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1Q2018

January 2018

January 2018

CEE Macro & Strategy Research

CEE Quarterly

Your Leading Banking Partner in Central and Eastern Europe

UniCredit Research

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See last pages for disclaimer.

January 2018

January 2018


CEE Quarterly

Contents 4

CEE in 2018: the age of resilience

13

The lure of the fringes: populism in CEE

24

CEE Strategy: EM performance to continue in 2018

34

CEEMEA FX: the “good”, the “bad” and the “in-between”

44

Acronyms and abbreviations used in the CEE Quarterly EU candidates and other countries

Countries 46

Bulgaria

74

Azerbaijan

50

Croatia

78

Bosnia and Herzegovina

54

Czech Republic

80

Russia

58

Hungary

84

Serbia

62

Poland

88

Turkey

66

Romania

92

Ukraine

70

Slovakia

72

Slovenia

Erik F. Nielsen, Group Chief Economist (UniCredit Bank, London) +44 207 826-1765, [email protected] Dan Bucşa, Chief CEE Economist (UniCredit Bank, London) +44 207 826-7954, [email protected] Artem Arkhipov, Head of Macroeconomic Analysis and Research Russia (UniCredit Russia) +7 495 258-7258 ext. -7558, [email protected] Anca Maria Aron, Senior Economist (UniCredit Bank Romania) +40 21 200-1377, [email protected] Hrvoje Dolenec, Chief Economist (Zagrebačka banka) +385 1 6006-678, [email protected] Dr. Ágnes Halász, Chief Economist, Head of Economics and Strategic Analysis Hungary (UniCredit Hungary) +36 1 301-1907, [email protected] Published on 9 January 2018

Ľubomír Koršňák, Chief Economist (UniCredit Bank Czech Republic and Slovakia) +42 12 4950-2427, [email protected]

Erik F. Nielsen Group Chief Economist (UniCredit Bank, London) 120 London Wall London EC2Y 5ET

Kiran Kowshik, EM FX Strategist (UniCredit Bank, London) +44 207 826-6080, [email protected]

Imprint: UniCredit Bank AG UniCredit Research Arabellastrasse 12 D-81925 Munich

Javier Sánchez, CFA, CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077, [email protected]

Supplier identification: www.research.unicredit.eu

Lubomir Mitov, Consultant (Lubomir Mitov is a Consultant for UniCredit Bank AG) [email protected]

UniCredit Research

Mauro Giorgio Marrano, Senior CEE Economist (UniCredit Bank, Vienna) +43 664 88 291 393 Kristofor Pavlov, Chief Economist (UniCredit Bulbank) +359 2 9269-390, [email protected]

Pavel Sobíšek, Chief Economist (UniCredit Bank Czech Republic and Slovakia) +420 955 960-716, [email protected]

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January 2018

January 2018


CEE Quarterly

CEE in 2018: the age of resilience Dan Bucşa, Chief CEE Economist (UniCredit Bank, London) +44 207 826-7954 [email protected]

■ ■ ■ ■ ■ ■ ■ ■

In 2018-19, economic growth in CEE is expected to be above potential but below that of 2017. EU funds, private investment and fiscal spending could take over from consumption and external demand in driving growth in EU-CEE. Economic growth could slow in Russia and Turkey as favorable base effects and temporary measures are unlikely to be repeated. The main themes in CEE for 2018 are a potential tipping point on labor markets, reflation, central bank differentiation and the impact of populism. Labor markets will tighten further, threatening to cap growth from 2018 onwards. Core inflation could take over from volatile prices as the main driver of reflation in all countries but Turkey. Central banks will react differently according to their assessment of monetary conditions abroad and labor market conditions at home. The negative impact of populism will worsen this year but the main risks may materialize in the next decade.

CEE enters 2018 at a cyclical peak. For EU-CEE 1, 2017 has been the best year on record, while the Turkish and Russian economies rebounded from below-potential growth rates in 2016. The cyclical slowdown in growth expected in 2018-19 will bring little change to CEE-EU economies, but will require structural reforms in Turkey and Russia to allow for a future improvement in living standards. 2018 will be a year of resilience: growth will slow only moderately, central banks are unlikely to make U-turns, elections may change little in policies or power structures. The external environment is likely to remain favorable, with solid growth in both emerging and developed economies and global trade rebounding further 2. If geopolitical risks outside CEE do not materialize, 2018 may turn out to be a quiet year, remembered more as a starting point for future developments, be they political (a resolution to the current standoff between EU-CEE and western Europe 3) or economic (the impact of fiscal and monetary policies falling further behind the curve).

The delayed cyclical slowdown Growth will remain above potential in 2018…

The cyclical slowdown in CEE that looked imminent at the start of 2017 was postponed for a year on the back of stronger growth in the eurozone and, in CEE, fiscal easing, faster revenue growth and higher EU fund inflows. While all these factors should remain supportive in 2018, last year’s performance may be difficult to match in 2018-19 (chart 1). This is due to slower economic growth in the eurozone and the US, higher inflation in CEE – pushing interest rates higher and eating into real income growth – and a weaker fiscal impulse in some countries, despite fiscal policy remaining stimulative.

…but a cyclical downturn is in the cards…

EU-CEE will continue to grow above potential in 2018-19 (chart 2), helped by EU funds, fiscal spending and foreign demand, while consumption and exports may rise more slowly than before. However, the economic performance could turn out more uneven this year, as countries with broad-based growth outperform those that rely heavily on fiscal stimulus.

1 2 3

Comprising EU members from CEE, namely Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania, Slovakia, Slovenia and the Baltics. For details, please see “The UniCredit Macro & Markets 2018 Outlook” published on 15 November 2017. Be it on migrant quotas or, for Hungary, Poland and Romania, on the curbing of judicial independence.

UniCredit Research

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… despite a further rebound in EU fund inflows

The cyclical upswing was extended in 2017 by the arrival of EU funds from the 2014-20 EU budget. For countries like Hungary and Slovenia, this will continue to play an outsized role this year and next. Last year, EU fund absorption fell short of expectations in Poland but the election cycle may lead to an improvement in 2018-19. Infrastructure projects are already on the rise ahead of local elections in November 2018 and general elections a year later. Slovakia may increase absorption if its long-delayed projects relying on public-private partnerships (PPP) get a green light. In contrast, the EU funds’ contribution to growth may be insignificant in the Czech Republic and Romania. A minority government in the Czech Republic could struggle to advance a bold investment agenda. In Romania, the 2018 budget draft shows clearly that investment will not be a priority while the government tries to fulfill its untenable populist promises.

A GRADUAL SLOWDOWN FROM A CYCLICAL PEAK Chart 1: Growth will remain above potential in CEE… 2019F

2018F

2017E

Chart 2:… and output gaps will turn positive everywhere Output gap, % of potential GDP

Potential growth (avg. 2017-19)

5.0

Romania Hungary Bulgaria Poland Turkey Slovakia Slovenia Czech Republic Serbia Bosnia-Herzegovina Croatia Ukraine Azerbaijan Russia -1.0

4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 2016 2017E 2018F 2019F 2016 2017E 2018F 2019F 2016 2017E 2018F 2019F 2016 2017E 2018F 2019F 2016 2017E 2018F 2019F 2016 2017E 2018F 2019F 2016 2017E 2018F 2019F 2016 2017E 2018F 2019F

-3.0

Russia 0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Slovakia Bulgaria

Poland

Hungary

Czech Republic

Turkey Romania

Source: Eurostat, national statistical offices, UniCredit Research

Tight labor market conditions may boost private investment…

… with public investment depending on the scope for fiscal spending

Private investment has been weak in this protracted cyclical upswing but it may finally improve in 2018 in countries with crippling labor shortages and high capacity utilization, such as the Czech Republic and Poland. Leaving aside large FDI projects, companies have been reluctant to increase capex and relever, despite above-potential growth since 2014. One reason for that has been the uncertain tax environment, with Polish companies withholding investment in 2015-16 and Romanian firms expecting to spend little on development in 2018. This year, corporate releveraging may be significant only in Hungary, owing to the central bank’s focus on reducing borrowing costs and extending maturities for fixed-interest rate loans. As a result, public investment could retain the lion’s share of total fixed investment, especially where governments can afford to spend more, both on investment and on co-financing EU-funded projects. Bulgaria stands out, its strong growth rates being achieved so far with very small deficits. Slovakia and Poland may benefit from higher budget revenues and spend more on infrastructure. Hungary is an atypical case: the government spent in advance of EU fund disbursements, widening its cash budget deficit to more than 5% of GDP last year. Thus, the cash deficit will be smaller this year, even if the structural deficit (computed on accruals) will continue to widen in 2018-19. Romania stands out because of the dramatic crowding out of public investment. No funds were allocated for existing highway projects in the 2018 budget, while new projects (including co-financing for EU funds) received a tenth of required funding. After successfully reducing their budget deficits, Croatia and Serbia are expected to spend more this year, both on social security and investment. Strong demand from the eurozone will support central European exports but weaker growth than in 2017 is in the cards in most countries. Large FDI projects in car manufacturing may postpone the export slowdown only in Hungary and Slovakia.

UniCredit Research

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Export growth could slow in 2018-19…

In 2018-19, export growth could slow further for two reasons: 1. No similar FDI projects are in the pipeline anywhere in the region and 2. The car sales cycle is approaching an end in the eurozone. Outside car manufacturing, FDI is focused on less capital-intensive sectors and on non-tradables. In a return to pre-crisis patterns, the largest share of FDI goes into retail and real estate, rewarding the prominence of domestic demand in driving economic growth. Private consumption will remain the most important growth driver in 2018-19, but its contribution may decline as inflation eats into real wage growth (chart 4). Releveraging may partly offset slower wage growth, but consumer lending could lag corporate loans and mortgages.

…alongside consumption

THE CONSUMER COULD DRIVE THE CYCLICAL SLOWDOWN Chart 3: Releveraging is not picking up fast enough…

0.8

Credit impulse for consumer credit , pp of GDP, yoy

2016

Chart 4: …to offset the slower rise in real revenues Real wage growth, yoy (%)

3Q17

2017E

2018F

2019F

25.0 20.0

0.6 15.0

0.4

10.0 5.0

0.2

0.0

0.0 -5.0

-0.2

-10.0

PL

HR

RS

CZ

HU

BG

RO

SI

RU

TR

TR

SI

HR

BH

RU

UA

AZ

RS

PL

SK

HU

CZ

BG

RO

Source: central banks, national statistical offices, UniCredit Research

Structural weaknesses may slow growth in Russia and Turkey…

… as significant reforms are unlikely…

… and procyclical policies may deepen macroeconomic imbalances

In line with EU-CEE, economic growth may slow this year in Russia and Turkey compared to 2017, while remaining above potential. In Russia, the post-crisis rebound has run its course and positive base effects have been exhausted, laying bare the weakness of domestic demand. In Turkey, the credit impulse boosted domestic demand temporarily in 2017 but may lead to larger macroeconomic imbalances if it is overused. More importantly, both countries cannot sustain last year’s growth rates due to structural weaknesses that are unlikely to be addressed in 2018-19. Although needed structural reforms are well known in Russia 4, the presidential election scheduled for 18 March 2018 has been the pretext for postponing them. Moreover, the reform window is a short one and may have to end well before Duma elections scheduled for 2021, according to government officials. Even if some structural measures are implemented (such as a higher retirement age or changes in taxation), their impact on growth may be modest, especially in 2018-19. In the absence of quick monetary and fiscal fixes, economic growth is likely to stay below 2% this year and next 5. In Turkey, the main goal of economic policies is a victory for President Recep Tayyip Erdogan and his Justice and Development Party (AKP) in the general elections scheduled for 3 November 2019. The government believes that growth in the range of 5-5.5% per year would be needed to absorb new entries into the labor force, estimated at approximately 900,000 people per year, and thus keep unemployment in check.

4

The latest comprehensive instalment is the economic program devised by former Finance Minister Alexei Kudrin, which addresses labor market rigidities, barriers to competition, Russia’s weak productivity, the need to move to a knowledge-based economy and other reasons for the low growth potential. The Ministry of Economic Development proposed a program that is complementary to Mr. Kudrin’s. The Stolypin Institute came up with one that puts much more emphasis on government spending. After elections, Mr. Kudrin’s appointment in a position that would allow him to implement at least part of his program would be a litmus test for the political resolve for reforms. 5

For details, please see the EEMEA Country Note “Russia – the perks and traps of macroeconomic stability” published on 1 December 2017.

UniCredit Research

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However, repeating last year’s growth rate of more than 6% will be challenging in 2018-19. First, growth will not benefit from large base effects such as the 2016 failed coup or the return of Russian tourists in 2017. Second, last year’s credit impulse supported by guarantees from the Credit Guarantee Fund (CGF) cannot be replicated without further stretching the financing needs of local banks and, thus, keeping TRY interest rates high for longer. Likewise, fiscal easing may be limited by access to funding through a combination of higher core rates, weak currency and stubbornly-high inflation 6. The government could use the Sovereign Wealth Fund to borrow against state assets, if risk appetite remains healthy worldwide. However, such borrowing may not be enough to provide a strong boost to growth.

The main themes of 2018 in CEE In our opinion, the main themes that may influence investment in CEE in 2018 are: labor market tightness, reflation, monetary policy normalization and populism. 1. Labor market tensions – 2018 may be a tipping point Tight labor market conditions are already an issue in EU-CEE and may become a problem in Russia. For the latter, low unemployment coupled with high labor participation 7 is likely to lead to deplete labor supply if the economy grows above potential. Immigration can alleviate part of this pressure only in Poland and Russia, keeping wage growth in check for a while. In Turkey, the workforce is growing too fast for the economy to absorb new workers. As a result, unemployment is unlikely to fall while wages may grow at a fast pace due to high inflation and government policies. Lacking a recovery in capex, the cyclical upswing in EU-CEE relied intermittently on productivity growth. Where productivity had a sluggish post-crisis recovery (chart 5), the growth model became more labor intensive. As a result, unemployment rates fell to the lowest levels since the fall of communism and the labor participation rate rose. Moreover, the fall in unemployment goes beyond a cyclical improvement, with long-term unemployment halving in most countries and the number of both low-skilled and higher-educated unemployed falling to the lowest levels since the mid-90s.

Labor shortages correlate with low productivity…

Lower unemployment laid bare the skill mismatches in central European economies, with the ratio of vacancies to unemployment rising close to 100% in the Czech Republic, 40% in Hungary and to 10-25% elsewhere (chart 6).

…and lay bare the skill mismatches

LABOR MARKET SHORTAGES REACHED POST-COMMUNIST HIGHS AMID SLUGGISH PRODUCTIVITY GROWTH Chart 5: The slow rise in productivity… %

Chart 6:… correlates inversely with labor shortages 2008 vs 2000

Real productivity per employee, annual average

2011 vs 2008

Vacancies / unemployment ratio (max 2005-17, %) Vacancies / unemployment ratio (min 2005-17, %) Vacancies / unemployment ratio (1Q17, %)

2017 vs 2011

10.0

120.0

8.0

100.0

6.0

80.0

4.0

60.0

2.0

40.0

0.0

20.0 0.0

-2.0 HU

RU

SI

CZ

BG

PL

SK

HR

TR

SK

RO

BG

HR

RO

PL

SI

HU

CZ

Source: Eurostat, UniCredit Research 6

For details, please see the EEMEA Country Note “Turkey: CBRT between a rock and a hard place” published on 11 December 2017.

7

Labor participation is 85% taking into account that school is mandatory up to the age of 18, the army service of two years for men and the retirement age (55 for women, 60 for men).

UniCredit Research

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Labor shortages may start to weigh on economic growth in 2018…

While the gradual tightening of labor markets has been evident for at least three years, 2018 may be a tipping point, with labor shortages starting to weigh on economic growth. The pool of available workforce (especially skilled labor) has been depleted and immigration can offset the lack of workers only in Poland. Even there, the number of Ukrainian workers fell in 2017 compared to 2016 and the opening of EU labor markets in June 2017 may further reduce their number. The Czech Republic has the second-highest number of economic immigrants, representing 9% of employment at the end of 2016, still insufficient to prevent the rise in vacancies. While the potential for immigration from the western Balkans and Ukraine should be significant, the anti-immigration stance of most EU-CEE governments is limiting the access of foreign workers mostly to the black market. Surveys show companies struggling to find workers, with shortages expanding from manufacturing to labor-intensive sectors such as construction and services. The missing workforce is the main issue for companies across the region (chart 7). However, the scope for a further large decline in unskilled unemployment is limited for at least two reasons. First, retraining facilities are underdeveloped and do not match the economy’s needs, despite the large EU funds available for improving human resources. Frustrated by the output of technical schools and retraining facilities in EU-CEE, many foreign investors opened their own vocational training facilities to ensure a continuous flow of labor to manufacturing. Second, geographical mobility is very limited, people preferring often to emigrate than to commute 8. We highlight three potential outcomes from the lack of labor force, two short term and one medium term.

…with potential negative effects outweighing positive ones

1. In 2018-19, capex may rise to boost productivity and partly offset the lack of workers. This could be the case in the Czech Republic, Poland and, Hungary and, to some extent, Bulgaria. The opposite is true in Romania, where the tax environment remains uncertain. 2. Wage growth will continue to exceed productivity. Companies may afford this where labor’s share in GDP remains below pre-crisis levels, but the number of those countries is falling 9 (chart 8). Country-level data show that low-margin manufacturers in light industry may be squeezed out further. TIGHT LABOR MARKET CONDITIONS COULD WEIGH ON ACTIVITY Chart 7: Labor shortages are the main issue for employers

HR

CZ

2004

Compensation of employees, % of GDP

2008

2016

9M17

60 50 40 30

HU

PL

SK

10

Ind

Ind

Constr

Ind

RO

Constr

Ind

Constr

Ind

Constr

20

Constr

Ind

Constr

Ind

Constr

Ind

Constr

Companies facing labour shortages, balance of answers (yes-no), % 90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 -10.0

BG

Chart 8: The labor share in GDP is rising in most CEE countries

Mazimum (2000-17) Minimum (2000-17) 2017

0

SI

TR

RO

PL

SK

CZ

BG

HU

HR

RU

SI

Source: Eurostat, national statistical offices, UniCredit Research 8

According to Eurostat, commuting times in EU-CEE are 20-30 minutes per day shorter than in western Europe. Factoring in the lower quality of infrastructure in EU-CEE, commuting distances are probably much shorter than in western Europe. Romania is an outlier: due to its road infrastructure being the worst in the EU, commuting times are longer than western Europe averages. 9

Namely in Romania, Poland, Hungary, Croatia and Slovenia.

UniCredit Research

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3. In the medium term, a lack of workers may affect potential growth if foreign companies shift their attention to other EM where labor costs are lower and workers plenty. Czech authorities fear that employment may start dropping already in 2018. Other countries may start feeling the crippling effects of missing labor before the end of this decade. 2. Reflation – mind the steep Phillips curves Tight labor market conditions may push core inflation above target…

Reflation may accelerate in 2018, especially if public policies do not address rising demand pressure on prices. The main reflationary risk is linked to labor shortages and fast wage growth.

… with the reaction likely to be non-linear as unemployment falls further

Phillips curves are alive and well in EU-CEE, with core inflation 10 higher where labor-market conditions are tighter. Moreover, core inflation is increasing where worker shortages are rising and Phillips curves are steep, especially in the Czech Republic and Hungary (chart 9). With unemployment expected to fall further, higher core inflation is likely to keep inflation close to or above target in EU-CEE once the impact of volatile prices (mainly fuels and food) subsides in 2H18. If oil prices remain close to USD 60/bbl and next year’s harvest is not a weak one, core inflation may end 2018 above headline inflation throughout EU-CEE.

Supply-side shocks to inflation will remain significant…

While baseline scenarios show inflation safely inside target ranges – the exception being Romania – the risk of steeper Phillips curves is not priced in currently. Chart 10 shows the impact of 5%, 10% and 20% declines in unemployment on core inflation. The impact is computed using polynomials of order three fitted on the Phillips curves for each country for the period January 2015 – October 2017. The strongest reaction is registered in Hungary, where unemployment is at an all-times low (and at the lowest level in EU-CEE). In Romania, the Phillips curve may less steep than data imply due to base effects leading to a sharp rise in inflation in 2H17. In addition to higher core prices, we see three sources of inflationary risks: 1. Higher commodity prices. While the risk of volatile price shocks has subsided, higher oil and/or food prices may push inflation above target in all EU-CEE countries. 2. Higher non-food inflation in the eurozone. Robust domestic demand in the monetary area may bridge the gap between eurozone price changes adjusted for currency moves and imported inflation in EU-CEE, which was lowered in the past three years by large discounts to transfer prices. Absent such discounts, the impact of strong domestic demand in EU-CEE on non-food prices may increase. A flat or downward trending EUR-USD would pose a related risk to our baseline scenario for EU-CEE inflation. 3. Higher food prices after a poor harvest. Food-price inflation accelerated in 2H17 and may continue to do so in 1H18, until the new harvest.

… especially in Russia and Turkey

This year, supply-side shocks could play an outsized role in driving inflation in Russia and Turkey. For the former, expected reflation may rely more on volatile prices than on much higher core inflation. A rise in food prices would accelerate reflation in the summer of 2018. In addition, the currency is unlikely to support disinflation as it did in 2017. Higher oil prices have allowed the RUB to remain overvalued in 2017, reducing the sensitivity of inflation to FX fluctuations compared to 2016. In 2018, the scope for a further decline in the FX pass-through is much smaller. In Turkey, headline inflation could fall in 1H18, helped by base effects from a higher FX pass-through in 1H17. This scenario assumes a stable currency. The scope for disinflation is limited by high core inflation. The highest inflationary risk stems from public policies: renewed fiscal and monetary stimulus could put pressure on the currency and on core inflation, leading to another episode of rising inflation in the second half of this year.

10

We are using a comparable measure of core inflation computed by Eurostat – HICP inflation excluding volatile prices and tax effects.

UniCredit Research

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TIGHT LABOR MARKET CONDITIONS MAY HAVE A NON-LINEAR IMPACT ON INFLATION Chart 9: Phillips curves are steep…

Chart 10: …leading to a non-linear impact of unemployment on inflation Change in inflation (pp from baseline)

HICP inflation excluding food, energy and tax effects (% yoy)

3.5

Unemployment rate (%, rs) CZ Oct 17

3.0 HU Oct 17

CZ Feb 17

2.5

RO Jun 16

HU Jun 16 1.0

PL Oct 17

PL Jun 16 0.0 0.0

3.0

9.0 7.5

2.0

6.0

HU Oct 15 RO Feb 15

1.5

4.5

1.0

3.0

0.5

1.5

HU Feb 15 PL Feb 17

CZ Feb 15

RO Feb 17

0.5

3.0 2.5

RO Oct 17 1.5

10.5

RO Oct 15

HU Feb 17 2.0

3.5

PL Feb 15 PL Oct 15

CZ Jun 16

6.0 9.0 12.0 Unemployment rate (%)

CZ Oct 15

15.0

0.0

0.0 -5% -10% -20% -5% -10% -20% -5% -10% -20% -5% -10% -20%

18.0

CZ

HU

PL

RO

Source: national statistical offices, Eurostat, UniCredit Research

3. Central bank reaction: the proactive, the reactive and the laggards Differentiation in central bank reactions stems from…

…differentiation in capital flows,…

…different attitudes to monetary policy in the eurozone and the US,…

In 2018, reflation could be a theme in all countries but Turkey. However, CEE central banks are likely to react differently to higher inflation pressure. This differentiation has several causes: 1. Differentiated support from capital flows. Sizeable stable capital inflows 11 in all EU-CEE countries but Romania may allow central banks to be more dovish than economic conditions would require. Similarly, capital flows have improved in Russia, owing to higher oil prices and to sanctions limiting capital flight. In contrast, the National Banks of Romania (NBR) and Serbia (NBS) and the Central Bank of the Republic of Turkey (CBRT) cannot afford similar lax monetary conditions due to sizeable current account deficits and the reliance on foreign funding. 2. Different attitudes towards central bank measures in the eurozone and the US. EU-CEE central banks may struggle to be truly independent from the actions of the ECB due to economic and financial integration with the eurozone, as well as the role of import prices in driving inflation. At the same time, a gradual shift in financial investors from the US to the eurozone leaves EU-CEE central banks less vulnerable to the Fed’s ongoing tightening cycle. This is not the case in Serbia and Turkey, where the need for foreign capital inflows make central banks more sensitive to moves in core rates.

…potential impact of supply-side shocks…

3. Different views on the impact of potential supply-side shocks. At one extreme, the National Bank of Hungary (NBH) seems to be quite certain that inflation cannot leave the 2-4% target range even if commodity or food prices continue to rise. At the other end, the Central Bank of Russia (CBR) seems almost certain that supply-side shocks will make its task more difficult in 2018. Somewhere in between, the CBRT seems to underestimate permanently the risk of currency depreciation and the size of the FX pass-through.

…and of tighter labor market conditions

4. Different attitudes towards the tightening of labor market conditions. With the exception of the Czech National Bank (CNB), other EU-CEE central banks seem to ignore the possibility of a steeper Phillips curve and risk falling too far behind the curve. The end result would be too sharp tightening if inflation threatens to exit the target range.

11

The so-called extended basic balance (EBB), which comprises the current account (C/A), foreign direct investment (FDI) and EU funds.

UniCredit Research

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We divide central banks into three categories according to their current stance and their potential reaction to shocks: Proactive central banks: the CNB and the CBR

1. The proactive central banks. We include here two of the most successful central banks in the region, namely the CNB and the Central Bank of Russia (CBR). The former remains the most credible central bank in the region 12. Its decision to increase interest rates was prompted by core inflation exceeding the target under the pressure of the tightest labor market conditions in CEE. We expect the CNB to increase the policy rate by 100bp to 1.50% by the end of this year and by an additional 50bp in 2019. 2. The CBR may continue its cautious easing cycle, but it stands ready to pause cutting rates if the anchoring of inflation expectations does not continue. We highlight two risks that may delay rate cuts: a new round of US sanctions before the end of February and a rise in inflation above the 4% target. The first risk may delay rate cuts temporarily and only if Russian financial asset prices come under pressure. However, if the currency depreciates strongly due to additional sanctions, the Ministry of Finance may play a bigger stabilizing role than the CBR by reducing temporarily its FX purchases. However, Russian authorities are unlikely to rush into defending the RUB, since the currency is slightly overvalued at the beginning of 2018. In the absence of further RUB appreciation, inflation may return this year to the 4% target, exceeding it if food price inflation accelerates. We believe that oil prices close to USD 60/bbl, weak domestic demand and a low, albeit positive, output gap will be sufficient to keep inflation close to target in the medium term, allowing the CBR to cut the key rate to 6% before the end of 2019.

Reactive central banks: the NBH, the NBP and the NBS

The laggards: the CBRT and the NBR

12 13

3. The reactive central banks. The National Banks of Hungary (NBH) and Poland (NBP) may afford to postpone rate increases based on three important assumptions: low inflation in the eurozone, a dovish ECB and large extended basic balance surpluses at home. All three conditions are likely to hold in 2018. However, a further rise in core inflation above the headline rate could threaten the credibility of these central banks. While we expect the NBP to increase rates in 2019 by 75bp, the NBH is likely to remain dovish, its dual policy of preserving low short-term interest rates via FX swaps and flattening the curve via IRS increasing the risk of a costly exit, either for the NBH or for commercial banks. The National Bank of Serbia (NBS) may be added to this group. Poor growth and a potential dip in inflation if regulated prices are not raised leave room for additional cuts to 3.0%. There are two factors that may prevent further easing: a dip in risk appetite that may affect the financing of the C/A deficit and the needed depreciation of the RSD, prevented in 2017 by strong demand for FX-indexed loans. 4. The laggards. The CEE central banks that should have tightened more already are the Central Bank of the Republic of Turkey (CBRT) and the National Bank of Romania (NBR). Both forecast inflation outside the target range in 2018 13. Neither can afford to remain too dovish due to the lack of external support to their currencies. The TRY and the RON remain the weakest currencies in the region but the latter is cushioned by sizeable FX reserves that allow the NBR to intervene when FX volatility increases too much. At the same time, inflation momentum probably favors the CBRT, which is hoping that disinflation will alleviate the pressure on the TRY and TRY rates in 1H18. However, the fall in headline inflation may be slowed by occasional bouts of FX volatility (due to the asymmetrical pass-through) and by the highest core inflation on record. Moreover, any attempt to boost domestic demand through credit or fiscal impulses may return inflation to double digits.

Measured by the level and stability of inflation expectations. Temporarily in Romania, for the whole forecast horizon in Turkey.

UniCredit Research

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4. Populism as an economic risk Populism is entrenched in CEE and will shape social and economic policies in the years to come. For 2018, we highlight three consequences of populism:

Three potential consequences of populism are…

1. A further widening of structural deficits at the peak of the business cycle. With the exception of the Czech Republic, all EU-CEE countries could deviate this year from their medium-term fiscal objectives (MTO), according to the European Commission (chart 11). Using our forecasts, Croatia may fulfill its MTO as well. At the other extreme stand Romania and Hungary, with structural deficits estimated at more than 2% of potential GDP. Moreover, in Romania’s case the widening of structural imbalances is rapid and, absent corrective measures before April 2018, the country could return to the excessive deficit procedure.

…wider structural deficits…

2. Higher risk premia if political risks flare up. The likely European backlash against judicial changes may expand from Poland to Romania and maybe Hungary. Of the three, Romania’s politicians are the likeliest to reverse the decisions and accept the recommendations of European partners. While Hungary and Poland can reciprocally neutralize the risk of suspending voting rights under Article 7 of the Treaty of the EU, Romania may not have a similar option.

…higher risk premia…

3. A weak hand in negotiations for the 2021-27 EU budget, which will start this year. In previous budgeting cycles, EU-CEE managed to negotiate as a single block, preserving its status as the main net recipient of EU funding. This time around, with Poland isolated in the EU and little credibility of Hungarian and Romanian governments, EU-CEE countries may be penalized with a cut in funding. Moreover, disbursements could be conditional on adhering to the rule of law and common European values. No matter how much CEE countries may try to downplay the importance of EU funds, the impact on economic growth could be significant, as shown in chart 12 14.

…and lower EU fund allocations in 2021-27

Since the impact of populism is likely to be lasting and very important, it is discussed separately in the next section of the Quarterly. POPULISM IS A THREAT TO MEDIUM-TERM GROWTH IN CEE Chart 11: Fiscal profligacy at the peak of the business cycle Deviation from fiscal medium term objective, % of GDP

2017

2018

Chart 12: Lower EU funds may affect growth in the next decade Range for the potential growth loss from a 30% cut in structural, investment and rural development funds, pp of potential GDP per year

2019

2.0

0.30

1.0

0.25

0.0

0.20

-1.0

0.15

-2.0

0.10

-3.0

0.05

-4.0

0.00 RO

HU

EE

LT

PL

SK

LV

BG

SI

HR

CZ

SI

CZ

RO

PL

BG

HU

SK

HR

Source: European Commission Autumn projection 2017, national statistical offices, UniCredit Research

14

The impact is computed using production functions estimated by UniCredit Research. We assume two different paths for the capital stock, one in which EU funds are those from the 2014-20 EU budget allocation and one in which the allocation is 30% lower. The range is given by different absorption rates based on historical absorption from the 2007-13 EU budget.

UniCredit Research

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The lure of the fringes: populism in CEE What we obtain too cheap, we esteem too lightly. Thomas Paine Dan Bucşa, Chief CEE Economist (UniCredit Bank, London) +44 207 826-7954 [email protected]

■ ■ ■ ■ ■ ■

Populism has many forms…

…but can be defined by three features

Populism is a global phenomenon…

…that survived the fall of communist regimes in CEE…

…weakened temporarily during the 2000’s boom…

…but became widespread after the global financial crisis

15

Populism is entrenched in CEE and blurs the lines between political left and right Populism has had a wider appeal among CEE parties after the global financial crisis We identify four types of populist parties, more than 50 being represented in CEE parliaments The most successful populist parties managed to improve living standards, their track record being much more impressive than that of their political predecessors and competitors From a political point of view, the main negative consequences of populism in CEE are the weakening of democratic institutions, the rise in nationalism and the weakening of the European project From an economic point of view, the main negative consequences are unsustainable public policies, suboptimal resource allocation, the worsening of human capital quality and lower potential growth in the medium term

Encyclopedia Britannica defines populism as a “political program or movement that champions the common person, usually by favourable contrast with an elite”. To appeal to the masses, populist movements often blur the lines between the political left and right and are usually run from the fringes (Jan Werner Müller, 2016). Luigi Guiso et al (2017) argue that the potential identification of populist parties often depends on the “relative entry space” on the political spectrum. Daron Acemoglu et al (2013) consider that populist politicians define themselves in antithesis to the dominating ideology among the country’s politicians. Ivan Krastev (2014) sees democratic regimes moving to a “democracy of rejection” that pits people against elites, rather than the left against the right. Populism can be economic or political or a combination of both. According to Luigi Guiso et al (2017), populist movements have three common features, namely the anti-elite rhetoric, short-term protectionism and the disregard for long-term consequences (or the concealment of future costs). Short-term protectionism is not confined only to economics, justifying nationalism, “illiberal democracy” 15 or a combination of both. From the US to Japan and from Russia to South Africa, populism is a global phenomenon, affecting both developed and emerging countries. Populism is not a new feature in CEE. Lacking an economic narrative, communist regimes retorted to economic short-termism and turned more nationalistic to appeal to the populace. The demise of communist regimes left a fertile ground for demagogues and nationalists ready to exploit the doubts and the impatience surrounding the development of democratic institutions. Moreover, the direct inheritors of former communist parties often ruled CEE countries at the start of their transitions with a populist agenda and a low appetite for reforms. The appeal of populist parties declined as democracies solidified and living standards improved. EU accession and fast growth up to 2008 confined most populists to the fringes of the political spectrum. However, the deep recession that followed the global financial crisis brought about a recrudescence in populism, with a wider reach than before. Thus, mainstream parties adopted populist causes, be it economic (social protection and rapid revenue growth) or political (opposition to immigration, nationalism). Few large CEE parties escaped the populist virus, while some decided to spread the disease themselves.

Coined by Fareed Zakaria in 1997, the term was publicly adopted by Hungarian Prime Minister Viktor Orban in 2014.

UniCredit Research

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Populism: a taxonomy Four main strands of populist parties

Protest parties include anti-system parties…

Rather than split populists into the left/right divide, we prefer using the features of economic and political populism mentioned above to identify four main strands of populism in Central Europe: 1. The protest parties define themselves in antithesis to traditional parties and promise to overhaul the political process. Sometimes, such parties have a nationalist agenda 16. Many times, though, they run on an anti-system platform and the message varies more due to the leader’s charisma (whose name they often carry) than to ideology 17. Protest parties can rely in most countries on a steady electorate of approximately 10% but their appeal is fleeting and such parties often disintegrate during their first parliamentary term. Protest parties rarely manage to win elections, notable exceptions being the National Movement Simeon II in Bulgaria in 2001 and the ANO of Andrej Babis, the designated prime minister of Czech Republic, in 2017. Nationalism was not a main theme for either party. The current Czech parliament is notable because three of the four largest party, ANO, the Pirate Party and Freedom and Direct Democracy started as protest parties.

…far-left parties…

Far-left parties, often heirs of former ruling communist parties, can be introduced in this category as they define themselves in antithesis with current political parties. They promise a return to a communist utopia that never actually existed in CEE. The Russian Communist Party is the largest such party.

…and some single-issue parties

On the right and the left, some single-issue parties defending the pensioners’ rights, opposing civil rights such as abortion and gay marriage or advocating more independence for ethnic minorities can be included among protest parties.

Few nationalist parties are represented in parliament…

…but nationalist and xenophobic messages spread after the migrant wave to Europe

2. The nationalist parties are usually considered far-right but some of them advocate heavy state interventionism in the economy that chimes more with the far left. In a region where borders were often redrawn, nationalist parties usually add a revisionist agenda to their program, which limits their appeal among likeminded parties in the region. The strongest such party in CEE is Jobbik, the second-largest party in the Hungarian parliament. Other examples are Attack in Bulgaria, the banned Workers Party of Social Justice in the Czech Republic, United Romania Party, Kotleba – People’s Party Our Slovakia, the National Movement Party (MHP) in Turkey, Svoboda in Ukraine, the Serbian Radical Party as well as an array of small nationalist parties that formed in the aftermath of conflicts in the former Yugoslavia. Jobbik, Attack (as a member of the alliance United Patriots), Kotleba, MHP and the Serbian Radical Party are represented in parliament but most extremist parties have a narrow reach and often need to move towards the center to boost their popularity. However, nationalist and xenophobic messages are not confined to extremist parties and this has been more evident since the refugee waves that hit Europe after the Arab spring upheavals, culminating in the Syrian civil war. Most EU-CEE governments spoke out against refugee quotas and in favor of keeping Europe “Islam-free”, to quote Slovak PM Robert Fico. The only slight reversal in nationalist rhetoric is in ex-Yugoslavia, where EU accession forced the largest parties to become more moderate. This is valid for HDZ, the senior ruling party in Croatia, and for the Serbian Progressive Party (SNS), the largest party in Serbia. However, both parties retain populist agendas that survived fiscal adjustments required after the global financial crisis.

16

Examples of protest parties with nationalist agendas are the Liberal Democratic Party of Russia founded in 1989, Attack, present in the Bulgarian parliament since 2005 and the Great Romania Party (PRM) that was a mainstay of Romanian politics for two decades after the fall of communism.

17

Examples of such parties are those of Simeon II in Bulgaria, Tomio Okamura in the Czech Republic, Janusz Korwin Mikke and Janusz Palikot in Poland and Dan Diaconescu in Romania. While the now defunct National Movement Simeon II had a moderate, centrist platform, the others found themselves on the fringes of local and European politics.

UniCredit Research

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Ukraine is an atypical case. Due to the annexation of Crimea and the frozen conflict in the Donbass, the political spectrum is polarized. Most parties either pursue a nationalist agenda (often with the desire to return Ukraine to its pre-2014 borders) or closer ties with Russia (as in the case of The Opposition Bloc and Revival, two parties originating in the former Party of the Regions). Moreover, economic populism pervades most party programs due to the deep 2014-15 recession.

