Hungary, Poland and Czech Republic largely shielded from the recent EM turbulence because of:
1. Strong fiscal positions, also owing to the Maastricht criteria
2. Solid current account balance
3. External debt levels manageable (and largely euro denominated)
3. Inflation below central banks’ targets
4. CEE-3 not directly in the US-China trade tensions firing line
Emerging markets (EMs) have been feeling the heat from a rise in risk aversion amongst investors, resulting in portfolio outflows from EMs, adding pressure on EM currencies, interest rates and stock markets. If we look at the EM asset class as a whole, it is fair to say that the effects of this year’s market turbulence on EMs has been comparable to the impact from the taper tantrum in 2013-14 (See: EM Watch, Differentiation still the dominant theme). Differentiation however within this very heterogeneous asset class has again proven to be an even more important investor theme than general contagion. In this respect, Hungary, Poland and Czech Republic (the Central Eastern Europe three biggest economies, henceforth: CEE-3) have been partly shielded from the EM turmoil. The equity indices of both Poland and Czech Republic have done better than the average EM equity index (MSCI EM Index), while Hungary’s equity performance is quite similar to the MSCI benchmark.
Also, CEE-3 currencies have not been hurt that much compared to other key EM currencies. At the start of the year (in January), the Polish zloty, the Hungarian forint and the Czech koruna strengthened versus the US dollar at a time when the US dollar was under pressure across the board. However, between mid-April and end of May when the US dollar started its recovery, these currencies have declined by around 10% versus the US dollar. Since May, they have been relatively resilient compared to other EM FX. The Turkey FX crisis only had a temporary negative impact on the zloty, forint and koruna. Their resilience is also reflected by the currency volatility, which was much lower in CEE-3 currencies compared to the broader EM basket.
Why are CEE-3 countries shielded?
There are several reasons why the CEE-3 countries have been relatively shielded from the EM turbulence. First of all, the CEE-3 countries have strong economic fundamentals. The fiscal and external positions are overall solid. Both Czech Republic and Hungary have current account surpluses. Inflationary pressures and fears for import inflation are moderate, in contrary to countries such as Argentina and Turkey that face double digit inflation. Also, as we explained in our recent EM Watch, countries whose growth models rely strongly on trade with US and/or China are hit hardest by the US-China trade conflict. Although the CEE-3 countries are heavily export oriented, they are less vulnerable to the US-China trade conflict, because their exports are mainly directed to the eurozone. That said, should the eurozone be hurt by these trade tensions, that could well have repercussions for CEE-3 exports.
- Fiscal positions are strong, also owing to the Maastricht criteria
On the fiscal side, especially Czech Republic shows strong figures. The government balance as percentage of GDP has been positive since 2016 and is expected to remain positive throughout 2019. The government debt is on a declining path, from a high of 45% of GDP in 2013 to a current level of 32%. Poland shows similar, albeit somewhat weaker fiscal figures. The government balance has been negative from many years despite strong economic growth and low unemployment rates. Government debt to GDP stands around 50% of GDP and is forecasted to decline slowly over the coming years.
Hungary shows some deterioration in its fiscal position over the last years, despite brisk economic growth. Government balance as percentage of GDP has been negative over the last years, and is estimated to reach -2.6% in 2018. Hungary also has the highest government debt ratio of the three countries (72% of GDP). While the current strong economic growth would offer an opportunity to cut the budget deficit in order to keep the public debt reduction on track, the government seems to opt for further fiscal stimulus. This goes against the recently issued country-specific recommendations by the European Commission for Hungary, proposing a continuation of the fiscal deficit reduction programme. Under the Maastricht criteria, public debt must be below 60% of GDP and the budget deficit less than 3% of GDP. The Commission proposes that the Council adopts a recommendation for Hungary to take appropriate measures in 2018 with a view to correcting this fiscal deviation. That said, Hungary’s fiscal erosion is not comparable to other, much more vulnerable EMs, such as South Africa that has seen a budget deficit over 4% in the last years and Brazil that saw an average budget deficit of 7.5% in the last three years. The Maastricht criteria therefore acts as a disciplinary mechanism for the CEE-3 countries to keep their fiscal positions healthy.
- External debt levels considerable, but external position solid
During the EM turbulence in the last months, especially countries with a (structural) current account deficit, such as Turkey and Argentina, have been hit hard. While Poland shows a small deficit on its current account, the deficit has narrowed considerably in recent years. Most of the adjustment has been driven by the trade balance; higher exports and stable imports. Poland’s external debt is moderate (43% of GDP) and its FX reserves cover 4 months of import. Moreover, due to the strengthened macro conditions, Poland decided to end the IMF Flexible Credit Line in November last year.
Both Hungary and Czech Republic have positive current account balances, but display substantial external debt to GDP figures (around 90% of GDP). That said, external debt for the CEE-3 region is on a declining path. Hungary for instance, had external debt levels of 135% of GDP in 2009. Furthermore, a bigger part of the CEE-3 external debt is euro-denominated (and Swiss-franc denominated), instead of dollar-denominated. This have shielded them from the stronger dollar in the last months. However, if the euro or Swiss franc were to rise sharply, the CEE-3 region is vulnerable. That said, we expect the euro to strengthen versus the US dollar next year but not versus these currencies. In addition, we expect a considerable weakness of the franc. Taking together, it is unlikely that CEE-3 debt denominated in euro and Swiss franc will unlikely pose a problem going forward, unless a new eurozone crisis were to erupt.
All countries have floating currencies, which provides an automatic stabilizer and supports exports when the currency comes under pressure.
- Inflationary pressures not really an issue
Dissimilar to many other EMs, CEE-3 does not fear the ‘inflation beast’ (anymore). The region actually suffered a period of deflation right after the euro crisis in 2014-15. This is also partly related to demographics, as population growth is slowing (in contrary to many other EMs) and the CEE-3 countries suffer ageing issues. In all three countries inflation has remained below the (upper limit) of the inflation targets of the central banks. Inflation gradually slowed in the beginning of this year on the back of weaker food prices, before picking up around April. Only in Hungary, inflation has showed a clear upward trend in the last months, reaching 3.6% yoy in September this year. However, this materialized on the back of generally loose monetary policy (key rate at 0.9% since May 2016) and a further rise in inflation would likely trigger a rate hike.
- CEE-3 not directly in the US-China trade tensions firing line, but will suffer de-globalization effects
Another key factor – not an issue during the taper tantrum – has been the escalation of trade tensions between the world’s major powers, particularly between the US and China. Financial markets are still worried by the stepping up of import tariffs and the uncertainty how far such a trade war may go. The CEE-3 trade ties with both the US and China are minimal. Exports to the US as % of total GDP is below 3% for all three countries. That said, the CEE-3 is very reliant on global value chains, also compared to other EMs. The value of exports as percentage of GDP is around 73% for Hungary, 70% for Czech Republic and 45% for Poland. This is substantially higher than other EMs such as Brazil, Russia and South Africa (15%, 25% and 30% respectively). Therefore, in a less supportive environment for global trade, CEE-3 will suffer as well, especially in case the eurozone – the region’s key export destination – would suffer from such trade conflicts. The region would no longer be able to reap the quick and large benefits of productivity boosting reforms focused on external liberalization.