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CEE Quarterly Economics & FI/FX Research Credit Research Equity Research Cross Asset Research 1Q2017 January 2017 January 2017 Economics & FI/FX Research CEE Quarterly “ Your Leading Banking Partner in Central and Eastern Europe UniCredit Research ” page 2 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly Contents 4 CEE in 2017: ups and down and growing divergence 14 CEE Strategy: Adapting to higher rates and inflation 27 CEEMEA FX: Not all “Tantrums” need be the same 78 Acronyms and abbreviations used in the CEE Quarterly EU canditates and other countries Countries 32 Bulgaria 60 Bosnia and Herzegovina 36 Croatia 62 Russia 40 Czech Republic 66 Serbia 44 Hungary 70 Turkey 48 Poland 74 Ukraine 52 Romania 56 Slovakia 58 Slovenia Erik F. Nielsen, Group Chief Economist (UniCredit Bank London) +44 207 826-1765, [email protected] Lubomir Mitov, Chief CEE Economist (UniCredit Bank London) +44 207 826-1772, [email protected] Artem Arkhipov, Head of Macroeconomic Analysis and Research Russia (UniCredit Russia) +7 495 258-7258 ext. -7558, [email protected] Anca Maria Aron, Senior Economist (UniCredit Bank Romania) +40 21 200-1377, [email protected] Published on 9 January 2017 Erik F. Nielsen Group Chief Economist (UniCredit Bank London) 120 London Wall London EC2Y 5ET Dan Bucşa, Lead CEE Economist (UniCredit Bank London) +44 207 826-7954, [email protected] Hrvoje Dolenec, Chief Economist (Zagrebačka banka) +385 1 6006-678, [email protected] Dr. Ágnes Halász, Chief Economist, Head of Economics and Strategic Analysis Hungary (UniCredit Hungary) +36 1 301-1907, [email protected] Ľubomír Koršňák, Chief Economist (UniCredit Bank Czech Republic and Slovakia) +42 12 4950-2427, [email protected] Kiran Kowshik, EM FX Strategist (UniCredit Bank London) +44 207 826-6080, [email protected] Imprint: UniCredit Bank AG UniCredit Research Arabellastrasse 12 D-81925 Munich Kristofor Pavlov, Chief Economist (UniCredit Bulbank) +359 2 9269-390, [email protected] Supplier identification: www.research.unicredit.eu Javier Sánchez, CEE Fixed Income Strategist (UniCredit Bank London) +44 207 826-6077, [email protected] Marcin Mrowiec, Chief Economist (Bank Pekao) +48 22 524-5914, [email protected] Pavel Sobisek, Chief Economist (UniCredit Bank Czech Republic and Slovakia) +420 955 960-716, [email protected] Dumitru Vicol, Economist (UniCredit Bank London) +44 207 826-6081, [email protected] UniCredit Research page 3 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly CEE in 2017: ups and down and growing divergence Lubomir Mitov, Chief CEE Economist (UniCredit Bank London) +44 207 826-1772 [email protected] 1 ■ Political shocks, financial markets’ volatility and sharp reversals in risk appetite turned 2016 into a rollercoaster ride. The benign global environment that had prevailed since the Brexit vote reversed sharply following Mr. Trump’s victory in the U.S. presidential election, triggering major capital outflows from EMs amid rising core yields and higher risk premia. ■ Against this background, the divergence within the CEE has deepened. Solid fundamentals have enabled the CEE-EU 1 to weather the post-U.S. election storm relatively unscathed. Russia has been resilient, too, thanks to sound policies and rising oil prices, while Turkey, with its large imbalances, misplaced polices and dysfunctional politics, has been hit hard. ■ Economic performance has diverged, too. In CEE-EU, growth slowed in 2016 to a still solid 3%, as a temporary drop in EU transfers cut public investment. Growth picked up in Croatia and Serbia thanks to strengthened confidence and improved policies, but still lagged CEE-EU. ■ Further east, growth remained elusive. Russia posted another year of contraction – the first back-to-back recessions since 1994, as Ukraine continues to crawl along the bottom. While in Russia prudent policies have boosted confidence, in Ukraine they have continued to languish. ■ For Turkey, 2016 was a year to forget. A series of political shocks, growing security concerns, and misguided policies have taken a heavy toll. The economy slipped into recession in 2H16, for the first time since 2009, as macroeconomic imbalances widened further. Financial markets have been battered, with the TRY and Turkish bonds among the worst performers globally. ■ In 2017-18, the external environment should be supportive for CEE. The outlook for the EA and the UK has improved as Brexit fears subside. Growth will be stronger also in the U.S due to a prospective fiscal stimulus, and in EM as commodity prices and trade recover. At the same time, rising oil prices and gradual reflation will constrain consumption, while global risk appetite will remain muted as markets adjust to higher U.S interest rates. ■ We expect growth to firm in most of CEE next year. In CEE-EU, it will top 3%, supported by a pickup in EU transfers, and remain only a tad slower in Croatia and Serbia, partly due to the need for further fiscal adjustment. Buoyed by a tenuous recovery in tourism, growth in Turkey will approach 3% this year as well. Growth will return also to Russia and Ukraine, but will remain anemic at 1-2%, constrained by ongoing structural rigidities. ■ Inflation developments will diverge. While in CEE-EU we expect gradual reflation as oil prices rise and with economies at or above potential, inflation will remain below targets through most of the year. In Russia, by contrast, tight monetary policies are likely to reduce inflation close to the 4% target, while in Turkey inflation is likely to accelerate into double digits as a result of a weak TRY and expansionary policies. ■ Scope for growth-supportive policies will be much more limited this year. There is no room for monetary accommodation anywhere in CEE, and fiscal space is absent outside CEEEU, as well as in Poland and Romania. Turkey will continue pursuing expansionary policies even though it should not, given rising macroeconomic imbalances. ■ With concerns about Brexit easing, external risks have abated. The expected changes in US economic policy look unlikely to affect CEE directly, but the indirect impact could be significant. While the rise in core yields will lead to a re-pricing of CEE bonds, for most the risks seem well contained, except for Turkey. At current policies, Turkish markets will remain volatile, limiting foreign interest, with risks for a disorderly adjustment rising. ■ Conversely, domestic political risks have increased. These are most pronounced in Turkey, where political tensions will weigh on confidence well into 2017. Elsewhere, dissatisfaction with political elites risks has brought to power populist and nationalist governments. CEE-EU include the EU members that joined in 2004-07 and have not adopted the euro (Bulgaria, Czech Republic, Hungary, Poland and Romania) UniCredit Research page 4 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly 2016: a rollercoaster ride 2016 was a year of political upsets and market volatility… …with the relative post-Brexit calm abruptly reversing after the U.S. election… …causing a major selloff in EM, depreciations and a surge in risk premia Despite this environment , most of CEE has done well… …with CEE-EU outperforming once again… …and Turkey hit the hardest among EMs Growth in CEE-EU slowed in 2016 due to a transient drop in EU transfers… 2016 was a year of surprises, stunning political upsets, and repeated bouts of financial markets’ volatility. Despite these shocks and after a dismal start, financial markets demonstrated a remarkable resilience until recently, essentially shrugging off concerns about the impact of the Brexit vote and resulting in a long run of risk-on sentiment that pushed portfolio flows to EM to a record high during the summer and early fall. However, this period of relative calm and buoyant risk appetite came to an abrupt halt with the victory of Mr. Trump in the November U.S. presidential election. This victory, which we cited as a potential risk in our previous quarterly report, has completely changed the mood in global financial markets. While little is still known about the exact intentions of the incoming U.S. administration, markets have already moved sharply in response to the anticipated fiscal easing and more protectionists stance on trade. The USD has surged, as have US bond yields, and the heavy portfolio inflows from the summer have been replaced by equally heavy outflows at a pace exceeding that during the 2013 taper tantrum. EM currencies have plummeted as a result and risk premia have widened. Despite this challenging environment, most of the CEE region has done relatively well. However,, the divergence within the region has widened yet again, with the core, comprising the CEE-EU, clearly outperforming both the rest of CEE and EM as a whole. Not only have these countries weathered the market storm that followed Mr. Trump’s victory relatively unscathed, but they have also demonstrated remarkable resilience, with growth still solid at near 3% in 2016 despite growing headwinds. Croatia and Serbia have done well, too, while further to the east growth remains elusive in Ukraine and Russia. However, the biggest outlier in CEE was Turkey which, due to a combination of major political shocks, geopolitical tensions and dysfunctional policies, suffered both a major blow to growth as well as one of the sharpest financial market deteriorations among the EM universe. This said, growth in CEE-EU in 2016 is likely to have slowed to around 3% from 3.9% in 2015. (taking into account the leap year effect, the slowdown was even stronger, some 1.1-1.2pp). However, we see this slowdown as largely temporary because it was caused by a drop in EU funds’ absorption. This drop, which was largely technical and was due to the shift to a new programming period, appears to have shaved off as much as 1.5pp from growth in 2016. The impact was particularly strong in the countries with the best EU funds absorption, such as Hungary and Poland, which have seen the sharpest slowdowns. CEE OUTLOOK HAS IMPROVED THANKS TO FINANCIAL MARKET RESILIENCE, STRONGER EA GROWTH Financial markets have remained broadly resilient post-Trump… 1000 JPM EMBIG Index 900 800 700 …whit a more subdued Brexit fallout boosting growth prospects Africa EM Asia EM Europe Latam Middle East 8.0 6.0 Real GDP, % change 2015 2016 old 2016 new 2017 old 2017 new 2018F 4.0 600 2.0 500 400 0.0 300 200 -2.0 100 -4.0 0 -6.0 EA HR SRB RU TK CEE5 Source: Bloomberg, IIF, UniCredit Research UniCredit Research page 5 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly …even though the underlying economic performance was strong Apart from EU-funded investment, the economic performance has remained strong, with all other expenditure components posting solid growth. Consumption, in particular, has become the main engine of growth in CEE-EU, bolstered by a further drop in unemployment, accelerating wage growth and absent inflation. EU funds absorption will pick up in 2017, adding back 1pp to growth, but the sharp slowdown in 2016 still underscores the high dependence of CEE-EU on EU transfers for growth and investment. Croatia and Serbia did better than expected… Outside CEE-EU, both Croatia and Serbia did better than expected in 2016, with growth picking up nicely – even though still lagging that in CEE-EU. Solid demand in the euro area (EA) has played a major role by boosting exports, but perhaps more important was the rebound in private consumption and investment on the back of firming confidence. An improved perception among foreign investors has helped, too, with both countries having made significant progress in fiscal adjustment and emerging from parliamentary elections with stronger pro-reform majorities. So far, financial market pressures have been manageable, although both are at higher risk than CEE-EU to a further deterioration in global sentiment. …thanks to improving confidence and firmer foreign demand Further east CEE’s most populous economies have struggled… …with Russia yet to emerge from recession… Further east, the region’s three most populous economies continued to struggle, further diverging from the core. However, the trends among them differed as well. While Russia will record another year of output contraction – albeit much shallower than in 2015 -- with the long-awaited recovery still not in sight, confidence and market perceptions have improved significantly. Fiscal restraint and prudent monetary policies have helped tame inflation and inflation expectations, and greatly reduced the economy’s vulnerability to the fluctuation in oil prices. Buoyed in part by the recovery in the latter, foreign capital has started flowing back, cushioning the adverse impact of the post-Trump selloff. …and Ukraine’s economy crawling along the bottom In Ukraine, the economy continued to crawl along the bottom. Some growth has returned, but remains feeble and uneven, and is subject to numerous political and policy risks, with reforms lagging and the political elite showing little resolve to tackle deeply-embedded corruption and nepotism. The country, alone in CEE, remains shut off from foreign financial markets and is fully dependent on official foreign funding, which is set to decline sharply already in 2017 For Turkey, 2016 was a year to forget… For Turkey, 2016 will be a year to forget. Hit by political shocks, such as the failed coup in July, the Russian export and travel bans (the latter partially lifted only in September), growing security concerns, and Moody’s downgrade to sub-investment grade in October, the economy slipped into recession after mid-year, for the first time since 2009. However, unlike 2009, the 2H16 recession in Turkey is domestically-bred and not driven by a global crisis. For FY16, growth is likely to come in at just 1.5%, again the worst print since the global financial crisis. …with the economy in recession in 2H16 and financial markets under duress Turkish markets have consistently underperformed their peers… Turkey’s financial markets have been also among the biggest losers globally. USD-TRY slumped as much as 17% against the dollar since mid-October, and yields on TURKGBs soared by more than 200bp. During most of the year, Turkish assets have underperformed their peers, both in times of upside (when they barely gained) as well as in selloffs, when they were among the hardest hit.. …which reflected in part deeply rooted structural problems and misguided policies This underperformance reflected the further deepening of Turkey’s longstanding structural weaknesses. These have been made worse by misguided policies, which focused on boosting growth via major fiscal and monetary easing, rather than addressing the underlying structural deficiencies. This policy stance has done little for growth, but has boosted the already very sizable imbalances. Despite the economic slowdown, the C/A deficit has continued deteriorating (both in volume and USD terms) and price pressures have intensified, leaving Turkey among the most exposed EM in the wake of the Trump selloff. UniCredit Research page 6 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly 2017: a better year in sight On balance, 2017 and 2018 ought to be good years for CEE Looking forward, 2017 and 2018 ought to be, on balance, good years for CEE. On the positive side, global demand looks likely to pick up markedly. Most important for the region is the significantly improved outlook for the EU. With the fallout from Brexit likely to take longer and be back-loaded closer to the date of actual exit (presumably by 2019), we have revised up our 2017 growth projections for EA from 1.0% to 1.4%, and for the UK from nil to 0.6%. The outlook for EU exports (which are of key importance for CEE-EU) has been upgraded as well, with U.S. growth revised up thanks to the fiscal stimulus which the incoming US administration has promised, and stronger EM demand amid recovering commodity prices, a gradual revival in global trade, and a stabilization of activity in China. …with global growth picking up… … and growth in EA, the U.S. and EM revised upwards… …while higher oil prices and tightening financial conditions act as a brake on growth On the negative side, higher oil prices and a tightening of global financial conditions will act as a brake on growth in CEE – albeit to varying degrees and via different channels in different countries. Rising oil prices and gradual reflation are likely to dampen private consumption in oil importers and cause some deterioration in C/A balances. The expected faster pace of Fed tightening, and the further rise in U.S. bond yields and continued re-orientation of capital flows away from the EM associated with it, will have an impact on the availability of capital, borrowing costs and financial conditions, especially where foreign borrowing needs are large. GROWTH PROSPECTS WILL IMPROVE IN 2017 For the first time since 2007 all CEE countries will register growth … 8.0 EA TR RU CEE5 HR … helpedininCEE-EU …helped CEE-EUby byimproved improvedEU EUfund fundabsorption absorption UA 2015 2016F 2017F 5.0 6.0 4.5 4.0 4.0 3.5 2.0 3.0 0.0 2.5 -2.0 2.0 1.5 -4.0 1.0 -6.0 0.5 -8.0 -10.0 2014 % of GDP …whi 0.0 2012 2013 2014 2015 2016F 2017F Slovakia Poland Bulgaria Romania Czech Rep Hungary 2018F Source: Bloomberg, national statistical offices, UniCredit Research We expect somewhat stronger growth in CEE in 2017-18… …with CEE-EU growing at slightly above 3% in both years The upside to growth in CEEEU will be constrained by the more limited policy room… …with monetary policy on hold through 2017 UniCredit Research Against this background, we expect growth to be somewhat stronger in CEE both in 2017 and 2018. The only exception will be Romania, where growth is likely to slow from an especially brisk pace as the massive pre-election fiscal stimulus that has pushed growth to 4.5% in 2016 withers due to limited fiscal space. In CEE-EU, a pickup in EU-funded public investment will support growth both years as well. All in all, we expect growth in CEE-EU to top 3% in both years and to be slightly stronger in 2017, adjusted for the leap year effect. The upside to growth in CEE-EU will be constrained by the more limited scope for policy accommodation – even though macroeconomic imbalances will remain all but absent. With policy rates at record lows, global financial conditions tightening, and the trough in inflation behind us, scope for further monetary easing is all but non-existent. We do not expect tightening within the next twelve months either, with inflation unlikely to hit central bank targets until late 2017. Even so, with real interest rates easing as inflation rises, and exchange rates tending to be a tad weaker amid heightened global risk aversion, monetary conditions could still ease somewhat. Prospects beyond that will depend on the course of ECB policy. page 7 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly Scope for fiscal policy is somewhat larger in some countries… Scope for fiscal accommodation in CEE-EU is somewhat larger, at least in part of the region. Hungary, the Czech Republic and Bulgaria have plenty of fiscal room to support growth. Nevertheless, we do not expect major fiscal relaxation in the former two. In Bulgaria, fiscal policy will almost certainly be eased in 2017, after a massive 4.4% of GDP tightening (although partly unintended) left the general government in a sizable surplus in 2016. At the same time, Poland and especially Romania have no fiscal room to maneuver. Moreover, both countries may well need to tighten in 2017 to avoid breaching agreements on deficit reduction reached with the EC. …but absent in Poland and Romania Growth in Croatia and Serbia will remain solid near 20116 levels… Growth in Croatia and Serbia will remain solid as well, close to its 2016 level of near 3%. This will be still somewhat slower than in CEE-EU, partly due to the lack of policy space. Both countries need to continue with their deficit reduction efforts, building on the strong progress achieved in 2016, and in both scope for monetary policy accommodation is nonexistent. This said, fiscal risks seem somewhat larger in Croatia where the government bets on a strong rebound in revenue to avoid further spending cuts. ...constrained by the need for further fiscal retrenchment SCOPE FOR FISCAL ACCOMMODATION TO DIMINISH IN 2017 Fiscal deficits likely to mostly widen next year… Fiscal balance (% of GDP) 1.0 CEE5 TR RU …but government debt will still stabilize HR Public Debt (% of GDP) 100.0 SRB 0.0 90.0 -1.0 80.0 TK RU HR SRB 70.0 -2.0 60.0 -3.0 50.0 -4.0 40.0 -5.0 30.0 -6.0 20.0 -7.0 10.0 -8.0 CEE5 2009 2010 2011 2012 2013 2014 2015 0.0 2016F 2017F 2018F 2009 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Source: ministries of finance, Haver, UniCredit Research In Russia, the economy will exit recession, but just barely Growth will be supported by higher oil prices and improved confidence In the short run, growth will be constrained by the tight fiscal stance The CBR is unlikely to cut before March 2017, and then only cautiously… UniCredit Research In Russia, we expect the economy to exit recession, but just barely, growing by only around 1% in both 2017 and 2018. Growth both years will be supported by the expected recovery in oil prices to USD 60/bbl by the end of 2017 and USD 65/bbl a year later, and a gradual upturn in domestic demand after more than two years of declines. Activity will also be supported by the return of capital inflows to non-sanctioned entities. On the other hand, growth will be constrained by the likely rebound in imports. Import substitution has not advanced much outside agro processing, with imports already recovering in 2016 despite the ongoing recession. In the short term, growth will be also constrained by the tight fiscal stance. If implemented as passed, the 2017 budget envisages an underlying tightening of about 1% of GDP. We expect higher oil prices than those assumed in the budget to provide some room for extra spending ahead of the March 2018 presidential election, but fiscal policy will still remain a brake on growth in 2017. We do not expect the CBR to cut rates before March 2017 at the earliest and then only cautiously, keeping the real policy rate at 3% or more, by far the highest in CEE. While this tightness may have some limited adverse impact on activity in the short run, the confidence this policy stance has instilled and the remarkable decline in inflation achieved are likely to pay off over the longer term by facilitating investment. page 8 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly …with inflation approaching the 4% target by late 2017 We expect inflation to ease to just above the CBR 4% target by the end of 2017 and be anchored around that level in 2018. In Ukraine, by contrast, where policies remain largely in limbo, growth will remain sluggish at just under 2% in both years – a pace that appears insufficient to dispel growing debt sustainability concerns once IMF disbursements cease and debt repayments rise from 2018 on. Public finances remain under pressure – both due to Parliament’s reluctance to push ahead with fiscal reforms and abolish numerous loopholes that benefit powerful vested interests, as well as the unfinished bank restructuring, with the takeover of Privatbank, the country’s largest bank, adding at least 3% of GDP to public debt -if not more. By contrast, Ukraine policies remain largely in limbo… …constraining growth at under 2% in both years… …a pace insufficient to dispel debt sustainability concerns After a dismal 2016, growth will rebound in Turkey… After a dismal 2016, we expect growth in Turkey to rebound towards 3% in 2017. This rebound, however, will be driven largely by base effects: a partial recovery in tourism, a better agricultural year, and the expected lifting of the Russian ban on Turkish agricultural exports. Activity will also be supported by significant competitiveness gains, with the TRY now at its lowest level in real effective terms since the 2001 crisis. …driven by both base effects and competitiveness gains. Continued aggressive policy accommodation will also be a supportive factor for growth, but will also contribute to the further increase in macroeconomic imbalances. Rising oil prices are likely to push the C/A deficit close to 6% of GDP in 2018, and combine with currency weakness to leave inflation in double-digits for most of 2017. Inflation will remain elevated and the currency weak due in part to the CBRT’s reluctance to tighten monetary policy as much as needed to stabilize the TRY. We expect the CBRT to hike by a total of 75bp during 2017, on a par with the Fed, which is unlikely to be enough to lure back investors. Fiscal policy will also contribute to price pressures, although low public debt ought to provide a safety cushion for public finances, at least in 2017-18. Continued aggressive policy accommodation will support growth… …but at the expense of a wider C.A deficit and higher inflation… …with the CBRT likely only to follow Fed interest rate hikes MACROECONOMIC INBALANCES MOSTLY UNDER CONTROL - BUT NOT EVERYWHERE Inflation well anchored - except or Turkey % CEE5 18.0 TR RU C/A deficits mostly modest - but a growing concern in Turkey HR C/A balance (% GDP) 8.0 SRB 16.0 6.0 14.0 4.0 TR UA HR SRB RU 2.0 12.0 0.0 10.0 -2.0 8.0 -4.0 6.0 -6.0 4.0 -8.0 2.0 -10.0 0.0 -12.0 -2.0 CEE5 2009 2010 2011 2012 2013 2014 2015 -14.0 2016F 2017F 2009 2010 2011 2012 2013 2014 2015 2016F Source: Haver, central banks, UniCredit Research This will leave Turkey highly vulnerable to shifts in market sentiment… …with Turkish assets under pressure, at least until the spring of 2017 UniCredit Research These developments will leave Turkish financial markets highly vulnerable to even modest shifts in market sentiment. Risks to external financing will remain elevated and financial markets under pressure, at least until domestic politics are sorted out. We do not expect this to happen before the likely referendum on granting the president executive powers, presumably by April or May 2017. A temporary rebound could follow and extend through the summer as tourism receipts rise; but with global financial conditions likely to continue tightening into 2018, risks to external financing will grow. Another potential risk is the significant deterioration of corporate balance sheets due to the TRY depreciation and the spillover effect this may have on domestic banks, especially in the case of a Fitch downgrade. page 9 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly Diminished external, growing domestic risks With immediate Brexit concerns easing, external risks to the CEE have subsided With the immediate concerns about Brexit subsiding, downside risks for the CEE region as a whole have abated significantly, at least for 2017-18. While we still expect Brexit to have a significant adverse impact on both the UK and the EA, this impact will be more protracted and become apparent by 2019 and beyond, close to the actual departure date. While a slowdown in the EA remains as always the key potential risk for CEE, odds for such a slowdown appear slim, at least in 2017. The risks related to the Trump victory do not pose major direct risks for CEE… On the other hand, other key global developments do not pose major risks for CEE at present. The expected changes in economic policy by the new US administration will actually benefit global growth, with those aspects that might be problematic such as increased protectionism unlikely to affect the region directly given relatively limited trade links. However, the indirect impact (via a slowdown in global growth and trade) could still be significant, especially in the case of far reaching trade restrictions. …although the indirect impact could be significant Fed tightening and the rise in core yields will affect everybody… …CEE-EU seem well ring-fenced… …with Russia resilient as well Turkey, on the other hand, remains by far the most vulnerable… …with odds of a major financial dislocation on the rise Conversely, domestic political risks have been on the rise… …especially in Turkey …extending the uncertainty well into 2017 In CEE-EU, domestic political tensions have spiked the most in Poland… …with electoral upsets in Bulgaria and Romania raising concerns about reforms… …and a snap election in Serbia posing a risk for the IMF program UniCredit Research While Fed tightening and the associated rise in core yields will lead to a re-pricing of CEE bonds, for most of CEE the risks seem well contained. In CEE-EU, financing needs are low thanks to large extended basic surpluses and modest fiscal deficits, leaving the region resilient to the pressures that have plagued other EMs. Moreover, with the ECB to keep its highly accommodative stance at least until December 2017, the core region ought to be cushioned to a significant extent from global turbulence. A solid external position, along with an attractive carry, are likely to support Russian assets, too, as will a growing expectation (unfounded in our view) about a possible thaw in Russia-US relations under President Trump. Turkey, on the other hand, is by far the most vulnerable in CEE and among the most exposed EM to the rise in core yields. Given current policies, Turkish markets will remain volatile and continue underperforming peers and limiting foreign interest despite attractive nominal returns. While we do not expect a full-blown financial crisis under our baseline scenario, risks for a “sudden stop” of capital inflows have greatly increased recently, and with them the odds for a major financial upheaval that could trigger major TRY depreciation, a spike in interest rates and result, eventually, in a recession. Conversely, domestic political risks have been on the rise. These risks are most pronounced in Turkey, where the intensification of the conflict with the Kurds both in southeast Turkey and in northern Syria has rattled confidence and reinvigorated security concerns that might be harmful to the anticipated revival of tourism. Furthermore, the increased interference of politicians in the decision making by independent policy-making bodies such as the CBRT have greatly increased the risks of a policy error. Last, but not least, the purge of many civil service officials has undoubtedly affected the quality of government institutions – something that will become apparent only in the future. Finally, the upcoming referendum on granting the president executive powers will also weigh on confidence well into 2017. As a result, market pressures will remain elevated for quite some time. In CEE-EU, domestic political tensions have spiked the most in Poland, where efforts by the PiS government to strengthen its grip on the judiciary and the media have sparked major protests and caused a spat with the EC. Further south, in Bulgaria and Romania, voters have ousted centrist well-performing governments in favor or populist and nationalists parties, underscoring the disillusionment with the elite. While unlikely to have an immediate economic impact, they may affect future reform prospects and policy making, especially in Romania. Finally, in Serbia, the recently elected government has surprisingly decided to call early elections in January – despite having won an overwhelming majority as recently as last April. This could again cause a slowdown in reforms (similar to the previous pre-election period a year ago), delaying IMF disbursements and affecting confidence of foreign investors. page 10 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly OUR GLOBAL FORECAST GDP CPI Policy interest rate 10Y bond yield Exchange rate (LC/EUR) 2016 2017 2018 2016 2017 2018 