Where’s the growth in emerging Europe? Russia and Ukraine ‘disappointing’
Most economies in Emerging Europe have now posted fourth quarter and full year 2010 real gross domestic product growth performance data. The over-riding story herein is of a region in recovery mode, but the pace of recovery across the region varies quite markedly.
Turkey, for example, leads the growth/recovery pack posting a stellar 8.9 percent year-on-year growth rate, and with growth actually accelerating to 9.2 percent year-on-year in Q4 2010. Commodity-driven Kazakhstan follows with 7 percent full year growth, Israel at 4.6 percent year-on-year, and with commodity-based economies Ukraine (+4.2 percent) and Russia (+4 percent) following some way behind. Of Emerging European EU member states, Poland managed to post the strongest growth rate of 3.9 percent for 2010, albeit note that Poland had managed to win the accolade for 2009 of being the only economy in the region (barring Israel) to post real GDP growth, and indeed was the only EU-27 member state to manage to record real GDP growth in 2009. This does suggest a higher base of comparison which did act as more of a drag on growth for 2010. At the bottom of the growth/recovery stakes were the Balkan/Baltic economies with Croatia, Latvia and Romania still posting real GDP declines in 2010 and with muted growth across the rest of the region, varying from 0.2 percent year-on-year in Bulgaria to a more stellar 3.1 percent in the case of Estonia.
Russia and Ukraine remain commodity based economies with similar characteristics to Kazakhstan, and hence are currently benefitting from favorable terms of trade from the hike in commodity prices partially driven by political instability in the Middle East.
In terms of Q4 national accounts, as an indicator of economies likely to surprise on the upside in 2011, Turkey as noted above again led the field posting real GDP growth of 9.2 percent, with Estonia surprising on the upside with 6.7 percent year-on-year growth, Israel growing by 6.2 percent year-on-year, alongside Lithuania (+4.8 percent year-on-year). The recovery in both Estonia and Lithuania, and indeed to a certain extent Latvia (+3.6 percent year-on-year), is particularly encouraging given the shear extent of the real GDP contraction these economies have experienced (up to one quarter) through the global crisis and offers some hope that the ‘domestic depreciations’ these economies have gone through provides some hope for the future. Croatia and Romania continue to lag on the growth/recovery stakes in Q4 2010, both remaining in recession. Indeed, Romania has now posted eight straight quarters of real GDP decline, albeit this reflects IMF-imposed fiscal austerity with the hope that after this “balance sheet cleansing” the economy will be in a much fitter state to expand.
Reviewing the above data and trying to explain the winners and losers
The dynamism of growth in Turkey has surprised most observers, including yours truly and the government, which had earlier forecast real GDP growth of only around 4.5 percent year-on-year in 2010. Turkey’s strengths include relatively clean balance sheets (public, household/corporate and banks), stable politics/policy with the AK party government heading for a third term in office after elections this June, a relatively good business environment, banks which have felt able/willing to lend to the real economy, and consumers of credit with appetite to borrow at near record low interest rates given the downward push in inflation.
Favorable demographics, success in job creation (partially publically driven), a vibrant manufacturing sector, and more diversified economy have all helped. The AK party government might argue that Turkey is entering a new paradigm, as with the party offering an almost unprecedented period of political stability and economic/political reform, the stop-go economy/policies of the past have been finally been relegated to a bygone era, and now Turkey has more characteristics of high growth Asian economies than their slower growth European peers.
In contrast to commodity-scare Turkey, Kazakhstan’s great advantage remains its huge resource base/potential and ability to continue to attract large foreign direct investment inflows into this sector; an average of around 9 percent per annum in net FDI inflows over the past decade which is three times the regional average.
The sovereign’s clean balance sheet (public sector debt/GDP ratio of only around 15 percent) also gave the government much scope to pump prime growth, which helped to offset the drag from continuing weakness/problems in the banking, real estate and construction sectors, stemming from the banking crisis which hit the economy hard from late 2007 and forced two of the country’s largest banks to restructure their external liabilities (equivalent to around 14 percent of GDP). These latter sectors are expected to continue to be a drag on growth going forward over the next 2-3 years, as banks in particular remain weighed down by high non-performing loan levels (20-30 percent) and are now understandably risk averse still in terms of (re)expanding balance sheets given their painful experience with un-seasoned borrowers through the recent global crisis.
The fact that Kazakhstan went into the global crisis early, from August 2007 on-wards, was nevertheless with hindsight, a key positive as it meant that counter-measures were already in place early, and around a year before the collapse of Lehman. The maintenance of high commodity prices for much of the past 3-4 years also helped cushion the adjustment.
