Economic Analysis - Few Signs Of Overheating, But Risks Rising - DEC 2017


BMI View: Despite very strong economic growth, tight labour markets and ongoing loose monetary policy , overheating risks remain broadly contained in emerging Europe. While inflation and wage growth are strong across the region , broadly speaking external imbalances are not emerging, while private and public debt levels remain modest. That said, idiosyncratic risks are apparent in individual markets , most prominently a rapidly widening twin current account and budget deficit in Romania, deteriorating competitiveness in the Baltics, and pro-cyclical fiscal stimulus in Hungar y.

With much of Central and Eastern Europe (CEE) seeing very strong economic growth, tight labour markets and ongoing loose monetary policy, the question arises whether any economies are overheating. In this context, overheating refers not only to accelerating inflation but also to the rise of macroeconomic imbalances in areas such as external accounts, competitiveness and debt, which make current growth rates unsustainable and store up risks for the future. The below table includes some of the key indicators we believe are important in this regard. Our main conclusion is that while wages and inflation are running hot across the region, severe overheating risks remain broadly contained. In most cases, current account balances are at moderate levels, exchange rate competitiveness has so far not been significantly impaired, and debt levels remain modest. That said, headwinds to growth are rising and idiosyncratic risks are apparent in individual markets.

Overheating Risk Map
CEE Macroeconomic Indicators
Note: Real interest rate defined as 3-month money market rate minus headline inflation. 'Hot money ' NIIP defined as net international investment position in portfolio and other investment liabilities. Current account and fiscal balance refers to most recent 4-quarter period. Public debt refers to Q117. Source: Bank for International Settlements, ECB, Eurostat, national sources, Bloomberg, BMI

Our main takeaways are as follows:

Inflation Making A Comeback

In contrast to Western Europe where inflation remains subdued and has yet to show concrete signs of accelerating, inflation in CEE is on the rise with both core and headline price growth rebounding to multi-year highs in 2017. After a prolonged period of supply-side disinflation brought about by lower commodity prices, traditionally-assumed relationships between inflation and variables such as unemployment and wage growth appear broadly intact in the region, which in turn suggests that inflation pressures can remain prominent over the coming quarters. This is most evident in the Baltics, where inflation is well above the European Central Bank (ECB)'s eurozone target level of just under 2.0%, but also in places like the Czech Republic and Hungary. In Romania, relatively low headline and core inflation at present largely reflects the impact of VAT cuts, with inflation poised to rise steadily as base effects wear off.

Inflation Returning
Consumer Price Index, % chg y-o-y
Note: Core CPI used for Hungary. Source: National sources, BMI

Loose Monetary Policy Has Kept A Lid On FX Appreciation, For Now

The Baltics again appear worse-off in terms of trends in exchange rate competitiveness, as rising inflation and a stronger euro have led to significant appreciation of the respective nominal and real effective exchange rates (REERs). Among non-eurozone countries, strong growth has not yet coincided with significant nominal appreciation or a significant deviation of effective exchange rates from long-term averages. Contributing to this has been loose monetary policy and the sluggish rebound in inflation since 2016. However, we believe the dovish bias among regional central banks is becoming increasingly untenable, and that REERs are poised to rise one way or another, either via policy rate hikes and more supportive interest rate differentials pushing up the nominal exchange rate, or via much higher inflation relative to developed state trading partners. In fact, we believe both will play a role. The Czech National Bank (CNB) has already begun to raise rates, while the National Bank of Romania (NBR) has also taken tentative steps towards tightening policy. Our core view is that the central banks of the Czech Republic, Hungary, Poland and Romania will all have to tighten policy more quickly in 2018 than consensus expects.

Starting To Rise Across The Board
Broad Real Effective Exchange Rates, 2010=100
Source: Bank for International Settlements, BMI

Competitiveness Under Pressure

Most of the economies in question are highly open, with exports making up a large share of GDP and the domestic manufacturing sectors having benefited significantly over the years from cost advantages over Western peers and inward foreign direct investment (FDI). In this context, strong growth in nominal wages and unit labour costs (ULCs), alongside our expectation for further appreciation of REERs, suggest rising headwinds to this growth model. Compounding this will be the challenges posed by full employment, labour shortages, and falling working age populations ( see ' Full Employment A Headwind For Growth ' , October 3 & ' Demographics Biggest Risk To EU Debt Sustainability', July 7). The upshot for the region is that competition from more frontier markets will rise, and that raising productivity, moving up the value chain, fostering innovation, and becoming more services-oriented economies are the crucial challenges for region over the medium-to-long term.

