the coming quarters as firms resume hiring. 120 Lithuania 120
(See Chart 1.) However, three factors suggest 115 115
110 110
that the pace of the economic recovery will 105 105
start to fade over the second half of this year. 100 100
95 95
90 90
• First, given the ongoing process of 2004 2005 2006 2007 2008 2009 2010 2011
deleveraging by households, the region’s
recovery must be export-driven and thus it Chart 3: Real GDP (Q1 2006 = 100)
remains particularly vulnerable to the renewed
125 125
Latvia Estonia Lithuania
leg-down in the global economy which we 120 120
expect. Second, although the recent pick-up in 115 115
110 110
inflation across the region is likely to prove 105 105
temporary, it will work against the need to 100 100
95 95
restore competitiveness in the context of fixed
90 90
exchange rates. Certainly, the depreciations in 85 CE Forecasts 85
the region’s real effective exchange rates have 80 80
2006 2007 2008 2009 2010 2011 2012
levelled off in recent months. (See Chart 2.)
This is a particular concern for Latvia.
TABLE 1: KEY FORECASTS %y/y unless stated
2008 2009 2010 2011 2012
• Finally, the need for further fiscal cutbacks –
Estonia
especially in Latvia and Lithuania – continues
GDP -5.1 -13.9 3.1 4.0 3.0
to overshadow prospects for domestic demand. HICP inflation 10.6 0.2 2.7 3.0 2.0
The former has tightened fiscal policy by Latvia
around 16% of GDP since its IMF-led GDP -4.2 -18.0 -0.3 3.0 2.0
programme started in 2008 and recently HICP inflation 15.3 3.4 -1.2 2.5 2.0
unveiled its latest supplementary budget aimed Lithuania
at trimming spending further this year. The GDP 2.9 -14.7 1.3 3.0 2.0
upshot is that while the crisis is over and the HICP inflation 11.1 4.2 1.2 2.5 2.0
Source – Thomson Datastream
recovery should continue, output is unlikely to
surpass its 2007-08 level within the next five
years or so. (See Chart 3.) Emerging Europe Analyst 1/2011 12
Ukraine
Domestic demand remains under the cosh
• Ukraine’s economic recovery remains broadly Chart 1: GDP Growth (% y/y)
on track, although further cuts in energy
15 15
subsidies, as well as tight credit conditions, 10 10
will continue to act as a brake on the recovery 5 5
in the near term. All told, after growing by 0 0
4.2% in 2010, GDP is unlikely to accelerate -5 -5
markedly over the coming years. (See Chart 1.) -10 CE
F'casts
-10
-15 -15
• On a positive note, the prospects for the all- -20 -20
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
important industrial sector – and steel
manufacturers in particular – remain
reasonably robust. While we expect steel Chart 2: Gas Prices for End-Users
(UAH per thousand cubic metres, final price net of VAT)
prices (and commodities in general) to
3000 3000
eventually fall back over the coming years the
2500 Import Price 2500
recent rise will give industry a boost in the near
2000 2000
term. We expect industrial output to expand by May-10 Aug-10
1500 1500
around 8% in 2011 and 7.5% in 2012.
1000 1000
• However, in the near term at least, two factors 500 500
0 0
mean that domestic demand will continue to
Households Utilities Budgetary Industries
partially offset this boost. First, given high Institutions
levels on non-performing loans in the banking
sector, credit conditions are likely to remain Chart 3: Headline Inflation (% y/y)
tight for some time. Second, while the 35 35
government has scaled back its planned 30 CE 30
Forecasts
reduction in domestic energy subsidies this 25 25
year (from 50% to 30%), higher gas prices will 20 20
15 15
weigh on household real incomes. We have
10 10
nudged down our inflation forecast as a result,
5 5
but we still expect inflation to rise to 10.5% in
0 0
2011 as a whole (See Chart 2.) 2005 2006 2007 2008 2009 2010 2011 2012
• Meanwhile, there appears to be a rising risk TABLE 1: KEY FORECASTS %y/y unless stated
that the government’s relations with the IMF 2008 2009 2010 2011 2012
could sour over the coming quarters too. Private cons’ptn 13.8 -14.2 5.0 4.5 3.5
Indeed, delays in implementing reforms to the Industrial Prod’n -2.5 -20.5 10.7 8.0 7.5
notoriously costly pension system mean that GDP 2.8 -15.2 4.2 4.5 3.5
the government is likely to miss its 3.5% of
GDP target for the fiscal deficit this year Unemp. rate %(1) 6.4 8.8 9.0 8.5 7.5
contained in its current loan programme. CPI inflation 24.6 16.0 9.4 10.5 9.5
Accordingly, while the authorities are likely to
Gen’l gov’t debt(2) 20.5 35.3 42.0 43.0 44.0
continue intervening heavily in the FX market
Gen’l gov’t bal(2) -3.2 -8.7 -6.5 -4.5 -3.5
to keep the hryvnia stable around 8.0/$, the
Current Account(2) -7.1 -1.5 -2.0 -2.5 -2.5
risks to the currency remain rooted to the Source – IMF, Thomson Datastream. (1) ILO definition, (2) as % of GDP,
downside. Emerging Europe Analyst 1/2011 13
Bonds and Equity Markets
Markets overstating the pace of rate hikes
• Equity markets in the region have made a Chart 1: Equity Markets (%-change since 1 Jan.)
