Economic Outlook Central Europe - July 2014

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Economic Outlook

Our publications are available online at www.kbc.be/economicoutlook/ or www.kbceconomics.be.

If you have any questions relating to the contents of this publication, contact: Dieter Guffens (32) (0)2 429.62.87 E-mail: [email protected]: Johan Van Gompel, Havenlaan 2, 1080 BrusselAddress for correspondence & subscription management: KBC Groep NV, GCE, Havenlaan 2, 1080 Brussel. E-mail: [email protected] publication is jointly produced by KBC’s economists in Belgium and Central Europe. Neither the degree to which the hypotheses, risks and forecasts contained in this report reflect market expectations, nor their effective chances of realisation can be guaranteed. The forecasts are indicative. The information contained in this publication is gen-eral in nature and for information purposes only. It may not be considered as investment advice according to the Act of 6 April 1995 on the secondary markets, the legal status and supervision of investment companies, intermediaries and investment advisers. KBC cannot be held responsible for the accuracy or completeness of this information. All historical rates/prices, statistics and graphs are up to date, up to and including 3 July 2014, unless otherwise stated. The views and forecasts provided are those prevailing on 7 July 2014.

Central Europe

• Moderate EU enthusiasm despite clearing economic skies• Czech economy is gaining momentum• Hungary: Central bank continues easing cycle• Solid Polish economy• Slovakia no longer a fiscal sinner• Bulgaria: Economy with two faces• In the spotlight: What to expect from Orban II?

Real GDP growth Inflation

2014 2015 2014 2015

Poland 3.4 3.7 0.7 1.7Czech Republic 2.2 2.5 0.8 2.0

Hungary 2.5 2.3 0.3 2.8Slovakia 2.0 3.0 0.3 1.5Bulgaria 1.7 2.5 -0.8 1.2

Russia 0.5 1.0 6.9 6.2Turkey 2.0 3.5 8.3 7.0

Policy rates

03-07-2014 +3m +6m +12m


Hungary 2.30 2.20 2.20 2.20Slovakia (ECB) 0.15 0.15 0.15 0.15

Romania 3.50 3.50 3.50 3.50Bulgaria - - - -

Russia 7.50 7.50 7.25 7.00Turkey 8.75 9.50 9.50 9.50

Exchange rates

03-07-2014 +3m +6m +12m

PLN per EUR 4.15 4.12 4.10 4.05CZK per EUR 27.44 27.20 27.20 27.00HUF per EUR 311.89 305.00 300.00 300.00RON per EUR 4.39 4.40 4.40 4.40BGN per EUR 1.96 1.96 1.96 1.96RUB per EUR 46.75 45.90 43.55 41.25TRY per EUR 2.91 2.85 2.80 2.80

10-year rates

03-07-2014 +3m +6m +12m


Hungary 4.35 4.70 4.90 5.20Slovakia 2.04 2.30 2.50 2.80Romania - - - -

Bulgaria 3.33 3.20 3.35 3.70Russia 8.53 8.50 8.50 8.25Turkey 8.79 8.90 9.00 9.00

July 2014

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Euro area Bulgaria Hungary Poland Slovakia Czech Rep.

K4 2013 K1 2014

Disinflationary trend even more pronounced than in the euro area

(y-o-y change in consumer prices in %)

Central European growth dynamic stronger than in the euro area

(real GDP growth, quarter-on-quarter in %)

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eurozone Bulgarije Hongarije Polen Slowakije Tsjechië

Q4 2013 Q1 2014

Euro area Poland Bulgaria Slovakia Hungary Czech Republic

Economic Outlook Central Europe

General perspective

Moderate EU enthusiasm despite clearing economic skies1 May marked the tenth anniversary of the biggest enlargement in the history of the European Union. At that point eight Central European countries were added to the EU (the Czech Republic, Slovakia, Hungary, Slovenia, Poland, Estonia, Latvia and Lithuania). Bulgaria and Romania followed in 2007, whereas Croatia joined only last year.