2016 2017 2018 2016 2017 2018 2016 2017 2018 1.6 1.5 1.4 0.2 1.5 1.4 0 0 0 - - - 1.05 1.10 1.16 1.8* 1.5* 1.6* 0.4 1.8 1.9 - - - 0.20 0.80 1.20 - - - France 1.2 1.2 1.1 0.2 1.3 1.3 - - - - - - - - - Italy 0.9 0.8 0.9 -0.1 1.1 1.1 - - - - - - - - - UK 2.1 1.2 0.8 0.6 2.3 2.8 0.25 0.25 0.25 1.23 2.00 2.10 1.23 1.25 1.30 USA 1.6 2.4 2.7 1.3 2.5 2.6 0.75 1.25 2.0 2.44 3.00 3.00 - - - Oil price, USD/bbl 57 60 60 Eurozone Germany *non-wda figures. Adjusted for working days: 1.7% (2016), 1.8% (2017) and 1.6% (2018) Source: UniCredit Research THE OUTLOOK AT A GLANCE Real GDP (% change) CEE-EU 2015 2016E 2017F 2018F CPI (% change) CEE-EU 2015 2016E 2017F 2018F -0.5 -0.4 1.8 2.3 -0.1 -0.8 1.1 1.6 0.3 0.6 2.0 C/A balance (% GDP) 2015 2016E 2017F 2018F 0.1 0.4 0.2 -0.4 Bulgaria 0.4 3.7 2.4 0.8 2.2 Czech Rep. 0.9 2.3 1.8 1.8 3.0 2.9 Hungary 3.4 4.4 4.3 4.2 -0.6 1.6 2.0 Poland -0.6 -0.7 -0.7 -1.7 Romania 3.9 2.9 3.0 3.2 Bulgaria 3.6 3.4 3.6 3.4 Bulgaria Czech Rep. 4.6 2.4 2.4 2.5 Czech Rep. Hungary 3.1 2.2 3.0 3.1 Hungary -0.1 0.5 Poland 3.9 2.7 3.0 3.4 Poland -0.9 Romania Romania CEE-EU 3.8 4.5 3.4 3.3 -0.6 -1.5 1.6 2.7 -1.2 -2.2 -2.2 -2.4 Croatia 1.6 2.7 2.7 2.9 Croatia -0.5 -1.1 1.3 1.5 Croatia 5.1 2.8 2.1 1.7 Russia -3.7 -0.8 0.9 1.1 Russia 15.6 7.1 4.8 4.2 Russia 5.3 1.9 1.2 0.8 Serbia 0.8 2.7 3.0 3.0 Serbia 1.4 1.1 2.5 3.7 Serbia 0.7 1.2 1.0 1.5 Turkey 6.1 1.5 3.0 3.3 Turkey 7.7 7.8 10.6 7.6 Turkey -3.7 -5.1 -5.6 -6.0 2015 2016E 2017F 2018F External debt (% GDP) 2015 2016E 2017F 2018F 2015 2016E 2017F 2018F CEE-EU 72.1 72.2 69.3 64.8 -1.8 -1.8 -2.3 -2.3 Extended basic balance (% GDP) CEE-EU General gov’t balance (% GDP) 4.2 4.4 4.4 3.8 Bulgaria 6.8 8.0 7.0 5.6 Bulgaria 75.3 72.8 67.9 63.8 Bulgaria -2.9 1.7 -1.7 -2.3 Czech Rep. 3.3 7.3 6.1 5.9 Czech Rep. 68.7 78.9 78.1 75.1 Czech Rep. -0.6 0.3 -0.4 -0.5 Hungary 8.3 9.0 10.1 10.0 107.7 98.6 94.3 89.3 Hungary -1.6 -2.0 -2.4 -2.0 Poland 3.8 2.3 3.0 2.1 Poland 70.3 70.8 67.6 62.4 Poland -2.6 -2.6 -2.8 -2.8 Romania 3.0 3.2 2.1 2.0 Romania 56.4 51.9 48.9 45.1 Romania -0.8 -2.8 -3.0 -3.0 Croatia 6.2 6.3 6.1 6.1 Croatia 103.8 96.8 94.4 91.9 Croatia -3.3 -2.1 -2.0 -1.6 Russia 3.9 0.6 0.3 0.2 Russia 39.3 39.1 31.7 29.9 Russia -2.4 -3.8 -3.6 -3.1 Serbia 0.7 1.2 1.0 1.5 Serbia 80.3 78.0 78.0 76.6 Serbia -3.8 -2.0 -1.8 -2.0 Turkey -2.4 -4.3 -4.7 -5.2 Turkey 46.0 46.9 48.3 54.1 Turkey -1.7 -2.6 -2.8 -3.1 Gov’t debt (% GDP) 2015 2016E 2017F 2018F Policy rate (%) 2015 2016E 2017F 2018F REER 2000 = 100 2015 2016E 2017F 2018F CEE-EU 48.3 49.4 50.1 49.6 1.2 1.1 1.2 1.7 CEE-EU 112.5 109.9 110.3 112.8 Bulgaria 25.6 28.7 25.2 25.3 Bulgaria 0.0 0.0 0.0 0.0 Bulgaria 136.9 136.0 135.4 136.1 Czech Rep. 40.3 38.6 37.9 36.8 Czech Rep. 0.1 0.1 0.1 0.5 Czech Rep. 105.3 106.4 108.7 110.8 Hungary CEE-EU CEE-EU Hungary 74.7 73.2 72.7 70.2 Hungary 1.4 0.9 0.9 0.9 Hungary 126.6 127.5 127.8 129.6 Poland 51.1 53.8 55.8 55.8 Poland 1.5 1.5 1.5 2.3 Poland 110.3 105.9 105.9 108.7 Romania Romania Romania 108.7 37.9 38.7 39.0 38.9 1.8 1.8 2.0 2.5 110.3 105.9 105.9 Croatia 86.7 85.2 83.6 81.5 Croatia 0.0 0.0 0.0 0.0 Croatia 95.1 97.2 97.2 97.3 Russia 10.3 11.0 10.4 11.2 Russia 11.0 10.0 8.0 6.5 Russia 178.0 179.2 205.9 206.7 Serbia 75.9 74.6 72.4 69.6 Serbia 4.5 4.0 4.0 4.0 Serbia Turkey 30.6 33.2 33.2 33.5 Turkey 7.5 7.8 8.5 8.0 Turkey 109.0 107.7 100.8 97.4 Source: National statistical agencies, central banks, UniCredit Research UniCredit Research page 11 See last pages for disclaimer. January 2017 Economics & FI/FX Research CEE Quarterly EM VULNERABILITY HEATMAP BG CZ HR HU PL RO RS RU SK TR UA MX BR CL SA ID IN CN Current account (% of GDP) 3.1 1.9 3.2 4.4 -0.5 -2.0 -4.2 2.4 -0.1 -3.8 -0.6 -2.9 -1.4 -2.0 -4.3 -2.1 -0.8 2.3 Extended Basic Balance (% of GDP) 7.8 5.6 7.4 9.7 2.6 2.9 1.3 1.7 6.9 -3.4 3.2 -2.3 2.5 0.8 -2.2 -0.6 1.3 0.0 FX Reserves coverage (months of imports) 9.3 5.1 7.1 3.4 5.3 5.4 6.9 14.5 - 5.5 2.8 5.1 21.2 6.7 4.0 8.9 8.4 20.4 External Debt (excl.ICL, % of GDP) 46.5 73.2 81.9 70.0 74.2 41.2 72.9 38.8 70.8 48.6 118.7 29.6 27.4 67.8 43.2 32.5 23.4 10.3 Short-term debt (% of GDP) 16.4 34.5 7.6 11.6 10.2 7.4 1.4 3.9 24.3 12.2 17.6 3.7 3.8 4.8 29.9 4.7 4.0 0.0 REER (Index, 2010=100)* 96.4 89.6 93.4 89.1 86.8 95.2 115.9 86.1 122.2 78.4 73.9 75.8 78.4 92.8 66.4 90.3 105.8 123.3 Corporate debt (% of GDP) 58.6 54.0 71.6 60.3 47.0 40.1 44.1 67.7 52.5 75.5 48.6 73.7 40.0 35.0 38.0 22.0 49.0 160.0 Household Debt (% of GDP) 20.3 33.6 39.9 23.7 37.2 - 19.9 13.0 39.6 21.0 7.8 15.2 20.0 23.6 - 9.9 10.7 36.2 1.3 30.6 59.4 27.6 32.8 18.4 - 26.8 40.4 16.9 - 33.7 14.4 - 35.3 37.0 - - External Liquidity Domestic Finances Nonresident holdings of gov.debt (% total) Banking System Credit Impulse (% of GDP) -0.6 0.2 -4.4 0.2 -0.5 0.2 2.8 1.6 0.1 5.8 -6.2 1.4 -0.3 7.9 4.9 2.6 5.6 19.7 Loans/deposit ratio (%) 75.1 78.7 90.0 79.1 99.9 82.7 103.4 108.3 93.1 126.0 127.1 93.5 132.5 105.1 98.7 114.2 114.2 65.1 NPL (% of total loans) 14.1 4.8 14.7 10.0 7.3 10.0 19.5 9.7 4.8 3.2 31.0 2.3 3.8 1.9 3.2 3.0 7.6 1.7 Domestic Banks CAR (%) 22.8 16.0 21.9 16.8 17.1 18.8 21.2 12.4 17.3 15.5 14.2 14.7 16.5 12.9 15.2 21.2 13.0 13.5 Domestic Banks RoE (%) 13.1 17.4 10.3 19.2 8.7 12.3 6.9 2.0 14.8 15.5 -10.8 16.2 13.3 13.8 21.3 15.4 4.4 15.0 *Increase means appreciation Source: Haver, Bloomberg, UniCredit Research Legend Not vulnerable Somewhat vulnerable Moderately vulnerable Highly vulnerable UniCredit Research page 12 See last pages for disclaimer. January 2017 Economics & FI/FX Research CEE Quarterly EM VULNERABILITY HEATMAP (CONTINUED) BG CZ HR HU PL RO RS RU SK TR UA MX BR CL SA ID IN CN Policy Policy Rate, nominal (%) - 0.1 - 0.9 1.5 1.8 4.0 10.0 - 8.0 14.0 5.8 13.8 3.5 7.0 6.5 6.5 4.6 Real policy rate (%) - -0.4 3.9 0.3 0.7 2.3 2.5 4.0 - -0.5 6.6 1.7 5.3 0.4 0.8 2.9 0.7 2.4 -0.2 1.5 -0.8 0.9 1.1 2.3 4.5 0.2 1.3 9.7 2.1 4.9 0.9 1.2 3.7 1.3 1.0 1.9 Real Money market rate (%) Headline inflation (% yoy) -0.5 0.5 -0.9 1.1 0.8 -0.6 1.5 5.7 -0.5 8.5 7.9 3.0 8.5 3.1 6.1 3.5 5.8 Core Inflation (% yoy) -0.3 1.1 -0.1 1.5 -0.1 0.5 1.9 6.7 0.1 8.7 6.3 3.3 7.1 3.4 5.6 3.5 4.5 1.6 1.0 -0.2 -1.2 -2.0 -1.8 -0.5 -2.5 -3.4 -2.4 -0.8 -1.4 -1.4 -7.6 -2.5 -3.4 -2.8 -5.5 -2.7 GG Fiscal balance (% of GDP) GG Primary balance (% of GDP) 2.3 0.8 3.2 1.4 0.2 0.6 0.8 -2.9 0.0 1.2 2.0 -0.1 -3.1 -1.7 0.6 -1.1 -1.5 -1.2 28.3 39.8 84.6 75.6 53.5 36.8 71.3 10.2 53.3 29.4 67.4 35.7 #N/A 32.3 55.9 30.9 61.4 57.2 Local Debt Spread (10Y, bp)** 196.7 47.5 253.3 60.7 82.0 181.7 214.6 136.9 31.7 336.1 580.9 179.0 268.7 86.6 287.8 215.6 - 104.7 Local Currency Curve (5Y, %) 0.7 -0.3 1.6 1.8 3.0 2.4 5.3 8.3 -0.2 11.0 - 7.3 11.4 3.9 8.3 7.3 7.4 2.7 Local currency bond spread (2s10s) 168.7 133.0 185.0 246.0 159.1 240.2 182.5 12.5 126.5 114.5 -704.4 72.0 45.9 61.0 133.0 39.3 41.4 30.4 CDS (5Y, bp) 133.0 43.5 203.3 108.5 69.5 105.7 - 172.5 44.2 272.5 - 162.7 258.2 79.8 206.5 156.5 119.3 114.0 - 2.8 4.0 5.8 6.8 4.3 - 15.6 - 15.7 - 16.1 16.2 10.7 20.2 10.7 6.7 5.5 IBRD Doing Business*** 39.0 27.0 43.0 41.0 24.0 36.0 47.0 51.0 33.0 69.0 80.0 47.0 123.0 57.0 74.0 91.0 130.0 78.0 WEF Competitiveness Ranking* 50.0 31.0 74.0 63.0 36.0 62.0 94.0 45.0 67.0 51.0 79.0 57.0 75.0 35.0 47.0 41.0 39.0 28.0 7.0 4.0 13.8 4.9 8.2 5.9 14.4 5.2 9.5 11.3 9.1 4.1 7.4 6.9 26.6 25.0 8.4 4.1 Government Debt (% of GDP) Markets FX 3m implied volatility (%) Structural Unemployment (%) **External Debt CZ, HU, SR (USD), SK for 5Y; ***IBRD and WEF indicators as of 2015 Source: Haver, Bloomberg, UniCredit Research Legend Not vulnerable Somewhat vulnerable Moderately vulnerable Highly vulnerable UniCredit Research page 13 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly CEE Strategy: Adapting to higher rates and inflation Javier Sánchez, CEE Fixed Income Strategist (UniCredit Bank London) +44 207 826-6077 ■ 2017 will see higher volatility in fixed-income markets, as global yields may be on the rise. We remain cautious about adding duration, particularly in EUR-denominated bonds as the gap between Bunds and US Treasury bond yields may narrow from the current historically elevated levels. We look at the sensitivities of emerging market bond spreads and the USD across emerging market bonds and conclude that so far the impact has been limited. ■ We expect headline inflation to accelerate in CEE and other emerging markets, increasing the risk of higher rates in local currency bonds. We do not expect central banks to change their stance in 2017 for most markets, with the exception of Russia where we expect additional cuts and in Turkey where we expect higher rates. ■ Flows to emerging markets were poor in 2016, but allocations by investment funds were at record highs. We look at the increasing role of ETFs in this trend and conclude that, as markets become deeper and allocations increase, their role will become more important. We also look at the differences in investor patterns between ETFs and other investment funds and find some differences in the initial reaction to stress events in the markets. ■ We discuss how 2016 marked a confirmation of the trend by US investors towards higher portfolio investment in CE and we look in some detail at foreign participation in the region’s markets. ■ Finally, we look at the performance of USD and EUR spreads and the yields of local currency bonds and make some recommendations for each currency group [email protected] 1. Outlook for 2017 and review of 2016 In 2017, we expect global rates to be on the rise and potentially steeper EUR curves, particularly at the long end. The increase in rates may be driven by less accommodative monetary policies on both sides of the Atlantic and the rise in inflation expectations, which in the US initially moved upward after the US elections. Our G10 strategists target 3% for the US 10-year and 0.8% for 10-year Bunds by the end of 2017, which is a rise of 40bp and 90bp from current levels. This increase in rates will result in lower returns in EM fixed income with higher volatility than over the past years of monetary accommodation. We therefore remain cautious about EM fixed income in general and about increasing duration in particular. EUR-denominated bonds are potentially at a higher risk of selloff should the current differential between Bunds and US Treasuries narrow from current levels which are at historic highs. For the same reason, local currency bonds will encounter headwinds in 2017. Headline inflation is on the rise across the CEE region, much of which is due to base effects, with an average increase over the last six months of 130bp (excluding Russia and Turkey). Core inflation fared better across the region and recent trends show significant variation across countries. Russia and Turkey ended the year with lower inflation rates and Russia’s will get close to target by the end of 2018. On the other hand, despite lower recent headline readings, Turkey saw in Q4 one of the sharpest depreciations in its recent history and we expect headline and core inflation to be on the rise as the currency depreciation is passed through to consumer prices. We expect, on average, that inflation will pick up by 175bp by the end of 2017 and continue increasing in 2018, albeit at a slower pace. Despite the return of headline inflation, we expect central European central banks to remain on hold for most of 2017 as inflation will remain below target in 2017 and for much of 2018 for most countries. Growth rates at a regional level are expected to increase in 2017 for most countries and flatten in 2018. With global rates on the rise, headline inflation picking up and no deceleration in sight, the outlook for CEE-EU local currency in CEE is not as favorable as in the beginning of 2016 and local curves may steepen during the year. UniCredit Research page 14 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly 2016 was a below-average year in terms of EM fixed-income returns, with USD bond returns annualized volatility of 6%p.a. compared to 7% p.a. in the period 2000-2015. Most of the shortfall in performance was due to a poor 4Q16, with the CEE region’s selloff overdone. In CEE, this gap was even more pronounced, with the volatility in 2016 half to one-third of that observed to 2015. With possibly both USD and EUR core rates on the rise and a return of headline inflation in the region, it is safe to expect that volatility will increase in the year ahead. ASSET CLASS RETURNS AND FI COUNTRY RETURNS Asset class returns and volatility in 2016 USD and local performance of EM sovereign debt 20% US HY LATAM Bonds 20% 25% Turkey Poland Lithuania Latvia Romania Europe Stocks 15% Philippines 10% Serbia US Tsy 10y -10.0% Hungary -5% 5% 0.0% Mexico 4% 0% 10.0% 0% Bunds 10y 2% 20.0% 5% Croatia 6% 30.0% Russia EM Europe Bonds 8% EM Sovereign CRB EM Stocks Indonesia 10% 40.0% 10% US Stocks EM Corporate 50.0% 15% EM Local 12% 70.0% 60.0% SA 14% Local (rs) 20% 16% Brazil 18% 0% USD 25% -20.0% Source: Bloomberg, UniCredit Research Following the US elections, higher global rates and a stronger USD have been flagged as major risks to EM fixed income. In Central Europe, we estimate that the sensitivity of long-term rates to changes in US Treasury yields is relatively low compared to other countries. For bonds in local currency, US Treasury betas are low and in most cases explain little of the variability in the local rate. Turkish and Mexican local and USD yields have the highest sensitivity to US rates of all large EM countries (and in both cases the US rate explains in excess of 2/3 of the countries’ rates variability). In Turkey, the sensitivity was amplified by domestic concerns. CEE local yields’ sensitivity to Bunds was higher in the last year than in 2015 (and highest in Russia and Turkey), but it also explained little of the total variability in local rates. Looking at the US Treasury yield widening after the US election on November 8 as a way to gauge US rates’ sensitivities, we reach a similar conclusion: the highest sensitivities in local yields are in Mexico and Turkey, with the group of CEE countries overall less sensitive than other EM countries. In the case of USD spreads, much of the initial widening has been corrected after the peak on 14 November. UniCredit Research page 15 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly BETAS TO 10Y RATES AND RATES MOVES AFTER US ELECTIONS Betas of USD and LC debt to 10Y US Treasury and Bunds USD vs UST 3.5 LC vs UST USD spread and LC yield widening from US election to end of the year LC vs Bunds 3.0 LT TU MX RO BR HU PL ID SB SA HR PH RU 2.5 2.0 1.5 1.0 0.5 0.0 Bulgaria Czech Croatia Hungary Russia Serbia Poland* Indonesia Philippines Romania* Mexico* Brazil SA -1.0 Turkey* -0.5 USD spreads Initial Net Widening* 43 27 56 24 71 22 65 21 50 20 46 19 25 17 55 11 55 7 74 5 51 4 31 -1 4 -40 MX TU PH ID SA RO PL HR LT BR SR HU RU LC Initial Net Widening* 113 134 107 91 75 61 94 60 51 31 28 26 35 25 12 17 18 15 107 14 6 3 29 -15 27 -18 Coefficient on UST10Y or Bund 10Y of a regression between the USD or local-currency country yields against UST or Bund 10Y for 2016. * For USD bonds, the initial widening was up to 14 November 2016 and for LC bonds most widening took place before November 28 Source: Bloomberg and UniCredit Research. Historically, USD strength has been a negative factor for emerging markets. USD strength was one of the factors leading to the wave of defaults and restructurings in Latin America in the 80s 2 and of the Asian defaults at the end of the 90s. In both cases, the accumulation of debt in foreign currency was one of the major causes leading to defaults. The US dollar has appreciated 20% in REER terms since 2014 (trade-weighted), leading to a prolonged decline in EM local currency bond returns but without a significant increase in defaults of either sovereign or corporate issuers. The USD REER is about 1 standard deviation above its average since 1972 and probably overvalued based on fundamentals. We therefore don’t expect a significant increase in the USD and do not consider this as a major risk affecting our markets in 2017, barring an intentional policy to promote a stronger USD. We study the effect of the USD on the USD yields of a panel of EM countries including seven in the CEE region and control for other factors such as domestic inflation, external debt, the VIX index and US Treasury 10 year yields 3. We find that the average sensitivity to the USD is small compared to other factors such as inflation and we observe that the yields of the USD bonds of CE countries have lower sensitivity than that in other EM countries. 1. Flows into EM fixed income markets We expect flows to EM in 2017 to remain challenging given the global backdrop as a continuation of the trend we have observed over the last few years. Non-resident flows to EM countries were poor in 2016, ending the year at about USD 40bn, the lowest portfolio inflows observed in recent years. According to IIF estimates, fixed-income portfolio flows would have ended 2016 with at least USD 23bn in outflows, with the trend accelerating after the US elections. In contrast to net portfolio inflows into EM countries, 2016 was the third best year in the last decade in terms of inflows to EM fixed-income dedicated funds with net inflows of USD 23bn. Only the years of 2012 with USD 38bn and 2010 with USD 35bn exceeded this amount. 2 Which led to the US-sponsored debt restructurings via the Brady plan and the birth of emerging market bonds. We run a estimate a panel two-stage-least-square (2SLS) model using as instruments the one period lag in EM USD bonds yield, Brent prices and the ratio of FX reserves to short-term external debt. 3 UniCredit Research page 16 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly According to EPFR data, investment fund net assets allocated to EM fixed-income at USD 311bn increased by 27% in 2016 and have doubled since 2011. The year saw a return of ETFs after three years of lackluster inflows into the asset class. ETF flows of USD11.2bn accounted for half of total fund inflows and with net assets of USD 39bn, or 13% of the total, their importance in the market markedly increasing compared to the last few years. EM FI FUND ASSETS Net assets of EM FI funds by asset class Total Sovereign Net assets of ETF FI funds (in % of total) Corporate Mixed sov+corp 14 350,000 12 300,000 10 250,000 8 200,000 6 150,000 4 100,000 2016 2016 2015 2015 2014 2013 2013 2012 2012 2011 2011 2010 2009 2009 2008 2008 2007 2006 2006 2005 2005 2004 2004 0 2007 2008 2008 2008 2009 2009 2009 2010 2010 2010 2011 2011 2011 2012 2012 2012 2013 2013 2013 2014 2014 2014 2015 2015 2015 2016 2016 2016 2 50,000 0 ETF FI funds 16 400,000 Source: EPFR and UniCredit Research 2.1 The increased importance of ETFs We expect the role of ETFs in the market to continue increasing over the following years as EM products offer liquidity to investors and the fees are generally lower than for comparable passive funds. We believe that, as EM allocations become more mainstream and the assets more widely traded, ETFs will become more important as the liquidity gap narrows between the ETF product and that of its underlying constituents. The landscape of EM fixed-income ETFs is very concentrated with the top 3 accounting for about ½ of total assets, the top 6 for 75% and the top 10 for 90%. In terms of the target asset class, about 90% is invested in sovereign bonds and 7% in corporate bonds, with the rest invested in mixed strategies. Most of the ETFs invest in foreign-currency bonds and just about ¼ target local-currency or mixed-currency strategies. FLOWS TO EM FUNDS YTD flows to all EM FI funds 2012 USD mn YTD flows to EM FI ETF 2013 2014 2015 2016 2013 2014 2015 2016 18,000 40,000 16,000 30,000 14,000 12,000 20,000 10,000 10,000 8,000 0 6,000 4,000 -10,000 2,000 -20,000 0 -30,000 -40,000 2012 USD mn 50,000 -2,000 -4,000 Jan Mar Apr May Jun Jul Aug Sep Nov Dec Jan Mar Apr May Jun Jul Aug Sep Nov Dec Source: EPFR and UniCredit Research UniCredit Research page 17 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly Most EM fixed-income ETFs were launched after 2008 and net asset build-up only took place in size from 2011, so the product remains relatively untested during times of crisis. We look at two metrics for assessing the risks so far: the evolution of net assets during periods of net asset loss greater than 10% and the price to NAV ratio. The period after 2011 has seen at least three episodes of cumulative net asset drawdowns of 10% or more: (1) In 2013 during the “taper tantrum”: aggregate fund net assets began declining in mid-May and only recovered prior AUM levels by August 2014. ETFs sold off first and lost as much as ¼ of total assets by the end of June but sharply recovered thereafter. In contrast, the drawdowns from other fund products were smaller initially and investors weathered the initial selloff relatively more calmly; (2) The period from mid-July 2015 until the beginning of 2016 saw net asset losses unrelated to EM performance. During this period, ETFs also sold off more aggressively initially but also recovered faster than the rest of EM FI funds, eventually losing proportionally less assets than other investment funds. (3) The period after US elections saw a drop in ETF net assets of about 15%, while that for other investment funds was about half of that. It seems that a similar pattern was followed during the three periods highlighted where the selloff is originally sharper for ETFs but also the subsequent recovery, with ETFs eventually recovering AUM faster. The fixed-income environment for 2017 is a challenging one, but we may see a similar pattern of recovery in AUM in 2017. ETF BEHAVIOR DURING CRISES Net asset drawdowns (% change) 0 iShares EM Bonds ETF premium to NAV iShares USD Emerging Market Bonds EM FI funds net asset drawdown (% change) 15 Price/NAV discount or premium -0.05 10 -0.1 5 -0.15 0 -5 -0.2 Total ex-ETF ETF EMBIG -0.25 -0.3 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 -10 Dec-16 -15 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Source: Bloomberg and UniCredit Research The other risk indicator we monitor is the ETF’s premium to NAV, which in the period after 2008 has behaved pretty well for the largest ETF funds. The iShares Emerging Market Bond ETF is the longest existing ETF, the largest in terms of AUM and therefore representative of the EM ETF asset class. We observe that from 2010 the premium/discount to NAV was never larger than 2.5% and averaged a premium of 41bp. During the “taper tantrum” with increased selling pressure, the maximum discount to NAV was 2%, and in the days after the US elections the discount exceeded 1.5% for only two days and returned to a premium in the days thereafter. Since 11 November 2016, the discount to NAV for other ETF funds in the top 10 also never exceeded 2% for more than a couple of days, in the face of a 15% loss in total assets, suggesting an orderly liquidation. UniCredit Research page 18 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly In conclusion, there is no evidence so far that ETFs have been disruptive to the liquidity of the asset class and we see the ETF funds share increasing. This highlights the need for alpha generation on the part of active portfolio managers in order to face the additional competition. 2.2 Foreign participation in fixed-income markets According to the IMF’s CPIS Survey and the US Treasury’s TIC data, US domiciled investors own about ¼ of the bond portfolio investment in EM and about 1/5 of the bonds in the CEE region (with Germany and Luxembourg-domiciled investors owning about 14% each). In 2017, foreign participation may remain at current or lower levels as global and domestic rates inch higher. The information up to September 2016 shows that bond investments in the top 30 countries (which represent about 90% of the EMBIG index weight) portfolio investment increased by 13% YTD, with 50% of the increase in investment going to LatAm. By country, the largest increases in holdings were in Argentina (+60%), South Africa (+35%) and Indonesia (+26%), and after 19 months of net reductions in CEE bonds’ holdings, US investors began increasing positions once again. However, excluding Russia and Turkey, bond portfolio investment in the CEE region actually declined slightly compared to the end of 2015. In CEE, the largest position increases by US investors were in Russian and Romanian bonds, with holdings increasing by 37% and 13% during the year. Although investors began accumulating Turkish bonds at the beginning of 2016, the data up to September show that they reduced positions after the coup in July, and CBRT data suggest that they also reduced positions during 4Q16. Eurozone-based investors’ position in CEE was flat in the first half of the year, with the largest position reduction in Hungary and Poland (down by EUR 1.6bn and EUR 0.9bn, respectively), but offset by position increases in Romania and Bulgaria. EZ investors also accumulated positions in Russia, but the portfolio investment stock is still about 20% below the presanctions’ peak in 2Q14. Further foreign investor participation may be limited unless sanctions are removed. FOREIGN PARTICIPATION IN EM FIXED INCOME Foreigners’ holdings of local government debt (12-month range, in %) 50 One-year range % US investors’ bond portfolio investment changes in 2016 (USD bn) 8,000 Current level 7,000 45 6,000 40 5,000 35 4,000 30 3,000 25 2,000 20 1,000 15 0 10 Peru Indonesia South Africa Malaysia Poland Mexico Hungary Czech Russia Colombia Romania Turkey Thailand Brazil Hungary Serbia Lithuania Croatia Romania Turkey Poland Russia South Africa Colombia Brazil -2,000 Indonesia 0 Mexico -1,000 Argentina 5 Source: National sources, TIC and UniCredit Research UniCredit Research page 19 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly 2. Redemptions and issuance for 2017 2.1 Redemptions We estimate that the sovereign bond-related debt service (including principal and interest) will amount to USD 140bn in 2017, of which USD 32bn is in foreign currency. International bond redemptions will be concentrated in the periods between February to April and September to November. Turkey will see the largest bond debt service requirements accounting for ¼ of total international redemptions at USD 7.1bn, followed by Russia and Poland with redemptions in excess of USD 5bn each. Local currency bond redemptions will amount to USD 108bn, with Turkey also representing ¼ of total regional redemptions. REDEMPTIONS IN 2017 Redemptions of international bonds (in USD mn equivalent) Redemptions of local currency debt (in USD mn equivalent) CZ+HR+LT+LV+RO SB HU PL RU TU 6,000 5,000 16,000 14,000 12,000 4,000 10,000 3,000 8,000 6,000 2,000 4,000 1,000 Dec-17 Nov-17 Oct-17 Sep-17 Aug-17 Jul-17 Jun-17 May-17 Apr-17 Mar-17 Feb-17 Dec-17 Nov-17 Oct-17 Sep-17 Aug-17 Jul-17 Jun-17 May-17 Apr-17 Mar-17 Feb-17 0 Jan-17 2,000 Jan-17 0 CZ+HR+LT+LV+RO SB HU PL RU TU Source: Bloomberg and UniCredit Research. Serbian local currency redemptions include Central Bank bills. 2.2 Issuance for 2017 We expect net bond issuance of EUR 57.9bn in 2017 (gross issuance of EUR 125bn and redemptions of EUR 67bn) in the major countries in our region, with Poland and Turkey the most active in the Eurobond market with approximately EUR 6bn each. Bond Gross Bond Issuance Net Redemptions Total o/w: Intl Bonds Issuance Poland 18.5 37.7 6.3 19.2 Turkey 18.8 35.3 5.7 16.5 Russia 7.7 23.6 2.8 15.9 Romania 3.6 7.9 2.0 4.3 Hungary 3.4 5.5 1.0 2.1 Ukraine 2.2 4.1 0.0 1.9 Croatia 1.3 1.9 1.5 0.6 Bulgaria 0.4 0.3 0.0 -0.1 Serbia 2.6 2.2 1.0 -0.4 Czech 8.5 6.4 0.0 -2.1 67.0 124.9 20.3 57.9 Total Source: ministries of finance, UniCredit Research UniCredit Research page 20 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly 3. Rating outlooks for 2017 Emerging markets’ foreign currency (FC) ratings drifted lower in 2016, with the unweighted average rating in the BB area. FC ratings in the CEE-EU region were relatively unchanged, but with some notable rating actions during the year, such as Hungary and Serbia on the plus side and Turkey on the verge of losing investment grade by the three major agencies. In 2017, we expect Bulgaria to be upgraded by S&P to investment grade after the downgrade below investment grade in December 2014. Serbia may be upgraded by Moody’s and S&P by one notch and Fitch may assign it a positive outlook. We also think that the Czech outlook will be changed to positive by Moody’s and Fitch. Russia’s and Croatia’s outlook may be improved, with the outlook changed to stable by Moody’s. We expect no changes to Romanian and Slovakian foreign currency ratings and we think that Turkey may be downgraded by Fitch as early as the end of January. RATINGS AND SPREADS Z-spreads per rating and duration buckets. Averages and 1st and 3rd quartiles Rating average per region B150 140 B+ Duration 2-6 A BBB BB B 130 BB120 BB 110 BB+ 100 BBB90 BBB Duration >6 A BBB BB B 80 BBB+ A-70 EM LATAM A 60 A+50 2007 2008 2009 CEE (EU) Asia 2010 2011 2012 CEE (Non-EU) Africa 2013 2014 USD Z-spreads Average 1Q 3Q 94 131 246 475 63 76 205 387 118 174 301 580 138 224 388 491 165 313 463 280 452 523 EUR Z-Spreads Average 1Q 3Q 5 160 232 391 -3 128 17 189 39 245 245 22 194 60 282 2015 Spreads per rating and duration buckets are calculated using a sample of 381 actively traded bonds issued by countries typically classified as emerging markets. Source: Bloomberg, rating agencies, UniCredit Research UniCredit Research page 21 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly 4. USD Bonds’ performance 4.1 The year in review EM sovereign bonds denominated in USD returned 10% in 2016. This was by all accounts a very good performance as it topped the 8.9% compounded return of the index between 1998 and 2015 and was the highest annual return since 2012. The year’s performance was divided into two, with the first three quarters returning solid positive returns and the last quarter being negative for almost all EM countries with the exception of the higher yielding ones such as Ukraine, Ghana and Nigeria. Returns were higher among the lowest-rated sovereign credits, with the BB and B-rated countries providing returns in excess of 10% p.a. and the higher-rated countries showing gross returns below 5% p.a. From a geographical point of view, the best performance was shown by the very high-yielders Venezuela and Ghana, which began the year with spreads in excess of 1000bp, with total returns in excess of 50% and 33%, respectively. The lowest performing USD sovereign bonds were to be found in Turkey with a total return of -1% for the year. In 2016, the CEE region’s USD bond returns were overall the lowest in EM at about 6% p.a., while on average exceeding 14% p.a. for Latin American and African sovereign issuers. However, European credits, on aggregate, provided the best longer-term risk-adjusted returns with an average Sharpe ratio of 0.7x over the last five years. This is higher than the riskadjusted returns for the EM composite index and it is double that of the LatAm region. Since 2012, the improved macroeconomic picture in the region has led to lower volatility of returns and higher risk-adjusted returns than other EM debt. The longer-term performance within the regions is however far from homogeneous. Turkey is at the bottom of the list with negative returns and higher volatility than the EM composite, while Russia and Croatia delivered returns in excess of 8% p.a. with lower volatility than regional peers. USD denominated bonds YTD Total Return (in %) Maturity BG RO 18 HU HR LV LT 2% 19 3% 5% 20 3% 6% 2% 3% 7% 2% 21 22 2% 23 2% 4% 8% 24 3% 4% 9% RU SB TU 2% 5% 2% 3% 1% 5% 2% 6% 2% 2% 4% RO HU HR 2% 1.2 2.8 0.7 2.2 0.1 0.7 2.0 0.3 1% 2% 2% 0.1 7% 0% 1% 0.2 0.5 1.7 0% 1% 0.2 0.5 1.8 0% LV LT 0.4 1% RU SB TU 0.8 1.9 0.5 0.9 -0.2 0.9 -0.1 0.9 0.1 1.8 0.2 0.2 4% 28 1% 30 1% 34 -3% 15% 43 17% 45 0.0 0.0 1.2 -0.3 -0.4 -0.3 -0.3 -7.1 -0.4 -2% 1.1 -0.6 -0.8 0.3 -1% -1.4 -0.8 -0.6 -3% 42 0.2 -0.1 -1% 7% 0.4 PL 1.2 0% 26 0.8 -0.6 1.5 -3% 1.5 -5% -0.4 -0.6 In gray bonds which issued in 2016 UniCredit Research BG 6% 25 41 3% YTD Sharpe ratio (w/ 10y Bunds) PL Source: UniCredit Research page 22 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly 4.2 What we like in USD On a relative valuation basis, Turkey appears mispriced against its rating peers, as the USD Z-spreads are at the higher end of the spreads observed for BB-rated sovereigns. In CEE-EU, Romania and Hungary trade at similar levels across the curve, but we prefer Hungary based on a continuation of the improvement in its fiscal and external metrics. Hungary has lower budget balances and a declining public debt to GDP ratio and also shows the largest current account surplus of all major emerging markets. The net IIP position has stabilized at about -60% of GDP and it is worth noting that it was twice this level in 2009. In the Baltics, Lithuania trades at spreads not commensurate with its rating in the context of a declining public debt and one of the highest primary balances in the region. It also hasn’t retraced much of the spread widening after the US elections, perhaps due to geopolitical considerations, which we believe are overstated. USD BOND CHARTS Investment grade rated issuers Issuers rated below investment grade 250 A s of December 28, 2016. 