st
decent start to 2011. While the MSCI Emerging 12 12
Market Index has lost 4.5% since the start of 10 10
8 8
the year, the MSCI Emerging Europe index is
6 6
up by just over 3%. (See Chart 1.) But there has 4 4
been a wide variation in performance at a 2 2
country level. Romanian and Hungarian stocks 0 0
-2 -2
are up by 10% and 5% respectively on the start
-4 -4
of the year. Conversely, Czech stocks have flat-
Rom. Hungary Russia MSCI Poland Czech. Turkey
lined while Turkish market has been hit by EMEA
unrest in the Middle East.
Table 1: Price-to-Earnings Ratios
• The relative outperformance of Emerging Peak in
Long-run
Europe stocks owes much to the strength of the Previous Bull Current P/E
Average
Market
Russian market, which accounts for 65% of the
Czech Rep. 16.6 34.6 12.2
regional index by market capitalisation and has
Hungary 11.1 18.3 13.2
been buoyed by the recent rise in oil prices.
Poland 15.5 24.0 14.0
But other factors are at play too. A number of
Russia 9.4 19.7 9.3
the concerns that have underpinned the flight
Turkey 10.4 16.3 11.0
from EM equities this year – such as stretched
valuations and fears about inflation – do not
Chart 2: Russian Equities & Oil Prices
apply to many markets in Emerging Europe.
3000 RTS Index (LHS) 140
• Looking ahead, valuations do not look too 2500
Oil Prices ($pb, RHS) 120
stretched, suggesting scope for further out- 2000
100
80
performance over the coming quarters. (See 1500
60
Table 1.) But we’re sceptical as to how long 1000 CE 40
the rally can last. The global environment for 500
Forecasts
20
equities is likely to turn less favourable later
0 0
this year as concerns about the frailties of the 03 04 05 06 07 08 09 10 11 12
world economy come to the fore once again.
More importantly, we expect oil prices to drop Chart 3: Interest Rates (%, End-2011)
back by the end of the year, which will hit 7 7
Russian stocks. (See Chart 2.) 6 Market Pricing 6
CE Forecast
5 5
• We are, however, more bullish on local 4 4
currency bond markets. This is particularly true 3 3
of Poland and the Czech Republic where the 2 2
pace of interest rate hikes priced into the 1 1
forward curve looks too aggressive (See Chart 0 0
Poland Czech Rep Hungary
3.) Turkey is the exception.
Sources – Thomson Datastream, Bloomberg, CE
Emerging Europe Analyst 1/2011 14
Market Forecasts
TABLE 1: CENTRAL BANK POLICY RATES
Forecasts
% Policy Rate End Latest Last Change Next Change End End
nd
2009 (22 Mar) 2011 2012
Russia Refinancing Rate 8.75 8.00 Up 25bp (Feb 11) Up 25bp (Q2 ‘11) 9.00 9.50
Central Europe
Poland Reference Rate 3.50 3.75 Up 25bp (Jan 11) Up 25bp (Q2 ‘11) 4.00 4.50
Czech Rep. Two-week Repo Rate 1.00 0.75 Down 25bp (May 10) Up 25bp (Q1 ‘12) 0.75 1.25
Hungary Base Rate 6.25 6.00 Up 25bp (Jan 11) Down 25bp (Q3 ‘11) 5.50 5.50
South-East Europe
Turkey 7-day Repo Rate 7.00 6.25 Down 25bp (Jan 11) Up 25bp (Q3 ‘11) 7.25 8.00
Romania Reference Rate 8.00 6.25 Down 25bp (Feb 10) Up 25bp (Q1 ‘12) 6.25 6.75
Euro-zone Refinancing Rate 1.00 1.00 Down 25bp (May 09) Up 25bps (Q2 ’11) 1.50 1.50
US Fed Funds Target 0-0.25 0-0.25 Down 75bp (Dec 08) None on horizon 0-0.25 0-0.25
Japan Overnight Rate 0-0.10 0-0.10 Down 20bp (Dec 08) None on horizon 0-0.10 0-0.10
TABLE 2: FX RATES & EQUITY MARKETS
Forecasts Forecasts
Currency End Latest End End Equity Market End Latest End End
nd nd
2009 (22 Mar) 2011 2012 2009 (22 Mar) 2011 2012
Russia/$ RUB 30.0 28.2 31.0 34.5
Russia/EUR RUB 43.3 40.0 37.5 34.5 RTS 1,370 1,740 1,650 1,550
Russia/Basket* RUB 36.0 35.9 34.0 34.5
Central Europe
Poland/EUR PLN 4.10 4.00 3.90 3.85 WIG 40,000 48,135 48,500 50,000
Czech Rep/EUR CZK 26.4 24.5 25.0 24.5 PSE 1,120 1,220 1,200 1,225
Hungary/EUR HUF 270 270 280 275 BUX 21,200 22,550 22,000 22,000
Slovakia EUR N/A N/A N/A N/A Slovak 270 223 220 225
South-East Europe
Turkey/$ TRY 1.49 1.55 1.50 1.50 ISE 100 52,800 64,800 65,500 67,500
Romania/EUR RON 4.23 4.15 4.20 4.25 BET 4,700 5,875 5,800 5,850
Bulgaria/EUR BGN 1.96 1.96 1.96 1.96 SOFIX 430 435 430 430
Croatia/EUR HRK 7.30 7.38 7.40 7.35 CROBEX 2,000 2,285 2,260 2,260
Baltics
Estonia/EUR EEK 15.7 15.7 15.7 15.7 OMX Tallinn 405 750 745 745
