Protracted recession in the eurozone, coupled with a reversal in global risk appetite for emerging market (EM) assets in Q213 following US Federal Reserve (US Fed) comments on an exit from quantitative easing (QE), have taken the edge off of economic recovery in Emerging Europe, including Russia and Turkey, says Fitch Ratings.
Even so, the credit ratings agency (CRA) said the majority of sovereign ratings in the region remained on stable outlook at end-June, with two (Poland and Latvia) on positive and four (Croatia, Slovenia, Serbia and Ukraine) on negative. Positive rating actions in H113 were confined to Lithuania and Poland, while Slovenia and Ukraine sustained negative actions.
With the eurozone set to register a further contraction of 0.6% in 2013, growth in Emerging Europe is expected to slow for the second year in succession to 2.3% in 2013 from 2.5% in 2012, with some countries (Croatia and Slovenia) sustaining outright contraction. In Slovenia’s case, this has been overlaid by the rising cost of recapitalising the banks; Fitch downgraded Slovenia to BBB+/negative from A-/negative in May.
The downturn in the eurozone has coincided with limited room for domestic policy manoeuvre in Emerging Europe. Fiscal policy is set to remain contractionary, weighing on growth. Poland and the Czech Republic are still constrained by the European Union’s (EU) excessive deficit procedure (EDP), while Bulgaria, Hungary and Romania will be anxious to preserve their EDP-free status.
Russia’s new fiscal rule maps out a path of gradual fiscal tightening until 2015, although ambitions to rebuild the Reserve Fund as a fiscal buffer have recently been scaled back. Turkey looks to have more room for fiscal stimulus, but Fitch expects heightened political unrest and deteriorating market sentiment to constrain its room for manoeuvre.
Ample global liquidity, shrinking current account deficits and low inflation allowed a number of countries in Emerging Europe to cut interest rates in H113. (Russia kept benchmark rates stable, but there are widespread expectations of policy easing in H213.) A surge in net capital inflows from H212, mostly portfolio investment in eurobonds and non-resident holdings of local currency debt, not wholly related to fundamentals, had begun to breed complacency in some cases. Thus, Hungary and Ukraine had both taken a step back from concluding new deals with the International Monetary Fund (IMF) in the belief that heavy repayment obligations to the Fund in 2013-14 could be funded in the market.
Ukraine a Casualty
An early casualty of the shift in market sentiment has been Ukraine where Fitch revised the outlooks on its B ratings to negative from stable on 28 June, to reflect an increasingly challenging external financing position. Hungary demonstrated a remarkable ability to substitute domestic for external financing in 2012; nonetheless, its fiscal financing requirement remains large and the forint (HUF) is vulnerable to shifts in market sentiment in the absence of a fresh EU-IMF agreement. Romania, too, suffers from large foreign exchange exposures at the sovereign, corporate and household levels. However, it is making faster progress with reforms and seems more amenable to a new IMF agreement.
Turkey presents more of a conundrum. Increased expectations of a US Fed exit from QE coupled with widespread anti-government protests since April have exposed the country’s chief vulnerability: a current account deficit equivalent to 6.8% of GDP, over 90% of which is funded by portfolio investors. Turkish asset prices have come under strong downward pressure, precipitating a sharp fall in the exchange rate and declining international reserves. Fitch elevated Turkey to investment grade in November 2012 and considers that these strains remain within the tolerance of its BBB- rating. However, prolonged social unrest, poorly handled, could deter tourism, exacerbate short-term capital outflows, drive-up inflation and damage economic growth, potentially putting Turkey’s sovereign rating at risk.
Poland and Czech Republic appear much more secure, notwithstanding less resilient growth in the former and continuing recession and increased political instability in the latter. Fiscal funding needs are well covered in both, while Poland enjoys the additional comfort of an IMF Flexible Credit Line. Russia, with its strong sovereign balance sheet, is also relatively immune to shifts in market sentiment, although Russian corporates and banks have been heavy issuers on the Eurobond market. However, growth slowed to less than 2% year-on-year in Q113 and it remains unclear how the economy will fare in the face of flat oil prices and only cosmetic improvements at best in the investment climate.
Fitch says that Emerging Europe has not been without its success stories. Thus the Baltics (Estonia, Latvia and Lithuania) continue to buck the broader austerity-bound economic outlook, posting some of the highest growth rates in the region. Latvia recently followed in the footsteps of Estonia, gaining the green light to formal eurozone membership from 1st January 2014, with Lithuania expected to follow suit in January 2015. Fitch upgraded Latvia’s sovereign ratings to BBB+/stable from BBB/positive on 9 July in recognition of the culmination of this long sought after policy goal.
The same cannot be said of Croatia and Serbia. A common theme running through these countries has been a deteriorating macroeconomic and fiscal outlook, coupled with a reluctance to undertake structural reforms. Fiscal financing does not pose immediate concerns, but public debt/gross domestic product (GDP) ratios continue to rise. Croatia (BBB-/negative) lacks a medium term fiscal consolidation programme and there is a risk that longstanding structural shortcomings will overshadow its recent admission to the EU. Serbia (BB-/negative) suffers from twin fiscal and current account deficits; the latter shows signs of rebalancing, while the economy has emerged from recession, but the government has been slow to address fiscal imbalances and public debt/GDP could rise to 70% by 2015.
Fitch concludes that, in most cases, Emerging Europe is expected to prove resilient to renewed turbulence in world financial markets. However, the region still bears the scars of the 2008-09 global financial crisis which, together with some country specific factors, are expected to temper governments’ policy responses and slow economic recovery.
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