Unicredit: CEE Quarterly

After three years of successful fiscal adjustment, growth remains Romania’s biggest challenge. But with domestic demand hit by austerity, a poor harvest and faltering exports amid weak economic activity in the EU, the country faces stagnation over the coming quarters. GDP contracted by 0.6% yoy in 3Q12 (-0.5% qoq) after drought hit wheat and maize crops and the government stopped infrastructure projects for lack of funding, causing investment to decline after growing 2.6% yoy in 1H12.



After three years of successful fiscal adjustment, growth remains Romania’s biggest challenge. But with domestic demand hit by austerity, a poor harvest and faltering exports amid weak economic activity in the EU, the country faces stagnation over the coming quarters. GDP contracted by 0.6% yoy in 3Q12 (-0.5% qoq) after drought hit wheat and maize crops and the government stopped infrastructure projects for lack of funding, causing investment to decline after growing 2.6% yoy in 1H12. Going forward, we expect a 0.1% yoy growth rate in 4Q12 driven by public consumption and rising inventories, bringing the annual growth rate to just 0.2%. On the supply side, the bad agriculture year spurs retail sales (up 3.6% yoy in 3Q12), but industry will not contribute to growth because of weakening activity in Germany.

Gross Domestic Product

GDP growth could pick up gradually in 2013 and 2014 to 1.3% and 1.8% respectively, in line with a slow recovery of economic activity in the euro area. Faster growth will depend on further structural reforms and better EU fund absorption. The former could aim at reducing public sector slack (while leaving more funds available for public investment) and increasing the participation of the labour force. The latter could offset poor foreign direct investment.

Absent such measures, GDP (without agriculture) cannot grow faster than 2% yoy. The current account deficit shrank to 3.6% of GDP at the end of September from 4.4% of GDP at the beginning of the year, but the improvement relies on a narrower income balance deficit, on larger transfers to the government and service balance surplus for a combined reduction of EUR 1.0bn. Despite a weaker RON in 2012, the goods trade balance hovers at EUR 7.0bn FOB-FOB (EUR 10.0bn FOB-CIF) due to inelastic imports of energy and food, coupled with a high content of imports for Romanian exports.

Fund flows

Romania continues to be one of the weakest fund flow stories in CEE. FDI and capital account flows cover the smallest share of the current account among new EU members, leaving a gap of approximately 1.7% of GDP to be financed from more volatile inflows, such as portfolio investment. The latter turned to EUR 2.0bn outflows during this summer’s political crisis and the 10M12 flows amounted to just EUR 1.0bn (0.7% of GDP). The dependence on volatile inflows could be reduced if Romania were to absorb more European funds. At less than 10% of fund allocation, Romania lags all other countries in CEE in terms of absorption of structural and cohesion funds and the country could try emulating Poland and the Baltics who have managed to attract 45%-60% of allocated funds. During the next financial programming period 2014-2020, the country risks receiving fewer funds than its size and needs would entail because European authorities want to punish underperformers.

Romania‘s budget deficit will fall in 2012 below 3% of GDP (based on accruals, ESA 95 methodology) and the country will exit the Excessive Deficit Procedure (EDP). On cash basis, the deficit has been flat at 1.2% of GDP between July and October but local authorities have accumulated arrears following local elections in June.

Fiscal reforms

Further fiscal consolidation in 2013 will necessitate additional reforms in order to meet the deficit target of 2.2% of GDP (too tight a target given the current economic weakness throughout Europe). The Romanian authorities intend to implement a list of reforms with help from the IMF and the World Bank (WB): improving tax collection, simplifying tax payment procedures, better monitoring the tax duties of wealthy individuals, prioritizing capital expenditure through multi-annual investment plans and further reducing the losses of state owned enterprises. The first and last two items on the list have been permanently on the priority list of Romanian governments, with limited results. There are a number of risks to next year's budget. GDP growth could fall short of the government's 2% assumption while the wage bill will rise to 7-7.1% of GDP as wages are returned to June 2010 levels. EU fund disbursements will restart gradually after a negative audit in 2012. Lastly there is likely to be pressure from local administration for higher expenditure. Even if Romania fails to meet the 2.2% deficit target, a gap below 3% of GDP in 2013 will be a positive result. The structural deficit could fall next year below 1% of GDP, approaching the 0.7% medium-term target.


