Economic Outlook Central Europe April 2014

Positive growth dynamic intact Exports driving Czech economic growth Hungarian monetary easing cycle nearing its end Polish economic recovery on track Slovakias first experience with negative inflation Fragile Bulgarian recovery with a deflationary twist In the spotlight: Central Europes exposure to the Ukrainian conflict

Real GDP growth

2014 2015 2014

Inflation
2015 02-04-2014 +3m

Policy rates
+6m +12m

Poland Czech Republic Hungary Slovakia Bulgaria Russia Turkey

2.8 1.5 2.0 2.0 1.8 1.6 1.2

3.4 2.5 1.8 2.0 2.5 1.8 3.8

1.5 1.0 1.2 1.0 -0.6 5.7 7.5

2.1 2.0 3.0 1.7 1.5 4.8 6.3

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

2.50 0.05 2.60 0.25 3.50 7.00 10.00

2.50 0.05 2.50 0.25 3.50 7.00 10.00

2.50 0.05 2.50 0.25 3.50 7.00 10.00

3.00 0.05 3.25 0.25 3.50 7.00 10.00

Exchange rates
02-04-2014 +3m +6m +12m 02-04-2014 +3m

10-year rates
+6m +12m

PLN per EUR CZK per EUR HUF per EUR RON per EUR BGN per EUR RUB per EUR TRY per EUR

4.18 27.46 307.29 4.47 1.96 48.76 2.96

4.15 27.40 305.00 4.50 1.96 49.00 2.90

4.12 27.20 303.00 4.55 1.96 50.00 2.85

4.05 27.00 300.00 4.60 1.96 52.00 2.80

Poland Czech Republic Hungary Slovakia Romania Bulgaria Russia Turkey

4.23 2.14 5.54 2.12 3.46 9.01 10.06

4.30 2.45 5.60 2.30 3.60 9.00 11.00

4.50 2.65 5.70 2.45 3.70 9.00 10.50

4.70 2.90 6.00 2.70 4.00 8.50 10.25

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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 2 April 2014, unless otherwise stated. The views and forecasts provided are those prevailing on 3 April 2014.

Economic Outlook

Central Europe

General perspective

Positive growth dynamic intact

Cyclical recovery
Economic growth is gaining strength in Central Europe in the wake of a gradual recovery in the euro area. Economic activity was up in the fourth quarter compared to the third quarter in virtually every country in the region, although real GDP growth remains relatively modest in most cases. Real fourth-quarter GDP growth of 1.6% year-on-year in Slovakia and 1.3% in Bulgaria, for instance, is still considerably lower than the pace of expansion prior to the Great Recession. In the Czech Republic, on the other hand, fourth-quarter economic activity rose by no less than 7.9% quarter-onquarter annualised. The figure ought, however, to be treated with a degree of caution. On the one hand, it is encouraging that the Czech economy has now been growing for three quarters in a row, indicating a sustainable recovery trend. On the other hand, we ought not to attach too much weight to this one figure. Czech GDP figures are known for their volatility, due primarily to sharp fluctuations in the inventory component. Whats more, a number of new taxes and duties came into effect on 1 January 2014, which is likely to have encouraged consumers to bring forward a certain amount of spending. All the same, the Czech Republic has now put its longest ever recession six successive quarters of contraction, beginning in the fourth quarter of 2011 and ending in the first quarter of 2013 firmly behind it.

Storm clouds to the east

Just as the euro area recovery means the regions western trading partners are finally doing better, there are ominous rumbles in the east. The Turkish economy is struggling with its dependence on external financing and the central bank was obliged to raise its policy rate substantially. Meanwhile, the chess game about Ukraine is weighing chiefly on the Russian economy. Most Central European countries, by contrast, are primarily embedded in Western-European production chains. Poland, 8% of whose total exports go to Russia and Ukraine together, is therefore one of the most vulnerable economies. This illustrates that trade links are relatively small and that the danger of contagion is therefore rather limited.