The first decade of EU membership represented a turbulent period for the Central European economies. The period may broadly be divided into two parts, separated by the collapse of the US bank Lehman Brothers in September 2008. The first of these periods saw flourish-ing economic activity. Central Europe integrated itself into West European production chains, with an important role for the car industry. With the aid of EU funds, progress was made towards closing the gap in the field of infrastruc-ture. Rapid strides were taken towards improving institutional quality. The financial ties with Western Europe also grew ever closer.

As from September 2008, the closer European integration had its flipside. Together with Western Europe the coun-tries of Central Europe slipped into a deep recession. Since then the story

in the region has largely been one of muddling along, with a similar com-bination to that in Western Europe of slack economic activity and a particu-larly weak inflation dynamic. Against this background it comes as no surprise that enthusiasm for the European Union has faded in many of these ‘new’ mem-ber states. This was also reflected in the recent European elections. Although the turnout in the European Union as a whole was on the lean side, that was even more the case in Central Europe. Just a quarter of Central European voters could be bothered to make their way to the polling station.

It may therefore be that the present economic revival could generate a more positive attitude towards the European Union. In the wake of the gradual eco-nomic recovery in the euro area, the economic skies in Central Europe are also clearing. As many countries in this region have small and open economies, they are benefiting more than propor-tionally from the recovery. Whereas real GDP in the euro area grew in the first quarter of 2014 by just 0.2% (quarter-on-quarter), growth in Central Europe was a good deal higher. Positive outper-formers in this regard were Hungary and Poland, both of which recorded quar-

terly growth of 1.1%. The 0.8% growth in the Czech Republic in that quarter fol-lowed the exceptionally strong growth in the fourth quarter of 2013 (+1.5% quarter-on-quarter). The fact that the economy continued to grow in the first quarter is an encouraging economic sign.

It is striking that the economic recovery has also been accompanied in Central Europe with strong disinflationary pres-sure, on perhaps an even stronger scale than in the euro area. In May, inflation in Hungary and Slovakia was 0% and even negative in Bulgaria (-1.8%), while in Poland (+0.3%) and the Czech Republic (+0.5%) it was not much above 0%. This illustrates that (i) even a deflation-ary environment need not by definition impede economic growth, and (ii) this also gives the regional central banks additional room to ease their policies. The exchange rate policy of the Czech National Bank provides one example of this, as do the further interest-rate reductions that the National Bank of Hungary is expected to make.

Dieter Guffens and Dieter [email protected], [email protected]

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Year-on-year (in %) Quarter-on-quarter (in %)

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quarter-on-quarter (in %) year-on-year (in %)

Fabourable real GDP growth dynamics

Public balance (left-hand scale) Public debt (right-hand scale)

Healthy fiscal position(% of GDP)


Czech Republic

Economy is gaining momentum

Petr Dufek ([email protected])CSOB Czech Republic

The Czech economy went through two significant recessions in the last five years. The first one in 2009 involved a huge economic downturn, caused by the slowdown of European eco-nomic growth, while the second one – which lasted for a record-long period (2012-2013) – was primarily caused by domestic factors curbing consumer and investment demand. However, since the second quarter of 2013, the Czech econ-omy has been growing again, driven by exports in particular. It is not only exports that are showing evident signs of recovery; consumption and invest-ment, which have been affected by sig-nificantly curbed public orders thus far, are also slowly gaining momentum. The Czech economy continued to develop favourably in the first quarter of this year. Real GDP grew by 0.8% quarter-on-quarter.

Economy growth is being primarily driv-en by the manufacturing industry – spe-cifically car production – with carmakers riding the wave of Europe’s recover-ing automotive market and increasing their market shares. The presence of the largest Czech carmaker in China is also successful, and China has thus become the key market. Car production is heading towards a new record this

year. Moreover, the construction sector, which has been strongly curbed in the last six years, is also rebounding slowly. There is still a lack of new orders, nota-bly from the public sector and housing construction, with the latter even being at half the level of the strongest years. However, at least the first signs of stabi-lisation of new orders, and consequently of the termination of their long-term fall, are evident. The service sector as a whole has not significantly contributed to growth thus far, except for finan-cial institutions, trade, and transport. Nevertheless, the renewed increase in domestic demand should also help other services, which are still close to their bot-tom, to grow again soon.

