Emerging Europe Outlook – Favourable economic outlook to persist

by: Peter de Bruin

Emerging-Europe-outlook-5-Nov-2015.pdf (486 KB)
  • CE-3 economies expected to continue to show a strong recovery
  • Lowflation environment masks rises in wage pressures
  • PiS election victory in Poland not as dramatic as feared


Economies in central Europe are firing on all cylinders

Economies in central Europe are firing on all cylinders. This can clearly be seen in CE-3 economies (i.e. Poland, Hungary, and the Czech Republic) which are the focus of this publication. Domestic demand is picking up briskly. This reflects that labour markets are recovering. With employment on the up and wages starting to increase, consumers have no trouble finding their way to the shops. Meanwhile, a strong economic background is prompting companies to invest. A final factor that is currently giving a strong boost to Central European economies is that their main trading partner, the eurozone, has embarked on a sustained path of recovery. All this explains why the Polish economy grew by 3.3% yoy in the second quarter of this year. Although recent data are in line with a slight deceleration in growth, the economy is still on track to post an annual average growth rate of 3.5% in 2015, the strongest performance since 2011. Developments are broadly similar in Hungary, where the economy grew by 2.7% in the second quarter. Here too, recent developments are in line with a slight slowdown. But the general outlook remains very healthy and the economy is on track to post a solid 3% average expansion in 2015. And then the Czech Republic. While special factors were partly behind its stellar performance in Q1, the economy grew by 4.6% in the second quarter. Unsurprisingly, growth is set to moderate somewhat in the third and fourth quarter. But for the year as a whole, growth should average around 4%. This would be the best performance since 2007.

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Lowflation environment masks tentative wage pressures

Despite the sustained upswing, CE-3 economies are barely experiencing any price pressures at the moment. We have looked at Eurostat’s Harmonized Indices of Consumer Prices, and only in the Czech Republic, inflation, at 0.2% yoy, was in positive territory in September. To a large extent, this reflects the softness in oil prices that has dragged down energy costs. But apart from Hungary, core inflation has been relatively muted as well. However, this is likely to change. Indeed, the environment of lowflation masks that wages pressures have slowly started to build.

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In particular, in the Czech Republic, we are seeing that wage growth has started to increase, while in Hungary, at more than 4% yoy, gains in wages are the strongest among CE-3 economies. The extent to which these developments are generating inflationary pressures differs. This is because Poland and the Czech Republic have been enjoying stronger gains in labour productivity which have offset the upward effects of higher wages on the cost of producing products. Meanwhile, gains in labour productivity in Hungary have been particularly disappointing. The latter helps to explain why core inflation in Hungary is much higher than in the other two CE-3 economies and is trending upwards.

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Another reason that is behind the stronger upward pressure on core consumer prices in Hungary is that according to the OECD, Hungary’s output gap has already closed. In comparison, the output gaps of both Poland and the Czech Republic are still open. This too is in line with a domestic economy in Hungary that is generating more price pressures than in Poland and the Czech Republic. The upshot is that all three CE-3 economies will see a rise in inflation next year – as the drag from sharply lower energy prices unwinds, and an ongoing recovery will continue to exert upward pressure on core consumer prices. This should bring average annual inflation to around 1.5% in both Poland and the Czech Republic in 2016. However, given that core inflation is already trending substantially higher in Hungary, we see average headline inflation around 2.5% in 2016.

CE-3 central bank tightening still far away,..

A very modest increase in inflationary pressures means that CE-3 central banks will keep monetary policy constant for the foreseeable future. The Polish central bank (NBP) should keep rates on hold in 2016. There are some risks to this view related to the fact that of all CE-3 economies, inflation, at -0.8%, is the most negative in Poland. Moreover, the composition of the Monetary Policy Committee will change in early 2016. The recently elected PiS party is likely to opt for more dovish members. But overall, we think that an ongoing recovery, favourable base effects helping to push yearly inflation rates higher at the end of this year and early next year will on balance prompt MPC member to vote to stay on hold. Ultimately, they should move to a tightening bias in the beginning of 2017. Monetary policy in the Czech Republic is even more loose than in Poland. In addition to policy rates bordering at zero, the CNB is using the exchange rate as a policy tool. It has weakened the koruna to CHZ 27 to the euro in order to support trade. In its latest statement, the CNB said that it intends to stop using the koruna as a policy tool around the end of 2016, which we think is credible given the muted inflationary backdrop. Indeed, despite the rise in wage growth, the economy has not yet convincingly started to generate inflationary pressures. However, given the more pronounced inflationary path in Hungary, we think that the Hungarian central bank, of all CE-3 central banks, will tighten first, possibly already at the end of 2016.

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…but to start earlier than the ECB, which should support CE-3 currencies

All this means that CE-3 central banks are likely to tighten policy earlier than the ECB. Indeed, we think that the ECB will step up its monetary stimulus programme in December. We expect it to cut the deposit rate to -0.3%, lower the refi rate by 5bp to zero, increase the size of its asset purchases from EUR 60bn to EUR 80bn, and extend the deadline of its QE programme beyond September 2016. All this implies that it has become very likely that the ECB will only start to remove stimulus in 2018, significantly later than CE-3 central banks. In turn, an expectation of monetary policy divergence should help to strengthen the Polish zloty, the Hungarian forint and the Czech koruna against the euro next year.

PiS likely to boost short-term GDP growth, at a cost of lower potential growth…

Meanwhile, on the political front, in Poland, the right-wing anti migrant Law and Justice Party (PiS) secured a majority during the elections, winning 235 seats in the 460-member Sejm, the lower house of Polish parliament. This marks the first time since Poland’s transition to democracy that a single party will be able to govern alone. Still, PiS has expressed its intention to form a coalition with one or two other right wing parties. Although it remains to be seen to what extent the PiS party will deliver on its election promises, short-term policy is likely to be supportive to GDP growth. However, this will most likely come at a cost of slightly lower potential growth. PiS wants to loosen fiscal policy by cutting the retirement age, increasing child benefits, and raising the tax-free income threshold. It wants to finance these measures by imposing taxes on the retail and banking sectors. It plans to tax banks’ assets, while banks may also bear most of the costs of a loan conversion programme that will force banks to convert Swiss franc denominated loans into zloty’s. In addition, PiS also wants to prioritise local firms over foreign ones. Finally, relationships with the EU are likely to become more strained. PiS strongly opposes climate change legislation and immigration from outside the EU into Poland. A strained relationship with the EU risks lowering foreign direct investment. Meanwhile a taxation of banks’ assets could hurt credit growth, while a lower retirement age is likely to adversely affect the supply of labour.

…but effects should not be exaggerated

We believe that the effects of PiS’s election victory should not be exaggerated. As is mostly the case with parties that win elections, electoral pledges tend to be scaled back whenever a party actually governs. Also, we think that a PiS government does not want to risk losing access to EU funds. This means that Poland’s new government will try to keep its budget deficit within 3% of GDP, as it needs to comply to EU fiscal rules. More generally, we believe that the new Polish government does not fundamentally want to damage its relationship with the EU.