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Economic Outlook Central Europe January 2014

Stability restored, time for growth Czech economy still affected by weak domestic demand Hungarian monetary easing cycle to continue Poland: gaining pace
Slovak inflation close to all time low in November Modest Bulgarian recovery in the making In the spotlight: The Czech National Bank intervenes in the FX market

Real GDP growth

2014 2015 2014

2015 07-01-2014 +3m

Policy rates
+6m +12m

Poland Czech Republic Hungary Slovakia Bulgaria Russia Turkey

2.8 1.5 1.8 1.5 1.8 2.3 3.3

3.2 2.5 1.8 1.7 2.5 2.1 4.1

1.8 1.0 1.5 1.3 2.2 5.1 6.2

2.4 2.0 3.5 1.7 2.7 4.4 6.3

Poland Czech Republic Hungary Slovakia (ECB) Romania Bulgaria Russia Turkey

2.50 0.05 3.00 0.25 4.00 8.25 4.50

2.50 0.05 2.70 0.25 3.50 8.25 4.75

2.50 0.05 2.70 0.25 3.50 8.25 4.75

2.75 0.05 3.50 0.25 3.50 8.25 5.00

Exchange rates
07-01-2014 +3m +6m +12m 07-01-2014 +3m

10-year rates
+6m +12m


4.18 27.48 300.19 4.50 1.96 45.28 2.97

4.15 27.45 300.00 4.50 1.96 45.00 2.97

4.13 27.20 310.00 4.55 1.96 45.00 2.95

4.10 27.00 300.00 4.60 1.96 45.00 2.85

Poland Czech Republic Hungary Slovakia Romania Bulgaria Russia Turkey

4.46 2.50 5.59 2.51 7.90 9.88

4.30 2.35 5.90 2.70 8.00 9.90

4.50 2.70 6.20 2.90 8.25 9.80

4.70 2.85 5.70 3.00 8.50 9.50

Our publications are available online at www.kbc.be/economicoutlook/.

If you have any questions relating to the contents of this publication, contact: Dieter Guffens (32) (0)2 429.62.87 E-mail: dieter.guffens@kbc.be Publisher: Johan Van Gompel, Havenlaan 2, 1080 Brussel Address for correspondence & subscription management: KBC Groep NV, GCE, Havenlaan 2, 1080 Brussel. E-mail: economic.research@kbc.be This publication is jointly produced by KBCs economists in Belgium and Central Europe. Neither the degree to which the hypotheses, risks and forecasts contained in this report reflect market expectations, nor their effective chances of realisation can be guaranteed. The forecasts are indicative. The information contained in this publication is general in nature and for information purposes only. It may not be considered as investment advice according to the Act of 6 April 1995 on the secondary markets, the legal status and supervision of investment companies, intermediaries 1 and investment advisers. KBC cannot be held responsible for the accuracy or completeness of this information. All historical rates/prices, statistics and graphs are up to date, up to and including 7 January 2014, unless otherwise stated. The views and forecasts provided are those prevailing on 8 January 2014.

Economic Outlook

Central Europe

General perspective

Stability restored, time for growth

2013 was a year that Central Europe will want to forget quickly. The Czech Republic and Hungary began the year in recession, and even the growth performance of strong regional players such as Slovakia, Poland and Bulgaria was relatively weak. The origin of this growth slowdown lay in the dampening effect of fiscal policy on domestic demand. Fiscal policy in Poland, Hungary, the Czech Republic and Slovakia is focused almost exclusively on following the EU guidelines relating to excessive budget deficits. The Bulgarian budget contraction, by contrast, is the result of the legislative framework designed to defend the currency board. The Bulgarian budget deficit and the debt ratio as a percentage of GDP are however among the lowest in the EU. The biggest fiscal corrections are now behind us, however, and there may be scope for Hungary and Bulgaria to give their economic growth a slight helping hand in 2014. swelled to unsustainable levels. In 2008 Bulgaria, Hungary and Slovakia posted substantial current account deficits of 23%, 7.4% and 6.6% of GDP, respectively. All three countries ended 2013 with an external surplus. The external position of the Czech Republic and Poland has also improved markedly in recent years, though these countries still have modest deficits. The central banks in Central Europe also have substantial FX reserves, suggesting that Central Europe is adequately positioned to withstand the scaling back of the American Feds debt purchase programme. Only Hungary is slightly vulnerable because a sizeable portion of its sovereign debt is financed abroad. Hungarian policy rate has been reduced to 3.00%, in a series of cuts of 20 basis points by the central bank over recent months. The central bank in the Czech Republic has been threatening to intervene in the exchange rate for almost a year. At its policy meeting of November, it decided to follow through on this. The growth in the money supply remains below par, and the central bank believes there is a real risk of deflation. It decided to set a ceiling rate of 27 CZK per EUR and to sell a potentially unlimited amount of koruna in order to maintain this rate. The combination of an accommodating monetary policy and a less restrictive fiscal policy leads us to be cautiously optimistic. Regional exports will also benefit from the recovery in the rest of the European Union, enabling Central Europe to begin 2014 with better growth figures.