Renewed growth of the economy and domestic demand has not yet had a visible effect on inflation, which cur-rently stands close to zero. January’s reduction in electricity and natural gas prices for households has contributed strongly to this low inflationary environ-ment. Moreover, stiff competition in the telecommunications market which has been liberalized recently has led to a significant decline in the prices of those services for households as well as busi-nesses. Although the Czech National Bank still forecasts that it will not leave

its current exchange rate regime before early 2015, when it also anticipates a significant rise in policy interest rates, we do not endorse this scenario. We believe that the exchange rate targeting will be abandoned much later (not before the second half of 2015), and that the move will certainly not be accompanied by a rise in policy rates, as suggested by the official forecast. The reason is that the inflation ‘threat’ continues to be virtual, and thus the central bank will have to revise its inflation outlooks downwards.

Meanwhile the fiscal position has turned healthier. In 2013 the government defi-cit was cut by a third compared to 2012. The fiscal deficit fell to 1.4% of GDP, leading to a significant decelera-tion of the rise in the overall public debt to 47.2% of GDP. Hence the Czech Republic continues to be one of the least indebted EU countries.

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Public debt (% of GDP, right) Public balance (% of GDP, left)

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Hungary

Central bank continues easing cycle

Inflation trending lower(year-on-year, in %)

Breakdown of real GDP growth (selected sectors)

GDP growth (year-on-year, in %) Construction Agriculture Services Industry

Headline CPI Inflation target Core CPI

David Nemeth ([email protected])K&H Bank ZRT

In April Hungarian inflation was nega-tive for the first time since 1968 (-0.2% year-on-year in April 2014), after which it returned to 0% in May. Headline inflation started its downward trend in September 2012 (6.4% year-on-year) and the disinflationary process has been faster than expected. Several factors were driving this disinflationary trend: last year’s good harvest, the still rela-tively subdued domestic consumption growth and the government’s frequent utility cost reductions. Inflation expec-tations also gradually trended down to around 3% in the first quarter versus still 4-6% the year before.

However, we see no risk of outright deflation as core inflation is still above 1.1% year-on-year and headline infla-tion will rise as a result of, among other things, the expected acceleration of domestic consumption. A lot will depend on the further inflation evolu-tion in the rest of the European Union. For 2014 we expect the average inflation rate to be 0.3% and for 2015 2.8%, close to the central bank’s inflation tar-get of 3%.

Economic growth accelerated further in the last months and was among the highest in the European Union. Real

GDP grew by 3.5% year-on-year in the first quarter, the highest year-on-year real GDP growth rate in seven years. The main growth contributions came from industrial production and construction. The favourable European business cycle, especially in Germany, along with the expansion in vehicle production capac-ity triggered industrial growth, while public investments and the usage of EU funds drove growth in construction. Investments increased 22.6% year-on-year in the first quarter.

Despite the recent, modest pickup in private consumption and investment Hungary’s external position remains comfortable. Domestic demand weak-ness has led Hungary’s current account surplus to widen from EUR 0.8bn EUR in 2012 to EUR 2.9bn EUR in 2013.

The low interest rate environment and the ongoing NBH’s funding for lending program should support investments in the coming quarters, although credit demand remains quite subdued. With only local municipality elections on the short horizon, public sector investments will most likely be lower in the quar-ters ahead. Therefore, the recent solid growth performance may not continue at the same pace in the quarters to

come. Private sector demand has to grow stronger in the coming quarters to be able to counterbalance the lower state investment demand. On balance, we expect real GDP growth to reach 2.5% in 2014.

Given the low inflationary environment, monetary policy will remain highly accommodative. In June, the National Bank of Hungary continued its gradual and cautious easing cycle, cutting its policy rate for a 23th time in a row to 2.3%. We do not believe this to be the end of the easing cycle and expect one additional rate cut of 10 basis points.

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Agriculture Industry

Construction Services

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Headline CPI (year-on-year, in %) Core CPI (year-on-year, in %)

Inflation target

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Poland

Solid economy

Real GDP growth Investments Private consumption Net exports Public consumption Inventory

Solid growth recovery(year-on-year, in %)

CPI PPI Core CPI

Very low inflation(year-on-year, in %)

Jaroslaw Antonik ([email protected])KBC Towarzystwo Fund. Inwest. A.S.

