Economic Outlook Central Europe September 2013

• First green shoots of recovery • Czech recession over but recovery remains weak • Hungarian public utility cost reductions keep inflation low • Polish pension fund ‘reform’ to reduce public debt
• Domestic demand slowly reviving in Slovakia • In the spotlight: The stalling macroeconomic convergence of Central Europe

Real GDP growth
2013 2014 2013

Inflation
2014 01-10-2013 +3m

Policy rates
+6m +12m

Poland Czech Republic Hungary Slovakia Bulgaria Russia Turkey

1.1 -1.3 0.4 1.0 0.6 1.7 3.5

2.2 1.5 1.5 1.5 1.8 2.4 3.8

0.9 1.6 2.3 1.5 0.7 6.0 6.4

1.8 1.6 3.0 1.5 2.7 5.1 6.2

Poland Czech Republic Hungary Slovakia (ECB) Romania Bulgaria Russia Turkey

2.50 0.05 3.60 0.50 4.25 8.25 4.50

2.50 0.05 3.40 0.50 4.25 8.25 4.50

2.50 0.05 3.40 0.50 4.25 8.25 4.50

2.50 0.05 4.50 0.50 4.25 8.25 4.50

Exchange rates
01-10-2013 +3m +6m +12m 01-10-2013 +3m

10-year rates
+6m +12m

PLN per EUR CZK per EUR HUF per EUR RON per EUR BGN per EUR RUB per EUR TRY per EUR

4.23 25.64 296.30 4.46 1.96 43.72 2.73

4.20 25.60 308.00 4.45 1.96 44.00 2.70

4.15 25.40 300.00 4.50 1.96 44.25 2.65

4.10 25.00 310.00 4.50 1.96 44.50 2.60

Poland Czech Republic Hungary Slovakia Romania Bulgaria Russia Turkey

4.45 2.27 5.83 2.71 7.66 8.85

4.55 2.30 6.20 2.70 7.90 9.00

4.60 2.40 6.70 2.85 7.90 9.30

4.60 2.70 6.60 2.90 8.00 9.50

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If you have any questions relating to the contents of this publication, contact: Dieter Guffens (32) (0)2 429.62.87 E-mail: dieter.guffens@kbc.be Publisher: Johan Van Gompel, Havenlaan 2, 1080 Brussel Address for correspondence & subscription management: KBC Groep NV, GCE, Havenlaan 2, 1080 Brussel. E-mail: economic.research@kbc.be This 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 general 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 1 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 1 October 2013, unless otherwise stated. The views and forecasts provided are those prevailing on 3 October 2013.

Economic  Outlook

Central Europe

General perspective

First green shoots of recovery
With the exception of Poland, all the economies in Central Europe are marked by a high degree of openness. This leaves the region highly vulnerable to changes in the global economy. The evidence in recent months suggests that the developed economies are recovering. That was already evident in the first quarter of 2013 in the United States and Japan. In the second quarter the UK and the EMU also joined the ranks. In line with the global economic recovery the first green shoots of an upturn are now also discernible in Central Europe. Both consumer and producer confidence are for example improving and industrial activity appears gradually to be picking up again. In addition, the rates of unemployment appear to have peaked. The less restrictive nature of fiscal policy in 2013 compared to previous years is also supporting domestic demand, a development that will be sustained in the coming months. The Polish Minister of Finance has even announced the temporary suspension of the Public Finance Act, meaning that policymakers will no longer be bound this and next year by the requirement to keep the government debt ratio below 50% of GDP, thus providing room for somewhat higher budget deficits. We expect that together with the economic recovery an end has come to the cycle of interest-rate cuts in Poland, where the key policy rate is now 2.5%. By contrast the Hungarian central bank has been unable to call a halt. After 14 successive interest rate cuts the key policy rate now stands at 3.6% and recent comments suggest that the bottom of the cycle is not yet reached. Nevertheless, caution is called for. A substantial proportion of Hungarian mortgage lending is denominated in foreign currency, thus limiting the capacity to tolerate a depreciation of the forint. Although the Hungarian government has been enjoying favorable financing conditions for some time, it became evident recently that this can turn around rapidly. Speculation that the US Fed might start tapering its purchasing programme sooner than expected drove up interest rates on government bonds throughout the world. In Hungary this was coupled with a depreciation of the exchange rate, as was the case in Poland. If the depreciation goes too far the Hungarian central bank will probably be obliged to offer support in the form of interest rate hikes. Surprisingly the Fed decided to delay the start of the tapering at its September meeting, pushing interest rates down again and providing relief for Hungary. The uptick in all sorts of confidence indicators remains fragile and is also at risk of being held back by a number of notable political upheavals in the region. In Bulgaria demonstrators have been demanding the dismissal of the government for several months now on account of corruption. In the Czech Republic the new government lost a vote of confidence in parliament and the president refused to appoint a new prime minister. In Hungary the parliamentary elections are scheduled for April 2014. If past experience is any guide we may anticipate a number of populist ad hoc measures on the part of the Orban administration over the next six months.