Monetary policy is supportive

We expect the positive dynamic to continue this year, underpinned by accommodating monetary policy. The exceptionally weak inflationary dynamic leaves scope for this. Regional central banks are following the example of the ECB and holding their policy rates at historically low levels. The Polish policy rate stands at 2.50% and the countrys central bank has stated that interest rates will remain at their present low levels until the end of the third quarter at least. The Hungarian central bank has now lowered its policy rate for 20 months in a row to 2.60% at present. The Czech policy rate has been at 0.05% since November 2012, so the central bank there is now opting for currency interventions. It has pursued a maximum rate of 27 koruna to the euro since last December, and is prepared, if necessary, to sell unlimited amounts of the Czech currency in order to maintain this level.

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

(annualised, quarter-on-quarter, in %) 10 8 6 4 2 0 -2 -4 -6 Czech Republic Q3 2012 Q4 2012 Q3 2012 Q1 2013 Slovakia Q4 2012 Hungary Q1 2013 Poland Bulgaria Q4 2013 7 6 5 4 3 2 1 0

Growth dynamic intact

Low inflation creates room for monetary manoeuvre

(year-on-year, in %)

-1 2009

10

11 Slovakia

12 Hungary Poland Hungary

13 Poland

14

Q2 2013 2013Q3 2013 Q2Q3 2013 Q4 2013

Czech Republic Slovakia Czech republic

Economic Outlook

Central Europe

Czech Republic

Exports driving economic growth

Eventually, the Czech economy grew even faster in the fourth quarter of 2013 than suggested by the initial flash forecast. Real GDP grew by 1.8% quarteron-quarter and by 1.2% year-on-year. Economic growth was driven by exports, investment, and eventually also by household consumption. However, the biggest growth contribution came from inventories. Therefore, given the strong effect of inventories and the increase of tobacco excise duties leading to a stocking-up of tobacco products in Q4, we should not overly rejoice at nearly 2% growth in the fourth quarter. It is certainly good that the economy emerged from the recession, as is the fact that consumption and investment are no longer falling. Nevertheless, the last quarter was largely exceptional, due to the above-mentioned extraordinary factors. As far as individual sectors are concerned, particularly the manufacturing industry fared well, followed by construction, which may be seen as a surprise. However we should keep in mind the very supportive weather conditions. Notwithstanding the latest three consecutive positive growth quarters, real GDP growth in 2013 was only -0.9%. Nevertheless, the Czech economys longest recession has ended and the economy has resumed growing, mainly thanks to export growth, based on the manufacturing industry. While economic growth has accelerated recently, inflation is not picking up. In February headline inflation was 0.3% year-on-year, owing to a significant reduction in electricity and natural gas prices for households. Prices of seasonal goods such as shoes and clothing went down. Food prices, to which consumers are most susceptible, only fell slightly by 0.1% monthon-month. Thus the Czech Republic is one of the EU countries with the lowest inflation, primarily due to cheaper energy, telecommunication services and mobile phones. There is no reason to be afraid of deflation, however. With the increased prices of food and certain imported goods, inflation is highly unlikely to become negative. The current low inflation is no reason for the Czech National Bank to change its current exchange rate regime. Owing to low inflation, the central bank can maintain the lower threshold of CZK 27 per EUR until the middle of 2015, although it originally cited the possibility of leaving the regime in early 2015. In the beginning of 2014 there are indications that export-oriented industrial firms are raising their production. Exports are clearly driving Czech economic growth and raising the trade balance surplus. The rising exports reflect the good competitive position of domestic firms on the one hand and the increasing demand on the European market on the other. Trade may also show favourable figures in the months to come. We do not expect that the weak koruna will significantly boost the volume of exports soon (aside from the conversion of euro invoices into korunas). Czech exporters will primarily benefit from the favourable demand trend in Europe. Economic growth is also starting to affect the labour market favourably. The number of unemployed fell slightly in February but still exceeds the 600,000 mark. The unemployment rate remained at 6.7% in February but it was nice to see the number of vacancies rise (to 38,300). As a result, the labour market has been stabilising in recent months. However, a return of the labour market to the condition prior to the first recession, when unemployment was below 5%, is nowhere near. A significant reduction of the unemployment rate in the 2014 is indeed unlikely. By late 2014, fixedterm employment contracts, which are increasingly popular among employers, again expire, and seasonal work ends.
Petr Dufek (pdufek@csob.cz) CSOB Czech Republic

