Bracing for the climb
CEE economies are well-positioned compared to their 2008/2009 battering to show positive economic growth rates in coming years. Years of poor growth are starting to make way for improved external balances and financial stability. However, increasing political and policy risks in the region cannot be ignored as numerous elections are approaching. Moreover, while most CEE countries are recovering, they remain some way from the heights achieved in the pre-2008 period.
By Rob Rühl, Head of Business Economics ING Economics Department/Global Markets Research, and Mohammed Nassiri, Researcher ING Economics Department/Global Markets Research
Compared with other regions CEE enjoyed moderate economic growth rates during 2013 with central banks across the region trying to support growth by lowering official interest rates or, in countries with relatively high inflation, implementing liquidity support measures. Positives for the region included a clear recovery in other parts of the world, low foreign interest rates, ample global liquidity and stable commodity prices. However, the ongoing recession in the EU had a major impact on trade and financial flows in CEE. Output weakness in 2012/2013 can nevertheless be attributed to a lack of domestic demand rather than disappointing export performance.
Fixed investment slowly recovered in 2013. This reflects lower capital inflows as well as policy restraints. Other headwinds for the region include deleveraging pressures on banks and regulatory changes which are increasing the cost of capital allocated to CEE. In the aftermath of the financial crisis there was a surge in non-performing loans as growth slowed, unemployment rose and the housing boom ended. Bank lending fell as a consequence while households facing an uncertain future in terms of income cut spending and boosted savings.
Most governments in the region have succeeded in keeping government deficits below the magic 3% of GDP level (the socalled Maastricht criteria for the eurozone). Exceptions include Poland, the Slovak Republic and Romania. Similarly, government debt was kept below 60% of GDP everywhere except Hungary and, outside the EU, Russia. While oil and gas revenues supported government finances and its international reserves position, the country nevertheless faces significant challenges. Insufficient investment, lagging structural reform and an adverse investment climate are constraints to potential growth.
One advantage of the slow growth in domestic demand across CEE is downward pressure on infl ation and improved current account deficits in many countries. The latter reduces the reliance of CEE countries on foreign savings. However, Turkey and Ukraine still depend on large foreign capital inflows. As a consequence both countries’ currencies depreciated heavily against the dollar and the euro following the 22 May announcement by the US Federal Reserve Bank that its loose monetary policy would be curtailed in future (a socalled tapering process starting in January 2014).
Prospects for 2014-2015
With growth in the eurozone picking up, the outlook for CEE countries will improve in 2014-2015. The EU5 (Bulgaria, Czech Republic, Hungary, Poland and Romania) will benefit the most with Turkey profiting to a lesser extent. ING’s base forecast for most of the region is for a slow growth recovery. The large build-up of slack in recent years will act as a stabilising factor for short-term interest rates as it will delay any build-up of inflation.
Consumers across the region will gain confidence and start spending money on consumer durables. Similarly, companies should resume investments, especially those associated with replacing existing production facilities to improve productivity and save energy. As a result imports are likely to pick up, reversing the trend towards lower current account deficits. Governments are expected to support the revival of private domestic demand as the key adjustments required to ensure economic stability have already been made. Bulgaria, Romania and Hungary may have room for fiscal relaxation to stimulate domestic demand while pension reforms in Poland have made room for extra government spending ahead of the 2015 parliamentary elections.
The EU5 countries will benefit from the disbursement of funds under the EU 2014- 2021 budget, as well as from a boost in infrastructure investments. Poland appears best-positioned to absorb these EU funds as the absorption capacity in the other four countries is still limited.
The downside risks to growth are most prominent in Hungary. Taxes on banks and schemes to convert foreign exchange-denominated mortgages into Hungarian forint will constrain bank lending. Meanwhile Turkey will have to adapt to years of lower foreign capital inflows. As a consequence the country faces difficult decisions if it is to reduce its current account deficit. One option would be a depreciation of the currency to stimulate exports and reduce imports. However, that would jeopardise the policy goal of the Turkish central bank to keep inflation under control. The most likely outcome would appear to be for the central bank to raise interest rates in order to reduce domestic demand.
Unlocking potential growth in Russia will require investments in infrastructure and improvements in the ease of doing business. Neither objective looks likely to be achieved in the short run. The government is expected to stick to fiscal tightening in line with the 2014-2016 budget framework. So while Russia will remain financially stable – thanks to its oil and gas reserves – the outlook for economic growth will be constrained. Neighbouring Ukraine faces a period of important adjustments to reduce its fiscal and current account deficits: the country could suffer a severe loss of income and output and from a depreciation of the hryvnia. Support from Russia will mitigate the negative impact of developments in Ukraine. All in all the CEE & CIS region will profit (GDP growth 3.5%) from a moderate economic recovery in the European economies (1.3%) and domestic policy adjustments in 2014/2015. Increasing political pressure due to upcoming elections may have a negative impact.
CEE and Western Europe growing closer
The CEE economic block is becoming a more open region with an increasingly important role as a global trading partner. CEE exports grew at a compound annual growth rate (CAGR) of 15% between 2002 and 2012 (figure 2). The merchandise trade ratio increased from 63% to 84% of GDP, showing that trade is becoming more important for the region’s economy. At the same time the region’s share of global trade increased by 1.2 percentage points to 5.0% of global exports. This is partly the result of a high growth rate of trade with the own region (so-called intra-regional trade). The euro area is still, however, the most important trade partner for the CEE countries, while emerging countries outside the own region only play a minor role (figure 1).
