Economic and Capital Market Forecast

Bond Research June 2008 Euro-Visions Economic and Capital Market Forecast Euroland: Slower growth at persistent high inflation ECB Council tightens monetary policy US: Arguments for recovery of the economy slightly outweigh CEE: Wide disparities between the countries, but overall solid development Corporate Bonds: No narrowing of credit spreads for now Overview Euroland's economy has developed quite well up to now despite the diverse burdening factors. After a strong first quarter, we expect a technical correction in the second quarter. In the second half-year, the dynamic will probably be subdued because of the high commodity prices. We expect the quarterly growth rates to accelerate in 2009, but as the starting level is high, the annual growth rate will remain low at 1.7%. The inflation rate will probably reach a level of over 3% this year, but in 2009, we expect it to decline significantly to 2.2%; however, this expectation is based on the assumption of stable commodity prices. Money market interest rates are expected to decrease slightly after an interest rate hike in July, as the risk premium should gradually decrease. Government bonds have undergone a hefty correction in the past few weeks which is expected to turn into a consolidation in the short-term. We expect yields on 10-year German government bonds to rise again to 4.7% in 3Q. The US economy seems to have roughly stagnated in the first half of the year despite the difficult setting. The risks for the rest of the year are considerable though. It is unclear how far the oil price will climb, and if the effects of the financial market crisis on lending practices will be long-lasting. The correction on the real estate market is in any case not expected to stop, but together with a stabilization of the other two factors, it should not stand in the way of a moderate recovery of the US economy. The oil price will, of course, play a key role for inflationary developments. Stabilization and a slower pace of increase of housing costs are indicators of lower inflation rates in our view. Thus, the US central bank will not have to tighten the interest rate screw and we expect an unchanged key lending rate into the year 2009. Thus, long maturities on the bond market are probably exposed to greater risk as soon as the economic data improves a bit. The latter should also lead to a firming of the US dollar, albeit only moderately. Economic growth in the countries of Central and Eastern Europe is expected to weaken slightly compared to the preceding years. This may be attributed mainly to cyclical factors, as after years of very strong growth inflationary risks increase that the central banks have already counteracted by raising interest rates. However, any statements on the region can only be very general, and the macroeconomic starting situation in country is the decisive factor for the outlook. Poland, Czech Republic and Slovakia are still reporting strong growth across a broad base. The economic recovery in Hungary is progressing only slowly after the fiscal consolidation. Romania will probably attain solid growth this year again, but the principal challenge will be the containment of the foreign trade deficit. We expect economic growth to slow to a solid level in Croatia. After the May elections, coalition negotiations are still underway in Serbia, the outcome of which will be decisive for the direction of the country's foreign policy. The Ukrainian economy is driven by robust domestic and foreign demand. However, for now inflation there will remain the highest of the countries we cover. Depending on the degree of risk tolerance, we perceive solid potential for investors in Croatia, Hungary, Romania and the Ukraine. In the second half of the year, the effects of the financial crisis on the real economy are the greatest unknown variable in the further development of spreads on the EUR Corporate Bond Market. An additional burdening factor is in our view the higher risk of inflation in Euroland which means that businesses might continue to be exposed to high financing costs. By contrast, we consider the fundamental situation of European companies as sound and the decreasing earnings dynamic in 2008 should be offset by sinking investment activity and will not lead to a deterioration of the debt situation. We expect spreads to move on a sideways trend until year-end, with a gradual narrowing being the most likely scenario. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 1 Content Page Overview 1 Forecasts 4 Euroland Economy Inflation Monetary policy Bond market USA Economy Monetary policy Bond market US-Dollar Central and Eastern European Countries Croatia Romania Serbia Slovakia Czech Republic 6 6 10 12 14 17 17 22 22 23 24 24 27 30 33 35 Euro-Visions Economic and Capital Market Forecast, June 2008 Page 2 Content Ukraine Hungary Corporate Bonds Review Outlook Conclusions Important Webpages 38 41 44 44 45 50 51 Contacts 52 Analysts: Alihan Karadagoglu Alen Kovac Veronika Lammer Martin Lobotka Michal Musak Orsolya Nyeste Rainer Singer Elena Statelov Mária Valachyová Paul Windisch Christian Mladen Eugen Sinca Roman Oliynyk Viktor Stefanyshyn Euro-Visions Economic and Capital Market Forecast, June 2008 Page 3 Forecasts 3 month money market rates End of the month EURO Japan USA Switzerland Czech Republic Hungary Poland Rom ania Slovakia Ukraine current 4.96 0.93 2.70 2.83 4.20 8.93 6.57 10.89 4.36 15.13 Sep-08 4.60 0.80 2.30 3.00 4.10 8.50 6.45 11.50 4.40 14.20 Dec-08 4.50 1.00 2.30 3.00 4.15 8.40 6.45 10.00 4.50 13.75 Mar-09 4.50 1.20 2.40 3.00 4.30 8.20 6.35 8.80 13.25 Jun-09 4.50 1.30 2.60 3.00 4.30 8.00 6.25 8.05 13.00 10y Yields End of the month Germany Austria Spread to GE USA Croatia Czech Republic Hungary Poland Romania Slovakia Ukraine** * 5Y Primary market, ** 3Y Source: Erste Bank Research current 4.38 4.63 0.25 3.92 5.80 5.10 8.61 6.37 10,30* 4.85 13.00 Sep-08 4.60 4.80 0.20 4.20 5.60 4.70 7.70 5.90 9.80 4.95 11.00 Dec-08 4.70 4.85 0.15 4.40 5.50 4.60 7.30 5.90 9.50 5.00 10.80 Mar-09 4.60 4.75 0.15 4.60 5.50 4.70 6.90 5.55 8.50 4.90 10.50 Jun-09 4.70 4.80 0.10 4.80 5.50 4.80 6.80 5.45 7.80 5.00 10.20 Exchange rates End of the month EUR/USD EUR/JPY USD/JPY EUR/CHF USD/CHF EUR/HRK EUR/CZK EUR/HUF EUR/PLN EUR/RON EUR/SKK EUR/UAH current 1.581 167.1 105.7 1.611 1.018 7.248 24.67 247.5 3.391 3.681 30.34 7.47 Sep-08 1.55 158 102 1.58 1.02 7.25 25.8 245 3.50 3.65 30.1 7.39 Dec-08 1.48 151 102 1.55 1.05 7.30 25.9 245 3.51 3.50 30.1 7.23 M ar-09 1.43 146 102 1.58 1.10 7.25 25.7 240 3.45 3.58 6.96 Jun-09 1.38 141 102 1.55 1.12 7.22 25.5 240 3.4 3.55 6.72 Source: Erste Bank Research Euro-Visions Economic and Capital Market Forecast, June 2008 Page 4 Forecasts Economy Changes y/y GDP growth Austria Germany France Italy Spain Netherlands Euroland USA Japan Switzerland Croatia Czech Republic Hungary Poland Romania Serbia Slovakia Ukraine Source: Erste Bank Research 2006 3.3 3.1 2.4 1.9 3.9 3.0 2.9 3.3 2.2 2.7 4.8 5.4 3.9 6.1 7.9 5.7 8.5 7.1 2007 3.4 2.7 2.1 1.4 3.8 3.5 2.6 2.2 2.0 2.5 5.6 5.7 1.3 6.5 6.0 7.3 10.4 7.6 2008f 2.1 2.3 1.7 0.5 2.0 2.4 1.8 1.7 1.7 2.3 4.6 3.6 2.2 5.5 7.0 6.3 7.6 6.6 2009f 1.7 1.8 1.6 1.0 1.8 2.0 1.7 2.1 1.9 2.2 4.8 5.2 3.2 5.7 6.0 6.8 6.0 6.0 Inflation Austria* Germany France Italy Spain Netherlands Euroland USA Japan Sw itzerland Croatia Czech Republic Hungary Poland Rom ania Serbia Slovakia Ukraine *national statistics Source: Erste Bank Research 2006 1.5 1.8 1.8 2.4 3.1 2.6 2.2 3.2 0.3 1.1 3.2 2.5 3.9 1.3 6.6 12.8 4.5 9.2 2007 2.2 2.3 2.0 2.5 3.2 2.7 2.1 2.8 0.6 1.6 2.9 4.9 8.0 2.6 4.8 6.8 2.8 12.8 2008f 2.9 2.9 3.1 3.2 4.0 2.0 3.2 3.1 1.0 1.8 5.2 4.8 6.4 3.8 7.8 8.2 4.2 24.0 2009f 2.3 2.0 1.9 2.2 3.0 2.6 2.2 2.1 1.5 2.0 3.2 2.8 4.0 3.2 4.9 5.1 4.0 13.6 Euro-Visions Economic and Capital Market Forecast, June 2008 Page 5 Euroland Economy Year-on-year change Private consumption Public sector consumption Capital expenditure Chandes in inventory in EUR bn Domestic demand Exports Imports Trade balance in EUR bn GDP, real Quelle: Datastream, Erste Bank Research in % of GDP 57.0% 19.6% 21.4% 0.0% 99.1% 41.1% 39.3% 0.9% 100.0% 2005 1.6% 1.5% 3.1% 13.4 2.0% 4.9% 5.7% 69.1 1.7% 2006 1.8% 2.0% 5.3% 32.2 2.9% 8.1% 7.8% 82.5 2.9% 2007 1.5% 2.2% 4.2% 24.0 2.1% 6.0% 5.2% 114.9 2.6% 2008f 1.2% 1.5% 3.1% 15.0 1.5% 4.8% 4.5% 131.1 1.8% 2009f 1.8% 1.5% 1.8% 11.5 1.7% 4.5% 4.7% 126.5 1.7% Euroland's economy surprisingly robust The economic outlook for Euroland has become a bit gloomier again in the past few months. If one considers the many burdening factors, it is still astounding that Euroland's rather fragile economy of the past few years has been able to withstand as well up to now. We expect proof of this relative strength to become evident in the coming months and in the year 2009. The reasons for the robustness of Euroland's economy are the structural improvements of the past few years and the improved balance sheets of companies and households compared to earlier external shocks. The starting situation at the beginning of 2007 was marked by a slight surplus in foreign trade and a low deficit of government budgets. Moreover, 2007 was only Euroland's second year of strong economic expansion after several years of low growth rates. This had an impact on the dynamic of investment activity as well as on the labour market. However, the individual economies have divergent growth cycles and therefore respond differently to negative influences. Wider diversity of burdening factors The factors of influence from the international environment remain unsure. On the one hand, the North American region is showing strong signs of a sharp economic downswing, and on the other, Asia and Latin America are still reporting high growth rates. The real estate crisis in the US seems to have hit the low point, but the probability of a fast recovery is still marginal at present. Although it will probably be possible for the US to avoid recession, our growth expectation for 2009 is still only 2.1%. Surprisingly, the Asian emerging markets have hardly responded to the downswing in the US. For China and India, the expected growth rates are over 10% for 2008 and over 8% for 2009. The second factor of insecurity is the steep rise of prices for energy and other commodities. The long-term forecasts for the oil price are constantly being revised upwards. This is having negative effects, as purchasing power flows out of Euroland into the oil-producing countries, while there are also some positive demand effects because the need to invest in the energy sector will probably even increase. The third major factor of insecurity is the still faulty functioning of financial markets and the related deterioration of credit terms for companies and households. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 6 Euroland Development of domestic demand, y/y 8% Forecast External balance of goods and services in EURbn q/q 40.0 35.0 30.0 6% 4% Private consumption Investment 25.0 Forecast 2% 0% -2% 20.0 15.0 10.0 5.0 -4% Q1 2000 Q4 2000 Q3 2001 Q2 2002 Q1 2003 Q4 2003 Q3 2004 Q2 2005 Q1 2006 Q4 2006 Q3 2007 Q2 2008 Q1 2009 Q4 2009 0.0 Q1 1998 Q4 1998 Q3 1999 Q2 2000 Q1 2001 Q4 2001 Q3 2002 Q2 2003 Q1 2004 Q4 2004 Q3 2005 Q2 2006 Q1 2007 Q4 2007 Q3 2008 -5.0 Q2 2009 Source: Datastream, Erste Bank Research Robust first quarter weighs down outlook for 2Q The first quarter was surprisingly robust, recording a growth rate of 0.8% vs. 4Q07. This was due almost exclusively to the exceptionally good results in Germany. Thus, in Germany the growth rate was 1.5% q/q driven one-third by inventory build-up and onequarter by brisk construction activity boosted by the mild weather this winter. The two factors do not harbour much good news for growth rates in 2Q. Thus, inventory build-up was probably not fully voluntary before the backdrop of unchanged high levels of order intake, but a repeat is not expected. The increase in construction activity that usually occurs after the winter break did not occur. However, if one removes these special factors, the data for Germany paints a positive picture. Thus, private consumption rose again after a plunge in 4Q and investments in plant and equipment gained ground again as well. The generally encouraging economic situation in Germany was therefore only exaggerated by the special factors. The development for 1Q in France was also positive. The increase in real GDP by 0.6% versus 4Q was supported by sustained lively investment activity as well as by a surplus in net exports. In contrast to the two major economies, Spain, as the fourth-largest economy, reported an only slight growth rate of +0.3% q/q. Italy, the third-largest economy achieved an increase of 0.4% q/q after shrinking by 0.4% in 4Q 2008. Generally, the growth cycle within the euro zone will continue to be marked by the adjustment effects. Countries with relatively high inflation rates like Spain, Greece and Ireland had a strong incentive to take advantage of the very low interest rates - compared to historic levels - for investments in the private sector in home construction in the past seven years. A correction of the overheated real estate sector is underway in these countries, the most pronounced one taking place in Spain. This is being felt in the job cuts in the sector and the speculation losses of households. Spain's households are not as over-indebted as in the US, but the higher interest rates and the decline in home prices are having a burdening effect. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 7 Euroland Capacity utilization in % 95 90 Order intake German industry 160 150 140 Intermediate Goods Capital Goods Consumer Goods 85 80 75 70 65 Q2 1998 Q4 1998 Q2 1999 Q4 1999 Q2 2000 Q4 2000 Q2 2001 Q4 2001 Q2 2002 Q4 2002 Q2 2003 Q4 2003 Q2 2004 Q4 2004 Q2 2005 Q4 2005 Q2 2006 Q4 2006 Q2 2007 Q4 2007 Q2 2008 Germany Netherlands France Spain Italy 130 120 110 100 90 80 Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 May-01 May-02 May-03 May-04 May-05 May-06 May-07 Nov-07 Source: Datastream Investment cycle on downswing In our forecast, the assumption is that the investment cycle will gradually shift downwards this year. Stagnation or even a decline will be seen mainly in private home construction, while commercial and public sector construction will report slight growth rates. Investments in plant and equipment are expected to rise slightly, as capacity utilization is still high and companies will report record profits this year again. The renewed increase in energy prices is expected to keep investment demand high in the areas of alternative energy generation and efficient energy use. This argument also applies to exports which stand to profit from robust investment activity and the prosperity gains in the oil-producing countries and could thus offset the economic downswing in the US. However, the high external value of the euro and the slower growth dynamic of global trade lead one to expect only below-average growth rates. Imports are expected to increase at the same pace as exports, and the contribution of foreign trade should remain more or less the same. Substantial divergences are expected to emerge again between the individual economies. Germany will again record the largest share of orders for capital goods, while France and Italy will post greater gains in the area of consumer goods. The unemployment rate dropped in 1Q to only 7.1% and thus hit a new low. After employment had risen in 2007 by 1.6%, the pace of growth is expected to slow this year to a still remarkable 0.8%. The EU Commission expects a further increase in employment by 0.5% for 2009. Despite the slowing growth rates, the tight labour market is already being felt in some sectors and leading to higher wage increase than in the previous years. The relatively high negotiated wages in Germany are a first sign and the other participating countries will follow. However, the average wage increase of 3.5% for 2008 only covers inflation, which we have meanwhile revised upwards for 2008 to 3.2%. Therefore, the pressure to raise wages will continue in 2009. Exports growing at a slower pace Labour market and wage trends supportive of consumption Euro-Visions Economic and Capital Market Forecast, June 2008 Page 8 Euroland New jobs and unemployment rate 12 10 8 6 -50 4 2 0 Jun-01 Oct-01 Feb-02 Jun-02 Oct-02 Feb-03 Jun-03 Oct-03 Feb-04 Jun-04 Oct-04 Feb-05 Jun-05 Oct-05 Feb-06 Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Employment change Germany m/m Unemployment rate Germany Unemployment rate Euroland Consumer confidence and sentiment indicator 150 100 50 0 1.0% 0.5% -10 -15 -20 -25 Jun-02 Oct-02 Oct-03 Feb-04 Jun-04 Oct-04 Oct-05 Feb-06 Jun-06 Oct-06 Oct-07 Feb-08 Feb-03 Jun-03 Feb-05 Jun-05 Feb-07 Jun-07 2.5% 2.0% 1.5% Retail sales Consumer Confidence, r.s. 5 0 -5 -100 -150 -200 0.0% -0.5% Source: Datastream Oil price could burden private consumption again Private consumption is the unknown variable in the forecast. Since private consumption has always been overestimated in past years, this time, the estimate might be a bit more cautious. Despite the robust increases in employment, private consumption rose only slightly in 2007 and in the first quarter of 2008. This may be attributed in part to the hike in VAT in Germany in 2007, but the principal reason is probably the meagre wage increases of the past few years. In an environment of, at best, unchanged purchasing power, it is not possible to substantially boost consumption. Thus, the considerable wage increases in Germany have their merits, as they will help to lift real incomes, at least in the biggest economy, despite the high inflation rate. Unlike in the case of investment activity and exports, the high energy prices definitely have a dampening effect. Therefore, we again expect an only slight rise in this demand segment for 2008. However, things should brighten by the year 2009. The combination of high employment and strong wage increases should have benign effects, at least over the medium term. Growth rate euro participating countries 0% Germany France Italy Spain Netherlands Belgium Austria Finland Portugal Ireland Greece Slovenia Malta Cyprus Source: Datastream, Erste Bank Research 1% 2% 3% 4% 5% 6% 7% 2007 2008f 2009f Euro-Visions Economic and Capital Market Forecast, June 2008 Page 9 Euroland Inflation Food and energy are driving inflation The steep rise in inflation of the past few months surprised both economists and central bankers. As illustrated in the chart, the overall inflation rate jumped in 4Q of last year by 1%-point and has since remained clearly above 3%. This movement was triggered by a combination of higher crude oil prices and food prices as well as the abatement of the inflation-dampening base effects. The steepest price rises are thus to be found in energy and non-processed food as well as in processed foods. The core inflation rate exclusive of all of these factors remained just below 2% and thus within the range considered to constitute price stability. The prices of services rose by around 2.5% y/y and the prices of industrial goods advanced by around 1%. Inflation development and forecast 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Page 10 Forecast HCPI, Overall index Core Inflation (excl. Energy, Food, Alcohol and Tobacco) Source: Datastream, Erste Bank Research Inflation will decrease slower than expected We have had to revise our inflation forecast upwards already several times this year, and now we have to change our forecast of expectations for 2008 upwards once again. Before the backdrop of a further rise in the commodity prices, we expect an average inflation rate of 3.2% for this year. We have revised our forecast for 2009 slightly down from 2.3% to 2.2%. We expect the oil price to stabilize within the range of USD 120 to 130 USD/ barrel and food prices to move into a sideways trend. The indicator of a stable oil price is the fact that the start of the driving season is already over and a level has been reached that is expected to entail a reduction in demand for energy. As insecurity is on rise at the same time regarding the quantity of reserves and future production expansion, we do not perceive much downside potential for the oil price. In the case of food, the outlook of good harvests in the northern hemisphere makes us optimistic that the uptrend will be stopped. In this case as well, a sustained decline in prices seems unrealistic, because inventories are depleted and the expected build-up should keep demand high. Euro-Visions Economic and Capital Market Forecast, June 2008 Euroland Commodity prices, Index 450 400 350 300 250 200 150 100 50 0 01/01/1995 01/09/1995 01/05/1996 01/01/1997 01/09/1997 01/05/1998 01/01/1999 01/09/1999 01/05/2000 01/01/2001 01/09/2001 01/05/2002 01/01/2003 01/09/2003 01/05/2004 01/01/2005 01/09/2005 01/05/2006 01/01/2007 01/09/2007 01/05/2008 CRB Spot Index Foodstuffs - PRICE INDEX CRB Spot Index Metals - PRICE INDEX 1000 900 800 700 600 500 400 300 200 100 0 Processed food Unprocessed food 2009f 2008f 2007 Goods excl. energy Energy Services Price increases by component in % 0 2 4 6 8 10 12 Source: Datastream, Erste Bank Research Second-round effects in the service sector are relatively marginal Services account for around 40% of the total index and 50% of the index of core inflation exclusive of energy and food. Although some isolated second-round effects have been observed in this sector - especially in tourism and restaurants - they have been moderate. Nonetheless, the steeper wage increases this year and next will probably be felt. No second-round effects have been detected as of yet in the segment of industrial goods exclusive of energy and we believe that still subdued demand for consumption goods will permit companies to pass on the higher costs only to a minor extent. A decline of the rate of increase of prices below the already low level of around 1% seems improbable though, considering the higher producer prices. Overall, we therefore expect a sideways trend of the core inflation rate at just below 2% for the rest of the year. As we had to raise our inflation forecast already in April to 2.9% at the time, we now have to revise expectations for 2008 again to 3.2% for the annual average. The peak of inflation should be reached in June at 3.6% and afterwards the inflation rate is expected to diminish due to the benign base effects and hit 2.8% by year-end. Starting out from this level, we expect a continuation of the downwards trend for 2009, but it will be influenced mainly by the energy and food prices. The core inflation rate will rise slightly in contrast and stop at above 2%. The annual average of the inflation rate will be again over 2%. We expect 2.2% and estimate the risk as pointing clearly upwards. Inflation over 2% in 2009 as well Euro-Visions Economic and Capital Market Forecast, June 2008 Page 11 Euroland Producer prices in % 6 5 4 3 2 1 0 -1 Feb-91 Feb-92 Feb-93 Feb-94 Feb-95 Feb-96 Feb-97 Feb-98 Feb-99 Feb-00 Feb-01 Feb-02 Feb-03 Feb-04 Feb-05 Feb-06 Feb-07 26/05/2008 EM PPI - CAPITAL GOODS INDUSTRY NADJ EM PPI - NON-DURABLE CONSUMER GOODS NADJ EM PPI - DURABLE CONSUMER GOODS NADJ Source: Datastream Monetary policy Risk premiums on the money market are high Money market rates are being influenced, on the one hand, by revived interest rate expectations, and on the other, by the insecurity prevailing on the capital markets. Thus, the 3M Euribor recently rose to nearly 5% although the key lending rate remained unchanged at 4%. The gap between the current interest on short-term T-bills and the Euribor rates has even narrowed to around 90 basis points and is thus much lower than in the phases of heightened insecurity regarding banking risk. However, things are still far from normality which would be a premium of around 20 basis points. The discussion in the past few weeks regarding possible hikes in key lending rates was clearly confirmed by the statements of ECB President Trichet at the last Council meeting. He said an interest rate hike was possible in July and pointed out that the ECB Council was monitoring developments very closely at present. Opinions within the Council were apparently divided, which is not surprising considering the divergent economic developments in the individual participating countries. The hawks within the Council apparently have the better arguments now and will probably be able to attain an interest rate hike in July. 3M Euribor minus 3M T-bills interest in % 1.8 1.6 1.4 1.2 1 Interest rate hike "announced" for July Key lending rates and 3M Euribor in % 6 5 4 3 Repo rate 2 1 0 Jan/ 99 Jan/ 00 Jan/ 01 Jan/ 02 Jan/ 03 Jan/ 04 Jan/ 05 Jan/ 06 Jan/ 07 Jan/ 08 Jul/ 99 Jul/ 00 Jul/ 01 Jul/ 02 Jul/ 03 Jul/ 04 Jul/ 05 Jul/ 06 Jul/ 07 Euribor 3M 0.8 0.6 0.4 0.2 0 11/12/2007 20/12/2007 31/12/2007 09/01/2008 18/01/2008 29/01/2008 07/02/2008 18/02/2008 27/02/2008 07/03/2008 18/03/2008 27/03/2008 07/04/2008 3M Euribor minus 3M Treasury Bill rate 16/04/2008 25/04/2008 06/05/2008 15/05/2008 04/06/2008 Source: Bloomberg, Erste Bank Research Euro-Visions Economic and Capital Market Forecast, June 2008 Page 12 Feb-08 Euroland Key lending rates moving sideways The greatest fear of European central banks is without doubt the fact that the medium-term inflation rate might be driven up sustainably by second-round effects and the inflationary expectations would increase accordingly. However, the marked slowdown of the economy in 2Q is expected to defuse some of these fears. The persistent insecurity regarding the creditworthiness of the banking sector and the economic weakness do not give the Council much room for further interest rate hikes in our view. As long as no lasting second-round effects are discerned, there is no urgent reason to raise interest rates, especially as the key lending rate of 4.25% is barely in the neutral range and the high external value of the euro and the more expensive financing costs for companies are having a restrictive effect anyway. If one takes these factors into consideration, the monetary environment in Euroland may already be assessed as restrictive. The Monetary Conditions Index confirms this view. The input factors are real money market rates, the real long-term government bond yields and the real external value of the euro. As shown in the chart, the MCI has assessed the monetary environment as restrictive since mid-2007. The steep increase in inflation was offset by the higher real external value of the euro. Moreover, if one takes into account the higher risk premiums on corporate bonds and credit since mid-2007, this reveals the monetary environment as even much more restrictive. Starting out from our forecasts, the Taylor Rule would recommend higher key lending rates for 3Q and slightly lower key lending rates for 1Q 2009. Taylor rule and key rates in % 16 Restrictiv Valuation indicators point to unchanged interest rates as of July Monetary Condition Index 8 6 4 2 0 -2 Accommodative Taylor rule with core inflation Key rates Forecast 14 12 10 8 6 4 2 0 -4 -6 -8 Jan/ 96 Jan/ 97 Jan/ 98 Jan/ 99 Jan/ 00 Jan/ 01 Jan/ 02 Jan/ 03 Jan/ 04 Jan/ 05 Jan/ 06 Jan/ 07 Jan/ 08 Q2 1975 Q1 1977 Q4 1978 Q3 1980 Q2 1982 Q1 1984 Q4 1985 Q3 1987 Q2 1989 Q1 1991 Q4 1992 Q3 1994 Q2 1996 Q1 1998 Q4 1999 Q3 2001 Q2 2003 Q1 2005 Q4 2006 Source: Datastream, Erste Bank Research Risk premium expected to decrease Therefore, we do not expect any change after the interest rate hike in July, but the risk premium on the money market should decrease in the course of the year. We expect a decline of the 3M Euribor to 4.6% by September, and by year-end, a more or less normal level of credit premiums should be reached at 4.5%. These values are much lower than the forwards priced into the current money market yield curve that forecasts an easing of the liquidity bottleneck only in the second quarter of 2009. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 13 Q3 2008 Euroland Forecast and forwards in % 5.60 5.10 4.60 4.10 3.60 3.10 2.60 2.10 1.60 Nov-08 May-09 Mar-09 Dec-08 Oct-08 Sep-08 Jan-09 Feb-09 Apr-09 Jun-09 Page 14 3M Euribor Forwards Forecast Source: Bloomberg, Erste Bank Research Bond market Government bonds shift into yield uptrend The government bond markets moved into a correction phase at the end of March that is still underway and even leaves room for another increase in yields. This correction was triggered by the recognition that the central banks have been able to control the banking crisis relatively well. The rapid rise of government bonds is not due only to an increase in risk tolerance, but also because it is becoming clear that the phase of easy monetary policy is coming to an end and inflation will remain an important theme for some time to come. In the past months, many forecasters have been forced to revise their inflation expectations repeatedly just like us. At the same time, the growth forecasts were left unchanged or revised downwards to a much lesser extent than the upwards revisions of inflation. Before this backdrop, the real 10-year yields of below one percent like in Euroland or even a negative value like in the US do not seem appropriate. Additionally, the bond market was shocked by the announcement of an interest rate hike in Euroland. We have therefore raised our yield forecasts for ten-year German government bonds to 4.7% by year-end. We expect a consolidation in the coming few weeks in the range of 4.45% to 4.4%, but this might be followed already in 3Q by an increase of up to 4.7%. This level is expected to form the upper limit of a sideways channel until year-end. Seitwärtstrends bilden. Yield forecasts revised slightly upwards Euro-Visions Economic and Capital Market Forecast, June 2008 Euroland Yield trend of German government bonds in % 6 5.5 5 4.5 4 3.5 3 2.5 2 1.5 01/01/1999 01/07/1999 01/01/2000 01/07/2000 01/01/2001 01/07/2001 01/01/2002 01/07/2002 01/01/2003 01/07/2003 01/01/2004 01/07/2004 01/01/2005 01/07/2005 01/01/2006 01/07/2006 01/01/2007 01/07/2007 27/03/2008 10y Yield German Bund 2y Yield German Bund Source: Datastream Inverse interest rate curve again The interest rate curve of German government bonds broke out of the steepening trend already in February and has since been flattening steadily between ten-year and twoyear maturities. The announcement of an interest rate hike reversed the curve within a few days into the inverse range. An immediate reversal into a normal situation cannot be expected before the current backdrop, but a longer term inversion of the government bond curve seems improbable. The long-term yield level may still be viewed as low and the foreseeable economic downswing is expected to ward off any further interest rate hikes. The yield spread between US Treasuries and German government bonds has shifted into a sideways trend. The expected narrowing of the short-term yield spread next year points to a narrowing of the yield spread over the medium term. German 10year government bonds are expected to perform better than US Treasuries in the next six months. 