CEEMEA: Slower Growth, Resilient Inflation in 2008

A US recession and prolonged tight credit conditions look unlikely to leave CEEMEA unscathed, albeit with pockets of relative resilience, notably in Poland and Russia. Countries with excessive credit booms and external imbalances, notably Romania and South Africa, look relatively vulnerable. Even with slower growth, we expect inflation to remain a concern across much of the region, significantly limiting the scope for a monetary policy response to growth.

CE4: Growth Set to Slow, Inflation to Remain a Concern

2007 was another year of above-trend growth across most of Central Europe, with the notable exception of Hungary, where the government’s fiscal package continued to depress household incomes. Growth looks set to slow in 2008, in line with core Europe, though we still believe that it will remain robust in most countries. However, inflation, which surprised on the upside this year, will remain a concern, as tight labor markets increase the chances of second round-effects from the recent spike in food and energy prices. Below, we identify what we think will be the main macro themes in each country in the region:

Czech Republic: The inflation-FX tug of war. In the Czech Republic, we expect growth to ease, but to remain relatively strong in 2008 at 4.8%, after 6.2% this year. We believe that the big macro theme in 2008 will be how the CNB will respond to rising headline inflation and a strong currency. This year’s rate hikes (+100bp) have lifted the koruna out of its funding currency status and contributed to sharp appreciation in 4Q, with the currency continuing to set all-time highs against the euro. At the same time, a combination of strong energy and food prices has lifted inflation to 5% in 4Q, and regulated price and tax increases will bring CPI above 6% in 1Q08. This will be well above the 3% inflation target (falling to 2% from 2010), and will keep the CNB in tightening mode, at least in the first half of the year. However, the central bank will also seek not to encourage further koruna gains, in our view, and deliver less tightening than what is currently priced into markets (50-75bp of rate hikes).

Hungary: Stuck in a low-growth rut. Hungary, the country in Central Europe that is most sensitive to a slowdown in the euro area, will continue to suffer from weak domestic demand, as the fiscal stance continues to tighten, bringing the deficit towards 4% of GDP in 2008 (it was headed towards 11% in 2006 before the approval of the fiscal package). With another year of sub-2% growth likely, the NBH will remain biased to ease, though stubborn inflation might once again delay the start of the easing cycle from March (our current expectations) to later in the year. We see more easing than the market is pricing in (100bp versus 50bp). If headline inflation proves stickier than anticipated and the central bank sees clear signs of a pass-through to higher CPI expectations, we expect discussions on the HUF band abolition (backed by the NBH, opposed by the government) to resurface, as the central bank might welcome FX gains to tame inflation. On the political front, a market mover might be the opposition referendum, likely to take place before the spring, to scrap tuition and doctor visit fees. While the budget impact might be limited to 0.5% of GDP, a resounding opposition victory might further weaken PM Gyurcsany’s position (his Socialist Party is lagging in the polls by a record 25 points), though a full-blown crisis is unlikely to happen before the 2009 European Parliament elections.

Poland: We like the zloty. With growth set to remain robust, supported by strong labor income gains, and inflation set to peak above the central bank’s 1.5-3.5% target band, we believe that the NBP will continue to raise interest rates, by at least 50bp next year (the market is more aggressive, pricing in nearly 125bp of rate hikes). Support from rate increases, coupled with prospects of a market-friendly economic policy and a resumption of the privatization process, will lend support to the zloty, our current favorite currency in the region. The new PO-led government, which received a warm welcome by markets and international observers, has thus far remained quite prudent with respect to EMU, saying that it is a matter for the next government. Even so, a responsible fiscal policy and pro-euro stance point to euro adoption in 2012, which implies ERM II entry in 1H09. The main risk in Poland next year will come from rising external imbalances, with the current account deficit likely to exceed 5% of GDP thanks to strong import growth. Despite a worsening BoP picture, we see good reasons to like the zloty on balance. On the political front, the cohabitation between the PO government and PiS President Kaczynski might prove troublesome at times, but the PO government should easily find the two-thirds votes to overrule any presidential veto, in our view.

Slovakia: EMU saga to come to a happy end. The May EU decision whether to recommend Slovakia’s admission into the euro area in 2009 will be the main event next year. We and the market expect a favorable outcome, with the main risks of a delay likely to come from the inflation criterion. While Slovakia will meet the criterion in nominal terms, the EU authorities might choose to focus on the sustainability of low inflation, objecting that fixing the exchange rate to the euro will result in a sharp rise in inflation, as FX gains no longer act as a source of disinflation. The Slovak authorities will need to make a convincing case that they stand ready to apply tight fiscal policy to avoid a wage-inflation spiral following EMU accession in January 2009. While we expect a positive assessment, we recognize that risks are asymmetric. A ‘yes’ outcome is unlikely to spark a huge rally in the currency, which we expect to be fixed at 32.5 against the euro. A decision to delay Slovakia’s euro adoption would lead to a very sharp sell-off, with contagion across the region (wider 5y-5y spreads versus the euro) as investors reassess the EU’s willingness to welcome new members into the euro area.