Dieter Franceus (dieter.franceus@kbc.be) KBC Group

Consumer confidence gradually improving
(standard deviation from LT-average) 3 2.5 2 1.5 1 0.5 0 -0.5 -1 -1.5 -2 -2.5 2006 07 08 09 10 11 Poland Slovakia 12 13 14 12 10 8 6 4 2 0 -2 -4 -6 Jan-2011

(year-on-year, three months moving average, in %)

Recovery in industrial activity

Jul-11

Jan-12

Jul-12 Slovakia Germany

Jan-13

Jul-13

Czech Republic Hungary

Czech Republic Hungary Poland

2

Economic  Outlook

Central Europe

Czech Republic

Recession over but recovery remains weak
Latest data confirmed that the yearand-a-half economic downturn is at last over. In the second quarter of 2013, GDP finally stopped shrinking, growing by a surprisingly large 0.6% quarteron-quarter. This marks the end of the second recession in the past five years. However, unlike the previous one, this one was primarily based on restrictive domestic policy. Lasting six quarters, it was the longest economic downturn in the Czech Republic’s history, albeit much lighter than the previous one. It did however involve the highest unemployment ever, a two-year decline in real household income, and last but not least strongly curbed investment activity across the entire economy. tic demand performed worse than in early 2013. While the recovery of gross fixed investment, household and government consumption was evident in the first quarter, these components went down again in the second quarter. Unemployment is still rising and the decline in real wages (0.3% year-onyear) continues to generate budgetary restrictions on any expenditure increase in households consumption. In addition, households saving rate will most likely remain high (8.7% in the first quarter) given the economic uncertainty and unemployment concerns. policy) will remain on the agenda.

Early elections will not change the 2014 budget significantly
Despite the approaching early elections in October, the government continues to prepare the 2014 budget. Given the subsequent time needed to form the government and the Chamber of Deputies the new Parliament may not be able to approve the budget before the end of 2013 and an interim budget would have to be used. If this period is not too long, the adverse impact on public sector management should be negligible. Also, the new government will not be able to implement the tax system changes and expenditure priorities promised before the elections. Existing opinion polls suggest that left-wing parties will win a majority (notably the Social Democrats) whose programmes offer a boost in public investment, progressive taxation, certain bank-specific taxes and increased assistance to families with children. Given the length of the legislative process, such steps are unlikely to be implemented before 2015.
Petr Dufek (pdufek@csob.cz) CSOB Czech Republic

Inflation recedes, interest rates at a low
Inflation declined to 1.3% year-on-year in August. Monetary relevant inflation, which is monitored by the central bank, is even at its lowest level in the last three years (0.5%) and below the lower threshold of the Czech National Bank’s tolerance band (inflation target of 2% +/-1%). With the base interest rate at a low of 0.05%, the central bank has been considering the possibility of exchange rate interventions. Although at its latest meeting the central bank decided against intervening, we believe that this option (as an instrument for monetary

Investment continues to be greatly subdued
With 0.6% quarter-on-quarter, GDP growth was strong, even in the European context. It was primarily driven by the positive foreign trade figure. On the one hand exports improved due to the recovery in primarily European demand. On the other hand imports were lower. Therefore the trade balance surplus increased further and consequently trade contributed positively to GDP growth. By contrast, domes-

