REGIONAL REPORT | CENTRAL & EASTERN EUROPE
Central European countries are starting to recover, with growth accelerating in most markets. But the region’s banks still have some trials to overcome.
The countries of Central Europe are emerging, blinking, into the light of economic recovery. According to a new World Bank report, “the EU 11” (the postcommunist countries within the European Union) are now in recovery mode, buoyed by supportive domestic policies and an EU-wide recovery. The World Bank says GDP growth should strengthen this year, from 2012’s anemic 0.8% and last year’s 1.4% to a decent 2.8%—better than most developed economies. It will be a long while, however, before there is a return to pre-crisis growth rates of 5% or more, so recovery will be gradual. Only Croatia, burdened by debt and poor competitiveness, is expected to remain in recession this year.
The most buoyant economies will be the Baltic states, Romania and the Visegrád Four: Poland, the Czech Republic, Hungary and Slovakia. Peter Brezinschek, chief analyst at Raiffeisen Bank International in Vienna, reckons Poland will grow this year by 3.3%, Hungary and Slovakia by 2.7% each, and the Czech Republic by 2.6%. He notes: “Domestic demand in the form of private consumption and private investment is increasingly responsible for growth; inflation has dropped to historic lows.”
The performance in Central Europe is better than expected, agrees Alex Lehmann, senior economist for the region at the European Bank for Reconstruction and Development (EBRD): “These economies are now enjoying balanced and meaningful growth.” He sees increasing evidence of strong export performance and the revival of domestic demand: Labor market expansion and wage growth are expected to feed into a pickup in local consumption. Domestic policy remains supportive. In late July, for example, the National Bank of Hungary cut benchmark interest rates by more than expected, to 2.1%. And loose monetary policy is expected to persist across the Visegrád countries, particularly as deflation is a risk.
The long-term outlook is also good. Research firm Capital Economics says years of wage cuts and continuing structural reforms have restored the external competitiveness of the Visegrád Four and other emerging European countries.
“So long as the eurozone and Germany in particular manage to muddle through, growth in the CEE economies should strengthen in the coming years,” says William Jackson of Capital Economics.
LOST GENERATION OF WORKERS
Yet despite these silver linings, clouds remain, with more gathering. The World Bank warns of stubbornly high youth unemployment, cautioning that “the persistence of large numbers of inactive youth poses unique risks of creating a lost generation of workers” and suggesting that countries are struggling to meet a major skills gap. Individual countries are generating concerns as well. Poland’s ambitions to become a largely knowledge-focused economy are being constrained by low levels of research and development spending—almost the lowest in the EU—while in Slovakia many believe the hitherto highly successful emphasis on the auto industry and on centering economic activity in the Bratislava region may need to be revised. In most countries over the long term there is a need to direct investment toward economically less advantaged regions, usually to the east.
A more pressing issue may well be corporate funding. Despite initial fears, Western parent banks of financial institutions in Central Europe haven’t deleveraged to reduce exposure in the region, but the EBRD’s Lehmann believes that the continued reluctance of banks to lend, coupled with low levels of fresh foreign direct investment (FDI) and sluggish inflows into local bond markets, raises financing concerns.
“Most FDI in these countries is coming from existing investors. FDI is around 2% of GDP, compared to the pre-crisis level of at least 5%,” says Lehmann. Which makes the role of local banks to the Visegrád countries—most of which have Western parents (Western financial institutions, for example, hold 90% of the bank market in Slovakia)—all the more important to economic revival. This role is especially important if, as many fear, the EU’s recovery stalls or hostility between Russia and the West turns nastier. In the worst-case scenario, sanctions could curtail vital energy supplies or act as a drag on the general investment and financial environment in emerging Europe.
Indeed, in late July there were signs that these outcomes were already under way in Prague and Budapest, where both stock markets experienced big month-on-month drops. However, observers say the drops reflect domestic concerns rather than a knock-on effect from the Ukraine crisis. Many market watchers see good prospects for both currencies and equities for countries in the region, pointing to recovering growth, low current-account deficits and historically low price-to-earnings ratios as reasons for confidence. “Spillovers from the crisis to the rest of region have been limited... We remain relatively upbeat on Central Europe,” notes Capital Economics’ Jackson.
