Blissful living in Central Europe

Ignorance is bliss, so they say. That should make Central Europe the happiest place on the planet in 2012, because as governments, analysts and the wider population try to gauge the depth and impact of the building crisis in the Eurozone, it's clear that no-one knows anything. Apart from the Hungarians of course, who know that everyone's out to get them. EU officials may feel the same way as they struggle to assemble the bazooka that the markets have been urging them to aim at the sovereign debt crisis. Instead, domestic politics in member states has helped to shackle an already slow process and reduced the firepower of the various bailout vehicles put on the table. Irked by this – never get between a banker and another round of quantative easing – the financial markets have punished heavily indebted states, and even Germany has seen its cost of borrowing rise.
Early December saw EU leaders – sans the UK – agree to tighten fiscal regulation from Brussels, which is essentially a step towards attempting to avoid such a mess again in the future, but it does little to help the here and now. Hence, the bloc's newest members go into 2012 balanced on a knife edge, with the crisis not only weighing on their currencies and pushing their borrowing costs higher, but also threatening to severely undermine economic growth. As East Capital suggests, the connections between Central Europe and the rest of the EU are so fundamental to the economies in the former that, "the starting point for any judgment on growth perspectives… is the rapid and marked slowdown in economic activity in the whole of Western Europe. The cooling down became apparent in late spring/early summer when economic indicators turned into a negative slope. Forecasters started revising their outlooks, first cautiously, later in huge leaps."
Still, as analysts point out, whilst many of the older members of the EU are facing recessionary scenarios, the Central European economies are likely to do much better. However, if the Eurozone goes into a deep recession, then Central European countries, with Hungary by far the most vulnerable, could go with it. Juggling the numbers
It's no wonder then that the second half of 2011 saw Central European government officials juggling with more scenarios than you can shake a stick at, with GDP growth forecasts tumbling across the board as draft budgets were prepared. While none of the countries has actually crossed the line to forecast a contraction, the hopeful predictions of 3-4% that reigned across the region before the summer are long forgotten in the face of predictions from the likes of the European Commission that forecast in November EU growth will remain at a near standstill throughout 2012, before returning to slow growth in 2013. "Since the last fully-fledged forecast in May," the Commission wrote in its Autumn Economic Forecast, "the outlook for the EU and the euro area has deteriorated. The protracted sovereign-debt crisis has taken its toll on confidence affecting investment and consumption. The first signs of improvements for GDP are projected for the second half of 2012, however, with very limited impact on job creation." "No economic growth is now expected in the current and coming quarters," the report warned. "Consequently, GDP is forecast to grow at a rate of only 0.5% in the EU and the euro area in 2012. Some acceleration is expected in 2013, when growth is set to reach 1.5% in the EU and 1.25% in the euro area. While growth rates will differ across the Union, no group of countries will remain unaffected by the slowdown."
Whilst Hungary, Slovakia and the Baltics have responded to the uncertainty by simply lowering the bar as confidence sank – it felt like it was almost on a weekly basis at points in the late autumn - the Czech Republic and Poland considered differing scenarios. However, the Czechs dispensed with these as a base for the budget, allowing them to even scout out a "catastrophe" model in which the euro collapses. Warsaw, meanwhile, eventually plumped for the middle course, which envisages "some slowdown" in the EU.
Both countries ended up with a forecast of 2.5% GDP growth. While analysts broadly agree with Poland's prediction, the Czechs essentially admitted their number is a fallacy, but pointed out that without a crystal ball, who cares? "Nobody is able to estimate now how the Eurozone will deal with the crisis and what its impact will be on the Czech economy," said Czech Finance Minister Miroslav Kalousek after budget was passed on December 14. As third-quarter manufacturing data for the region came in, it became more obvious that the problems in the EU were already hitting the Central European economies where it hurts: exports. Whether, like the Czech Republic, it was set up several years ago or, like the Baltics, in the last 24 months or so, the region's exposure to export demand in the 27-member bloc has been a boon which now threatens a bust, with domestic demand in Central Europe's small open economies in no state to take up the strain. The one exception is possibly the far-larger Polish economy, but even there the eventual 2012 budget saw its GDP growth forecast cut from an original estimate of 4%, with a tough set of austerity measures promised on top. Falling risk appetite and reduced financial flows are also likely to continue to effect the cost of borrowing for sovereigns, and in one case, Hungary, could even risk closing access to debt markets altogether should the situation take a bad turn and the government continues to play the maverick. That leaves governments across the region facing a conundrum, especially should they all sign up to the EU fiscal compact, handing Brussels greater powers to oversee their national budgets. Tasked with commitments to lower deficits, and debt in the case of Hungary and Poland, they're left with little room to stimulate the economy, particularly via interest rates. However, without