Recession finally ends
(real GDP growth, in %) 6 4 2 0 -2 -4 -6 2008 09 10 11 12 13 Quarter-on-quarter Year-on-year 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 2009

Inflation recedes, interest rates at a low
(in %)

10

11

12

13 Central bank target Policy rate

Inflation (year-on-year) Monetary relevant inflation (year-on-year)

3

Economic  Outlook

Central Europe

Hungary

Public utility cost reductions keep inflation low
Headline CPI inflation decreased substantially from 1.8% year-on-year in July to 1.3% year-on-year in August. This was due to weak domestic demand, moderating fuel and food prices and public utility cost reductions (government cut the price of water, sewage disposal and rubbish carriage). The government approved a next round of public utility cost reductions starting in November, which may push CPI inflation below 1% year-on-year. Core inflation stuck around 3.0% year-on-year, which suggests that after the one-off drop due to a statistical base effect, inflation is expected to return to the central bank’s target of 3% year-on-year. However, in the short run inflation may remain below 2% year-onyear, which gives the central bank room to manoeuvre. GDP growth slowed down significantly to 0.1% quarter-on-quarter in the second quarter of 2013 from 0.7% quarteron-quarter in the first quarter. On a yearon-year basis the Hungarian economy expanded by 0.5% in the second quarter versus a contraction of 0.4% in the first. The details of the GDP figure confirm our concern that agriculture and a low starting base remained the main drivers of this rebound and that the acceleration of construction growth was driven by public investments and orders. Markets became more optimistic about the prospects for the European economy, which is still a key factor for Hungary’s economic performance as households’ consumption remained weak. At least the good news is that the fall of domestic consumption looks to be stopped and that net real wage growth provides some stability of households’ consumption. The next step would be the acceleration of lending activity and spending of savings when households start to believe the end of the recession. So far we see only marginal signs of an improvement of consumer confidence so the external environment may remain extremely important at least in the next few months. We see GDP growth at 0.4% year-on-year for 2013 and 1.6% year-on-year for 2014. After the excessive deficit procedure (EDP) against Hungary was lifted we already see several measures which endanger the fiscal targets. The government increased the targeted budget deficit to 2.9% of GDP for 2013 and 2.8% of GDP for 2014. Although these targets are still below the Maastricht criterion of 3% of GDP deficit, we see more slippages on revenue and expenditure sides as well. With parliamentary elections coming up within 8 months, the government started to focus on more populist measures, like further reductions in public utility costs, an increase of teachers’ salary and the employment of more people in public work programmes in order to decrease the unemployment rate. So the budget is stretched and there is a risk that the European Commission may state some strong recommendations in the next 6 months on how to tighten the budget if Hungary wants to avoid a restart of the EDP. In the meantime, the central bank has continued the gradual rate cut cycle. The base rate has now reached a historic low level of 3.6%. The big innovation has been the change of the size of possible base rate modifications to less than 25bp. This confused the market and the 20bp rate cut of August was a surprise for most market participants. Additionally the sharp drop of the August inflation figure from 1.8% to 1.3% year-on-year fuelled expectations that the NBH may cut the base rate even as far as 3%. We expect only rate cut of 10 to 20 basis points, depending on the future monetary policy of the Fed.
David Nemeth (david2.nemeth@kh.hu) K&H Bank ZRT

Slight improvement in industrial activity
70 50 30 10 -10 -30 -50 2005 120 115 110 105 100 95 90 85 80 06 07 08 09 10 11 12 13 300 250 200 150 100 50 0 -50 -100 -150 2005 06

Consistently positive trade balance
(trade balance, bn HUF)

07

08

09

10

11

12

13

Industrial production (year-on-year, seasonally adjusted, in %, left-hand scale) German business climate index (IFO, right-hand scale)

