Emerging Europe Outlook – Slower but still healthy

by: Peter de Bruin

In this publication: Growth slowed in CE-3 economies in Q1,… …but economic backdrop remains healthy. Inflation should gradually start to rise towards the end of the year.

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Following a year of strong growth…

Although growth in the eurozone remained moderate, 2015 marked a bumper year for Poland, Hungary and the Czech Republic (CE-3 economies). Despite its political challenges, Polish GDP grew by 3.6% in 2015, the strongest growth rate since 2011. Meanwhile, the Hungarian economy grew by 3% in 2015. Granted, that marked a slightly slower growth rate than in 2014, but apart from that year growth was the strongest since 2006. Finally, growth in the Czech Republic amounted to 4.2%. This was the fastest growth rate since 2007, even though the stellar performance was partly caused by special circumstances.

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…the beginning of 2016 saw a loss of momentum…

However, first quarter GDP data showed that CE-3 economies lost momentum in the first quarter of this year. In Poland, growth slowed from 4.3% in Q4 of last year to 3.0% in year-on-year terms. In quarterly terms, the economy even shrunk by 0.1%, though this followed an exceptionally firm 1.3% gain in the final quarter of last year. The slowdown in Hungary was even more pronounced. Yearly growth fell from 3.2% to 0.9%. This was due to an 0.8% quarterly contraction in the first quarter of the year that followed an 0.6% gain in the quarter before. First quarter GDP data for the Czech Republic will only be released next week, but according to our estimates the Czech economy shifted into a lower gear as well. Based on monthly data, we estimate that GDP growth fell from 4.3% to around 3%, though in quarterly terms the economy should have posted some growth.

…but economic backdrop remains healthy

While, given the relatively weak first quarter, we think that CE-3 economies will grow a bit less strongly this year than last year, we think that the loss of momentum of the region in the first quarter will be temporary. Although Hungary’s slowdown was also attributed to a drop in construction as works performed from EU funds were completed, we suspect that the moderation of growth in CE-3 economies mostly reflects payback from the very strong performance that we saw last year. This is because the main factors that propelled growth in 2015 have all remained in place this year. Indeed, in Poland, Hungary and the Czech Republic, labour markets have continued to improve. In all three countries, unemployment rates have remained on downward trends, while wage growth is slowly accelerating. This implies that households are enjoying strong gains in disposable income that will support consumption. With demand set to continue to increase and companies enjoying sound financial positions, investment activity is also likely to continue to expand. Finally, we think that the eurozone recovery, while remaining modest, will continue. In turn, this should support exports. However, we think that the contribution from net trade will be less strong than last year given that strong domestic demand will fuel imports.

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Disinflation has continued…

Despite the ongoing recovery, the period of disinflation has continued. According to Eurostat, in March, HICP inflation remained negative in Poland (-0.4%) and in Hungary (-0.2%), while in the Czech Republic, it was barely positive (0.3%) in that month. Inflation is primarily being dragged down by low energy prices. However, given the recent modest rebound in oil prices, we expect that the past weakness in oil prices will fall out of the annual comparison towards the end of the year. Base effects will thus ensure that headline inflation will converge to core inflation, which is running more decisively above zero.

…but price pressures building under the surface

Another reason why we think that inflation will slowly rise in CE-3 economies is that, core inflation should also gradually start to rise in coming years. This is because the ongoing recovery in the labour markets in CE-3 economies has slowly started to ignite wage growth. Admittedly, in Poland and the Czech Republic, gains in wages are still being easily offset by rises in productivity, implying that the costs to produce an unit of output have continued to decline. But we think that a further tightening of the Polish and Czech labour markets will lead to an acceleration in wage growth that will eventually exceed productivity gains. This suggests that unit labour costs should gradually start to rise in coming time. Wage growth is also slowly picking up in Hungary, but that CE-3 economy has enjoyed substantially lower gains in productivity than Poland and the Czech Republic. As a result, unit labour costs have already started to rise, albeit very modestly. This explains why, according to Eurostat, core inflation is the highest in Hungary among CE-3 economies.

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Finally, core inflation should also find support from the gradual disappearance of spare capacity. According to data from the OECD, the output gaps of CE-3 economies are on the verge of being closed. This suggests that spare capacity in the economy is slowly disappearing, which should also underpin core consumer prices. Interestingly, the output gap of Hungary, has narrowed the most. So, this country seems prone for a relatively sharper gain in inflation than Poland and the Czech Republic.