Big tent centrist have flexible ideologies…

…and monopolize several popular messages

3. The big-tent centrists. Parties like United Russia and the Serbian Progressive Party claim no strong left or right affiliation. The mantle of centrism gives these parties the flexibility to use cautious fiscal policies in time of stress and resume populist spending before elections. They also tend to monopolize messages with popular appeal, such as the need for a strong state – which supersedes the democratic separation of powers – and for protecting the poor. Thus, such parties use the economic insecurity of low-earners or rural dwellers to their advantage. Worse-off voters prefer stability instead of costly structural reforms and incompetent leaders who are unlikely to betray their expectations (Rafael Di Tella and Julio J. Rotemberg, 2016). Protest parties often turn into big-tent centrists when their appeal increases, as in the case of the National Movement Simeon II and the ANO.

Born-again populists found new impetus after the global financial crisis…

…have a divisive discourse…

…and cater to voter disenfranchisement

18

4. The born-again populists or mainstream-turned-populist parties have been a postfinancial crisis phenomenon. Banking at first on unpopular austerity programs, born-again populists found new impetus amid a widening gap in living standards between urban, industrialized areas in CEE and unproductive rural and mining regions. Fidesz in Hungary and the Social Democrat Party (PSD) in Romania returned to power after the Great Recession amid high unemployment, forced deleveraging, revenue cuts and austerity programs needed to reduce macroeconomic imbalances. The Law and Justice (PiS) managed to gain the first single-party majority in Poland’s post-communist history by addressing those left behind by globalization in a country that avoided recession in 2008-09. A special case is that of the Justice and Development Party (AKP) in Turkey, whose agenda of reform and moderate Islamism from the 2000s morphed into a populist program combined with a gradual crackdown on civil liberties. The AKP, the longest ruling Islamist party in the world, turned to populism to offset declining potential growth after successive governments neglected structural reforms. Nationalist messages intensified in parallel with the country’s isolation in the region and inside NATO. Being a mainstay of local politics, born-again populists cannot blame political elites for the country’s woes. Instead, they accuse outside forces – countries, organizations, multinational companies, individuals or a “parallel state” – of wanting to destabilize their countries or leaderships. In Jan Werner Müller’s words 18, “[the populists’] real business is division”. The divisive discourse helps born-again populists address different voter groups that, in normal circumstances, would have different priorities. One reason why mainstream parties may adopt populist messages is voter disenfranchisement. Luigi Guiso et al (2017) show that populism is stronger where voter turnout is lower, often because people feel disillusioned with the mainstream parties’ policies. Shifting the voters’ attention away from economic issues may be a good strategy when parties fail to deliver on their promises.

Jan Werner Müller (2016).

UniCredit Research

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Table 1 shows a list of CEE populist parties currently in parliament or part of parliamentary alliances, compiled from the research of Stijn van Kessel (2015) 19 and Ronald F Inglehart and Pippa Norris (2016) 20, updated with the changes in parliamentary representation and party structure between 2014 and 2017. TABLE 1: POPULIST PARTIES IN CEE (CURRENTLY IN PARLIAMENT OR PART OF PARLIAMENTARY ALLIANCES) Percent of MPs in Type of 21 22 parliament populism

In government (Y/N)

van Inglehart & Kessel Norris

Country

Party

BG

Bulgarian Socialist Party (BSP)

4

33.3

N

-

-

Movement of Rights and Feedoms (DPS, Turkish minority)

1

10.4

N

-

-

Volya

CZ

HR

1

5.0

N

-

-

Bulgarian National Movement (VMRO, part of United Patriots)

1,2

4.6

Y

0

1

National Front for the Salvation of Bulgaria (NFSB, part of UP)

1,2

3.8

Y

0

1

Attack (part of United Patriots)

1,2

2.9

Y

1

1

Average European Class (part of United Patriots)

2

0.0

Y

-

-

Union of the Patriotic Forces “Defense” (part of United Patriots)

2

0.0

Y

-

-

ANO

3

39.0

1

0

Pirates

1

11.0

-

-

Freedom and Direct Democracy – Tomio Okamura (from Usvit)

1

11.0

1

1

Croatian Democratic Union (HDZ)

3

40.4

Y

0

1

Croatian Peasant Party (HSS)

3

3.3

N

0

1 1

Croatian Democratic Alliance of Slavonia and Baranja (HDSSB)

HU PL

RO

RU

1,2

0.7

N

0

Croatian Growth (HRAST)

2

0.7

N

-

-

Croatian Party of Rights (HSP-AS)

2

0.0

N

1

1

FIDESZ-KDNP

4

66.8

Y

1

1

Jobbik, the Movement for a Better Hungary

2

12.1

N

-

-

Law and Justice (PiS)

4

51.5

Y

1

1

Kukiz’15

1

6.5

N

-

-

United Poland (SP)

2

2.0

Y

0

1

Liberty (Janusz Korwin-Mikke)

1

0.2

N

-

-

Right Wing of the Republic (PR)

1

0.2

Y

-

-

Social Democratic Party (PSD)

4

47.5

Y

-

-

Democratic Alliance of Hungarians in Romania (UDMR)

1

6.5

Y

-

1

Alliance of Liberals and Democrats (ALDE)

3

4.9

Y

1

United Russia

3

75.6

Y

-

-

Communist Party of the Russian Federation (CPRF)

1

9.3

N

-

-

Liberal Democratic Party of Russia A Just Russia (SR)

1,2

8.9

N

-

-

3

5.1

N

-

-

Next legislative election 2021

2020

2020

2018 2019

2020

2021

Continued on next page

19

Stijn van Kessel (2015) identifies a list of populist parties in Europe. The criteria he uses are 1. the appeal to the virtue and homogeneity of the people; 2. the support for popular or direct rule over government by the elites; 3. the anti-system stance of the party. 1 signifies the party is identified as populist. 0 means that the party is not identified as populist. – means the party (or the country for Serbia, Russia and Ukraine) was not included in the analysis.

20

Ronald F Inglehart and Pippa Norris (2016) identify a list of populist parties in Europe based on the 2014 Chapel Hill Expert Survey (CHES) that uses national experts to rate parties on issues, policies and positions. Ronald F Inglehart and Pippa Norris (2016) consider parties as being populist if they score more than 80 points out of 100 on a standardised scale that uses thirteen factors surveyed by CHES. The coding is similar as for van Kessel.

21 22

According to the taxonomy presented above, 1 denotes protest parties, 2 nationalist parties, 3 big-tent centrists and 4 born-again populists. Single chamber or lower chamber of parliament everywhere with the exception of Romania, where both the Chamber of Deputies and the Senate are included.

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Percent of MPs in Type of 23 24 parliament populism

In government (Y/N)

van Inglehart & Kessel Norris

Country

Party

RS

Serbian Progressive Party (SNS)

3

42.0

Y

-

-

Serbian Radical Party (SRS)

2

8.8

N

-

-

Socialist Party of Serbia (SPS)

2

8.0

Y

-

-

Social Democratic Party of Serbia (SDPS)

3

4.0

Y

-

-

Party of United Pensioners of Serbia (PUPS)

1

3.6

Y

-

-

Dveri

1,2

2.8

N

-

-

United Serbia (JS)

1,2

2.4

N

-

-

Movement of Socialists (PS)

SI

SK

TR UA

1,2

1.2

Y

-

-

Strength of Serbia Movement - BK (PSS-BK)

1

0.8

Y

-

-

Bosniak Democratic Union of Sandžak

2

0.8

N

-

-

Party of Democratic Action of Sandžak

2

0.8

N

-

-

Serbian People's Party

1

0.4

Y

-

-

New Serbia (NS)

1

0.4

Y

-

-

Party for Democratic Action (Albanian minority)

2

0.4

N

-

-

Slovenian Democratic Party (SDS)

3

21.1

N

0

1

Democratic Party of Pensioners of Slovenia (DeSUS)

1

11.1

Y

-

-

The Left

1

5.6

N

-

-

Direction – Social Democracy (Smer-SD)

3

32.7

Y

1

0

Ordinary People and Independent Personalities (OL’aNO)

3

12.7

N

1

0

Slovak National Party (SNS)

2

10.0

N

1

1

People’s Party – Our Slovakia (L’SNS)

2

9.3

N

-

-

We Are Family

2

7.3

N

-

-

Justice and Development Party (AKP)

4

57.5

Y

-

-

National Movement Party (MHP)

2

6.5

N

-

1

Petro Poroshenko Bloc "Solidarity" (BPPS)

3

31.8

Y

-

-

People's Front (NF)

3

18.0

Y

-

-

Opposition Bloc (OB)

1

9.8

N

-

-

Self Help

1

5.8

N

-

-

Revival

1

5.1

N

-

-

Radical Party of Oleh Liashko (RPOL) All-Ukrainian Union (Batkivshchyna) People's Will (VN)

1,2

4.4

N

-

-

3

4.4

N

-

-

1,2

4.0

N

-

-

Next legislative election 2020

2019

2020

2019 2019

Source: national parliaments, party programs, Luigi Guiso et al (2017), UniCredit Research

All CEE countries are affected by populism

There is no CEE country currently unaffected by populism, but the political endurance of populists varies greatly. President Vladimir Putin’s United Russia has been in power since 2000. Recep Tayyip Erdogan’s AKP has been ruling Turkey for more than 15 years and may tighten its grip on power in 2019 elections with the move to a presidential regime. Viktor Orban’s Fidesz has been governing Hungary for two election cycles in a row and is likely to win a third consecutive mandate this year. The party’s message is overtly populist and nationalist in a country still scarred by the memory of shock therapy in the 90s and the dismantling of Greater Hungary after World War One. Other parties like the ANO or the Kotleba contested elections only once or twice.

The most successful populists have a good track record in improving living standards

Judging by the weak staying power of most populists in CEE, it takes more than a populist message to perform well in consecutive elections. As Peter Pomerantsev (2017) noted, a divisive message preaching opposing measures may work in elections but not when in power. Mr. Putin, Mr. Erdogan and Mr. Orban have a good track record of improving living standards. While this was achieved with help from soaring commodity prices (Russia) and abundant foreign capital inflows (Turkey), the performance stands out against previous governments.

23 24

According to the taxonomy presented above, 1 denotes protest parties, 2 nationalist parties, 3 big-tent centrists and 4 born-again populists. Single chamber or lower chamber of parliament everywhere with the exception of Romania, where both the Chamber of Deputies and the Senate are included.

UniCredit Research

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Russia’s stabilization under Mr. Putin, Turkey’s immergence from crisis at the beginning of the millennium (with help from international financial institutions) and Hungary’s impressive recovery in the aftermath of the global financial crisis helped the three leaders remain popular and gradually cement their power. But good economic stories were not the only means to repeated election success.

Hollowing out democracy with popular consent Populists often resort to controlling the media and the judicial system

An important means to hold on to power is control over the media and the judicial system. According to Reporters without borders, Russia and Turkey rank worst in CEE in terms of press freedom, while Bulgaria and Hungary saw the biggest decline in press freedom between 2003 and 2017 (chart 1). With the exception of Romania, press freedom fell everywhere in CEE since 2008. Turkey and Russia rank worst in CEE in terms of judicial independence, according to the 2016 Rule of Law Index compiled by the World Justice Project. The World Bank shows that the rule of law has improved in very few CEE countries after the global financial crisis. Moreover, the data stop in 2015, missing the crackdowns on judicial independence in Poland (2016-17), Romania (2017) and Turkey (2016-17). The governments and parliaments of Poland and Romania are actively trying to curb judicial independence as governing parties look to cement their legacy. Mr. Erdogan used a failed coup in July 2016 to accelerate the curbing of judicial independence and the purge of judges and prosecutors disliked by the AKP. So far, local opposition to the attack on judicial independence has been too weak to stop the process. Moreover, a significant part of the population supports these parties and their policies, especially their nationalist, anti-immigration stance. However, migration and globalization (both fostering xenophobia in the West 25) did not have the same negative impact in CEE. To start with, there are no obvious reasons for the anti-immigration stance in CEE. Immigration is limited, with the notable exceptions of Russia (mainly from central Asia and the Caucasus), Turkey (harboring 3.3-3.6 million Syrians) and Poland (accepting approximately one million Ukrainian workers). In addition, all CEE countries became ethnically more homogenous after the Second World War through ethnic cleansing and population swaps.

Nationalism may have historical roots in CEE…

…and could be used as an easy communication vehicle by populists

CEE is one of the big winners of globalization…

25

Branko Milanovic (2017) believes that there are two historical reasons for nationalism and the opposition to immigration in CEE. First, the history of EU-CEE and the Balkans consists of centuries of “struggles for national and religious emancipation”. Second, 1989 revolutions strived for “national emancipation”, not democracy. They were “latest unfolding of centuries-long struggle for freedom“. Thus, nationalism may be one of the defining features of EU-CEE countries and, consequently, immigration may be perceived as affecting ethnic homogeneity. At the same time, nationalism may be an easy vehicle for the divisive message preferred by populists that plays on tvoters’ insecurity and discontent. Guiso et all (2017) find statistical evidence that “[p]opulism does not have a cultural cause, but rather an economic insecurity cause, with an important and traceable cultural channel”. Besides being little affected by immigration, CEE has been one of the big winners of globalization. Dani Rodrik (2017) points out that, under the Stolper-Samuelson theorem, low-skilled workers in Western Europe and the US were the big losers from the removal of trade barriers. That said, some of the biggest winners were in CEE. However, higher-skilled workers in tradable sectors in EU-CEE were far better off than those in agriculture and mining. The change in income distribution to benefit higher-skilled workers was also a correction of a communist legacy.

Marco Tabellini (2018)

UniCredit Research

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The communists’ emphasis on manual labor, heavy industry and agriculture was reflected in wages, with relative pay favoring low-skilled workers over high-skilled ones compared to market economies. After communism fell, EU-CEE countries failed to reform their agriculture sectors, condemning people in the countryside to inactivity, underemployment or low-paying jobs. The growing inequality and memories of much higher purchasing power during communism for low-skilled employees were exploited by born-again populists, despite their share of the blame for the lack of structural reforms.

…but low-skilled workers have seen their living standards drop compared with high-skilled workers

It is unlikely that populism will lose its appeal in CEE before the end of the decade, despite a further improvement in living standards. In fact, the approval ratings of populists who are in power improve in line with better economic conditions. Moreover, the populism’s staying power is fostered by supportive media and its main themes (social security, nationalism, people versus elites) are now some of the most important issues for voters throughout the region.

Populism is unlikely to weaken in CEE before the end of the decade

PRESS FREEDOM ARE IS FALLING IN CEE. THE RULE OF LAW IS NOT IMPROVING Chart 1: The freedom of the press declined since 2008

Chart 2: The rule of law improved in few CEE countries since 2008

Change 2008-17 (+ = improvement) Change 2003-08 (+ = improvement) Rank in 2017 (out of 180 countries)

Freedom of the press

160

Change 2003-08 (positions, + = improvement) Change 2008-15 (positions, + = improvement) Rank in 2015 (out of 192 countries)

Rule of law 160

120

120

80

80

40

40

0

0

-40

-40

-80

-80 SK

CZ

SI

RO

PL

RS

HU

HR

UA

BG

RU

TR

CZ

SI

PL

SK

HU

HR

RO

TR

RS

BG

RU

UA

Source: Reporters without borders, World Bank, UniCredit Research

Economic populism: choking up the future Some populist regimes have a very good economic track record…

…but medium term risks are significant

Populists win voters over via “mass clientelism”

UniCredit Research

Some populist governments have had a very good economic track record that may explain their staying power. The AKP in the 2000s, Fidesz since 2011 and PiS more recently managed to generate growth while avoiding large macroeconomic imbalances. Although in Turkey many of the achievements have been reversed this decade, the economies of Hungary and Poland are going from strength to strength. Above-potential growth is combined with large trade surpluses, better tax collection, improved infrastructure – helped by EU fund inflows – and higher labor participation. Inflation remains inside target ranges and financing costs for both the private and the public sectors are close to all-time lows. From an economic point of view, the case for investment in these countries – be it FDI or portfolio investment – remains strong in the coming years. However, the rosy picture hides medium-term risks that may become apparent especially if economic growth slows in the next decade. In our opinion, the most important consequences of populism are: 1. The rise in government spending on social security and wages. Dubbed “mass clientelism” by Jan Werner Müller, wide-reaching social security outlays are used to appease voters’ opposition to corruption and the rise of a patrimonial state.

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CEE Quarterly

As shown in chart 3, the post-crisis adjustment in the structure of public spending is being reversed quickly, with the share of wages and social security spending rising across CEE. Only Hungary and Serbia register a decline compared to 2008, when they were the highest in the region. More importantly, the rise in social security and wage spending happened while economies were booming. The subsequent widening in structural deficits is likely to continue in 2018-19 in most countries 26. However, only in Romania is the budget deficit at risk of exceeding 3% of GDP this year and next. There are positive examples as well. The senior ruling party in Bulgaria, GERB, is running one of the tightest fiscal policies in the EU without jeopardizing growth. While the party is not immune to populist measures, and the structural budget deficit is higher than the country’s MTO, fiscal policy will remain a confidence anchor for foreign investors. In the western Balkans, the need to reduce public debt forced the HDZ in Croatia and the SPS in Serbia to implement reforms and restrain the rise in wages and pensions. However, both are likely to turn more populist in 2018-19 as the scope for fiscal spending increases. 2. Labor costs are outpacing productivity, especially in the state sector and for those earning minimum wages. The fast increase in public-sector and minimum wages ate into post-crisis productivity gains at a time when labor market conditions are already tight (chart 4). Governments justify fast wage growth with the share of wages in GDP being below 2008 levels, but this is not the case in the Czech Republic, Slovakia or Bulgaria.

Labor costs are outpacing productivity

3. Low or inefficient investment. The crowding out of public investment is evident in countries that focused on populist measures. Romania and Poland stand out. For the former, public investment is expected to plunge further to all-time lows in 2018-19. Large social security outlays reduced the appetite for multi-annual budgeting and the number of large infrastructure projects fell in EU-CEE. Where countries managed to supplement shrinking public resources with EU funds, the efficiency of allocation declined and, with it, the impact on economic growth. The most important examples are Hungary – with its centralized absorption system – and Poland – with its reliance on small projects started by local authorities. Where infrastructure works are badly needed (Bulgaria, Romania, Slovakia, Serbia), governments are struggling with implementing measures needed to speed up investment (land purchases, tenders, PPP legislation etc.).

Public investment is crowded out by social spending

POPULISM IS AFFECTING PUBLIC SPENDING AND COMPETITIVENESS Chart 3: Social security and wage spending is rising in CEE Govt. spending on wages and social security, % of non-interest public expenditure

2003

2008

Chart 4: Unit-labor costs are rising in CEE 2014 vs 2009

Increase in EUR ULC (%; annual average)

2016

80

6

70

5

2017 vs 2014

4

60

3

50

2 40 1 30

0

20

-1

10

-2 -3

0 TR

HU

RO

RU

HR

CZ

RS

BG

SI

PL

SK

PL

HU

RU

BG

HR

SI

CZ

RO

SK

Source: Eurostat, UniCredit Research

26

Chart 11 on page 12 shows that most EU-CEE countries are missing their medium-term fiscal objectives (MTO) at the moment.

UniCredit Research

page 20


January 2018

January 2018


CEE Quarterly

Risk premia for financial asset prices are rising due to political risk

The quality of human capital is falling

CEE populists are weakening the EU…

1. Higher risk premia attached to CEE financial asset prices due to political noise. The spreads between Polish and German bond yields widened after PiS started implementing controversial measures and never recovered. The same is valid for Romania and Turkey, whose risk premia on EUR and USD bonds widened last year amid controversial measures. 2. The low importance of human capital. One of the most glaring features of CEE economies is the gradual decline in labor quality as the quality of education falls (chart 5). While the deterioration seems to have stopped in some countries, it is obvious that education systems fail to provide the skills required in manufacturing and services, especially in EU-CEE. The populists’ base consists mostly of less educated and elderly people and for both categories education is not a priority. Poor education ensures that most of the populists’ electorate remains captive. In addition, the quality of healthcare is poor in most countries due to inefficient spending and large-scale emigration of doctors and nurses. No EU-CEE country managed to comprehensively reform its healthcare system. 3. The weakening of the EU. Populism and nationalism are eroding the commitment of EU-CEE countries to the European project. The approval ratings of the EU are falling under the assault of government-friendly media throughout CEE, despite the obvious benefits of EU membership (chart 6). The exceptions are Croatia (the latest joiner) and, to some extent, Hungary, despite the government running several anti-EU media campaigns. Most populists see the negative reactions of European institutions to fiscal and political populism as an infringement of national sovereignty. In other words, to many EU-CEE populists, the EU is a union of rights but not of obligations. The fractures became more apparent in 2017, when Hungary and the Czech Republic vowed to oppose stripping Poland of its voting rights in the European Council under Article 7 of the Treaty of the EU. It remains to be seen whether a potential triggering of Article 7 against Romania in 2018 would be similarly opposed by its neighbors since the EU-CEE block is far from being a solid one. Longer term, turning against the EU may backfire due to CEE’s economic and financial dependence on the EU. A cluster of small, open economies, CEE continues to benefit from access to the largest consumer market in the world and to EU funds. 4. The breaking of the EU-CEE block. While Hungarian Foreign Affairs and Trade Minister Péter Szijjártó calls the Visegrad Four 27 “the most solid entity in the EU”, it is clear that CEE-EU countries are pursuing different agendas. On the one hand, some countries remain aligned with the eurozone, either because they are members (the Baltics, Slovakia, Slovenia) or they wish to join (Bulgaria, Croatia, Romania). Poland, once the informal leader of EU-CEE, has isolated itself inside the EU under the PiS government but remains a committed NATO member. Poland has no obvious allies outside the EU and protracted isolation would only weaken its bargaining power in the EU. Hungary, the largest net recipient of EU funds (in percent of GDP) is led by the most eurosceptic government in EU-CEE, whose close relations with Russia make most neighbors uncomfortable. That said, Mr. Orban’s government has aligned itself with the EU on sanctions against Russia, probably because economic dependence on the EU comes before ideology.

…and increasing the chances of a cut in EU funds in 2021-27

27

The divisions inside EU-CEE may become apparent once negotiations for the 2021-27 EU budget start this year. The threat of a cut in funding (a 30% reduction has been mentioned by French and German politicians) as well as disbursements conditional on adhering to European values and rule of law may open up rifts between newer EU members. For the 2014-20 budget, EU-CEE acted as a block, its bargaining power enhanced by its vote tally. This time around, such an agreement could be more difficult to achieve and the likely outcome is a significant decline in EU fund disbursements in the next decade.

The Czech Republic, Hungary, Poland and Slovakia.

UniCredit Research

page 21


January 2018

January 2018


CEE Quarterly

The end result may be lower growth in the next decade

The end result may be lower potential growth in the next decade. A combination of lower EU funds, poor labor quality, inefficient or low public investment and increased labor costs is likely to slow potential growth to or below 2% throughout EU-CEE in the next decade. As shown in chart 12 on page 12, a 30% cut in the allocation of structural and investment EU funds would lower potential growth by 0.1-0.6pp per year, with Hungary being the hardest hit. A turn to Chinese financing in exchange for little conditionality is unlikely to offset the aforementioned factors. This would slow convergence to eurozone living standards.

POPULISM IS AFFECTING PUBLIC SPENDING AND COMPETITIVENESS Chart 5: The quality of education is deteriorating

Chart 6: Pro-EU sentiments are weakening in CEE

Change in quality in 2017 vs 2008. Original scores are on a scale from 1 (worst) to 7 (best). A negative number signifies deterioration.

The capacity of education to fulfill the economy's needs

0

SI

Change in views on the EU, May 2017 vs Oct. 2008, pp. A positive number means a higher percent of answers

BG

-0.1

Very negative

Fairly negative

Neutral

Fairly positive

Very positive

30

-0.2 TR

-0.3

PL

-0.4 -0.5

CZ

-0.6 -0.7

20

RU

HU

-0.8 -0.9

10 0

HR

-10

SK

-20

RO

-1 -1.5

-1

-0.5 Quality of primary education

0

-30

0.5

BG

CZ

HR

HU

PL

RO

SI

SK

TR

Source: EU barometer, UniCredit Research

Conclusions Populism is entrenched in CEE and flourished since the global financial crisis. In CEE, populism may be fueled by the widening disparities in living standards between urban and rural or mono-industrial areas, rather than by the fear of immigration or globalization. In fact, CEE governments should try to foster globalization, since its economic benefits have been overwhelming. However, the populists’ short-term focus is undermining the gains made by CEE countries since their transition from communism or, in Turkey’s case, since the deep crisis at the end of last century. The negative effects are both political (a distancing from western allies leaves CEE countries with few alternative alliances) and economic (lower potential growth in the next decade due to poor investment, lower quality of human capital, lower EU funds). Strong economic growth and improving living standards are unlikely to undermine populism that continues to pander to the economic insecurity of the worse-off and to nationalist feelings. However, improving living standards would require structural reforms addressing low labor participation, overemployment in agriculture and mining, the quality of education and healthcare etc. Unfortunately for CEE voters, populists are not the ones who will deliver such reforms.

UniCredit Research

page 22


January 2018

January 2018


CEE Quarterly

References

■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

UniCredit Research

Daron Acemoglu, Georgy Egorov and Konstantin Sonin (2013), “A Political Theory of Populism”, Quarterly Journal of Economics, 771-805. Rafael Di Tella and Julio J. Rotemberg (2016), “Populism and the Return of the ’Paranoid Style’: Some Evidence and a Simple Model of Demand for Incompetence as Insurance Against Elite Betrayal.” Harvard Business School Working Paper, No. 17-056. Luigi Guiso, Helios Herera, Massimo Morelli and Tommaso Sonno (2016), “Demand and supply of populism”, CEPR DP 11871. Ronald F Inglehart and Pippa Norris (2016), “Trump, Brexit, and the Rise of Populism: Economic Have-Nots and Cultural Backlash", Harvard Kennedy School RWP16-026. Ivan Krastev (2014), “Democracy Disrupted. The Politics of Global Protest”, University of Pennsylvania Press Branko Milanovic (2017), Democracy of convenience, not of choice: why is Eastern Europe different, December 2017, http://glineq.blogspot.de/2017/12/democracy-of-conveniencenot-of-choice.html Jan-Werner Müller (2016), „Capitalism in One Family”, December https://www.lrb.co.uk/v38/n23/jan-werner-muller/capitalism-in-one-family

2016,

Peter Pomerantsev (2017), “The Mirage of Populism”, December 2017, https://www.theamerican-interest.com/2017/12/22/the-mirage-of-populism/ Dani Rodrik (2017), “Populism and the Economics of Globalization”, NBER Working Paper No. 23559, July 2017 Marco Tabellini (2018), “Gifts of the Immigrants, Woes of the Natives: Lessons from the Age of Mass Migration”, MIT, http://economics.mit.edu/files/13646 Fareed Zakaria (1997), “The Rise of Illiberal Democracy”, Foreign Affairs, Nov-Dec 1997

page 23


January 2018

January 2018


CEE Quarterly

CEE Strategy: EM performance to continue in 2018 ■

Javier Sánchez, CFA CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077 javier.sanchezbarrueco@ unicredit.eu

■

Most asset classes provided above average returns with low volatility …

We expect 2018 to be a good year for EM bonds as the factors that have driven performance since 2016 remain in place. In CEE external issuance will remain subdued and negative in net terms for many countries and the region as a whole and this will be supportive of Eurobonds. In CEE local currency we expect returns to be attractive as well, particularly in countries with external surpluses which provide a larger degree of protection from global shocks. In 2017 the performance of EM fixed-income was above average and was marked by a remarkable decline in the cross-country dispersion of returns in both USD bonds and local-currency bonds. On an aggregate level the drivers of local currency performance were evenly distributed between carry, capital gains and currency effects but the latter were more important in driving the performance in CEE bonds.

2017 was a remarkable year for risky assets, in particular for EM bonds and stocks, and especially if measured on a risk-adjusted basis. The total return of broad indices of EM stocks was in excess of 30% in USD and were the best performing major asset class as shows in Chart 1 below. Returns were broad-based across countries and asset classes and also the realized volatility in returns and that of macroeconomic variables were at historic lows. The first quarter of 2016 marked the start of a new wave of inflows into the asset class that continued in earnest in 2017 and, for the second consecutive year, EM fixed-income had a strong performance with compounded returns of 10% p.a. for USD sovereign bonds and 13% p.a. for local bonds (in USD equivalent). The two-year annualized performance exceeds that in the recent past which for the period between 2002 and 2016 was of 9% p.a. for USD bonds and 8% p.a. for local currency bonds.

…and this was also the case for EM bonds in local and foreign currency

For local currency bonds, the performance attribution in Chart 2 shows that, on aggregate, carry, capital gains (yield compression) and currency effects were evenly split. The aggregation masks large regional and country trends, with the USD weakness – or to a large extent the EUR strength – providing a strong boost to the performance of CEE local currency bonds and less so in other countries.

Local currencies appreciated against the USD and EUR and the currency component was particularly important for CEE local bonds

Chart 1: EM sovereign debt was among the best performing fixed-income asset classes on a risk-adjusted basis… 35%

Chart 2: …with the USD depreciation against local currencies providing a significant lift to performance EM foreign and local bonds

EM Stocks 28

30% 24

25%

Total Return

US Stocks

20%

performance and attribution (in %)

USD bonds (total) Yield compression (LC bonds)

Carry (LC bonds) FX vs USD (LC bonds)

28

LC

24

bonds

20

20

16

16

US HY

5%

Global bonds

EM Local

12

8

8

4 0

Europe Stocks

4 0 -4

-4

US Tsy 10y 0%

12

FX

EM Sovereign 10%EM Corporate EM Sov Europe

Gold

Carry

15%

Yield

EU HY

CRB

Bunds 10y

-8

USD

-8

bonds

-12

-12

-5% 0%

2%

4%

6%

8%

10%

Index HU PL RO RU TU ZA CH ID

12%

Realised Volatility

CEE countries and SA

IN MY PH BR CL CO MX PE EM Asia

LatAm

All asset classes total return and volatility in USD equivalent except for EU high-yield, Bunds and European stocks which are in EUR. Source: Bloomberg, UniCredit Research

UniCredit Research

page 24


January 2018

January 2018


CEE Quarterly

A combination of benign global and domestic EM factors have been driving EM assets’ returns since 2016…

The following five factors helped in driving performance in 2017: 1. the starting base was positive thanks to the short-lived correction following the US election in November, 2. the USD depreciation gathered momentum and fell by 10% in trade-weighted terms, which helped boost fixed-income returns, 3. the cycles of economic expansion accelerated in both emerging and developed countries, 4. global financial conditions remained accommodative, 5. global investors’ are still rebuilding the allocations to EM which declined in the period between 2013 and 2016 and so foreign positioning in several countries was low and 6. fixed-income valuations are attractive and domestic macro conditions have improved for a large section of EM countries.

…and we think that these will remain in place throughout 2018 auguring positive returns

We think that many of these factors will remain supportive for EM fixed-income investments in 2018. Local currency bond returns tend to show a boom and bust pattern with wide swings in annual returns and positive returns rarely lasting more than two consecutive years. However, we think that the support of past drivers could extend well into 2018 and result in positive returns: 1. the USD remains overvalued in trade-weighted terms probably by 10% 28, 2. activity indicators remain solid with 13/16 of EM PMI indicators that we track in expansion territory. This is also one of the longest periods of expansion in developed countries, particularly in the Eurozone, and as shown in Chart 3 below. Moreover, several EM countries only recently starting a new cycle of expansion, 3. financial conditions may gradually tighten but we are not expecting a sharp increase in core yields which could put the EM rally at risk and expect the 10Y UST to be at 2.75% and 10Y Bunds at 80bp by the end of 2018, 4. allocations to EM bonds are slowly regaining the peak achieved in 2013 and cross-over investors increased allocations in 2017 after a net reduction in 2016 29.

Chart 3: PMI indicators point to broad based expansion in EM and for some CEE countries the longest period within the last 15Y…

Chart 4: …while global financial conditions remain accommodative

Cycles of expansion: number of months

Financial conditions indices

US

Expansion continues into current period

of PMI>50 and start date

70

70

3

60

60

2

50

50

40

40

30

30

20

20

10

10

0

0

EZ

JP

1 0 -1 -2 -3 -4

Jul'05 Oct'09 Jul'13 Mar'03 Nov'09 May'13 Jun'05 Nov'09 Jul'13 Oct'14 Dec'04 Jan'10 Oct'11 Aug'16 May'09 Sep'12 Mar'17 Jul'12 Sep'16 Jul'06 Aug'09 Oct'12 Apr'17 Aug'13 Nov'17 Jun'12 Sep'13 Aug'17 Apr'09 Nov'13 Jan'16 Aug'17

-5

EZ

CZ

PL

RU

TU

ZA

BR

MX

ID

2010

2011

2012

2013

2014

2015

2016

2017

IN

Source: Bloomberg, MarkIT, UniCredit Research

28 29

See “The UniCredit Macro & Markets 2018 Outlook” of 15 November 2017. According to EPFR data the flows into EM of FI funds with Global mandates allocated USD 32bn in 2017 after net outflows of USD 16bn in 2016.

UniCredit Research

page 25


January 2018

January 2018


CEE Quarterly

We think that the volatility in cross-country returns is related to a lower dispersion in macroeconomic outcomes in EM

We think that two aspects of the performance in the past two years stand out: 1. returns were broad-based across countries and asset classes and 2. the realized volatility of returns and macroeconomic variables is at historic lows. We look at a panel of 21 large EM countries and calculate the trends and dispersion 30 over time for the major activity, fiscal and external macroeconomic variables and find the results remarkable. As shown in Chart 5, the dispersion of GDP growth, annual inflation, the current account and fiscal primary balance across EM countries are the lowest in 20 years with a broadly improving trend over time on aggregate. Moreover, according to the IMF forecasts for these variables the dispersion is to decline even further in GDP growth and CPI inflation among others. This may suggest that there is a large degree of synchronization among EM economies or a global factor driving these outcomes, such as the strength in the US and EZ economies, but also that EM countries post the financial crises in 2008 and the drought in inflows in the period between 2013 and 2016 have gone to great strides to adjust. In this context, the subdued cross-country volatility in EM asset returns appears less a surprise. As we show in Chart 6, cross-country annual bond returns are clustered in the narrowest range since 2000 for both USD bonds and local-currency bonds in USD equivalent. A parsimonious explanation could be that the USD weakness drove this narrowing in the spread of returns. However, this is at odds with the dispersion observed in cross-country equity returns which shows as wide a range as at other points in the past. Fiscal and external variables have arguably a larger effect on bond returns than on stocks and therefore we think that the improvements observed in aggregate EM macro variables had a positive effect in reducing the observed cross-country volatility.

Chart 5: The dispersion of key macroeconomic variables in EM is at near all-time lows … 100

Rank (0-100) of cross-country dispersion in macroeconomic variables for a panel of 21 EM countries (12Y range values and 2017)

Chart 6: …and the cross-country returns of EM bonds’ are clustered at high levels and also show low dispersion between countries Cross-country distribution of EM assets' annual returns (in %)

100

in 2000 in 2010

in 2005 in 2017

.12 2017

80

60

60

40

40

20

20

.10

Distribution density

80

.08

2017

.06

.04 2017

.02 0

Rating

Public debt

Prim. Bal

Budget Bal

IIP

C/A

CPI yoy%

GDP yoy%

0

.00 0 20 Annual USD sov. bonds returns of....

40

0

20

40

LC sov. bonds in USD

-40 0 40 EM stocks in USD

Source: Bloomberg, IMF WEO, UniCredit Research

30

In the charts above we use two measures of dispersion: 1. for macroeconomic variables: we measure the dispersion at each annual point between 1990 and 2022 (using IMF WEO forecasts) as the difference between the 85th and 15th percentile of the cross-country distribution using a panel of 21 countries. We rank this dispersion measure between 0 and 100 on the basis of the whole 23 year period analysed and we plot the rank 12Y range and 2017 value in the chart on the left. 2. for EM risk assets: we measure the cross-country distribution of USD annual returns for EM stocks and bonds (denominated in local currency and in USD) using a panel of between 17 and 21 countries for each of the three asset classes. The chart on the right shows the Kernel-density distribution of cross-country returns in 200, 2005, 2010 and 2017. The curves are a stylised representation of the return distribution and show that the cross-country bond returns in 2017 are clustered in the narrowest range since 2000 and with very little dispersion. In the case of EM stocks returns are more dispersed on a country by country basis.

UniCredit Research

page 26


January 2018

January 2018


CEE Quarterly

Flows into EM FI funds achieved a record in 2017 but the cumulative flow since 2016 barely exceeds the outflows between 2013 and 2016

Flows into EM FI funds reached record highs in 2017 with USD 80bn allocated to EM-dedicated funds and an additional USD 32bn allocated to EM bonds by funds with global mandates. As we discussed on our previous CEE Quarterly publication 31, the outlook for flows in 2018 is positive and the 2016-17 inflows to EM-dedicated funds have just reversed the outflows in the period between 2013 to 2016 32 while, as we noted before, allocations to EM fixed-income remain below the peak in 2013.

Chart 7: Flows into EM-dedicated fixed-income funds reached an all-time high in 2017 100,000

2013 2016

Cumulative flow s to EM FI funds in USD mn

2014 2017

Chart 8: ...with funds following the sovereign USD benchmarks receiving the bulk of allocations

2015

Foreign in USD bn

Sovereigns

Local

100

100

80

80

60

60

40,000

40

40

20,000

20

20

0

0

-20

-20

-40

-40

2017

80,000 60,000

Corporates

Mixed s ov+corp

Blended

2016

0 2014

-20,000 2013

2015

-40,000 Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

-60

-60 13

14

15

16

13

17

14

15

16

17

Source: EPFR, UniCredit Research

Foreign currency bonds We have a constructive view on EM foreign currency bonds with the caveat that CEE bonds spreads are among the tightest compared to their rating peers driven by a dearth of issuance, particularly in USD and a preference for issuing in the domestic market.

We remain constructive on external debt

SPREADS ON USD AND EUR-DENOMINATED BONDS Chart 9: USD spreads to US Treasury bonds

Chart 10: EUR spreads to Bunds

350

350 CI

300

NG TU

250

DR

LK

250

MN MK

SA

200

MX 100 PE PL

50

A 60

TT KZ RU ID CO UY RO PH HU

TU

200

BR

150

0

300

HR

RS

PT MX

VN

100

ID IT

ES 50

BBB 90

AL

HR 150

BB 120

0

B 150

LV

A

60

BR

RO

BG

PL LT

BBB 90

BB

120

B 150

Ratings are an average of Moody’s, S&P and Fitch foreign-currency ratings, spreads are an average of government spreads for bonds with 3Y maturities or longer. Source: Bloomberg, UniCredit Research 31

See CEE Quarterly 4Q17 “Focus: EM bonds, what’s not to like?” On the basis of EPFR data tracking monthly flows for 1957 EM-dedicated fixed-income funds the period between 2013 to 2016 saw a net outflow of USD 110bn and since the beginning of 2016 there have been inflows of about USD 125bn.