Czech central bank steps in

The elimination of macroeconomic imbalances makes the region better able to withstand external shocks, but the price for achieving this stability is high. The unemployment rate in the region is particularly high, especially in Slovakia where it stands at 13.8%. Inflation is low, and is often below the comfort zone of the central bank, despite repeated interest rate cuts by the ECB. The Polish interest rate cycle appears to have bottomed out at 2.50%, while the

Macroeconomic imbalances eliminated

The fiscal corrections carried out in recent years went hand-in-hand with the disappearance of external imbalances. Mirroring the strong inflow of capital in the pre-crisis years, external deficits had

Dieter Franceus (dieter.franceus@kbc.be) KBC Group

Weak inflationary dynamic

(year-on-year, in %) 9 8 7 6 5 4 3 2 1 0 -1 -2 2008 09 10 11 Poland Slovakia 12 13

Czech central bank sets ceiling rate at 27 CZK per EUR

28 27.5 27 26.5 26 25.5 25 24.5 24 23.5 Jan-2013 Apr-13 July-13 Oct-13

Czech Republic Hungary

Economic Outlook

Central Europe

Czech Republic

Economy still affected by weak domestic demand

The Czech economy has gone through two recessions in the last five years and has not left the latest one yet. After very promising data in Q2 2013, real GDP again dropped in Q3 by 0.1% quarteron-quarter. The main reasons for this included negative investment growth in both the private and the public sector. Investment activity is weak across all types of investment from construction to machinery investments. Household consumption growth also remains subdued as a result of the combination of a persisting decline in real disposable household income and a high level of household savings.

Inflation returns to the tolerance band for a while

Year-on-year inflation has returned to the central banks tolerance band. Nevertheless, the inflation rate as defined for monetary policy purposes continues to be close to zero. Low inflation is the result of among other things, the significant reduction of the prices of mobile telecommunication services and the disappearance of the base effect of the VAT a year earlier. In addition, electricity prices will be reduced significantly in the beginning of 2014, which may make headline inflation even negative. However, this represent a temporary positive cost shock, which would boost real purchasing power of households and consequently also consumption growth.

approved in its first reading. The Czech Republics deficit in 2014 will probably be CZK 112bn, which is higher than in 2013, but again below 3% of GDP. For the years thereafter, however, the introduction of another reduced VAT rate on pharmaceuticals or the imposition of a special income tax on banks, and possibly also on telecommunications and utilities, cannot be ruled out.

Czech industry maintained strong momentum in October

Other macroeconomic data surprised moderately on the upside, mainly thanks to higher than expected industrial output growth. In October, Czech industrial production grew by 3.5% year-on-year and even by 6% year-on-year after seasonal adjustment. This was mainly driven by the sharp increase of new orders for motor vehicles during the past several months. Moreover, new orders sustained their strong momentum in October and grew by nearly 10% year-on-year.

Government formation still pending

The composition and programme of the future government coalition are slowly but surely becoming clear after Octobers early election. At the moment, it looks like 2014 will see no unexpected tax changes or significant modifications of the proposed budget for 2014, which the Lower Chamber of Parliament

Petr Dufek (pdufek@csob.cz) CSOB Czech Republic

Recession not yet over

(real GDP growth, in %) 6 4 2 0 -2 -4 -6 2008 40 30 20 10 0 -10 -20 -30 09 10 11 12 13 -40 2009

Industrial production growth rising sharply

(3 month average, year-on-year, in %)