440 As of December 28, 2016. 400 360 150 USD Z-spread (in bp) USD Z-spread (in bp) 200 100 50 0 -50 320 280 240 45 200 160 120 80 0 2 4 6 8 10 12 14 40 Modified Duration Hungary (Baa3/BBB-/BBB- | 100) Rom ania (Baa3*+/BBB-/BBB- | 98) Lithuania (A3/A-/A- | 70) 0 2 4 6 8 10 12 14 Modified Duration Poland (A2*-/A-/BBB+ | 72) Latvia (A3/A-/A- | 70) Turkey (Ba1/BBB-*-/BBu | 112) Serbia (B1*+/BB-/BB-*+ | 130) Rus s ian Federation (Ba1*-/BBB-/BB+ | 108) Croatia (Ba2*-/BB*-/BB | 123) Source: Bloomberg, UniCredit Research UniCredit Research page 23 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly 5. EUR Bonds 5.1 The year in review Within the CEE wider region, EUR-denominated bonds performed comparatively better than USD-denominated bonds, with Bulgaria delivering returns in excess of 8% across the curve and about 13% in the long end. Croatian bonds and Russian 20 bonds returned double digits. EUR bonds yielded better risk-adjusted returns than USD bonds with similar maturities. In riskadjusted terms, the Sharpe ratios (vs. Bunds) several times exceeded that for USD bonds. We believe that the performance of EUR-denominated bonds will encounter headwinds if the current historically wide spread between Bunds and US Treasury bonds narrows, whether this is a result of a reallocation of sovereign investment away from Bunds or because of a less accommodative monetary policy by the ECB. We think that EUR spreads may have room to narrow in countries such as Bulgaria and Croatia. EUR-denominated bonds YTD Total Return (in %) Maturity BG 18 RO HU HR LV LT 1% 1% 4% 1% 0% 3% 3% 19 RU 2% 21 11% 2% 22 6% 23 8% 24 8% 25 TU 2% 1% 2% 1% 2% 5% 26 27 8% 28 10% 6% 35 13% 7% 36 13% BG RO HU HR LV LT 2.0 3.3 5.1 0.8 0.2 3.3 1.3 1% 3.7 3% 4.0 3.0 3% 3% 5% 4% 2% -4% 4% 6% 7% 0% TU 0.4 0.6 0.5 0.7 1.0 0.4 2.0 1.6 2.5 -4% 3.4 1.9 -1% 2.0 1.1 3.1 PL 1.0 3.4 4% 9% SB 0.3 2.1 1.2 3% RU 2.9 3.3 3% 10% 5% YTD Sharpe ratio (w/ 10y Bunds) PL 0% 2% 20 SB 1.3 1.6 1.8 0.9 1.7 1.6 0.9 -3.9 1.4 1.5 0.8 -3.2 1.6 0.0 -0.2 1.7 46 -5% -1.9 55 -3% -0.3 In gray bonds which issued in 2016 Source: UniCredit Research 5.2 What we like in EUR The belly of the curve, in the 4-7 duration range, offers the best roll-down in Z-spread terms. EUR curves of lower-rated credits Romania and Bulgaria are very steep compared to higher rated ones, but we would hesitate to recommend longer duration positions until we have more clarity in respect to the yield differential between US Treasury bonds and Bunds. On credit metrics and scarcity value, Bulgaria offers a good pick versus higher-rated credits such as Poland, with a Z-spread twice as high as the latter in the belly but with low liquidity. In Croatia we like both the EUR and USD spreads supported by fiscal consolidation and improvement in the foreign currency rating outlook. UniCredit Research page 24 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly EUR BOND Z-SPREADS Mid-IG issuers 100 Low-IG issuers As of December 28, 2016. 250 As of December 28, 2016. 80 200 EUR Z-spread (in bp) EUR Z-spread (in bp) 60 40 20 0 -20 150 100 50 0 -40 0 2 4 6 8 10 12 -50 14 0 2 4 6 Modified Duration Lithuania (A3/A-/A- | 70) Poland (A2*-/A-/BBB+ | 72) 10 12 14 Modified Duration Latvia (A3/A-/A- | 70) Slovenia (Baa3*+/A-/A*+ | 73) Romania (Baa3*+/BBB-/BBB- | 98) Hungary (Baa3/BBB-/BBB- | 100) The score in parenthesis is an average rating score computed using ratings and outlooks. 6. 8 Bulgaria (Baa2/BBB-/BB+ | 100) Source: Bloomberg, UniCredit Research Local-currency bonds 7.1 The year in review The GBI-EM, an aggregate EM local currency index, posted a USD-equivalent return of 11.5% p.a. in 2016, well above the average annual return of the index since 2001 of 7% p.a. In USD-equivalent, Russia, Brazil and Colombia provided the best returns, with Turkish, Mexican and Nigerian the worst performing ones. In the CEE region, the EUR-equivalent performance of local currency bonds was better than that of international bonds denominated in EUR, albeit with slightly higher volatility. Russia was the star performer, delivering a 40%+ total return in EUR equivalent, followed by Croatia which performed well in the 10-year maturity area with a 13%+ return p.a., and HGBs which returned between 7-10% p.a. in EUR equivalent. Local currency bonds YTD Total Return (in %) (EUR equivalent) Maturity BG RO HU HR 18 1% 7% 6% 19 2% 6% 20 4% 6% 7% 21 2% 10% 3% 22 2% 9% 43% 23 4% 8% 45% 24 25 4% RU SB TU PL 39% 3% -6% 41% 4% 3% 6% 41% 7% 18% 13% 15% 5% 28 31 LT 9% 26 27 LV RO HU HR -1% 0.6 1.7 3.6 -6% -1% 0.7 1.4 -9% -1% -5% -1% -9% -2% -9% -2% -9% LT RU SB TU PL 2.3 1.1 -0.6 -0.2 2.3 3.9 0.8 1.9 3.7 0.7 1.7 2.3 1.0 1.5 2.3 2.3 1.3 -3% -2% 9% 44% -5% 5% 45% -6% -2% 0.9 1.0 -0.6 -0.2 -0.8 -0.2 1.9 -0.5 -0.1 -0.7 -0.3 -0.7 -0.3 2.3 4.5 5.4 1.3 1.4 1.0 -0.7 -0.6 2.8 -0.6 -0.4 -0.3 1.1 2.2 -1.8 0.8 2.2 -0.8 -1.1 -9% In gray bonds which issued in 2016 UniCredit Research LV 1.4 -9% 18% 37 YTD Sharpe ratio (w/ 10y Bunds) BG -1.2 Source: UniCredit Research page 25 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly 7.2 What we like in local currency Most currencies in the region are at multi-year lows in terms of realized volatility and appear relatively fairly valued in terms of a CPI-based REER index compared to its 10-year average. By this last metric, Croatia, Poland and Russia are between 5-8% below average and Turkey is below by about 15%, suggesting undervaluation. This pattern is also apparent in other emerging markets, partly due to the strength of the USD, which in REER terms is above 1 standard deviation away from its average since 1972. Turkey appears therefore as the only potential currency which remains substantially undervalued. Since the economic crisis in 2001, TRY has rarely been at this level of undervaluation on a trade weighted and CPI-adjusted basis. A combination of tighter monetary policy with the current historically high real and nominal interest rates would make TURKGBs a compelling trade for 2017, as yields get closer to 12% p.a. However, entering into such a trade will remain highly speculative until the policy response becomes firmer. Despite economic stagnation, Russia benefitted in 2016 from solid monetary policy, high real rates and the RUB rising in tandem with oil prices. However, we still like Russian local debt on the basis of our forecast for a higher oil price in 2017 of USD 60 per bbl, our expectation for CPI inflation close to target by 2018 and continuation of the disinflationary process throughout 2017, which makes current OFZ rates relatively high in real terms. The current wider levels in OFZs compared to the beginning of 4Q make a good re-entry point. The RUB appreciated by 32% in REER terms and is currently just below its 10-year average; therefore we expect lower returns in 2017 compared to 2016 as the currency may be close to fair value; there is an increased risk of domestic issuance and foreign positioning is heavy. In CEE, Hungary and Romania have the steepest curves in the region, but we prefer HGBs in the longer end based on our outlook for inflation in 2017, and in the belly as the MNB continues to provide excess liquidity to the banking system. Of these two, we prefer HGBs in the belly of the curve. LOCAL CURRENCY CHARTS Nominal rates and expected disinflation in 2017 10Y-1/2 Y rate differential in bp 350.0 10y LC Real 300.0 12.0 bra tur 250.0 10.0 200.0 zaf 8.0 rus idn 150.0 mex 100.0 6.0 4.0 0.0 pol hrv 2.0 rom hun -50.0 Brazil Russia Indonesia Mexico SA Philippines 400 Czech 300 Turkey 200 Change in CPI to 2017 Bulgaria 100 Serbia 0 Poland -100 Croatia cze -200 Romania -100.0 bgr Hungary 0.0 -300 50.0 srb phl Source: Bloomberg, UniCredit Research UniCredit Research page 26 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly CEEMEA FX: Not all “Tantrums” need be the same Kiran Kowshik, EM FX Strategist (UniCredit Bank London) +44 207 826-6080 [email protected] Main points 1. The “Trump Tantrum” will have a more differentiated impact on EM currencies compared to the “Taper Tantrum”. Commodities and external balances are on a better footing. 2. We prefer commodity exporters like ZAR and RUB over importers like TRY. 3. PLN will rally on renewed inflows in the absence of reserve accumulation. HUF would require a strong recovery in financial flows to see a sustainable rally. 4. Following an initial selloff, EUR-CZK should grind higher once the floor is removed in mid-2017. 5. We stay bearish on TRY even at oversold technical levels but would change our view if the CBRT were to tighten policy significantly. Nuanced on the EMFX view: Not all “tantrums” need be the same For EM currencies, higher commodity prices will partially offset higher core yields In our last quarterly update, we made the point that after 2Q16 ample global liquidity had taken over as the driver of several EM currencies rather than the positive demand impulse coming from China (see “CEEMEA FX: A liquidity driven rally” in September’s 4Q16 CEE Quarterly [pages 22-28]). The election of Donald Trump has seen markets price in a strong fiscal policy response, better growth outcomes down the line and, as a result, sharply higher nominal US yields. As per our prior 4Q quarterly diagnosis, this constitutes a global liquidity tightening and should be, across-the-board, negative for EM currencies, especially those countries with weak external balances and a high proportion of financing in US dollars. Two reasons why we should view the “Trump tantrum” differently compared to the “Taper tantrum” However, the situation is now more nuanced in our view; while US yields are moving higher, there are increasing signs of improvement in EM growth, particularly in China. In recent months, we have seen firmer data on industrial activity (especially for “old” commodityintensive industries like construction), credit as well as commodity import volumes. This has coincided with a strong bid under industrial metal prices, seen even before the outcome of the US election. Our analysis suggests that modest rises in US real yields alongside signs of reflation may be consistent with a positive view on a number of currencies, especially those of commodity producers (see FX Perspectives: EM FX & the "Trump Tantrum" - why this time could be different, 17 November). EMFX: BETTER EXTERNAL BALANCES AND HIGHER COMMODITY PRICES COMPARED TO 2012-13 Chart 1: Industrial metals provide a positive EMFX signal EMFX index Chart 2: The average EM C/A position has improved since the 2013 taper tantrum CRB raw industrials index (rs) 1,750 600 1,700 2.0 -1.0 -2.0 Jun-17 Dec-15 Sep-16 Jun-14 Mar-15 Dec-12 Sep-13 Jun-11 Mar-12 Dec-09 Sep-10 Jun-08 Mar-09 Dec-06 Sep-07 Jun-05 Mar-06 Nov-16 Aug-16 Feb-16 May-16 Nov-15 Aug-15 Feb-15 May-15 Nov-14 Aug-14 Feb-14 May-14 Nov-13 Aug-13 Feb-13 May-13 Nov-12 Aug-12 Feb-12 May-12 Nov-11 350 * average reading of 16 liquid EMs that have released 3Q data Dec-03 -3.0 But right now, commodities are rallying Sep-04 1,400 Jun-02 400 Mar-03 1,450 1,350 0.0 450 Sep-01 2013 "taper tantrum" saw EM currencies fall sharply, and in line with commodities which had been falling for several months 1.0 Mar-00 1,500 500 Dec-00 1,600 1,550 3.0 550 1,650 EM average* current account (% of GDP) 4.0 Source: Bloomberg, MSCI, UniCredit Research UniCredit Research page 27 See last pages for disclaimer. <date> January 2017 Economics & FI/FX Research CEE Quarterly Here, we quickly point out two reasons why we should not view the “Trump Tantrum” as having the same impact on EMFX as the “Taper Tantrum”. First, EM (and China) growth prospects appear stronger now, as reflected in the surge in industrial raw material prices. Back in mid-2013, EM currencies were trading far too high relative to the latter, which had already been falling for several months (likely reflecting weakening EM growth prospects). Instead, now we have a bullish divergence for EM currencies (chart 1). Second, the average EM current account balance has improved substantially compared to 2013 (chart 2). Our working assumptions for 1Q Looking forward, there is a high degree of uncertainty over how things pan out, especially on the future path of US policies. These relate to fiscal policy, trade policy as well as how US monetary policy shifts. For our base-case scenario, we assume the following: 1. US 10Y yields grind up to 3.00% by end-2017, 2. No punitive trade tariffs are implemented and China does not retaliate via step-wise devaluations, and 3. Chinese authorities continue to push the pedal on fiscal expansion to ensure growth continues “at any cost” ahead of the crucial 19th National Congress of the Communist Party of China to be held sometime in 2H17 (with the date still to be determined). Overall, under such assumptions, we maintain our preference for the commodity exporters (RUB and ZAR) relative to the importers (TRY). What about the risks? We can think of a few risks which could hinder the cited backdrop. We list three here, all of which pertain to the evolution of US policies. Hopes of a fiscal stimulus are dashed First, Trump significantly dashes expectations of a fiscal stimulus focusing on “infrastructure build”. This would place commodities under some pressure and weigh on RUB and ZAR. At the same time, lower US yields may result in some respite for the currencies of commodity importers dependent on fixed income inflows. In such a scenario, commodity exporter currencies could suffer relative to commodity importers (including PLN, HUF and TRY). A more protectionist turn in US policies will initially hurt commodity exporters Second, Trump moves to highly protectionist trade policies. Apart from CNY and MXN, this seems underpriced in other currencies; TWD and KRW – two potential casualties given their status as serial currency manipulators and having very open economies – have held up quite well so far. We would be less worried about the US labeling China a “currency manipulator”. A much bigger concern would be the US slapping tariffs on Chinese imports, as this would surely weaken China’s trade balance (one of the few strong components of the country’s balance of payments at present) significantly. Note that that China’s trade balance with the US contributed to over 30% of China’s total trade balance. In such a scenario, initially we would expect: 1. A sharper weakening in CNY, 2. Selloff in Asian currencies (like TWD and KRW- heavily linked to China via supply chains), and 3. Some weakness for EM commodity producer currencies as markets price in the outcome as a negative Chinese growth shock. That said, while numbers 1 and 2 seem like reasonable longer-term market responses, we see number 3 as temporary. This is because we believe that authorities could well respond to weaker external demand with even more fiscal stimulus targeted even at “old” and commodity-intensive industries to shore up growth (as they have recently). Eventually, this should allow EM commodity currencies to recover. De-regulation of the US energy sector would weigh on RUB UniCredit Research Third, a further de-regulation of the US energy sector could place energy prices under more pressure and provide headwinds for the Russian ruble and could help oil importers like the Turkish lira (our least favored CEEMEA currency) as well as the Hungarian forint. However, our base-case scenario remains for energy prices to grind higher. page 28 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly PLN appreciation pressure may increase… A recovery in portfolio flows has seen Poland’s broad basic balance of payments (BBoP) recover and signal appreciation pressures. We assume that the appreciation pressure builds up further next year as EU fund inflows recover strongly. That said, this year such pressures have not been adequately reflected in the currency, and appear to have been absorbed by rising currency reserves. Indeed, as a proportion of GDP, reserve accumulation is running at an exceptionally high pace, last seen when PLN was at much stronger levels (at or below 4.00 on EUR-PLN – chart 3). Authorities seem to favor a weaker currency, but we assume constraints, such as a negative cost of sterilizing such reserves, will see policymakers foster a faster pace of appreciation next year should inflows improve. But the trend in reserves will be a key one to watch, in our view. …which could see a stronger PLN if reserve accumulation is curbed NBH liquidity policy may have a diminishing impact on depressing HUF in 1Q The forint came under pressure in 4Q, in part on account of the NBH’s policies aimed at increasing the banking sector liquidity surplus. We think such policies could have a diminishing impact over 1Q17, with yields having already turned negative. However, we do not think that EUR-HUF will break familiar ranges (300-320) anytime soon. The last time EUR-HUF traded well below 300 on a sustainable basis was over 2012 and 2013. There are two important factors which support the forint at this time. Besides a strong C/A surplus, a revival of portfolio inflows would be a prerequisite for EUR-HUF to sustainably break below the 300-320 range First, rates were much higher in Hungary over 2012-13; the 3M bill yielded some 300-600bp over the comparable 3M bill in the euro area. That same spread currently is only minus 46bp. The NBH seems quite comfortable in remaining dovish and will likely continue to hold such a stance even as inflation rebounds. Secondly, just a few years ago (from 1Q12 to 4Q13), the current account surplus was still quite strong, averaging 2.4% of GDP. But in addition, financial inflows (portfolio plus FDI) were also solid at +3.2% of GDP. In contrast, over the past two years (3Q14 to 3Q16), while it is true the C/A has firmed even further (averaging 3.5% of GDP), financial outflows (at -4.2% of GDP) have more than overwhelmed the C/A surplus (chart 4). After July, foreign investor demand for local bonds increased sharply, but recently enthusiasm appears to have waned. A strong improvement in financial flows may be a prerequisite for a sustained break in EUR-HUF below 300. Barring an initial dip, EUR-CZK to be well supported after removal of floor Elsewhere, the EUR-CZK floor will likely be removed around June 2017 in line with the CNB’s guidance. Barring an initial 3-4% decline (perhaps to 26.00), the cross should grind back higher because of: 1. Somewhat higher global yields allowing the country to recycle the still modest C/A surplus abroad, and 2. CNB will likely continue to maintain its intervention policy even after the floor is removed. The nature of the financial inflows being seen going forward will be crucial in determining how sustainable any EUR-CZK drop will be; the more speculative, the greater the odds of a reversal higher in EUR-CZK, but if the inflows are stickier flows (like FDI), EUR-CZK could stay under pressure requiring persistent CNB intervention. PLN & HUF: INTERVENTION AND FINANCIAL FLOW PRESSURES IN FOCUS Chart 3: Poland accumulating FX reserves at fast pace even at weaker PLN levels Official reserve assets (3M sum, % of GDP) 12 Chart 4: HUF: Financial outflows have been fully re-cycling the C/A surplus EUR-PLN (rs) 5 35 4.8 7 4.6 FDI plus Port inv. net inflow C/A 4.2 330 310 25 290 2012-13: strong C/A and financial inflows 4.4 2 EUR-HUF (rs) both series in % of GDP, 3Q moving average 270 15 250 4 -3 3.8 5 230 3.6 Jun-17 Apr-16 Nov-16 Sep-15 Jul-14 Feb-15 Dec-13 Oct-12 May-13 Mar-12 Jan-11 Aug-11 Jun-10 Apr-09 Nov-09 Sep-08 Jul-07 Feb-08 Dec-06 Oct-05 3 May-06 Jun-17 Apr-16 Nov-16 -15 190 Financial outflows more than fully re-cycling C/A surplus after 2015 3.2 Sep-15 Jul-14 Feb-15 Dec-13 Oct-12 May-13 Mar-12 Jan-11 Aug-11 Jun-10 Apr-09 Nov-09 Sep-08 Jul-07 Feb-08 Dec-06 Oct-05 May-06 Mar-05 Jan-04 Aug-04 -13 210 -5 3.4 As of October-end Mar-05 -8 170 Source: Bloomberg, UniCredit Research UniCredit Research page 29 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly In the three most recent instances of strong intervention (4Q13, 3Q15 and now 3Q16), the flows appeared to be of the more speculative variety, described under “other investments” in the financial account. Net inflows here run in excess of 10% of GDP in all above instances. We assume such flows are more prone to a reversal after an initial CZK strengthening as positions are reversed. At the margin, we point out that higher global yields would place less strengthening pressure on CZK, as seen in the reduced intervention pressure seen over November. Despite three years of losses, most of the reasons for our bearish TRY view (see FX Perspectives Turkish Lira - the fragile one) remain intact. The current account is likely to remain under widening pressure as energy prices rise in the months ahead. Medium-term momentum indicators on USD-TRY are at levels that preceded strong TRY relief rallies. However, in all those instances, the real CBRT funding rate (deflated by inflation expectations) was well north of 100bp (chart 5). Hence, we stay bearish on TRY even at current levels. A sharp tightening from the CBRT (over 200bp) would make us more constructive on TRY; however, such a prospect appears unlikely. A referendum on a move to a presidential system (likely around April) will keep foreign investors wary of committing to anything but tactical positions. Still no reason to for turn positive on TRY Strong CBRT response would change our view While there will be bouts of volatility, we continue to hold a constructive stance towards the two commodity producers (RUB and ZAR). For South Africa, we think the year 2017 will be of two halves; a better performance in 1H on strong terms of trade support and diminished political and rating risk, followed by weakness from 2H on for exactly the opposite reasons. The outperformance in the currency has come hand in hand with the outperformance of the materials sector in equity markets (chart 6). The latter still flags some further gains ahead. For Russia, higher energy prices should see the currency strengthen. The oil price (in RUB terms) is now close to RUB 3400/bbl, the highest level in over a year and some 20% above the government’s current budget assumption of RUB 2720/bbl. Hence, there is plenty of scope for the RUB to catch up to rising terms of trade without sparking verbal intervention from the government. ZAR will perform well in 1H but 2H brings risks We like RUB on higher energy prices TRY WILL CONTINUE TO UNDERPERFORM BOTH ZAR & RUB Chart 5: Low real yields suggest USD-TRY unlikely to sell-off despite overbought medium term technical conditions 14-week RSI on USD-TRY 90 Real CBRT average funding rate (rs) USD-TRY overstretched on momentum ... 80 70 60 Chart 6: Outperformance of EM materials sector has come hand in hand with a stronger ZAR MSCI EM materials/broader index 850 110.00 0.62 650 0.57 550 0.52 90.00 0.47 80.00 450 50 ZAR NEER (rs) 750 350 100.00 0.42 40 250 30 150 20 50 0.32 -50 0.27 50.00 -150 0.22 40.00 Oct-16 Dec-15 May-16 Feb-15 Jul-15 Sep-14 Nov-13 Apr-14 Jan-13 Jun-13 Aug-12 Oct-11 Mar-12 Dec-10 May-11 Feb-10 Jul-10 Sep-09 Jun-08 Nov-08 Apr-09 Feb-16 Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 0 USD-TRY to sell-off 60.00 Jan-08 But much higher real rates required to allow 10 70.00 0.37 Source: Bloomberg, UniCredit Research UniCredit Research page 30 See last pages for disclaimer. <date> January 2017 Economics & FI/FX Research CEE Quarterly Countries UniCredit Research page 31 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Bulgaria (Baa2 stable/BB+ stable/BBB- stable)* Outlook – Given the country’s very strong position – with a solid growth momentum, twin surpluses and abundant fiscal and FX reserves – the immediate impact of the GERB’s government resignation on growth and policy making more generally would be rather small. Growth is likely to remain strong in early 2017, and if the general elections don’t produce a pronounced shift toward more dysfunctional policies, the economy is likely to reach its cyclical peak in end of 2017 or in early 2018 – roughly two years after the rest of CEE-EU. Downside risks have risen, in the meantime, as odds for a populist-nationalist coalition winning the general elections have increased. If such a scenario materializes, the hard-won stabilization of the energy sector would be most at risk, in our view. Author: Kristofor Pavlov, Chief Economist (UniCredit Bulbank) MACROECONOMIC DATA AND FORECASTS 2014 2015 2016F 2017F 2018F GDP (EUR bn) 42.8 45.3 46.5 48.6 51.1 Population (mn) 7.2 7.2 7.1 7.1 7.0 5,937 6,330 6,528 6,871 7,252 GDP 1.3 3.6 3.4 3.6 3.4 Private Consumption 2.5 3.9 3.4 3.2 3.3 Fixed Investment 3.4 2.7 0.2 3.5 4.5 -0.8 2.9 -2.1 2.5 4.0 Exports 3.1 5.7 5.4 4.8 4.9 Imports 5.2 5.4 3.8 4.2 5.2 Monthly wage, nominal (EUR) 420 458 493 533 577 Real wage, change (%) 7.4 9.0 8.6 6.9 6.7 Unemployment rate (%) 11.4 9.1 7.7 6.8 6.0 Budget balance -3.6 -2.9 1.7 -1.7 -2.3 Primary balance -3.0 -2.0 2.5 -0.9 -1.5 Public debt 26.4 25.6 28.7 25.2 25.3 Current account balance (EUR bn) 0.0 0.2 1.7 1.2 0.4 Current account balance/GDP (%) 0.1 0.4 3.7 2.4 0.8 Extended basic balance/GDP (%) 4.4 6.8 8.0 7.0 5.6 Net FDI (% of GDP) 2.1 3.5 3.0 3.3 3.5 Gross foreign debt (% of GDP) 92.0 75.3 72.8 67.9 63.8 FX reserves (EUR bn) 16.5 20.3 22.7 24.3 26.2 6.5 8.0 9.2 9.2 9.2 CPI (pavg) -1.4 -0.1 -0.8 1.1 1.6 CPI (eop) -0.9 -0.4 -0.2 1.8 1.9 Central bank reference rate (eop) 0.02 0.01 0 0 0 USD/BGN (eop) 1.79 1.76 1.77 1.81 1.71 EUR/BGN (eop) 1.96 1.96 1.96 1.96 1.96 USD/BGN (pavg) 1.47 1.76 1.83 1.78 1.69 EUR/BGN (pavg) 1.96 1.96 1.96 1.96 1.96 139.8 136.9 136.0 135.4 136.1 -1.1 -2.1 -0.6 -0.5 0.6 KEY DATES/EVENTS ■ Mid-Feb: GDP flash estimates for 4Q16 ■ Mid-Feb: Labor force survey data for 4Q16 ■ End-Mar/early Apr: General government elections GDP per capita (EUR) Real economy, yoy change (%) GDP GROWTH TO STABILIZE AT ROBUST LEVELS Fixed Investments Private consumption Net Export Public consumption GDP, real growth yoy (%) 5.0 3.6 4.0 Public Consumption 3.4 3.6 3.4 3.0 1.3 2.0 1.0 Fiscal accounts (% of GDP) 0.0 -1.0 -2.0 -3.0 2014 2015 2016F 2017F 2018F CPI INFLATION WILL CONTINUE TO ACCELERATE yoy (%) 3.0 2.0 Months of imports, goods & services 1.0 Inflation/Monetary/FX 0.0 -1.0 -2.0 -3.0 Dec-14 External accounts Dec-15 Dec-16 Dec-17 Dec-18 Source: NSI, UniCredit Research Real effective exchange rate, 2000=100 Change (%) Source: Eurostat, NSI, BNB, MoF, UniCredit Research *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 32 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Outlook remains favorable, but downside risks are rising The sizeable fiscal boost, which the public sector was set to provide in the remainder of the year, failed to materialize Survey results point to continued solid growth momentum in 4Q16 Meanwhile, business and consumer sentiment proved very resilient in the period between the first and the second round of the presidential election, which suggests that, apart from the shift to growth-negative fiscal policy in 2H16, the short-term outlook for the economy is likely to remain little changed. Indeed, the headline business sentiment indicator in November rose to its highest level in seven years (see lhs chart), with the employment expectation component being particularly buoyant across the board. Consequently, we decided to revise our full-year GDP growth projection for 2016 downward to 3.4% yoy from 3.7%. Consumption-driven growth will remain strong in 2017 and 2018… …but will slow down thereafter, in the absence of growthenhancing reforms …but will keep long-term arrangements in relations between UK and EU uncertain for a protracted period of time The upward revision of GDP growth in 2017 also reflects stronger investment We expect a slight acceleration in growth in 2017 to 3.6% – just a notch higher vis-à-vis our previous forecast. As before, domestic demand and individual consumption in particular will be in the driver’s seat. The latter will mostly draw support from the solid rise in wages, while the pace of job creation is forecasted to shift to a lower gear, as labor shortages constrain the pace of economic expansion in some sectors. At the same time, there are indications of a somewhat stronger global recovery. This is mostly attributable to the upward revision of our GDP growth projection for the EA (to 1.5% from 1%), which reflects a shift in our perception of the impact of Brexit, which we now see as an unfolding event with only a limited negative impact in the short run, while keeping uncertainty elevated over the longer term. With the trade shock from Brexit now less than feared, we expect real export volumes to rise close to 5% in 2017, much stronger than our previous projection in September for a 3.5% rise. Meanwhile, the gap between EU funds absorption on a contractual and cash basis rose to a whopping 27% (see the rhs chart), pointing to a large volume of infrastructure projects which are about to enter the construction phase. Thus, after a slow start of EU projects from the new planning period in 2016, public investments are likely to receive a significant boost in 2017 and thereafter. Sentiment recovery to new post-crisis highs continues ESI - total (rs) Construction Industry Households EU funds absorption is set to shift into higher gear Services 60 150 40 100 20 50 0 0 -20 -50 -40 -100 -60 -150 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14 Nov-15 Nov-16 35 % of total Programme budget So far, the negative impact from Brexit proved smaller than expected… The acceleration in GDP growth in 2H16 (pushing full-year GDP growth to 3.7% from 3.5% in 1H16), which we anticipated in September, failed to materialize. Real GDP increased by 3.4% yoy in 3Q16, somewhat weaker than both the 3.6% 2Q16 outturn and our 3.7% forecast. While we were right to expect that the record-breaking increase in tourist arrivals and wheat harvest would boost output in 3Q16 and further in 4Q16, it was the jump in fiscal spending that we foresaw three months ago where our forecast missed the mark. We were expecting that the drag from investment was about to ease, as the budget balance was set to shift from a 3.7% of GDP surplus in July to a 1.6% deficit in December, but the unexpected loss of the presidential election forced the GERB government to resign and altered its fiscal plan for the remainder of the year. We