32

UniCredit Research

page 27


January 2018

January 2018


CEE Quarterly

Spreads on medium-to-long term duration continued tightening during the last quarter, particularly for higher-rated credits but the spread between credits of different credit-worthiness levels remained relatively stable and within historical levels. SPREADS PER RATING Chart 11: USD Z-spread average per rating (bp) BBB

BB

B

Chart 12: Average Z-spread pickup for bonds across rating categories (bp) BBB-A

A

700

600

600

500

BB-A

B-A

500

400 400

300 300

200 200

100

100

0

0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2014

2015

2016

2014

2017

2015

We use in our calculations 186 USD-denominated EM bonds with a modified duration greater than 6 in order to partially account for term premium.

The dearth of external issuance has led to tighter spreads

2017

2016

Source: Bloomberg, UniCredit Research

Eurobond sovereign issuance in 2017 of USD 23bn was slightly above that in 2016 but has markedly declined compared to previous years. With the exception of Turkey, CEE issuers tapped the EUR market but did not place any USD paper. Russia and Turkey dominated the issuance of dollar paper with USD 7bn and USD 6bn each. Redemptions in 2018 will be light in the region and concentrated in June and July.

ISSUANCE AND REDEMPTIONS Chart 13. Eurobond EUR and USD sovereign issuance in CEE-13 increased compared to 2016 (USD mn) 2014

2013

2015

2016

Chart 14. Eurobond redemptions will be concentrated in June and July (USD mn)

2017

TU SB

40,000

RU CZ

PL Other

HU

10,000

30,000

8,000

6,000

20,000

CZ

4,000

HU

10,000 RU

2,000 RU

TU

0 Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

0

Dec

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

2018

CEE-13 refers to the countries listed on the right chart including SK and SV and the “Other” category which includes BG, HR, LT, LV and RO

UniCredit Research


page 28


January 2018

January 2018


CEE Quarterly

We expect Turkey to remain the larger issuer in the external market in 2018

For 2018 we expect gross external debt issuance to reach EUR 20.3bn and net issuance to be negative, particularly in Russia. BOND ISSUANCE AND AMORTIZATION IN 2018 Domestic bonds EUR bn

External bonds and loans

Issuance

Amort.

Net

Issuance

Amort.

BG

0.6

0.5

0.1

0

0

Net 0

HR

1.2

0.8

0.4

1.0

1.3

-0.3

CZ

2.3

1.0

1.3

0

2.0

-2.0

HU

8.0

5.2

2.8

1.0

1.6

-0.6

PL

30.5

19.5

11.0

3.5

3.5

0

RO

7.0

3.5

3.5

4.5

1.5

3.0

RU

15.4

7.5

7.9

2.3

7.8

-5.5

RS

2.0

1.7

0.3

1.0

1.7

-0.7

TU

31.5

14.9

16.6

7.0

4.3

2.7

Source: UniCredit Research

Local currency markets High real interest rates and a large unhedged spread to US Treasuries continue to make local rates attractive. In CEE, the rate dynamics for countries with strong external positions are different compared to other emerging markets. Hungary stands out as being able to conduct very accommodative monetary policy and negative real rates thanks an extended basic balance position of 11.2% of GDP in 2018 insulating it to some extent from potential global shocks. Also the successful development of the retail bond market has reduced the reliance on the traditional domestic capital providers. Real rates are particularly elevated in Turkey, for good reasons in our opinion, and in Russia, where we think they will decline as we discuss in the country section.

We have a constructive view on most local currency markets thanks to a combination of high real rates and large external surpluses

REAL RATES IN EMERGING MARKETS Chart 15: CEE real rates stand out in comparison to other EM… nominal rates minus 2018/19 600

Policy rate

average CPI inflation, in bp

5Y

Chart 16: …and when related to the cyclical state of the economy 400

10Y

RU

600

300 500

400

400

300

300

200

200

100

100

0

0

-100

-100

-200

-200

BR ID

Real Policy rate (in bp)

500

TR

MX

200 ZA

CO

100 RS

0

MY TH PL

-100

RO

CZ

-200

HU

-300 -300

-300 CZ

HU

PL

RO

CEE countries

RS

RU

TU

TH

MY

CO

ZA

ID

MX

-4

BR

Other EM countries

-3

-2

-1

0

1

2

3

4

5

Estimated Ouput Gap (in % of potential)

Source: Bloomberg, central banks, UniCredit Research

UniCredit Research

page 29


January 2018

January 2018


CEE Quarterly

During 2018 we expect policy rate hikes in Czech Republic and Romania, stability in Poland and Hungary and cuts in Russia and Turkey, in line with market-implied indicators for all markets except for Turkey. MARKET EXPECTATIONS OF POLICY RATES Chart 17: 1Y XCCY swaps in Turkey and Russia show divergent monetary policies… XCCY sw ap minus policy rate (in bp)

Turkey

Chart 18: …and the FRA markets price moderate hikes in Poland and Hungary and about 150bp hikes in Czech over the next 2Y FRA minus 3m interbank rate

Russia

Last

(range over 3M, in bp)

300

120

CBRT +30bp

Czech

Poland

1m

120

Hungary

CBRT +50bp

200

100

100

100

80

80

60

60

40

40

20

20

0

-100

CBR -25bp

CBR -25bp

-200 Mar

Apr

Jun

May

CBR -50bp

Aug

Jul

Sep

CBR -25bp

Oct

CBR -50bp

Nov

0

Dec

0 9x12

21x24

9x12

21x24

9x12

21x24

2017


Foreign participation in local markets remains within historical ranges with the exception of Czech were it is excessive

Foreign participation in the local sovereign markets remained relatively stable in most markets with the exception of Czech Republic, where it has been falling over the last months. Even so. investors remain overexposed to the bonds and the CZK. In Russia, foreign participation has increased substantially over the last year and is in line with other major EM countries such as Mexico or Poland. Banks have been a strong support for local bonds particularly in Hungary and Poland where the holdings in relation to total banking assets are at multi-year highs. The Russian banking system exposure to Federal government securities appears low by international standards and we expect banks to support OFZs in 2018.

HOLDINGS OF LOCAL CURRENCY BONDS Chart 19: Non-resident holdings of local currency sovereign bonds (range over last 12M)

Chart 20: Banking system exposure to government bonds (in % of total assets, range over last 5Y)

60

60

24

24

50

50

20

20

16

16

40

40 12

12

8

8

4

4

30

30

20

20

10

10 BR

TH

RO

TU

CO

MY

HU

RS

MX

RU

PL

ID

ZA

0

0 HU RO SV

CZ

PL

TU

SK

IT

HR BG PT ES

CZ

LT

LV

RU

Source: Bloomberg, ministries of finance, UniCredit Research

UniCredit Research

page 30


January 2018

January 2018


CEE Quarterly

Most CEE local currency markets continue to deliver higher risk-adjusted returns than Bunds

With the exception of Romania and Turkey, local currency bonds in EUR equivalent provided another year of returns above Bunds on a risk-adjusted basis and offer attractive unhedged returns against EUR-denominated Eurobonds, particularly in Poland and Romania.

PERFORMANCE AND VALUATION AGAINST EUR-DENOMINATED BONDS Chart 21: …while offering attractive unhedged spread, particularly for POLGB and ROMGB

Local currency bonds continue to outperform Bunds …

4.1%

n.a.

Vol

3.4%

4.0%

4.6%

n.a.

CZGB

Return

1.5%

2.4%

1.6%

3.5%

Vol

3.9%

3.1%

4.1%

5.3%

HGB

Return

5.6%

6.6%

6.2%

7.1%

Vol

4.1%

6.7%

8.4%

11.1%

OFZ

Return

3.0%

20.6%

-3.2%

0.8%

Vol

12.1%

24.6%

27.9%

24.1%

TURKGB

Return

-12.7%

-10.6%

-7.7%

-4.3%

Vol

15.0%

16.8%

16.2%

14.8%

200

200

100

100

0

0

-100

-100 20

0.9%

18

-3.8%

19

Return

21

8.3%

ROMGB

22

4.5%

7.5%

18

3.3%

7.3%

20

3.2%

5.0%

27v25

11.0%

Vol

31v28

Return

400

300

18

POLGB

Hungary

300

21v20

4.5%

Czech

25v24

3.6%

19

3.7%

Romania

20

3.2%

Local markets total return in EUR

Poland

27

Vol

Unhedged yield differential between local currency and EUR bonds (range over last 6M)

400

18

7Y 4.2%

25

5Y 2.7%

26

3Y 1.1%

21

1Y -0.5%

23

Metric Return

20

Bund


UniCredit Research

page 31


January 2018

January 2018


CEE Quarterly

A SUMMARY OF OUR FIXED-INCOME COUNTRY VIEWS Local currency

Foreign currency

Bulgaria

Not covered

BGARIA bonds are supported by strong fiscal and external accounts , lack of bond supply in the horizon and excess liquidity in the banking system which will increase as the 2018 bonds mature in January. For these reasons, the bonds are attractive but scarce.

Croatia

Not covered

CROATI bonds in USD are attractive from a diversification perspective in a CEE context for investors willing to add exposure to below investment-grade credits and offer a pick-up compared to ROMANI bonds.

Czech

We recommend paying the 1Y IRS in line with our expectations of higher policy rates and inflation on the rise. Foreign investors exposure to CZGBs is the largest in EM and the yield levels are not still attractive.

CZECH negative EUR z-spreads are not attractive on a standalone basis or when compared to similar rated EU credits.

Hungary

We recommend duration exposure in HGBs via the HGB25b, which has the largest ASW of the bonds in the curve, or receiving 10Y IRS rates in order to profit from the MNB’s stated goal of flattening the long-end of the curve. Foreign investors have been active in long bonds and this policy will lead to additional support from local banks.

Both the REPHUN EUR and USD bonds are trading in line with higher rated credits such as Poland. The EUR-denominated bonds have benefitted from the accommodative monetary policy of the MNB and may continue to do so.

Poland

The Polish economy is expanding at the highest rate in years and this benefits the zloty valuation. We recommend unhedged positions in the 2025 bonds as they have the highest ASW in the curve and an attractive spread to Bunds. Bond supply will increase in 2018 but local banks’ support will remain firm.

POLAND EUR bonds offer a premium over the similarly rated Baltic countries Latvia and Lithuania but do not benefit from the ECB APP program or the Baltic bonds’ scarcity.

Romania

ROMGBs levels are nominally attractive but we expect both headline and core inflation to increase significantly in 1Q18 and the bonds have almost never traded at negative yields. We think there will be better entry levels in 1Q18 and our stance will be determined by the policy response to the inflationary and fiscal risks.

ROMANI bonds offer the highest spreads in EUR among similarly rated credits and the curve is quite steep. In USD we prefer POLAND bonds which trade quite tight in z-spread levels compared to ROMANI but are rated three notches higher.

Russia

Russia has one of the favorable macro fundamentals for bond investors: high real bond rates, low inflation and manageable bond supply. We recommend owning the RFLB 2026 bond as we expect the curve to shift lower and benefit more the 10Y area. The risk of sanctions looms large and this may lead to a reduction in foreigners’ positions in OFZs. However, fixed-coupon OFZ are almost carry positive and banks’ positions in government bonds are small compared to other countries which may lead banks to start accumulating these bonds in 2018.

Since 2014 Russian Eurobonds issuance has barely kept with redemptions but foreign investors have reduced their holdings by 50% and their ownership of the outstanding amount has declined from 70% in 2014 to barely 40% currently. RUSSIA USD bonds in the short-end of the curve trade in line with other lower rated credits such as Croatia and Serbia. The bonds should be trading at lower spreads but the effect of sanctions is negative on valuations.

Serbia

No progress has been made regarding the inclusion of SERBGBs in the major EM local-currency indices and bond liquidity remains low and concentrated on a handful of bonds. SERBGBs were one of the best performing local-currency bonds in 2017 thanks to the dinar strength, which may reverse in the course of 2018. Yields barely compensate for inflationary risks and low liquidity in our opinion.

We have been arguing for a while that Serbia should issue a EURdenominated bond in order to broaden the Eurobond investor base. The universe of sub-investment grade EUR-denominated bonds is small and there are few convergence investment stories. For this reason a EUR bond supply would be welcome. We also marginally prefer SERBIA USD to CROATI bonds.

Turkey

We closed our TURKGB recommendation in 4Q avoiding much of the sharp correction in bond prices and the lira. Yields are nominally attractive now although it is unclear that the lira is undervalued. Positions show an imbalance with foreign inflows in 2017 at multiyear highs and local banks involvement limited by negative carry in the bonds maturing beyond 3Y. Inflation is proving to be more persistent than expected, both in headline and core terms, and for this reason policy rates will remain high. We will become more constructive on TURKGBs when disinflation materializes.

TURKEY USD bonds have widened in z-spread terms compared to similarly rated credits and the gap is at 9M high against South Africa. The spread between these two is attractive but is not at oversold levels, unlike at the beginning of 2017.


New trades and review of our trade recommendations During 4Q17 we closed a TURKGB recommendation that we initiated in April at a 2.5% total return gain in USD terms and we added to our long duration view on HUF rates by recommending receiving 10Y swap rates as the MNB will begin offering unconditional IRS contracts at a discounted level. Our target level of 1.5% has been reached but we extend the recommendation to 1.25%. We maintain our core trade recommendations in local currency bonds in POLGBs, OFZs and HGBs with a cautious view on ROMGBs and TURKGBs and an outright negative view of CZGBs particularly on the long-end of the curve. We also maintain our recommendation to pay 1Y CZK IRS.

UniCredit Research

page 32


January 2018

January 2018


CEE Quarterly

We don’t think that any of the CEE sovereign external debt credits offer significant upside over and above market weight. We have a constructive view on external credit for 2018 and our views on relative valuation are discussed in the previous page. Hits and misses in 2017 Our core trade recommendations listed below performed well in 2017 with all trades delivering positive total returns in USD terms and POLGB, HGB and OFZ trade recommendations ending the year among the top of performers local currency bonds. We also rightly avoided long positions in the CEE markets that had negative returns: ROMGBs and CZGBs, whereas our TURKEY and TURKGB recommendations were timed to deliver positive returns. SERBGBs rank high among the trades we missed this year. Our view is that the market development has stalled, bonds are illiquid and foreign participation has dwindled. We estimated that the inflationary risks were higher than the actual inflation and were surprised by the dinar’s appreciation. On TURKGBs our view was more sanguine than some and were attracted by the very good summer performance which is when the position should have been exited.

Entry

Valuation (Dec 29) Rate/ Date Yield Target

Total return (TR) Rate/Yield TR TR change (%) CCY USD

B/S R/P*

Name

CCY

Date

Rate/ Yield

B

TURKEY 3 1/4 03/23/23

USD

18-Jan-17

5.40

12-Apr-17

4.67

closed

84

-0.73

5.16%

5.41%

S

SOAF 5 7/8 05/30/22

USD

18-Jan-17

3.75

12-Apr-17

4.07

closed

84

0.32

-0.53%

-0.28%

-1.05

5.68%

B

TURKEY 6 1/4 09/26/22

USD

18-Jan-17

5.42

12-Apr-17

4.65

closed

84

-0.77

4.79%

S

TURKEY 7 03/11/19

USD

18-Jan-17

3.97

12-Apr-17

3.17

closed

84

-0.80

2.32%

0.03

2.47%

2.47%

2.50% -4.60%

S/L

Days

1.65

1.45

5.68%

TR EUR

5.70% 5.05% 2.57% 2.48%

B

TURKGB 11 03/02/22

TRY

26-Apr-17

10.58

06-Oct-17

10.99

closed

11.00

163

0.41

3.40%

B

RFLB 7 3/4 09/16/26

RUB

07-Feb-17

8.25

29-Dec-17

7.49

7.25

8.00

325

-0.76

11.58%

B

POLGB 3 1/4 07/25/25

PLN

30-Jan-17

3.75

29-Dec-17

3.07

3.00

4.00

333

-0.68

7.89%

25.52% 11.95%

B

HGB 5 1/2 06/24/25

HUF

12-Jun-17

2.63

29-Dec-17

1.67

1.50

2.10

200

-0.96

7.29%

13.55%

P

PAY 1Y IRS

CZK

22-Sep-17

0.67

29-Dec-17

1.11

1.20

0.67

98

0.44

R

RECEIVE 10Y IRS

HUF

18-Dec-17

1.75

29-Dec-17

1.63

1.50

2.00

11

-0.12

*B: long bond, S: short bond, P: pay IRS, R: receive IRS

UniCredit Research

15.82%

2.32% 5.98%


page 33


January 2018

January 2018


CEE Quarterly

CEEMEA FX: the “good”, the “bad” and the “in-between” Kiran Kowshik, EM FX Strategist (UniCredit Bank, London) +44 207 826-6080 [email protected]

Main points 1. On the whole, we stay constructive on EMFX, but gains could be more measured in 2018 given the large appreciation already seen over 2016-17. We find that global growth and commodity prices tend to matter more for EMFX prospects than tightening US monetary conditions. 2. If we are right that global growth becomes more investment-driven in 2018, global trade volume growth could increase further and this should provide a natural underpinning for EM currencies even keeping in mind a measured tightening in G4 monetary policy. A very rapid tightening of US monetary conditions, which we do not expect, presents risks. 3. We classify our CEEMEA FX views into three broad groups: the “good” (RUB and CZK), the “bad” (TRY and RON) and the “in-between” (PLN, HUF and ZAR). 4. The first two groups are self-explanatory: we expect both RUB and CZK to perform well given strong fundamental signals and/or support from external balances, though there are some notable risks to consider in the months ahead. 5. On the other hand, we believe that both TRY and RON should remain the weakest links in CEEMEA FX, with central banks lagging behind the inflation curve and external balances worsening. 6. The “in-between” group includes those currencies that have a mix of both good and bad things going for them, keeping them choppy and broad ranges. In this group, we believe the PLN has the best chance of breaking out into the “good” camp in 2018 if the markets start discounting political risks. 7. ZAR has a good chance too, if the reform cycle begins to look up, as external balances continue to improve (like Brazil after 2015), but this is a much tougher call. For HUF, a resolutely dovish central bank should prevent the HUF from gaining from strong external balances.

EMFX outlook – stronger global growth matters more than rising core bond yields Constructive EMFX but greater differentiation required

We maintain a constructive stance overall towards EMFX, given the synchronized global recovery underway and with financial conditions globally likely to remain relatively easy. A shift in the texture of global growth more towards investment further supports such a stance. However, gains for EMFX will be more moderate following two strong years of appreciation. Greater differentiation will be required: we like currencies of countries with good (or improving) external balances and either high real yields or compelling valuation signals.

For EMFX, global growth and US monetary conditions matter …

Our analysis of EM currencies shows that two factors explain broader EM currency movements: global growth dynamics (which we proxy using raw industrial metal prices) and US monetary conditions (which we proxy using US real yields). The drivers work in opposite directions, i.e., a rise in raw industrial prices helps EMFX and a rise in US real yields hurts EMFX. But global growth turns out to be much more important as a driver (see FX Perspectives – EMFX & the ‘Trump Tantrum’ – why this time could be different). However, global growth matters far more and EMFX can withstand higher bond yields provided global growth is strong. Thus, we believe EMFX will suffer if global growth softens noticeably- even if bond yields were to fall further.

…but global growth matters the most Only a very rapid rise in US real yields would present risks…

UniCredit Research

Furthermore, the pace of increase in US real yields also counts: we find that very sharp gains in real yields – in excess of 15-20bp per week- would hurt EM currencies (see FX Perspectives – EMFX – when should we start fretting about US yields?).

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January 2018

January 2018


CEE Quarterly

…but this seems less likely

Such gains were seen when the Fed moved to tighten or signal tightening in 1994 and 2013. However, this seems less likely as the Fed appears to be signaling a modest and pre-determined tightening path-somewhat more similar to 2005. We do not anticipate a strong positive impact on US growth from the fiscal stimulus under way. At the same time, global FX reserves are rising once again (unlike the 2013 tantrum phase when reserves were falling sharply). This will likely help moderate the rise in real yields. Hence, overall EMFX should be able to weather the tightening cycle.

A sharp downturn in Chinese investment would present risks

What is more important for the EMFX view forecast would be a sharp downturn in Chinese investment growth, especially in the construction sector. Here, lower property prices and housing sales have long been flagging a deceleration. But this has not materialized, and lower housing inventories as well as still strong credit growth may be factors that have kept investment relatively resilient (see FX Special – EMFX: Four Chinese charts on our radar). However, this will be something to monitor on an ongoing basis.

Bucketing CEEMEA FX into three: the” good”, the “bad” and the “in between”

We classify our CEEMEA FX views into three broad groups: the “good” (RUB and CZK), the “bad” (TRY and RON) and the “in- between” (PLN, HUF and ZAR). The first two groups are self-explanatory: we expect both RUB and CZK to perform well given strong fundamental signals and/or support from external balances, although there are risks to consider for each in the months ahead. On the other hand, both TRY and RON should remain on the back foot with central banks lagging behind the inflation curve and external balances weak. The “in-between” include those currencies that have a mix of both good and bad things going for them, keeping them choppy and in broader ranges. Here, the PLN looks most promising in terms of breaking into the “good” group. We look at these groups in the following.

The “good”: RUB and CZK We like both RUB and CZK on fundamentals…

We have been constructive on both the RUB and CZK over 2017. In a nutshell, for the RUB, good external balances and still high real yields should offer support. Indeed, the inability of private sector outflows to recycle the current account surplus (chart 1) points to ongoing appreciation pressure. Even with the CBR set to ease policy further, real rates will remain elevated, offering further support to the currency. In the case of the CZK, strong external balances as well as valuation signals, such as productivity differentials (chart 2), point to ongoing appreciation. The country faces strong demand-pull inflationary pressures with the tight labor market translating into higher wages and core inflation. Our economists expect the CNB to hike rates by 100bp this year, which should offer support to the currency. But while we like the RUB and the CZK, both come with their own set of risks in the months ahead, which could create some volatility.

…but both currencies face some risks

In the case of the RUB, the risks which stand out are: 1. the revamped budget rule, and 2. potential tightening of financial sanctions. For the CZK, the bigger risks are: 1. extended CZK positions held by foreign investors and 2. political uncertainty surrounding government formation. We take these in turn.

MinFin FX purchases likely to lessen RUB’s sensitivity to energy prices further…

Taking the RUB first, the new budget rule should result in the CBR making a larger amount of FX purchases (on behalf of the finance ministry) on a monthly basis. The amounts may potentially be 2 to 3 times that seen in 2017 (which averaged USD 1.25bn per month). For context, the higher amount would still be below the USD 4.4bn per month purchases made under the CBR’s own independent reserve-building program (May to July 2015).

UniCredit Research

page 35


January 2018

January 2018


CEE Quarterly

At the same time, the mechanism for determining of the amounts has been flagged in advance (unlike the CBR’s purchases back in 2015) and will be proportional to the level of energy prices (via-a-vis that assumed in the budget). Such purchases are unlikely to weigh on the currency by themselves, but they will likely further reduce the sensitivity of RUB to higher energy prices. Our prior analysis showed that FX purchases had no strong bearing on the exchange rate if properly flagged in a transparent way (see FX Perspectives – RUB: why CBR FX purchases are unlikely to hurt the ruble). WE REMAIN CONSTRUCTIVE ON RUB AND CZK Chart 1: Private capital outflows have been unable to recycle the Russian C/A so far, resulting in RUB appreciation pressure

15

4Q sum, % of ann. GDP

Chart 2: Relative productivity trends in themselves suggest that EUR-CZK should be lower

C/A

FDI

Port Inv

E&O

reserves

Other inv

Productivity: Output per Employed Person (ratio of Euro area to Czech Republic) EUR- CZK

BBoP 10 5

1.40

40

1.35

38

1.30

36

1.25

34

1.20 0

32

1.15

30

1.10

-5

28

1.05 -10

26

0.95

24

0.90

22 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19 Mar-20

Jul-17

Nov-17

Mar-17

Jul-16

Nov-16

Mar-16

Jul-15

Nov-15

Mar-15

Jul-14

Nov-14

Mar-14

Jul-13

Nov-13

Mar-13

Jul-12

Nov-12

Mar-12

Jul-11

Nov-11

Mar-11

Jul-10

Nov-10

Mar-10

-15

1.00

Source: Bloomberg, Haver, UniCredit Research

…but sanctions targeting OFZs would cause more pain…

A potential tightening of financial sanctions such as restricting purchases of OFZs could have a more meaningful negative impact on Russian asset prices, including the currency. However, beyond the initial headline shock, we doubt that this will result in trend weakness in the RUB once the amounts are considered.

…though in context, foreign bond holdings seem less significant for Russia compared to other EM…

Putting some perspective on the amounts involved: on a flow basis, net portfolio investment has amounted to 0.36% of GDP in the 12 months up until 3Q17. More specifically, the 12M sum of portfolio investment liabilities (coming from secondary market purchases of OFZs) stood at 0.50% of GDP. This is lower than the 2.3% and 1.09% for the C/A and FDI, respectively. Hence, the part of the net inflow at risk is the one which has contributed least so far to underlying RUB flows looking at overall balance of payments. On a stock basis too, foreign investor OFZ holdings stand at 9% of GDP, much lower than other EM countries (chart 3). Hence while sanctions on non-resident OFZ purchases could hurt the RUB, we would not overstate the impact of resulting in a bearish RUB trajectory. Indeed, sanctions could very well diminish non-portfolio capital outflows form the domestic investor base over time, and hence perversely help the currency further out.

…and tougher sanctions may discourage domestic capital flight

CZK faces risks from overbought CZK positions as seen in foreign bond holdings…

UniCredit Research

For the CZK, the large increase in non-resident CZK positions – both in anticipation of the FX cap removal as well as after – remain a risk. The outstanding holdings of debt comprise 45% of GDP, high by EM standards – opposite to the situation in Russia (chart 3). Hence, anything which results in foreign investors sharply reducing exposure would have a huge impact. However, considering that the Czech Republic has good ratings and macroeconomic balances to support it, and has just been included in bond benchmarks (like the JPM index), this seems less likely.

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January 2018

January 2018


CEE Quarterly

A policy mistake, i.e. a sharp move up in yields as inflation gets out of hand, would be another risk. However, given that the CNB has long been credible in its inflation-targeting policy, so this too seems like a smaller risk. …but especially flows into bank deposits…

While foreign investor purchases of debt have been an important factor behind the surge in reserves, other types of inflows, including bank deposits (included under “other investments” in the BoP), have been an even bigger driving force. Looking at cumulative FX reserve accumulation between January 2016 and March 2017 – a period of large inflows before the floor was removed in April 2017 – a larger proportion (45%) has been driven by “other investments”, compared with portfolio investments (31%). See chart 4.

BUT BOTH WILL HAVE TO NAVIGATE RISKS Chart 3: Non-resident debt holdings as proportion of GDP for various EM countries

Chart 4: Czech Republic: BoP components that contributed to rise in reserves before FX floor was abandoned (January 2016-March 2017)

Non-resident govt debt holdings (% of GDP)

Unexplained

50

Other Inv.

Port Inv.

FDI

C/A

100% 45 90% 40 80%

35

70%

30

60%

25

Contribution to cumulative rise in FX reserves

50%

20

40%

15

(Jan 2016-Mar 2017)

30%

10

20%

5

10%

0 RUB RON TRY THB KRW ZAR

IDR

BRL MXN HUF PLN CZK MYR

0%


…which are likely more speculative and tied to EUR-CZK movements

“Other investments” usually consist of FX borrowing as well as bank deposits. The share of non-residents on banks’ total loan and deposits has risen close to 30% from 10-20% seen before 2016. Such flows are probably more speculative and hence dependent on the direction of EUR-CZK. A sharp and continued rally in EUR-CZK would likely see these positions being closed, which would exert further upward pressure on the cross. However, given the positive fundamentals noted above (including valuation signals coming from productivity differentials), this seems less of a concern, but one that will need to be monitored. It seems more likely that such flows will prevent the CZK from rallying strongly, rather than result in trend weakness.

…and, to a lesser extent, political developments

UniCredit Research

Politics will remain important, with Andrej Babiš now given a second chance at forming a government, coinciding with the presidential election this month. Our economists point out that the least desirable outcome is an unstable minority government seeking ad-hoc support across the political spectrum. This could make government policy unpredictable and probably more populist. That said, more populist “economic” policy (fiscal expansion) could actually prove more CZK bullish to the extent that it comes when the economy is already firing on all cylinders. The near-term risk of policies infringing on the rule of law (like in Poland recently) seems quite low, in our view.

page 37


January 2018

January 2018


CEE Quarterly

The “bad”: TRY and RON We have structural bearish views on the TRY and the RON

A combination of weakening external balances, deteriorating inflation, overly lax fiscal stance as well as a questionable monetary policy response keeps us bearish on the TRY and the RON.

TRY may appear undervalued, but conditions aren’t in place for a recovery

While in a number of models the TRY appears very undervalued, in our opinion, the conditions are not in place for a recovery: real rates are far too low, and the current account deficit, which we expect to widen further, is being inadequately funded.

A wider C/A deficit and weaker inflows…

We expect the C/A deficit expected to widen further to beyond 6% of GDP for both 2018 and 2019, from the 3.5 to 4.5% region seen for most of 2016 and 2017. In terms of its financing, we doubt that portfolio flows will be as stellar as seen over 2017 – which, at near 2.5% of GDP, was the strongest since 2014. While inflation will moderate, it will likely still remain elevated enough to keep real yields low.

WE ARE BEARISH ON THE TRY AND THE RON Chart 5: Other investments no longer adequately financing Turkey’s C/A deficit like before C/A

FDI

Port. inv

Chart 6: Lower FX debt will gradually allow the NBR to liberalize the FX regime and focus more on inflation-targeting 70

Other inv

13 65

All series 12M sum, % of GDP (last data point October)

8

60 55

3 50 FX share in corporate loans 45

-2

FX share in household loans

40

FX share in total loans

-7 35

Last date point: October

-12

Oct 17

Mar 17

Jan 16

Aug 16

Jun 15

Apr 14

Nov 14

Sep 13

Jul 12

Feb 13

Dec 11

Oct 10

May 11

Mar 10

Jan 09

Aug 09

Jun 08

Apr 07

Nov 07

Sep 06

Jul 05

Feb 06

Dec 04

Oct-17

May-17

Jul-16

Dec-16

Feb-16

Sep-15

Apr-15

Jun-14

Nov-14

Jan-14

Aug-13

Oct-12

Mar-13

May-12

Jul-11

Dec-11

Feb-11

Sep-10

30


…including in FX borrowing, will hold TRY back

Furthermore, bank FX borrowing – historically an important source of C/A deficit financing – is likely to remain weak (see FX Flash – TRY: staying focused on those ‘other’ flows).

Sharp CBRT tightening could turn things around, but seems less likely

With net FX reserves low, the TRY will remain under depreciation pressure in the absence of sufficient monetary policy tightening. Very sharp tightening by the CBRT that slows domestic demand and, in turn, compresses the current account deficit would make us more optimistic. However, this seems unlikely, with political preferences still skewed in favor of growth rather than control of inflation. Hence, the lira should continue to remain the laggard among high-yield EM currencies for 2018 as well.

The move to FX flexibility in Romania should see EUR-RON edge up towards 4.70…

Romania, on the other hand, is seeing a transition in policy regime to allow for more FX flexibility while moving towards “pure” inflation targeting. However, the economy is running too “hot” currently: growth has shot up (even overtaking Chinese growth rates!) given lax fiscal policy, and inflation is likely to exit the target range already in 1Q18. Romanian inflation has shown upward surprises in each of the last three prints. We expect hikes to the key policy rate starting from February, but the risk is that the NBR may not be hawkish enough, in our view.

…with external balances set to worsen

External balances are likely to turn less supportive: a continued widening of the C/A deficit coupled with a further slowing in EU fund flows will make it all the more important for either portfolio investment and/or FX borrowing to pick up the slack.

UniCredit Research

page 38


January 2018

January 2018


CEE Quarterly

However, portfolio investment is unlikely to roar ahead if the CB is behind the curve. Furthermore, as authorities further liberalize the FX regime (and allow EUR-RON to move higher), it is unclear that there would be much in the way of FX borrowing (which entails FX risks). Indeed, one reason authorities are more comfortable in allowing EUR-RON to move higher is the decline in FX debt seen in recent years (chart 6).

The “in-between”: PLN, HUF and ZAR Currencies like the PLN, the HUF and the ZAR have been “mixed” bags for the most part…

The “in-between” include those currencies that have a mix of both good and bad things going for them, keeping them choppy and in broader ranges.

■ ■ ■

For the PLN, the “good” includes undervaluation and positive macroeconomic fundamentals, but the “bad” includes ongoing political uncertainty regarding the “rule of law” and a more dovish NBP. For the HUF, the “good” includes very strong external balances and positive macroeconomic fundamentals, but the “bad” comprises extremely lax monetary policy and an implicit (yet clear goal) of the NBH to keep the currency weak. For the ZAR, the “good” includes ongoing external rebalancing, high real yields and supportive terms of trade, but the “bad” includes structurally weak growth, political uncertainty and rating downgrade risks.

…but PLN could have a chance to move to the “good” category

Of the three, we believe that the PLN has the highest chance of moving to the “good” category in 2018: higher growth argues for a stronger currency and this year we expect a recovery in capital inflows, including EU funds. That should allow the currency to strengthen, assuming the NBP refrains from accumulating FX reserves (like in 2016). The NBP is unlikely to provide a catalyst; we expect unchanged rates through 2018.

Risks related to PiS policies unlikely to hurt PLN like in 2015…

However, we are less concerned about ongoing noise of PiS policies regarding the “rule of law”. Back in 2015 when the PiS came to power, there was a big question on the future evolution of macroeconomic policies (including over both fiscal and monetary policy) under the new government. Hence Polish hard currency debt (which is insulated from FX risk) as well as the currency came under pressure. In short, different asset classes were punished.

…and PLN looks too low relative to optimism seen in debt markets

However, this time around, it is clear that the market perceives issues surrounding PiS policies as not affecting macroeconomic policies. Bonds are performing very well even though the currency has lagged behind (chart 7), which could well indicate that some FX hedges are in place. Taken together, the natural course of EUR-PLN is likely lower once FX investors become more sanguine about the path of PiS policies.

EUR-HUF should remain in a broad range…

For the HUF, extremely lax monetary policy and a clear goal to keep the currency weak are the main obstacles to the currency embarking on an appreciation path. On the other hand, with easier monetary policy yielding diminishing returns, the central bank’s balance sheet continuing to contract (chart 8) and external balances stellar, the currency is unlikely to weaken meaningfully from here. Further unconventional policies from the NBH may only prevent a further contraction in the balance sheet, but are unlikely to result in an outright expansion. Hence, EUR-HUF should remain in broad ranges: we would sell near 313-315 and buy the pair closer to 302-305.

…should NBH succeed in halting decline in balance sheet

UniCredit Research

page 39


January 2018

January 2018


CEE Quarterly

PLN AND HUF HAVE GOOD FUNDAMENTALS BUT HAVE BEEN HELD BACK BY OTHER FACTORS Chart 7: PiS policies are not seen as impacting monetary and fiscal policy, limiting the PLN impact

Chart 8: Shrinking NBH balance sheet has prevented HUF from weakening at a faster pace over past two years

4.7

50 170

4.3 4.1

40

110

35

90

30

60 50 40

25

30

20

30 10

15

-10

10

20 10 Sep-07 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10 Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Feb-13 Jul-13 Dec-13 May-14 Oct-14 Mar-15 Aug-15 Jan-16 Jun-16 Nov-16 Apr-17 Sep-17 Feb-18

Feb-18

Apr-17

Feb-17

Oct-16

Dec-16

Aug-16

Apr-16

Jun-16

Feb-16

Oct-15

Dec-15

Aug-15

Apr-15

Jun-15

Feb-15

Oct-14

Oct-17

...as future fiscal/monetary policies seen going in the wrong direction

Dec-17

Recent political noise has weighed on PLN , but not on debt markets

3.5

Dec-14

70

50

Aug-17

PiS comes to power

Jun-17

3.9

130

70

Hard - currency debt and currency under pressure...

HUF EUR

45

150

4.5

3.7

PLN RON CZK (rs)

CB balance sheet (% of GDP)

EUR-PLN Yield spread: Poland EUR over Germany, 10Y issued in 2014 (rs, bp)


We liked ZAR given external balances and real yields…

Finally, the ZAR has already faced several months under both the sun and clouds since 2016 i.e. it was already in our “good” camp before (through 2016 and 1H17), but risks surrounding politics and rating risks had shifted the currency back to the “in between” group. That said, our general view for some time now has been that the ongoing external rebalancing has been far more important for the ZAR than the increase in foreign investor participation following South Africa’s inclusion in bond benchmarks (see charts 9 and 10). Hence, we have had a more constructive view, though penciling in uncertainty surrounding political developments.

…but had held back in 4Q17 given uncertainty surrounding the ANC outcome …however, political developments have turned more constructive following Ramaphoosa’s win…

However, following the unexpected victory of Cyril Ramaphoosa, markets will compare South Africa today with Brazil after 2015 following the ouster of Dilma Rousseff, i.e. there will be anticipation of an upturn in the reform cycle (whether this occurs or not). Combined with improving external balances and high real yields (which Brazil also had), this should see ZAR continue to perform well if commodity prices hold up as well. The caveat is that, unlike Brazil, South Africa does not have the luxury of receiving 3 to 4% of annual GDP in “sticky and more committed” FDI inflows. Hence, the ZAR will face more volatility, but we think further gains are likely - especially if President Zuma is ousted before his term is set to end in 2019.

