The banking sector across emerging Europe is varied, and although even its most dynamic economies are being impeded by the slowdown, forecasts suggest they have the growth potential to bounce back, reports UniCredit Group's global economics, fixed income and foreign exchange research team.

The central and eastern European (CEE) region is extremely diverse and variegated, encompassing small, open economies such as the Czech Republic and larger economies with heavier reliance on domestic demand such as Poland, countries rich in natural resources such as Russia and Kazakhstan and commodity importers such as Turkey, and many others. Ten countries in the region are members of the EU and two (Slovenia and Slovakia) have already joined the eurozone.

Its diversity has not prevented the region from falling into the grip of the global economic downturn, which has sent most developed economies spinning into a deep recession and has caused a significant slowdown of economic activity even in the most dynamic emerging markets. It is expected that the aggregate output of the CEE 19 region will contract by some 3.5% in 2009, after registering 4% growth last year. In some countries the contraction will be extremely severe - Latvia's gross domestic product (GDP) is expected to shrink by almost 15% this year. In some other countries, such as Poland and Slovakia, the growth rate will dip just under the zero line, more a stagnation than a true recession.

Like other emerging markets, CEE countries were dealt a significant twin blow in Q4 2008 and Q1 2009 by the collapse in both global manufacturing and capital flows. For a region with a relatively large industrial sector and which has been relying to significant extent on external financing flows to fuel its growth performance, this was a hard blow. The net result of this shock was a sharp regional collapse in beginning-of-year growth indicators, significant market weakness and relatively limited differentiation on fundamentals between countries.

Across the board

The intensity of this across-the-board shock is easing, however. Specifically:

- Leading industrial indicators globally have improved recently. From a medium-term perspective, a recovery in global manufacturing would be very important for the CEE region, both given its importance as a GDP driver and given the significant increase in competitiveness that CEE producers have experienced in the past 12 months.

- There is very tentative evidence of a pick-up of net capital flows, as shown by firmer currencies.

- The International Monetary Fund (IMF) has, alongside a tripling of promised lendable resources, launched a new flexible credit line facility (FCL) for 'very strong performing' members to receive high and front-loaded resources. We expect the majority of countries in the region to either end up with a standby IMF package or an FCL, which will further strengthen sustainability in the region.

The economic downturn in the CEE region mirrors very closely the downswing in western Europe. Trade links between the eurozone and the CEE have been growing stronger and stronger during the past 15 years, to the point where a number of central and eastern European countries send more than 70% of their exports to western European partners. This is a great asset when the eurozone experiences robust growth, as was the case for several years leading up to the current crisis, but it obviously turns into a liability once the eurozone slides into a recession. The eurozone is expected to contract by about 3.5% in 2009, in line with the CEE region. Plotting the CEE's GDP growth against the eurozone's import demand gives a very clear and immediate picture of the interdependence of the two regions.

Although the close interdependence with western Europe can sometimes be a cause of cyclical weakness, it is an undeniable key source of structural strength. The progress of steady convergence to the EU with the consequent undertaking to eventually become members of the eurozone has served as a powerful anchor for macroeconomic and structural policies in the region, and has driven a sustained improvement in the institutional setup of most countries in the region. One important example is the soundness of the bank regulatory environment, but more generally many CEE countries rank high on indices of competitiveness and ease of doing business.

The structural strength of the region, together with the anchoring of many of its countries within the EU, suggests there is tremendous potential for real income convergence. The country where real incomes have come closer to the eurozone average is the Czech Republic, where GDP per capita on a purchasing power parity (PPP) basis is about 75% of the eurozone average. For many other countries in the region, the percentage is still somewhere between 40% and 60%, leaving ample room for an increase in real incomes and purchasing power in the years ahead. This makes the CEE region an extremely appealing market.

Financial deepening

Similarly, the financial deepening process that naturally accompanies economic growth still has a long way to go in the CEE region. In line with relatively lower real GDP per capita compared to western Europe, the CEE region still has a rather low level of banking sector penetration, as measured by total banking assets as a percent of GDP. As economic growth resumes and picks up pace, closing the real income gap with Western Europe, financial deepening will proceed apace. It is exactly this prospect that has made the region extremely appealing to foreign banking groups, which have invested heavily in the region.