10-year yield spread US Treasuries and German Bund in % 0.8 Slope of yield curve in % 2.5 2 1.5 10y Yield - 2y Yield US curve Euro curve 0.6 0.4 0.2 0 -0.2 -0.4 1 0.5 0 -0.6 -0.5 27/03/2007 27/04/2007 27/05/2007 27/06/2007 27/07/2007 27/08/2007 27/09/2007 27/10/2007 27/11/2007 27/12/2007 27/01/2008 27/02/2008 27/03/2008 27/04/2008 27/05/2008 -0.8 27/03/2007 27/04/2007 27/05/2007 27/06/2007 27/07/2007 27/08/2007 27/09/2007 27/10/2007 27/11/2007 27/12/2007 27/01/2008 27/02/2008 27/04/2008 27/05/2008 Source: Datastream, Erste Bank Research Spreads have slight narrowing potential With the reversal in government bond yields upwards, a trend towards lower risk premiums set in. The 10-year swap spread narrowed by 20 basis points to 40 basis points, and the two-year swap spread even decreased by more than 20 basis points. However, the expectations of higher key lending rates quickly reversed this trend again. Over the medium term, we expect a phase-wise normalization along with the narrowing Page 15 Euro-Visions Economic and Capital Market Forecast, June 2008 01/01/2008 Euroland risk premium on the 3M Euribor, with the swap curve expected to point upwards again around year-end. The yield spreads of the other euro participating countries to German government bonds decreased again a bit recently, but are still far below the peaks. We expect another slight narrowing of spreads in the coming months. The reasons are a general trend towards slightly higher risk tolerance and the fact that the government budgets have improved enormously in the past two years and this year none of the participating countries have exceeded the 3% Maastricht limit for new debt. Our preferences are Austria, Spain and Greece, with the potential apparently being limited to around 10 to 15 basis points. Swap spreads in basis points 100 90 80 70 60 50 40 30 20 10 0 11/12/2007 20/12/2007 31/12/2007 09/01/2008 Swap spread 10 years Swap spread 2 years 18/01/2008 29/01/2008 07/02/2008 18/02/2008 27/02/2008 07/03/2008 18/03/2008 27/03/2008 07/04/2008 16/04/2008 25/04/2008 06/05/2008 15/05/2008 26/05/2008 04/06/2008 Yields spread of other member states to German Bunds in % 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 15/06/2006 15/08/2006 15/10/2006 15/12/2006 15/02/2007 15/04/2007 15/06/2007 15/08/2007 15/10/2007 15/12/2007 15/02/2008 15/04/2008 -0.1 15/06/2008 Greece Austria Italy Spain Portugal Source: Bloomberg Source: Datastream, Erste Bank Research Veronika Lammer Euro-Visions Economic and Capital Market Forecast, June 2008 Page 16 USA Economy y/y change GDP grow th (%) Investment (%) Private consumption (%) Exports (%) Imports (%) Current account balance (% of GDP) CPI (y/y, average%) Unemployment rate (%) Govt. budget balance (% of GDP) Public debt (% of GDP) 2006 2.9 2.8 3.1 6.9 5.9 -6.2 2.8 4.6 -1.9 37.0 2007 2.2 -4.9 2.9 8.4 5.9 -5.5 2.8 4.6 -1.2 36.8 2008f 1.7 -3.8 1.6 8.1 1.9 -4.7 3.1 5.0 -2.7 38.0 2009f 2.1 2.0 1.9 5.9 -0.3 -4.2 2.2 5.2 -1.8 38.2 Source: Congressional Budget Office, Erste Bank Research Higher oil price and more restrictive lending policy are the greatest risk to a recovery in 2HY In a difficult environment the US economy has surprised on the upside in the past few months. The collapse of the housing and financial markets had caused massive slowdown of the economy, but this did not continue in 1Q of this year. Rather, the dynamic of the last months of 2007 was more or less sustained, which is a positive surprise. Was this already the stabilization phase before recovery starts or are we still in for another downswing? We tend to believe in the first option, but are less confident than we were, for example, in 1Q. Apart from the never-ending story of rising oil prices, more restrictive lending policies by banks pose the greatest risk to the economy. The US imports 10 million barrels of crude oil daily. In the past 12 months, the oil price has risen by USD 50. Therefore, USD 15bn purchasing power is lost every month. Projected for the full year, the figure is USD 180bn, which is around 1.5% of GDP, which is quite striking. These are the effects that can be measured, but the extent to which the constantly rising oil price is unsettling consumers is shown in the relevant sentiment indicators. The negative effects of the oil price can also be presented in a different light. If the oil price were to remain at the current level, one may assume an average inflation rate of over 3%, which would almost entirely erode any wage increases. The second decisive factor for the economy will be the development of lending practices. According to the latest surveys, the banks are currently tightening lending in other areas as well that are not directly affected by the subprime crisis such as consumption and commercial loans. Even though the harsher terms can still be coped with and explained by the environment at the time of the survey, it is unsure when the situation will ease. The economic stimulation package, stabilization of the oil price, low interest rates and a recovery of the financial sector indicate an improving economy Ultimately, those arguments have more weight in our view that indicates a slight improvement of the economy in the second half-year. In the short term, the economic stimulation package of the government, which refunds some USD 600 to every tax payer, will bring some relief. On the whole, the tax refunds correspond to around 0.6% of GDP. Furthermore, the gasoline price at current levels will probably trigger a change in behaviour among consumers. Lower demand in the US, which is by far the largest consumer, is not expected to remain without effect even if the emerging markets continue to report solid growth rates. Thus, we expect to see the oil price slightly lower to stable, admittedly a courageous stance, but so is any assumption on the further development of the oil price. What should not be underestimated are the effects of the interest rate cuts up to now. It was not even one year ago that the key lending rate was more than 300 bps higher and the swap curve was practically flat; today, the spread to 3M money market rates and 10y swap rates is 180 basis points, which is not a bad setting for a recovery of the banking sector. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 17 USA Real estate market will burden US economy far into next year The correction on the real estate market will remain a burdening factor for the US economy. While sales figures might be bottoming out, the number of unsold homes is still very high. A reduction is inevitable and will definitely last for some time more. However, the situation is different for new homes and resold homes. Progress in inventory reduction has already been achieved in the former. In the past 12 months, the level of inventories declined by 20%. This took place despite the steep drop in sales by around 40% during the same period. This "achievement" was caused by continuously shrinking construction activity. We expect the inventory correction to last around one year. The assumption underlying this assessment is that construction activity and sales figures will stagnate at the current level. In the past 12 months, the stock of unsold home was reduced by almost 100,000. Higher average construction activity in the like periods of comparison would indicate an acceleration of inventory reduction in the coming 12 months, but at the same time, sales figures were higher on average than at present. On the whole, these two effects should offset each other and it seems realistic that inventories will decrease by another 100,000 units in the coming 12 months, which would be a reasonable level. Housing market 1900 1700 1500 1300 1100 900 700 500 300 Q1 1965 Q2 1967 Q3 1969 Q4 1971 Q1 1974 Q2 1976 Q3 1978 Q4 1980 Q1 1983 Q2 1985 Q3 1987 Q4 1989 Q1 1992 Q2 1994 Q3 1996 Q4 1998 Q1 2001 Q2 2003 Q3 2005 Q4 2007 0.5 0 2 1.5 1 New Home Sales Housing Vacancy, r.s. Single Housing Starts 3 2.5 Source: Bloomberg, Census Bureau The situation is different for resold (existing) homes. Apparently the number of homes coming into the market equals more or less the number of homes sold and thus the inventory level has hardly changed up to now. The surge in foreclosures seems to be having an impact in this context. Since April 2007, 2 million applications for foreclosures were registered. By way of comparison: The number of properties for sale is currently around 4.5m, which is 2 million more than the equilibrium level. The foreclosures are expected to peak soon, but supply will continue to burden the market. Accordingly, prices will remain under pressure and the adjustment of the market in this case will also last well into next year. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 18 USA Homes for sale 700 New homes for sale, annual in ´000 600 500 400 300 200 100 0 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Existing homes for sale, mn r.s. 5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 Source: Bloomberg Consumers have fared well in the difficult environment up to now - the housing market crisis alone is not expected to change this Decisive for the further course of the economy will be how consumers - the backbone of the US economy - survive these crises. In fact, the environment right now is pretty gloomy. Apart from the price plunges on the housing market, the highly indebted US households are exposed to an inflation rate of over 4%. Sentiment indicators have developed accordingly, but as regards spending, "only" the effects of inflation have been observed; in real terms some (marginal) increases have been reported. This means that restraint in spending due to the uncertain environment has not been observed up to now. It is possible that the tax refunds checks, which are now being mailed, have boosted the propensity to spend even in advance. What is also crucial is the fact that the labour market has declined but not collapsed. The acid test for consumer sentiment is what consumers will do with the USD 600. This will reveal the real sentiment among consumers. At present, it seems as if households would be able to survive the difficult phase, but it is still too early to shut off the alarm. It is quite feasible that spending propensity has not yet hit the bottom and the cumulative effects of the financial market crisis, the housing crisis and energy prices have not yet fully reached consumers. This is even truer considering that the downswing on the housing market is still underway and energy prices have been on the rise until recently. Nonetheless, we expect the oil price to at least stabilize or even decline a bit. On the financial markets, the normalization of the situation is expected to continue. Thus, only the real estate market remains a problem in which the correction is expected to last far into next year. Consumers should be able to cope if this is the only burdening factor and therefore, we expect a weak, but still positive development of consumer spending in the second half of the year. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 19 USA US-Indicators 200 1.2 150 0.7 140 100 50 0 -50 -100 Jul-07 -0.9 Retail Sales, m/m r.s. Non-farm payrolls, in ths Nov-07 Dec-07 Aug-07 Sep-07 Oct-07 -76 Jan-08 -76 Feb-08 -80 Mar-08 Apr-08 50% 45% 40% 8% 35% 6% 4% 2% 0% 10% -2% -4% Profits annual. Financial Gap Debt Outstanding r.s. 2Q 2Q 2Q 2Q 2Q 2Q 2Q 2Q 2Q 2Q 2Q 2Q 2Q 2Q 2Q 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 5% 0% 30% 25% 20% 15% 1.5 1 0.6 0.2 0 60 41 -0.5 -20 0 -0.2 -0.5 -1 -1.5 0.5 0.4 0.2 74 57 81 Source: Bloomberg Solid profitability of companies good for labour market One of the reasons for the robustness of the labour market and thus for the entire US economy is probably the solid situation of companies. A comparison of the current situation with the year 2000, for example, shows higher profitability of US companies. Earnings are one-third higher in relation to GDP, while debt in relation to GDP is the same. The internal financing of investments is still relatively high, but still below the level of the year 2000. What is critical is the relation between internal financing and earnings, and this has been constant for several quarters. This shows that investments are being made efficiently. Critical for the labour market and thus consumption is the fact that high profitability gives companies room for manoeuvring. They do not need to respond to slower revenue growth immediately by cutting jobs. But the longer demand remains weak, the more likely job cuts become. Corporate key data, in % of GDP 12% 10% Source: Bloomberg, Federal Reserve Financial institutions are still hoarding liquidity, relief at the earliest in July Looking ahead the development of lending practices will be a crucial factor for companies. Banks have tightened their lending policies even more in the course of this year to date, which is not surprising in the light of the financial market crisis. In April, the time of the last survey among banks, the shock of the just barely avoided insolvency of Bear Stearns still had everyone shaking. The financial markets have stabilized since then in many areas, but the situation on the interbank market is still tense. Money market rates are still very high, which implies that banks are hoarding liquidity and thus Page 20 Euro-Visions Economic and Capital Market Forecast, June 2008 USA restrictive in their lending practice. Apparently, it is still believed possible that individual banks might fall into serious difficulties due to the need for more write-offs, and banks want to be prepared. The earliest point in time that we will see a calming on the interbank market will probably be after the release of the quarterly reports by major US financial institutions in July. This will show the extent of the decline in the write-offs versus the preceding quarter, which may be viewed as an indication of future trends. Risk premium on the interbank market (3m Libor - 3m Treasury Bill) 3 2.5 2 1.5 1 0.5 0 Nov-06 May-06 May-07 Nov-07 May-08 Mar-06 Mar-07 Sep-06 Sep-07 Mar-08 Jan-06 Jan-07 Jan-08 Jul-06 Jul-07 Source: Bloomberg We expect inflation to decline Despite the apparent weakness of the US economy, inflationary fears keep cropping up. The magnitude of the price increases apparently carries the risk of inflation spreading to other areas of the economy. At the same time, this has not happened yet. The core rate (excl. energy and food) has been moving sideways after a slight increase at the end of last year. Even though there are inflationary risks, the arguments against an acceleration of inflation carry more weight in our view. What must be mentioned first is surely the persistent sluggishness of the economy in the US. Although the situation will improve in the second half of the year, it will not be strong enough to keep price increases from being a risk for companies. We do not expect further significant inflation in the food component, because harvests are forecast to be good this year. The probability statistics also point in the same direction. A similarly bad harvest like in the previous year happened last time at the beginning of the 1960s, and therefore an improvement is the least one can expect. The negative development on the housing market is expected to ultimately have an impact on the inflation rate, which it has not done up to now. The US basket of goods only considers rents and they have not reacted to declining home prices up to now. This decoupling will only be possible for a limited time though, because the offsetting mechanism of the markets should kick in. Finally, as regards the oil price - we admit this is the most audacious of our assumptions - we expect the oil price to stabilize, because the global weakening of the economy together with the most recent price levels reached should have an effect on (anticipated) demand. Even though it cannot be ruled out that the oil price will continue to defy the forces of supply and demand, it is the most unlikely scenario on the whole. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 21 USA Inflation y/y 5 4.5 4 3.5 3 2.5 2 1.5 1 CPI Core rate 0.5 0 Dec-06 Dec-07 Aug-06 Aug-07 Aug-08 Dec-08 Apr-06 Apr-07 Oct-06 Oct-07 Apr-08 Feb-07 Feb-08 Jun-06 Jun-07 Jun-08 Oct-08 CPI Forecast Source: Bloomberg Monetary policy No need for action by central banks until 2009 There will not be much work for the US Fed in 2HY. A sluggish economy, falling inflation rates and normalization on the financial markets indicate unchanged interest rates. Where are the risks? At least for 3Q, they are pointing downwards for the economy and interest rates. A wave of bad news from banks and from the economy is possible, even though it does not seem likely now. Delays, overlapping and accounting policies make it difficult to asses which of the negative effects have already been digested by the real economy or how many write-offs are yet to come, not to mention the persistently gloomy situation on the real estate market. On the other hand, the probability that interest rates will be raised before the end of the year is very low in our view. This would require the economy to jump start fast enough to convince the Fed. The tax package will support a solid development of demand over the summer, but the Fed will hardly derive a selfsustaining upswing from this, and even if it were true, it would still have to be accompanied by an increase in the core inflation rate to trigger a tightening of monetary policy. Bond market Steepening yield curve For now, we hardly expect any movement on the bond market, but until year end, the yield curve could steepen starting out from the long end. The current yield level is commensurate with the economy and with the risks in our view. Another wave of bad news irrespective of whether from the economy or financial markets would push yields down again, and this is in our opinion the greatest risk to our forecast. A historic comparison illustrates the developments of the past year very well. While it took around three years for the trend to move from the peak of the dot.com bubble to the low of the Iraq war, a similarly hefty change of the yield curve took place within eight months as a consequence of the financial market crisis, albeit starting out from a somewhat lower level. The stabilization of the financial markets triggered a flattening of the yield curve that was determined strongly by the correction in interest rate cut expectations. Now we have entered into a phase of unchanged key lending rates, which should give the short end stability. However, the long end will react to the stabilization of the economy and diminishing insecurity with a rise in yields. The risk here as well is that sentiment will dim again before and yields will drop. The short maturities are set to profit more from this than long maturities, but we still do not expect a slope of the yield curve like the one Euro-Visions Economic and Capital Market Forecast, June 2008 Page 22 USA last seen in mid-March. Overall, we expect a steepening of the curve, which, if at all, could start from the short end temporarily. Generally, we recommend overweighting the short maturities. Cyclical yield curve shifts 7 6 5 4 3 2 1 0 2y 5y 10y 30y Dot com bubble End of Iraq war Before financial market crisis Bear Stearns rescue Current Source: Bloomberg Dollar EUR/USD to drop below 1.5 only in 4Q The stabilization of interest rate expectations for the US led to an end of the plunge of the greenback in April. The expected trend of the interest rate spread seems to be the determining factor for the further course of the exchange rate. The fact that the interest rate spread to Euroland is considerable and will probably remain wide for the time being should not be sufficient to push the USD to a new low, but just enough to offset the historically extremely low exchange rate. In other words, there have to be very good reasons not to sell the euro at the current high level such as an interest rate spread of more than two percentage points on the money market. However, the development of interest rate expectations indicates a slight firming of the USD in the course of the second half-year. Due to the recent shift at the ECB, we might still have to wait for a recovery of the USD, because the central bank recently transferred its focus to inflationary risks again. In line with interest rate speculations, the euro might still remain high versus the US dollar in 3Q. Ultimately though, the weaker economic data from Euroland are expected to deflate interest rate hopes in the market. Over the mediumterm, the very low valuation of the US dollar and an improved macro-economic environment in the US point to a firming. This is all the truer considering the unusually strong support for the US dollar from the Fed Chairman just recently. Mr. Bernanke stressed the close attention that the central bank was devoting to the effects of any changes to the exchange rate of the USD on inflation and inflationary expectations. Such statements belong to a different category than the past statements by the diverse secretaries of the Depart of the Treasury (strong dollar policy). The difference being that Mr. Bernanke's statements could be followed by action, if necessary. Should the USD slip again, the Fed apparently has the intention of taking countermeasures. Rainer Singer Euro-Visions Economic and Capital Market Forecast, June 2008 Page 23 Croatia Real GDP (grow th y/y %) Private Consumption (grow th y/y %) Fixed Capital Formation (grow th y/y %) CPI (y/y, average%) Current account balance (% of GDP) Govt. budget balance (% of GDP) Short term interest rate (3 months) year-end Long term interest rate (10 years) year-end Loc. Curr./EUR year-end 2006 4.8 3.5 10.9 3.2 -7.9 -3.0 4.6 4.7 7.35 2007 5.6 6.2 6.5 2.9 -8.6 -2.3 6.9 5.5 7.33 2008f 4.6 3.9 6.3 5.2 -8.1 -2.8 6.0 5.3 7.30 2009f 4.8 3.8 9.0 3.2 -7.9 -3.0 5.0 5.0 7.27 Economy GDP growth moderating in 2008 After a robust 1H07, economic activity slowed down in 2H07, rising 5.1% y/y in 3Q and 3.7% y/y in 4Q07, and thus bringing the FY07 figure to a solid 5.6% y/y. The growth drivers were unchanged. Thus, private consumption continued to contribute strongly, growing 5.6% y/y on average in 2H07. Fixed capital formation moderated, as a high base and tighter monetary conditions burdened investment activity, which slowed to 4.9% y/ y growth in 2H07. Public consumption remained supportive, as the November parliamentary elections stimulated fiscal expenditure. The external balance remained the weak point, despite the fact that, on the yearly basis, imports were only a notch higher than exports (5.8% vs. 5.7%), as export activity failed to expand at a more robust pace and thereby moderate the imbalance. For 2008, consumption should be less supportive than in 2007, due to the deteriorating purchasing power, which is in turn due to the higher inflation rate and lower availability of credit in real terms. Investment activity should remain supportive overall. Nevertheless, some moderation with respect to 2007 may be expected, as credit conditions are tighter and construction activity is not expected to offer as strong support to investment activity as in previous years. Also, public consumption in a post-election year should contribute to a lesser extent than was the case in 2007, while the external balance is unlikely to offer significant improvement. Therefore, our GDP forecast for 2008 is set at 4.3%. The current account deficit widened in 2007 to 8.6% of GDP, again driven by the poor trade balance performance (which exceeded 25% of GDP). The service sector performed well, driven by solid tourist sector performance. Financing was comfortable, as FDI inflows accounted for 9.7% of GDP, thus easing the pressure somewhat on debt-creating financing. Significant positive developments are not expected in 2008, as the trade balance deficit (boosted by higher food and energy prices) should continue to burden the current account, thus putting our estimate at slightly below 9% of GDP. GDP and inflation development 12 11 10 9 8 7 6 5 4 3 2 1 0 2001 2002 2003 2004 2005 2006 2007 2008 6.4 6.2 6.0 GDP in constant prices, % yoy (LS) 8.0 Forecast CPI, % yoy (LS) 7.8 Forecast HRK/EUR, eop (RS) 7.6 Forecast 7.4 7.2 7.0 6.8 6.6 Source: CNB, CBS, ESB Euro-Visions Economic and Capital Market Forecast, June 2008 Page 24 Croatia Inflation pressure persists The end of last year and the first months of 2008 brought intensified inflation pressures, peaking at 6.2% y/y in January. Food and energy prices continued to provide the greatest contribution to the inflation pressures. As the pressures are coming from the supply side, there is relatively little room for maneuver. The government tried to ease the pressures by making an agreement with the large retailers and postponing hikes of some regulated prices. However, the government had to abandon the retail gasoline price ceiling. Thus, gasoline prices remain under constant upward pressure. Monetary policy options are rather limited. Hence, the central bank will continue to maintain exchange rate stability and fine-tune interest rate levels to moderate eventual demand pressures in the economy. The pressures are expected to last in the coming quarters, as some administrative prices should eventually be hiked and food and oil prices are likely to remain on an upward trajectory. Therefore, we see the average inflation rate at close to 6% in 2008 and anticipate a slowdown towards the year-end, as the base effect unwinds. Monetary policy Monetary policy framework unchanged The CNB continues to stick to the present monetary policy setup, having only marginally changed the regulation. The CNB continues to aim for credit growth at 12% p.a. and wants to keep banks' incentives for financing credit activity abroad at low levels by keeping the obligatory and marginal reserve requirement at prohibitively high levels (given the level of international interest rates). As a result, the orientation of banks has shifted more strongly toward domestic sources of financing, thus producing some pressure on deposit and lending rates, which the CNB would not likely oppose, given the inflation pressures. Also, we do not anticipate a significant easing of the monetary stance, at least in a scenario in which credit growth should stand close to the targeted 12% level, which the CNB sees as adequate to support credit growth. Capital markets Exchange rate to remain stable The exchange rate moved in the expected 7.25-7.35 band throughout the previous six months, close to the lower part of the band. The beginning of the year brought stronger appreciation pressures, driven by low kuna liquidity and the changing CNB attitude towards repo tenders, as the central bank was reluctant to offer excess liquidity to the markets and support a stable exchange rate as the base anchor in controlling inflation pressures. Afterwards, the situation stabilized and the exchange rate performed in a very stable manner (7.25-7.28), with pressure shifting directions from time to time, but failing to move the exchange rate out of this interval. Typically, as the tourist season approaches, the pressure on the appreciation side should intensify somewhat, bringing the exchange rate into the 7.20-7.25 band. Nevertheless, we do not anticipate a significant deviation from this band on the appreciation side. After the season, the pressure should ease, and we expect the exchange rate in the stable 7.25-7.35 band, with rather low volatility. Overall, this would mean a 1% stronger exchange rate on average than in 2007. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 25 Croatia Spreads on pure kuna bond 350 300 250 200 150 100 50 0 -50 -100 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 2010 2015 2017 Source: ESB, Reuters Financial markets: Stabilization after turbulent beginning of year The beginning of 2008 brought additional pressures to the money market, thus continuing in the turbulent manner seen since 2H07. As mentioned earlier, the low kuna liquidity and CNB decision to keep liquidity tight brought on nervousness among market participants. Gradually, the situation stabilized and interest rates normalized to the region close to 6%. The money market is expected to remain sensitive to short-term liquidity shocks and, on average, MM rates should remain above 2007 levels. The bond market also suffered at the beginning of the year, driven by money market developments. Also, the unfavorable real interest rate developments burdened the bond market performance. The yield curve first shifted to 6%, but, along with the stabilization on the money market, the curve then shifted downwards to the 5.6-5.8% region and has remained stable in the past few months. The outlook is rather unclear, as the saturation of demand and lasting inflation pressures are unsupportive. However, lower supply and the expected inflation moderation could support bond performance. In any case, a significant oscillation from the present levels is not expected. Alen Kovac Euro-Visions Economic and Capital Market Forecast, June 2008 Page 26 Romania Real GDP (grow th y/y %) Private Consumption (grow th y/y %) Fixed Capital Formation (grow th y/y %) CPI (y/y, average%) Current account balance (% of GDP) Govt. budget balance (% of GDP) Short term interest rate (3 months) year-end Loc. Curr./EUR year-end 2006 7.9 11.4 19.3 6.6 -10.4 -1.6 8.6 3.38 2007 6.0 10.2 28.9 4.8 -13.9 -2.3 8.4 3.61 2008f 6.1 9.2 22.5 7.8 -14.2 -2.7 10.0 3.50 2009f 6.0 8.5 16.5 4.9 -14.1 -2.7 7.3 3.50 Economy Stronger economic growth expected in 2008 Economic growth stood at 6% in 2007, above market expectations. Investments in construction were very strong last year, mitigating the negative contribution of agriculture to GDP formation. Industry remained rather modest, influenced by the low activity in the mining and energy sectors; manufacturing, a sector with important export potential, saw good development. 2008 might bring considerably higher economic growth, following further investments in construction, better results for agriculture and improved collection of indirect taxes for the consolidated state budget. Assuming an exceptional agricultural year, real GDP growth could exceed 7%. GDP growth RON bn 600 500 400 300 200 100 0 -100 2004 2005 2006 2007 2008f % 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Final consumption Net exports Source: BCR, Statistical office Gross capital formation real GDP growth rate (rhs) Late summer should bring disinflation process The annual inflation rate continued to increase in 1Q08 and reached 8.63% y/y, above the central bank's forecast. Inflation was driven by increases in administered prices, the higher oil price on international markets and RON depreciation in early 2008. The inflation outlook for the rest of the year depends heavily on the results of domestic agriculture, especially as food products currently have a share of 37.5% in the CPI basket. Some uncertainties also arise from administered prices (gas and electricity), as there is no official calendar for future hikes and 2008 is an election year in Romania. According to our scenario, the inflation rate should peak in July, while August should represent the beginning of a disinflation process, triggered by a base effect and lower food prices. The evolution of the national currency also plays a crucial role in our scenario. We expect lower RON volatility compared to 2007, with a positive impact on the inflation rate through services tariffs and prices for imported goods. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 27 Romania Forecasted inflation and key rate development 12.0 10.0 8.0 6.0 4.0 2.0 Mar-08 Jun-08 Inflation rate Sep-08F Key rate Dec-08F Source: BCR More stable C/A deficit compared to 2007 The current account deficit slowed down significantly in 1Q08. The trade balance had a considerably improved performance in early 2008, which could translate into low but sustainable RON appreciation in the long run. The more mature consumer markets and RON depreciation contributed to an import slowdown, while the export acceleration was determined by the improved supply of the local manufacturing industry (automotive), following significant FDIs in recent years. In January-February, the export growth rate outran that of imports. We expect high FDIs in the coming months, based on increased business relocation of foreign investors and the completion of the privatization process of the last state-owned companies. FDIs could reach EUR 7.8bn this year. Some risks to the C/A deficit may arise from a possible slowdown in remittances and a wider income balance deficit, as a result of higher outflows of dividends and interest payments. Monetary policy Central bank to maintain restrictive monetary policy in 2008 The central bank strengthened the monetary policy beginning in 4Q07 by increasing the key rate by a total of 275bp and firming control over money market liquidity via open market operations. These decisions came as a response to the higher inflation rate and sharp RON depreciation. Until now, short-term money market rates have mirrored the central bank's move, positioning above the key rate. It is very likely that the central bank will maintain a restrictive monetary policy until mid-2009, in order to reach the inflation target for next year. The monetary policy transmission mechanism has a lag of 2-3 quarters, so the maximum effect of a hike of the key rate will be visible in the future. Central bank officials said recently that the NBR will change its role in the banking system. Currently, the central bank draws deposits from banks, but the situation will change and it will become a creditor for the local banking sector. As a result, the interbank market will change gradually from a market with a liquidity surplus into a market with refinancing needs. At the same time, monetary policy will be more efficient. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 28 Romania Capital markets FX rate strongly linked to international context In 2007, the average RON FX rate appreciated considerably (+5.4% in nominal terms), to 3.33 against the EUR (from 3.52 in 2006), while in 2H08 it is expected to hover at a more stable level of 3.5-3.7, based on a more cautious approach among short-term investors in the aftermath of the sub-prime crisis. The central bank has shown great determination recently and sent out clear signals that they want to make sure that the inflation outlook is on the right track. Since the beginning of 2008, the central bank has reinforced the sterilization process, draining excess liquidity in the market as often as twice a day. This led to an increase in short-term interest rates to close to the key rate. This process is expected to continue in the second part of the year, while the official reserves will be kept at a comfortable level. The government targets a budget deficit of 2.3% of GDP in 2008. After the first budget revision in early March (from 2.7% to 2.3%), which represents a positive signal for the domestic and international markets, as it shows the government's commitment to increasing efficiency in public spending, the second revision will most likely happen in June. However, the planned deficit target is likely to remain unchanged. The government will struggle to keep expenditures under tight control, but a slightly upward deviation from the target should not raise concerns if this can be attributed exclusively to CAPEX. This year, the MoF plans to issue securities amounting to EUR 3.3bn, including 15Y maturity T-bonds. So far, five out of 19 tenders were called off, most of them in March. Total state securities issued this year amounted to EUR 1.2bn, out of which EUR 637mn were in short-term debt instruments. The planned Eurobond tender scheduled for 4Q07 has been postponed again, due to the appearance of consistent resources from the privatization process. The MoF is now waiting for an improvement on international markets and a spread reduction. More prudent expenditure policy in 2008 Cristian Mladin cristian.mladin@bcr.ro Eugen Sinca eugen.sinca@bcr.ro Euro-Visions Economic and Capital Market Forecast, June 2008 Page 29 Serbia Real GDP (grow th y/y %) CPI (y/y, average%) Current account balance (% of GDP) Govt. budget balance (% of GDP) Short term interest rate (3 months) year-end Loc. Curr./EUR year-end 2006 5.7 12.8 -11.7 0.2 15.6 79.0 2007 7.3 6.8 -16.8 -1.0 10.3 79.0 2008f 6.3 8.2 -16.0 -0.5 10.7 78.0 2009f 6.8 5.1 -16.2 -0.5 9.7 76.0 Economy Politics still in spotlight Since the last Eurovisions, political issues have dominated, as the government split up over the Kosovo issue. After the unilateral proclamation of independence by Kosovo, the ruling coalition was unable to reach a consensus over the course of policy, resulting in new parliamentary elections at the beginning of May. The results were a surprise, as the coalition around President Tadic's DS party won a comfortable majority (38.7% of votes and 103 out of 250 places in the Parliament) over the radical SRS (29.1%; 77 seats) and PM Kostunica's DSS (11.3%; 30 seats). The post-election math brought the no. 4 socialist party SPS (the party of former president Milosevic) to the forefront, as they could be the decisive factor for the other leading parties. Negotiations are proceeding. It is still unclear which option will prevail, and it would not come as a surprise if we see long-lasting negotiations, as was the case in 2007. A government led by democrats would boost Serbia's EU prospects and the accession process would accelerate. Also, capital inflows would also favor this outcome, spurring additional investment activity. A government comprised of radical parties would have a negative effect on the EU prospects, implying greater macroeconomic risks. On top of that, Serbia has failed since 2006 to establish a relatively stable government, making the institutional framework harder to operate and further structural reforms a struggle. Economic activity accelerated in 2007, as GDP growth picked up to 7.5% y/y. The service sector remained the main growth driver, as wholesale and retail trade (+19.3% y/y) contributed strongly to the GDP growth. Also, transport and communications (+24% y/y) and financial intermediation (+20.3% y/y) were supportive. Hence, GDP growth remains largely driven by domestic demand, which has been boosted by the continuation of strong wage growth trends and still robust credit growth. However, in 2H07, economic activity moderated somewhat, as rising inflation negatively affected purchasing power, while agricultural and construction activity were sluggish. As far as 2008 is concerned, we expect a slowdown, but a still rather solid GDP growth rate - in excess of 6%. The drivers should remain unchanged, but at somewhat more moderate rates. In particular, a lower contribution from consumption spending is expected, as it should remain burdened by inflation pressures. We see real wage trends stabilizing in the course of 2008. On the other hand, the external balance has brought rather unfavorable trends, as the C/A deficit widened from 9.8% to 13.2% of GDP, due to the deterioration of the trade balance performance (the trade balance deficit reached 22% of GDP). Traditionally, current transfers had a large offsetting role. At present, external imbalances remain pronounced, implying relatively high financing needs. This is another reason why Serbia should seek to avoid raising political and macro instabilities, in spite of its sizable international reserves (covering roughly 50% of total foreign debt). As expected, inflation pressures persisted throughout 1H08, bringing the retail price index back above 10% to 11.6% y/y in May. Inflation drivers are more or less well known: food prices continued to add pressure, accompanied by rising oil prices. The weaker exchange rate also had a negative affected via imported inflation. Hence, given the pressures on the supply side and rising inflationary expectations, the average inflation rate in 2008 should be significantly higher than in 2007 (we see it in the 10-11% band). Also, as the unfavorable base effect should reverse towards the year-end and pressures could weaken somewhat, we anticipate a downward trend, bringing the headline rate back to the single-digit zone. Page 30 Robust GDP performance followed by rising external imbalances Inflation back to double-digit zone Euro-Visions Economic and Capital Market Forecast, June 2008 Serbia Monetary policy NBS in hiking mode In the last six months, the NBS has significantly tightened its monetary stance, hiking the 2W reference rate extensively, from 9.50% to 15.75%. The rate hikes were fuelled by rising inflation pressures, which forced the NBS to take a more aggressive and cautious approach. The NBS used the interest rate differential to support the exchange rate, as the dinar lost ground, due to the political instability. Overall, the NBS' behavior has not been a surprise, as both inflation and exchange rate developments have indicated interest rate moves. Although we expect the NBS to remain cautious, we do not anticipate further significant rate hikes, as long as the exchange rate does not come under severe depreciation pressure. At present, it is too early to address when the NBS could go for rate cuts, as inflation pressures still exist. Nevertheless, there could be some room towards the year-end if inflation pressures moderate. Regarding the prudential measures, only minor changes occurred. Hence, the monetary framework remains tight, as reserve requirements for foreign and FX financing remain high (45%), while the NBS' measures are directed towards stimulating dinar savings, which are subject to a 5% reserve requirement. Thus, the monetary framework should seek to stabilize monetary trends, moderate credit growth, shift the preferences away from consumer household loans (since the beginning of the year, banks are allowed to extend consumer credit to households only up to 150% of the bank's capital) and lower demand pressures in the economy. Development of the exchange rate and interest rates 30.0 BELIBOR3M (%) 2W repo rate (%) EURRSD (rhs) 90 88 86 84 82 15.0 80 78 10.0 76 74 72 0.0 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Source: NBS, Reuters 25.0 20.0 5.0 70 Euro-Visions Economic and Capital Market Forecast, June 2008 Page 31 Serbia Capital markets Turbulent FX market developments As could have been assumed, exchange rate developments remained highly sensitive to political developments. After some appreciation pressures in 4Q07, the situation reversed; towards the year end, the exchange rate hovered around 80 RSD per EUR. Afterwards, Kosovo's proclamation of independence and the government split triggered additional depreciation pressures, which brought the exchange rate to the 84 level, triggering NBS rate hikes to support the dinar. Since then, the exchange rate has been hovering in a rather broad range of 79-83 RSD per EUR, showing rather high volatility and sensitivity to political developments. Volatility is expected to remain pronounced as long as the political situation remains unresolved. The NBS should strive to keep the exchange rate stable, in order to preserve macro and price stability. While we see the exchange rate coming under appreciation pressure in the mid run (due to strong capital inflows), for the immediate future, uncertainty over the political outcome is keeping the outlook quite opaque. Alen Kovac Euro-Visions Economic and Capital Market Forecast, June 2008 Page 32 Slovakia Real GDP (grow th y/y %) Private Consumption (grow th y/y %) Fixed Capital Formation (grow th y/y %) CPI (y/y, average%) Current account balance (% of GDP) Govt. budget balance (% of GDP) Short term interest rate (3 months) year-end Long term interest rate (10 years) year-end Loc. Curr./EUR year-end 2006 8.5 5.9 6.6 4.5 -7.2 -3.6 4.7 4.3 34.6 2007 10.4 7.1 7.1 2.8 -5.3 -2.2 4.3 4.8 33.6 2008f 7.6 5.8 8.0 4.2 -3.7 -2.0 3.7 4.8 30.1 2009f 6.0 5.5 6.0 4.0 -3.5 -2.4 4.7 5.1 30.1 Economy Economic growth to slow down After reaching a strong 10.4% last year, Slovak economic growth will slow down this year to around 7.5%, due to the smaller contributions from key industrial sectors. The automotive, machine building and electronics industries are likely to increase their production to a lesser extent than they did last year. Although smaller than in 4Q07, the first quarter GDP growth reached a still rapid pace of 8.7% y/y, according to the flash estimate from the Slovak Statistical Office. The detailed GDP growth has not been released yet, but we suspect domestic demand (household consumption and gross investments) to be the main growth driver (judging by the strong retail sales and employment gains). At the same time, net exports likely contributed positively to the growth. For the first time in 13 years, we expect the trade balance to finish the year with a mild surplus in 2008. The surge in global food prices continues to weigh on price growth, as HICP inflation increased to 3.7% y/y in April, compared to an average of 2.4% y/y in the fourth quarter of 2007. Inflation is still likely to see a peak, though, as we expect further acceleration to around 4.3-4.5% in the summer months, before a retreat to around 3.5% by the yearend. This includes the one-off impact of the excise tax hike on cigarettes, which should fuel inflation once last year's inventory is sold out (the impact on HICP inflation should be about 0.4pp). On the other hand, the conversion rate will likely be stronger than previously assumed and will hence play an anti-inflationary role. We also increased our estimate for food price growth (it stood at 8% y/y in April), which provides uncertainty to the inflation forecast. We also regard energy prices as an upward risk to our base forecast after the significant oil price growth (this was to some degree mitigated by the exchange rate strengthening). Slovakia should become the next addition to the Eurozone in 2009, after the country met all of the Maastricht criteria. Although the ECB voiced 'considerable concerns' over inflation sustainability during the euro criteria evaluation (the issue posed the biggest uncertainty to the success of Slovakia's euro bid), the European Commission gave the recommendation that Slovakia adopt the euro in 2009. The bid still needs approval by EU bodies, but this is seen as a formality after the EC's favorable assessment. The only open issue is the level of the conversion rate, which should be formally announced at the beginning of July. An indication of the possible conversion rate is the new ERM-2 central parity, which was revalued on May 28 to 30.1260 SKK/EUR. While there is a good probability that this will be the conversion rate, the politicians will make the final decision. Slovak policy rates have remained intact for more than a year now. While we expected the NBS to follow ECB steps as soon as Slovakia's euro adoption was confirmed, CB Governor Ivan Sramko suggested a delay in alignment with the ECB in May, when he said that harmonization with the ECB would not be logical at present. However, since an independent monetary policy will be ineffective once the euro conversion rate is known, we still regard early harmonization of policy rates as the more likely scenario (i.e. by July or August). Whether an early or late harmonization is chosen, Eurozone Page 33 Food prices led inflation up Euro to become reality in 2009 Central bank to deliver final rate cut Euro-Visions Economic and Capital Market Forecast, June 2008 Slovakia rates will be valid for Slovakia from the beginning of next year. Since we now expect the ECB to keep rates intact this year, this would mean only one 25bp rate cut to 4.0% by the year-end, instead of the previously anticipated 75bp. Since market rates in the Eurozone are significantly above the ECB base rate, Slovak market interest rates might increase by the year-end, despite the NBS rate going down. Monetary policy Free reign for koruna to strengthen On the FX market, the koruna saw a huge rally after the EC's positive verdict that paved the way for Slovakia to adopt the euro in 2009. Encouraged by bullish comments by government politicians, markets pushed the koruna up in anticipation of a strong euro conversion rate. Half a year ago, we wrote in Eurovisions that the conversion rate would depend on the equilibrium estimated by the central bank and the spot market rate. In the end, after the central bank ceased to voice its discontent with the koruna's strength, the political view prevailed and the ERM-2 central parity was revalued to the bottom margin of the ERM-2 band at 30.1260 SKK/EUR. This level is seen as the most likely level of the euro conversion rate, once it is formally announced at the beginning of July. However, there is a non-zero risk of a stronger conversion rate. Central parity was revaluated to bottom boundary of ERM-2 45 40 35 30 EURSKK ERM-2 central parity +/-15% band 25 2005 2006 2007 2008 Source: Reuters, SLSP Capital markets Bond spreads declined, thanks to Eurozone, koruna In general, Slovak T-bond yields have continued to follow the development in the Eurozone. After Slovakia received an invitation to join the Eurozone in 2009, the bid spread between Slovak and German 10Y T-bonds declined from around 60bp in 1Q08 to 40bp at the end of May. In the next couple of months, Slovakia might see rating upgrades (reflecting the success of the euro bid), which should act in favor of spread compression. On the other hand, the strengthening of the koruna may have played an even stronger role in the spread decline. After the conversion rate is set, the currency will no longer contribute to additional profit; hence, its compressing impact on spreads should vanish. In general, we expect the 10Y bond spread within 10-30bp once in the Eurozone, but this assumes that the liquidity premium in the Eurozone declines to a 'standard' level. Michal Musak Maria Valachyová Euro-Visions Economic and Capital Market Forecast, June 2008 Page 34 Czech Republic Real GDP (grow th y/y %) Private Consumption (grow th y/y %) Fixed Capital Formation (grow th y/y %) CPI (y/y, average%) Current account balance (% of GDP) Govt. budget balance (% of GDP) Short term interest rate (3 months) year-end Long term interest rate (10 years) year-end Loc. Curr./EUR year-end 2006 6.4 5.4 5.5 2.5 -3.0 -2.9 2.7 4.1 28.0 2007 6.6 6.1 5.6 2.9 -3.2 -1.9 4.1 4.7 26.9 2008f 4.3 3.6 5.8 6.1 -3.6 -2.9 4.1 4.5 25.9 2009f 5.4 3.7 7.9 4.3 -2.2 -2.7 4.6 4.7 25.3 Economy Economy resilient in 1Q, slowdown to be shallower than originally thought The economy grew at 6.5% in 2007, marking the third year in a row in which the economy grew at over 6%. As opposed to 2005 and 2006, the primary driver of the growth was not net exports, but household consumption, which expanded by 5.7% in real terms in 2007. As for 1Q08, the economy proved somewhat resilient - even though most observers expected a quite sizeable slowdown in household consumption (due to the drop in real wages) and a subsequent brake on growth to below 5%, the economy