…which should see ZAR perform over 1Q18

ZAR: EXTERNAL BALANCES MORE IMPORTANT THAN POTENTIAL REMOVAL FROM WGBI BOND BENCHMARK Chart 9: Improving current account has historically provided a positive signal for the rand ZAR REER

Chart 10: South Africa’s entry into the WGBI bond benchmark did not really do much for the currency ZAR NEER Non-resident holdings of domestic sovereign debt (%, rs)

C/A to GDP (%, rs)

130

8

150

50

6

110

45 130

4 90 70

2

110

0

90

35 30 25 20

-2

50

40

70

15

-4 -6

5 Apr-17

Nov-17

Sep-16

Jul-15

Feb-16

Dec-14

Oct-13

May-14

Mar-13

Jan-12

Aug-12

Jun-11

Apr-10

Nov-10

Sep-09

Jul-08

Feb-09

Dec-07

Oct-06

May-07

Mar-06

0 Jan-05

Nov-17

Apr-17

Feb-16

Sep-16

Jul-15

Dec-14

Oct-13

May-14

Mar-13

Jan-12

Aug-12

Jun-11

Apr-10

Nov-10

Sep-09

Jul-08

Feb-09

Dec-07

May-07

Oct-06

Mar-06

Jan-05

South Africa gains entry to Citi WGBI local bond benchmark (September 2012)

30

-8 Aug-05

10

10

50

Aug-05

30


UniCredit Research

page 40


January 2018

January 2018


CEE Quarterly

OUR GLOBAL FORECAST GDP

CPI

Policy interest rate

10Y bond yield

Exchange rate (LC/EUR)

2017E

2018F

2019F

2017E

2018F

2019F

2017

2018F

2019F

2017

2018F

2019F

2017

2018F

2019F

2.3

2.3

1.9

1.6

1.5

1.4

0

0

0.25

0.43

0.80

1.00

1.20

1.25

1.28

Germany

2.2

2.3

1.9

1.7

1.6

1.5

-

-

-

-

-

-

-

-

-

France

1.8

1.8

1.6

1.0

1.1

1.0

-

-

-

-

-

-

-

-

-

Italy

1.6

1.5

1.2

1.2

1.1

1.1

-

-

-

-

-

-

-

-

-

UK

1.5

0.8

1.2

2.7

2.5

2.0

0.50

0.50

0.75

1.19

1.50

1.60

1.35

1.37

1.42

USA

2.2

2.6

2.0

2.1

2.3

2.4

1.50

2.25

2.50

2.40

2.75

2.60

-

-

-

World

3.6

3.9

3.5

-

-

-

-

-

-

-

-

-

-

-

-

Oil price, USD/bbl

3.6

3.9

3.5

-

-

-

-

-

-

-

-

-

66.9

60.0

60.0

Eurozone


THE OUTLOOK AT A GLANCE Real GDP (% change) CEE-EU

2016 2017F

2018F

2019F

CPI (% change) CEE-EU

2016

2017F

2018F

2019F

-0.4

2.0

2.9

2.6

-0.8

2.0

1.7

2.3

C/A balance (% GDP)

2016

2017F

2018F

2019F

0.8

0.3

0.2

-0.3

Bulgaria

5.3

4.9

3.7

3.1

2.2

Czech Rep.

1.1

0.6

0.6

0.5

3.6

3.4

Hungary

6.1

3.9

4.8

4.8

2.0

2.4

2.5

Poland

-0.3

0.1

-0.1

-1.1

Romania

3.1

4.7

4.0

3.4

Bulgaria

3.9

4.0

4.4

4.2

Bulgaria

Czech Rep.

2.5

4.5

3.5

2.8

Czech Rep.

0.7

2.4

2.6

Hungary

2.2

4.0

4.5

3.3

Hungary

0.5

2.7

Poland

2.9

4.5

4.0

3.6

Poland

-0.6

Romania

Romania

CEE-EU

4.8

6.6

4.6

3.5

-1.5

1.3

4.4

3.1

-2.1

-3.8

-4.3

-4.3

Croatia

3.2

3.0

2.8

2.8

Croatia

-1.1

1.2

1.8

1.5

Croatia

2.6

3.6

2.5

2.2

Russia

-0.2

1.8

1.3

1.2

Russia

7.1

3.6

3.5

4.0

Russia

2.1

2.1

1.7

1.3

Serbia

2.8

1.8

3.3

3.0

Serbia

1.1

3.1

2.4

3.0

Serbia

-3.6

-5.0

-4.6

-4.6

Turkey

3.2

6.8

4.0

3.7

Turkey

7.8

11.2

11.0

9.5

Turkey

-3.7

-5.5

-6.2

-6.5

2016 2017F

2018F

2019F

External debt (% GDP)

2016

2017F

2018F

2019F

2016

2017F

2018F

2019F

CEE-EU

74.3

70.5

66.2

63.1

-1.7

-1.6

-1.9

-2.1

0

0.2

-0.3

-0.7

0.7

0.7

0.2

-0.5

Extended basic balance (% GDP) CEE-EU

General gov’t balance (% GDP)

4.2

3.4

4.0

3.6

Bulgaria

8.1

7.9

6.7

6.4

Bulgaria

70.7

64.1

60.0

56.1

Bulgaria

Czech Rep.

6.2

5.1

5.4

4.9

Czech Rep.

74.0

90.1

90.5

89.9

Czech Rep.

Hungary

7.9

7.7

11.2

10.3

Hungary

96.1

86.4

79.1

74.0

Hungary

-2.0

-2.4

-2.4

-2.2

Poland

1.9

2.2

2.6

1.9

Poland

75.0

65.6

59.2

55.2

Poland

-2.5

-2.0

-2.4

-2.5

Romania

3.0

-0.2

-0.3

0.4

Romania

54.8

50.7

48.9

47.2

Romania

-3.0

-3.0

-3.5

-3.7

Croatia

7.9

7.7

7.8

7.6

Croatia

89.8

81.8

76.8

74.4

Croatia

-0.9

-0.9

-0.8

-0.6

Russia

2.9

2.1

1.7

1.4

Russia

41.9

32.8

32.5

32.1

Russia

-3.4

-2.1

-1.0

-0.9

Serbia

2.2

0.9

1.1

1.0

Serbia

73.9

70.5

64.4

63.1

Serbia

-1.3

0.5

-0.6

-0.5

Turkey

-2.8

-4.5

-5.2

-5.4

Turkey

47.6

48.3

55.0

55.6

Turkey

-2.2

-3.1

-3.2

-3.0

Gov’t debt (% GDP)

2016 2017F

2018F

2019F

Policy rate (%)

2016

2017F

2018F

2019F

REER 2000 = 100

2016

2017F

2018F

2019F

CEE-EU

50.6

47.7

47.3

48.7

CEE-EU

Bulgaria

28.6

25.1

23.9

23.2

Bulgaria

0

0

0

0

Bulgaria

136.6

138.7

139.0

137.5

Czech Rep.

36.8

34.0

32.2

31.5

Czech Rep.

0.05

0.75

1.50

2.00

Czech Rep.

135.3

140.0

145.1

142.3

Hungary

73.9

73.3

73.2

71.6

Hungary

0.90

0.90

0.90

0.90

Hungary

120.9

122.8

122.3

120.5

Poland

54.4

52.1

51.0

50.5

Poland

1.50

1.50

1.50

2.25

Poland

101.9

104.2

106.9

105.4

Romania

37.6

37.2

37.7

38.8

Romania

1.75

1.75

3.00

3.00

Romania

121.2

119.0

119.7

117.9

Croatia

82.7

80.3

77.9

75.7

Croatia

0

0

0

0

Croatia

99.8

99.8

98.0

92.7

Russia

12.9

12.7

13.5

14.3

Russia

10.00

8.00

6.75

6.00

Russia

176.9

203.6

187.4

176.3

Serbia

73.0

67.1

64.7

63.0

Serbia

4.00

3.50

3.00

3.00

Serbia

-

-

-

-

Turkey

30.3

30.1

29.6

29.2

Turkey

7.50

8.00

8.00

8.00

Turkey

106.1

94.2

85.6

77.5

2017F 2018F

2019F

FX vs. EUR EoP Bulgaria Czech Rep. Hungary

2016 2.0

2.0

2.0

2.0

27.0

25.4

25.0

25.0

311.0

310.1

313.0

313.0

Poland

4.4

4.2

4.1

4.1

Romania

4.5

4.7

4.7

4.8

Croatia

7.6

7.6

7.5

7.5

Russia

63.8

70.4

76.1

78.5

Serbia

123.5

120.0

123.0

125.4

Turkey

3.5

3.9

4.3

4.5

Source: National statistical agencies, central banks, UniCredit Research

UniCredit Research

page 41



January 2018

CEE Quarterly

EM VULNERABILITY HEATMAP BG

CZ

HR

HU

PL

RO

RS

RU

SK

TR

UA

MX

BR

CL

SA

ID

IN

CN

Current account (% of GDP)

4.8

0.6

Extended Basic Balance (% of GDP)

5.4

3.6

2.5

4.8

-0.1

-4.3

-4.6

1.7

-1.4

-6.2

-4.9

-2.2

-2.0

-3.5

-3.8

-1.9

-2.4

0.2

7.8

11.2

2.6

-0.3

1.1

1.7

1.9

-5.2

-3.2

0.7

3.0

-2.0

-3.3

0.3

0.9

FX Reserves coverage (months of imports)

7.7

1.5

11.3

7.3

2.7

4.4

4.5

4.7

11.7

-

3.5

3.4

4.7

29.4

7.5

6.3

10.0

11.0

21.1

40.7

90.5

76.8

79.1

59.2

48.9

64.4

32.5

94.0

55.0

111.8

40.2

34.4

66.1

49.6

34.5

20.7

13.5

9.8

54.6

17.6

11.2

10.5

7.1

1.5

4.5

27.5

12.1

15.7

3.1

2.8

5.3

29.8

4.6

3.9

8.1

99.7

97.2

94.1

91.0

92.1

95.5

99.2

87.0

98.4

72.3

76.7

80.8

83.1

95.8

76.2

91.7

102.9

121.4

Corporate debt (% of GDP)

54.4

58.3

67.5

69.2

49.1

37.3

42.7

51.0

56.7

68.9

80.5

26.2

42.4

141.8

38.5

22.3

48.3

165.3

Household Debt (% of GDP)

20.1

31.4

36.5

20.1

36.5

20.5

20.3

15.5

42.2

17.6

6.0

16.5

22.1

36.5

34.3

16.9

10.7

45.5

1.4

42.0

-

26.0

32.9

18.1

30.6

32.7

49.7

19.0

-

0

12.7

-

41.4

40.0

-

3.5

External Liquidity

External Debt (excl. ICL, % of GDP)** Short-term debt (% of GDP) REER (Index, 2010=100)* Domestic Finances

Nonresident holdings of gov. debt (% total) Banking System Credit Impulse (% of GDP)

2.6

1.1

2.5

1.3

-0.8

1.2

0.2

1.2

0.6

4.2

0.3

-1.6

-1.9

0

0.8

-1.1

2.0

0.2

Loans/deposit ratio (%)

73.5

71.3

75.2

73.5

97.3

80.8

104.1

91.4

99.5

121.5

120.8

111.9

82.1

163.7

185.9

95.4

79.0

73.5

NPL (% of total loans)

11.7

3.8

13.7

5.4

4.1

8.0

12.2

9.7

4.0

3.2

55.1

2.0

3.7

1.9

2.8

2.9

9.7

1.7

Domestic Banks CAR (%)

22.2

17.4

23.2

17.2

18.0

19.0

22.5

13.4

18.8

16.0

13.7

15.4

17.3

13.7

16.1

26.7

13.0

13.1

Domestic Banks RoE (%)

10.7

17.7

3.4

20.8

7.8

12.9

11.0

12.3

10.9

17.5

7.8

20.2

12.1

16.3

21.7

16.0

4.5

7.6

*Increase means appreciation; **External Debt CZ, HU, SR (USD), SK for 5Y; ***IBRD and WEF indicators as of 2015


Legend Not vulnerable Somewhat vulnerable Moderately vulnerable Highly vulnerable

UniCredit Research

page 42



January 2018

CEE Quarterly

EM VULNERABILITY HEATMAP (CONTINUED) BG

CZ

HR

HU

PL

RO

RS

RU

SK

TR

UA

MX

BR

CL

SA

ID

IN

CN

Policy Policy Rate, nominal (%)

-

0.5

3.0

0.9

1.5

1.8

3.5

7.8

0

12.8

14.5

7.3

7.0

2.5

6.8

6.5

6.0

4.4

Real policy rate (%)

-

-2.1

-

-1.6

-0.5

-1.5

0.7

5.2

-1.9

0.8

0.9

0.6

4.2

0.8

2.1

2.9

1.1

2.7

Real Money market rate (%)

-

-1.9

-0.9

-2.5

-0.3

-1.4

0.4

4.3

-2.3

0.9

4.4

0.9

5.0

0.7

2.2

1.7

6.6

3.1

1.8

2.6

1.2

2.5

2.0

3.2

2.8

2.5

1.9

11.9

13.6

6.6

2.8

1.7

4.6

3.6

4.9

1.6

-0.2

2.1

1.4

1.1

0.9

0.8

1.7

2.3

2.8

12.3

8.6

4.9

3.9

1.8

4.4

3.0

4.7

2.3

0.4

0.5

-1.3

-2.6

-2.7

-3.0

-1.0

-2.1

-1.2

-3.2

-2.9

-1.4

-9.2

-3.1

-4.5

-2.7

-6.4

-3.7

Headline inflation (% yoy) Core Inflation (% yoy) GG Fiscal balance (% of GDP) GG Primary balance (% of GDP)

1.2

1.2

1.7

0.1

-0.9

-1.8

2.1

-1.6

0.1

-1.6

1.2

1.8

-2.5

-2.8

-0.9

-1.1

-1.5

-2.8

25.1

34.5

81.9

72.9

54.2

38.9

70.9

17.4

50.9

27.9

86.2

53.3

83.4

24.9

53.0

28.7

68.7

47.6

72.6

23.2

162.7

46.0

58.6

167.3

91.6

145.5

27.3

254.8

430.5

119.4

191.4

46.0

189.9

107.4

119.1

87.0

0

0.9

1.0

1.1

2.7

3.8

4.7

7.0

-0.2

12.0

14.9

7.6

8.4

3.6

7.9

6.0

7.1

3.8

111.0

68.9

198.3

198.3

158.3

152.2

-

78.2

0

-163.0

-

6.8

201.4

178.3

142.6

78.0

72.5

29.2

55.0

33.0

92.0

83.0

46.0

87.0

129.0

116.0

44.0

160.3

427.0

97.7

147.0

45.8

149.6

79.3

66.0

48.0

0

3.9

4.0

4.2

5.0

3.8

0

10.8

0

12.5

n.a.

13.2

12.7

9.0

14.5

5.2

5.3

4.2

IBRD Doing Business

50.0

30.0

51.0

48.0

27.0

45.0

43.0

35.0

39.0

60.0

76.0

49.0

125.0

55.0

82.0

72.0

100.0

78.0

WEF Competitiveness Ranking

49.0

31.0

74.0

60.0

39.0

68.0

78.0

38.0

59.0

53.0

81.0

51.0

80.0

33.0

61.0

36.0

40.0

27.0

5.3

3.9

10.7

4.1

6.7

4.8

13.0

5.1

6.0

10.6

8.9

3.4

12.0

6.5

27.7

5.5

8.0

4.0

Government Debt (% of GDP) Markets Local Debt Spread (10Y, bp) Local Currency Curve (5Y, %) Local currency bond spread (2s10s) CDS (5Y, bp) FX 3m implied volatility (%) Structural*

Unemployment (%)

*Increase means appreciation; **External Debt CZ, HU, SR (USD), SK for 5Y; ***IBRD and WEF indicators as of 2015


Legend Not vulnerable Somewhat vulnerable Moderately vulnerable Highly vulnerable

UniCredit Research

page 43



January 2018

CEE Quarterly

Acronyms and abbreviations used in the CEE Quarterly BNB Bulgarian National Bank

IMF

International Monetary Fund

C/A

MoF

Ministry of finance

current account

CBR Central Bank of Russia

NBH National Bank of Hungary

CBRT Central Bank of the Republic of Turkey

NBP

CE

Central Europe

NBR National Bank of Romania

CEE

Central and Eastern Europe

NBS

National Bank of Poland

National Bank of Serbia

CNB Czech National Bank

NBU National Bank of Ukraine

DM

developed markets

PLL

Precautionary and Liquidity Line (from the IMF)

EA

euro area

PM

prime minister

EC

European Commission

PPP

public – private partnership

EBB

extended basic balance

qoq

quarter on quarter

ECB

European Central Bank

sa

seasonally adjusted

EDP

Excessive Deficit Procedure of the European Commission

SBA

Stand-by Arrangement (with the IMF)

EM

emerging markets

SOE

state-owned enterprise

EMU European Monetary Union

WB

World Bank

EU

European Union

yoy

year on year

FCL

Flexible Credit Line (from the IMF)

ytd

year to date

FDI

foreign direct investment

IFI

international financial institutions

UniCredit Research

page 44


January 2018


CEE Quarterly

Countries

UniCredit Research

page 45



January 2018

CEE Quarterly

Bulgaria

Baa2 stable/BBB- stable/BBB stable*

Outlook – Our baseline scenario envisages real GDP growth to accelerate to 4.4% this year, well above the 4% likely to have been recorded in 2017. Importantly, the structure of GDP growth will improve, with investment expected to join the strong expansion in consumption and exports, thus helping improve the sustainability of growth. 2019 is likely to be another strong year as well, with growth easing only marginally to 4.2% on the back of the anticipated slowdown in global growth and weaker job creation at home as labor market conditions tighten. Risks for this above-consensus macroeconomic forecast remain broadly balanced, with the main question whether the authorities will use the very favorable environment afforded by the strong cyclical recovery to deal with some of the remaining long-term structural weaknesses. Strategy – Bond scarcity and bank excess liquidity will continue supporting Bulgarian bonds. Authors: Kristofor Pavlov, Chief Economist (UniCredit Bulbank) Javier Sánchez, CFA, CEE Fixed Income Strategist (UniCredit Bank, London) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS

■ 1H18: Bulgaria to preside over EU Council ■ Mid-Feb: GDP flash estimates for 4Q17 ■ Mid-Feb: Labor force survey data for 4Q17

yoy (%)

Public consumption Net Export

6.0 3.9 3.6

4.0

4.4

2016

2017E

2018F

2019F

45.3

48.1

51.0

54.1

57.6

Population (mn)

7.2

7.1

7.1

7.0

7.0

6,330

6,777

7,222

7,703

8,245

GDP

3.6

3.9

4.0

4.4

4.2

Private Consumption

3.9

3.4

4.5

4.6

4.5

Fixed Investment

2.7

-6.6

2.7

5.5

6.2

Public Consumption

2.9

2.6

3.0

3.5

3.1

Exports

5.7

8.1

5.6

6.1

5.9

Imports

5.4

4.5

5.6

6.5

6.6

Monthly wage, nominal (EUR)

449

492

540

592

647

Real wage, change (%)

7.0

10.3

7.9

7.8

7.1

Unemployment rate (%)

9.1

7.6

6.2

5.3

4.6 -0.7

Real economy, yoy change (%)

8.0

4.0

2015

GDP (EUR bn) GDP per capita (EUR)

FASTER GROWTH ON THE HORIZON Private consumption Fixed Investments GDP, real growth

EUR bn

4.2

Fiscal accounts (% of GDP)

2.0

0.0

-2.0

2015

2016

2017F

2018F

2019F

INFLATION ON AN UPTREND yoy (%) 4.0

Budget balance

-1.6

0

0.2

-0.3

Primary balance

-0.7

0.8

0.9

0.3

-0.1

Public debt

25.6

28.6

25.1

23.9

23.2

Current account balance (EUR bn)

0

2.6

2.5

2.0

1.8

Current account balance/GDP (%)

0

5.3

4.9

3.7

3.1

Extended basic balance/GDP (%)

8.0

8.1

7.9

6.7

6.4

Net FDI (% of GDP)

5.1

0.7

2.3

2.2

2.3

Gross foreign debt (% of GDP)

73.6

70.7

64.1

60.0

56.1

FX reserves (EUR bn)

20.3

23.9

22.9

24.3

26.2

8.0

9.4

8.2

7.8

7.6

External accounts

3.0

Months of imports, goods & services 2.0

Inflation/Monetary/FX

1.0

CPI (pavg)

-0.1

-0.8

2.0

1.7

2.3

0.0

CPI (eop)

-0.4

0.1

2.4

1.7

2.7

Central bank reference rate (eop)

0.01

0

0

0

0

USD/BGN (eop)

1.79

1.86

1.64

1.56

1.53

EUR/BGN (eop)

1.96

1.96

1.96

1.96

1.96

USD/BGN (pavg)

1.76

1.77

1.73

1.60

1.54

EUR/BGN (pavg)

1.96

1.96

1.96

1.96

1.96

137.5

136.6

138.7

139.0

137.5

-2.1

-0.6

1.5

0.2

-1.0

-1.0 -2.0 -3.0 Dec-15

Dec-16

Dec-17

Dec-18

Dec-19

Source: NSI, UniCredit Research

Real effective exchange rate, 2000=100 Change (%)

Source: BNB, Eurostat, MoF, NSI, UniCredit Research *

Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch respectively

UniCredit Research

page 46



January 2018

CEE Quarterly

Wind in the sails for the economy We keep our above consensus growth forecast for 2018 (4.4% versus 3.3% Consensus)

For the Bulgarian economy, 2017 was a very strong year, with GDP growth likely to have reached 4%. The outlook remains very favorable, and we expect GDP growth will accelerate to 4.4% in 2018, before easing only slightly to 4.2% in 2019. The acceleration in growth in 2018 will be driven by four main factors: a rebound in global trade; a shift toward more growth- supportive fiscal policy; stronger private sector capex in both construction and machinery and equipment, and more EU funds-financed public infrastructure projects. The less vigorous growth expectations for 2019 are mostly attributable to the anticipated slowdown in global growth and weaker job creation at home as the labor market recovery reaches an advanced phase and the number of sectors facing labor shortages increases. We expect headline inflation to remain weak, while core prices will be on a shallow upward trend in both 2018 and 2019, as the economy is coming closer to full employment. Importantly, strong GDP growth will be accompanied by a further reduction in external debt, which will help the net international investment position to improve to a level below the -35% of GDP threshold set in the EC macroeconomic imbalances procedure in 2018, after peaking at -92% of GDP in 2010. The rebound in global trade, which already started in 2017, is set to continue into 2018. Against this very positive external backdrop, we expect Bulgarian export growth to firm slightly to 6.1% in 2018, from an already strong 5.6% in FY2017 (see lhs chart), with the impulse from the solid global trade growth more than offsetting the negative impact stemming from the euro’s appreciation. Export volumes will also draw support from the gradual expansion of production capacities in manufacturing and higher business travel revenues associated with the rotating Presidency of the EU in 1H18. A slight moderation in export growth is envisaged in 2019 (to 5.9%) to reflect the continuing euro appreciation and a tad weaker global growth.

Strong global trade will offset the drag stemming from euro appreciation

After fiscal policy remained broadly growth neutral last year, it is set to turn slightly stimulative in 2018. With nominal GDP growth likely to be stronger than the 5.3% (real GDP growth plus average HCPI) envisaged in the fiscal program, revenues are likely to exceed the 35.8% of GDP target. This, in turn, should create additional fiscal room to increase spending, on top of the moderate rise in public sector wages and capex already incorporated in the budget. All in all, we expect the ESA 2010 general government balance to shift to a 0.3% of GDP deficit (slightly below the balanced budget target in the fiscal plan), which, given the 0.2% surplus expected in the previous year, should translate into a modest fiscal stimulus in 2018.

Fiscal policy will be growth supportive

Large part of the acceleration in GDP growth will come from investment

The recovery in investment is likely to gain traction in 2018. Business sentiment is at a post-2009 high both for companies in manufacturing and in construction (see rhs chart). Fixed investment will continue benefiting from improved corporate profitability, sizeable net corporate savings, and loose financial conditions, which are likely to push bank lending rates down even further in 2018.

The export focus of the economy will deepen…

…pulling sentiment higher across the economy Headline industrial confidence indicator Headline construction confidence indicator

Export of goods and services/GDP (rs) Export of goods and services, real yoy growth

%

20

9.0

90

8.0

80

7.0

70

6.0

60

5.0

50

4.0

40

3.0

30

0

2.0

2014

2015

2016

2017F

2018F

2019F

-20

-40

-60 Nov-09

20

Nov-10

Nov-11

Nov-12

Nov-13

Nov-14

Nov-15

Nov-16

Nov-17

Source: Eurostat, NSI, UniCredit Research

UniCredit Research

page 47



January 2018

CEE Quarterly

The recovery in GFCF is likely to broaden in 2018…

This reconfirms the pattern in place so far in this upswing, with companies financing new investment through internally generated funds. This explains the still very lackluster credit growth so late in the cycle. It was private residential construction that helped boost the fixed investment rise in 2017 by an estimated 2.7%. In 2018, we forecast investment to accelerate to 5.5% (see lhs chart), supported in two ways. First, we expect public sector construction to finally join the recovery, with earlier delays in the preparation of the EU-funded projects now overcome and a large number of infrastructure projects from the new planning period likely to start soon. Second, and perhaps more importantly, we expect private investment in machinery and equipment to rise as well. This is because export-oriented manufacturers, belonging to global production chains, are set to expand their production capacity. This expansion, in our view, is likely to go beyond large cities, where unemployment is already only a fraction of the national average, and include regions with pockets of high unemployment in order to benefit from the still available labor pool.

…to involve public on top of private sector …

…and not only construction, but also machinery and equipment component

We forecast private consumption to expand by 4.6% in 2018 – similar to the 4.5% likely to have been recorded in 2017. This is supported by solid wage growth, which has pushed household confidence to its highest post-crisis level (rhs chart below), and has been the main driver behind the pronounced growth in disposable income. This GDP recovery has seen an increase in the labor participation rate to a level never seen since the onset of the transition. Nevertheless, at 67.2% labor participation is still below that in many CEE EU members, which suggests that there is room for a further increase in job creation, especially if more and better financed programs are put in place to promote employment among young people and women. The positive outlook for individual consumption is further underpinned by low retail credit rates and the positive wealth effect thanks to the ongoing rise in housing prices.

Private consumption is far from losing steam

Despite the favorable outlook, a number of risks remain. On the external front, geopolitical risks abound. Further escalation of the tension between Saudi Arabia and Iran could potentially lead to much higher crude oil prices. Higher inflation in developed economies could hurt economic growth in some of Bulgaria’s main trading partners and force central banks to bring their accommodative monetary policy to a halt. The potentially most damaging effect from such a scenario, however, is likely to be indirect, as the resulting reversal of capital flows could deal a major blow to growth in Turkey – Bulgaria’s third largest export market.

Geopolitical risks remain elevated

There are also several internal risks to watch. Potentially most disruptive among them would be a resurgence of inflation. So far, high wage growth has had almost no impact on core inflation, suggesting that the pronounced rise in labor costs over the past two years mostly reflects a reduction of the grey economy, while the genuine rise in labor costs is smaller – something which strong export growth seems to reconfirm. But with house price inflation returning and with the economy now close to full employment, the “wrong type” of inflation may prove closer than anticipated. And finally, while the risks of a policy slippage seem limited, it would be wrong to think of them as nonexistent, especially on structural reforms.

Higher headline inflation can hurt consumption

Investment is on course to recover

Optimism is close to pre-crisis highs Headline households confidence indicator

Gross fixed capital formation/GDP (rs) %

Gross fixed capital formation, real yoy growth

Household's unemployment expectations, inverted (rs)

15.0

24.0

10.0

22.0

5.0

20.0

0.0

18.0

-5.0

-10.0

-20

-10

-30

-30

-40

-50

16.0

2013

2014

2015

2016

2017F

2018F

2019F

-50 Nov-09

14.0

Nov-10

Nov-11

Nov-12

Nov-13

Nov-14

Nov-15

Nov-16

-70 Nov-17


UniCredit Research

page 48



January 2018

CEE Quarterly

Strategy: nice bond, if you can get it Javier Sánchez, CFA CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077 Javier.sanchezbarrueco@ unicredit.eu

Bulgarian bonds were among the top CEE Eurobond performers in 2017, supported by strong external and fiscal accounts and an overall improvement of the macro environment that was rewarded in December with rating upgrades by S&P, to a low BBB- investment grade, and by Fitch to BBB. However, ratings are of secondary importance in determining bond valuations and spreads had traded in line with higher-rated credits for a while. Bond scarcity and local banks’ excess liquidity have driven spreads down and will continue to do so in 2018. Bonds will remain scarce as we do not foresee any Eurobond issuance in 2018-19 and the large EUR 500mn in maturities of BULGGB in January will further increase banking liquidity. Bulgarian Eurobonds are tightly held by resident investors, in particular banks, which own about 52% of the total outstanding. Local investment alternatives are limited, with BULGGB having negative yields up to the 2023 maturities, and the 2028 and 2035 bonds will remain well bid as local participation is relatively smaller and is set to increase across the curve.

Bulgarian bonds are good alternatives to Poland and Hungary 200

With the bonds set to remain well bid in 2018 Bulgarian EUR bonds

EUR denominated bond

BG

z-spread (in bp)

HU

RO

PL

320

2023

z-spread (in bp)

2028

2035

280

EUR Z-spread (in bp)

150

240 200

100 160 120

50

80

0

40 0

-50 0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

-40 Q1

Q2

Q3

Q4

Q1

Q2

Q4

Q3

Modified Duration

2016

2017


GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit (cash basis) Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other Fiscal reserves change (- =increase)

2017E 1.3 -0.3 1.5 0.4 0.4 0 0 1.1 1.0 0.2 1.3 0.4 0.4 0 0 0.1 0 0.1 0 0.8

2018F 1.0 0.3 0.7 0.5 0.5 0 0 0.2 0 0.2 1.0 0.6 0.6 0 0 0.1 0 0.1 0 0.3

GROSS EXTERNAL FINANCING REQUIREMENTS 2019F 1.2 0.6 0.7 0.5 0.5 0 0 0.2 0 0.2 1.2 0.9 0.9 0 0 0.1 0 0.1 0 0.2

EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- =increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net

2017E 9.5 -2.5 4.6 1.1 0.4 3.0 7.4 9.5 1.2 -1.2 3.1 0.1 0.4 2.6 7.2 0.3 -2.1 -1.0

2018F 8.7 -2.0 3.5 0.2 0.4 2.9 7.2 8.7 1.2 -0.2 3.2 0.1 0.4 2.6 7.0 0.4 -1.5 1.4

2019F 8.5 -1.8 3.3 0.2 0.4 2.7 7.0 8.5 1.3 -0.2 3.1 0.1 0.5 2.6 6.8 0.5 -1.2 1.8

0 -1.0

0 0

0 0

Source: BNB, MoF, UniCredit Research

UniCredit Research

page 49



January 2018

CEE Quarterly

Croatia

Ba2 stable/BB positive/BB stable*

Outlook – The near-term outlook remains constructive, with growth likely to continue at about 2.8% a year in both 2018 and 2019. Growth will be supported by expected robust demand from the eurozone and CEE-EU countries, as well as the expected acceleration of fixed investment afforded by improved EU fund utilization, offsetting a likely moderation in private consumption. The solid economic growth should support the sustainability of government revenues, leaving the fiscal deficit below 1% in the medium term and ensuring a further decline in public debt at the solid pace of about 2.5% of GDP per year. Such developments may initiate a long-awaited sovereign rating upgrade to Investment grade by the end of the forecast period. Current market risk premia already price in such a view. Authors: Hrvoje Dolenec, Chief Economist (Zagrebačka banka) Javier Sánchez, CFA, CEE Fixed Income Strategist (UniCredit Bank, London) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS

■ 28 Feb: Flash estimate 4Q and FY17 GDP ■ 2 Mar: 4Q GDP detailed release ■ 30 Mar: 4Q and FY17 BoP ■ Apr: Fiscal notification

4

2015

2016

2017E

2018F

2019F

GDP (EUR bn)

44.5

46.4

48.5

50.3

52.4

Population (mn)

4.2

4.2

4.1

4.1

4.1

10,597

11,115

11,696

12,231

12,827

GDP

2.3

3.2

3.0

2.8

2.8

Private Consumption

1.0

3.5

3.6

2.8

2.5

Fixed Investment

3.8

5.3

4.2

6.1

6.7

-0.9

1.9

1.9

1.5

1.5

Exports

9.4

5.6

6.5

6.1

5.5

Imports

9.2

6.2

7.8

7.2

6.4

1,000

1,029

1,078

1,114

1,152

GDP per capita (EUR) Real economy, change (%)

EXPORTS AND INVESTMENT AS FOUNDATION Private Consumption Investment Net Exports

EUR bn

Government Consumption Inventories GDP

3 2

Public Consumption

Monthly gross wage, nominal (EUR) Real wage, change (%)

1.8

3.0

2.5

1.5

1.7


16.3

13.1

12.0

10.7

10.0

Budget balance

-3.3

-0.9

-0.9

-0.8

-0.6

Primary balance

0.2

2.3

1.9

1.9

1.9

85.4

82.7

80.3

77.9

75.7


2.1

1.2

1.8

1.2

1.1


4.7

2.6

3.6

2.5

2.2


6.0

7.9

7.7

7.8

7.6

Net FDI (% of GDP)

0.6

4.2

1.8

2.8

2.8

101.9

89.8

81.8

76.8

74.4

13.7

13.5

14.5

15.5

16.6

8.1

7.6

7.4

7.3

7.2 1.5

Fiscal accounts (% of GDP) 1 0

Public debt

-1

External accounts

-2 2014

2015

2016

2017E

2018F

2019F

DISTORTING EFFECT OF ENERGY PRICES

Gross foreign debt (% of GDP) % yoy 3.0


2.5

Months of imports, goods & services

2.0


1.5 1.0

CPI (pavg)

-0.5

-1.1

1.2

1.8

0.5

CPI (eop)

-0.6

0.2

1.7

1.3

2.2

-0.5

Central bank target

n.a.

n.a.

n.a.

n.a.

n.a.

-1.0


n.a.

n.a.

n.a.

n.a.

n.a.

3M money market rate (Dec avg)

1.24

0.82

0.70

0.75

0.90

USD/FX (eop)

6.99

7.17

6.31

6.00

5.86

EUR/FX (eop)

7.64

7.56

7.58

7.50

7.50

USD/FX (pavg)

6.86

6.81

6.58

6.13

5.88

EUR/FX (pavg)

7.61

7.53

7.46

7.46

7.44

Real effective exchange rate, 2000=100

99.8

99.8

99.8

98.0

92.7

Change (%)

-1.3

0

0.1

-1.9

-5.4

0.0

-1.5 -2.0 -2.5 Dec-13

Dec-14

Dec-15

Dec-16

Dec-17

Dec-18

Dec-19

Source: Crostat, UniCredit Research

Source: Eurostat, NSI, UniCredit Research *


UniCredit Research

page 50



January 2018

CEE Quarterly

Eyeing sovereign rating upgrade as fiscal position improves Pace of economic growth is being maintained, building solid foundation for near-term outlook…

…based on external demand from eurozone and CEE-EU and domestic demand, where fixed investment should gradually replace private consumption

Croatia’s economy has maintained a solid growth pace, now spread over most sectors, brushing aside the risks stemming from the collapse of Agrokor, the country’s largest employer. Growth has been underpinned by strong private consumption and a solid export performance of both goods and services (mostly tourism), benefitting from the upsurge in growth in the eurozone. During January-September, real GDP expanded at a 3% annual pace, which we foresee for FY 2017. Strong merchandise exports and robust gains in employment and wages have laid a solid foundation for growth in 2018 and 2019, buoyed also by the solid growth outlook for the eurozone and CEE-EU. However, 2017 was disappointing in terms of investment growth, with Agrokor failing, and EU funds’ absorption below public expectations. Looking forward, we expect investment to replace private consumption as the main driver of domestic demand and to accelerate over the medium term. Our growth projections remain at 2.8% for both 2018 and 2019, with two major potential risks. First, a creditors’ agreement on Agrokor is pending. It should result in a restructuring of Agrokor that would almost certainly result in downsizing of the holding companies, including employment redundancy cuts. It may also affect Agrokor’s large suppliers’ network. These potential employment losses could additionally affect private consumption, already set to slow once the impact of the 2017 tax stimulus fades. The second important factor is lackluster potential GDP growth which, at around 1.4%, remains less than half that in the rest of CEE-EU peers (estimated at 2.4-2.9%).

We keep 2.8% outlook view for both 2018 and 2019…

...faced with risks of final outcome in Agrokor restructuring and comparably low potential GDP estimates

Inflation is to remain in 1-2% range, testing occasionally the upper bound due to fading potential output gap and administrative price adjustments

The combination of robust near-term growth and low potential GDP growth implies that the output gap is about to close or may have already closed during 2017. This could certainly result in inflation pressures, something that has been avoided for many years. With inflation in Croatia mainly imported from the eurozone, and the latter still subdued, we do not expect an additional push. Moreover, Croatia already went through increases in administrative energy prices last autumn, which should result in a mitigating base effect in the latter part of the 2018. Therefore, we expect inflation, after temporarily rising above 2% during the summer, to slow in the second half of 2018, before picking up again in late 2019.

CA surplus should be sustained in medium term, although rising imports might reduce it gradually…

Croatia’s very strong external position should start weakening slowly in 2018/2019 as the C/A surplus narrows. With the contribution of domestic demand to GDP evolving, dependence of the economy on imports should result in faster import growth that would outpace the continued solid performance of exports and tourism revenues. However, combined with strong capital inflows (mainly EU funds and FDI), the extended basic balance surplus should be sustained in the medium term, helping to extend the decline in foreign debt.

…indicating that the recent slowdown in the investment recovery might be only temporary

Investment to replace moderating consumption… GFCF

yoy (%)

…but potential output weighs on growth yoy (%)

Private consumption

10

CEE10

HR

6 5

5

4 0

3

-5

2 1

-10

0 -15

-1 -2

-20 1Q10

1Q11

1Q12

1Q13

1Q14

1Q15

1Q16

1Q17

2004

1Q18

2006

2008

2010

2012

2014

2016

2018

Source: Crostat, European Commission, UniCredit Research

UniCredit Research

page 51



January 2018

CEE Quarterly

Debt indicators in the country improve rapidly from comparably high levels…

…including public debt and fiscal gaps – developments that should support…

The improvement in foreign debt indicators is closely related to the improvement in broader debt metrics, both of the private and the public sector. The former was mostly linked with developments in the banking sector. The CHF loan conversion and accelerated NPL disposal by banks reduced significantly the debt burden of both companies and individuals, bringing private debt levels below levels resulting in widening macroeconomic imbalances. However, this trend needs to continue as the Croatian economy is still operating at higher debt levels compared to CEE-EU peers.

