- The region is adjusting to slower growth across its trading partners, growth patterns up to 2008 will not be repeated
- Further gradual improvement of industry to be supported by the availability of spare capacities and improved competitiveness but demand remains the primary challenge
- External deleveraging shows signs of petering out, in many countries deposit growth creates some upside for new credit extension
Industry growth has improved recently, while credit is bottoming out. External bank deleveraging has eased significantly in the newer EU states. Finally, the years leading up to 2008 were unique in terms of growth and its patterns will not be repeated, instead CEE is determining a ‘new norm’. The region is still struggling with low external demand and reduced foreign capital.
Significant differences in the improvement of industry, crediting and inflation
Industry was performing better in Q1 than at the end of last year, mostly because of the improvement in vehicle production. Looking at the average manufacturing Purchasing Managers´ Indexes of Q2, Czech Republic could keep up with the good results and with its exports rising, but all other countries fell below previous quarter´s performance. Further improvements are expected in industry, but it will be gradual and at times volatile. This should be supported by the availability of spare capacities and improving competitiveness, despite a slump in FDI to manufacturing in the region. Demand represents the primary challenge and is translating into a loss in world market shares.
Similar to industry there is improvement in the impact of credit on domestic demand, but it is only gradual and with large variation across CEE. “External deleveraging has slowed significantly while in many countries deposit growth exceeds credit growth, creating some upside for new credit extension, though this is materializing only slowly in the newer EU state”, says Gillian Edgeworth, chief EEMEA economist at UniCredit. Bulgaria, Czech Republic, Poland and Lithuania are the only ones with positive year-on-year credit growth, albeit only at a low level. The most important problems are still the high number of non-performing loans and the lack of demand for credit.
In Hungary, Latvia, Romania and Croatia the shrinkage of credit is slowing, whereas in Romania and Croatia the situation is still challenging. Exceptions are Turkey and Russia, where the credit growth is stronger and the foreign ownership of banks lower. But while new credit extension is accelerating in Turkey, the growth is slowing due to financing and regulatory constraints in Russia.
This improvement in the industry and in the credit environment combines with a lower pace of fiscal consolidation. In most countries budget balances are non-problematic, some of the largest improvements globally are found in the newer EU states. Czech Republic, Hungary and Romania for example were able to bring their structural budget balances within 3 per cent of GDP. Many countries are slowing consolidation in order to support activity. But in some countries, like Croatia, Slovenia, Serbia and Ukraine, further consolidation is needed due to weaker fiscal performance and the threatening of exceeding the deficit targets.
Fortunately the current inflation environment allows some countries to ease their monetary policy. Inflation pressures have let up, thanks to the lower oil prices and regulated prices. Slower food price inflation combined with expected good harvests also creates a less problematic inflation environment. Many countries already took major steps on fiscal consolidation and therefore tax measures pose less of a risk to inflation going forward. But similar to other areas of economy, there are significant differences across the region also in terms of the ability of central banks to bring headline inflation in line with target. While Czech Republic and Poland are below target, Turkey and Russia still struggle with above target inflation.
External financing as a risk to economic recovery
The primary risks to the recovery path are more negative external financing conditions. As the global appetite for risk has reduced, there is a more limited inflow of foreign capital to CEE. With the region still having significant outflows, the risk of countries paying back its debt at a higher cost increases. Here again there is a considerable cross-country differentiation within CEE. In Poland and Turkey portfolio inflows were large. Croatia and Lithuania are also relying on foreign inflows.
FX reserve accumulation has not kept pace with inflows of portfolio capital. Most central banks have not adopted a policy of reserve accumulation to keep pace with portfolio inflows.
Although there is already improvement in activity in the region and the inflation pressure on central banks is easing, the risks to financial stability have to be considered by each country which will result – again, due to the significant differentiation within the region – in different monetary policies and actions. In countries which have already taken steps towards reaching the inflation target and creating financial stability – e.g. Poland, Hungary and Czech Republic – the monetary policy will be showing easier conditions.
“The tentative recovery that we are seeing in industry across the region is being put at risk by less favourable external financing conditions, therefore the case for building buffers is significant”, states Gillian Edgeworth. Many countries are short on FX reserves and negative domestic and external developments represent a downside risk to the financial system. CEE countries need anchors in order to be able to stabilize their financial environment. One such anchor could be IMF programmes, another one may be the banking union within the EU which has the potential to boost credibility of financial systems.