Macroeconomic data published in the first quarter of 2014 indicate that the Polish economy is performing well. Real GDP growth accelerated to 3.4% year-on-year in the first quarter of 2014 from 2.7% year-on-year in the last quarter of 2013. Consumption growth accelerated to 2.6% year-on-year and investments grew 10.7% year-on-year in the first quarter of 2014. The contribution of net exports to real GDP growth was 0.5%. However, the most recent economic data disappointed somewhat with pro-ducer confidence dropping slightly, probably affected by the conflict in Ukraine. Industrial production dynamics also weakened somewhat. Retail sales growth, however, remains at a decent level.

As a result, the positive picture of the Polish economy remains intact. In the coming quarters, consumption should be supported by real wage growth, improving employment growth, stronger consumer confidence and a substantially lower cost of credit. Also, investment growth potential is substantial. In recent quarters, entrepreneurs have restrained their investments as a result of the eco-nomic slowdown. Currently, the improv-ing economic conditions both on the domestic market and in the euro area,

Poland’s main trading partner, should translate into a higher willingness to investment. Additionally, the effect of the transfers from the new EU budget should become visible in the near future.

A risk factor remains the political insta-bility and recession in Ukraine and the economic slowdown in Russia. However, as a result of the limited trade relations with these two countries, this should have only a moderate impact on the Polish economy.

The economic recovery takes place in a low inflation environment. In May consumer price inflation was only 0.3% year-on-year. Inflation will probably turn negative during the summer and infla-tion will remain below the central bank’s inflation target of 2.5% at least until the end of 2015. Nevertheless the cen-tral bank left its policy rate unchanged at 2.5%. Governor Marek Belka made it clear that the monetary policy com-mittee (MPC) considered an imminent rate cut unlikely although the MPC did not exclude this possibility. Although low inflation and the ongoing non-conventional ECB easing measures have increased the possibility of an additional rate cut, real GDP growth is too strong to make it the most likely scenario.

Public finances appear healthy and the ministry of finance has already covered 90% of its borrowing needs for 2014. Positive economic growth, accommoda-tive monetary policy and healthy public finances should support the fixed income market. The Polish currency proved to be resistant against the Ukraine turmoil and will probably appreciate again versus the euro on the back of strong economic fundamentals and the improvement of the current account balance.

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CPI core CPI PPI

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Private consumption Public consumption Investments

Net exports Inventories Real GDP growth

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Slovakia

No longer a fiscal sinner

Public debt on a rising trajectory(public debt, % of GDP)

Slovakia leaves the European Commissions EDP(fiscal balance, % of GDP)

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Marek Gabris ([email protected])CSOB Slovakia

In the first quarter of 2014 Slovakian economic growth in Slovakia acceler-ated further to 2.4% year-on-year from 1.5% year-on-year in the fourth quarter of 2013. What is especially encouraging is the composition of economic growth as the economy is no longer solely driven by foreign demand. In recent quarters, net export growth helped Slovakia to avoid a deeper economic downturn. More recently, growth became more broadly based. Although export of prod-ucts and services increased by 9.6% year-on-year in the first quarter of this year, import growth also accelerated and even outpaced export dynamics (+10.8% year-on-year). This was supported by the revival of household consumption, growing 3.4% year-on-year after a mod-est 0.4% year-on-year growth in the fourth quarter of 2013.

The rise of household consumption is driven by higher real wages. Moreover, the unemployment rate has been declin-ing slowly but gradually and consumer confidence is on the rise. Government consumption accelerated from 2.5% year-on-year in the fourth quarter of 2013 to 4.4% year-on-year in the first quarter of this year. This is interesting as Slovakia has to keep its public finances under control as it exited the exces-

sive deficit procedure only weeks ago, after reducing its deficit from -4.5% to -2.8% of GDP. The biggest surprise came from the investment component, which increased by 3.6% year-on-year, illustrating the renewed business confi-dence. In Slovakia the disinflationary trend start-ed in November 2011 and continued throughout 2013 and 2014. For example, headline CPI inflation gradually fell from 2.5% year-on-year in January 2013 to 0% in May 2014. Falling food prices and base effects were the main reason. However, the absence of demand-led price pressures played a significant role too. Core inflation was only 0.4% year-on-year at the end of 2013 and reached 1.5% year-on-year on average. The very low inflation will probably persist in the second half of 2014 and only very gradu-ally and mildly rise to slightly above 1% year-on-year in December 2014.