Although all parliamentary parties are committed to the IMF agreement, privatisations and public sector reforms have dragged over the past year. Romanian authorities would like to sign a third agreement when the current one expires in March 2013, but the IMF would like t see more results before that happens. The small amount and volatile nature of FX fund flows are likely to weigh on the RON in 2013. In this environment, the monetary policy will probably focus on the exchange rate, rather than interest rates. Although inflation was at 4.6% in November and will miss the 3% target this year, the National Bank of Romania (NBR) is unlikely to hike in 2013. The inflationary shock is caused by a temporary spike in food prices and the central bank believes it should not squeeze other categories of prices with tighter monetary policy for lack of structural reforms in agriculture and trade. Moreover, the central bank sees inflation returning to the target interval by the end of next year and fears moving against the easing trend in CEE. With limited scope for direct interventions, the NBR has used the supply of liquidity in order to fight depreciation. Since 8 October, one-week repos have been capped at a third of demand, while additional liquidity was provided through bilateral operations. The results are a 1.5% RON appreciation between mid-September and end-November and 3M money market rates above 6%.


The banking system remains in the red, with the NBR expecting a slow recovery. EUR lending has been capped through a series of regulations aimed at reducing FX risk for unhedged borrowers, while RON lending remains expensive due to the high cost of funds and increasing NPLs (17.3% in September, with further increases expected). Slow deleveraging continues with the foreign liabilities of the banking system declining by EUR 1.5bn between September 2011 and September 2012. The real growth rate of lending turned negative during the autumn, with demand declining as economic prospects worsened.

The MinFin has had its best year on international markets, selling EUR 2.25bn and USD 2.25bn of debt. The MinFin focuses now on local issuance, extending maturities and increasing liquidity to benchmark size for 2Y, 3Y and 5Y bonds, while accepting to pay higher yields (the spread between the average accepted yield and that of all bids has fallen below 20bp for 2 and 3Y from more than 1.5pp earlier this year). Hence, foreign interest in RON bonds has risen, fuelled by the inclusion in the Barclays local bond index from 31 March 2013 and advanced negotiations with JP Morgan. Foreign investors owned just 5.4% of RON marketable debt at the end of September, while the share for FX debt issued locally was 24.9%. During 2013, the MinFin plans to issue the equivalent of EUR 2.25bn in Eurobonds and found demand for 7-10Y debt in EUR and for 10-30Y debt in USD.


RON bonds – the potential of a rally

Romania’s local bond market has been an underperformer among regional peers. Foreign investors own 45% of Hungary’s local debt, 30% of Poland’s, and only 5.4% of Romania's. RON sovereign bonds pay a liquidity premium over HUF bonds, while ASW spreads for comparable FX bonds were 55 to 90 bp in favour of the RON at the beginning of December. We suppose JP Morgan will follow Barclay’s and include RON bonds in local bond indices in 2013. The MinFin increased liquidity on 2Y, 3Y, 5Y and 15Y, allowing yields to rise 20bp since mid-October.

The only threat to a rally in 2013 is political noise. While general elections are expected t yield the same governing coalition (the Social Liberal Union will probably have more than 50% of MPs), the president could prolong uncertainty by denying Victor Ponta another stint as PM (thus offering a more attractive entry price for a long RON bond position). Even if this scenario materialises, we expect a government to form and a new IMF agreement to be signed after the current one expires in March, providing further support to RON yields. Subsequently, we expect the 5Y RON yield to rally at least 60bp, closing the negative spread vs. HUF 5Y yield.

CEE: Working through the collateral damage

The combination of stronger external demand, lower interest rates, lower inflation which should help boost consumer purchasing power, upside risks from credit and the potential for a modest bounce from inventories supports a gradual recovery in GDP growth across the region over the course of 2013.

But the collateral damage from the EMU crisis and a broader global slowdown has been significant and will take time to work through. We expect more positive data to begin to filter through only towards end-Q1 and into Q2 next year. Industry and external demand in particular are crucial and will have to lead the way in any recovery. Only once this is convincing will a recovery in domestic demand become realistic.

In the face of a slowdown in activity this year, the most predominant theme across CEE and emerging markets more broadly was the influx of foreign portfolio capital but looking ahead proper management of these flows is crucial. Some countries have left themselves vulnerable to the extent that FX reserve accumulation has not kept pace. Moreover a normalisation of G7 yields, even if this is to occur gradually, risks feeding into higher external financing costs for CEE, putting some countries in the region at a disadvantage to their global EM peers.