4

Economic  Outlook

Central Europe

Poland

Pension fund ‘reform’ to reduce public debt
In the second quarter real GDP growth increased to 0.8% year-on-year from 0.5% in the previous one. The contribution to real GDP growth by expenditure type was as follows: consumption +0.8%, investments -0.6%, change of inventories -1.9%, net export +2.5%. We do expect the recovery will gradually continue, with GDP growth reaching 1.1% this year and 2.2% in 2014, with the consumption being the main driver on the back of improving labour market conditions. Recent data from large companies suggest some improvement in investments is underway but we do not expect an increase in investment demand before 2014. Positive net export contribution will gradually decline as the recovery will continue. The composition of GDP growth had a very positive impact on the trade balance and the current account. As the consequence of weak domestic demand (weak import growth and a favourable exchange rate for exporters), the trade balance in 13Q1 was positive for the first time since 2000. Despite the still high unemployment rate of currently 13%, real wages have been clearly rising recently. Based on higher frequency data, economic activity slightly improved in August, reflected by a favourable manufacturing PMI reading of 51.7, compared to 49 in the previous month. In August Poland’s consumer price inflation reached 1.1% year-on-year. The inflation rate will likely stay at a relatively low level and then only gradually return to the central bank’s inflation target range as currently there is no inflationary pressures visible. Domestic demand will grow at a moderate pace which will favor price stability. With that in mind, the Monetary Policy Council (MPC) decided to cut interest rate by 0.25% to 2.5% on its July meeting. Markets have received a clear message from the central bank governor that this marked the end of the easing cycle. The Ministry of Finance revised the central government budget deficit upward by PLN 16bn to around PLN 51bn. This Budget revision comes as a consequence of the fact that economic growth turned out massively below the government’s forecasts. At the beginning of September this year, Prime Minister Donald Tusk announced changes to the pension fund system in Poland. The key features of the pension fund ‘reform’ include: - Government bonds, bills and Treasuryguaranteed papers held by OFEs (Private Pension Funds) will be transferred back to ZUS (State Pension System), and then government bonds will be redeemed. It will amount to around PLN 141bn or 51% of the assets of the pension funds. - Contributions to OFEs will become voluntary. If the OFE’s members will fail to make a declaration they will be automatically moved to the ZUS. Contributions for those who remain in OFEs will be set at 2.92% of wages (2.8% currently). - Implementation of the so-called ‘safety mechanism’. Pension payouts would be made by the ZUS. Assets of OFE’s members with 10 or less years to retirement will be gradually transferred to ZUS. The transfer out will be in cash only. - Reduction of the fees for management charged by Pension Funds by a half. The main reason for the changes to the pension system is to reduce the pressure on public finances. The changes will result in a reduction in public debt by 7.5% of GDP as well as in a lower budget deficit.
Tomasz Kowalski (tomasz.kowalski@kbctfi.pl) KBC Towarzystwo Fund. Inwest. A.S.

(growth contribution, year-on-year in %) 12 10 8 6 4 2 0 -2 -4 -6 2005 06 07 08 09 10 11 12 13 20 18 16 14 12 10 8 6 4 2 0 -2 2007

GDP growth structure

Real wage growth turns positive again
(year-on-year in %)

