Emerging Europe – Sharply divergent trends

by: Peter de Bruin

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Growth in emerging Europe slowed through most of the year, reflecting the effects of the Ukraine/Russia crisis, and the slower-than-expected recovery in the Eurozone. Encouragingly, timelier data suggest that there were some bright spots in the fourth quarter, and we expect a gradual strengthening of growth during our forecasting horizon. This masks sharply divergent trends among the region’s countries, though. Russia’s economy, at best, will stagnate, while the Czech Republic, Hungary and Poland should benefit from a gradual strengthening of the Eurozone. Meanwhile, growth in Turkey should hold up reasonably well, despite relatively tight monetary policy.

Emerging Europe slowed through most of the year…

Over the past year, emerging Europe has continued to slow. While annual growth in the region peaked at 2.7% in the fourth quarter of last year, growth slowed to 1.3% in Q3, according to our estimates. Broadly speaking, this reflects two trends. Unsurprisingly, the Ukraine/Russia crisis proved to be a powerful headwind. Due to the conflict, Ukraine’s economy has fallen off a cliff. Meanwhile, in Russia, capital outflows in conjunction with rising uncertainty dented the investment outlook, while a sharp rise in inflation due to the slide in the rouble eroded household purchasing power, which hurt consumption. As a result, Russia’s economy is bordering on, or already in, a recession and spillover effects of the conflict have also affected other economies in the region. Although the outlook for the Czech Republic, Hungary and Poland remains much healthier, there has been some general weakening in the confidence indicators over the past months. In addition to the Ukraine/Russia conflict, growth in the region has been dragged down by the slower-than-expected recovery in the eurozone. Historically, growth in emerging Europe and the eurozone has been highly correlated, as the latter serves as the main export destination for emerging European economies.

 

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…but some bright spots in Q4

It is encouraging to note that preliminary indicators suggest that there were some bright spots in the fourth quarter. This was reflected in October’s round of manufacturing PMIs. The Polish PMI moved above the boom-bust mark again, while the modest rise in the Turkish PMI marked the third month above the 50-mark. This suggests that here, too, growth has troughed. While Russia’s PMI fell back a bit, the other economies in the region, on balance, also saw some modest improvements, with our GDP-weighted emerging European manufacturing PMI rising from 50.6 to 51.1 in October.

 

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A number of positive developments…

Looking further down the road, we think that growth in emerging Europe will gradually pick up during our forecasting horizon. However, it is important to note that we are likely to see sharply divergent trends among the region’s countries. To start with the positive news, we anticipate stronger growth in the Eurozone in 2015 and 2016. This should brighten the export prospects for countries like Poland, the Czech Republic and Hungary. In addition, these countries should benefit from a firming of domestic demand, on the back of an ongoing improvement in their labour markets and gradually rising wage growth. While growth should pick up as a result, we are a bit cautious about the prospects for Hungary. This reflects the Fidesz party’s unorthodox economic policies such as its loan reimbursement programme. This should weigh on the banking sector and subsequently lead to a tightening of lending standards, while EU funding will also be lower than in 2014. Meanwhile, a stronger eurozone recovery should also help strengthen growth in Turkey, even though we think monetary policy will remain relatively tight.