Very strong real GDP growth in fourth quarter

(in %) 6 4 2 0 -2 -4 -6 2008 5 4 3 2 1 0 -1 09 10 11 12 year-on-year 13 -2

(consumer basket decomposition, in %)

Low inflation

11

12

13

14

Year-on-year Quarter-on-quarter quarter-on-quarter

Headline CPI inflation Food Alc. beverages, tobacco

Housing, water, energy, fuel Health Other Transport

Economic Outlook

Central Europe

Hungary

Monetary easing cycle nearing its end

Real GDP grew by 2.7% year-on-year and by 0.5% quarter-on-quarter in the fourth quarter of 2013. This was the highest growth rate in the past 8 years. Even more surprising was the growth composition. Since 2007 net exports have been the main and almost sole driver of economic growth. In the fourth quarter, however, all GDP components contributed positively to growth. Household consumption increased by 0.5% year-on-year, government consumption by 5.7% year-on-year, gross capital formation by 10.4% year-on-year and net exports contributed 1.2% yearon-year. Although these figures are very impressive, especially if we take into account the poor performance of the economy in the last years, the sustainability is questionable. Once we filter all the one-off effects (low base effects, election spending) out of economic growth, we would have seen real GDP growth around 1.5% year-on-year in the fourth quarter. For 2014 we expect real GDP to grow by 2% after which it will slow to 1.8% in 2015. Industrial production rose by 6.1% yearon-year in January. Vehicle production is still the main growth driver, while electronic device production growth is still weak. Retail sales increased 3.9% yearon-year in January. Beside food, durable goods sales and fuel sales are also increasing. This suggests that households are starting to spend their higher disposable income, which can stabilise retail sales growth around 3% year-onyear, even without an acceleration in consumption loan growth. twentieth consecutive month the central bank lowered its policy rate, this time by an additional 10 basis points to 2.60%. However, we believe the national bank of Hungary is nearing the end of its easing cycle, especially given the recent weakening of the HUF. The market is already pricing in a rate hike on a six months horizon.

Surprising fall of inflation...

Inflation surprisingly slowed further from 0.8% year-on-year in January to 0.3% year-on-year in February. Market services prices decreased by 0.6% monthon-month. The limited tradable goods price increase of 0.1% month-on-month suggests that the pass-through of the exchange rate channel is weak. Nevertheless, we believe that there is definitely no deflationary risk in Hungary, as low inflation is partly explained by several one-off effects (such as the public utility cuts in 2013 and 2014). We believe inflation will return to around 3% year-on-year in six to eight quarters.

No political change expected

At the time of publication the April 6 election results were not yet available. The current governing party Fidesz was the clear favourite to win these parliamentary elections. We therefore expect a continuation of current macroeconomic policy.