Israel’s continued resilience/dynamism reflects a combination of relatively clean balance sheets, small-open economy status and recent success in attracting FDI into high tech sectors, which gives the economy more of an Asian feel than of Emerging Europe. In this respect its problems have been more to do with controlling evidence of over-heating, e.g. particularly inflation and this has seen the BOI move pre-emptively to hike/normalize its main policy rate from 2009 onwards. The Israeli economy’s close historical/cultural/political and economic ties with the US, and its Diaspora there, inevitably provides some underpinning, particularly given the US guarantee over a weight of the country’s still hefty public sector liabilities.
Russia and Ukraine remain commodity based economies with similar characteristics to Kazakhstan, and hence are currently benefitting from favorable terms of trade from the hike in commodity prices partially driven by political instability in the Middle East. Growth/recovery has lagged in both economies due to a combination of factors, prime amongst these have been deep structural vulnerabilities laid bare through the crisis in these economies, in particular weak banks/institutions around credit, including relatively lowly willingness to pay in stress situations, lack of openness to FDI, and a poor business environment more generally.
Ukraine, like Kazakhstan, has been through a brutal banking crisis (NPLs ~ 30 percent) and hence banking, real estate and construction are likely to be drags on growth over the medium term. Relatively speaking, and given the tailwind provided by low base period effects, fiscal stimulus, and terms of trade Russia’s and Ukraine’s performances in 2010 was relatively disappointing in our view and a reflection of the structural weakness revealed above. That said, and with the tailwind provided by high oil/commodity prices, and in Russia’s case continued fiscal stimulus in the run up to the parliamentary elections (already talk of another RUB300bn in new budget spending allocations) due in November, and presidential elections the following March, growth should be sustained in the 4-4.5 percent range for 2011, and 2012.
Poland’s durability through the global crisis reflects a range of factors, but including its large, closed economy status, which benefitted from existing plans to ease fiscal policy in 2009 via hikes in pensions/public sector wages, relative durability in terms of employment (evidence that Polish companies were slower to shed labour through the global crisis), exchange/interest rate flexibility through the crisis, relatively healthy banks with better “behaved” borrowers, lower value added export profile, plus strong trading relations with core Europe, e.g., Germany.
The Czech Republic has surprised on the downside in terms of its growth/recovery story, suffering a steeper recession in 2009 than its Polish peer, and a much more subdued recovery subsequently. Clearly The CR’s small, open economy status left it vulnerable, especially in the context of its large auto/manufacturing sector. That said, its relatively clean balance sheet (Sovereign, households and banks) and strong trade integration into core-European economies would suggest a more robust real GDP growth bounce back than the mediocre 2.3 percent growth delivered in 2010, and 2.9 percent in Q4 2010. A combination of persistently high unemployment (9.6 percent), a tightening in fiscal policy and the strength of the crown is perhaps weighing on growth/recovery, plus also the relatively prudent nature of Czech consumers of credit and banks.
Relatively speaking, and given the tailwind provided by low base period effects, fiscal stimulus, and terms of trade Russia’s and Ukraine’s performances in 2010 was relatively disappointing in our view and a reflection of the structural weakness revealed above.
Hungary emerged from recession in 2010, posting 1.2 percent real GDP growth, which arguably surprised on the upside, after a deep recession in 2009 (minus 6.7 percent) and two prior years of very weak growth (sub-1 percent) as Hungary was hit with its own crisis (double digit deficits) from late 2006 onwards. The government is putting much faith in its new pro-growth agenda (which amongst other things aims to create 1 million jobs over the next decade), and while much has been done to stabilise markets - assure the sovereign’s financing position - recent higher frequency indicators suggest recovery might be running out of steam somewhat on the back of high unemployment, weak banks/credit environment and little scope for fiscal stimulus.
Bulgaria, Croatia and Romania arguably all fit into a similar basket of economies that were hit hard by the Lehman crisis as previous sources of growth (FDI, real estate and credit were all hit badly) and they are now struggling to identify new sources of growth. Croatia, in particular, suffers from unfavourable demographics, a high cost base, high tax environment, perhaps an over-reliance on the tourism sector and lack of broader diversification, and deeper structural reforms are required. Bulgaria and Romania appear more competitive, but the same issues remain for these economies, i.e. what are the new sources of growth over the medium to longer term as base period driven growth begins to run out of steam.
What are the new regional drivers?