The close trade interdependence, the strengthening of the institutional set-up, the anchoring of many CEE countries within the EU and their eventual membership in the eurozone, and the prospect of real income convergence and financial deepening have proved a powerful magnet to attract the interest of foreign direct investors (FDIs), notably of course from western Europe. For a region which has been relying heavily on external financing to fuel its buoyant economic growth, the fact that a large part of these external financing flows have come in the form of FDIs is extremely important. Compared to portfolio investments, FDIs tend to have a much more powerful impact in raising productivity levels and the long-term growth potential in the recipient country. In addition, FDIs tend to be more permanent as they are largely in the form of industrial plants and offices. They are therefore the sign of a much more durable commitment to the country, and they are much more difficult to uproot. As such, they tend to have a much higher degree of stability, which is especially important in times of economic weakness or instability. To this extent, the heavy FDI flows which have been coming into the CEE region in the past few years are an extremely positive factor. It is instructive to note that, for example, the accumulated level of FDI stock in CEE countries today is much higher than it was in Asian countries 1o years ago.

As the financial and economic crisis has started to impact upon emerging markets, many observers have compared the CEE region today to Asia just before the 1997/98 crisis, arguing that in both cases emerging countries that had fuelled high growth through fast credit creation have been fuelled in turn by external financing flows, resulting in wide current account gaps. The parallel seems to hold only to a very limited extent, and an important difference is the nature of these external financing flows: the CEE region has accumulated a much higher stock of FDIs, which gives it a greater degree of resilience in the current environment.

An important part of these FDI flows have come in the form of a strong presence of foreign banks in the banking sectors of CEE countries. About 45% of the CEE region's banking sector is foreign-owned but this percentage masks very significant differences. At one extreme, only about 12% of Russia's banking sector is foreign-owned, and about one-third in Turkey, Slovenia and Ukraine. All other countries, however, have at least 60% of foreign presence in their banking sectors, and at the other extreme, in countries such as Slovakia, the Czech Republic and Estonia, foreign banks account for nearly the totality of national banking assets. Over the past few years, the strong presence of foreign banks has facilitated a faster improvement in the efficiency of the sector and helped to foster sound lending practices and strong risk controls. These should prove particularly helpful as the region starts to feel the pinch of the recession, which will inevitably bring some increase in non-performing loans. Moreover, throughout the crisis so far, the strong presence of foreign banking groups has played a stabilising role, as CEE-based banks have been able to rely on the strong shoulders of their mother companies.

cp/49/CEE Chart 1.jpg

CEE gross domestic product and eurozone imports (% growth) Finance flow

To be sure, a large, accumulated stock of FDIs does not eliminate the problem of the flow of new financing, which in the current environment of deleveraging in the financial system at large has decreased substantially. This, however, is being alleviated by the ongoing correction in external imbalances in most CEE countries. This is the virtuous side-effect of the downswing in growth: lower or contracting economic growth means a substantial decline in import demand, which translates into an improvement of current account balances. In addition, those countries in the region which import energy have benefited enormously from the sharp decline in oil prices since summer 2008. Turkey is a case in point, with the current account gap projected to halve from about 6% of GDP last year to about 3% of GDP this year, largely on the strength of lower energy prices.

The decline in energy prices, combined with the slowdown in economic growth, has brought another side benefit: similarly to the rest of the world, the CEE region is experiencing a significant decline in inflation rates, which is slated to continue into 2010. This decline in inflation rates is beneficial in two respects. First, it provides support to domestic consumption by bolstering households' purchasing power, partially counteracting the negative effect of weaker wage dynamics and flagging labour markets. Second, in several countries it has opened up room for monetary policy to support economic activity by lowering interest rates.

The extent to which different countries in the CEE region can support economic activity with economic policy action so as to navigate through the recession, with minimum damage, depends on the degree to which their macroeconomic fundamentals are sound - as does their vulnerability to the ongoing dislocations in international financial markets.

Given that the ongoing financial crisis is still essentially a crisis of deleveraging translating in lower levels of capital flows and credit availability at both the national and the international level, the countries which are most vulnerable are those with wider external financing gaps, such as Bulgaria, Ukraine, the Baltics and Hungary. The three Baltic countries still appear among the most vulnerable in the region, starting with 2008 current account deficits at or near double digits, and set to experience a severe contraction in output this year: real GDP is forecasted to contract by almost 10% in Estonia and Lithuania and almost 15% in Latvia, with the recession slated to continue into 2010.