…intention of the authorities to pursue euro adoption strategy in the medium term

Furthermore, the public debt decline becomes increasingly important in terms of: 1) the perception of investors as regards Croatia’s sovereign debt and 2) the authorities’ new strategy on eurozone accession. The general government deficit in 2017 should at least remain at levels of 2016, when it fell to a historic low of 0.9% of GDP. Revenues, buoyed by strong growth, have been performing well yet again. The government has allowed spending volumes to adjust to revenues, but they also reshuffle it to cover gaps in specific areas – health care sector and education – areas we always point out as weak spots requiring reforming efforts. The outlook for 2018 is just mirroring these historic performances.

Fiscal policy targets are in this direction, but face some risks in terms of spending structure

Going forward, the government aims to cut the deficit to 0.5% of GDP in 2018 and shift to balance in 2019, with public debt declining towards 70% by 2020. However, we see significant risks to these targets. One is that nondiscretionary spending (salaries, social transfers) is accelerating. This, however, does not fit with the sustainability of the structural balance. Thus far, it has been offset by the decline in interest expenditures, benefiting from the replacement of high-cost old debt with new debt at much improved terms. The government also initiated a restructuring of the state-owned road sector debt to lower funding costs and extend duration, removing pressure on the redemption profile. The second risk is, above all, the health sector, which generates significant deficits year after year. It is in urgent need of reforms if these deficits are to be closed and the burden it creates on public finances eased. Finally, the long-term sustainability of the pension system remains an issue, with the current pay-as-you-go system being financed partly from general taxes, with pension contributions covering only 55% of pension benefits, and the second-pillar system has only started to disburse funds.

Some of the fiscal issues call for urgent reforms, like in health care sector or pension system to make them sustainable

Eurostrategy may prove to be a catalyst for reform impetus, as the list seems demanding given… …euro accession requirements, alignment of headline quantitative criteria, fulfillment of institutional convergence and real convergence

There is also a separate list of reforms on the government’s agenda incorporated in the authorities’ Eurostrategy. The latter aims at euro adoption, but for now has only one target – entering ERM II by 2020. Achieving this goal would require strong dedication towards meeting the budget targets and reducing public debt well below 80% of GDP in the next couple of years. At present, public debt and the budget deficit targets are on the right track. However, besides quantitative targets (which, besides the public debt, are more/less within the required range), there is a lot do on institutional convergence. This includes at least two areas: judicial reform, especially in respect to commercial law, and public administration reform.

Debt metrics improve for Croatia despite lag…

140

…with public finances maintaining momentum

Net international investment position (-) External debt net External debt gross Private consolidated debt Public debt

GDP (%)

General government balance Primary balance GDP (%)

Structural balance

4.0

120

2.0

100

0.0

80

-2.0

60 -4.0 40 -6.0

20 0

-8.0

-20

-10.0 HR

HU

RO

BG

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Source: Crostat, Eurostat, EC, CNB, UniCredit Research

UniCredit Research

page 52



January 2018

CEE Quarterly

Strategy: an interesting diversification play Javier Sánchez, CFA CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077 Javier.sanchezbarrueco@ unicredit.eu

Croatian USD bonds were among the best performing bonds in CEE, particularly at the longer end of the curve. The performance of EUR-denominated bonds was better than USD ones but lagged those of other lower-rated CEE credits in the EUR indices such as Montenegro and Macedonia. Among its credit peers, the choice between Serbia and Croatia is a matter of relative valuation, as the metrics in both credits have improved and are trading in line with higher-rated credits. Croatia has better external accounts than Serbia – with a current account surplus and a narrowing net debtor international position – but for most other metrics the two credits are hardly different: fiscal balances are expected to be in surplus, with Serbia’s structural balance slightly better than that in Croatia, public debt is expected to decline in the years ahead, growth rates are similar and inflation is within the target bands. Valuation favors Serbian USD bonds at the short end and is a toss-up in the belly of the Croatian curve. The bonds are an interesting diversification play compared to higher credits such as Romania and Hungary and are attractive in comparison..

Croatia is a good diversification play in CEE

And are attractive against Romanian bonds

RO (Baa3/BBB-) HR(Ba2/BB)

USD bond yield pick-up of

HU (Baa3/BBB-*+) RS (Ba3)

Croatia vs. Romania (in bp)

160

USD '23

USD'24

80

USD Z-spread (in bp)

70

120 60

80

50

40

40

30

0 0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

20 Jan

Modified Duration

Feb

Mar

Apr May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

2017


GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other

2017E 10.0 0.4 9.5 7.1 1.3 3.9 1.9 2.5 2.4 0.1 10.0 7.2 2.3 3.9 0.9 2.6 2.5 0.1 0.2

2018F 5.9 0.4 5.5 4.1 0.8 2.4 0.9 1.4 1.3 0.1 5.9 4.4 1.2 2.4 0.8 1.4 1.0 0.4 0.1

GROSS EXTERNAL FINANCING REQUIREMENTS EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- = increase) Memoranda: International bond issuance, net

2019F 7.9 0.3 7.6 5.3 1.0 3.9 0.4 2.2 2.1 0.1 7.9 6.5 1.3 3.9 1.2 1.3 1.3 0.1 0.1

2017E 13.4 -1.8 7.9 2.5 1.0 4.4 7.3 4.4 1.8 1.1 13.4 0.9 0.7 5.7 2.6 1.0 2.1 6.1 1.0 0 -1.0

2018F 10.8 -1.2 5.5 1.4 1.0 3.1 6.5 4.0 1.5 1.0 10.8 1.4 0.7 4.1 1.4 1.0 1.7 4.4 1.1 0 -1.0

2019F 9.1 -1.1 4.8 2.2 0.8 1.8 5.4 3.6 0.8 1.0 9.1 1.5 0.7 3.3 1.5 0.8 1.0 3.5 1.2 0 -1.1

1.2

0.3

0.1

Source: CNB, Crostat, MoF, UniCredit Research

UniCredit Research

page 53



January 2018

CEE Quarterly

Czech Republic

A1 stable/AA- stable/A+ stable*

Outlook – GDP growth is seen slowing to a still above-potential 3.5% in 2018. We expect the CNB to recognize the need for faster monetary policy tightening in its February forecast, paving the way for the repo rate to reach 1.50% by late 2018. The EUR-CZK exchange rate may not systemically drop below 25.0 due to the overbought CZK positions as well as less support than in 2017 for CZK from economic fundamentals. In 2019, less support from external demand and tight domestic labor market conditions may slow growth to below 3%. Strategy – investors are overexposed to CZK and CZGBs and we expect money-market rates to continue rising. Authors: Pavel Sobisek, Chief Economist (UniCredit Bank Czech Republic and Slovakia) Javier Sánchez, CFA, CEE Fixed Income Strategist (UniCredit Bank, London) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS

EUR bn

2015

2016

2017E

2018F

2019F

■ 1 Feb, 21 Mar: CNB policy meetings ■ 14 Feb, 3 Mar, 31 Mar: 4Q17 GDP: (flash, structure, accounts) ■ 12-13 Jan, 27-28 Jan: presidential elections (1st and 2 leg)

GDP (EUR bn)

168.5

176.5

192.0

211.4

220.3

Population (mn)

10.5

10.6

10.6

10.6

10.6

15,985

16,705

18,136

19,922

20,728

GDP

5.4

2.5

4.5

3.5

2.8

Private Consumption

3.7

3.5

4.0

4.2

3.4

10.4

-2.5

5.2

4.1

4.0

Public Consumption

1.9

2.0

2.0

2.0

2.0

Exports

6.2

4.3

6.6

5.3

4.1

Imports

7.0

3.1

5.8

5.4

4.8


975

1,020

1,125

1,271

1,339


2.9

3.0

4.6

5.2

2.8


6.5

5.5

4.2

3.9

4.2

Budget balance

-0.6

0.7

0.7

0.2

-0.5

Primary balance

0.4

1.6

0

0

0

40.0

36.8

34.0

32.2

31.5


0.4

1.9

1.1

1.3

1.2


0.2

1.1

0.6

0.6

0.5


2.2

6.2

5.1

5.4

4.9

Net FDI (% of GDP)

-1.1

3.0

2.6

3.0

2.7


69.5

74.0

90.1

90.5

89.9


59.2

81.3

125.0

126.0

127.0

5.6

7.7

12.5

11.3

9.7

CPI (pavg)

0.3

0.7

2.4

2.6

2.2

CPI (eop)

0.1

2.0

2.4

2.4

2.2

Central bank target

2.0

2.0

2.0

2.0

2.0


0.1

0.1

0.5

1.5

2.0


0.3

0.3

1.0

1.7

2.2

USD/FX (eop)

24.8

25.6

21.2

20.0

19.5

EUR/FX (eop)

27.0

27.0

25.4

25.0

25.0

USD/FX (pavg)

24.6

24.4

23.1

20.6

19.7

EUR/FX (pavg)

27.3

27.0

26.3

25.1

25.0

132.2

135.3

140.0

145.1

142.3

0.8

2.4

3.5

3.6

-1.9


nd

Fixed Investment

SLOWER GDP GROWTH DESPITE POSITIVE PRIVATE CONSUMPTION Consumption Contribution to GDP (p.p.)

Gross capital

Export

6.0

GDP (yoy %)

4.0

Fiscal accounts (% of GDP) 2.0

Public debt

0.0

External accounts -2.0 2014

2015

2016

2017F

2018F

2019F

CPI TO BE DRIVEN MORE BY DEMAND THAN COSTS CPI

yoy (%)

PPI

4.0


Corecast 3.0

2.0

1.0

0.0 Jan-17

Jul-17

Jan-18


Jul-18

Jan-19





UniCredit Research

page 54



January 2018

CEE Quarterly

Mind the output gap Lower contribution from investment and net exports will affect GDP growth in 2018

Car demand in Europe is seen as a potential drag on exports

Following a cyclical peak of 4.5% reached in 2017, GDP growth is seen slowing to a still above-potential 3.5% in 2018. With net exports and fixed capital formation expected to contribute less to growth than in 2017, private consumption may, in contrast, contribute marginally more. Tight labor conditions may force many manufacturers to shift their focus to increasing productivity, which is in general welcome but is unlikely to be smooth. We expect the CNB to recognize the need for faster monetary policy tightening in its February forecast, paving the way for the repo rate to reach 1.50% by late 2018. The EUR-CZK exchange rate may not systematically drop below 25.0 due to overbought CZK positions as well as less support for CZK from economic fundamentals. The external environment may remain supportive for Czech exports longer than previously thought, with above-potential growth in the eurozone in 2018-19. At the same time, we continue to believe that demand for cars in Europe will start to ease in 2018 after four years of an uninterrupted expansion. As a result, a slowdown in Czech exports of which a third is linked to the automotive industry seems inevitable in 2018. Our call is for real exports to increase by 5.3%, with the weakness gradually spreading through the year. Net exports may boost GDP growth in 2018, albeit to a lesser extent than in 2017. Weaker car demand from Europe could be offset in net exports by lower imports of machinery, while the share of construction in investment rises. The cyclical peak in corporate investment in machinery and transport equipment may be behind us as corporate profits may rise slower in 2018 and could start falling in 2019. In addition, the regular poll of manufacturers’ investment intentions for 2018 is the least optimistic since 2013. The 4% growth forecast for fixed capital formation is based on a bigger role of public infrastructure projects, financed partially with EU funds. The share of public investment in total gross capital formation may rise further in 2019 if the cyclical slowdown continues. In the same vein, fiscal policy is set to be broadly neutral in 2018 and moderately expansionary in 2019.

Corporate investment in machinery may face a cyclical slowdown; construction projects to become more important

Private consumption will be the key growth engine in 2018, slowing in 2019 in line with the rest of the economy. Employment growth may weaken already this year due to tight labor market conditions. However, households’ purchasing power could increase due to nominal wage growth peaking at more than 8% yoy, boosting real consumer spending by 4.2% in 2018 (slightly faster than in 2017). A slowdown is expected this year. Higher private wealth continues to push real estate prices higher. Prices are rising faster outside Prague, helped by mortgage loans increasing close to 10% yoy, faster than in the region. The average unemployment rate may fall to 3.9% in 2018 (by local standards), from 4.2% in 2017, as the skill mismatch between unemployed and job openings rises. With labor shortages looming across CEE, the arrival of workers from abroad can offset only part of the labor shortfall.

Private consumption is bolstered more by wage growth than by higher employment

Fixed capital formation mirrors gross operating income

Housing prices growing firmly in double-digits and accelerating

Gross operating surplus yoy

Fixed capital formation

Current prices yoy, NSA

Prague-secondhand

Total-secondhand

Prague - new

120.0

15

10 110.0 5

0 100.0 -5

90.0

-10 1Q10

1Q11

1Q12

1Q13

1Q14

1Q15

1Q16

2Q11

1Q17

1Q12

4Q12

3Q13

2Q14

1Q15

4Q15

3Q16

2Q17

Sources: CZSO, UniCredit Research

UniCredit Research

page 55



January 2018

CEE Quarterly

Labor costs outpace productivity, putting pressure on low-margin businesses

Faster wage growth may stem from both the labor shortage and the government’s plan for double-digit raises for public sector employees and those making the minimum wage. Wage costs have been rising faster than productivity since 2016, affecting the activity of low-margin businesses. The situation may trigger welcomed changes, especially in manufacturing, leading to a focus on higher value-added production and on improving productivity. However, such a process never tends to be smooth and higher unemployment could be a temporary consequence. As a result, this also adds to our cautiousness on the 2019 economic outlook.

The CNB may turn more hawkish in February…

The overheated economy is set to keep pressure on inflation. In line with the CNB’s forecast from November, we expect both headline and core inflation to stay between 2% and 3% yoy in 2018. The same CNB forecast, however, assumes a pause in interest rate increases lasting for most of 2018, which is a scenario contradicted by the policymakers’ views on the appropriate tightness of monetary policy. In particular, CNB Governor Jiří Rusnok has mentioned repeatedly that the policy rate is heading towards a neutral level of about 3%. In our view, the CNB is set to recognize the need for faster policy tightening in its February forecast. The forecast update could be close to the central bank’s alternative scenario from November, which showed slightly higher consumer prices, nominal wage and GDP growth while penciling in less currency appreciation.

…paving the way for the repo rate to reach 1.50% by late 2018

EUR-CZK is not seen dropping systematically below 25.0

Uncertain political outlook in case of a minority government

The CNB will resume disclosing its FX assumptions in February. The central bank hinted that EUR-CZK at around 25.50 was in line with the required real monetary conditions mix at the end of 2017. In fact, the koruna’s 5% appreciation since the end of CNB interventions may capture the strength of the Czech economy, the EUR-USD path, as well as the anticipated widening in the interest rate spread between the Czech Republic and the eurozone. As understood from CNB statements, the exchange rate’s reaction to higher CZK interest rates has been so far surprisingly weak, being attributed to long CZK positions on the FX market. With the positions changing little unless the CNB starts selling its FX reserves, we see scope for CNB hikes up to the repo rate of 1.50% without dragging EUR-CZK significantly below 25.0. By late 2018, the koruna may also lose support from above-consensus macroeconomic data, which is why we keep our end-2018 forecast for EUR-CZK at 25.0. Following the confidence vote on the minority government, which is deemed to fail on 10 January, Andrej Babiš will be given a second chance to form a government. The least desirable outcome is an unstable minority government seeking ad-hoc support across the political spectrum. This could make government policy unpredictable and probably more populist, hurting confidence in the private sector and on financial markets. Government formation will be complicated by the presidential elections. The incumbent president Miloš Zeman is the frontrunner in presidential elections and may be joined in the second round by Jiří Drahoš, an academic supported by higher-educated voters. We believe the government talks will not reach a final stage until a new president is known on 28th January.

All-time low unemployment, all-time high job vacancies Unemployed local

Vacancies - RS inversed

650

Compensation of employees has strongly outpaced productivity '000

yoy

25

Compensation of employees

Productivity

Compens. avg. since 1996

Product. avg. since 1996

10.0%

550

75

450

125

8.0%

6.0%

4.0%

350

175 2.0%

250 Jan-14

Oct-14

Jul-15

Apr-16

Jan-17

225 Oct-17

0.0% 1996-2000

2001-2005

2006-2010

2011-2015

2016-2017

Source: CZSO, UniCredit Research

UniCredit Research

page 56



January 2018

CEE Quarterly

Strategy: overexposed Javier Sánchez, CFA CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077 Javier.sanchezbarrueco@ unicredit.eu

Foreign investors’ exposure to Czech assets is at near all-time highs, both measured in terms of deposits and ownership of government bonds. Non-resident deposits exceeded EUR 66bn in October 2017 (about 30% of GDP) and foreigners own about 42% of local government bonds and have declined in recent months. With inflationary pressures running high, this exposure overhang is preventing a tightening of monetary conditions via a sustained appreciation of the CZK and we expect the CNB to continue hiking rates throughout 2018, which should continue putting pressure on short-term IRS rates as inflation expectations for 2018-19 are in excess of 2% and the current monetary policy mix remains too accommodative. In October 2017, we initiated a 1Y payer IRS recommendation at 67bp and maintain this recommendation with a target at 130bp. CZGB yields have widened significantly over the last months and are at levels against Bunds that begin to be attractive. However, the overhang of foreign investors’ exposure is a significant headwind for making a recommendation on the bonds, and real rates and asset-swap spreads are not attractive at these levels.

Non-resident deposits and ownership of CZGBs are rising

70,000

And so are rates

deposits of non-residents (EUR mn) non-resident holdings of CZGBs in % (rs)

Non-residents deposits (EUR mn) and CZGB ow nership (in %)

1.6

60

IRS 1Y and 2w repo rate forecasts

UC repo rate

1.4

forecast

60,000

50

1.2 1Y IRS

50,000

1.0

40 0.8

40,000

1Q f /c path

0.6

30 30,000

2Q f /c path

0.4

20,000

10,000 2010

2011

2012

2013

2014

2015

2016

3Q f /c path

20

0.2

10

0.0 Q1

2017

Q2

Q3 2016

Q4

Q1

Q2

Q4

Q3

Q1

Q2

Q3

Q4

2018

2017

Sources: CNB, UniCredit Research


2017E 10.8 0.2 10.6 10.6 8.6 2.0 0 0 0 0 10.8 10.8 8.3 2.5 0 0 0 0 0

2018F 14.8 2.0 12.8 10.7 8.0 2.5 0.2 2.0 2.0 0 14.8 12.7 10.8 1.8 0.1 2.1 2.0 0.1 0

GROSS EXTERNAL FINANCING REQUIREMENTS EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net

2019F 13.9 2.0 11.9 11.9 9.8 2.0 0.2 0 0 0 13.9 13.8 11.7 2.0 0.1 0.1 0 0.1 0

2017E 82.4 -1.1 12.1 7.8 2.9 1.5 71.4 82.4 4.9 -1.1 18.3 13.9 2.9 1.5 100.2 3.7 0 -43.7

2018F 77.8 -1.3 11.1 7.5 2.2 1.4 68.0 77.8 6.4 -0.5 9.0 5.4 2.2 1.4 60.2 3.8 0 -1.0

2019F 75.6 -1.2 10.8 7.4 2.1 1.3 66.0 75.6 6.0 0 8.6 5.2 2.1 1.3 57.3 3.7 0 0

6.2 0

-2.2 0

-2.2 0

Source: CNB, MoF, UniCredit Research

UniCredit Research

page 57


January 2018


CEE Quarterly

Hungary

Baa3 stable/BBB- positive/BBB- positive*

Outlook – Economic growth could reach a cyclical peak of approx. 4.5% in 2018, with external demand, EU funds, fiscal policy and base effects in industry and agriculture contributing. Growth may slow below 4% in 2019. Consumption will remain the biggest growth driver amid tightening labor market conditions. Monetary policy will remain loose, while the HUF may trade range-bound. Fidesz is expected to win this year’s parliamentary elections. Strategy – We favor duration exposure whether via HGB 25b or 10Y IRS receivers as the MNB starts providing unconditional swaps. Authors: Dan Bucșa, Chief CEE Economist (UniCredit Bank, London) Ágnes Halász, Head of Economics & Strategic Analysis (UniCredit Hungary) Javier Sánchez, CFA, CEE Fixed Income Strategist (UniCredit Bank, London)

MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS

EUR bn

2015

2016

2017E

2018F

2019F

■ 30 Jan, 27 Feb, 27 Mar: NBH monetary policy meetings ■ 14 Feb, 6 Mar: 4Q17 GDP (flash, structure) ■ April or May: parliamentary elections

GDP (EUR bn)

110.8

113.6

122.5

131.9

140.9

9.9

9.8

9.8

9.8

9.7

11,214

11,537

12,487

13,490

14,450

GDP

3.4

2.2

4.0

4.5

3.3

Private Consumption

3.6

4.3

4.5

4.2

2.8

Fixed Investment

1.9

-10.6

21.3

6.8

4.6

Public Consumption

1.0

0.8

-0.7

2.0

0.4

Exports

8.5

3.4

6.4

7.6

5.6

Imports

6.4

2.9

8.9

7.4

6.0

8.0


800

857

976

1051

1122

6.0


4.4

7.3

10.1

4.5

3.2

4.0


6.9

5.3

4.3

4.1

4.1

Budget balance

-1.6

-2.0

-2.4

-2.4

-2.2

Primary balance

2.0

1.2

0.8

0.8

1.0

74.7

73.9

73.3

73.2

71.6


3.8

7.0

4.7

6.3

6.7


3.5

6.1

3.9

4.8

4.8


9.1

7.9

7.7

11.2

10.3

GDP GROWTH FORECAST

yoy (%)

Net exports Fixed investment Private consumption

Change in inventories* Public consumption GDP

Population (mn) GDP per capita (EUR) Real economy, change (%)

Fiscal accounts (% of GDP) 2.0 0.0

Public debt

-2.0

External accounts

-4.0 2015

2016

2017E

2018F

2019F

*Adjusted with the statistical error

Net FDI (% of GDP)

INFLATION FORECAST

yoy (%)

1.0

1.7

0.9

2.1

1.7

108.2

96.1

86.4

79.1

74.0


30.0

24.0

23.7

24.0

25.9


13.0

3.2

2.8

2.7

2.8

CPI (pavg)

-0.1

0.5

2.7

3.6

3.4

CPI (eop)

0.9

1.8

2.7

2.7

3.3

Central bank target

3.0

3.0

3.0

3.0

3.0

1.35

0.90

0.90

0.90

0.90


Annual inflation rate

Base rate

Inflation target

Target range


4.5

3.5

2.5

Central bank reference rate (eop) 1.5


0.5

-0.5 Dec-15

Jun-16

Dec-16

Jun-17

Dec-17

Jun-18

Dec-18

Jun-19

Dec-19

Source: HCSO, UniCredit Research

1.36

0.34

0.03

0.03

0.15

USD/FX (eop)

286.6

293.7

258.8

250.4

244.5

EUR/FX (eop)

313.1

311.0

310.1

313.0

313.0

USD/FX (pavg)

279.3

281.5

274.4

255.0

244.8

EUR/FX (pavg)

309.9

311.8

309.3

310.7

310.6


120.2

120.9

122.8

122.3

120.5

-0.3

0.7

1.5

-0.4

-1.5

Change (%)

Source: Eurostat, HCSO, NBH, UniCredit Research

*


UniCredit Research

page 58



January 2018

CEE Quarterly

The best is yet to come 2018 may be the best year for the economy in three decades

2018 may be the best year for the Hungarian economy in the post-Communist era. The factors that could help growth accelerate to around 4.5% are strong demand from Europe, larger EU fund flows, a positive fiscal impulse and positive base effects in agriculture and industrial production. Hungary will benefit this year from growth in the eurozone exceeding 2% and from a renewed boost to exports coming from additional production capacities at car manufacturers. The latter reduced work shifts in 2017 while expanding production facilities and are now ready to boost production and sales. Thus, car and car-part manufacturing may account in 2018 for more than a third of manufacturing output and will add to the strong rise in output in electronics, chemicals and food processing. The potential result is a larger trade surplus (8.4% of GDP) despite private consumption and fixed investment growing by a combined 4.5% this year.

Car manufacturing could contribute more to growth in 2018…

Public investment is expected to grow slower than in 2017 due to base effects but EU funds will play a bigger role. Last year, the government pre-financed projects to the tune of EUR 9bn (8% of GDP), but managed to receive less than EUR 4bn in structural and investment funds. With EU inflows expected to rise this year, the government will be able to spend on consumption without weakening its focus on investment. In addition, the expansion of the Paks nuclear power plant will start this year, boosting investment and imports. The project relies on a EUR 10bn loan from Russia. The headline deficit number will be similar to last year’s 2.4% of GDP (using EU accounting standards), but the structural deficit will widen slightly, providing for a small, positive fiscal impulse.

… alongside debt and EU funded-investment…

Private investment could accelerate, helped by EU funds, demand for housing and the NBH’s efforts to reduce and fix the cost of longer-term borrowing for companies and households. Private consumption may grow by 4.2% in 2018 as labor market conditions tighten further. Given wage increases for low earners and public employees, real wages could rise by 4.5% this year. Finally, agriculture may boost growth after a weak harvest in 2017.

…and private consumption and investment

While economic growth could slow in 2019, it will remain above potential at around 3.3%. The drivers will be consumption, exports and investment backed by EU funds. With positive base effects gone, industrial production and exports are likely to grow at a slower pace, with the trade surplus falling again. In addition, labor shortages may slow the expansion, especially in construction and services. Immigration helps neighboring countries alleviate the lack of workers, but the Hungarian government wants to open borders only to ethnic Hungarians. Thus, growth is set to enter a downward trend next year that may accelerate in the next decade due to lower EU funds, skill mismatches and strong youth emigration.

Growth may slow in 2019 amid critical labor shortages

GROWTH MAY REACH A CYCLICAL PEAK IN 2018 Broad-based growth could come close to 4.5% in 2018

yoy (%) 5.0

Agriculture Construction Financial services Other services GDP

Labor shortages could be the biggest risk to the pace of growth

Industry Market services Real estate services Net taxes

% of companies declaring a shortage of labor, SA

Industry

Construction

90 80 70

4.0

60

3.0

50 40

2.0

30 1.0 20 0.0

10

-1.0 2015

2016

2017E

2018F

0 Dec-99

2019F

Dec-08

Dec-17

Source: HCSO, Eurostat, UniCredit Research

UniCredit Research

page 59



January 2018

CEE Quarterly

Low short-term interest rates through FX swaps…

The NBH has played a pivotal role in the post-crisis growth model. In 2018, the central bank will go against the regional trend, continuing to ease monetary conditions. The NBH is improving short-term interbank liquidity by recycling the large extended basic balance using HUF-providing FX swaps with maturities of up to one year. As a result, the basis swap is not turning positive, keeping EUR-HUF in a 308-315 range, with potential seasonal swings on both sides. The FX swaps could expand further from approximately EUR 5bn at the beginning of the year, since the extended basic balance may exceed 8% of GDP this year and next.

…and lower long-term yields through discounted IRS

The NBH support for long-term rates includes mortgage bond purchases and discounted 5Y and 10Y interest rate swaps (IRS). Both operations aim to reduce the long-term cost of funding for banks and help them lend to the private sector at fixed rates and for longer maturities. In addition, the IRS aim to lower and stabilize HGB yields by widening the asset swap spreads when yields are under pressure. IRS rates and bond yields fell substantially before the launch of the facility, showing that investors believe in the NBH’s commitment. The planned HUF 1-1.5tn is below the HUF 1.68tn in IRS expiring in 2018-19 (HUF 390bn this year and HUF 1290bn in 2019). IRS could be effective as long as interest rates and inflation remain low in the eurozone. Thus, we see no risk of loose policies being reversed in 2018-19. The government is reeling from an unexpectedly large budgetary effort in 2017. Starved of EU fund inflows, the Economy Ministry ran a cash deficit of more than 5% of GDP. The recovery of flows from Europe should realign the cash and ESA deficits in 2018. The government plans to reduce the budget shortfall to 1.8% of GDP in 2019, insufficient to lower the structural budget deficit. The authorities’ aim to balance the budget by 2020 may prove too ambitious, especially if EU fund inflows fall as Hungary approaches the limit of its allocation.

The cash budget execution may improve this year…

…while the structural deficit could widen further

Rating upgrades are in the cards

Fidesz is expected to retain its parliamentary majority

Hungary faces a loss of EU funds in 2021-27

Lower budget deficits will allow a reduction of public debt towards 70% of GDP by the end of the decade or to around 72% of GDP if the debt of Eximbank, NBH foundations and other state-owned entities is consolidated in public debt. The gradual fall in public and external debt may trigger rating upgrades that are already priced in HUF asset prices. The good economic situation leaves ruling Fidesz in a strong position to win the parliamentary elections expected in April or May 2018. A more nationalist line will help Fidesz poach some votes from its largest competitor, far-right Jobbik. Meanwhile, the fractured left may be unable to mount a strong challenge. Thus, policies are unlikely to change in the next election cycle. The state’s involvement in the economy could increase further, while the standoff with the EU may lead to a significant loss of EU funds allocated in the 2021-27 EU budget. This would pose a threat to Hungarian growth. For example, a cut of 30% in EU funds could lower growth by up to 0.6pp per year and potential growth by 0.2pp during the next budgeting period.

LAX MONETARY AND FISCAL POLICIES TO CONTINUE IN 2018-19 HUF-providing FX swaps are expected to increase further

HUF bn 1,250 1,000 750 500 250 0 -250 -500 -750 -1,000 -1,250 -1,500 01-Jun

FX swaps providing HUF (inverse sign) Repos (inverse sign) Excess reserves O/N preferential deposits O/N deposits Net liquidity balance (- = deficit) 1W Hufonia - base rate (%, inverted, rs)

The structural budget deficit may widen in 2018-19 % of GDP

Budget deficit

Structural budget deficit

0.0 -0.5 -1.2

-1.0

-1.0

-1.5

-0.8 -2.0

-0.6 -0.4

-2.5

-0.2

-3.0

0.0 -3.5

0.2

-4.0

0.4 24-Aug

16-Nov

08-Feb

03-May

26-Jul

2015

18-Oct

2016

2017E

2018F

2019F

Source: Bloomberg, HCSO, NBH, MNE, UniCredit Research

UniCredit Research

page 60



January 2018

CEE Quarterly

Strategy: we favor duration exposure Javier Sánchez, CFA CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077 Javier.sanchezbarrueco@ unicredit.eu

We think that the current monetary policy stance of the NBH will benefit HGBs in the 5-10Y area of the curve and we maintain our long duration buy recommendation on the HGB 25/b, initiated in June 2017, or via receiving 10Y IRS. The 25b bond remains cheap to the curve in yield terms and asset-swap terms, possibly as a result of its high cash price level. The 2022-25 area of the HGB curve and the 10Y IRS contract have the highest carry and roll-down and the IRS spread in the 5Y/10Y area is high on a regional comparison. In 2018, HGBs will benefit from a continuation of the trends observed in 2017: 1. A structural liquidity surplus in the banking system and an explicit monetary policy target to flatten the longer-end of the yield curve; 2. Reduced supply of long HGB bonds and higher supply of retail bonds; 3. A surplus of external savings, which will insulate the HGB market from potential shifts in global risk aversion and forint depreciation; 4. Foreign investor positioning, at 26%, that remains light compared to other CEE local currency markets; and 5. A global environment favorable to EM bonds and to extending duration exposure in local markets.

HGBs asset-swap spreads curve (bp)

Foreign participation in HGBs

HGB ASW spreads 3m range (in bp)

Last

1m

1w

Nominal holdings (HUF bn, rs) in %

Non-resident holdings of HUF bonds

80

80

60

60

44

4,800

40

40

40

4,400

20

20

36

4,000

0

0

32

3,600

28

3,200

24 Q1

31a

28a

27a

26d

25b

24b

23a

22b

22a

20c

21b

20b

19c

20a

18c

-40

19a

-40

18b

-20

18a

-20

5,200

Q2

Q3

2015

Q4

Q1

Q2

Q3

Q4

2016

Q1

Q2

Q3

2017

Q4 Q1 2018

Source: AKK, Bloomberg, UniCredit Research

GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans & retail securities External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans & retail securities External borrowing Bonds IMF/EU/Other IFIs Change in fiscal reserves (- = increase)

2017E 28.1 6.1 22.0 18.7 4.5 2.9 11.3 3.3 1.7 1.6 28.1 27.0 7.0 1.9 18.1 1.6 1.3 0.3 -0.5

2018F 28.4 4.5 23.9 21.9 5.2 3.4 13.3 2.0 1.6 0.4 28.4 27.4 8.0 3.7 15.7 1.2 1.0 0.2 -0.2

GROSS EXTERNAL FINANCING REQUIREMENTS EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves/NBH op(-=increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net

2019F 27.5 3.1 24.4 21.8 3.7 3.7 14.4 2.6 0.1 2.5 27.5 26.5 8.9 2.2 15.4 1.0 0 1.0 0

2017E 17.1 -4.7 9.1 3.6 3.7 1.8 12.7 3.0 4.3 5.4 17.1 0.9 -0.3 3.9 1.4 0.4 1.9 8.7 3.6 0 0.5

2018F 13.2 -6.3 7.5 2.3 3.6 1.6 12.0 1.9 4.5 5.6 13.2 2.1 0 3.2 1.2 0.4 1.6 7.5 5.7 1.0 -5.4

2019F 11.9 -6.7 9.1 4.0 3.0 2.2 9.5 1.4 2.5 5.6 11.9 1.7 0 4.1 1.7 0.3 2.2 7.1 5.4 2.0 -6.5

-0.2 -0.4

0 -0.6

0.7 -0.1


UniCredit Research

page 61



January 2018

CEE Quarterly

Poland

A2 stable/BBB+ stable/A- stable*

Outlook – In 2018-19, investors may focus on strong economic growth (4.0% and 3.6%, respectively), turning a blind eye to political risks. Growth will rely on consumption and private investment, as EU fund inflows and corporate profitability improve. The government is trying to boost its chances in local and general elections by implementing a populist agenda backed by strong tax collection and focused on redistribution. We expect the policy interest rate to be kept on hold this year, followed by 75bp in hikes next year. The PLN may strengthen further. Strategy – We expect POLGBs to remain well bid in 2018 but returns to be lower than in 2017. Authors: Dan Bucșa, Chief CEE Economist (UniCredit Bank, London) Javier Sánchez, CFA, CEE Fixed Income Strategist (UniCredit Bank, London) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS

■ 9-10 Jan, 6-7 Feb, 6-7 Mar: monetary policy meetings ■ Mar: NBP forecast (key figures, inflation report) ■ 14-16 Feb, 28Feb-1 Mar: 3Q17 GDP data (flash estimate, structure)

GDP COMPONENTS

yoy (%)


Change in inventories* Public consumption GDP

EUR bn

2015

2016

2017E

2018F

2019F

GDP (EUR bn)

429.9

424.2

465.5

512.4

547.0

Population (mn)

38.4

38.4

38.4

38.4

38.4

11,185

11,038

12,114

13,335

14,237

GDP

3.8

2.9

4.5

4.0

3.6

Private Consumption

3.0

3.9

4.9

4.7

4.0

Fixed Investment

6.1

-8.0

3.4

4.8

3.7

Public Consumption

2.3

1.8

1.8

2.2

2.9

Exports

7.8

8.8

7.0

6.7

5.1

Imports

6.6

8.0

7.0

6.4

6.1


982

979

1,062

1,156

1,222


4.5

4.7

3.7

3.1

2.5


10.5

8.9

7.3

6.7

6.4 -2.5


5.0 4.0 3.0


2.0

Budget balance

-2.6

-2.5

-2.0

-2.4

1.0

Primary balance

-1.0

-0.7

-0.4

-0.9

-1.0

0.0

Public debt

51.1

54.4

52.1

51.0

50.5


-2.4

-1.3

0.6

-0.4

-6.1


-0.6

-0.3

0.1

-0.1

-1.1


3.9

1.9

2.2

2.6

1.9

Net FDI (% of GDP)

2.1

1.2

1.1

1.3

1.4


70.3

75.0

65.6

59.2

55.2


81.9

103.5

89.9

93.5

94.3

4.9

6.0

4.8

4.4

4.2

External accounts

-1.0 -2.0 2015

2016

2017E

2018F

2019F

CPI, PPI AND CORE INFLATION

yoy (%)

Annual inflation rate

Base rate

Inflation target

Target range


4


3

CPI (pavg)

-0.9

-0.6

2.0

2.4

2.5

2

CPI (eop)

-0.5

0.8

2.0

2.4

2.8

2.5

2.5

2.5

2.5

2.5


1.50

1.50

1.50

1.50

2.25


1.72

1.73

1.73

1.80

2.58

USD/FX (eop)

3.90

4.18

3.48

3.28

3.20

EUR/FX (eop)

4.26

4.42

4.17

4.10

4.10

USD/FX (pavg)

3.77

3.95

3.78

3.39

3.23

EUR/FX (pavg)

4.18

4.36

4.26

4.13

4.10

106.2

101.9

104.2

106.9

105.4

-0.7

-4.1

2.3

2.5

-1.4

Central bank target 1 0 -1 -2 Dec-15

Jun-16

Dec-16

Jun-17

Dec-17

Jun-18

Dec-18

Jun-19

Dec-19

Source: CSOP, UniCredit Research




UniCredit Research

page 62



January 2018

CEE Quarterly

Investors turning a blind eye on politics In 2018, investors may continue to focus on the good economic story, ignoring the populist political agenda. Halfway through the election cycle, the Law and Justice (PiS) government is at the peak of its popularity. Clashes with European authorities are unlikely to reduce PiS approval ratings as long as living standards continue to improve.