10 Industry Car industry




Quarter-on-quarter Year-on-year

Car industry - new orders

Economic Outlook

Central Europe


Monetary easing cycle to continue

In 2013, headline inflation surprisingly fell from 3.7% year-on-year in January to 0.9% year-on-year in October. This was mainly driven by changes of regulated prices and fuel and energy prices. Core inflation, on the other hand, remained within a range between 3% and 3.5% year-on year. One positive effect of low headline inflation so far has been a fall of inflation expectations during the same period. They fell from a range between 6% and 8% to a range between 4% and 6%. This was the level they reached in mid-2010, which is still slightly higher than the bottom they reached in Q1 2006 (between 3% and 4%). Once the effects of one-off measures disappear and domestic consumption growth accelerates, long term inflation may reach a level of about 3.5%, somewhat higher than the central banks inflation target of 3%. Following very modest growth in 201011, the Hungarian economy slid again in recession in 2012, its second recession in 5 years. However, since the beginning of 2013, the economy positively surprised and returned to positive growth in the first three quarters of the year. For 2013 as a whole, real GDP growth probably amounted to 1.1% and further growth acceleration to 1.8% in 2014 is likely. The more favourable growth outlook means that the Hungarian economy caught up to the average regional growth performance. The big breakthrough came in Q3 2013, when Hungary had one of the highest GDP growth rates in the Central European region. The short term outlook is definitely positive and the longer term fundamentals have improved too, suggesting that the economic upturn is sustainable. The government has every incentive to continue its growth stimulating policy, as parliamentary elections are scheduled for April 2014 at the latest. The central banks funding for lending program, which provides subsidized lending to SMEs, will probably boost economic growth by between 0.2% and 0.4% year-on-year in the coming quarters. In the meantime, low inflation leads to net real wage growth of between 3% and 4% year-on-year, supporting domestic consumption growth. Public investment too will contribute to growth at least until the middle of 2014, while private investment, on the other hand, will remain subdued. Finally, a temporary stop of production in some industrial sectors at the end of 2012 and the beginning of 2013 provides a very low comparison base which is promising for 4Q13. For 2014, we expect real GDP growth to accelerate to 1.8%. Ahead of the elections the government increased its spending, financed by off-balance sheet operations and delayed invoice payments. In part, this will pay off in terms of stronger economic growth, but there is a risk that the government will have to scale back some measures after the elections to keep the budget deficit below 3% of GDP. However, the pre-election budget loosening is much less than in similar periods in the past. While the pre-election fiscal loosening amounted to between 4% and 5% of GDP before 2010, the current easing only amounts to between 1% and 2% of GDP.

David Nemeth (david2.nemeth@kh.hu) K&H Bank ZRT

Subdued headline inflation

(year-on-year, in %) 10 9 8 7 6 5 4 3 2 1 0 2007 08 09 10 11 12 13 14 -8 -10 2007 08 4 2 0 -2 -4 -6

Real GDP growth firming

(year-on-year, in %)






Headline CPI Core CPI

Inflation target

Economic Outlook

Central Europe


Gaining pace
The Polish economy reached the bottom of its latest economic cycle in the first quarter of 2013, before recovering in the subsequent quarters. In the third quarter, real GDP growth accelerated to 1.9% year-on-year. The latest economic data are consistent with a sustained recovery. Producer confidence in the manufacturing sector improved further to 54.3 in November, while industrial production and retail sales rose by respectively 4.4% and 3.2% year-on-year in October. taking a wait and see approach. At its latest meeting the policy rate remained unchanged at 2.50%. We expect no further changes in monetary policy at least until mid-2014.

Fiscal creativity
Obviously, the economic recovery is supportive for public finances. However, the biggest fiscal change this year will come from the pension system reform. A substantial part of the Open Pension Funds (OPF) assets will be transferred from the private sector to the government sector. As a consequence of this operation the general government will post a sizeable surplus in 2014 as opposed to a sizeable deficit in 2013. The short term effect of this operation is beneficial for economic growth. It will create room for additional fiscal stimuli, enhanced by the eligibility for EU funds. In the long term however this nationalisation leads to an increase in future obligations.

Export-driven growth
In recent quarters net export was the main GDP growth driver, thanks to the geographical proximity to the wellperforming German economy. However, as the recovery moves forward, net exports growth contribution will diminish and investment and consumption growth will take over. In the meantime, the labour market stabilised. In the light of the high unemployment rate, a gradual improvement will be possible without the risk of creating inflationary pressure. Indeed, GDP remains far below its potential level. As a result of the absence of inflationary pressure and the slack on the labour market, the Monetary Policy Council is

Tomasz Kowalski (tomasz.kowalski@kbctfi.pl) KBC Towarzystwo Fund. Inwest. A.S.

