Emerging Europe – Growth set to return in 2016

by: Peter de Bruin

ENG-2015-Em-Europe.pdf (126 KB)

Following a deep contraction, Russia should grow modestly next year,…
…while central European economies continue to expand robustly
Not much scope for acceleration in Turkey’s economic growth

Contraction in Russia, but CEE fared well

Developments in emerging Europe played out quite differently than we had expected last year. While we had thought that Russia’s economy would stagnate, the deep slide in the ruble on the back of a drop in oil prices led to a banking crisis at the end of 2014, prompting the central bank to raise rates to a staggering 17%. The subsequent recession is likely to have led to a 4% contraction in output. In addition, the Russian-Ukrainian conflict has had a significantly deeper impact on the Ukrainian economy, with the latter expected to have shrunk by about one-tenth this year. In contrast, central European economies did, on balance, slightly better than we had anticipated. They staged a robust recovery, helped in part by an accelerating eurozone economy. There were few surprises in Turkey’s performance, with average growth likely to come in at 3% this year, roughly the same pace as last year. Still, the developments in Russia and Ukraine dragged the average growth rate of the entire region into negative territory, marking the first contraction since the great recession.

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Russia and Ukraine are out of recession…

The good news is that Russia’s economy is showing tentative signs of stabilising. The central bank has lowered rates to 11%, while consumers and firms have adjusted their spending patterns to the spike in inflation that resulted from the deep slide in the ruble. In the third quarter, the economy shrank by 4.1% compared to a year ago, down from a 4.6% contraction in Q2. According to our estimates, this translates into an 0.2% expansion compared to the second quarter. This implies that Russia’s recession has ended. That said, despite the loosening of the central bank, financial conditions remain tight. The EU/US sanctions will also continue to weigh on the economy, as will low oil prices. Finally, the economy is in need of structural reforms. Growth in 2016 is therefore expected to be very modest, at best. In Ukraine, helped by a cease-fire in the East of the country, the economy grew by 0.7% in third quarter from the second quarter, implying that the recession ended here too. However, the outlook for Ukraine remains dim as well.

…while economies in Central Europe should continue to propel ahead…

Meanwhile, closer to home, the economies in Central Europe, such as Poland, the Czech Republic and Hungary, should continue to propel ahead. These economies are benefiting from a modestly accelerating recovery in the eurozone, their main trading partner. In addition, consumption is being underpinned by an improving labour market, which has started to drive up wages. A solid economic backdrop is also prompting companies to invest. As a result, third quarter GDP results were upbeat. The Polish economy grew by 3.4% yoy, while the Czech economy, partly helped by special circumstances, expanded by an impressive 4.3%. Growth in Hungary though was modestly softer, at 2.3%. Generally, the performance of CEE economies was relatively strong this year. This implies that we are likely to see some payback next year. This holds particularly for the Czech Republic, where growth should return to a more normal level.

…and growth in Turkey moves sideways

Finally, growth in Turkey is expected to move sideways at around 3% next year. Third quarter GDP figures have not yet been released, but developments over the year as a whole are in line with an average expansion of around 3%. While such a growth rate is something most developed economies can only dream of, it is not strong enough for Turkey to absorb its growing labour force. As a result, the unemployment rate has remained on an upward trend. Even though we expect world economic growth to be modestly stronger next year, the many structural flaws in Turkey’s economy are likely to prevent the economy from accelerating too much. If the government wants to see a stronger economic performance, it should implement structural reforms. In particular, its savings rate is too low, there is an overreliance on the low value added construction sector, and labour market regulation is too tight.

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Russian central bank to continue loosening policy

Turning to the outlook for monetary policy, we think that further monetary easing is on the cards in Russia next year. Granted, the Russian central bank (CBR) refrained from loosening policy in past meetings as inflation, which stood at 15.5% in October, remained stubbornly high. But inflation should soon start to fall more convincingly as the effects of the past ruble weakness fall out of the annual comparison, and the economic weakness weighs on prices. As a result, we think inflation will drop to around 8% at the end of next year, roughly bringing it back to a level we saw before the eruption of the financial crisis at the end of 2014. Against this background, the CBR should continue to loosen monetary policy.

CE-3 central banks to remain on hold for the foreseeable future

Meanwhile, central banks in central European countries are likely to remain on hold for the foreseeable future. Despite the sustained upswing, CE-3 economies are barely experiencing any price pressures at the moment. Inflation is currently deeply negative in Poland, while just positive in the Czech Republic and Hungary. To a large extent, this reflects the softness in oil prices, which has dragged down energy costs. But, with the exception of Hungary, core inflation has also been muted. The low inflation environment masks the fact that in all CE-3 economies, wage pressures have gradually started to build. This should translate to a modest increase in inflationary pressures in 2016, particularly as the drag from lower energy prices unwinds. However, given the low starting point, we do not think that inflationary pressures will be sufficiently pronounced to trigger a central bank response. We therefore expect that the Polish central bank will only move to a tightening bias in the beginning of 2017. Meanwhile, the Czech Central Bank (CNB) has not only cut rates to almost zero, but has also weakened the koruna to CHZ 27 against the euro in order to support trade. During its latest meeting, the CNB said it intends to stop using the koruna as a policy tool around the end of 2016. A next step would be a gradual increase in policy rates, which we think will start in 2017. However, given the more pronounced path of core inflation in Hungary, total inflationary pressures are likely to be higher next year than in Poland and the Czech Republic. This suggests that of all CE-3 banks, the Hungarian central bank will probably tighten first, possibly already at the end of 2016.

Turkey’s central bank to keep monetary policy tight

Finally, Turkey’s monetary policy is expected to remain tight in 2016. Inflation has remained stubbornly high, and – at 7.6% in October – well above the central bank’s target of 5%. In addition, the significant weakening of the lira we have seen over the past months suggests that upward pressure on consumer prices will likely continue to persist. What is more, we anticipate that the Fed will start normalising its monetary policy in December, with the federal funds rate heading to 1.25% at year-end 2016. All this suggests that Turkey’s central bank (CBT) should keep policy tight to prevent the lira from depreciating even more when the Fed normalises monetary policy. This explains why the CBT has continued to push interbank rates against the upper bound of its interest rate corridor. And next year, in line with the CBT’s intention to simplify its monetary policy framework, we also expect to see increases in the one-week repo rate.
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Geopolitics and Fed present main risks to the outlook

Looking at the main risks to the outlook, the current low level of oil prices means the risk of another sharp drop in oil prices has diminished. This has reduced the risk of another financial crisis in Russia. Given the cautious ceasefire in the East of Ukraine, geopolitical concerns have also eased slightly, though geopolitical developments remain key risks to our growth outlook. As we mentioned above, Turkey is expected to pursue a tight monetary policy stance during the time that the Fed normalises its monetary policy. Still, a sharper pace of tightening in the US could have significantly adverse effects on Turkey’s economy. This is because the country’s current account deficit is expected to amount to 5% of GDP next year, notwithstanding the recent improvement. In addition, the country must also service a lot of debt repayments. Together with its current account deficit, Turkey’s financing requirements are expected to reach 13% of GDP. All this implies that the country is dependent on the capital of foreign investors, making it susceptible to swings in investor sentiment.

This article is part of the “Global View” of 25 November 2015.