... allows central bank to further cut policy rate

Against the favourable inflation background, the national bank continued its gradual rate cutting cycle. For the

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

Composition of real GDP growth

(year-on-year, in %) 6 4 2 0 -2 -4 -6 -8 -10 2006 07 08 09 10 11 12 13 GDP growth 4 2 0 2006 8 6 10

Inflation trending lower

(year-on-year, in %)

07

08

09

10

11

12

13

14

Real GDP growth Agriculture Agriculture Industry Industry

Construction Services Services Construction

Headline CPI Core CPI

Inflation target

Economic Outlook

Central Europe

Poland

Economic recovery on track

Macroeconomic data published in the first quarter of 2014 indicates that the Polish economic recovery is on track. In the fourth quarter of 2013 real GDP increased 2.7% year-on-year versus 1.9% year-on-year in the third quarter. Economic growth is mainly driven by consumption and net exports. Domestic demand increased to 1.2% year-on-year in the fourth quarter from 0.5% in the third quarter with consumption increasing 2.1% year-on-year and investments rising to 1.3% year-on-year from 0.6% in the third quarter. partner, should translate into a higher willingness to invest. However, the recent political unrest surrounding the Ukrainian conflict is a risk factor. A deep Ukrainian recession would adversely impact trade and weigh on entrepreneurs sentiment. However, economic links should not be overestimated and we believe the impact on the Polish business cycle will be limited. end of the third quarter. This change in monetary rhetoric surprised the markets, that expected the policy rate to be hiked earlier. In the short term, we believe the zlotys exchange rate may be rather volatile as a result of the unrest on Polands eastern border. In the medium term, however, we believe that the zloty will resume its appreciating trend given solid economic fundamentals and the improvement of the current account balance.

Low inflation
The economic recovery takes place in a context of low inflationary pressure. In February CPI inflation increased to 0.7% year-on-year. The central bank now expects a lower inflation path in the coming months with inflation remaining well below the central banks inflation target of 2.5%. The Ukrainian crisis and the Russian restrictions imposed on Polish pork exports can pull down the CPI by around 0.2% in the coming months.

Pent-up investment demand

The high level of manufacturing producer confidence in March supports our view of a continuation of the positive trend in the coming quarters. Consumption should be driven by an increase in real wages, a more upbeat labour market, a visible improvement in consumer optimism and a significant drop of loan servicing costs. The potential for investment growth is sizable, mainly due to supplyside constraints in the past quarters. Entrepreneurs limited their investments when the economy was slowing down. Currently, the improved situation on the domestic market as well as the recovery in the euro area, Polands main trading

Central bank communication surprised markets

After the latest monetary policy meeting, governor Belka declared that interest rates should be kept unchanged at the current level (2.5%) at least until the

Jaroslaw Antonik (jaroslaw.antonik@kbctfi.pl) KBC Towarzystwo Fund. Inwest. A.S.

Solid growth recovery

(year-on-year, in %) 8 6 4 3 2 0 -2 -4 2 1 0 2007 5 4

Low inflationary pressure

(year-on-year, in %)

2010

11 Real GDP growth Private consumption Public consumption Private Consumption Investments Inventories

12 Investments Net exports Inventory

13

08 Headline CPI Core CPI

09

10

11

12

13

14

Government Consumption Net exports Real GDP Growth

Economic Outlook

Central Europe

Slovakia

Slovakias first experience with negative inflation

Car production supports growth
The Slovak economy expanded by 0.9% year-on-year in 2013 after it rose by 1.8% year-on-year during the previous year. Foreign demand continued to be the main engine of growth. Real export growth was 4.5% in 2013. Export growth dynamics even accelerated towards the end of the year, increasing 6.6% yearon-year in the fourth quarter as demand from Slovakias trading partners in the euro area strengthened somewhat. Auto production in particular was supportive for growth. The main car manufacturers were able to increase their production despite the already high capacity utilisation rates of production lines. below 3% of GDP. The biggest positive surprise came from gross fixed capital formation. Fourth quarter investments increased by 4.0% year-on-year after they declined almost 10% year-on-year in the third quarter. During the whole of 2013 investments declined by 4.3%. With a real GDP growth of 1.5% yearon-year in the fourth quarter, Slovakia belonged to the better half of the EU economies. According to the Slovak central bank and the Ministry of Finance, growth is set to accelerate in 2014. We think growth close to 2% is possible although the recent Crimean crisis might weigh on sentiment in Western Europe. Real GDP growth of 1.5% should be achieved without any significant problems. The main driver will continue to be foreign demand with strong growth of auto exports and an increasing share of local sub-contractors resulting from capacity constraints. Moreover, the recent revival of consumer confidence and the stabilization of the unemployment rate should support household consumption. Furthermore, with the low inflation environment continuing in 2014, real wage growth is set to continue. Real wages started growing again in 2013 after they declined in the two previous years.