now expect a 1.7% of GDP budget surplus in December which, if correct, would produce considerable fiscal tightening equivalent to 4.6% of GDP in 2016. Gap between Contracted and Paid (2014-2020) Programme period 2014-2022 - CONTRACTED Programme period 2014-2022 - PAID 30 25 20 15 10 5 0 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 Months since start of Programme period Source: Eurostat, EU funds-single information web portal, UniCredit Research UniCredit Research page 33 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly FDI stabilizing close to 3% of GDP, as stronger EU inflows and higher lending, all point to more investment… …boosting further both productivity and exports Solid corporate profits and improving productivity, coupled with signs that production capacity is falling short to meet expected demand in a number of sectors, also bode well for investment. Lending conditions are likewise improving, helped by a favorable combination of abundant liquidity, the falling cost of borrowing and stronger provisions of credit from multinational institutions such as the EIB, which have focused on the SME segment where local players have been less eager to expand. With households more confident about the stability of their income and job and banks willing to lend more, the outlook for the residential construction sector has also improved (see lhs chart), which points to both more construction activity and moderately higher house prices in both 2017 and 2018. The number of employed in 3Q16 posted a decline yoy (-1%) for the first time since 4Q14, but the big picture looks reassuring. This reflects a drop in the number of self-employed in agriculture, which has been under way for years since jobs are migrating to sectors with higher productivity, as well as job losses in construction, due to the slow start of EU projects under the new planning period. As these trends are not entirely new, the drop seems also driven by weaker job creation in the rest of the economy, including a limited number of sectors facing labor shortages. We are not particularly worried, however, because job losses in construction should be over soon, as more EU projects are started, and especially because the fall comes against the backdrop of two consecutive quarters of an outstandingly strong pace of job creation (1.2% on average in 1H16 yoy vis-à-vis 0.4% in both 2014 and 2015), which makes the 3Q16 result look like a technical correction. Wage growth has been strong, at the same time, while risks for price competitiveness appear well contained, given a recordbreaking C/A surplus which is estimated to come close to 3.7% of GDP at the end of 2016. The drop in the number of employed in 3Q16 looks like a technical correction… . ..as it comes against the backdrop of exceptionally solid job growth in the preceding two quarters The outcome of early parliamentary elections is highly uncertain… …with odds for the emergence of a populist-nationalist coalition being significant A potential shift towards populist policies (similar to the ones in 2013 – 14) could have a far-reaching adverse impact Hard-won stabilization of the energy sector may prove only short-lived if populists return to power Deceleration of growth-enhancing reforms following snap elections is the key downside risk to our benign baseline scenario. This will amount to a major setback, given that the long-term outlook is already dark as a result of sharply deteriorating demographics. Efforts to cut corruption and overhaul sclerotic prosecution remain the key concerns, while there has been only limited progress thus far in identifying the policy changes needed to make growth not only stronger but also more inclusive. Given the country’s very strong position – with solid growth momentum, twin surpluses and abundant fiscal and FX reserves – the risk for a sharp immediate deceleration of growth is small. We think that any incoming government will keep the budget deficit below the 3% threshold to avoid a standoff with European Commission that may put access to EU funding at risk. If the past has any clue to offer, budget implementation risks are likely to increase if socialists win, given their poor track record in boosting tax collection. Previous socialist-led governments have also favored social spending over investment, reducing infrastructure spending and co-financing for EU funds. In case of an excessive reversal of regulations enacted by the outgoing administration, risks for the stability of the energy sector may resurface. The past proclivity of socialist-led governments to committing to large-scale energy infrastructure projects with huge corruption potential, which at the same time make little sense on purely economic grounds, is also a risk worth watching. Housing demand is on an upward trend Drop in 3Q16’s hours worked seems driven by technical factors Number of mortgages, yoy growth, 12m MA Housing price index, yoy growth, 12m MA % % 50 40 2.0 30 1.5 20 1.0 10 Industry, contribution to growth BPO, contribution to growth Total, yoy growth 0.5 0 0.0 -10 -20 -0.5 -30 -1.0 -40 -1.5 -50 -2.0 -60 -70 Agriculture, contribution to growth Construction, contribution to growth Other services, contribution to growth 3Q07 3Q08 3Q09 3Q10 3Q11 3Q12 3Q13 3Q14 3Q15 -2.5 3Q16 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 Source: NSI, Registry agency, UniCredit Research UniCredit Research page 34 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Strategy: Value in scarcity Javier Sánchez, CEE Fixed Income Strategist (UniCredit Bank London) +44 207 826-6077 [email protected] Bulgarian bonds will continue to have scarcity value in 2017 with a light redemption calendar, the budget balance turning to a large surplus in 2016 and little additional issuance until 2019. Local banks continue to be awash with liquidity and will continue to be strong bid. In 2015 and 2016, the Sovereign tapped the 7, 12 and 20-years’ maturity in international markets on several occasions, issuing EUR 3.1bn in 2015 and EUR 2bn in 2016. The redemption calendar for 2017 is very light with EUR 1bn maturing in July, which was prefunded in early 2016, and the following scheduled maturity is for 2022. Hence, the USD curve will remain empty going forward, and the EUR curve relatively light. Bulgarian EUR bonds have issue sizes slightly below other bonds in the region and the lack of USD-assets will continue to limit international portfolio investment, particularly from the US. US investors own approximately 8% of all the stock of foreign investment, which is about 1/3 of the ownership in Hungary and Slovenia or half of the ownership in Romanian bonds. Eurobond issues are mostly owned by local banks which are currently awash with liquidity; they hold the largest positions in short-term maturities, while owning relatively less of longer-term bonds. Bond scarcity has created value and rewarded foreign investors with a better performance in 2016 compared to rated peers Hungary and Romania, with the 2023 and 2028 bonds issued in 1Q16 performing particularly well. We continue to like BGARIA bonds for their scarcity value and fiscal metrics and we prefer the belly of the curve, which currently has a lower ownership rate by local banks. GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other Fiscal reserves change (- =increase) GROSS EXTERNAL FINANCING REQUIREMENTS 2016F 2017F 2018F -0.1 -0.8 0.7 0.5 0.5 0 0 0.2 0 0.2 -0.1 0.3 0.3 0 0 2.1 2.0 0.1 0 2.4 0.8 1.5 0.4 0.4 0 0 1.1 1.0 0.2 2.4 0.3 0.3 0 0 0.1 0 0.1 0 2.0 1.2 0.8 0.6 0.6 0 0 0.2 0 0.2 2.0 1.3 1.3 0 0 0.1 0 0.1 0 -2.4 1.9 0.6 EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (-= increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net 2016F 10.1 -1.7 3.9 0.2 0.5 3.2 7.9 10.1 1.4 0.9 5.4 2.1 0.3 3.0 7.7 1.4 -4.3 2.4 2017F 11.1 -1.2 4.7 1.1 0.4 3.1 7.7 11.1 1.6 -0.7 3.3 0.1 0.4 2.7 7.4 1.5 -0.4 1.6 2018F 10.7 -0.4 3.7 0.2 0.4 3.0 7.4 10.7 1.8 -0.2 2.8 0.1 0.5 2.2 7.2 1.6 -0.6 1.9 0 2.0 0 -1.0 0 0.0 Source: BNB, MoF, UniCredit Research UniCredit Research page 35 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Croatia (Ba2 negative/BB stable/BB negative)* Outlook – With GDP growth accelerating further in 3Q, boosted by a strong tourism season, we revised our 2016 growth forecast to 2.7% from 2.2%. The momentum should continue during 2017 based on private consumption growth boosted by envisaged tax reform, and stepped-up investment growth driven by continuously improving EU funds’ absorption and progress in easing obstacles to business. The fiscal position should improve further, but challenges abound as the government is facing so far the most demanding year in terms of public debt redemptions while global financial markets remain unsettled. We therefore find the country’s strong extended basic balance position and prospects of credit rating improvements in the medium term encouraging. Author: Hrvoje Dolenec, Chief Economist (Zagrebačka banka) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS EUR bn 2014 2015 2016E 2017F 2018F ■ 28 Feb: 4Q GDP and FY 2016 flash estimate ■ 7 Mar: 4Q GDP and FY 2016 detailed release ■ 31 Mar: FY 2016 Balance of Payments ■ 20 Apr: EDP notification GDP (EUR bn) 43.0 43.9 45.5 47.4 49.5 Population (mn) 4.2 4.2 4.2 4.2 4.1 10,146 10,419 10,875 11,375 11,950 GDP -0.4 1.6 2.7 2.7 2.9 Private Consumption -1.6 1.2 3.2 3.1 2.6 Fixed Investment -2.8 1.6 4.2 6.0 6.7 Public Consumption -0.8 -0.3 1.4 1.0 1.0 Exports 7.6 10.0 5.3 4.5 4.8 Imports 4.5 9.4 5.9 5.8 5.5 Monthly gross wage, nominal (EUR) 985 1,000 1,035 1,066 1,105 GDP per capita (EUR) Real economy, change (%) DOMESTIC DEMAND ACCELERATES Household Consumption Investments Net Exports 6 Government Consumption Inventories GDP 4 Real wage, change (%) 0.4 1.8 3.5 1.4 2.0 2 Unemployment rate (%) 17.3 16.3 13.7 12.0 10.9 0 Fiscal accounts (% of GDP) -1.6 -2 -4 Budget balance -5.4 -3.3 -2.1 -2.0 -6 Primary balance -1.9 0.3 1.3 1.3 1.6 -8 Public debt 86.6 86.7 85.2 83.6 81.5 Current account balance (EUR bn) 0.9 2.2 1.3 1.0 0.8 Current account balance/GDP (%) 2.1 5.1 2.8 2.1 1.7 Extended basic balance/GDP (%) 4.1 6.2 6.3 6.1 6.1 Net FDI (% of GDP) 1.9 0.4 2.2 1.9 2.2 108.4 103.8 96.8 94.4 91.9 12.7 13.7 14.0 14.8 15.8 8.0 7.9 7.8 7.7 7.6 -10 External accounts -12 -14 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 HEADLINE INFLATION TO REBOUND Gross foreign debt (% of GDP) 10 FX reserves (EUR bn) 8 Months of imports, goods & services 6 Inflation/Monetary/FX 4 CPI (pavg) -0.2 -0.5 -1.1 1.3 1.5 CPI (eop) -0.5 -0.6 0.0 1.7 2.0 3M money market rate (Dec avg) 1.08 1.24 0.90 0.90 1.00 USD/FX (eop) 6.30 6.99 7.08 6.88 6.49 EUR/FX (eop) 7.66 7.64 7.58 7.57 7.53 USD/FX (pavg) 5.75 6.86 6.79 6.98 6.62 EUR/FX (pavg) 7.63 7.61 7.53 7.51 7.49 104.1 100.4 104.9 106.9 107.9 -5.3 -3.6 4.5 1.9 0.9 2 Central bank target 0 Central bank reference rate (eop) Jan-18 Jan-17 Jan-16 Jan-15 Jan-14 Jan-13 Jan-12 Jan-11 Jan-10 Jan-09 Jan-08 -4 Jan-07 -2 Source: UniCredit Research Real effective exchange rate, 2000=100 Change (%) *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 36 Source: Eurostat, NSI, UniCredit Research See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Domestic demand recovery encouraged by tax reform With political uncertainty behind us, the policy support to the ongoing economic recovery is back in focus… …with tax reform and work on removing obstacles to business added to the fiscal consolidation efforts The recovery of the economy is continuing… …with private consumption accelerating thanks to rising employment, higher real wages, debt write-offs and income tax cuts… …as investment, now led by state-owned companies, should be boosted by rising EU fund absorption and easing of obstacles to business The recovery of the Croatian economy gained momentum through 2016 despite political uncertainty that dominated most of the year, thanks to both expanding domestic demand and the benefits of a strong tourism season. Fortunately, this uncertainty was replaced by a more stable environment after snap elections. Following the formation of the new government again around a coalition of two center-right parties, the largest one, HDZ, and the newest one, MOST, economic sentiment recovered,, reflecting the benefits of broad-based economic growth. The good news was that the new government continued to work on the reforms announced in the spring by the old government: tax reform and improvements in the business environment, while insisting on a fiscal policy that should result in a lower government deficit and public debt. During 2016, GDP growth accelerated to 2.9% yoy in 3Q, enjoying the benefits of larger investment in private tourist accommodation capacity in previous years as well as weaknesses in some of the major Mediterranean competitors hit by conflicts and migration. The strong 2016 tourism season provided a tailwind for further investment in capacity as the sector starts preparing for the 2017 season. However, growth in the tourism sector was accompanied by an across-the-board expansion in all sectors and expenditure components. Private consumption in 2016 has been supported by rising employment (1.8% yoy ytd), real wages (2.7% yoy ytd) and declining household indebtedness, especially after the write-offs of the principal of some housing loans as a result of the CHF loan conversion. These factors boosted private consumption growth to 3%+ yoy in 2016. Improved economic sentiment, combined with a decline in interest rates on savings, might trigger a decline in households’ gross saving rate, which reached more than 14% of disposable income in Croatia, well above the average for CEE and even above the levels in some old EU members. Implementation of tax reform during 2017 means cuts in personal income tax both through lower tax rates and widened tax brackets where a lower tax rate is implemented, giving an additional boost to private consumption and keeping the growth rate at the same levels as in 2016. Domestic demand should also be buoyed by the envisaged reduction in the corporate tax rate (from 20% to 18%, for SMEs to 12%). Investment already accelerated in 2016 following capital spending in state-owned companies and improved EU funds’ absorption. Ongoing progress on removing obstacles to business has also supported investment activity (and the government just announced improvements in public procurement, introducing more flexibility). The absorption of EU funding is an area where we already see progress and we expect further acceleration in the short term, as Croatia is still missing sustainable momentum in private investment, apart from that related to tourism. LABOR MARKET DEVELOPMENTS IMPROVE… Employment Labour force Unemployment rate (rs) …BOOSTING DOMESTIC DEMAND GROWTH. Real net wages 20 5 4 18 4 3 16 2 14 1 12 0 10 5 -1 8 -2 6 -3 4 -4 2 -5 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Real disposable income 3 2 1 0 -1 -2 -3 -4 -5 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: Crostat, European Commission, UniCredit Research UniCredit Research page 37 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Tax reform found solid ground on the basis of rising public revenues and both intentional and unintentional spending control The determination to advance tax reform has been underpinned by recent favorable fiscal developments. A significant decline in the government deficit was achieved already in 2015, when the former government was faced with challenging Excessive Deficit Procedure targets. More recently, budget revenues started benefiting from the upside in the economic cycle as revenue growth accelerated to 6% in 2016, in line with stronger GDP growth. At the same time, the government imposed tighter spending controls, albeit some of the spending restraint was unintentional and reflected budget rules during periods when caretaker governments were in charge. These developments should bring the cash government deficit in 2016 well below 2% of GDP. However, with government arrears on the rise (predominantly in the health sector), the deficit, based on ESA 2010 standard, is likely to surpass 2% of GDP. Budget proposal for 2017 sets ambitious target for revenue performance despite cut in income and corporate taxes… The 2017 budget is based on the same presumptions of strong growth of central government revenues (4.5%, including EU fund disbursements and based on the assumption of 3.2% real GDP growth). The government expects growth to accelerate thanks to strengthened private consumption and EU-funded investment growth. Faster growth is supposed to compensate for lower corporate and income tax rates. This approach should allow the government to plan bigger central government expenditures, rejecting the strategy of attaining fiscal consolidation through lower expenditure shares in GDP. The 2017 budget projects surpluses of extrabudgetary funds and of local government, enabling the general government deficit to still be lower than in 2016. The budget also targets a primary surplus, which ought to allow public debt to decline relative to GDP. …to allow deficit shrinkage and public debt ratio decline despite spending acceleration Such a plan is facing several risks… …as the government is facing demanding financing needs in 2017 but… …it can be met by more favorable Croatian risk premium after the recent improvements in the fiscal position, GDP growth, political outlook and rating outlook A number of risks are linked to such projections. First, we expect real GDP growth to be weaker in 2017 at 2.7% rather than the 3.2% assumed by the government, based on slower growth of private consumption, with tax reform likely to have a bigger impact on the income of the population with a higher propensity to save, and of investment as we still miss evidence of accelerated private investment. Real GDP growth will also be susceptible to uncertainty linked to the global trade outlook. Second, rising arrears might result from expanded expenditures (in terms of cash outlays) like on a few occasions in the past. Third, the government has envisaged moderate growth in employees’ compensation, while in the meantime reaching an agreement with trade unions for gradually phasing in a 6% increase in public sector salaries. Buoyant revenues in 2016 and the cash buffer, which the government created from 2015, allowed public debt to be financed without tapping international debt markets in 2016. We should not forget, however, that the redemption profile for 2016 was very light. However, funding needs for 2017 will be very challenging. The budget-funding plan for 2017 envisages large bond issuance on both the domestic market (equivalent to about EUR 1.9bn) and on international markets (EUR 1.5bn), along with stepped-up support from international financial institutions such as the World Bank. However, the implementation of this plan will be challenging given the potential rise in US interest rates and global long-term yields. BUDGET PROPOSAL EASED ON EXPENDITURES… 41 central government expenditures* …BUT STILL TARGETING LOWER DEFICITS. central government revenues* 10 39 general government deficit (ESA2010) primary balance 8 37 6 35 33 4 31 2 29 0 27 25 -2 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 * Excluding the operations of the Croatian Health Insurance Fund in 2015 UniCredit Research Source: Crostat, European Commission, UniCredit Research page 38 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Strategy Javier Sánchez, CEE Fixed Income Strategist (UniCredit Bank London) +44 207 826-6077 The ongoing fiscal in improvement should provide support for the bonds. The budget deficit will remain below 3% of GDP allowing the debt to GDP ratio to fall gradually. The redemption calendar for 2017 has the USD1.5 bn CROATI 17 maturing in April for which the MinFin is planning its financing via issuance of Eurobonds according to the budget plan depending on market conditions. Croatia hasn’t issued any USD Eurobonds since April 2013 and the international markets and current spread levels should be acceptable to the government for considering new issuance. [email protected] Croatia offers the highest EUR and USD spreads of any EU countries and we expect that the rating agencies will improve the foreign currency rating outlook during the year which will provide further support for the bonds. CROATIA AND OTHER SUB-IG CREDITS Z-SPREADS Croatia 2024 Russia 2023 DEBT SERVICE (IN USD MN EQUIVALENT) Turkey 2024 USD mn Eurobonds Government bonds T-bills 3000 400 2500 350 2000 300 Dec-17 Nov-17 Oct-17 Sep-17 Aug-17 Jul-17 Jun-17 May-17 Dec-16 Dec-16 Oct-16 Nov-16 Sep-16 Sep-16 Jul-16 Aug-16 Jul-16 Jun-16 May-16 Apr-16 May-16 Mar-16 Mar-16 Jan-16 Feb-16 0 Jan-16 150 Apr-17 500 Mar-17 200 Feb-17 1000 Jan-17 1500 250 Source: Bloomberg, central bank, MoF, UniCredit Research GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other GROSS EXTERNAL FINANCING REQUIREMENTS 2016F 2017F 2018F 8.4 1.0 7.4 6.5 0.5 3.7 2.3 0.9 0.8 0.1 8.4 7.4 1.3 3.8 2.2 0.2 0.0 0.2 0.8 10.2 0.9 9.2 6.9 1.3 3.9 1.8 2.3 2.2 0.1 10.2 7.2 1.9 3.9 1.5 1.9 1.5 0.4 1.0 8.5 0.8 7.7 6.4 0.8 3.9 1.7 1.3 1.2 0.1 8.5 6.9 1.6 3.9 1.5 1.3 1.0 0.2 0.4 EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net 2016F 14.4 -1.3 6.7 0.9 0.7 5.1 9.0 4.6 3.9 0.5 14.4 1.0 0.2 6.2 0.2 2.0 4.0 5.1 0.6 1.6 -0.3 2017F 10.7 -1.0 6.3 2.3 1.2 2.8 5.4 3.0 2.0 0.4 10.7 0.9 0.5 6.6 1.9 1.0 3.7 2.4 1.0 0.0 -0.8 2018F 8.1 -0.8 3.8 1.3 1.0 1.5 5.1 3.7 1.0 0.4 8.1 1.1 0.5 6.0 1.3 1.0 3.7 0.5 1.1 0.0 -1.0 n.a. 0.0 n.a. 0.2 n.a. 0.3 Source: CNB, Crostat, MoF, UniCredit Research UniCredit Research page 39 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Czech Republic (A1 stable/AA- stable/A+ stable)* Outlook – The Czech economy is heading for policy shifts in 2017 on several fronts, the end of the CNB’s EUR-CZK floor of 27.0 being the most important one. With headline inflation set to reach 2% yoy before mid-2017, we expect the CNB to exit its policy in 2Q17. Moderate tightening in monetary conditions may be offset by slight fiscal easing, leaving the GDP growth momentum broadly unchanged. Strategy – The end of interventions is set to terminate the recent outperformance of CZK bonds versus German Bunds, putting upside pressure on CZK bond yields for short-term tenors. Authors: Pavel Sobisek, Chief Economist (UniCredit Bank Czech Republic and Slovakia) Patrik Rozumbersky, Economist (UniCredit Bank Czech Republic and Slovakia) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS ■ CNB policy meetings: 2 Feb, 30 Mar ■ 4Q16 GDP: 14 Feb (flash), 3 Mar (structure), 31 Mar (accounts) ■ FX intervention exit: expected sometime in 2Q17 GDP GROWTH: STABLE DYNAMIC WITH A CHANGING STRUCTURE Contribution to GDP (pp) 5.0 Consumption Gross capital Export GDP (yoy %) 2.5 2015 2016F 2017F 2018F 156.6 167.0 174.1 183.6 193.0 Population (mn) 10.5 10.5 10.6 10.6 10.6 14,882 15,842 16,477 17,350 18,224 GDP 2.7 4.6 2.4 2.4 2.5 Private Consumption 1.8 3.1 2.7 3.0 2.2 Fixed Investment 3.9 9.1 -0.8 2.0 3.0 Public Consumption 1.1 2.0 2.4 2.3 1.5 Exports 8.7 7.9 3.8 2.7 4.0 Imports 10.1 8.4 3.0 2.9 4.0 Monthly wage, nominal (EUR) 936 970 1,020 1,092 1,144 Real wage, change (%) 2.5 2.4 3.8 2.7 1.8 Unemployment rate (%) 7.7 6.5 5.5 5.2 5.1 Budget balance -1.9 -0.6 0.3 -0.4 -0.5 Primary balance -0.6 0.4 1.1 0.4 0.4 Public debt 42.2 40.3 38.6 37.9 36.8 Current account balance (EUR bn) 0.3 1.5 4.0 3.2 3.5 Current account balance/GDP (%) 0.2 0.9 2.3 1.8 1.8 Extended basic balance/GDP (%) 4.0 3.3 7.3 6.1 5.9 Net FDI (% of GDP) 1.9 -0.6 2.9 2.3 2.2 Gross foreign debt (% of GDP) 68.3 68.7 78.9 78.1 75.1 FX reserves (EUR bn) 44.9 59.2 82.0 87.0 88.0 4.5 5.5 8.9 8.9 8.6 CPI (pavg) 0.4 0.3 0.6 2.0 2.2 CPI (eop) 0.1 0.1 1.6 2.2 2.2 Central bank target 2.0 2.0 2.0 2.0 2.0 0.05 0.05 0.05 0.05 0.50 GDP per capita (EUR) Real economy, change (%) External accounts 2013 2014 2015 2016F 2017F BOTH CPI AND PPI ARE HEADING TO 2% YOY BY MID-2017 CPI 5.0 PPI Corecast Months of imports, goods & services Inflation/Monetary/FX 2.5 0.0 Central bank reference rate (eop) -2.5 -5.0 Jan-14 2014 GDP (EUR bn) Fiscal accounts (% of GDP) 0.0 -2.5 EUR bn 3M money market rate (Dec avg) Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Source: Eurostat, UniCredit Research 0.34 0.29 0.29 0.30 0.80 USD/FX (eop) 22.83 24.82 24.15 23.04 22.03 EUR/FX (eop) 27.73 27.03 27.05 26.50 26.00 USD/FX (pavg) 20.75 24.60 24.41 23.25 22.29 EUR/FX (pavg) 27.53 27.28 27.10 26.50 26.30 Real effective exchange rate, 2000=100 105.2 105.3 106.4 108.7 110.8 -0.3 0.1 1.0 2.2 1.9 Change (%) *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 40 Source: Eurostat, CNB, UniCredit Research See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Heading for policy shifts Shifts in economic policies expected in 2017 After several years of relative stability in economic policies, the Czech economy is heading for policy shifts in 2017 on several fronts. With the unemployment rate sinking below 5% (4.9% for November 2016), the mounting labor shortage is pushing up wages and may boost corporate investment, leading, in turn, to productivity gains. Inflation is seen moving up as a result of not only wage pressure but also a cyclical upturn in prices of food and fuels. The on-line reporting system for restaurants and retail sales - the key policy measure introduced to fight tax avoidance - may contribute a bit to higher inflation as well. The inflation uptick will fulfill the CNB’s key condition to exit its FX intervention policy. The underlying tightening of monetary conditions will be offset by fiscal easing, as public-funded investment is set to recover from a low level in 2016. In addition, the Social Democrats are expected to push for generous social policies in the run-up to general elections to be held in autumn 2017, which may ease fiscal policy in 2018. Nominal wage growth at close to 5% yoy is believed to be sufficient for private consumption to avoid a slowdown despite higher inflation in 2017. Thus, private consumption growth (+3% yoy) could remain the key contributor on the demand side to a GDP expansion of 2.4%. Fixed capital formation is projected to resume growing in 2017, although the pace is uncertain. On the one hand, manufacturers are optimistic about their investment in modernization and costsaving measures (albeit less so in extending their production base) and some infrastructure projects are also expected to proceed. On the other hand, investment in transport equipment may slow after two solid years, and so will housing projects (where both demand and supply constraints could emerge). In 2018, domestic demand is seen expanding at a pace broadly unchanged from 2017. Private consumption and fixed capital formation are expected to support GDP growth Slow growth for exports… Exports will contribute less to GDP growth in 2017 and in 2018, despite receiving support from the expected rebound in global trade. Demand for new cars in Europe provided a big boost to Czech exports in recent years. With that demand getting close to saturation after more than three years of uninterrupted growth in the number of car registrations in Europe, we believe that Czech exports may only grow marginally above the pace of global trade. The situation reminds us a bit of 2013, when Czech exports stagnated. Our export growth forecast of 2.7% for 2017 means net exports will cease to contribute to GDP growth …and industrial output On the production side, industrial output growth could slow down further to 2.5% in 2017 before picking up slightly to 3% in 2018. GDP growth will rely more than in 2016 on construction, trade (probably helped by potential currency appreciation) as well as business services (ICT in particular should continue expanding). Czech manufacturing PMI has sunk below German PMI Germany 58 Outperformance of Czech over global export yoy dynamics is over Jan 2013=100 Czech CZ exports, MA(3) World exports 125 120 115 54 110 105 50 100 46 Jan-13 Aug-13 Mar-14 Oct-14 May-15 Dec-15 95 Jan-13 Jul-16 Aug-13 Mar-14 Oct-14 May-15 Dec-15 Jul-16 Source: Markit, CPB World Trade Monitor, Eurostat, UniCredit Research UniCredit Research page 41 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly The EUR-CZK floor could be abandoned in 2Q17 The end of the CNB’s EUR-CZK floor of 27.0 is set to be the key policy event of the year. Of the two potential obstacles to the CNB’s exit, i.e. low inflation and the ECB’s QE, the former is probably almost gone. We expect headline inflation to reach 2% yoy before mid-2017, with higher core inflation adding to food and fuel price inflation. As to the ECB, the issue is how its QE extension will be interpreted by the CNB’s MPC. Comments made ahead of the extension nevertheless tended to play down the ECB as a factor for CNB policy. This makes us believe that the exit from interventions is more likely to come in 2Q17 than in 3Q17. More specifically, our preferred scenario is that of an early April exit, which would minimize the spell of uncertainty after expiration of the CNB hard commitment at the end of 1Q16. The decision would be based on the inflation outlook to be released in early February, with inflation data for January and February expected to support the decision. The CNB may resume interventions should EUR-CZK drop below 25.0 If EUR-CZK appreciates, we expect verbal interventions below EUR-CZK 25.50 and actual interventions if EUR-CZK drops to 25.00. In the logic of the CNB model, the EUR-CZK at 25.00 would correspond to five 25bp repo rate hikes, which appears to be significant tightening. The CNB may prefer not to intervene during the initial market reaction and wait for a significant portion of investors to take profits before correcting a potential excessive appreciation of the CZK. Moreover, fine-tuning real monetary conditions using a managed float may prove a difficult task. Once investors start taking profits on their positions, we expect EUR-CZK to return towards 26.5, given the shallow local market and the lack of euros. After that, EUR-CZK could appreciate gradually towards 26.00 in 2018, a move equivalent to approximately 60bp in interest rate increases. This would leave monetary conditions laxer than at the time when the EUR-CZK floor was introduced. The CNB may hike a couple of months later than its current forecast suggests We do not expect any rate hike in 2017 if the CZK appreciates by more than 5%. The current CNB model assumes 3M Pribor a full percentage point above its current level by end-2017 on the condition that there would be no CZK appreciation. In reality, our envisaged EUR-CZK path would be consistent with a couple of 25bp repo rate hikes by the end of 2017. However, the CNB may delay the start of rate increases by several months, taking into account both the ECB’s easing and the risk of CZK firming later. Taxes and social security are set to be the key general election topics As a policy issue unrelated to the CNB, tax and social security issues appear to be the main topics in the run-up to next autumn’s general elections. With exact campaign agendas yet to be formulated, the Social Democrats (CSSD) have started to speak out about progressive tax rates being implemented for individuals as well as companies. In contrast, the ANO movement promises to reduce social contributions paid by low-earners, thereby boosting their disposable income. ANO has lately taken a 10pp lead over CSSD in opinion polls, with no other party strong enough to challenge the two. So far, euro adoption has been completely ignored as a campaign topic. Unless this changes unexpectedly in the next couple of months, a decision on the euro is not to be expected before 2021. Productivity gains are poor both per employee and per hour,… yoy Productivity/employee …while unemployment