grew at a still healthy 5.4% in the first quarter. This was mainly due to the good evolution of foreign trade for most of 1Q, which, coupled with industrial production, helped the labor market and aggregate wages (unemployment slid to as low in 5.2% in April), and thus limited the impact of higher inflation. What do we expect for the remainder of the year? Although the US has probably narrowly escaped an outright recession, the effects of the US slowdown (and only mild and protracted recovery) will be felt in Europe in the coming quarters. We thus anticipate a slowing of Czech growth, in response to the moderation in the economies of Czech trading partners, albeit not as dramatically as it had appeared at the end of 2007. Although a few recent indicators (March retail sales, foreign trade and industrial production) were well below expectations, it is premature to conclude that this is the beginning of a downward trend (especially in light of the still robust 1Q EU growth). Rather, only once the EMU economies slow in 2Q/3Q will we also see the Czech economy slow to below 5% growth. The average for FY08 is thus seen at 4.9%. GDP growth (%) 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 GDP y/y (%) Forecast Source: CS estimates, Czech Statistical Office Euro-Visions Economic and Capital Market Forecast, June 2008 Page 35 Czech Republic Consumption will still be supported by the solid labor market performance - the labor market is slow to respond to the real economy (thus, the slowdown will not be reflected there) and will still provide a cushion to aggregate spending. Also, slowing inflation should help real wages. All of this together points in one direction - consumption should not drop as much as originally thought and should help the economy grow at close to 5% in 2008. Inflation to moderate on currency, base effects Qualitatively, the inflation situation did not change much since the last issue of this report. A host of factors combined around the end of 2007 and the beginning of 2008 to propel inflation to above 7% in January 2008 - rising food prices (a global phenomenon), energy prices (also a global phenomenon) and administrative measures (fiscal reform) were all behind the recent inflationary spike. Demand inflation still remains relatively subdued, although some pickup is visible there as well. Due to the nature of the shocks that sent inflation to a 10Y high (1Q average was 7.4%), we expect it to revert back to under 4% towards end of the year. This will be due essentially to two reasons - base effects and the strong CZK. While the former is pretty self-explanatory, the latter is worth elaborating on. The CZK is some 10% stronger than it was a year ago; this alone helps to keep a lid on prices (via lowering the prices of imports and indirectly via discouraging domestic producers from increasing prices of those products that have foreign substitutes). One example of the beneficial influence of the CZK on inflation comes from oil products - these would likely have been nonnegligibly pricier had it not been for the offsetting effect of the strong currency. On top of this, the expected slowdown of the economy will also provide a disinflationary stimulus, albeit a mild one (the economy will not slow substantially). Undoubtedly, risks to this scenario abound - further increases in (notoriously volatile and hard to predict) food and energy prices and a deeper slowdown in the European Union would all mean higher than expected inflation for a longer than expected period. Monetary policiy Monetary policy groping for direction Monetary policy is torn between a tight labor market, better than forecast real economy in 1Q, elevated inflation and oil prices breaking record after record on one hand, and a strong currency and the uncertain outlook in the Eurozone on the other. The latest prognosis of the Czech National Bank assumes a limited impact of the higher headline on inflation expectations (the changes made to the CNB projection model ensure this), and thus a relatively rapid fall in inflation to around the target. It is no surprise then that the staff prognosis of the CNB calls for a drop in rates. We, on the other hand, are not tampering with the model and thus see a possibility for inflation expectations to be affected by the recent spike in inflation. This, combined with the tight labor market (the y/y drop in number of unemployed is approx.100 ths.) and the high visibility (as opposed to just the sheer size) of inflation, makes it possible for the expectations to feed into wages. Also, a CZK correction is now overdue - we expect it to weaken to slightly above 26.10 before reentering a strengthening path (even though the rate of strengthening should be slower than what we have witnessed over the last year). This should diminish the tightening effect of the CZK on local monetary conditions and remove the single largest factor preventing the CNB from hiking. We therefore think that there is scope for one more hike this year (2W repo at 4.00% at the end of 2008). Apart from what has already been mentioned as the reasons for the CNB to nudge the rates up, we think this would also be a tactically sound move. Should it later turn out to be the case that inflation indeed receded as fast as forecast, it would be easy to take the hike or two implemented in the meantime back. However, should our scenario play out, the CNB would not be accused of having to chase inflation and would thus limit the extent to which its credibility might be at stake. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 36 Czech Republic Capital markets Financial markets CZK to weaken before starting to strengthen again The koruna has strengthened in two big waves since July - the first one primarily driven by carry trades unwinding, the other by the sell-off in the dollar and stampede to CEE currencies that (mostly) boast solid macro fundamentals and growth prospects. Except for the HUF (which is on a different exchange rate regime), all of the other CEE currencies strengthened since July - the koruna so much that it reached (in our view) a point where its value is not fundamentally justified. We expected a weakening of the CZK in 1Q07, but this has not materialized, in our view, because of the continued USD weakness in 1Q (the average daily turnovers on the EURCZK and USDCZK markets have gone up by 50% since October, suggesting this might have played a role in the strengthening of the CZK). On the contrary, the CZK strengthened to as low as 24.80 at some moments and became the currency that strengthened the most against the EUR y/y. We thus still view the CZK as being away from its fundamentally justified value; we think that the CZK should now be at around 26.10. Therefore, we expect the koruna to weaken. However, the timing is uncertain. Given that we think that 1Q/2Q will be the trough for the US economy, we should see a turnaround for the CZK in summer. EUR/CZK development 28.8 28.3 EURCZK Past 27.8 27.3 26.8 26.3 25.8 25.3 24.8 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 EURCZK Prognosis Source: CS estimates, Bloomberg Bonds have traded relatively uneventfully (at least in comparison with developments abroad) in 1H, in a range of 4.60-4.80% (10Y bond). Demand at local auctions has been relatively light (the Ministry of Finance has had problems selling the intended volumes to banks), the outlook for interest rates did not change significantly and no sustained hiking campaign by the CNB is expected. The spread between 10Y bonds here and in Germany widened on falling German yields (flight to quality, with the German economy performing far better than, e.g. Italy's, Spain's or Portugal's); we expect this to narrow. This will be a two-sided process - on one hand, German yields will rise; on the other, Czech ones will fall slightly. This will be driven by a smaller supply of domestic bonds, as a consequence of the (at least one) planned Eurobond emission this year (of up to a billion EUR and with maturity between 10 and 20 years) and overall lower funding needs of the government. Martin Lobotka Euro-Visions Economic and Capital Market Forecast, June 2008 Page 37 Ukraine Real GDP (grow th y/y %) Private Consumption (grow th y/y %) Fixed Capital Formation (grow th y/y %) CPI (y/y, average%) Current account balance (% of GDP) Govt. budget balance (% of GDP) Short term interest rate (3 months) year-end Loc. Curr./EUR year-end 2006 7.1 14.4 18.7 9.2 -2.9 -0.7 15.0 6.65 2007 7.6 17.1 24.8 12.8 -4.2 -1.1 8.7 7.42 2008f 6.6 8.7 10.0 24.0 -5.8 -2.0 13.8 6.55 2009f 6.0 10.0 10.0 13.6 -7.0 -3.0 10.5 5.94 Economy Coalition showing some cracks After the long process of forming the Orange Coalition, disagreements have arisen between the main coalition parties BYuT (the party of Prime Minister Yulia Tymoshenko) and Our Ukraine (the party of President Viktor Yushchenko). Moreover, the president and PM have different positions on several key issues, ranging from managing inflation and the privatization of state-owned companies to constitutional reforms. The high point of the disagreements took place on May 13, 2008, when the BYuT party blocked the president's annual speech (the Ukrainian state of the union address) in protest over the president's position on privatization and constitutional reforms. All the major political parties, including the opposition (pro-Russian) Party of Regions, in effect started their presidential campaigns (the next presidential election will take place in January 2010). Both the president and the PM stated that the Orange Coalition will be preserved, despite several key areas of disagreement. After posting hefty 7.6% growth in 2007, the Ukrainian economy slowed down to 6.0% y/ y in Jan-Mar 2008. The economy is expected to pick up in the second half of the year, posting 6.6% growth in 2008, on the back of strong domestic and external demand. Manufacturing and trade contributed the most to GDP growth in 1Q08, whereas the construction sector has decelerated, after real estate prices rose on average by 40% p.a. for the past three years. Household consumption has continued to be driven by increased real wages (13.3% y/y in 1Q08) and credit growth (loans went up by 13% q/q in 1Q08). We expect 2008 GDP to be driven mainly by consumption. Exports are expected to stay strong, in spite of the recent UAH revaluation, propped up by strong global steel and fertilizer prices and the opening of the European markets to Ukrainian products. Imports are expected to outpace exports again, driven by surging domestic demand. The current account balance, which posted a deficit at 4.2% of GDP in 2007 should deteriorate further to 6-7% of GDP, as the merchandise trade deficit should increase substantially in 2008. The natural gas price hike (+38% in 2008) will be one of the main contributors to the growing current account deficit. Foreign investment in the Ukrainian economy increased by 60% y/y in 2007 to USD 9.3bn and the positive dynamic will be carried over into 2008. One large-scale privatization, which is currently running behind schedule, should be an additional boost to FDI growth in 2008. Inflation beat all expectations, accelerating to 30.2% y/y in April 2008. The inflation spike was caused by several factors. A poor harvest in 2007 (agricultural output declined by 5.6%), the high weight of food in the CPI basket (52%), loose monetary policy in 2007 and the UAH peg to the USD (which lost 11% against the EUR in 2007) were the main drivers of CPI growth. In late 2007 and 2008, the central bank reversed its policy by introducing tightening measures. On the other hand, the government's social spending program (social benefits increased by more than 30%) and repayment of USD 1.2bn in cash to former clients of the USSR's Oschadbank put some additional upward pressure on CPI. The government has even introduced anti-inflationary administrative measures, such as a price cap for food retailers. PPI accelerated, caused by the increase in utility and commodity prices. The government will start increasing natural gas prices for households by 3-5% starting in June 2008 and the process of convergence of natural gas prices will be even faster for industrial users. As a result, we expect year-end CPI to reach 19.2% and year-end PPI to reach 29.0% in 2008. Page 38 Economy to show moderate growth of 6.6% in 2008 Inflation expected to subside in second half of 2008 Euro-Visions Economic and Capital Market Forecast, June 2008 Ukraine Inflation sub-aggregates (m/m) 7,0 6,0 5,0 4,0 3,0 2,0 1,0 m/m % Price indices (y/y) 35 % y/y 30 25 20 15 10 Vebraucherpreise Produzentenpreise BIP Deflator Nahrungsmittel Güter ex. Nahrunsmittel Dienstleistungen 0,0 -1,0 -2,0 Mär.07 Jun.07 Sep.07 Dez.07 Mär.08 5 0 2002 2003 2004 2005 2006 2007 4M08 Source: State Statistics Committee, Erste Bank Ukraine Monetary policy Tightening may be overdone The central bank (NBU) took measures during the preceding 10 months targeted at curbing foreign currency loans and - especially - limiting consumer loans, which were seen as the major reason for the accelerating inflation. The NBU has started draining liquidity, having resumed deposit certificate placement in 2H07, and later increased reserve requirements. The discount rate has been increased to 12% and refinancing rates went up to 15% on loans secured by government bonds, and to 16% for unsecured loans. Besides monetary tightening, the local banking system has been drained on the fiscal side as well. Due to increased revenues from customs and taxes, caused by more effective collection and the elimination of some shadow schemes, there was an accumulation of extra funds on the state Treasury accounts. The consolidated state budget surplus reached UAH 5.6bn in 1Q08. As a result, the liquidity situation worsened in April-May, with a serious lack of hryvnia resources. Many banks even stopped retail and corporate lending in local currency. Later on, the situation worsened, as some banks reached their refinancing limits. The KIEVPRIME 3M money market rate soared in April to 16-18%. To cope with the lack of liquidity, some banks opened short positions in foreign currency, which brought additional appreciation pressure on Ukrainian currency. We expect liquidity to improve, as the Ministry of Finance will release more money from the state Treasury accounts (expected in the second half of 2008) and will reimburse VAT to local enterprises. As NBU officials have stated that they are aware of possible risks that tightening may bring to the local economy, we expect a gradual easing of monetary policy. Recently, the NBU resumed interventions on the foreign exchange market, buying US dollars, and thus contributing to hryvnia liquidity. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 39 Ukraine Liquidity monitor UAH mn 35,000 30,000 25,000 20,000 15,000 NBU mid- and longterm certificates Excess liquidity NBU resumed selling Required reserves Tresury account KIEVPRIME 3M deposit certificates to reduce the excess liquidity and to slow down the inflation KIEVPRIME, % 30 10 High tax collection -10 -30 -50 10,000 5,000 0 Mar-07 Jun-07 Sep-07 Increased reserves requirements Liquidity squeeze -70 -90 Mar-08 Dec-07 Source: NBU, BLOOMBERG, Erste Bank Ukraine Capital markets Hryvnia revalued by 4% Our forecast for hryvnia revaluation in 2008 proved accurate. On May 22, 2008, the NBU changed the official exchange rate to 4.85 UAH/USD, thus revaluing the hryvnia by 4%. This happened after the interbank exchange rate reached 4.55 UAH/USD, i.e. 10% strengthening of the hryvnia. NBU officials brought clarity to the market, resuming interventions and buying USD at the level of 4.8-4.84 UAH/USD, which might be the new lower currency band limit. Although the NBU has not set a free float policy for UAH, the wider exchange corridor is expected. We think that this is a positive development, as it will have a soothing impact on inflation in the short term, reducing the impact of imported inflation. There has been low demand for local bonds in 1Q08 because of the current liquidity situation on the market. The Ministry of Finance attracted a mere USD 77mn via placing treasury bonds on the domestic market in 1Q08, with the quarterly target at USD 198mn. However, the positive dynamics of revenue collection have put the government in a comfortable position for right now. The yields for local bonds have been on the rise. One characteristic of Ukrainian bonds is that 90% of them have put options. To keep investors from exercising their put options, some issuers raised the yields to 16-18% for corporate bonds, which further increases the cost of resources for local borrowers. Ukrainian banks increased their issuance of bonds on the local market. After a short break in 1Q08, some banks began to place Eurobonds on the foreign market in late April-May, raising USD 210mn. The Ministry of Finance announced the coming issuance of Ukrainian Sovereign Eurobonds (the government plans to raise USD 1.7bn). We expect the bond market to be volatile and yields to stay elevated for local Ukrainian bonds in 2008. Roman Oliynyk Viktor Stefanyshyn Euro-Visions Economic and Capital Market Forecast, June 2008 Page 40 Hungary Real GDP (grow th y/y %) Private Consumption (grow th y/y %) Fixed Capital Formation (grow th y/y %) CPI (y/y, average%) Current account balance (% of GDP) Govt. budget balance (% of GDP) Short term interest rate (3 months) year-end Long term interest rate (10 years) year-end Loc. Curr./EUR year-end 2006 3.9 1.9 -2.8 3.9 -6.1 -9.2 8.1 6.7 252 2007 1.3 -0.3 1.0 8.0 -5.0 -5.5 7.5 7.1 253 2008f 2.2 0.2 2.5 6.4 -4.6 -4.0 8.4 7.3 245 2009f 3.2 2.9 5.1 4.0 -4.2 -3.9 6.8 6.2 242 Economy Economic growth showed only tiny revival in 1Q08… According to the CSO's flash estimate, GDP rose 1.6% y/y in the first quarter of 2008, after the 0.8% y/y seen in 4Q07. The picture suggested by the calendar-adjusted figures is gloomier, however. Taking the calendar effect into consideration, the economy grew much more slowly, by just 0.9% y/y in 1Q08, compared to 0.7% y/y in 4Q07. As the most important export market, the higher than expected 1Q GDP growth in Germany suggested that the main driver of economic growth in Hungary during the first quarter may have still been net exports. On the other hand, the poor retail sales figures (a 3.1% y/y drop) seen in the first quarter do not indicate a revival of private consumption in the period. Furthermore, investment figures for the first quarter were rather disappointing, showing a 4.8% y/y decline. In particular, the 9.8% y/y drop in investments in the processing industry shows that confidence seems to have remained low in the corporate sector, which is not encouraging in terms of future growth prospects. As for the outlook, some revival of the economy is expected for 2008; GDP growth should reach 2-2.5% y/y this year, after the tiny 1.3% y/y published for 2007. However, this is still below the potential level, as plenty of the structural problems seen in the economy pose a significant barrier to a more spectacular acceleration of GDP growth. The lagging structural reforms may prove more of a burden to the prospects for private investments in the mid run. On the other hand, downside risks relating to the growth outlook for Hungary's main export partners could have a negative impact on the performance of exports this year. Private consumption, however, may revive somewhat in 2H, as real wages are expected to slightly rise again this year, after the 4.8% y/y drop seen in 2007. Due to fiscal austerity measures, Hungary managed to curb its unsustainable budget deficit (standing at 9.2% of GDP in 2006) last year. After the deficit of 5.5% of GDP seen in 2007, we continue to believe that this year's budget deficit goal of 4% of GDP will be reached relatively easily. One should note that the revenue side of the budget balance will again be supported by higher tax and contribution inflows, partly due to the higher than planned inflation. On the other hand, some one-off items are to disappear from the expenditure side, helping the deficit reduction this year. Nonetheless, concerns on markets about the 2009-10 budget processes have already appeared, as pre-election loosening is a traditional phenomenon in Hungary. All in all, further deficit reductions, indicated in the Convergence Program for these years, will be reached only with strict control on the expenditure side of the budget. The yearly inflation rate slowed to 6.6% y/y by April, from the 7.4% y/y seen at the end of 2007. In this period, the main drivers of inflation remained prices of food, fuel and energies. The declining process in the 12-month rate should slowly continue in the coming months, but is expected to become swifter in the last quarter of the year, due to the high base figures. Some upside risks still exist, however, as the ongoing acceleration in global oil prices could lead to an increase in the administratively-affected gas prices in the near future. However, we do not count on another sharp increase in food prices for the remainder of the year. We expect the disinflation process to continue in the mid run. The 12-month inflation rate should be closer to the mid-term target of 3% in 2009, but is expected to be above this level in average until 2010. Page 41 ...and should expand below potential in mid run Budget deficit on track this year Inflation declining slowly Euro-Visions Economic and Capital Market Forecast, June 2008 Hungary Inflation and core inflation 15.0% 13.0% 11.0% Fuel (right axis) 9.0% 10.0% 7.0% 5.0% 5.0% 3.0% 1.0% -1.0% Jan-05 Jun-05 Nov-05 Apr-06 Sep-06 Feb-07 Jul-07 Dec-07 0.0% -5.0% -10.0% Headline CPI Core CPI Food (right axis) 15.0% 25.0% 20.0% Source: Central statistical office Monetary policy Central bank delivered rate hikes The central bank has delivered a rate hiking cycle this year. From March to May, the base rate was raised by 100bp, altogether, to 8.50%, as a response to the increased risk of inflation sitting permanently higher than 3%. Our view is that the central bank has managed to restore its credibility by strongly expressing its commitment to the inflation target with the rate hikes carried out in the recent period. Although more rate hikes cannot be ruled out (partly depending on the data on inflation and wage growth in the coming months), our base forecast is that the current small rate hiking cycle will come to a halt, especially if the forint is able to preserve its current strength against the euro for a longer period. Taking the upside risks on inflation and the central bank's hawkish stance into consideration, however, no rate reduction is expected to be carried out before 2009. Capital markets Exchange rate regime changed to free float One of the most important events of this year was the central bank's announcement on the abolition of the forint exchange rate band at the end of February; thus, the exchange rate regime was changed to free float. By eliminating the possible contradictions between the existence of the band and the inflation targeting system, the step should lead to greater credibility of the monetary and economic policy. In the new regime, there is more room for real price convergence to be driven by the forint's nominal appreciation than by higher inflation in the mid and longer run. However, due to the recession fears in the US in the first quarter, the forint exchange rate has started to capitalize on the new regime just in the last couple of weeks, as the improved sentiment on global markets has led to a spectacular forint appreciation. As for the internal aspects, the increased interest rate differential and the country's decreasing financing needs serve as the most important fundamental supports for the stronger exchange rate. Provided that the international market environment remains supportive, the forint is expected to stabilize in a stronger range than predicted earlier. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 42 Hungary Base rate and forint exchange rate 10% 9% 8% 7% 6% 265 5% 260 4% 3% 2% 1% 0% Jän.05 Jul.05 Jän.06 Jul.06 Jän.07 Jul.07 Jän.08 Source: National Bank of Hungary EUR/HUF r.S. Leitzinssatz 285 280 275 270 255 250 245 240 Bond market attractive The unfavorable processes on global capital markets, recession fears in the US and further increased level of risk aversion had an extremely negative affect on the domestic FI market, leading to a big jump in bond yields in a relatively short period. Furthermore, as private pension funds started to increase the share of equities in their portfolios (in line with new regulations), their bond selling brought even more upward pressure on bond yields in the first quarter. For the medium and longer term, however, we remain confident about Hungarian long-term bonds, as the country's economic balance fundamentals should further improve and inflation will decline. Moreover, the better credibility of the central bank makes long-term government bonds attractive at their current levels, suggesting that a drop in yield spreads should start soon. Orsolya Nyeste Euro-Visions Economic and Capital Market Forecast, June 2008 Page 43 Corporate Bonds Review Return of confidence End of March 2008, credit markets have calmed considerably. The measures taken by the central banks to stabilize the international financial system were effective. The participation of the US central bank - Fed - in the takeover of Bear Stearns by JP Morgan Chase and the regular supply of liquidity made available by the central banks to financial institutions have succeeded in reinstating confidence in the markets. Moreover, the opinion of many market participants that the first quarter of 2008 might have been the peak of the wave of write-offs in the financial sector also led to a widening of the risk appetite of investors and narrowed the risk premiums on corporate bonds. During the turbulences of the subprime crisis, bonds with the best credit ratings (AAA) and government bonds were the outperformers, but since mid-March, the situation has reversed. The calming on the markets has lead to decline in risk aversion and in this environment confidence in riskier securities could increase. iBoxx Index: Overall performance by rating category 10.0% 8.0% 6.0% 4.0% Relative performance by rating category vs. government bonds 6.0% 4.0% 2.0% 0.0% 2.0% -2.0% 0.0% -2.0% -4.0% Q1 2008 Q2 2008 (until end of may) Year to date -4.0% -6.0% Q1 2008 Q2 2008 (until end of may) AAA AA A BBB Year to date BBB A AA AAA iBoxx € Government Bonds Total Corporates Source: iBoxx, Erste Bank Research, * until end of May 2008 Source: iBoxx, Erste Bank Research Development of benchmark spreads by rating category 300 250 200 150 100 50 0 Jul-05 Jul-06 Jan-05 Jan-06 Jan-07 Jul-07 Sep-05 Sep-06 Sep-07 Mar-05 Mar-06 Mar-07 Jan-08 May-05 May-06 May-07 Mar-08 May-08 Nov-05 Nov-06 Nov-07 € Corporates AAA Source: iBoxx, Erste Bank Research € Corporates AA € Corporates A € Corporates BBB Euro-Visions Economic and Capital Market Forecast, June 2008 Page 44 Corporate Bonds Outlook Even though sentiment on the credit market has brightened since mid-March, insecurity still prevails. The most important and difficult question to which everyone would like to have an answer is whether the credit crisis is over or not. In our opinion, the climax of the banking crisis is over - this is indicated, among other things, by the easing on the market for assetbacked securities and leveraged loans that came under heavy pressured during the crisis. As regards the threat of more write-offs on subprime mortgage loans, these are expected to be much lower in the coming quarters than since the start of the crisis. Nonetheless, the situation on the US housing market is still tense. High interbank lending rates are burdening the efficient liquidity management of the financial sector and problems with the bond insurers are far from solved, and the earnings dynamic of European companies is slowing (high commodity prices as a burdening factor). All of these factors mentioned are the reasons for continued uncertainty on the credit markets. In our view, the principal factors that will influence the further development of the credit market are the following: z Banking crisis z Credit quality z Fundamental situation of companies z Primary market Financial market crisis to slow down According to figures released by Bloomberg, banks have up to now - since the start of the subprime crisis - written off some USD 386bn worldwide. There are divergent estimates of the total sum of the required write-offs. Our estimate is of a decreasing dynamic of write-offs, among other things, due to the reduction of the total volume in the riskier sectors by financial institutions such as in leveraged loans (takeover loans), a trend that started already in 1Q 2008 vs. the previous quarter. A preview of further trends will be delivered by the earnings figures of the US investment banks Lehman Brothers and Morgan Stanley for 2Q to be announced on 16 and 20 June. Write-offs and capital increases by major banks (in USD bn) Citigroup UBS 147.5 Write-offs and credit losses from lending transactions (in USD bn) 200 180 160 140 120 100 80 60 40 20 0 Global America Q4 2007 Europe Q1 2008 Asia 13.4 2.6 79.1 69.7 65.7 102 185.1 44.1 42.9 28.8 17.9 3.5 19.5 13.1 15.9 23.7 15.4 19.7 14.8 12.6 9.8 7.8 1.5 0 38.2 37.1 Merrill Lynch HSBC IKB Deutsche Industriebank Royal Bank of Scotland Bank of America Morgan Stanley JPMorgan Chase Credit Suisse 5.6 9.5 10 20 30 40 50 Write offs & credit losses Capital increases Source: Bloomberg Euro-Visions Economic and Capital Market Forecast, June 2008 Page 45 Corporate Bonds The positive sentiment on credit markets was also supported by the capital flows into the finance sector. From the perspective of bondholders, capital increases are clearly positive events, because they strengthen the equity base. This year, financial institutions carried out capital increases totaling some USD 220bn to date. Alone Citigroup, which up to now has reported the largest write-offs, has raised a total of around USD 44bn in fresh capital since the financial market crisis broke out - partly through the entry of foreign government funds as a major new investor. Tense situation on the EUR interbank market Such liquidity measures by financial institutions as a preventive measure to ward off new problems are welcomed also by the US Fed. It is generally assumed that earnings will be lower, especially from investment banking activities, and so an increase in liquidity prevents the structural problems of the real estate sector from spreading to other credit areas, such as consumer credit and credit cards. Already at the beginning of March, Fed Chief Bernanke warned investors that some smaller US banks would not survive the current credit market crisis. In this context, the negative outlook of prominent rating agencies for the banking sector in the US and Europe is a reflection of the sustained phase of weakness, which in our opinion has already been largely priced into spreads. Despite the provision of liquidity by the ECB through short-term refinancing transactions, the tense situation on the EUR interbank market persists. The still high 3-month Euribor (4.97%) is a clear signal that confidence among banks has not yet been restored. Moreover, the high level of the average bid rate for the three-month refinancing transactions of the ECB also indicates sustained insecurity. 3-Month Euribor vs. ECB base rate 5.0 4.8 4.6 4.4 4.2 4.0 3.8 3.6 3.4 3.2 3.0 May-07 Nov-07 May-08 Mar-07 Dec-07 Mar-08 Apr-07 Feb-07 Oct-07 Aug-07 Sep-07 Feb-08 Jan-07 Jun-07 Jan-08 Apr-08 Jun-08 Jul-07 in% ECB 3-month refinancing transactions Settlement 27/03/2008 02/05/2008 22/05/2008 29/05/2008 Maturity 26/06/2008 31/07/2008 14/08/2008 28/08/2008 Volume, in EUR bn 50.0 50.0 50.0 50.0 Weighted average interest rate 4.53% 4.75% 4.68% 4.62% 3M Euribor ECB Key interest rate Source: Bloomberg, EZB Crisis among bond insurers not yet over After the high 1Q 2008 losses of the two US bond insurers MBIA (USD -3.0bn) and Ambac (USD -1.6bn), the capital base of the two monolines was again questioned by the rating agencies. Moody's has already placed the two monolines on the watchlist with negative implications. In the past nine months, the bond insurers have been confronted with losses of more than USD 13bn as a consequence of the crisis on the US mortgage market and were forced to carry out massive capital increases to keep their top ratings. A downgrading of bond insurers also means a downgrading of the bonds they insure and more write-offs for the banks. The first priority of a bond insurer is to guarantee sufficient liquidity to ensure the timely payment of the principal and interest should an issuer of an insured bond default on payment. The entire industry insures a bond volume of some USD 2.4 trillion. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 46 Corporate Bonds Because of the key role of the monolines in the credit crisis, the US has tightened the rules governing the accounting and disclosure practices of the ailing sector that will take effect as of 15 December 2008. In the future, they will have to disclose the securities they insure that are having problems and create reserves for these securities at an earlier point in time. They must also disclose which securities are on their watchlists and provide more information on their risk management. Declining global credit quality The restrictive credit supply and the higher refinancing costs for companies since June are expected to have a negative effect on creditworthiness and entail successive downwards adjustments. In the first two quarters of the current year, the rating agency Moody's has downgraded the long-term rating of a total of 75 companies and upgraded only 43. Half of the companies whose ratings were downgraded were financial institutions. The credit ratio (ratio of upgrades to downgrades) has declined steeply since 1Q 2007 when Moody's adjusted the rating of many banks upwards due to the application of a new method. Thus, in 2Q 2008, the credit ratio was 0.38, which is a clear deterioration compared to the long-term average of 1.32. The negative outlook of many companies also indicates a continuation of the deteriorating rating trends. Due to the financial crisis prevailing since the middle of last year and the growing insecurity regarding the effects on the real economy, the outlook of many companies was changed to negative. In the second quarter of 2008, 30 companies lost their stable outlook, while only four were assigned better ones. Furthermore, Moody's expects the global, speculative default rate to reach its long-term average of 3.62% by the end of 2009. The most strongly affected sectors in the US are the construction industry and transport, while in Europe it is the hotel sector and mining. Western Europe, investment grade: Development of the credit ratio (upgrades/downgrades) 350 300 250 200 3 150 100 50 0 Q1 01 Q3 01 Q1 02 Q3 02 Q1 03 Q3 03 Q1 04 Q3 04 Q1 05 Q3 05 Q1 06 Q3 06 Q1 07 Q3 07 Q1 08 2 1 0 6 5 4 Down Up Up/Down Ratio, r.s. Source: Bloomberg, Moody's Risk aversion declined The mass panic on the markets, which was due mainly to the systematic risk, drove spreads to all-time highs in mid-March, with the credit curve steepening sharply (midMarch: Spread HY - Spread investment grade = 413bp). Meanwhile, fears have abated significantly, which is not only reflected in the flattening of the credit curve but also in the lower risk aversion as measured by the VDAX. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 47 Corporate Bonds Spread difference vs. VDAX 450 Spread difference (HY-IG) 400 350 300 250 200 15 150 100 Nov-06 May-06 May-07 Nov-07 May-08 Mar-06 Mar-07 Sep-06 Sep-07 Mar-08 Jan-06 Jan-07 Jan-08 Jul-06 Jul-07 10 25 VDAX in %, r.s. 30 35 20 Source: Bloomberg, Erste Bank Research Earnings dynamic slows While it was mostly banks and monolines that were at the center of events in the beginning, the current question is how hard the concerned companies have been affected by the crisis. The fundamental situation has not generally deteriorated among most companies (exclusive of banks) and most results presented for the first quarter were in line with expectations. A number of companies have revised their earnings forecasts for the full year downwards, which was due to the effects of the financial crisis as well as to the high commodity prices and the strong euro versus the USD. Thus, earnings growth for the DJ STOXX 600 companies is expected to be 7.7% in 2008 which is 2%-points lower than the previous year and for 2009, the rate of increase is estimated at 11.4%. A breakdown by sector shows that the segment of cyclical consumption (-6%) and telecoms (-5%) will fare the worst in 2008. As regards the debt situation, we expect most companies to be able to bear the currently high refinancing costs without negatively affecting their credit quality. The debt problems we saw in the years 2001 and 2002 are not expected to be repeated that fast. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 48 Corporate Bonds DJ STOXX 600 (exclusive of Financials): Earnings growth y/y 16 14 12 10 in % 8 6 2007: 9.7% 4 2008: 7.7% 2009: 11.4% 2 0 Apr-05 Apr-06 Apr-07 Oct-05 Oct-06 Jan-05 Jan-06 Jan-07 Oct-07 Jan-08 Apr-08 Jul-05 Jul-06 Jul-07 DJ STOXX 600 (exclusive of Financials): Earnings growth by sector y/y 60% 50% 40% 30% 20% 10% 0% Automobiles und Parts Communications Consumer, NonCyclical -10% Consumer, Cyclical Industrials Basic Materials Retailers Energie Utilities FY 2007 FY 2008 FY 2009 2006 2007 2008e 2009e 2010e Source: Bloomberg, Erste Bank Research Primary market picks up As a consequence of the relatively narrow spreads, the primary market for EUR investment-grade bonds also picked up in May. Bonds with a total volume of some EUR 20bn were issued in May. This corresponds to around 30% of total issuing volume since the start of the year. A comparison of monthly issuing volumes with the development of the JP Morgan BBB Credit Index shows the negative correlation of the two. From the perspective of investors, the attractive yields on bonds with high ratings are good news. New issues on the EUR Corporate Market 2007-2008 vs. JPMorgan Credit Index BBB Govt Spread 25 250 15 in EUR bn 150 10 100 5 50 0 May-07 May-08 Mar-07 Nov-07 Dec-07 Mar-08 Apr-07 Aug-07 Sep-07 Jan-07 Feb-07 Jan-08 Feb-08 Jun-07 Oct-07 Apr-08 Jul-07 0 Investment Grade HY BBB-Government Spread, r.s. Source: Bloomberg, Erste Bank Research The current lending survey of the European Central Bank (ECB) of April 2008 reveals that banks have tightened their lending policies further, especially for large companies. Thus, the capital market is gaining significance as a source of financing, especially for large corporations. Another finding in this study is that the credit demand of companies decreased in 1Q 2008 primarily due to the slowing dynamic of M&As and investments in plant and equipment; alone this year, maturing bonds would cover the refinancing needs especially among the telecoms and utilities. However, no companies from the high-yield segment have issued bonds on the primary market since August 2007. As the lines of credit granted have not yet been drawn on, the lack of capital inflows from the Euro-Visions Economic and Capital Market Forecast, June 2008 Page 49 Government Spread, in Bp 20 200 Corporate Bonds primary market has not become a risk up to now, but the tighter lending standards will probably cause capital to become scarce for this group of companies in the future. Conclusions Although the EUR corporate bond market has improved since mid-March 2008, it is still marked by numerous factors of insecurity. From today's perspective, the financial crisis seems to have peaked. In this context, the write-offs that financial institutions were forced to make in 2Q also serve as an indication of developments to come. The expected weakness in earnings in the sector, especially in the segment of investment banking due to structural problems has already been largely priced into spreads in our opinion. We do not expect the risk premiums to reach the heights of mid-March in the second half of the year. Nonetheless, we do expect a volatile development. One reason is the lower global credit quality that has been affected by the more restrictive supply of credit and the persistently relatively higher re-financing costs. The still prevailing uncertainty regarding the effects of the financial crisis on the real economy and high commodity prices has motivated many companies to revise their earnings expectations downwards for the full year. An additional burdening factor is the higher inflation risk in Euroland which will expose companies to higher financing costs in the future. However, the debt situation is not a risk because investment activity is on a decline. Neither is the primary market expected to create any widening pressure on credit spreads and we believe that the supply dynamic will develop in line with demand. On the whole, we do not expect any significant setbacks in risk premiums in 2HY 2008 and our most-likely scenario is a sideways trend with gradually narrowing spreads. For bondholders, we view the attractive yields on corporate bonds as a good entry opportunity, with our preference being in investment grade bonds. Alihan Karadagoglu, Elena Statelov Publisher: Erste Bank der oesterreichischen Sparkassen AG Graben 21; A-1011 Vienna, P.O. Box 162 Telex 11-5818, Phone +43 (0)50 100 ext. SPV Druck GesmbH Vienna Friedrich Mostböck, CEFA June 12, 2008 Printed by: Published and printed in: Responsible for contents: Sent to print on: This report is meant as supplementary economic information for our clients and is based on information available on the date of sending to print and will not be updated thereafter. Our analysis and conclusions are of a general nature and do not take into account the individual circumstances or needs of investors such as income potential, tax situation or the level of risk he or she is prepared to undertake. Information about previous performance does not guarantee future performance. Although we judge our sources to be reliable, we do not accept any responsibility for the completeness and accuracy of our information. This report is neither an offer to sell nor an offer to buy any securities. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 50 Important web pages ERSTE BANK Erste Bank Erste Bank Treasury Sparkassen ecetra.com Brokerjet Erste Netbanking International Organisations OECD Internationaler Währungsfond Weltbank European Institutions Europäischer Rat Europäische Kommission Europäisches Parlament Europäischer Gerichtshof Statistical Offices Europa Dänemark Deutschland Finnland Frankreich Irland Italien Luxemburg Niederlande Österreich Portugal Schweden Spanien UK Central banks Euroland Belgien Dänemark Deutschland Finnland Frankreich Italien Luxemburg Niederlande Österreich Portugal Spanien Schweden UK Schweiz Stock exchanges Wiener Börse AG Deutsche Börse AG LIFFE Matif http://www.wienerboerse.at http://www.deutsche-boerse.com http://www.liffe.com http://www.matif.fr http://www.erstebank.at http://treasury.erstebank.com http://www.sparkasse.at http://ecetra.com http://www.brokerjet.at http://www.netbanking.at http://www.oecd.org http://www.imf.org http://www.worldbank.org http://ue.eu.int/de/summ.htm http://europa.eu.int/comm/index_de.htm http://www.europarl.eu.int/home/ http://curia.eu.int/de/index.htm Eurostat Denmark Statistics Statistisches Bundesamt Statistics Finland I.N.S.E.E. 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Using content of information from these sites is at your own risk. Euro-Visions Economic and Capital Market Forecast, June 2008 Page 51 Contacts Group Research Head of Group Research Friedrich Mostböck, CEFA CEE Equity Research Co-Head: Günther Artner, CFA Co-Head: Henning Eßkuchen Günter Hohberger (Banks) Franz Hörl, CFA (Steel, Construction) Gernot Jany, CFA (Banks, Real Estate) Daniel Lion (IT) Martina Valenta, MBA (Transp., Paper) Christoph Schultes, CIIA (Ins., Util.) Vera Sutedja, CFA (Telecom) Thomas Unger (Telecom) Vladimira Urbankova (Pharma) Gerald W alek, CFA (Machinery) International Equities Hans Engel (Market strategist) Ronald Stöferle (Asia) Jürgen Rene Ulamec, CEFA (Europe) Macro/Fixed Income Research Head: Veronika Lammer (Euroland) Alihan Karadagoglu (Corporates) Rainer Singer (US) Elena Statelov, CIIA (Corporates) Mildred Hager (SW , Japan) Macro/Fixed Income Research CEE Co-Head CEE: Juraj Kotian (Macro/FI) Co-Head CEE: Rainer Singer (Macro/FI) Editor Research CEE Brett Aarons Research, Croatia/Serbia Head:Mladen Dodig Damir Cukman (Equity) Ivan Gojnic (Equity) Alen Kovac (Fixed income) Uros Mladenovic (Equity) Davor Spoljar (Equity) Research, Czech Republic Head: David Navratil (Fixed income) Petr Bartek (Equity) Maria Hermanova (Fixed income) Lenka Slamova (Equity) Radim Kramule (Equity) Martin Lobotka (Fixed income) Lubos Mokras (Fixed income) Jakub Zidon (Equity) Research, Hungary Head: József Miró (Equity) Zoltan Arokszallasi (Equity) Mihaly Tatar (Equity) Orsolya Nyeste (Fixed income) Research, Poland Head: Artur Iwanski (Equity) Magda Jagodzinska (Equity) Marcelina Hawryluk (Equity) Tomasz Kasowicz (Equity) Piotr Lopaciuk (Equity) Marek Czachor (Equity) Research, Romania Head: Lucian Claudiu Anghel +43 (0)5 0100 - 11902 +43 +43 +43 +43 +43 +43 +43 +43 +43 +43 +43 +43 (0)5 (0)5 (0)5 (0)5 (0)5 (0)5 (0)5 (0)5 (0)5 (0)5 (0)5 (0)5 0100 0100 0100 0100 0100 0100 0100 0100 0100 0100 0100 0100 11523 19634 17354 18506 11903 17420 11913 16314 11905 17344 17343 16360 Mihai Caruntu (Equity) Dumitru Dulgheru (Fixed income) Cristian Mladin (Fixed income) Loredana Oancea (Equity) Raluca Ungureanu (Equity) Research, Slovakia Head: Juraj Barta (Fixed income) Michal Musak (Fixed income) Maria Valachyova (Fixed income) Research, Ukraine Viktor Stefanyshyn (Fixed income) Roman Oliynyk (Fixed income) +40 2 +40 2 1312 +40 2 1312 +40 2 +40 2 1311 6773 6773 1311 1311 2754 1028 1028 2754 2754 +42 1 25957 - 4166 +42 1 25957 - 4512 +42 1 25957 - 4185 +38 044 593 - 1784 +38 044 593 - 9188 Institutional Sales Head of Sales Equities & Derivatives Michal Rizek +44 207 623 - 4154 Brigitte Zeitlberger-Schmid +43 (0)5 0100 - 83123 Equity Sales Vienna XETRA & CEE Hind Al Jassani +43 (0)5 0100 - 83111 Werner Fuerst +43 (0)5 0100 - 83114 Josef Kerekes +43 (0)5 0100 - 83125 Cormac Lyden +43 (0)5 0100 - 83127 Stefan Raidl +43 (0)5 0100 - 83113 Simone Rentschler +43 (0)5 0100 - 83124 Sales Derivatives Christian Luig +43 (0)5 0100 - 83181 Manuel Kessler +43 (0)5 0100 - 83182 Sabine Kircher +43 (0)5 0100 - 83161 Christian Klikovich +43 (0)5 0100 - 83162 Armin Pfingstl +43 (0)5 0100 - 83171 Roman Rafeiner +43 (0)5 0100 - 83172 Equity Sales, London Dieter Benesch +44 207 623 - 4154 Tatyana Dachyshyn +44 207 623 - 4154 Jarek Dudko, CFA +44 207 623 - 4154 Federica Gessi-Castelli +44 207 623 - 4154 Declan Wooloughan +44 207 623 - 4154 Sales, Croatia Zeljka Kajkut (Equity) +38 5 6237 - 2811 Damir Eror (Equity) +38 5 6237 - 2813 Sales, Czech Republic Michal Brezna (Equity) Ondrej Cech (Fixed income) Michal Rizek Jiri Smehlik (Equity) Pavel Zdichynec (Fixed income) Sales, Hungary Gregor Glatzer (Equity) Krisztián Kandik (Equity) Istvan Kovacs (Fixed income) Sales, Poland Head: Andrzej Tabor Pawel Czuprynski (Equity) Lukasz Mitan (Equity) Jacek Krysinski (Equity) Sales, Slovakia Head: Dusan Svitek Rado Stopiak (Derivatives) Andrea Slesarova (Client sales) +420 +420 +420 +420 +420 2 2 2 2 2 24995 24995 24995 24995 24995 523 577 537 510 590 +43 (0)5 0100 - 19835 +43 (0)5 0100 - 11723 +43 (0)5 0100 - 16574 +43 +43 +43 +43 +43 (0)5 (0)5 (0)5 (0)5 (0)5 0100 0100 0100 0100 0100 11909 19633 11185 19641 17331 +43 (0)5 0100 - 17357 +43 (0)5 0100 - 11185 +420 2 24995 - 904 +38 1 112200 - 866 +38 5 6237 - 2820 +38 1 112200 - 852 +38 5 6237 - 1383 +38 1 112200 - 872 +38 5 6237 - 2825 +420 +420 +420 +420 +420 +420 +420 +420 2 2 2 2 2 2 2 2 24995 24995 24995 24995 24995 24995 24995 24995 439 227 232 289 213 192 456 340 +36 1 235 +36 1 235 +36 1 235 +36 1 373 - 5131 5135 5134 2830 253 250 255 251 252 254 +36 1 235 - 5144 +36 1 235 - 5140 +36 1 235 - 5846 +48 +48 +48 +48 2 2 2 2 23306 23306 23306 23306 203 212 213 218 +48 2 23306 +48 2 23306 +48 2 23306 +48 2 23306 +48 2 23306 +48 2 23306 - +40 2 1312 - 6773 +42 1 25050 - 5620 +42 1 25050 - 5601 +42 1 25050 - 5629 Treasury - Erste Bank Vienna Sales Retail & Sparkassen Head: Manfred Neuwirth Equity Retail Sales Head: Kurt Gerhold Domestic Sales Fixed Income Head: Thomas Schaufler Treasury Domestic Sales Head: Gottfried Huscava Corporate Desk Head: Leopold Sokolicek Alexandra Blach +43 (0)5 0100 - 84250 +43 (0)5 0100 - 84232 +43 (0)5 0100 - 84225 +43 (0)5 0100 - 84130 +43 (0)5 0100 - 84601 +43 (0)5 0100 - 84141 Roman Friesacher Helmut Kirchner Christian Skopek Fixed Income Institutional Desk Head: Thomas Almen Martina Fux Michael Konczer Ingo Lusch Ulrich Inhofner Karin Rauscher Michael Schmotz +43 (0)5 0100 - 84143 +43 (0)5 0100 - 84144 +43 (0)5 0100 - 84146 +43 +43 +43 +43 +43 +43 +43 (0)5 (0)5 (0)5 (0)5 (0)5 (0)5 (0)5 0100 0100 0100 0100 0100 0100 0100 84323 84113 84121 84111 84324 84112 84114 Euro-Visions Economic and Capital Market Forecast, June 2008 Page 52