16 March 2017

Comments and analysis

Erste Group Research - Are CEE economies at risk of overheating

Erste Group Research: Are CEE economies at risk of overheating?

  • Economic growth continues apace in CEE (3.3% expected in 2017), yet substantially improved current account positions  – and in many cases even surpluses – point to balanced rather than overheated economies
  • Inflation rates have increased significantly; yet they may peak in March and undergo a correction after that in all countries except RO
  • Despite increasing inflation (+2pp on average), most CEE central banks will remain in wait-and-see mode until it is settled above target for a longer period of time
  • Stricter macro-prudential policies such as those seen in CZ, SK and PL may delay need for rate hikes, as they tighten credit conditions

The raft of strong recent macroeconomic data in Central and Eastern Europe, such as steeply increasing inflation rate, tightening labor markets and buoyant manufacturing production may prompt a legitimate question: is economic overheating on the horizon for CEE countries? To detect any early signs of such a phenomenon potentially occurring, Erste Group analysts use current account deficits as an adequate benchmark for open economies such as CEE ones. They point out that a material deterioration in the current account would flag emerging imbalances in the economy. At the moment, however, this does not seem to be the case.

“Both from a historical and a fundamental perspective, current account balances in the region look very good. Prior to the crisis, all CEE countries ran huge – in some cases even double-digit – current account deficits relative to GDP. While current account deficits are not problematic in and of themselves, given that converging economies need to attract foreign capital, the fact that in CEE they were excessive and often debt-financed increased the vulnerability of the economies during the financial crisis in 2008-09.

Since then however, CEE economies have rebalanced and made tremendous improvements to their current account balances, even turning them into surpluses in Croatia, the Czech Republic, Hungary, Slovenia and Slovakia. The largest part of the adjustments has been driven by the positive development of the trade balance. Dropping commodity prices and the stronger inflow of EU funds have also contributed to improved current account positions,” explains Juraj Kotian, Head of CEE Macro/FI Research at Erste Group.

Inflation rates have increased significantly – but most central banks are expected to remain in wait-and-see mode

The inflation rate in CEE has increased substantially i.e. by about 2pp on average since September 2016. However, a large part of the increase had been anticipated and had nothing to do with demand pressure; the strong reverse in oil and energy y/y price development was caused by the abnormally low base in 1Q16, rather than the steep increases in recent months. Inflation rates have either reached or came close to the target in the Czech Republic, Hungary, Poland, Slovenia and may climb further in March, but a correction is expected to ensue as the base effect resulting from low oil prices in 1Q16 will start to diminish. That is why Erste analysts do not expect central banks to act prematurely and rush to hike interest rates anytime soon. “We expect central banks will rather remain in wait-and-see mode and not act until they see core inflation being settled above the target for a longer time or with a safe margin,” points out Zoltan Arokszallasi, Chief Analyst, CEE Macro/FI Research.

Serbia is the only CEE country where analysts expect the key rate to be hiked this year (also in reaction to FED hikes due to the significant role of the investor base in USD). In Romania, only the O/N deposit rate might be lifted in order to bring money market rates closer to the key rate. The strongest monetary policy action in reaction to higher inflation should be seen in the Czech Republic. “We expect the CNB to abandon its FX cap policy in April and avoid further speculative hot money inflow into CZK. A stronger Czech koruna in the medium term should tighten monetary conditions in this export-orientated economy and help to tame inflation,” Zoltan Arokszallasi concludes.

First round of tightening  conducted via stricter macro-prudential policies

Before central banks in CEE decide to lift interest rates, Erste analysts expect some credit tightening to be conducted via stricter macro-prudential policies. Some initiatives are already under way in the Czech Republic, Slovakia and Poland, where regulators have requested higher down payments for mortgages, lower loan-to-value and debt-service-to-income ratios.

2017 outlook

  • Growth in the CEE region is expected to accelerate to 3.3% (versus 3% in 2016), fuelled by domestic demand. Household consumption is expected to remain the backbone of this growth, while investments could recover after the poor performance in 2016, mainly due to EU funds.
  • The inflation rate is projected to increase by more than 2pp on average in 2017 compared to 2016, with the peak expected in March (due to the base effect). Afterwards, inflation should moderate or even retreat in CEE countries, excepting Romania, where inflation has been kept artificially low, thanks to a cut of indirect taxes. As this effect will fade out, the inflation rate is going to end up much higher in Romania by year-end compared to where it stands now.
  • Current account balances will deteriorate only slightly (0.4% of GDP on average), and the region should remain in a minor surplus (0.2% of GDP). Within CEE, Romania should experience the strongest widening of the current account deficit (by about 1pp to 3.3% of GDP), but the deterioration should be contained, as some tightening should come from the fiscal side next year, given that Romania might be put under the Excessive Deficit Procedure by the EC in 2018, due to its overshooting a 3% deficit.
  • CEE currencies will continue to diverge in the coming quarters. By year-end, two currencies might become stronger vs. the euro, with three weaker compared to now. The Czech koruna fundamentally has the largest potential to gain after the abandonment of the FX cap, but the excessively high stock of long positions in CZK looking to be closed may limit the gains or even cause some strong corrections. Analysts see some room for appreciation of the Polish zloty vs. the euro by year-end, as Poland offers an interesting carry relative to fundamentals, while the Polish market may start to price in the first rate hike in 1H18 too. In Romania and Hungary, where both central banks have some dovish bias, currencies might mildly depreciate, which is not going to cause worries to central banks, and is currently seen as a desirable outcome.