FX Watch – CEEMA FX Strategy

by: Georgette Boele , Peter de Bruin

141125-CEEMA-FX-Strategy.pdf ()
  • Currencies from Central and Eastern Europe should outperform the euro in 2015 and 2016…
  • …as long as sentiment remains constructive, growth picks up and the ECB continues to ease
  • PLN is the most attractive, but it is too early to move it on our high conviction list
  • (Geo) political risks make us cautious about the Russian ruble, Turkish lira and Hungarian forint

Supportive drivers…

Currencies of Central and Eastern Europe should outperform the euro in 2015 and 2016. First, an above-consensus growth outlook for the eurozone for 2015 and 2016 should have a positive spillover to the countries in this region. In particular, this points to stronger export prospects for countries such as 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. On the other side of the growth spectrum lies Russia where growth will at best stagnate.

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Second, it is likely that loose monetary policy pursued by ECB President Draghi and his companions will push the euro down further (also versus CEEMA currencies). This also has other side-effects. For example, investors will be more confident that market supportive measures are taken. As a result, substantially more liquidity will flow into the direction of investments with more attractive returns. Investments into Central and Eastern European currencies fall into this category. This is because these currencies have interest rates that are above those of the ECB. Furthermore, their economies and currencies are exposed to the global economic cycle.

Third, it is unlikely that central banks in the region will loosen monetary policy further. This should be a major support for the various currencies versus the euro. The reasons for not easing monetary policy further may well differ from country to country. For example, it is likely that the central banks of Russia and Turkey will not ease monetary policy because of inflationary pressures and to prevent capital outflows. In the case of Poland and Czech Republic, their respective policies have supported sentiment and growth and therefore further monetary easing is unlikely.

…PLN is the most attractive, but it is too early to move it on our high conviction list

In general, we expect CEEMA currencies to do well in 2015 and 2016 versus the euro, in particular the Polish zloty. For starters, the economy is set to further improve and to profit from a recovery in the eurozone. Polish economic growth will be an outperformer in the region in 2015 and 2016, in our view (see table on the left). Low oil prices are also a tailwind for the Polish economy as it is an oil importer. Moreover, we judge the (geo) political risks in Poland are relatively low compared to the other currencies in the region such as Russian ruble, Hungarian forint and Turkish lira. However, the National Bank of Poland could reduce interest rates further if deflationary pressures persist, if the economy disappoints or if the Polish zloty strengthens sharply. Therefore, we judge that it is too early to move the Polish zloty back on our high conviction list.

Effect of lower oil prices?

Overall, we judge that lower oil prices are supportive for the region (excluding Russia). Most countries (Turkey, Hungary, Poland and Czech Republic) in the region are major oil importers. Therefore, it is likely that lower oil prices will improve economic growth and the inflation outlook for these countries. As a result, these currencies will set a lift.

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A lower oil price is in general negative for the Russian economy. However, the impact of a lower oil prices has been muted so far, because the Russian ruble has dropped more substantially than oil prices. According to reports, the break-even oil price for its budget is 3,700 RUB per barrel of oil. This is based on an oil price of 100 USD per barrel and USD/RUB of 37. Despite the substantial drop in oil prices since June of this year, oil prices denominated in ruble are still around the break-even level of the fiscal budget. As long as this trend continues, theoretically the Russian fiscal budget should not be negatively affected. Despite the muted impact on the budget, the Russian economy will suffer from indirect effect of lower oil prices. For example capital outflows and less hard currency being available to rebuild reserves.

A new ruble crisis?

The sharp decline in the value of the Russian ruble against the dollar this year has prompted some to speculate that Russia is about to experience another ruble crisis like the one we saw in 1998. While it is difficult to compare Russia’s economy in 1998 with its economy today, it provides an interesting point of comparison. An ongoing slide in the ruble will affect Russia’s banking sector. Indeed, according to Russia’s central bank, banks in Russia in August of this year, had around $190bn of foreign currency loans in their books. This represents around 10% of Russian GDP. In comparison, foreign currency loans amounted to just 3.8% of GDP in 1999 (unfortunately the data do not run further then 1999). A lower ruble will make it more difficult for companies to service these loans, which would thus lead to a deterioration of the quality of banks’ assets. On the liability side of their balance sheets, Russian banks have external debt of around $190bn (worth around 10%). Again, this is sharply up from levels seen in 1998, when banks’ external debt was just $10bn (worth around 4% of GDP), though foreign liabilities to total funds remain relatively modest. All else equal, a weaker ruble will push up the value of banks’ external debt, eroding banks’ capital.

