CEE-3 Watch: Momentum is here

by: , Georgette Boele

In this publication: Economic indicators in Czech Republic, Hungary and Poland (CEE-3) have surprised to the upside in recent months. Loose fiscal policy in Hungary and Poland remains concerning. Inflation in CEE-3 is nearly on target, but central banks maintain a cautious stance. A combination of wage pressures and no further acceleration in growth in the eurozone indicate that the CEE-3 has likely reached its growth limit. We expect growth to remain around current levels in 2018.

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Economic momentum is here

The first quarter growth performance of the Czech Republic, Hungary and Poland (CEE-3) clearly surpassed Q4 levels and consensus expectations. In Q1 2017, GDP growth was 2.9% yoy in the Czech Republic, 4.1% yoy in Hungary and 4% yoy in Poland. Economic growth was driven by private consumption, which was higher mainly due to increased real wages. Hungary and Poland are more frequently dealing with shortages in the labour market, which has substantially pushed up wage growth in both countries over the past few months. This, together with fiscal transfers, has supported household spending. CEE-3 also profited from the pick-up in growth in the eurozone, which has lifted exports of goods and services. Furthermore, there are signs in Poland and Hungary that after a dip in 2016 investment has rebounded due to a renewed inflow of EU funds following a slow start to the new funding period last year.

Czech Republic improves fiscal policies; Poland and Hungary still struggling

Both Hungary and Poland are currently testing the limits of the EU Stability and Growth Pact rule. This rule requires that countries maintain budget deficits below 3% and total public debt below 60%. If they breach the SGP’s rules, an Excessive Deficit Procedure (EDP) is initiated, which outlines an adjustment path to get the country back on its fiscal track. Since the EDP ended for Hungary in 2013, strong economic growth and several large one-off receipts have helped the government deficit stay below the 3% threshold. However, recent tax cuts and the increased minimum wage has put the budget under renewed pressure. Furthermore, budgeting is based on a GDP growth of 4.3%, which we consider optimistic. Therefore, we think Hungary is likely to surpass its budget deficit target of 2.5%. Given the country’s government debt of 75% of GDP (which is considered excessive under the Pact), there is a risk that Hungary will fail to comply with the Pact’s budget rules. Consequently, it may be thrown back into EDP or face restrictions on access to European funds.

The situation is similar in Poland, where the 2017 budget bill foresees a rise in spending on defence and infrastructure alongside a reduction in the retirement age. This, combined with the suspension of the government’s new retail tax in September, will put the budget deficit under renewed pressure. We expect the general government budget deficit to be around 3% in 2017, but there is a risk that disappointing government revenues could return Poland to the EDP (which ended in 2015). Poland’s government debt is well below 60% and it has implemented a public debt brake, which imposes austerity if the debt ratio surpasses 55%. This may soften the EU’s reaction if deficit levels exceed 3%. However, prolonged testing of the Pact’s budget rules will result in another EDP.

Inflation edges up…

After a long period of around zero headline inflation in CEE-3, the rate edged up at the end of 2016. In Q1 2017, headline inflation reached its highest point since the beginning of 2013 while core inflation exceeded the eurozone average, especially in the Czech Republic.

We expect inflation to remain around the same level (2.1%) in the Czech Republic and to edge up in Hungary (3.1%) and Poland (1.5%) at year-end 2017. This on the back of higher wage growth in the course of 2017-18. Unemployment is historically low and both Poland and Hungary are dealing with declining populations, while all three countries are grappling with ageing populations. Poland in particular has one of the most rapidly aging populations in the EU. As a consequence, its retirement age will be lowered to 60 years for women and 65 years for men in October 2017. Both Hungary and Poland have ignored the immigrant quota system and the supply of new labour is scare. On balance, this will drive-up wage growth, thus creating further inflationary pressures.

… the Czech Republic abandoned the FX floor to temper inflation…

At the beginning of April, the central bank of the Czech Republic (CNB) removed its cap on the koruna versus the euro (or the floor of the EUR vs CZK at 27) which it implemented in 2013. The central bank initially imposed this limit in an effort to combat deflation. With interest rates around zero and no desire to cut them below this threshold, the central bank used this policy to cap the strength of the koruna with a view to fighting deflationary pressures and supporting exports. This policy resulted in a substantial rise in FX reserves (which have doubled since 2012), a undesirable situation for the CNB. Since the central bank abandoned the floor, the CZK has appreciated to levels below 26.5 versus the euro. Still, the CNB stands ready to intervene in the currency market if the EUR/CZK fluctuates too much. In April, inflation rose to a new four-year high, exceeding the level of 2% (March: 2.6%), and has currently reached the central bank’s target. Meanwhile, core inflation moved to around 2% in March this year. This was partly due to one-off price increases. As the CNB removed the currency floor in EUR/CZK, we expect that inflationary pressures will be partially offset by a higher koruna (resulting in lower import price inflation). So, by allowing the koruna to strengthen, the CNB has taken the first step of tighter monetary policy. It is likely that the CNB will continue to take this approach and allow the CZK to appreciate at a modest pace versus the euro to dampen inflationary pressures. This will buy the CNB time to wait as long as possible before hiking interest rates although it is likely that the CNB will hike before the ECB next year (we expect a ECB rate hike in Q3 2018). In view of this, we have adjusted our year-end EUR/CZK forecasts. We expect the CZK to appreciate towards 26.0 at the end of 2017 and to 25.5 at the end of 2018.