European authorities may do little to reverse Polish judicial reforms…

…but are likely to penalize Poland’s next EU fund allocation

Economic populism is focusing on redistribution…

…helped by better tax collection

The populist agenda has a political and an economic dimension. The former’s main goal is to ensure PiS continuity in power, with a short-term focus on local elections in November 2018 and parliamentary elections a year later. New laws increase the parliament’s power in appointing judges, prosecutors and members of election boards, increase mandates for mayors to five years while capping them to two terms, and make it more difficult for independent candidates to run in local elections. While recent judicial changes may reshape the political landscape for a generation, they were met with little domestic resistance. The European Council will probably fail to suspend Poland’s voting rights using Article 7 of the EU Treaty. Similarly, the Council of Europe’s Group of States against Corruption (GRECO) may fail to punish Poland when its enquiry ends in March. Retaliation may come in the form of lower EU fund allocation in the 2021-27 EU budget, for which negotiations will start this year. Economic populism is built on three main pillars: redistribution, good tax collection and selective nationalism. Redistribution is used to create a broad voting coalition for PiS by increasing the size of discretionary spending. The worst-off, families with children and pensioners are targeted at the cost of increasing non-discretionary spending. Thus, the two instruments that helped Poland avoid a recession in 2008-10 – flexible spending structure and reliance on EU funds – may not be available for the next economic downturn. Better tax collection helped the government cover its ambitious spending plans in 2017 while running the tightest budget execution on record. This was possible due to better tax collection, mostly for indirect taxes, but also to one-off non-tax revenues. As the latter are set to plummet this year mainly due to lower NBP profit, the budget deficit may widen from around 2.1% of GDP in 2017 to 2.7% of GDP in 2018 and stay at a similar level next year. As a result, the structural budget deficit could increase further towards 2.5% of GDP by 2019. Selective nationalism has the government blaming foreign companies for inequality while trying to lure large FDI projects to Poland. In addition, the hard stance on migration contrasts with Ukrainian workers accounting for more than 6% of employment. Immigration cannot solve the structural tightening of labor market conditions, with several metrics pointing to unprecedented tensions: the ratio of vacancies to unemployment is likely to exceed 10% in 2018, the number of low-skilled unemployed halved in four years and accounts now for 30% of unemployment, long-term unemployment dipped below 500,000 for the first time etc.

Labor market conditions are expected to tighten further

Strong improvement in VAT revenues since PiS came to power…

…and higher non-discretionary spending increased Interest expenditure Wages Subsidies and subventions

Revenues from corporate income tax Revenues from personal income tax % of GDP

% of GDP

Revenues from VAT

16

14

14

12

12

10

10 8 8 6

6

4

4

2

2 0

0 2014

2015

2016

2017E

2018F

2014

2019F

2015

2016

2017E

2018F

2019F

Source: CSOP, Ministry of Finance, UniCredit Research

UniCredit Research

page 63



January 2018

CEE Quarterly

PiS is favorite in local and parliamentary elections

We expect the government’s policies to help it perform well in local and general elections. The improvement in living standards may be sufficient to offset the negative newsflow from changes in legislation. A repeat of 2015’s win would require a less controversial legislative agenda, with the electorate being currently deeply divided on the PiS’ reform agenda.

Economic growth expected at 4.0% in 2018 and 3.6% in 2019…

Economic growth may reach 4.0% in 2018 and 3.6% in 2019, helped by private consumption. Household spending will benefit from public spending and tight labor market conditions, with the real wage bill likely to grow in excess of 8% in 2018-19. Higher public spending ahead of local and general elections will continue to favor social security over investment, with a 500+ program for pensioners in the pipeline. Investment could recover further in the private sector to offset high capacity utilization and insufficient workers. Three additional factors may boost private investment: higher corporate profitability, EU funds and demand for new construction. That said, private sector releveraging remains slow, with the wealth transfer to real estate continuing. Local authorities may continue to invest in infrastructure projects ahead of this year’s local elections, with the central government likely to follow suit, especially in 2019.

…supported by consumption and private investment

EU fund inflows are expected to accelerate in 2018

The extended basic balance is expected to increase again, mostly on the back of EU fund inflows. The latter could reach PLN 50bn in 2018, according to the government. While this would mark a clear improvement vs. 2016-17, it would still be below the 2010-12 inflows. Larger EU fund flows are needed to offset the lack of large FDI projects. Poland missed out on recent major investment projects in the central European car industry but continues to be one of the main destinations for foreign investment in retail and IT (which are not capitalintensive) as well as construction. Exports and industrial production are expected to benefit from strong European demand in 2018-19, but imports may outpace both.

Rates on hold in 2018, three hikes in 2019

The NBP is expected to remain on hold in 2018, despite inflation returning to target. Headline inflation may exceed the 2.5% target temporarily in 1H18, falling towards 2% later this year if oil prices remain close to USD 60/bbl and inflation in the eurozone hovers at 1.5%. Core inflation may exceed 3% next year, moving above headline. As a result, we expect the NBP to increase interest rates by 75bp. However, with inflation inside the target range, the central bank could consider staying on hold for longer and waiting for the ECB to start increasing interest rates before it reacts. Thus, the main risk for the NBP is a delayed reaction to an acceleration in core inflation on the back of tighter labor market conditions.

A stronger currency is on the cards

A stronger currency would offset some of the missing rate hikes and we expect the NBP to continue signaling its preference for a lower EUR-PLN. Out of the four rate increases needed to turn real monetary conditions neutral, EUR-PLN at 4.10 would replace 50bp in rate hikes. A stronger PLN may be prompted by a larger extended basic balance and by a lower risk premium attached to the standoff between Polish authorities and European institutions.

Better corporate profitability may boost productive investment

Real monetary conditions could remain loose in 2018-19

Investment in machinery (% of GDP, SA)

Real monetary conditions index

Gross operating surplus of non-financial companies (% of GVA, SA, rs)

Private consumption and private investment (% yoy, rs)

9.0

52.0

3.0

16.0

8.5

51.5

2.0

12.0

8.0

51.0

7.5

50.5

1.0

8.0

0.0 7.0

4.0

50.0 -1.0

6.5

49.5

6.0

49.0

5.5

48.5

-3.0

48.0

-4.0

5.0 Sep-10

Sep-11

Sep-12

Sep-13

Sep-14

Sep-15

0.0

-2.0

Sep-16

-4.0 -8.0 2010

2011

2012

2013

2014

2015

2016

2017 2018F 2019F

Source: CSOP, NBP, MinFin, UniCredit Research

UniCredit Research

page 64



January 2018

CEE Quarterly

Strategy: POLGB to remain well bid Javier Sánchez, CFA CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077 Javier.sanchezbarrueco@ unicredit.eu

We recommended POLGB exposure throughout 2017 and we think that there are further gains that can be achieved in 2018 in the 10Y area of the curve for the following reasons: 1. The spread to Bunds of similar maturity has been hovering around 300bp, which is elevated in historical terms and 20bp higher compared to July 2017; 2. Fiscal accounts have been outperforming expectations and will be supportive in 2018; 3. Foreign investor positions have barely increased over the last year despite the outperformance of bonds and have been declining since June 2017 in nominal terms, with most foreign investor positions concentrated in the 10Y area; 4. The yield curve is quite steep, particularly in asset-swap spread terms (or versus Bunds) with 2025 bonds offering among the highest carry-roll down on the curve. We currently have a trade recommendation in the POLGB 3.25 7/2025 (DS0725) with a target yield of 2.75% and a stop loss at 3.3%.

POLGB non-resident holdings are concentrated in the 10Y area…

…where the asset-swap is also the highest POLGB ASW spreads 3m range (in bp)

Non-resident holdings of POLGB bond by bond (in % of total)

1m ago

Last

80

60

60

70

70

40

40

60

60

20

20

50

50

WS0429

DS0727

WS0428

DS0726

DS0725

DS1023

WS0922

PS0721

-100

DS1021

ws0447

ws0429

ws0437

ds0727

ws0428

ds0725

ds0726

iz0823

ds1023

ps0422

ws0922

ps0721

ds1021

ds1020

ps0421

ds1019

ps0420

ok1018

ps0719

ps0418

ps0718

ok0717

ds1017

0

-80

PS0421

0

-80 -100

PS0420

10

DS1020

10

-60

PS0719

20

-40

-60

DS1019

20

-40

OK0419

30

PS0718

40

30

-20

OK1018

40

0

0 -20

PS0418

80

Source: Bloomberg, MinFin, UniCredit Research


2017E 31.2 9.2 22.0 18.3 18.3 0 0 3.7 3.7 0 31.2 26.2 22.2 0 4.0 2.5 2.3 0.2 2.5

2018F 39.8 12.3 27.5 22.4 22.4 0 0 5.1 3.7 1.4 39.8 34.6 33.2 0 1.4 5.2 4.0 1.2 0

GROSS EXTERNAL FINANCING REQUIREMENTS EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net

2019F 40.9 13.7 27.3 20.1 20.1 0 0 7.1 5.6 1.5 40.9 34.0 33.0 0 1.0 7.0 5.5 1.5 -0.1

2017E 93.6 -0.6 45.2 9.2 14.3 21.7 49.0 18.6 12.2 18.3 93.6 2.5 0.5 44.7 9.4 11.5 23.8 36.5 4.5 -8.6 13.5

2018F 84.7 0.4 47.7 11.8 12.6 23.3 36.5 3.0 13.0 20.5 84.7 6.6 0.7 48.8 13.1 10.1 25.6 33.8 7.3 -9.0 -3.6

2019F 88.3 6.1 48.4 13.2 11.4 23.8 33.8 3.0 7.8 23.0 88.3 7.5 0.5 50.0 14.7 9.2 26.1 30.4 9.2 -8.5 -0.8

1.6 -1.4

1.6 0.3

2.2 -0.1


UniCredit Research

page 65



January 2018

CEE Quarterly

Romania

Baa3 stable/BBB- stable/BBB- stable*

Outlook – Economic growth is expected to slow to 4.6% in 2018 and 3.5% in 2019 due to fiscal uncertainty, a tightening in real monetary conditions and the poor structure of growth in 2017. Inflation is expected to exit temporarily the target range in 2018, forcing the NBR to tighten, either via rate hikes or via FX interventions. The main risks are fiscal and political, the latter referring to the attempt to curtail judicial independence. Both risks set Romania on a collision course with the European Commission. Strategy – although nominal ROMGB yields appear attractive there are significant upward risks to inflation that may materialise in 1H18. Authors: Dan Bucșa, Chief CEE Economist (UniCredit Bank, London) Anca Aron, Senior Economist (UniCredit Bank Romania) Javier Sánchez, CFA, CEE Fixed Income Strategist (UniCredit Bank, London) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS

EUR bn

2015

2016

2017E

2018F

2019F

■ 8 Jan, 7 Feb: NBR monetary policy meetings ■ 12-16 Feb, 3-9 Mar: 4Q17 GDP (flash, structure) ■ Mar: deadline for GRECO analysis of judicial changes ■ Apr: deadline for submitting corrective fiscal measures to the EC

GDP (EUR bn)

160.0

169.6

185.1

196.7

208.6

Population (mn)

19.9

19.8

19.6

19.6

19.5

8,049

8,581

9,428

10,047

10,687

GDP

3.9

4.8

6.6

4.6

3.5

Private Consumption

6.0

7.4

8.9

6.1

3.9

Fixed Investment

8.3

-3.3

2.8

0.7

3.1

Public Consumption

0.1

4.5

2.3

1.6

0.9

Exports

5.4

8.3

9.2

7.4

6.0

Imports

9.2

9.8

10.5

10.2

8.1


576

643

722

916

959


9.1

14.6

12.7

23.2

2.0


6.8

5.9

5.0

4.8

4.6

Budget balance

-0.8

-3.0

-3.0

-3.5

-3.7

Primary balance

0.5

-1.7

-1.8

-2.1

-2.2

38.0

37.6

37.2

37.7

38.8


-2.0

-3.5

-7.0

-8.4

-8.9


-1.2

-2.1

-3.8

-4.3

-4.3


2.9

3.0

-0.2

-0.3

0.4

Net FDI (% of GDP)

1.8

2.7

2.8

2.7

2.7


57.6

54.8

50.7

48.9

47.2


32.2

34.2

33.5

33.1

31.5

5.8

5.7

4.9

4.5

4.0

CPI (pavg)

-0.6

-1.5

1.3

4.4

3.1

CPI (eop)

-0.9

-0.5

3.3

3.4

3.2

Central bank target

2.50

2.50

2.50

2.50

2.50


1.75

1.75

1.75

3.00

3.00


1.03

0.83

2.13

3.05

3.10

USDRON (eop)

4.15

4.30

3.89

3.74

3.71

EURRON (eop)

4.52

4.54

4.66

4.68

4.75

USDRON (pavg)

4.01

4.06

4.05

3.80

3.71

EURRON (pavg)

4.44

4.49

4.57

4.63

4.65

123.7

121.2

119.0

119.7

117.9

-1.5

-2.1

-1.8

0.6

-1.5

GDP GROWTH FORECAST Private consumption Public consumption Net Export

yoy (%, pp)

Fixed Investment Change in inventories GDP

8.0 7.0 6.0



5.0 4.0 3.0 2.0

Public debt

1.0 0.0

External accounts

-1.0 -2.0 -3.0 2015

2016

2017E

2018F

2019F

INFLATION AND INTEREST RATE FORECASTS

yoy (%)

Consumer price inflation

Inflation target


Target range

Monetary policy rate


6.0

4.0

2.0

0.0

-2.0

-4.0 Dec-15

Sep-16

Jun-17

Mar-18

Dec-18

Sep-19

Source: NIS, UniCredit Research


Source: Eurostat, NIS, UniCredit Research *


UniCredit Research

page 66



January 2018

CEE Quarterly

On the cusp Economic growth is expected to slow to 4.6% this year and 3.5% in 2019 from 6.6% in 2017. This could be the direct result of growth relying heavily on consumption and inventories, while investment is crowded out by populist measures or affected by fiscal uncertainty. Growth may slow even more if stealth fiscal tightening is used to keep the budget deficit below 3% of GDP. Rising borrowing costs and the unpredictable tax environment could weigh on economic growth in 2018-19. The NBR expects higher ROBOR rates to lead to an increase in loan defaults in 2018 vs. 2017. To tackle the lowest tax compliance in the EU, authorities will finally introduce a central registry for retail sales in June-Aug. 2018, targeting optimistically RON 9bn (almost 1% of GDP) in additional revenues. In addition, split VAT payments will be applied selectively 33. Frequent U-turns in tax plans may be extending payment delays in the private sector, which at 69 days are the longest in CEE 34. This is because companies keep larger cash buffers to prevent potential payment bottlenecks and cover unforeseen tax increases.

Domestic demand may be affected by higher borrowing costs …

… and unpredictable fiscal policy

In addition, stealth fiscal tightening could slow sharply the growth of net wages. First, the social security contribution of employers will be transferred to employees. Unless companies increase gross wages to match this transfer, net wages will grow much slower than last year. Second and more importantly, the flat personal income tax (PIT) may be replaced with a progressive system including a higher tax rate for high earners. The budget deficit is likely to be above 3% of GDP in 2018 unless the government increases the PIT on higher earners and cuts public investment again. Moreover, the aggressive program of wage and pension increases may have to be scaled back to keep the budget deficit below 3% of GDP in 2019. In the meantime, the structural budget deficit is likely to exceed 5% of GDP by the end of next year, a level not seen since 2008.

Fiscal tightening needed to keep the budget deficit below 3% of GDP

Romania stands out in CEE because higher revenues in the private sector are boosting CPI inflation more than house prices. The latter are growing slower than in the region due to households’ lower financial wealth and the reliance on government-guaranteed mortgages for houses and flats sold for a maximum EUR 72,500. Even this implicit price cap for most borrowers is unlikely to stop the housing market from growing further. While building output – retail, industrial, logistic and housing – could rise in double digits, fixed investment growth may underperform central Europe due to the bigger weight of infrastructure in total construction. We expect public investment to decline further in the coming years.

Private construction will remain strong

STRONG DOMESTIC DEMAND GROWTH HIDES STRUCTURAL WEAKNESSES Payment delays may increase due to fiscal uncertainty

House prices remain well below pre-crisis levels

Days sales outstanding

1Q09 = 1

BG

CZ

HU

PL

RO

1.30 Greece Turkey

1.20

Spain 1.10

France Romania

1.00

Bulgaria Russia

0.90

Poland 0.80

Germany Austria 0

20

40

60

80

0.70 Mar-09

100

Mar-12

Mar-15

Source: Eurler Hermes, “New DSO Data: A High Stakes Game”, July 2017, NIS, Eurostat, UniCredit Research 33

Due to negative effects on cash flows and menu costs, the measure may disrupt activity more than improving collection, according to the main audit companies in the country. Romania will introduce the VAT split only for insolvent companies or with unpaid VAT duties. 34 According to Euler Hermes’ “New DSO Data: A High Stakes Game” from July 2017.

UniCredit Research

page 67



January 2018

CEE Quarterly

Industrial production may benefit from strong demand in the EU and at home, but exports are likely to trail imports as the latter fuel the ongoing consumption boom. While the central bank is highlighting the rise in consumer lending – especially outside the banking system – it has not moved to slow households’ releveraging, which remains low as a percent of GDP. Real monetary conditions need to tighten…

… either orderly or under market pressure

The NBR cannot prevent a further rise in short-term interest rates due to rapid reflation. Headline inflation will exit the 1.5-3.5% target range in 1Q18 and could rise close to 5% yoy over the summer, with core inflation peaking above 4%. Inflation could re-enter the target range in 4Q18, when the large monthly inflation rates from 4Q17 – caused by high food prices and fiscal measures – will exit the base. We expect headline and core inflation close to 3% in 2019. The NBR delivered a first interest rate increase on 8 January 2018. We expect an additional 1pp in hikes to align interest rates to the inflation rate expected in 2019. If the central bank delivers less, the RON may come under renewed pressure. With the NBR likely to defend the RON through interventions, interbank interest rates could increase even if the central bank hikes less, the choice being between an orderly or a disorderly adjustment. The currency remains too strong, despite the NBR shifting the trading range above EUR-RON 4.60. A test at EUR-RON 4.70 may occur if the central bank remains on hold in the coming months. An orderly increase in interest rates has the advantage of preventing FX volatility and setting the stage for a rally in local-currency bonds once inflation falls towards 3%. We believe that a loss of investment grade is not warranted despite the re-emergence of twin deficits because public and external debt remain low. Neither is likely to rise at a worrying pace because the government’s annual gross financing needs remain below 6% of GDP and the private sector continues to delever externally.

We do not expect a loss of investment grade

The biggest risks are fiscal…

… and political, pertaining to the attempt to undermine the anticorruption campaign

The biggest two risks are a stand-off with the EU due to fiscal easing and the judicial changes adopted by parliament in December 2017. The excessive deficit procedure may be re-opened in 2019. The risk is lower this year, unless the 2017 ESA deficit exceeded 3% of GDP. The European Commission is worried about the widening structural budget deficit and asked Romania for fiscal tightening measures of 0.8% of GDP by April 2018. Laws implemented in late 2017 reduce judicial independence and hollow out the anticorruption campaign. They can be rejected by President Klaus Iohannis only once. Thus, the laws may be implemented before mid-year, despite being widely condemned by European and US authorities, as well as most judicial bodies in the country. The Council of Europe’s Group of States against Corruption (GRECO) started an enquiry that will end in March 2018. This setback in judicial reform sets Romania on course for another clash with the European Commission and could trigger an Article 7 discussion. This may be prevented if the Social Democrat Party changes its leadership and backtracks on these changes of the law.

THE TRADEOFF BETWEEN HIGHER INTEREST RATES AND CREDIT QUALITY The NBR expects credit quality to worsen this year… Probability of failing to reimburse loans (baseline forecast of the NBR, %)

…as real monetary conditions need to tighten significantly

Sep-15

Sep-16

Sep-17

Sep-18 F

Real monetary conditions index (real interest rate & REER - 5:3) Private consumption and fixed investment (% yoy, rs)

5.0

8.0

4.5

6.0

4.0

30.0 20.0

4.0

3.5

10.0

2.0

3.0 2.5

0.0

2.0

-2.0

0.0 -10.0

1.5

-4.0

1.0

-20.0

-6.0

0.5 0.0 Companies

Households - mortgages

-30.0

-8.0

Households - consumption

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Source: Eurostat, NBR’s Financial Stability Report, December 2017, pages 51 and 64, NBR, UniCredit Research

UniCredit Research

page 68



January 2018

CEE Quarterly

Strategy: looking forward to good news Javier Sánchez, CFA CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077 Javier.sanchezbarrueco@ unicredit.eu

In 2017, ROMGBs were among the worst performing local currency bonds in EM, delivering negative returns in EUR terms. The deterioration started during the summer and accelerated in 4Q, leading to a spike in short-term yields and a flattening of the ROMGB curve. We think that bonds still have some downside risks, as by mid-2018 inflation is expected to exceed the target band by more than 1pp. The economy is overheating due to a mix of loose fiscal and monetary policies, and the NBR is hesitating to hike rates to address inflationary risks. A better mix of policies is required for a constructive view on local bonds. Valuation is not yet sufficiently discounting upside risks to inflation. The short end of the curve is in line with our expectations of the NBR policy rate in 1Q18 (2.25%) and the long end at 4% assumes that investors will see through the inflationary spike from currently 3% to 4.9% by 3Q18. Considering that the 10Y area of ROMGBs has never traded at negative real yields, this level may be too complacent. With the currency also hovering around the lower end of the unofficial 4.60-70 range, we think there will be better entry levels during 1Q18.

The short-end of the ROMGB curve is in line with our expectations for the NBR but the long end does not discount inflation risks

ROMGB 10Y and inflation measures ROMGB 10Y and CPI inflation

ROMGB yield curve (in %) Jun 30 2017

Sep 30 2017

Jan 2 2018

8

10Y ROMGB yield Adj CORE2

Headline CPI yoy IT bands

5.1% f orecast f or CPI y oy in June 2018

5 6

RON YTM (in %)

4 4

3 2 2.5% f orecast of NBR policy rate

2

by mid-June 2018

0

1 -2

0 0

1

2

3

4

5

6

7

8

9

10 -4 2012

Modified Duration

2013

2014

2015

2016

2017

2018

Source: NBR, MinFin, UniCredit Research

GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other Fiscal reserve change (- = stock increase)

2017E 13.4 5.8 7.6 6.4 3.5 2.6 0.3 1.2 0 1.2 13.4 8.6 6.7 1.8 0.1 3.5 2.8 0.7 0 1.3

2018F 15.1 6.6 8.5 5.6 3.5 1.8 0.3 2.9 1.5 1.4 15.1 9.1 7.0 2.0 0.1 5.2 4.5 0.7 0 0.8

GROSS EXTERNAL FINANCING REQUIREMENTS EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net

2019F 16.4 7.7 8.7 6.2 3.9 2.0 0.3 2.5 1.5 1.0 16.4 12.1 10.0 2.0 0.1 4.2 3.5 0.7 0 0.1

2017E 41.3 7.0 22.0 2.2 6.8 13.1 12.3 0.3 3.2 8.7 41.3 5.1 0.4 22.2 4.5 4.8 12.9 11.2 1.6 0 0.8

2018F 42.3 8.4 22.3 4.4 6.1 11.8 11.6 0.3 3.0 8.3 42.3 5.4 0.1 23.9 6.0 4.3 13.6 10.1 2.5 0 0.4

2019F 41.0 8.9 21.6 3.8 5.5 12.3 10.5 0.3 2.7 7.5 41.0 5.7 0.1 20.4 5.4 3.8 11.1 9.2 3.9 0 1.7

0.4 2.8

0.8 3.0

1.5 2.0


UniCredit Research

page 69



January 2018

CEE Quarterly

Slovakia

A2 stable/A+ stable/A+ stable*

Outlook – Economic growth is expected to accelerate to 3.9% in 2018 and 4.1% in 2019, benefitting from larger production capacity in the automotive industry offsetting the cyclical slowdown in European demand in 2019. The C/A deficit will start to narrow, driven by car exports from 2H18 onwards, and may close by the end of 2019. Labor market conditions will continue to tighten, supporting wage growth, household spending and reflation. Fiscal goals are less ambitious than in the past, relying mostly on strong growth. A balanced budget may be reached in 2020, one year later than previously projected. Author: Ľubomír Koršňák, Chief Economist (UniCredit Bank Czech Republic and Slovakia)


■ 11 Jan, 9 Feb, 13 Mar – Industrial production ■ 15 Jan, 15 Feb, 14 Mar – CPI ■ 14 Feb – flash 4Q16 GDP ■ 7 Mar – 4Q16 GDP structure

EUR bn

2015

2016

2017E

2018F

2019F

GDP (EUR bn)

78.9

81.2

85.0

89.9

95.2

Population (mn)

5.4

5.4

5.4

5.4

5.4

14,546

14,953

15,657

16,562

17,552

GDP

3.9

3.3

3.4

3.9

4.1

Private Consumption

2.3

2.6

3.7

3.5

2.7

19.8

-8.3

4.1

4.7

0.7

Public Consumption

5.4

1.6

-0.5

0.5

1.5

Exports

6.4

6.2

4.2

5.5

6.8

Imports

8.4

3.7

4.5

4.5

4.7


883

912

955

1,006

1,056


Fixed Investment

INFLATION REBOUNDING BUT STAYING CLOSE TO 2% yoy (%) 2.5


3.3

3.8

3.4

3.2

2.9

2.0


11.5

9.6

8.0

6.9

6.4

1.5


1.0

Budget balance

-2.7

-2.2

-1.6

-0.8

-0.2

0.5

Primary balance

-1.0

-0.7

-0.3

0.6

1.2

Public debt

52.3

51.8

51.0

49.6

47.6


-1.4

-1.2

-1.6

-1.2

-0.3


-1.7

-1.5

-1.8

-1.4

-0.3


1.9

-0.1

1.0

1.9

2.8

Net FDI (% of GDP)

0.1

-0.6

1.7

2.1

1.7


85.2

90.9

92.9

94.0

93.4


EUR

EUR

EUR

EUR

EUR

-

-

-

-

2.0

0.0 -0.5

External accounts

-1.0 Sep-19

Jan-19

May-19

Sep-18

Jan-18

May-18

Sep-17

Jan-17

May-17

Sep-16

Jan-16

May-16

Sep-15

Jan-15

May-15

Sep-14

Jan-14

May-14

Sep-13

Jan-13

May-13

-1.5

GDP GROWTH TO BE DRIVEN BY BOTH DOMESTIC AND EXTERNAL DEMAND

Months of imports, goods & services Inflation/Monetary/FX

Domestic demand

yoy (%; pp)

Net export

GDP

6.0

CPI (pavg)

-0.3

-0.5

1.3

2.1

5.0

CPI (eop)

-0.5

0.2

1.8

1.7

2.1

4.0

Central bank target

EUR

EUR

EUR

EUR

EUR

3.0


EUR

EUR

EUR

EUR

EUR

2.0


EUR

EUR

EUR

EUR

EUR

1.0

USD/FX (eop)

EUR

EUR

EUR

EUR

EUR

0.0

EUR/FX (eop)

EUR

EUR

EUR

EUR

EUR

-1.0

USD/FX (pavg)

EUR

EUR

EUR

EUR

EUR

-2.0

EUR/FX (pavg)

EUR

EUR

EUR

EUR

EUR

168.6

168.6

166.5

164.2

156.6

-1.8

0

-1.2

-1.4

-4.6

2014

2015

2016

2017F

2018F

2019F

Source: SO SR, UniCredit Research


Source: Eurostat, SO SR, NBS, UniCredit Research

*


UniCredit Research

page 70


January 2018


CEE Quarterly

Business cycle extended by car manufacturing

Economic growth to be driven by new investment in auto industry

Household spending to support economic growth…

… despite rebounding inflation

Balancing of fiscal budget postponed to election year 2020…

The Slovak economy, a small and open one, stands to benefit from the recovery in global trade in 2018, while the slight cyclical slowdown expected in the eurozone in 2019 may be delayed by larger production capacity in the local automotive sector. At the beginning of this year, investment to expand production will start at the Volkswagen car plant, Slovakia’s largest. In addition, the new Jaguar Land-Rover car plant, fourth in the country behind VW, PSA and KIA, is scheduled to be opened in mid-2018. Thus, economic growth is set to accelerate this year and next, with the peak of the business cycle reached in mid-2019 or later. Exports will take over this year as the main growth driver, as strong base effects in private investment will weigh on domestic demand dynamics. At the same time, public investment may recover further from a 10-year low reached in 3Q16. Two potential drivers of infrastructure projects may contribute more in 2018 than last year, namely EU funds and PPP. EU fund inflows from the 2014-20 budget are weaker than in the previous budget due to poor programming. Meanwhile, PPP-financed highway projects were delayed by land purchases. Further delays would be the main risk to growth. Meanwhile, residential construction is set to slow as new central bank regulation is cooling off mortgage credit growth. The C/A deficit will start to narrow, driven by car exports from 2H18 onwards, and may close by the end of 2019. Labor shortages are expected to rise in the coming years, especially in western Slovakia. They may prove to be a brake on medium-term growth, while supporting household spending in the short term. Employment growth has been boosted by the manufacturing sector, lowering the unemployment rate close to 6% by the end of 2019. A further drop may be prevented by structural issues, such as regional disparities, low domestic mobility and the high number of long-term, unskilled unemployed. All these factors add to rising wage pressure. A rebound in inflation above 2% in 2018-2019 is expected to offset only part of nominal income growth. The budget deficit may fall further but improvement will be driven exclusively by a cyclical acceleration in economic growth. Furthermore, the reliability of fiscal goals is relatively low. The public finance deficit is projected to moderate this year to a historical low at -0.8% GDP, with a balanced budget expected in 2020, when parliamentary elections will be held. Public expenditure may increase in 2018-19 due to additional social measures increasing support for family care and some allowances for workers. Other measures may be added later to the package and the total cost could reach 0.3% of GDP. At the same time, government revenues may increase at the expense of higher labor costs for employers due to the introduction of a taxable night-work allowance, the cancellation of deductible health insurance costs and non-mandatory 13th and 14th monthly wages. Public debt should decline below the debt-brake level of 50% of GDP in 2018, but remain close to it. This level should start to decline by 1pp per year after 2018 according to the debt rule. The government tried to scrap it but failed to find enough support in parliament. The main risks to the economic outlook are external. Brexit may affect the economy after the end of 2019 if the UK and the rest of the EU agree on a transition period. Jaguar Land Rover announced that the Slovakian investment will not be affected if the UK leaves the EU. Domestic risks are related to public investment and increasing political tensions inside the coalition in the run-up to general elections in 2020.

Political noise is expected to rise in the run-up to general elections in 2020

UniCredit Research

The governing coalition remains stable so far, despite repeated disagreements. Public support has been declining for all coalition parties, rendering early elections unlikely. Polls suggest a strengthening of non-extremist opposition parties after local government elections held in November 2017. The extremist People’s Party Our Slovakia dropped below 10% in polls for the first time since 2016’s general elections. Municipal elections are expected in the autumn of 2018. Their results usually depend on the popularity of local politicians and are loosely correlated with parties’ national support. The field for presidential elections scheduled for the spring of 2019 is wide open, with President Andrej Kiska yet to express his intention, while Prime Minister Robert Fico announced that he will not run.

page 71



January 2018

CEE Quarterly

Slovenia

Baa1 stable/A+ stable/A- stable*

Outlook – After a very good 2017, with strong GDP growth, improvement in fiscal metrics, and Moody’s upgrade, we see no scope for a further decline in Slovenian government bond yields in 2018. We expect GDP growth to slow in 2018 and 2019 but to remain above potential (3.5% and 3.0% respectively). Lack of progress in banking sector privatization and structural reforms remain the biggest macroeconomic risks. Author: Mauro Giorgio Marrano, Senior CEE Economist (UniCredit Bank, Vienna)

MACROECONOMIC DATA AND FORECASTS 2015

2016

2017E

2018F

GDP (EUR bn)

38.8

40.4

42.9

45.1

47.0

Population (mn)

2,063

2,065

2,068

2,070

2,072

18,823

19,576

20,751

21,789

22,709 3.0

KEY DATES/EVENTS

■ 7 Feb, 28 Feb, 30 Mar – Consumer Price Index ■ 31 Jan, 28 Feb, 30 Mar – Retail Sales ■ 10 Jan, 9 Feb, 21 Mar – Industrial Production ■ 28 Feb – 4Q17 GDP

GDP per capita (EUR) Real economy, change (%) GDP

2.3

3.1

4.5

3.5

Private Consumption

2.1

4.2

3.1

2.8

2.6

-1.6

-3.6

8.8

8.5

7.0

Public Consumption

2.7

2.5

1.4

1.4

1.2

Exports

5.0

6.4

10.0

8.2

5.7

Fixed Investment

PRIVATE CONSUMPTION TO SUPPORT GDP GROWTH

yoy (%) 8.0

Household Consumption Investments Net Exports

2019F

Government Consumption Inventories GDP Growth

7.0 6.0

Imports

4.7

6.6

9.6

8.7

6.4

1,556

1,584

1,616

1,664

1,714


1.4

2.0

0.5

1.3

1.3


9.0

8.0

6.3

5.8

5.4 0.2


5.0


4.0

Budget balance

-2.9

-1.9

-0.8

-0.3

3.0

Primary balance

0.3

1.1

1.8

1.8

2.0

82.6

78.5

76.4

74.5

72.5

2.0

Public debt

1.0

External accounts

0.0 -1.0


1.7

2.1

2.0

1.9

1.7

-2.0


4.4

5.2

4.7

4.2

3.6


7.6

7.4

6.4

5.8

5.2

Net FDI (% of GDP)

3.3

2.2

1.7

1.6

1.6

120.1

110.9

107.2

104.2

102.0

2015

2016

2018F

2017F

2019F


INFLATION TO REMAIN LOW IN 2017 yoy (%) 3.0


0.8

0.7

0.8

0.8

0.8


n.a.

n.a.

n.a.

n.a.

n.a.

CPI (pavg)

-0.8

-0.2

1.5

1.7

1.7

CPI (eop)

-0.6

0.6

1.6

1.7

1.8


2.5 2.0 1.5

Source: SORS, UniCredit Research

1.0 0.5 0.0 -0.5 -1.0 -1.5 Dec-14

Jun-16

Dec-17

Jun-19

Source: NBS, MinFin, UniCredit Research

*


UniCredit Research

page 72


January 2018


CEE Quarterly

Rising government bond yields and lower GDP growth 2017 was a good year for Slovenia

No scope for further decline in bond yields in 2018

GDP growth to slow from recent rates but to remain above potential

The government is negotiating again to postpone NLB’s privatization

Fiscal metrics continue to improve but progress needed on structural reforms

UniCredit Research

2017 has been a good year for Slovenia: it had one of the strongest economic growth rates in the region (estimated at 4.5% yoy, it continued the fiscal adjustment and Moody’s upgraded its sovereign rating by two notches. In 2018 and 2019, the focus will be on two developments: 1) The scope for a further decline in government bond yields, after the significant decline in 2017; and 2) The sustainability of recent economic growth. We see no scope for a further decline in Slovenian government bond yields in 2018. On one side, ECB purchases will continue to put downward pressure on yields as they will likely remain greater than net issuance in 2018 (despite the lower monthly amount of purchases). Based on some simplifying assumptions, we estimate that purchases in 2018 will likely amount to EUR 0.6bn, while using the government deficit as a proxy we estimate net issuance at around EUR 0.2bn, therefore around three times lower than ECB purchases. On the other side, this downward pressure on yields is likely to be offset by upward pressure from the expected increase in German government bond yields. At 60bp, the spread vs. 10Y Bunds looks already tight and we see little room for spread tightening due to the limited supply. Therefore, Slovenian bond yields could move broadly in parallel with German bond yields in 2018. Assuming no further ECB purchases in 2019 beyond reinvestment, SLOVEN yield spreads vs. Bunds may widen. We expect GDP growth to slow to 3.5% in 2018 and 3.0% in 2019 after a post-crisis high of 4.5% reached in 2017. In 2018, consumption growth is likely to remain solid on the back of rising wages and high consumer confidence, while investment will most probably accelerate also thanks EU funds disbursement. Exports will continue to be strong reflecting the good performance in the main trading partners but will be in part offset by a surge in imports as domestic demand strengthens. The growth slowdown expected in 2019 mirrors that in the eurozone. Labor market conditions will likely improve further putting pressure on nominal wage growth which, however, we expect to remain at around 3%. This is due partly to stalling labor productivity but also to looser labor market conditions than in the rest of the region. Real wage growth may be sapped by reflation. Inflation is likely to accelerate gradually towards 2% over the forecasts horizon, as domestic demand strengthens further. Growth cannot remain at 2017 levels without the private sector releveraging. This would require additional reforms in the banking sector. However, these have been postponed due to the economic recovery. Lending growth improved in 2017, especially for non-financial corporations, and the NPL ratio declined further to 7.1%. That said, there was no major progress on the privatization of Nova Ljubljanska Banka, the largest bank in the country. European authorities refused the government’s request to postpone the privatization by three years, forcing Slovenian authorities to look for other privatization strategies. Reducing the state’s share in the banking sector before interest rates start rising would be a prerequisite for a sustainable recovery in lending. Most fiscal metrics continue to improve but reducing the structural deficit requires structural reforms in the pension and healthcare systems. The general government deficit is expected to have narrowed from 1.9% GDP in 2016 to 0.8% in 2017, thanks to strong economic growth which boosted revenues. In addition, interest payments fell due to the refinancing of 47% of the outstanding USD-denominated bonds. A further improvement is likely in 2018 and 2019, owing to economic growth and improved labor market conditions. Public debt probably narrowed to around 76% of GDP in 2017 and further improvement in the government balance could push it to 70% of GDP by the end of the decade. However, most of the fiscal improvement is cyclical. The European Commission expected the structural deficits at 1.6% of GDP in 2017, broadly similar to 2016, and remaining around that level also in 2018 and 2019 in absence of decisive reforms of the pension and healthcare systems.

page 73



January 2018

CEE Quarterly

Azerbaijan

Ba2/BB+ negative/BB+ negative*

Outlook – The near-term outlook has improved thanks to tighter policies and higher oil prices. The economy bottomed out in 2017, with modest growth expected in 2018-19, mostly due to recoveries in agriculture and services. Inflation has receded back to single digits and ought to ease gradually further with output below potential, the AZN likely to remain stable, and most administered price hikes completed. Buoyed by the recovery in oil prices, fiscal and C/A surpluses will return. The structural reforms agenda remains incomplete, however, especially in the financial sector, where significant problems remain. Risks of policy slippage loom large and the rise in oil prices reduces incentives for fiscal prudence, and the high dollarization limits the effectiveness of monetary policy. Over the medium term, the development of large natural gas projects will be crucial for growth, along with efforts to boost the non-oil sector beyond agriculture and non-tradables. Author: Lubomir Mitov**, Consultant

THE ECONOMY HAS BOTOOMED OUT…

MACROECONOMIC DATA AND FORECASTS EUR bn

2015

2016

2017E

2018F

2019F

GDP (EUR bn)

33.9

34.1

35.3

36.0

38.1

15

Population (mn)

9.6

9.7

9.8

9.9

10.0

10

GDP per capita (EUR)

3,536.0

3,516.6

3,594.9

3,633.0

3,804.1


GDP (%)

Inventory investment Government consumption GDP (yoy)

Real economy, change (%)

5

GDP

1.1

-3.8

-1.1

1.8

2.8

-1.0

-2.7

-3.8

1.5

2.5

Fixed Investment

8.0

12.8

-3.0

3.0

5.0

-10

Public Consumption

6.0

0.3

1.6

3.5

3.0

-15

Exports

4.1

-4.7

-3.5

2.8

3.8

Imports

0.2

-2.5

-7.2

3.0

5.0

401.1

276.7

266.5

271.3

287.9


1.0

-3.9

-5.9

2.8

3.3


5.0

5.0

5.0

5.0

5.0

Budget balance

-4.8

-1.4

-10.1

2.9

3.6

Primary balance

-4.4

-0.5

-9.4

3.8

4.7

Public debt

28.3

37.7

33.1

30.8

30.8


-0.1

-1.3

1.3

1.6

1.6


-0.4

-3.8

3.7

4.3

4.2

20.0


1.7

1.3

8.5

7.9

7.1

0.0

Net FDI (% of GDP)

2.1

5.1

4.8

3.6

2.9

-20.0


28.0

33.7

29.8

15.1

33.6


4.8

3.8

4.4

5.2

6.3


4.0

3.2

2.9

3.2

4.2

CPI (pavg)

3.1

11.4

12.7

7.0

4.5

CPI (eop)

4.0

12.4

9.0

5.0

4.0

Central bank target

n.a.

n.a.

n.a.

n.a.

n.a.