(quarter-on-quarter annualised, in % of GDP) 15 10 5 0 -5 -10 Q2-2011 Private consumption Public consumption Investments 6 5 4 3 2 1 0 -1 -2 2012 2013 Net exports Inventory and errors Real GDP growth -3 2007 08

Growth contributions

Absence of inflationary pressure

(year-on-year, in %)






Headline CPI Core CPI

Inflation target

Economic Outlook

Central Europe


Slovak inflation close to all time low in November

In line with the European economic recovery, Slovak real GDP growth increased slightly in Q3 2013 from 0.8% to 0.9% year-on-year. This was mainly the result of external demand growth. The small and open Slovak economy is still benefiting from its car export despite the difficulties on the European car markets. Indeed, 2013 marked a new historical high of numbers of produced cars. Household consumption growth, on the other hand, slowed from 0.9% in Q2 to 0.1% in Q3 (year-on-year). A positive surprise was government consumption growth, which increased by 2.8% in Q3 compared to 0.4% in Q2 (year-on-year). Retail sales, adjusted for cars, picked up in Q2 2013 after several years of decline. Unfortunately, this short-term consumption revival did not persist in Q3 2013. Retail sales recorded consecutive yearon-year declines in August (-0.2%) and in September (-1%). In the course of 2014, however, improvements are likely. Rising real wages should support households purchasing power as employment will probably stabilise. Nominal wage growth will still be low, but low inflation and scope to lower the savings rate (which currently is at a record high) improve prospects for future consumption growth. As a result, domestic demand growth will gradually replace net exports as the main driver of the economic growth. To be sure, consumer confidence has already improved considerably. Investment growth will not support real GDP growth much in 2014. Demand for corporate loans is weak, not so much due to financial constraints in the banking sector, but because of the low appetite for corporate investments. Investments, both public and private, could nevertheless slightly revive in 2014 as a result of support from EU projects related to highway construction and of some private investment projects as well. Finally, government spending will not contribute much to GDP growth in 2014 either. Indeed, the need to consolidate public finances is constraining public spending. Inflation reached its peak in December 2011 and kept declining through 2012 and 2013. In 2013, headline inflation gradually fell from 2.4% year-on-year in January to 0.5% year-on-year in November. Falling food and gasoline prices together with low demand-led price pressures and statistical base effects are the main reasons for the November dip. In 2014, the low inflation environment is likely to persist. In line with weak labour market dynamics, wage increases will be very modest, restraining unit labour costs. Additionally, a cut in electricity prices by 7% to 10% for households is possible. As a result, inflation will probably fall further to 1.3% in 2014 after 1.5% in 2013. The government budget deficit will probably be reduced in 2014 to 2.8% of GDP, compared to 3.0% in 2013. The new long term budgetary plan envisages a further deficit reduction to 2.6% in 2015 and 1.5% in 2016. The 2014 budget is working on the assumption of real GDP growth of 2.2%, which is above our more conservative estimate of 1.5%. In 2014 there are presidential, European and local elections. Therefore, there are risks that the government will not reach its deficit target, particularly if economic growth disappoints. However, it is highly unlikely that the government would renege on its policy commitments towards EU. Therefore, in case of a shortfall, higher taxes, state asset sales or another change in the second pension pillar would be on the table and implemented to offset that shortfall.
Marek Gabris (mgabris@csob.sk) CSOB Slovakia

Inflation close to all time low

(year-on-year, in %) 12 10 8 6 4 2 0 -2 -4 -6 -8 2005 06 07 08 09 10 11 12 13

Decreasing loans to non-financial corporates

(in 1000 EUR) 16,500,000 16,000,000 15,500,000 15,000,000 14,500,000 14,000,000 13,500,000 13,000,000 12,500,000 2008 09 10 11 12 13

CPI inflation Food

Economic Outlook

Central Europe


Modest recovery in the making

2013 has been a bumpy year for the Bulgarian economy. In the first quarter real GDP growth was sluggish but moderately positive. Amid political turbulence and social unrest growth turned negative in the second quarter. The drop in economic activity was short-lived since in the subsequent quarter economic activity surprised on the upside as real GDP growth was 0.5% quarter-onquarter. This relatively strong recovery was almost entirely export-driven. The political environment is still marked by a high degree of instability leading to an uncertain business climate and firms postponing or cancelling investments. To offset domestic demand weakness the government decided to increase government consumption and as a result also the projected budget deficit in 2013 to 2% of GDP. Recent activity indicators suggest that the recovery was sustained towards the end of 2013, albeit at a moderate pace. 2014 promises to bring a continuation of this export-led recovery. About half of Bulgarias exports are headed towards the EMU with Germany being the most important trading partner. Bulgarias exports will benefit from the expected euro area recovery. Moreover, this dynamic should be reinforced somewhat by a small revival of private consumption growth. Although the labour market continues to be weak, real disposable household income has risen recently, due to low inflation. board arrangement. This proved to be effective in maintaining confidence. The external balance improved with a large current account deficit turning into a solid surplus. Moreover, the net international investment position and the gross external debt are gradually declining. Finally, foreign exchange reserves remain substantial. Despite the solid macroeconomic fundamentals, challenges remain considerable. The political framework makes it difficult to take necessary but unpopular measures. Corruption remains a major problem. In the latest Corruption Perception Index of Transparency International, Greece was the only EU country ranking lower than Bulgaria. The working-age population continues to decline, due to the ageing of the population and exacerbated by emigration. To offset this adverse demographic trend, it is key that policymakers focus on productivity-enhancing measures to improve Bulgarias medium-term growth outlook. .