In aggregate reviewing the regional drivers for growth, what remains clear is that the region faces significant headwinds which would still suggest underperformance relative to peers in Asia and Latin America.
Foreign direct investment
Prime amongst the new impediments to growth is the new found dearth of foreign direct investment (FDI). Herein it is important to remember that FDI inflows were a powerful source of growth, structural reform and typically non-debt forms of financing wide current account deficits for much of the decade prior to the collapse of Lehman. We estimate that net FDI inflows into Emerging Europe over the decade to 2009, amounted to around 3.5 percentage points of GDP, a hugely powerful driver for the convergence trade across the region. The fact that a weight of these inflows were bank-related (e.g. foreign banks buying local entities) and that foreign banks subsequently leveraged up aggressively offshore to expand their balance sheets in a region recognized as being under-banked but offering high growth potential as compared to their seasoned home markets, gave this initially FDI flow huge additional weight/power. These bank-related inflows probably added another couple of percentage points onto the flow, drove currency appreciation and attracted yet more portfolio investment as a result. Remarkably, and running somewhat against the textbook theory of FDI which has these flows as being relatively sticky, FDI inflows to Emerging Europe have dropped by 40-50 percent in the period since the collapse of Lehman, and are showing little evidence of recovery.
The fact that FDI inflows have fallen off a cliff reflects a combination of factors but prime herein being that a weight of these flow were bank-related, and foreign banks (aside from perhaps Gulf, Turkish and Russian banks/investors - with intra-regional flows being the new trend) have little appetite, post Lehman, to put new money to work in the region. Second, there has been little evidence of multinationals engaged in manufacturing looking to re-locate from higher cost Western Europe to cheaper locations in Emerging Europe. Anecdotal evidence suggests that given the weak growth outlook and still balance sheet problems (particularly in banks) in Emerging Europe, MNCs typically see themselves as being over-invested in the region. What seems clear therefore is that the FDI cake is going to be much reduced over the medium to longer term, and that countries in the region will have to work that much harder to attract FDI, which means offering the best business environment, and the best tax/incentives regimes. Even then FDI as a major driver for growth is set to take something of a back seat relative to the past decade.
Banks and credit growth
The other key driver of growth over the past decade, and linked above to the weight of inflows of FDI has been credit growth/expansion; many Emerging European economies saw credit growth rates running at 50-70 percent year-on-year in the years immediately prior to the collapse of Lehman, albeit from relatively low levels. Understandably credit extension collapsed post Lehman and the recovery has been slow-moving though, even in economies where NPLs remained relatively well contained. For those economies such as in Ukraine, Kazakhstan and the Baltics where NPLs ballooned, banks remain extremely risk averse to quickly re-extending credit to households and corporates. All these latter economies are likely to experience several years of very low single digit credit growth, as banks concentrate on cleaning up existing balance sheets, and profitability of banks will be largely determined by their ability to write back looses incurred through the crisis. More generally foreign owned banks in the region generally lack appetite to aggressively extend out credit, given the experience through the global crisis, and deleveraging still remains the dominant occupation.
There are some exceptions to the above credit “lite” environment, with both Turkey and Russia seeing a marked recent pick up in credit growth. In Turkey, the robust recovery in the economy, its “outperformance” through the crisis and the relatively clean balance sheet position of banks (NPLs of less than 4 percent) plus some pent up demand for credit in the household sector has seen credit growth pick up to 30-35 percent in late 2010/early 2011. This has in turn led to concern that the economy is overheating as reflected in the wide current account deficit (~7 percent of GDP) and the CBRT forced to respond with aggressive macro-prudential measures, including aggressive hikes in reserve requirements. In Russia, and despite weaknesses in the institutions around credit exposed through the global crisis (e.g. NPLs of around 10 percent), state-owned banks are currently aggressively re-extending credit to the economy, and particularly the household sector. Russia and Turkey though seem to be the exceptions, with the regional story still being for very subdued credit growth in aggregate across the region.
Exports - close proximity to core Europe
With core-Europe showing strong evidence of growth/resilience through the global crisis there is a sense that proximity to core European markets could provide an important growth ticker for some economies in the region. Economies most closely integrated into the EU, and then Germany in particular, tend to be those in Central Europe, and in particular the Czech Republic and Hungary. In the Czech Republic’s case over 30 percent of exports by value are Germany-bound, with a ratio of in excess of 25 percent for Hungary and Poland. Correlations between German and CEE-3 growth tend to be high - around 0.8 percent. That said, the Czech and Hungarian economies have struggled for traction on the export side to gain ground in the rest of the economy, partly a reflection of the drag on domestic demand from persistently high unemployment, and on-going fiscal adjustment (see below). The message herein seems to be that while close proximity to Europe can be important, it should not be relied upon to be the prime driver for growth, and economies in the region look at other options.