hit a long-term low and vacancies soar Productivity/hour Unemployed local 5.0% 2.5% Vacancies - rs 650 persons in '000 20.0 590 46.0 530 72.0 470 98.0 410 124.0 0.0% -2.5% -5.0% 1Q12 3Q12 1Q13 3Q13 1Q14 3Q14 1Q15 3Q15 1Q16 350 Jan-13 3Q16 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 150.0 Source: Eurostat, UniCredit Research UniCredit Research page 42 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly CNB reserves set to exceed 50% of GDP FX hedging activity will drive CNB reserves further up in early 2017 Over the four months ending in November 2016, the CNB added EUR 9.2 billion to its FX reserves via interventions. While part of the pressure on CZK came from exporters’ hedging, foreign purchases are believed to be the main culprit. In a similar vein, the share of CZK government bonds held by non-residents jumped to 30.6% in November. The level of CNB reserves amounted to 46% of annual GDP at the end of November despite signs of purchases easing. With the assumed end of CNB interventions coming closer, we expect FX hedging activity to intensify in the first months of 2017. CNB reserves will likely exceed an equivalent of 50% of GDP by the time the intervention policy will be discontinued. The end of interventions is set to terminate the recent outperformance of CZK bonds versus German Bunds, putting upside pressure on CZK bond yields for short-term tenors in 2017. More upside pressure, spread over the whole curve, may come in 2018 when refinancing needs are set to rise. The third wave of CNB interventions was the highest Accommodative monetary conditions will continue until late 2018 CZGB net purchases by non-residents (CZK bn) Real monetary condition index CNB FX purchases (CZK bn) 120 CNB repo rate (%, rs) 3.0 1.0 Restrictive 2.0 0.5 90 1.0 60 0.0 30 -1.0 0 -2.0 0.0 -0.5 -30 Accommodative Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 -3.0 Dec-12 Oct-16 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 -1.0 Dec-18 Source: CNB, UniCredit Research GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other GROSS EXTERNAL FINANCING REQUIREMENTS 2016F 2017F 2018F 13.0 -0.3 13.3 12.7 9.5 3.2 0.1 0.6 0.5 0.1 13.0 12.4 9.1 3.3 0 0.6 0.5 0.1 0 11.2 0.9 10.3 10.2 8.2 1.9 0.1 0.1 0 0.1 11.2 11.0 8.1 2.9 0 0.2 0.0 0.2 0 15.2 1.5 13.7 11.6 9.5 1.9 0.2 2.1 2.0 0.1 15.2 14.6 10.8 3.8 0 0.6 0.5 0.1 0 EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- = increase) Source: CNB, MoF, UniCredit Research Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net UniCredit Research page 43 2016F 57.3 -3.0 7.7 0.5 4.5 2.7 52.6 0.1 29.8 22.7 57.3 5.0 2.5 14.2 4.3 3.9 6.0 53.8 3.7 0 -21.9 2017F 58.4 -2.9 7.9 0 5.1 2.8 53.4 0.1 30.3 23.0 58.4 4.1 1.5 11.7 0 5.4 6.3 42.3 3.7 0 -5.0 2018F 61.1 -2.7 10.0 2.0 5.0 3.0 53.8 0.1 30.5 23.2 61.1 4.2 0.5 9.5 0.5 4.0 6.9 45.2 3.8 0 -2.0 3.8 0 -1.5 0 0 0 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Hungary (Baa3 stable/BBB- stable/BBB- stable)* Outlook – Growth should accelerate to 3% in 2017 and 3.1% in 2018, helped by EU funds, strong consumption and a positive fiscal impulse. The budget deficit will widen temporarily in pre-election year 2017, but public debt will continue to fall as a percent of GDP. The NBH is expected to remain on hold in 2017-18, despite inflation returning to target. Risks stem from US economic and monetary policies, volatile appetite for EM assets, and EU politics. Strategy – EUR-HUF could trade range-bound in 2017-18. Hungary is expected to sell a EUR bond this year, with a maturity of at least 10Y. HGB belly will remain supported by monetary policy. Authors: Dan Bucșa, Lead CEE Economist (UniCredit Bank London) Ágnes Halász, Chief Economist, Head of Economics & Strategic Analysis (UniCredit Bank Hungary) MACROECONOMIC DATA AND FORECASTS EUR bn 2014 2015 2016F 2017F 2018F GDP (EUR bn) 105.0 109.7 112.8 118.9 126.0 9.9 9.9 9.8 9.8 9.8 10,593 11,108 11,454 12,113 12,879 GDP 4.0 3.1 2.2 3.0 3.1 Private Consumption 2.5 3.4 5.1 4.5 3.7 Fixed Investment 9.9 1.9 -9.8 6.2 4.6 Public Consumption 4.4 0.9 2.0 2.4 1.7 Exports 9.8 7.7 6.2 5.7 6.3 Imports 10.9 6.1 7.0 6.2 6.6 4.0 Monthly wage, nominal (EUR) 770 800 861 912 966 3.0 Real wage, change (%) 3.3 4.4 7.8 2.9 3.1 2.0 Unemployment rate (%) 7.9 6.9 5.3 4.7 4.6 1.0 Fiscal accounts (% of GDP) -2.0 KEY DATES/EVENTS ■ 24 Jan, 28 Feb, 28 Mar: NBH monetary policy meetings ■ 14 Feb, 7 Mar: 4Q16 GDP (flash, structure) ■ 25 Jan, 1 Mar, 29 Mar: 3M deposit tenders Population (mn) GDP per capita (EUR) Real economy, change (%) GDP GROWTH FORECAST 5.0 yoy (%) Net exports Fixed investment Private consumption Change in inventories* Public consumption GDP 0.0 Budget balance -2.1 -1.6 -2.0 -2.4 -1.0 Primary balance 1.9 2.0 1.2 0.8 1.2 -2.0 Public debt 75.7 74.7 73.2 72.7 70.2 Current account balance (EUR bn) 2.2 3.7 5.0 5.1 5.3 Current account balance/GDP (%) 2.1 3.4 4.4 4.3 4.2 Extended basic balance/GDP (%) 8.5 8.3 9.0 10.1 10.0 -3.0 2014 2015 2016E 2018F 2017F INFLATION FORECAST yoy (%) Annual inflation rate Base rate Inflation target Target range External accounts Net FDI (% of GDP) Gross foreign debt (% of GDP) 2.7 0.4 2.1 2.3 2.2 116.7 107.7 98.6 94.3 89.3 33.7 30.0 26.0 30.1 34.7 4.7 4.0 3.4 3.7 4.0 5 FX reserves (EUR bn) 4 Months of imports, goods & services 3 Inflation/Monetary/FX 2 CPI (pavg) -0.2 -0.1 0.5 3.0 2.9 1 CPI (eop) -0.9 0.9 1.7 3.0 2.6 0 Central bank target 3.0 3.0 3.0 3.0 3.0 2.10 1.35 0.90 0.90 0.90 Central bank reference rate (eop) -1 -2 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Source: CSO, UniCredit Research 3M money market rate (Dec avg) 2.10 1.35 0.41 0.45 0.45 USD/FX (eop) 259.1 286.6 293.7 284.5 271.6 EUR/FX (eop) 314.9 313.1 311.0 313.0 315.0 USD/FX (pavg) 232.6 279.3 281.5 290.6 275.4 EUR/FX (pavg) 308.7 309.9 311.8 312.1 312.5 Real effective exchange rate, 2000=100 126.9 126.6 127.5 127.8 129.6 -3.8 -0.3 0.7 0.2 1.4 Change (%) *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 44 Source: EcMin, NBH, CSO, UniCredit Research See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Better growth ahead Hungary enters 2017 as an investment-grade country after a six-year hiatus. The impressive adjustment in stock imbalances is expected to continue as budget deficits are reined in and the extended basic balance (EBB) remains in surplus. Moreover, 2017 should mark a rebound in GDP growth triggered by larger EU fund inflows. Risks stem from US economic and monetary policies, swings in appetite for EM assets, and EU politics. Economic growth to accelerate to 3% in 2017… GDP growth should rebound to 3.0% in 2017 as EU fund inflows recover, leading to the fastest growth in fixed investment across CEE. Besides EU-funded projects, large investment at car companies will add to capex growth. The downside is the expected loss of a shift at the Audi plant, which will affect industrial production and exports for most of 2017. That said, export growth is expected to rebound after a weak 2H16, in line with robust demand from the eurozone, especially Germany. Strong sales abroad should offset larger imports, keeping the trade balance above 10% of GDP. …helped by investment and public spending… The government will play a major role in boosting growth, with the budget deficit expected to widen to 2.4% of GDP (3.1% on cash basis) in pre-election year 2017. Most of 2016’s budget deficit was incurred in the second half of December, impacting growth in 2017. Households will benefit the most from larger social security transfers and support for the housing market, with private consumption growing by an average of 4% per year in 2017-18. At the same time, companies will get a boost in 2017 (estimated by the government at HUF 145bn or 0.4% of GDP) from a cut in the corporate tax rate to 9%, the lowest level in the EU. Next year, growth could accelerate slightly to 3.1%. EU funds, real revenue growth, lax real monetary conditions and the second-round effects of 2017’s fiscal easing will boost domestic demand. Meanwhile, the trade surplus could increase again owing to new production capacities for car manufacturers, as long as European demand remains robust. Two consecutive years of above-potential growth (which we estimate at around 2.5%) should open up a positive output gap that will accelerate the rise in core inflation. …with EU fund inflows increasing this year and next Reflation could accelerate in 2017 amid base effects from oil prices and a weaker EUR, as well as higher core inflation. As a result, annual inflation may temporarily exceed the 3% target in 1Q17 and remain close to this level throughout this year and next. Imported inflation from the eurozone could continue to mitigate part of demand-side pressure on prices. That said, headline inflation may test the upper limit of the 2-4% target range if the EU removes sanctions on Russia, triggering a faster rise in food prices throughout central Europe. Inflation will remain inside the target range ECONOMIC GROWTH IS EXPECTED TO ACCELERATE THIS YEAR The 2017 fiscal impulse* will be the largest since 2011 % of GDP 4 Fiscal impulse Industry and construction will drive the growth rebound in 2017 % yoy, pp of GDP Output gap 5 3 Net taxes Real estate services Market services Industry GDP Other services Financial services Construction Agriculture 4 2 3 1 2 0 1 -1 0 -2 -1 2014 2015 2016 2017 2018 *We assume that most spending incurred in December 2016 will impact growth in 2017. UniCredit Research page 45 2014 2015 2016F 2017F 2018F Source: CSO, EcMin, UniCredit Research See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly The NBH could ease further by increasing the liquidity surplus The NBH is unlikely to increase the base rate in 2017 and 2018, unless inflation exceeds the target range. Moreover, the central bank may loosen liquidity conditions further by capping 3M deposits at HUF 750bn (at most) in 1Q17. The gradual increase in the structural liquidity surplus pushed interbank interest rates below the policy rate. This wedge is expected to widen further, at least in 1H17, lowering borrowing costs in HUF. The main beneficiaries are likely to be households, the real estate sector and SMEs, while larger companies may continue to rely mostly on their own liquidity or on funding from parent companies. A large, positive EBB will facilitate external deleveraging After falling temporarily in 2016, the EBB is expected to rise to 10% of GDP this year amid a recovery in EU fund inflows and FDI. A large EBB doubled by slow releveraging may push external debt to below 90% of GDP in 2018. A temporary increase in the budget deficit in 2017… Public-sector deleveraging will be slower, but will continue despite a larger budget deficit in 2017. Moreover, most one-off budget revenues may be used to reduce public debt further. We expect fiscal policy to tighten again after next year's parliamentary elections. This can be achieved even if Hungary increases EU-fund cofinancing in an attempt to draw down most available European funding before the end of next year. The focus on covering public financing needs on the local market will be maintained. Demand for retail bonds is expected to grow further as banks slash deposit rates. Reflation may increase the attractiveness of inflation-linked bonds, such as the PEMAKs, after poor demand in 2016. …will still allow for a reduction in the debt to GDP ratio Nationalism and euro-skepticism will be prominent before elections In the run-up to general elections, the ruling Fidesz is likely to intensify its nationalist rhetoric as it tries to poach voters from the second-largest party in the country, the far-right Jobbik. The eurosceptic, nationalist stance of Fidesz contrasts with Hungary’s reliance on funding and demand from the EU, which will remain the main growth drivers in 2017 and 2018. Fidesz is likely to win another outright majority, even though a constitutional majority would need temporary support from Jobbik. Meanwhile, the political left remains divided. Even an alliance of most left-wing parties may struggle to get 25% of the vote, according to opinion polls. External risks stem from US policies, … Faster growth in the US amid laxer fiscal policy from the Trump administration could benefit European (including Hungarian) exports, as long as trade barriers are not considered. At the same time, rate increases by the Fed may lead to outflows from EM assets, slowing the flattening of the HGB curve. 2017 will be a busy election year in the eurozone, with France, Germany and the Netherlands going to the polls. While we believe that threats to EU cohesion are not significant at this stage, the advancement of populism and the reversal of globalization threaten growth in open economies such as Hungary’s. ...European elections… …and the reversal of globalization THE EXTERNAL DELEVERAGING IS SUPPORTED BY LARGE EBB AND RETAIL BOND ISSUANCE The extended basic balance will dwarf bank deleveraging Investment funds Foreign investors Banks % of GDP, 4Q MA 12 Households hold as much in bonds as foreign investors Insurance & pension funds Households % of GDP 55 9 Public sector Insurance & pension funds Households NBH 50 45 6 40 35 3 30 25 0 20 -3 15 -6 5 -9 Others Investment funds Foreign investors Banks 10 0 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 1Q12 4Q12 3Q13 2Q14 1Q15 4Q15 3Q16 2Q17 1Q18 4Q18 Source: AKK, NBH, UniCredit Research UniCredit Research page 46 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly More curve flattening in the belly EUR-HUF could trade rangebound in 2017 and 2018 With external deleveraging continuing, we expect appreciation pressure on the HUF to re-emerge periodically. The NBH is fighting this by loosening real monetary conditions, but low interest rates may not be sufficient to depreciate the HUF. As a result, we expect EUR-HUF to trade in a 305-320 range for most of 2017 and 2018. Spikes may be caused by temporary swelling of liquidity surpluses if the central bank chooses not to sterilize them. Hungary is expected to return to EUR bond markets this year and we expect good demand and a maturity of at least 10Y. The short end and the belly of the HGB curve should remain well supported by lax monetary policy and demand from local banks, even if inflation rebounds toward the target. The longer end remains a play on risk appetite for EM assets. A new EUR bond is in the pipeline The HGB 21/B offer a pickup over the HGB 19/C offer a pickup of about 80 bp which we think is interesting and both bonds are included in major indices. The gap between the two may narrow between 20-30bp as domestic banks extend duration. The structural liquidity surplus is rising in the money market HGB yield curve to compress more in the belly Repos (inverse sign) Excess reserves O/N deposits Net liquidity balance (HUF bn, - = deficit) 1W HUFONIA - base rate (%, inverted, rs) 800 5 600 -0.8 400 -0.6 200 -0.4 0 -0.2 28-Dec 14-Dec 30-Nov 16-Nov 19-Oct 02-Nov 05-Oct 21-Sep 07-Sep 24-Aug 27-Jul 10-Aug 13-Jul 29-Jun 15-Jun 01-Jun 18-May 0.4 20-Apr -600 04-May 0.2 06-Apr -400 23-Mar 0.0 09-Mar -200 As As of of Jan Jan 3, 3, '17 '17 As As of of Sep Sep 30, 30, '16 '16 As As of of Jun Jun 30, 30, '16 '16 4 -1.0 HUF YTM (in %) HUF bn 3 2 1 0 -1 0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 10 10 Modified Modified Duration Duration Source: NBH, MinFin, UniCredit Research GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans & retail securities External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans & retail securities External borrowing Bonds IMF/EU/Other IFIs Change in fiscal reserves (- = increase) GROSS EXTERNAL FINANCING REQUIREMENTS 2016F 2017F 2018F 20.7 2.7 18.0 13.8 3.8 2.8 7.1 4.2 1.6 2.6 20.7 20.0 6.1 3.1 10.8 1.2 1.0 0.2 -0.3 25.3 3.7 21.6 19.4 4.5 2.9 12.0 2.3 0.6 1.6 25.3 25.2 7.1 3.4 14.7 1.0 1.0 0 -0.9 26.4 2.5 23.9 21.6 4.7 3.4 13.5 2.2 0.3 1.9 26.4 25.1 7.6 2.5 15.0 1.3 1.0 0.3 0.3 EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net Source: NBH, EcMin, UniCredit Research UniCredit Research page 47 2016F 16.5 -5.0 7.2 3.6 1.8 1.8 14.3 3.0 6.2 5.1 16.5 2.1 -1.3 2.1 -0.2 0.5 1.8 6.8 2.8 0 4.0 2017F 10.8 -5.1 8.1 2.6 3.7 1.8 7.8 1.9 1.9 4.1 10.8 2.3 -0.3 3.3 1.0 0.4 1.9 5.6 4.1 0 -4.1 2018F 10.5 -5.3 9.3 4.4 3.8 1.1 6.6 1.5 0.9 4.1 10.5 2.2 0 3.1 1.6 0.4 1.2 4.9 4.8 1.0 -4.5 -1.4 -0.6 0 0.4 0.3 0.7 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Poland (A2 negative/BBB+ stable/A- stable)* Outlook – Economic growth is expected to rebound this year on the back of larger EU fund inflows and the start of large FDI projects. Private consumption will grow strongly this year before moderating in 2018 due to base effects. Fiscal risks may lead to an uncertain tax outlook that, in turn, may weigh on private-sector investment. Inflation is likely to rise to 2% this year, remaining below the 2.5% target in 2018. We expect three rate increases in 2018 in the absence of large negative growth shocks and sharp PLN appreciation. Strategy - We expect EUR-PLN to fall towards 4.25 in 2017 as growth rebounds in 2H17 and FX flows increase on the back of FDI and EU funds. Tighter monetary conditions in the US and large financing needs at home may prevent a flattening of the POLGB curve. Author: Marcin Mrowiec, Chief Economist (Bank Pekao) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS ■ 10-11 Jan, 7-8 Feb, 7-8 Mar: MPC decision-making meetings ■ 8 Mar: Inflation Projection (key figures), full document released on 10 or 13 March ■ 26-31 Jan: 2017 GDP release (whole year flash), 15 Feb: 4Q16 GDP flash, 28 Feb: Full GDP data for 2016 Public consumption Inventories GDP pp (contribution to GDP growth) 6 4 3.3 5.0 3.7 1.6 3.9 2.7 1.4 3.0 3.4 2 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F HEADLINE INFLATION VS. TARGET CPI (%, yoy) Target range 6 2016F 2017F 2018F 429.8 425.9 448.5 489.1 Population (mn) 38.5 38.5 38.5 38.5 GDP per capita (EUR) 10,672 11,164 11,066 11,657 38.5 12,719 Real economy, change (%) GDP 3.3 3.9 2.7 3.0 3.4 Private Consumption 2.7 3.2 3.6 3.7 3.0 10.0 6.1 -5.2 -0.8 8.0 Public Consumption 3.7 2.3 3.5 3.5 2.5 Exports 6.7 7.7 7.7 5.3 6.0 Imports 10.0 6.6 7.7 5.0 7.0 Monthly wage, nominal (EUR) 948 979 978 1041 1122 Real wage, change (%) 3.8 4.4 4.7 3.5 3.4 Unemployment rate (%) 12.3 10.5 9.0 8.3 8.1 Budget balance -3.4 -2.6 -2.6 -2.8 -2.8 Primary balance -1.4 -0.8 -0.9 -1.2 -1.3 Public debt 50.2 51.1 53.8 55.8 55.8 Current account balance (EUR bn) -8.5 -2.6 -2.9 -3.3 -8.5 Current account balance/GDP (%) -2.1 -0.6 -0.7 -0.7 -1.7 Extended basic balance/GDP (%) 2.7 3.8 2.3 3.0 2.1 Net FDI (% of GDP) 2.4 2.1 1.9 2.0 2.0 Gross foreign debt (% of GDP) 71.4 70.3 70.8 67.6 62.4 FX reserves (EUR bn) 82.6 86.9 102.9 95.4 93.8 5.2 5.2 6.0 5.2 4.7 CPI (pavg) 0.0 -0.9 -0.6 1.6 2.0 CPI (eop) -1.0 -0.5 0.2 2.1 1.7 Central bank target 2.50 2.50 2.50 2.50 2.50 Central bank reference rate (eop) 2.00 1.50 1.50 1.50 2.25 3M money market rate (Dec avg) 2.06 1.73 1.73 1.86 2.55 USD/FX (eop) 3.51 3.90 4.18 3.70 3.57 EUR/FX (eop) 4.26 4.26 4.42 4.25 4.20 USD/FX (pavg) 3.16 3.77 3.94 3.79 3.59 EUR/FX (pavg) 4.19 4.18 4.36 4.31 4.22 110.9 110.3 105.9 105.9 108.7 2.0 -0.6 -4.0 -0.0 2.6 Fiscal accounts (% of GDP) Months of imports, goods & services Inflation/Monetary/FX 5 4 3 2 1 0 -1 -2 2010 2015 410.9 External accounts 0 -2 2014 GDP (EUR bn) Fixed Investment GDP COMPONENTS Household consumption Fixed investments Net exports EUR bn 2011 2012 2013 2014 2015 2016 2017 Source: CSOP, NBP, UniCredit Research Real effective exchange rate, 2000=100 Change (%) Source: CSOP, NBP, MinFin, UniCredit Research *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 48 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly In need of larger investment Economic growth is expected to accelerate to 3.0% in 2017, after dipping to approximately 2.7% in 2016. Last year, growth had to rely overwhelmingly on robust private consumption growth amid fast revenue growth and larger fiscal transfers (of which the “Family 500+” child subsidy program is the most important). At the same time, low EU fund inflows weighed on investment growth far more than expected. 2018 and 2019 will see a significant acceleration in EU co-financed investment that may push GDP growth to 3.4% if private investment rebounds as well. Beyond 2019, a sharp drop in EU fund inflows will require a coordinated strategy to spur domestic and foreign investment in order to offset the negative impact on potential growth. Absent such measures, economic growth is likely to decelerate towards 2.5% (or lower) at the end of the decade. A rebound in EU fund inflows… … may offset slower consumption growth… … but an uncertain regulatory outlook could weigh on privatesector investment Tight labor market conditions will continue to support private consumption growth, which will remain the main growth driver in 2017. A cyclical improvement in labor demand adds to a structural decline in available labor supply due to an ageing population, pushing the unemployment rate to 8.1% by the end of 2017 and 8.0% at end-2018, still above NAWRU (estimated by the NBP at 6.4% in 2017 and 6.1% in 2018), and increasing the pressure on wage growth. In 2017, the pace of growth of employment in the corporate sector may slow down to 2.1% (from 2.9% in 2016), but there will be increasing pressure on wages, pushing their growth up to 5.2%, from 4.1% yoy in 2016. As inflation picks up, the real wage bill growth in the corporate sector will slow from 7.8% yoy in 2016 to 5.7% in 2017. In 2018, wages are expected to increase by 5.5%, also because the pool of available workers will be shrinking. Hence, we anticipate employment growth to slow down to just 0.5% yoy. Private consumption growth is likely to decelerate to 3.0% in 2018, after 3.6% and 3.7% in 2016 and 2017, respectively, as the impact of the 500+ program disappears. Private investment is expected to stay relatively flat in 2017 - although we expect annual growth rates to turn slightly positive in 2H17. High capacity utilization could push more companies to increase capital expenditure. In addition, investment could be boosted by some recently-announced big-ticket FDI projects from Daimler-Chrysler, Fiat, Toyota and Rolls Royce (aviation). The key reason for weak private investment is the high level of regulatory uncertainty. The government decided in December 2016 not to unify the personal income tax with health and social security contributions in 2018, after pondering such a move for most of last year. A clearer tax outlook should help private investment accelerate gradually. Any further delay in private-sector investment threatens growth in the coming years as the economy runs out of unused production capacity. Aggregate wage growth in the economy propels consumption growth Increasing demand boosts rising corporate sector employment real retail sales (%, yoy, 3-month average) real wage bill (%, yoy, 3-month average) 12 Non-subsidized job offers (k, yoy) Employment in the corporate sector (%, yoy, rs) 40 10 8 30 6 8 20 4 6 10 2 4 0 0 2 0 -2 -4 2009 -10 -2 -20 -4 -30 -6 -40 2002 2010 2011 2012 2013 2014 2015 2004 2006 2008 2010 2012 2014 2016 -8 2016 Source: CSOP, UniCredit Research UniCredit Research page 49 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly There is a strong political commitment to keeping the budget deficit below 3% and avoiding a return to the excessive deficit procedure. That said, the 2017 budget is based on optimistic assumptions regarding economic growth and budget revenues. At the same time, mitigating measures in case of negative surprises are small. The most important may be solid NBP profit in 2016 that could boost government revenues this year. If the government’s assumptions prove too optimistic, the risk of an uncertain tax environment will remain elevated. 2017 net borrowing needs are set to increase by ca. 20% vs. 2016 We expect total net borrowing needs for 2017 at PLN 69.4bn (EUR 16.0bn), almost flat vs. PLN 67.7bn in 2016. Gross borrowing needs are forecasted at PLN 165.3bn this year vs. PLN 181.5bn in 2016, falling by 1.2pp to 8.6% of GDP in 2017. The government intends to finance net borrowing needs predominantly on the domestic market by issuing fixed-rate T-bonds. A better-than-expected budget execution in 2016 allowed the government to cover some of spending initially planned for 2017. Inflation is likely to approach the 2.5% target by end-2018 Headline inflation is expected to rise to 2.1% by end-2017 from 0.2% in December 2016, approaching the 2.5% target by end-2018. Our forecast for average inflation is 0.3pp and 0.5pp higher than the NBP’s for 2017 and 2018, respectively, due to rising inflationary pressure as past supply-side shocks are reversed. Higher commodity and energy prices pushed the PMI sub-index for input prices to the highest level since 1H12 and should translate into both output and consumer prices. PPI inflation turned positive in September 2016 and is expected at 1.7% yoy by the end of 2017. In addition, higher oil prices lead to higher global food prices (as seen, e.g., via the FAO index) and should accelerate food price reflation in Poland. Core inflation is also likely to rebound in 2017 as wage growth accelerates further. NBP President Adam Glapiński has stated repeatedly that interest rate increases will probably be discussed in late 2017. This would be in line with inflation re-entering the target range (1.5-3.5%) in mid-2017. We expect three rate increases in 2018, but the decision to tighten will have to take into account ECB policies (low rates and a potential extension of QE to 2018), as well as broader real monetary conditions. In 2016, the hawkish tone of the MPC was supported by currency undervaluation. Adjusted with unit labor costs, the real effective exchange rate of the PLN is at its weakest level since the financial crisis. In central Europe, only the CZK has weakened more since 2010. We expect rate increases only in 2018 If economic growth disappoints in early 2017 (when we expect it below 3% yoy) and the PLN firms from current levels, the MPC may have to moderate its hawkish tone. That said, outright rate cuts are excluded in our baseline scenario, since they would do little to boost investment, while affecting savings. Only sharp PLN appreciation could push the MPC to lower rates. INFLATIONARY PRESSURE WILL RISE IN 2017 Commodity and energy price increases are pushing input prices up 80 PMI, output prices pts Food prices (almost 25% of CPI basket) will likely push CPI up PMI, input prices FAO index (yoy, USD-PLN adjusted) 75 70 CPI food (%, yoy, rs) 40 10 30 8 6 20 65 4 10 60 2 55 0 50 -10 -2 -20 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 -4 45 40 2010 2011 2012 2013 2014 2015 0 2016 Source: Markit, FAO, CSOP, UniCredit Research UniCredit Research page 50 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Range-bound PLN, POLGBs likely to stay under pressure We expect gradual PLN appreciation in 2017 EUR-PLN is expected to trade in the 4.35-4.50 range during 1H17 as growth and inflation remain low. Accelerating growth later in 2017 could support the PLN and we look for gradual appreciation towards EUR-PLN 4.25 by end-2017. We maintain the view that EUR-PLN levels above 4.40 are an opportunity to go short EUR-PLN. We see room for a steeper POLGBs curve in the coming months. Short-term T-bonds should be stable within the range of 1.90-2.10% in 1H17. Expectations of a long period of flat NBP rates should support this scenario. However, if the Ministry of Finance focuses on this sector on the primary market, yields could increase even at the short end and the belly. We expect more volatility at the long end, mainly due to the Fed’s normalization of interest rates. Risk-off episodes and a lower level of pre-financing than in previous years may also push yields higher. Thus, 10Y yields could rise to 3.80-4.00% by mid-2017. Higher levels are possible if risk appetite for EM bonds is low. Tighter monetary conditions in the US and large financing needs at home may weigh on POLGBs PLN vs. FX financing of net borrowing needs of the state budget non-PLN financing Change of POLGB holdings of various types of investors PLN instruments financing 80 70 70 60 60 50 2014 2015 Jan-Nov 2016 40 50 30 40 20 30 10 20 0 10 0 PLN bn -10 2010 2011 2012 2013 2014 2015 2016 Banks Foreign investors Insurance Investment funds 2017 Source: MinFin, UniCredit Research GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans/Other External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans/Other External borrowing Bonds and loans IMF/EU/Other IFIs Privatization/Other GROSS EXTERNAL FINANCING REQUIREMENTS 2016F 2017F 2018F 41.7 17.0 24.7 21.5 18.6 1.5 1.3 3.2 3.2 0 41.7 36.8 35.0 1.5 0.3 6.7 6.7 0 -1.8 42.4 18.0 24.4 20.7 18.2 2.3 0.2 3.7 3.7 0 42.4 37.7 35.9 1.8 0 6.2 6.2 0 -1.5 44.1 18.2 25.9 21.0 18.7 2.3 0 4.9 4.9 0 44.1 36.8 33.3 3.1 0.4 6.6 6.6 0 0.7 EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- = increase) Source: BNB, MoF, UniCredit Research Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net UniCredit Research page 51 2016F 94.9 2.9 44.9 3.2 5.6 36.1 47.1 0 13.7 33.4 2017F 89.1 3.3 42.3 3.7 5.2 33.4 43.5 0 12.7 30.8 2018F 95.2 8.5 44.2 4.9 5.3 34.0 42.5 0 12.5 30.0 94.9 8.0 1.7 43.6 3.2 6.1 34.3 45.1 5.0 6.5 -15.0 89.1 9.0 1.2 40.7 3.2 5.7 31.8 41.8 8.0 -12.3 0.7 95.2 10.0 1.5 42.1 6.6 5.5 30.0 40.8 9.0 -7.2 -1.0 -4.0 3.8 -1.8 1.6 0 0 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Romania (Baa3 positive/BBB- stable/BBB- stable)* Outlook – Economic growth is expected to slow gradually in 2017 and 2018 to 3.5% and 3.3%, respectively. Lower EU fund inflows and a slowdown in real wage growth could lead to a deceleration in domestic demand growth. Exports are unlikely to rebound strongly in the absence of large FDI projects. Inflation is expected to return close to target in late 2017. The NBR may postpone rate increases to November 2017 or later. Strategy – Reflation and local political risks may prevent a return of ROMGB yields to 2016 lows. The roll-down of DBN056 (Dec 22) makes it an interesting switch from DBN032 (June 21). Authors: Dan Bucșa, Lead CEE Economist (UniCredit Bank London) Anca Aron, Senior Economist (UniCredit Bank Romania) MACROECONOMIC DATA AND FORECASTS 2014 2015 2016F 2017F 2018F GDP (EUR bn) 150.2 160.4 168.6 179.9 190.8 Population (mn) 20.0 19.9 19.8 19.7 19.6 7,528 8,071 8,534 9,130 9,717 GDP 3.0 3.8 4.5 3.4 3.3 Private Consumption 3.8 6.1 8.1 7.4 5.7 Fixed Investment 2.5 8.8 3.3 0.6 2.1 Public Consumption 0.3 1.6 2.1 2.2 1.6 Exports 8.6 5.5 6.2 4.6 4.7 Imports 8.9 9.1 8.7 7.2 7.0 Monthly wage, nominal (EUR) 531 576 643 693 729 Real wage, change (%) 4.2 9.1 14.5 5.9 2.8 Unemployment rate (%) 6.8 6.8 6.1 5.8 5.5 -3.0 KEY DATES/EVENTS ■ 6 Jan, 7 Feb: NBR monetary policy meetings ■ 9 Feb: Inflation report GDP per capita (EUR) ■ 1 Feb, 1 Apr: new fiscal easing measures ■ 14 Feb, 7 Mar: 4Q16 GDP (flash, structure) ■ 1Q17: attempts to water down judicial reforms Real economy, change (%) GDP GROWTH FORECAST Private consumption Public consumption Net Export yoy (%, pp) 7.0 Fixed Investment Change in inventories GDP 6.0 5.0 Fiscal accounts (% of GDP) 4.0 Budget balance -0.8 -0.8 -2.8 -3.0 3.0 Primary balance 0.7 0.5 -1.4 -1.5 -1.5 39.4 37.9 38.7 39.0 38.9 Current account balance (EUR bn) -1.0 -1.9 -3.7 -4.0 -4.5 Current account balance/GDP (%) -0.7 -1.2 -2.2 -2.2 -2.4 Extended basic balance/GDP (%) 3.7 3.0 3.2 2.1 2.0 Net FDI (% of GDP) 1.8 1.8 2.4 2.2 2.1 Gross foreign debt (% of GDP) 63.1 56.4 51.9 48.9 45.1 FX reserves (EUR bn) 32.2 32.2 34.2 35.4 35.4 6.2 5.8 5.8 5.6 5.3 2.7 2.0 1.0 Public debt 0.0 External accounts -1.0 -2.0 -3.0 2014 2015 2016F 2017F 2018F INFLATION AND INTEREST RATE FORECASTS yoy (%) 4.5 Consumer price inflation Inflation target Target range Monetary policy