Pasquale Diana | London For Central Europe, 2006 was another year of strong growth, with GDP growth surpassing analysts’ expectations across most of the region. For next year, we expect a benign outlook for Eurozone growth and supportive domestic demand dynamics to bode well for continued above-trend growth in the region, with the exception of Hungary, where growth looks set to slow dramatically due to the fiscal package.
Poland: strong fundamentals to support the zloty and cap monetary tightening
Across the region, Poland is probably the country that enjoys the most favourable fundamentals. Investment-led growth has raised the country’s growth potential and inflation has remained well under control. Continued fiscal discipline should lead to a narrowing of the budget deficit (from around 4% of GDP this year to 3.7% next year), and the current account, whilst likely to widen on the back of strong import growth, should remain capped at around 3% of GDP, mostly financed by net FDI. Whilst politics are likely to remain shaky, our base case is that the PiS-led coalition will hold together and there will be no early elections. With this backdrop, we believe that the pressure on the zloty will be to appreciate, and we see EUR/PLN trending towards 3.65 by end-2007.
On the monetary policy front, the NBP is expected to come under pressure to raise rates as early as Q1, as inflation rises above 2% due to base effects and some regulated price adjustments. However, we would argue that the scope for rate hikes is quite limited, as a strong zloty and favourable base effects should keep headline inflation below the 2.5% target. In addition, we note that the end of Balcerowicz’s term as Governor of the NBP (he will be replaced by the less known Mr Sulmicki) in January 2007 is likely to result in an even more dovish skew on the board. Our outlook is for Polish rates to rise at most 50bp in H107, and then hold at 4.50% for the rest of the year.
Hungary: fiscal progress to pave the way for rate cuts in H22007
After many years of seemingly unstoppable fiscal profligacy and a dismal track record of missing budget targets, Hungary seems to finally have embarked on a credible path of fiscal consolidation. A large dose of fiscal tightening should drive the fiscal deficit down from over 10% of GDP this year to around 7% of GDP next year. The impact on growth will be large, though some degree of consumption smoothing should cushion the effect on household consumption. We expect overall GDP growth to slow from this year’s 3.8% to just over 2% in 2007, and see the current account deficit narrowing by nearly two points, to 5% of GDP. While Hungary’s imbalances remain large, we believe that what will drive markets next year will be recognition that the country’s fundamentals are at last improving. For this reason, we are constructive on the HUF, which we see appreciating to around 245 against the euro by end-2007.
In terms of interest rates, large increases in regulated prices should push inflation up sharply in Q12007, to around 9%. We expect this spike to keep the NBH on edge, and perhaps to trigger another hike, to 8.25%. That said, with growth and inflation slowing during the course of the year and the fiscal numbers showing signs of improvement, we believe that the second half of the year will be characterised by rate cuts. Also, we note that the departure of some hawkish MPC members from the MPC will likely further increase the number of doves on the Council. We see Hungarian official rates at 7% by end-2007.
Slovakia: advancing steadily towards the euro
Following a rise in headline inflation, a bout of SKK weakness and euro-unfriendly comments by the new SMER-led government, Slovakia’s chances of meeting the Maastricht criteria looked seriously in danger earlier this year. However, a drop in oil prices and renewed SKK strength have dramatically improved the country’s chances of meeting the inflation criterion, which in our view was (and remains) the most challenging. In addition, a relatively conservative 2007 budget and a favourable fiscal starting point imply that the chances of keeping the deficit below 3% of GDP in 2007 are good.
The National Bank of Slovakia increased official rates by 175bps in 2006, in an effort to tighten monetary conditions to rein in inflation. We believe that the combination of higher rates and a firmer SKK (currently roughly 10% stronger than the ERMII parity) have tightened monetary conditions sufficiently and that the NBS will refrain from hiking again. In addition, a sharp improvement in the current account due to auto exports coming on the market should keep the market biased towards SKK strength in the quarters ahead (we expect an exchange rate of 33.5 against the euro by end-2007), which would also support disinflation. It is worth bearing in mind that more pronounced SKK appreciation might even test the lower end of the +/-15% ERM2 band, with the NBS forced to intervene or revalue the central parity, or even cut rates.
Czech: economy still in good shape despite lack of leadership
The June elections delivered an inconclusive outcome, with both factions winning exactly 100 seats. To date, no cabinet has yet been able to gain a confidence vote in parliament, and early elections look like the only sensible way out (other than a German-style grand coalition between centre-right ODS and the Social Democrats). Meanwhile, the economy has shown no sign of weakness yet, with growth on track to be around 6% this year and to slow down marginally to 5.5% next year, still above potential. While the growth outlook is positive, we note that, in contrast with the rest of the region, there are signs of fiscal slippage. The 2007 budget envisages a deficit of CZK91bn, up from this year’s upwardly revised target of 83bn. In ESA95 terms, the deficit next year could be as high as 4% of GDP. Note that, unlike in the rest of the region, the Czech Republic still has to approve the pension reform, which will add to the deficit in the short-medium term.
On the policy front, the CNB has raised rates twice in 2006, to 2.50%, in response to fears about the inflationary consequences of expansionary fiscal policy and possible second-round effects from hikes in regulated prices, which will take place in 2007. With inflation currently already tracking 0.5% below the latest CNB estimates, we believe that the CNB will not hike again until March at the earliest. In total, we believe that a favourable growth-inflation trade-off will limit the scope for hikes to 50bps next year.