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Hungarian central bank set to ease further…

Against this background, it is perhaps surprising that the Hungarian Central Bank (MNB) has signalled that it is willing to continue to ease policy. In March, it cut its policy rate by 15bps to 1.20%, and reduced rates another time to 1.05% in April. In the accompanying press statement, the MNB said that a sustainable achievement of the inflation target pointed to a ‘further slight reduction in the policy rate’. This suggests that the central bank will reduce its policy rate further. However, given the low level of its policy rate, rate reductions will continue to be small in size, and the amount of further monetary easing is likely to remain limited, though the MNB could opt to implement further unorthodox measures. We think that the central bank will cut its policy rate two more times by 15bp, bringing it to 75bp. But that should be it. And we expect that rates will then remain on hold during the most of 2017. The central bank will most likely only begin to tighten policy at the end of that year, or in the beginning of 2018.

…but Central bank in Poland to hold policy unchanged,…

The story is a bit different for both Poland and the Czech Republic. In Poland, the central bank (NBP) acknowledges that Poland is currently still in deflation. However, the central bank believes that this has not ‘adversely affected decisions of economic agents so far’. To us, this suggests that the NBP will have a more growth oriented focus than a focus on price movements. As explained above, we think that Poland’s weakness in the first quarter was temporary. As a result, we expect the central bank to keep rates on hold for the remainder of this year, and during most of next year. At this stage it is difficult to precisely forecast when the central bank will begin its tightening cycle, but we think that this will be at the end of next year or the beginning of 2018.

CNB more dovish – but we do not expect additional measures

The central bank of the Czech Republic (CNB) will also likely keep its policy unchanged this year. It has left its policy rate at almost zero percent, and continued to keep the exchange rate at a low level of CZK 27 to the euro in an attempt to support exports. In its latest press statement, the central bank struck a slightly more dovish tone. It said that it was ready to move the exchange rate commitment to a weaker level, if lower inflation expectations would manifest itself in slower wage growth. The central bank also discussed the possibility of negative rates. However, at the same time, the CNB stated that it expects that wages would rise at a steady pace this year and accelerate next year. This suggests that the bar for additional easing is high, and thus unlikely. Indeed, the CNB expects that it will use the exchange rate as a policy tool until the middle of next year, which we think is credible given the outlook for inflation. The central bank will most likely start raising its policy interest rate at the end of 2017 or the beginning of 2018

Removal of stimulus should underpin CE-3 currencies

If we are right in our forecasts, CE-3 central banks will start to remove monetary stimulus earlier than the ECB. The prospect of the appearance of this trend explains why we expect that the Hungarian forint and the Polish zloty will start to strengthen from 2016Q4 onwards. We also see a strengthening of the Czech Republic’s koruna, but only from 2017Q3 onwards, as the central bank will likely continue to keep the koruna at CZK 27 to the euro until the second quarter of next year.

Most upside for Hungarian forint

Of the three CE-3 currencies, we see the Hungarian forint strengthening the most during our forecasting horizon. This reflects that we think that, given the Hungary’s inflation outlook, its central bank will be forced to tighten its policy the most. Admittedly, Hungary’s political situation – with Prime Minister Viktor Orban’s government having taken a strong anti-immigration stance and having implemented a range of unorthodox measures over the past years, posts a risk. But a strong offsetting factor is that the country’s current account surplus has moved even further into surplus, while external debt – though still high – has started to come down. The country thus seems relatively well positioned to deal with any political uncertainty. Indeed, Moody’s and Fitch recently changed their outlook to positive, while S&P raised its rating to BB+.

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Czech koruna should also strengthen

We are also positive about the Czech koruna. This reflects that the Czech Republic has sound economic fundamentals, such as low fiscal and external debt. Among the CE-3 economies, it enjoys the highest credit ratings. Obviously, the Czech central bank will keep a wary eye on the behaviour of the koruna once it lets the koruna float freely. Too strong an increase would most likely prompt the central bank to intervene again, preventing very sharp rises of the currency. But our general impression is that the koruna will gradually strengthen in the second half of next year, in line with the healthy performance of the economy.

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…but cautious about Poland

However, we are more cautious about Poland. This is because the PiS government has moved to reshape public institutions, eroding the checks and balances in the country. This has led to fears that Poland may face another downgrade, after S&P cut its rating from A- to BBB+ in the beginning of this year. While Poland enjoys relatively low levels of fiscal debt, manageable levels of external debt, and has sound economic fundamentals, this explains why the Polish zloty has been the currency among CE-3 currencies that performed the worst since the beginning of this year. Even though we continue to think that the zloty will on balance strengthen during our forecasting horizon, we expect it to increase the least among CE-3 currencies.