This has occurred at a time when domestic policy decisions have taken different directions across the region. Efforts in the Baltics, Bulgaria, Czech, Poland and Romania to secure public debt sustainability are impressive. Russia and Turkey have fallen short in terms of reducing macro vulnerabilities but lower debt ratios provide a cushion. Croatia, Hungary, Serbia, Slovenia and Ukraine represent the laggards.

The 2008/09 crisis prompted a downgrade of potential growth across the region due to developments within the region. 2012 has brought another downgrade, albeit smaller, but this time mostly due to factors outside of the region's control. Looking forward most of the region remains in a strong position to take advantage of a recovery in EMU and more globally but this cannot be taken for granted. Domestic policies will play an increasing role in differentiating economies.


2013 will be a better growth year for CEE than 2012…

2013 should see a gradual recovery in economic activity in the region following a weak 2012. We forecast GDP growth at 2.5% in 2012, unchanged from our last quarterly but still representing the slowest pace of growth in 3 years. We now see GDP growth in 2013 at 2.9% (previously 3.1%), before rising to 3.4% in 2014. A number of factors favour such a recovery:

1. Stronger external demand should support industry and exports across the region amidst a recovery in China and easing uncertainties on the US fiscal cliff, both of which help Germany where the non bank corporate sector sits on substantial cash balances. China's manufacturing PMI clawed its way back above 50 in November for the first time since Jun-11 while we expect the fiscal cliff to be addressed by year-end, removing uncertainties on that front as we enter 2013. This should support industry and exports in CEE, particularly in those closest to EMU, following an exceptionally weak 2012.

2. Unlike the beginning of 2012, we enter 2013 with much less financial stress and easier monetary policy in most countries in the region. This should over time feed into an improved growth performance. This time last year both Poland and Turkey were intervening to defend their currencies from further depreciation while Turkey, Hungary, Poland, Russia and Serbia hiked rates either late last year or over the course of this year. But this year even some of the weakest macro stories in CEE (with the exception of Ukraine) have enjoyed currency stability in H2 2012 while interest rates have already fallen and in some cases will continue to do so. We do not foresee a tightening of interest rates in any country, with the exception of Serbia, next year. Money market rates across many countries in the region have returned to their historical lows once again.

3. The better than expected inflation prints that we have seen across the region over the past 2-3 months mark a downward trend in inflation in many inflation targeting economies in the region (e.g. Czech, Poland, Turkey) that should remain over the coming quarters. This follows an extended period of above target inflation in a number of countries, capturing currency volatility, rising energy and at times food prices. But currencies have been stable across the region over recent quarters, as have oil prices. Food price inflation is likely to edge higher but is manageable. This not only supports lower rates for longer but also should help boost real consumer purchasing power.

4. The risks to domestic demand from credit growth are weighted to the upside across the region for 2013 as a whole, with the exception of Russia and to a much lesser extent Turkey. For many countries in CEE, credit trends dragged on domestic demand in 2013 as they were impacted by a slowdown in deposit growth and declining foreign funding. But for those countries where banking sectors are predominantly foreign owned, we do not expect an increase in the pace of deleveraging from here, though trends are significantly differentiated across the region (e.g. Hungary suffers much more than Poland). Meanwhile banking sectors have adjusted to funding credit growth via (relatively low) deposit growth. Russia may prove the exception in 2013 to the extent that credit growth is already high and while we expect the banking sector to increase its reliance on foreign funding,

5. Though not as large as was the case in 2008/09, Slovenia, Czech, Romania, Poland, Turkey and Hungary has all seen a run-down in inventories in the past four quarters, opening some space for a bounce.

…but the collateral damage from the EMU crisis has been significant

But the collateral damage from a combination of the EMU crisis and a broader global slowdown has been significant and will take time to work through. We expect more positive data to begin to filter through only towards end-Q1 and into Q2 next year. This is in line with our German and EMU forecast, showing a bottom in the cycle this quarter, followed by the resumption of positive growth rates in Q1 (0.5%) and Q2 (0.2%) respectively.