Bulgaria's current account deficit is projected to shrink fast this year, for the same reasons, but starting from an impressive 25% of GDP last year it will still settle just below 10% of GDP in 2009, a level that implies a not insignificant financing requirement. This is partially compensated by a very strong fiscal position: Bulgaria has been running budget surpluses for several years, accumulating important fiscal reserves that can now be drawn upon to support economic activity. In Ukraine, a wide external financing gap is accompanied by faltering domestic demand and an elevated degree of political uncertainty; the external financing need has been filled by an IMF lending programme, although this has been complicated by some contentious negotiations on fiscal targets. In Hungary, real GDP is set to contract by 6% in 2009 and pressure to reduce the external financing gap together with the associated restrictive monetary/fiscal policy mix will mean another weak year in 2010.

On a brighter note, the significant IMF/EU balance-of-payments support has sharply reduced external financing risks but significant private sector foreign exchange exposure suggests that the currency is unlikely to recover meaningfully. Romania has also suffered from a significant external financing gap, with a current account deficit of 17% of GDP in 2008, and is probably faced with a domestic demand-led 4% contraction in GDP this year, with the flipside being a significant improvement in the current account deficit. A significant IMF-led balance-of-payments support package reduces risks to the economy, though given downside risks to growth.

Recovery prospects

At the other end of the spectrum, the Czech Republic, Poland and Turkey have probably the best economic recovery prospects, due largely to the fact that a sound macroeconomic framework has allowed for a more proactive economic policy response against the background of very solid financial sectors. Poland and Turkey, in particular, benefit from being two large economies which rely to a significant extent on domestic demand, and are therefore relatively less exposed to the slowdown in global trade.

For Poland a very mild 0.5% contraction in real GDP is forecasted for this year, with a return to positive growth of about 2% next year. Poland also seems likely to request a FCL from the IMF, which would bolster market confidence and ensure stability of the currency. Turkey will be hit somewhat harder, with a contraction in real GDP of 3% this year and a moderate rebound to 1.5 % growth in 2010. Turkey still benefits from the tremendous strengthening of its macro framework that followed its 2002 banking and currency crisis, resulting in a substantial strengthening of the fiscal position and a dramatic reduction in public debt levels. As a consequence, and due to the ongoing decline in inflation, the central bank has been able to counteract the slowdown with an important measure of monetary easing.

Underpinning stability

Discussions have also begun on an IMF lending programme, which should further underpin stability. In the Czech Republic, despite its low external debt levels, the economy is set to contract by 1.8% in 2009, with its heavy reliance on manufacturing the key drag. Further ahead, however, the Czech economy seems among the best placed in Europe to recover, due to its strong banking sector, flexible monetary policy and low external financing gap. Slovakia is a case apart: as one of the region's most open economies Slovakia is particularly exposed to the collapse of European trade and therefore manufacturing, with euro adoption also preventing exporters from benefiting from exchange rate depreciation. The positive flipside of the euro, however, is that it keeps the cost of debt low. The local banking sector remains strong and has one of the lowest loan/deposit ratios in the region with no foreign exchange debt.

In Russia, the economic outlook remains challenging against the backdrop of tight financial conditions, increasing spare capacity and deteriorating labour markets. As a result, Russian real GDP growth is forecasted at a negative 3.6% in 2009, mostly on an expected 7% contraction in consumption. As an oil exporter, Russia has obviously suffered from the sharp decline in oil prices since summer 2008. However, Russia had managed carefully the period of high and rising oil prices, running a prudent fiscal policy and accumulating an impressive stock of foreign exchange reserves, which it has gradually used to control the pressure on the rouble. The pressure on the exchange rate to depreciate has eased partly because the unit is now closer to fair value and also because of a more hawkish central bank interest rate policy. This, coupled with stabilising oil prices has also meant that reserves have climbed up from their low point.

Overall, the CEE region seems set to weather the economic and financial crisis fairly well, and the strong growth potential of the region should allow it to bounce back healthily as the global economy starts to recover. Its firm anchoring within the EU and eurozone framework should then continue to ensure a sustained rise in income levels.

cp/49/CEE Chart 2.jpg

Foreign bank presence (2007, % of total assets)

cp/49/CEE Chart 3.jpg

Impact of oil price change on current account balance

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