rate Months of imports, goods & services Inflation/Monetary/FX 3.5 CPI (pavg) 1.1 -0.6 -1.5 1.6 2.5 CPI (eop) 0.8 -0.9 0.0 1.9 2.5 1.5 Central bank target 2.50 2.50 2.50 2.50 2.50 0.5 Central bank reference rate (eop) 2.75 1.75 1.75 2.00 2.50 3M money market rate (Dec avg) 1.69 1.03 0.80 1.23 1.85 USDRON (eop) 3.69 4.15 4.30 4.09 3.88 EURRON (eop) 4.48 4.52 4.54 4.50 4.50 USDRON (pavg) 3.35 4.01 4.06 4.18 3.96 EURRON (pavg) 4.44 4.44 4.49 4.49 4.50 126.1 124.2 121.7 121.2 122.7 0.9 -1.5 -2.1 -0.4 1.2 -0.5 -1.5 -2.5 -3.5 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec- Source: NIS, UniCredit Research Real effective exchange rate, 2000=100 Change (%) Source: NBR, NIS, MinFin, UniCredit Research *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 52 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Post-election splurge Romania enters a new election cycle with economic growth slowing down and public finances overstretched. The new government led by the Social Democrats (PSD) adopted several fiscal easing measures that add to the ones voted by the previous parliament. While these measures bode well for consumption, they are likely to weigh on growth from 2H17 onwards. Economic growth is expected to slow down this year and next Economic growth is expected to slow to 3.5% this year and 3.3% in 2018 as some of the past growth factors weaken. First, a rebound in inflation and slower nominal wage increases will reduce real revenue growth. Second, the credit impulse may turn negative due to lower real wage growth and smaller state guarantees for mortgage lending. Third, EU fund inflows are likely to fall markedly vs. 2017 because Romania lags the region in implementing projects under the 2014-20 EU budget. Fourth, the fiscal impulse, which will remain positive in 1H17, could turn negative in 4Q17 if the government wants to keep the budget deficit below 3% of GDP. Fifth, the bumper harvest in 2016 is expected to lead to a negative base effect this year. The budget deficit is likely to be on the cusp of 3% of GDP… The government will struggle to keep the budget deficit below 3% of GDP in 2017 and 2018. Cuts in the main VAT rate (1pp) and excise duties for fuels (USD 0.07) implemented on 1 January, 4 as well as new measures adopted in early January could push the budget deficit above 4% of GDP this year. As a result, planned infrastructure investment and co-financing for EU funds may be cut this year by a quarter (more than 1% of GDP) to meet the deficit target. Fiscal easing at the peak of the business cycle may weigh on policies beyond 2017: the scope for increasing investment in 2018 and later will remain small unless taxes increase. …at the cost of lower investment Net exports could remain a drag on GDP growth in 2017 and 2018 Fast private consumption growth will further widen the trade deficit with goods. Exports are unlikely to help in the absence of large FDI projects. We expect annual growth rates to fall below 5% in 2017 and 2018, even if global trade rebounds. Demand from Europe will remain paramount: in 2016, it accounted for almost 90% of export growth, out of which 2/3 was German demand. With car production peaking in 2015, electronics and lower-value added exports such as furniture and food will have to perform strongly. At the same time, light manufacturing is hit by falling margins due to rising labor costs. Stable capital flows could fall in 2017 The wider trade deficit will shrink the EBB to 2.2% and 2.3% of GDP in 2017 and 2018, respectively. Besides lower EU fund inflows, FDI will continue to hover at 2% of GDP. Romania is unable to compete with its neighbors for large investment projects in manufacturing due to poor infrastructure and a lack of expertise at the government level. DOMESTIC DEMAND GROWTH COULD SLOW IN 2017 Retail sales could slow due to falling real wage growth Real wage growth yoy (%) Net stable capital flows will decline in the coming years Bank deleveraging FDI Net stable capital flows % of GDP Retail sales growth 15.0 6.0 EU funds Current account 5.0 12.0 4.0 3.0 9.0 2.0 1.0 0.0 6.0 -1.0 -2.0 3.0 -3.0 -4.0 0.0 2013 2014 2015 2016F 2017F 2015 2016E 2017F 2018F 2018F Source: NIS, NBR, MFE, UniCredit Research 4 Among them, new VAT exemptions, lower taxes for pensioners and self-employed, and pension and wage increases. UniCredit Research page 53 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly EUR-RON stuck in a tight range The loss of competitiveness should drive EUR-RON higher, but the NBR is still holding onto the EUR-RON 4.40-4.50 range, with the RON trading closer to the upper limit of the range. FX loans are expected to represent more than 30% of the total by the end of 2018, limiting the NBR’s incentive to let the currency depreciate. A smaller EBB than in other central European countries will continue to cover bank deleveraging, but will leave little support for the RON from stable capital flows. That said, the RON may be cushioned from swings in risk appetite by the low foreign ownership of ROMGBs, dominated by eurozone investors. The central bank offset real currency appreciation by maintaining lax liquidity conditions. The structural excess liquidity is unlikely to be sterilized because of costs. However, the central bank will have to consider tightening liquidity conditions due to rapid reflation. Reflation will pick up in 2017… Inflation returned inside the 1.5-3.5% target range at the beginning of 2017, but could remain below the 2.5% target this year after the VAT and excise duty cuts. Excluding tax cuts, the rebound in prices is broad-based, with volatile fuel prices leading the way. Next year, inflation could exceed temporarily the target as core inflation and fuel prices rebound further. Even so, end-2018 inflation could be close to 2.5% or even below, if the main VAT rate is cut again by 1pp to fulfill PSD’s pre-election promise. The central bank may want to align the policy interest rate to the new inflation level, but the timing of tightening is uncertain. The NBR could choose to look through the initial reflation episode in 1H17 and start raising rates only when inflation approaches the 2.5% target. We believe this could happen in late 2017. As a result, we expect three interest rate increases to 2.5% starting in November 2017. …but rate increases may be delayed to November 2017 An earlier tightening of monetary conditions by narrowing the interest rate corridor may be unwarranted, unless the NBR re-widens the corridor when increasing the key rate. If it keeps a narrow corridor, the central bank would face a high marginal deposit rate and, thus, higher costs. At the same time, it would increase the carry and narrow the scope of using liquidity conditions to stabilize the currency, leading to more FX volatility. A higher EUR-RON could keep the topic of an administrative FX loan conversion in the limelight. We expect the Constitutional Court to let lower courts decide whether conditions are met for a conversion at lower exchange rates 5. A large-scale conversion of FX loans into RON represents the biggest risk for the banking sector in the coming years. The main internal risks are a conversion of FX loans into RON… … and a potential reversal of judicial reforms Local political developments pose a risk to asset prices as the new government prepares to repeal some of the judicial reforms implemented in the past. This could trigger a stand-off with the European Commission and could keep more risk-averse European bond investors away from Romanian bonds. While Romanian authorities usually try to avoid major confrontations with European institutions, watering down judicial reforms is too important an objective for the PSD leadership. THE NBR MAY POSTPONE TIGHTENING REAL MONETARY CONDITIONS TO THE END OF 2017 The RON has appreciated in real terms vs. peers since 2012 ULC-based REER, 1 = 2009 1.15 CZK HUF PLN The NBR may delay tightening due to the uncertain inflation path Inflation forecast - baseline scenario RON yoy (%) Inflation with a 1pp VAT cut in 2018 Inflation target 1.10 Target range 4.0 1.05 2.0 1.00 0.0 0.95 -2.0 0.90 0.85 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 -4.0 Jan-15 Mar-16 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Source: central banks, Eurostat, NIS, UniCredit Research 5 For details, please see the “EEMEA Macro Flash - Trip notes: Romania – post-electoral cool-down” from 31 October 2016. UniCredit Research page 54 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Uncertain path for ROMGBs Reflation may prevent a return of ROMGB yields to 2016 lows Uncertainty will remain high after a seesaw year for ROMGBs. Several factors may prevent a flattening of the yield curve going forward: 1. Reflation and a potentially more hawkish tone from the NBR; 2. A gradual deleveraging of US investors from the region, especially if the USD continues to strengthen against the EUR; 3. Local political risks and a potential confrontation with the EU if Romanian authorities try to reverse some of the judicial reforms. At the same time, factors supporting ROMGBs are still in place: 1. Large MinFin reserves and manageable funding needs; 2. Large amounts of cash at local fund and pension managers; 3. Attractive valuation; 4. The persistence of a large liquidity surplus on the local interbank market that will keep short-term rates below the policy rate. Although there are headwinds to a flattening of the curve, the DBN056 (Dec 22) has the highest roll-down on the ROMGB curve and is interesting as a switch from the DBN032 (June 21). Local interest will increase in the DBN056 as its remaining maturity falls to 5 years. ROMGB yield curve 5 DBN056 vs DBN032 yield differential ROMGB Dec 22 spread pickup to Jun 21 70 As of Jan 5, '17 As of Sep 30, '16 As of Jun 30, '16 4 60 3 50 2 1 40 0 30 -1 0 1 2 3 4 5 6 7 8 9 10 20 IV I II IV III Source: Bloomberg, UniCredit Research GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other Fiscal reserve change (- = stock increase) GROSS EXTERNAL FINANCING REQUIREMENTS 2016F 2017F 2018F 14.0 3.8 10.2 8.6 6.3 2.0 0.3 1.6 1.5 0.1 14.0 11.1 8.9 2.1 0.1 4.0 3.2 0.8 0 -1.1 12.5 5.4 7.2 6.0 3.6 2.1 0.3 1.2 0 1.2 12.5 9.8 7.9 1.8 0.1 2.7 2.0 0.7 0 0 14.3 5.7 8.6 5.7 3.6 1.8 0.3 2.9 1.5 1.4 14.3 10.1 8.0 2.0 0.1 2.7 2.0 0.7 0 1.5 EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net Source: NIS, NBR, MinFin, UniCredit Research UniCredit Research page 55 2016F 31.5 3.7 14.3 3.6 4.8 5.8 13.5 0.0 4.9 8.6 31.5 4.0 0.1 11.8 5.0 1.9 4.8 10.8 5.1 0 -0.3 2017F 27.7 4.0 12.5 2.8 3.9 5.8 11.2 0.3 3.5 7.4 27.7 4.0 0.1 10.5 3.8 1.9 4.8 10.5 3.8 0 -1.2 2018F 28.8 4.5 13.4 4.5 2.9 6.0 10.9 0.2 3.1 7.6 28.8 4.0 0.1 10.2 3.9 1.5 4.9 10.2 4.3 0 0 1.3 1.7 1.2 2.0 1.2 0.5 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Slovakia (A2 stable/A+ stable/A+ stable)* Outlook – Economic growth is expected to accelerate to 3.2% in 2017 and 3.7% in 2018, driven this year by rebounding investment. Labor market conditions will continue to tighten, supporting household spending. Inflation is expected to bottom out amid higher energy prices and rising consumption. In 2017, the structure of EU growth will be less favorable for Slovak exports, which are dominated by durable consumer goods. Lower car production could be at least partially offset by a pickup in global trade. Fiscal goals are less ambitious than in the past, relying mostly on strong growth in 2017. A balanced budget is expected to be reached in 2019. Author: Ľubomír Koršňák, Chief Economist (UniCredit Bank Czech Republic and Slovakia) MACROECONOMIC DATA AND FORECASTS EUR bn KEY DATES/EVENTS ■ 11 Jan, 10 Feb, 13 Mar – Industrial production ■ 13 Jan, 15 Feb, 15 Mar – CPI 2017F 2018F 75.9 2014 78.7 80.8 83.5 87.0 Population (mn) 5.4 5.4 5.4 5.4 5.4 14,016 14,507 14,890 15,390 16,031 GDP 2.6 3.8 3.2 3.2 3.7 Private Consumption 1.4 2.2 2.7 2.7 2.7 Fixed Investment 1.2 16.9 -6.5 6.5 2.3 Public Consumption 5.3 5.4 2.5 2.1 1.5 Exports 3.7 7.0 3.4 3.7 4.4 Imports 4.4 8.1 1.5 4.4 2.2 Monthly wage, nominal (EUR) 858 884 912 942 974 GDP per capita (EUR) ■ 10 Feb – flash 4Q16 GDP ■ 8 Mar – 3Q16 GDP structure 2015 Real economy, change (%) INFLATION REBOUNDING FROM HISTORICAL LOW 2.5 2016F GDP (EUR bn) % yoy 2.0 1.5 Real wage, change (%) 4.2 3.3 3.7 2.3 1.9 1.0 Unemployment rate (%) 13.2 11.5 9.7 9.0 8.4 0.5 Fiscal accounts (% of GDP) -0.8 0.2 0.0 -1.1 -0.8 1.2 0.2 0.0 -1.3 -0.9 Extended basic balance/GDP (%) 2.7 3.8 2.4 3.7 4.3 Net FDI (% of GDP) 0.6 0.0 0.7 3.3 3.5 Gross foreign debt (% of GDP) 89.2 85.4 86.9 86.9 86.7 FX reserves (EUR bn) EUR EUR EUR EUR EUR - - - - - CPI (pavg) -0.1 -0.3 -0.5 1.0 1.6 CPI (eop) -0.1 -0.5 0.0 1.5 1.7 Central bank target EUR EUR EUR EUR EUR Central bank reference rate (eop) EUR EUR EUR EUR EUR 3M money market rate (Dec avg) EUR EUR EUR EUR EUR USD/FX (eop) EUR EUR EUR EUR EUR EUR/FX (eop) EUR EUR EUR EUR EUR USD/FX (pavg) EUR EUR EUR EUR EUR EUR/FX (pavg) EUR EUR EUR EUR EUR Real effective exchange rate, 2000=100 175.9 173.1 171.7 171.4 170.9 0.2 -1.6 -0.8 -0.2 -0.3 Sep-18 0.9 Current account balance/GDP (%) Jan-18 Current account balance (EUR bn) May-18 External accounts Sep-17 -1.5 Jan-17 51.7 May-17 52.8 Sep-16 53.6 Jan-16 52.5 May-16 53.6 Sep-15 Public debt Jan-15 0.7 -1.0 May-15 -0.1 Sep-14 -1.5 -0.5 Jan-14 -2.1 -1.0 May-14 -2.7 -0.8 Sep-13 -2.7 Primary balance Jan-13 Budget balance May-13 0.0 -0.5 GDP GROWTH TO BE DRIVEN BY INVESTMENT IN 2017 AND EXPORTS IN 2018 5.0 Domestic demand yoy (%; pp) Net export GDP Inflation/Monetary/FX 4.0 3.0 2.0 1.0 0.0 -1.0 Months of imports, goods & services 2013 2014 2015 2016F 2017F 2018F Source: SO SR, UniCredit Research Change (%) Source: SO SR, NBS, Eurostat, UniCredit Research *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 56 See last pages for disclaimer. <date> January 2017 Economics & FI/FX Research CEE Quarterly 2017: the year of investment GDP growth is expected to recover gradually in 2017 to 3.2% and 3.7% in 2018 from 2.8% in 2H16, driven by stronger investment activity. Economic growth could accelerate towards 4% in 2018-19, boosted by larger investment and production in the automotive industry. The main growth driver will shift from net exports to domestic demand in 2017. The C/A will turn temporarily to a deficit due to recovering foreign direct investment triggering larger imports. The C/A deficit will start to narrow again from 2018 onwards, when new car production capacities will add to exports, which will be again the main GDP growth engine. At the same time, strong base effects in private investment will weigh on domestic demand dynamics in 2018. Economic growth to be driven by new investment in automotive industry Investment growth will be supported by both public and private projects in 2017. Public investment will benefit from a restart in highway construction financed by new EU funds and by PPP. These projects were postponed from 2016 to early 2017 due to obstacles in procurement. The automotive sector will dominate corporate investment, led by the new Jaguar Land-Rover car plant. However, construction permits suggest a strong recovery also in non-residential building (offices, retail, storage). The residential market is expected to peak in 1H17 as a new central bank regulation implemented in March 2017 may slow mortgage credit growth below 10% yoy. Household spending to support economic growth… Household spending will also contribute to domestic demand growth, supported by tight labor market conditions and consumer confidence at post-crisis highs. Unemployment could test alltime lows below 9% by the end of 2017. A further reduction may be prevented by structural issues, such as regional disparities, low internal mobility and the high share of long-term, unskilled unemployed. All these factors add to rising wage pressure. At the same time, a gradual rebound in inflation is expected to slow down real income growth. Inflation bottomed out with low oil prices and should turn positive in January 2017, ending a three-year fall in prices. Nevertheless, price increases will remain subdued in 2017, rising above 1% only gradually due to cuts in regulated electricity and heating prices. Inflation may stay below 2% throughout 2017 and 2018, in line with eurozone inflation. …despite rebounding inflation European car market growth to slow down… …partially offset by pick-up in global trade Fiscal drag to continue, budget to be balanced in 2019 Coalition government remains stable UniCredit Research The main risk to the economic outlook comes from external demand. The cyclical growth in European demand is expected to peak as the support from lower FX and oil prices wanes. The European growth structure will be less favorable for Slovak exports, which are dominated by durable consumer goods. Rebounding inflation is expected to gradually slow down real income growth in the EU, affecting sales of durable goods, including cars. New car sales are close to long-term potential and are approaching 2008 levels at the EU level, leaving room for further growth only in southern European countries, while Scandinavia and Czech Republic are close to a cyclical peak in car demand. Thus, further growth in Slovak car production will not depend on model production cycles. On the positive side, weaker European demand could be at least partially offset by a pickup in global trade in 2017. The fiscal stance is expected to tighten from 2018 onwards. The 2017 budget law forecasts a fall in the deficit from an expected 2.0% of GDP in 2016 to 1.3% of GDP in 2017. However, the 2017 fiscal goal cannot be considered ambitious: the improvement will be driven exclusively by economic growth, with constant expenditures leading to a deficit of 0.9% of GDP. The fiscal drag should accelerate in 2018 and afterwards. The government still aims to balance the budget in 2019, with the primary balance turning positive in 2018. Public debt should decline towards 50% of GDP by 2019, remaining close to the debt-brake level, which will start to decline by 1 pp every year after 2018 from the current level of 50% of GDP. The left-right coalition remains stable and so far handled well several potential crises. However, support for the strongest coalition party – the Social Democrats of Prime Minister Robert Fico - is falling amid several corruption scandals. This could prevent potential discussions about early elections. Local government elections are scheduled for autumn 2017 having limited informative value as the turnout is usually only 10-20%. page 57 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Slovenia (Baa3 positive/A positive/A- stable)* Outlook – Stronger-than-expected consumer spending and buoyant foreign demand led us to upgrade Slovenia’s GDP growth projection for 2016 to 2.4%. We expect growth to accelerate further to 2.6% in 2017 on recoveries in EU funds absorption and private investment, while domestic demand will be supported by improving labor markets. Inflation, meanwhile, is expected to gradually accelerate to 0.9% yoy by the end of 2017 as base effects fade, oil prices rise, and the output gap closes. The major near-term risks are related to fiscal policy: we see downside risks for the government’s budget deficit targets for 2017 (1.6% of GDP) and 2018 (0.7% of GDP) as they assume above-consensus growth.. Author: Dumitru Vicol, Economist (UniCredit Bank London) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS 2014 2015 2016F 2017F 37.3 38.6 40.1 41.6 2018F 43.3 ■ 6 Feb, 28 Feb, 31 Mar – Consumer Price Index GDP (EUR bn) Population (mn) 2,061.8 2,063.3 2,066.2 2,069.1 2,071.2 ■ 31 Jan, 28 Feb, 31 Mar – Retail Sales GDP per capita (EUR) 18,107 18,693 19,395 20,123 20,887 ■ 10 Jan, 10 Feb, 21 Mar – Industrial Production GDP 3.1 2.3 2.4 2.6 2.3 Private Consumption 1.9 0.5 2.4 2.1 1.9 Fixed Investment 1.4 1.0 -4.0 5.8 4.8 -1.2 2.4 2.0 1.2 0.6 5.7 5.6 5.8 5.4 4.9 Real economy, change (%) ■ 9 Jan, 9 Feb, 10 Mar – Trade balance ■ 28 Feb – 4Q16 GDP Public Consumption PRIVATE CONSUMPTION TO SUPPORT GDP GROWTH Imports 8.0 Exports Household Consumption Investments Net Exports yoy (%) Government Consumption Inventories GDP Growth 4.6 5.3 5.9 5.3 1555.7 1585.3 1620.1 1634.7 Real wage, change (%) 1.1 1.4 2.1 0.9 -0.3 Unemployment rate (%) 9.7 9.0 8.0 7.7 7.4 Budget balance -5.0 -2.7 -2.3 -2.0 -1.6 Primary balance -1.9 0.3 0.4 0.8 0.9 Public debt 80.7 83.2 80.2 78.2 76.5 Fiscal accounts (% of GDP) 6.0 4.0 2.0 0.0 External accounts -2.0 -4.0 -6.0 -8.0 4.2 1545.4 Monthly wage, nominal (EUR) 2011 2012 2013 2014 2015F 2016F 2017F 2018F Current account balance (EUR bn) 2.3 2.0 2.7 2.3 2.3 Current account balance/GDP (%) 6.2 5.2 6.7 5.6 5.3 Extended basic balance/GDP (%) 7.8 8.4 8.8 7.6 7.2 Net FDI (% of GDP) 1.6 3.2 2.1 2.0 1.9 124.6 116.6 114.7 112.8 110.8 0.8 0.8 1.4 2.1 2.8 CPI (pavg) 0.4 -0.8 -0.2 1.3 1.2 CPI (eop) -0.1 -0.6 0.6 0.9 1.2 EUR EUR EUR EUR EUR Gross foreign debt (% of GDP) FX reserves (EUR bn) INFLATION TO REMAIN LOW IN 2017 8.0 Inflation/Monetary/FX yoy (%) 7.0 Central bank target 6.0 5.0 Central bank reference rate (eop) EUR EUR EUR EUR EUR 4.0 3M money market rate (Dec avg) EUR EUR EUR EUR EUR 3.0 USD/FX (eop) EUR EUR EUR EUR EUR 2.0 EUR/FX (eop) EUR EUR EUR EUR EUR 1.0 USD/FX (pavg) EUR EUR EUR EUR EUR 0.0 EUR/FX (pavg) EUR EUR EUR EUR EUR -1.0 -2.0 Jan-07 Source: NBS, MinFin, UniCredit Research Jul-08 Jan-10 Jul-11 Jan-13 Jul-14 Jan-16 Jul-17 Source: NBS, MinFin, UniCredit Research *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 58 See last pages for disclaimer. <date> January 2017 Economics & FI/FX Research CEE Quarterly Finding the path back to growth Domestic demand is poised to become the main GDP growth driver Stronger-than-expected consumer spending buoyed by an improving labor market and low inflation, combined with a strong tourist season, firmer euro area (EA) demand, led us to upgrade our FY16 GDP growth projection to 2.4% from 1.9% previously. Growth should accelerate further to 2.6% yoy in 2017, driven by a recovery in investment, both public and private. Pubic investment will be boosted by the expected recovery of EU fund absorption, while private investment is likely to gain momentum on supportive financial conditions and strong corporate balance sheets. Improving financial conditions as banks’ deleveraging moderates, and stronger wage growth, should also support private consumption despite the slight rise in inflation and in oil prices. At the same time, the contribution of net exports to growth is poised to shrink as import growth picks up on strengthening domestic demand. The impact of falling oil prices has faded and inflation is expected to accelerate on base-effects and a recovery in commodity prices, with average inflation in 2017 reaching 1.3%. Strengthening of domestic demand and the closing output gap, or even turning positive, in 2017-18 are likely to fuel the upward trend. Excessively optimistic assumptions for economic growth might mean the government misses budget deficit targets The increased global uncertainty related to the impact of Brexit, to the Trump victory in the U.S. election and to the pace of Fed tightening, has translated into considerable uncertainty as regards growth, with estimates ranging from 1.8% to 2.6%. At the same time, the government has assumed real GDP growth of 2.9%. This apparently optimistic assumption seems to stem from escalating political pressure to boost spending, forcing the government to assume higher growth in 2017-18 in order to accommodate these demands. The budget bills for 2017 and 2018 6 have been adopted with deficit targets of 1.6% and 0.7% of GDP, respectively. These targets, however, seem too optimistic both to us and to the European Commission, which has already warned about the risk of non-compliance with the Stability and Growth Pact. Even so, the political process is not yet finished. The upper chamber of parliament, the National Council, vetoed the budget bills on alleged inadequate funding for municipalities. However, the three-party coalition has a majority of 52 out of 90 MPs, which should allow it to overturn the veto, especially after having recently reaching an agreement with trade unions on public sector wages. Initially, the trade unions demanded the abolishment of all austerity measures 7 that would cost around EUR 215mn (0.5% of 2016 GDP). The final agreement envisages a package of additional wage and benefit increases worth EUR 70mn, out of which EUR 58mn will be included in the 2017 budget. These expenses are likely to be implemented to the detriment of public investment, since the government insisted that the financial framework remain unchanged. The privatization of NLB was again postponed to 2017 In regard to structural reforms, progress has been made in bank consolidation as Nova KBM (the second biggest bank) and KBS Banka officially completed their merger. At the same time, the privatization of NLB has been postponed again for 2017, when the deadline imposed by the EC expires, due to unfavorable conditions. While there were some rumors that Slovenia might ask permission from the EC for a three-year delay, Slovenian Sovereign Holding appears to be committed to proceed with the privatization in 2017, most probably via an IPO. The downside risks for 2017 seem to have eased, with slower EA growth remaining the most significant factor. Additionally, faster wage growth in Slovenia resulting from the trade union agreement, and improving labor markets (from an already elevated level relative to peers), could harm the country’s competiveness, adding to risks, especially if external demand proves weaker than anticipated. 6 The budget bills for 2017 and 2018 are designed in line with the fiscal rule law adopted in 2015, which set upper limits for expenditures for several years in advance and have strict parameters on how austerity measures can be lifted. Hence, social transfers, allowances, wages and other items can be raised only by a limited amount over a certain period of time. 7 Pensioners got the first regular increase since 2008 of only 1.15%, while all the other allowances and unemployment benefits were capped for another two years. UniCredit Research page 59 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Bosnia and Herzegovina (B3 stable/B stable/not rated)* Outlook – Weaker growth continued in 2H16, so the full year GDP growth is now seen being lower (2.5% yoy from 2.8% before). Domestic private consumption remains the main driver of growth due to a rise in households’ real disposable income, while exports and, especially, investment activity are still subdued. Acceleration of growth towards 3% in 2017 is expected, supported by a recovery in investment and export demand. The fiscal position has stabilized as tax collection has strengthened substantially, while spending remains under control (the EFF program conditions approved in September ought to be met, albeit with delays). However, the progress in advancing crucial reforms and the growth outlook remain dependent on the fragile and unconvincing decision-making process. Author: Hrvoje Dolenec, Chief Economist (Zagrebačka banka), Nenad Golac, Senior Economist (Zagrebačka banka) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS EUR bn 2014 2015 2016E 2017F 2018F GDP (EUR bn) 13.96 14.65 14.87 15.55 16.41 3.8 3.8 3.8 3.8 3.8 3648 3844 3916 4110 4359 GDP 1.1 3.1 2.5 3.0 3.5 Monthly wage, nominal (EUR) 659 659 663 678 699 Real wage, change (%) 0.7 1.0 1.6 0.7 1.1 Unemployment rate (%) 43.9 43.2 41.9 40.2 38.5 Budget balance -2.9 -0.1 -0.8 -0.8 -0.6 Primary balance -2.1 0.7 0.1 0.2 0.4 Public debt 44.0 44.0 44.2 43.2 42.3 Current account balance (EUR bn) -1.0 -0.8 -0.9 -1.2 -1.4 Current account balance/GDP (%) -7.4 -5.7 -6.1 -7.7 -8.6 -2.0 Extended basic balance/GDP (%) -4.6 -4.2 -4.7 -5.3 -5.6 -3.0 Net FDI (% of GDP) 2.8 1.5 1.5 2.5 3.0 ■ 20 Jan: CPI FY 2016 ■ 20 Jan: Foreign trade FY 2016 ■ 20 Jan: Industrial Production FY 2016 ■ 24 Mar: Balance of payments FY 2016 ■ 24 Mar GDP 4Q 2016 ANNUAL INFLATION Population (mn) GDP per capita (EUR) Real economy, change (%) Fiscal accounts (% of GDP) CPI (%, yoy) 4.0 3.0 2.0 External accounts 1.0 0.0 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 -1.0 63.7 62.7 63.4 62.4 61.1 FX reserves (EUR bn) 4.0 4.4 4.9 5.0 5.2 Months of imports, goods & services 6.1 6.8 7.4 7.0 6.7 CPI (pavg) -0.9 -1.0 -1.0 1.5 2.0 CPI (eop) -0.4 -1.3 0.1 2.0 2.1 25 1M money market rate (Dec avg) 0.02 -0.21 -0.35 -0.35 -0.35 20 USD/FX (eop) 1.61 1.79 1.83 1.78 1.69 EUR/FX (eop) 1.96 1.96 1.96 1.96 1.96 USD/FX (pavg) 1.47 1.76 1.76 1.81 1.71 EUR/FX (pavg) 1.96 1.96 1.96 1.96 1.96 INDUSTRIAL PRODUCTION AND EXPORTS 35 ytd (% yoy) 30 Industrial production, growth rate Merchandise exports, growth rate Merchandise imports, growth rate 15 10 5 0 -5 Gross foreign debt (% of GDP) Inflation/Monetary/FX -10 -15 Source: Eurostat, National statistical office, UniCredit Research 2010 2Q11 4Q11 2Q12 4Q12 2Q13 4Q13 2Q14 4Q14 2Q15 4Q15 2Q16 4Q16 Source: National Statistical office, UniCredit Research *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 60 See last pages for disclaimer. <date> January 2017 Economics & FI/FX Research CEE Quarterly Growth should regain momentum in 2017 The main growth driver is growing personal consumption while exports and investment are still subdued. Therefore, we lowered our 2016 growth estimate to 2.5% The period of weaker growth extended into 2H 2016, so we have lowered our 2016 GDP forecast from 2.8% to 2.5%. Growth in 2016 has been driven primarily by private consumption due to the strong increase in households’ real disposable income. The latter reflect rising employment (by 1.9% yoy on average in the nine months of 2016), slightly increased nominal wages (by 0.7%) and pensions, and still strong CPI deflation (-1.3%). At the same time, investment activity and export performance remained subdued. Merchandise export growth slowed down to 2.6% yoy during January-October, while the lack of investment activity is visible from a decline in the construction .sector. They are 0.3% yoy lower during the first three quarters of 2016, of which civil engineering works declined as much as 3.2%. An important reason for this decline in investment (primarily public works)y, appears to have been difficulties and delays in securing international funding, i.e., from the IMF and the World Bank as both were waiting for a new EFF to be agreed on. FDI is also underperforming – net inflows in 1H16 were one-third lower compared to 1H15. Acceleration of growth seems plausible, provided the current pace of reform implementation keeps momentum to support the delayed investment recovery On a positive note, prospects for 2017 and following years seem more favorable – growth should accelerate to 3.0% and perhaps more in 2018. In 2017, we expect the acceleration of growth to be driven by strong personal consumption, on the back of rising employment and households’ real disposable income, but now accompanied again by improved external and investment demand. Some encouraging signs for the latter were already visible in 2H16 in the area of residential construction. Apart from that, there are a number of infrastructure and other large investments in the pipeline put on hold in 2016 due to procedural problems in project preparation and gaps in ensuring funding (especially for sections of the corridor Vc motorway, which are expected to be predominantly financed by international financial institutions). World Bank and other financing could reach some EUR 750mn, if political parties in the government make progress to meet their obligations under the Letter of Intent under the EFF arrangement with the IMF. Provided IMF funding is restored soon (only the first tranche in the amount of EUR 79mn of the two that had been