Latvia/EUR LVL 0.71 0.71 0.71 0.71 OMX Riga 280 450 445 445
Lithuania/EUR LTL 3.45 3.45 3.45 3.45 OMX Vilnius 260 400 395 395
Euro-zone/$ EUR 1.43 1.42 1.30 1.00 DAX 30 6,000 6,820 6,750 6,750
US USD - - - - S&P 500 1,125 1,300 1,200 1,200
Japan/$ JPY 93 81 90 100 Nikkei 225 10,500 9,600 9,000 9,000
* = (0.55 X USDRUB) + (0.45 X EURRUB)
Emerging Europe Analyst 1/2011 15
Long-term Growth Prospects
Country Potential GDP Per Comments
(ranked by potential Growth Rate Capita as a
growth rate) (per annum) %-age of euro-
zone average
Good demographic outlook but politics remain a
risk. On the economic front, a widening current
1. Turkey 5.5% 15% account deficit reflects the low level of domestic
savings. Further fiscal reforms are needed to address
this frailty.
Dependence on oil, lack of progress on structural
reforms and poor demographics cloud medium-term
2. Russia 4.0% 20%
outlook. 2012 elections could be key to determining
the future pace of reform.
Significant scope for catch-up but legacy of last
3. Romania 4.0% 15% decade’s credit boom clouds near-term outlook.
Banking sector heavily exposed to Greece.
Significant scope for catch-up but legacy of last
4. Bulgaria 4.0% 10% decade’s credit boom clouds near-term outlook.
Banking sector heavily exposed to Greece.
Banking sector managed to avoid the excesses of last
decade’s credit bubble. But labour market reforms
5. Poland 4.0% 25%
critical to boosting growth and large structural budget
deficit yet to be properly tackled by the government.
Economy has stabilised after last decade’s boom and
6. Lithuania 3.5% 25%
bust, but medium-term growth will depend upon
shifting to an export-led growth model. This will
require significant investment in new industries.
7. Latvia 3.5% 25%
Growth won’t return to pre-crisis highs; 3-4% a year
will be the new norm.
Further reforms needed to boost labour market
8. Slovakia 3.5% 30%
flexibility.
Fiscal and banking concerns persist. Less scope for
9. Hungary 3.5% 35%
catch-up means slower potential growth.
Recovery from current slump will be slow, but good
10. Estonia 3.5% 35%
policy should ensure solid medium-term growth.
Less scope for catch-up means slower potential
11. Czech Rep. 3.0% 40%
growth.
Emerging Europe Analyst 1/2011 16
The Path to EMU
Summary Estonia became the 17th member of the euro-zone earlier this year but a number of factors mean that it is likely to be the last country to join for a
long time. First, following the recent problems in the periphery of the euro-zone, we suspect that the existing members will be reluctant to allow
further countries in for some time. Second, the economic upheaval of the past few years has made it much less attractive for prospective countries
to enter the rigidity of a currency union. Finally, most countries in Emerging Europe are at least 3 years away from fulfilling the current Maastricht
criteria for euro entry.
Likely EMU Developments
Comment
entry date since last EEA
ERM II Members Lithuania 2015+ Negative
Latvia 2015+ Negative
} Estonia became the 17th member of the euro-zone in January. However, budget
deficits in Latvia and Lithuania remain well above the Maastricht limit.
Non-ERM II Very little political or public appetite for EMU. Fiscal deficit remains well above
Czech Rep. 2015+ Negative
Members Maastricht limit, although inflation and debt fulfill criteria.
Political support for EMU much greater than in the neighbouring Czech Republic, but
Poland 2015+ Negative
still unlikely to join in the near term.
The new Fidesz government now appears less keen on euro-entry: having previously
suggested that accession would not be possible until 2015, ministers have recently
Hungary 2015+ Negative pushed this back to 2020. Either way, the government’s high debt level remains a
major obstacle to meeting Maastricht criteria – and absent of accounting tricks we
do not expect it to fall significantly over the next few years.
Bulgaria 2015+ Negative
Romania 2015+ Negative
} Both countries have pro-European governments, but the public finances are the
major impediment for EMU entry (particularly in Romania).
Emerging Europe Analyst 1/2011 17