The top three exporting countries in the CEE region in descending order are Poland, the Czech Republic and Turkey. The same countries are the main importers and are together responsible for 57% of the region’s foreign trade. Intra-regional trade increased between 2002 and 2012 from 16% to 22% of total exports, reflecting the growing interdependence between countries within the region. Poland (17%), Czech Republic (17%), Slovakia (15%) and Hungary (14%) are together responsible for 63% of this intra-regional trade. Growth in intra-regional trade is one of the quick wins for the region’s trade development and is mainly due to an increasing importance in the European supply chain. This will continue in 2014/2015. Not only by trade ties between CEE and WEU ties became stronger. Foreign direct investment and bank lending from Western European banks helped to finance the transfer of production capacity to CEE countries, enabling CEE to link its industrial sectors to the successful European supply chains in the technological industries.
Trade within CEE and with CIS and the Middle East & North Africa (MENA) is gradually increasing. However, CEE exports continue to depend heavily on Western European markets, which accounted for 53% of exports in 2012 (the EU accounts for 43% of the total). Consequently, the outlook for CEE is closely linked to recovery in the EU. The nascent recovery in many eurozone countries therefore bodes well for CEE in 2014/2015. 12% of CEE goods go to emerging countries in other regions such as Asia, Latin America (LATAM) and MENA. Excluding trade with the MENA region – which is dominated by Turkey with almost 75% of the total CEE trade – this share is even smaller (5%). Despite this low share CEE is well-positioned through its ties to the supply chains of countries like Germany to benefit indirectly from high growth rates in emerging countries. Nevertheless, exporting more to emerging countries directly could help CEE become more diversified and less susceptible to a possible economic slowdown in Europe.
Cars and machines in exchange for mineral fuels
Much of CEE’s dependence on the EU as an export market stems from developments in the 1990s when there was a considerable transfer of production capacity by original equipment manufacturers from Western Europe. From the mid-90s onwards CEE became a major exporter of machinery and transport equipment. The continued high share of intermediary products in total exports shows the importance of the region’s role as a supplier for both the euro area and the region itself. The CAGR of machinery and transport equipment exports between 1995 and 2012 was 17%, making it by far the most important export sector. By 2012 machinery and transport equipment represented 39% of exports (with 61% of these exports shipped to Western Europe).
Machinery and transport equipment is generally characterised by its high added value, underlining the increasingly sophisticated export profile of CEE (figure 3). In Germany in particular (which accounts for 20% of CEE exports) CEE products are important input for the production of cars and machines. Almost 50% of all foreign intermediate products for motor vehicles and 30% of the machinery used by German sectors is produced in the CEE region. This makes CEE well-positioned to benefit from the positive outlook for German sectors such as the transport and machinery sectors in coming years.
Despite the export success of CEE the trade deficit almost doubled in the last decade from USD 64 billion to USD 102 billion. The main contributors to the region’s trade deficit (60%) are Turkey and Romania (oil bill). Czech Republic, Slovakia and Hungary were able to turn their deficit into a surplus mainly by exporting more road vehicles, electrical machinery and telecommunication appliances. More exports of cars and machines in exchange for mineral fuels will be the name of the game in CEE in the coming years. The expansion of the production capacity of high-tech goods and the continued strong market position in intermediary products will help to achieve this goal.
CEE technological sector continues to grow
The CAGR of the production of investment goods and consumer durables was between 8.6% and 8.8% from 1998 until 2012 – double the regional GDP growth rate. Globally CEE accounted for 7.6% of worldwide durable consumer goods production and 4.8% of the production of investment goods in 2013. As shown in figure 4 we expect industries included in the production of technological goods (indicated by blue bulbs) to show the highest growth rates in 2013-2018. Foreign direct investment made before the start of the global crisis and adjustments to investment plans resulted in idle production capacity later. This capacity will be used in the coming years to increase production for domestic sales and exports. European producers will continue to allocate production to the CEE region. Some critical production processes for the European market can be transferred from Asia to countries in the CEE region. With sales prospects for Asian companies improving in Europe, more Asian companies are expected to step up foreign investments in CEE. Cost advantages of producing in CEE, direct access to the EU market and lower transport costs are the main drivers for Asian companies to establish themselves in the region. Foreign direct investment by companies in the automotive, computer and office equipment, and domestic appliances sectors have driven production growth: 65% of automotive production in the region was started by Western European companies. The best-known examples of international firms that have established a significant presence in CEE are Volkswagen in Czech Republic and Renault in Romania. Asian companies have also established production facilities in the region, such as Kia in Slovakia and Toyota and Honda in Turkey.
Russia, Poland, Turkey and Czech Republic are the most important producers of technological products. Although technological production attracts most of the attention, the production of intermediate products and food is still an important cornerstone for the CEE economies. Growth in the production of chemicals, wood products, coke and refined petroleum products and basic metals will keep pace with GDP growth. Turkey will be the main source of growth in these sectors as investment activity in Turkey is highly focused on these sectors. Food, beverages and tobacco will continue to play an important role (7% of global production) with Turkey, Russia and Poland being the main food-producing countries in the region. Turkey’s leading role is supported by its high agricultural share (3.5%) of global production.
Russia: global producer for domestic market
Russia’s economic performance is mainly linked to the oil and gas industry. A lesser-known fact is that the country is by far the largest producer of investment goods with a global market share of 5.1% for the production of computers, for example. The country is also the largest producer of cars and other vehicles, with a global market share of 2.1%. The focus of Russian production is mainly on the domestic market and the markets of the countries of the Customs Union (Russia, Belarus and Kazakhstan). At the same time the Russian market is known as one of the most protected markets. Russia’s focus on the creation of a customs union and the protection of its own markets limits the Russian technological sector’s ability to play a more important role in global trade, thus preventing Russian industry from unlocking its potential.