Industry and external demand in particular are crucial and will have to lead the way in any recovery. As 2011 drew to a close, industry was the primary crutch for growth across the region, in part because some economies never saw a real bounce in domestic demand (Hungary, Czech, Croatia) post 2008 and in part because those that did were already in the process of seeing domestic demand growth slow (Turkey, Poland). But 2012 proved an exceptionally weak year for industry. At the time of writing, we had October data to hand and once again that showed little signs of improvement. Once the support from industry was removed, it was inevitable that domestic demand faltered further.

Only once the recovery in external demand is convincing will a recovery in domestic demand become realistic. We enter 2013 with nominal wage growth across the region well below its pre-crisis average and often times further eroded by inflation. Unemployment has begun to edge upwards in a number of countries. Meanwhile with the exception of a few countries, investment growth has either ground to a halt or turned negative. Russia, Romania (H1-12) and Latvia are the exceptions on this front.

Fiscal policy has played a differentiating role to the extent that for the first time countries such as Turkey have been able to avoid pro-cyclical policies. Fiscal policy has also supported activity in Russia. Poland and Czech plan a slower pace of consolidation ahead but have not actively used policy to support activity. Other weaker performing economies continue to face tighter policies ahead, e.g. Croatia, Hungary, Slovenia.


Liquidity, liquidity, liquidity

In the face of this slowdown in economic activity, the most predominant theme across CEE and emerging markets more broadly in 2012 was the influx of foreign liquidity via portfolio flows, acting as a crucial source of relatively cheap funding for public and private sectors and as a substitute for weak FDI and bank flows. Part of these inflows are structural in nature, reflecting a shift in asset allocation from developed to developing markets. But part is cyclical, in search of yield in the face of record amounts of G7 central bank liquidity.

Looking ahead proper management of these flows is crucial. While in the absence of these flows, financing constraints across the region would undoubtedly have been much more negative for growth, these flows have fostered vulnerabilities. For example foreign holdings of domestic government debt are at all time highs across a number of countries in the region.

To gauge in more depth relative external vulnerabilities across the region, we construct our own indicator focusing on a combination of short term inflows to capture the shift in the composition of capital to the region since 2009 and upcoming external government redemptions to the market and IMF/EU. The methodology is as follows:

-    We sum portfolio inflows and short term external borrowing between Q1-08 and Q3-08 and calculate the percentage of these inflows that reversed between Q4-08 and Q2-09, as well as sovereign redemptions coming due, all as a percent of FX reserves;

-    We repeat the exercise but this time summing inflows to the 6 quarters to 2Q12. We assume the same portion of outflows as in late-08/early-09, then add IMF/EU and sovereign Eurobond redemptions.

By this metric, Croatia, Czech, Bulgaria, Russia and Kazakhstan are at very limited risk of currency pressure over the coming quarters. Vulnerabilities in Romania are unchanged while they have improved in Hungary. In other words, should Hungary see the same portion of portfolio outflows as in end-08/early-09 and pay down all external redemptions from FX reserves in 2013, FX reserves would decline by just 20%2. But Poland, Ukraine and Turkey emerge as considerably more vulnerable. Should the NBP in Poland wish to cover outflows in full in this scenario, it would require a decline in reserves equivalent to over 30% of the total, compared with less than 10% in 2008. This is because FX reserve accumulated have failed to keep pace with short term inflows, though we do not take account of Poland’s USD 30bn FCL from the IMF. Turkey and Ukraine are bottom of the pack.

Of course a withdrawal of funding is a particularly negative scenario but what does seem possible is that a number of countries will have to reckon with higher external funding costs ahead, generated by higher yields in G7. This is a process which is likely to materialize gradually in the face of a continued recovery in activity in the US and China, followed by Germany, over the course of 2013. Examining the change in external financing costs in CEE since 2007, as proxied by 5 year sovereign CDS over mid-swaps, all countries have seen an increase in their own sovereign risk premium, which in turn carries implications for their banks

and non-financial corporates. This stands even post the rally that we have seen this year, though there is differentiation. The increase in Turkey has been smallest while in Croatia, Hungary, Slovenia and Ukraine it has been much more pronounced. But this has been more than neutralized by lower rates in EMU and the US to date.

Should we see higher yields in G7 pass-through in full to financing costs in CEE, the region as a whole will prove more vulnerable than other EM regions due to its higher stock of external debt. But once again it is important to differentiate. In Russia, Turkey and Czech Republic, a 100bp increase in the cost of external funding would imply a widening in the incomes deficits in the C/A of less than 0.5% of GDP. In contrast in Hungary and Slovenia it would narrow C/A surpluses by over 1.0pp of GDP.