0

Private Consumption -5

2011

2012

2013

2014

2015

2016

2017E

2018F

2019F


…AS INFLATION HAS BEGUN SUBSIDING

Fiscal accounts (% of GDP) yoy (%)

CPI yoy

AZN basket (rs)

yoy (%)

20.0

120.0

18.0 100.0

16.0 14.0

80.0

External accounts

12.0 10.0

60.0

8.0

40.0

6.0 4.0 2.0 0.0 2017

2016

2015

2014

2013

2012

2011

-2.0

Source: Azstat, CBRA, Haver, IMF, UniCredit Research


11.0

10.0

8.0

7.0

6.5

USD/AZN (eop)

1.6

1.8

1.7

1.7

1.7

EUR/AZN (eop)

1.6

1.9

2.0

2.1

2.1

USD/AZN (pavg)

1.0

1.6

1.7

1.7

1.7

EUR/AZN (pavg)

1.1

1.8

1.9

2.1

2.1


*


**Lubomir Mitov is a Consultant for UniCredit Bank AG

UniCredit Research

page 74



January 2018

CEE Quarterly

No room for complacency Azerbaijan’s economy turned the corner in 2017… …with growth returning and inflation abating

The nascent recovery has been driven by the non-oil sector…

…as manufacturing and oil output continued decreasing

On the expenditure side, activity weakened across the board… …as real wages fell and public investment has been cut… …the OPEC agreement constrained oil exports… ...and imports were hit by weak domestic demand

Inflation peaked in mid-2017 due to earlier AZN weakness…

…but has eased since as the AZN firmed and with demand weak

The recovery in oil prices has buoyed the AZN… …shifting the C/A into surplus… …and is likely to remain stable at current oil prices Growth will pick up in 2018-19… …driven initially by the non-oil sector

Azerbaijan’s economy turned the corner in 2017. Although belated, the authorities’ steps to advance the adjustment to lower oil prices have begun to bear fruit. Activity bottomed out in 2Q17, with preliminary data pointing to a modest recovery in 2H17. Nevertheless, for the full year, real GDP likely declined 1.1%, extending the cumulative contraction since 2015 to 5%. The nascent recovery has been driven by the non-energy sector, which likely expanded 2.5% in FY17, after a 4.4% drop in 2016. The recovery has been centered on non-tradables and agriculture, while manufacturing fared much worse, with industrial production down 3.5%. This mostly reflected the continued slide in oil output, with oil-related GDP down 4.5% in 2017. This decline was partly due to the impact of the OPEC agreement to cut global supply, but also reflected a secular trend due to the ageing of many mature oilfields. On the expenditure side, activity weakened across the board last year. Private consumption is likely to have shrunk 3.8% in 2017 and fixed investment by 3%. The former reflected a marked drop in real incomes as the surge in inflation cut real wages nearly 6%, only part of which was offset by stepped-up social spending. Fixed investment slumped due to a drop in public capital outlays. The latter surged in 2015-16 as part of a misplaced counter-cyclical stimulus which failed to revive growth, but added to macroeconomic imbalances. Net exports made a positive contribution to growth – but only due to a larger drop in import volumes than in exports. The former appear to have slumped more than 7%, in line with the decline in real incomes and investment, but also in response to earlier AZN depreciation. Export volumes probably fell 3% in 2017, mostly due to lower oil and oil product shipments. The AZN steep depreciation in 2016 (roughly 50% in nominal effective terms) led to a surge in inflation through mid-2017. Administered price hikes in late 2016 also added to price pressures at that time. However, with the economy well below potential and consumption subdued, and the currency retracing some of the lost ground in 2H17, inflation pressures have abated. After peaking at 14% by mid-2017, yoy inflation fell to 8% by December, once the base effects of the 2016 administered price hikes lapsed. Thanks mostly to the recovery in oil prices, the AZN has gradually firmed against the USD since the middle of 2017. This, along with tighter policies, helped shift the C/A to a sizable surplus in 2017 and, combined with ongoing strong FDI and foreign borrowing, support the currency. Assuming no policy slippages, we expect this trend to continue into 2018-19, with oil prices likely to oscillate around USD 60-65/bbl and no major geopolitical tensions. Looking forward, we expect economic activity to gradually gain traction, with real GDP likely to rise 1.5-2% in 2018 and close to 3% in 2019. The recovery in 2018 will still be driven by the nonenergy sector, which ought to benefit from a likely pickup in investment (especially construction) and in private consumption as real incomes begin to recover as inflation recedes towards 4-5%.

Activity in the non-oil sector has begun recovering… Overall GDP Oil

yoy (%)

Nonoil Oil price (Brent, rs)

… as higher oil prices shifted the C/A back into surplus Trade balance, oil Services net, oil Income oil, net Transfers, net Oil price (Brent, rs)

USD/bbl

10

140 USD bn

120 5 100

Trade balance, nonoil Services net, nonoil Income nonoil, net C/A

USD/bbl

12.0

140.0

10.0

120.0

8.0

0

80 60

-5

100.0

6.0

40

4.0

80.0

2.0

60.0

0.0

-10

40.0

-2.0

20 -15 2011

2012

2013

2014

2015

2016

20.0

-4.0 -6.0

0

0.0 2010

2017

2011

2012

2013

2014

2015

2016

2017

Source: Azerstat, CBRA, Haver, UniCredit Research

UniCredit Research

page 75



January 2018

CEE Quarterly

…as policies become more growth-supportive… …afforded by the benign global environment

With current oil prices above breakeven, there is scope for some easing…

…while still leaving the general government budget in surplus

The same factors will provide a boost to the external position… …with the C/A in sizable surplus and the large wealth fund proving a solid buffer

Despite the upbeat outlook, risks remain… …mostly related to the unfinished reform agenda…

…and risks of policy slippage as external pressures abate…

…that would limit the ability to cope with future market shocks

By 2019, the oil sector should begin contributing to growth as well. Policies are likely to turn modestly growth-supportive, too, thanks to the benevolent external environment, with oil prices likely to settle at USD 55-65/bbl, and global growth and trade remaining robust. While far from the pre-2014 peak, oil prices at this level are above the current IMF estimate of the fiscal breakeven price (USD 50-52/bbl), leaving scope for some fiscal easing. We expect the general government budget to shift to a 2.5-3.5% of GDP surplus in 2018-19 from a deficit of 1.1% in 2017. (Including the costs of the recapitalization of IBA, the country’s largest bank), the overall deficit in 2017 probably reached 10% of GDP. Most of this was financed via an exchange of banks; liabilities for newly issues Eurobonds). The same factors should also support Azerbaijan’s external position. The C/A already shifted back to a sizable surplus in 2017, which we expect to widen to more than 4% of GDP in 2018-19. A larger increase looks unlikely given the level of oil prices and the anticipated rebound in import demand. Such developments are likely to help replenish FX reserves and add further to SOFAZ’ assets, which, at USD 36bn, or 93% of estimated 2017 GDP, provide a solid cushion against external shocks. Despite the upbeat outlook, significant risks remain, mostly related to the economy’s structural weaknesses. In the near term, risks of policy slippage loom large, with the recovery in oil prices likely to tempt authorities to return to the previous pattern of spending, given the absence of a binding and credible fiscal rule. IMF estimates suggest that such a rule ought to target a non-oil deficit at 30% of GDP vs. 34% at present, implying the need for more fiscal adjustment. This is even more important given the limitations to monetary policy. With FX accounting for 75% of banks’ liabilities and the degree of dollarization on the rise since 2014, the central bank (CBA) has limited scope to use interest rates to influence demand and inflation. Even though plans are in place for a future shift to inflation targeting, temptation to return to the fixed exchange rate regime is strong. This would limit the authorities’ flexibility to react to market shocks and further increase the strain on fiscal policy. The fragile banking system represents another potential risk. While the authorities did enact a number of measures aimed at strengthening supervision, many banks remain weak and undercapitalized, with doubtful asset quality and large currency mismatches. While the share of NPLs is officially reported at less than 14%, a more stringent classification puts it at more than 30%. Moreover, the high degree of dollarization leaves banks highly vulnerable to exchange rate fluctuations and significantly constrains their ability to intermediate savings – something without which dynamic growth in the non-oil sector will be difficult to achieve. Over the longer term, the development of new projects (mostly in natural gas production) will be key for sustaining growth as oil production from the mature fields continues to decline.

The fragile banking system remains a potential risk… …with poor loan quality, weak capitalization, and high dollarization All this will continue to hamper growth and investment outside energy

Further tightening will be needed to achieve fiscal sustainability….

…as high dollarization limits scope for monetary policy

Fiscal balance

AZN deposits (AZN bn)

FX deposits (AZN bn)

20

Bank recapitalization

FX deposits (USD bn)

Deposit rate (USD, %, rs)

15

Nonoil balance*

Deposit rate (AZN, %, rs)

Policy rate (%, rs)

GDP (%)

18

Nonoil balance - IMF benchmark*

10 5 0

16

16

14

14

12

12

-5

10

10 8

-10

8

-15

6

-20

4

4

-25

2

2

*Excluding one-offs

-30

6

0

0 2010

2011

2012

2013

2014

2015

2016

2011

2017E 2018F 2019F

2012

2013

2014

2015

2016

2017

Source: Azersat, CBAR, ministry of finance, IMF, UniCredit Research

UniCredit Research

page 76


January 2018


CEE Quarterly

GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Budget deficit Domestic borrowing, net Bonds/bills External borrowing, net Bonds Loans Privatization/Other Sovereign Funds

2017E 3.6 0.1 0.1 2.8 2.0 0.7 1.3 -0.6

2018F -1.0 0.2 0.2 0.5 0 0.5 0.1 -1.7

GROSS EXTERNAL FINANCING REQUIREMENTS EUR bn External financing C/A deficit Financing FDI (net) Portfolio equity, net Foreign borrowing, net Government/central bank Banks Corporates/Other Other Change in FX reserves (- = increase)

2019F -1.4 0.2 0.2 0.5 0 0.5 -0.1 -2.0

2017E

2018F

2019F

-1.3

-1.6

-1.6

1.7 -0.1 1.3 2.8 -1.6 0.1 -3.4 -0.9

1.3 0.1 1.1 0.5 0.3 0.3 -2.7 -1.1

1.1 0.3 1.4 0.5 0.4 0.5 -2.7 -1.2

Source: Azerstat, CBAR, UniCredit Research

UniCredit Research

page 77



January 2018

CEE Quarterly


B3 stable/B stable/not rated*

Outlook – After a temporary slowdown in 2Q, economic activity has rebounded, driven by a very strong export performance and buoyant private consumption. However, weaker drought-related agricultural output and the slowdown in industry in 2Q led us to trim our full-year GDP growth forecast for 2017 from 3% to 2.8%. Growth ought to accelerate to 3.3% in 2018 on the back of the strong momentum from 2017, but is likely to slow again to 3% in 2019, with foreign demand expected to weaken. Faster growth in 2019 might still be possible, but only if investment picks up significantly. This, however, would require much-improved availability of foreign official funding. With the latter largely dependent on unlocking disbursements under the IMF’s EFF program, a significant acceleration in reforms is needed, as well as a smooth government transition after the parliamentary elections due in October. Authors: Hrvoje Dolenec, Chief Economist (Zagrebačka banka), Nenad Golac, Senior Economist (Zagrebačka banka)


EUR bn

2015

2016

2017E

2018F

2019F

■ 22 Jan: CPI FY17 ■ 22 Jan: Foreign trade FY17 ■ 22 Jan: Industrial Production FY17 ■ 30 Mar: Balance of payments FY17 ■ 30 Mar: GDP 4Q17

GDP (EUR bn)

14.6

15.3

15.9

16.7

17.6

Population (mn)

3.5

3.5

3.5

3.5

3.5

4,154

4,354

4,548

4,796

5,073

GDP per capita (EUR) Real economy, change (%) GDP Monthly wage, nominal (EUR)

STIMULUS FROM EXTERNAL DEMAND

3.2

2.8

3.3

3.0

665.0

677.0

700.0

728.0


1.0

2.0

0.5

1.7

1.8


43.2

41.7

39.4

37.5

35.2

Budget balance

-0.1

-0.8

-0.8

-0.6

-0.3

Primary balance

0.7

0.1

0.2

0.4

0.6

42.8

41.6

40.5

39.4

38.7


Industrial production, growth rate Merchandise exports, growth rate Merchandise imports, growth rate

yoy (%)

3.1 659.1

20

Public debt

15

External accounts

10


-0.8

-0.8

-0.8

-0.9

-0.9

5


-5.7

-5.1

-5.0

-5.3

-5.1

0


-2.7

-2.3

-1.6

-1.5

-0.9

1.7

1.6

2.1

2.6

3.2

62.9

61.7

60.8

59.4

57.3


4.4

4.9

5.1

5.3

5.3


6.8

7.3

6.7

6.4

6.1

CPI (pavg)

-1.0

-1.1

1.3

1.7

2.2

CPI (eop)

-1.3

0.3

1.8

2.2

2.0

-0.21

-0.37

-0.37

-0.35

0.10

Net FDI (% of GDP)

-5

Gross foreign debt (% of GDP) 1-9/17

1-10/17

1-6/17

1-3/17

1-9/16

1-12/16

1-6/16

1-3/16

1-9/15

1-12/15

1-6/15

1-3/15

1-9/14

1-12/14

1-6/14

1-3/14

1-9/13

1-12/13

1-6/13

1-3/13

1-12/12

-10


RISING DEMAND IS RESTORING CPI GROWTH

1M money market rate (Dec avg) 3.0 2.5

USD/FX (eop)

1.79

1.86

1.63

1.56

1.53

2.0

EUR/FX (eop)

1.96

1.96

1.96

1.96

1.96

USD/FX (pavg)

1.76

1.77

1.73

1.60

1.54

EUR/FX (pavg)

1.96

1.96

1.96

1.96

1.96

1.5 1.0 0.5 0.0


-0.5 -1.0 -1.5 -2.0 Dec-18

Sep-18

Jun-18

Mar-18

Dec-17

Sep-17

Jun-17

Mar-17

Dec-16

Sep-16

Jun-16

Mar-16

Dec-15

Sep-15

Jun-15

Mar-15

Dec-14

Jun-14

Sep-14

Mar-14

Dec-13

Sep-13

Jun-13

Mar-13

Dec-12

-2.5


*


UniCredit Research

page 78


January 2018


CEE Quarterly

Growth remains dependent on foreign funding inflows Exports were the main growth driver in 2017, supported by buoyant private consumption…

…however, investment has lagged…

…leading real GDP to increase 2.8% in 2017

The outlook for 2018 is more favorable, with real GDP likely to expand by 3.3%...

…before slowing to 3% in 2019 when global growth eases

Stronger growth is possible if investment picks up…

…which requires stepped-up foreign funding and a resumption of IMF lending C/A deficit is likely to widen to 5.3% of GDP in 2018 before easing to 5.1% in 2019

The fiscal position is likely to remain strong in both years

Growth could accelerate beyond 3% only if it shifts to investment…

…which requires the resumption of foreign funding…

..currently on hold with the IMF EFF program on hold due to lagging reforms amid weak political resolve

The political environment could deteriorate further in 2018 ahead of October elections It will be important to unlock IMF EFF disbursements as soon as possible… …by pushing ahead with the required prior actions before the election campaign begins

UniCredit Research

After a temporary weakening in 2Q17, economic activity rebounded in 2H17, mainly on the back of rapidly expanding exports, supported by ongoing strong private consumption. This acceleration came against the background of a significant upward revision by the statistical office of GDP growth in 2016 (from 2.1% to 3%), also predominantly driven by exports and buoyant private consumption. This trend was temporarily dented in 2Q17, when real GDP rose just 1.7% yoy, down from 2.8% in 1Q17, as unfavorable weather conditions (drought) led to lower electricity output. In 2H, however, export growth accelerated substantially to 22.8% yoy in EUR terms and remained strong in October (+20.5%). This pushed the yoy increase in exports in Jan-Oct to 18.2%. However, investment activity remained subdued, as demonstrated by the decline in construction 1.4% yoy in Jan-Sep. Strong exports and private consumption, the latter aided by rising employment and real wages, will remain the main growth drivers in 2018 and 2019. Judging by available high-frequency data, and taking into account the carryover of the rebound in activity in 2H and the low base from 1H17, GDP growth should accelerate to 3.3% in 2018. In 2019, however, growth is likely to slow towards 3.0%, given expectations of a deceleration in growth in the eurozone and CEE-EU. Faster growth could still be possible if investment picks up significantly. This is contingent on the availability of foreign financing and depends crucially on whether IMF disbursements are unlocked and, ultimately, on the progress in reforms. The expected acceleration in domestic demand will likely cause the C/A deficit to widen in 2018, but should help cut the fiscal deficit as the primary balance increases. In 2019, the trend should reverse, with C/A pressures easing and fiscal deficit rising, but judging by the authorities’ track record, one would expect spending to be adjusted accordingly. The CA deficit, after narrowing to 5% of GDP in 2017, is expected to widen to 5.3% in 2018 as imports pick up. The deterioration would have been larger but mitigated by a marked increase in workers’ remittances. FDI has recovered in 2017 and it is likely to stay at similar levels in the following years. The fiscal position, meanwhile, remains almost balanced and, given the acceleration in growth, the budget deficit ought to shrink further in the coming years. This improvement reflects not only authorities’ readiness to adjust spending to available revenues and financing, but also improved tax collection and the complex decisionmaking process on large capital outlays that usually delays implementation. Growth could accelerate well beyond 3% in 2018-19, but only if the necessary foreign financing is unlocked. The current model based on foreign demand and private consumption cannot produce more than 3% growth. Any acceleration beyond that depends on the revival of investment, which, due to the lack of domestic saving, is not possible without foreign financing. However, significant foreign financing inflows currently are absent as foreign investors and IFIs are waiting for the unlocking of the disbursements under the IMF’s three-year EFF program. A number of prior actions are needed to complete the first review of the IMF program. These in fact represent the progress needed in structural reforms, whose pace has weakened markedly in 2017 due to insufficient political commitment. Moreover, the political environment for reforms could deteriorate further in 2018 ahead of the parliamentary elections due in October. However, important legislation for timely elections has yet to be approved, with the changes in the electoral law dependent on a decision of the Constitutional Court which has been delayed due to the absence of a political agreement. Under these circumstances, it will be crucial to meet the performance criteria as soon as possible in order to limit the fallout of the election campaign. It should not be that difficult to agree on such actions, like the increase in fuel excise taxes, to approve several amendments to the Deposit Insurance Act, to initiate due diligence in the two telecom companies in the Federation of B&H (BH Telecom and HT Mostar), to have the Tax Authority endorse quarterly indirect tax allocation coefficients and the settlement of inter-entity debts. In case of further delays of external funding, a number of infrastructure projects will suffer. Therefore, the downside risks to growth rest primarily with the fragile and complex political setup.

page 79



January 2018

CEE Quarterly

Russia

Ba1 stable/BB+ positive/BBB- positive*

Outlook: With President Putin’s announcement that he will run for re-election removing any lingering doubts about the outcome of the March election, the focus has shifted to the likely policies during his next term. The most acute problem at present is the sluggish economic growth, as the momentum of the post-crisis recovery seems to have waned. The current base case scenario could yield growth of 1-1.5%, close to (now greatly diminished) potential, inflation at around 4%, absence of macroeconomic imbalances, and a broadly stable RUB. A change in the economic model would require much more ambitious reform than contemplated at present,, although it remains unclear whether there will be enough political willingness for a major shift towards a knowledge-based innovation-driven economy. Strategy – high real rates and macro stability are strong anchors for OFZ investors. Authors: Artem Arkhipov, Head of Macroeconomic Analysis and Research Russia (UniCredit Russia) Anna Bogdyukevich, CFA, Economist (UniCredit Russia) Javier Sánchez, CFA, CEE Fixed Income Strategist (UniCredit Bank, London) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS

■ 18 Mar – presidential elections ■ 9 Feb, 23 Mar – MPC meeting ■ 18-23 of every month – short-term statistical overview SLOW GROWTH IN THE ABSENCE OF REFORMS

yoy (%)

Personal Consumption

Public Consumption

Fixed Capital Formation

Inventories

Net export

Gross Domestic Product

10

5

EUR bn

2015

2016

2017E

2018F

2019F

GDP (EUR bn)

1,224

1,157

1,378

1,319

1,294

Population (mn)

146.5

146.9

147.2

147.5

147.7


8,354

7,876

9,364

8,945

8,758

GDP

-2.8

-0.2

1.8

1.3

1.2

Private Consumption

-9.8

-4.5

3.1

2.5

2.5

Fixed Investment

-9.9

-1.8

4.2

3.7

3.6

Public Consumption

-3.1

-0.5

0

0.1

0

Exports

3.7

3.1

4.4

3.1

2.1

Imports

Real economy, change (%)

-25.8

-3.8

16.2

12.2

8.2


500

493

595

577

572


-9.0

0.8

3.0

2.6

2.4


5.6

5.5

5.2

5.0

5.0

Budget balance

-2.4

-3.4

-1.9

-1.0

-0.9

Primary balance

-1.7

-2.7

-1.1

-0.1

-0.1

Public debt

13.2

12.9

11.5

13.5

14.3


62.0

23.8

29.5

21.7

16.8


5.1

2.1

2.1

1.6

1.3


3.9

2.9

2.1

1.6

1.4

Net FDI (% of GDP)

-1.1

0.8

-0.1

0

0.1


38.2

41.9

32.8

34.7

36.3

293.2

301.9

295.9

316.0

336.0

13.9

15.1

12.7

12.8

12.8

CPI (pavg)

15.6

7.1

3.6

3.1

4.1

CPI (eop)

12.9

5.3

2.5

4.0

4.1

-

-

4.0

4.0

4.0

11.00

10.0

7.75

6.75

6.00

USD/RUB (eop)

73.8

60.66

57.60

59.80

60.27

EUR/RUB (eop)

80.3

63.81

68.87

74.75

77.15

USD/RUB (pavg)

61.3

67.19

58.29

58.87

60.89

EUR/RUB (pavg)

68.0

74.39

65.87

71.86

77.19


175.8

176.9

203.6

187.4

176.3

Change (%)

-14.5

0.7

15.1

-8.0

-5.9


0

-5

External accounts

-10 2015

2017Е

2016

2019F

2018F

LOW INFLATION ALLOWS A CUTS IN RATES Headline CPI

Key CBR rate


20%


15%

10%

Central bank target Central bank reference rate (eop)

5%

0% Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17

Jan-18

Jan-19


*

Source: CBR, Rosstat, Haver, UniCredit Research Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch respectively

UniCredit Research

page 80


January 2018


CEE Quarterly

In search of new growth drivers After President Vladimir Putin’s announcement that he will run for re-election, the outcome of the March election is very clear. The focus is shifting now to the likely policies during his next term. These remain uncertain at present, with the new administration having a choice ranging from liberal pro-market reforms proposed by former Finance Minister Alexei Kudrin to the expansionary government-driven approach suggested by the Stolypin Club. Whatever the approach, the most acute problem at present is sluggish economic growth. The momentum of the post-crisis recovery seems to have waned, with 3Q17 GDP growth slipping to 1.8% yoy from 2.5% in 2Q17. The earlier optimism about the pace of recovery has been short-lived, leading to FY17 growth at 1.8%, a tad weaker than our previous projection and less than half the pace of global growth.

Optimism about the pace of recovery has been short-lived, leaving FY17 growth at 1.7%…

More worrisome, we do not see significant growth drivers in the coming years, leaving us with a very conservative view for 2018-19. We expect real GDP growth to slow to 1.3% in 2018 and, given current policies, to 1.2% in 2019. Oil prices are likely to remain close to USD 60/bbl and, while adding to stability, they are no longer able to provide a stimulus to activity. Oil and gas sector projects have a diminishing spillover effect for the rest of the economy, and their future remains uncertain due to the dependence on foreign capital and technology, much of which is subject to EU/US sanctions that may be further tightened in 2018.

…and we do not see significant growth drivers in the coming years

Fixed investment is unlikely to become a strong growth driver. While an uptick is evident, it has been uneven – both across industries and regions, and highly dependent on oil and gas companies and natural monopolies, as well as on preparations for the World Cup in 2018 and other large-scale public projects. These factors are insufficient to keep investment growth above 3% yoy in 2018-19. The outlook for private consumption demand is mixed as well. Pent-up demand boosted retail sales, but their structure does not bode well for consumption in 2018. With short-term growth drivers being quite weak, the potential policy choices of the new administration are likely to have an impact after 2019.

While an uptick in investment is evident, it has been uneven…

…and the outlook for private consumption demand is mixed

Overall, with the authorities opting for stability, macroeconomic policies are likely to remain conservative. Continued spending restraint (despite the pre-election year) drove the fiscal deficit to 2.1% of GDP in 2017. While the underlying fiscal stance will stay broadly unchanged in 2018-19 under expectedly similar policies in the coming years, the deficit is seen falling to less than 1% of GDP in 2019. However, budget execution will remain highly dependent on oil prices. Markedly improved tax collection, especially of VAT, has also boosted the fiscal outlook.

Macroeconomic policies are likely to remain conservative

Putin’s support is close to record highs (% of votes)

Investment is recovering, albeit slowly Current accounts to deposits ratio

80

70

Capital investment, yoy (%; rs)

1.1

30%

1.0

20%

0.9

10%

60 0.8

0% 0.7

50

-10%

0.6 40

-20%

0.5 30 2012

2013

2014

2015

2016

0.4 2008

2017

-30% 2009

2010

2011

2012

2013

2014

2015

2016

2017

Source: CBR, UniCredit Research

UniCredit Research

page 81


January 2018


CEE Quarterly

The new budget rule will lead to higher FX purchases, exerting moderate pressure on the RUB

The implementation of the newly-designed budget rule, which requires the ministry of finance to purchase FX equal to the difference between actual oil and gas revenues and those that would have been received if the oil price was equal to the projected one (i.e., USD 40.8/bbl in 2018 and USD 41.6/bbl in 2019) at the market exchange rate and put them in the oil reserve fund rather than spend them will also lead to fiscal prudence. Moreover, the new rule will increase FX purchases by the ministry of finance compared with the current one, 2.5-3.0 times during 2018-19, exerting moderate downward pressure on the RUB.

Support for the RUB from monetary policy is also expected to ease

A combination of positive factors such as the bumper harvest, RUB appreciation and a negative output gap contributed to sharp disinflation in 2017, but are expected to weaken this year. Therefore, negative base effects and sticky inflation expectations are expected to bring inflation closer to the 4% target in 2018. Mild reflation may prompt the CBR to remain cautious, cutting the key rate gradually in 2018 by a total of 100bp to 6.75%. A one cut per quarter is the most likely scenario. However, rate cuts may take a break over the summer, when base effects will be the strongest. We expect the terminal policy rate of 6% (implying a 2% real rate seen as the ‘equilibrium’ by the CBR) only in 2019. A lower carry may offer less support to the RUB than in 2017.

We expect the RUB to be at 60-61 vs. the USD in 2018 and 61.3 in 2019

Consequently, we expect the RUB to be somewhat weaker than in our earlier projections, at 60-61 vs. the USD in 2018 and 61.3 in 2019. In nominal effective terms, the weakening will be slightly larger due to the expected appreciation of the EUR vs. the USD. The RUB could come under downward pressure in early 2018 if US sanctions are extended to encompass Russian sovereign debt, triggering a potential selloff by non-residents who currently hold almost 40% of the overall tradable OFZ volume. Nevertheless, this pressure will be transitory as the CBR has ample FX reserves and domestic banks are able to absorb large volumes of OFZ. At present, the Russian economy seems to be in a temporary equilibrium. Assuming no external shocks, the current base case scenario could yield growth of 1-1.5%, close to (now greatly diminished) potential, inflation at around 4%, a broadly stable RUB and absence of macroeconomic imbalances. However, in this case Russia will continue to lag most other EM (and many advanced economies), underscoring the need for reforms.

At present, the Russian economy seems to be in a temporary equilibrium

At this time, the odds of passing such reforms are unclear and their details unknown. Among the most discussed are amendments to the tax system (including cuts in social security contributions while raising VAT rates), a phased-in increase in the retirement age, measures to encourage internal migration, changes in financial regulations related to the treatment of sanctioned banks etc. It remains unclear whether there will be enough political courage to shift Russia away from the current resource-based economic model with pervasive government involvement to a knowledge-based economy driven by innovation and technological advances.

The odds of passing much needed reforms are unclear and their details unknown

Pension fund financing needs are high and set to increase Contributions Other expenses

RUB correlation with oil price is diminishing

Pension obligations Financing requirement

2014-16

2017

90

6 4 2

USDRUB

70

0 -2

50

-4 -6 30 20

-8 2011

2012

2013

2014

2015

2016

2017YTD

40

60 Oil, USD/bbl

80

100

Source: Bloomberg, CBR, UniCredit Research

UniCredit Research

page 82


January 2018


CEE Quarterly

Strategy: strong fundamentals for OFZ investors Javier Sánchez, CFA CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077 Javier.sanchezbarrueco@ unicredit.eu

With a combination of low and declining inflation, moderate growth, high real rates and improving fiscal and external accounts, Russia has one of the most favorable macro environments for bond investors in EM. The CBR is slowly cutting the policy rate and we expect that the OFZ curve will compress further to between the current curve and that in 2013, when 1Y ahead expected inflation and nominal growth were about 150bp and 300bp higher, respectively, than current expectations. This evolution of the yield curve, as per the chart on the left below, continues to favor long duration exposure with our current recommendation, the RFLB 2026, offering the highest total return – in excess of 9% – on a 6-month investment horizon. Allocations to Russian assets remain low in a historical context and compared to other EM countries. We expect foreign investors to continue increasing their OFZ holdings in 2018, but also for local banks to allocate further to fixed-coupon bonds as their carry turns positive.

We expect OFZ yields to compress further

Which favors the 5-10Y area of the curve

8.00

0

7.75

2012 average

7.50

OFZ nominal bond yield minus RUONIA (in bp)

2Y

5Y

10Y

Oct

Nov Dec

-40

Current yield curve -80

7.25 7.00

-120

Target yield curve

6.75

2013 average -160

6.50 -200

6.25 -240

6.00 2

3

4

5

6

7

8

Jan

9

Feb Mar

Apr May Jun

Jul

Aug Sep

2017


GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other Sovereign Funds

2017E 54.6 26.7 27.8 20.3 12.6 0 7.7 7.5 7.5 0 54.6 31.1 25.8 0 5.3 6.2 6.2 0 0.3 17.0

2018F 36.5 13.6 23.0 15.1 7.5 0 7.5 7.9 7.9 0 36.5 29.1 23.7 0 5.4 5.7 5.7 0 0 1.7

GROSS EXTERNAL FINANCING REQUIREMENTS EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing Other Change in FX reserves (- = increase)

2019F 33.4 12.2 21.2 14.3 10.0 0 4.3 6.8 6.8 0 33.4 27.5 22.6 0 4.9 5.5 5.5 0 0 0.3

2017E 82.9 -29.5 70.6 3.3 22.9 44.4 41.8 82.9 -1.0 2.5 53.4 6.2 16.0 31.2 27.0 -5.0 6.1

2018F 74.6 -21.7 69.3 1.4 17.5 50.3 27.0 74.6 0 0.5 56.7 5.7 14.0 36.9 42.6 -5.0 -20.2

2019F 94.9 -16.8 69.1 2.0 17.4 49.7 42.6 94.9 1.5 -2.0 62.6 5.5 15.7 41.4 57.7 -5.0 -19.9

Source: CBR, MoF, UniCredit Research

UniCredit Research

page 83



January 2018

CEE Quarterly

Serbia

Ba3 stable/BB stable/BB stable*

Outlook –We expect growth to accelerate to 3.3% in 2018, in part due to a positive base effect related to the supply shocks in 2017, and remain close to 3.0% in 2019. Serbia’s good fiscal performance may be reversed slightly in 2018-19. No significant progress in structural reforms in sight, which leaves the Serbian economy vulnerable to one-off shocks. Monetary policy easing may continue if the international environment remains favorable and inflation stays below target. Strategy – We think that markets would receive well a Eurobond in EUR but we see less value in SERBGBs. Authors: Mauro Giorgio Marrano, Senior CEE Economist (UniCredit Bank, Vienna) Javier Sánchez, CFA, CEE Fixed Income Strategist (UniCredit Bank, London)


EUR bn

2015

2016

2017E

2018F

2019F

■ 11 Jan, 8 Feb, 8 Mar: NBS monetary policy meetings ■ 31 Jan, 28 Feb: 4Q17 GDP (flash, structure) ■ Feb: Conclusion of the IMF Stand-by Arrangement

GDP (EUR bn)

32.8

33.5

35.6

38.0

39.3

Population (mn)

7.1

7.1

7.0

7.0

6.9

4,624

4,740

5,072

5,442

5,661

GDP

0.8

2.8

1.8

3.3

3.0

Private Consumption

0.5

1.0

1.8

2.3

2.1

Fixed Investment

5.6

5.1

4.3

7.2

7.2

Public Consumption

-1.5

2.2

1.3

2.0

2.0

Exports

10.2

12.0

10.8

11.1

7.5

Imports

9.3

9.0

10.0

9.0

6.7

4.0


506

515

543

579

596

3.0


-1.8

2.6

0.8

3.1

2.5


18.2

15.9

13.5

13.0

12.6

Budget balance

-3.7

-1.3

0.5

-0.6

-0.5

Primary balance

-0.5

1.8

3.3

2.1

2.2

Public debt

75.9

73.0

67.1

64.7

63.0


-1.6

-1.2

-1.8

-1.8

-1.8

Current account balance (% of GDP)

-4.8

-3.6

-5.0

-4.6

-4.6


0.7

2.2

0.9

1.1

1.0

Net FDI (% of GDP)

5.5

5.8

5.9

5.8

5.6


80.0

73.9

70.5

64.4

63.1


11.5

10.6

10.4

9.9

9.9

7.3

6.5

5.6

4.7

4.4


GDP GROWTH yoy (%), pp of GDP

Inventories and discrepancy

Net exports

Gross fixed capital formation

Public consumption

Private consumption

GDP

2.0

Fiscal accounts (% of GDP) 1.0 0.0 -1.0

External accounts

-2.0 2015

2016

2017F

2018F

2019F

INFLATION FORECAST

yoy (%)

Headline inflation

Inflation target

Target range

Core inflation

6.0

Months of imports, goods & services 5.0


4.0

CPI (pavg)

1.4

1.1

3.1

2.4

3.0

3.0

CPI (eop)

1.6

1.5

3.1

3.0

3.2

Central bank target

4.0

4.0

3.0

3.0

3.0

4.50

4.00

3.50

3.00

3.00 3.53

2.0

Central bank reference rate (eop) 1.0


3.38

3.20

3.31

3.05

0.0 Dec-15

USD/FX (eop)

111.2

117.1

100.0

98.4

98.0

EUR/FX (eop)

121.6

123.5

120.0

123.0

125.4

USD/FX (pavg)

108.8

111.3

107.7

98.7

97.1

EUR/FX (pavg)

120.8

123.1

121.5

120.3

123.2

Jun-16

Dec-16

Jun-17

Dec-17

Jun-18

Dec-18

Jun-19

Dec-19

Source: SORS, UniCredit Research

Source: Eurostat, SORS, NBS, UniCredit Research

*


UniCredit Research

page 84



January 2018

CEE Quarterly

Low budget deficits as a substitute for reforms One of the weakest growth in CEE in 2017, in part due weather related shocks…

In 2017, Serbia’s GDP growth has been one of the weakest in CEE. We estimate GDP growth at 1.8% in 2017, which compares to an average growth rate of more than 4.0% in EU members from CEE. In part, the weak performance was due to two supply shocks: cold winter weather that affected the energy supply and a drought over the summer. The latter led to a 10% yoy fall in the harvest and subtracted about 0.6pp from GDP growth in the first three quarters of the year. Excluding these one-offs, growth would have been in the 2.6-2.7% range in 2017, still significantly lower compared to most other CEE countries.

…but also reflecting structural weaknesses

Serbia’s economic underperformance compared to other CEE countries reflects the country’s structural weaknesses. Despite some progress in the past years, the investment rate is just 18%, large and inefficient state-owned enterprises (SOE) still represent a large part of the economy, while the business climate, education and healthcare need improvement.

Economic growth expected at 3.3% in 2018 and 3.0% in 2019

We expect growth to accelerate to 3.3% in 2018, in part due to a positive base effect related to the supply shocks in 2017, and remain close to 3.0% in 2019. Looking through the volatility related to base effects, underlying growth is likely to remain just below 3% in the next two years, which is a good result compared to the post 2008-09 crisis period but still too low for a sustained convergence towards the living standards of EU-CEE countries. Household consumption and investment may be the main growth drivers. Household consumption growth is likely to accelerate on the back of higher salaries and pensions, as well as an increase in employment. We expect investment growth to pick up owing to credit growth and government investment spending. Net exports could be a small drag to GDP growth, as solid exports growth is offset by a pickup in imports. Serbia’s good fiscal performance may be reversed slightly in 2018-19. In 2017, the general government probably had its first surplus since 2005 of approximately 0.5% of GDP compared to a deficit target of 1.7% of GDP. The outperformance was mainly driven by revenue growth, lower interest expenditure (helped by RSD appreciation and lower interest rates) and lower capital expenditure. Public debt, measured according to ESA methodology, probably fell from 73% of GDP in 2016 to 67% of GDP in 2017. The government set a target for the fiscal deficit of 0.7% of GDP for 2018, which should help lower debt to around 65% of GDP (ESA methodology). The fiscal easing will be used to increase public sector wages and pensions by 7.5% and 5%, respectively, according to the Fiscal Council. Public investment may increase to around RSD 180bn which is about 30% above the estimate for 2017, in good part related to infrastructure. According to the IMF, the financing of weak public entities through arrears to Srbijagas and electricity company EPS has been significantly reduced. Nevertheless we continue to see it as a fiscal risk.