Russia and CIS

Russia remains resilient, and inflationary. In Russia, we continue to see the recent resolution of presidential election uncertainty as a significant positive for the market and, in the near term, for the economy. We expect a modest GDP growth slowdown in 2008 (still to 5.8%) as tighter funding conditions begin to bite at the lower end of the banking market, but see few serious short-term macro risks from a US recession. Monetary policy will remain closely focused on maintaining liquidity and supporting the smaller banks, even at the expense of further inflation. Morgan Stanley remains relatively bullish on energy prices (Brent oil averaging US$79 in 2008’s stronger dollars) but, even with a sharper drop, risks to domestic demand are clearly limited, given the current determination to accelerate spending out of fiscal reserves. While the framework for macro policy is likely to remain unchanged, guaranteed by Putin’s continuing influence, some policy questions remain. Among these is Putin’s own position – we continue to have doubts about him taking the PM position offered by Medvedev. We also expect Medvedev’s perceived liberal inclinations to be balanced by senior appointments from the securocrat wing. Pressures over tax policy are likely to intensify. In a speech this week to business leaders, Putin appeared to hint at even higher taxes for the commodity sector, though Kremlin aides denied that such plans were being prepared. Given the state’s clear difficulties in spending its surpluses, we still see a strong case for tax cuts on oil and the non-commodity private sector, but change does not look imminent. In the context of a declining current account surplus, the strength of capital inflows will also be a key issue. While we do not expect 2007’s circa US$90 billion of net capital inflows to be repeated, a current account surplus that we forecast at around US$40 billion, net capital inflows of around US$40 billion and a budget surplus in the order of US$10 billion still imply, ceteris paribus, a reserve money increase in the order of 40%. We expect CPI growth to average 12.3%Y in 1H08, slowing only to 10.0%Y by year-end. Under a new regime, sharp measures to check domestic demand pressure look unlikely, but we continue to expect gradual further rises in market interest rates, and a 3.5% appreciation of the RUB against the basket over the year (politically likely to be easier, given a recovering US dollar).

Slower growth and more flexible FX in Ukraine. We expect a slightly sharper GDP slowdown in Ukraine (to 5.4%) although here, too, the direct impact of US consumers and the credit squeeze looks relatively modest. Bank credit growth was still up a robust 5.8% in November, to 74.3%Y, with funding helped by foreign ownership approaching 50% of assets. We expect terms of trade to deteriorate more strongly than for Russia, with a second consecutive annual 38% increase in imported gas prices already agreed. Steel, the dominant export product, still appears to have price upside, with major producers announcing plans for 20-30% price hikes, but here the global environment may prove less supportive. Scope for fiscal stimulus is clearly more limited than in Russia, though unaffordable promises by the incoming administration remain a concern. We still expect the current account deficit almost to double to around 7.0% of GDP in 2008. This still looks fundable to us, with net FDI already running at 6.4% of GDP, only the second major sale in the steel sector just announced, and strong prospects for further asset sales and foreign-funded investments as concerns over property rights continue to diminish. We expect a gradual widening of the UAH flotation band from early in 2008, but the scope for this to prompt significant appreciation, and to restrain inflation, currently looks limited. We expect CPI growth to average 15.5% next year, even with no significant retail gas price pass-through.

Tougher times in Kazakhstan, but banks and KZT to cope. Current inflation in Kazakhstan looks even more challenging, with headline CPI growth already at 17.5%Y. Yet this looks likely to be low on the list of 2008 policy challenges. We continue to expect a sharp growth slowdown (to around 3.5%) and significant further real estate market corrections as banks shrink balance sheets to meet foreign debt repayments. Narrow money growth has already slowed from 125%Y in January to 26%Y in October. However, the aggregate macro and debt repayment situation continues to look manageable to us. President Nazarbayev has reiterated his explicit guarantee of state support for the banking sector, and state resources continue to look more than adequate to deliver on this. FX reserves including the oil fund cover 137% of M2 and 259% of short-term external debt. We expect further bailouts to be announced but, with energy prices firm, and Kazakhstan still attracting inward investment (notably recently through ENRC and Mittal), the underlying balance of payments position still looks comfortably strong enough to allow the National Bank to continue to support the KZT.

South-East Europe

In 2008, South-East Europe will likely continue to grow rapidly above 6% on the back of increasing investment in infrastructure and construction. Stable FDI inflows along with sizeable EU funds are set to contribute to the government spending commitments, improving competitiveness and export capacity. Main risks for the region remain related to the widening external imbalances, the upsurge in inflation and loose fiscal policy. So far, domestic credit has proved resilient to the global financial turmoil. Nevertheless, rising risk aversion is likely to increase banks’ borrowing costs and squeeze financial inflows, which are critical for the sustainability of the current account deficits next year.