Emerging Europe, in general is a net commodity importer, with the exceptions of Russia, Kazakhstan, South Africa and Ukraine (metals). Already high oil/commodity prices seems to be spurring a recovery across the CIS, albeit experience has shows that the benefits of high oil prices are something of a twin-edged sword, as it has in the past tended to create reform inertia and builds concern over so-called Dutch disease. In Russia’s case this just creates higher vulnerability to downward shifts in commodities prices, e.g. with the Federal budget now thought to balance at an oil price of around USD115 per barrel, four times the level a decade ago. Higher oil/commodity prices should act as a drag on growth in the higher energy/commodity importing credits in the region, in particular, Turkey, Poland and Romania. Interestingly, in the case of Turkey while the combination of high rates of real GDP growth, and high oil commodity prices, are creating concern over overheating of the economy, recent months have seen a pick up in capital account inflows which anecdotally appear to consist o recycling of petrodollars from the Gulf to the newly-tagged “safe-haven” Turkey.
Internal sources of demand
Domestic drivers for growth in economies across CEEMEA remain fairly moribund, perhaps with the exception herein of Israel and Turkey. Problems herein remain the drag of unemployment sustained through the global crisis and the relatively limited fiscal space to pump prime growth with the exception herein of perhaps Russia and Kazakhstan.
Unemployment has emerged as a significant problem across the region, with rates rising by as much as eight-ten percentage points at the extreme in some of the Baltic republic since the global crisis hit. Note that in some economies (Turkey/Russia) unemployment rose quickly as the global crisis initially hit, but has subsequently been quick to recede a reflection of relatively flexible labour markets and dynamic public job creation projects - both benefitted from relative fiscal space to maintain such pro-job policies. Elsewhere, e.g. the Czech Republic and Hungary, unemployment has proven much stickier and is evidently acting as a significant break on growth/recovery.
Fiscal drivers for growth have also varied enormously across the region, a reflection of both solvency/liquidity. Russia and Kazakhstan, for example, although significantly impacted by the global crisis, benefitted from the fact that sovereign indebtedness was low (public sector debt/GDP ratios of 10-15 percent of GDP), they were running budget surpluses in the run up to the collapse of Lehman, and had sizeable fiscal reserves (close to USD200bn in the case of Russia). This gave both economies a substantial ability to run aggressively countercyclical fiscal policies, secure in terms of their financing. In Russia’s case its anti-crisis programme accounted for around 10 percent of GDP. Beyond Russia/Kazakhstan, fiscal space to loosen through the global crisis as fairly limited, not particularly due to concerns over solvency, as the region benefitted from relatively lowly public sector debt/GDP ratios (less than 40 percent for Emerging Europe still, i.e. half the EU average) but liquidity, as access to financing at the outset through the global crisis were fairly limited. To some extent where budget funding shortfalls (liquidity) pressures were most extreme (Belarus, Hungary, Latvia, Lithuania, Romania, Serbia, Ukraine) IMF/EC support programmes were extended, but these typically came with IMF/EC conditionality. The EU’s own concerns over sovereign debt sustainability in along the EU periphery meant that efforts to loosen policy with more pro-growth strategies, e.g. in Hungary and Latvia, were quickly nipped in the bud. At the extreme, in Latvia, real government spending was cut around 20 percent over the period 2009-2011, with similarly large cuts of 8.8 percent in Lithuania. Interestingly, Bulgaria, which arguably had some fiscal space to loosen policy through the crisis, given its low public sector debt/GDP ratio (~15 percent) and over EUR 3bn (10 percent of GDP) held in its fiscal reserve, because of the rigours of its fixed exchange rate regime, tightened policy fairly aggressively which added to the extent of the slowdown and is perhaps now still acting as a drag on growth/recovery. A question for next few years is that with Emerging Europe generally benefitting from low sovereign leverage and with financing (market & IMF) generally assured, will policy makers, and multilaterals feel willing now to provide a little more kick to growth with loosening fiscal policy, particularly in economies where policy has tended to be tightest, e.g. the Baltic states and Balkans. Given the maintenance of fixed exchange rates, and past track record of building up large external imbalances once growth rebounds.
Timothy Ash is global head of emerging markets research at the Royal Bank of Scotland in London.