Q4 growth generally surprised on the upside
From the point of view of the Central and Eastern European region, where most economies show a relatively high degree of openness (measured by the share of exports in GDP), the euro area is a key business partner. Despite that, the significant slowdown in the euro area’s economic growth since the end of 2017 has been ambiguously reflected in the foreign trade balance of the region. The resilience contributes to the fact that the countries of Central and Eastern Europe can still boast solid growth dynamics that markedly surpasses economic growth in the euro area.
The flash estimates of regional real GDP growth for the last quarter of 2019 plainly confirm this argument. Notwithstanding the fact that economic activity is gradually slowing down in most of the Central and Eastern European economies, the headline growth figures generally surprised on the upside (figure CEE1). This is especially true for Romania, which saw a significant upswing from 0.5% qoq in Q3 to 1.5% qoq in Q4. On a year-on-year basis, this translates into a jump from 3.0% to 4.3%. A positive surprise combined with a pick-up in real GDP growth from 1.3% yoy in Q3 to 2.1% yoy in Q4 was also registered in Slovakia.
Meanwhile, both Hungary and Poland, traditional growth champions in the region, experienced a less severe slowdown than expected in the fourth quarter of 2019. While the Hungarian economy expanded by 1.0% qoq in Q4 from 1.1% qoq in Q3, the Polish economy eased more markedly from 1.3% qoq in Q3 to 0.2% qoq in Q4. Still, the Polish economy was able to avoid a contraction on a quarter-on-quarter basis (which had been expected based on the earlier publication of annual growth for 2019) and kept a solid growth dynamic of 3.1% on a year-on-year basis.
The Czech Republic registered a continued slowdown in economic activity that was broadly expected. Real GDP growth decelerated from 0.4% qoq in Q3 to 0.2% qoq in Q4, while on a year-on-year basis it eased from 2.5% in Q3 to 1.7% in Q4. Last but not the least, a mild slowdown was seen also in Bulgaria. The Balkan economy grew 0.7% qoq in Q4 from 0.8% qoq in the previous quarter, while year-on-year growth slowed to 3.5% in Q4 from 3.7% in Q3.
Trade balance dynamics mixed
The different CEE economies reported diverging dynamics in their respective trade balance over the past few years. With regard to the Czech Republic and Slovakia, their respective trade balances show a relatively stable development during the last quarters. (figure CEE2) While the balance of merchandise trade over the last two years worsened in Hungary and even more so in Romania, we can see improvement in Poland and particularly in Bulgaria.
To understand the above specified divergence better, the export and import sides of the trade balance need to be analysed separately. Regarding exports, in all six economies in the region except for one – Romania – the factors offsetting a drop in the eurozone’s aggregate import demand had the upper hand (figure CEE3). In Poland and Hungary, exports even registered an increase by 7% and 4% respectively between January 2018 and November 2019.
The growth of exports in Poland and Hungary was strongly supported by increased competitiveness which was in turn driven by real depreciation of the zloty and forint (figure CEE4). Moreover, real depreciation of a local currency supports the local trade balance from a different side too: it inhibits import growth as foreign goods become relatively more expensive. While in the case of Poland, the import contraction combined with export growth proved enough for improving the trade balance over the last two years, this was not the case in Hungary. The import absorption in the fastest-growing Central European economy was so strong that it trumped even the booming exports.
The development of the foreign trade balance in Bulgaria and Romania paints a more complicated picture. On the one side, the Bulgarian trade balance has seen the greatest improvement among the six CEE countries. The reason for the record improvement of the Bulgarian trade balance lies on the import side. While the aggregate volume of exports remained virtually unchanged in 2018-2019, imports in November 2019 lagged behind the level in January 2018 by ten percent. A change in the real exchange rate of the local currency was not the main driver, nor can we find an explanation in the development of economic growth (which has remained buoyant and above 3% yoy since the beginning of 2018). Evidently, Bulgaria saw a rare (and likely temporary) occurrence of two mostly asynchronous events: accelerating economic growth and decreasing import demand.
The above-mentioned has important implications. A temporary decline in the growth performance of the euro area within the range of 1-1.5 percentage points poses no immediate threat for the trade balance (and indirectly the growth of GDP) of the Central Eastern European countries. Moreover, helped by a real depreciation of exchange rates and the consequent export boost, regional trade balances can even improve despite a decrease in aggregate demand from the euro area. At the same time, real depreciation of a local currency efficiently dampens demand for imports, which helps maintain favourable dynamics for the trade balance, even in a relatively fast-growing economy.