growth, it will be difficult to reduce debt and deficits sufficiently. Private borrowers are unlikely to find it much easier or cheaper to get hold of credit. With the catastrophe in Greece – and worries over the likes of Italy and Portugal persisting – banks in the EU have been instructed to raise their Tier-1 capital ratios to 9%. The latest European Banking Association stress tests in December said that overall the banks need to find €115bn to satisfy that stipulation. With their markets largely dominated by Western European banks, Central European borrowers are likely to find credit harder to get, adding another drag on growth. On top of weakening local currencies, this bodes ill for investment also. That said, Commerzbank analysts suggest that one silver lining from the last crisis is that it pushed the region to drastically cut its dependence on foreign financing. They estimate that the potential external funding gap for Central and Eastern Eurtope in 2012 is likely to narrow to just $10bn or so "from over $100bn in 2008 (estimated pre-IMF, pre-Vienna initiative)." Meanwhile, the final outlier for the individual Central European economies is the swift contagion still seen across the region. For instance, the Czechs can run as conservative a fiscal policy as they like, or the Poles can enjoy robust domestic demand, but their currencies and bond yields are still hit when Hungary earns itself a downgrade. Czech Republic – steady as she goes While a conservative fiscal policy means that the Czechs head into the euro storm in a relatively robust state – state and private debt levels are relatively low, the currency relatively stable, inflation under control, and the banks reported to be well capitalized – the risk to 2012 growth of this small, open and export-led economy ranks amongst the highest in the region. Low domestic demand, and that very same conservative policy which promises further austerity, are expected to compound the effects of the EU slowdown. The state budget for 2012 went through based on a growth forecast of 2.5% and targets a deficit of 3.2% of GDP. However, analyst forecasts range from recession to a peak of 1%. Finance Minister Miroslav Kalousek admitted weeks before the plan was passed that 1% is more likely, and that there are downside risks even to that prediction. The Czech National Bank tops the latest forecasts at 1.2%, although the deputy governor, Vladimir Tomsik, was fretting in early December that the effect of the EU crisis could be similar to 2008, when the economy nosedived by 4.5%. That contraction was largely due to the country's massive reliance on trade with the EU, which constitutes around 75% of total GDP, and nothing has changed there. In turn, a full 80% of exports go to the EU, with next year's defensive markets such as China (1%) and the former Soviet Union (6.3%) providing little demand. Moreover, as Deutsche Bank points out, the country's lack of diversification goes even further than that: "Germany is by far the Czech Republic's largest export partner, accounting for 22% of GDP in exports. A more protracted recession in Germany leaves a significant risk of recession in the Czech Republic." Compounding this risk is another of the country's perceived strengths. The Czech population has been lauded for its conservative spending and propensity to save, but that leaves the country "with net exports being the only meaningful driver of growth," points out Martin Lobotka at Ceska Sporitelna. "With VAT rises [due in January 2012], employment forecast to fall, and zero growth of the real wage rate, one should expect another outright fall of household consumption." "Additionally," points out Jaromir Sindel at Citigroup, who forecasts the economy will see no growth at all in 2012, "the government is likely to introduce additional fiscal austerity measures to keep public finances under control." Meanwhile, the worry over external demand is already being encouraged by data from the third quarter, with the country seeing it's first GDP contraction (0.1%) in two years, while manufacturing data illustrated a sharp slowdown in September. Analysts across the board are fretting that the fourth-quarter numbers are headed over a cliff.
One of the central pillars of defence is said to be the stability of the banks, which, like the government, have ploughed a conservative and classical course, while the population likes to stash its cash with them rather than spend. The Czech National Bank reported in November that the sector is well capitalized, pointing to an annual rate of lending growth of around 5% in October to back up its claim. One of the keys for the sector is that it is extremely liquid, with a loan/deposit ratio of 78%. Those resources may well be needed to continue supporting growth however with the Western European banks that control the vast bulk of the Czech market set to deleverage to raise their own capital ratios throughout the year.
At the same time, some worry over the quality and diversity of the assets on their balance sheets and rising non-performing loans (NPLs). It was just this picture that prompted Moody's Investors Service to cut its outlook on the sector from stable to negative in December. As bne reported, some in the industry say that exposure to real estate is a huge risk in particular, with a huge volume of loans coming up for refinancing.
Meanwhile, UBS analysts worry that the country's strong inflation record is about to break in 2012, with the introduction of a VAT rise (from 10% to 14% for the lower rate) in January teaming up with rising utilities costs to "add around 1 percentrage point to the headline rate."
However, not everyone is as confident as UBS that "an inflation rise to 2.9% in 2012, from 1.9% in 2011, before falling back to 2% in 2013" will be enough to prevent the central bank from cutting its 0.75% policy rate in a bid to stimulate growth.

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