Falling inflation
In January 2013 headline inflation was 2.5% year-on-year and it has gradually declined throughout the year to reach 0.4% year-on-year in December. This year the downward trend is continuing with inflation reaching 0.0% year-onyear in January and even turned negative in February (-0.1% year-on-year). We do not think negative inflation will persist, although we do expect inflation to be very low during the remainder of the year.

Weak consumption
Household consumption on the other hand decreased by 0.1% year-on-year in 2013. However, since the second quarter of 2013 consumption dynamics have improved. Government consumption also contributed positively to growth in 2013. This was slightly surprising as the government tried to consolidate public finances further and fulfil its obligation towards the European Commission to keep the budget deficit

Marek Gabris (mgabris@csob.sk) CSOB Slovakia

Inflation turns negative

(year-on-year, in %) 12 10 8 6 4 2 0 -2 -4 -6 -8 2006
3 94 95

Car production in Slovakia

(number of cars) 1200000 1000000 800000 600000 400000 200000 0

96 97 98 99 200 0 01 02 03 04 05 06

09 10 11

07

08

09

10

11

12

13

14

Headline CPI Food

199

Volkswagen PSA Peugeot Citron Volkswagen PSA Peugeot Citron

Kia Motors Slovakia Kia Motors Slovakia

12 13

07 08

Economic Outlook

Central Europe

Bulgaria

Fragile recovery with a deflationary twist

Exports lead the way
Prior to the Great Recession of 20082009 Bulgaria enjoyed spectacular growth rates. Between 2000 and 2008 real GDP growth averaged 5.8%. The shock of the global economic crisis on the Bulgarian economy was severe. Today, output is still below its pre-crisis level as the recovery is proving to be very slow and fragile. Full year real GDP growth in 2013 was 0.9%, only marginally above the real GDP growth rate of 0.8% in 2012. This was disappointing as fiscal policy in 2013 was more supportive than in previous years. The general government deficit increased from 0.8% of GDP in 2012 to 1.9% of GDP in 2013 with the structural budget deficit widening. The subdued recovery in 2013 can partly be explained by the fact that last year was marked by a high degree of social and political unrest, which depressed the investment climate. However, as the political environment calmed somewhat towards the end of the year investments already picked up somewhat. Exports remain the main engine of growth, increasing by 8.9% in 2013. As economic growth in Bulgarias key trading partners in the euro area is also strengthening, we expect exports to continue leading the way in 2014.

Labour market weakness

The export-led economic recovery will continue to be slow and gradual as domestic demand remains subdued. Household consumption in particular is unlikely to rebound substantially in the short term as the labour market remains in very bad shape. In January the unemployment rate increased further to 13.1%, the highest level since August 2003. Furthermore, over half of the unemployed are long-term unemployed and therefore at risk of becoming structurally unemployed. On a positive note, consumer confidence has been improving steadily in recent months, suggesting that some improvement lies ahead.

Deflation deepens
Moreover, households purchasing power actually has increased in the past year due to a combination of positive nominal wage growth and negative inflation. Average monthly gross wage increased by 2.2% year-on-year while headline inflation in December was -0.9% yearon-year. Since then deflation has deepened even further. In February headline

inflation was -2.1% year-on-year. Core inflation is also firmly negative (-1.6% year-on-year in February). First of all, deflation is driven by the still significant slack in the economy. Secondly, this dynamic was further exacerbated by some administratively-set price cuts in the energy sector. In the last 12 months the electricity price was cut three times (in March and August 2013 and in January 2014). In February electricity price inflation was -13.5% year-on-year. Thirdly, credit dynamics are very weak. Fourthly, as a consequence of a strong harvests, food price inflation is also negative. In Bulgaria the share of food in the CPI basket is relatively large. We therefore revised downward our fullyear inflation forecasts for 2014 and 2015 to -0.6% and 1.5% respectively. We only expect inflation to turn positive again in the last quarter of this year.