Inflation set to turn positive again

There are several factors in play to explain why inflation turned negative in Bulgaria in 2013. First of all, there is still a significant amount of slack in the economy. For years, the economy has been operating below its potential, as reflected by the high unemployment rate. Secondly, energy prices have dropped substantially. In Bulgaria energy prices are set administratively. For instance, in August, household electricity prices were cut by 5%. We expect inflation to turn positive again in 2014 as the statistical base effect fades.

Macroeconomic stability
Despite the political instability and the dismal growth performance, macroeconomic stability actually has improved in recent years. Policymakers had the fiscal discipline required under the currency

Dieter Franceus (dieter.franceus@kbc.be) KBC Group

Gradually improving net international investment position

(in % of GDP) 0 -20 -40 -60 -80 -100 -120 2005 14 12 10 8 6 4 2 0 -2 -4 06 07 08 09 10 11 12 13 -6 Jan-2011 July-11

Deflationary environment
(year-on-year, in %)





CPI inflation PPI inflation

Economic Outlook

Central Europe

In the spotlight
The Czech National Bank intervenes in the FX market
In the Czech economy, there are no longterm inflationary pressures. Occasional overshooting of the official inflation target was mainly the result from adjustments of indirect taxes or regulated prices. Although both VAT rates were raised by 1 %-point in 2013, inflationary pressures remain strongly subdued as a result of the persisting weakness of domestic demand and growing competition in the service sectors. As a result, yearon-year inflation fell below the lower threshold of the tolerance band of the Czech National Bank (CNB). The CNB has exhausted the possibility of cutting its policy rate, which since November 2012, has been at technical zero (0.05%). The central bank made in clear on several occasions that it does not consider negative rates to be a policy option. For about a year the CNB talked about the possibility of exchange rate interventions, thus successfully keeping the koruna at weaker levels, and preventing it from strengthening below 25.50 CZK per EUR. However, at its November meeting, the central bank decided to take it one step further by putting in place an intervention regime, with a target exchange rate of currently 27.00 CZK per EUR. With large-scale FX interventions, the central bank succeeded in weakening the Czech currency by approximately 5% in a single day and pushing it to the desired target exchange rate. In addition, central bank representatives made it clear that this new monetary policy regime would be in place until strong inflationary pressures become evident in the economy. Hence the CNB will very likely maintain that exchange rate throughout 2014. The exchange rate threshold will be reviewed at each CNB Board meeting. However, changes to the parity should be less frequent than interest rate changes usually are. As a result, we do not believe that the CNB will decide to weaken the koruna further within the next six months. However, the market exchange rate of the koruna is not limited on the weaker side and already reacts very sensitively to messages from the central bank that could point towards a weaker parity. The main policy objectives of the new regime include boosting inflation through increased import prices, raising inflation expectations and thus making households consume and invest more. Possible side effects include improved competitiveness, the creation of new jobs and higher real GDP growth. According to the CNBs new forecast, the 2014 GDP should grow by 2.1% rather than by the originally predicted 1.2%, thanks to the weakened koruna. For a long time there has been speculation as to how strongly the CNB had to intervene at the beginning of its new exchange rate regime, in order to drive the koruna to close to CZK 27 per EUR. After a few weeks, the central bank announced that in the initial days its interventions reached approximately CZK 200 bn in total. Although this corresponded to an increase of the central banks balance sheet total by approximately 18%, this has not reduced the central banks determination to intervene with additional newly printed korunas if needed. Another result of the FX interventions is the rather sharp increase of the koruna liquidity in the market, preventing any rise in interest rates, and consequently in government bond yields as well. Thus the Czech yield curve has decoupled somewhat from the evolution of European interest rates and yields, but we believe this to be only temporary. In any case, the need for a further CNB intervention has decreased in recent weeks, as the market itself has pushed the koruna towards CZK 27.50 per EUR.
Petr Dufek (pdufek@csob.cz) CSOB Czech Republic

Very low inflation

4 3.5 3 2.5 2 1.5 1 0.5 0 2011 12 13 28 27.5 27 26.5 26 25.5 25 24.5 24

Czech central bank starts FX interventions

(CZK per EUR)

23.5 Jan-2013


July-13 CZK per EUR


Headline CPI (year-on-year, in %) Inflation target (in %)