Sharp coronavirus-induced downturn
While the available data suggest that Central and Eastern European economies started the year 2020 on a solid footing, the outbreak of the new coronavirus in China and more importantly its rapid spread throughout Europe has changed the situation dramatically. In many previous international downturns, Central and Eastern Europe appeared to be remarkably resilient. Unfortunately, that doesn’t seem to be the case with the corona crisis. Over the last two weeks, the number of coronavirus cases has risen sharply across the region. This triggered unprecedented quarantine measures with severe disruptions to economic activity. Additionally, the export-oriented nature of the CEE economies is set to propagate negative spill-over effects from the euro area. As a result, despite generally strong macroeconomic fundamentals, we except a temporary but severe economic downturn across the CEE region during 2020, with a gradual recovery already in the second half of 2020 and in 2021 (figure CEE1).
The economic impact of country-specific containment measures is yet to be fully estimated, but the most recent developments suggest that it will be harsh. While different quarantine measures have been taken by the CEE governments, they are in general rather stringent (compared to Western Europe) and in some countries not far from an Italy-style national shutdown. The Czech Republic has been the most aggressive in this sense by declaring a state of emergency and being the first European country to reintroduce border controls, shortly after followed by Poland, Slovakia and Hungary. With large gatherings prohibited, and schools and retails shops (except drug stores and groceries) closed, the governments are now effectively restricting the movement of people.
Unsurprisingly, these steps are a huge blow to domestic demand with consumer spending plummeting (primarily hitting the services sector) and investments being crippled by extreme uncertainty and production bottlenecks. The latter suggests that the economies are facing not only a severe demand shock, but also a supply-side shock. That is to say, supply chain disruptions are already adversely affecting regional industries as witnessed in Slovakia with Volkswagen’s plant (the largest private sector-employer) suspending car production.
Furthermore, the synchronised economic downturn across the CEE region will be exacerbated by weaker external demand, particularly from the euro area, the region’s key trade partner. This is a result of the high integration of regional economies into European trade flows and supply chains. Essentially, high trade openness (ranging from slightly above 90% in Slovakia to 40% in Romania, with most economies being closer to the upper end) leaves the economies vulnerable to the adverse external backdrop. That is to say, with euro area growth now expected at -0.7% in 2020, net exports will inevitably work as a drag on growth. The most prominent exposure for most CEE economies is to the German manufacturing sector (already struggling for a more than a year). However, other channels of negative spillovers might also be important for individual countries, e.g. a sharp decline in tourism for Bulgaria.
Overall, the corona crisis has significantly changed our economic outlook for annual real GDP growth in the CEE region this year. The size of downward revisions range from 1.5 ppt for the Czech Republic to 2.2 ppt for Poland. This leaves 2020 economic growth at 0.5% for the Czech Republic and Slovakia, 1.4% for Bulgaria, 1.5% for Hungary, 1.6% for Poland and finally 2.1% for Romania (figure CEE1). Still, two important elements need to be emphasised. First, given how fast the situation around the coronavirus outbreak is evolving, the outlook remains subject to a high degree of uncertainty and tilted to the downside. Second, our key assumption is that the draconian containment measures will be lifted by the end of the second quarter. In other words, we expect a large but temporary drop in economic activity concentrated in the first half of 2020, followed by a gradual pick-up in the second half of 2020.
Fiscal and monetary stimulus to provide significant support
Ultimately, the magnitude of the coronavirus-induced slowdown will not depend only on the scope and duration of the outbreak, but also on the policy responses. In general, public finances in CEE are in better shape than in most euro area countries. On the fiscal front, government debt-to-GDP ratios have declined substantially over the last few years on the back of strong economic growth and accompanied by relatively prudent budget management. Notwithstanding the fact that major spending programmes have yet to be announced, the significant fiscal leeway is expected to be gradually utilised to mitigate the impact of the coronavirus on the regional economies. The only exception might be Romania, where the budget deficit reached 4.6% of GDP in 2019.
Meanwhile, we believe that regional central banks will not be standing aside and will provide substantial support to combat the downturn. After all, on March 16, the Czech National Bank already reversed its early-February 25 bps hike and cut its key interest rate by 50 bps, bringing it to 1.75%. Moreover, the CNB left the door open for further cuts and some extraordinary measures to support the rapidly weakening koruna (more in Box CEE1). The National Bank of Poland also reacted to the corona crisis by lowering interest rates by 50 bps to 1.0% and introducing a comprehensive monetary easing package. This includes a de facto quantitative easing programme (i.e. large-scale purchases of government bonds in the secondary market), an extension of repo operations to boost banks’ liquidity and a reduction in the reserve requirement ratio from 3.5% to 0.5%. Since the Hungarian National Bank’s key rate is already at -0.05%, the central bank is likely to focus on maintaining the excess liquidity in markets and, if needed, to introduce a new funding programme for the SMEs (more in Box CEE2).