08

09

10

11

12

13

Private consumption Public consumption Gross fixed capital formation

Change in inventories Net exports Real GDP growth

CPI Wages in enterprise sector

5

Economic  Outlook

Central Europe

Slovakia

Domestic demand slowly reviving
Economic growth accelerated slightly in the second quarter from 0.6% yearon-year to 0.9% year-on-year. Foreign demand is still the main engine of the Slovak economy. Foreign trade registered a huge surplus in May and June. Slovakia remains one of the fastest growing economies in the EMU. However, growth is not strong enough to create new jobs since the employment fell by 1.3% year-on-year. The economy has been losing jobs for approximately four quarters now. Economic growth is mainly driven by foreign demand and companies are hesitating to start hiring (due to unstable and less predictable factory orders). However there have been signs of improvement lately of some soft leading indicators both domestically and abroad (with Slovak trading partners). For the first time since the crisis household consumption started to rise. It probably reacted to the rise of real wages due to the low inflation this year. The headline CPI inflation declined to 1.6% year-on-year in June and to 1.5% year-on-year in July compared to 2.4% year-on-year reported in January. The core inflation also decelerated from 2.8% year-on-year to 1.6% year-on-year suggesting an absence of demand-led price pressures. Nominal wages, which usually copy the trend of past inflation therefore rose faster than prices, something which may not be the case next year. The reviving domestic demand was also confirmed by strong retail sales. Growth in retail sales was in positive territory in the second quarter after several years of a steep decline. The rise of 2% year-on-year is supported also by the increase of consumer confidence, which is slightly above its long term average. Industrial production is still rising around 2.6% year-on-year (average in the first half of 2013) and in June it was supported mainly by two sectors, the auto production and metallurgy. The car industry is gradually losing steam and production dynamics are decelerating. However, KIA reported the growth of production in its Slovak plant by around 6% in the first half of 2013 and VW by approximately 5% year-on-year. The negative news came from the PSA production factory. Due to weak demand for cars, production was interrupted in September (and partially also in October and November). Eurostat reports that public debt was close to 55% of GDP at the end of the first quarter. According to the Slovak constitutional Budget Responsibility Act expenditures have to be frozen once public debt reaches this threshold. A stronger than expected GDP growth together with the fact that a lot of pre-funding has already been done by ARDAL should leave enough space for the Ministry of Finance to keep the debt level below the threshold. The Ministry of Finance increased its GDP growth forecast for 2013 from 0.5% to 0.8% year-on-year and it expects the economy to grow by 2.2% in 2014. We believe that growth will be higher this year (1%) and lower next year (1.5%) due to external risks and a slightly higher statistical base. The Smer party is still leading in the opinion polls. Given the large fragmentation of the opposition parties this means that it has a good position to go to the regional election this autumn. There is also a possibility that Prime Minister Fico is a candidate in the presidential elections in May 2014.

Marek Gabris (mgabris@csob.sk) CSOB Slovakia

Economic growth picks up again
(real GDP, year-on-year, in %) 15 12 10 10 8 6 5 4 2 0 0 -2 -5 -4 -6 -10 2001 03 05 07 09 11 13 -8 2005 06 07

Benign inflation dynamics
(year-on-year, in %)

08

09

10

11

12

13

Headline Food

6

Economic  Outlook

Central Europe

Bulgaria

Investments drop amid ongoing political uncertainty
The May elections resulted in a weak center-left minority government. Ever since, political tensions have been high in Bulgaria. After some highly controversial appointments, demonstrators began to demand the resignation of this government as well as major changes in the political system and culture. These anti-government protests have continued since and the political stress remains high. Not surprisingly, the impact on the economy was already clearly visible in the second quarter of 2013. Real GDP growth was negative at -0.1% (quarteron-quarter). The negative political environment had a strong adverse impact on the investment climate. Investments decreased strongly in the second quarter by 2.4% (quarter-on-quarter). Private consumption on the other hand contributed positively in quarter-on-quarter terms. Remarkably, there was also a small, negative quarter-on-quarter contribution of net exports. In comparison to other Central European economies, Bulgaria’s export structure is to a lesser extent oriented towards the EMU. Therefore Bulgaria appears to have benefited less from the second quarter EMU recovery than other economies in Central Europe. The economic weakness is also evident by recent consumer price dynamics. Headline CPI inflation turned negative in August at -0.7%. This negative number can partly be explained by a series of administered price cuts in the energy sector. However, core inflation in August was also slightly negative at -0.2%, as a result of the domestic demand weakness and the still high unemployment. As a consequence of subdued inflation, real disposable income has risen recently, which explains the gradual recovery in retail sales volumes. Consumer confidence is on a rising trajectory and it appears that the growth momentum has improved significantly in the third quarter with export numbers improving again. Therefore we do not expect a technical recession (two consecutive quarters of negative growth) in Bulgaria. Although we see the economy improving further towards the end of the year, we only expect a disappointing 0.6% of real GDP growth in 2013. Ever since a currency board was adopted in 1997, Bulgaria has been characterized by its sound fiscal framework. The fiscal deficit is very modest and the public debt of only 18% of GDP is among the lowest in the European Union. Moreover, the current account recorded a surplus in the first half of this year, adding to financial stability. This explains why despite the political crisis the Bulgarian government still enjoys favorable financing conditions and government bond yields remain low, suggesting that near-term financial risks remain well contained. This might change in the medium to long term however. The government’s recent decision to revise this year’s budget and allow for a higher budget deficit is troubling. Although at first the president vetoed the revision because it lacks transparency, this was later overruled by Parliament. Fiscal prudence has served Bulgaria well in the past and it is key that the government sticks to this policy.

