Emerging Europe outlook – Weathering the Russian storm

by: Peter de Bruin

Emerging-Europe-Quarterly - 26 March 2015 - Weathering the Russian storm.pdf ()

Although Russia’s economy is sinking into a deep recession, other central eastern European economies are in good shape, and are expected to post a decent economic performance in coming years. This is mainly due to a strengthening eurozone economy, CEE-economies’ main trading partner. In addition, domestic demand in these economies is firming. This trend is being reinforced due to the drop in oil prices, which has boosted consumers’ and firms’ real purchasing power. Moreover, it has opened the door for further monetary easing.

Russia sinking into recession,…

Incoming data in Russia clearly shows that the economy is sinking into a deep recession. Retail sales plummeted by 7.7% yoy in February, as sky-high inflation is eating into real wages. Meanwhile, the uncertain economic backdrop continues to prompt companies to shelve their investment plans. In February, fixed capital formation declined by 6.5% compared to a year ago, slightly down from -6.3% the month before. Finally, industrial production fell by 1.6% in February, the first decline since November of last year. All in all, we think that the data in Q1 are in line with a contraction in GDP of around 4% yoy. The recession is likely to deepen in the second quarter. But, it should moderate somewhat later in the year, as inflation slowly comes down and the central bank loosens policy further.


…but CEE-economies weathering the storm well,…

The good news though is that the economies in central and eastern Europe are weathering the Russian storm. In most CEE-economies, GDP growth in 2014 accelerated in comparison to 2013. What is more, this trend is likely to continue in 2015. This can, for instance, be seen when looking at the manufacturing PMI’s of the different countries, which are clearly on the up. Indeed, the manufacturing PMI’s of the Czech Republic, Poland and Hungary are all hovering around 55, a level that is in line with decent growth.
…as the eurozone economy shifts into higher gear,…
One of the reasons that the CEE-economies are doing well is that the eurozone recovery is shifting into a higher gear. For instance, the eurozone composite PMI rose to 54.1 in March, the highest level in almost four years. A sharply lower oil price, and the ECB’s QE programme leading to a plunge in the euro and government bond yields are likely to continue to stoke up the recovery in the coming time. Indeed, we recently raised our eurozone GDP growth forecast from 1.6% to 1.8%, which is even further above consensus. All this is important as the eurozone is the main trade partner for CEE-economies, easily dwarfing Russia in importance. For example, Czech exports that are being shipped to the euro area account for almost 50% of GDP, whereas exports to Russia amount to a paltry 2.5% of GDP. The trade interconnectedness of CEE-countries with the eurozone also explains why the business cycles of both regions closely track each other.


…and domestic demand firms,…

At the same time, CEE-countries are benefiting from a strengthening of domestic demand. The labour markets in the Czech Republic, Poland and Hungary have continued to strengthen and unemployment rates are on a modest downward trend. This has resulted in a moderate pickup in wage growth, which should underpin consumption. Against a backdrop of firmer economic growth, companies should also increasingly feel confident to invest, implying that CEE-economies are likely to fire on all cylinders next year.

…partly helped by a lower oil price,…

The sharp drop in oil prices that we saw in the second half of 2014 is another reason why we are optimistic about the prospect for CEE-economies. These economies are large energy importers. Cheaper oil prices will thus improve their terms of trade. In turn, as consumers and companies can devote a larger part of their budgets to non-energy related expenditures, this will boost consumption and investment even further.

…and even looser monetary policy

The drop in oil prices has also pushed inflation further down, and in most countries it is deeply in negative territory. This has opened the door for further monetary loosening. In Poland, the central bank has cut its key policy rate by 50bp to 1.5%. Meanwhile, the Czech central bank, which has already brought its policy rate to an absolute low of 0.05%, will try to weaken the koruna for longer than earlier communicated. This is done to support exports. The central bank has said that it wants to keep the floor between the euro and the koruna in place until the second half of 2016, roughly half a year longer than it had earlier intended. Finally, on the 24th of March, the Hungarian central bank reduced its interest rate by 15bp to 1.95%, and signalled that more rate cuts are on the cards.


Markets will start to focus on central banks’ exit at turn of the year

However, we think that around the turn of the year, markets will increasingly start to think about when a period of ultra-loose monetary policy will end in CEE-economies. Given its growth and inflation forecasts, the Czech central bank has already indicated that it intends to remove the floor between the euro and the koruna in the second half of 2016, opening the door for rate hikes later in that year. In Hungary and Poland, we are looking for the first rate hike towards the end of 2016 or possibly the beginning of 2017. If we are right, this means that a period of financial markets anticipating that the ECB will start to taper its asset purchase programmes will be accompanied by markets’ expectation of the beginning of monetary policy tightening in CEE-countries. This explains why we see the Polish Zlotty moving roughly sideways against the euro in 2016, though we think that there is a bit more room for the Czech koruna to strengthen once the floor is removed.

Hungarian forint and Turkish Lira to come under pressure

In contrast, we are cautious about the Hungarian forint and the Turkish lira. This reflects that these currencies are vulnerable to shifts in market sentiment when the Fed starts to tighten policy. Admittedly, we recently changed our Fed call. Instead of three rate hikes, we now see only two rate increases in 2015, bringing our call a bit closer to what markets expect. But, we think that the Fed in 2016 will be forced to bring rates all the way to 2.25%, which is still roughly a full percentage point higher then what financial markets are currently pricing in. This means that towards the end of 2015 and in the beginning of 2016, currencies of countries with poor economic fundamentals and unorthodox are likely to come under pressure.


Rising oil prices should support the ruble

Perhaps somewhat paradoxically, we think that there is some room for the Russian ruble to strengthen. While our scenario continues to see the central bank bringing down its policy rate, as the past ruble weakness induced inflation will slowly abate, we think that the effects will be more than offset by increasing oil prices. We think that Brent oil price will rise to $65 a barrel at year-end 2015 and to $80 a barrel at year-end 2016. As Russia’s economy is heavily dependent on energy exports, a higher oil price should support the ruble, an eventual flaring up of geopolitical tensions notwithstanding.

Geopolitics and Fed remain biggest risks

In thinking about the main risks to our scenario, the risk of the eurozone recovery failing to gain strength has fortunately diminished somewhat, in our view. However, another escalation of the ruble crisis remains a possibility, in particular if oil prices were to drop and/or if geopolitical risks rise to the forefront and derail market sentiment again. In this case, the central bank will be forced to defend the ruble by massively hiking rates, akin to what we saw at the end of last year. This will push Russia’s economy into an even deeper recession, while confidence effects will likely also depress other CEE-economies. Finally, while having incorporated the effects of the Fed ending its loose monetary policy in our currency forecast, the tapering dry run in 2013 has clearly showed that financial markets can respond in a unpredictable way when the US central bank intends to tighten its policy. As such, a faster-than-expected Fed exit remains a risk to the outlook.