Good fiscal performance in 2017, some slight deterioration in 2018-19

FISCAL POLICY IS NOT A SHORT-TERM MACROECONOMIC RISK ANYMORE Higher revenues and lower spending led to a budget surplus in 2017

% of GDP, yoy 12M rolling 5.0

Other expenditure (+ = reduction) Interest expenses (+ = reduction) Non-Tax Revenues Tax Revenues Budget balance (% of GDP; rs)

Limited fiscal easing ahead Budget balance, GDP (%) 1 0

2.0

-1

4.0

1.0

3.0

0.0

-2

2.0

-1.0

-3

1.0

-2.0

0.0

-3.0

-1.0

-4.0

-5

-2.0

-5.0

-6

-3.0

-6.0

-4.0 Jan 13

-4

-7

-7.0 Jan 14

Jan 15

Jan 16

2013

2014

2015

2016

2017F

2018F

2019F

Jan 17

Source: MinFin, SORS, UniCredit Research

UniCredit Research

page 85



January 2018

CEE Quarterly

Privatization targets are timid

Unfortunately, the good fiscal performance has not been accompanied by significant progress in reforms, in particular privatization and the restructuring of state owned enterprises. Some measures are in the pipeline: authorities are expected to launch and complete the privatization of Komercijalna Banka by mid-2018. In addition, chemical producer MSK has been put on sale in December and the privatization of copper smelter RTB Bor is expected to start in 1Q18. At the same time there are no clear signs that the problems of the Resavica mines have been addressed and progress in restructuring other companies has been slow. A new IMF program and the prospects of EU accession by 2030 could be credibility anchors and spur reform momentum. The current IMF Stand-by Arrangement (SBA) will end in February but the IMF seems more willing than the Serbian government to follow it up with a new program focusing on competitiveness and employment. The European Commission believes that Serbia might be able to join the EU by 2025. We believe that this timeline is too ambitious. Serbia opened 12 out of 35 negotiations chapters with the EU and it may take ten years to complete them all. The latest two chapters, on corporate law and external relations, were opened on 11 December.

A new IMF agreement is desirable for structural reforms

Inflation is expected to remain inside the 1.5-4.5% target range in 2018 and 2019. Inflation may stay below target in 2018 if the government fails to increase regulated prices in line with the program convened with the IMF. Inflation is likely to remain around 3% in 2019 in the absence of significant supply-side shocks affecting food and/or fuel prices.

Inflation expected to remain inside the 1.5%-4.5% range

Monetary policy easing may continue with two cuts to 3% if the international environment remains favorable and inflation stays below target. The main reasons for cuts are: 1) The need to boost RSD lending. Private-sector releveraging was based last year on strong FX-indexed lending (up by 1.3% of GDP in 10M17). This led to unwanted RSD appreciation at a time when the currency remains overvalued; 2) A negative output gap; 3) Downside risks to the central bank’s GDP growth forecasts, which look a bit optimistic at 3.5% for both 2018 and 2019. The main risk to our call is a change in risk appetite for EM bonds. Serbia remains vulnerable to the normalization in interest rates in advanced economies, especially in the US, due to its large shares of FX-denominated debt and foreign investors in SERBGBs. Therefore, the National Bank of Serbia may be more cautious if risk appetite wanes.

The NBS might deliver an additional cut by year end

We expect the RSD to depreciate by about 2% per year in 2018 and 2019, reversing the unwanted appreciation in 2017. Of the factors that pushed EUR-RSD lower last year, FX-linked lending may remain strong. At the same time, balance of payment flows may be less supportive, especially if higher interest rates in the US reduce foreign appetite for Serbian bonds.

EURRSD is poised to resume its depreciation trend

RSD APPRECIATION SHOULD BE REVERSED A sharp rise in FX-linked loans helped the RSD appreciate…

…but fundamentals point towards a weaker RSD EURRSD

FX indexed lending - EUR mn equivalent 10,800

126

10,600

124

10,400

Forecasts

122

10,200

120

10,000 118

9,800 116

9,600 Dec-19

Aug-19

Apr-19

Dec-18

Apr-18

Aug-18

Dec-17

Aug-17

Apr-17

Dec-16

Apr-16

Aug-16

Dec-15

Aug-15

Dec-14

Oct-17

Jul-17

Apr-17

Jan-17

Oct-16

Jul-16

Apr-16

Jan-16

Oct-15

Jul-15

Apr-15

Jan-15

Apr-15

114

9,400

Source: NBS, SORS, MinFin, UniCredit Research

UniCredit Research

page 86



January 2018

CEE Quarterly

Strategy: a propitious time for a EUR bond issue Javier Sánchez, CFA CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077 Javier.sanchezbarrueco@ unicredit.eu

Dinar-denominated SERBGBs were well bid during 4Q17, with the bid-to-cover ratio of the 6Y paper auction in November exceeding 2x. Demand for SERBGBs has continued, as the NBS cut rates by 50bp in 2H17 and the dinar appreciated against the euro. The SERBGB is steep by regional standards and the long end of the curve may continue to attract demand as inflation hovers around 3%. We think that the dinar is overvalued and the risk-reward of SERBGBs is not sufficiently attractive at these levels as the bonds are illiquid. However, the bonds could continue to be well bid if the NBS continues cutting rates. In December, S&P upgraded Serbia’s foreign-currency rating to BB. USD bonds continue trading in line with higher-rated countries and will remain well bid by investors seeking additional yield in the CEE region. As we have mentioned before, we continue to wait for the issuance of a first EUR-denominated bond in 2018 as this would be well received by investors and would help fill a gap in the BB rated sovereign credit universe, which currently has Turkey and Croatia as the sole CEE issuers.

SERBGB auctions were well bid

Serbia’s external rating continues improving Foreign-currency rating

Amounts offered and excess bids on RSD SERBGB auctions (in RSD mn)

Offered

Excess bids

Croatia Macedonia

average of Moody's, S&P and Fitch

Serbia Turkey

Montenegro

60,000

B

50,000

B+

40,000

BB-

30,000

BB

20,000

BB+

10,000

BBB0 Q1

Q2

Q3

Q4

2016

Q1

Q2

Q3

BBB

Q4

2010

2017

2011

2012

2013

2014

2015

2016

2017

Source: Bloomberg, Rating Agencies, Serbian DMO, UniCredit Research

GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills External borrowing Bonds IMF/EU/Other IFIs Other Fiscal reserves change (- =increase)

2017E 3.9 -0.2 4.0 3.3 2.6 0.7 0.7 0.7 0 3.9 2.6 2.6 0 1.8 0 0.9 0.9 -0.5

2018F 3.9 0.2 3.6 1.9 1.7 0.2 1.7 1.7 0 3.9 2.2 2.0 0.2 1.7 1.0 0.4 0.3 0

GROSS EXTERNAL FINANCING REQUIREMENTS EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net

2019F 3.2 0.2 3.1 2.4 2.2 0.2 0.7 0.7 0 3.2 2.2 2.0 0.2 1.3 1.0 0.3 0 -0.3

2017E 6.5 1.2 5.0 0.6 1.0 3.4 0.3 0 0.2 0.1 6.5 1.2 0 4.1 -0.1 0.8 3.4 0.3 0 0.9

2018F 7.3 1.8 4.9 0.7 0.7 3.5 0.7 0 0.6 0.1 7.3 1.2 0 5.5 1.5 0.5 3.6 0.4 0 0.2

2019F 8.3 1.8 5.9 1.7 0.6 3.6 0.7 0 0.6 0.1 8.3 1.2 0 5.8 1.6 0.6 3.6 0.7 1.0 0.5

-1.9 -0.6

-0.2 0

0.3 0


UniCredit Research

page 87



January 2018

CEE Quarterly

Turkey

Ba1 negative/BB negative/BB+*

Outlook – Massive policy stimulus and one-off factors pushed growth to 6.8% in 2017 – but at a high cost, with inflation at a 14-year high and the TRY at a 15-year low. Activity has been slowing since mid-2017, but high inflation and TRY volatility are here to stay in 2018 if not for longer, with policies likely to remain stimulative ahead of the twin elections due in 2019. With no more one-offs and less scope for policy stimulus, growth will ease to 4% in 2018 and 3.7% in 2019. Along with ongoing geopolitical tensions, misguided policies will continue to weigh on Turkish asset prices. The weak external position is the key risk, with the C/A deficit set to rise above 6% of GDP amid dwindling capital inflows and heavy dependence on portfolio capital. Strategy – TURKGBs have negative carry which make them unattractive to local banks and foreign investor exposure is high. We would wait for inflationary pressures to abate before recommending to initiate a position. Authors: Lubomir Mitov**, Consultant Javier Sánchez, CFA, CEE Fixed Income Strategist (UniCredit Bank, London) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS

■ 3 Jan, 2 Feb, 7 Mar – Consumer price index ■ 18 Jan, 7 Mar – MPC meetings ■ 18 Jan, 15 Feb, 15 Mar – Central government balance ■ 15 Jan, 13 Feb, 13 Mar – Current account balance ■ 29 Mar – 4Q17 GDP

EUR bn

2015

2016

2017E

2018F

2019F

GDP (EUR bn)

776.2

778.0

738.5

769.2

744.2

Population (mn)

78.2

79.0

79.8

80.6

81.3

9,931.5

9,852.1

9,258.7

9,549.1

9,151.4

Real economy, change (%) GDP

6.1

3.2

6.8

4.0

3.7

Private Consumption

5.5

3.7

6.1

4.5

4.0

Fixed Investment

9.2

2.2

9.0

6.0

5.0

Public Consumption

4.1

9.5

3.3

1.0

1.5

Exports

6.6

-2.0

10.6

6.3

4.9

Imports

3.8

3.9

8.1

5.5

5.0

1,058.2

1,141.8

1,078.5

1,079.9

1,018.3


5.2

11.4

4.3

0.9

2.3


10.3

10.9

10.8

10.7

11.0

Fiscal accounts (% of GDP) Budget balance

-1.4

-2.2

-3.1

-3.2

-3.0

0.7

-0.3

-0.3

-0.3

0

28.3

30.3

30.1

29.6

29.2


GROWTH SET TO BE MODERATE…

Monthly wage, nominal (EUR) Personal consumption Gross fixed capital Inventories

yoy (%)

Public consumption Net exports GDP

16 14 12 10 8

Primary balance

6

Public debt

4 0

External accounts Current account balance (EUR bn)

-29.1

-29.0

-40.8

-45.1

-48.4

-2


-3.7

-3.7

-5.5

-6.2

-6.5


-2.4

-2.8

-4.5

-5.2

-5.4

1.3

0.9

1.0

1.0

1.1


47.6

48.3

55.1

54.7

56.6


2

-4 -6 2010

2011

2012

2013

2014

2015

2016

2017E 2018F 2019F

88.5

86.3

74.3

70.7

69.9


4.7

4.8

4.1

3.5

3.3

Inflation/Monetary/FX CPI (pavg)

7.7

7.8

11.2

11.0

9.5

CPI (eop)

8.9

8.5

12.5

9.6

8.6

25

Central bank target

5.0

5.0

5.0

5.0

5.0

20


7.5

7.5

8.0

8.0

8.0

15

Central bank effective cost of funding (eop)

7.5

9.3

12.8

11.8

10.8

…WITH INFLATION ELEVATED yoy (%)

CPI

14

Inflation target

TRY basket (rs)

Trend CPI 35 30

12 10 8 6 4 2

Net FDI (% of GDP)

10


9.3

8.5

13.0

12.5

11.0

0

USD/TRY (eop)

2.9

3.5

3.9

4.3

4.5

-5

EUR/TRY (eop)

3.2

3.7

4.6

5.3

4.8

-10

USD/TRY (pavg)

2.7

3.0

3.6

4.0

4.3

EUR/TRY (pavg)

3.0

3.4

4.1

4.6

5.5

107.4

106.1

94.2

85.6

77.5

0.3

-1.2

-11.3

-9.1

-9.4

5

-15 0 -20 Jan-07 Apr-08 Jul-09 Oct-10 Jan-12 Apr-13 Jul-14 Oct-15 Jan-17 Apr-18 Jul-19


Source: Turkstat, CBRT, UniCredit Research


*

Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch respectively **Lubomir Mitov is a Consultant for UniCredit Bank AG

UniCredit Research

page 88



January 2018

CEE Quarterly

Fast forward to the past? 2017 was characterized by incongruous economic trends…

…with stellar growth, rising macroeconomic imbalances and heightened market volatility

Looking forward, growth is set to decelerate…

…but elevated inflation and market volatility are here to stay

Expansionary policies were the main driver behind the surge in growth…

…but scope for policy stimulus will be more limited in 2018-19

We expect only slight further fiscal easing in 2018… …and a rollover of the CGF to avoid drop-off in credit

The challenges for monetary policy are bigger… …with interest rates raised only reluctantly and under market pressure and stepped-up CBRT funding and the weak TRY offsetting much of their impact …even though yoy inflation will ease gradually during the year

2017 was characterized by incongruous economic trends. On the one hand, growth surged to an impressive 6.8%, buoyed by a combination of massive policy stimulus, favorable base effects and one-off factors such as the lifting of the Russian sanctions on Turkish exports and the return of Russian tourists. On the other hand, inflation hit a 14-year high and the TRY a 15-year low in real terms. Despite robust exports, the C/A deficit rebounded to 5.5% of GDP, while capital flows shrank and FX reserves dropped. Finally, Turkish bonds are among the few EM assets to end 2017 on a losing streak. Looking forward, growth is set to moderate substantially, but elevated inflation and market volatility are here to stay. Activity started decelerating in seasonally adjusted terms already in 3Q17, with high-frequency indicators pointing to a further slowdown in 4Q. One-offs and base effects added some 1.2 pp, and past data revisions 0.3 pp to GDP, accounting for most of the upside growth revision in 2017. With the positive base effects gone and no more one-offs, growth looks set to slow to 4% in 2018 and 3.7% by 2019, in line with potential. This said, the main driver behind the surge in growth in 2017 was the strongly expansionary policy stance. Fiscal policy probably added some 1.5 pp to growth, with a surge in bank lending afforded by the State Credit Guarantee Fund (CGF) extending a powerful albeit short-lived boost. However, in 2018 scope for further major policy stimulus is more limited. Further sizable increases in the fiscal deficit might well upset investors and could be difficult to finance, given more limited foreign funding and growing liquidity strains among domestic banks. The latter will also limit scope for another round of CGF expansion, with loan/deposit ratios approaching 130% for the banking system and even higher for state-owned banks. The 2018 budget calls for sizable fiscal tightening, but we do not see this as plausible as growth slows, given the authorities’ political priorities (keeping growth as high as possible ahead of the twin elections due in 2019). Therefore, we expect fiscal policy to stay slightly expansionary or neutral at best, with the deficit remaining just above 3% of GDP (a level that looks sustainable for now), and the CGF to be rolled over to avoid a drop-off in credit. The challenges to monetary policy are bigger. With inflation at a 14-year high and the TRY under persistent pressure, the CBRT has been forced to hike its average cost of funding by more than 400bp since the start of the year. However, with the central bank under intense political pressure to keep interest rates low, these hikes have been implemented only reluctantly and under market pressure, which has limited their signaling impact. Moreover, their impact has been partly offset by sharply increased CBRT funding (in an attempt to provide liquidity to domestic banks), and by the weaker TRY. Measured by the monetary policy index, the monetary stance is the easiest since 2013.

Monetary policy has been easing since 2013… % p.a.

Monetary condition index

…even though output has been above potential since 2012

Average cost of funding (rs)

1.05

14.0

1.00

13.0

0.95

12.0

%

0.85 0.80

Output Gap

TFP

7.5

10.0

5.0

9.0

2.5

8.0

0.75

Labor

Potential Growth

10.0

11.0

0.90

Capital

0.0

7.0 6.0

0.65

5.0

0.60

4.0

-5.0 -7.5

Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18

0.70

-2.5

-10.0 2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020

Source: CBRT, Turkstat, Haver, UniCredit Research

UniCredit Research

page 89


January 2018


CEE Quarterly

We expect a similar policy stance in 2018-19…

We expect this policy stance to continue in 2018. Assuming improving US-Turkey relations, USD-TRY should stabilize at 3.80-3.90 in 1H18. This, along with positive base effects, should put 12-month inflation on a downward path, but only gradually, with the pass-through of the 4Q17 depreciation still felt in 1Q18. With the CBRT more likely to ease as price pressures abate starting in 2Q, inflation is unlikely to return to single-digits before late 2018.

…with inflation in double digits for most of 2018… …despite broad TRY stability…

Assuming a similar policy stance in 2019, and a broadly stable TRY (in real effective terms), inflation could settle at 8-9% in 2019, still way above target. Under these circumstances, the CBRT looks set to gradually reduce average costs of funding to about 10.5% (and the late liquidity rate to 11% from 12.75% at present). Larger cuts could unsettle investors and lead to renewed volatility, but cannot be ruled out given the political pressure on the central bank.

…before settling within the 8-9% range in 2019… …enabling the CBRT to cut interest rates by 175bp or more The misguided policy mix is to blame for rising inflation and weakening external position

More broadly, the current policy mix is misguided, in our view, as it tries to tackle the slowdown in growth by boosting demand. However, this slowdown reflects a decline in potential growth since 2009 (due mainly to lower productivity). Therefore, stimulative policies have kept growth above potential since 2012, pushing inflation up and causing the external position to weaken. While low oil prices kept the C/A deficit below 4% of GDP for a few years, in 2017 it surged to 5.5% of GDP – despite roughly 1% of GDP in extra receipts thanks to the normalization with relations with Russia. In the absence of further one-offs, we expect the C/A shortfall to widen further to 6.2% in 2018 and 6.5% in 2018, when global trade is expected to slow. Moreover, the rise in the C/A deficit in 2017 came against the background of dwindling capital inflows, which fell to USD 35bn, or 4.2% of GDP, excluding errors and omissions. FX reserves slipped to USD 88bn as a result, or just four months of import cover, the lowest level since 2008. Net of domestic banks’ FX deposits with the CBRT, reserves fell as low as USD 10bn in 2017.

The C/A deficit will widen to above 6% of GDP in 2018-19….

…against the backdrop of dwindling capital inflows…

…that cut the reserves’ import cover to a nine-year low …

The structure of capital inflows is worrisome as well. As much as 75% of the 2017 inflows reflected portfolio capital (USD 3.7bn in equity, USD 15bn in net foreign bond issuance and USD 8bn in foreign purchases of TURKGBs), with most of the rest short-term bank borrowing. It is this combination of a widening C/A shortfall and excessive reliance on volatile capital inflows and short-dated borrowing that remains Turkey’s biggest challenge and risk factor.

…amid heavy dependence on volatile portfolio capital…

...leaving Turkey vulnerable to shifts in market sentiment

With global liquidity likely to tighten as the Fed curs its balance sheet and global interest rates rise, securing the ever-higher portfolio inflows needed to finance the rising C/A deficit will be increasingly challenging. Risks for a reversal are high and growing, both related to the global environment as well as to geopolitics, with the current tensions with the US the biggest risk. Policy-related risks loom large as well, with potential excessive or premature easing likely to trigger market turmoil. Even a modest portfolio outflow could have a major impact on the economy, triggering a spike in yields and a drop in the TRY and forcing the CBRT, given low FX reserves, to hike rates sharply, forcing a major slowdown in growth or even a recession.

Risks for a reversal in capital inflows are high and rising… …both related to the global environment… …as well as geopolitics…

…and potential policy errors

The underlying C/A deficit has been deteriorating... Trade balance adj

ToT gains

…with external financing dwindling and FX reserves falling CA balance adj

6 % GDP

4

14

2

12

0

10

-2

8

FDI Banks Other Capital, net Net FX reserves (rs)

Portfolio Foreign buying TURKGB FX bonds, net USD bn C/A deficit 100.0 90.0 80.0 70.0 60.0

6

-4

50.0

4

-6

40.0

2

30.0

Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 Jan-17 May-17 Sep-17

Jul-17

Sep-17

May-17

Jan-17

Mar-17

Nov-16

Jul-16

Sep-16

May-16

Jan-16

Mar-16

Nov-15

Jul-15

Sep-15

May-15

Jan-15

Mar-15

0.0

Nov-14

-4

Jul-14

10.0

-12 Sep-14

-2

May-14

20.0

-10 Jan-14

0

Mar-14

-8

Source: Bloomberg, CBRT, Haver, UniCredit Research

UniCredit Research

page 90



January 2018

CEE Quarterly

Strategy: TURKGB, handle with care Javier Sánchez, CFA CEE Fixed Income Strategist (UniCredit Bank, London) +44 207 826-6077 Javier.sanchezbarrueco@ unicredit.eu

TURKGB yields and the lira took a pummeling since September 2017 and the current levels seem like attractive entry points. However, we would wait for confirmation that disinflation is under way beyond the transitory effects related to the high base of December 2016 and January 2017. Strong domestic demand thanks to large credit and fiscal impulses combined with lira depreciation is leading to higher inflation expectations and inflation more persistent than what the CBRT currently expects. As we discussed in our recent EEMEA Country Note – Turkey: CBRT between a rock and a hard place, Turkish local bond returns in USD equivalent tend to move in cycles which show persistence, an advantage to early movers, but also many false starts. Since 2010, the lira has shown a strong depreciating trend in nominal and real terms and, given the current policy mix, the potential for sustained appreciation is limited in our view. We don’t think that the lira is cheap at these levels and we expect most returns to come from carry. For this reason, we prefer to wait for further signs of stabilization in inflation before initiating a trade recommendation.

While negative carry in the 3-10Y area makes them unattractive for local banks

Foreign flows into TURKGBs were at record highs in 2017 YTD Non-resident net flow s

12,000

2013 2016

into TURKGB (USD Mio)

2014 2017

2015

150

TURKGB yield curve minus CBRT w /av CoF (in bp)

Jan 1 '18 Mar 30 '17

Sep 30 '17

Jun 30 '17

100 8,000

50 4,000

0 -50

0

-100 -4,000

-150 -200

Dec

Nov

Sep

Aug

Jul

Jun

May

Apr

Mar

Jan

-8,000

6m 1y

5y

10y



2017E 44.3 22.9 21.4 14.6 14.6 n.a. n.a. 6.8 3.4 3.4 44.3 30.0 30.0 n.a. n.a. 7.3 8.3 -1.0 7.0

2018F 45.6 24.5 21.1 14.9 14.9 n.a. n.a. 6.2 4.3 1.9 45.6 31.5 31.5 n.a. n.a. 7.5 7.0 0.5 6.6

GROSS EXTERNAL FINANCING REQUIREMENTS EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net

2019F 37.0 22.7 14.3 9.1 9.1 n.a. n.a. 5.3 3.5 1.7 37.0 25.6 25.6 n.a. n.a. 6.5 5.5 1.0 4.9

2107F 183.0 40.8 55.4 6.8 30.9 17.7 86.8 181.0 6.9 2.8 62.3 7.3 30.0 25.0 98.7 0 3.6 6.7

2018F 182.3 45.1 41.5 6.2 20.4 14.9 95.7 180.9 7.6 2.1 61.1 7.5 28.1 25.5 99.7 0 8.3 2.1

2019F 169.5 48.4 32.6 0 18.9 13.7 88.5 169.5 8.1 1.8 53.6 0 28.1 25.5 99.7 0 6.3 0

6.4 12.0

4.0 2.5

4.0 2.5

Source: CBRT, Treasury, Turkstat, UniCredit Research

UniCredit Research

page 91


January 2018


CEE Quarterly

Ukraine

Caa2/B-/B-*

Outlook – Economic performance deteriorated in 2017, with growth slowing, inflation surging, the C/A deficit wider, and domestic politics becoming increasingly dysfunctional. Economic policies have increasingly shifted into a pre-election mode, with steep wage hikes, largely halted reforms and more spending promises eroding competitiveness and undermining the fragile and tenuous stability. While renewed access to capital markets has provided temporary relief, it has also eroded the willingness for reforms, with IMF support seen as less urgent now. This policy does not bode well: Ukraine is repeating the same policy mistakes that had led to repeated crises in the past. Growth will remain stuck at 2%, inflation in double digits, and the C/A deficit at 5% of GDP or higher. Given the viciousness of the current political standoff, we do not expect breakthroughs on reforms until after the May 2019 presidential election. Author: Lubomir Mitov**, Consultant MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS

■ 11 Jan, 9 Feb, 9 Mar – Consumer price index ■ 23 Jan, 23 Feb, 23 Mar – Industrial production index ■ 25 Jan, 1 Mar, – Key rate decision ■ 31 Jan, 20 Feb, 30 Mar – Current account balance, monthly ■ 17 Feb, 23 Mar – GDP 4Q17 (preliminary, final)

EUR bn

2015

2016

2017E

2018F

2019F

GDP (EUR bn)

81.4

84.4

92.7

92.6

87.8

Population (mn)

42.8

42.3

41.9

41.5

41.1

1,903.2

1,995.6

2,212.6

2,231.6

2,136.1

GDP per capita (EUR) Real economy, change (%) GDP

-9.8

2.3

1.8

2.1

2.3

-20.7

1.8

3.0

3.2

3.5

-9.2

20.1

19.0

8.0

9.0

1.7

0

3.5

1.0

2.5

Exports

-13.2

-1.6

-0.1

3.3

3.3

Imports

-17.9

8.4

8.4

6.7

6.2


172.9

183.2

236.7

238.7

232.0


-18.9

8.5

19.7

2.8

4.3


9.6

9.7

9.8

9.6

9.6 -3.7

Private Consumption Fixed Investment Public Consumption

GROWTH CONTINUES TO DISAPPOINT…

GDP (%) 20

Private consumption Gross fixed capital formation Inventory investment

Public consumption Net exports GDP (% yoy)


15 10

Budget balance

-4.5

-7.6

-3.2

-3.3

5

Primary balance

-0.3

-3.0

1.3

1.2

0.8

Public debt

84.6

82.5

82.2

78.2

79.3

0 -5 -10

External accounts

-15


-0.2

-3.4

-3.9

-4.5

-5.2


-0.2

-3.8

-4.4

-4.9

-6.0


3.7

0

-2.6

-3.2

-4.0

Net FDI (% of GDP)

4.0

3.8

1.8

1.8

2.0

131.9

121.7

113.6

111.8

117.3

14.0

16.0

15.8

16.6

15.5

3.1

3.5

3.4

3.4

3.0

-20 -25 -30 2015

2016

2017E

2018F

2019F

Gross foreign debt (% of GDP) FX reserves (EUR bn)

…WITH INFLATION STUCK IN DOUBLE DIGITS


CPI

yoy (%)

NEER (rs)

70

180

CPI (pavg)

48.7

13.9

14.5

11.9

10.3

60

160

CPI (eop)

43.3

12.4

13.8

10.3

10.5

140

Central bank target

n.a.

n.a.

n.a.

n.a.

n.a.


22.0

14.0

14.5

12.5

11.0

50 120 40

100

30

80


19.0

15.0

15.0

13.0

12.0

20

60

USD/UAH (eop)

23.4

27.3

27.5

29.0

32.5

40

EUR/UAH (eop)

23.0

26.9

31.9

35.1

41.0

USD/UAH (pavg)

21.9

25.6

26.6

28.1

32.0

EUR/UAH (pavg)

24.3

28.3

30.0

34.2

40.5


79.0

77.3

81.0

79.9

80.5

0.6

-2.1

4.8

-1.4

0.7

10 20 0 -10 Jan-13 Nov-13 Sep-14

0 -20 Jul-15

May-16 Mar-17 Jan-18 Nov-18 Sep-19

Source: NBU, Ukrstat, UniCredit Research

Change (%)

Source: Ukrstat, NBU, Haver, UniCredit Research *

Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch respectively **Lubomir Mitov is a Consultant for UniCredit Bank AG

UniCredit Research

page 92



January 2018

January 2018

CEE Quarterly

Been there, done that Economic performance deteriorated in 2017…

The economic performance deteriorated in 2017. Real GDP growth likely slipped to less than 2%, inflation surged to near 14%, exports have stalled and the C/A deficit swelled to 4% of GDP, despite resurgent global demand and massive terms of trade gains. While the March decision to suspend trade with the rebel-controlled areas may have played a role, the major factor behind this deterioration was misguided economic policies.

…with growth slower, inflation up and the C/A deficit wider…

Demand management in 2017 was strongly expansionary, implemented mostly via incomes policy. Real wages jumped 20%, led by a 40% hike in government wages, following smaller but still sizable increases in 2016. While partly justified given their drop during the crisis, the pace was clearly excessive: in 2017, real wages regained their 2013 level, while real GDP remained 12% lower. With the UAH appreciating in real terms, relative unit labor costs surged 30% in 2017, resulting in large competitiveness losses and a shift in demand towards imports.

…reflecting expansionary policies…

…with real wages surging and competitiveness weaker

While the headline fiscal deficit more than halved in 2017 to 3.2% of GDP, this was due to much smaller bank recapitalization costs and large one-off receipts (mostly reflecting confiscated property from the former president, Yahukovich). Net of these, the primary surplus appears to have remained little changed as the rise in revenues afforded by the higher-than-assumed inflation and the surge in tax-rich personal income, consumption, and imports was mostly used to boost spending.

The headline fiscal deficit narrowed thanks to one-offs…

…but the underlying stance was broadly unchanged

The outcome of this policy mix was a double whammy: higher inflation and a wider C/A deficit. Inflation topped 16% in September before easing to just under 14% by end-2017 (mostly thanks to favorable base effects), above both the 2016 outcome and the IMF target. Inflation rose even though UAH nominal depreciation slowed to 5% from 16% in 2016. This, together with a spike in core inflation, suggests that most of the pickup in inflation was demand-driven.

Inflation has surged well into double digits a result…

…despite a broadly stable UAH

At the same time, the C/A deficit rose to 4.4% of GDP in 2017, as export volumes stagnated while import volume growth accelerated. The deterioration in the C/A would have been larger still but for sizable terms of trade gains. While some of the disappointing export performance could be attributed to the suspension of trade with separatist-held territories, most appears to have reflected steep losses in competitiveness, which is here to stay.

The C/A deficit rose markedly despite terms of trade gains…

…as competitiveness weakened

Against this background, monetary policy has been behind the curve. Despite the acceleration in inflation and mounting demand pressures, the NBU continued easing through June and began tightening only in September, when inflation topped 16%. Even so, at the end of 2017 the policy rate was lower than a year before. The NBU also allowed the UAH to strengthen excessively in real terms, limiting the addition to reserves mostly to the amount of net financing received by the government.

Monetary policy has been behind the curve…

…with tightening delayed and UAH stability in mind

Output growth slows, exports weaken…

…with monetary policy behind the curve

Exports

3 mo avg, 2010=100

IP, sa

Imports

yoy (%)

180

NEER

CPI

Policy rate (% p.a.)

60

160

50

140

40

120

Jul-17

Aug-17

Jun-17

Apr-17

May-17

Mar-17

Jan-17

Feb-17

Dec-16

Oct-16

Nov-16

Sep-16

Jul-16

Aug-16

Jun-16

Apr-16

May-16

Mar-16

Jan-16

Aug-17

May-17

Jan-17

Sep-16

May-16

Jan-16

Sep-15

May-15

Jan-15

Sep-14

May-14

Jan-14

-10

Sep-13

0

40

May-13

10

60

Jan-13

20

80

Feb-16

30

100

Source: Ukrstat, NBU, UniCredit Research

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We expect a similar policy stance in 2018-19…

Looking forward, we expect a similar policy stance, given the approach of the 2019 twin elections and temporarily eased financing pressures. The recent sharp escalation of domestic political tensions is likely to reinforce the populist bias in Parliament. While the assault on President Poroshenko by former Odessa Governor Saakashvili and former PM Tymoshenko are unlikely to lead to his removal, they have been distracting attention from the economy and have led to repeated assaults on the just created anti-corruption body.

…given heightened political tensions ahead of 2019 elections

Fiscal policy is all but certain to ease…

Fiscal policy is all but certain to ease and strong wage growth to continue. Even though the 2018 budget formally complies with the IMF’s 2.5% of GDP deficit target, it is based on unrealistic assumptions, incorporates few structural measures, and suspends some already in place. It was met with criticism by the IMF, which thinks that meeting the target would require measures totaling 3.2% of GDP in 2018 and 4.5% in 2019. We still expect some restraint in 2018, with the authorities expecting USD 1.5bn from the IMF before the program expires, leaving the deficit slightly wider than in 2017. A larger deterioration looks likely in 2019.

…with the budget incorporating few structural measures

Under these circumstances, monetary policy will be mostly aimed at damage control. Given the likely intensification of demand pressures and the limited effectiveness of its interest rate policy, the NBU is likely to opt for broad UAH stability as the only tool left to restrain inflation. This, however, would hurt competitiveness further, pushing the C/A deficit to 6% of GDP.

Monetary policy will be mostly aimed at damage control… …with UAH stability as an inflation anchor

Under these policy assumptions, we expect inflation to remain in double digits through the forecast period, even though growth is likely to linger near 2% as the policy stimulus is largely offset by the shift in demand towards imports. With foreign official financing smaller as the IMF program and related bilateral programs wind down, and private financing likely to remain modest, we expect the UAH to begin weakening in 2H18 and more so into 2019.

We expect inflation in double digits, growth near 2%... …a rising C/A deficit and UAH weakening in 2H18-2019

A better outturn seems out of reach for now, given misguided policies and lagging reforms. The latter, which have been slow even in better times, are likely to be on hold until after the 2019 election. Moreover, recent challenges to already implemented measures (especially on corruption), including from within the government, do not bode well for the outlook. As a result, growth will remain sluggish, stabilization tenuous and uneven, foreign investment limited, and external financing pressures rising.

A better outturn is out of reach for now…

…with reforms and the anticorruption drive stalling

While the return to capital markets helped smooth the debt servicing profile, leaving the financing outlook for 2018-20 manageable, medium-term debt-servicing challenges loom large. External borrowing requirements amount to USD 8-10bn through 2025, assuming a C/A deficit near the current USD 5bn a year. Of these, the government would have to raise USD 3-4bn a year on capital markets. This would be sustainable only if growth rises to 4-5% and competitiveness improves. Unfortunately, Ukraine is going in the opposite direction, once again repeating the same mistakes that had led to successive crises in the past.

The return to capital markets has improved the near-term financing outlook… … but medium-term challenges loom large …with Ukraine repeating the same mistakes that led to successive crises in the past

External financing pressures are set to intensify from 2018… Official Financing Resident Capital C/A

USD bn

…with MLT debt servicing needs on the rise after 2019

Equity Foreign borrowing Change in reserves

USD bn

C/A deficit

private

gov loans

IMF

Bonds

2025

2026

25.0

30 25

20.0

20 15

15.0

10 5 10.0

0 -5

5.0

-10 -15

0.0

-20 2010

2011

2012

2013

2014

2015

2016

2019

2017E 2018F 2019F

2020

2021

2022

2023

2024

Source: IMF, NBU, UniCredit Research

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2017E 10.8 3.0 7.8 3.9 2.1 1.8 0 3.9 1.3 2.6 10.8 4.4 3.4 1.0 0 6.3 2.5 3.8 0.1

2018F 10.6 3.1 7.5 4.0 3.0 1.0 0 3.5 0 3.5 10.6 4.1 4.1 0 0 6.3 0.8 5.5 0.2

GROSS EXTERNAL FINANCING REQUIREMENTS EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net

2019F 11.7 3.2 8.5 3.7 3.7 0 0 4.7 1.2 3.6 11.7 7.6 7.6 0 0 3.8 2.0 1.8 0.3

2017E

2018F

2019F

31.3 3.9 11.0 3.9 2.5 4.6 16.5 31.3 1.6 0.2 12.0 6.3 0.4 5.3 18.8 0.8 -2.2

34.0 4.5 10.8 3.5 2.3 5.0 18.8 34.0 1.6 0.3 12.7 6.3 1.1 5.2 20.8 0 -1.5

36.3 5.2 10.4 4.7 2.2 3.4 20.8 36.3 1.7 0.3 11.6 3.8 1.4 6.4 21.4 0.5 0.8

0 2.5

0 1.5

0 2.8


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UniCredit Research*

Erik F. Nielsen Group Chief Economist Global Head of CIB Research +44 207 826-1765 [email protected]

Head of Macro Research

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Hrvoje Dolenec Chief Economist, Croatia +385 1 6006 678 [email protected]

Dr. Ágnes Halász Chief Economist, Head, Economics and Strategic Analysis, Hungary +36 1 301-1907 [email protected]

Ľubomír Koršňák Chief Economist, Slovakia +421 2 4950 2427 [email protected]

Kristofor Pavlov Chief Economist, Bulgaria +359 2 9269-390 [email protected]

EEMEA Economics Research

Pavel Sobíšek Chief Economist, Czech Republic +420 955 960-716 [email protected]

CEE FI Strategy Research

Javier Sánchez, CFA +44 207 826-6077 [email protected]

EM FX Strategy Research

Kiran Kowshik +44 207 826-6080 [email protected]

UniCredit Research, Corporate & Investment Banking, UniCredit Bank AG, Arabellastrasse 12, D-81925 Munich, [email protected] Bloomberg: UCCR, Internet: www.research.unicredit.eu

CEE 18/1

*UniCredit Research is the joint research department of UniCredit Bank AG (UniCredit Bank, Munich or Frankfurt), UniCredit Bank AG London Branch (UniCredit Bank, London), UniCredit Bank AG Milan Branch (UniCredit Bank, Milan), UniCredit Bank New York (UniCredit Bank, New York), UniCredit Bank AG Vienna Branch (UniCredit Bank, Vienna), UniCredit Bank Austria AG (Bank Austria), UniCredit Bulbank, Zagrebačka banka d.d., UniCredit Bank Czech Republic and Slovakia, ZAO UniCredit Bank Russia (UniCredit Russia), UniCredit Bank Romania.

UniCredit Research

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