…though the Ukraine/Russia conflict remains a risk

Russia and Ukraine are on the other side of the growth spectrum. While we continue to think that somewhere down the road, both countries will recognise that some type of solution is needed, recent developments have made us more cautious. In particular, the separatist elections in eastern Ukraine and Russia’s subsequent recognition of ‘the will of the region’s inhabitants’ have made any near-term scaling back of US/EU sanctions unlikely. Together with renewed uncertainty, this suggests that capital will continue to flow out of Russia. Meanwhile, the steep slide in the rouble has forced the central bank, which recently moved to a de facto free floating currency, to aggressively raise interest rates, leading to a tightening of lending standards. And more rate hikes are probably needed to stem the ruble’s fall. A final negative for the country is the steep slide in oil prices over the past months. Granted, the ruble’s decline will cushion most of the blow. Indeed, it has depreciated at a faster pace than oil prices have slid, implying that in ruble terms, the price of a barrel of Ural oil has actually gone up and suggesting that the effect on the fiscal budget will be small. But fewer dollars for a barrel of oil in a country where – due to sanctions – foreign currencies are scarce, risks even more capital flight, which could dent the prospects for investment even further. All in all, Russia’s economy will at best stagnate in the coming years. Indeed, we have reduced our 2015 GDP growth forecast from 1.0% to 0.5%, and we see growth in 2016 at only 1.5%, a far cry from the 4% growth seen a couple of years ago.

Monetary policy in Russia and Turkey will remain tight…

Sharply divergent trends in the outlook for GDP growth explain why we will also see stark differences in monetary policy during our forecasting horizon. We already said that in the near term, Russia’s central bank will need to do more to stem the slide in the ruble. And we will probably have to wait for the end of 2015, when the conflict has lost most of its edge and the rouble has stabilised, before the CBR will loosen policy again. In Turkey, monetary policy will also remain relatively tight. In the course of this year, following the sharp tightening in response to market tensions, the CBRT cut its benchmark rate by 175bp. However, since September, it has pushed the interbank rate to the upper ceiling of its interest rate corridor. Although still somewhat lower than at the end of 2013, interbank rates are now 200bp higher than at the start of September. Indeed, given Turkey’s persistently large current account deficit, sticky high inflation, the Fed starting to hike rates in 2015, and geographical disputes at its border, monetary policy is expected to remain relatively tight for the foreseeable future.

…while CE-3 economies maintain extremely loose policy

In sharp contrast, monetary policy in the Central European economies is expected to remain extremely loose during our forecasting horizon. In Poland, inflation has been below zero for the past four months, and the recent drop in oil prices suggests that it may decline even more. This prompted the Polish central bank to cut its benchmark rate from 2.5% to an all-time low of 2.0% during its October meeting. An improvement in more recent survey and activity data probably explained why policy was not loosened further during its November meeting. While a negative inflation surprise could trigger the bank to cut its rate one more time, the bigger picture is that abundant slack in the economy will continue to keep a lid on price pressures, implying that the first rate hike will probably have to wait for 2016. Meanwhile, Hungary is also mired in deflation. So far, the central bank has refrained from further loosening, but core inflation has also gradually started to come down, making additional rate cuts in 2015 a distinct probability. Again, any rate hikes will have to wait for 2016. The inflationary picture in the Czech Republic is a bit better, as inflation has started to edge up. This suggests that a further loosening of policy is not on the cards. Indeed, at its latest meeting, the central bank kept its key policy rate at 0.05% and left its exchange rate target of EUR/CZK 27 in place. Still, the recent drop in oil prices, and significant spare capacity will ensure that inflationary pressures remain relatively muted. As such, we think that the CNB will wait until 2016 before winding down its FX interventions, while the first rate hike will come even later.

 

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Geopolitics and Fed are main downside risks

In thinking about the main downside risks to our view, the most obvious is an escalation of the Ukraine/Russia conflict. In such a scenario, ongoing Russian support of the rebels would probably result in a scaling up of sanctions, a sharper contraction in investment, and an even deeper slide in the ruble. Another leg down in oil prices could also lead to more ruble weakness. In a tail risk scenario, this could trigger a financial crisis as people try en masse to switch their rouble deposits into more stable currencies. And the geopolitical risks involved in the battle between Isis and the Kurds at Turkey’s southern border represent another downside risk. But Turkey faces yet another risk: despite a slight decline, its current account deficit remains large. What is more, it is mostly financed by portfolio investments, which could easily reverse if market sentiment deteriorates due to more aggressive-than-expected rate hikes by the Fed. A final risk would relate to another year of disappointing growth in the eurozone, which would leave its mark on emerging Europe.