However, every comparison to the 1998 crisis stops about there. Indeed, while the more than 40% slide in the ruble easily makes it one of the poorest performing currencies this year, its decline pales in comparison to the more than 250% drop that we saw in 1998. Moreover, although Tier 1 Capital Ratios of Russian banks have gradually come down over the past years, Russia’s banking sector is still much better capitalised than in 1998. What is more, Russia’s economic fundamentals are also much healthier. The total economy’s external debt, at around 30% of GDP, is low for emerging countries. Russia’s fiscal situation is also sound, and substantially better than in 1998. While the country is expected to run a small deficit of around 1% next year, this compares favorably to the deficit of more than 5.5% in 1998. As a result, debt levels today, are about a seventh of the levels seen before the 1998 crisis.

Political headwinds are substantial

(Geo) political risks are a major headwind for this region and their currencies. For starters, the Ukraine crisis and sanctions imposed on Russia have created a US dollar shortage in Russia, which has accelerated the sell-off in the Russian ruble. While we continue to think that somewhere down the road, both countries will recognise that some form of a 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.

Another major headwind for this region are the developments in Syria and Iraq and the role Turkey decides to play in the conflict. Due to the battle between Isis and the Kurds at the South of Turkish border, geopolitical risks here too form a downside risk. It is unlikely that this conflict will ease anytime soon. In addition, Fed rate hikes in 2015 and 2016 may put pressure on the lira due to Turkey’s large current account deficit. Therefore, we are very reluctant to be positioned in the Turkey lira.

Last but not least in Hungary, the Fidesz party’s unorthodox economic policies could hurt sentiment and economic growth. These policies 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. In addition, the government tries to control public opinion and to increase state control on the economy. The relationship between Hungary and the European Commission and IMF is far from ideal, which would be a major risk if Hungary were to need help from the IMF in the future. Therefore, we would also avoid the Hungarian forint.

Central Bank of Russia only wants to use reserves in case of emergency…

A more flexible exchange rate regime has come into force in Russia. After aggressive interventions in the FX markets to stop the fall of the ruble, the central bank has adopted a new strategy. What is this new strategy? This has the following elements:

–       More exchange rate flexibility,

–       only exceptional currency interventions when needed,

–       higher benchmark official interest rates,

–       and limiting ruble liquidity.

Despite the dire growth outlook, the Central Bank of Russia only wants to use its reserves in case of emergency. This implies that it must hike its policy rates in order to defend its currency. It is likely that higher benchmark rates will further depress growth. In the near-term, sentiment towards the Russian ruble remains negative and USD/RUB could reach 50 (just below 33 at the start of this year). However, if sanctions are not increased further and the central bank continues to lean against the trend, the ruble should start to regain its footing. We think that weakness in the ruble due to the recent events has overshot.

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 …but no change in FX policy in Czech Republic yet

Despite the changes in the regime in Russia, more FX flexibility is not part of a wider trend. For example, the Czech central bank has not signalled any change yet. In August last year, it decided to introduce a EUR/CZK level at 1.27 to prevent a stronger currency from impacting the growth outlook. This policy has been quite successful as inflation has picked up. This is in sharp contrast to Poland and Hungary where consumer prices are still falling. It is likely that the Czech central bank will keep this policy in place to further support economic growth. We expect the central bank to abandon the EUR/CZK peg in 2016 when growth is strong enough to handle a stronger Czech Koruna with rate hikes at a later stage. In general, we judge that euro adoption for central and eastern European countries is still a long way off.


In general, currencies from Central and Eastern Europe should outperform the euro in 2015 and 2016 as investor sentiment remains constructive, growth picks up helped by a strengthening eurozone recovery and the ECB continues to ease. The Polish zloty is the most attractive in the region, but it is too early to move it on our high conviction list.  This is because the National Bank of Poland could reduce interest rates further if deflationary pressures persist, if the economy disappoints or if the Polish zloty strengthens sharply. Moreover, (geo) political risks make us cautious on Russian ruble, Turkish lira and Hungarian forint. These currencies also have major fundamental negatives, such as high debt level (Hungary), high uncertainty and low growth (Russia) and a substantial current account deficit (Turkey). This will make them very vulnerable in case of a sharp deterioration in sentiment. The Czech Koruna will likely be an attractive currency later in 2015 once the economy becomes strong enough to deal with a stronger currency and to abandon the peg.

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