Differing domestic vulnerabilities

It is against this backdrop of a gradual recovery in growth combined with the potential for somewhat higher external financing costs that we expect more differentiation across sovereign credits over the course of the coming quarters. While the overall size of portfolio inflows risks moral hazard, some economies continue to perform impressively. Romania is the only country in the region to consistently maintain a programme with the IMF amidst commendable budget performance. Though fiscal performance is at risk of slippage in Poland and Czech next year, the authorities have put in place over the past 3 years a series of consolidation measures to protect public debt to GDP while banking sectors have emerged solid. Fiscal performance in the currency board countries, namely Bulgaria, Latvia and Lithuania, also require mentioning while Kazakhstan’s balance sheets incorporate a large cushion to protect against a decline in commodity prices, even if the authorities have addressed banking sector shortfalls much too gradually.

Russia and Turkey fall in between the leaders and laggards. From a capital flows perspective, both have seen an increase in vulnerabilities but low public and external debt ratios continue to provide a cushion. In Turkey this takes the form of increased banking sector reliance on foreign capital flows, pushing its net foreign asset position to -10.8% of GDP from -1.4% of GDP at end-09, financed by portfolio capital to some extent. Meanwhile co-ordination across the government, central bank and financial regulator is lacking on macro management. In Russia there has been a structural shift in domestic capital outflows, reflecting in part higher oil prices but also greater political uncertainty and a weak investment climate. At 5.8pp of GDP over Q1-Q3 this year, this sort of capital outflow represents a structural growth impediment.

But it is Ukraine, Hungary, Slovenia, Serbia and Croatia that fall into the laggards camp. The good news is that in Slovenia and Croatia, should the authorities not succeed in pushing through the necessary measures themselves, the coming 1-2 quarters will in any case see the introduction of external anchors. A halt to the government’s plan for a bad bank in Slovenia will likely see the introduction of a Troika programme. In Croatia the government has performed poorly in terms of expenditure and broader public sector reform but will face pressure from EU to do so upon entry mid next year.

It is not a coincidence that the remaining three of this group of five were forced to enter IMF programmes upon the onset of the crisis in 2008 but have since discarded cooperation. Over the past 12 months access to external capital, either via domestic or external markets or Russia, has helped to sustain a sub-optimal policy mix for longer. At this stage, Ukraine’s shortfall requires addressing most urgently, given the combination of a halt in GDP growth, a decline in steel prices, declining FX reserves and a large gross external financing requirement. In Hungary the pressure is much less significant at this stage, though 2012 has been a year littered with policies that damage the banking sector, avoid necessary adjustment

in the size of the public sector and harm the investment environment. Serbia also drags its heels in terms of implementing the necessary central bank and fiscal measures to secure another programme. As shown below, Hungary and Ukraine face sizeable IMF/EU redemptions, as well as the largest upside risks in terms of refinancing costs in the external market.

Don’t take convergence for granted

The 2008/09 crisis prompted a downgrade of potential growth across the region as foreign investors re-assessed their willingness to invest, particularly at the low lending rates that they had in the past. 2011/12 has prompted another round of revisions, this time because of a combination of funding and growth constraints that foreign investors faced domestically, particularly in developed Europe.

At least when we examine labour flexibility and costs in the newer EU countries, the case for a recovery in foreign inflows to real economies in the region, supporting overall growth prospects looking forward, remains strong. With the exception of Slovenia, minimum wages are competitive while metrics such as trade union coverage or wage bargaining powers suggest that labour market flexibility acts as much less of a constraint than in EMU. But growth in many countries in the region is as much, if not more, a demand rather than a supply issue at this stage. This is captured in the most recent FDI trends, showing a decline once again following only a very modest recovery post 2008.

But CEE cannot take growth for granted, even in a stronger external environment. Ill-advised domestic policies have shown clear evidence of impacting overall wellbeing. For example, in Hungary real private consumption has fallen to levels last seen in Q3-02, in Croatia in Q1-05. Charting savings versus investment, CEE ex-CIS significantly underperforms all other EM regions which ultimately risks constraining growth. With this in mind, domestic policy makers' initiatives to keep potential growth on track are essential. Those that act in the opposite direction are increasingly at risk of a more persistent downturn.


More about the CEE region's countries in the pdf study