… and Poland’s and Hungary’s monetary stance remains cautious

Headline inflation in Hungary rose sharply to 2.1% yoy in May this year, but core inflation has lagged behind (0.3% in April). Therefore, monetary policy is set to remain accommodative (key rate stands at 0.9%) going forward. The central bank even commented that it is willing to lower rates further if inflation “remains persistently below” the current target of 3.0%. The central bank aims to reach this target by mid-2018, and we therefore anticipate that it will take a ‘wait-and-see’ approach at least until Q4 2017. Meanwhile, we expect the Hungarian central bank MNB to leave its policy rate unchanged.

In Poland, inflation also increased at the end of 2016 and headline inflation now stands at 2% (close to the 2.5% target). Core inflation rose from 0% in December last year to 0.9% in April 2017. The rise in inflation is mainly due to the tightening labour market, including the pick-up in wage growth. However, the National Bank of Poland (NBP) was dovish at its 4-5 April monetary policy meeting and decided to keep the reference rate at the record low of 1.50%. At the same time, we expect wage pressures to continue rising (see also: FX Watch: PLN – Look before you leap). With higher energy prices, a closing output gap and fiscal and monetary stimuli, we think inflation may shoot above target in the second half of 2017. Nevertheless, the central bank sees a limited risk of inflation running persistently above target in the medium term and we foresee the central bank remaining dovish at least until Q1 2018.

The CEE-3 is set for short-term improvements

We expect growth momentum in the CEE-3 to carry on into the third quarter of 2017, followed by a growth stabilisation at the end of 2017. We believe that, on balance, growth in 2017 and 2018 will not outpace the levels experienced in the past two years.

Fiscal stimuli and the return of EU funds in 2017 will further support growth. This is especially the case in Poland, which has received EUR 104 billion from EU Funds over the period 2014-2020. This is equal to 3.5% of GDP per year. In comparison, from 2007-2013 Poland received 2.3% per year on average. Meanwhile, Hungary and the Czech Republic are projected to receive slightly higher percentages of funds from 2017 onwards. However, the funds are not substantial enough to lift growth to higher levels in the short term and are mainly improving the long-term outlook because they target improved infrastructure and education.

The ongoing economic recovery in the eurozone has benefitted the CEE-3 countries. In particular, strong growth in domestic demand in Germany has given a further push to exports, since Germany is the region’s most important trading partner. We expect the eurozone economy (and Germany) to continue growing at a rate somewhat above trend throughout 2017 and 2018, although the risks to the growth outlook seem to be to the downside.

Furthermore, all three countries are facing tightening labour markets. This will drive-up wage growth, which will create further inflationary pressures and will come at the expense of these countries’ competitiveness.

Taking these effects into account, we expect the Czech Republic to maintain an economic growth trajectory of 2.5% in 2017-18. Ahead of parliamentary elections in Hungary in the spring of 2018, we have accounted for some extra fiscal stimuli and therefore forecast growth in Hungary to be slightly above 3% in 2017-18. In Poland, on the back of a fiscally simulative environment and accelerating EU fund utilisation, we anticipate that the economy will growth by 3% in 2017-18.

Downside political risk to growth trajectory for Poland and Hungary

Both Poland and Hungary are governed by conservative, Eurosceptic parties. The biggest concern is not internal stability, since both parties enjoy considerable approval ratings and have majorities in parliament, but the deteriorating relationship with the EU. In Poland, the Law and Justice party (PiS) has been accused of dismantling democracy and limiting civil liberties. Changes to the constitutional tribunal provoked the European Commission (EC) to initiate a rule-of-law procedure. In Hungary, the Fidesz-Hungarian Civic Alliance (Fidesz) faced criticism for strengthening its grip on public institutions, such as the central bank, the judiciary and the media. The EC has launched a number of proceedings against Hungary, claiming that new legislation has breached EU rules by jeopardising democratic principles. Hungary and Poland’s recent refusal to take any refugees within the EU migrant redistribution quota has added to the strain on relations with the EU. At this time, we believe it is unlikely the EC will impose sanctions on Poland or Hungary for their policy direction as this will only cause a further division in Europe. However, in the longer term, with a pro-Europe president in France and following elections in Germany, European leaders may come to the conclusion that they must toughen their stance to ensure European unity. Further tensions with the EU may compromise foreign investor confidence in Poland and Hungary. And looking further ahead, the erosion of the independence of institutions such as the constitutional court, the media and the National Bank will have implications for these countries’ growth trajectories as well.