UniCredit Economics & FI/FX Research:
Improving global business activity backs recovery in Central and Eastern Europe
- Especially a stronger Germany and EMU should be supportive and encourage the long-awaited enhancement in domestic demand
- CEE appears better positioned than other emerging markets to weather an increase in financing costs due to reform efforts undertaken since the 2008 crisis
- In the newer EU member states credit growth has already adjusted lower, progress on banking union should bring positive spillovers over time
The recovery in business activity in the developed world and the beginning of a related normalisation of interest rates presents opportunities and risks for CEE. Within Central Europe, those opportunities already began to materialise in 2013 in the form of a higher external demand. In 2014 this trend is expected to continue, supported by a stronger Germany and EMU more broadly, and to feed into a long-awaited recovery in domestic demand. This is one of the key findings of the latest CEE Quarterly published by UniCredit's Economics & FI/FX Research. As a consequence UniCredit researchers have revised upwards their forecasts for most of the newer EU member states. Moreover many of the newer EU member states are better positioned than other emerging markets to weather an increase in financing costs in the coming quarters, because of the reform efforts undertaken since the 2008 crisis.
Working through portfolio flow excesses, as the region benefits from stronger industry
Contrary to the beginning of 2013, when much of the debate about emerging markets was centered around the management of record portfolio inflows to the asset class, at the beginning of 2014 the primary challenge for emerging markets is the management of outflows amidst a normalisation of interest rates in the developed world. This process looks set to play out over a multi-year horizon. In the meantime the extent to which past inflows reverse remains uncertain, but should prove a function of a combination of domestic and external factors. "From a domestic perspective, the busy election schedule in emerging markets in 2014 is a risk but also an opportunity in terms of re-igniting reform momentum", says Gillian Edgeworth, chief EEMEA economist at UniCredit. "For instance in Central and Eastern Europe elections are scheduled in Turkey and Hungary." From an external perspective, the Fed's decision to delay tapering in September acts as a valuable reminder of its willingness to take action to contain any sudden tightening of monetary conditions.
Nevertheless the stickiness of institutional capital in the face of retail outflows over recent quarters is encouraging. UniCredit analysts are convinced that a return to the magnitude of inflows experienced between 2011 and early 2013 is not very likely to happen, instead capital flows will remain characterised by a greater volatility than in the past. Overall the worst in terms of outflows may be done by the end of 1Q this year, after the market has digested the Fed's initial tapering steps.
The most obvious positive macro trend to emerge across CEE in 2013 was the rebound in industry, which should continue in 2014. Over the first 9-10 months last year, industrial production gained more than 10 per cent on an annualised basis in Hungary, Slovakia and Turkey, in excess of 8 per cent in Romania and Poland. Part of this improvement captures payback for a particularly weak finish in 2012 and as such suggests that this current pace of industry growth will not be maintained. Given its house view of continued export growth in Germany in 2014, followed by a recovery elsewhere in EMU, UniCredit researchers expect further gains in industry ahead.
EU funds could boost recovery this time, banking union may act as policy anchor
The downward adjustment in FDI to CEE since 2008 is more pronounced than in other emerging markets but from a much higher starting point. Over 2011-12 FDI to CEE was only 0.2 percentage points below the EM average. Moreover FDI to manufacturing has shown a recovery since 2011. Manufacturing FDI represented over 22 per cent of total FDI over 2011-12 and in nominal terms is broadly in line with its average over 2004-08. Czech Republic, Poland and Serbia lead in terms of their ability to attract manufacturing FDI over 2011-12 relative to pre-crisis times, Bulgaria, Croatia and Lithuania lag. This regional trend is re-inforced by the fact, that Hungary, Romania, Serbia and Slovakia all benefitted from new car production facilities coming on line last year.
"Assuming continued growth in German GDP, accompanied by signs of recovery in EMU and a smooth slowdown in China, we should see persistently increasing FDI to manufacturing sectors across the region this year", states Gillian Edgeworth. "The sluggishness in global trade is the primary risk to this scenario." As the next round of funds from the 2014-20 EU budget was approved only recently, these are likely to materialise only towards the end of 2014 or early 2015. As such, just as EU fund inflows played an important role in smoothing the downturn post 2008 in a number of economies such as Poland and the Baltics, they also have the potential to boost a recovery this time.
Besides industry GDP growth will also benefit from a stronger support from credit in some countries. Credit growth across the newer EU states has already slowed well below deposit growth. Banking systems continue to repay funding to mother banks, but the ECB's potential willingness to provide another LTRO further reduces the risk that this accelerates. Even assuming that credit growth does not accelerate but stays stable from here, Czech Republic and Poland in particular should enjoy a stronger growth of domestic demand. A more positive credit impulse is also materialising in Hungary, but largely due to the NBH's 'funding for growth' scheme.
More broadly, progress on a banking union within EMU should provide some positive spillovers for those countries in CEE, where foreign ownership of banking systems is high. 2013 has been disappointing to the extent, that plans on a banking union have progressed without notable advances on the inclusion of the newer EU states which remain outside of EMU. Moreover other challenges persist, including the need for Greek banks to dispose assets across CEE and high NPLs in some countries. That said, progress on reducing banking fragmentation within EMU at a minimum reduces tail risks for CEE. Once the SSM has been established within EMU, both EMU member states and other EU states outside of EMU may prove more open to a renewed discussion on future inclusion. By this it may act a much-needed policy anchor for CEE region.
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