Romania: CA deficit concerns will not abate in 2008. In Romania, we expect growth to total 5.7% in 2007 (affected by poor harvests) and stay robust at 6.0% in 2008, driven by buoyant investment in infrastructure and construction. The major macro challenges we envisage next year are: i) double-digit wage growth and expansionary fiscal policy; ii) higher food inflation; and iii) a widening CA deficit. The government is set to increase minimum wages by 28.0% in 2008, ahead of next year’s parliamentary elections. Real wages were up 25.2%Y in October 2007, and we expect double-digit wage growth to continue next year, which will further harm competitiveness. Also adding to domestic demand, fiscal policy will remain expansionary, although we see the contribution of private consumption to GDP likely declining next year. Higher public spending also fuels inflation, which stood at 6.7%Y in November, up from as low as 3.8%Y in July. We anticipate increases in the policy rate by 50bp in 1H08 from the current 7.50%, as the NBR tries to stem inflationary pressures coming from processed food prices, strong domestic demand, pro-cyclical fiscal policy and the lagged effects of the recent FX weakness. A widening CA deficit (14% of GDP in 2007, likely to expand further next year), financed mainly by debt-creating inflows, is a major concern for the NBR. Tighter global credit markets are likely to constrain foreign financing in 2008 and exacerbate external imbalances, increasing the likelihood of severe bouts of currency volatility.

South Africa : Weaker Growth, Tight Policy, FX Weakness

Tighter money and weaker global growth cloud growth prospects. After decelerating from 5.4% in 2006 to some 5% in 2007, we expect the South African economy to show further signs of weakness in 2008, thanks to tighter monetary conditions and weaker global growth prospects. Morgan Stanley has held an out-of-consensus call on growth of 4.2% for 2008 since the June MPC meeting, where the SARB first decided to tighten money in response to exogenous drivers of first-round inflation such as food and energy. Since then, consensus numbers (currently at 4.4%) have progressively converged toward our own estimates as manufacturing production fell into technical recession earlier than even we were expecting. With our US colleagues now officially calling for a mild recession there next year, and our European colleagues having shaved as much as a fifth off their initial growth estimates in response, we are inclined to believe that the external sector could turn out to be a large drag on growth in 2008. At the same time, higher interest rates are likely to place a lid on consumption growth, while contemporaneously capping growth in private fixed investment, although public sector capital deepening is likely to remain somewhat robust ahead of the 2010 World Cup. On the whole, therefore, we now expect South Africa’s GDP growth in 2008 to come in at around 4%, with downside risk.

Monetary policy to remain tight throughout 2008. We believe that we may have reached the peak of this tightening cycle; however, upside inflation risks continue to cloud the outlook. Most significant for policy will be the possibility of higher-than-expected energy prices, coupled with food inflation that may not ease to the extent that is currently priced into the monetary authorities’ forecasts: Although the onset of summer rains suggests that local food prices could moderate from their exceptionally strong increases in 2007, it is important to note that commodities such as wheat and maize will to some extent continue to be influenced by export parity pricing too. And from anecdotal evidence here it is by no means conclusive that global food price inflation will moderate next year. Should South Africa experience another round of accelerating food prices, or a sustained move in international oil prices above US$100/bbl, further monetary policy tightening in an effort to restrain second-round inflation and anchor inflation expectations cannot be ruled out. As far as the timing of interest rate easing is concerned, we do not expect the SARB to cut rates before the middle of 2009. This is contrary to consensus expectations of policy rate cuts as early as 4Q08. We believe that a weak current account position will likely combine with mounting evidence of second-round inflation pressures in 2008 to prevent the SARB from cutting rates.

Currency will likely come under pressure. As discussed, even in a situation of no further tightening in 2008, we expect the action taken to date to engineer a slowdown in South Africa’s growth prospects. In our opinion, such a growth slowdown raises the probability of a pull-back in the international capital inflows that have thus far been attracted to the country’s attractive growth dynamics. It has been our long-held view that as these foreign inflows abate, the currency is likely to depreciate. We stick to this view. In our most recent note on the 3Q07 balance of payments (see South Africa: Dividend Payments Abound, December 12, 2007), we indicated that South Africa’s current account is bleeding profusely, as dividend payments on both direct and non-direct investments push the deficit into uncharted territory. Also, although we believe that the strength of institutions and cohesion of the current economic policy framework is solid, the market appears to have completely disregarded rising political risk as the ruling ANC looks to elect new leadership. We do not expect this disregard to continue, and look for some correction in 2008.

On the whole, therefore, in the coming year, we look for weaker-than-consensus growth prospects, tight monetary policy for longer than most expect, and a possible correction in the currency to reflect deteriorating external account imbalances and rising political risk.

By P. Diana, M. Kafe, O. Weeks, K. Kalcheva, A. Masia
Morgan Stanley
December 17, 2007