Employment started to increase again at the end of 2013 after several quarters of labour shedding. In the first quarter of 2014, employment growth accelerated to 0.2% year-on-year. The (harmonised) unemployment rate has been stable at a high level for the last several quarters and only very mildly declined to 13.9%

in May 2014. The improved outlook for economic growth will probably also be favourable for the outlook for the labour market. However, the latest drop of the registered unemployment rate is partly due to higher employment as a result of additional government spending of EU social funds. While the sustainability of the unemployment drop is far from clear, the underlying trend remains posi-tive and the start of new construction projects could further support it.

According to Eurostat, the public deficit dropped from 4.5% of GDP in 2012 to 2.8% in 2013. Therefore the European Commission decided that Slovakia is no longer subject to special supervision under the Excessive Deficit Procedure. However, the debt ratio has already breached the 55% threshold set by Slovakia’s Budget Responsibility Act. This breach triggers the freezing of certain spending items already in 2014. Therefore, the expected acceleration of GDP growth in 2014 and 2015 is very welcome as higher nominal GDP growth would facilitate the consolidation efforts of public finances.

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Economic Outlook

Bulgaria

Economy with two faces

Risk premium Bulgarian government rising(10 year bond yield spread with Germany, in percentage points)

Bulgarian economic growth consistently outperforming euro area

(real GDP growth, quarter-on-quarter in %)

Bulgaria Euro area

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Bulgaria Euro Area

Fundamentally sound economy (for the time being)…

The Bulgarian economy has two distinct faces. On the one hand, the macro-eco-nomic fundamentals are relatively healthy, particularly when compared to the Euro Area. Real GDP growth (+0.3% quarter-on-quarter in Q1 2014) was stronger than in the Euro Area (0.2%). Moreover it is worth noting that during the second phase of the European recession (from Q4 2011 onwards), the Bulgarian econ-omy had only one quarter of very mild contraction (-0.1% in Q3 2012). This is in sharp contrast with six consecutive quar-ters of negative growth in the Euro Area.

The long phase of deflation Bulgaria has been going through has clearly not caused too much damage to the real economy. From August 2013 on, headline inflation has been negative. With the exception of Greece, the Bulgarian deflation in May 2014 (-1.8% year-on-year) was the deep-est in Europe. The persistent price fall has mainly been the result of administrated price cuts in the energy sector, nega-tive import price inflation and significant slack on the labour market. However, the unemployment rate is gradually falling in line with the moderate growth cycle. Compared to its peak of 13% in October

2013, the Bulgarian unemployment rate has fallen by 1.1 percentage points in May 2014. This is almost four times faster than the fall of only 0.3 percentage points in the Euro Area in the same period.

…but increasing political and institutional instability

This relatively favourable economic analysis was shared by the latest IMF staff report in mid-June. Related to the Bulgarian banking sector in particular, the IMF considered “[...] the system stable and liquid, with banks’ non-performing loans buffered by provisions and significant cap-ital, as well as a positive net foreign asset position.” Ironically, a little more than a week later, two bank-runs occurred (on June 20th and June 27th), two banks had to be taken over by the Bulgarian National Bank (BNB) and be recapitalised by the state-owned Bank for Development and Deposit Guarantee Fund. President Plevneliev announced that he will dissolve parliament on August 6th and call elec-tions for October 5th. A caretaker govern-ment will be appointed in early August.