STRONG HEADWINDS FOR CEE BANKS
This hasn’t been a benign time for the region’s banks. First there were concerns that Western parents would reduce their exposure because of rising consumer debt and nonperforming loans (NPLs): With the latter still in low single digits (except in Hungary where they are around 15% of GDP), this reduction hasn’t happened, and the likes of Austria’s Raiffeisen, Spain’s Santander, Italy’s UniCredit and Belgium’s KBC remain as committed to their local subsidiaries as ever.
There have been other worries, however. In June, Bulgaria experienced a run on its fourth-largest bank, Corporate Commercial (KTB); more than $550 million was withdrawn in a single day (June 27). The panic threatened to engulf a second bank, First Investment Bank, before the government gave full guarantees to support it and protect depositors. As Global Finance goes to press, crisis continues to buffet the sector even though Bulgaria has announced it is to follow Romania and join the ECB’s Single Supervisory Mechanism as soon as this is feasible.
Gunter Deuber, head of CEE bond and currency research at Raiffeisen Bank International in Vienna, believes the risk of contagion is very low and says the structure of KTB—the bank is linked to an oligarch—and its financial practices made it a special case. “With genuine and viable new business in Bulgaria at a premium, there was something strange about this banks’ speed of growth; local regulators should have been looking more closely at the business model and funding strategy,” he says.
Meanwhile, in Hungary, populist initiatives by the ruling Fidesz party have resulted in a 0.6% transactions tax and other charges on the sector. And more challenges for the financial sector are on the way. The government is upholding a Supreme Court decision obligating banks to compensate customers who took out foreign exchange loans ahead of the 2008 financial crisis—because the interest rates were lower—but who then lost out because the Hungarian forint dropped in value against most foreign currencies, especially the euro and Swiss franc, in which the foreign loans were denominated.
Eventually, banks will have to convert all foreign exchange loans back into the forint, at a rate of exchange yet to be determined. Estimates of how much this will cost the banks vary, with Moody’s suggesting around €1 billion ($1.3 billion)—about 11% of the banking system’s total capital—while the National Bank says it could top €2.5 billion. Economy minister Mihály Varga has said that “no bank will go bankrupt.” However, though there could yet be some changes to the compensation requirement under the Supreme Court decision that would make consumers bear some of the cost, it will hit most foreign banks in Hungary, with smaller local banks being less affected. Earlier this year Austria’s Erste Group, for example, warned that the measures, coupled with new rules in Romania aimed at reducing NPLs, would mean a net loss of around €1.5 billion for the year. Other foreign banks with Hungarian holdings are expected to take a hit as well.
Many market participants think the measures are politically motivated and go too far—even though before 2008, foreign banks were regularly reporting returns on equity of up to 20% on their Central and Eastern European operations. “Sure, it’s reasonable that banks should shoulder some losses and there should be a reduction in some of the foreign loan stock, but this looks rather overdone,” says Deuber.
Deuber is more optimistic about the rest of the Visegrád region, especially Slovakia and the Czech Republic, where NPLs are only around 6%, and sees business strengthening as growth recovers. “Loan growth was very subdued last year and into 2014, but there is now a gradual recovery that we expect to see continue: Retail lending is already quite healthy, especially mortgage financing, whilst corporate lending is picking up,” he says.
Investment banking activity should also pick up, Deuber reckons, although it will continue to be directed out of London. Pricing will be aggressive, with institutions eager to get business, especially in Poland, the Czech Republic and Romania—the latter because privatization of state-owned assets is still under way and the market is large. “Investment banks have lots of capacity and, frankly, they need the business,” he says. This aggressive competition for investment banking business is likely to increase, given the drop in the Russian market over 2014 as a result of Western sanctions, with institutions now constrained from doing business in a market where returns on equity were once quite considerable.
Deuber anticipates a gradual uptick in bank business volumes along with a recovery in earnings. However, he argues that returns will be lower than before—no more than around 10%—and there will be a strong focus on unproblematic markets where short-term profitability is assured.