expected was disbursed in 2016 as the authorities have not increased excise duties according to the plan) can help government capital outlays to return to levels above 5% of GDP, encouraging private investment to rise as well. The C/A deficit has widened on subdued merchandise exports and lower remittances.. The C/A deficit is slightly widening despite the low energy prices, suffering from subdued merchandise export volumes and the lower-than-expected inflow from remittances. The estimated CA deficit in 2016 is somewhat higher than in 2015 (6.1% vs. 5.7% of GDP), resulting from stagnant exports of goods and services and slightly faster growth in services’ imports. Despite historically low imported energy prices, merchandise imports have not decreased, while slightly lower remittances also contributed to the widening of the C/A deficit. We see much higher external imbalances in 2017 and 2018 (7.7% and 8.6% of GDP, respectively) due to the forecasted robust investment growth and given the strong dependence of the economy on imported investment goods’. As energy and other primary material prices are expected to increase, the four-year-long period of deflationary trends should be ended. In 2017, we expect consumer price growth of close to 2% yoy. … and looks set to widen further as investment picks up in 2017 and 2018 Fiscal stability improved via higher tax collection and controlled public spending supported now by the EFF UniCredit Research Fiscal sustainability should be reinforced by the EUR 554mn EFF arrangement agreed with the IMF in September. The initial results of the implementation of the Reform Agenda and the measures agreed on under the EFF resulted in an improved fiscal position, with the expected general government deficit below 1% of GDP and a primary surplus in 2016. These were achieved through improved tax collection (4% yoy rise in indirect tax receipts during January-November in a deflationary environment) and restrained public spending – partly as a response to delays in the second EFF tranche disbursement. However, we expect that the issues causing delays will be resolved very soon and would not pose a risk to future fiscal stability, with the EFF now providing roughly EUR 250mn in 2017, and governments at all levels ensuring the continuation of the public sector reforms needed to ensure a sustainable fiscal stabilization path. The key risk, therefore, remains the complex decision making process. page 61 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Russia (Ba1 negative/BB+ stable/BBB- stable)* Outlook – Despite the improving external environment, the recovery remains elusive as the weakness of internal drivers continues to be a drag on growth. We expect consumption to start recovering in the months ahead, although its overall contribution to GDP will be restrained by a pickup in imports. We therefore maintain our forecast of a contraction of 0.8% in 2016, followed by a modest recovery in 2017-18 at a pace of roughly 1% per year. The current and prospective slowdown in inflation should permit the CBR to resume rate cuts in 2017, albeit at a moderate pace, given still significant risks to the inflation outlook. Fiscal risks remain the key issue, especially in regard to deficit financing. The future growth outlook crucially depends on the supply response, institutional reforms and structural changes. Author: Artem Arkhipov, Head of Macroeconomic Analysis and Research Russia(UniCredit Bank Russia) Anna Bogdyukevich, CFA, Economist (UniCredit Bank Russia) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS ■ 3 Feb, 24 Mar – MPC meeting ■ 10 Jan 7 Feb 7 Mar – Consumer price index ■ 3 Feb – National accounts FY16 ■ 23 Jan 16 Feb 16 Mar – Industrial production index ■ 18-23 of every month – short-term statistical overview MARGINAL GROWTH AHEAD Personal Consumption Fixed Capital Formation Net export yoy (%) Public Consumption Inventories Gross Domestic Product EUR bn GDP (EUR bn) 2014 1,527 2015 1,188 2016F 1,150 2017F 1,376 2018F 1,404 146.3 146.5 146.9 147.1 147.3 10,441 8,110 7,833 9,353 9,526 GDP 0.7 -3.7 -0.8 0.9 1.1 Private Consumption 1.5 -9.6 -4.2 1.5 2.0 -2.6 -7.6 -6.1 1.1 1.2 0.2 -1.8 -1.0 -0.4 -0.3 0.5 Population (mn) GDP per capita (EUR) Real economy, change (%) Fixed Investment Public Consumption Exports 0.6 3.6 -1.5 0.5 Imports -7.6 -25.7 -6.2 3.0 3.5 Monthly wage, nominal (EUR) 637 500 474 556 569 Real wage, change (%) 1.2 -9.3 0.5 1.3 1.5 8 Unemployment rate (%) 5.2 5.6 5.6 5.7 5.6 6 Fiscal accounts (% of GDP) Budget balance -0.4 -2.4 -3.8 -3.6 -3.1 Primary balance 0.1 -1.8 -3.1 -2.9 -2.4 10.1 10.3 11.0 10.4 11.2 Current account balance (EUR bn) 43.9 62.7 22.0 17.2 11.9 Current account balance/GDP (%) 2.9 5.3 1.9 1.2 0.8 Extended basic balance/GDP (%) 1.1 4.0 1.3 0.8 0.8 Net FDI (% of GDP) -1.7 1.3 -0.6 -0.4 0 Gross foreign debt (% of GDP) 29.6 39.3 39.1 31.7 29.9 279.2 293.2 294.6 295.7 300.0 10.3 13.9 16.6 13.5 12.1 CPI (pavg) 7.8 15.6 7.1 4.8 4.2 CPI (eop) 11.4 12.9 5.7 4.5 4.0 - 4.0 4.0 4.0 4.0 Central bank reference rate (eop) 17.0 11.0 10.0 8.0 6.5 USD/RUB (eop) 60.7 73.8 60.7 59.8 60.6 EUR/RUB (eop) 73.2 80.3 63.8 65.8 70.3 USD/RUB (pavg) 38.6 61.3 67.2 60.8 59.7 EUR/RUB (pavg) Real effective exchange rate, 2000=100 Change (%) 51.0 68.0 74.4 65.3 67.8 208.0 178.0 179.2 205.9 206.7 -8.7 -14.4 0.7 14.9 0.4 4 2 0 -2 Public debt -4 External accounts -6 -8 -10 2014 2015 2016Е 2017F 2018F INFLATION SLOWDOWN TO CONTINUE 19% FX reserves (EUR bn) Months of imports, goods & services Key CBR rate Headline CPI Inflation/Monetary/FX 15% Central bank target 11% 7% 3% Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Source: CBR, UniCredit Research Source: CBR, Rosstat, Haver, UniCredit Research *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 62 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly No easy way out We maintain our forecast of a contraction of 0.8% in 2016, followed by a slow recovery in 2017-18… The economic contraction appears to have come to an end, with 3Q16 GDP falling 0.1% qoq adjusted for seasonality, or 0.4% yoy. The recovery, however, still remains elusive with preliminary estimates suggesting no change in seasonally-adjusted GDP in October. Despite the projected improvement in the external environment, the weakness of the internal drivers will remain a drag on growth. In addition, the leap year effect will subtract some 0.2 pp from the headline growth rate in 2017 after a similar addition in 2016. As a result, we maintain our FY 2016 GDP forecast at -0.8% and cut the FY 2017 outlook to just short of 1%. In the absence of structural reforms, growth is unlikely to accelerate much in 2018 either, expanding at 1.1%. …despite the improvement in external conditions External conditions for the Russian economy have improved since our September publication, with growth in the EU and the U.S. now expected to be stronger and oil prices on the rise. However, even the projected 25-30% increase in the average oil price is unlikely to benefit the Russian economy much, as it will result in appreciation pressures, reversing much of the positive impulse back to external markets via an increase in import volumes. While Mr. Trump’s election as the next U.S. president has been largely acclaimed as beneficial for Russia, we remain skeptical. While some thaw in relations could well occur, we do not expect any imminent improvement, at least not in regard to sanctions. We therefore maintain our assumption that financial sanctions will remain in place during the whole forecasting period, implying that external debt is likely to diminish further in 2017-18, albeit at a slower pace. At the same time, the current external debt rollover ratio is rather high (close to 80%), indicating that companies are receiving adequate refinancing, even if a large part of this comes from affiliated entities registered abroad. This said, deleveraging will contribute to resident capital outflows, which are likely to rise again, in line with export earnings. We assume that financial sanctions will remain in place in 2017-18 Domestically, consumption has yet to recover, with retail sales down by 4.4% yoy in October (-5.3% YTD). We however expect consumption to start recovering in the months ahead due to several reasons. First, falling inflation has already helped push real wage growth into positive territory (albeit modestly) and we expect this trend to gain momentum. Second, the population’s savings behavior is returning to normal after being in a ‘crisis mode’ for a long time. This implies that any further increase in income levels is likely to be spent rather than saved, especially given sizable deferred demand for durables. Finally, the 2017 budget, despite a headline contraction in real spending, is skewed towards social outlays, especially ahead of the presidential election scheduled for 2018, which will also boost consumption. We expect consumption to start recovering in the months ahead Under this base-case scenario, we believe the USD-RUB exchange rate is likely to be broadly flat amid a shrinking current account surplus (with the increase in commodity prices offset by higher import volumes). The stable ruble and a still sluggish consumption will help inflation to decelerate, although reaching the 4% target by the end of 2017 remains challenging. USD-RUB exchange rate is likely to be broadly flat, helping inflation to decelerate External debt rollover is high despite the sanctions Saving mode is returning back to normal 20 750 % of income saved Rollover rate 78% Rollover rate 48% 650 15 2009-10 average 2015 average 550 non-crisis average 10 2014 average 450 Oct-16 Rollover Repaym. FX effect Oct-15 Rollover Repaym. FX effect Oct-14 350 5 0 2008 average Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec Source: Rosstat, CBR, UniCredit Research UniCredit Research page 63 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Even if the deficit is kept at 3.2% of GDP, deficit-financing options remain a concern There are some risks to the current outlook, however, mostly related to the authorities’ likely policy response. Even with our less conservative assumptions on the oil price path, the budget deficit in 2017-18 is likely to exceed 3% of GDP, as in this case a stronger RUB will constrain the value of the oil-and-gas component of revenues (40% of the total at present). Tax revenues will also remain under pressure due to still weak economic activity, and due to the renewed increase in the shadow economy and tax optimization schemes. Even if the deficit is kept at 3.2% of GDP as targeted, deficit-financing options remain a concern. The Reserve Fund is likely to be depleted in 2017. External refinancing options are limited due to the implicit sanctions. This leaves the government with two choices: to borrow domestically, or to draw on the National Wellbeing Fund (NWF). Domestic debt issuance plans are rather extensive already (RUB 1.6tn gross in each of the next two years), and may create a supply overhang on the OFZ market, especially with the share of foreign ownership already at record highs. The second option would require changes to the NWF’s mandate, which currently limits its use to maintaining the stability of the pension system. Finally, the government might extend privatization plans after the successful disposal of stakes in Rosneft and Bashneft, although there is little envisaged in the current budget. Depletion of the Reserve Fund leaves two options: domestic borrowing or NWF The CBR’s policy response, on the other hand, has been straightforward: assuming no significant price shock, the regulator is likely to maintain 2.5-3.5% real interest rates, implying policy rate cuts at a pace of roughly 50bp per quarter starting in the spring. However, if risks to the inflation outlook materialize (e.g., from higher food prices or larger administered price adjustments), the CBR may defer the cuts by 1-2 quarters, resulting in a 50-100bp higher key rate at the end of 2017 than the base case. The potential adverse impact on growth is, however, likely to be limited given the weak transmission mechanism. Similarly, faster policy easing is unlikely to boost growth as Russian companies have already accumulated significant amounts of deposits. Faster easing, in our view, would be possible only in case of undesirable RUB appreciation (to 55 vs. the USD or below), in order to discourage carry investors. In this case, the CBR may also begin FX purchases to replenish reserves. The CBR is likely to cut the policy rate at a pace of roughly 50bp per quarter starting in spring This said, the future growth outlook crucially depends on the supply response. Even though output currently seems to be stuck well below potential, we believe that demand-side policies are capable of providing only a short-term cure. An extended period of underinvestment (YTD fixed investment declined by 2.3% yoy, following two years of contraction) has negatively affected domestic production capacities, resulting in lower potential growth. Therefore, institutional reforms and structural changes are crucial for medium and long-term growth. Given that the agenda mostly depends on political willingness, we do not expect much progress before the 2018 election. There have been some signs that the Russian political elite has come to realize the need for reforms, but it is yet uncertain whether these shifts will result in policy actions after the 2018 election. Future growth outlook crucially depends on the supply response… …institutional and structural reforms are crucial for medium and long-term growth Potential GDP growth has declined… 2014 RUB trln, in const 2008 prices 45 2016 …and growth is unevenly distributed across industries Actual GDP, saar 3Y CAGR 200% 150% 43 100% 41 50% Average growth ≈ 0 39 0% -50% 37 35 2007 -100% 2008 2009 2010 2011 2012 2013 2014 2015 Production, ranked by CAGR 2016 Source: Rosstat, UniCredit Research UniCredit Research page 64 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Strategy: disinflation to continue Javier Sánchez, CEE Fixed Income Strategist (UniCredit Bank London) +44 207 826-6077 Russian bonds were the best performers in 2016 largely due to the strength of the ruble supported by several years of credible monetary policy. Local currency investments returned in EUR equivalent 40% and foreign-currency bonds returned between 8-10%. [email protected] Investors piled into OFZs and other Russian assets. The OFZ curve has been floored at about 8% yield for the last 6 months despite headline inflation continuously decreasing. The ruble appreciated by 30% in real terms and is about 5% below its 10 year average. We expect oil prices to inch slightly higher from current levels towards 62 bbl and therefore see the ruble slightly undervalued. Therefore, we do not expect the currency to deliver the same level of returns in 2017. We expect disinflation to continue and find current real OFZ rates attractive targeting 100-150 bp of yield compression which would still result in real rates in excess of 200bp. Foreign participation in Russian OFZ bonds (% of total) OFZ yields and target inflation Russia OFZ yield (in %) Foreign participation in OFZ bonds 12 25 10 20 8 RUB YTM (in %) 30 15 10 6 CPI yoy 2017e 4 Jul-16 Oct-16 Apr-16 Jan-16 Jul-15 Oct-15 Apr-15 Jan-15 Jul-14 Oct-14 Apr-14 Jan-14 Jul-13 Oct-13 Apr-13 Jan-13 0 Jul-12 0 Oct-12 2 Apr-12 5 Jan-12 As of Jan 3, '17 As of Sep 30, '16 As of Jun 30, '16 CPI yoy 2018e 0 1 2 3 4 5 6 7 8 9 10 Modified Duration Source: Bllomberg, UniCredit Research GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other Sovereign Funds 2016F 56.3 43.5 12.8 9.4 9.4 --3.4 1.4 1.9 56.3 13.4 13.4 --2.7 2.7 0 15.0 25.2 2017F 59.4 49.5 9.8 7.7 7.7 --2.1 1.9 0.3 59.3 23.6 23.6 --2.8 2.8 0 7.2 25.7 GROSS EXTERNAL FINANCING REQUIREMENTS 2018F 54.2 43.5 10.7 7.6 7.6 --3.1 3.1 0 54.2 23.0 23.0 --2.6 2.6 0 7.3 21.2 EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net 2016F 96.0 -22.0 74.1 3.4 23.1 47.6 44.0 96.0 -9.0 5.0 57.0 2.7 16.2 38.1 44.5 -1.0 -0.5 2017F 102.3 -17.2 75.0 2.1 19.7 53.2 44.5 102.3 -6.1 4.2 61.1 2.8 15.7 42.6 49.3 -5.0 -1.2 2018F 118.0 -11.9 80.6 3.1 17.1 60.4 49.3 118.0 -0.6 4.8 64.6 2.6 13.7 48.3 53.5 0.0 -4.3 5.7 1.1 3.0 -0.3 3.0 -0.9 Source: CBR, MoF, UniCredit Research UniCredit Research page 65 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Serbia (B1 positive/BB- positive/BB- stable)* Outlook – The economy is in its best shape since the financial crisis, with growth expected at 3% this year and next supported by investment in 2017 and consumption in 2018. Budget deficits of around 2% of GDP will help reduce the debt and improve the rating outlook. Pressure on the RSD from volatile capital flows and a lower inflation target will postpone monetary easing. The main domestic risks are loan euroization and potential early parliamentary elections in April. Strategy – Serbia needs to issue a EUR bond to stabilize external financing and lower the pressure on local issuance. SERBIA USD bond spreads could tighten vs CROATI if early parliamentary elections are not called for April. Author: Dan Bucșa, Lead CEE Economist (UniCredit Bank London) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS ■ 12 Jan, 14 Feb, 14 Mar: NBS monetary policy meetings ■ 1-3 Feb, 27-28 Feb: 4Q16 GDP (flash, structure) ■ Mar: quarterly IMF review ■ 9 Apr: presidential (and potentially parliamentary) elections Inventories and discrepancy Net exports Gross fixed capital formation Public consumption Private consumption GDP 2014 2015 2016F 2017F 2018F GDP (EUR bn) 33.1 32.8 33.4 34.8 36.6 Population (mn) 7.1 7.1 7.1 7.0 7.0 4,638 4,624 4,734 4,957 5,243 GDP -1.8 0.8 2.7 3.0 3.0 Private Consumption -1.3 0.5 0.9 2.8 3.2 Fixed Investment -3.6 5.6 5.9 4.5 3.8 Public Consumption -0.6 -1.5 2.3 2.5 2.5 Exports 5.7 10.2 10.2 5.5 5.3 Imports 5.6 9.3 7.1 5.5 5.2 Monthly wage, nominal (EUR) 524 506 515 526 543 GDP per capita (EUR) Real economy, change (%) GDP GROWTH yoy (%), pp of GDP EUR bn Real wage, change (%) -0.9 -1.8 2.6 1.0 1.0 5.0 Unemployment rate (%) 19.9 18.2 16.4 15.3 14.9 4.0 Fiscal accounts (% of GDP) -2.0 6.0 3.0 2.0 Budget balance -6.6 -3.8 -2.0 -1.8 1.0 Primary balance -3.7 -0.5 1.2 1.5 1.3 0.0 Public debt 71.8 75.9 74.6 72.4 69.6 Current account balance (EUR bn) -2.0 -1.6 -1.3 -1.4 -1.5 Current account balance/GDP (%) -6.0 -4.8 -3.9 -4.0 -4.1 Extended basic balance/GDP (%) -2.3 0.7 1.2 1.0 1.5 3.7 5.5 5.1 5.0 4.6 Gross foreign debt (% of GDP) 77.6 80.3 78.0 78.0 76.6 FX reserves (EUR bn) 11.1 11.5 11.2 11.6 11.7 7.4 7.3 6.7 6.5 6.1 CPI (pavg) 2.1 1.4 1.1 2.5 3.7 CPI (eop) 1.8 1.6 1.4 3.8 3.6 3.0 Central bank target 4.0 4.0 4.0 3.0 3.0 2.0 Central bank reference rate (eop) 8.00 4.50 4.00 4.00 4.00 1.0 3M money market rate (Dec avg) 8.59 3.86 3.45 3.97 4.00 USD/FX (eop) 99.5 111.2 117.1 114.5 110.3 EUR/FX (eop) 121.0 121.6 123.5 126.0 128.0 USD/FX (pavg) 88.4 108.8 111.3 116.2 111.5 EUR/FX (pavg) 117.2 120.8 123.1 124.8 126.5 -1.0 External accounts -2.0 -3.0 2014 2015 2016F 2017F 2018F Net FDI (% of GDP) INFLATION FORECAST yoy (%) Headline inflation Inflation target Target range 6.0 Months of imports, goods & services 5.0 Inflation/Monetary/FX 4.0 0.0 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Source: SSO, NBS, UniCredit Research Source: SSO, NBS, MinFin, UniCredit Research *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 66 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Optimistic outlook clouded by domestic risks The economy is in the best shape since the financial crisis… …with growth expected at 3% this year and next… …supported by investment in 2017… …and consumption in 2018 The Serbian economy enters 2017 in the best shape it has been in since the financial crisis: above-potential growth, low budget deficit, stable stock imbalances and moderate inflation. Rating agencies took note and improved Serbia's rating outlook. The IMF considers the precautionary agreement broadly on track. However, the risk of stalling reforms is also materially higher than in the past. SOEs remain loss making 8, a drag on the budget and economic growth. Addressing these losses remains the main item on the IMF’s agenda. Labor, judicial and institutional reforms are needed to improve the business environment, increase private and foreign investment and accelerate growth on a sustainable basis. Economic growth should reach 3% this year and next, although the composition may change. Public infrastructure investment will remain the biggest growth driver, with projects in rail and road infrastructure financed with Russian, Chinese and Azeri loans. A bumper harvest and new foreign investment projects in siderurgy, car parts and agriculture could keep export growth above 5%, offsetting falling output at Fiat, the country's largest exporter. Private consumption is likely to rise faster than in 2016, but higher inflation and the possibility of additional lay-offs in the public sector will slow real wage growth, despite higher operating margins in the private sector. In 2018, we expect private consumption to play a more prominent role in keeping GDP growth close to 3%. At the same time, public investment could slow, unless the government reduces SOE losses or borrows more. Despite good export growth, a rebound in consumption and in investment projects is likely to boost imports as well. Thus, any additional adjustment in the C/A deficit may be only marginal. Moreover, this assumes that remittances will offset higher interest expenditure as public external debt rises further. FDI will continue to cover the external shortfall, but the RSD will remain vulnerable to swings in external risk appetite. Budget deficits of around 2% of GDP… ... will help reduce debt and improve the rating outlook Serbia's budget deficit is expected to remain close to 2% of GDP in 2017 and 2018, with a significant reduction below this threshold unlikely as long as SOEs continue to generate large costs. Moreover, contingent liabilities remain high: the IMF highlighted that SOEs are running large arrears with Srbijagas and EPS. Eventually, these will have to be covered by the government or affect energy companies’ results. A stable budget deficit of around 2% of GDP will lead to a reduction in public debt to GDP. The pace is likely to be slower than in 2016, when the government reduced its fiscal reserves by 1.5% of GDP. Stable debt metrics may lead first to an upgrade from Moody's in 2017, thus aligning the three ratings. While rating upgrades will probably continue, the investment grade remains years away. IMPROVING SITUATION IN THE PRIVATE AND THE PUBLIC SECTOR Companies’ financial health is improving yoy (%), SA, CPI-adjusted Public debt started falling last year (in percent of GDP) Operating income Public debt (EUR bn) Operating costs Public debt (% GDP, rs) 20 27.0 80.0 15 25.0 75.0 23.0 70.0 21.0 65.0 19.0 60.0 17.0 55.0 10 5 0 -5 15.0 -10 1Q09 4Q09 3Q10 2Q11 1Q12 4Q12 3Q13 2Q14 1Q15 4Q15 2012 2013 2014 2015 2016E 2017F 2018F 50.0 3Q16 Source: SSO, MinFin, UniCredit Research 8 The IMF mentioned on1 November 2016 the copper mine RTB Bor, the Resavica mines, and the chemical producers Petrohemija, Azotara and MSK. UniCredit Research page 67 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly The RSD remains vulnerable to volatile capital flows In 9M16, foreigners reduced their holdings of Serbian bonds by EUR 683mn (2% of GDP). While most outflows were accounted for by a single investor, US investors are less keen on Serbian bonds since yields are three times lower than their peak in 2H12. Tapping European debt markets would make sense at this stage and would alleviate the depreciation pressure on the RSD. Otherwise, the NBS will have to keep tight monetary conditions, thus supporting further euroization. Inflation is expected inside the target range in 2017 and 2018 The NBS decided to lower its inflation target from 4% to 3% starting in 2017. As a result, additional rate cuts are unlikely this year and next due to expected reflation. Headline inflation could exceed 3% in both 2017 and 2018. This year, a combination of higher oil prices and core inflation, stronger USD and regulated price increases could push inflation temporarily close to 4%, without threatening to exceed the target band of 1.5-4.5%. Interest rate increases are unwarranted, since the output gap will remain negative. Loan euroization remains the biggest risk for the banking system The biggest local risks refer to loan euroization and to political stability. The IMF believes that reducing the inflation target will help the dinarization of the economy, but the process is not straight-forward. The current rise in private-sector borrowing is supported mostly by FX loans, which remain significantly cheaper than RSD loans. High euroization compels the NBS to defend the currency at the cost of keeping monetary conditions tighter than the economy would require in this phase of the business cycle. This is likely to continue if the structure of external financing does not change to more stable sources and the average duration of government bonds does not increase. The failure to reverse euroization remains one of the biggest macroeconomic risks for a country that attempts a quasi-currency peg while running a current account deficit. After a Novi Sad court granted a CHF borrower the termination of his loan agreement at a total cost that covers 60% of the value of the principal at the current exchange rate, approximately 18,500 CHF borrowers may seek a similar settlement. This would affect the banking sector at a time when the NPL ratio remains high (19.5% in September 2016). Early parliamentary elections would be bad for reforms and asset prices The newest local risk is another round of early parliamentary elections. PM Aleksandar Vučić will decide by the end of January whether to call early parliamentary elections at the same time as the regular presidential elections, expected on 9 April. This would help the SNS candidate (yet to be determined) for the largely-ceremonial president position fight off a potential single candidate from the opposition (the early favorite is former Foreign Minister Vuk Jeremić). If Mr. Vučić decides to call early elections, the risk of stalling reforms and delays in public financing could reemerge, affecting Serbian bond yields and the RSD. EUROIZATION IS THE BIGGEST PROBLEM OF THE BANKING SECTOR RSD loans are more expensive than EUR ones interest rate on new loans (%) 25.0 Loans to households in RSD Loans to households in EUR FX loans dominate lending and continue to grow Loans to companies in RSD Loans to companies in EUR RSD bn Household loans in other FX Household loans - FX indexed Household loans in RSD Household loans in CHF Household loans in EUR 1200 20.0 1000 800 15.0 600 10.0 400 200 5.0 0.0 Sep-10 0 Jan-12 Jun-11 Mar-12 Dec-12 Sep-13 Jun-14 Mar-15 Dec-15 Oct-12 Jul-13 Apr-14 Jan-15 Oct-15 Jul-16 Sep-16 Source: NBS, UniCredit Research UniCredit Research page 68 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Strategy: Issuance in EUR would be welcome Javier Sánchez, CEE Fixed Income Strategist (UniCredit Bank London) +44 207 826-6077 With the Fed expected to increase rates further in 2017 and reflation reducing the scope for monetary easing in Serbia, the government will have to focus on expanding the bond investor base to Europe. A first EUR international bond would be a step in the right direction, even if issued at a significant premium over regional peers. [email protected] The SERBGB market needs to develop further in order to attract eurozone investors. Making SERBGBs euroclearable, choosing primary dealers who can provide liquidity in the secondary market and continuing to focus on a limited number of benchmarks are steps that could increase liquidity in the market and lead to inclusion in local currency bond benchmarks. SERBIA USD 20 and 21 offer a pickup over CROATI USD of about 40bp, close to the highs registered since 2014. Although Croatia has a better macro outlook, the spread may narrow if the Serbian government does not call early parliamentary elections for April 2017. SERBGBs offer one of the highest yields in the CEE region 6 6 Serbia and Croatia USD z-spreads differential Z-spreads, bp As As of of Jan Jan 3, 3, '17 '17 As As of of Sep Sep 30, 30, '16 '16 As As of of Jun Jun 30, 30, '16 '16 5 5 spread SERBIA to CROATI 20 spread SERBIA to CROATI 21 100 RSD YTM (in %) 80 60 4 4 40 3 3 20 0 2 2 -20 -40 1 1 -60 0 0 0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 -80 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 10 10 Residual Residual Maturity Maturity * 7Y bond for Serbia Source: Bloomberg, MinFin, UniCredit Research GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills External borrowing Bonds IMF/EU/Other IFIs Other Fiscal reserves change (- =increase) GROSS EXTERNAL FINANCING REQUIREMENTS 2016F 2017F 2018F 4.6 0.7 3.9 3.3 1.9 1.4 0.6 0.6 0.1 4.6 3.2 2.4 0.8 1.2 0.0 0.6 0.6 0.3 4.8 0.6 4.1 3.4 2.6 0.8 0.7 0.7 0 4.8 3.1 2.2 0.9 1.8 1.0 0.2 0.6 -0.1 4.4 0.7 3.7 2.8 1.9 0.9 0.9 0.9 0 4.4 2.8 2.0 0.8 1.6 1.0 0.2 0.4 0 EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Government/central bank Banks Corporates/Other Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing EU structural and cohesion funds Change in FX reserves (- = increase) Source: NBS, MinFin, UniCredit Research Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net UniCredit Research page 69 2016F 6.7 1.3 5.1 0.6 1.0 3.5 0.3 0 0.2 0.1 2017F 6.7 1.4 5.1 0.7 1.0 3.4 0.2 0 0.1 0.1 2018F 7.0 1.5 5.2 0.9 1.0 3.4 0.2 0 0.1 0.1 6.7 1.5 0 4.6 0.4 0.8 3.5 0.3 0 0.3 6.7 1.5 0 5.9 1.8 0.7 3.4 0.2 0 -0.9 7.0 1.5 0 5.8 1.7 0.7 3.4 0.2 0 -0.5 -0.8 -0.6 0.0 0.3 0.1 0.1 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Turkey (Ba1/BB+/BBB- negative)* Outlook – Economic performance worsened sharply in 2H16 with political shocks, security concerns, and rating downgrades pushing the economy into recession. Macroeconomic imbalances have widened, with policies aiming at boosting demand rather than addressing the underlying structural rigidities, and financial markets have been battered by the slump in risk appetite after Trump’s victory. While growth should pick up in 2017 in the absence of further shocks, political uncertainty will keep markets volatile at least through mid-2017. With global financial conditions set to tighten further, and the CBRT unlikely to tighten as needed to lure investors back, Turkish assets will remain under pressure. Odds of a major financial dislocation will rise, with a potentially severe adverse impact on growth and incomes. Author: Lubomir Mitov, Chief CEE Economist (Unicredit Bank London) MACROECONOMIC DATA AND FORECASTS EUR bn 2014 2015 2016F 2017F 2018F GDP (EUR bn) 703.6 776.2 750.5 727.0 753.7 Population (mn) 77.3 78.2 79.0 79.8 80.6 9,100 9,931 9,504 9,114 9,351 GDP 5.2 6.1 1.5 3.0 3.3 Private Consumption 3.0 5.5 1.5 3.3 3.8 Fixed Investment 5.1 9.2 3.1 0.5 3.5 Public Consumption 3.1 4.1 17.5 10.0 6.0 Exports 10.8 6.6 -0.6 4.0 4.6 Imports 1.7 3.8 4.5 3.9 4.1 Monthly wage, nominal (EUR) 968 1,029 1,072 1,036 1,071 14.0 Real wage, change (%) 1.0 2.3 7.6 0.4 2.9 12.0 Unemployment rate (%) 9.9 10.3 10.8 10.7 10.5 -3.1 KEY DATES/EVENTS ■ 11 Jan 14 Feb 13 Mar – Current account balance ■ 24 Jan – MPC meeting GDP per capita (EUR) ■ 3 Feb 3 Mar – Consumer price index ■ 16 Mar – National accounts 4Q16 Real economy, change (%) GROWTH HAS DECELATED SHARPLY… 16.0 yoy (%) Personal consumption Public consumption Gross fixed capital Net exports Inventories GDP 10.0 8.0 Fiscal accounts (% of GDP) 6.0 Budget balance -1.9 -1.7 -2.6 -2.8 2.0 Primary balance 0.8 0.8 0.1 -0.1 -0.2 0.0 Public debt 31.0 30.6 33.2 33.2 33.5 Current account balance (EUR bn) -32.8 -29.0 -37.8 -39.8 -43.6 Current account balance/GDP (%) -4.7 -3.7 -5.1 -5.6 -6.0 Extended basic balance/GDP (%) -3.9 -2.4 -4.3 -4.7 -5.2 0.8 1.3 0.8 0.9 0.8 Gross foreign debt (% of GDP) 44.6 46.0 46.9 48.3 54.1 FX reserves (EUR bn) 87.1 101.4 91.1 85.7 83.3 4.7 5.4 4.8 4.5 4.2 4.0 -2.0 External accounts -4.0 -6.0 2010 2011 2012 2013 2014 2015E 2016F 2017F 2018F …WITH INFLATION SET TO ACCELERATE CPI yoy (%) Inflation target TRY basket (rs) 14.0 35.0 12.0 30.0 Months of imports, goods & services 25.0 Inflation/Monetary/FX 20.0 10.0 8.0 6.0 15.0 CPI (pavg) 8.9 7.7 7.8 10.6 7.6 10.0 CPI (eop) 8.2 8.9 8.6 9.2 7.7 5.0 Central bank target 5.0 5.0 5.0 5.0 5.0 -5.0 Central bank reference rate (eop) 8.3 7.5 7.8 8.5 8.0 -10.0 3M money market rate (Dec avg) 9.6 9.3 8.5 9.8 8.3 USD/TRY (eop) 2.30 2.92 3.52 3.70 3.90 EUR/TRY (eop) 2.83 3.18 3.71 4.07 4.52 USD/TRY (pavg) 2.19 2.72 3.04 3.58 3.74 EUR/TRY (pavg) 2.91 3.01 3.35 3.85 4.13 108.6 109.0 107.7 100.8 97.4 -4.3 0.3 -1.2 -6.4 -3.4 0.0 4.0 2.0 0.0 Jan-07 Net FDI (% of GDP) -15.0 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 -20.0 Source: Turkstat, CBRT, UniCredit Research Real effective exchange rate, 2000=100 Change (%) Source: Turkstat, CBRT, Haver, Bllomberg,UniCredit Research *Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch, respectively UniCredit Research page 70 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly A year to forget 2016 was the worst year since the global financial crisis… For Turkey, 2016 was the worst year since the global financial crisis. Hit by a series of political shocks, such as the failed coup in July, a collapse in tourism caused by the Russian travel ban (lifted only in September) and growing security concerns, as well as Moody’s downgrade to sub-investment grade in October, the economy slipped into recession after midyear, for the first time since 2009. However, unlike then, this time the recession is domestically-bred. …with the economy in recession after midyear The slump in activity was particularly steep in 3Q16. Private consumption slipped, dragged down by weak confidence in the wake of the coup attempt and the government’s response that followed. Investment fell again and export growth softened. However, the major culprit was tourism, with arrivals falling more than 30%, the largest drop on record. While most of the exceptional factors that pulled down growth in 3Q have lapsed, activity remained subdued also in 4Q, setting the stage for a second consecutive quarterly yoy decrease in real GDP. For FY16, growth is likely to have come in at just 1.5%, again the worst outcome since 2009. The slump in activity was particularly deep in 3Q16… …with real GDP likely to have contracted yoy in 4Q16 as well… …as financial markets have come under intense pressure following Trump’s victory… To add injury to insult, financial markets have come under intense pressure towards the end of the year, when Trump’s victory triggered a major global selloff. Turkey again was among the biggest losers: the TRY has slumped as much as 17% against the USD since midOctober, and yields on TURKGBs soared by more than 200bp. In general, in 2016 Turkish assets have consistently underperformed other EM, both in times of upside, gaining the least among peers, as well as in selloffs, when they were among the most affected. …and Turkish assets among the worst performers globally This underperformance cannot be explained just by one-off shocks but was rather rooted in Turkey’s longstanding structural weaknesses. These have been reinforced by misguided policies which focused on boosting growth via major policy easing rather than addressing underlying structural deficiencies. The fiscal stance eased by more than 2% of GDP, with government spending surging 15-20% in real terms. Monetary policy has remained lax, with the CBRT reluctant to hike rates despite the drop in the TRY, opting to boost liquidity instead. This underperformance is mostly rooted in major structural deficiencies… …reinforced by strongly expansionary policies… This policy stance has done little for growth, boosting the already sizable macroeconomic imbalances instead. Despite the slowdown in economic activity, the C/A deficit has widened to 5% of GDP from 3.7% in 2015. While about 1pp of this deterioration was due to the collapse in tourism, the underlying trade balance (adjusted for terms of trade changes) has deteriorated markedly again. Inflation has remained elevated at just under 8%, despite a sharp slowdown in food price increases and lower oil prices. With both set to reverse this year and the TRY sharply weaker, price pressures will intensify again in 2017. …that have done little for growth… …but have widened further the sizable macroeconomic imbalances Economic activity has remained subdued… …as the C/A has deteriorated further Business confidence Consumer confidence Industrial production (rs) 130.0 140.0 120.0 130.0 110.0 120.0 100.0 90.0 110.0 ToT gains CA balance adj 2.0 0.0 -2.0 -4.0 -6.0 100.0 70.0 Jul-16 Sep-16 May-16 Jan-16 Mar-16 Nov-15 Jul-15 Sep-15 May-15 Jan-15 Mar-15 Nov-14 Jul-14 Sep-14 May-14 Sep-16 Jan-16 May-16 Sep-15 Jan-15 May-15 Sep-14 Jan-14 May-14 Sep-13 Jan-13 May-13 Sep-12 Jan-12 May-12 Sep-11 Jan-11 May-11 Sep-10 Jan-10 May-10 -12.0 80.0 Jan-14 90.0 60.0 -8.0 -10.0 Mar-14 80.0 50.0 Trade balance adj 4.0 Source: Turkstat, CBRT, Haver, UniCredit Research UniCredit Research page 71 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly We expect growth to rebound in 2017 and 2018… After a dismal 2016, we expect growth in Turkey to rebound to slightly above 3% in 2017. This rebound will partly benefit from the expected recovery in global growth, but will largely reflect the weak base from 2016 and one-off factors such as a partial recovery in tourism and the expected lifting of the Russian ban on agricultural exports from Turkey. Growth ought to be also supported by competitiveness gains, with the TRY now at its weakest level in real effective terms since 2001 – a weakness that has more than offset the surge in unit labor costs. …thanks to firmer foreign demand, one-off factors and competitiveness gains Continued aggressive policy accommodation would lend some support to growth as well, but at the expense of a further increase in macroeconomic imbalances. The resulting boost to demand, along with the projected rise in oil prices, is likely to push the C/A deficit close to 6% of GDP in 2017. The same factors, together with a rebound in food prices and weak TRY, will lift inflation into double-digits for most of 2017. Aggressive policy accommodation will support growth on the margin… …but will add to the large C/A deficit… Inflation will remain elevated and the TRY weak due in part to the CBRT’s reluctance to tighten monetary policy as needed. We expect the CBRT, under heavy political pressure, to limit rate hikes to 75bp in 2017, on a par with the Fed, which is unlikely to be enough to lure back investors. Fiscal policy will remain strongly expansive, with the deficit near 3% of GDP in 2017. Even so, risks to financial stability will be modest given Turkey’s low government debt. …and leave inflation elevated Rate hikes will mirror the Fed… …as the fiscal deficit widens further The heavy reliance on foreign financing, against the background of misguided policies, will leave Turkish financial markets highly vulnerable to shifts in market sentiment. Risks to external financing will remain elevated and asset prices under pressure, at least until political tensions ease, presumably after the referendum on granting the president executive powers expected by May. A rebound could follow through the summer as tourism receipts rise, but is likely to ebb by the fall as global financial conditions continue tightening. Another risk is the marked deterioration of corporate balance sheets due to TRY depreciation and the spillover effect this may have on domestic banks. Financial markets will be volatile until late spring… …with a brief rebound possible in the summer… …followed by more pressure… The risks to our baseline scenario are tilted towards the downside. Turkey’s major challenge is the adjustment to the expected tightening in global liquidity conditions and the rise in core yields. Given current policies, Turkish assets will continue underperforming their peers, limiting foreign interest despite attractive nominal returns. While we do not expect a full-blown financial crisis under our baseline scenario, risks for a “sudden stop” of capital inflows are not negligible. A “sudden stop” could unleash a major financial upheaval, with an abrupt TRY depreciation triggering a spike in interest rates that could eventually result in a recession. …and potential risks to corporate balance sheets The risks are tilted to the downside… …with the rise in core yields the main challenge… ..and odds of a major financial upheaval rising Messy domestic politics are another risk factor to consider. Fighting with the Kurds and Turkey’s involvement in northern Syria have reinvigorated security concerns that might be harmful to the revival of tourism. Furthermore, the purge of numerous civil service officials has undoubtedly affected the quality of government institutions – something that will become apparent only in the future. Finally, the upcoming referendum on granting the president executive powers will also weigh on confidence well into 2017 if not beyond. limiting any potential upside to the TRY and government bonds. Messy politics are another risk factor to consider… …with potential adverse impact on tourism, the quality of institutions and on confidence Monetary policy has eased sharply…. …as external financing conditions have become more difficult FDI Banks EOM 14 12 15.0 10 10.0 8 5.0 6 0.0 CBRT O/N 1w repo Deposit O/N weighted avg cost of funding 4 2 0 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Portfolio Other private Reserves Official Resident Lending C/A balance -5.0 -10.0 -15.0 Jan-17 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016E 2017F 2018F Source: Turkstat, CBRT, Bloomberg, UniCredit Research UniCredit Research page 72 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Strategy: not there yet Javier Sánchez, CFA EM Fixed Income Strategist (UniCredit Bank London) +44 207 826-6077 Turkish market dynamics have gone from bad to worse this year. Looking at the last decade’s metrics, the currency and both local and foreign bonds appear at the tail of the valuation levels which signaled in the past good entry levels. However, we believe that we still need more clarity on policy and to see how the effects of the large and persistent depreciation in the currency affect the inflation and external metrics in order to issue an entry recommendation. We may be close to that point but much will depend on the policy response and the evolution of domestic politics at a time when the external environment is not helpful. [email protected] We expect inflation to reach 9.2% by year-end, but only after peaking at levels that could be as high as 11-12% in the first half of the year with significant volatility. We therefore think that current TURKGB yield levels still have some downside, with Fitch’s downgrade looming and a busy domestic political calendar, and therefore we target an entry level of 12%. USD bonds are trading at the higher end of the BB group, but current spread levels still do not offer a compelling entry level. Real TURKGB yields Turkey USD Z-spreads vs. BB and BBB group 10y Source: Bloomberg abd UniCredit Research. 700 BBB average BB average Turkey '23 3 600 500 2 400 300 1 200 0 100 -1 2012 2013 2014 2015 I 2016 III II IV I II III IV 0 2016 2015 Source: Bloomberg, UniCredit Research GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other GROSS EXTERNAL FINANCING REQUIREMENTS 2016F 2017F 2018F 42.0 19.4 22.6 17.8 17.8 --4.8 2.5 2.3 41.9 28.4 28.4 --6.1 5.0 1.1 7.4 44.6 20.2 24.4 18.6 18.6 --5.8 3.1 2.8 44.6 35.3 35.3 --6.6 4.1 2.5 2.7 47.7 23.0 24.5 18.8 18.8 --5.9 4.3 1.6 47.5 37.2 37.2 --7.7 5.7 2.0 2.8 EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net 2016F 191.3 37.8 58.4 5.1 37.4 15.9 95.1 191.3 6.0 1.1 73.3 10.4 39.3 23.6 90.0 10.0 11.0 2017F 171.6 39.8 41.8 7.3 22.1 12.3 90.0 171.6 6.3 4.2 59.1 6.6 30.0 22.5 87.6 11.5 2.9 2018F 171.9 43.6 40.8 7.2 21.6 12.0 87.6 171.9 6.3 4.0 61.3 7.7 28.1 25.5 90.6 10.1 -0.4 2.5 1.8 2.3 2.0 4.0 2.1 Source: CBRT, Treasury, Turkstat, UniCredit Research UniCredit Research page 73 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly Ukraine (Caa3 stable/ B- stable/ B- stable)* Outlook – The worst of the crisis seems to be over, with inflation abating and growth returning, even if barely. The recovery has been driven by strong wage growth and a sizable fiscal easing, which has resulted in renewed widening of the C/A deficit amid weak exports. While encouraging progress was made recently in bank restructuring, the overall pace of reforms has disappointed. We expect the authorities to do just enough to secure the renewal of IMF lending, but prospects after 2017 remain clouded. At current policies, growth is unlikely to top 1-2% with financial stabilization remaining fragile. With IMF lending tapering off and repayments to official and private creditors commencing in 2018, debt sustainability concerns will return unless growth and reforms pick up much more than likely at present. Author: Lubomir Mitov, Chief CEE Economist (Unicredit Bank London) MACROECONOMIC DATA AND FORECASTS KEY DATES/EVENTS ■ 06 Jan 08 Feb - Consumer price index ■ 23 Jan 23 Feb- Industrial production index ■ 26 Jan - Key rate decision ■ 3 Feb – Current account balance, 4Q16 FY16 ■ 18 Feb 21 Mar – GDP Q1417 FY17 15.0 2016F 2017F 2018F 81.6 82.6 86.9 89.9 Population (mn) 42.9 42.8 42.3 41.9 41.9 GDP per capita (EUR) 2289 1909 1953 2073 2145 GDP -6.8 -9.7 1.3 2.0 1.7 Private Consumption -9.0 -20.2 3.8 4.2 4.0 -22.4 -9.3 12.5 10.0 8.0 0.4 1.0 -1.0 -0.8 0.5 Exports -14.1 -16.9 -3.2 3.2 0.9 Imports -21.3 -22.0 4.8 5.7 5.0 Monthly wage, nominal (EUR) 218 173 185 195 209 Real wage, change (%) -5.2 -18.7 8.9 4.6 8.2 Unemployment rate (%) 9.3 9.6 9.7 9.6 9.6 Budget balance -4.5 -1.2 -3.8 -3.3 -3.0 Primary balance -1.2 3.0 0.8 1.2 1.5 Public debt 71.2 91.3 93.3 95.9 95.2 Current account balance (EUR bn) -4.2 -0.2 -2.6 -2.8 -3.9 Current account balance/GDP (%) -3.9 -0.2 -3.0 -3.2 -4.4 Extended basic balance/GDP (%) -3.7 3.7 0.6 0.0 -0.8 0.2 3.9 3.7 3.2 3.6 96.8 131.5 129.8 129.6 134.6 Public Consumption 10.0 Fiscal accounts (% of GDP) 5.0 0.0 -5.0 -10.0 External accounts -15.0 -20.0 2015 98.2 Fixed Investment Private consumption Public consumption Gross fixed capital formation Net exports yoy (%) 2014 GDP (EUR bn) Real economy, change (%) GROWTH REMAINS LACKLUSTER 20.0 EUR bn 2010 2011 2012 2013 2015 2016f 2017f 2018f Net FDI (% of GDP) INFLATION SLOWING BUT STILL ELEVATED yoy (%) 70.0 CPI NEER 60.0 50.0 Gross foreign debt (% of GDP) FX reserves (EUR bn) 5.0 11.3 12.5 14.0 15.8 180 Months of imports, goods & services 0.9 2.5 2.9 3.2 3.5 160 Inflation/Monetary/FX 140 CPI (pavg) 12.1 48.7 13.9 10.9 7.2 CPI (eop) 24.9 43.3 12.0 8.3 6.4 -- -- -- -- -- 14.0 22.0 14.0 11.0 9.0 120 40.0 100 30.0 20.0 10.0 0.0 80 Central bank target 60 Central bank reference rate (eop) 40 3M money market rate (Dec avg) 21.0 19.0 15.0 12.0 10.0 20 USD/UAH (eop) 15.67 23.44 26.25 28.00 30.00 EUR/UAH (eop) 14.54 23.03 27.46 30.73 34.22 USD/UAH (pavg) 12.02 21.93 25.55 27.19 29.00 EUR/UAH (pavg) 15.96 24.26 28.23 31.05 33.64 79.1 79.6 77.9 81.9 80.6 -20.6 0.6 -2.1 5.1 -1.7 0 -10.0 Jan-13 Sep-13 May-14 Jan-15 Sep-15 May-16 Jan-17 Sep-17 May-18 -20 Source: UniCredit Research Real effective exchange rate, 2000=100 Change (%) * Source: Ukrstat, NBU, Haver, UniCredit Research Long-term foreign currency credit rating provided by Moody’s, S&P and Fitch respectively UniCredit Research page 74 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly A tenuous recovery as risks loom large The recovery which began in late 2015 has continued but at a very slow pace… The recovery that began in late 2015 continued into 2016, but at a very slow and uneven pace, with occasional reversals. Buoyed in part by a bumper crop and recoveries in industry and construction as tensions in the East eased, FY16 real GDP expanded perhaps by 1.3%. This was in line with our initial projection but lower than the IMF’s 1.5% program target. The tenuous recovery has been driven by domestic demand. Private consumption jumped nearly 4% and investment 15%, although from a very low level. Compared with the 2013 peak, both remain 20-25% lower. Fiscal policy was also supportive, adding some 2.8pp to growth as the budget deficit widened to 3.8% from 1.5% in 2015. This nearly reversed a largely unintended 3% tightening in 2015 afforded by lower interest payments in the wake of the debt restructuring and a largely inflation-driven higher-than-projected rise in revenues. The government used this fiscal room to partially compensate for the steep drop in real pensions and government wages, with the latter rising roughly 10% in real terms in 2016. …driven by a rebound in consumption and investment… …both of which were policy driven, with the fiscal stance easing sharply In contrast, the external sector has disappointed… The external sector has disappointed, however. Hit by a combination of terms of trade shocks, subdued demand for key exports, such as metals, and tighter trade restrictions by Russia, export volumes fell again, some 3% in 2016 and more than 30% since 2013. Import volumes have begun recovering, rising nearly 5% in 2016, but still 35% lower than before the crisis. …with exports shrinking and imports rising… These developments not only pushed the C/A deficit to 3% of GDP in 2016 from near balance in 2015, but also underscored Ukraine’s key structural weakness – a savings rate of only 14-15% of GDP, which is insufficient to support a meaningful rebound in investment without a sizable C/A deficit. The latter, however, is something the economy cannot afford, with virtually all financing coming from official sources and no access to private markets. …pushing the C/A deficit to 3% of GDP from 0.2% in 2015… …underscoring Ukraine’s main structural issue – a very low savings rate The rebound in domestic demand was policy-driven… What is perhaps more worrisome, the recovery in domestic demand has been almost entirely policy driven. The January-October fiscal deficit surged to 3.5% of GDP from just 0.5% a year before. Monetary policy has been eased as well, albeit quite cautiously and in line with the decline in inflation. The latter dropped to 12% in November from 43% at the end of 2015, but the decline mostly reflected the high base in 2015 when inflation surged as a result of steep adjustments in administered energy prices, especially natural gas. These adjustments were much smaller in 2016, both because import prices dropped in line with the decline in global oil prices (to which they are linked) and relative UAH stability. Room for a more active monetary policy has remained constrained by the need to keep most FX restrictions in place, given the lack of access to foreign markets as well as the continued difficulties in the banking system, which remains fragile. …with the fiscal deficit soaring Monetary policy was eased cautiously… …as inflation fell to low double digits… …but remained constrained by weak banks and FX shortage Activity has stabilized at a low level… yoy (%) …as export volumes continued contracting Retail trade 20.0 Industrial production Index (2010=100) Imports 160.0 10.0 140.0 0.0 120.0 -10.0 100.0 -20.0 80.0 Jul-16 Oct-16 Apr-16 Jan-16 Jul-15 Oct-15 Apr-15 Oct-14 Jan-15 Jul-14 Apr-14 Jan-14 Jul-13 Oct-13 Apr-13 Jul-16 Oct-16 Apr-16 Jan-16 Jul-15 Oct-15 Apr-15 Jan-15 Jul-14 Oct-14 Apr-14 Jan-14 Jul-13 Oct-13 Apr-13 Jan-13 Jul-12 Oct-12 Apr-12 Jan-12 40.0 Jan-13 60.0 -30.0 -40.0 Exports 180.0 Source: Ukrstat, NBU, UniCredit Research UniCredit Research page 75 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly The outlook for 2017-18 remains highly uncertain, despite stronger global growth… The outlook for 2017 and 2018 remains highly uncertain. While the pickup in global growth and recovering commodity prices should provide an upside to exports, higher oil prices will boost the import bill and necessitate further sizable adjustments in domestic energy prices that will add to inflation. Moreover, tighter global liquidity conditions as U.S. interest rates rise will further complicate Ukraine’s return to capital markets. Finally, the uncertainty related to the future course of U.S. foreign policy vis-a-vis Russia will also weigh on confidence. …as higher oil prices, tighter global liquidity and political concerns weigh on confidence However, dysfunctional policies and politics are the main impediments to recovery… However, the by far most important factor constraining the recovery involves domestic policies and politics. Despite the significant progress made in divesting the sizable macroeconomic imbalances, the progress achieved has been uneven and subject to reversals. This fragility reflects to a large extent the lack of tangible progress in structural reforms. The fight against corruption remains in nascent stages and institutional capacity very weak. The reforms needed to put public finances on a sustainable footing have yet to be designed, and the role of the state in the economy remains pervasive. …with progress on structural reforms disappointing All these shortcomings reflect to a great extent Ukraine’s dysfunctional politics. The country’s political system has remained largely unreformed, with heavy influence of vested interests that have opposed any move to limit tax loopholes or push ahead with the fight against corruption. Instead, Parliament has repeatedly pushed strongly populist or self-serving ideas, which would have been detrimental to stability if implemented. While MPs had eventually to back off under pressure from the IMF, concerns have been on the rise about the future course of policies when the IMF program expires in 2018. Dysfunctional politics remain the main culprit… …with vested interests blocking reforms and pushing ahead with populist ideas… …for now blocked by the IMF Given current policies, growth will remain sluggish as macroeconomic imbalances grow Given current policies, we expect the supply side response to be limited, capping growth at 2% in the coming years. At the same time, macroeconomic imbalances will remain an issue. We expect the C/A deficit to widen to 3.2% of GDP in 2017 and 4.4% in 2018, once Russian natural gas transit via Ukraine falls as alternative pipelines come into operation. While inflation should ease into single digits by 2018, it would remain among the highest in CEE. External financing will become a growing source of concern… Under these circumstances, external financing will become a source of growing concern. While in 2017 the availability of foreign official financing should provide a cushion, external financing challenges will be much tougher in 2018, when IMF lending tapers off and repayments commence to both official creditors and private bondholders. The IMF program assumes Eurobond issues of USD 1bn already in 2017 and USD 2bn in 2018, assuming growth strengthens to 3% by then, and a C/A deficit of 2% of GDP. With growth almost certainly likely to be lower and the deficit more than twice as large, borrowing needs from the financial markets are more likely to amount to USD 4-5bn. – something which will be very difficult to achieve given current policies and given tightening global liquidity conditions. Unless policies are changed and reforms implemented, debt sustainability concerns will remerge by 2018. …once official financing tapers off and debt repayments surge… …boosting borrowing needs from private markets in 2018 Unless policies are changed, debt sustainability worries will re-emerge External financing remains dependent on official creditors… 30.0 Official Financing Resident Capital C/A USD bn 25.0 …as borrowing needs from private creditors surge after 2018 Equity Foreign borrowing Change in FX reserves Official Debt Restructuring Other Private 30 25 20.0 20 15.0 10.0 15 5.0 0.0 10 -5.0 5 -10.0 -15.0 -20.0 0 2010 2011 2012 2013 2014 2015 2016 2015 2016 2017 2018 2019 2020 2021 2022 2017 Source: NBU, IMF, UniCredit Research UniCredit Research page 76 See last pages for disclaimer. January 2017 <date> Economics & FI/FX Research CEE Quarterly GOVERNMENT GROSS FINANCING REQUIREMENTS EUR bn GROSS EXTERNAL FINANCING REQUIREMENTS 2016F 2017F 2018F Gross financing requirement Budget deficit Amortization of public debt Domestic Bonds Bills Loans External Bonds and loans IMF/EU/Other IFIs Financing Domestic borrowing Bonds Bills Loans External borrowing Bonds IMF/EU/Other IFIs Privatization/Other Memoranda: 9.5 3.1 6.4 3.8 2.6 1.2 0 2.6 1.9 0.7 9.5 3.6 2.8 0.8 0 3.8 0.9 2.9 2.1 10.1 2.9 7.2 3.0 2.2 0.8 0 4.2 2.9 1.3 10.1 6.7 5.5 1.2 0 3.0 0.0 3.0 0.4 11.1 2.7 8.4 3.3 2.1 1.2 0 5.1 2.8 2.3 11.1 7.6 6.5 1.1 0 3.1 0.0 3.1 0.4 Bank recapitalization 3.2 3.8 0 Naftogaz financing 0.7 1.2 0 EUR bn Gross financing requirement C/A deficit Amortization of medium and long term debt Government/central bank Banks Corporates/Other Amortization of short-term debt Financing FDI (net) Portfolio equity, net Medium and long-term borrowing Government/central bank Banks Corporates/Other Short-term borrowing Other Change in FX reserves (- = increase) Memoranda: Nonresident purchases of LC govt bonds International bond issuance, net 2016F 28.6 2.6 13.1 2.6 2.4 8.1 12.8 28.6 3.0 0 23.1 7.5 8.4 7.2 12.9 -3.5 -1.6 2017F 24.9 2.8 9.2 4.2 0.6 4.4 12.9 24.9 2.9 0 12.9 6.6 1.9 4.4 12.7 -1.6 -2.0 2018F 27.9 3.9 11.2 5.1 1.0 5.1 12.7 28.1 3.3 0 12.0 4.8 1.8 5.3 12.5 2.5 -2.2 0 0.8 0 0 0 0.8 Source: NBU, MoF, IMF UniCredit Research UniCredit Research page 77 See last pages for disclaimer. January 2017 January 2017 Economics & FI/FX Research CEE Quarterly Acronyms and abbreviations used in the CEE Quarterly UniCredit Research ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ BNB – Bulgarian National Bank ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ECB – European Central Bank C/A – current account CBR – Central Bank of Russia CBRT –Central Bank of the Republic of Turkey CE – Central Europe CEE – Central and Eastern Europe CNB – Czech National Bank DM – developed markets EA – euro area EC – European Commission EDP – Excessive Deficit Procedure of the European Commission EM – emerging markets EMU – European Monetary Union EU – European Union FCL – Flexible Credit Line (from the IMF) FDI – foreign direct investment IFI – international financial institutions IMF – International Monetary Fund MoF – Ministry of finance NBH – National Bank of Hungary NBP – National Bank of Poland NBR – National Bank of Romania NBS – National Bank of Serbia NBU – National Bank of Ukraine PLL – Precautionary and Liquidity Line (from the IMF) PM – prime minister PPP – public – private partnership qoq – quarter on quarter sa – seasonally adjusted SBA – Stand-by Arrangement (with the IMF) SOE – state-owned enterprise WB – World Bank yoy – year on year ytd – year to date page 78 See last pages for disclaimer. 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Banja Luka Aleksandar Bereta Phone: +387 51 246 622 E-mail: [email protected] Bulgaria Aldo Andreoni Phone: +359 2 923 3560 E-mail: [email protected] Croatia Paolo Garlanda Phone: +385 1 630 5320 E-mail: [email protected] Czech Republic Fabio Bini Phone: +420 955 961 524 E-mail: [email protected] Hungary E-mail: [email protected] Macedonia Milan Djordjevic Phone: +389 70 267 034 E-mail: [email protected] Romania Raluca Popescu Phone: +4 021 200 1616 E-mail: [email protected] Russia Pietro Pasqualucci Phone: +7 495 723 7126 E-mail: [email protected] Serbia Niccolo Bonferroni Phone: +381 11 3204 677 E-mail: [email protected] Slovakia Fabio Bini Phone: +420 955 961 524 E-mail: [email protected] Slovenia Natasa Markov Phone: +386 1 5876 874 E-mail: [email protected] Turkey Nicola Longo-Dente Phone: +90 212 339 7988 E-mail: [email protected] Ukraine Roberto Poliak Phone: +38 044 529 0583 E-mail: [email protected] UniCredit Research page 83 January 2017 January 2017 Economics & FI/FX Research CEE Quarterly UniCredit Research* Erik F. Nielsen Group Chief Economist Global Head of CIB Research +44 207 826-1765 [email protected] Dr. Ingo Heimig Head of Research Operations +49 89 378-13952 [email protected] Economics & FI/FX Research Economics Research EEMEA Economics & FI/FX Strategy Global FI Strategy European Economics Lubomir Mitov, Chief CEE Economist +44 207 826-1772 [email protected] Michael Rottmann, Head, FI Strategy +49 89 378-15121 [email protected] Artem Arkhipov, Head, Macroeconomic Analysis and Research, Russia +7 495 258-7258 [email protected] Dr. Luca Cazzulani, Deputy Head, FI Strategy +39 02 8862-0640 [email protected] Marco Valli, Chief Eurozone Economist +39 02 8862-0537 [email protected] Dr. Andreas Rees, Chief German Economist +49 69 2717-2074 [email protected] Stefan Bruckbauer, Chief Austrian Economist +43 50505-41951 [email protected] Tullia Bucco, Economist +39 02 8862-0532 [email protected] Edoardo Campanella, Economist +39 02 8862-0522 [email protected] Dr. Loredana Federico, Lead Italy Economist +39 02 8862-0534 [email protected] Chiara Silvestre, Economist [email protected] Dr. Thomas Strobel, Economist +49 89 378-13013 [email protected] Daniel Vernazza, Ph.D., Lead UK Economist +44 207 826-7805 [email protected] US Economics Dr. Harm Bandholz, CFA, Chief US Economist +1 212 672-5957 [email protected] Anca Maria Aron, Senior Economist, Romania +40 21 200-1377 [email protected] Anna Bogdyukevich, CFA, Russia +7 495 258-7258 ext. 11-7562 [email protected] Dan Bucşa, Lead CEE Economist +44 207 826-7954 [email protected] Hrvoje Dolenec, Chief Economist, Croatia +385 1 6006 678 [email protected] Dr. Ágnes Halász, Chief Economist, Head, Economics and Strategic Analysis, Hungary +36 1 301-1907 [email protected] Ľubomír Koršňák, Chief Economist, Slovakia +421 2 4950 2427 [email protected] Marcin Mrowiec, Chief Economist, Poland +48 22 524-5914 [email protected] Kristofor Pavlov, Chief Economist, Bulgaria +359 2 9269-390 [email protected] Javier Sánchez, CFA, CEE Fixed Income Strategist +44 207 826-6077 [email protected] Pavel Sobisek, Chief Economist, Czech Republic +420 955 960-716 [email protected] Chiara Cremonesi, FI Strategy +44 207 826-1771 [email protected] Alessandro Giongo, FI Strategy +39 02 8862-0538 [email protected] Elia Lattuga, FI Strategy +44 207 826-1642 [email protected] Kornelius Purps, FI Strategy +49 89 378-12753 [email protected] Herbert Stocker, Technical Analysis +49 89 378-14305 [email protected] Global FX Strategy Dr. Vasileios Gkionakis, Global Head, FX Strategy +44 207 826-7951 [email protected] Kathrin Goretzki, CFA, FX Strategy +44 207 826-6076 [email protected] Kiran Kowshik, EM FX Strategy +44 207 826-6080 [email protected] Roberto Mialich, FX Strategy +39 02 8862-0658 [email protected] Dumitru Vicol, Economist +44 207 826-6081 [email protected] Publication Address UniCredit Research Corporate & Investment Banking UniCredit Bank AG Arabellastrasse 12 D-81925 Munich [email protected] Bloomberg UCCR Internet www.research.unicredit.eu *UniCredit Research is the joint research department of UniCredit Bank AG (UniCredit Bank), UniCredit Bank AG London Branch (UniCredit Bank London), UniCredit Bank AG Milan Branch (UniCredit Bank Milan), UniCredit Bank New York (UniCredit Bank NY), UniCredit Bulbank, Zagrebačka banka d.d., UniCredit Bank Czech Republic and Slovakia, Bank Pekao, ZAO UniCredit Bank Russia (UniCredit Russia), UniCredit Bank Romania. EFI 37 UniCredit Research page 84