Big Divergence From Eurozone
Unit Labour Cost per Hour Worked Index, 2010=100
Source: Eurostat, BMI

Fiscal And External Dynamics Insulate Baltics

The Baltic countries fare poorly in terms of inflation and competitiveness dynamics, and with the ECB poised to keep monetary conditions quite loose for some time, authorities have limited recourse to cool the domestic economy. That said, several mitigating factors keep risks contained and suggest a stable medium-term outlook. First, fiscal policy is generally very conservative across the Baltic region, with broad political consensus and policy continuity in terms of keeping debt and deficit levels in check. All three countries ran a balanced or budget surplus in Q117 (on a four-quarter rolling basis). Second, current accounts remain broadly balanced and exposure to short-term external liabilities remains low. Third, bank lending is still subdued amidst ongoing deleveraging pressures. Finally, the Baltic countries were among the hardest hit during the global financial crisis, having undergone severe internal devaluations in order to keep eurozone accession hopes alive. As such, a stronger degree of catch-up is to be expected in the Baltics in terms of wages and labour costs.

Baltics Sovereign Profile Robust
Public Debt, % of GDP
f = BMI forecast. Source: National Sources/BMI

Credit Dynamics Still Subdued, Corporate Debt Overhang Still A Drag

A key factor differentiating the current period of strong growth with the pre-global financial crisis period is that credit growth has until recently remained relatively subdued across the region, with many countries just emerging from a protracted period of deleveraging. Private sector credit-to-GDP gaps, defined as the difference between credit-to-GDP and its long-run trend, are firmly negative in most countries with the exception of the Czech Republic. Household debt levels are generally at moderate levels, although we are now beginning to see a broad pick-up in mortgage and other lending activity. Non-financial corporate lending has also begun to pick up, although debt overhangs following the rapid pre-crisis build-up of leverage are still dragging on credit demand in countries such as Hungary, Bulgaria, Latvia and Estonia. Although corporate deleveraging is a necessary process, its stifling impact on investment acts as a drag on medium-term growth potential.

Prolonged Deleveraging
Bank Loans To Households & Non-Financial Corporations, % of GDP
f = BMI forecast. Source: National Sources/BMI

Trade Imbalances Minimal , But Exposure To Capital Flight Still Significant

With the exception of Romania, current accounts remain broadly balanced and underlying directional trends remain relatively benign despite strong domestic demand. Nevertheless, capital flight risks are still prominent in some countries due to the relatively large stock of short-term external liabilities ('hot money'), expressed in the Overheating Risk Map as the net international investment position (NIIP) in portfolio and 'other' investment, the latter largely representing cross-border banking flows. Exposure is most prominent in Hungary and Poland where political and fiscal risks are also rising, implying sudden shifts in investor sentiment and capital flows could theoretically destabilise the growth outlook. Although the Czech Republic is comparable in terms of 'hot money' exposure, the country's safe haven status reduces capital flight risks.

Pro-Cyclical Fiscal Stimulus Raises Risk Profile Of Romania, Poland and Hungary

As we have been flagging up for some time ( see 'Emerging Europe: Fiscal Expansion Has Opportunity Cost ' , 22 June 2016), pro-cyclical fiscal stimulus in Poland, Romania and Hungary is contributing to the build-up of inflationary pressures, exacerbating labour market shortages, eroding fiscal buffers necessary to counter any downturn in economic growth, and leaving the respective economies more exposed to shifts in global risk appetite. Relative to the most recent figures shown in the above table, all three countries' deficits are expected to widen, impeding public debt reduction efforts. Despite robust growth we forecast the public debt ratio to rise in Romania in 2017 and 2018, while the country's rapidly widening twin current account and fiscal deficit suggests to us that it is perhaps the most exposed in the regional to financial stability risks ( see ' Robust Growth Disguises Build-Up Of Risks ' , August 30). Hungary meanwhile has the highest public debt ratio in the region, yet will make minimal progress deleveraging in the coming years given fiscal stimulus efforts.