This Perspectives article is the second of two. To read the first, which addresses the topic of global inflation and looks into the changing role of the emerging markets, read The Changing Role of Emerging Markets.
Poland: European Superstar!
Poland’s economic performance over the past three years has been nothing short of remarkable. Though the republic experienced a severe slowdown in GDP growth through the credit crunch, it avoided recession and has been the fastest growing European country in recent years. In fact, apart from its geographical location, Poland’s experience is more akin to that of emerging Asian economies.
The key difference between Poland and the rest of the CEE was its reluctance to take part in the credit binge that had been taking place elsewhere (especially the Baltics), following its accession to the European Union.
In the same way former US President Bill Clinton claimed that he “…tried marijuana once. (But) I did not inhale”, Poland’s experience with foreign credit inflows was late and limited, mainly thanks to the National Bank of Poland’s (NBP) tight control of bank reserves.
For many years, the NBP was seen as an over-bearing, restrictive central bank, keeping interest rates too high and holding back growth. It now seems that the prudence of both the central bank and the ministry of finance have left Poland in a strong position to continue to outperform the rest of the region. As a result, the unemployment rate in Poland only returned to 2007 levels through the downturn, in comparison with for example Hungary or Estonia, where they have been set back at least a decade.
Looking ahead, firms are enjoying the sweet spot of low inflation, and strong and steady growth. However, the NBP is now tightening monetary policy, which along with the resulting stronger Polish Zloty, should help moderate growth and longer-term inflation pressures.
Hungary: Serious Headwinds Remain
As far as the big CEE countries go, Hungary is the polar opposite to Poland. With the exception of perhaps Iceland, Hungary may have had the worst starting position of any other country heading into the credit crunch.
With the help of the IMF, Hungary was undergoing dramatic fiscal reforms following Greek style indiscretions in 2006/07. As an all embracing new member state to the European Union, Hungary opened up its financial system to foreign banks which led to huge inflows of foreign credit, which was being sold to households at European and Swiss interest rates. The influx of cheap credit swelled very quickly, doubling household debt in the six years to 2009, with from 2005, more than all of the new net loans being made in foreign currencies.
The interest rate charged for this foreign credit tended to cost between a third and a half of the cost of a typical domestically sourced loan. However, there was a catch. Borrowers had to borrow in Euros and Swiss Francs to benefit from the lower interest rates (most of the loans were in these currencies, though others did exist).
As Hungary's sovereign crises unfolded, the Hungarian Forint depreciated sharply, which resulted in an increase in the stock of debt owed by local homeowners to foreign banks and their subsidiaries. As this happened at the same time as aggressive fiscal tightening, it came as no surprise that many loans turned bad. For example, the proportion of unsecured FX loans that are non-performing increased from 3% in mid-2008 to 9% in the third quarter of last year. Worse still, the proportion of non-performing household loans in Forints increased from 6% to 22% over the same time period (see chart 13 above). Given the level of distressed indebtedness, it will be difficult to expect much of a recovery in domestic demand.
Nevertheless, the newly elected conservative leaning Fidesz party won a mammoth majority in last year's election on a promise to reverse some of the fiscal tightening to help stimulate the domestic economy. This began in 2010 with tax cuts worth 2% of GDP, which may raise real disposable household incomes by as much as 5%. However, in order to avoid a potential downgrade of its sovereign rating to speculative grade, the new government must re-establish its budget surplus in a way that is more than just to nationalise private pension funds. Structural reforms must be introduced to reform long-term pension and medical costs, which are increasing due to deteriorating demographics.
As for monetary policy, despite the deep recession, the National Bank of Hungary (NBH) has struggled to bring down inflation, partly due to the overdependence of overseas energy and regulated prices, but also because of unanchored inflation expectations. The NBH twice hiked rates in late 2010 to 6% with more hikes likely this year. However, due to the uncertainty surrounding the government's credit worthiness and household sector's indebtedness, we do not think higher rates will necessarily lead to currency appreciation. In addition the NBH is nearing the end of its rate hiking cycle.
Czech Republic: Where Is the Final Demand?
If Poland and Hungary are the two extremes in terms of domestic indebtedness, the Czech Republic falls in between the two. Like Poland and Hungary, the Czechs are also deeply dependent on the German business cycle, which along with an investment led boom in solar energy, has recently been very beneficial for Czech manufacturers.
Due to the difficulties with FX denominated debt, GDP growth is unlikely to return back to the same rates of 6% plus seen before the crisis. Indeed, taking a closer look at recent economic performance, it appears that the contribution from final demand to annual GDP growth has been falling since the first quarter of 2010, in fact turning negative in the second and third quarter. Had it not been for the contribution from the inventory cycle, annual GDP growth would have been negative (see chart 14). This raises questions around the sustainability of the Czech recovery, especially if we see a slowdown in activity in the Eurozone.
