Emerging Europe Watch: Enduring Russia’s collapse

by: Peter de Bruin

151501-Emerging-Europe-Watch.pdf ()

With a deep recession in Russia now looking as pretty much unescapable, many fear that the outlook for the other economies in emerging Europe will take a turn for the worse. We disagree. Although the negative drag from trade will be substantial, the region will benefit from an upswing in the eurozone economy, its largest trade partner, the sharp drop in oil prices, and modest monetary easing. As a result, while this year GDP growth of emerging Europe as a whole (including Russia) is likely to contract for the first time since the financial crisis, there are good reasons to remain optimistic about the prospects for the other countries in the region. All this implies that this year’s growth outlook will be characterised by sharply diverging trends.

Russia’s collapse will hurt Eastern European economies…

After we lowered our Russian GDP forecast for this year from  -1% to -4% (please see our latest Russia Watch, A near perfect storm), we have been thinking about what this would mean for the other economies in the region. The bad news is quite a lot. Exports from Central and Eastern European economies to Russia typically amount to 2% to 2.5% of GDP, though Turkey’s exposure is somewhat lower. That may not seem like an awful lot, but we need to bear in mind that the very sharp depreciation of the ruble, in conjunction with a deep contraction in final domestic demand, will cause Russian imports to fall by around 40% this year. As such, we think that the drag from trade will amount to around 0.8 – 1 percentage points of GDP, which is quite substantial.

20150116 ee1

But outlook of Eurozone is a far more important driver…

However, other economies in emerging Europe will also be benefiting from a couple of significant tailwinds this year, and we stress that we therefore should not become too negative about the region’s growth prospects. For a start, we remain optimistic about the outlook for the eurozone, the region’s main trading partner. Indeed, we continue to hold on to our above consensus growth forecast of 1.5% (consensus 1.1%) for this year, following an expansion of 0.9% in 2014, as a steep drop in the oil price, a cheaper euro, and lower borrowing costs should spur growth in the region.

20150116 ee2

20150116 ee3

It is important to realise that Emerging European economies’ exposure to the eurozone dwarfs the exposure of the region to Russia. So the prospects of the eurozone are a far more important driver of the region’s outlook, which explains why the business cycles of emerging Europe and the eurozone are so highly correlated, as the third graph clearly illustrates.

 …while lower oil prices will provide another tailwind,…

But emerging Europe will benefit from a lower oil price as well. Although the steep drop in oil prices was one of the reasons why we sharply lowered our Russian GDP forecasts for this year, the other economies in the region will benefit from an improvement in their terms of trade, as they rely on imports for their energy consumption.

20150116 ee4

Indeed, using oil consumption estimates of BP’s Statistical Review of Energy Report and taking into consideration that we recently lowered our average Brent oil forecast for this year by $30 dollars to $60 a barrel, we estimate that the windfall from lower oil prices could be around 1 percentage point of GDP over time. This means that the drop in oil prices should roughly offset the effects of sharply falling exports to Russia.

20150116 ee5

…as well as looser monetary policy

But there is more. The drop in oil prices should also open the door for a modest regional monetary easing, which should also underpin growth. For instance, in Turkey, inflation fell from 9.2% to 8.2% in December, on the back of lower food and energy prices. In conjunction with a slight downward trend in core inflation and the unemployment rate rising modestly, we think that an ongoing drop in inflation will trigger the Central Bank of Turkey to start to push the interbank rate down from the upper bound of its interest rate corridor in coming months.

Meanwhile, deflation is set to deepen and last for longer in both Poland and Hungary. Although the National Bank of Poland (NBP) left its policy rates on hold during its latest meeting in January, the Monetary Policy Committee struck a dovish tone in the press statement accompanying the decision. It said that CPI had remained ‘negative’ and that there had been ‘a decrease’ in the majority of core inflation indices, which confirmed ‘the absence of demand pressures’ in the economy. As a result, the MPC signalled a readiness to loosen policy further, if the expected period of deflation were to ‘extend’ and if the growth outlook were to disappoint. All in all, while a strengthening in the activity indicators could keep the NBP on the side lines, we now think that the Polish Central Bank will reduce its key rate by 50bp in coming months.

20150116 ee6

We also expect to see rate cuts in Hungary. The country has been mired in deflation, with inflation falling to -0.9% yoy in December of last year. Moreover, as in Poland, core inflation has been trending down too. Admittedly, the National Bank of Hungary has not yet discussed the option of loosening policy, but we think that, now that oil prices have fallen by so much, a prolonged period of deflation risks that  inflation expectations become dislodged, jeopardising the long-term inflation outlook. As a result, while being a close call, we expect the Hungarian central bank will cut its benchmark rate by 50bps too in coming months.

Finally, inflation in the Czech Republic has remained in positive territory so far, with inflation falling to 0.1% yoy in December. But it will only be a matter of time before it will turn negative. That said, the period of deflation is likely to be shorter and shallower than in Poland and Hungary. While there has been some speculation in financial markets that the Czech National Bank will raise its EUR/CZK floor, which currently stands at EUR/CZK 27.00, to loosen its policy stance further, we think that such a move is probably a bridge too far. As such, we continue to think that monetary policy will remain on hold for the foreseeable future.

Sharply diverging trends

Overall then, although Russia’s economic problems definitely are a negative for Emerging Europe that cannot be looked away from, its impact is likely to be offset by the upswing in the eurozone economy, the fall in oil prices, and looser monetary policy. As such, while this year, GDP growth of emerging Europe as a whole (that is including Russia) is likely to dip into negative territory for the first time since the financial crisis, we continue to think that growth in the other economies of the region will hold up relatively well. The upshot is that this years’ growth outlook will be characterised by sharply diverging trends.

20150116 ee7