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

Labour market remains weak

(unemployment rate, in %) 20 18 16 14 12 10 8 6 4 2000 02 04 06 08 10 12 14 14 12 10 8 6 4 2 0 -2 -4 -6 2011

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

12 Consumer price inflation Producer price inflation

13

14

Economic Outlook

Central Europe

In the spotlight
Central Europes exposure to the Ukrainian conflict
The ongoing crisis in Ukraine and the mounting tensions between the EU and Russia have been at the centre of attention for a few months now. Given their proximity to Ukraine, Central European economies are at the geographical heart of this conflict. Remarkably, market reaction so far has been relatively muted. Only at the height of the Crimean conflict, there was a noticeable reaction in some CEE currencies and bond yields but this movement has been mostly reversed since. We briefly discuss the two main channels by which an escalation of the Ukrainian conflict could adversely affect Central Europe, namely the trade channel and the energy supply channel. We focus our attention on Poland, the Czech Republic, Slovakia, Hungary and Bulgaria. Germany is also included because of the large trade links with Central European economies in what the IMF recently labelled the GermanCentral European supply chain. should not be overestimated however. Of the five Central European economies we discuss here Poland is the most heavily exposed with a combined share of Russia and Ukraine in its total exports of 8.0%, equivalent to 3.7% of GDP. Although this certainly is not negligible, Central European economies direct trade links with Russia and Ukraine are modest. This is also the case for Germany with a combined share of only 3.8% in its total exports. If a scenario unfolded where Russian energy to the EU is disrupted Central European economies would be hit severely worse than the rest of the EU. Obviously different possibilities exist here and the impact varies on the energy intensity of the economy, the access to alternative sources and the length of the interruption. If only the share of Russian gas supply transiting via Ukraine is cut off as part of the ongoing conflict, this would pose a problem for Hungary and Bulgaria. Germany, Poland, the Czech Republic and Slovakia have either alternative suppliers or alternative supply routes from Russia not running through Ukraine. If a scenario unfolded where all Russian energy to the EU is cut off, Central European economies would be hit severely worse than the rest of the EU and be thrown into deep recessions. However, we deem the chance of this risk materializing to be very small as Russia would suffer the most under this scenario. Indeed, oil and gas exports generate about half of its federal budget revenue. After all, even at the height of the cold war, Russia never stopped supplying energy to the West.

Very high energy dependence

Germanys high dependence on Russian energy supply has received the most attention (35% for gas, 29% for petroleum). However, the energy dependence of Central European countries is more than twice as high as the German dependence. The energy dependence is mutual, however, as Russian energy exports to the EU account for 38% of Russias total exports. Another aspect is related to the transportation of Russian gas. Several supply routes exist between Russia and the EU. One of these routes runs via Ukraine. This route is particularly crucial for Hungary and Bulgaria as for these countries no immediate alternative exists.

Limited trade links

The most obvious channel by which Central European economies could be hit is via the direct trade links with Ukraine and Russia. These trade links

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

Energy imports from Russia

(% of total energy imports) 100 6 5 4 3 40 2 20 1 Czech Hungary Slovakia Republic Gas, natural and manufactured Petroleum, petroleum products and related materials Poland 0

Share of Ukraine and Russia in total exports

(2012, in %)

80 60

Germany

Bulgaria

Germany

Poland

Czech Republic

Hungary

Slovakia

Bulgaria

Russia Ukrane