While we do expect the recovery to continue, it appears that the government's recent attempt to tighten fiscal policy may have been started too soon. The European Commission expects the Czech government to tighten fiscal policy by just over 1% of GDP in 2011, following 0.5% of GDP tightening in 2010. As the Czech Republic still has relatively low levels of debt (40% of GDP in 2010), the government should consider easing fiscal consolidation in order to allow domestic demand to gather momentum.
In terms of monetary policy, the Ceská Národní Banka (CNB) is keen to limit appreciation of the Czech Koruna particularly against the Euro, and has traditionally tracked the ECB in terms of interest rates. In addition, unlike most central banks, the CNB has an explicit mandate to pay close attention to "monetary-policy relevant inflation" - net of changes in taxes and regulatory prices. We bet Governor of the Bank of England Mervyn King would give his right arm for such a flexible mandate. Overall, with plenty of spare capacity in the economy and not much in the form of domestically generated inflation, we doubt the CNB will deviate much from the actions of the ECB.
Russian Federation: Addicted to Oil
On the 23rd of January 2008, Russia's Minister for Finance, Aleksey Kudrin, speaking at the World Economic Forum in Davos, offered to mitigate the world credit crisis with the help of Russia's reserves. Kudrin stated that Russia was an "island of stability in the sea of the world crisis...Investors will continue to invest billions of dollars in the rising Russian economy. Stock market crises and the consequences will not be utterly negative for us." Two years later, the Russian economy contracted by 7.9%. So much for the "island of stability".
Russia quickly learnt that it had become excessively dependent on oil and gas exports, not just for businesses, but also for government revenues, which fund a large proportion of government spending. The decade preceding the global credit crunch saw the government reduce personal and business taxation, as the price of oil, and therefore oil revenues, continue to rise. At the same time, the oil surpluses were being used to subsidise domestic demand, as the contribution from net trade to annual GDP growth turned negative from 2004, despite increases in oil and gas prices.
In 2009, Russian imports of goods and services fell by 30% as oil revenues dwindled, which in inadvertently helped lift the net trade contribution, by far more than the collapse in household consumption. More recently, imports have been growing at approximately twice the pace of exports, as domestic demand continues to struggle.
The recovery in Russia has been hampered by the impact of the heat wave and drought along with the damage concentrated in the agricultural sector. Should crop yields improve in 2011, then there could be a significant rebound in growth.
In terms of fiscal policy, the IMF estimates that the Russian government increased the nation's deficit from 8.25% of GDP in 2008 to 15% of GDP - the largest fiscal stimulus in the G20. Almost all of the fiscal expansion was caused by higher spending. However, as most of the increases went to sectors such as defence and security, the Keynesian multiplier was limited.
In order to fund the increase in borrowing, the government has been drawing on the Reserve Fund, which was set up to save part of the oil windfall and to reduce the vulnerability of the budget against oil-price volatility. In 2009, reserves in the fund fell from $130bn (US) to $60bn, before declining further to $40bn September 2010.
Moving on to monetary policy, the Central Bank of Russia (CRB) manages the Russian Rouble against a weighted basket of US dollars (55%) and Euros (45%). In late 2008, the CBR intervened in the currency market aggressively by selling $200bn of hard currency reserves in order to support the Rouble. Last year, the exchange rate stabilised and the CRB began to re-build its FX reserves.
In a break away from other EM central banks, the CRB has been allowing the Rouble to appreciate in line with oil prices, mainly to combat high food inflation (which is worth approximately 40% of the Russian CPI basket). However, as oil prices and the Rouble have risen, speculative flows into Russia have accelerated, which is currently deterring the CRB from tightening monetary policy further in order to control the pace of currency appreciation. At the moment, the CRB sees the recent spike in oil prices as a speculative move caused by problems in North Africa, rather than a permanent move which would warrant further appreciation. Moreover, political uncertainty in the country means Russia is susceptible to sudden withdrawal of capital. Another reason for the CRB to remain on its guard.
Conclusions
Although CEE risk assets look attractive in general, there are significant differences in performance between the larger states in the region. Poland is much further ahead in its economic cycle than the Czech Republic, and as a result, we like the idea of using the Czech Koruna to fund a long position in the Polish Zloty. Meanwhile, though Hungary is also likely to raise interest rates, fears over the state of its sovereign finances will deter investors. Finally, despite the reluctance of the Russian Central Bank to allow the Rouble to follow oil prices, we think that there is a risk that the price of oil could rise further (see the global section), and so, we like the strategy of being long oil related currencies (including the Canadian Dollar and the Norwegian Kroner).
Disclaimer: All views expressed in this third party article are those of the author(s) alone and not necessarily those of Morningstar. Morningstar is not responsible for the comments nor will it be liable in any way for any information provided by the author.
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