Of course, this may hold true only within certain limits. When a drop in the GDP of the euro area or an increase in the growth differential between the euro area and a Central Eastern European country widens too much, this can worsen the latter´s trade balance and inevitably cause a negative impact on growth.
Surprising step by the CNB
At its first session this year, the Czech National Bank’s (CNB) Bank Board quite surprisingly decided to increase the base interest rate by a quarter of a percent. The primary interest rate (two-week repo) was thus raised to 2.25%, where it last was eleven years ago. It was an unexpected and, at the same time, a very tight decision (4:3). The CNB explained it by pointing to greater inflation pressures, which constitutes grounds to review the inflation prognosis upward. Nonetheless, the central bank expects inflation to return to its target level of 2% in the monetary policy horizon (1-1.5 years), which is likely from our viewpoint as well.
On the other hand, the CNB’s prognosis of Czech GDP growth and the CZK exchange rate seems less likely to materialise. The central bank namely assumes that, after a short slowdown late last year, economic growth is now beginning to accelerate again, and GDP is expected to grow by 0.8% qoq in Q1 2020. Considering the negative signals coming from the Czech and other foreign economies, this outlook seems to be rather too optimistic. In the case of the Czech koruna, on the contrary, the CNB is a bit too pessimistic as it expects that the interest rate differential, extended to its twenty-year high (275 bps), will have virtually no effect on the currency, and foresees the exchange rate remaining around 25.30 EUR/CZK for the entire year.
The principal question to be answered is what the CNB is going to do after abandoning its interest rate smoothing approach and adopting an activist stance. Another interest rate increase seems to be the least probable variant at this time, which the central bank itself does not foresee in its current prognosis. On the contrary, the prognosis mentions that the CNB might even reduce the interest rates within half a year. Nonetheless, it is not at all clear whether the Bank Board will be that flexible as well; for this reason, we are inclined towards a stable scenario with a risk of the rates being reduced, which will be proportionate to the extent in which the optimistic prognosis does not get fulfilled.
Bulgaria and the euro
Following the fall of communism, Bulgaria experienced several episodes of hyperinflation and a sharp currency devaluation. As a reaction, in 1997, the Bulgarian lev was pegged to the German mark and Bulgaria started to operate under a currency board arrangement, meaning that all Bulgarian currency in circulation has been backed by foreign exchange reserves held by the Bulgarian National Bank. After the birth of the euro, the lev’s peg effectively switched to the common European currency at the rate of 1.95583 BGN per EUR.
Bulgaria’s authorities have expressed intention to join the euro area ever since the country became a member state of the European Union in 2007. Over the years, Bulgaria has achieved substantial progress in all aspects of its euro adoption plan. Most importantly, this progress is reflected in improved macroeconomic stability, underpinned by prudent fiscal policy, and one of the lowest government debt-to-GDP ratios in the European Union. Hence, attention has largely shifted to the stability of the financial system in Bulgaria. According to a recent finding by the European Central Bank, two locally owned Bulgarian banks have insufficient capital buffers, which requires follow-up actions to further strengthen their capital positions.
Provided the capital shortfalls are appropriately addressed, Bulgaria may receive an invitation to join the Banking Union and the Exchange Rate Mechanism (ERM II) as early as April 2020. Then, if Bulgaria meets all nominal convergence criteria (inflation, long-term interest rates, budget deficit and public debt) and participates in the ERM II without severe disruptions for at least two years, it qualifies to join the euro area. According to Bulgarian authorities, the euro adoption might take place on January 1st, 2023.
During the stay in the ERM II, Bulgaria intends to maintain both its
current exchange rate regime and the central exchange rate of 1.95583
BGN per EUR. Some interpretations of legal amendments required by the
ECB and the European Commission for compliance with the ERM II
regulatory framework sparked fears among the population of forced
devaluation of the lev before the euro adoption. These amendments are,
however, technical in nature and do not call into question the current
exchange rate regime. Still, in order to reassure citizens, the
National Assembly passed a resolution, according to which Bulgaria
would only adopt the euro at the current exchange rate.