Dieter Franceus (dieter.franceus@kbc.be) KBC Group

GDP growth turns negative in second quarter
(quarter-on-quarter, in %) 8 6 4 2 0 0 -2 -4 -6 2010 -5 -10 -15 May-2009 15 10 5

Deflation
(in %)

11

12

13

10

11

12

13

GDP growth (annualised) Investments

CPI inflation PPI inflation

7

Economic  Outlook

Central Europe

In the spotlight
The stalling macroeconomic convergence of Central Europe
Convergence in macroeconomic terms is usually considered to be the process of catching up with developed economies by less developed ones. Measuring macroeconomic convergence between countries requires the ability of comparing economic data, often expressed in units of national currency, across countries. Broadly speaking, two means of conversion exist, i.e. using market exchange rates and Purchasing Power Parities (PPPs). PPP is the exchange rate that equates the cost of a ‘typical’ basket of goods and services in both countries. Since the market exchange rate does not necessarily reflect the relative purchasing power of currencies in their national markets, PPPs should be used to make ‘volume’ comparisons, and to answer certain questions with respect to standards of living. In reality, economic agents use the market exchange rate. Therefore here we consider macroeconomic convergence to be the convergence of nominal GDP per capita at market exchange rates between countries. We observe this between the Central European economies on the one hand and Belgium on the other hand. Macroeconomic convergence can occur not only due to a positive growth differential, but also due to a real exchange rate appreciation, e.g. via the convergence of price levels. Before 2008 most Central European economies were enjoying a steady converging dynamic relative to Belgium, due to a positive growth differential and a steadily appreciating real exchange rate. Notable exception is Hungary, where convergence already halted in 2004, mostly attributable to adverse nominal exchange rate dynamics. This contrasts strongly with the Czech Republic where a large part of the convergence before 2008 is attributable to the steady appreciating trend of the CZK relative to the EUR. Since the onset of the financial crisis in 2008 nominal GDP per capita at market exchange rate convergence has halted in the Czech Republic, Hungary and Slovakia. After 2008 macroeconomic convergence only occurred in Bulgaria and Poland. Convergence in Bulgaria was modest and it can solely be explained by a structurally higher inflation rate than Belgium. Only the Polish economy managed to sustain a positive growth differential after 2008 as the main driver of macroeconomic convergence. The sudden stop of macroeconomic convergence of the Central European economies relative to Belgium occurred together with a sharp correction in the external position in most countries, which is most visible in Slovakia, Bulgaria and Hungary. In the years prior to the crisis these economies were benefiting from the large inflow of foreign direct investments as an important engine of macroeconomic convergence. In recent years those FDI inflows dried up leading to a sputtering convergence engine. Looking forward, some acceleration of macroeconomic convergence in Central European countries is again to be expected, although not at the same pace as in the previous era 2004-2007. In the ‘new normal’ postcrisis era FDI’s, credit availability and capital inflows will no longer reach the same high level as in 2004-2007, when they also contributed to huge external imbalances (current account deficits and accumulation of foreign debt) that ultimately proved to be unsustainable.

Dieter Franceus (dieter.franceus@kbc.be) KBC Group

Stalling convergence of nominal GDP per capita
(EUR, end-of-year exchange rate, Belgium = 100) 45 40 35 30 25 20 15 10 5 2000 02 04 06 08 Slovakia Bulgaria 10 12 4 2 0 -2 -4 -6 -8 -10 -12 2001

Sharp correction in current account deficits
(% of GDP) 5 0 -5 -10 -15 -20 -25 -30 03 05 07 09 11 13 Slovakia Bulgaria (right-hand scale)

Czech Republic Hungary Poland

Czech Republic Hungary Poland

8

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