Box CEE1 – CNB started the monetary easing cycle
At the beginning of February, the CNB shocked financial markets by raising interest rates by 25bps due to high inflation. At their extraordinary meeting on March 16, under the imminent threat of an adverse impact from the coronavirus pandemic on the economy, the CNB Board decided to reverse their monetary policy. The central bank not only lowered its key interest rate by 50bps to 1.75% but also informed the public about complementary measures aimed at strengthening liquidity (refinancing repo operations) and financial stability (leaving the countercyclical capital buffer at 1.75% instead of the planned increase to 2%).
The CNB cut rates despite a sharp depreciation of the koruna (breaking the level of 27 CZK/EUR shortly before the policy change) and declared readiness to counter excessive fluctuations of the CZK exchange rate in the future. There is undoubtedly enough room for such interventions, given the large volume of foreign exchange reserves the CNB accumulated during the period of its exchange rate commitment (2013-2017, the CNB then prevented local currency from strengthening below CZK/EUR 27.00). The level of the Czech international reserves amounted to EUR 135bn, or 61% of GDP, in February 2020.
As the general economic situation is set to deteriorate due to the spread of coronavirus, it is likely that the CNB will cut its interest rates further. Specifically, with the ongoing economic downturn, inflationary pressures can be expected to weaken, creating additional room for further lowering interest rates. Therefore, we predict another CNB repo rate reduction by at least 25bps in the near future. The subsequent central bank policy will be driven by the new CNB forecast (in May) as well as by further economic developments in the euro area.
Crashing oil prices will ease inflationary pressures and support post-coronavirus recovery
The combined deflationary impact of the coronavirus shock, and even more importantly, a recent collapse of oil prices is set to keep inflationary pressures contained throughout 2020. The Brent crude oil price has dropped by almost 40% since the beginning of March, following the start of a full-blown oil price war between Saudi Arabia and Russia amid tumbling oil demand. This prompted us to slash our baseline oil price forecast for 2020 and consequently revise our inflation outlook sharply downward across the CEE region. As a result, we project annual average inflation in 2020 at 2.0% for Slovakia and Bulgaria, 2.6% for the Czech Republic, 2.8% for Poland, 3.2% for Hungary and 3.3% for Romania (figure CEE2).
This outlook is in sharp contrast to the most recent inflation developments. In fact, last few months saw inflationary pressures building up across the CEE economies due to the combination of accelerating core inflation (owing to the tight labour market), surging food prices (e.g. due to the African swine fever in China) and country-specific factors, particularly administered price hikes. With February headline CPI inflation at 3.7% yoy in the Czech Republic, 4.4% yoy in Hungary and 4.7% yoy in Poland, the latest readings were well above the respective central bank targets. This was, after all, the main argument of the CNB to hike interest rates in February. A month later, inflationary pressures, however, cease to be the main concern for the regional central banks; instead, a downward inflation trend should be another argument to support monetary easing in cushioning the economic downturn.
Finally, we believe that significantly lower oil prices should help the post-coronavirus economic recovery in the second half of this year. The CEE economies are net importers of crude oil and refined products (as are most European countries). Lower fuel prices are therefore set to provide a boost to households’ disposable income. The reason why we believe that lower oil prices will do little to ease the immediate economic pain is that extensive quarantine measures have left little scope for demand elasticity. Still, once these disruptions ease, the CEE economies should visibly benefit from the positive supply shock.
Box CEE2 – NBH to maintain wait-and-see approach
The international environment has changed substantially since the latest NBH monetary policy decision in March, when the Monetary Council left all its monetary policy instruments unchanged, but at the same time opened the door for monetary tightening should inflationary developments require it.
Although the February inflation figure was slightly above market expectations (4.4% yoy vs. 4.3% yoy survey) and it moderated from a seven-year peak of 4.7% yoy a month earlier, the sudden drop in oil prices and the global slowdown due to the coronavirus have triggered a substantial change to the inflation outlook. We now expect Hungarian headline inflation to drop below 3% yoy already in April, and it may remain around the NBH’s inflation target of 3.0% for the remainder of the year. In other words, the strong inflationary pressures from the beginning of the year are set to diminish at least for the next couple of quarters. The NBH will publish its next quarterly inflationary report in March, so it will be important how the central bank evaluates current developments and what its inflation outlook for the next two years will be. We expect that the NBH will confirm our view that inflation is set to drop and remain around the NBH inflation target.
We therefore assume that the NBH will maintain its wait-and-see approach regarding the interest rate decision. Nonetheless, it cannot ignore the negative effects caused by containment measures due to the coronavirus. This means that the NBH is likely to focus on maintaining the excess liquidity in markets available for the banks. A new funding for lending program for SMEs might also be introduced, even though Hungary already has similar existing programs. All in all, we except that this policy stance may be maintained until other central banks start their tightening cycles, or until the risk factors are diminishing and the Hungarian economy returns to what we have seen in the last years. In the meantime, the NBH might react to economic and market developments with its flexible tools.