These events illustrate the inability of Bulgaria’s political and financial authori-ties to supervise a fundamentally healthy financial sector. While the orchestration

of the two bank runs illustrates the deeply rooted corruption and crime in Bulgarian business, the need to seize and recapi-talise a bank with public funds is the result of an inadequate liquidity provision by the BNB. It is true that the currency board arrangement poses a restriction on such liquidity provision, but the request by the BNB for liquidity assistance from the European Commission (made and approved on June 29th) came too late to prevent the banking crisis.

Currency board only source of stability for the moment

The damaged confidence in the govern-ment has already led to a rising spread between Bulgarian and German govern-ment bonds. The credibility of the currency board is the only stabilising factor for the economy at a moment without a func-tioning government. The inherent stability of a currency board and the fact that no rational policy maker would want to go back to the times before the currency board was introduced in July 1997 (with inflation reaching 1061% in that year), feed the hope that a negative spill-over from political chaos to the real economy can still be contained.

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Mrch-2014 Apr-14 May-14 June-14 July-14

Central Europe

Dieter Guffens ([email protected])KBC Group

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In the spotlightWhat to expect from Orban II


Growth contributions to potential output(in %)

Short-term external debt on a downward trajectory(bn EUR)

As expected, Fidesz comfortably won the parliamentary elections held on April 6th. With 133 out of 199 seats in parliament they just retained a two-third major-ity. Prime Minister Viktor Orban was relatively vague with respect to economic policy in the next four years. Taking into account some targets set by Fidesz in the previous years, we can make some preliminary conclusions of what Fidesz’ policy will look like in the next four years.

The relatively tight fiscal policy will most likely be continued, especially since the primary budget balance has been dete-riorating in the last two years. Interest spending has been decreasing while there was no improvement in the general fis-cal balance. Meanwhile Fidesz will most likely continue to maintain a supportive environment for the domestic companies and sectors. The nationalization of foreign owned companies will continue, although this highly depends on the international market sentiment as the government has to issue bonds to be able to finance these purchases. If market sentiment deterio-rates or budget balance slippage were to occur, the government may increase the tax wedge of multinational companies. For example, Parliament already approved a new, extremely progressive tax on adver-tisement revenues, which will result in HUF

6-10bn income to the budget. Although Fidesz previously has promised that chang-es to the legislation will be slower, more predictable and more transparent, so far this has not been the case under Orban II.

Regarding the banking sector, the govern-ment and the National Bank of Hungary would like to radically decrease the level of non-performing loans (NPLs). They con-sider it to be the main reason why lending activity remains so weak. According to unofficial plans, banks have to raise their provision levels for NPLs from the cur-rent level of around 60%. Additionally, it is also quite likely that the government comes up with a solution for the foreign currency denominated mortgage loans problem. The banks’ association would like to see a program similar to the current existing one, namely a program in which monthly instalments are calculated at a fixed exchange rate which is well below the market price, and the loss is divided evenly between the state and the banks. It would allow a gradual write-down of the foreign currency denominated mortgage loans and wouldn’t create huge immedi-ate losses for the banking sector. The decision is expected around September.

What is also in the cards is a further centralization of policy. The Debt

Management Agency might be integrat-ed in the National Bank of Hungary (NBH). The cooperation between these two independent institutions is already sub-stantial. For example, the NBH introduced new tools to encourage the banking sec-tors to buy more Hungarian government bonds. It is also clear that the Hungarian government is making an effort to return to an investment grade rating for its debt. For this to be achieved, the Hungarian government will need a reduction in gross external debt, especially short-term external debt and a reduction of foreign holdings of this debt.

Unfortunately, what is missing (again) so far are measures to boost Hungary’s potential GDP growth. Government poli-cy doesn’t appear to be more transparent and predictable so far. For steady conver-gence to materialize, policy changes in education, innovation and productivity are required. The Hungarian government and the NBH expect additional economic growth to come from an acceleration in lending and from a further depreciating currency. It is likely that, as before the financial crisis, potential real GDP growth will remain in the vicinity of 2%.

Potential output growth Average working hours Capital accumulation Productivity Employment

Foreign exchange reserves Credit institutions General government Corporations

David Nemeth ([email protected])K&H Bank ZRT

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Economic Outlook Central Europe - July 2014

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Transcript of Economic Outlook Central Europe - July 2014